We built our investment thesis for Hugoton Royalty Trust (NYSE:HGT) back in March 2013 when the units were priced around $8.00. This note provides an update reflecting the rise in the natural gas futures curve and the increase in the HGT monthly distributions since our research was originally published.
As spot natural gas prices moved higher after the colder than normal March and April 2013, HGT's monthly distributions stabilized around $0.07 - $0.08 and the unit price gradually moved higher to the $8.50 - $9.50 range.
The long-term natural gas curve has also moved up, especially after the announcement of a second U.S. LNG facility receiving export approval from the U.S. Department of Energy.
We recently updated our discounted cash flow model for HGT and see it as still significantly undervalued relative to the expected future payouts. Even if we assume that the trust has to pay the remaining $24.1 million charge in full, using the Henry Hub futures curve settles as of June 17, we calculate an approximate NPV of $12.5 for the units.
Our updated assumptions are as follows:
- Revised the assumed NG volume decline rate to 7% through 2016.
- Used a 4% annual production cost decline with reduced withdrawals
- Used an 84% NG / 16% oil revenue breakdown to reflect the recent increase in the price of crude oil
There is of course a certain range around these assumptions, as they are based mainly on information provided in the monthly reports by the Trust. For example, the natural gas sales volume reported in the most recent (June 18th) announcement is actually higher than the volume reported 5 months ago - this makes the 7% decline assumption appear overly aggressive.
In addition, the future split between the gas and oil revenues will obviously depend on the prices of the two commodities. A higher oil price will result in a greater share of oil in the mix.
We reiterate our recommendation to accumulate HGT at current prices. Our main reasons are as follows:
1. HGT is significantly undervalued relative to the NPV of its reserves and currently delivers a stable monthly cash return between 8.5 and 9 percent (annualized), which will continue to attract yield-minded investors. Moreover, because of the depletion allowance, the income tax on the distributions is effectively deferred until the units are sold.
2. HGT is one of the few "pure play" instruments that allow investors to take a direct long position in unhedged natural gas reserves. While equities of gas-heavy E&P companies provide long exposure to natural gas prices, they also carry the risk of management hedging too early or over-leveraging and having to sell reserves at depressed levels. Investors in HGT are essentially paid to wait for a further NG price recovery.
We are very bullish the commodity considering the current storage fundamentals and withdrawal of capex from natural gas drilling. On the demand side, increased industrial demand and the certainty of LNG exports via at least two Canadian and two USA terminals by 2016 will provide further price momentum.
HGT is very sensitive to shifts in the natural gas futures curve. For example, a 10% upward move in futures prices will increase the NPV of the Trust reserves by about $2.
3. There is a strong possibility that the Nov 2013 arbitration will be resolved favorably for the Trust. Such an announcement could be an additional positive catalyst.