Top picks 2012: Chesapeake Granite Wash

by Elliott Gue, editor The Energy Strategist

Chesapeake Granite Wash Trust (CHKR), the newest addition to the universe of US oil and gas trusts, went public on Nov. 11, 2011.  The trust is also among the most promising and fastest growing trusts in my coverage universe.

Trusts pass through the income and profits earned to individual unitholders who pay tax on their share of the income. Its sponsor is US independent oil and gas producer Chesapeake Energy Corp. (CHK).

This structure prevents the double taxation that occurs when the Internal Revenue Service (IRS) taxes dividends at the corporate and individual level. And like Master Limited Partnerships (MLPs), trusts incur significant depreciation and depletion charges that provide a tax shield.

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.

The Granite Wash is typically produced using horizontal wells and fracturing techniques. Natural gas liquids (NGLs) account for about 47 percent of production from this wet-gas field, which also includes negligible volumes of oil.

Given the high liquids content of the Colony Granite Wash and relatively low production costs, the formation is an economically attractive drilling target at current oil, gas and NGL prices. The wells contributed to the trust fall into one of two categories:

• The AMI includes 69 completed and producing wells. Unitholders will receive 90 percent 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. Unitholders will not be responsible for the cost of drilling these wells. The operator intends to finish drilling the development wells by June 30, 2015, and once completed, trust unitholders are entitled to receive 50 percent of the net proceeds from these wells.

Chesapeake Granite Wash 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 about 37 percent of the trust’s total revenue through mid-2015.

The S-1/A form the trust filed with the Securities and Exchange Commission sets forth targeted quarterly distributions through the second quarter of 2017.

The targeted distributions rise steadily until late 2013 and then flatten out a few years before falling after 2014.

That’s because 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 percent between now and mid-2013.

In addition, over the next few years, if quarterly distributions fall below 80 percent of those targeted levels, Chesapeake Energy will forgo a portion of its distributions to maintain the payout to public unitholders.  

Like all US trusts, Chesapeake Granite Wash Trust can’t make acquisitions or expand organically beyond the limits set forth in the prospectus. Investors will continue to receive distributions until the trust is dissolved in 2031 and the proceeds are distributed among untholders.

 In its first four quarters as a public company Chesapeake Granite Wash should pay around $2.72 per unit, equivalent to 12.5 percent yield at current prices.

Learn more about this financial newsletter at Elliott Gue's The Energy Strategist.