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.
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.
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