Editor's Note: This research note was originally sent to subscribers on May 20, 2014 by Hedgeye Energy analyst Kevin Kaiser. Follow Kevin on Twitter @HedgeyeENERGY.
I'll pay you $1 per year for the next 8 years. The payments are not guaranteed, they have equity-like risk. How much would you pay me today for this deal? A BPT long would give me $10.
BP Prudhoe Bay Royalty Trust (BPT) lives in the obscure world of high-yielding energy equities where retail investors value securities as if the current distribution is a perpetuity – the ultimate Efficient Markets Hypothesis refutation...
We added Short BPT to our Best Ideas list on 1/15/2014 at $77.24/unit. We've been wrong on the scoreboard, but don't believe that the fundamental analysis is off. In our view, BPT is still a $1 bill selling for $2. And sure, this $1 bill could trade at $2.50 or $3.00, but that only makes it more of a short.
In hindsight, we underestimated just how inefficient the market for BPT is. With virtually no institutional holders and limited units available to borrow, it's uncertain when (not if) BPT will move to intrinsic value, which we calculate to be $49.70/unit, 47% below the current price of $94.40.
Perhaps we are too early, as the true distribution-destroying function of this trust – the automatic increases to the trust's chargeable costs – do not begin to increase drastically until 2018. By that point, the writing on the wall should be more obvious. However, BPT collapsed ~50% in the second half of 2012, and the same thing could have been said back then.
In the short-term, seasonality is now on our side, as the next two distributions payments should be below the $3.01/unit distribution paid in the second quarter of 2014 given summer field maintenance.
Provided the borrow cost is reasonable, we still think that BPT is a solid short. If you hedge out the WTI price risk, you're short negative carry and playing for ~50% downside to net asset value (NAV). Pair a quality, reliable oil producer like an EOG Resources, Anadarko, Denbury Resources, Suncor Energy, Canadian Natural Resource, or Imperial Oil against it.
We've updated our BPT NAV model for the recent increase in the WTI strip, the changes to the production tax regime, and a lower discount rate. Our base case NAV assumes: production declines at 2% per annum; future oil prices equal the current WTI strip; the current tax regime (35% base + a production credit); 1.5% annual CPI; and a 7.75% discount rate. We calculate the discount rate (BPT's cost of equity) using the capital asset pricing model and the following assumptions: R-free = 2.50%, R-market = 10.0%, Beta = 0.70.
The result is a NAV of $49.70, 47% below BPT's current price. And the undiscounted sum of future distribution payments is only $66.20.