A volatile stock market offers investors an opportunity to lock in favorable yields on this trust, writes Elliott Gue of Energy Strategist.

SandRidge Mississippian Trust I (SDT) went public in April 2011 and owns royalty interests in 37 horizontal wells producing oil and natural gas from the Mississippian formation in Oklahoma, as well as a stake in 123 additional horizontal wells to be drilled over the next few years by the grantor, SandRidge Energy (SD).

All of these wells are located on a 64,200 acre “area of mutual interest” in Oklahoma’s Alfalfa, Garfield, Grant, Major, and Woods counties.

Here’s how the royalty structure breaks down.

  • The trust is entitled to receive 90% of all proceeds from the sale of oil and natural gas associated with the existing 37 producing horizontal plays after deducting post-production costs and taxes. The remaining 10% is paid to SandRidge Energy.
  • The trust is entitled to receive 50% of the proceeds from the 123 wells scheduled to be drilled over the next few years, with the balance paid to SandRidge Energy.

Note that SandRidge Energy doesn’t own a 100% interest in all the wells covered by the trust. In these cases, trust’s share of a particular well’s proceeds will be adjusted according to its stake in the particular well.

SandRidge Energy is required under the terms of the trust to drill the 123 additional wells on the AMI properties by December 31, 2014, though that deadline can be extended by one additional year under certain circumstances.

A horizontal well’s productivity depends in part of the length of the well’s laterals, or the horizontal segment that intersects the oil and natural gas reservoir. The terms of the trust stipulate that only wells with a perforated lateral segment—the portion of the well that produces oil and gas—of at least 2,500 feet will count toward the 123 wells. In addition, SandRidge must have at least a 57% working interest in each well.

The trust structure also includes offsets to these requirements. For example, SandRidge Energy could reduce the number of wells it must sink by drilling longer laterals and focusing on projects in which it has a higher ownership stake.

Note that the trust itself isn’t responsible for the costs associated with drilling these 123 new horizontal wells, limiting trustholders’ exposure to the rising cost of hydraulic fracturing and other critical production services.

However, the trust is liable for its share of the post-production costs, including gathering and processing fees. Administration expenses associated with running the trust also reduce trustholders’ cash receipts. In general, post-production and administration costs are significantly lower and far more predictable than operating and drilling costs.

This trust stands out because of two other risk-reducing features. At the time of its initial public offering, the trust had hedged roughly 54% of its planned production and 60% of its estimated revenue between April 1, 2011, and December 31, 2015.

Also, management expects the trust’s output to be split evenly between oil and natural gas. The trust has hedged about 40% of its gas production and around 70% of planned oil output through 2015.

These hedges offer significant near-term protection from fluctuations in commodity prices, while offering exposure to oil and gas prices after 2015—a potential upside catalyst.

Although we expect oil prices to remain elevated over coming years because of rapidly increasing global demand and constraints on supply growth, our intermediate- and long-term outlook for US natural gas prices remains sanguine. This stance might come as a surprise to readers, as we remain bearish on domestic gas prices in the near term.

But the coming years will be kind to natural gas. With rising concern about carbon dioxide emissions, US utilities are increasingly turning to natural gas-fired power plants to boost baseload capacity. Meanwhile, nuclear reactors take far too long to build, while alternatives only generate power intermittently and can’t add baseload power to the grid.

The nation’s vast gas shale reserves also make it difficult to envision a world in which domestic demand for natural gas doesn’t improve over the long term.

In short, the trust’s structure ensures a reliable income stream in the early years and the potential for additional upside after 2015. We also like that SandRidge Energy has retained ownership of 3.75 million shares in the trust, equivalent to a 17.8% stake. The parent company will receive the same distributions as individual holders.

In addition, SandRidge Energy owns 7 million subordinated shares that will pay out a regular distribution only if the trust generates sufficient cash flow to disburse at least 80% of the targeted quarterly distribution. If quarterly cash flow falls short of this threshold, the subordinate shares will forego part or all of their contingent distribution, until common shareholders are made whole.

These 7 million subordinate shares account for 25% of outstanding shares (21 million common shares and 7 million subordinate shares), providing a substantial cushion against shortages in cash flow.

However, SandRidge Energy does receive a carrot for providing this cushion. When distributions exceed 120% of their targeted quarterly amounts, the subordinated shares entitle SandRidge Energy to a 50% bonus on all amounts over this threshold. The subordinated units will convert into common units four calendar years from the date that SandRidge Energy completes its obligation to drill those 123 wells.

Although these subordinated units limit potential upside when quarterly distributions are high, the downside protection that this structure provides in lean times is a welcome offset. In addition, the size of SandRidge Energy’s bonus should incentivize the company to exceed the 120% distribution threshold as often as possible by accelerating drilling activity.

A high-yield play on a rebound in WTI prices, SandRidge Mississippian Trust I rates a buy up to $24.

Note that SandRidge Mississippian Trust is taxed as an MLP, so you will receive a K-1 form at tax time. Part of your income will be considered a return of capital and will not be taxable until you sell the trust. The rest will be considered ordinary income and taxed at your marginal income tax rate.

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