Seeking Alpha
Long/short equity, deep value, long-term horizon, energy
Profile| Send Message|
( followers)

The Hugoton Royalty Trust (NYSE:HGT) was created in 1998 and distributes to its unitholders 80% of the net proceeds from certain gas-producing properties in the Hugoton, Anadarko, and Green River Basins in Kansas, Oklahoma, and Wyoming. The trust was set up by XTO Energy.

Why Long Natural Gas

After the coldest November nationwide in the last 10 years and a very cold start of December, by the end of the year we will have 500 bcf less gas in storage than last year. This will be the lowest level since December 2008, when the commodity was trading $8/MMbtu. Even a normal January is likely to drive prices toward the $5 level.

On the supply side, it appears that the endless "glut" of natural gas at prices below $4 is not really there. Evidence of that is the first month-over-month production drop this September, per the EIA 914 report.

Production did tick up in November as new pipelines in the Northeast connected wells that had been drilled but shut in; however, production other than in the Marcellus shale is flat to declining. Moreover, heating industrial and residential / commercial demand has grown faster than expected, as indicated by the last 3 surprisingly large storage withdrawals

There are multiple ways to benefit from the upcoming rise in prices, including derivative plays such as coal producers and merchant power generators. Gas-heavy royalty trusts like HGT are as close to pure plays on the commodity as the futures themselves. Unlike E&P companies, many of which have hedged the next 2 years at lower than current prices, gas royalty trust distributions vary directly with the realized cash price for the commodity.

Why Long HGT

Compared to most other oil / gas royalty trusts, HGT derives about 90% of its revenues from natural gas. It generates royalty payments from some of the most established and long life / slow decline basins in the US. The trust operator, XTO Energy, is now a part of Exxon Mobil (NYSE:XOM).

It is our opinion that HGT is significantly undervalued. There are a number of probable reasons. Many unitholders lost substantial amounts after the stunning drop in price in May of 2012. The drop looked very much like an institutional "capitulation" during a period of very low natural gas prices. It would be natural for these unitholders to wait before reestablishing or adding to their positions until they see an increase in distributions.

In addition, there have been several bearish articles on Seeking Alpha regarding the trust, some of which have used aggressive / unrealistic assumptions in their valuation approach. We present and substantiate our own assumptions further in this note.

The most significant driver of a resource royalty trust is the forward price of the commodity itself. Indicative of the appreciation potential for the trust is that the correlation between HGT and the prompt month gas futures has broken down since the middle of September 2013. In other words, gas prices have moved up sharply since the August 8, 2013 $3.20 low while HGT has lagged:

(click to enlarge)

The main chart shows the percent change of the rolling futures contract (candlesticks) and HGT (LINE) since the beginning of 2013. As the bottom chart illustrates, the 10-day rolling correlation was (logically) high during the rise and subsequent fall in natural gas prices between March and September 2013 but has interestingly disappeared in the last few weeks. There hasn't been any news that would call for a fundamental valuation revision and distributions have come in as expected.

We see this as an aberration which will correct itself in the next weeks and months, when increased monthly distributions are announced. (Distributions are based on production 2 months prior to the month for which the royalty is announced - the latest payout, announced November 18, was for production during the month of September).

Discounted Cash Flow Valuation

Below is a snapshot of our base case valuation model, using the Henry Hub natural gas and WTI crude oil curves as of 12/9/2013.

(click to enlarge)

Our base case values HGT around $9 / unit. The main modeling assumptions are as follows:

3.5% decline rate for the natural gas reserves and 6% for the crude oil reserves

The most recent 10-K mentions a 6-7% decline rate for the gas reserves, which is an understandably conservative estimate not supported by the recent monthly results. The daily production rate in the last 11 months has been constant, which validates our assumption.

In addition, the most recent proven reserves estimate was for 248,181 Mcf of gas, 2,513,000 bbls of oil. A higher decline rate would assume that the trust continues operation much beyond the average reserve to production ratio of 14 years. We still can't "fit" into 14 years with a 3.5% decline rate and the proven reserve constraints but are reasonably close.

(click to enlarge)

1.1 multiple of HGT realized prices ($/Mcf) to the Henry Hub average settle prices ($/MMbtu)

A projection of this multiple is needed as we are using the futures curve (in $/MMbtu at Henry Hub, LA) to estimate the future realized prices for the HGT gas production. Historically, as the chart below shows, the multiple varies depending on a number of factors such as the heat content of the gas, the day-to-day volumetric differences in production, the locational spread differentials between the hub and where HGT sells its production, etc.

We used a 1.1 ratio to be conservative in the valuation, even though the average of the last 24 months is 1.15. A higher ratio assumption would result in a higher valuation.

(click to enlarge)

6% discount rate

A 6% discount rate is comparable to a high yield corporate bond of a similar duration. It is reasonable in the current low interest rate environment and for the HGT risk profile.

The impact of some of the variables to the valuation is presented in the sensitivity analysis below:

(click to enlarge)

Cost Assumptions

Some of the costs passed through to the trust before calculating the royalty distribution vary with production and some are fixed. We assume that the fixed costs would increase with the general level of inflation and the variable ones will decline with production.

The table below presents the history of these cost categories since 2007 and our assumed annual rate of change.

(click to enlarge)

Our base case assumes that the trust will be dissolved around the end of 2030 and the remaining royalty interest - sold. We estimate around $1 PV of the termination proceeds based on a 6% discount rate and a 15% distributions decline in perpetuity after 2030.

The Fankhouser Settlement and the Arbitration

Much has been written on SA about this issue and investors have been aware of it since early 2012. XTO settled the Fankhouser lawsuit in April 2012, passing 28.5 million to the trust. Of the 28.5 million, 4.4 was taken out of the Sep 2012 and Oct 2012 distributions, before the matter was challenged by the trustee, submitted for arbitration, and further charges suspended. The arbitration hearings were held in November 2013 and the results are yet to be announced.

We don't see the arbitration outcome as a concern. We believe that the market has priced in a worst case outcome and is likely to adjust quickly upward to anything but that. The composition of the panel - one member chosen by the trustee, one by XTO, and the third - selected by the other two, makes it logical to expect a middle ground resolution. And even in the unlikely event that the panel decides entirely against the trust, the remaining amount of the charge is only 60 cents / unit. Hardly enough to justify the precipitous drop in price in 2012 and the units still trading $2 below NPV.

Conclusion

HGT is a pure play long natural gas position which provides a low risk 12% monthly cash royalty. It combines the safety of recurring monthly income with the advantage of unhedged participation in any future increases in natural gas prices. The income is based on long life, slow decline oil and gas reserves and is effectively shielded from taxation until the units are sold. We expect that there will be an upward step change in the price of HGT within the next two months, as investors see higher distributions following the rapid increase in natural gas prices this winter.

We are long HGT and other royalty trusts heavily weighted toward natural gas.

Disclosure: I am long HGT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.