zhengzaishuru
In the summer of 2022, I recommended selling Permian Basin Royalty Trust (NYSE:PBT) due to its excessive risk, given the multi-year high stock price and the high cyclicality of the oil and gas industry. A few months later, I reiterated my bearish thesis, despite the positive effect of the deep production cuts of OPEC and Russia on the stock. Since my first article, the stock has dramatically underperformed the broad market, as it has offered a total return of -9%, whereas the S&P 500 has rallied 26%.
It is also remarkable that the stock has vastly underperformed its sector over the last 12 months, as it has declined 41%, whereas the Energy Select Sector SPDR ETF (XLE) has shed only 2%. The underperformance has resulted primarily from the disappointing business performance of Permian Basin Royalty Trust. After such an underperformance, some investors will be tempted to buy the stock, thinking that it will outperform the broad market and its sector as a result of reversion to the mean. However, the stock remains unattractive, as it still carries a great amount of risk.
Business overview – The reasons behind the underperformance
Permian Basin Royalty Trust is an oil and gas trust that has royalty interests in some properties in Texas. It generates 86% of its revenues from oil and hence it should be viewed as an oil trust. It is thus paramount to examine the outlook of the global oil market.
The status of the global oil market could not have been more favorable for Permian Basin Royalty Trust since early 2022. Shortly after the invasion of Russia in Ukraine, the U.S. and the European Union imposed strict sanctions on Russia. As the latter was producing about 10% of global oil output, the price of oil skyrocketed to a 14-year high. The benefit from the sanctions was evident in the performance of Permian Basin Royalty Trust, which quintupled its distributions per unit, from $0.23 in 2021 to a 10-year high of $1.15 in 2022.
After the initial shock caused by the sanctions on the global oil market, the latter began to stabilize and the price of oil began to moderate. However, OPEC and Russia did not let the price of oil fall below $70 for a meaningful period thanks to the unprecedented production cuts they implemented, which kept the oil market tight.
Unfortunately for oil producers, this aggressive strategy of OPEC seems to have exhausted its potential. Every time OPEC has reduced its production, U.S. oil producers have taken advantage of the situation. As a result, the U.S. has grown its total output to new all-time highs. It has thus become inefficient for OPEC to keep cutting its production, as its lost barrels are replaced by countries outside the cartel, namely the U.S. and Canada. To be sure, the market share of OPEC has shrunk from 41.5% in 2018 to 27.4% now.
The tough situation was prominent in the latest meeting of OPEC, in November. The cartel did not announce new production cuts, as its members were reluctant to curtail their output further. Even worse, Angola announced its exit from the cartel, as it did not see any benefit from being a member of the cartel anymore. To cut a long story short, Permian Basin Royalty Trust runs the risk of realizing oil prices below $70 in the upcoming quarters, as OPEC seems to have run out of ammunition.
The other major factor behind the decline of the stock was the disappointing quarterly report of the trust, which was released in November. In the third quarter, the trust reported that its average realized prices of oil and gas decreased 35% and 69%, respectively, over the prior year’s quarter due to the fading tailwind from the Ukrainian crisis. Even worse, the working costs on the Waddell Ranch properties exceeded operating income and thus those properties did not contribute to the distributions of the trust. Consequently, the total distributions of the trust plummeted 88% in the third quarter, from $0.58 to $0.07.
On the bright side, Permian Basin Royalty Trust greatly increased its distributions after its quarterly report, from $0.0429 in October to $0.1572 in November and $0.1062 in December. This is probably a signal that the operating costs at its producing properties came under control. Nevertheless, there is no guarantee that this issue will not show up at some point in the future.
Moreover, due to the energy crisis caused by the war in Ukraine all around the globe, nearly all the countries are currently running an unprecedented number of renewable energy projects, in order to avoid a similar crisis in the future. The total global investment in green energy projects exceeded the global investment in fossil fuels by 60% in 2022 and 66% in 2023. Most green energy projects take about 2-4 years to come online. As soon as all these clean energy projects begin generating energy, they are likely to weigh heavily on the price of oil. This is a significant risk factor to keep in mind.
Declining output
Investors should also keep in mind that Permian Basin Royalty Trust cannot expand to new areas. As a result, it faces a long-term headwind, namely the natural decay of its existing properties. The natural decay causes the production of the oil and gas trust to decline over the long run. While this factor is negligible in the short run, it is likely to exert a strong drag to the performance of the trust over the long run. That’s why Permian Basin Royalty Trust is not a buy-and-hold-forever stock. To be sure, the stock has dramatically underperformed the broad market over the last decade, as it has gained 10%, whereas the S&P 500 has rallied 168%. The immense gap between the performance of the trust and the index is a testament to the risk involved in a highly cyclical stock that also suffers from a long-term decline in its volumes.
Distribution yield
Permian Basin Royalty Trust distributes all its earnings to its unitholders and hence there is no need to examine its P/E ratio. Instead, the stock can be evaluated based on its distribution yield. The stock has offered an average distribution yield of 6.5% over the last decade. This yield seems to correspond to a fair valuation level for this stock. It is certainly above the average yield of a typical stock but it is warranted to compensate investors for the high risk related to the declining output of the trust and its cyclical nature.
Permian Basin Royalty Trust has offered total distributions of $0.59 in the last 12 months. Some investors may claim that these distributions underestimate the potential of the trust due to the aforementioned operating costs in the Waddell Ranch properties. On the other hand, this issue affected the distributions of only three months, while the remaining nine months were boosted by the above average oil prices that prevailed. Given also the 10-year average distribution of $0.60 of the trust, it is reasonable to conclude that the distributions of the last 12 months represent a fair mid-cycle level.
The distributions of $0.59 correspond to a yield of 4.3% at the current stock price. This yield is much lower than the 10-year average distribution yield of 6.5%. In addition, a 4.3% yield is not sufficient to compensate investors for the above mentioned risks of the trust. Therefore, despite its 41% decline in the last 12 months, the stock remains unattractive.
Upside risk
If the operating costs at the producing properties of Permian Basin Royalty Trust moderate and the price of oil rallies, e.g. due to geopolitical tensions or an acceleration of the global economy, the stock is likely to rally in the short run. However, it is not a sound investing strategy to rely on short-term factors for a potential quick profit. The aforementioned vast underperformance of Permian Basin Royalty Trust vs. the S&P 500 is a stern reminder of the high risk of the stock. Only when this stock has been beaten to the extreme during a fierce downturn of the energy sector should investors consider purchasing this stock. At its current valuation, the stock is far from such a point. If the stock plunges to a point (e.g. $7) that its yield becomes much higher than the historical average yield of 6.5%, the stock will become interesting again.
Final thoughts
After a steep decline and underperformance of a stock, some investors rush to purchase it in order to benefit from a potential recovery. However, Permian Basin Royalty Trust has not become cheaply valued, as it is still offering a lackluster yield, which does not compensate investors adequately for the risks of the stock. While the stock may enjoy a relief rally in the short run after its steep decline, investors should refrain from timing the stock due to its high long-term risk.
