Hugoton Royalty Trust (HGT) had a rather tumultuous 2012. Having traded between $20 and $24, the units dropped to the $14 - $16 range in the beginning of 2012 after a sharp decline in realized and forward natural gas prices in association with the anomalously warm 2011 / 2012 winter. The units dropped from $14 to $7 in May 2012 after a 10-Q filing mentioning a $28.5 million litigation settlement charge, helped by a concerted (and successful!) effort by short sellers to create panic. The unit price has recovered somewhat but is still significantly below NPV.
Several developments since last spring have dramatically improved the HGT valuation outlook. First of all, the settlement charge is being rightfully disputed by the trustee and the dispute is tentatively scheduled for arbitration on October 7, 2013. $4.4 million towards the settlement was already deducted from the 7/12 and 8/12 distributions and will be returned if the resolution is favorable to the unit holders. Even if the outcome of the arbitration is negative, the present value of the remaining charge is only about $0.50. Obviously, that hardly justifies the difference between where the units were trading before the announcement and where they are now.
In addition, the natural gas pricing environment has changed dramatically since the spring of 2012. A climatologically normal winter of 2012/2013 combined with a massive reduction in the natural gas rig count has resulted in a much tighter natural gas market. This is evidenced by the fact that storage will end the withdrawal season close to the mid-point of the historical range. As a result, Henry Hub physical gas prices have moved from sub $2.00 / MMbtu to close to $4.00 / MMbtu. The current forward curve through January 2015 is above where it was as of 3/1/2012. Yet HGT is trading at $8.19 now but was $14 as of 3/1/2012.
As the chart below shows, monthly distributions have climbed back close to $0.07/unit and will reach $0.10/unit by January 2014, assuming realized gas prices are similar to what the current forward curve suggests. HGT has recovered a bit, with two notable breakout attempts in November 2012 and January 2013.
Below is a snapshot of our DCF valuation model for HGT:
We believe that a 6% discount rate is appropriate for the current interest rate environment and is commensurate with other instruments with a similar tenor and risk profile. Keeping in mind that the valuation is sensitive to this and other assumptions (production decline rates, gas/oil revenue ratio, etc.), we are confident that HGT is worth between $12 and $13, even after taking into account the remaining settlement charge. In other words, the current $8.20 level represents an approximately 12% IRR.
1. The May 2012 price drop was a clear overreaction, albeit not surprising in an environment of multi-year low natural gas prices and panic fanned by short sellers. Even if the arbitration decision is detrimental to the unit holders, the present value of the remaining settlement payment is only about 50 cents / unit.
2. HGT is one of the few "pure play" instruments that allow investors to take a long position in unhedged natural gas reserves. The commodity is currently traded for $19 / MMbtu in Japan, $12 in Europe, and $4 in the US.
3. There is a significant potential for a short squeeze considering that:
- At the present natural gas curve, the monthly distributions will increase to 0.10 / unit by January 2014 and therefore will continue to attract more yield-minded investors.
- There is a strong possibility that the arbitration will be resolved favorably for the trust. Such an announcement will be a positive catalyst.
4. Using forward natural gas and oil prices as of 3/20/2013, discounted at 6%, and even assuming a negative dispute resolution, the trust units are worth between $12 and $13.