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SandRidge Mississippian Trust II

April 19, 2012

SandRidge Energy (SD) has formed a second royalty trust to help finance its drilling in the Mississippian formation.  In April of 2011, SandRidge offered SandRidge Mississippian Trust I (SDT).  This trust has performed well since its IPO, paying unit holders at over 120% of the target distributions for the past 2 periods which has caused the stock price to trade at over 40% above its IPO price.  Now the shares of SandRidge Mississippian Trust II (SDR) began trading on April 18th, offered at $21 per unit.

If you have not invested in a royalty trust before you should be aware that these are vehicles used to help finance the drilling operations.  The trust has a finite life.  The wells will be drilled, the oil and gas extracted and sold and over time the output from the wells will diminish as will the distributions from the trust.  The trust will liquidate after December 31, 2031.  If there is any value left in the output of the wells at that time, a perpetual royalty interest will be sold and any proceeds will be distributed to the unit holder.  Also, be aware that this is a publicly traded partnership so you will receive a Schedule K-1 at tax time.

The trust is entitled to 80% royalty interest in 67 producing wells plus a 70% royalty interest in 206 development wells to be drilled.  SandRidge Energy bears the cost for drilling and the trust is responsible for post-production costs.  SD is obligated to complete drilling the development wells by December 31, 2016.  As a unit holder you will receive quarterly distributions from the trust that represent the net royalty income from the sale of oil and gas extracted from these wells.  As of December 31, 2011, the proved reserves attributable to the trust are estimates at 26.1 million barrels of oil equivalent consisting of 46.8% oil and 53.2% natural gas.  In addition, there is 9.8 million barrels of probable reserves.  Let’s look at a comparison of SDR to SDT for some of these key metrics:

SDT SDR
Existing wells 37 67
Royalty interest 90% 80%
SD net rev interest 56.3% 53.6%
% rev to the trust 50.7% 42.9%
Development wells 123 206
Royalty interest 50% 70%
SD net rev interest 57.0% 47.4%
% rev to the trust 28.5% 33.2%
Proved reserves 19.2MMBoe 26.1 MMBoe
Oil portion 49% 46.80%
Nat gas portion 51% 53.20%

To understand how the trust participates in the revenue from drilling, you have to combine 2 factors.  First you look at the “Royalty interest” as stated separately for existing wells vs. development wells.  Then you combine this with the net revenue interest held by Sandridge for the wells.  This is related to the means by which Sandridge has acquired its interest in the properties.  From these two factors you arrive at the actual percentage of revenues to be paid to the trust.  From the prospectus for SDR:

The percentage of production proceeds to be received by the trust with respect to a well will equal the product of (a) the percentage of proceeds to which the trust is entitled under the terms of the conveyances (80% for the Producing Wells and 70% for the Development Wells) multiplied by (b) SandRidge’s net revenue interest in the well. SandRidge on average owns a 53.6% net revenue interest in the Producing Wells. Therefore, the trust will have an average 42.9% net revenue interest in the Producing Wells.

In the table above I have shown all of the percentages for both SDT and SDR so that you can see what portion of the revenue will flow to the trust for both existing wells and the development wells to be drilled.

SandRidge intends to complete the drilling of the development wells by December 31, 2015 and is obligated to complete the drilling by December 31, 2016.  As a unit holder you have some assurance that SandRidge will meet its obligations through two primary incentives.  The first incentive is that they will retain a substantial share of the trust.  Of the 48 million shares issued, SD retains 23 million (or 19.25 million if the underwriters exercise their over allotment; 47.9% and 40.1% of the units respectively).  So SD will participate in the distributions from the trust alongside unitholders and cannot sell any of these units for 180 days following the IPO date.  The second incentive is that 12 million of their retained units will be subordinated units.  Here’s how the subordinated units work.

The first 5 years of the trust during which time the additional wells will be developed is referred to as the “subordination period”.  In the prospectus for SDR, SandRidge has provided a projection of distributions to be paid to the unit holders through the life of the trust by quarter, the target distribution.  During the subordination period, they have also defined a subordination threshold, 20% below the target distribution and an incentive threshold, 20% above the target distribution.  During the subordination period, if the cash available for distribution would result in a payment below the subordination threshold, then the distribution to the subordinated units will be reduced or eliminated in order to increase the distribution to the common units up to the subordination threshold.  Conversely, if the cash available for distribution exceeds the incentive threshold then SandRidge would receive 50% of the amount by which the cash available for distribution exceeds the threshold, with all unit holders sharing the other 50%.  Here is a table of the target distributions through the first 6 years of the trust.  As you can see distributions are expected to peak in 2015 once all development wells have been completed.

Subordination Target Incentive
Threshold Distribution Threshold
2012: 1st Qtr 0.21 0.26 0.32
2012: 2nd Qtr 0.37 0.46 0.56
2012: 3rd Qtr 0.45 0.56 0.68
2012: 4th Qtr 0.48 0.60 0.71
2013: 1st Qtr 0.52 0.65 0.78
2013: 2nd Qtr 0.55 0.69 0.83
2013: 3rd Qtr 0.54 0.67 0.81
2013: 4th Qtr 0.56 0.71 0.85
2014: 1st Qtr 0.58 0.72 0.86
2014: 2nd Qtr 0.60 0.74 0.89
2014: 3rd Qtr 0.60 0.75 0.90
2014: 4th Qtr 0.58 0.72 0.87
2015: 1st Qtr 0.63 0.79 0.95
2015: 2nd Qtr 0.64 0.81 0.97
2015: 3rd Qtr 0.64 0.80 0.96
2015: 4th Qtr 0.64 0.80 0.96
2016: 1st Qtr 0.67 0.84 1.00
2016: 2nd Qtr 0.64 0.80 0.96
2016: 3rd Qtr 0.58 0.73 0.87
2016: 4th Qtr 0.54 0.68 0.81
2017: 1st Qtr 0.51 0.64 0.77
2017: 2nd Qtr 0.48 0.60 0.73
2017: 3rd Qtr 0.46 0.58 0.69
2017: 4th Qtr 0.44 0.55 0.66

Note that both SandRidge and the trust may enter into hedging arrangements.  Under the combined hedging agreements, approximately 42% of the expected production and 69% of the expected revenues upon which the target distributions are based from April 1, 2012 through December 31, 2014 will be hedged.

Certainly the track record for SDT is no guarantee of what you can expect from SDR.  However, the distributions from SDT for the past two quarters have exceeded the incentive threshold, more than 20% above the target distributions:

Target

Actual

+/-

2011: 1st & 2nd Qtr

1.01

1.07

5.94%

2011: 3rd Qtr

0.67

0.82

22.39%

2011: 4th Qtr

0.63

0.79

25.40%

The trading in shares of SDT has generally kept the stock price at a level that works out to approximately a 10% yield on the expected distributions.  Naturally, there is some volatility based upon the move in the price for oil but it tends to trade around a 10% yield target.  If we assume a similar pattern for SDR, then using the target distributions for the first few years of the trust we could imply the following for the share price:

2012  $    18.80
2013  $    27.20
2014  $    29.30
2015  $    32.00
2016  $    30.50
2017  $    23.70

Or expressed differently, based upon the $21 IPO price, here are the annual rates of yield based upon the target distributions for each of the first 6 years.

2012

$1.88

8.95%

2013

$2.72

12.95%

2014

$2.93

13.95%

2015

$3.20

15.24%

2016

$3.05

14.52%

2017

$2.37

11.29%

Given the track record for SD with SDT, I think SDR represents a reasonably priced opportunity for a good distribution yield (at least for the first 3 to 4 years of the trust) with upside in the unit price.

Disclaimer: Please do your own research prior to making any investment decision. This article is not a recommendation to buy or sell any security and is the opinion of the author.

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