December 10, 2011
Written By Chloe Lutts Jensen
“Chesapeake Granite Wash Trust (CHKR – yield 14.10%) began trading on Nov. 11, 2011, making it the newest addition to the universe of U.S. oil and gas trusts. The trust is also among the most promising and fastest growing trusts in my coverage universe. … The trust’s sponsor is U.S. independent oil and gas producer Chesapeake Energy Corp (CHK). To form the trust, Chesapeake contributed royalty interests in existing and planned wells in the Colony Granite Wash play located in Washita County, Okla.
“The area of mutual interest (AMI) contributed to the trust spans 45,400 gross acres and is in the heart of a broader oil and gas-producing region known as the Anadarko Basin. … NGLs [natural gas liquids] account for about 47% of production from this wet-gas field, which also includes negligible volumes of oil. [Parent] Chesapeake Energy is the most active and experienced producer in the Colony Granite Wash, where it has drilled 133 of the 173 existing wells and operates nine of the 15 rigs in the region. Management has amassed proprietary data on historical decline rates and understands how and where new wells should be drilled. The wells contributed to the trust fall into one of two categories: The AMI includes 69 completed and producing wells. Unitholders will receive 90% of the net proceeds from the sale of oil and gas produced from these wells. Chesapeake Energy also plans to drill 118 horizontal development wells in the AMI [by June 30, 2015.] Once completed, trust unitholders are entitled to receive 50% of the net proceeds from these wells. [The] trust will pay out virtually all of the income it receives to holders as regular quarterly distributions. The trust has two mechanisms in place to protect those payouts. Chesapeake Energy has contributed hedges that cover 50% of expected oil and NGL production through June 30, 2015. In other words, over the next four years, about 37% of the trust’s total revenue will be protected from commodity price volatility. [The second mechanism is depicted in] this line graph that tracks the trust’s distribution target, as well as an incentive distribution and a subordination distribution. The distribution targets depicted in this graph are based on the amounts of oil, NGLs and gas the firm expects the trust to produce and a set of commodity price expectations. … As you can see, the targeted distributions rise steadily until late 2013 and then flatten out for a few years before falling precipitously after 2014. That’s because as Chesapeake Energy drills the 118 horizontal development wells required in the trust’s registration document, the trust’s oil, gas and NGL output and revenue will increase. The trust is expected to boost its payout by about 65% during between now and mid-2013. … Investors will continue to receive distributions until the trust is dissolved in 2031 and the proceeds are distributed among unitholders. The subordination threshold is located 20% below the target distribution rate; at this level, the parent steps in to support the quarterly distributions. … When the distributable cash flow drops below the subordination threshold, Chesapeake Energy will reduce the distributions it’s entitled to receive on its subordinated units until other unitholders (public investors) receive at least that subordinated distribution rate. … In exchange for the downside protection offered by Chesapeake Energy’s subordinated units, the company also receives an incentive distribution in good times. When the trust’s distributions exceed that incentive threshold depicted on the graph, Chesapeake Energy will receive a 50% bonus on all payments in excess of the incentive distribution level. Although this structure limits distribution upside in strong commodity markets, that’s a small price to pay for downside protection. … Typically trusts are a bit conservative in setting distribution targets in an effort to under-promise and over-deliver on their yield. In addition, the parent would like to hit the incentive threshold as often as possible to maximize its distribution bonus. I’d expect the trust to distribute more than its target payout over the next few years. CHKR has yet to pay a distribution, so most brokerage and financial websites will still list the yield as zero; savvy investors have an opportunity to pick up units before the public catches on to the trust’s distribution potential. If in its first four quarters as a public company Chesapeake Granite Wash pays its targeted distribution of $2.72 per unit, that’s equivalent to 14.1% yield at current prices. And if the trust generates cash flow that exceeds the incentive threshold, the yield jumps all the way to 17%. With a high-quality asset base and the promise of a sky-high yield, Chesapeake Granite Wash Trust rates a buy up to 22.”
Elliott Gue, The Energy Strategist, 11/23/11