Brandon Bell

Introduction

Every crisis creates an opportunity. In Europe, the main current crisis is not the war in Ukraine but the fallout from this war which is causing major problems in the energy supply chain. Natural gas flows to Europe have fallen a cliff and it is of course wishful thinking that a reliable supply chain can be put in place before winter hits. Of course, LNG imports are increasing, but obviously there are limits and there is a zero percent chance that LNG will cover the shortfall due to the drop in Russian gas imports this winter. This will create a binary scenario: either a solution will be found with Russia opening the floodgates, or Europe will wake up abruptly for having depended for so long on cheap Russian natural gas. Natural gas will be available, but the question will be at what price. In the past month alone, the price of natural gas in Europe has doubled, likely in anticipation of the Nord Stream pipeline being taken out of service for maintenance and the uncertainty surrounding the reopening of this pipeline. It is not unthinkable that there are “sudden technical problems” that cannot be solved immediately “because Western sanctions against Russia mean that the latter does not have the technical capabilities to solve the problems”.

Come on stage, North European Oil Royalty Trust (NYSE: NRT). Despite the trust’s name, there is virtually no exposure to oil. Natural gas sales provide more than 90% of revenue, with sulfur making up roughly the remainder of consolidated revenue. Sulfur is a by-product of sour gas treatment at the desulphurization plant.

Chart
Data by YCharts

The Trust model is very simple and straightforward

Philip MacKellar did a good job of explaining what NRT is in his April article. I highly recommend his article to learn more about the background of the North European Oil Royalty Trust and what royalty is.

Philip considered NRT to be an excellent hedge against inflation. Although this may be true, I see NRT as an excellent vehicle to take advantage of the very high natural gas prices in Europe. Let’s look at the one-year chart for TTF natural gas for delivery in October 2022. Note: European gas prices are expressed in EUR per MWh.

Evolution of the price of natural gas

Intercontinental Exchange Web Page

As you can see above, the price of natural gas has increased eightfold (!) in just one year. This automatically means that a natural gas lease royalty owner should be doing just fine, as they are immediately exposed to the revenue side of the equation and don’t have to deal with operating expenses.

There are two caveats here in the case of NRT. The natural gas price used by Exxon Mobil (XOM) and Shell (SHEL) as concession operators is not the TTF gas price but the import price at the German border. It is not easy to find exactly this price, but I assume that the variation of the widely used TTF price will be relatively small. And since Germany has supplied a very large part of its natural gas needs to Russia, which now suddenly has to be replaced, I do not expect the price of German natural gas to be significantly lower than the price reference of the TTF. As such, while not 100% correct, I believe it is realistic to use the TTF benchmark price to calculate future royalty cash flows.

The second problem is the lag between spot prices and realized prices. While natural gas field operators pay monthly royalties, the price used is based on a three-month moving average. There will therefore be a small delay between the spot prices and the fact that NRT actually receives the higher prices. I don’t see that as a major factor either, as it’s NRT that will end up profiting from the higher prices.

The North European Royalty Trust’s year runs from 1 November to 31 October, so the most recent financial results take into account the months of February-March-April, while the next quarterly report, due at the end of August, will provide quarterly details from May to July.

As NRT is a trust that distributes its royalty income, its balance sheet looks very clean. There are no assets other than cash temporarily parked on the balance sheet prior to the payment of a distribution. There’s no debt either, which means NRT has one of the simplest balance sheets I’ve ever seen. This is the balance sheet situation at the end of April.

Balance sheet

NRT Investor Relations

So it’s a very simple model. Money comes in, money goes out. That’s it. And the inflow of cash obviously depends on a number of reasons: the rate of production of natural gas, the price of natural gas and the exchange rate (because natural gas is sold in EUR but NRT declares its profits and its distributions in USD).

Extrapolate Q2 results to what we can expect in the current quarter

Based on the performance of the first and second quarters, we can make very educated guesses about what the distribution will be for the next few quarters. We know the price of natural gas and we know the exchange rate. The only unknown right now is the production rate, but to keep things simple, I’ll assume that the second quarter production rate is steady-state production.

T2 income statement

NRT Investor Relations

So in the second quarter we see that the trust generated $3.77 million in royalty income and had just under $215,000 in operating expenses to end up with distributable income of $3.56 million. dollars. In the same quarterly report, we find that the price of gas was around $16/MMcf in the first quarter of the calendar year. But equally important is the gas price in euro cents per kilowatt hour of 5.144 and 5.246.

Sales' repartition

NRT Investor Relations

This makes it easier to compare apples to apples because you only need to multiply the price per kWh by 1,000 to get the price per MWh. Thus, at an average price of EUR 52 per MWh, distributable income was $3.56 million.

Now let’s see what would happen if we used a price of EUR 105 per MWh, which is double the average price of natural gas in the previous quarter. Revenue would increase to $7.45M (sulphur revenue would not double) and even if I increased overhead by about 15% to $0.25M, distributable income would increase to $7.2M. Spread over the 9.2 million units outstanding, the distributable income would be $0.78/share. The exchange rate still fluctuates and we don’t know the exact production rate, so a margin of error should be applied here, maybe 5-10% on either side.

Applying the current spot price of EUR 170 per MWh would result in a quarterly dividend of approximately $1.30 for an annual dividend above $5. This means that at current spot prices, NRT would yield over 40%.

Proven production reserves underpin a useful life of around 7 years, but the main ‘problem’ is that Niedersachsen, the area where the Oldenburg concession is located, has not allowed new onshore drilling. since a while. This means that Exxon and Shell can only rework existing wells to maximize performance and hopefully the urgent need to secure a natural gas supply in Germany will help with the licensing of new wells. Earlier this year offshore drilling and development of an offshore gas field in Niedersachsen was approved, so hopefully this means that Niedersachsen will also consider allowing the development of onshore gas wells. If this does not happen, we should expect a gradual decline in annual natural gas production.

Investment thesis

The only unknown at this stage is the tax treatment of distributions for Europeans. I won’t know until August when the distributions hit my accounts. But given the likely massive payouts for the next few quarters, I wouldn’t be discouraged by a high withholding tax, similar to LPs. Of course, when the price of natural gas drops again, the total tax burden comes into play, but I expect to have sold the position before that.

At this point, my strategy is to use NRT as a hedge against the natural gas bill as there will be a direct correlation between the household natural gas bill in Europe and the distributions paid by North European Oil Royalty Trust.

One of the commentators on Philip’s article said: “all trusts eventually go to zero and a 4% return is not good enough”. It’s correct. But given natural gas prices over the last quarter and the evolution of natural gas prices over the current quarter, I think it’s not unrealistic to expect a total distribution of 1 $.75 for the next two ads. I hope this will lead to a revaluation of the stock, as it would allow me to realize a capital gain, as I see NRT as a way to take advantage of European natural gas prices. I think the market is being misled by the word “oil” in the trust’s name and perhaps the next distribution announcements will be a revelation.

I have a long position in NRT and I will look to increase this position further in case of weakness (provided of course that the price of European natural gas does not suddenly collapse).