It has been said, practically since the dawn of time, that one of the greatest enemies investors face is their own emotions. Adopting affection or disdain for a stock as it is real person that can return those feelings usually ends poorly for investors. BP Prudhoe Bay Royalty Trust's (NYSE: BPT) is starting to prove as much.
For those that have not actively followed BP Prudhoe Bay Royalty Trust, here is a brief rundown of what has been happening since late August. For starters, some royalty trust basics are needed. BPT and scores of other royalty trusts are prized by income investors for high yields, strong payouts and tax advantages that are not found with ownership of common shares.
Along those lines, it is vital to note that while an energy-based royalty trust may be able to extract oil from a certain location for years upon years, the legal structure of U.S. trusts forbids the acquisition of new assets, meaning that at some point, royalty trusts are sitting on top of depleting assets. Granted, full depletion for many trusts, BPT included, is well into the future.
So this is what has been happening with BPT, the most recognizable brand name among royalty trusts, since late August. On August 24, the Wall Street Journal publish an article questioning BPT's market value while highlighting recent distribution cuts from other royalty trusts. The Journal piece was followed by this one on August 29 that highlighted some of the dangers income investors need to be aware of with royalty trusts.
What ensued was a firestorm of controversy. Between the Journal piece and the other article published on Seeking Alpha, nearly 60 comments were left on the two web sites, few of which were flattering. Acknowledging the obvious difficulty in summarizing almost 60 comments from dozens of different people, the crux of the criticisms of both articles was that since BPT had fallen from $120 on August 17 to below $77 on August 29, the sell-off combined with the seductive payout meant a buying opportunity.
Additionally, many BPT bulls all but acknowledged that oil production in Alaska is waning, but said the income offered by BPT is too compelling to ignore. Here is a harsh reality about Alaskan oil production. Peak production was reached in the 1988-1990 time frame. Alaska has been usurped by North Dakota as the No. 2 oil-producing state behind Texas. Alaska's 2010 oil output was the lowest since 1977.
Simply put, Alaska produced almost 2.1 million barrels per day in 1988. In 2011, that number plunged to 608,000.
Falling KnifeThose audacious enough to ignore all those facts and get involved with BPT in high $70s or low $80s, at a time when the units looked like a falling knife, could have done quite well for themselves. That is if they traded BPT, which is often used as a long-term instrument, as a trade.
An unfortunate reality of investing is that few investors are able to buy at a stock's absolute bottom and sell right at its peak. In other words, it is unlikely a lot of retail investors caught BPT at $76 and some change on August 29. More than likely, those investors were lured in by the yield sometime over the next few days in the $87-$89.
That made for a decent trade, assuming those folks dumped BPT on one of the multiple occasions the units hit $94 later in September. Chances are that did not happen because the primary reason investors own royalty trusts in the first place is the dividends. BPT's ex-dividend date was October 11 and the record date was four days later.
By the time payout arrived on October, investors that got involved in the $87-$88 area were out of the money by a couple of bucks, but the dividend would have them close to breakeven. That is not terrible, but now BPT is within spitting distance of its August low. BPT's almost 14 percent loss in the past month is nearly seven times as the SPDR S&P 500's (NYSE: SPY).
Flawed ReasoningTo be sure, some BPT bulls have made strong arguments. Read a few of them and it is clear this stock has some intelligent, savvy supporters. Unfortunately, a lot of those arguments revolve around the assumption that BPT will be able to pump 90,000 barrels of oil per day for as much as another 15 years.
Alaska's declining production numbers do not bode well for any company operating there being able to say with any modicum of certainty that it will be able to produce a static number of barrels for 15 months let alone 15 years. BPT proves as much. Third-quarter output was less than 66,000 barrels per day. That is down from less than 86,000 bpd in the second quarter and over 94,000 bpd in the first quarter.
Bottom line: It can be inferred from reading the comments of BPT supporters that these investors either believe Alaska's faltering crude output does not pertain to BPT or that BPT units and the dividend can at least remain stable in the face of that declining output.
The DividendThen there is the matter of the dividend. Since the payout from many trusts is based on production levels, dividends from trusts fluctuate. Said another way, assuming no increases, investors no that next year, Exxon Mobil (NYSE: XOM) will pay $2.28 a share in dividends. BPT's dividend is anything but static. That is not necessarily a bad thing, but dividend cuts have hit royalty trusts in force this year.
Hugoton Royalty Trust (NYSE: HGT) has seen seven consecutive months of lower dividends. Three of the past four payouts from Permian Basin Royalty Trust (NYSE: PBT) have been lower than the previous months. Same goes for San Juan Basis Royalty Trust (NYSE: SJT).
And like the dividend, BPT's proved reserves fluctuate, another factor investors have a hard time acknowledging. It might be an oversimplification, but the trust's proved reserves total moves in tandem with oil prices.
At the end of the day, there are some irrefutable truths about BPT. Investors are emotional about this stock. It has a seductive yield and payout. Oil production in Alaska is declining. Those that bought the stock in early to mid-September are now sitting on loser of a trade, the percentage loss of which cannot be covered by the most recent dividend. If another $4 or $5 comes off the units, BPT will be trading at its lowest levels in over three years. None of this sounds attractive, does it?
Sentiment: Strong Sell
Your analysis is pertinent; I posted similar thoughts not long ago. I believe there are 3 stages in the life of a US Royalty trust:
1. The ramp up to full projected production. A trust is IPOed as soon as first oil or gas is sold. But it takes several months to increase the production to the designed level. This is called in the trust bylaws, the number of wells or the number of wells per acres is stated. So for the first 30% of the life of the trust production ”MAY” increase.
2. The infrastructure is in place and is designed to produce at projected level for 60% of the life of the trust. The production infrastructure has an economic component. It must produce long enough at max rate to amortize the capital invested. That what the 60% represent, and is when the distribution is outstanding.
3. The last 30% represent the rate of reservoir depletion. The loss of production can and in many cases is replaced by the price increase of the oil or gas. At some point the loss of production cannot keep up with the prices. Distribution goes down or the unit price goes down more than the distribution. This is the time when perception by investors is all over the place.
Conclusion BPT is in the latter 30% and opinions are all over the place. I have been out of BPT since Q3, 2010, I sold at $105.
An alternative is to put money into a money market or CD for less than 1% instead of buying BPT low. Lower oil production may result in 5-6% returns, provided share price holds up. 5-6% return is a lot better than the expected Federal Reserve loan rate into 2015 or 2016.
Well written post. However it has been said that the devil is in the details. I have been retired from work at Prudhoe Bay since 1986 but I can recall from the peak production years that even then there were quarters with considerably lower deliveries than other quarters and this was with a virtually brandnew pipeline. Even then there were occasional problems with the pipeline and the pipeline had to be shut down until a bypass could be finished perhaps with a loss of delivery for a month. Various scheduled turnarounds will have a similar but lesser effect and now with continuous pumping for over 35 years an aging pipeline/pumpstations will need increased service. The point here is that declining production is only part of the equation. In addition from what I recall is that the pipeline was designed for 2 million barrels per day but was never operated at full capacity. I had stayed away from BPT for several years but when it dropped below $80 I became interested again. IMO under $80 it is worth taking a chance.
Speaking of the pipeline. I understand that the pipeline is designed to operate at 300,000 barrels per day or more. If the volume drops below 300,000 barrels per day they have to shutdown the pipeline or it will freeze up. With declining production from the Northshore, when does the pipeline reach this magic number ? By my math, unless new production is brought online, this magic number will be reached within 3 years.