Whiting USA Trust I (NYSE: WHX)

Exploration and production outfit Whiting Petroleum Corp (NYSE: WLL) formed Whiting USA Trust I (NYSE: WHX) in 2007 and took the trust public in April 2008.

Trust holders are entitled to a 90 percent interest in net profits from about 3,100 oil- and natural gas-producing wells in four core markets: the Rockies (37 percent of reserves), the Mid-Continent (40 percent), the Permian Basin (14 percent) and the Gulf Coast (9 percent). High-value oil and natural gas liquids (NGL) account for roughly 60 percent of the trust’s total output, with natural gas making up the remaining 40 percent.

Net profits are to the total proceeds from oil and gas produced from these fields and wells minus basic costs such as well maintenance, royalties, payments made related to hedges and the cost of plugging old wells for abandonment. Whiting Petroleum agreed to shoulder the costs of recompleting existing wells and additional developments that increase production. 

The properties covered by the trust are mature, low-risk fields in well-known regions. For example, in the Rockies, Whiting Trust USA I’s wells are in Montana, North Dakota and Wyoming. Although North Dakota and Montana’s oil production has soared in recent years because of frenzied drilling in the Bakken Shale and Three Forks/Sanish, the trust holds conventional wells in the Tyler Sandstone and other shallower formations.

In other words, Whiting Trust USA I is not a play on the oil-rich Bakken Shale, even though its sponsor operates primarily in this region.

Nevertheless, the trust’s focus on mature wells has certain advantages. Not only does production from these wells tend to decline at a predictable rate as the geologic pressure diminishes, but the wells have also produced hydrocarbons for years, limiting risk and the expense of additional development. As long as the operator performs periodic maintenance on these wells, the oil and gas will continue to flow.

Whiting USA Trust I has a finite life span and will cease to exist once the underlying properties have yielded 9.11 million barrels of cumulative oil equivalent output. At the time of the trust’s initial public offering (IPO) in 2008, management estimated that the trust would reach that milestone at the end of 2017.

But in the intervening years, the output from these fields has outstripped this initial forecast; by the end of September, the trust had already produced more than 57 percent of its allotted 9.11 million barrels of oil equivalent output. Based on updated reserve reports, the trust should reach this milestone on Nov. 30, 2015. At the time of termination, trust holders won’t receive any additional money or income from the sale of assets; distributions will cease at this time, and the trust will no longer exist.

When Whiting Petroleum formed the trust, the firm also established hedges that cover about 80 percent of planned production from the IPO to the end of 2012. These hedges take the form of collars that place a floor under the price of oil and gas that the trust produces, as well as a ceiling above which the trust would no longer benefit from rising commodity prices.

For the remainder of 2011 and into 2012, the floor on oil hedges is about $74 per barrel and the ceiling is about $140 per barrel, leaving the trust with plenty of upside potential if oil prices continue to rally.

In the most recent quarter, the trust realized an average oil price of $91.40 per barrel, a level that’s above the collar’s floor and below the ceiling. In short, the trust received no benefit from its oil hedges. Unless oil prices were to dive precipitously from current levels–an unlikely occurrence–the trust’s oil hedges won’t come into play.

As for gas, the trust’s collars provide a floor between $6 and $7 per thousand cubic feet in each quarter from now to the end of 2012. Because this floor is almost double the current US price of natural gas, the trust has benefited handsomely from these hedges. In the most recent quarter, the trust realized an average price of $4.19 per thousand cubic feet of gas; the hedges bump this figure to $5.29 per thousand cubic feet. But these hedges will expire at the end of 2012.

Our forecast calls for US natural gas prices to remain depressed for the next two to three years; the loss of these hedges will reduce the cash available for distribution to the trust’s unitholders.

Whiting USA Trust I disburses virtually all of its earnings as dividends. Total dividends for the first nine months of 2011 amounted to $2.284 per unit, compared to $2.036 in the year-ago period. All this growth has stemmed from higher price realizations for the trust’s oil production, which jumped 20 percent in the first nine months of 2011. Including hedging effects, price realizations on the trust’s natural-gas production also increased 1.2 percent from year-ago levels, overcoming lower gas prices.

Meanwhile, the volumes of oil and gas produced has declined. The trust’s wells produced 566,000 barrels of oil in the first nine months of 2011, compared to 598,000 barrels in the equivalent period one year ago, a decline of about 5.4 percent. Natural gas output tumbled 13.5 percent over the same period.

With the firm’s last hedges expiring at the end of 2012, oil prices would need to increase substantially for the trust to maintain or grow its current payout. Moreover, Whiting USA Trust I will likely last another four years before the trust reaches its production threshold and is formally terminated.

Over the past four quarters, Whiting USA Trust I disbursed $2.952 in dividends per unit, equivalent to a yield of about 17 percent at current prices. Over the next four years, the trust will likely pay another $11 to $13 in total distributions. Nevertheless, the trust is wildly overvalued at $17 per unit–likely because shortsighted investors have flocked to the trust’s 17 percent yield and are unaware of its looming termination.

The minimal upside offered by Whiting USA Trust I serves as cautionary tale for any investor who blindly puts money into high-yielding trusts. Whiting USA Trust I rates a sell in the Energy Watch List.

VOC Energy Trust (NYSE: VOC)

VOC Energy Trust (NYSE: VOC) went public on May 5, 2011. Unitholders are entitled to 80 percent of the net profits from a series of 881 wells located in Kansas and Texas.

In 2010 VOC Energy Trust’s underlying properties produced about 2,547 barrels of oil equivalent per day, 90 percent of which was oil. About 60 percent of the trust’s total production currently comes from its wells in Kansas.

Unitholders’ interest in the trust’s net profits will terminate on the later of these two dates: Dec. 31, 2030, or when the underlying fields have produced a cumulative total of 10.6 million barrels of oil equivalent output. Once either condition is met, the trust will dissolve and cease to exist. All rights to these fields reverting to the trust sponsor, the privately-held VOC Energy Partners LLC.

VOC Energy Trust focuses on mature fields that entail little to no exploration and development risk. On average, the fields in the VOC Energy Trust have been in production for more than 38 years; the sponsor has a long history of well data to draw on when it estimates the rate at which production will decline.

In addition, the work needed to maintain output from mature fields is relatively inexpensive, and the trust won’t be exposed to the big cost increases that operators in a number of shale fields have faced in recent years. The trust’s prospectus estimates production expenses at $19.21 per barrel of oil equivalent. The operator and its predecessor, Vess Oil, have about 30 years of experience in Kansas and a shorter history in Texas, so management knows the ropes.

The sponsor is entitled to receive the 20 percent of the net proceeds not distributed to public unitholders. In addition, VOC Partners has retained about a 25 percent position in the trust units. Combined, these stakes are a powerful incentive for management to operate the wells in a way that maximizes value for unitholders.

In addition, the operator of the wells intends to do significant low-risk development, particularly around its Texas wells. With these enhancements, management believes that the trust’s production will grow in the near term and slow the rate of decline over the next few years.

In particular, the sponsor plans to spend about $2.5 million drilling and completing 13 additional wells in its Kansas properties. The trust already has 742 wells in Kansas, and these new wells will be low-risk infill drilling opportunities. Infill drilling refers to new wells drilled in between wells that are already in production.

In addition, the sponsor intends to spend another $0.7 million on well recompletions and workovers. In a recompletion, the operator might decide to extend an existing well to a deeper depth to target another productive layer of oil-bearing rock. Alternatively, the operator could plug a portion of the well and then produce hydrocarbons from a shallower formation. Workovers involve performing maintenance work on wells to improve the rate of production or remove obstructions.

In east Texas, the sponsor intends to spend $22.5 million drilling and fracturing horizontal wells in a formation called the Woodbine C sand. The sponsor firm had already drilled four horizontal wells in this formation prior to forming the trust. These wells featured a relatively short lateral segment of 3,000 feet.

Readers of The Energy Strategist should be familiar with the rapidly growing oil and gas output from unconventional plays such as the Bakken Shale and the Eagle Ford Shale of south Texas. (For a refresher, check out Rough Guide to Shale Oil from Oct. 20, 2010.) To liberate hydrocarbons trapped in shale and other tight reservoir rocks, producers use two key innovations: horizontal drilling and hydraulic fracturing.

Horizontal drilling involves drilling laterally off of a traditional vertical shaft to increase the well’s exposure to the productive portion of the formation. Hydraulic fracturing involves pumping a liquid into a well to crack the reservoir rock and facilitate the flow of oil and gas through the field and into the well. In the nation’s most prolific shale plays, producers are drilling incredibly complex wells that can involve 30 or more fracturing stages and lateral segments that measure more than 12,000 feet in length.

Horizontal drilling and hydraulic fracturing can also enhance the output from mature fields. For example, producers have used these methods with great success in the Permian Basin of west Texas, an area that’s been in production for more than 50 years. VOC Partners has drilled some horizontal wells in its Texas acreage that have yielded solid production rates. This low-risk strategy should provide a modest boost to the field’s output in the near term. The sponsor also plans to spend another $1.5 million or so doing basic recompletion and workover projects on the Texas wells included in the trust.

Members of VOC Partners’ management team were also involved with MV Oil Trust’s (NYSE: MVO) IPO in 2007. Falling commodity prices hit MV Oil Trust hard in 2008, and SemGroup Corp (NYSE: SEMG), the company that handled the trust’s oil marketing and sales, declared bankruptcy during the credit crunch. But MV Oil Trust has recovered from these setbacks, and the units now trade at roughly nine times their 2009 low and about double the IPO price.

MV Oil Trust has successfully employed some of the same techniques that VOC Partners plan to use to slow production declines from its mature wells. From January 2007 until the end of 2010, MV Oil Trust’s output has declined just 8.3 percent, from 2,859 barrels of oil equivalent per day to 2,621 barrels of oil equivalent per day–an impressive performance.

VOC Energy Trust should also benefit from a hedge book that covers about 61 percent of its planned production from 2011 to mid-2014. Under the terms of these contracts, oil prices are hedged at $94.90to $102.15. After June 2014, VOC has no hedges in place and isn’t authorized to take on new hedges; at that point, the trust’s exposure to oil prices increases significantly.

VOC Energy Trust has disbursed two dividends thus far in 2011: a payment of $0.86 per unit that covers the first half of the year and a payment of $0.56 per unit for the third quarter. Unitholders received distributions that covered the period beginning Jan. 1, 2011, even though the trust didn’t go public until May. For now, the trust is on track to meet its first-year distribution estimate of about $2.09 per unit. Given the inherent volatility of commodity prices and the fact that VOC Energy Trust doesn’t fully hedge its output, investors should be prepared for significant quarterly volatility in distributions.

Additional production from the drilling projects mentioned earlier should begin to kick in during 2012. The company’s oil hedges also jump to more $100 per barrel next year. Barring a collapse in oil prices, VOC Energy Trust should pay out about $2 per unit annually, equivalent to a 10 percent yield at current prices. Although these distributions eventually will diminish with production, the decline rate should be slow. A spike in oil prices after 2014 could also provide significant upside.

All told, VOC Energy Trust is an attractive play on oil prices that offers a high current yield. We will track VOC Energy Trust as a buy under 20 in the Energy Watch List and in the future will consider adding the stock to the model Portfolios.

Prospective investors should note that VOC Energy Trust reports its annual distributions on a form 1099, as opposed to the K-1 partnership form used by Wildcatters Portfolio holding SandRidge Mississippian Trust I (NYSE: SDT). However, the trust doesn’t pay corporate tax at the entity level but instead passes through all profits and tax deductions to individual unitholders. Generally, a portion of the income you receive would be taxed at normal income tax rates, with the remainder considered a return of capital. VOC Energy Trust’s trustee will send out more details of exactly how distributions are to be treated at roughly the same time you receive K-1 forms from the master limited partnerships (MLP) in the model Portfolios.

Chesapeake Granite Wash Trust (NYSE: CHKR)

Chesapeake Granite Wash Trust (NYSE: CHKR), the newest addition to the universe of US oil and gas trusts. 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. (See the Oct. 6, 2011, issue of The Energy Strategist, The Yield Issue.)

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. 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 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 terminate on June 30, 2031, 20 years after its initial formation. Unlike Whiting USA Trust I and VOC Energy Trust, Chesapeake Energy’s trust will then sell its royalty interests in the Colony Granite Wash wells and distribute the proceeds to unitholders. Chesapeake Energy has the right of first refusal on buying these royalty interests.

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. The trust’s management based these assumptions on 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.

Of course, these distribution targets are based on estimates, and commodity price assumptions that are prone to error. But 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, flatten out  few years and then fall precipitously after 2014. That’s because when 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 the wells in 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 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 an 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 almost 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.

Trusts usually err on the conservative side when setting their 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. I have also added the stock to the Fresh Money Buys list.

Note that Chesapeake Granite Wash Trust is taxed as a partnership. You will receive a K-1 form at tax time. Roughly 55 percent of the income you receive will be taxable, with the rest considered a return of capital.

SandRidge Permian Trust (NYSE: PER)

Like Wildcatters Portfolio holding SandRidge Mississippian Trust I, SandRidge Permian Trust (NYSE: PER) was formed by SandRidge Energy (NYSE: SD), an independent oil and gas producer. The trust went public in mid-August 2011.

The trust owns royalty interests in wells located on 16,800 gross acres located in Andrews County, Texas. This is the heart of the Permian Basin, one of the oldest and largest oil-producing fields in the US. Crude oil accounts for roughly 87 percent of production in this area, while NGLs account for about 9 percent–a favorable mix in the current environment of high crude prices and ultra-cheap natural gas.

At the time of the trust’s initial IPO, the AMI was home to 509 producing wells. SandRidge Energy has also committed to drilling an additional 888 development wells on or before March 31, 2016. The parent believes it can drill those 888 development wells by the end of March 2015.

Investors in the trust are entitled to receive 80 percent of the net proceeds from the existing proven wells and 70 percent of the proceeds from the wells to be drilled. All drilling costs for the new wells will be borne by the parent, though the trust will be responsible for paying ongoing operating expenses related to the wells.  

SandRidge Energy has established hedges that cover about 73 percent of expected production and 79 percent of revenue through March 31, 2015. No hedges are in place after 2015, nor will the trust be able to take on additional hedges.

Like Chesapeake Granite Wash Trust and SandRidge Mississippian Trust I, SandRidge Permian Trust features a subordinated unit structure that protects payouts to individual unitholders. In this case, SandRidge Energy’s subordinated units represent a 25 percent stake in the trust. If the distribution falls below 20 percent below the target, the parent will suspend payments to its subordinated units to make public unitholders whole on their investment.

The subordinated trust units will convert to ordinary units four calendar quarters after SandRidge Energy drills the 888 development wells required in the prospectus.

The trust will terminate on March 31, 2031. At this time, 50 percent of all royalty interest on both the existing and development wells will revert to the parent, SandRidge Energy. Meanwhile, the trust will receive the remaining royalties, which will be sold, with the proceeds distributed to unitholders. SandRidge Energy has the right of first refusal to buy the royalty interests held by the trust.

If the quarterly distribution exceeds the targeted level by at least 20 percent, SandRidge Energy receives an additional bonus distribution. This graph depicts the target, subordinated and threshold distribution levels for SandRidge Permian trust.

Source: SandRidge Permian Trust, Prospectus

As you can see, management expects the trust’s distribution to grow steadily through 2015 as SandRidge Energy drills the required 888 development wells. After 2015, targeted distributions will fall because no new wells will be brought online to offset natural production declines. Of course, this forecast could change if oil prices rally significantly after the trust’s hedges expire in 2015.

The trust has already paid out its first distribution, which covered the second and third quarters of 2011. At $0.723 per unit, the first payout was considerably higher than the target of $0.66 per unit, though the distribution fell below the incentive threshold. The next distribution will be a bit lower because it will cover only production from the fourth quarter of 2011.

Based on target distributions for 2012, the Permian Trust currently yields 11.75 percent. If the underlying wells generate cash flow that exceeds the established incentive levels, the trust yields 14.1 percent. I’d expect the actual payout to be closer to the incentive level than the target level over the next year.

We already have exposure to SandRidge Energy in the model Portfolios through SandRidge Mississippian Trust I. I will track SandRidge Permian Trust as a buy under 22 in the Energy Watch List and would consider adding the stock to the Portfolios in the event of a major correction in the broader market.