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The following segment was excerpted from this fund letter.
During the fourth quarter, we joined with Shipyard Capital in filing a joint 13D on Pacific Coast Oil Trust (OTC:ROYTL). We subsequently added a private investor and Evergreen Capital, who owns 8.5% of the units, to the group bringing it to over 21% of outstanding units. We have called for a Special Meeting to remove the Trustee. We think that the operator, PCEC, is improperly trying to assess Asset Retirement Obligations (ARO) to the trust. ARO’s are the cost to return a well back to normal state (i.e., plugging the well and removal of equipment, etc.). PCEC contends the Conveyance Agreement allows for it (pages 7 (n), 22 (l)). We contend that the Conveyance Agreement forbids any assessment of costs incurred or accrued prior to April 1, 2012 (pages 5, 20 that govern what pages 7 and 22 refer to) and secondarily that the pro forma financials in the offering documents clearly show the liability remaining with PCEC (see the offering documents page PCEC F-30 asset retirement obligation line). Meaning, it did not transfer to the Trust.
PCEC had already accrued an ARO obligation when it purchased additional properties in 2008, evaluated it annually, and made adjustments accordingly, prior to the trust being created in 2012. At that time, April 2012, the ARO was approximately $22.3 million and should have accreted (compounded) at approximately a 7 to 9% rate annually. After ten years of accretion, it would be nearly double the original $22.3 million, which is nearly the amount the operator says the assessed ARO obligation was. Further, in all the offering document pro forma no assessment was made to the trust for asset retirement obligations, nor was the Trust assessed any ARO obligation from 2012 through 2019 when, interestingly enough, PCEC was purchased by new owners.
Our argument is that the ARO should not have been assessed to the Trust (unit holders) at all. Thus, all the funds that have been withheld need to be repaid with interest. If true, the operator owes the trust roughly $25 to $30 million, or $0.65 to $0.80 per unit, versus its current $17 million market cap and $0.44 per-unit price, and distributions would resume at approximately $.023 per unit per month, or $0.28 annually. We think the fair value of the units would be in excess of $2.00 per unit under this scenario, or five times the current price.
What if courts disagreed that the ARO was assessable? Would it be fully assessable or partially? We contend that it is clear in the conveyance agreement that the Trust can only be assessed costs related to production during its existence, not production that predates the creation of the trust or future production. That would mean the ARO cost has to be allocated to production units since PCEC, the operator, purchased the fields, and only the portion related to the time the Trust has been a recipient of cash flows is assessable to the Trust. This would still mean excess funds have been withheld and would be returned and distributions would resume. Under this scenario, we think fair value would be above $1.25 per unit, or nearly three times the current price.
We also believe that the funds should be escrowed since if any of the properties/fields were sold, the ARO transfers to the buyer, thus releasing the obligation. Further, we contend that the funds withheld should be credited the discount rate, currently 9%, used in the ARO calculation to avoid double assessment. In other words, the amount that has been paid is the present value of future costs discounted back to the present. It would be double assessment to then assess the increase in the present value due to time to the Trust. Since the amount is pre-paid, the obligation to earn the discount rate should be borne by the operator.
Obviously, there is some chance that the courts deem the ARO fully assessable, ignore our calling of a Special Meeting, and allow the Trustee to proceed to an auction since the Trust did not receive the minimum required distributions from PCEC in 2020 and 2021. A strong case can be made that an auction of the properties is clearly a sale and that the ARO obligation transfers to the buyer and the withheld ARO must be paid back to the Trust with interest along with any proceeds from the auction. Even if that argument was rejected, then the near full payment of the ARO obligation means that cash flows would resume six months from today and in even less time by the time any auction closed. While the buyer has to assess the attractiveness of working with PCEC, we still think fair value is above the current price and likely above $1.00 per unit since the ARO obligation would have been paid and monthly distributions resume.
While there are a wide range of possible outcomes, we are optimistic that most, if not all, of the ARO that has been assessed is improper. If we are correct, the potential Bonanza scenario we described in our 2022 Q2 letter is more likely. As we said before, time will tell. We added to the position during the quarter.
DISCLAIMERSFund PerformanceThe financial performance figures for 2022 presented in this report are unaudited estimates based on the best information available at the time of the letter and are subject to subsequent revision by the Fund’s auditors. Past performance may not be indicative of future results and no representation is made that an investor will or is likely to achieve results similar to those shown. All investments involve risk including the loss of principal. Net Return reflects the experience of an investor who came into the Fund on inception and did not add to or withdraw from the Fund through the end of the most recently reported period. The reported net return figures will therefore include the impact of high water marks in the cumulative return. Individual investor returns will vary depending upon the timing of their investment, the effects of additions and withdrawals from their capital account, and each individual’s high water mark figure, if any. Index ReturnsThe S&P500 Index returns are reported using the S&P500 Depository Receipt Trust (SPDR) which trades under the ticker symbol SPY. Reinvested dividends are included in these figures. A spreadsheet showing the SPY performance versus the fund since inception is available upon request. Nasdaq performance excludes dividends, which historically have been immaterial to the total return of that index. In recent years more technology stocks have begun paying dividends thus the inclusion of dividends would increase the reported figures. Russell 2000 performance is from data reported on Russell’s website, and includes reinvested dividends. DJIA returns are reported using the SPDR Dow Jones Industrial Average which trades under the ticker symbol DIA. Reinvested dividends are included in these figures. A spreadsheet showing the DIA performance versus the fund since inception is available upon request. While reported returns for SPY and DIA will likely be a few tenths of a percentage lower than the representative index annually, we believe they are a better reflection of what a non-institutional investor would earn following a passive investment approach. Index returns are provided as a convenience to the reader only. The Fund’s returns are likely to differ substantially from that of any index, and there can be no assurance that the Fund will achieve results that are superior to such indices. Share PricesShare price figures for listed stocks are from Yahoo! Finance and unless specified otherwise are the closing price as of the previous month end. Share price figures for unlisted stocks are closing bid prices as reported on otcmarkets.com, except for unlisted stocks classified as expert market, which do not have public availability of quotes, and are marked to last sale. Forward Looking StatementsThis letter and the accompanying discussion include forward-looking statements. All statements that are not historical facts are forward-looking statements, including any statements that relate to future market conditions, results, operations, strategies or other future conditions or developments and any statements regarding objectives, opportunities, positioning or prospects. Forward-looking statements are necessarily based upon speculation, expectations, estimates and assumptions that are inherently unreliable and subject to significant business, economic and competitive uncertainties and contingencies. Forward-looking statements are not a promise or guaranty about future events. |
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