BP Prudhoe Bay (BPT) is a royalty trust which we estimate will stop paying dividends after 2023.  We believe that shorting BPT is a compelling risk/reward opportunity.  We estimate that the current stock price exceeds the remaining distributions by over 105%. We believe that the stock price is driven by the dividend, which is almost certain to drop steadily in the short and long-term.  The retail investor base may also have been fooled into driving up the premium to remaining distributions by recent rising dividends caused by a one-time change in tax code, a momentary jump in production and a rise in oil prices.  A declining dividend could cause the yield demanded by investors to rise and thus accelerate the stock’s fall.

Business: 

BPT is a royalty trust which receives 16.4246% of up to 90,000 barrels per day (oil and condensate) of BP’s working interest in the Prudhoe Bay oil field in Alaska.  The royalty is based a strict formula of the WTI oil price – a predetermined cost which rises over time and is also multiplied by a CPI factor, the trust  must then pay production taxes based on this net price. BPT is an incredibly simple entity the only variables are inflation, production and most importantly the oil price.

Why distributions should decline and eventually cease:

Prudhoe Bay is a very old oil field. Production, though still the largest oil field in North America, is in slow decline. Production peaked in 1988 and has declined an average of 3.7% per year since 2005. In addition to declining production, the trust’s costs are also rising. The base charge of $16.90 (over $31.00 after the CPI adjustment) is set to rise a dime per year through 2017 and then start rising roughly $3.00 per year. This rate rise is further multiplied by the CPI rate.  The cumulative effect of these increases will eventually wipe out BPT’s margin. The largest part of the dividend decrease over the next 12 months will likely come from falling oil prices. The current oil price is $103.48, but the 1Q 2015 price is $96.52. The cumulative effect of these drivers (see exhibit 1 below) will cause the dividend to decrease xx%, which will more than [?] the dividend over the next year, and thus the short will have a positive return even if BPT’s stays flat and thus becomes more overvalued. We would note that oil prices (based on futures prices) are predicted to decline through 2022.

Valuation:

We used forward futures for oil through 2022 and an inflation rate after.  We assumed 3% inflation and a 3% production decline along with an 8% discount rate for our DCF value.

Reasons for Overvaluation:

The low yield environment is forcing investors to stretch for yield.  BPT’s shareholder base is almost entirely retail investors. The dividend was recently pushed up by a likely temporary jump in production and a change in tax rate that lowered the rate in the short-run but increased it in the long-run (likely from 2016 on).  Production increased over 16% in the last two quarters from the two preceding quarters.  Production can vary quarter to quarter, even if this extremely old field were to suddenly show a large sustainable increase in production BPT holders would not benefit materially from this since their share is capped at 90K BPD and last quarter’s production was 86.937 BPD.  The Alaskan royalty tax formula was changing, the new rate was roughly 35% in 1Q vs. the old rate equating to roughly 43%, but the new rate has a minimum of 35% vs. 25% previously and should lower long-term value for BPT shareholders.

Additional Downside Factors and Catalysts:

Higher inflation, interest rates and lower oil prices could all undermine BPT’s share price.  The rising amount and types of yield oriented products, such as MLPs and other royalty trusts competing for investor dollars is another factor against BPT shares. Another royalty trust Whiting USA Trust I (WHX) fell over 50% in two trading sessions when Russian Hill Capital, LP issued a press release on March 28 pointing out the warning in the 10-K filing.  While the exact same phrases do not appear in BPT’s 10-K and WHX is a lot closer to ending dividends, we could see a similar strategy or statement impacting BPT shares.  We would note that WHX shares have not rebounded substantially since.

Risks:

Given the straight-forward nature of the trust, most of the risk in shorting BPT is short-term.  If oils prices are to rise, then BPT shares could spike.  Long-term oil prices would have to rise over 50% in order to justify the current stock price of BPT.