Welcome to Episode 99 of Special Situation Investing.
In June 2017, it was revealed that a potential Jackson Pollock canvas found in a Sun City, Arizona, garage could be worth as much as $15 million. When appraiser Josh Levine was evaluating an elderly man’s belongings, he began to suspect that one painting might be a Pollock. Over the course of 18 months, Levine spent tens of thousands of dollars to authenticate the canvas, making the important discovery that its owner’s sister ran in an elite artistic social circle that included Pollock himself. The painting was scheduled to go up for auction that June with a starting bid of $5 million and an estimated value of $10 million to $15 million, but the sale was indefinitely postponed when prospective bidders failed to pass credit and bank checks. With two Pollock paintings found in improbable spots in recent decades, it might be wise to keep an eye out for his signature splattered canvases at flea markets, garage sales and thrift shops.
This story from history.com typifies one that we’ve all heard before: a valuable item sits unappreciated in plain sight, waiting to be scooped up at a bargain price, but is for one reason or another overlooked. The subject of today’s write-up is no different. It’s a rare and valuable asset sitting in the proverbial “old man’s garage” of the stock market just waiting to be discovered.
The description of the company that follows is sourced from the July 2022 Cedar Creek Partners Second Quarter Results Letter. The letter was written by fund manager Tim Eriksen of Eriksen Capital Management, LLC, and is used here with his permission.
Pacific Coast Oil Trust (ROYTL) is an expert market stock. It is one of the more complicated and interesting stories we have come across. It is an oil and gas trust that was sold to the public in 2012 at $20 per unit. The trust gives unit holders the right to 80% of cashflow after the payment of production and development costs for oil fields located in Los Angeles and Santa Barbara counties. At the time it went public, the seller, Pacific Coast Energy Company (PCEC), formerly Breitburn Energy, was retaining 52% of the trust units and selling 48% to the public.
Fast forward a few years, oil prices had declined from $100 per barrel to $60 and production had declined from 3,400 barrels per day to 2,200 resulting in sharply lower distributions. By 2018 the trust was trading between $2 and $2.50 per unit and paying roughly $0.30 per unit annually. In September 2019 PCEC was acquired by NewBridge Resources. Just a few weeks later, in October 2019 PricewaterhouseCoopers (PwC), the trust’s auditors resigned. In the 8-K filing on October 4, 2019 it stated, “PwC advised the Trust that information had come to PwC’s attention that causes PwC to be unwilling to be associated with the Trust’s financial statements in the future.” You don’t see that every day. The November 13, 2019 8-K notes that a 50% owner of NewBridge was or may have been affiliated with a company that filed for bankruptcy in 2015. Clearly there was more to the story. We have read unconfirmed reports that allege the buyers have criminal records that include embezzlement and insider trading. Talk about messy. Yet we aren’t actually done yet. That is only the who and the what, it is the how and the why that complete the picture.
In the same November filing, PCEC notified the trust that PCEC intended to deduct future plugging and abandonment costs (also known as asset retirement obligations, or ARO) from the amounts otherwise payable to the Trust under its Net Profits Interest beginning January 2020. The amount of estimated cost was $56.7 million. Annual payout from the trust at the time was about $10-11 million. The costs were not expected to occur for a number of years. Some wells were expected to be exhausted within five years, while for other wells it would be thirty years or more into the future. The assessment would result in no payments to unit holders for a number of years, which would trigger a clause forcing sale of the trust.
The trustee must have pushed back because PCEC commissioned Moss Adams to assist in determining the estimated asset retirement obligation (ARO). Moss Adams calculated it at $45.7 million, which was $11 million lower than before but would still trigger an eventual sale. The trust commissioned their own study by Martindale and came up with $28.7 million and communicated that the trust conveyance permits the amount to be accrued versus how PCEC wanted to treat it (all up front). It seems that the new owners of PCEC wanted to charge it up front knowing it would force sale of the trust in two years, and give PCEC all the cash flows in the interim. The trustee wanted to amortize the ARO over five years believing that was most equitable to unit holders, which was logical, but probably not consistent with GAAP (generally accepted accounted principles) which would require recognizing the present value of the liability immediately.
The prospect of no further distributions sent the unit prices plummeting to 30 cents. No quarterly or annual filings were filed as there was no auditor. Unit holders did get monthly updates via press releases and 8-K filings from the trustee on production, revenues, expenses, operating income and the 80% net profit interest. Then COVID hit and oil plummeted from $60 per barrel to near $0 before resettling around $30 and slowly climbing back toward $60 by fall 2021. Due to COVID, PCEC shut some production in. In July 2020 a unitholder filed suit. Unit prices fell to around 10 cents. Then it got even stranger. PCEC’s CEO who had the troubled past was ousted and supposedly blew the whistle in court. To make a long story a bit shorter. The court granted standing and prohibited dissolution of the trust. That eventually led to a three person arbitration panel that decided for PCEC, but that decision is still on hold pending settlement discussions.
Units are currently trading around $0.32 per unit. So why did we buy units? We came to the conclusion that there were only a few likely outcomes:
1) Worst case – Unitholders have to pay full ARO and it leads to Dissolution of Trust. The two years of no payments by the trust has already occurred (from spring 2019 to spring 2021), and assuming court decisions all go against unitholders it would lead to an auction of the interests, where after payment of what remains of the ARO the remaining balance of the proceeds would go to unitholders. In this scenario time is our friend, particularly now that oil has risen to around $100 per barrel. As of May 2022, the higher estimate of the ARO remaining was $14.3 million and the balance was declining at about $1.5 million per month. By the time of an auction it could be paid off or nearly so. With oil at $100 the trust is generating roughly $4.5 million per quarter or $0.12 per unit. What would an investor pay for the that? Assuming a conservative three-year payback for the buyer comes to $1.50, and a 5x return for the fund from current prices. If the buyer assumes oil averages $80 per barrel, then cash flow is $12 million per year, or $0.32 per unit, and a three-year payback valuation comes to $1 per unit or 3x the current price.
2) Some kind of settlement where PCEC buys out unitholders or agrees to amortize the ARO. A buyout would likely have a similar valuation of the worst case scenario. A settlement about ARO treatment would result in the trust continuing in existence and unit holders receiving monthly payments. With oil at $100, the trust would earn $0.12 per unit per quarter. What is that worth in the (expert) market if the ARO issue is settled? We think more than the worst case.
3) Bonanza – somehow the court finds PCEC acted inappropriately, or it finds that a major portion of the ARO has already been assessed. We noted to the group filing suit that the original prospectus noted that $22.3 million of ARO had already been accrued before the trust was created. Thus we think it is possible, if not likely, that PCEC is charging something that was already (partially) accrued for. If so, that is $0.66 per unit based on 38 million units outstanding. The value of the units could be near $2 or more.
The bottom line is we don’t know precisely what the units are worth, but our analysis concluded that it is likely more than the current price. We made it a 4% position in the fund. Hopefully we are not missing a key issue. Time will tell.
Again, the above thesis was written by fund manager Tim Eriksen who’s Cedar Creek Partners private investment firm has significantly outperformed the major indices since its inception in January of 2006. We encourage our readers to check out his website and twitter account for more insights from this thoughtful investor. But before we wrap up todays episode, it’s worth touching on one unusual barrier to investing in this stock.
Pacific Coast Oil Trust is traded on the OTC Expert Market. Due to the SEC’s amendments to Rule 15c2-11 that went into effect September 28th, 2001, companies that do not make or can not make current information publicly available to investors are listed on the Expert Market. Once on the Expert Market, trading the securities is limited by most major brokerages in the following ways:
Retail investors are not permitted to purchase the stock. Those who owned stock prior to the company being listed on the expert market can execute sell orders only.
Accredited investors can purchase the stock.
Fund managers can purchase the stock
It’s worth noting that Rule 15c2-11 itself does not limit who can or can not purchase expert market securities, rather it restricts broker-dealers ability to make quotes of those securities publicly available. It is the brokerages themselves, such as TD Ameritrade and Charles Schwab, that added the trading restrictions on top of the SEC’s amended rules.
With this limitation in mind investors, who can’t purchase expert market stocks, have a few options available if they want to purchase Pacific Coast Oil Trust. They can obtain authorization to purchase the security through a broker that is willing to purchase the security for them. They can invest in a fund such as Cedar Creek Partners which has a significant stake in the stock. Or they can wait for the stock to be moved off of the Expert Market once the company resumes filing of public financial information. The last option offers investors the lowest return of the three given that much of the money will have been made before it is relisted in the standard OTC market.
While the obstacles to purchasing Pacific Coast Oil Trust are frustrating we should keep in mind Charlie Munger’s fitting wisdom on the subject:
“Why should it be easy to do something that, if done well, two or three times, will make your family rich for life?”
Indeed, why should it be easy.
Wit that we wrap up another episode of the show.
Pacific Coast Oil Trust (ROYTL)