CHESAPEAKE GRANITE WASH TRUST 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 Annual Report on Form 10-K for the year endedDecember 31, 2019 . Recent Developments COVID-19 Pandemic and Impact on Global Demand forOil and Natural Gas OnMarch 11, 2020 , theWorld Health Organization declared the ongoing coronavirus (COVID-19) outbreak a pandemic and recommended containment and mitigation measures worldwide. The pandemic has reached more than 200 countries and territories and has resulted in widespread adverse impacts on the global economy and on Chesapeake's customers and other parties with whom it has business relations. To date, Chesapeake has experienced limited operational impacts as a result of the work from home restrictions or COVID-19 directly. As an essential business under the guidelines issued by each of the states in which it operates, Chesapeake has been allowed to continue operations, although for the health and safety of its employees Chesapeake chose to have its non-essential personnel work remotely. As a result, since mid-March, Chesapeake has restricted access to all of its offices and has directed employees to work remotely to the extent possible. Those employees who are unable to work from home are being closely monitored and are taking precautions to minimize the risk of exposure. These restrictions have allowed Chesapeake to maintain the engagement and connectivity of its personnel, as well as minimize the number of employees required in the office and field. However, future operations could be negatively affected if a significant number of Chesapeake's employees are quarantined as a result of exposure to the virus. There is considerable uncertainty regarding the extent to which COVID-19 will continue to spread and the extent and duration of governmental and other measures implemented to try to slow the spread of the virus, such as large-scale travel bans and restrictions, border closures, quarantines, shelter-in-place orders and business and government shutdowns. One of the largest impacts of the pandemic has been a significant reduction in global demand for oil and, to a lesser extent, natural gas. This significant decline in demand has been met with a sharp decline in oil prices following the announcement of price reductions and production increases inMarch 2020 by members of theOrganization of Petroleum Exporting Countries , or OPEC+, and other foreign, oil-exporting countries. The resulting supply/demand imbalance is having disruptive impacts on the oil and natural gas exploration and production industry and on other industries that serve exploration and production companies. These industry conditions, coupled with those resulting from the COVID-19 pandemic, is expected to lead to significant global economic contraction generally and in our industry in particular. 10
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Oil and natural gas prices have historically been volatile; however, the volatility in the prices for these commodities has substantially increased as a result of COVID-19 and the OPEC+ decisions mentioned above. While an agreement to cut production has since been announced by OPEC+ and its allies, the situation, coupled with the impact of COVID-19, has continued to result in a significant downturn in the oil and gas industry. Oil prices declined sharply inApril 2020 and remain volatile. Strip pricing for natural gas has increased as a result of the oil price war; however, the impact of these recent developments and our business are unpredictable. We expect to see continued volatility in oil and natural gas prices for the foreseeable future, and such volatility, combined with the current depressed prices, has impacted and is expected to continue to adversely impact Chesapeake's business, financial condition and results of operations and proceeds to the Trust and the Trust's reserves and quarterly cash distributions to unitholders. A continued low level of demand or prices for oil and natural gas or otherwise would have a continued material adverse effect on Chesapeake's business, financial condition and results of operations and on proceeds to the Trust and the Trust's reserves and quarterly cash distributions to unitholders. InMay 2020 , Chesapeake disclosed that, if depressed commodity prices persist, combined with the scheduled reductions in the leverage ratio covenant and an expected significant reduction in Chesapeake's borrowing base in its scheduled determination, its liquidity and ability to comply with the leverage ratio covenant under its revolving credit facility during the next 12 months will be adversely affected, which raises substantial doubt about its ability to continue as a going concern. Based on Chesapeake's current forecast, it does not expect to be in compliance with its financial covenants beginning in the fourth quarter of 2020. Failure to comply with these covenants, if not waived, would result in an event of default under Chesapeake's revolving credit facility, the potential acceleration of outstanding debt thereunder and the potential foreclosure on the collateral securing such debt, and could cause a cross-default under its other outstanding indebtedness. We cannot predict the full impact that COVID-19 or the significant disruption and volatility currently being experienced in the oil and natural gas markets will have on Chesapeake's business, cash flows, liquidity, financial condition and results of operations or on proceeds to the Trust and the Trust's reserves and quarterly cash distributions to unitholders due to numerous uncertainties. The ultimate impacts will depend on future developments, including, among others, the ultimate geographic spread of the virus, the consequences of governmental and other measures designed to prevent the spread of the virus, the development of effective treatments, the duration of the outbreak, actions taken by members of OPEC+ and other foreign, oil-exporting countries, governmental authorities, Chesapeake's customers and other thirds parties, workforce availability, and the timing and extent to which normal economic and operating conditions resume. For additional discussion regarding risks associated with the COVID-19 pandemic, see Item 1A "Risk Factors" in this Quarterly Report. Overview 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, and currently operates 96% of the Producing Wells and the completed Development Wells. 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 Chesapeake's 11
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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 Chesapeake'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 Chesapeake or its 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 ending
• timing and amount of production and sales from the Development and
Producing Wells;
• oil, natural gas and NGL prices received;
• volumes of oil, natural gas and NGL produced and sold;
• certain post-production expenses and any applicable taxes; and
• the Trust's expenses.
Results of Trust Operations The quarterly payments to the Trust with respect to the Royalty Interests are based on the amount of proceeds actually received by Chesapeake during the preceding calendar quarter. Proceeds from production are typically received by Chesapeake in the month following the month of production. Due to the timing of the payment of production proceeds, quarterly distributions made by Chesapeake 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. Chesapeake is required to make the Royalty Interest payments to the Trust within 35 days after the end of each calendar quarter. During the three months endedMarch 31, 2020 , the Trust received payments on the Royalty Interests representing royalties attributable to proceeds from sales of oil, natural gas and NGL forSeptember 1, 2019 toNovember 30, 2019 . The Trust's revenues and distributable income available to unitholders were adversely affected throughout 2019 and to date in 2020 by natural declines in production and depressed commodity prices including, with respect to the current quarter, as a result of COVID-19 and the OPEC+ decisions discussed in this Quarterly Report. 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. In the three months endedMarch 31, 2020 and 2019, the Trust recognized no impairments of the Royalty Interests.See Investment in Royalty Interests in Note 2 to the financial statements contained in Item 1 of Part I of this Quarterly Report and Trust Operations for further discussion. 12
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Distributable Income
Three Months Ended March 31,
2020 2019 Change
($ in thousands, except per unit data)
Distributable income available to
unitholders $ 1,733 $ 2,952 (41 )%
Distributable income per common unit $ 0.0371 $ 0.0631 (41 )%
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The
Royalty Income
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Three Months Ended March 31,
2020 2019 Change
($ in thousands, except per unit data)
Royalty income(a) $ 2,016 $ 3,363 (40 )%
Estimated production from trust properties:
Oil sales volumes (MBbl) 20 25 (20 )%
Natural gas sales volumes (MMcf) 511 618 (17 )%
Natural gas liquids sales volumes (MBbl) 42 51 (18 )%
Total sales volumes (Mboe) 147 179 (18 )%
Average prices received for production(b):
Oil ($/Bbl) $ 51.06 $ 61.22 (17 )%
Natural gas ($/Mcf) $ 0.81 $ 1.09 (26 )%
Natural gas liquids ($/Bbl) $ 14.17 $ 23.02 (38 )%
Total average price received ($/boe) $ 13.69 $ 18.79 (27 )%
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(a) Net of certain post-production expenses.
(b) Includes the impact of certain post-production expenses but excludes
production taxes.
The decrease in the average price received per barrel of oil equivalent (boe) in
the current production quarter compared to the prior production quarter resulted
in a decrease of approximately
Production Taxes
Three Months Ended March 31,
2020 2019 Change
($ in thousands, except per unit data)
Production taxes $ (164 ) $ 241 (168 )%
Production taxes per boe $ (1.12 ) $ 1.35 (183 )%
Production taxes are calculated as a percentage of oil, natural gas and NGL revenues, net of any applicable tax credits. The decrease in production taxes in the current quarter is primarily due to a decrease in volumes produced and tax refunds received in the current quarter related to taxes paid from 2010 to 2017.
Trust Administrative Expenses
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Three Months Ended March 31,
2020 2019 Change
($ in thousands, except per unit data)
Trust administrative expenses(a) $ 377 $ 63 498 %
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(a) Including cash advance for administrative expenses.
Trust administrative expenses primarily consist of the administrative fees paid to the Trustees and Chesapeake as well as costs for accounting and legal services. The increase in expenses in the current quarter is primarily due to the timing of cash advances and increases audit fees incurred.
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Liquidity 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 Chesapeake 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 Chesapeake 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 Chesapeake. 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 and the OPEC+ decisions discussed in this Quarterly Report. 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 adversely impact Chesapeake'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 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 2020 first quarter distribution of$0.0371 per common unit, consisting of proceeds attributable to production fromSeptember 1, 2019 throughNovember 30, 2019 , was made onMarch 2, 2020 to record unitholders as ofFebruary 19, 2020 . The Trust's quarterly income available for distribution was$0.0291 per common unit consisting of proceeds attributable to production fromDecember 1, 2019 toFebruary 29, 2020 . OnMay 5, 2020 , the Trust declared theMay 2020 Distribution, attributable to such production period. The distribution will be paid onJune 1, 2020 to common unitholders of record as ofMay 20, 2020 . All Trust unitholders share on a pro rata basis in the Trust's distributable income. Distributable income attributable to production fromDecember 1, 2019 toFebruary 29, 2020 was calculated as follows (in thousands, except for unit and per unit amounts): REVENUES: Royalty income(a)$ 1,788
EXPENSES:
Production taxes(b) (46 ) Trust administrative expenses(c) (311 ) Total expenses (357 ) Cash withheld to increase cash reserves(d) (70 )
Distributable income available to common unitholders
Distributable income per common unit(e)$ 0.0291
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(a) Net of certain post-production expenses.
(b) Includes
(
taxes paid from 2010 to 2017.
(c) Includes the cash advance for administrative expenses.
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(d) Commencing with the distribution to unitholders payable in first quarter
2019, the Trustee began withholding the greater of $70,000 or 3.5% of the
funds otherwise available for distribution each quarter to gradually increase
existing cash reserves by a total of approximately $850,000 . The Trustee may
increase or decrease the targeted amount 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. 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 of
March 31, 2020 , $387,075 has been withheld to increase cash reserves.
(e) Calculation of distributable income per common unit is based on 46,750,000
commons units issued and outstanding as of
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, Chesapeake will loan funds to the Trust necessary to pay such expenses. Any funds loaned by Chesapeake 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 Chesapeake loans funds pursuant to this commitment, unless Chesapeake 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 ofMarch 31, 2020 andDecember 31, 2019 . Off-Balance Sheet Arrangements The Trust has no off-balance sheet arrangements. The Trust has not guaranteed the debt of any other party, nor does the Trust have any other arrangements or relationships with other entities that could potentially result in unconsolidated debt, losses or contingent obligations. Critical 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 2019 Form 10-K. ITEM 3. Quantitative and Qualitative Disclosures about Market Risk
Oil, Natural Gas and NGL Price Risk. The Trust's primary asset and source of
income is the Royalty Interests, which generally entitles the Trust to receive a
portion of the net proceeds from the sales of oil, natural gas and NGL from the
Credit Risk Associated with Chesapeake. Chesapeake's ability to perform its obligations to the Trust will depend on its future results of operations, financial condition, liquidity and ability to comply with the financial covenants contained in its debt instruments, which in turn will depend upon the supply and demand for oil, natural gas and NGL, prevailing economic conditions, and financial, business and other factors, many of which are beyond Chesapeake's control and subject to the continued impact of the COVID-19 pandemic and related economic turmoil. See Risks and Uncertainties in Note 2 to the financial statements contained in Item 1 of Part 1 of this Quarterly Report for further discussion of Chesapeake's ability to continue as a going concern.
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In the event of a bankruptcy of Chesapeake or the wholly-owned subsidiaries of Chesapeake that conveyed the Royalty Interests to the Trust, the Trust could lose the value of all of the Royalty Interests if a bankruptcy court were to hold that the Royalty Interests constitute an asset of the bankruptcy estate. Chesapeake could also be unable to provide support to the Trust through loans and performance of its management duties. ITEM 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures. The Trust's disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Exchange Act are designed to ensure that the information required to be disclosed by the Trust in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in theSEC's rules and forms. Disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed by the Trust is accumulated and communicated by Chesapeake toThe Bank of New York Mellon Trust Company, N.A. , as the Trustee of the Trust, and its employees who participate in the preparation of the Trust's periodic reports as appropriate to allow timely decisions regarding required disclosures. The Vice President of the Trustee has evaluated the effectiveness of the Trust's disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b) as of the end of the period covered by this Quarterly Report. Based on her evaluation, as ofMarch 31, 2020 , she has concluded that the Trust's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) were effective. Due to the nature of the Trust as a passive entity and in light of the contractual arrangements pursuant to which the Trust was created, including the provisions of (a) the Trust Agreement, (b) the administrative services agreement, (c) the development agreement and (d) the conveyances granting the Royalty Interests, the Trust's disclosure controls and procedures necessarily rely on (i) information provided by Chesapeake, including information relating to results of operations, the costs and revenues attributable to the Trust's interests under the conveyance and other operating and historical data, plans for future operating and capital expenditures, reserve information, information relating to projected production, and other information relating to the status and results of operations of the underlying properties and the Royalty Interests, and (ii) conclusions and reports regarding reserves by the Trust's independent reserve engineers. Although the Trustee does rely on Chesapeake to perform certain functions and to provide certain information that impact the Trust's financial statements, the Trustee remains responsible for evaluating, as appropriate, the Trust's disclosure controls and procedures as well as its internal control over financial reporting. Changes in Internal Control over Financial Reporting. There were no changes in the Trust's internal control over financial reporting during the three months endedMarch 31, 2020 that materially affected, or were reasonably likely to materially affect, the Trust's internal control over financial reporting. 18
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