damircudic
Almost a year ago, I stated that investors should be aware of the long-term risks of PermRock Royalty Trust (NYSE:PRT). Since my article, the stock has rallied 30% thanks to the sanctions of western countries on Russia for its invasion in Ukraine. These sanctions have led the prices of oil and gas to 13-year highs this year. Some investors may blame me for poor timing but no-one could have predicted the war in Ukraine. More importantly, while PermRock is likely to continue thriving in the short run, it remains risky from a long-term perspective.
Business overview
PermRock produces oil and gas in the Permian Basin, at an 84/16 ratio. It thus benefits from the rally of the price of natural gas close to its all-time highs lately but the trust is much more sensitive to the gyrations of the price of oil. Moreover, the merits of producing oil in the most prolific production area of the U.S. are obvious. PermRock owns properties with long-life reserves and decent rates of natural decline.
According to its annual report, PermRock currently has 7.6 million barrels of oil equivalent of proved reserves. At its current production rate of approximately 428,000 barrels per year (~214,000 barrels in the first six months of 2022), the trust can continue producing oil and gas for another 17.7 years. Therefore, it has a decent estimated lifetime of reserves.
On the other hand, investors should be aware that the reserves of all the oil and gas trusts are extremely sensitive to the underlying prices of oil and gas. Higher commodity prices render greater amounts of oil and gas economically extractable and thus they increase the amounts of proved reserves. On the contrary, when commodity prices are depressed, some reserves become unprofitable and hence the reported proved reserves decline significantly. To provide a perspective, PermRock more than doubled its proved reserves between the end of 2020 and the end of 2021, from 3.1 million barrels to 7.6 million barrels, thanks to the rally of the prices of oil and gas.
PermRock is thriving this year thanks to the sanctions of the U.S. and Europe on Russia for its invasion in Ukraine. Before the war in Ukraine, Russia was producing approximately 10% of global oil output and 33% of the natural gas consumed in Europe. As a result, the sanctions of the western countries on Russia have greatly tightened the global markets of oil and gas. It is thus natural that the prices of oil and gas have rallied to 13-year highs this year. As PermRock is much more sensitive to the price of oil, it is better to focus on the outlook of the oil market.
Thanks to the rally of the price of oil, PermRock has offered total distributions of $0.89 per unit in the last 12 months. These distributions correspond to an annualized distribution yield of 9.9%, which is undoubtedly attractive on the surface. However, the big question is whether the price of oil can remain excessive for years.
Numerous countries have been severely hurt by the ongoing energy crisis. Consequently, they are doing their best to reduce their dependence on oil. Sweden, Norway and Finland have proved exemplary in this aspect, as they are immune to the energy crisis thanks to their excessive investments in renewable energy projects in recent years. Most countries are doing their best to imitate the Scandinavian countries and thus a record number of clean energy projects is under development right now. These projects will definitely take their toll on global oil consumption, though it will probably take at least 2-3 years for their effect to become noticeable, as the projects are currently in their development phase.
It is also important to realize that the price of oil reflects future expectations. In other words, as soon as the market focuses on the expected impact of renewable energy projects, it will cause a significant decline of the oil price even if the prevailing conditions in the global oil market are still tight. Moreover, it is remarkable that the price of oil has fallen lately below its level just before the onset of the war in Ukraine. In other words, the current oil price signals that most of the damage caused in the global oil market by the war has already been absorbed via reduced consumption and intense investment in alternative energy sources. The plunge of the oil price below its level before the war is certainly a bearish signal.
Whenever the price of oil has traded around $100, a fierce downcycle has ensued, as high oil prices take their toll on consumption while they also provide an incentive for higher production. This cycle is somewhat different, as most oil producers are reluctant to invest in new oil projects due to the secular shift of the world from fossil fuels to clean energy sources. Nevertheless, the decrease in consumption and the expected impact of clean energy projects on global oil consumption are likely to send the oil price much lower in the next few years. After all, the oil industry is infamous for its dramatic cyclicality.
Distribution
As mentioned above, PermRock is offering an exceptionally high distribution yield. Based on its distributions in the last 12 months, the stock is offering a 9.9% yield. If only the last two monthly distributions are taken into account, they correspond to an annualized yield of 12.0%. Such a high yield is sufficient to attract many income-oriented investors.
In the short run, oil prices are likely to remain above average and hence PermRock will probably continue offering exceptionally high distributions in the upcoming months. On the other hand, investors should be aware of the long-term risk of the stock before purchasing it.
As mentioned earlier, the current level of the oil price seems unsustainable in the long run and hence investors should be prepared for lower prices in the upcoming years. More importantly, due to its pure upstream nature, PermRock is extremely sensitive to the dramatic cycles of the oil price, much more than the well-known integrated oil majors, such as Exxon Mobil (XOM) and Chevron (CVX).
To be sure, in the first two months of the pandemic, the stock of PermRock slumped 83%. In addition, the trust suspended its distribution for 5 months and then reinstated a distribution that was 80% lower than the pre-pandemic distribution. Most income-oriented investors cannot tolerate such extreme volatility in stock prices and income and hence they should stay away from this volatile stock.
Finally, it is important to keep in mind that most oil and gas trusts suffer from a strong headwind in the long run, namely the natural decline of their producing fields. This decline may not be evident within a time frame of a few years, as the reported proved reserves are highly dependent on the prevailing commodity prices, as analyzed earlier. However, the natural decline of fields undoubtedly takes its toll on the production of these trusts in the long run, especially given that these trusts are static, i.e., they cannot add new properties in their asset portfolios.
Final Thoughts
PermRock is currently offering a 9.9% distribution yield thanks to the rally of the prices of oil and gas, which has resulted from the Ukrainian crisis. However, as experience has proved in all the past incidents of energy crisis, the world is doing its best to adjust and become more resilient to this crisis. The record number of renewable energy projects that are under development right now are likely to take their toll on future oil prices. When the market shifts its focus on the impact of these projects on the oil market, PermRock will have significant downside risk.
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