BP Prudhoe Bay Royalty Trust: Looking over a cliff edge (NYSE: BPT)
For a brief overview, the BP Prudhoe Bay Royalty Trust (NYSE: BPT) was incorporated in 1989 for the sole purpose of administering royalty rights. The Royalty Interest allows the Trust a 16.4246% royalty on the first 90,000 barrels of the Prudhoe Bay field from BP Alaska’s working interest. After subtracting expenses which consist mainly of a billable cost multiplied by a cost adjustment factor (protection against inflation), production taxes and administrative costs, the royalty per barrel is calculated and paid to unitholders. each quarter in the form of a distribution. Each quarter, the royalty interest is reset, meaning it will not bear a debt even if the royalty per barrel was negative. It is important to know that there is no management team, there are no additional assets, the trustee simply passes on the cash flow generated by the royalty.
How Trusts Trade
After a decade of trading O&G trusts, I have learned two facts. The first is that retail investors make up a large part of the unitholder base. The second is that these unitholders rarely understand what they own. To really get to know an oil and gas trust, an investor should read the prospectus and annual reports. Many variables can significantly alter the value of the trust. These variables include, but are not limited to, royalty interests, operator(s), location of assets, transportation costs, ability to drill more wells, pending lawsuits, and termination clause. It can take dozens of hours of research to fully understand a single trust. It’s much easier for investors to trade trusts purely on performance, which is exactly what they’re doing.
In the case of BPT, the most important variables today are the billable cost and the cost adjustment factor. Between inflation and an ever-increasing billable cost, the royalty per barrel needs higher oil prices to pay for distributions. Previous Seeking Alpha articles have gone into great detail about this and I suggest reading the annual report and any attached notes to understand how it works. The retail investment base mostly ignores this crucial aspect and instead opts to trade BPT based on its expected future performance for the next 2-4 quarters. Historically, BPT unitholders demand between 10% and 30% return. When there is no yield, it trades below $5 as a call option on oil. In this article, I want to focus on this future performance and why BPT is looking over the edge of a cliff.
What $90 oil means for BPT
Due to high inflation, the break-even price of oil continues to rise for BPT. At $90 oil, to maintain an average return of 15%, the trust must drop from $15 to $5 over the next twelve months. At this point, it should return to trading as a CALL option on oil. Adding in the distributions, that’s a 50% haircut on capital if oil doesn’t rise from today’s price. The chart below shows previous months based on past monthly oil prices to show the correlation between future yield and unit price. For the first half of 2022, the future yield fluctuated between 15% and 30%, with the monthly price of oil rising from $83.22 to $114.84. For BPT to maintain a 15% future return at $90 oil, the unit price must drop 40% by the end of the year.
In a more efficient and logical investment world, BPT would trade on its discounted future cash flows. Even though the recent correlation is low, I wanted to include the chart to inform unitholders of the expected capital they will recoup if they hold $90 worth of oil. The expected share price is based on the return of 15%, so it slowly returns to the total expected payout. At the beginning of 2022, the total payment was almost equal to the unit price. In July, the units were trading 50% higher than its expected payout. Today, the discount is hovering around 25%, which means BPT is trading at a massive premium.
What $85 oil means for BPT
Most people look for leveraged investments on the upside. Unfortunately for BPT unitholders, it is the opposite. With a drop of less than 10% in the price of oil, BPT would have to drop to $5 to obtain a future return of 15% after the October distribution. For the expected distribution of $1, investors are now risking $10/share or more than half their capital. Below is a chart showing the expected future unit price of $85 oil and a 15% yield. Notice the difference in the slope of the sell to get a similar return to today.
What $110 Oil Means for BPT
It is certainly possible for oil to rise, which will lead to an increase in future yield. In this scenario, BPT owners will likely have a chance to sell for a profit as long as they don’t make their investment a long-term hold. However, this scenario is short-lived unless oil continues to exceed billable cost. Below is a graph showing what BPT would do at $110 worth of oil and a future return of 20%. The expected final price does not include approximate $6 distributions over the next 4-5 quarters. I’ve also included the terminal value to show the drop to $110 for anyone holding beyond 2023. In my view, the upside would be limited to a short-term boom in the stock price and would only last a year.
What $150 oil means for BPT
If you’re ultra bullish on oil and think $150 of oil is achievable, I’ve included the expected payout from 2022 to 2030. The amount received would be around a 300% return or 56% IRR . After 2030, payments are pennies each quarter.
Alternatives for BPT Longs
There are many oil and gas companies, due to their free cash flow generation, that would equate to the 300% return of BPT at $150 oil. The main difference is that these companies can continue to generate cash flow at $80 oil while BPT would face termination from 2023. And even at $150 oil, termination comes in less than a decade . For a long-term alternative, I would suggest pairing Buffett with Occidental Petroleum (OXY) or if you need income, try Pioneer Natural Resources (PXD). If you want to play it safe and prefer the royalty model, check out Sitio Royalties (STR). Finally, a well-structured options bet on $150 oil could yield between 10 and 20 times the return for the more daring. Regardless of the price of oil, the BPT buying crowd will be giving up a huge opportunity cost by not choosing a sounder investment.
The siren sounded
I have seen many trusts crumble and end up failing over the past decade. It could be wells that no longer work, an old lawsuit that drops a bomb, or a termination clause triggered in a down cycle. Almost always, retailers are caught off guard, their blissful ignorance turns into a nightmare. Due to inflation and a rising billable cost, BPT is gearing up for a big sell off in the next 1-2 quarters unless oil recovers towards $100. Even then, BPT will not reward its long-term unitholders relative to other oil investments.