We like the idea of energy royalty trusts, but we are not always comfortable that there will be enough life in the reserves to both recover the cost of the shares and provide an appropriate cash return on investment.
Let's look at Hugoton Royalty Trust (HGT) as an example.
We have owned it upon occasion. It has provided some trading opportunities, but we have significant doubts about it as a long-term hold.
This article will probably get some strong push back from some readers, and we hope it does, because we'd like someone to counter our view with some other information such that we feel more comfortable with the trust.
HGT is a primarily (87%) natural gas royalty trust created in December 1998, currently managed by Exxon (XOM) with Bank of America (BAC) as trustee. It receives an 80% net profits interest in the underlying properties. The properties are in the Anandarko Basin of Oklahoma, the Green River Basin of Wyoming, and the Hugoton area of Kansas and Oklahoma. It makes monthly cash distributions.
The chart below plots the weekly price of HGT from inception through today (September 27, 2011), and at the bottom plots its percentage performance versus the percentage price changes in natural gas and West Texas crude oil.
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If our skepticism is justified, it is unfortunate. That is because as a near pure play on ownership of natural gas it could become more attractive if the U.S. uses more gas as a transportation fuel and as a fuel for electrical generation.
If the U.S. should decide that switching from oil (and corn-based ethanol) to gas for transport, and if the electric utilities should convert more rapidly and more fully to gas from coal, gas prices have a good chance of coming closer to the energy equivalent cost of oil. That change would possibly absorb the excess supply we have today and increase prices. Add to that more infrastructure to liquefy and export gas, then the world of gas prices would be much different.
The Short Story:
The "reserve-to-production ratio" -- estimated future gross cash flows from proved reserves divided by the trailing 12-month production -- is 10.6 years. If there are only 10.6 more years of production at the current rate, before reserve replacement by development activities, then if there is no development, a yield of approximately 9.5% after-tax would be required for share price cost recovery. That assumes that if there were no more gas or oil to pump, the shares would sell for zero.
Today the yield is about 7.3%, and for a variety of reasons that is not an after-tax number.
The historical record shows that even though various development efforts to enhance production from existing wells and new well drilling were undertaken, the physical reserves are depleting.
If gas prices rise significantly, or well enhancement or new well drilling increases reserves, the story improves, but if not HGT will not even recover cost, let alone provide a positive return.
The Long Story:
From the IPO documents filed on 04/09/1999, we get these baseline facts.
- Estimated future cash flows $539,615,000.
- Stated reserves-to-production ratio 12.9 years.
- Underlying properties proved reserves: 515.1 bcf gas, 4.0 million Bbl oil
- Proved developed reserves 93%; proved undeveloped 7%
- Proved reserves 95% gas, 5% oil
- Sales in 1996: 36,708 bcf gas, 450,000 Bbl oil
- Sales in 1997: 38,126 bcf gas, 477,000 Bbl oil
- Sales in 1998: 38,810 bcf gas, 490,000 Bbl oil
- Natural annual depletion rate before development: approx. 6% -10%
- Projected annual depletion rate after future development: approx. 4%
- Expected economic life (any level of sales) 40 years of more
- Price of gas: $2.01 mcf
- Price of oil: $11.24 Bbl
From the 10-K for 2010, we get these facts.
- Estimated future cash flows $663,763,000
- 12-month trailing sales $62,883,000 (10.6 reserves-to-production ratio)
- Underlying properties proved reserves: 315.0 bcf gas, 2.9 million Bbl oil
- Proved reserves 87% gas, 13% oil
- Sales in 2008: 28,176 bcf gas, 342,000 Bbl oil
- Sales in 2009: 26,642 bcf gas, 260,000 Bbl oil
- Sales in 2010: 24,075 bcf gas, 267,000 Bbl oil
- Price of gas: $4.45
- Price of oil: $75.91
- 2010 gas reserves depletion: 8.3 bcf
- 2010 oil reserves depletion: 100,000 Bbl
In the 11 operating years since inception, the proved reserves of the underlying properties declines by 38.8%. The proved oil reserves declined by 27.5%.
The 2010 net profits interest in production sales of natural gas were 62% of 1998 sales (down 38%). The 2010 sales of oil were 54.5% of 1998 (down 45.5%).
The straight line average depletion on gas has been 3.5% (better than the 1998 projection of depletion net of development of about 4%). The straight line depreciation on oil has been 2.5%.
Straight Line Depletion With Constant Conditions:
We don't know how petroleum engineers figure out useful life and rates of change of depletion, so we'll take the simplistic assumption of straight line depletion. While the quantity of annual depletion has been declining, at some point there is a minimum pumping level to make it worth the effort. We'll assume we are at that point now.
The following table assumes no change in gas or oil prices, proportional depletion of oil and gas, no cessation of pumping until reserves equal zero, and straight line depletion until 2039 (40 years after inception to be consistent with the IPO document). The table assumes that the annual distribution is the same ratio to the gas reserves of the underlying properties as the distribution was in 2010 to the year-end gas reserves.
In this simple approach the sum of distributions over the next 29 years would be $23.25. If we use a discount factor of 6%, the sum of the discounted distributions is $14.20.
The current market price is $22.25, and the single undisclosed broker 1-year price target is $14.00
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Natural Gas Price Ratio To West Texas Oil Price:
Natural gas has declined in price relative to oil, which gives some credibility to the argument that the price of gas should rise (assuming oil has a natural base level in the $70-$80 area due to reserve replacement costs and Saudi price needs to sustain its national economy). That, of course, is thwarted currently by the abundance of gas finds and the limited ability to liquefy and export the gas.
HGT Ratio To The Price of Natural Gas:
HGT it appears has gotten ahead of itself. Gas prices are down, but HGT is up. Are investors buying it for yield not appreciating the depletion aspect?
What Is HGT Good For?
If our analysis is even close to reasonable, then HGT is a long-term loss if conditions do not change.
However, if the price of natural gas doubles in the short-term, or triples or more in the intermediate and long-term; or if improved development of controlled land occurs, or if new technologies or higher prices make reserve expansion possible, there could be good total return from HGT.
It does seem to be starting from a negative long-term total return position, but seems to essentially be not so much a current yield opportunity, as a very long-term option on both the price of natural gas and the improvement in extractive technologies.
If the price does not rise significantly, or reserves do not expand signficantly, then the price paid is probably a loss. Sounds like the way options work. If the underlying stock price goes up enough the option buyer wins, if it does not go up enough the option buyer loses.
Maybe HGT is a Boone Pickens CALL option.
Disclosure: QVM does not have HGT in any managed account, and does not hold any of the other securities mentioned in this article as of the creation date of this article (September 27, 2011).
Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions. This article is presented subject to our full disclaimer found on the QVM site available here.