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SDR > SEC Filings for SDR > Form 10-Q on 13-Nov-2012All Recent SEC Filings

Show all filings for SANDRIDGE MISSISSIPPIAN TRUST II

Form 10-Q for SANDRIDGE MISSISSIPPIAN TRUST II


13-Nov-2012

Quarterly Report


ITEM 2. Trustee's Discussion and Analysis of Financial Condition and Results of Operations

Introduction

The following discussion and analysis is intended to help the reader understand the Trust's financial condition, results of operations, liquidity and capital resources. This discussion and analysis should be read in conjunction with the Trust's unaudited financial statements and the accompanying notes included in this Quarterly Report, the Trust's audited financial statement and the accompanying notes included in the Prospectus and the "Discussion and Analysis of Historical Results from the Producing Wells" contained in the Prospectus.

Overview

The Trust is a statutory trust created on December 13, 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's purpose is to hold the Royalty Interests, to distribute to the Trust unitholders cash that the Trust receives in respect of the Royalty Interests and the Trust's derivative contracts (described in Note 5 to the unaudited financial statements contained in Part I, Item 1 of this Quarterly Report) and to perform certain administrative functions in respect of the Royalty Interests and the Trust units. Other than the foregoing activities, the Trust does not conduct any operations or activities. The Trustee has no involvement with, control or authority over, or responsibility for, any aspect of the operations on or relating to the properties in which the Trust has an interest. The Trust derives all or substantially all of its income and cash flow from the Royalty Interests and the Trust's derivative contracts. The Trust is treated as a partnership for federal income tax purposes.

Initial Public Offering. In April 2012, the Trust completed an initial public offering of 29,900,000 Trust common units for net proceeds, after payment of underwriting discounts and commissions, of approximately $590.2 million. The Trust delivered the net proceeds of the offering, which were further reduced by $3.1 million for a structuring fee paid to certain of the underwriters, along with 7,393,750 common units and 12,431,250 subordinated units to certain wholly owned subsidiaries of Sandridge in exchange for the conveyance of the Royalty Interests to the Trust. Upon completion of these transactions, there were 49,725,000 Trust units, consisting of 37,293,750 common and 12,431,250 subordinated units, issued and outstanding.

Properties. Concurrent with the public offering, SandRidge conveyed to the Trust, effective January 1, 2012, Royalty Interests, which at September 30, 2012 included interests in (a) the Initial Wells, (b) 67 additional wells (equivalent to approximately 77 Trust Development Wells under the development agreement as described below) that were drilled and perforated for completion between December 31, 2011 and September 30, 2012, and (c) the equivalent of approximately 129 Trust Development Wells to be drilled within an AMI consisting of approximately 66,400 gross acres (52,500 net acres) in northern Oklahoma and southern Kansas.

The Royalty Interests entitle the Trust to receive 80% of the proceeds (after deducting post-production costs and any applicable taxes) from the sale of oil, including natural gas liquids, and natural gas production attributable to SandRidge's net revenue interest in the Initial Wells and 70% of the proceeds (after deducting post-production costs and any applicable taxes) from the sale of oil, including natural gas liquids, and natural gas production attributable to SandRidge's net revenue interest in the Trust Development Wells, in each case, beginning on January 1, 2012, the effective date of the conveyance.

As specified in the development agreement executed by the Trust with SandRidge in April 2012, effective January 1, 2012, SandRidge is obligated to drill, or cause to be drilled, the Trust Development Wells on or before December 31, 2016. SandRidge is not permitted to drill and complete any well within the AMI for its own account until it has satisfied the drilling obligation to the Trust. SandRidge has granted to the Trust a lien covering its interest in the AMI (except its interest in the Initial Wells) in order to secure the estimated amount of the drilling costs for the Trust's interests in the undeveloped Underlying Properties, the balance of which is reduced proportionately, once SandRidge has completed 103 Trust Development Wells, as each of the remaining Trust Development Wells is drilled. At September 30, 2012, the amount potentially recoverable under the lien was approximately $269.1 million.

The Trust is not responsible for any costs related to the drilling of the Trust Development Wells or any other operating or capital costs related to the Underlying Properties. The following table presents the number of Initial Wells, Trust Development Wells drilled and Trust Development Wells to be drilled as of April 23, 2012, the date of the Royalty Interests conveyance, and September 30, 2012.

                                                                                         Trust
                                                               Trust                  Development
                                                            Development               Wells To Be
                                   Initial Wells          Wells Drilled(1)              Drilled                  Total
April 23, 2012                                 67                        24                      182                    273
September 30, 2012                             67                        77                      129                    273

(1) SandRidge is credited for having drilled one full Trust Development Well if a well is drilled and perforated for completion with a perforated length between 3,500 feet and 4,500 feet within the Mississippian formation and SandRidge's net revenue interest in the well is equal to 47.4%. For wells with a perforated length of less than 3,500 feet or greater than 4,500 feet and for wells in which SandRidge has a net revenue interest greater or less than 47.4%, SandRidge receives proportionate credit for such well.


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Distributions. The Trust makes quarterly cash distributions of substantially all of its cash receipts, after deducting amounts for the Trust's administrative expenses, property taxes and cash reserves withheld by the Trustee, on or about 60 days following the completion of each quarter. The Trust's subordinated units are entitled to receive pro rata distributions from the Trust each quarter if and to the extent there is sufficient cash to provide a cash distribution on the common units that is at least equal to the Subordination Threshold. If there is not sufficient cash to fund such a distribution on all of the common units (including the common units SandRidge owns), the distribution to be made with respect to the subordinated units is reduced or eliminated for such quarter in order to make a distribution, to the extent possible, to all of the common units (including the common units held by SandRidge) up to the Subordination Threshold. However, there is no minimum distribution. If the cash available for distribution on all of the Trust units in any quarter exceeds the Incentive Threshold for the corresponding quarter, SandRidge, as holder of the Trust's subordinated units, is entitled to 50% of the amount by which the cash available for distribution exceeds the Incentive Threshold.

The following table sets forth the Subordination Threshold and Incentive Threshold for each remaining calendar quarter through the fourth quarter of 2017, as set out in the trust agreement and as included in the Prospectus.

                                    Subordination        Incentive
                  Period(1)         Threshold(2)       Threshold(2)

                  2012
                  Third quarter    $          0.45     $        0.68
                  Fourth quarter              0.48              0.71

                  2013
                  First quarter               0.52              0.78
                  Second quarter              0.55              0.83
                  Third quarter               0.54              0.81
                  Fourth quarter              0.56              0.85

                  2014
                  First quarter               0.58              0.86
                  Second quarter              0.60              0.89
                  Third quarter               0.60              0.90
                  Fourth quarter              0.58              0.87

                  2015
                  First quarter               0.63              0.95
                  Second quarter              0.64              0.97
                  Third quarter               0.64              0.96
                  Fourth quarter              0.64              0.96

                  2016
                  First quarter               0.67              1.00
                  Second quarter              0.64              0.96
                  Third quarter               0.58              0.87
                  Fourth quarter              0.54              0.81

                  2017
                  First quarter               0.51              0.77
                  Second quarter              0.48              0.73
                  Third quarter               0.46              0.69
                  Fourth quarter              0.44              0.66

(1) Due to the timing of the payment of production proceeds to the Trust, each distribution covers production from a three-month period consisting of the first two months of the most recently ended quarter and the final month of the quarter preceding it.

(2) Each of the Subordination Threshold (80% of quarterly target distribution) and Incentive Threshold (120% of quarterly target distribution) terminates after the fourth full calendar quarter following SandRidge's completion of its drilling obligation.


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Pursuant to Internal Revenue Code Section 1446, withholding tax on income effectively connected to a United States trade or business allocated to foreign partners should be made at the highest marginal rate. Under Section 1441, withholding tax on fixed, determinable, annual, periodic income from United States sources allocated to foreign partners should be made at 30% of gross income unless the rate is reduced by treaty. This is intended to be a qualified notice to nominees and brokers as provided for under Treasury Regulation
Section 1.1446-4(b) by the Trust, and while specific relief is not specified for
Section 1441 income, this disclosure is intended to suffice. Nominees and brokers should withhold 35% of the distribution made to foreign partners.

A portion of the revenues associated with oil production attributable to the Royalty Interests are economically hedged with fixed price swaps from July 1, 2012 to December 31, 2014 through a derivatives agreement between the Trust and SandRidge and certain derivative contracts underlying the derivatives agreement that SandRidge novated to the Trust. The Trust's distributable income includes net settlements under these derivatives contracts.

The Trust will dissolve and begin to liquidate on December 31, 2031 (the "Termination Date") and will soon thereafter wind up its affairs and terminate. At the Termination Date, 50% of the Royalty Interests will revert automatically to SandRidge. The remaining 50% of the Royalty Interests will be retained by the Trust at the Termination Date and thereafter sold, with the net proceeds of the sale, as well as any remaining Trust cash reserves, distributed to the unitholders on a pro rata basis. SandRidge has a right of first refusal to purchase the Royalty Interests retained by the Trust at the Termination Date.

Results of Trust Operations

The primary factors affecting the Trust's revenues and costs are the quantity of oil and natural gas production attributable to the Royalty Interests, the prices received for such production and amounts paid or received as net settlements under the derivatives agreement and the Trust's derivative contracts with unaffiliated counterparties. Royalty income, post-production expenses, production taxes and derivative settlements are recorded on a cash basis when net revenue distributions are received by the Trust from SandRidge and net derivative settlements are received from the Trust's derivative counterparties. Although the Trust was formed on December 13, 2011, the conveyance of the Royalty Interests did not occur until April 2012, and no proceeds from the sale of oil and natural gas production were received by the Trust until May 2012. As a result, the Trust did not recognize any income or make any distributions until May 2012. Information regarding the Trust's production, pricing and costs for the three and nine-month periods ended September 30, 2012 is presented below.

                                                Three Months  Ended            Nine Months  Ended
                                               September 30, 2012(1)          September 30, 2012(2)
Production Data
Oil (MBbls)(3)                                                    231                            365
Natural gas (MMcf)                                              1,553                          2,461
Combined equivalent volumes (MBoe)                                490                            775
Average daily combined equivalent
volumes (MBoe/d)                                                  5.3                            5.1

Average Prices
Oil (per Bbl)(3)                              $                 93.64        $                 94.59
Natural gas (per Mcf)                         $                  2.34        $                  2.62
Combined equivalent (per Boe)                 $                 51.59        $                 52.87

Average Prices - including impact of
derivative settlements and
post-production expenses
Oil (per Bbl)(3)                              $                 98.96        $                 97.96
Natural gas (per Mcf)                         $                  1.80        $                  2.09
Combined equivalent (per Boe)                 $                 52.38        $                 52.75

Expenses (per Boe)
Post-production                               $                  1.72        $                  1.70
Production taxes                              $                  0.89        $                  0.77

Total expenses                                $                  2.61        $                  2.47

(1) Oil and natural gas volumes and related revenues and expenses for the three-month period ended September 30, 2012 (included in SandRidge's August 2012 net revenue distribution to the Trust) represent oil and natural gas production from March 1, 2012 to May 31, 2012.

(2) Oil and natural gas volumes and related revenues and expenses for the nine-month period ended September 30, 2012 (included in SandRidge's May 2012 and August 2012 net revenue distribution to the Trust) represent oil and natural gas production from January 1, 2012 to May 31, 2012.

(3) Includes natural gas liquids.


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Trust Operations for the Three Months Ended September 30, 2012

Royalty Income. Royalty income received during the three-month period ended September 30, 2012 totaled $25.3 million. This was based upon production attributable to the Royalty Interests of 231 MBbls of oil and 1,553 MMcf of natural gas for the period from March 1, 2012 to May 31, 2012. Average prices received for oil and natural gas production, excluding the impact of post-production expenses, during the three-month period ended September 30, 2012 were $93.64 per Bbl of oil and $2.34 per Mcf of natural gas.

Derivative Settlements. The Trust's derivatives agreement with SandRidge reduces the Trust's exposure to commodity price volatility attributable to a portion of production from the Royalty Interests effective April 1, 2012 through December 31, 2014 through the use of oil fixed price swaps. Net cash settlements under the derivatives agreement for the three-month period ended September 30, 2012 for production from April 1, 2012 to May 31, 2012 were approximately $2.5 million, and included net settlements received of approximately $1.2 million related to production from April 1, 2012 to May 31, 2012 and net settlements received of approximately $1.3 million related to June 2012 production. Total net derivative settlements received by the Trust for production from April 1, 2012 to May 31, 2012 effectively increased the average price received for oil by $5.32 per Bbl to $98.96 per Bbl.

Post-Production Expenses. The Trust bears post-production expenses attributable to production from the Royalty Interests. Post-production expenses generally consist of costs incurred to gather, store, compress, transport, process, treat, dehydrate and market the oil and natural gas produced. Post-production expenses for the three-month period ended September 30, 2012 totaled approximately $0.8 million.

Property Taxes. Property taxes paid during the three-month period ended September 30, 2012 totaled approximately $165,000.

Production Taxes.Production taxes are calculated as a percentage of oil and natural gas revenues, excluding the effects of derivative settlements and net of any applicable tax credits. Production taxes for the three-month period ended September 30, 2012 totaled approximately $0.4 million, or $0.89 per Boe, and were approximately 1.7% of royalty income.

Distributable Income. Distributable income for the three-month period ended September 30, 2012 was $26.0 million, which included a net increase to the cash reserve for payment of future Trust expenses of approximately $94,000 (approximately $503,000 withheld from the August 2012 cash distribution to unitholders partially offset by approximately $409,000 used to pay Trust expenses during the period).

Trust Operations for the Nine Months Ended September 30, 2012

Royalty Income. Royalty income received during the nine-month period ended September 30, 2012 totaled $41.0 million. This was based upon production attributable to the Royalty Interests of 365 MBbls of oil and 2,461 MMcf of natural gas for the period from January 1, 2012 to May 31, 2012. Average prices received for oil and natural gas production, excluding the impact of derivative settlements and post-production expenses, during the nine-month period ended September 30, 2012 were $94.59 per Bbl of oil and $2.62 per Mcf of natural gas.

Derivative Settlements. Net cash settlements under the derivatives agreement for the nine-month period ended September 30, 2012 for production from April 1, 2012 to May 31, 2012 were approximately $2.5 million, and included net settlements received of approximately $1.2 million related to production from April 1, 2012 to May 31, 2012 and net settlements received of approximately $1.3 million related to June 2012 production. Total net derivative settlements received by the Trust for production from April 1, 2012 to May 31, 2012 effectively increased the average price received for oil by $3.37 per Bbl to $97.96 per Bbl.

Post-Production Expenses. Post-production expenses for the nine-month period ended September 30, 2012 totaled approximately $1.3 million.

Property Taxes. Property taxes paid during the nine-month period ended September 30, 2012 totaled approximately $165,000.

Production Taxes. Production taxes for the nine-month period ended September 30, 2012 totaled approximately $0.6 million, or $0.77 per Boe, and were approximately 1.5% of royalty income.


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Distributable Income. Distributable income for the nine-month period ended September 30, 2012 was $39.3 million, which included a net increase to the cash reserve for payment of future Trust expenses of approximately $1.4 million (approximately $2.3 million withheld from the May 2012 and August 2012 cash distributions to unitholders partially offset by approximately $0.9 million used to pay Trust expenses during the period).

Liquidity and Capital Resources

The Trust's principal sources of liquidity and capital are cash flow generated from the Royalty Interests, derivative contracts and borrowings to fund administrative expenses, including any amounts borrowed under SandRidge's loan commitment described in Note 4 to the unaudited financial statements contained in Part I, Item I of this Quarterly Report. The Trust's primary uses of cash are distributions to Trust unitholders, including, if applicable, incentive distributions to SandRidge, payment of amounts owed under the Trust's derivatives contracts, payment of Trust administrative expenses, including any reserves established by the Trustee for future liabilities, and payment of expense reimbursements to SandRidge for out-of-pocket expenses incurred on behalf of the Trust. Under the conveyances granting the Royalty Interests, the Trust does not have any capital requirements related to drilling wells or any other operating and capital costs related to the wells.

Administrative expenses include payments to the Trustee and the Delaware Trustee as well as a quarterly fee to SandRidge 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 sale of oil and natural gas production attributable to the Royalty Interests for the quarter, over the Trust's expenses for the quarter, subject in all cases to the subordination and incentive provisions previously described. If at any time the Trust's cash on hand (including available cash reserves) is not sufficient to pay the Trust's ordinary course administrative expenses as they become due, the Trust may borrow funds from the Trustee or other lenders, including SandRidge, to pay such expenses. If such funds are borrowed, no further distributions will be made to unitholders (except in respect of any previously determined quarterly distribution amount) until the borrowed funds have been repaid, except that if SandRidge loans such funds, SandRidge may permit the Trust to make distributions prior to SandRidge being repaid. There was no such loan outstanding at September 30, 2012 or December 31, 2011.

Under the derivatives agreement, SandRidge pays the Trust amounts it receives from its counterparties and the Trust pays SandRidge any amounts that SandRidge is required to pay such counterparties. Additionally, the Trust receives payment directly from its counterparties to the contracts novated to the Trust by SandRidge and is required to pay any amounts owed under those contracts directly to the counterparties. Significant payments by the Trust to SandRidge or the counterparties to the novated contracts could reduce or eliminate distributions paid to unitholders.

2012 Trust Distributions to Unitholders. During the nine months ended September 30, 2012, the Trust's distributions to unitholders were as follows:

                                           Covered                                                                                     Total
                                       Production Period               Date Declared                   Date Paid                  Distribution Paid
                                                                                                                                   (in millions)
Calendar Quarter 2012
First Quarter                                           N/A                             N/A                         N/A                            N/A
                                          January 1, 2012 -
Second Quarter                            February 29, 2012                  April 30, 2012                May 30, 2012                      $    13.3
                                            March 1, 2012 -
Third Quarter                                  May 31, 2012                   July 26, 2012             August 29, 2012                      $    24.7

Future Trust Distribution to Unitholders. On November 1, 2012, the Trust declared a cash distribution of $0.598636 per unit covering production for the period from June 1, 2012 to August 31, 2012 for record holders as of November 14, 2012. The distribution will be paid on or about November 29, 2012 and was calculated as follows (in thousands, except for unit and per unit amounts):

Revenues
Royalty income                                                             $    27,322
Derivative settlements, net                                                      4,360

Total revenues                                                                  31,682

Expenses
Post-production expenses                                                         1,100
Production taxes                                                                   378
Cash reserves withheld by Trustee(1)                                               437

Total expenses                                                                   1,915

Distributable income available to unitholders                              $    29,767

Distributable income per unit (49,725,000 units issued and outstanding)    $  0.598636

(1) Includes amounts withheld for payment of future Trust administrative expenses.


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Critical Accounting Policies and Estimates

Refer to Note 2 to the unaudited financial statements contained in Part I, Item I of this Quarterly Report and the audited financial statements of the Trust and notes thereto included in the Prospectus for a description of the Trust's accounting policies and use of estimates.

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