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, 2020 . Recent Developments Tapstone's Agreement to be acquired by Diversified Energy OnOctober 6, 2021 ,Tapstone Energy Holdings, LLC entered into a conditional Agreement and Plan of Merger with Diversified Energy to acquire all upstream assets, field infrastructure, equipment and facilities owned by Tapstone, which includes theUnderlying Properties of the Trust. The Acquisition has not yet been consummated and is subject to certain closing conditions. Additional information about Diversified Energy, including its presentation of the Acquisition is available on Diversified Energy's website at www.div.energy. No information regarding Diversified Energy, including any information on its website, is incorporated into this filing. COVID-19 Pandemic and Impact on Global Demand forOil and Natural Gas The global spread of COVID-19 created significant volatility, uncertainty, and economic disruption during 2020. The pandemic has reached more than 200 countries and territories and has resulted in widespread adverse impacts on the global economy and on Tapstone and Tapstone's customers and other parties with whom it has business relations. To date, Tapstone has experienced limited operational impacts as a result of COVID-19 or the related governmental restrictions. While 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 Tapstone'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 2020 Form 10-K and Item 1A "Risk Factors" in our 2020 Form 10-K. Winter Weather Event InJune 2021 , Tapstone, pursuant to certain royalty trust conveyances between Tapstone and the Trust, deposited$0.5 million of proceeds received by Tapstone associated with theFebruary 2021 production period in a separate escrow account. Significant demand, coupled with freeze related natural gas production curtailment resulted in supply shortages prompting natural gas prices to spike in mid-February in the centralUnited States (the "Winter Weather Event"). Natural gas produced from theUnderlying Properties and other Tapstone assets inFebruary 2021 realized a significant increase in prices for natural gas during such period, causing the related natural gas production revenues generated from theUnderlying Properties (the "Winter Weather Event Proceeds") to significantly increase, which is not expected to be a normal or recurring event. To ensure the proper allocation of the Winter Weather Event Proceeds to Tapstone's mineral interest owners, including the Trust, from this event, Tapstone deposited$0.5 million , an estimate of the amount at issue, in an escrow account (the "Escrowed Funds") to avoid possible allocation controversy while it reviewed the allocation between mineral ownership of theUnderlying Properties . Interest on the Escrowed Funds attributable to the Royalty Interests was paid to the Trust inNovember 2021 . Tapstone concluded its allocation review process inJuly 2021 and submitted the Winter Weather Event Proceeds attributable to the Royalty Interests in the amount of$0.4 million net of production tax to the Trust for distribution to Trust unitholders as a part of theAugust 2021 Distribution. 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 10 -------------------------------------------------------------------------------- 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 Tapstone pursuant to the Assignment Agreement, and Tapstone 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 Tapstone'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 Tapstone'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 Tapstone or Tapstone 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 nine months endedSeptember 30, 2021 , a distribution was paid onMarch 1, 2021 ,June 1, 2021 and August 30, 2021. 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 revenues and cash distributions to Trust unitholders fluctuates from quarter to quarter depending on several factors, including, but not limited to: •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. 11 -------------------------------------------------------------------------------- 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 Tapstone during the preceding calendar quarter. Proceeds from production are typically received by Tapstone in the month following the month of production. Due to the timing of the payment of production proceeds, quarterly distributions made by Tapstone 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. Tapstone is required to make the Royalty Interest payments to the Trust within 35 days after the end of each calendar quarter. During the nine months endedSeptember 30, 2021 , the Trust received payments on the Royalty Interests representing royalties attributable to proceeds from sales of oil, natural gas and NGL forSeptember 1, 2020 toMay 31, 2021 . The Trust's revenues and distributable income available to unitholders were affected throughout 2020 and to date in 2021 by natural declines in production and commodity price volatility including, with respect to theCurrent Quarter , as a result of COVID-19. The Trust expects production to decline further and expects distributable income to continue to be adversely affected. The Trust's distributable income available to unitholders declared inAugust 2021 totaled$1.7 million and was inclusive of proceeds attributable to the Escrowed Funds related to theFebruary 2021 Winter Weather Event totaling$0.4 million . The average price received for natural gas production as a part of this distribution was$2.38 ($/MCF), however adjusting for the Escrowed Funds, the average price received was$1.02 ($/MCF). The average realized natural gas price received by the Trust is burdened by post-production expenses, including gathering, storage, compression, transportation, processing, treating, dehydration, and non-affiliated marketing expenses. The distributable income available to unitholders declared inNovember 2021 totaled$2.3 million . The average price received for natural gas production as a part of this distribution totaled$1.73 ($/MCF), an increase as compared to the$1.02 ($/MCF) realized price included in the distribution declared inAugust 2021 after adjusting for the Escrowed Funds. This increase is primarily a result of an improvement in NYMEX commodity pricing. The Trust's Investment in Royalty Interests is subject to a quarterly full cost ceiling test. The Trust recognized a$0.84 million impairment of the Royalty Interests in the Current Period with no impairment of the Royalty Interests in theCurrent Quarter . The Trust recognized a$3.69 million impairment of the Royalty Interests in the Prior Period and a$0.64 million impairment of the Royalty Interests in the Prior Quarter.See Investment in Royalty Interests in
Note 2 to the financial statements contained in Item 1 of Part I of this Quarterly Report for further discussion.
Distributable Income
Three Months Ended September 30, Nine Months Ended September 30,
2021 2020 Change 2021 2020 Change
($ in thousands, except per unit data)
Distributable income available to
unitholders $ 1,744 $ 247 606 % $ 4,220 $ 3,340 26 %
Distributable income per common unit
604 %$ 0.0903 $ 0.0715 26 % The$1.50 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 fromMarch 1, 2021 toMay 31, 2021 (the "Current Production Quarter ") inclusive of the Winter Weather Event Escrowed Funds as compared to the production period fromMarch 1, 2020 toMay 31, 2020 (the "PriorProduction Quarter "), combined with an increase in total sales volumes in theCurrent Production Quarter . The$0.88 million increase in distributable income during the Current Period was due to an increase in average realized price per boe inclusive of the Winter Weather Event, offset by both the natural decline in production volumes and increase in production tax expense (tax refunds received in the Prior Period) in comparing to the Prior Period. 12 --------------------------------------------------------------------------------
Royalty Income
Three Months Ended September 30, Nine Months Ended September 30,
2021 2020 Change 2021 2020 Change
($ in thousands, except per unit data)
Royalty income(a) $ 2,299 $ 377 510 % $ 5,799 $ 4,181 39 %
Estimated production from trust
properties:
Oil sales volumes (MBbl) 14 13 8 % 33 52 (37) %
Natural gas sales volumes (MMcf) 323 357 (10) % 949 1,353 (30) %
Natural gas liquids sales
volumes (MBbl) 40 30 33 % 102 114 (11) %
Total sales volumes (Mboe) 108 102 6 % 293 392 (25) %
Average prices received for
production(b):
Oil ($/Bbl) $ 58.33 $ 17.91 226 % $ 47.27 $ 43.21 9 %
Natural gas ($/Mcf)(c) $ 2.38 $ 0.05 4,660 % $ 2.63 $ 0.47 460 %
Natural gas liquids ($/Bbl) $ 18.27 $ 4.48 308 % $ 16.98 $ 11.39 49 %
Total average price received
($/boe) $ 21.34 $ 3.70 477 % $ 19.76 $ 10.67 85 %
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(a)Net of certain post-production expenses. (b)Includes the impact of certain post-production expenses but excludes production taxes. (c)The Trust was adversely affected by depressed commodity prices throughout 2020 as a result of 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$1.90 million in royalty income. The increase in royalty income is primarily attributable to an increase in commodity pricing, inclusive of the Winter Weather Event Escrowed Funds. Additionally, higher sales volumes in theCurrent Production Quarter increased royalty income by approximately$0.02 million , for a total increase in royalty income of approximately$1.92 million in theCurrent Production Quarter compared to the PriorProduction Quarter . The 6 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 Wells and Development Wells. The increase in the average price received per boe in the Current Period compared to the Prior Period resulted in an increase of approximately$2.67 million in royalty income. The increase in royalty income is primarily attributable to an increase in commodity pricing, inclusive of the Winter Weather Event. Additionally, lower sales volumes in the Current Period decreased royalty income by approximately$1.05 million , for a total increase in royalty income of approximately$1.62 million in the Current Period compared to the Prior Period. The 99 mboe decrease in total sales attributable to the Royalty Interests for the Current Period compared to the Prior Period is due to weather related curtailments and natural declines in production from the Producing Wells and Development Wells. 13 --------------------------------------------------------------------------------
Production Taxes
Three Months Ended September 30, Nine Months Ended September 30,
2021 2020 Change 2021 2020 Change
($ in thousands, except per unit data)
Production tax expenses(income) $ 146 $ 27 (441) % $ 388 $ (91) (526) %
Production taxes per boe $ 1.35 $ 0.26 (419) % $ 1.32 $ (0.23) (674) %
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
the Current Quarter and Current Period compared to the Prior Quarter and Prior
Period relates primarily to an increase in royalty income and to tax refunds
received related to taxes paid from 2010 to 2017.
Trust Administrative Expenses
Three Months Ended September 30, Nine Months Ended September 30,
2021 2020 Change 2021 2020 Change
($ in thousands)
Trust administrative expenses(a) $ 364 $ 33 1,003 % $ 993 $ 722 38 %
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(a)Includes a change in cash advances resulting in a$0.20 million increase and a$0.10 million decrease in administrative expenses for the three and nine months endedSeptember 30, 2021 , respectively. Trust administrative expenses primarily consist of the administrative fees paid to the Trustees and Tapstone, as well as costs for accounting and legal services. The increase in expenses in theCurrent Quarter is primarily due to the timing and amount of the change in the cash advance. The increase in expenses in the Current Period is due to an increase in administrative expense activity primarily related to accounting, tax preparation, and regulatory compliance expenses. 14
-------------------------------------------------------------------------------- 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 Tapstone 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 Tapstone 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 Tapstone. 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 Tapstone'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 (payable in 2022), the Trustee shall begin 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 ofSeptember 30, 2021 ,$794,578 has been 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 2021 third quarter distribution of$0.0373 per common unit, consisting of proceeds attributable to production fromMarch 1, 2021 throughMay 31, 2021 , (net of administrative expenses) was made onAugust 30, 2021 to record unitholders as ofAugust 19, 2021 . 15 -------------------------------------------------------------------------------- OnNovember 3, 2021 , the Trust declared theNovember 2021 Distribution. The Trust's quarterly income available for distribution was$0.0496 per common unit consisting of proceeds attributable to production fromJune 1, 2021 toAugust 31, 2021 (net of administrative expenses). The distribution will be paid onNovember 29, 2021 to common unitholders of record as ofNovember 19, 2021 . All Trust unitholders share on a pro rata basis in the Trust's distributable income. Distributable income attributable to production fromJune 1, 2021 toAugust 31, 2021 was calculated as follows (in thousands, except for unit and per unit amounts): REVENUES: Royalty income(a)$ 2,899 EXPENSES: Production taxes (202) Trust administrative expenses(b) (377) Total expenses (579) Cash withheld to increase cash reserves - Distributable income available to common unitholders$ 2,320 Distributable income per common unit(c)$ 0.0496
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(a)Net of certain post-production expenses. (b)Includes the quarterly change in cash advance resulting in a decrease in administrative expenses totaling$0.05 million (c)Calculation of distributable income per common unit is based on 46,750,000 commons units issued and outstanding as ofNovember 2, 2021 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, Tapstone will loan funds to the Trust necessary to pay such expenses. Any funds loaned by Tapstone 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 Tapstone loans funds pursuant to this commitment, unless Tapstone 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 ofSeptember 30, 2021 andDecember 31, 2020 . 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 2020 Form 10-K. 16
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