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Welcome to Special Situation Investing Episode 44.
Today we dive into another potential investment opportunity in the form of a small and thinly traded oil and gas royalty trust. As is always the case, we openly share our investment research with you here and in the Substack so that you can jump-start your own research, but your final investment decisions should always be the result of your own research and convictions.
Chesapeake Granite Wash Trust is an oil and gas royalty trust that distributes royalty income to unit holders quarterly via a K-1. Royalty interest were conveyed to Chesapeake Granite Wash Trust from Chesapeake Energy’s interest in the underlying properties effective 1 July 2011. As of 31 December 2021, the Trust on average owns a 47.8% net revenue interest in the producing wells and a 28.6% net revenue interest in the completed development wells. The operator retains 10% of the proceeds from the sales of oil, natural gas and NGL production attributable to its net revenue interest in the producing wells, and 50% of the proceeds from the sales of production attributable to its net revenue interest in the development wells.
One unique feature of this oil and gas trust is that it liquidates on June 30th 2031 or sooner if:
1. The trust sells the royalty interest
2. The aggregate quarterly cash distribution amounts for any four consecutive quarter is less than $1.0 million. (At current 46,750,000 shares outstanding a $1 mm distribution for any quarter equals $0.02139/unit. Over the life of the Trust three distributions fell below that threshold and they were as follows: Aug 2020 ($0.0053), Nov 2020 ($0.0012), and Feb 2021 ($0.0063). The low distributions correspond to the 2020 pandemic low oil price which corresponded with never before seen negative oil futures prices.)
3. Majority of owners vote to liquidate.
4. Trust is judicially dissolved.
Upon the trust’s termination date, all cash remaining will distribute to unit holders. Fifty percent of the royalty will revert to the operators and 50% of the royalty interest will be retained by the trust and sold with proceeds being distributed among the unit holders. The operator will have a right of first refusal to purchase the perpetual royalties retained by the trust.
The trust owns royalty rights covering 40,500 gross acres and 26,400 net acres in Washita County Oklahoma. Tapstone Energy is the operator, bound by the December 2011 Trust Agreement, who operates the underlying properties in the Area of Mutual Interest (AMI). The AMI includes the properties on which the royalty interest reside. The Trust has 46,750,000 units issued and outstanding, 50.8% of which are owned by Tapstone.
Below is a chart reflecting the current oil and natural gas reserves attributable to Chesapeake Granite Wash Trust. Reserve estimates fluctuate for all commodity companies and must be treated with an appropriate level of skepticism. Three main variables add to the difficulty of calculating reserves. They are the commodity price, the technology used to extract, and the imperfect knowledge of exactly what is in the ground at any given location. The first two points are the biggest drivers as an increase in commodity price leads to greater reserves because more of the commodity is made economically recoverable and improvements in technology allow for the extraction of more resources at lower cost.
Using a 12 month trailing oil price of $67 and $3.60 for natural gas, the chart discounts the trust’s future cash flows at 10% to arrive at a present value of $41,544,000. As I write this on the second of October 2022, oil trades at $79.74 and natural gas sits at $6.83. With Chesapeake Granite Wash Trust’s market cap fluctuating around 47mm it’s only just above the 41mm present value reflected in the 10% discount to present value chart in the company’s 10K. At this point, assumptions concerning the future price of oil become all important. Will oil and natural gas return to their 2015 lows and remain there until the trust liquidates in 2031 or will global supply shortages persist and keep prices elevated?
In my own view, prices are unlikely to sink back to 2015 lows due largely to the influence of Environmental, Social, and Governance (ESG) policies against a backdrop of ever increasing energy demands. In short, oil and gas are hated by governments, capital, and even some of the energy companies themselves and many are scrambling to exit the industry at the same time. With global demand rising faster than supply, society has decided to keep prices in check via financial engineering rather than increasing supply in the physical world. In other words, most of the proposed oil shortage solutions suggest everything except drilling into the earth to increase supply. At some point, supply and demand can not be balanced with financial tools but rather will require actual increased energy production in the real world.
With renewable energy unable to pick up the load in the short term and nuclear energy requiring tremendous lead time to bring online, it would seem that an eventual price spike must be the driver to increase production. At a high enough oil price, entrepreneurial forces will take over and new supply will be identified and developed. After production is increased, the stage will be set for an inevitable decrease in the oil prices to finish out the cycle but that phase of the cycle is still years away and will be easy to identify once capacity is increased in a meaningful way. Until that cycle has played out, however, it’s difficult to imagine 2015 level oil and gas prices persisting for any length of time.
Against that backdrop, the Granit Wash’s oil reserves could be viewed in another way. Consider the number of shares, currently trading for $1.00, that an investor must purchase to “own a single barrel of oil.” Dividing the shares outstanding, 46,750,00 by the 385,000 barrels of oil remaining and you get about 121 shares per barrel of oil. $121 per barrel is not a bargain given that it’s close to the all time high price, but what happens when you add in the natural gas that 121 shares would give you a claim to? Using round numbers, each 4 units of the trust is equivalent to one mcf of natural gas or about 30 mcf per 121 shares.
Given current prices, $79 per barrel of oil and $7 per mcf of natural gas, $121.00 buys you 121 shares of the CHKR which is equivalent to owning one barrel of oil and 30 mcf of natural gas or in dollar terms $79 + (30 x $7) = $289 in oil and gas value per 121 shares purchased. This calculation does not include the companies LNG resources which depending on how you calculate their value could add another $200 per 121 trust units of value to the $289 already mentioned.
At first glance, the trust’s mandatory liquidation in 2031 would seem to demand an additional step in calculating the trust’s current value. What will the terminal value of the royalty stream be when it’s sold in 2031? Personally, I don’t think this issue is as significant as it would be for a royalty company that simply ended its operations without selling the remaining royalty interest.
If the trust paid out its remaining cash in 2031, but did not sell its royalty interest, then its terminal value would be zero and the trust units would trade down exponentially as June 2031 approached. Very similar to an out of the money option prior to its expiration date. Because the remaining royalty interest will be sold, however, the trust units will have value up to the very last day of its existence with the only serious issue being the price of oil and gas in June 2031.
If oil and gas prices are elevated in 2031 then the value of the royalty stream will follow suit and the opposite will be the case if energy prices are depressed. Given this assessment the terminal value of the trust could safely be placed at somewhere between zero and a lot. In all seriousness though, I believe it’s best to analyze the trust based on the likely stream of cash flow generated from all of its oil and gas sales from now until the reserves are depleted knowing that we can’t predict exactly what those cash flows will be worth on any specific day to include June of 2031.
A point worth touching on while we’re on the topic of the trusts terminal value is the incentive structure of the 50.8% owner and operator, Tapstone. Tapstone has the right of of first refusal to purchase the remaining 49.2% interest of the Trust in 2031. Is this an issue for unit holders? I think it is not as the unit holders will have the right to expect a market price for the royalty interest on that date. The PV-10 or price of the remaining oil reserves discounted back to present value at 10%, used in the chart previously shown, is a common valuation method in the industry and any bid by Tapstone below that value would draw well-deserved skepticism from unit holders as well as industry leaders who would have bid a fair market price for the royalty interest.
Now as clunky as it is to present a list of positive and negatives bearing on a decision, let’s go through the positive and negatives relating to this investment:
Negatives:
The trusts directive to liquidate early after four consecutive quarters of less than $1mm in distributions per quarter could result in a forced sale in the worst possible market. The intent behind this provision was most likely to liquidate the trust when reserves dwindled to unprofitable levels, but as we saw in the spring and summer of 2020, demand destruction alone could reduce distributions to such levels without any correlated impairment of the reserves. In other words, prices could fall so low that, for a time, distributions would dip below $1mm per quarter regardless of the volume of oil and gas remaining in the trust. This would be a terrible environment in which to liquidate an oil and gas trust.
Positives:
It’s one of the cheapest oil and gas trusts in the market. Trading close to it’s 10% discounted present value even when calculated at below market oil and gas prices gives the investor downside protection and plenty of room to benefit from any increase in prices going forward.
Almost zero operating costs which protect the investor from margin compression related to rising labor and capital expenditure costs. This point has been covered extensively in other podcasts regarding royalties in general.
Tapstone, the operator, owns 50.8% of royalty units meaning that the operators interest is largely aligned with the remaining royalty trust unit holders. This should prevent the type of conflicts that arise when the operator does not have an interest in the royalty and therefore has no incentive to run the operation well or indeed sabotages the operation out of a feeling that they’re being exploited.
Reasons for this opportunity, or why is the market discounting the stock?
- Nobody wants to own a trust which is especially true for institutional money and ETFs.
- The trust has a very low market cap at 47mm and is thinly traded making it difficult for even the smallest funds to invest a meaningful amount of capital.
- The trust liquidates in 2031 which appears to limit its upside, but as discussed before, the fact that the remaining royalty interest will be sold means that the units should not trade like out of the money options leading up to the liquidation date.
- It isn’t included in an ETF or fund of any size meaning that no “automatic” buy pressure exists to elevate the share price.
- K-1 distributions trigger tax considerations and paperwork beyond what a typical qualified dividend or stock sale would generate. Because a trust is considered a pass through entity and issues a K-1, all taxes are paid at the individual investor level. Depending on the investors tax basis, distributions from the trust may be taxed at the individual investors earned income tax level.
Additionally, K-1 distributions can trigger tax events within IRA accounts making them undesirable in that application. Because of the added tax complexity around K-1 trust distributions, many funds won’t purchase a stock like Chesapeake Granite Wash Trust which could be one of the reasons it trades at half the P/E of many other oil and gas trusts in the space. Assuming you understand the K-1 impact on your own tax situation, this could be an opportunity for an individual investor with limited capital.
- ESG is placing downward pressure on all oil and gas stocks and CHKR is no exception. As discussed previously, even many of the fossil fuel companies don’t want to be associated with themselves and whether or not you agree with the ESG thesis supply and demand will ultimately determine the price of energy.
- Most stocks today can be traded commission free but CHKR commands a high commission per trade of nearly $7.00.
Conclusion:
Given the above information, who might consider owning this company and how might they go about it? Beginning with who. This works best for an individual investor with limited capital who’s earned income tax bracket isn’t too high. This is better for individual investors because K-1 distributions are a significant challenge for funds to deal with. An investor with thousands to invest and not millions can get a meaningful portion of their net worth in this investment without driving the unit price up and down through their purchase and or sale of the stock. A low earned income tax bracket is beneficial as it limits the tax payable on your K-1 distributions and most of this investments upside is in the potentially significant distribution you might receive in the future. Keeping taxes on those payout low is a benefit for obvious reasons.
As to how an investor could buy into Chesapeake Granite Wash Trust the following makes sense. First, purchase units in blocks large enough to negate the effect of the $7.00 per trade commission. Purchasing a single share for $1.00 is unlikely to ever pay off after you’ve spent an additional $7.00 in commission on the trade. Purchases of 1,000 shares at a time begin to negate the flat $7.00 commission on a trade of that size. Again, I do not recommend this investment for a tax-free account as it can generate tax consequences inside the account and negate the benefits of that structure. Finally, I would buy blocks of the stock slowly over time with the intention to hold until the liquidation date in 2031. With any luck the unit price will continue to decline against a backdrop of further supply constraints and increased demand. So long as market driven prices are re-established before the trust liquidates unit holders should be repaid well for their patience.
Well, that wraps up another episode of Special Situation Investing. We hope you’re research is benefited by your ability to share in the work we’re doing. Best of luck and we’ll see you again soon with another episode and more investing insights.
SUBSTACK ONLY BONUS
Special situations take many forms. One is when the majority of the market irrationally shuns an investment for reasons irrespective of its investment merits. We believe this is the situation with oil and gas today. It is currently socially unacceptable to invest in oil and gas. At the same time, oil and gas are still the backbone of our way of life. We believe this irrationality provides an opportunity.
Two sources that are essential to our research of the oil and gas industry are Trading Economics and the Railroad Commission of Texas. You can access these sites here and here.
Chesapeake Granite Wash Trust (CHKR)