2023-07-14 14:45:37 ET
Summary
- BP Prudhoe Bay Royalty has had no net revenue in the first two quarters of 2023. It will likely not have any net revenue in the third quarter either.
- If BPT has less than $1 million/yr. of net revenue for two years, the Trust is terminated and Trust owners receive no further compensation.
- The breakeven oil price which generates revenue is $10 above the current WTI level of about $75 per barrel.
- The Trust incurs an artificial and rapidly increasing cost which places it at substantial risk of legal termination after Q4 2024 results are announced.
- If oil prices do rally substantially, there are much better alternative investments in the oil patch.
Background
I have written several articles about BP Prudhoe Bay Royalty Trust ( BPT ) over the past 10 years, generally warning investors that it has a limited life and a deteriorating value due to its unique structure.
My initial article regarding the company, actually my first article as a Seeking Alpha author, written in early 2013, was titled " BP Prudhoe Bay; a Derivative Security in Disguise ." I highlighted then that BPT's own projections indicated that the Trust might terminate about 2027. I warned at the time that under certain circumstances, it could happen a few years earlier, with decreasing distributions in the meantime.
In particular, I had warned investors about its artificial cost structure and the rapid artificial cost increases BPT would become encumbered with starting in 2018. It appears to be a mechanism to ensure that the Trust does not continue indefinitely, in fact potentially not even as long as there is oil to be profitably gotten from Prudhoe Bay.
My most recent subsequent article regarding BPT, written in January, can be found here . Although my articles have generally warned about BPT's overvaluation, I did recommend going long temporarily in October of 2021. This was based upon my estimate of a substantial upcoming increased distribution at the time as the quarterly distributions sometimes appear to be a more pertinent factor in short-term unit price moves than the ultimate intrinsic value of the units.
From the time of my initial article in 2013 to my October 2021 long trade suggestion,, BPT has decreased in price from over $70 per unit to roughly $5, while paying out less than $40 in total distributions. In fact, $25 of the total was paid out in 2013 through 2015 with only about $15 in total being paid out in the subsequent six years as the Trust structure began to take its toll.
Historical Perspective
As indicated above, my warnings from 10 years ago are turning out to be quite accurate. It shouldn't be too surprising to anyone who understands the history and purpose of the Trust. BP Prudhoe Bay was established by BP (British Petroleum) in 1989 simply as a mechanism to help fund its Prudhoe Bay development commitment. In the intervening 34 years, BP's interest in the Prudhoe Bay oil field has been sold twice, and it is now owned by Hilcorp.
Units were sold in 1989 to investors interested in sharing in the financial benefits of the huge new Prudhoe Bay oil field, a project that captured the imagination of the country at the time along with the associated Trans-Alaska pipeline. The structure of the Trust, with extremely small annual increases in the artificial Chargeable Cost in the first 29 years of its existence ($.10-$.25 most years with a few exceptions) provided investors with some assurance that payments might continue for 30 years or more, assuming the entire Prudhoe Bay field wasn't exhausted in the meantime. The huge annual increases of $2.75 in the Chargeable Cost factor starting in 2018 was a red flag that the Trust's life would be limited after that date, however.
In any case, BP likely and logically did not want this entity, along with the associated payments and paperwork, to be a "forever" commitment. BP management must have also decided that even if a potential investor were reasonably assured of getting payments for 30 years or more based upon the Trust structure, such investor would likely have been unwilling to pay more for a more generous structure.
As a result, BP would have had no incentive to make the structure more accommodating. In fact, the risk of the field being exhausted in 30 years or less would likely have been a more prominent concern among potential investors in 1989 than a structure that might have theoretically extended payments to 40 years or more assuming there still remained oil to be pumped.
Taking all of these factors into account, it makes perfect sense that the Trust was structured to terminate sometime not too long after 30 years of existence. Not only people, but also trusts, look forward to retirement after 30 or more years of hard work...
Minimum Quarterly Requirement for Future Distributions
Although it is impossible to predict with absolute certainty the specific future amount the Trust will pay in any particular quarter, the minimum conditions which would allow ANY future payments to be made can be modeled.
The table below provides the actual figures for the most recent three quarters as well as my projection for breakeven for each quarter through the end of next year. This information allows investors to make their own assessment of the likelihood of there being a payment in a specific future quarter.
BPT Quarterly Breakeven Cost (BPT filings and Author's Projections)
The most recent quarter in which WTI was greater than the total cost, thereby generating a distribution, was in Q4 of last year. There were no earnings or distributions in the first two quarters of this year. My estimate of breakeven costs is about $85 in Q3, while WTI has only averaged about $73 so far in July and is currently around $75. About 15% of the quarter is already over, so WTI will need to average in the upper $80's for the remainder of the quarter for there to be a distribution.
This suggests that there is little likelihood of a distribution for Q3 either. The real question becomes whether WTI will increase to $86 or more in Q4, thereby generating a distribution then. If not, the hurdle increases substantially in January to almost $94.
This hurdle rate become extremely important over the next six quarters due to a provision in the Trust indenture:
The Trust will terminate if either ((A)) holders of at least 60% of the Units outstanding vote to terminate the Trust or ((B)) the net revenues from the Royalty Interest for two successive years are less than $1,000,000 per year (unless the net revenues during the two-year period have been materially and adversely affected by a “force majeure” event).
I chose to provide my estimates of the quarterly breakeven WTI figures for the quarters only through Q4 of next year because if no quarter between now and then generates any "net revenue" (or even a minor amount), the Trust will terminate then with no further payments. Although the Trust life would legally be extended if there is a temporary spike in oil prices and a distribution, I believe the probability of this is less than 50/50. If WTI says in the 70's for the remainder of the year, though, even this probability becomes considerably smaller.
The one unknown variable in my estimates is the CPI adjustment factor to use. I chose a conservative 1% quarterly (4% annualized) increase in the CPI, a bit less than it has been running the past few quarters.
Any bull who thinks oil will increase enough to again be generating distributions needs to be aware that oil prices are a component of CPI and therefore the 4% figure may be too low under such a scenario, causing the breakeven price to increase more rapidly. It is this aspect of the Trust structure that must have made the creators of BPT confident that it would not go on forever, irrespective of how long Prudhoe Bay may produce oil. In a sense, the Trust is chasing its tail...
Alaska production taxes also need to be a consideration for anyone bullish on BPT. Although production taxes are modest and only slowly increase when WTI is under $100, the marginal tax rate begins to increase rapidly around $100. In fact, looking at some historical numbers, in the first quarter of 2022, when WTI averaged $94.45, production taxes were only $3.42, while in the following quarter when WTI averaged $108.70, production taxes more than doubled to $7.21.
What if WTI Increases Dramatically?
If oil prices increase materially (above the breakeven price), there is a short-cut approach I use to estimate what the quarterly distributions may be. Generally, for each dollar WTI is above breakeven, a BPT unit will likely generate a little over 4c per quarter.
As an example, let's assume WTI suddenly goes to $100/barrel at the beginning of Q4. In January, BPT would make a distribution of about $.56/unit ($100-$86 x $.04). However, at the same $100/barrel, the BPT distribution for Q1 '24 next April would only be $.24/unit ($100-$94 x $.04), with it gradually decreasing further in the subsequent quarters of the year (and further minor amounts would be deducted for administrative expenses).
This would result in only $1.50 or so being earned between now and the end of 2024. On January 1, 2025, the breakeven WTI would increase to roughly $106 or more, with subsequent annual increases being around $10/year. If WTI then remains below these hurdle rates, BPT investors would have collected less than 1/3 of the current market price for BPT. It requires extremely aggressive assumptions about oil price increases to justify paying $5+/unit today.
At various times in the past, some investors have speculated that there might be a material payment for the remaining oil reserves when BPT is terminated. This would not be the case, as the Trust does not own any of the oil at Prudhoe Bay; the only property right Trust owners have, as clearly defined in various Trust documents, is to the payments generated as a result of the Trust formula. At best, there is a possibility there could be 5c or 10c per unit remaining in the reserve account for expenses at termination, which would be distributed to unit owners.
If an investor is extremely bullish on oil prices over the next few years, I would recommend investing in a real oil exploration and production company, not this royalty trust which is being charged an artificial and rapidly increasing cost.
Do Not Short BPT; Simply Avoid or Sell
Although I am currently short BPT via both the stock and written OTM calls in modest amounts, I would not recommend that others do so. Although BPT is almost undoubtedly extremely overvalued, shorting it can be quite tricky for a few reasons. The bid/ask spreads on BPT's illiquid options are typically huge. To actually short the stock generally requires paying a substantial stock borrow fee, currently at about 20% p.a. (2%/month), so only a short-term well-timed short trade has a reasonable possibility of being profitable.
Of course, if BPT makes any distributions, anyone who borrowed units and is short would also be required pay the distribution. However, BPT is quite unique in that it is quite easy to model the Trust near the end of each quarter to determine if this would be a real risk. I know of no other entity where it is possible to model with a great degree of accuracy earnings on a daily basis simply using daily WTI and Prudhoe Bay production volumes reported by the state of Alaska in conjunction with the cost formula.
An additional risk is that sometimes the unit price moves in a direction which does not necessarily seem logical. This past week or so is a perfect example; a zero distribution was announced but the unit price has subsequently increased materially. I can come up with a couple of theories as to why. It's possible that some shorts covered once the news was out. (Possibly "sell on the news" or maybe more accurately "cover on the news"...). Oil has also moved up modestly since then, although it is still way below the level necessary for any distribution to be made in the future; BPT sometimes overreacts to minor changes in WTI.
For further details see:
BP Prudhoe Bay: The Termination Clock Is Ticking