Description

Summary

Whiting USA Trust II (the “Trust”) is a relatively straightforward security and this is going to be a short write-up. This is likely a PA investment but the expected return may make it worthwhile.

Purchasers of Trust units have the right to receive one distribution to be paid on May 28 and three potential distributions that represent the Trust’s 90% share of net profits from energy production from the underlying properties through December 31, 2021. At the conclusion of the year, the Trust will terminate. Unitholders will receive no distributions attributable to production after December 31, 2021. Unlike certain other trusts, there will be no sale of the trust interest at termination. To be clear, there is no further value for unitholders following the final of the four distributions.  

The first distribution, which mainly relates to oil production and prices from January – March 2021 and gas production and prices from December 2020 – February 2021, was announced on Thursday evening and will be $0.0829 per unit. The distribution will be paid on May 28 to holders of record on May 20.  

Based on current commodity prices and a number of factors regarding the most recent distribution, I anticipate the three remaining distributions to aggregate at least $0.25, resulting in a total return of more than 50% from current levels. With more than a third of the purchase price to be distributed in two and a half weeks, the expected IRR is significantly higher.

Risks

I want to highlight the major risk up-front. I do not believe the Trust is governed with the interests of the unitholders at the front of the line and there is next to nothing that can be done about it. I have spoken a number of times to Mike Ulrich, the prior trustee. He talked a good game with respect to looking out for the interests of unitholders vis-à-vis Whiting Petroleum, the trust sponsor and operator of most of the underlying properties. My impression, however, was and remains that Whiting is completely in charge and that the Trust will not interfere if Whiting takes actions that benefit itself at the expense of the unitholders. Sarah Newell is the current trustee of the Trustfor BNY Mellon along with a number of other energy trusts. Clearly, 2020 was a terrible time for cash flow from energy but I will still point out that things have gone badly for the unitholders of these trusts.

Detrimental actions could involve higher operating expenses, development expenses and/or other actions that would benefit production following termination of the Trust at the expense of current production and distributions. Whiting does not own any units in the Trust though it does receive 10% of the net profits from the underlying properties.

The next major risk is the price of oil. At a quarterly average WTI price below $45, the Trust is unlikely to have cash for distribution. 

The Q1 Distribution Level and Future Distributions

There are a number of factors that point to future distributions coming in higher than the Q1 level.

The Q1 distribution was reduced by $424,000 to recover prior period losses. Additionally, the trustee withheld $250,000 for estimated Trust expenses compared to the usual amount of $200,000. An additional $474,000 of distributable cash would provide an incremental $0.0258 per unit such that the pro forma level of distributable cash for Q1 was actually $0.1087.

The discount at which the Trust’s oil was sold during Q1 (21.5%) was materially higher than usual. At a more typical 15% discount, the distribution would have been $641,000 ($0.0348 per unit) higher. ($57.79 WTI x 6.5% x 199,543 x 95% x 90% NPI = $640,868.) Additionally, the price of WTI is currently just under $65, compared to an average price of $57.80 during Q1. At current production levels, a $5.00 increase in WTI should increase each quarterly distribution by about $0.04.

While not discussed in the PR or 10-Q, it is likely that February production was reduced due to the freeze in Texas and surrounding areas which provide a large share of the Trust’s production. PermRock Royalty Trust saw its oil production fall by 18% in February over January and noted that the drop related to temporary shut-ins due to the winter storm.     

Lastly, Whiting Petroleum has entered into four farm-out agreements relating to the underlying properties. While 2020 saw no activity under the agreements, one additional farmed-out well in Winkler County, Texas was drilled in Q1 and could come on line in Q3. Under the farm-out agreement, the Trust receives a 25% working interest and the corresponding share of profit from the well without any contribution to the DCET costs of the well.  Another well was drilled in Nueces County, Texas at the end of Q1 and may provide additional production at some point this year. The Trust would only receive a 10% working interest for this (and any other) Nueces County well. While prior farm-out wells have not been large producers, new wells have typically added about 7,000 - 10,000 barrels of oil per quarter which can make up for natural declines.

On the flip side, development costs have been low in recent quarters and could increase during the remainder of the year. According to the reserve report, the underlying properties do not have any planned capital expenditures through the trust termination date of December 31, 2021; however, this may reflect the much lower input prices used in the reserve report. Development costs came in at $1.4M, $2.0M and $3.3M in 2020, 2019, and 2018, respectively. There is a capital expenditure limitation amount which caps total development costs attributable to the Trust in the concluding years of the Trust period, which is $4.3M for 2021.

Conclusion

Taken together, I believe it is reasonable given current commodity price levels that the final three distributions should aggregate at least $0.25. Combined with the already announced distribution, unitholders would receive total value of $0.33 as compared to a purchase price in the low $0.20s. Additionally, any near-term increases to the price of oil should significantly increase the coming distributions. My estimate is for each $5.00 increase in WTI to increase the quarterly distribution by about $0.04.    

A final note. While I don’t want to delve into the tax treatment of distributions, I will point out that the Trust units can be held in non-taxable accounts. While the Trust has not received an IRS ruling, the Trust should be considered a mineral royalty interest rather than an operating entity and therefore would not give rise to UBTI.

Catalyst

Near-term distributions and potential increase in oil prices