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About four months ago, I recommended avoiding Permian Basin Royalty Trust (NYSE:PBT) due to the risk related to its exposure to the next downturn of the energy sector. Since my article, the stock temporarily dipped 10% but it has retrieved all its losses thanks to the recent rally of the entire energy sector amid favorable prices of oil and gas. In addition, the trust is likely to greatly benefit from the recently announced decision of OPEC to reduce drastically its production. This decision will provide a tailwind to the results of the trust in the short run. However, PBT remains highly risky from a long-term perspective.
Business overview
Permian Basin Royalty Trust has royalty interests in some oil and gas properties in Texas. In contrast to the well-known oil majors, such as Exxon Mobil (XOM) and Shell (SHEL), PBT is a pure upstream company, without any downstream segments. In addition, it cannot expand to new areas and hence the trust will remain in existence only as long as its properties remain prolific and profitable. Overall, PBT is far more vulnerable to the cycles of the prices of oil and gas than the integrated oil majors. This is positive during boom times, like this year, but it is negative during recessions or downturns of the energy sector, as there is no buffer in these adverse periods.
PBT is thriving right now thanks to the exceptionally favorable business conditions it enjoys. Due to the invasion of Russia in Ukraine, the U.S. and Europe have imposed strict sanctions on Russia. Before the sanctions, Russia was producing approximately 10% of global oil output and one-third of natural gas consumed in Europe. Due to the sanctions, Russia has reduced its oil and gas production and thus the global oil and gas markets have greatly tightened. As a result, the prices of oil and gas have rallied to multi-year highs.
As PBT is extremely sensitive to the underlying prices of oil and gas, it has greatly benefited from the excessive prices of oil and gas this year. In the first ten months of the year, the trust has offered total distributions of $1.03 per unit. These distributions correspond to an annualized yield of 6.0%. They also correspond to a total annual distribution per unit of $1.24, which is more than 5 times the distribution per unit of $0.23 in 2021.
Even better for the trust, its last three monthly distributions are far greater than its distributions in the first months of the year, as there is a lag between the prices of oil and gas and the distributions and the trust has also reduced its operating costs on its Waddell Ranch properties lately. If only the last three monthly distributions are taken into account, they correspond to an annualized yield of 12.3%. Moreover, the trust is on track to offer a 10-year high total annual distribution this year thanks to the exceptionally favorable business landscape.
On the other hand, the prices of oil and gas have incurred an approximate 30% correction off their peak in the last four months. Their correction has been caused primarily by fears of an upcoming global recession due to the aggressive interest rate hikes implemented by central banks. In addition, the high prices of oil and gas have provided incentive to U.S. and Canadian producers to boost their output. As a result, the oil and gas markets have become more balanced lately.
Due to the correction of the price of oil, OPEC recently announced that it will reduce its production by 2 million barrels per day. As its members already operate below their quotas, the decision essentially means that OPEC will reduce its production by one million barrels per day from its current production level. This is an unprecedented move of OPEC; the cartel used to target a maximum oil price around $80 in order to avoid providing incentive for alternative energy projects. However, now that the world is already doing its best to diversify away from fossil fuels, OPEC chose to support the price of oil at a much higher level for the first time in history and thus provided a short-term floor to the oil price.
The decision of OPEC is likely to greatly benefit U.S. oil producers, including PBT, as most countries do not have the potential to increase their output meaningfully. In fact, the U.S. and Canada are the only oil producers outside OPEC that have enough spare capacity to increase their production meaningfully. Thanks to the elevated oil price, U.S. oil producers will do their best to enhance their production.
It is also important to note that U.S. oil production has recovered strongly from its pandemic lows and has returned to the level it was in March 2020. According to the Energy Information Administration [EIA], U.S. shale oil production is expected to reach an all-time high in November. To cut a long story short, U.S. oil producers are likely to continue taking advantage of the tight production quotas of OPEC in the upcoming months. PBT will almost certainly benefit from the reduced output of OPEC.
However, investors should never forget the dramatic cyclicality of the oil industry. Whenever oil prices have remained high for a considerable period, they have always provided great incentive to producers to boost their output. At some point, global supply is likely to exceed global demand and thus the next downcycle of the energy market will show up. At that point, PBT will have to reduce its distribution sharply.
Apart from the incentive to maximize oil production, high oil prices have given rise to another threat to PBT, namely the record number of renewable energy projects that are under development right now. Most countries are suffering from the excessive prices of oil and gas this year and thus they are doing their best to shift from fossil fuels to clean energy sources. When all these projects come online, in about 2-4 years, they will take their toll on global oil consumption and hence they will probably impart a major hit on the business of PBT.
Some investors claim that this time is different and expect the oil market to remain tight for years. However, the oil market is infamous for its cyclicality. It is highly risky to conclude that the oil market is not cyclical anymore and expect the oil price to remain around its 14-year highs for years, as this has never happened before.
It is important to form rational expectations for the distributable income of PBT whenever the energy market reverts to a normal condition. During the years 2015-2016 and 2020-2021, the oil market went through major downturns and hence these periods are not representative of normal conditions. On the contrary, the period 2017-2019 can be used as a benchmark for normal oil prices. During that 3-year period, the average price of WTI was $58 and PBT offered an average annual distribution per unit of $0.57.
At the current stock price, this distribution corresponds to a yield of only 2.8%, which is far lower than the average distribution yield of 6.5% of PBT over the last decade. Therefore, if the price of oil reverts to its normal range and the yield of PBT remains in line with its 10-year average, the stock of PBT will have 57% (=3.7/6.5*100) downside from its current price.
Upside risk
Global economic growth has markedly decelerated in recent months due to the aggressive interest rate hikes implemented by central banks in an effort to put a lid on inflation. As inflation remains at a 40-year high, central banks are likely to maintain their aggressive stance for longer than initially expected and thus an imminent recession seems inevitable. If a recession does not show up and the global economy recovers strongly from its latest slowdown, the price of oil may remain elevated for a considerable period. In such a case, PBT is likely to continue offering above-average distributions and its stock will probably remain around its 10-year highs.
Another potential positive catalyst for PBT could be another production cut by OPEC in the future. However, there are limits in the ability of OPEC to reduce its output. Most of its members rely heavily on oil to fund their budgets and thus they are usually reluctant to reduce their production below a given level. Moreover, North American oil producers, which do not belong to the cartel, take advantage of every production cut of OPEC and make up for a great portion of the lost barrels of OPEC. In other words, OPEC members see their sacrifices partly wasted every time they reduce their output due to the ability of North American oil producers to grow their production.
To sum up, there are some factors which can delay the emergence of the next downcycle of the oil industry. However, given the proven cyclicality of this industry and the unprecedented number of renewable energy projects under development right now, it is highly risky to expect the price of oil to remain excessive for years. Therefore, PBT is highly risky around its 10-year highs.
Final thoughts
The price of oil temporarily slumped below its level at the time of the invasion of Russia in Ukraine but OPEC recently triggered a relief rally with its bold strategic decision. While the price of oil is unpredictable in the short run, it is likely to enter a downcycle at some point in the upcoming years due to the accelerated efforts of most countries to shift from oil to clean energy sources. PBT is highly vulnerable to this secular threat and hence investors should not be enticed by its exceptional current distribution yield.
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