2023-09-11 06:33:15 ET
Summary
- A tighter crude oil market is predicted by industry tracking groups into next summer, creating the potential for sharply higher prices.
- BP Prudhoe Bay Royalty Trust holds serious investment leverage to rising crude oil prices, weighted against abnormal royalty company risks.
- BPT's low-revenue termination clause and high breakeven cost structure are worries, but a spike in crude oil quotes could make it a top-performing investment.
- In many respects, BPT represents something akin to a call option on crude oil, expiring in 1-3 years. Invest with caution.
I have been bullish on crude oil for several months now. I wrote an article on the United States Oil Fund ETF (USO) back in July here , explaining why the odds favored another push higher for energy prices, especially crude oil. With Russia and Saudi Arabia sticking to OPEC+ production cutbacks, the U.S. SPR emergency inventory getting closer to empty, and a global economy still not in recession, the prospect for severe crude oil shortages in this worldwide commodity by next summer are very real (even predicted by industry tracking groups in my USO effort).
I have also mentioned a short list of other ideas to own as ways to take advantage of any oil & gas surge in prices. I have written bullish views on names like Exxon Mobil (XOM), Texas Pacific Land (TPL), Riley Exploration Permian (REPX), Callon Petroleum (CPE), and Vital Energy (VTLE) as reasonable choices during the summer.
Of course, a number of variables could keep crude oil under US$100 a barrel next year. My thinking is a recession may do the trick. But what if a new and unexpected supply shock hits the oil market, like a major war in the Middle East. If some unknown event to us today does appear over the next 12 months, crude oil could spike well above $100.
Don't laugh (maybe cry), but the 2008 spike high of $140 a barrel adjusted for inflation is roughly $230 a barrel in current dollar terms 15 years later. To be honest, reviewing its price adjusted for inflation in the overall U.S. economy since 1989, crude oil is sitting at a LOWER than "average" price level vs. the latest 35 years of trading history.
Anyway, the last few weeks I have been researching which investments have the best "leverage" to sharply higher crude oil, without taking on insane amounts of risk. My answer for a play on rising crude oil, that could turn out to be a terrific hedge in your portfolio if energy prices jump dramatically during 2024, is to purchase a small stake in BP Prudhoe Bay Royalty Trust (BPT).
Trust Setup
BP Prudhoe Bay Royalty Trust operates as a grantor trust in the United States. It holds overriding royalty interest in the Prudhoe Bay oilfield located on the North Slope of Alaska, set up by British Petroleum p.l.c. (BP) in 1989. The Prudhoe Bay field extends approximately 12 miles by 27 miles and contains approximately 150,000 gross productive acres. Currently, the Prudhoe Bay oilfield is owned and managed by privately held Hilcorp .
Seeking Alpha contributor Bill Cunningham is basically the expert on this security, writing on it for better than a decade. The trust has a unique termination clause, where the agreement could be dissolved after several years of weak production in Alaska (depleted reserves) or very low crude oil prices. In his article summary from July here , Mr. Cunningham lays out the framework for BPT's possible dissolution,
If BPT has less than $1 million/yr. of net revenue for two [consecutive] years, the Trust is terminated and Trust owners receive no further compensation.
And, with no revenue during the first two quarters of 2023, it is entirely possible low crude oil prices will mean the trust heads closer to zero for price into the end of 2024. So, in a sense, low energy prices would bring an expiration date eventually, just like a call option traded on regular financial securities.
Mr. Cunningham also reviewed his estimates on the "minimum" crude oil prices necessary to generate BPT revenue out a few years (pictured below). In the end, if these cutoff prices are breached to the upside over the next year and a half, the odds favor BPT sticking around for owners. The good news is crude oil prices are today in the low-$80s per barrel, near the necessary prices for the trust to generate revenue again. You will also note the breakeven price is escalating rather quickly between 2022-24, rising from $76 a barrel in December 2022 to an estimate of $96+ by the end of 2024.
Below you can see how the trust got perilously close to being terminated into early 2022, after 6 quarters of minimal revenues, following the once-in-a-lifetime pandemic bust in energy prices during early 2020. The trust's price fell under $1.30 in October 2020 on worries crude oil would not rebound in time to save BPT owners.
BPT Price Change History
On the long-term chart from 1989 (when BPT went public), several things regarding how the trust has fluctuated in price vs. crude oil jump out to me. First is the gargantuan price rise from $6 in 1999 to $130 in 2011. Including steady dividends over most of the period, BPT gained +1200% for shareholders vs. just +27% in total returns between March 1st, 1999 and January 3rd, 2011 for the S&P 500 index. During this span, crude oil rose from $13 a barrel to $110.
Second, you will notice the rotten performance since 2011, as crude oil prices have failed to keep pace with inflationary rises overall. Today's trust quote of $6.53 is back to 1999 levels. Remember, the way the trust is designed, a currently rapid rise in breakeven costs to generate revenue and cash for dividends is shutting the window for the trust to remain in operation.
The trust has been able to pay dividends really in every year outside of parts of 2020, 2021 and now 2023. The structural and mandated design of climbing breakeven costs is bringing the idea of trust "expiration" to the fore. BP never intended for the trust to live forever.
The 2-year daily price chart (adjusted for dividends) below outlines a nice summary of the rewards and risks of owning the trust. The monster advance in crude oil during the first half of 2022 supported a spike in BPT from $3 to $22 per unit, which produced one of the top oil/gas gains during the Russian invasion of Ukraine (energy shortages for Europe). Then, a normalization of supply/demand for oil has pushed the trust back into worries about its long-term viability.
Peer Royalty Trust Performance
Because of trust termination risk being different than other oil/gas royalty names, it is truly a boom/bust pick for performance. On the 5-year total return graph vs. peers below, you can easily see BPT has been the worst buy-and-hold idea of the group. Plainly stated, if crude oil prices do not rebound over $90 the rest of 2023 and/or $100 in 2024, BPT's price will decline markedly and no serious dividends will be paid.
However, the +53% gain in crude oil between the end of December 2021 and June 2022 helped BPT owners to a +637% advance over six months! My research conclusion is a major spike in crude oil to $120 or even $150 a barrel in 2024 could turn the BP Prudhoe Bay Royalty Trust into the top performing oil/gas royalty investment again.
Final Thoughts
I am personally torn about what to do with BPT. My official 12-month rating is Hold/Neutral . Yet, I wanted to highlight the upside potential of this honestly degrading/decaying crude oil leverage name. If I knew $120 oil was approaching next summer, I would be bullish on owning the trust. If I knew $150 oil was coming by early 2025, I would be wildly bullish on BPT.
The trust did pay out $4.15 in dividends between late 2021 and early 2023. So, a large spike in crude oil may allow the opportunity to get most of your purchase price today ($6.53) back in cash distributions.
However, if crude oil succumbs to recessionary demand over the next 6-12 months, with quotes under $80 a barrel next year, BP Prudhoe Bay Royalty Trust may be headed to $1 or less by the end of 2024.
Given trouble in the Middle East erupting soon, a buy now decision will likely prove a great hedge for your portfolio. Otherwise, any drift lower in price at the same time as crude oil zigzags higher (above $90) would deliver a better risk/reward proposition, in my opinion. For the moment, I am holding off purchasing a stake. But, BPT is on my radar for instant leverage to climbing crude oil quotes.
Thanks for reading. Please consider this article a first step in your due diligence process. Consulting with a registered and experienced investment advisor is recommended before making any trade.
For further details see:
BP Prudhoe Bay Royalty: Call Option Like Gamble On Higher Crude Oil