New and Fabulous
Chesapeake Granite Wash Trust (NYSE: CHKR), the newest addition to the universe of US oil and gas trusts, went public on Nov. 11, 2011. The trust is also among the most promising and fastest growing trusts in my coverage universe and is structured in a similar fashion to Wildcatters Portfolio holding Sandridge Mississippian Trust I.
The trust’s sponsor is US independent oil and gas producer Chesapeake Energy Corp (NYSE: CHK). To form the trust, Chesapeake contributed royalty interests in existing and planned wells in the Colony Granite Wash play located in Washita County, Okla. The area of mutual interest (AMI) contributed to the trust spans 45,400 gross acres and is in the heart of a broader oil and gas-producing region known as the Anadarko Basin.
The Colony Granite Wash formation is widely distributed in the AMI and located at a depth of about 11,000 to 13,000 feet. The Granite Wash is typically produced using horizontal wells and fracturing techniques. NGLs account for about 47 percent of production from this wet-gas field, which also includes negligible volumes of oil. The Granite Wash also produces significant amount of natural gas, but an unusually large spread between natural-gas and NGL prices (which tend to follow the price of crude oil) means that liquids account for roughly three-quarters of net revenue generated in the field.
Given the high liquids content of the Colony Granite Wash and relatively low production costs, the formation is an economically attractive drilling target at current oil, gas and NGL prices.
Chesapeake Energy is the most active and experienced producer in the Colony Granite Wash, where it has drilled 133 of the 173 existing wells and operates nine of the 15 rigs in the region. Management has amassed proprietary data on historical decline rates and understands how and where new wells should be drilled.
The wells contributed to the trust fall into one of two categories:
Chesapeake Granite Wash Trust will pay out virtually all of the income it receives to holders as regular quarterly distributions. The trust has two mechanisms in place to protect those payouts. Chesapeake Energy has contributed hedges that cover 50 percent of expected oil and NGL production through June 30, 2015. In other words, over the next four years, about 37 percent of the trust’s total revenue will be protected from commodity price volatility. After 2015, neither the trust nor Chesapeake Energy can institute additional hedges; at that point, the trust’s revenue base will be more exposed to commodity prices.
The S-1/A form the trust filed with the Securities and Exchange Commission sets forth targeted quarterly distributions through the second quarter of 2017. Check out this line graph that tracks the trust’s distribution target, as well as an incentive distribution and a subordination distribution.
Source: Chesapeake Granite Wash Trust S-1 A
The distribution targets depicted in this graph are based on the amounts of oil, NGLs and gas the firm expects the trust to produce and a set of commodity price expectations. To set its oil and gas price expectations, the trust’s management used futures prices on the New York Mercantile Exchange (NYMEX) from Oct. 28, 2011. After 2014, Chesapeake Energy assumes a 2.5 percent annualized increase in oil and gas prices up to a cap level of $120 per barrel for oil and $7 per million British thermal units for gas.
These distribution targets are based on production estimates and commodity price assumptions that are prone to error. But it’s worth noting that the NYMEX futures curve for natural gas on Oct. 28, 2011 held out little hope for upside to US gas prices over the next few years; management’s gas price assumptions seem reasonable and conservative.
As you can see, the targeted distributions rise steadily until late 2013 and then flatten out a few years before falling precipitously after 2014. That’s because Chesapeake Energy drills the 118 horizontal development wells required in the trust’s registration document, the trust’s oil, gas and NGL output and revenue will increase. The trust is expected to boost its payout by about 65 percent between now and mid-2013.
Like all US trusts, Chesapeake Granite Wash Trust can’t make acquisitions or expand organically beyond the limits set forth in the prospectus. Eventually, all of the wells on Chesapeake Trust’s area of mutual interest will mature, and output will begin to decline, reducing cash available for distribution. Investors will continue to receive distributions until the trust is dissolved in 2031 and the proceeds are distributed among untholders.
The subordination threshold is located 20 percent below the target distribution rate; at this level, the parent steps in to support the quarterly distributions. Specifically, Chesapeake retained about a 50 percent ownership stake in the trust after the IPO. The company also subordinated half its stake in the trust or 25 percent of total outstanding units.
When the distributable cash flow drops below the subordination threshold, Chesapeake Energy will reduce the distributions it’s entitled to receive on its subordinated units until other unitholders (public investors) receive at least that subordinated distribution rate. In other words, if conditions deteriorate, the parent reduces its own distribution to preserve the payouts disbursed to public shareholders. This is an important guarantee and makes it unlikely that Chesapeake Granite Wash Trust’s payouts will drop below that minimum threshold for the foreseeable future.
In exchange for the downside protection offered by Chesapeake Energy’s subordinated units, the company also receives a incentive distribution in good times. When the trust’s distributions exceed that incentive threshold depicted on the graph, Chesapeake Energy will receive a 50 percent bonus on all payments in excess of the incentive distribution level. Although this structure limits distribution upside in strong commodity markets, that’s a small price to pay for downside protection.
Chesapeake Energy also owns nearly 50 percent of the outstanding trust units and significant stakes in all of the trust’s wells, especially the 118 that have yet to be developed. That aligns management’s interests with those of shareholders.
Typically trusts are a bit conservative in setting distribution targets in an effort to under-promise and over-deliver on their yield. In addition, the parent would like to hit the incentive threshold as often as possible to maximize its distribution bonus. I’d expect Chesapeake Granite Wash Trust to distribute more than its target payout over the next few years.
Chesapeake Granite Wash Trust has yet to pay a distribution, so most brokerage and financial websites will still list the yield as zero; savvy investors have an opportunity to pick up units before the public catches on to the trust’s distribution potential.
If in its first four quarters as a public company Chesapeake Granite Wash pays its targeted distribution of $2.72 per unit, that’s equivalent to 14.1 percent yield at current prices. And if the trust generates cash flow that exceeds the incentive threshold, the yield jumps all the way to 17 percent. With a high-quality asset base and the promise of a sky-high yield, Chesapeake Granite Wash Trust rates a buy up to 22 and is the latest addition to the Wildcatters Portfolio.
The trust’s sponsor is US independent oil and gas producer Chesapeake Energy Corp (NYSE: CHK). To form the trust, Chesapeake contributed royalty interests in existing and planned wells in the Colony Granite Wash play located in Washita County, Okla. The area of mutual interest (AMI) contributed to the trust spans 45,400 gross acres and is in the heart of a broader oil and gas-producing region known as the Anadarko Basin.
The Colony Granite Wash formation is widely distributed in the AMI and located at a depth of about 11,000 to 13,000 feet. The Granite Wash is typically produced using horizontal wells and fracturing techniques. NGLs account for about 47 percent of production from this wet-gas field, which also includes negligible volumes of oil. The Granite Wash also produces significant amount of natural gas, but an unusually large spread between natural-gas and NGL prices (which tend to follow the price of crude oil) means that liquids account for roughly three-quarters of net revenue generated in the field.
Given the high liquids content of the Colony Granite Wash and relatively low production costs, the formation is an economically attractive drilling target at current oil, gas and NGL prices.
Chesapeake Energy is the most active and experienced producer in the Colony Granite Wash, where it has drilled 133 of the 173 existing wells and operates nine of the 15 rigs in the region. Management has amassed proprietary data on historical decline rates and understands how and where new wells should be drilled.
The wells contributed to the trust fall into one of two categories:
- The AMI includes 69 completed and producing wells. Unitholders will receive 90 percent of the net proceeds from the sale of oil and gas produced from these wells.
- Chesapeake Energy also plans to drill 118 horizontal development wells in the AMI. Unitholders will not be responsible for the cost of drilling these wells. The operator intends to finish drilling the development wells by June 30, 2015, and according to the terms of the trust, all development drilling must be complete by June 30, 2016. Once completed, trust unitholders are entitled to receive 50 percent of the net proceeds from these wells.
Chesapeake Granite Wash Trust will pay out virtually all of the income it receives to holders as regular quarterly distributions. The trust has two mechanisms in place to protect those payouts. Chesapeake Energy has contributed hedges that cover 50 percent of expected oil and NGL production through June 30, 2015. In other words, over the next four years, about 37 percent of the trust’s total revenue will be protected from commodity price volatility. After 2015, neither the trust nor Chesapeake Energy can institute additional hedges; at that point, the trust’s revenue base will be more exposed to commodity prices.
The S-1/A form the trust filed with the Securities and Exchange Commission sets forth targeted quarterly distributions through the second quarter of 2017. Check out this line graph that tracks the trust’s distribution target, as well as an incentive distribution and a subordination distribution.
Source: Chesapeake Granite Wash Trust S-1 A
The distribution targets depicted in this graph are based on the amounts of oil, NGLs and gas the firm expects the trust to produce and a set of commodity price expectations. To set its oil and gas price expectations, the trust’s management used futures prices on the New York Mercantile Exchange (NYMEX) from Oct. 28, 2011. After 2014, Chesapeake Energy assumes a 2.5 percent annualized increase in oil and gas prices up to a cap level of $120 per barrel for oil and $7 per million British thermal units for gas.
These distribution targets are based on production estimates and commodity price assumptions that are prone to error. But it’s worth noting that the NYMEX futures curve for natural gas on Oct. 28, 2011 held out little hope for upside to US gas prices over the next few years; management’s gas price assumptions seem reasonable and conservative.
As you can see, the targeted distributions rise steadily until late 2013 and then flatten out a few years before falling precipitously after 2014. That’s because Chesapeake Energy drills the 118 horizontal development wells required in the trust’s registration document, the trust’s oil, gas and NGL output and revenue will increase. The trust is expected to boost its payout by about 65 percent between now and mid-2013.
Like all US trusts, Chesapeake Granite Wash Trust can’t make acquisitions or expand organically beyond the limits set forth in the prospectus. Eventually, all of the wells on Chesapeake Trust’s area of mutual interest will mature, and output will begin to decline, reducing cash available for distribution. Investors will continue to receive distributions until the trust is dissolved in 2031 and the proceeds are distributed among untholders.
The subordination threshold is located 20 percent below the target distribution rate; at this level, the parent steps in to support the quarterly distributions. Specifically, Chesapeake retained about a 50 percent ownership stake in the trust after the IPO. The company also subordinated half its stake in the trust or 25 percent of total outstanding units.
When the distributable cash flow drops below the subordination threshold, Chesapeake Energy will reduce the distributions it’s entitled to receive on its subordinated units until other unitholders (public investors) receive at least that subordinated distribution rate. In other words, if conditions deteriorate, the parent reduces its own distribution to preserve the payouts disbursed to public shareholders. This is an important guarantee and makes it unlikely that Chesapeake Granite Wash Trust’s payouts will drop below that minimum threshold for the foreseeable future.
In exchange for the downside protection offered by Chesapeake Energy’s subordinated units, the company also receives a incentive distribution in good times. When the trust’s distributions exceed that incentive threshold depicted on the graph, Chesapeake Energy will receive a 50 percent bonus on all payments in excess of the incentive distribution level. Although this structure limits distribution upside in strong commodity markets, that’s a small price to pay for downside protection.
Chesapeake Energy also owns nearly 50 percent of the outstanding trust units and significant stakes in all of the trust’s wells, especially the 118 that have yet to be developed. That aligns management’s interests with those of shareholders.
Typically trusts are a bit conservative in setting distribution targets in an effort to under-promise and over-deliver on their yield. In addition, the parent would like to hit the incentive threshold as often as possible to maximize its distribution bonus. I’d expect Chesapeake Granite Wash Trust to distribute more than its target payout over the next few years.
Chesapeake Granite Wash Trust has yet to pay a distribution, so most brokerage and financial websites will still list the yield as zero; savvy investors have an opportunity to pick up units before the public catches on to the trust’s distribution potential.
If in its first four quarters as a public company Chesapeake Granite Wash pays its targeted distribution of $2.72 per unit, that’s equivalent to 14.1 percent yield at current prices. And if the trust generates cash flow that exceeds the incentive threshold, the yield jumps all the way to 17 percent. With a high-quality asset base and the promise of a sky-high yield, Chesapeake Granite Wash Trust rates a buy up to 22 and is the latest addition to the Wildcatters Portfolio.
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