Evaluating Whiting USA Trust II

Whiting USA Trust II (NYSE: WHZ) went public on March 23, 2012. The trust’s initial public offering priced at $20 per unit–the midpoint of management’s projected range–and the stock finished its first full day of trading above $24 per unit.

Whiting USA Trust II is the second oil and gas trust spun off by Whiting Petroleum Corp (NYSE: WLL), an independent producer seeking to raise capital to support an ambitious drilling program in the Bakken Shale.

The exploration and production company listed its first royalty trust, Whiting USA Trust I (NYSE: WHX), in early 2008–about nine months before Lehman Brothers declared bankruptcy and the stock market imploded. Nevertheless, the stock has generated a total return of about 75 percent since its first day of trading, compared to the S&P 500’s paltry 10 percent gain over the same period.

Whiting USA Trust II represents a royalty interest in oil and gas properties located in the Rocky Mountains, Permian Basin, Gulf Coast and Mid-Continent. The acreage covered by the trust includes 49 fields, the majority of which are mature, and 1,300 gross wells, all of which are in production.

More than 96 percent of these reserves are classified as proved, developed producing (PDP), indicating that these featur little production risk. Crude oil accounts for about 72 percent of the hydrocarbons extracted from the area of mutual interest, while natural gas accounts for 25 percent and natural gas liquids (NGL) make up the remaining 3 percent.

Investors in the trust are entitled to 90 percent of the net proceeds–the gross proceeds from the sale of commodities minus production, development and operating expenses–from the sale of oil, NGLs and natural gas produced in the area of mutual interest.

Whiting USA Trust II will terminate on Dec. 31, 2021, or when 11.79 million barrels of oil equivalent from these wells have been sold–whichever occurs last.

Whiting Petroleum has contributed hedges covering about 50 percent of the trust’s expected oil and gas production between April 1, 2012, and Dec. 31, 2014. The contracts feature a price floor of $80 per barrel and a ceiling of $122.50 per barrel. After these hedges expire, the trust’s cash flow and distributions will hinge on production levels and prevailing commodity prices.

Investors must remember that US royalty trusts aren’t operating companies; these pass-through entities can’t take on additional hedges or bolster production through acquisitions.

Valuing the Trust

When evaluating US oil and gas trusts, you should first consider the pass-through entity’s production mix and the outlook for commodity prices.

Our forecast calls for North American natural gas prices to remain depressed for at least the next two to three years, though an extraordinarily hot summer, a frigid winter or hurricane-related supply disruptions in the Gulf of Mexico could lead to temporary spikes to $4 per million British thermal units. Nevertheless, the ongoing flood of production from the nation’s prolific shale plays should overwhelm these short-lived tailwinds.

With oil prices likely to remain elevated as the global supply-demand balance tightens, Whiting USA Trust II’s oil-weighted production profile bodes well for its future cash flow and distributions.

We also prefer oil and gas trusts that can grow production dramatically in the near term. As I noted in the Jan. 25, 2012, issue of The Energy Letter, SandRidge Mississippian Trust II’s (NYSE: SDR) sponsor has agreed to augment the 67 producing wells on the trust’s underlying acreage by sinking 206 developmental wells before the end of 2015.

As these new horizontal wells come onstream, output from the properties covered by the trust will increase, resulting in higher quarterly distributions for unitholders. Check out this graph of SandRidge Mississippian Trust II’s targeted disbursements.

Source: SandRidge Mississippian II S1/A

Although this trust’s initial public offering won’t take place until early April 2012, similarly structured pass-through entities such as SandRidge Mississippian Trust I (NYSE: SDT) and Chesapeake Granite Wash Trust (NYSE: CHKR) have generated substantial returns in their short lives. In this low-yield environment, a growing quarterly distribution is bound to attract investors’ attention.

Whiting USA Trust II, on the other hand, lacks the potential upside associated with additional field development; the trust’s sponsor will act “as a reasonably prudent operator” and perform basic maintenance to support ongoing production. Whiting Petroleum’s 10 percent royalty stake in these wells incentivizes the firm to take these obligations seriously.

Nevertheless, management expects output from the trust’s underlying wells to decline at an annualized rate of 8.4 percent over the next decade.

The fledgling trust’s predecessor, Whiting USA Trust I, launched about four years ago and provides a reasonable preview of what investors should expect in terms of production. In the first quarter of Whiting USA Trust I’s existence, its underlying properties flowed 204,026 barrels of oil, compared to a quarterly average of 185,000 barrels in 2011.

The graph below tracks management’s production estimates for Whiting USA Trust II’s royalty interest.

Source: Whiting USA Trust II S-1/A

Based on these production estimates, the trust’s distributions have two upside catalysts: Rising commodity prices or a slower-than-anticipated decline rate on the trust’s wells. Although we expect oil prices to remain range-bound in the near term, growing demand in emerging markets and challenges bringing incremental supply growth online should send oil prices higher in coming years. US natural gas prices could also strengthen over the long term as new sources of demand emerge.

Output from the wells in which Whiting USA Trust II has an interest could also surprise to the upside.

At the time of Whiting USA Trust I’s initial public offering in 2008, management estimated that the trust would terminate in 2017 after achieving the production milestone established in its prospectus. In the intervening years, output from these fields has outstripped this initial forecast; based on updated reserve reports, Whiting USA Trust I should reach this milestone on Nov. 30, 2015. At the time of termination, unitholders won’t receive any additional money or income from the sale of assets; distributions will cease at this time, and the trust will no longer exist.

Whiting USA Trust II has removed the possibility of an early termination by instituting terms that will ensure that the pass-through entity will continue until at least Dec. 31, 2021, even if production from the underlying wells reach their targeted output earlier.

What’s a reasonable market value for Whiting USA Trust II?

Let’s use the dividend discount model (DDM), a classic valuation method that reflects one of finance’s core principles: the time value of money, or the idea that $1 today is worth more than a $1 in the future. This general increase in the price of goods and services means that rational investors would regard $1 paid a year later as less valuable than $1 received today.

Opportunity cost also factors in to the equation. That is, if you lend someone $100 today, you give up the chance to invest that $100 in a portfolio of stocks or bonds or to put that $100 in a savings account. You would seek some sort of return on the loan as compensation.

The DDM assumes that a stock is worth the net present value (NPV) of its future dividend payments to shareholders. This approach requires an estimate of how much a company will pay in dividends over the holding period and to discount the total based on a desired annualized rate of return. The sum of all these discounted payments represents the security’s current value.

This valuation technique has a number of shortcomings. First and foremost, predicting the dividends a company will pay in the future is rife with uncertainty and subject to significant error.

Selecting an appropriate discount rate is another challenge. You usually increase the discount rate for a stock that entails more risk or volatility, a decision that reduces the security’s NPV. The required discount rate should also vary with prevailing interest rates. When 10-year US Treasuries yielded almost 7 percent in early 2000, few investors would have taken on the additional risk involved in holding a stock expected to offer a 6 percent annualized return. However, the prospect of a 6 percent annualized return is far more enticing today, with 10-year US government bonds yielding less than 2 percent.

Unlike operating companies that can grow through acquisitions, trusts have a finite life span and hold royalty interests in specified oil and gas wells. Whereas an operating company might grow production by drilling more aggressively or targeting another oil- or gas-bearing formation, trusts are bound by the terms laid out in their prospectus.

Whiting USA Trust II’s most recent S-1/A statement doesn’t offer detailed distribution forecasts through its projected termination date in 2021, though the document includes several clues.

In 2011 the trust’s properties yielded 1.41 million barrels of oil and 2,885 million cubic feet of natural gas, which would have amounted to a full-year total distribution of $3.53 per unit. Management estimates that the wells in which Whiting USA Trust II holds a royalty interest will produce 1.259 million barrels of oil and 2,228 million cubic feet of gas, which would represent production declines of 10.7 percent and 22.8 percent, respectively. Despite the decline in output, management expects the full-year distribution to increase to $4.02 per unit, largely because of higher price realizations on oil output.

I recalculated the trust’s 2011 pro forma distributions using commodity price assumptions for 2012. On that basis, 2011 distributions would have been about $4.33 per unit, had commodity prices in 2011 been as high as they’re projected to be in 2012. This calculation take into account considerably lower natural gas prices in 2012. In other words, on a constant-commodity-price-basis, the trust’s distributions are expected to decline about 7.2 percent.

Whiting USA Trust II’s S-1/A statement estimates that production from the underlying wells will decline at an average annual rate of 8.4 percent over the next decade.

When evaluating an oil and gas trust, I consider conservative and aggressive forecasts of its future distributions, especially in instances where details are scarce.

My conservative case assumes that Whiting USA Trust II’s disbursements will decline at an average annual rate of 9.5 percent over the next 10 years; my aggressive forecast calls for a 7 percent annualized decline in the payout to unitholders. The first scenario factors in a discount rate of 7.5 percent discount rate, while the aggressive forecast includes a discount rate of 6.5 percent.

My conservative model estimates the trust’s market value at $20.25 per unit, while my aggressive valuation scenario yields a value of $23 per unit.

Historically, oil and gas trusts tend to trade at levels that outstrip my aggressive valuations in their first year or two as a publicly traded entity, likely because investors are attracted to the stocks’ elevated yields. Whiting USA Trust II’s trading history could follow this pattern. If the trust hits its first-year distribution target, the stock would yield 17.5 percent at current prices. This sky-high distribution yield should prove popular with investors, even though the trust’s quarterly payouts will likely decline as production from the underlying wells declines.

Based on the trust’s structure and my valuation model, Whiting USA Trust II is a good buy if the stock dips to less than $22 per unit.