About four months ago, I recommended avoiding the Permian Basin Royalty Trust (New York Stock Exchange: PBT) due to the risk related to its exposure to the next downturn in the energy sector. Since my article, the stock was temporarily down 10% but has recovered all of its losses thanks to the recent rebound of the entire energy sector amid favorable oil and gas prices. In addition, the trust is likely to benefit greatly from the recently announced decision OPEC to drastically reduce its production. This decision will boost the results of the trust in the short term. However, PBT is still very risky from a long-term perspective.
The Permian Basin Royalty Trust has royalty interests in some oil and gas properties in Texas. Unlike well-known oil majors such as Exxon Mobil (XOM) and Shell (SHEL), PBT is a purely upstream company, without any downstream segments. Also, you cannot expand into new areas and therefore the trust will continue to exist as long as your holdings remain prolific and profitable. In general, PBT is much more vulnerable to oil and gas price cycles than the integrated oil majors. This is positive in good times, like this year, but it is negative in recessions or slowdowns in the energy sector, since there is no buffer in these adverse periods.
PBT is currently prospering thanks to the exceptionally favorable trading conditions it enjoys. Due to Russia’s invasion of Ukraine, the United States and Europe have imposed strict sanctions on Russia. Before the sanctions, Russia produced approximately 10% of the world’s oil production and a third of the natural gas consumed in Europe. Due to sanctions, Russia has reduced its oil and gas production and thus global oil and gas markets have tightened considerably. As a result, oil and gas prices have risen to multi-year highs.
Since PBT is extremely sensitive to underlying oil and gas prices, it has benefited greatly from excessive oil and gas prices 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 return 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, their last three monthly distributions are much larger than their distributions in the first few months of the year as there is a lag between oil and gas prices and distributions and the trust has also reduced its operating costs by their Waddell Ranch properties lately. If only the last three monthly distributions are taken into account, they correspond to an annualized return of 12.3%. In addition, the trust is on track to deliver a 10-year high total annual distribution this year thanks to the exceptionally favorable business outlook.
On the other hand, oil and gas prices have suffered a correction of approximately 30% from their maximum of the last four months. Its correction has been mainly due to fears of an upcoming global recession due to aggressive interest rate hikes implemented by central banks. In addition, high oil and gas prices encouraged US and Canadian producers to increase their production. As a result, oil and gas markets have become more balanced of late.
Due to the oil price correction, OPEC recently announced that it will reduce its production by 2 million barrels per day. As its members are already operating 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 by OPEC; the cartel used to target a maximum oil price of around $80 to avoid providing incentives for alternative energy projects. However, now that the world is already doing its best to diversify away from fossil fuels, OPEC has chosen to support the price of oil at a much higher level for the first time in history and thus provided a short-term floor for the price of oil.
OPEC’s decision is likely to greatly benefit US oil producers, including PBT, as most countries do not have the potential to increase their production significantly. In fact, the US and Canada are the only non-OPEC oil producers with enough additional capacity to increase their production significantly. Thanks to the high price of oil, US oil producers will do everything they can to improve their production.
It is also important to note that US oil production has rebounded strongly from its pandemic lows and is back to the level it was in March 2020, according to the Energy Information Administration. [EIA]US shale oil production is expected to reach an all-time high in November. To cut a long story short, US oil producers are likely to continue to take advantage of tight OPEC production quotas in the coming months. PBT will almost certainly benefit from reduced OPEC production.
However, investors must never forget the dramatic cyclical nature of the oil industry. Whenever oil prices have been high for any considerable period, they have always provided a great incentive for producers to increase their production. At some point, global supply is likely to outstrip global demand and thus the next down cycle of the energy market will appear. At that point, PBT will have to drastically reduce its distribution.
In addition to 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 being developed right now. Most countries are suffering from excessive oil and gas prices this year and are therefore doing their best to switch from fossil fuels to clean energy sources. When all of these projects come online, in about 2-4 years, they will affect world oil consumption and thus probably deal a big blow to the PBT business.
Some investors say this time is different and expect the oil market to remain tight for years. However, the oil market is famous for its cyclical nature. It is very risky to conclude that the oil market is no longer cyclical and expect the oil price to hover around its 14-year highs for years as this has never happened before.
It is important to form rational expectations for PBT’s distributable income whenever the power market returns to a normal condition. During the years 2015-2016 and 2020-2021, the oil market went through major recessions and therefore these periods are not representative of normal conditions. Rather, the 2017-2019 period 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 return of only 2.8%, which is well below the average distribution return of 6.5% of PBT in the last decade. Therefore, if the oil price returns to its normal range and PBT’s yield remains in line with its 10-year average, PBT stock will be 57% (=3.7/6.5*100) down from its current price.
Global economic growth has slowed markedly in recent months due to aggressive interest rate hikes implemented by central banks in an effort to cap inflation. With inflation hovering at a 40-year high, central banks are likely to maintain their aggressive stance for longer than initially expected, and thus an impending recession seems inevitable. If a recession does not occur and the world economy recovers strongly from its latest downturn, the price of oil may remain high for a considerable period. In such a case, PBT is likely to continue to offer above-average distributions and its shares are likely to hover around their 10-year highs.
Another potential positive catalyst for PBT could be another production cut by OPEC in the future. However, there are limits to OPEC’s ability to reduce its production. Most of its members rely heavily on oil to finance their budgets and are therefore often reluctant to reduce their production below a certain level. In addition, non-cartel North American oil producers take advantage of every OPEC production cut and make up for much of OPEC’s lost barrels. In other words, OPEC members see their sacrifices in part wasted every time they cut production due to the ability of North American oil producers to increase production.
In summary, there are some factors that can delay the emergence of the next down cycle of the oil industry. However, given the proven cyclicality of this industry and the unprecedented number of renewable energy projects in development right now, it is very risky to expect the price of oil to remain excessive for years. Therefore, PBT is highly risky around its 10-year highs.
The price of oil temporarily tumbled below its level at the time of Russia’s invasion of Ukraine, but OPEC recently triggered a relief rally with its bold strategic move. While the price of oil is unpredictable in the short term, it is likely to enter a downward cycle at some point in the next few years due to the accelerated efforts of most countries to switch from oil to clean energy sources. PBT is highly vulnerable to this age-old threat and therefore investors should not be seduced by its current exceptional distribution performance.