This is certainly an unusual one but I think it’s a cheap way to get exposure to an uptick in natural gas prices.  I’m by no means an expert in well dynamics or the natural gas space in general and I often steer clear of names that require understanding the differences in the reserve quality of one company vs. another, but it appears you don’t need to be an expert in these areas to find value here.  Despite my belief this is an attractive risk/reward, I would appreciate and welcome all feedback on my analysis and will do my best to respond to comments in the Q&A.  Also, this is small and illiquid so if you are looking for ideas for your fund then this isn't it.  This is more suitable for a personal account.

Note: NGT is a grantor trust for federal and state income tax purposes so unitholders are taxed on their prorata share of the income and expenses of the Trust as if they were the direct owner of a prorata share of the Trust assets, so to keep things simple, all of these numbers are pre-tax. For tax information, visit www.businesswire.com/cnn/ngt.htm.

What is NGT?

NGT is a natural gas Trust formed under a Trust Agreement among Eastern American Energy Corporation (ECA), Bank of Montreal Trust Company, and Wilmington Trust Company, (although today, The Bank of New York Mellon Trust is the Trustee).  The Trust was formed to acquire and hold Net Profit Interests (NPI) created from the working interests owned by ECA in a set of 650 producing natural gas wells and 65 proved development well locations inWest VirginiaandPennsylvania.  In March of 1993, 5.9 million Depository Units were issued in a public offering and each Unit consists of beneficial ownership in two NPI and the right to a zero coupon U.S. Treasury security.  This means the units really represent a set of three assets and these are:

1. A passive Term Net Profit Interest (NPI) in 353 natural gas wells which expires worthless on May 15th, 2013.  (Note: an NPI provides unitholders with quarterly distributions based on the production of the wells associated with the NPI.)
2. A passive Royalty NPI in an additional 315 wells.  Unlike the Term NPI, the Royalty NPI is not limited in term or amount.  Under the Trust agreement, the Trustee is directed to sell all remaining Royalty NPI and liquidate prior to May 15, 2013 and unitholders will receive the proceeds on the first quarterly payment date following the receipt of such proceeds by the Trust. ECA has a right of first refusal to purchase the Royalty NPI at fair market value (which I’ve assumed is the PV10), or, if applicable, the offered third-party price, prior to May 15, 2013 (the “Liquidation Date”).
3. $20 (or 1/50th) per unit of a $1,000 face amount zero coupon U.S. Government Treasury security maturing May 15, 2013.  The Trust agreement allows unitholders to strip out the Treasury if they desire (and that’s an important piece of my thesis)

As I write this the units trade for $21.20 but per the last 10-Q, $19.94 of each share is represented by the zero coupon Treasury security, so stub that out and you are paying $1.26 per unit for the Term NPI and the Royalty NPI, and that brings me to the execution of this idea; I am recommending investors buy the units and then strip out the Treasury so they are left with the two NPI’s alone.  See the section at the end of this write-up for instructions on how to strip out the treasury.  I did it and while it’s a tedious exercise it was pretty easy and didn’t take a whole lot of time. 

 

Valuation 

So the questions to ask are: (A) what’s the stub worth? I.e. what are the distributions expected from the Term NPI and Royalty NPI worth and what will the proceeds be from the ultimate sale of the remaining reserves associated with the Royalty NPI? (B) considering natural gas futures prices, what’s the best way to exploit the mispricing if a mispricing does indeed exist? 

Answer A:  I think the stub is worth about $1.92 and this is based on the $3.52 futures price for May 2013 Henry Hub listed on the CME website at the time of this write-up.

(http://www.cmegroup.com/trading/energy/natural-gas/natural-gas.html). 

$1.92 represents a 52% gain above the stub price of $1.26.  If we assume the futures price comes down roughly 30% to $2.50, I wind up with a target price for the stub of $1.45, still 15% upside.  To breakeven, I estimate natural gas would have to trade to $2.09, roughly 40% below the current May 2013 futures price of $3.52.

Answer B: I don’t know if the way I’ve approached this is the best way to exploit the pricing anomaly I see but it is certainly one way to do it.  An alternative might be arbitraging this somehow and locking in a spread against current natural gas futures prices but I haven’t investigated how that might work.  I’m all ears if anyone believes there is a better way to extract value from the stub.

 

How I get to $1.92 Part I: The Quarterly Distributions

The trust expires in May of 2013 and quarterly distributions are payable to unitholders of record on the last day of the 2^nd month following the end of the calendar quarter.  So investors who buy this prior to Friday, August 31^st are entitled to three distributions in addition to the lump sum payment for the Royalty NPI.  You can try and get a precise estimate of expected distributions by forecasting various production rates and coming up with a sensitivity analysis on distributions but the distributions are a small piece of the valuation so I think a wet finger in the air is all you really need here to judge the wind. 

 My wet finger in the air analysis:  In Q1 they paid out $0.146 per unit with an average Henry Hub price of $3.845 for the quarter.  Henry Hub natural gas is about $3.00 right now but considering these wells are nearing the end of their lives production is declining too, so I’m assuming unitholders will collect about $0.30 in distributions over the coming three payment periods (see the filings but it looks to me like the Q1 2013 payment won’t be made until the Royalty NPI is sold so there are really two payment periods remaining prior to the lump sum investors should expect). 

 

How I get to $1.92 Part II: Proceeds from the sale of the Royalty NPI

This is where I am leaning on the VIC community.  I looked at this by trying to come up with a PV10 value for the reserves I expect to remain in May of 2013.  I made the assumption this would be fair value because the petroleum engineering consulting firms calculate the present value of future net income using a 10% discount rate (PV10) and seem to indicate this provides a reasonable estimate of fair value, and I have no basis to disagree.

Below is a table of the reserve history going back to 2008.  As you can see, production is declining and I estimate roughly 6,311 MMcf will be remaining come May 2013.  My assumptions are in bold.

 

Royalty NPI Reserve History
	Beginning		% of reserves		Ending
Year	Reserves	Production	produced	Revisions	Reserves
2008	10,012	(707)	7.1%	530	9,835
2009	9,835	(694)	7.1%	(758)	8,383
2010	8,383	(654)	7.8%	(152)	7,577
2011	7,577	(646)	8.5%	272	7,203
2012	7,203	(630)	8.7%	-	6,573
May-13	6,573	(263)	4.0%	-	6,311

 

To come up with an estimate of the PV10 for the 6,311 MMcf of reserves I forecast to be remaining in May 2013, I calculated the PV10 per MMcf of reserves as a percentage of the price for Henry Hub natural gas and tracked this relationship over time.  I found that since the year 2000, the PV10 per MMcf of reserves as a percentage of the price for Henry Hub natural gas has averaged 46%.  I also found this relationship held true at a correlation of 73%.  See the table below.

 

					Ratio of
			Ratio of		PV10 to Reserves
Year	Royalty NPI	Royalty NPI	PV10 to	Henry Hub	as % of
end	Reserves (MMcf)	PV @ 10%	Reserves	Price	Henry Hub price
2000	14,983	$     35,074	2.3x	$     4.75	49%
2001	12,905	$     20,009	1.6x	$     2.94	53%
2002	12,025	$     22,953	1.9x	$     4.47	43%
2003	11,294	$     27,357	2.4x	$     4.90	49%
2004	11,456	$     38,406	3.4x	$     6.99	48%
2005	11,266	$     59,278	5.3x	$    11.15	47%
2006	9,885	$     33,779	3.4x	$     7.06	48%
2007	10,012	$     33,727	3.4x	$     7.19	47%
2008	9,835	$     37,634	3.8x	$     8.35	46%
2009	8,383	$     19,490	2.3x	$     5.53	42%
2010	7,577	$     17,157	2.3x	$     5.34	42%
2011	7,203	$     15,163	2.1x	$     4.93	43%
				Avg.	46%
				R-Square	73%

 

One thing to note about the relationship is that the PV10 per MMcf of reserves as a percentage of the price for Henry Hub natural gas has been declining and was 43% in 2011.  Intuitively, I think this makes sense because it reflects the aging of the wells and the associated declining production rates that make older wells less valuable, but whether it makes sense or not, it’s obvious using 43% as the input to back into the PV10 for the expected reserve level of 6,311 MMcf in May of 2013 is a more conservative method to forecast the potential value than it is to use the average of 46%.  Here is how I did it:

 The May 2013 Henry Hub natural gas futures price is currently $3.52 which indicates the PV10 per MMcf would be $1.51mm (43% x $3.52 = $1.51).  So, multiplying my estimate for remaining reserves of 6,311 MMcf by the value per MMcf of $1.51mm gets me an estimated reserve value of $9.6mm.  There are 5.9mm shares outstanding so this implies a value of $1.62 per unit.  See the table below (my assumptions are in bold).

 

(A) Remaining NPI Reserve in May 2013 (MMcf)	6,311
(B) May 2013 futures price	$     3.52
(C) Discount for PV Estimate	43%
(A x B x C = PV Estimate) PV Estimate	$    9,552
Units outstanding (thousands)	5,900
Value per unit	$     1.62

 

 How I get to $1.92 Part III: Part I + Part II = Part III (the value)

Adding $0.30 in undiscounted and untaxed distributions to $1.62 in undiscounted and untaxed proceeds from the sale of the Royalty NPI gets you $1.92. If Henry Hub prices end up being $4.00 in May 2013, then this stub of the combined NPI could be worth $2.14, 70% upside from today’s price.  Alternatively, accepting my expectation the distribution will reach $0.30 (see assumptions above) then the breakeven natural gas price is $2.09, i.e. under my correlation assumption of 43%, the market is implying the PV10 will be based off of a Henry Hub natural gas price of $2.09.  Keep in mind these are undiscounted and untaxed figures, but the point is, I think the stub looks pretty cheap and the risk of loss looks minimal.

 

Conclusion

The two key variables to this investment are future natural gas prices and the level of reserves remaining in the wells associated with the Royalty NPI upon liquidation of the Trust.  There might be better ways to value these pieces but I think if you play with the numbers you will see the risk/reward is favorable enough to warrant parking some sideline money in the stub.  I’m not exactly sure what it will be worth, but it seems to me it’s likely the stub will be worth more than $1.26 and there is a built-in catalyst due by May 15, 2013. 

 

Risks

-          Natural gas prices and associated PV10 figure at time of sale

-          Any final distribution will be subject to the prior payment of all expenses and liabilities of the Trust, and to the establishment and funding of any reserves the Trustee deems appropriate for contingent liabilities.  I don’t know how large a figure this could be but anything larger than zero obviously eats into the return and it will most likely be larger than zero.

 

How to separate the Treasury from the units

 1. Contact your broker and request they place your units with the transfer agent. They will likely have to issue you a DRS form, which you will receive in the mail.

2. Contact the transfer agent, (Bank of NY Mellon) and request a physical certificate be sent to you in the mail. Their phone number will be on the DRS form, or you can just go to their website and look it up.

3. Send the trust certificate and a signed letter of instruction to the Trustee (address below) requesting the treasury securities be separated from the units and delivered to your broker. In your letter of instruction, be sure to provide your broker's DTC code, your account number and the name on your account. Also, you will have to get a medallion stamp on the letter of instruction. Your local bank should be able to provide it.

After that, you should receive your treasury units in your brokerage account and your distributions in the mail. Call Sarah Newell at BNY Mellon if you have any questions. I probably called her five times and she seemed happy to explain the process.

Trustee: 
Bank of New York Mellon 
919 Congress Avenue, Suite 500 
Austin, TX 78701 
phone: 512-236-6555

 

 

Sale of Royalty NPI