2014 Oil & Gas Royalty Trust Roundup

Disclaimer: I know a lot more about building software than I do about investing, so please take everything you read below with a heaping spoonful of pink Himalayan salt.

Picking stocks is a fool's errand for individual investors. With an entire industry devoted to finding inefficiencies in equity markets, the chance of me finding one is probably pretty slim. In light of this, many choose instead to focus on asset allocation, building portfolios out of entire asset classes and rebalancing as the performance of those asset classes diverges.

While active security selection is futile in crowded, efficient markets, it may be quite profitable in markets where pricing inefficiencies persist for weeks, months, or even years. In this post, I'll be doing some naive analysis to attempt identify undervalued assets in a market that seems rife with inefficiency: publicly traded oil and natural gas royalty trusts in the United States.

The mechanics of a royalty trust are fairly simple. A trust owns rights to the net profits from the sale of oil and natural gas from a specified number of producing wells. The value of a trust is therefore equal to the net present value (NPV) of the stream of distributions it will pay to its unit-holders. Once we've calculated this, we only need to find the number of outstanding units and do some simple arithmetic to determine at a reasonable per-unit price.

Some time in February or March, each trust publishes its annual 10-K report for the previous year, which includes a measure of NPV called the "standardized measure of discounted future cash flows". This measure is calculated using current oil and natural gas prices, the trust's estimate of proven reserves, and a discount rate of 10%. I could try to back my own NPV calculation, but I'm feeling lazy, so we'll use this to generate our target prices.

The following table contains the data I was able to collect from annual reports, current year dividend histories, and current market prices for all but a handful of the publicly traded oil and natural gas trusts in the United Staes.

Symbol	NPV w/ 10% Discount Rate at EOY 2013	Units Outstanding	2014 Distributions (Per Unit) as of 4/22	Expected Unit Price	Actual Unit Price	Premium to NPV
ROYT	$501,822,000.00	38600000	$0.51	$12.49	$13.01	4.16%
MVO	$279,592,525.00	11500000	$1.71	$22.60	$24.98	10.50%
WHZ	$225,064,440.00	18400000	$0.65	$11.58	$13.47	16.30%
SDR	$378,716,000.00	49700000	$0.57	$7.05	$8.28	17.45%
PER	$584,300,000.00	52500000	$0.64	$10.49	$12.62	20.31%
WHX	$37,151,000.00	13900000	$0.56	$2.11	$2.57	21.64%
VOC	$231,220,050.00	17000000	$1.09	$12.51	$15.38	22.93%
BPT	$1,546,123,000.00	21400000	$5.54	$66.71	$85.67	28.42%
SDT	$174,423,000.00	28000000	$0.50	$5.73	$7.91	38.06%
NDRO	$287,495,000.00	33000000	$0.32	$8.39	$12.34	47.08%
HGT	$206,431,000.00	40000000	$0.28	$4.88	$7.96	63.06%
CHKR	$317,151,000.00	46800000	$0.66	$6.11	$10.72	75.33%
CRT	$108,416,000.00	6000000	$0.91	$17.16	$31.11	81.30%
ECT	$88,370,000.00	17600000	$0.36	$4.66	$8.84	89.74%
PBT	$333,638,000.00	46600000	$0.34	$6.82	$13.36	95.91%
SBR	$258,163,000.00	14600000	$1.22	$16.46	$51.15	210.71%
DOM	$16,843,000.00	7900000	$0.17	$1.96	$7.32	273.46%
SJT	$236,622,000.00	46600000	$0.40	$4.68	$17.95	283.73%

A quick glance at the right-most column of our table seems to indicate that, while there are a few trusts with a reasonable chance of providing our desired 10% annualized return, most of them are significantly overvalued. At the extreme, the model suggests that SBR, DOM, and SJT are comically expensive.

Now, before you go out and buy all the ROYT you can get your hands on, remember that this model probably has some significant deficiencies. First, the tax issues surrounding royalty trusts are not taken into account here. Because the assets of a trust are depleted over time, a portion of its distributions are not subject to federal income tax. This would put most of these trusts in a more positive light.

Second, the most important values in this analysis, the measures of NPV, are pulled from the trusts' own annual reports. They are not generated from extrapolating actual production data and probably don't take things like the building of new wells or well attrition into account. Perhaps even more important is that not all trusts are perpetual in duration. Some may terminate before all distributions implied by the trust's NPV have occurred. Also, the extent to which taxes and production costs are internalized in the estimate is not always clear.

Third, changes in the price of oil and natural gas could drastically affect the value of the trusts' assets. (Royalty trust ownership is, in some ways, a pure play on commodities that doesn't require involvement in the futures market.) The reasonableness of the price assumptions made in official trust documents is certainly something to evaluate.

P.S. If you found anything in this post interesting, there is a great series of articles on royalty trusts by The Forensic Accountant over at Seeking Alpha.

Pepper Spray and Airport Security: A Lesson for the Terrorists

I've relayed this story to a few friends, but I thought I should just blog it...

Last May, when my wife an I were living in Connecticut, my mother paid me a weekend visit.  We drove to Boston to walk the Freedom Trail one day and then took the Metro North into New York to visit the Statue of Liberty the next.  Before you board the boat to visit Ellis Island and old lady herself, you have to pass a security checkpoint on the edge of Battery Park roughly comparable to one you would encounter at a local airport.

Quite on accident, my wife had in her purse a little pick canister of pepper spray.  The security personel at the checkpoint identified it and forced us to discard it.  This was an obvious bummer, but it wasn't really that interesting until a remembered something...

...she had taken that purse, with its contents, on at least 2 previous round-trip flights, which means she had somehow gotten that pepper spray through 4 airport security checkpoints.

No, I'm not kidding.

Emmett Caption Contest

And...GO!

Megatron

Last week, Holly and I had another ultrasound. One of the print-outs we received was a view of Liam's face.

For some reason, the first thing I thought of was...MEGATRON!

Toyota Corolla Usability Fail

I think you can imagine my surprise when, upon approaching my '02 Corolla the other day, I noticed that most of my left headlight assembly, including the turn signal, where totally smashed. After a bit of an investigation, including security at the firm I work at, it became apparent I wasn't going to find out who did it. While this sucks hard, it isn't the really interesting thing about this story.

As I got back into the (thankfully) still drivable car and headed home, I noticed that the left turn signal indicator was blinking a bit more rapidly than the right. I then realized that this had been happening for at least a week. Apparently, the slightly faster blink rate on the dashboard display indicates that the turn signal is out. At first glance, one might think, "How nice of Toyota to include a warning to tell me that my turn signal is broken!" If we think a bit more deeply though, it is quite apparent that the signal they chose will fail miserably in achieving its goal for many people.

Any well designed system must provide both feedback for user actions and visibility into the present state of the system. One way to accomplish this is to exploit natural mappings. For instance, the blinking turn signal on a car dashboard maps very well to the operation of the car's actual turn signal. When we see this, we can safely assume that the signal is operational. In my case, it was not at all apparent that a slightly more rapid blink mapped to the real signal being broken. If anything, I would simply assume that the real signal is blinking a bit faster.

What puzzles me about this situation is that Toyota made probably the worst design choice possible given the obvious intent. Imagine that instead of a slightly more rapid blink, they would have chosen not to have the dashboard blink at all when the light is out. This would lead a reasonable user to conclude that, since the blinking no longer occurs, either the dashboard or the signal itself is malfunctioning. Even a solid red light (as opposed to the blinking green) would probably do the trick. Either of these solutions would result in the user/driver taking a quick look at the actual turn signal.

In my case, I may have actually been able to figure out who/what trashed the front of my car.

A Value Added Approach to Teacher Performance

My wife, Holly, spent 4 years as a public high school English teacher in California.  From time to time, she would tell me about the "evaluations" she had coming up, which would consist of a senior teacher or administrator (usually her principal) sitting in on a lesson and giving her feedback about both the content of the lesson and some peripheral items, like how she managed her classroom.  While I don't doubt the necessity of these sorts of evaluations, especially for teachers in their first few years on the job, I couldn't help but wonder why there weren't any good, objective measures of teacher performance in place.

Every year, elementary, junior high, and high school students take standardized tests across a broad range of subjects.  Most importantly, they are tested against state-wide benchmarks for basic quantitative and language skills.  Students are graded on a relative basis, so a student placed in the 50th percentile is approximately average.  Changes in these percentile scores over time could provide and objective way to measure teacher performance.

For instance, let us imagine that an English teacher begins the year with a class of 20 freshman who scored, on average, in the 70th percentile on the previous year's standardized English test.  The material on the new year's test will be more advanced, but the average teacher should be able to maintain student scores in the 70th percentile.  A less talented teacher will cause those scores to drop, while a more talented teacher will cause those scores to rise.

While this idea alone could form the core of an objective, fully automated way to track teacher performance, there are still some rough edges that would have to be ironed out.  The most obvious is that is is likely much more difficult to help a student from the 98th to the 99th percentile than it is to help a student from the 50th to the 51st.  If teachers were evaluated solely on the absolute improvement they generated, teachers who inherited already stellar performers would be at a severe disadvantage in relation to those inheriting mediocre performers.

Fortunately, a basic solution to this problem is not too difficult to imagine.  All that would be necessary is to create a scale defining equivalent values for improvements from certain levels.  For instance, it may be determined that moving a student from the 70th to the 75th percentile is equivalent in value to moving a student from the 95th to the 96th.

Ultimately, it may not even be necessary to solve the problem.  It may be that some teachers work best with students in certain percentile brackets.  A performance evaluation system like the one I've described would provide the information necessary to identify the teachers and instructors that are best equipped to handle students at various aptitude levels.  I expect parents would find this information an invaluable resource as they work to provide the best education for their children.

Wheeling the Gurney Over a Cliff

The recent passage of health care reform by the federal government has been a topic of great contention in every corner of this nation, and it will continue to be so as dozens of states line up in opposition to the bill on constitutional and other grounds.  However, there seems to be only a feeble attempt in all of this noisy discussion to answer the fundamental question that underlies the debate: "Is access to medical care a fundamental right?"  Reason, a tool foreign to and inconsistently applied by most of our leaders, suggests that it is not.

This case suggests a proof by contradiction.  First, we will assume that no fundamental right may infringe upon any other fundamental right.  (This is necessary for the set of fundamental rights to be intelligible and consistent.)  Let us then assume that access to medical care is a fundamental right.  Also, we acknowledge that one of the most fundamental human rights is the right to freely dispose of one's abilities and resources.  If it can be shown that the right to medical care conflicts with this right, we must conclude that either one or both of them are not, in fact, rights at all.

If every human being is entitled to medical care, then it will be necessary for some entity to provide it.  In a free society, health care is provided in a marketplace where all transactions occur with the consent of all relevant parties.  In the case where no voluntary arrangement can be reached, the only way for the transaction to occur is through coercion by some outside authority.  It is in this way that the right to medical care obliterates the right of some individual to his or her own abilities or resources.  Whether we consider the surgeon who is forced to take less than market price for his services or the taxpayer who is forced to pay for the medical care of others, the right to medical care is entirely incompatible with individual liberty.

We are then forced to chose which of our supposed rights are valid.  Unless we wish to sacrifice liberty for the promise of care from a bankrupt bureaucracy and essential freedom for secondary want, we must dismiss the notion that medical care even remotely resembles something we would call a fundamental human right.  This moral reality makes possible a principled opposition to all forms of socialized medicine.

A friend of mine recently reminded me of Thomas Jefferson's advice on the subject.  He said, "I predict future happiness for Americans if they can prevent the government from wasting the labors of the people under the pretense of taking care of them."  Free men and women everywhere would do well to heed our third president's wisdom.