Description

Overview: BP Prudhoe Bay Royalty Trust is a residual interest in an oil field on the North Slope of Alaska. Standard Oil and BP Exploration established the trust in 1989 with The Bank of New York as trustee. The trust pays a quarterly distribution based on royalties it receives on 16.4246% of the first 90,000 barrels of the average actual daily net production of oil. The precise distribution received is based on a formula laid out in the company’s annual report that is dependent almost entirely on the price of West Texas Intermediate Oil. Trust expenses are held to a few hundred thousand dollars per quarter as the interest is entirely passive. BPT plays no part in managing the production or any like activity and the Trustee is empowered only to collect royalties, pay expenses and distribute income to unit holders. There is a sizeable short interest here (around 9 days), so the borrow may be somewhat tight.

Short Thesis: Investors are simply buying this stock for yield (currently shown on Bloomberg as 9.6% which is calculated by annualizing the most recent distribution) and exposure to currently sky high oil prices and ignoring the formulaic economics behind the distributions and the fact that no return of principal will ever take place. In fact, the distributions are not interest payments; they are the payments. The only unknown factor that materially affects the distributions received by unit holders is the price of oil. In addition, there is an adjustment for inflation that is part of the calculation. The other relevant but known factors are the following:

- Production Allocated for Royalties: This is set at 16.4246% of the first 90,000 barrels per day noted above. Thus, increases in production at the field have absolutely no impact on cash distributions to BPT unit holders. According to the latest annual report, production at the field is expected to last at a declining rate until 2030. The trust, however, will likely cease paying distributions long before this date due to the impact of rising allocated costs described below.

- Adjusted Chargeable Costs: Every year, the trust is stuck with a planned higher cost allocation that is steadily eating in to its royalties. This factor is the product of a stated base cost per barrel, which escalates yearly, and an inflation adjustment which ties the factor back to 1999 CPI levels. In 2000, the base cost per barrel allocated was $10.00 while in 2002 it was $11.25 and for 2003 it stands at $11.75. Because of this escalating cost structure, the breakeven level for unit holders to receive any quarterly payments rises each year. For 2004, 2005, 2006 and 2007 the respective breakeven average WTI prices, assuming inflation of 2%, are $19.50, $20.35, $21.15 and $22.07, respectively. Should oil prices stabilize at $24 in 2006, unit holders will receive 95 cents in total dividends for the year.

- Production Taxes: Currently set at 15%

Trust Total Quarterly Revenue = 1.33mm bbls * (Avg WTI - Adjusted Chargeable Costs – Taxes)

Current Opportunity / Valuation: Due to a confluence of factors including the war in Iraq, OPEC policy, Chinese-led worldwide demand increases, etc., oil is currently trading at very high historical levels. For those of you who believe this trend will continue and oil will trade into the 40s and 50s and remain there, this pitch is not for you and I have no argument to necessarily say that you’re wrong. The market as a whole, however, as shown by the current forward curve, thinks that crude prices will stabilize around $26 a few years out (CLA Commodity CTG on Bloomberg). Most experts see prices settling in the low – mid $20s. As such, I believe that the current stock price of $25.93 is far out of whack with reality as the following data points regarding potential total dividends show:

Total undiscounted dividends received per unit assuming the following forward oil prices indefinitely:

-- $20 WTI = $1.13 total undiscounted dividends
-- $22 WTI = $2.08 total undiscounted dividends
-- $24 WTI = $4.01 total undiscounted dividends
-- $26 WTI = $6.55 total undiscounted dividends
-- $28 WTI = $9.35 total undiscounted dividends
-- $30 WTI = $12.31 total undiscounted dividends
-- $32 WTI = $16.18 total undiscounted dividends
-- $34 WTI = $21.22 total undiscounted dividends
-- $36 WTI = $36.00 total undiscounted dividends

Note: As shown, $36 forward WTI is the nominal inflection point where a positive IRR could be generated buy purchasing this stock. That totally ignores, however, the time value of money as many of the distributions would be received well out in to the future.

Termination / Tail: As for eventual termination of the trust, there is no set date. If oil actually does keep climbing to the high 30s and beyond, this trust could have a long tail. It is not, however, likely to last past 2017 because there is a $3 step-up in 2018 for the cost factor that would require $50+ WTI for any payout at that point. There are also successive $3 step-ups annually after that. The trust will terminate upon any of the following, at which point, BP Exploration Alaska will have the right to purchase the residual interest:

-- if 70% of unit holders vote for termination at any time prior to 12/31/10
-- if 60% of unit holders vote for termination at any time after 12/31/10
-- if revenues from the interest fall below $1mm per year for two consecutive years after 2010 assuming no "event constituting force majeure" occurs

For 2011, '12, '13, and '14, the avg WTIs required at 2% inflation for $1mm in annual revenue (2-3 cents annual dividends at that level) are around $30.10, $30.87, $31.67 and $32.50, respectively and increasing from there..

Summary: BPT bulls are buying this trust for yield and crude oil exposure without doing the math on how future distributions should be properly valued. Investors can gain comfort by building out the formula for themselves as it is described in the trust’s annual report. One may also want to consider hedging out some of the oil price risk with call options.

Risk: Oil prices continue to skyrocket for a very long period of time.

Catalyst

Break in WTI