Analysis of May Cash Distribution
Investors were overly exuberant when they saw the $0.263851 per unit monthly distribution for May. They drove the price of the units from a range of approximately between $7.00 and $9.00 to an intraday high of $12.04 on May 27. Since then the price of the units has come down, but the units are still significantly overpriced, currently in the range of $9.65 to $11. The units should probably be priced in a range of $7 to $8, where they were priced before the one-time extraordinary May distribution.
Those investing in Hugoton Royalty Trust (NYSE:HGT) may very well be misled by the yield they read in Value Line and Yahoo. Value Line quotes a yield of 10.60% and Yahoo reports a yield of 9.90%. Total cash distributions, including the one-time, extraordinary, additional distribution, for the 12 months ended July 31, 2014, were $1.06. If one excludes the one-time, extraordinary, additional distribution, the yield is 9.08%. Value Line computes its yield by dividing the trailing twelve-month distributions of $1.06 by the closing price of HGT on Aug. 8. I am unable to determine exactly how Yahoo has computed its reported yield.
The May cash distribution included $4,386,396 which was deducted from HGT Trust proceeds in September and October 2012, and $1,985,438, which represents attorney fees, arbitration expenses, and interest. The per unit distribution for these two items is $0.159296 and is a non-recurring amount. Eliminating this one-time, extraordinary, additional distribution would have resulted in the May distribution being only $0.104555 per unit. The June distribution was $0.094512 per unit, and the July distribution was $0.086540 per unit. Clearly, the monthly cash distribution is declining and will decline even more as the price of natural gas declines. This decline in the price of natural gas is discussed in the next section.
Another future occurrence to consider, and perhaps more important than declining gas prices, that will cause future monthly distributions to decline is natural production decline. Reading page 17 of HGT's recently published 10-Q one can see there was a 7% decline in sales volume for the three months ended June 30, 2014, compared to the same period in 2013. Management clearly states the reason for this decline, "Gas sales volumes decreased 7% for the second quarter of 2014 and 6% for the first six-month period of 2014 as compared with the same 2013 periods primarily because of natural production decline."
Long term, there is this added effect of lower production from maturing wells that also reduces the monthly distributions over any six-month period or longer. It is this very reduction in production rates that defines the end date of the HGT Trust, when production is no longer high enough or economical enough to continue profitably. So we are on a declining slope from current levels to when the HGT Trust runs out about 10 years from now. For a discussion of the life of the HGT Trust, see the discussion under the section below titled "NPV of Future Cash Flows."
For more information regarding the May distribution, I refer you to the news release announcing the distribution and the settlement of the arbitration resulting in the extraordinary, one-time additional amount distributed.
Declining Price of Natural Gas
HGT's cash distributions depend heavily on the price of natural gas. In recent weeks, the price of natural gas has decreased significantly, and the trend, according to recent articles, is for natural gas prices to continue to decline.
In a July 14, 2014, article published by Bloomberg titled "Natural Gas Supply Gains Keep Driving Bulls From Market" it is reported that "twelve weeks of above-average gains in U.S. natural gas supply are easing concern over winter fuel shortages and spurring speculators to cut their bets on rising prices." The article states we can expect further price declines. Those of you wishing to read the article can do so here. At the time of writing this report on HGT (Aug. 8, 2014), the price of natural gas (September contract) has fallen below $4 per MMBtu to $3.96. As of July 31, it had fallen to $3.74 per MMBtu ($3.83 per Mcf.). The July 31 price was near the lowest it has been during the past 52 weeks. However, for the week ending Aug. 8 natural gas futures capped the biggest weekly gain since February as forecasts showed heat returning to the eastern U.S., spurring demand for power generation after weeks of mild weather. This uptick in gas prices is most likely temporary because the hot August weather will turn into mild September and October weather as it has in the past.
There is a possibility gas prices could increase significantly. Prices have certainly been volatile in the past. However, prices have never remained high, and one should not expect prices to remain high should they increase significantly. Gas prices never go up and stay up for many years without subsequently falling to equally low prices for as long or longer. Like any other commodity, high prices provide an incentive for other producers to increase output, which for natural gas is a simple proposition in the US. This brings prices back in line. One need only look at gas price charts to verify this. Therefore, to bet on high gas prices to increase the price of HGT units is not a good long-term bet.
NPV of Future Cash Flows
Some investors make the error of assuming the cash distributions are distributions of income. This is not entirely true. The distributions consist of income and a return of original investment. The HGT Trust is not a perpetuity. It has a limited life based on the extraction of gas and oil in the underlying reserves in the wells, and these reserves will eventually be depleted. Since the cash distributions consist of a return of investment and profit, the best way to determine the value of the Trust is to discount the future estimated cash flows to their present value. This is called the NPV of future cash flows.
While there may be future reserves discovered, it is currently estimated that the HGT Trust has a remaining life of approximately 10 years (see Section 3 of "Energy Investing 101: Tackling Oil and Gas Royalty Trusts"). At a future date when the oil and gas has been extracted and there are no remaining profitable reserves, HGT Trust's Royalty Properties will be sold for market value and the cash received from the sale, less any applicable administrative costs, will be distributed to the unit holders of record at that time. The value of the HGT Trust will then become zero and cease to exist. For this reason, investors should consider the cash distributions to be a combination of return of original investment and income. To read more about the life of HGT Trust, see Footnote 1 of "Notes to Financial Statements," and frequently asked questions on Hugoton's website.
HGT Trust estimates the NPV of its future cash flows to be $206.4 million. As of August 8, 2014, the market value of HGT Trust is $396.8 million. Therefore, the current market value of HGT Trust exceeds its NPV by $190.4 million. On a per unit basis the current market value is $9.92, and the per unit NPV is $5.13. For a discussion regarding the computation of the NPV of future cash flows, see Item 2, page 12 of HGT Trust's 2013 10-K.
Total cash flows for the 12 months ended Dec. 31, 2013, were $0.862682 per unit. Using the adjusted Dec. 31, 2012, closing per unit price of $6.13 the yield on the units for 2013 was 14.07%. Unit holders received an $0.85 increase in the value of their units with the Dec. 31, 2013, unit price at $6.98. Unit holders were obviously expecting a much higher yield for 2013 than the 9.08% yield they are receiving today. The price of the units will have to decrease significantly to obtain the same yield for the next 12 months.
As investors realize their excessive exuberance believing they will receive a yield of 10.60%, (as published by Value Line, including the one-time, extraordinary May distribution, and including a return of original investment), they will reduce their holdings in HGT. New investors will expect a yield more in the range of what they saw in 2013. In order to obtain that yield, they will buy HGT more in the range of $7.00 to $8.00. When investors realize they do not own a perpetuity (HGT Trust has a limited life and the monthly distributions include a return of original investment), the per unit price of the Trust could fall to $5.16. A price of $5.16 is the NPV of the expected future cash flows as explained above.
The calculation of the NPV of those future cash flows assumes a price of $3.92 per Mcf for gas. The price of gas is extremely volatile, and as discussed above, the price is expected to decline. Any decline in the price of gas will result in a lower NPV of future cash flows and a resulting decline in the per unit NPV and per unit market price
Investors should be cautious in shorting HGT. Natural gas has proven to be very volatile in the past, and there is no assurance this volatility will not continue. A long-term rise in the price of natural gas could cause HGT to rise causing losses for short sellers.
Disclosure: The author is short HGT, has sold units of HGT short, and own puts on units of HGT. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.