CHESAPEAKE GRANITE WASH TRUST Trustee’s Discussion and Analysis of Financial Condition and Results of Operations (Form 10-Q)
Introduction
The following discussion and analysis is intended to help the reader understand the Trust's financial condition and results of operations. This discussion and analysis should be read in conjunction with the Trust's unaudited interim financial statements and the accompanying notes relating to the Trust and theUnderlying Properties included in Item 1 of Part I of this Quarterly Report as well as the Trust's 2021 Form 10-K.
RECENT DEVELOPMENTS
COVID-19 pandemic and impact on global demand for
The global spread of COVID-19 has created significant volatility, uncertainty, and economic disruption. The pandemic has resulted in widespread adverse impacts on the global economy and on Diversified and Diversified's customers and other parties with whom it has business relations. To date, Diversified has experienced limited operational impacts as a result of COVID-19 or the related governmental restrictions. We cannot predict the full impact that COVID-19 or the current significant disruption and volatility in the oil and natural gas markets will have on Diversified's business, cash flows, liquidity, financial condition and results of operations. For additional discussion regarding risks associated with the COVID-19 pandemic, see Part II, Item 7. Trustee's Discussion and Analysis of Financial Condition and Results of Operations in our 2021 Form 10-K and Item 1A "Risk Factors" in our 2021 Form 10-K.
Military conflict in
We are actively monitoring the military conflict inUkraine and assessing its impact on the Trust's business. To date, we have not experienced any material interruptions to our business given our properties are exclusively located withinthe United States . The extent and duration of the military action, sanctions and resulting market disruptions could be significant, including significant volatility in commodity prices, supply of energy resources, instability in financial markets, supply chain interruptions, political and social instability, changes in consumer or purchaser preferences as well as increases in cyberattacks and espionage, each of which could have a substantial impact on the global economy and consequently our business for an unknown period of time. We currently do not expect any material impact on the Trust's business, cash flows, liquidity or financial condition; however, we have no way to predict the progress or outcome of the military conflict inUkraine as the conflict, and any resulting government reactions, are rapidly developing and beyond our control.
Insight
The Trust is a statutory trust formed inJune 2011 under the Delaware Statutory Trust Act. The business and affairs of the Trust are managed by the Trustee and, as necessary, the Delaware Trustee. The Trust does not conduct any operations or activities other than owning the Royalty Interests and activities related to such ownership. The Trust's purpose is generally to own the Royalty Interests, to distribute to the Trust unitholders cash that the Trust receives in respect of the Royalty Interests and to perform certain administrative functions in respect of the Royalty Interests and the Trust units. The Trust derives all or substantially all of its income and cash flow from the Royalty Interests. The Trust is treated as a partnership forU.S. federal income tax purposes. Concurrent with the Trust's initial public offering inNovember 2011 , Chesapeake conveyed the Royalty Interests to the Trust effectiveJuly 1, 2011 , which included interests in (a) 69 Producing Wells in the Colony Granite Wash play and (b) 118 Development Wells that Chesapeake was obligated to drill, cause to be drilled or participate as a non-operator in the drilling of, from drill sites in the AMI, on or prior toJune 30, 2016 . As ofJune 30, 2016 , Chesapeake fulfilled its drilling obligation under the development agreement. Chesapeake retained an interest in each of the Producing Wells and Development Wells, which were acquired by Diversified pursuant to the Assignment Agreement and the Merger, and Diversified currently operates 96% of the Producing Wells and the completed Development Wells. 10 -------------------------------------------------------------------------------- The Trust was not responsible for any costs related to the drilling of the Development Wells and is not responsible for any other operating or capital costs of theUnderlying Properties , and Chesapeake was not permitted to drill and complete any well in the Colony Granite Wash formation on acreage included within the AMI for its own account until it had satisfied its drilling obligation to the Trust. The Royalty Interests entitle the Trust to receive 90% of the proceeds (after deducting certain post-production expenses and any applicable taxes) from the sales of production of oil, natural gas and NGL attributable to Diversified's net revenue interest in the Producing Wells and 50% of the proceeds (after deducting certain post-production expenses and any applicable taxes) from the sales of oil, natural gas and NGL production attributable to Diversified's net revenue interest in the Development Wells. Post-production expenses generally consist of costs incurred to gather, store, compress, transport, process, treat, dehydrate and market the oil, natural gas and NGL produced. However, the Trust is not responsible for costs of marketing services provided by Diversified or Diversified affiliates. The Trust is required to make quarterly cash distributions of substantially all of its cash receipts, after deducting the Trust's administrative expenses, on or about 60 days following the completion of each calendar quarter through (and including) the quarter endingJune 30, 2031 . During the six months endedJune 30, 2022 , a distribution was paid onMarch 3, 2022 andMay 31, 2022 . See Liquidity and Capital Resources below and Note 5 to the financial statements contained in Item 1 of Part I of this Quarterly Report for more information regarding these distributions.
The amount of Trust income and cash distributions to Trust Unitholders will fluctuate from quarter to quarter depending on several factors, including but not limited to:
• Timing and amount of production and sales from development and production wells;
• Price of oil, natural gas and NGLs received;
•Volumes of oil, natural gas and NGLs produced and sold;
•Certain post-production expenses and all applicable taxes; and
•Trust expenses.
Results of fiduciary operations
The quarterly payments to the Trust with respect to the Royalty Interests are based on the amount of proceeds actually received by Diversified during the preceding calendar quarter. Proceeds from production are typically received by Diversified in the month following the month of production. Due to the timing of the payment of production proceeds, quarterly distributions made by Diversified to the Trust generally include royalties attributable to sales of oil, natural gas and NGL for three months, comprised of the first two months of the quarter just ended and the last month of the quarter prior to that one. Diversified is required to make the Royalty Interest payments to the Trust within 35 days after the end of each calendar quarter. During the six months endedJune 30, 2022 , the Trust received payments on the Royalty Interests representing royalties attributable to proceeds from sales of oil, natural gas and NGL forSeptember 1, 2021 toFebruary 28, 2022 . The Trust's revenues and distributable income available to unitholders were affected throughout 2021 and to date in 2022 by natural declines in production and commodity price volatility. The Trust expects production to decline further and expects distributable income to continue to be adversely affected. The Trust's Investment in Royalty Interests is subject to a quarterly full cost ceiling test. The Trust recognized no impairment of the Royalty Interests in the Current Period or theCurrent Quarter . The Trust recognized a$0.84 million impairment of the Royalty Interests in the Prior Period with no impairment of Royalty Interests in the Prior Quarter.See Investment in Royalty Interests in
Note 2 to the financial statements appearing in point 1 of part I of this quarterly report for a more in-depth analysis.
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Distributable Income
Three Months Ended June 30, Six Months Ended June 30,
2022 2021 Change 2022 2021 Change
($ in thousands, except per unit data)
Distributable income available to
unitholders $ 2,524 $ 2,182 16 % $ 5,644 $ 2,476
128%
Distributable earnings per ordinary share
16 %$ 0.1207 $ 0.0530 128 % The$0.34 million increase in distributable income during theCurrent Quarter was primarily due to an increase in the average realized price per boe in the production period fromDecember 1, 2021 toFebruary 28, 2022 (the "Current Production Quarter ") as compared to the production period fromDecember 1, 2020 toFebruary 28, 2021 (the "PriorProduction Quarter "), combined with an increase in total sales volumes in theCurrent Production Quarter . The$3.17 million increase in distributable income during the Current Period was a result of both an increase in the average realized price per boe and an increase in total sales volumes as compared to the Prior Period. Royalty Income Three Months Ended June 30, Six Months Ended June 30, 2022 2021 Change 2022 2021 Change ($ in thousands, except per unit data) Royalty income(a)$ 3,233 $ 2,546 27 %$ 6,926 $ 3,500 98 % Estimated production from trust properties: Oil sales volumes (MBbl) 14 9 56 % 30 19 58 % Natural gas sales volumes (MMcf) 304 285 7 % 639 626 2 % Natural gas liquids sales volumes (MBbl) 37 31 19 % 77 62 24 % Total sales volumes (Mboe) 102 88 16 % 213 186 15 % Average prices received for production(b): Oil ($/Bbl)$ 78.36 $ 46.01 70 %$ 76.08 $ 39.52 93 % Natural gas ($/Mcf)$ 3.27 $ 5.25 (38) %$ 3.35 $ 2.76 21 % Natural gas liquids ($/Bbl)$ 30.35 $ 19.87 53 %$ 32.87 $ 16.15 104 % Total average price received ($/boe)$ 31.79 $ 28.99 10 %$ 32.50 $ 18.84 73 %
(a) Net of certain post-production costs.
(b) Includes the impact of certain post-production expenses but excludes production taxes.
(c) The Trust was affected by lower commodity prices in early 2021 due to the impact of COVID-19
The increase in the average price received per barrel of oil equivalent (boe) in theCurrent Production Quarter compared to the PriorProduction Quarter resulted in an increase of approximately$0.29 million in royalty income. Additionally, higher sales volumes in theCurrent Production Quarter increased royalty income by approximately$0.40 million , for a total increase in royalty income of approximately$0.69 million in theCurrent Production Quarter compared to the PriorProduction Quarter . The 14 mboe increase in total sales attributable to the Royalty Interests for theCurrent Production Quarter compared to the PriorProduction Quarter is primarily the result of improved operational performance, offset by natural declines in production from the Producing and Development Wells. 12 -------------------------------------------------------------------------------- The increase in the average price received per boe in the Current Period compared to the Prior Period resulted in an increase of approximately$2.91 million in royalty income. Additionally, higher sales volumes in the Current Period increased royalty income by approximately$0.52 million , for a total increase in royalty income of approximately$3.43 million in the Current Period compared to the Prior Period. The 27 mboe increase in total sales attributable to the Royalty Interests for the Current Period compared to the Prior Period is primarily the result of improved operational performance, offset by natural declines in production from the Producing and Development Wells. Production Taxes Three Months Ended June 30, Six Months Ended June 30, 2022 2021 Change 2022 2021 Change ($ in thousands, except per unit data) Production tax expenses$ 228 $ 187 (22) %$ 491 $ 243 102 % Production taxes per boe$ 2.24 $ 2.13 (5) %$ 2.31 $ 1.31 76 % Production taxes are calculated as a percentage of oil, natural gas and NGL revenues, net of any applicable tax credits. The increase in production taxes in theCurrent Quarter and Current Period compared to the Prior Quarter and Prior Period relates primarily to an increase in royalty income.
Administrative expenses of the trust
Three Months Ended June 30, Six Months Ended June 30,
2022 2021 Change 2022 2021 Change
($ in thousands)
Trust administrative expenses(a) $ 382 $ 95 302 % $ 593 $ 629 (6) %
(a) Includes a change in cash advances leading to a
Trust administrative expenses primarily consist of the administrative fees paid to the Trustees and Diversified, as well as costs for accounting and legal services. The increase in expenses in theCurrent Quarter is primarily related to the net changes in the cash advance of$0.33 million . The decrease in expenses in the Current Period is due to a reduction for the change in cash advance of$0.30 million in the Prior Period offset by an increase in administrative expense activity of$0.34 million primarily related to the timing of accounting and tax preparation expenses. 13 --------------------------------------------------------------------------------
Cash and capital resources
The Trust's principal sources of liquidity and capital are cash flows generated from the Royalty Interests and the loan commitment as described below. The Trust's primary uses of cash are distributions to Trust unitholders, payments of production taxes, payments of Trust administrative expenses, including any reserves established by the Trustee for future liabilities and repayment of loans and payments of expense reimbursements to Diversified for out-of-pocket expenses incurred on behalf of the Trust. Administrative expenses include payments to the Trustees, as well as a quarterly fee of$50,000 to Diversified pursuant to an administrative services agreement. Each quarter, the Trustee determines the amount of funds available for distribution. Available funds are the excess cash, if any, received by the Trust from the sales of oil, natural gas and NGL production attributable to the Royalty Interests during the quarter, over the Trust's expenses for the quarter and any cash reserve for the payment of liabilities of the Trust. The Trust does not undertake or control any capital projects or capital expenditures. These capital expenditures, if any, are controlled and paid by Diversified. The Trust's revenue and distributions are substantially dependent upon the prevailing and future prices for oil, natural gas and NGL, each of which depends on numerous factors beyond the Trust's control such as economic conditions, regulatory developments and competition from other energy sources. Oil, natural gas and NGL prices historically have been volatile and may be subject to significant fluctuations in the future; however, the volatility in the prices for these commodities has substantially increased as a result of COVID-19. We expect to see continued volatility in oil and natural gas prices for the foreseeable future, and such volatility has impacted and is expected to continue to impact Diversified's business, financial condition and results of operations and proceeds to the Trust and the Trust's reserves and quarterly cash distributions to unitholders. The Trust does not have the ability to enter into derivative contracts to mitigate the effect of this price volatility. The Trustee may increase or decrease the targeted amount of the cash reserve at any time, and may increase or decrease the rate at which it is withholding funds to build the cash reserve at any time, without advance notice to the unitholders. Without limiting the foregoing, the Trustee has reviewed the adequacy and sufficiency of the existing cash reserve and determined that, commencing with the distribution to unitholders for the fourth quarter 2021, which was paid inMarch 2022 , the Trustee began withholding the funds otherwise available for distribution to the unitholders each quarter to increase existing cash reserves by a total of approximately$3,200,000 over a period of several quarters. Cash held in reserve will be invested as required by the Trust Agreement. Any cash reserved in excess of the amount necessary to pay or provide for the payment of future known, anticipated or contingent expenses or liabilities eventually will be distributed to unitholders, together with interest earned on the funds. As ofJune 30, 2022 ,$992,078 has been so withheld to increase cash reserves. The Trust is required to make quarterly cash distributions of substantially all of its cash receipts, after deducting the Trust's administrative expenses, on or about 60 days following the completion of each calendar quarter through (and including) the quarter endingJune 30, 2031 . The 2022 second quarter distribution of$0.0540 per common unit, consisting of proceeds attributable to production fromDecember 1, 2021 throughFebruary 28, 2022 , (net of administrative expenses) was made onMay 31, 2022 to record unitholders as ofMay 20, 2022 . 14
-------------------------------------------------------------------------------- OnAugust 3, 2022 , the Trust declared theAugust 2022 Distribution. The Trust's quarterly income available for distribution was$0.0849 per common unit consisting of proceeds attributable to production fromMarch 1, 2022 toMay 31, 2022 (net of administrative expenses). The distribution will be paid onAugust 29, 2022 to common unitholders of record as ofAugust 19, 2022 . All Trust unitholders share on a pro rata basis in the Trust's distributable income. Distributable income attributable to production fromMarch 1, 2022 toMay 31, 2022 was calculated as follows (in thousands, except for unit and per unit amounts): REVENUES: Royalty income(a)$ 4,429 EXPENSES: Production taxes (308) Trust administrative expenses(b) (54) Total expenses (362) Cash withheld to increase cash reserves (99) Distributable income available to common unitholders$ 3,968 Distributable income per common unit(c)$ 0.0849
(a) Net of certain post-production costs.
(b) Includes the quarterly change in the cash advance leading to an increase in administrative expenses totaling
(c) The calculation of distributable income per Ordinary Unit is based on 46,750,000 Ordinary Units issued and outstanding at
The Trustee can authorize the Trust to borrow money to pay Trust expenses that exceed cash held by the Trust. The Trustee may authorize the Trust to borrow from the Trustee as a lender provided the terms of the loan are fair to the Trust unitholders. The Trustee may also deposit funds awaiting distribution in an account with itself, if the interest paid to the Trust at least equals amounts paid by the Trustee on similar deposits, and make other short-term investments with the funds distributed to the Trust. The Trustee may also hold funds awaiting distribution in a non-interest-bearing account. Pursuant to the Trust Agreement, if at any time the Trust's cash on hand (including cash reserves, if any) is not sufficient to pay the Trust's ordinary course expenses as they become due, Diversified will loan funds to the Trust necessary to pay such expenses. Any funds loaned by Diversified pursuant to this commitment will be limited to the payment of current accounts payable or other obligations to trade creditors in connection with obtaining goods or services or the payment of other current liabilities arising in the ordinary course of the Trust's business and may not be used to satisfy Trust indebtedness for borrowed money of the Trust. If Diversified loans funds pursuant to this commitment, unless Diversified agrees otherwise in writing, no further distributions may be made to unitholders (except in respect of any previously determined quarterly cash distribution amount) until such loan is repaid. There were no loans outstanding as ofJune 30, 2022 andDecember 31, 2021 .
Significant Accounting Policies and Estimates
Refer to Note 2 to the financial statements contained in Item 1 of Part I of
this Quarterly Report for a discussion of significant accounting policies and
estimates that impact the Trust's financial statements. Critical accounting
policies and estimates relating to the Trust are contained in Item 7 of Part II
of the 2021 Form 10-K.
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