Description

The Sky IS Falling

I have posted this idea on other outlets. It's not the type of idea that I think is well suited for VIC. However, the last few weeks I've grown to like it more and figured I'd post for those who might be in the market for an oil/gas commodity hedge with limited upside and a fair amount of downside. I like this idea more now because:

• Commodity prices have weakened further, but the stock has held up. A current commodity prices PSK's coverage ratio is likely around 0.6x and the next year's future's curve would put it around 0.7x. I am more confident that a dividend cut will occur and, with a yield around 4%, I think there is plenty of downside
• Producers are starting to announce their 2015 capex budgets, and they suggest meaningful production declines on PSK's lands
• I am growing more convinced that we will see a low natural gas price throughout 2015, and that Canadian NGL pricing will be quite weak as well

Thesis

PrairieSky is an unhedged, low-growth Canadian oil and gas royalty trust trading at +30x my estimate of 2015 cash flow. Given its concentration in low-return Canadian oil acreage, I think there is a serious possibility that most of its assets will be permanently impaired. I believe PrairieSky is a compelling short, with 50% potential downside and minimal upside.

At current strip prices and my estimate of potential 2015 production declines, PrairieSky should generate around $0.94/share in cash flow. With a current dividend of $1.30/share, I think there is a very strong chance that the dividend gets cut 40% to +50% in the next three to six months. Considering the fact that the stock is trading at a 4.4% yield, which is already far more expensive than peers, I conclude the market is expecting high growth rates from PrairieSky. I expect that a distribution cut would cause the market to revalue PrairieSky, leading to a very severe price decline.

I am short PrairieSky stock because it is one of the most - if not the most -expensive energy stocks in the market, and I think the investing community has fundamentally misunderstood the volatility in its cash flow and the limited growth profile going forward, even in a more robust commodity price environment.

Background

PrairieSky is the largest oil and gas royalty trust in North America. It was spun out of Encana in May 2014 through an IPO. The stock priced above its $23-$26 range at $28 (6% below today's price), and quickly rose to +$40. The motivations for Encana's pursuit of the spin-out are very clear - it needed liquidity to pursue its push into US shale, and selling the royalty rights for the lands it no longer planned on drilling was an ideal funding source. After selling a 45% interest in the IPO, Encana made a beeline for the exit, and sold its remaining 55% interest in a secondary less than four months later. Except for being PrairieSky's largest source of royalty revenues, Encana has no remaining relationship with the company.

Company Overview

Following its recent acquisition of Range Royalty, PrairieSky owns over 5 million acres of mineral interests across Alberta and Saskatchewan. Pro forma for the recent acquisition, PrairieSky receives royalty fees for 18,365 boe/d of net production. Over the past few years, oil and natural gas liquid (NGL) production increased at a mid-teens rate per year, while dry gas production declined at a low-double digits rate. The decline in gas production is largely attributed to the fall in natural gas prices that has rendered most Canadian dry gas plays non-economic. The majority of the company's production growth has come from a liquids-rich play called the Glauconite, which is located just southwest of Edmonton. Additional growth has come from the Halkirk Viking, Lochend Cardium, Ellerslie and a Canadian extension of the Bakken formation called Ferguson Bakken. These plays are generally not economic at current prices, and even in a higher commodity price environment, their economics rank well behind the high-quality shale plays in the US.

Production Growth Trends

While the liquids growth rate from 2011 through early 2014 was impressive, it has since slowed so much that we are now seeing sequential production declines. From Q1 2013 to Q1 2014, oil and liquids production grew over 40% as drillers such as Bonavista, the largest producer in the Glauconite, poured capex dollars into the play. However, from Q1 2014 to Q3 2014, oil and liquids production actually declined almost six percent. How does such strong growth reverse so quickly, you ask? Well, these liquids plays have really high decline rates. A typical Glauconite well's initial production (IP) is generally around 550 boe/d. At six months, production falls to around 200 boe/d. After a year, production is less than 150 boe/d. That's a +70% decline in the first year of production. While these decline rates are by no means out of the norm for hydraulically fractured wells, they point to a very important consideration when thinking about PrairieSky's revenue stream. Producers have to spend a lot of money to keep production flat, much less grow it. They need robust cash flow, projects that can be drilled economically and healthy balance sheets to fund this growth - something that is tough to come by in today's oil price environment.

Even before the recent oil sell-off, producers on PrairieSky's acreage were planning on spending less money drilling new wells. In 2013, Encana drilled 283 wells on PrairieSky's lands. Year-to-date, Encana has only drilled 66 wells, and zero since Q1. While Bonavista's 2014 well drilling activity in the Glauconite increased from 2013, the company's most recent plans called for drilling 62 wells in 2015, down from 69 this year. This plan was articulated in mid-November. Since then, Canadian liquids pricing has declined anywhere from 25% to 60%. Bonavista is levered +3.5x debt-to-cash flow at strip pricing, well above its stated goal of 2x. It is very likely that its cap ex budget will get revised downward.

PrairieSky's existing production is declining +20% per year. Prior to the acquisition of Range Royalty, the company estimated that it needs $300MM in cap ex to be spent on its land to keep production flat. Per the prospectus, in 2013, producers spent $368.7MM in connection with development activities on company lands. We don't know how much cap ex has been spent in 2014, but we can observe that production has declined over the course of the year. With oil prices down +45% year-to-date, 2015 cap ex budgets will likely be significantly lower. And with that, I think it is reasonable to expect mid-to-high single digit production declines. But wait, there's more.

Canadian oil and gas leases are frequently structured based on a sliding-scale royalty, whereby royalty rates increase as prices rise and vice versa. As of the third quarter, around 30% of PrairieSky's production was tied to sliding royalty rates. Again referencing the prospectus, these sliding royalty scales are based on two government-established structures - "The New Royalty Framework" from 2008 and the "Alberta Royalty Framework" from 2010. Royalty rates for these types of leases range from a minimum of 25% at a <$55 oil and 40% max when oil prices exceed $120. During the third quarter, oil prices averaged just over $100 (in Canadian dollars). Today, they are just under $57. At a $100 oil price, the average royalty for sliding scale leases is around 35%; at $57, the royalty falls to under 26%. This suggests that in addition to receiving lower proceeds due to falling commodity prices, PrairieSky is also experiencing a declining royalty rate that would result in around 7% lower production. Combined with the effect of natural decline rates at the wellhead, PrairieSky could see low-to-mid double digit production declines in 2015. So what might the distributable cash flow look like in 2015?

Cash Flow Estimate

Since PrairieSky's royalty revenues are a function of spot commodity prices and drilling activity from over 300 third-parties, estimating revenues and cash flow is, well, an estimate. Nonetheless, using a range of assumptions, I think you can get a reasonable sense for cash flow at various commodity prices and production levels.

Assuming fixed inputs for natural gas prices (current strip), NGL prices (60% of Edmonton par), Edmonton basis differentials ($5 per barrel, versus near-$7 today) and a USD/CAD conversion rate of 1.16, I get the following range of cash flow per share:

I've highlighted what I consider the range of "base-case" scenarios. Using the average strip price for the next twelve months ($58.40) and assuming a 10% decline in production, I get $0.94/share in 2015 cash flow, which would suggest a near-140% payout ratio. Though PrairieSky could take on debt to fund its distribution, the company has made numerous references to its debt-free balance sheet, and debt-financed distributions are not typically well received by the market. On that basis, I believe PrairieSky will cut its distribution sometime in the first quarter of 2015. Aside from the obvious assumption that the stock would go down significantly in this scenario, what is a reasonable price for PrairieSky?

Valuation

I value PrairieSky based on its relative valuation to other royalty trusts. Though each trust differs based on the size and quality of its asset footprint, and the composition of royalty versus working interests, there are enough companies to rough out a value for PrairieSky. The three best options are likely Canadian peer Freehold Royalties (OTCPK:FRHLF, TSE: FRU), fast-growing Viper Energy Partners (NASDAQ:VNOM) and the well-diversified Dorchester Minerals (NASDAQ:DMLP). Following is a brief description of each.

Freehold Royalties

Freehold Royalties owns around 3.1mm acres in Alberta and Saskatchewan, with production of 9,100 boe/d. Production is around 63% oil/NGLs and 37% dry gas. Unlike PrairieSky, Freehold contributes capital for a portion of its production. This is referred to as a "working interest," and it comprises around 34% of the total production. Because this portion of production requires some level of investment from the trust, it is worth less than a royalty interest. However, similar to PrairieSky, production on Freehold's land is not likely to grow meaningfully. Freehold trades at a 9.7% current yield and around a 5%-5.5% yield on 2015 production at current commodity prices. Should commodity prices stay at their current level, I believe Freehold will continue to see share price declines.

Viper Energy

Viper Energy Partners owns the mineral rights for land operated by Diamondback Energy, one of the leading Permian Basin players. Though Viper appears expensive, based on its 3,400 boe/d of production and only 16k net acres, its assets are focused in some of the highest-quality, fastest-growing oil producing counties in North America. Additionally, Diamondback Energy, who continues to hold an 88% interest in the partnership, has committed to drilling on Viper's land and grow production at a rapid rate. Viper trades at a 6.5% yield, based on current production and Q3 commodity prices. Looking out to 2015, assuming strip oil pricing and 30% production growth, Viper is likely trading around a 5.5% yield. If and when oil prices rebound, Viper's production growth will support very rapid distribution increases.

Dorchester Minerals

With 378,000 net mineral acres and working interests in 860,000 gross acres spread across 25 states, Dorchester Minerals is one of the most diversified royalty trusts in the US. While working interests contributed 22% of distributions, the company's opportunities to invest in wells located in the core of the Bakken and Permian Basin are quite valuable. Similar to Viper, Dorchester's Permian and Bakken acres are amongst the highest-quality US shale assets, and production will continue to grow even in the current commodity environment. Though the overall production growth will be limited, thanks to legacy dry gas production that is declining at a mid-single digit rate, Dorchester's production is likely to grow for decades to come. The stock trades at an 8.5% current yield, and is likely around a 6%-6.5% yield, based on current commodity prices and modest growth expectations.

Valuation Conclusion

Based on a relative comparison to these trusts, whereby one balances the growth/quality characteristics of each, I think that a fair value yield for PrairieSky's 2015 distribution is around 6%. At $0.94/share, this would suggest a $15-$16 share price, 45%-50% below the current price.

Catalyst

Dividend cut

Market realization that flat to declining production and unhedged commodity-linked revenues is not worth 30x cash flow