- An ongoing dispute between HGT and its proprietor, XTO Energy, Inc., has been resolved.
- The conclusion requires XTO to pay HGT $6.2M and also removes a significant point of uncertainty regarding future distributions.
- As a result, HGT’s valuation increases, but the market price reaction may be creating a sell-side opportunity.
Tribunal issues ruling
On April 21, the tribunal responsible for resolving an ongoing dispute between Hugoton Royalty Trust (NYSE:HGT) and its proprietor, XTO Energy, Inc., issued a final ruling requiring XTO to reimburse the trust for all prior deductions, plus costs, expenses, and interest. HGT announced the ruling in a press release on April 23:
On April 21, 2014, the three member panel of arbitrators delivered its unanimous ruling as follows:
i) awarding declaratory relief to the Trustee that the Fankhouser settlement, in whole or in part, is not a production cost under the conveyances governing the Trust's net profits interest, and therefore not chargeable to the Trust
ii) awarding permanent injunctive relief to the Trustee barring XTO Energy from treating the Fankhouser settlement, in whole or in part, as a production cost under the conveyances governing the Trust's net profits interest, or otherwise modifying or reducing the Trust's payments, now or in the future, based on the Fankhouser settlement,
iii) awarding the Trustee $6,110,961.71 from XTO Energy, comprised of: [a] $4,386,396 representing amounts withheld from the September and October 2012 Trust distributions; [b] $371,931.72 representing interest to December 18, 2013; [c] $1,167,563 of Trustee attorneys' fees; [d] $185,070.99 of Trustee arbitration expenses;
iv) awarding the Trustee interest on the $4,386,396 from December 18, 2013 until paid at $871.27 per day, and
v) ordering XTO Energy to reimburse the Trustee $117,984.13 for administrative fees and expenses of the American Arbitration Association and compensation and expenses of the arbitrators incurred by the Trustee.
Source: HGT press release 4/23/14
As a result of the ruling, which should be considered as nothing less than a complete victory by HGT, current investors should expect an additional $0.16 spread over the May and June distributions.
Ruling reduces uncertainty regarding future distributions
The tribunal's decision concludes an 18-month dispute between the trust and XTO regarding the trust's responsibility to pay $28.5M as part of a legal settlement in a separate case involving XTO, Fankhouser v. XTO Energy, Inc. A full victory by XTO energy would have cost the trust at least $22M. The decision of the tribunal is both final and binding; it conclusively decides the liability of HGT and removes all uncertainty regarding the direct impact of this case on the trust's future distributions.
Depite the near term financial implications, the ruling also suggests that HGT may be partially shielded from costs related to other legal cases involving XTO and stemming from the same underlying issues from Fankhouser v. XTO Energy, Inc. The tribunal's ruling specifically notes that the Fankhouser costs to XTO were not production-related and, therefore, not applicable to the trust. As such, XTO may treat the costs related to the remaining lawsuits as independent of the trust. It's great news for HGT investors.
HGT valuation post-ruling
As those familiar with my articles know, I analyze trusts using a bottom-up, engineering-style model that considers forecasts of production, sales prices, and expenses. Since last reviewing HGT, the forecasts of future oil and gas prices have risen markedly, which more than offset a decline in production and increase in costs. The model considers a middle case, which is based on current production trends and market-based price futures, as well as best and worst cases, which assume higher/lower than expected production and sales prices.
Now, the effect of the tribunal's ruling may also be considered. The current NPV of HGT for various discount rates, after considering the impact of the ruling, are shown in the following table. Alternatively, HGT's ROI for its current market price ($10/sh., as I write this) is roughly 2.5% per year.
Source: Author's analysis, based on HGT SEC filings and NYMEX price futures
The choice of an appropriate discount rate should reflect the relative risk of the investment. The tribunal ruling not only removes risk form the Fankhouser settlement, it reduces the risk exposure to the remaining lawsuits. In my opinion, an appropriate rate of return would be or 8%, which is on par with other established trusts, resulting in a market price of $6.58/sh.
Current investors should note that the ruling offers nothing but great news. However, the market's current reaction (+$2.00/share) seems to be very excessive given that the ruling offers a positive increase of less than $0.20/share. Although some of the additional increase is the reduction in downside risk, I don't see such an increase as being justified on a fair cost basis. Alternatively, some of the upward price movement may be due to the closing of short positions; meaning that there could be a short opportunity given the current price bounce.
Additional disclosure: I have taken a small short position on elevated prices.