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Nathan Weiss
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Nathan Weiss is the Senior Analyst and company founder of Unit Economics, a Boston-based independent research firm. Nathan Weiss was the author of The Weiss Report, a monthly newsletter focused on risk arbitrage and market neutral strategies from 1998 to 2000. From 2000 to 2006 Mr. Weiss was a... More
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  • The San Trust (SJT): Buying $.18 For A Dollar

    Hugoton Offers $.60 for a Buck

    Yesterday, Sir Perfluis wrote a good piece here on Seeking Alpha describing the units of the Hugoton Royalty Trust (NYSE:HGT) as offering a chance to "Buy 60 Cents for a Dollar." His analysis was largely based on the company's own disclosure of the NPV of their expected cash flows. The article also helped bring to light XTO Energy's recent $37 mln Fankhouser class action litigation settlement, scheduled to be approved at a formal court hearing today. XTO Energy, the operator of the properties covered by the Hugoton Trust Royalty Agreement, has advised that upon payment of the settlement, the Hugoton Trust will bear its 80% interest in the settlement, or $29.6 mln. According to Hugoton's most recent filing, "Based on recent revenue and expense levels, it is expected that costs will exceed revenues for approximately 18 months."

    Both the Hugoton Trust (HGT) and the San Juan Trust (NYSE:SJT) disclose several lawsuits in the 'Legal Proceedings' sections of their recent annual reports (http://www.hugotontrust.com/images/pdfs/Reports/HRT_annual_11.pdf pg. 7-8, http://www.sjbrt.com/files/2011_Annual_Report.pdf pg. 15-16). Hugoton's 2011 annual report disclosed the pending Fankhouser class action suit, but advised that "XTO Energy has informed the trustee that it believes that XTO Energy has strong defenses to this lawsuit and intends to vigorously defend its position." We are not blaming XTO Energy for misleading investors - the outcome of court proceedings are very uncertain.

    Trust Investors Face Significant Risks

    The Fankhouser settlement, currently pummeling shares of the Hugoton Trust (HGT), brings up an important consideration for trust investors: Not only are many trusts overvalued based on expected future cash flows, the frequent legal proceedings faced by trusts increases the risk of a 'Hugoton-like' plunge in value if distributions are impacted.

    In addition to the often significant legal risks faced by trusts, their relative size, inability to borrow funds to make investments or upgrades and lack of management teams (or even employees) often results in operating issues, such as the pipeline leaks faced by the BP Prudhoe Bay Trust (NYSE:BPT) in January 2011, the bankruptcy of a major customer that impacted the MV Oil Trust (NYSE:MVO) in July 2009, or Hurricanes Katrina and Rita, which effectively wiped out the LL&E Royalty Trust (OTCPK:LRTR) in 2005. Combine these factors with potential tax legislation risks (investor income from trusts may face increased tax rates), one thing becomes clear: Trusts investors should look for assets trading at sharp discounts to their expected value in order to compensate for the high level of risk. Buying even $1.20 in Trust cash flows for $1.00 probably doesn't produce a risk-adjusted positive return.

    The San Juan Basin Royalty Trust (SJT)

    The San Juan Basin Royalty Trust (SJT) consists of a 75% net overriding royalty interest in oil and gas (99% gas on a BOE basis in 2011) properties located in the San Juan Basin of northwestern New Mexico. Burlington Resources Oil and Gas (BROG) is the operator of San Juan properties, which consist of 1,181 net wells with an average reserve to production, or production index, of 8.9 years. In 2010, 7.28 net wells were drilled to the benefit of the trust and in 2011, 13.09 net wells were added. Not surprisingly, total production declined by 4.82% in 2010 and 1.24% in 2011.

    Based on the San Juan Trust's 2011 annual report, petroleum consultants Cawley, Gillespie and Associates calculate that the discounted (10%) present value of the producing, non-producing and undeveloped reserves of the trust, using $3.94 per MMbtu natural gas and $96.19 per bbl oil, was $384.41 mln. The San Juan Trust currently has 46.61 mln shares outstanding, making the discounted present value $8.24 per share. Based on this analysis, San Juan Investors are receiving $.50 for their buck.

    We have read arguments on Seeking Alpha that the discounted value of oil and gas assets do not properly value production growth and field development over time, which is the case for traditional E&Ps, but we kindly point out that the San Juan Trust (SJT) drills approximately 10 net wells per year on a base of 1,181 net wells - less than 1%. Production growth will not bail out San Juan Trust investors.

    If we calculate our best estimates of the future distributions of the San Juan Trust, the value of the units appears to be even lower. Starting with 2,969,084 Mmbtu of monthly gas production and 2,217 bbl of monthly oil production, the most recent data announced by the trust (March 2012), at average pricing of $3.00 per Mmbtu for gas and $100.00 for oil, the underlying properties of the San Juan Trust would generate $9.13 mln in revenue per month. Multiply this by the 75% net overriding royalty of the trust and San Juan's monthly revenues are $6.85 mln. Take away average capital costs of $1.7 mln per month (based on their 2012 budget), average lease operating expenses of $2.20 mln and taxes of $.90 mln (9.85% of gross revenues) and the trust has $2.05 mln to distribute per month, or $.044 per share (there are 46.609 mln shares out).

    The problem with the San Juan Trust is that due to their expense load, they distribute only 30% of revenues in the current environment. At $4.00 natural gas, the trust would distribute almost exactly 50% of revenues: $1.00 income - $.50 expenses = $.50 to distribute. With a 3.5% production decline rate and steady prices, $1.00 of revenues turns into $.965 next year. At the same time, given normal oil patch service cost inflation (5%), $.50 in expenses turns into $.525 next year. The distribution in this scenario falls from $.50 to $.44 over one year. In a mere eight years, based on a 3.5% production decline rate and 5% service cost inflation, the trust would no longer pay monthly distributions.

    Our simple analogy is not far from the truth: When we calculate the monthly distributions likely to be paid by the San Juan Trust over time based on a 3.5% annual production decline rate, $3.00 natural gas in 2012, rising to $4.00 from 2013 on, $100 crude as far as the eye can see and 5% annual Capital and Lease cost inflation, we find that the anticipated distributions cease in September 2020 as expenses overcome revenue. The total, undiscounted payout through September 2020 is $4.06 per unit. At a 10% discount rate, the current value of all future distributions is just $2.99 per units! If we increase our gas price assumptions to $5.00 in 2014 and $6.00 from 2015 onward, the net present value of the distributions only increases to $5.97 per share.

    Conclusion - SJT Offers $.18 for a Buck!

    Based on $4.00 natural gas, we believe that investors in the San Juan Trust are receiving just $.18 on the dollar. If gas moves to $6.00 by 2015, quite unlikely in our view, investors receive just $.36 on the dollar!

    [A spreadsheet detailing our monthly production, commodity price, cost inflation and dividend payment assumptions is available at http://uniteconomics.com/files/SJTDistributionWorksheet.xlsx]

    Disclosure: I am short SJT.

    Additional disclosure: My firm advises clients on trusts and has recommended that clients sell or sell short shares of HGT and SJT.

    May 23 12:55 PM | Link | 2 Comments
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