PRT - Beware Of The Risk That Comes With The 13.8% Yield Of PermRock Royalty Trust

Summary

• PRT is thriving right now thanks to the favorable price of oil, which has resulted primarily from the Ukrainian crisis.
• The distributions of PRT in 2022 correspond to an annualized yield of 13.8%.
• However, PRT is likely to be highly vulnerable whenever the next downturn in the oil industry shows up.
• PRT suspended its distributions for five consecutive months in 2020 due to the pandemic and its stock plunged 80% at the onset of that crisis.

More than a year ago, I stated that PermRock Royalty Trust ( PRT ) was offering an exceptionally high distribution yield of 10.2% but it was risky from a long-term point of view due to its high vulnerability to the downturns of the oil industry. Since my article, the stock has appreciated 10%, primarily thanks to the unforeseeable crisis in Ukraine, which sent the prices of oil and gas to 13-year highs last year. Given the exceptionally favorable business conditions prevailing right now and the 13.8% distribution yield of the trust, many investors will be enticed to purchase it. However, PermRock remains risky from a long-term perspective.

PermRock is an oil and gas trust that was formed in 2017 by Boaz Energy, which is focused on the acquisition and development of oil and natural gas properties in the Permian Basin. PermRock produces oil and gas at an 84/16 ratio . It is thus extremely sensitive to the cycles of the price of oil.

Thanks to the unique advantages of the Permian Basin, PermRock has superior production characteristics when compared to other oil and gas trusts. Sabine Royalty Trust ( SBR ) and Cross Timbers Royalty Trust ( CRT ) have warned investors that they expect their output to decrease by 6%-8% per year on average in the long run due to the natural decline of their producing wells. On the contrary, the Permian Basin is well known for the long-life reserves of its conventional fields, which are characterized by low decline rates. This helps explain why PermRock has never provided a warning for a decline in its production in the long run, in sharp contrast to most other trusts.

Despite the significance of the confidence of PermRock in its future production, it is always important to take a deep look into the proved reserves of an oil and gas trust. The proved reserves of PermRock plunged 51% between the end of 2018 and the end of 2020, from 6.3 million barrels of oil equivalent to 3.1 million barrels of oil equivalent. However, they recovered strongly and stood at 7.6 million barrels at the end of 2021. At the current production rate of about 318,000 barrels in the first nine months of 2022, the proved reserves of the trust are expected to last for 18 years.

Nevertheless, investors should be aware that this estimate is not written in stone. As it is evident from the dramatic swings in the estimates of proved reserves from year to year, proved reserves are highly sensitive to the underlying prices of oil and gas. Higher prices make it economical to extract more oil and gas from a given number of wells whereas low prices greatly reduce the amounts of oil and gas that are economical to extract.

Overall, as long as commodity prices remain favorable, PermRock is likely to continue producing appreciable amounts of oil and gas for several years. In fact, it can exceed the above estimated life of reserves thanks to water-flooding techniques. On the other hand, if the price of oil enters a prolonged downtrend, it will reduce the amount of economical reserves sharply while it will also greatly reduce the distributable income of the trust.

On the bright side, PermRock currently enjoys ideal business conditions. Due to the Russian invasion of Ukraine, the U.S. and Europe have imposed unprecedented sanctions on Russia. Before the sanctions, Russia was producing approximately 10% of global oil output. Due to the sanctions, the global oil market became exceptionally tight and thus the price of oil rallied to a 13-year high shortly after the onset of the war in Ukraine and remained excessive throughout 2022. As a result, PermRock grew its annual distribution per unit 66%, from $0.61 in 2021 to $1.01 in 2022. The new distribution corresponds to an exceptionally high yield of 13.8% at the current stock price. If this distribution was safe, the stock would undoubtedly be extremely attractive at its current price.

However, the rally of the prices of oil and gas in 2022 exerted great pressure on numerous households around the globe and thus caused a global energy crisis. Consequently, most countries have greatly accelerated their efforts on transitioning from fossil fuels to renewable energy sources. To this end, a record number of clean energy projects is being developed right now and is expected to come online within the next 2-5 years. When all these renewable energy projects come online, they are likely to exert great pressure on the prices of oil and gas.

It is also remarkable that the prices of oil and gas have recently declined below their level just before the onset of the Ukrainian crisis. This is a strong bearish signal, which indicates that the global energy market has absorbed the impact of the war. When all the clean energy projects begin to generate energy, they will probably exert additional pressure on the prices of oil and gas. In such a case, PermRock is likely to be severely hurt.

PermRock has proved highly vulnerable to the downturns of the oil industry. As the trust was formed only in late 2017, it has a short history but the coronavirus crisis provided a reliable stress test for the trust. Due to the collapse in the prices of oil and gas in 2020, PermRock suspended its distribution for five consecutive months in that year and then paid a distribution that was 80% lower than the distribution before the pandemic. It is also important to note that the stock of PermRock collapsed at the onset of the pandemic, with an 83% plunge in the first two months of that crisis.

Most income-oriented investors would definitely suffer if they incurred such a drastic reduction in their income stream and such a slump in the stock price. It is thus evident that PermRock is unsuitable for most income-oriented investors.

Moreover, given the high cyclicality of the prices of oil and gas and the high vulnerability of oil and gas trusts to these cycles, it is risky to invest in these trusts during boom times, near the peak of the cycle. Instead, experience has shown that the best time to invest in these trusts is during a downturn, when the stocks of the trusts collapse and thus become grossly undervalued from a long-term perspective. Therefore, those who are interested in buying PermRock should probably wait for the next downturn of the energy sector to show up.

To sum up, as long as the price of oil remains elevated, PermRock will continue thriving and offering excessive distributions to its unitholders. However, whenever the oil industry faces its next downturn, the trust will probably cut its distributions drastically and its stock price will probably plummet, as evidenced at the onset of the pandemic. A downturn in the oil industry seems inevitable at some point in the upcoming years, given the record number of clean energy projects being developed now. Therefore, investors should be especially careful before initiating a position in PermRock.

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