Six U.S. Royalty Trusts are the most oversold stocks in our coverage of 42 income, small cap and large cap oil and gas producer stocks. Among the next stocks under the most selling pressure are the three conventional Canadian Income Stocks and our natural gas buy recommendation among Small Cap Independent Producers. We define oversold as the stocks with the lowest ratio of enterprise value to 50-day moving average. Nine of the ten oversold stocks have McDep Ratios of 0.52 or less, implying undervaluation by our analysis.
As we watch the stocks in our coverage over the days, weeks and months, the same stocks do not stay oversold for long as extreme action seems to rotate from one stock group to another. For a while, near-month natural gas had a lower ratio of price to 50-day average, but no longer as momentum in the commodity has improved. Moreover, several of the most oversold stocks have a majority of value concentrated on oil rather than natural gas.
The six most oversold stocks, with ratios of price to 50-day average and McDep Ratio in parentheses, are Cross Timbers Royalty Trust ((CRT), 0.64, 0.41), buy-recommended Hugoton Royalty Trust ((HGT), 0.70, 0.32), hold-rated San Juan Basin Royalty Trust ((SJT), 0.70, 0.43), Mesa Royalty Trust ((MTR), 0.73, 0.35), Sabine Royalty Trust ((SBR), 0.78, 0.64) and Permian Basin Royalty Trust ((PBT), 0.79, 0.50). We have further comments on uncharacteristic reserve increases for SBR, CRT, PBT and Dorchester Minerals (DMLP).
Proven Reserves Surprises
Normally, investors would not expect much growth from income stocks because most of the gain in economic value is periodically paid out to unit, or share, holders. That expectation would likely be stronger for royalty trusts that are chartered with specific properties and restricted from active management to take on debt or acquire new properties. As a result, when new estimates of proven reserves of remaining oil and gas to be produced are released each year, investors expect the total to decline by the amount produced in the past year.
At the same time, the amount of oil left to be produced is sensitive to price as production is projected to end some years in the future when the cost of the last barrel equals the revenue to be received. For an estimate of future price to be used in calculating remaining production, the Securities and Exchange Commission requires producers to use the price quoted on the last day of the year. Thus, with oil and gas price down at the end of 2008, estimates of reserves would normally be revised downward. The impact on present value of the volume change is diminished by the fact that the omitted amounts would apply to oil and gas to be produced only in the final years of field life.
Given that long explanation of what to expect, we are surprised to see that year-end reserve estimates were higher than the previous year for three royalty trusts and one partnership. The four entities have in common whole or part concentration on what we call revenue royalties rather than the more common net profits royalties. SBR, with 100% revenue royalties, reported higher reserves and higher volume for 2008. Revenue royalties give SBR a free carry on investment made by others who apparently found it worthwhile to do more drilling on SBR’s proven lands or on land not previously proven. CRT registered an increase in reserves on oil properties in which it holds revenue royalties. PBT registered increases on both oil and gas properties subject to revenue royalties. The partnership, DMLP, which operates with the restrictions and tax benefits of a royalty trust, scored gains on revenue royalty properties under development by its limited partner. When those gains are added to gains on properties already reported in the partnership, overall reserves increased as well.
Reported reserves on revenue royalty properties include multiple layers of conservatism. Part of the reason is that revenue royalty owners seldom have access to property information beyond the disclosures of volume produced which must be reported. Engineers making estimates of reserves may rely primarily on extrapolated production by well or groups of wells with no information about new wells that might be drilled. Accordingly, the reported reserves of revenue royalty properties include no noticeable quantities in the proved undeveloped category (colloquially known as “PUDs”) that typically account for a third of proven reserves of operating companies.
On one hand, reported reserves can cause investors to underestimate the true value of revenue royalties. On the other hand, there is a tax advantage to unit holders of conservative reporting. It translates to a higher rate of depletion that increases the rate at which cost of purchase can shelter current distribution from taxation.
Mesa Royalty Trust to Cure Reporting Deficiency
Look for a new reserve report shortly from truly small market cap MTR. A year ago, ConocoPhillips (COP), the operator of the trust’s properties in the San Juan Basin, apparently declined to furnish a reserve estimate, a reasonable stance, in our opinion, considering potential legal liability. Instead we expect to see an estimate for 2008 from an independent engineer like DeGolyer & MacNaughton, the trust’s original engineer when MTR was formed in 1979. In the meantime, the New York Stock Exchange has issued repeated non-compliance notices for failure to provide such disclosure. The dire notices may have contributed, needlessly, we believe, to a lack of confidence accompanying the recent stock price collapse.
Originally published on March 13, 2009.