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Royalty Trusts and the Affective Fallacy

By Elliott H. Gue on Mar. 26, 2013

Chesapeake Granite Wash Trust on March 15 filed its annual report in which it disclosed a significant decline in its estimate of remaining reserves and PV-10, a metric that applies a 10 percent discount to the present value of the trust’s estimated future cash flow

Although PV-10 is a useful metric, investors must understand its limits. First and foremost, PV-10 assumes steady commodity prices throughout the trust’s life; most trusts use the trailing 12-month average price for oil, gas and NGLs to determine the PV-10. This approach contrasts with our valuation method, which reflects the price of commodity futures that trade on the New York Mercantile Exchange. (See A Deep Dive into SandRidge Permian Trust.) Accordingly, our valuations assume that oil prices will increase at a modest rate in coming years.

The prospectus that a US-listed royalty trust issues prior to its initial public offering usually includes a schedule of targeted distributions that also factor in an outlook for future commodity prices.

Investors should also note that PV-10 doesn’t account for any hedging contracts that a royalty trust may have in place. SandRidge Permian Trust, for example, has a hedge book that ensures above-market price realizations in the current market.

The metric also fails to capture the value of a trust whose float also includes a percentage of subordinated units, a share class that’s equivalent to the common stock, save for one salient difference: If the cash available for distribution were to fall short of a predetermined threshold in a given quarter, these units would forego their distribution to ensure that holders of the common stock receive a minimum payout.

Investors in Chesapeake Granite Wash Trust have already benefited from this structure, receiving $0.67 per unit for the fourth quarter of 2012 even though the trust’s royalty interests generated only $0.5968 in distributable cash flow. In this scenario, the subordinated units–all of which are held by the trust’s sponsor, Chesapeake Energy Corp (NYSE: CHK)–were entitled to a reduced payout of $0.3772 per unit.

Although this subordinated structure has protected the distributions received by investors during several quarter since the trust went public, PV-10 doesn’t factor in these benefits.

In short, PV-10 is conservative valuation metric; we would expect a royalty trust’s units to command a significant premium to this measure in a normal market environment–especially in the early years of a trust’s life cycle.

Even with these caveats, the year-over-year deterioration in Chesapeake Granite Wash Trust’s PV-10 metric paints a bleak picture. At the end of 2011, the trust sported a discounted present value of $847.160 million, or $18.12 per unit; by the end of last year, PV-10 estimate had plummeted to $442.409 million, or roughly $9.50 per unit.

If we assume that the stock should fetch 25 percent to 50 percent premium to its PV-10, a unit of Chesapeake Granite Wash Trust is worth about $11.90 to $14.25. Based on the approach, the security appears to be fully valued at its current price of $13.79 per unit.

While the precipitous decline in Chesapeake Granite Wash Trust’s PV-10 is cause enough for concern, the factors driving this lost value suggest that additional downside could be in the cards. NGL prices have likely bottomed, but higher-than-expected depletion rates suggest that the trust’s underlying wells will prove less productive than originally anticipated.

According to Chesapeake Granite Wash Trust’s annual report, the pass-through entity’s total reserves tumbled to 28.203 million barrels of oil equivalent from an estimated 42.184 million barrels of oil equivalent at the end of 2011. Some of this downward revision reflected extracted volumes of oil, NGLs, and natural gas over the course of the year. However, the bulk of this correction–a whopping 10.4 million barrels of oil equivalent–stemmed from elevated depletion rates.   

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