What happened

Shares of oil and gas royalty trust BP Prudhoe Bay (NYSE:BPT) are down 17% as of 11:45 a.m. EDT today. The likely impetus for today's drop was the Friday announcement of the trust's dividend payout for the quarter. 

So what

If you were to look up BP Prudhoe Bay's dividend payouts over the past year, you would find that the trust paid out about $5.07 per share -- which, at today's stock price, makes for a rather fat yield of better than 18%.

I'm sure that there were a few people out there who saw that number and immediately assumed this stock was a steal.

The trouble is, BP Prudhoe Bay's dividend isn't a fixed amount. It is a royalty payment based on the price of a barrel of oil during the quarter and the amount that the operator of the field -- in this case, BP (NYSE:BP) -- extracts. During the fourth quarter, oil prices were considerably lower than what they were in the previous quarters. As a result, the royalty payment for the quarter was $0.33 per unit.

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Valuing BP Prudhoe Bay Royalty Trust

Summary /

It has been challenging to determine a price target for BPT despite expectations for declining future cash flows.

Attempts to apply the dividend discount model have grossly underestimated the price that market participants have been willing to pay.

Historical yields may provide some clue to the future price.

In my article from last March, I set out a base case for the future distributions likely to be paid by BP Prudhoe Bay Royalty Trust (BPT). With the release of the Trust’s 2018 10-K, I wanted to update my thoughts regarding valuation.

Using the WTI price at the time, $62.12, I estimated that the distributions for 2018 would total $4.84. Despite the twelve-month average WTI price rising to $65.56, however, the actual distributions totaled only $5.07, offset by lower production in the Prudhoe Bay field.

This leads me to updated predictions for this year’s distributions and beyond. According to the 2018 10-K:

Based on the 2018 twelve-month average WTI Price of $65.56 per barrel…BP Alaska calculated that as of December 31, 2018 production of oil and condensate from the proved reserves allocated to the 1989 Working Interests will result in undiscounted estimated future cash flow to the Trust of $154.662 million, with a net present value of estimated future cash flows at 10% discount of $138.541 million.

This equates to future distributions per unit of $7.23 and $6.47, respectively. Furthermore:

Based on the 2018 twelve-month average WTI Price of $65.56 per barrel…it is estimated that royalty payments to the Trust will continue through the year 2022, and would be zero in the following year.

These estimates are to be expected, as the 10-K has previously utilized the prior year’s twelve-month average WTI price in making its calculations. Therefore, these estimates are backward looking.

If we take a real time approach, however, the outlook is not as positive. For this, we can utilize the formula for determining the quarterly distribution:

(WTI Price - (Chargeable Costs x Cost Adjustment Factor) - Production Taxes) x 0.164246 x Daily Net Production x Days in Quarter / Unit Count = Quarterly Distribution

The average WTI price for the first quarter of 2019 is currently at $53.24. With Chargeable Costs increasing to $23.75, a most recent Cost Adjustment Factor of 1.942, estimated Production Taxes of $1.82, and a maximum possible Daily Net Production of 90,000 barrels per day, I predict that the distribution for the first quarter will be approximately $0.33.

. . . It is pretty clear that BPT has a limited lifespan. Indeed, as the 10-K states: “Royalty Production from the Prudhoe Bay field is projected to decline and will eventually cease.” What has eluded many of us is how to assign a valuation to this asset now that the accelerated Chargeable Costs that began in 2018 are significantly impacting cash flows.

Attempts to apply the dividend discount model to BPT (which seems like a logical approach) have grossly underestimated the price that market participants have been willing to pay for it. As illustrated above, one can argue that current fair value is as low as $2.50—a far cry from the most recent close of $26.86.