The area of mutual interest (AMI) covered by SandRidge Mississippian Trust II includes about 81,200 gross acres in northern Oklahoma and southern Kansas. Unitholders will receive 80 percent of net proceeds from oil and natural gas production from 67 producing wells in the AMI and 70 percent of the net proceeds 206 horizontal wells that the sponsor, SandRidge Energy (NYSE: SD), will drill in the area. These developmental wells will be completed by Dec. 31, 2015; rising production during this drilling program should generate substantial distribution growth during the trust’s first two to three years.

The net revenue from the sale of oil and natural gas production will vary with commodity prices. But SandRidge Mississippian Trust II includes two features that protect unitholders from volatile commodity prices in the intermediate term: extensive hedging and a subordinated-unit structure.

Although the trust will hedge its expected production in the first few years after the IPO, the recently amended prospectus didn’t include an estimate of the exact percentage of the expected oil and gas output that these hedges would cover.

The trust’s subordinated units will also insulate the quarterly distribution from volatile commodity prices for a time. SandRidge Energy will own a little less than half the trust’s units after the IPO, including subordinated units that will account for 25 percent of all 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.

In its most recent registration statement, SandRidge Mississippian Trust II updated its target distributions to reflect shifts in commodity prices since filing its initial S-1 form in January. These new estimates reflect prices in the oil and gas futures markets on March 5, 2012.

Oil accounts for just under half the reserves on the trust’s AMI, with natural gas accounting for the remainder. Although the outlook for oil prices remains sanguine, natural gas prices continue to hover near multiyear lows and should remain depressed for at least next two to three years.

Fortunately, gas futures near their nadir on March 5, suggesting that management didn’t factor in any significant upside for this commodity price when estimating the trust’s quarterly distributions. In fact, the trust assumes that US natural gas prices won’t eclipse $7 per million British thermal units between now and 2031–an extremely conservative outlook.

This graph tracks SandRidge Mississippian Trust II’s targeted distributions from its inception to its termination.

Source: SandRidge Mississippian II S-1/A, Amended March 15, 2012

The trust expects to increase its payout rapidly through 2016–when SandRidge Energy will drill actively in the AMI–with the estimated distribution topping out at $0.86 per unit in the first quarter of 2016. After this drilling program is completed, the trust’s quarterly disbursements will drop sharply before declining at a slow-but-steady pace until the trust terminates in 2031.

SandRidge Mississippian Trust II will also sell the AMI acreage at this end date and distribute the proceeds (an estimated $3.93 per unit) among investors.

Based on the structure and performance of SandRidge Mississippian Trust I, the trust’s distribution estimates will likely prove conservative. In particular, I suspect that SandRidge will sink the required 206 developmental wells more quickly than anticipated over the next two years. Buy SandRidge Mississippian Trust II (NYSE: SDR) under 23.