Description

The BP Prudhoe Bay Royalty Trust (BPT) has been written up twice (Dec. 2018 by cable888 and June 2014 by Reaper666).  Both write-ups were well timed and the shorts performed well. I think this is another attractive time to short the stock as it hasn’t followed oil prices lower and, given spot/strip WTI, dividends are likely to hit 0 shortly.

Overview:

The Trust owns an interest in the production from a BP operated oil field in the Prudhoe Bay of Alaska.  BPT receives an overriding royalty interest of 16.4% on the lesser of 90,000 bbls/d of crude and condensate or the actual average daily net production of crude and condensate from the working interest of BP Alaska in the Prudhoe Bay field; unlike some other overriding royalty interests, however, BPT’s cash-flow is reduced against a cost calculation.

The cost calculation is easy to forecast as it isn’t related to real world costs.  Instead, the cost structure follows a formula established in the trust agreement. To be specific royalties are calculated as (Revenue per Bbl - Costs per Bbl) * Attributable Production (16.4% of lessor of 90,000 bbls/d or actual production) with:

Revenue per Bbl = Daily WTI Cushing Price

Costs per Bbl = “Chargeable Costs” * “Cost Adjustment Factor” + Production Taxes

The revenue calculation is straight-forward but the cost calculation is a bit more complicated.

Chargeable costs are determined by the trust agreement and escalate annually on a predetermined schedule.  In 2020, Chargeable Costs, are $26.50/bbl and will rise by $2.75/bbl every year hereafter. Historically costs rose much more slowly but the current, rapid acceleartion of Chargeable Costs was added as an eventual way to knock-out the royalty.

The Cost Adjustment Factor (CAF) is essentially cumulative inflation since the trust was established (with some caveats that are unimportant/immaterial to the thesis).  The most recent reported CAF was 1.972 for Q2 of 2019

The production tax rates are a real world expense and are done on a sliding scale (they rise rapidly with WTI prices above $70) but appear to be the result of a complex calculation covering a number of taxes (severance, excise, sales, VAT etc.).  For context, the tax per bbl was $20 when WTI was in the high 90’s, taxes were in the mid to high single digit $’s per bbl when WTI was in the 70’s, and taxes were ~$2 when WTI was in the 50’s.

Beyond this, the trust has ~$1.2mm of annual expenses.

After any cash held back to cover future trust expenses, the available CF after trust expenses is distributed to unit holders.

Putting this together, it’s easy to see that BPT needs rapid and sustained appreciation in WTI to continue generating cash from their royalty interests.

For 2020 the breakeven is ~$55/bbl and rises in the following years to approximately $62, $70, $81, $94 and well over $100/bbl in 2025.  Note: Because I’ve had to make some simplifying assumptions about the tax structure this may be off by a few $’s in any year.

Thesis:

At present BPT has a breakeven of ~$55 WTI ($26.50*2 + 2/bbl of taxes).  With oil prices at $51 and the curve at $51-52 for the rest of the year, BPT’s dividends should soon be $0.  As the stock is held by yield hogs an announcement of no or a very limited dividend in early March should be a catalyst for BPT to sell off.

While there should be a little bit of CF from the beginning of the year when oil prices were in the high 50’s/low 60’s, the Trustee may hold this cash back to cover future expenses as the strip implies there is likely to be no future cash-flow, the current cash balance will only cover 1 year of expenses, and BPT could exist through 2022 even on the current strip before it would have to be liquidated. Even if the Trustee distributes the CF the dividend should be just $.05-.06/share which would be an 85% reduction from the Q4 ‘19 dividend and would be just ~3% annualized for a stock which has historically traded with a double digit yield.

Option Value:

One concern investors might have is that BPT should probably be valued like an option (rather than a DCF of the central case).  BPT will continue to exist until net revenues for two successive years are less than $1mm per year. At the end of this period the trust will be sold (with BP having an option to purchase it).  Obviously there’s some value to the Trust interests even if they’re generating no CF but with a $160m market cap and a rapidly escalating cost structure there’s not a lot of option value. Some data points:

• Every $1 WTI is above its breakeven price for a full year generates ~$.25/share of CF (i.e. is worth ~3-4% of current stock price on an undiscounted basis).

• The breakeven in 2020 is ~$55

• The breakeven in 2021 is ~$62

• The breakeven in 2022 is ~$70

• The breakeven in 2023 is ~$81

• The breakeven in 2024 is ~$94

• The breakeven in 2025 is ~$118

After 2025 things get crazy as production taxes appear to go parabolic.  To justify its current value on an undiscounted basis, BPT needs 30-dollar-years above breakeven (i.e. $30 above breakeven for a single year, $10 above breakeven for 3 years etc.).  That seems unlikely and the mispricing can be illustrated by listed WTI option pricing.

Each unit, assuming production is at the maximum 90,000 bbls/d, is entitled to .25bbls/year of production.  That is, 4,000 shares ($30,000) would get you 1,000 bbls/year of exposure.

Alternatively, call options struck at BPT’s breakevens would cost ~$11,500 for 1,000 bbls of annual exposure:

Note: 2020 & 2021 prices are done at the Ask, 2022 is done at 125% of the Jan 31st Close, 2023-2025 are done at their last (Dec. 15 2019) price when the strip was higher.

The call options are better than BPT shares because:

1. They are struck in December of their respective years and thus have more time value than BPT whose average bbl should be produced in June/July

2. BP’s working interest has recently been producing in the mid to high 70,000 bbls/d not 90,000.

3. These are true calls on WTI.  If WTI prices at $100 in 2021 the 2021 calls will pay you $38.  BPT, however, will pay you less than that because, as realized prices rise, so do production taxes (BPT would generate ~$15/bbl of CF at $100 in 2021).

On the other hand BPT could theoretically continue to exist with option value beyond 2025.

Assuming these were equivalent trades, BPT would be worth just ~$2.50/share and be down by almost two thirds.

Borrow Costs:

Borrow is currently fairly tight and costs are high (~50% from IBKR whereas its more typically been 20-30%).  Some of this may be due to the recently paid out Q4 dividend - holders of the stock are incentivized to pull lent shares before the dividend date so as to get better tax treatment but availability and rates tend to moderate in the days/weeks after the dividend.  Alternatively, others may have realized that the recent swoon in oil prices, which hasn’t been met with a similar swoon in BPT’s price, is an attractive catalyst given the likely size of the Q1 ‘20 dividend.

Catalyst

• Q1 2020 Dividend announcement in very early April (possibly $0, probably not higher than $.06)