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Doug Meeks, Pier LLC (15 clicks)
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Hugoton Royalty Trust (HGT) announced a settlement of $37 million concerning the underpayment of expenses in the case Frankhourser vs. XTO, Inc. (see 2012 Q1 report). For its part of the settlement, HGT has to deduct $28.5 million from the royalty income streams from its Oklahoma and Kansas properties. This has created a temporary discount in the price of Hugoton Royalty Trust that an investor can profit from over the next year.

The settlement deductions began in September 2012 and affected the October distribution as well. A Tribunal overseeing the ruling temporarily suspended these deductions until a final decision will be made in May next year (could be sooner). See the report here from HGT web site.

The chart below, from Ycharts.com, shows the effect of the lawsuit on the distributions and on the price of HGT. In fairness, it also shows the declining price of natural gas over most of the year (red line).

(click to enlarge)

  1. May 22, 2012, the price plummeted due to the outcome of Frankhourser vs. XTO, Inc.
  2. A new price channel was formed based on expectations of royalty cuts.
  3. HGT hit a unit low price of $5.86 on September 4, 2012.
  4. With the suspension of deductions, Hugoton's distribution is back and gave HGT the price uptick.

The waterfall price decline was based on the lawsuit, but additional downside action was related to the falling price of natural gas which hit a ten-year low in April 2012.

As natural gas moved up from that low, investors expected that the settlement would have an accelerated payment schedule from higher royalties, but the Tribunal's suspension of the settlement payments changed that.

The markets do not like this lawsuit-related uncertainty and are most likely still discounting the price of HGT. I feel that this discount is an opportunity for the patient investor.

Evaluating the Opportunity

The November distribution will be paid on December 14 and will be $0.053 per trust unit. This is based on the average price of natural gas sold by HGT in September of $3.45 per Mcf. This is a very low price level for natural gas being sold from these properties, but it gives a prudent investor a good point to evaluate HGT without giving in to hopes of a big natural gas rally.

Let's use a longer-term chart to find a HGT unit price level that an investor can expect from a $0.05 per month distribution rate. The date range on this chart is November 2007 to November 2009.

(click to enlarge)

In the chart above the blue line shows HGT price, and the orange line shows the distribution amount.

  1. The yellow box shows the period from February 2009 to July 2009 with distributions paid in the $0.05 per month range.
  2. The lowest HGT unit price in the time frame is $7.41.
  3. The highest HGT unit price in the time frame is $14.96.
  4. The black line shows the $0.05 per month distribution level.

The yield range started at 8% when the price was low and moved to 4% when the price was high.

A ten-year yield chart will show that HGT has historically traded just above that level between the 9% and 5% yield. This yield range does not include the effects of the two periods of extreme volatility shown on the chart; however, a ten-year time frame is long enough to see how the market efficiently prices HGT. See the chart below from Ycharts.com.

(click to enlarge)

Although a yield chart is not a reliable technical indicator, as its data is limited and overly related, it does do a good job showing investor reaction to the effects of changes in natural gas pricing and thus the royalty distribution.

Actionable Trade Information and Summary

The effects of the lawsuit have been delayed for another six months, so while that unknown effect is priced into this stock, it should continue to trade at a discount. Once resolved, the lawsuit will have at most a twelve-month effect on the bulk of the distributions. This time frame is discussed in the September and October HGT news releases.

Once the lawsuit is reinstated or resolved, the discount will be removed from the price of Hugoton units. At that point the balance between the historical yields of 5 to 9% will return. If the payout remained at $0.63 per year, a trust unit of HGT would be priced between $7.00 and $12.72 based on historical yield information. That price range gives us the trade parameters.

Entry point for Hugoton Royal Trust

We are cautiously adding HGT below the $7.00 range. This would be a pullback from the current price of $7.41 on 12/11/2012.

Exit point for Hugoton Royalty Trust

To further bias these figures, an investor could apply the depletion rate for the entire HGT property set. I use the number of 9.5% per year for a depletion rate (see HGT annual report page 13 for production decline).

That brings a prudent exit point down to $10.96 per trust unit. This is the $12.72 value (from above) depleted by 9.5% per year for 1.5 years.

Brief Trade Summary:

  • Buy HGT below $7.00.
  • Enter initial stop loss order at -10% of entry level.
  • Move stops up if price rises.
  • Sell HGT in the $10.96 range.

This is a risky trade with an upside potential in the range of 60% in a time frame of 18 months or less. If the unit price moves up, we strongly advise moving up stop loss orders to ensure profits are realized. It is important to understand that this accounts for a neutral view of the natural gas market over this time frame and does not include distributions paid over the length of the trade.

Source: Trade Hugoton Royalty Trust On A Settlement-Related Discount