Oct. 17, 2014 5:00 AM ET | 24 comments | About: SandRidge Permian Trust (PER), Includes: SD
Summary
- PER’s share price has been hammered by a drop in oil prices.
- The market correction is undervaluing PER’s near-term distribution hedges.
- Even with the drop in oil prices, PER’s near-term distribution is on target for a near 30% forward yield.
- An additional return in share price appreciation of more than 25% is possible in the next year.
- PER’s fair value today is $12.72, resulting in a significant margin of safety; however, the trust is exposed to further oil price declines.
As investors in oil and gas trusts are aware, the sector has been and is experiencing a sharp correction in market prices, with shares of some oil trusts down by a third, or more. One such trust that has been adversely affected is SandRidge Permian Trust (NYSE:PER), whose share price has declined from a high of $13 in August to as low as $7.76 on Wednesday.
However, the decline in oil prices does not affect all trusts equally. PER's underlying structure includes hedges that will keep the distribution at or near current levels through 2015 despite the decline. Investors at Thursday's close could see more than 55% upside over the next year in distributions and share price accumulation.
Model Results Suggest 55% Upside at Current Prices
As those familiar with my articles know, I analyze oil and gas trusts using a bottom-up, engineering-style model that forecasts future distributions. The model includes explicit consideration of oil commodity prices, as well as PER's subordinated share structure.
Using oil price futures from Thursday, 10/16/2014, the model forecasts that PER will return $2.57 over the next four quarters and $23.92 over the life of the trust. The current Fair Value (NPV-9) of these future distributions is $12.72 and the average ROI at current market prices is an outsized 16.9%/year, better than any other trust that I follow.
Looking one year out, the model suggests that investors at today's market price, $8.92 as I write this, could see a total return of 55% over the next year; 29% in distributions and 27% in additional share price appreciation should PER reach its Nov-15 Fair Value forecast price of $11.30.
Fig. 1: Forecast 1-year return on investment. Source: Author's analysis.
To understand both why such outsized gains are possible and the risks to the forecast, let's get to the details of the model…
PER's distribution is protected through 2015 by subordinated shares and price hedges
PER's underlying trust agreement includes two key measures that will help keep the distribution near current levels through 2015, despite the recent decline in commodity prices.
First, PER also owns a series of contracts that partially hedge oil production at over $100/bbl through Q1 2015. As PER's oil production revenues fall, its hedge revenues will increase, offsetting a substantial portion of declining sales revenues.
Second, PER's common shareholders are guaranteed a series of minimum distributions during the construction of the trust's wells and for four full quarters after. To guarantee these minimum payments, 25% of PER's shares, originally granted to the proprietor, SandRidge Energy (NYSE:SD), are "subordinated" and only receive a distribution if there are enough funds to meet the minimum target.
Although the subordinated shares are not an iron clad guarantee that the target distributions will be met, the model that I use forecasts that PER will maintain a coverage ratio of at least 1.25 for the minimum distribution targets through Q1 2015. After Q1, when hedge revenue is gone, the cover ratio will drop to just above 1.0. If prices stay where they are, PER should make the minimums, if prices fall, shareholders would feel a pinch.
Fig. 2: Target minimum distributions by year with forecast coverage ratio. Source: author's analysis.
The value of these distribution hedges to shareholders will depend on when SD completes its last well. Based on the last well development progress report provided by PER (8/8/14), SD could finish this quarter. However, it is much more likely that SD finishes next quarter or the quarter after, meaning that the subordinated share protection will last at least five and possibly seven more quarters. The total distributions to common shareholders during this period will be between $3.12 and $4.19. That's a nice payout.
Now let's look at what to expect with PER's distributions over the medium and long terms.
PER Shares are Underpriced Even Given Long-Term Pessimistic Forecasts
All forecasts are subject to uncertainty. Even though PER may have substantial upside under nominal, or "base," assumptions, it is critical to consider what PER could be worth given alternative forecasts. The two largest sources of uncertainty for PER are production and oil prices, so let's look at those in more detail.
To forecast production, the model fits historical production to the number of producing wells and determines an average well decline curve. The "base" production forecast used by the model assumes that existing and new wells will decline as forecast by this curve, resulting in a total production volume of 14.5 bbbl. For pessimistic and optimistic cases, the forecast is adjusted by a full standard deviation below and above the baseline, for total volumes of 15.3 and 12.5 bbbl, respectively.
Fig. 3: Forecast production for PER. Source: PER SEC filings and author's analysis.
To forecast future oil prices, the model uses NYMEX WTI futures, adjusted for PER's 12-month trailing spread, which is -$9.40/bbl. For reference, based on today's NYMEX WTI futures, the model assumes that oil prices in 2024 will be ~$86/bbl. For the pessimistic and optimistic cases, the model raises/lowers prices by 15%, to $99/bbl and $73/bbl, respectively.
Fig. 4: Forecast WTI oil prices with optimistic and pessimistic bands. Source: NYMEX and author's analysis.
Put together, the pessimistic and optimistic scenarios provide a range of values for future distributions for the life of the trust. Under the optimistic scenario, PER could return more than $30 in distributions, resulting in a fair value today of $15.58 and a 21.4% annual ROI at today's market price.
On the downside, the pessimistic scenario would result in $17 in distributions, a fair value of $10.17, and an 11.9% ROI. Bearing in mind that the pessimistic forecast assumes faltering production and $73 oil, these results suggest to me that PER offers a substantial margin of safety at current prices.
The table below summarizes the optimistic, base, and pessimistic scenarios.
Fig. 5: Summary of scenario analysis. Source: author's analysis.
The table above also provides insight into why Mr. Market has created such an opportunity. The right-most column forecasts PER's value based on the 2014 Reserve Report. This forecast assumes the production and cost estimates from the report, which were produced using data available on 12/31/13, subtracts 2014 production to date, and applies an $85 price forecast. It does notconsider the value of PER's oil price hedges or the impact of the minimum distribution targets. I would also argue that the Reserve Report's production forecast is overly conservative.
Under these assumptions, the resulting NPV-10 is $7.71, which is below, but not too far off of Wednesday's market price. These results suggest to me that Mr. Market is not considering the near-term protection offered by the price hedges and distribution targets.
Risks are Hedged, but Not Absent
As I noted above, PER's exposure to falling oil prices is greatly reduced over the next three quarters and common shareholders are further protected for the next five to seven.
However, PER is not without risk. Once the subordinated shares convert to common shares, PER's distribution will drop significantly. And a continued slide in oil prices will chip away at the distribution, fair value, and share price. With $60 oil not completely out of the question, investors should be prepared for this possibility. Furthermore, production could also decline faster than expected or falter due to mismanagement or some other unforeseen error.
That said, PER's current price suggests that many of these risks are already priced in. If that is the case, and if PER's distributions do line up in the neighborhood of the forecasts discussed above, the greatest risk may be that Mr. Market simply never recognizes PER's value. If that is that case, shareholders could see their capital locked away in the trust for years before the full value of the investment can be realized.
PER Value Plays
As I read the model results, they suggest that at today's prices, PER represents a substantial long opportunity. PER is likely to return almost 30% in distributions over the next year and could more than 25% in additional price upside, even if commodity prices do not rebound. Upside cases suggest even greater returns are possible, while pessimistic cases suggest that there would still be value, though it may take a while for shareholders to realize it.
Given the uncertainty regarding market price, I would suggest avoiding options plays and focusing on true long positions, buying in tranches to give the market time to settle. A key date to keep in mind will be the next ex-dividend date, which has not yet been announced, but should fall on/around November 12. Noting that PER's value is tied to the distribution, I would seek to establish long positions in time to grab it.
Author's Note:
I wrote the first version of this article late Wednesday, when PER was trading at $7.80 and offered an eye-popping 75% upside. Thursday's market action, during which PER shot up more than 10%, opens the door to a regression over the next week. If PER does regress, my own strategy will look to buy shares on weakness, especially if it gets down near $8.
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