Due to the Recent Fall in Oil Prices, Losses to Holders of BP Prudhoe Bay Royalty Trust (BPT) are a Near Certainty, According to HITE Hedge Asset Management

HITE Hedge Asset Management LLC highlights losses in nearly all crude price scenarios

NOTE TO EDITORS: The following is an investment opinion issued by HITE Hedge Asset Management LLC

NEWTON, Mass.--()--HITE Hedge Asset Management LLC (HITE Hedge), which has a 13-year track record in the US energy sector, is encouraging holders of BPT to consider the potential losses they face under almost all crude price scenarios. Here are the losses we estimate investors can expect based on BPT’s recent $20.00 share price in different crude price scenarios, assuming WTI trades around $50 for the remainder of 2017:

                         

WTI Crude price
after 2017

     

Estimated final
dividend payment

     

Estimated total
remaining dividends

     

Undiscounted return
based on $20 price

$35       1Q 2018       $3.04       85% loss
$40       4Q 2018       $3.19       84% loss
$45       1Q 2019       $4.39       78% loss
$50       1Q 2020       $6.08       70% loss
$55       3Q 2020       $8.55       57% loss
$60       1Q 2021       $12.13       39% loss
$65       1Q 2022       $16.51       17% loss
$70       4Q 2022       $21.53       8% gain
                 

How can any investment be this bad?

While other oil producers are reducing their cost every year, the BP Prudhoe Bay Trust (BPT) cost per barrel of oil increases perpetually. BPT is forced by contract to pay a fixed amount per barrel every year, and starting in 2018 that amount is going up by >$5 per year forever. By 2020, the breakeven crude oil price reaches about $57 and by 2025 it could exceed $90.

Could this analysis be wrong? Unlikely

Unlike most investments, BPT is very simple. It receives a royalty on about 90,000 barrels of oil per day of production. Its cash flow per barrel is not related to the actual economics of producing barrels out of the Prudhoe Bay, it is based on a formula set out in a contract between BPT and its primary counterparty, British Petroleum (BP). That formula is as follows:

******************************

WTI crude price

minus

Production tax (was about $1.37 in 2016, but moves up with crude oil prices)

minus

CPI factor (1.84 in 2016 and increases with the CPI inflation index every year)

X

Cost base ($17.10 in 2016 rising to $29.25 in 2021)

Equals

Dollars of cash flow to the trust per barrel of crude oil

******************************

Based on a $50 crude price, this means the 2017 profit per barrel would be in the range of:

50 – 1.64 - (1.88 x 17.20) = profit of $16.02/barrel

However, by 2021, the profit per barrel looks much more grim:

50 – 1.64 – (2.03 x 29.25) = loss of $11.02/barrel

It only gets worse from there, with cost per barrel moving up by at least $5 per year forever. The only action that could save BPT would be a renegotiation of the contract with BP, but that is extremely unlikely. BP created this contract structure originally, disclosed it in BPT’s IPO prospectus and in more than 25 years of 10-Ks, and is the direct beneficiary of this structure. Other royalty trusts have terminated contractually without any relief from their sponsor, including WHITING USA TRUST I (delisted, last report on sec.gov on 8/27/15).

Could anything make the losses even greater? Yes.

BPT is only entitled to royalties on the first 90,000 barrels per day of crude and condensate produced from its properties, or actual production, whichever is less. We modelled the estimated losses assuming that production is maxed out, but the reality is likely to be worse.

According to page 32 of BPT’s 2016 10-K, production was only 89,000 barrels per day in 2016 and is likely to be below the 90,000-barrel mark in all future years. Consequently, the losses will almost certainly be higher than the estimates we produced.

The downside could be even greater, however. Production taxes were unusually low in 2016, causing us to model an effective tax rate of <5%. However, in 2014, the production tax rate was about 20%. Should the effective production tax rate return to this level, it would imply substantially more downside and earlier termination, particularly in higher crude price scenarios.

Is it wise to hold on for another quarter or two of dividends? No.

It is difficult to predict when exactly BPT will move toward its fair value of $5-$6 per share, but it will move there eventually, and the clock is ticking. Since BPT is highly likely to terminate in the next few years, every distribution you receive lowers its remaining value. Note that on BPT’s most recent dividend date, 4/11/2017, it was down 6%, including the benefit of the distribution received.

What if I expect crude to rally?

As illustrated in the table at the start of this note, BPT will lose money and terminate over the next few years even if oil rallies substantially. You would be much better off buying a high quality E&P company or buying oil exposure directly through an ETF like the United States Oil Fund (USO). Here is a comparison of returns under different crude price scenarios of the next few years:

                 

WTI Crude price
after 2017

     

BPT undiscounted
return

     

USO undiscounted
return (baseline to
$50 WTI price)

$35       85% loss       30% loss
$40       84% loss       20% loss
$45       78% loss       10% loss
$50       70% loss       0% gain
$55       57% loss       10% gain
$60       39% loss       20% gain
$65       17% loss       30% gain
$70       8% gain       40% gain
           

What if I need the yield?

There are several equity yield opportunities in the energy space that are likely to perform substantially better than BPT. Here are some examples based on recent share prices:

                                 
Ticker      

Share
price used

     

Current
yield

     

2020 yield
at $50 WTI

      Notes
BPT       20.00       21.2%       0-2%       Distributions very likely ending due to contract
APLP       15.66       7.3%       13.3%       Natural gas compression business that benefits from growing US volumes and has strong distribution coverage
ETP       22.24       9.6%       12.6%       Benefits from growing Permian and Marcellus volumes
DKL       30.80       8.9%       10.9%       Stable midstream business that benefits from activity in the Permian
GLP       19.10       9.7%       10.5%       Stable business distributing gasoline in the Northeast with strong distribution coverage
KRP       19.50       7.0%       9.3%       Owns oil and gas royalties across the US including in the Permian
VNOM       17.18       7.0%       8.9%       Owns royalties associated with Permian production, mostly from FANG and RSPP, and likely to grow through 2025 or longer
AM       34.42       3.5%       8.2%       Likely to continue growing distribution 10%+ through 2025+
                       

What is BPT’s fair value? About $5 per share

WTI crude oil futures through 2020 are trading at about $50. At this level, and assuming a 10% discount rate, the few years of remaining dividends BPT offers are worth about $5, 75% below the current price. Even if crude rallies all the way to $65 as some analysts predict, BPT is only worth about $13, representing 40% downside to the current price.

Can you trust us?

We like to think so, but the good news you don’t need to. Do yourself a favor and call the trustee, Elaina Rogers of the Bank of New York Mellon. Note that there is no active management, so the trustee is the best point of contact. She is very professional and honest, and can be reached at 713-483-6020.

Even easier, refer to BPT’s 2016 10-K, which on pages 17 and 23 suggests that if oil falls back to the low $40s, dividends will end by 2018, consistent with our analysis: https://www.sec.gov/Archives/edgar/data/850033/000119312517065805/d335309d10k.htm#rom335309_11

We plan to continue a public education campaign, so please stay tuned. Please visit www.bptfacts.com for ongoing updates. Also note that HITE Hedge is currently short BPT and holds put options related to BPT due to our negative view on the security. We trade actively and could expand or reduce our position based on valuation.

Forward Looking Statements

This press release contains "forward-looking statements." Generally, the words "anticipate," "believe," "estimate," "expect," "intend," "may," "predict," "project," "plan," and similar expressions identify forward-looking statements. These forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements to differ materially from any future results, performance, or achievements expressed or implied by such forward-looking statement. Consequently, no reliance should be placed on any forward-looking statements contained herein and the reader should consider any such forward-looking statements only as HITE Hedge's current beliefs as of the date of this press release. Even if these beliefs change because of future events or circumstances, HITE Hedge declines any obligation to publicly update or revise any such forward-looking statements.

HITE Hedge Asset Management LLC is registered as an investment adviser under the Investment Advisers Act of 1940, as amended. This document shall not constitute an offer to sell or the solicitation of an offer to buy interests in any of the HITE funds, which may only be made at the time a qualified offeree receives a Confidential Private Placement Memorandum describing the offering and related subscription agreement.

Contacts

HITE Hedge Asset Management LLC
Matt Niblack
mniblack@hitehedge.com

Release Summary

Significant losses are likely to holders of BP Prudhoe Bay Royalty Trust (BPT) given its contractual design

Contacts

HITE Hedge Asset Management LLC
Matt Niblack
mniblack@hitehedge.com