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Energy Investing: Eagerly Awaiting the IPO of SandRidge Mississippian Trust II

By Elliott H. Gue on January 25, 2012

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Editor’s update: Shares of SandRidge Mississippian Trust II began trading on April 18, 2012. For more MLP IPOs, seeThe MLP IPO Boom and Its Discontents.

Closely monitoring the schedule of master limited partnerships (MLP) and US oil and gas royalty trusts slated for initial public offering (IPO) can pay off handsomely for income-seeking investors. Financial websites routinely miscalculate the yields offered by these securities until the fledgling stock has paid a full year of distributions. This oversight means that these high-yielding gems often don’t appear on investors’ radar screens for at least six months after going public.

Few investors bother to read the lengthy S-1 registration statements that sponsors file with the Securities and Exchange Commission prior to the IPO. These documents outline the MLP or royalty trust’s asset base, their exposure to commodity prices and management’s assessment of how quickly the distribution will grow during the first few years as a publicly traded entity.

If you take the time to cull through these statements and identify the likely winners, you can get in before the herd notices the trust’s rapidly growing quarterly payout and piles into the stock.

Looking Good

SandRidge Mississippian Trust II (NYSE: SDR) filed its first S-1 registration statement with the SEC on Jan. 5, 2012. Although this initial filing often lacks certain details, the document often contains enough information for you to ascertain whether the proposed IPO warrants further monitoring. This first glimpse into the structure and growth potential of SandRidge Mississippian Trust II, a spin-off of independent producer SandRidge Energy (NYSE: SD), suggests that the latest offering could be a winner–provided that the price is right.

SandRidge Energy’s first royalty trust, SandRidge Mississippian Trust I (NYSE: SDT), amended its S-1 form six times during the three months that transpired between the initial filing and the security’s first day of trading. Based on this precedent, SandRidge Mississippian Trust II’s IPO would likely occur in April.

SandRidge Mississippian Trust II represents a royalty interest in a series of existing and planned oil and gas wells in northern Oklahoma and southern Kansas. The 81,200 gross acres covered by the royalty interest, or area of mutual interest (AMI), are located in the Anadarko Basin, a mature oil- and gas-producing region where SandRidge Energy has amassed 1.5 million net acres.

These royalties entitle unitholders to 80 percent of the proceeds from 67 existing wells within the AMI and 70 percent of the proceeds generated by 206 developmental wells that SandRidge Energy will drill before the end of 2015. These wells will target the Mississippian formation, an oil-bearing deposit that’s been in production since the 1940s. Decades’ worth of geologic data and production records dramatically reduce drilling risk in the region.

Much like the Permian Basin of south Texas, portions of the the Anadarko Basin have recently enjoyed a renaissance, thanks to hydraulic fracturing and horizontal drilling.

Directional drilling enables producers to target a field’s most productive portions by carving out a well that branches off horizontally from the vertical shaft. Fracturing, or stimulation, increases the permeability of the reservoir rock, allowing natural gas to flow from the reserve rock into the well. This process involves pumping large quantities of water and a small percentage of chemicals into the rock formation at high pressure, producing a network of cracks.

Producers have drilled about 400 horizontal wells targeting the Anadarko’s Mississippian formation since 2007. With 19 horizontal drilling rigs, SandRidge Energy is one of the play’s most active operators.

Although crude oil accounts for slightly more than half the output from the AMI, elevated oil prices and depressed natural gas prices should ensure that more than three-quarters of the trust’s total revenue will come from oil sales.

SandRidge Mississippian Trust II won’t be responsible for the costs associated with drilling the 206 developmental wells outlined in the S-1 registration statement, though the trust will pay its share of post-production expenses. Investors will receive virtually all revenue net of expenses in a quarterly distribution. The trust will disburse these payouts about 60 days after the end of each quarter; unitholders will likely receive their distributions at the end of February, May, August and November.

The trust officially launched on Jan. 1, 2012, and will disburse its first payout (covering royalties from January and February) on May 30. Future distributions will cover three-month periods. Investors should note that the quarterly payouts will vary based on prevailing commodity prices, though SandRidge Mississippian Trust II will include two features that mitigate the effect any fluctuation in oil and gas prices have on the trust’s cash flow.

First, SandRidge Energy will hedge a portion of the trust’s oil and gas output. Amendments to the trust’s initial S-1 filing should outline the extent to which these hedges will cover estimated production, the commodity prices locked in by these hedges, and when these contracts will expire.

For a time, the trust’s subordinated units will also insulate the quarterly distribution from volatile commodity prices. SandRidge Energy will own about half the trust’s units after the IPO, including subordinated units that will account for 25 percent of the total outstanding units.

As long as the quarterly distribution received by individual investors exceeds 80 percent of the targeted payout, SandRidge Energy’s subordinated units will entitle the firm to the same payout. However, if the trust fails to generate sufficient cash flow to meet the minimum payout to all unitholders, SandRidge Energy would forego some of the distribution from its subordinated units to ensure that investors are made whole. As compensation for this risk, SandRidge Energy will receive a bonus payout on its subordinated shares if the quarterly distribution exceeds 120 percent of the targeted distribution.

Four quarters after SandRidge Energy completes the 206 developmental wells outlined in the prospectus, the subordinated units will automatically convert to common units. That is, if SandRidge Energy completes the 206 development wells as scheduled on Dec. 31, 2015, the subordinated structure will remain in place until Dec. 31, 2016. After this point, unitholders will have less protection against volatile commodity prices.

The subordinated and incentive thresholds established in the S-1 statement are based on targeted distributions; whether the trust’s cash flow enables its quarterly payout to meet these estimates hinges primarily on how much oil and gas SandRidge Energy lifts during the quarter and the prevailing prices for these commodities.

With years of experience operating in the AMI and decades of data, SandRidge Energy should have a good handle on oil output from the existing 67 wells and likely production rates from the 206 planned wells. SandRidge Energy likely erred on the side of conservatism when estimating quarterly production from the trust’s underlying wells; the subordinated units incentivize the sponsor to under promise and over deliver.

Check out this graph of the projected output from the trust’s producing wells and proven undeveloped (PUD) and probable reserves. The producing category comprises the trust’s 67 existing wells, while the other two categories estimate production from the 206 developmental wells. Output from PUD wells is less subject to risk, while those categorized as probable entail a bit more drilling risk.


Source: SandRidge Mississippian Trust II S-1

The forecast calls for output to increase through 2015 and taper off once SandRidge Energy completes its drilling program. Although production tends to decline quickly in the first few years after a well’s peak, this deterioration tends to stabilize at a slow-but-predictable pace thereafter. These wells won’t become uneconomic for some time and should have a relatively long life.

In fact, SandRidge Energy estimates that the trust’s assets could fetch about $185 million–more than $3.50 per unit–upon termination in 2031. In the interim, the trust will continue to generate quarterly income, albeit at a diminishing rate. Oil and gas trusts usually don’t suddenly crater in value once the underlying wells hit their peak production. However, rising output and distributions will attract income-seeking investors and send the stock price higher in the trust’s early years.

The commodity price assumptions underlying SandRidge Mississippian Trust II’s targeted distributions also appear reasonable.

Through 2014, SandRidge’s forecast calls for oil and natural gas prices to correspond to futures contracts on Jan. 3, 2012, a time when gas declined to a record low because of glutted inventories. Beginning in 2015, the company projects that commodity prices will increase 2.5 percent annually, with oil capped at $120 per barrel and natural gas capped at $7 per million British thermal units. Check out this graph depicting the firm’s forecast for natural gas prices.   


Source: SandRidge Mississippian Trust II S-1

The trust’s underlying commodity price assumptions call for natural gas to average less than $3.50 per million British thermal units in 2012 and to increase gradually to $4.50 per million British thermal units by mid-decade. According to this forecast, US natural gas wouldn’t hit $7 per million British thermal units until 2031. Although US natural gas prices should remain depressed for at least the next two to three years, the commodity’s long-term prospects are brighter. Despite my bearish near-term outlook for natural gas prices, SandRidge’s long-term projections could prove conservative.

Meanwhile, SandRidge Mississippian Trust II’s targeted distributions reflect oil prices that average $102.50 per barrel in 2012, $99 per barrel in 2013 and $95 per barrel in 2014. This forecast calls for oil to trade for less than $120 per barrel throughout next 20 years–an extraordinarily cautious outlook. I expect oil to eclipse $120 per barrel with increasing frequency in coming years.

The short distribution history of SandRidge Mississippian Trust I likewise suggests that SandRidge Mississippian Trust II’s targeted distributions (depicted below) will prove somewhat conservative.


Source: SandRidge Mississippian Trust II S-1

SandRidge Mississippian Trust I has paid two quarterly distributions since going public on April 1, 2011. The first of these payouts exceeded the target but not the incentive threshold, while the second topped the incentive level by a considerable amount. This admittedly brief distribution history suggests that SandRidge Energy may have under promised on its initial distribution targets.

My previous articles on US oil and gas royalty trusts–Trust in the Marcellus Shale and Why San Juan Basin Royalty Trust Rates a Sell–elicited a number of questions about the tax implications of investing in these pass-through entities.

This particular trust has elected to be taxed as a publicly traded partnership and will issue a K-1 form to investors. Investors usually receive the K-1 in March of each year. The document will detail exactly how your distributions will be taxed.

As a pass-through entity, SandRidge Mississippian Trust II won’t pay corporate taxes; instead, each unitholder will pay tax on their share of the partnership’s profits, eliminating the double taxation that occurs on most corporate dividends.

Even better, noncash accounting charges such as depletion and depreciation mean that the Internal Revenue Service (IRS) will consider a portion of your distributions as a return of capital, deferring your tax liability until you sell the trust’s units.

SandRidge Mississippian Trust II’s initial S-1 statement omitted an estimate of what percentage of the trust’s payout would be tax-deferred; amended registration statements will likely contain this information.

In general, investors should steer clear of holding pass-through entities such as MLPs and US royalty trusts in an IRA and other tax-advantaged accounts.

For one, holding pass-through securities makes their tax advantages redundant. Also, publicly traded partnerships generate unrelated business taxable income (UBTI), which can trigger taxes in a tax-advantaged account. You’re exempt from paying tax on up to $1,000 in total UBTI; after that, you can actually owe some taxes on UBTI payments.

Some investors make far too much of the potential tax liability associated with UBTI. Often, you would have to have a large amount invested in MLPs and other pass-through entities before exceeding the $1,000 threshold. In addition, the individual taxpayer is not the one who pays UBTI-related taxes; the IRA’s administrator muyst file a tax return and claim the UBTI (on IRS form 990). These taxes are owed by the IRA or 401(k) itself. Presumably, the administrator would then pass along any tax charges to you.

But SandRidge Mississippian Trust II’s S-1 statement indicates that the trust’s structure will avoid UBTI-related complications:

Tax-Exempt Organizations. Employee benefit plans and most other organizations exempt from U.S. federal income tax including IRAs and other retirement plans are subject to U.S. federal income tax on unrelated business taxable income. Because all of the income of the trust is expected to be royalty income, interest income, hedging income and gain from the sale of real property, none of which is unrelated business taxable income, any such organization exempt from U.S. federal income tax is not expected to be taxable on income generated by ownership of trust units so long as neither the property held by the trust nor the trust units are debt-financed property within the meaning of Section 514(b) of the Internal Revenue Code. In general, trust property would be debt-financed if the trust incurs debt to acquire the property or otherwise incurs or maintains a debt that would not have been incurred or maintained if the property had not been acquired and a trust unit would be debt-financed if the trust unitholder incurs debt to acquire the trust unit or otherwise incurs or maintains a debt that would not have been incurred or maintained if the trust unit had not been acquired.

This passage indicates that payments made by SandRidge Mississippian Trust II could be held in an IRA without incurring UBTI tax.

A British reader also asked about his tax liability on distributions paid by US royalty trusts. In this instance, SandRidge Mississippian Trust II’s S-1 indicates that “non-US” investors will have a portion of their distributions withheld; the US government routinely withholds taxes paid on dividends at different rates for investors who live in other countries. In most cases, treaties between the US and foreign tax authorities allow you to reclaim any taxes withheld as a credit against your foreign tax liability.

At this early stage in the security registration process, SandRidge Mississippian Trust II’s tax advantages, exposure to oil prices and potential for distribution growth make the stock worthy of consideration. However, much of this depends on the price at which the trust debuts; no stock is a buy at any price.

Based on the current distribution estimates and the yields of other, similar trusts I would regard SandRidge Mississippian Trust II as a buy under $24 per unit and a steal at less than $20.50 per unit. I will continue to track the trust’s IPO process in upcoming issues of The Energy Strategist.

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Stock Talk

  1. avatar
    Elliott Gue Reply April 5, 2012 at 6:03 PM EST

    Dear Mr. Wilson —
    I think there’s been a bit of confusion about this. There is actually no change on the latest amended S-1 Registration statement for SandRidge Mississippian II (SDR). The trust will receive royalties of 80% on producing wells and 70% on development wells. But these percentages are based on SandRidge Energy’s stake in the wells. In other words these are a percentage of the net revenues the parent SandRidge Energy (SD) receives from the underlying wells.

    SandRidge owns an average working interest of a little over 50% on the producing wells and a bit less than 50% on the development wells. So, the 35% figure you quote is simply that 70% gross percentage adjusted by SandRidge’s stake in the wells (35% is roughly half of 70%).

    To compare the two SandRidge Mississippian trusts on an apples to apples basis, one must look at net percentage interests. On that basis SandRidge Mississippian II (SDR) actually has a higher percentage stake in development wells than SandRidge Mississippian I (SDT). SandRidge Mississippian I’s net interest in development wells was only 28.5%.

    By the way, this IPO is coming very soon and looks like it will price in the $19 to $21 range. We’ll have to see how it trades after coming public to determine if it’s a good buy.

  2. avatar
    jon wilson Reply April 3, 2012 at 10:10 PM EST

    thr amended registration agreement indicates the trust will have a 35% interest in the 206 development wells. This is a far cry from the 70% interest held by SDT.
    I just lost interest!

  3. avatar
    Scott Reply April 1, 2012 at 10:46 AM EST

    Nice info

  4. avatar
    FEW Reply March 30, 2012 at 9:17 PM EST

    I suspect that the “under the radar” syndrome may be a thing of the past, since so many of these IPO’s seem to go to a premium faster and faster. I hope this one is priced right. Good show Elliott. FEW

  5. avatar
    tom velte Reply March 30, 2012 at 8:59 AM EST

    when will ipo take place

  6. avatar
    Elliott Gue Reply March 28, 2012 at 12:21 AM EST

    Thanks for all of the comments about my article. There is no way to be absolutely certain but I suspect SandRidge Miss. II (SDR) will go public in either the first or second week of April.

    Also, please see my article about another new trust, Whiting USA II (NYSE: WHZ), posted today http://www.investingdaily.com/14981/evaluating-whiting-usa-trust-ii

  7. avatar
    robert millman Reply March 26, 2012 at 3:44 PM EST

    I am writing as of March 26 2012/ When do you expect the Sandrigde Miss. II IPO to take place? Thank you

  8. avatar
    B Reply March 25, 2012 at 10:46 PM EST

    B

  9. avatar
    Joseph Gamarano Jr Reply March 24, 2012 at 5:45 PM EST

    I Own SDT. Please advise when SDT II is available to buy. Thank You. JG

  10. avatar
    Jayne Ryan Reply March 19, 2012 at 12:08 PM EST

    Can you please advise when SDR will be available for buying?

  11. avatar
    lois truelson Reply March 17, 2012 at 12:07 PM EST

    I am very interested in purchasing – Please advise as soon as possible re the IPO date.

  12. avatar
    ronald gurak Reply March 16, 2012 at 1:45 PM EST

    I would like an advance notice as to the IPO date.
    Please keep all of us in-formed as more news comes out.

  13. avatar
    Jerry Hodgdon Reply March 15, 2012 at 1:45 PM EST

    I am very interested in purchasing shares of SDR. Please let me know in advance as when the IPO is available Thanks

  14. avatar
    william bollow Reply March 12, 2012 at 12:56 PM EST

    All the information I’ve been looking in one great article. Please keep all of us in-formed as more news comes out.

  15. avatar
    william bollow Reply March 12, 2012 at 12:47 PM EST

    All the information I’ve been looking for and in one great article. Please keep us updated as news comes out.

  16. avatar
    larry cadle Reply March 11, 2012 at 4:52 PM EST

    I would like an advance notice as to the IPO date. Thanks.

  17. avatar
    Huff Reply March 11, 2012 at 11:51 AM EST

    Nice article. Looking forward to future info on SDR and others.

  18. avatar
    Huff Reply March 11, 2012 at 11:28 AM EST

    Very nice. Looking forward to future information.

  19. avatar
    james t. Reply March 8, 2012 at 3:27 PM EST

    Can you let me know when the first chance I can purchase. Thanks, Jim

  20. avatar
    Bruce Reply March 8, 2012 at 11:00 AM EST

    A Very thorough treatment of SDR. Much appreciated Elliott, thanks. I hope to read your followups. Bruce

  21. avatar
    ANDY PRESENT Reply February 24, 2012 at 2:19 PM EST

    WHEN WILL SANDRIDGE MISS TRUST BE PUBLIC AND WHO ARE THE UNDERWRITERS?

  22. avatar
    ROBERT McGINNIS Reply February 21, 2012 at 4:05 PM EST

    pls. keep me informed when the new issue will be out

    THANKS / ROBERT

  23. avatar
    VINOD MOTIANI Reply February 19, 2012 at 12:26 PM EST

    interesting article
    keep us posted when the IPO floats

  24. avatar
    kenneth kam Reply February 19, 2012 at 1:00 AM EST

    dear sir,

    please keep me updated of the ipo sdr trust. i never bought trust, but i have reits such as agnc, arr, and intc. i was looking at sdt,per,chkr. i do not know which one is better. it sounds like sdr is the best trust. the whx and northern ore trust terminate soon 2015 and 2017.

    thank you,
    kenny

  25. avatar
    j Reply February 18, 2012 at 11:56 AM EST

    Looks good.

  26. avatar
    bill wardle Reply February 18, 2012 at 11:18 AM EST

    how do I buy sandridge trust 11-it aooears tha #1 is listed.thanks ,bill

  27. avatar
    Michael Smith Reply February 17, 2012 at 12:14 AM EST

    The ticker symbol of the Mississippian Trust II will be SDR, and it is to IPO around mid April. As like everyone else, still waiting for the prospectus, but this should be another good Sandridge Trust. I own PER, and SDT already, and playing long on both. Good Luck

  28. avatar
    David Dicus Reply February 8, 2012 at 6:34 PM EST

    I am locked out of the IPO because Vanguard doesn’t allow investment via IPO’s. Please let me know when SDR goes public, a date would be good?

  29. avatar
    James Robinson Reply February 5, 2012 at 11:20 PM EST

    Dear Sir/Mam, I’m a share holder of ‘SD’ and would love to get ticker symbol for the new ” SandRidge Mississippian Trust 11″ Also when will this Trust be in effect.

    Thank You, JAMES ROBINSON

  30. avatar
    Paul Rosen Reply February 1, 2012 at 11:16 PM EST

    Dear Mr Gue:

    I am writing to you at the suggestion of Roger Conrad. As an income investor, my broker has recommended SDT and PER. I am a little concerned about buying either of them at current prices. Comparing the two, which do you prefer and what are your feelings about buying them at their current high prices.

    Thank you
    Paulro413@Gmail.com.

  31. avatar
    John Friedlund Reply January 31, 2012 at 8:16 PM EST

    GREAT article, thanks.

  32. avatar
    Donald Dahler Reply January 31, 2012 at 7:48 PM EST

    Very interesting article please keep me informed.

  33. avatar
    Yellojs Reply January 30, 2012 at 7:33 AM EST

    do we have any idea when the “shares” of the SandRidge II trust will hit the market?

  34. avatar
    Michael BeernaertMichaqel Reply January 29, 2012 at 5:41 PM EST

    Good analysis

  35. avatar
    lonnie perry Reply January 29, 2012 at 4:21 PM EST

    thanks for the info. verry Good reading

  36. avatar
    Richard Pfeifer Reply January 29, 2012 at 9:59 AM EST

    looking forward to this IPO.

  37. avatar
    bill boyce Reply January 29, 2012 at 9:42 AM EST

    is per as good an investment as sdt?

  38. avatar
    Richard Hodges Reply January 28, 2012 at 8:03 PM EST

    Interested – have shares of SDP – will follow/watch for updates

  39. avatar
    Martin Gough Reply January 28, 2012 at 7:08 PM EST

    What on earth is the point of having to type the hieroglyphic words below ?

  40. avatar
    PMWilliams Reply January 28, 2012 at 4:44 PM EST

    Mr. Jim,
    This is interesting. From everything you read the Mississippian Lime play seems to be much more prolific than the Permian situation. We might consider maybe selling the PER and then trying to pick – up the Mississippian Trust II. If we can get it for around 20.00, it would be even better.
    See what you think.

    Regards,
    PWilliams

  41. avatar
    John Wright Reply January 28, 2012 at 3:05 PM EST

    Just when did you put the above recommendation out (date), as stock has not traded anywhere near that level in sometime.

  42. avatar
    robert wilt Reply January 28, 2012 at 1:58 PM EST

    Very good. Thank you.
    I am interested in buying.

  43. avatar
    Bob Carr Reply January 28, 2012 at 1:24 PM EST

    The US government does not have a tax treaty with Great Britain. If for instance you wanted to buy Royal Dutch Shell if you buy the British version there is no tax with held but if you buy the Dutch version 15% is with held by the Dutch with whom we do have a tax treaty. The US government does not withhold taxes from British Citizen or Bermuda either.

  44. avatar
    ronald ferrill Reply January 28, 2012 at 12:11 PM EST

    Excellent piece on the SR M trust II. You have covered more detail and explained more about the specifics of the trust’s properties and the investment implications than any of the underwriters. They just said, wait until the prospectus comes out.

    this is the kind of information that can truly help an informed investor make decisions – Thank You.

  45. avatar
    Ron Engan Reply January 28, 2012 at 11:25 AM EST

    great article. well written. simple read. keep me posted. thanks

  46. avatar
    dick congel Reply January 28, 2012 at 10:43 AM EST

    if the stock sells for $24. what would be the app interest return..
    thank you

  47. avatar
    H Moreau Reply January 28, 2012 at 10:25 AM EST

    Thhx,please keep me advised.

  48. avatar
    Robert Boos Reply January 28, 2012 at 9:15 AM EST

    Thank you for the update as we all await an opportunity to purchase this new trust.

  49. avatar
    Robert Smith Reply January 28, 2012 at 7:50 AM EST

    As an investor in SandRidge Mississippian Trust I, I’m interested in learning more about SDR.