I was a big fan of HGT's monthly dividend and play on the ongoing arbitration. But a deep technical review shows that HGT may be overvalued and ready for a big fall.
This is the third article in a series on oil and gas trusts in which I use an engineering-style model to estimate a trust's net present value, or NPV. This article discusses the model as applied to Hugoton Royalty Trust (NYSE:HGT), whose ongoing legal troubles attracted me as a possible play. A summary of the fair value for HGT for various rates of return and risk is provided at bottom. The text of the article discusses the model and key assumptions in the analysis, which are shared to promote dialogue. Comments, challenging questions, and discussion on the assumptions are encouraged.
Forecasts for the distributions of other trusts are also available:
- Enduro Royalty Trust (NYSE:NDRO) (Forecast as of 11/12/13)
- ECA Marcellus Trust I (NYSE:ECT) (Forecast as of 11/19/13)
A General Model of an Oil and Gas Trust
Oil and gas trusts are a type of commodity investment in which an investor purchases the right to future net profits from a set of wells. HGT was created by XTO Energy Inc. (now a subsidiary of ExxonMobil (NYSE:XOM)) to "collect and distribute… 80% of the net proceeds received from certain working interests in predominantly gas-producing properties in Kansas, Oklahoma and Wyoming." (Source: HGT website 11/25/13.)
For an investor, HGT's value, as that of all trusts, is based entirely on the NPV of its distribution stream. Although other methods, such as trailing yield and proven reserves, are sometimes used to compare trusts, these other methods ignore critical considerations, such as the cost to extract resources, uncertainty related to extraction economics, and the reality that trusts have no influence over capital investment. Only the NPV of future distributions measures what matters; it is the value of the cash that a trust will put in your hand.
Generally speaking, a trust's distributions are determined in a two-step process that is illustrated below. First, the proprietor calculates the overall net property income by subtracting production and sales-related expenses from the underlying properties' gross revenues. Then, the trust administration determines the total distribution by subtracting their expenses from the trust's share of the net property income.
Although trusts typically report only historical performance, forecasts may be developed for future well production, sales, and expenses (and, therefore, the resulting distributions) through a careful reading of a trust's SEC filings and some number crunching.
Of course, in the case of trusts, the devil is in the details. As discussed in my earlier article, "Tricks that Inflate the Value of Oil and Gas Trusts," trusts and well proprietors use a number of accounting and contractual techniques to manipulate net income and, indirectly, the distribution. These tricks can mislead the investor, so it is wise to be aware of them when investing in trusts. To account for these details, the generalized model must be modified significantly to estimate a specific trust's distributions. The rest of this article discusses these modifications as made for HGT.
HGT Trust Distribution Model
HGT is a gas-heavy trust that also produces a small amount of oil. Historical sales numbers, which are generally 2-3 months behind production, are available in HGT's quarterly SEC 10-Q filings. Over the past 5 years, natural gas production has declined at an average of 8.4%/year, while oil production has declined 4.28%/year. HGT suggests that forward-looking decline rates will be between 6-8%/year, which would be in line with the performance of other trusts.
The estimated rate of natural production decline on the underlying oil and gas properties is approximately 6% to 8% a year
(Source: 10-Q filed 11/12/13, see above link)
To estimate future sales volumes, I separated oil and gas production and generated roughly a dozen yield curves for each. Test curve methods included best-fit straight-line, power-curve reduction, and fixed decline, each fit to historical performance. Three curves were selected for oil and three for gas to represent possible future production as best, middle, and worst cases, whose results are shown below.
Both sets of forecasts are 5-period seasonal moving averages. For oil, the assumed annual declines are 4%, 5.5%, and 7% y/y, respectively. For gas, the declines are 6%, 7.5%, and 9% y/y. For both, the middle case is well within the region defined by historical performance and HGT's limited guidance, while the best and worst cases push the boundaries of what might be expected under reasonable circumstances.
As a side note, each forecast also assumes that future capital investment in the underlying properties will be minimal, which means that production declines will continue until the trust terminates. This assumption is reasonable given that the proprietor has only a 20% stake in the revenues from underlying properties. I'll save further discussion on this point for the comments, if folk are interested.
Oil and gas from the underlying properties is sold through closed contracts. Contract terms are unavailable to the investor, but published historical sales numbers roughly reflect NYMEX Henry Hub prices. Therefore, the model assumes that future oil and gas prices will equal the value of NYMEX futures contract prices for WTI Light Sweet Crude and the Henry Hub, respectively. As of 11/25/13, these values are similar to those for spot sales today and gradually move to long term values of $79.70/BBL for oil and $5.27/MCF for gas.
XTO deducts a series of categorical expenses from gross revenues before the trust receives its share. These costs amount to more than 50% of the gross revenues, including more than $1M spent on "Overhead." (The overhead expense seems excessively high to me, but HGT does not provide further detail on the nature of this expense.) For future expenses, the model assumes that:
- "Taxes, transportation, and other" and "Production" will change in proportion to the future volume of oil and gas production
- "Development" will decrease at 0.5%/month from current levels
- "Overhead" will increase at a rate equal to that of the past 12 months
The figure below shows the historical and forecast revenues and expenses for the underlying properties.
HGT trust administration deducts a single, regular quarterly charge for trust expenses. Over the past 20 quarters, the charge has varied between $112,267 (Dec. 2010) and $982,022 (Sept. 2012), with an average of $285,250/quarter. Trust administration also credits the trust with a nominal interest payment, of $200/qtr on average. The model assumes that both of these charges will continue at current average levels.
In addition to recurring charges, HGT administration has deducted occasional, non-recurring charges for legal expenses related to the myriad of legal suits that the trust, XTO Energy, and the trust administrator have been party to. HGT provides little guidance in terms of estimating future legal expenses, so the model assumes that future charges are $0.
HGT has no set dissolution date, but does have several dissolution conditions. The model forecasts distributions out until they reach a dissolution threshold, at which point it assumes that the remaining interest in the revenue stream is sold with the proceeds going to the trust holders. The sale value assumes a forward-looking 10% ROI, ongoing transportation and production costs, and a minimal overhead cost (assumptions which may be optimistic). The NPV of this residual is nontrivial and varies between $0.14/share and $0.90/share depending on case and ROI.
Regarding HGT's and XTO's ongoing litigations (there are several), the model's underlying assumption is that these litigations will remain unresolved. However, a "what-if" discussion is included in the next section.
So what's HGT worth? Well, that depends on an investor's desired NPV and risk level. The model calculates the NPV of future distributions for the best, middle, and worst cases, with a substantial residual payout, and for various rates of return. These results are summarized below.
As I read the table, it suggests that the current market valuation of HGT ($7.35, as I write this), assumes that production will follow the best case with an appropriate rate of return around 5%. As compared to the other trusts that I have reviewed, the market valuation appears to be unreasonably optimistic.
A more fair valuation might assume the middle case and a return of 10-12%, with a risk premium related to ongoing litigation. This would value HGT between $3.88 and $4.26. The following illustration shows the forecast of distributions in future and present value. To me, the chart suggests that HGT's distribution will gradually decline over the next decade and that the real culprit for its low valuation is the fact that the distribution is already low.
So what about the XTO arbitration?
Bearing in mind that the valuation above assumes that the XTO arbitration will remain unresolved, it is reasonable to ask how the outcome of the arbitration will affect the NPV.
The arbitration in question refers to an earlier legal settlement made in Fankhouser v. XTO Energy, Inc. XTO claims that HGT's share of the settlement is approximately $28.5M, of which XTO has already deducted $4.4M from HGT's royalties. If HGT wins the settlement, I assume that a best case outcome would be the immediate recuperation of the $4.4M, roughly $0.11 per share. If HGT loses, the worst case might be that XTO deducts the remaining balance of $24.1M, or $0.60/share from future trust royalties.
Now, I'm not a lawyer, and I have no knowledge of the arbitration other than what I have read in HGT's SEC filings. And, while it seems to me that HGT would not have gone to arbitration unless the administrator had a very good case, given that I believe that the market valuation is already far above the best legal outcome, HGT is simply not worth the risk to me. Therefore, as a result of this analysis, I closed a small position in HGT that I had previously held.
For other consideration
In addition to the trusts that I have mentioned above, investors wishing to do their own comparative analysis may wish to consider:
- Chesapeake Granite Wash Trust (NYSE:CHKR)
- Mesa Royalty Trust (NYSE:MTR)
- MV Oil Trust (NYSE:MVO)
- SandRidge Permian Trust (NYSE:PER)
- Pacific Coast Oil Trust (NYSE:ROYT)
- SandRidge Mississippian Trust II (NYSE:SDR)
- SandRidge Mississippian Trust I (NYSE:SDT)
- Whiting USA Trust I (NYSE:WHX)
- Whiting USA Trust II (NYSE:WHZ)
Disclosure: I am long ECT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.