Hugoton Royalty Trust Is Overvalued By 45%

| About: Hugoton Royalty (HGT)
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Hugoton Royalty Trust (NYSE:HGT) is a trust, originally set up by XTO Energy, which has a net profits interest in properties located in Kansas, Oklahoma, and Wyoming. With the Fed's ZIRP policy, investors have been forced into riskier assets to find yield. Royalty trusts are one place where investors have ended up. Several of these have been bid up without investors realizing what the underlying properties are actually worth. I believe HGT is overvalued by 45%.

My production model assumes the following:

  • Gas production declines at 7.5% per year. The past three years the decline rate has been 6%, 9.9% and 9.6%. A little bit of variance there, but I tried to pick a middle of the road number.
  • Oil production declines at 7% per year. The past three years have been 8%, 6.7%, and 2.3%.
  • Gas pricing through 2017 follows the forward strip from this website. Each year in my model is just an average of the 12 months listed on this website. Once past 2017, I escalated the pricing by 5% per year.
  • Oil pricing starts at $100/bbl this year and escalates at 3% per year. This is very generous compared to the forward strip, which has oil below $100 after 2013.
  • Taxes appear to run around 11% of revenues so I used that number. Production expenses decline at 7% per year.
  • Development expenses decline at 7% per year from the midpoint guidance of $7 million in 2013. The resulting total for 13 years matches roughly with the estimates in the trust's NPV calculations.
  • Overhead has continually increased so I have escalated it at 3% per year. Administrative costs for the trust are held flat at $850,000 per year.

The length of analysis is 13.5 years. Reserves are roughly equal to 13 years of production. Yes the trust life will likely be longer, however the outer years will be much lower in production and more heavily discounted. Using the above assumptions for mid 2013 through the year 2026, I estimate the NPV10 of the trust to be roughly $200 million. The trust's current estimates for NPV10 as of December 2012 are ~$163 million. The current price of the trust is $9.10 per unit resulting in a market value of $364 million. The unit price would need to fall 45% to around $5 a unit to match this NPV10 from my model and even lower if you use the trust's NPV numbers.

The current market value is actually even higher than the undiscounted value of the cash flows on both my estimate and the trust's estimate. Perhaps the market thinks 10% is too high of a discount rate, but certainly these cash flows way out in the future must be discounted. I ran the model again at a 5% discount rate and this NPV5 value is $262 million. This corresponds to a unit value of $6.55, a 28% decline from the current price.

5% discount rate

Please note that this model does not take into consideration any of the pending lawsuits or other issues the trust is involved with. A huge issue for the trust is the arbitration hearing in October regarding the Fankhouser settlement. The results of the arbitration hearing will determine how much, if any, XTO can charge the trust for the Fankhouser settlement. To me, this seems pretty similar to a clawback. The trust received income that should have gone to the royalty owner. I believe XTO will at least partially, if not fully, be able to charge the settlement to the trust.

XTO advised the trustee in September 2012 that it deducted $35,601,400 ($28,481,120 net to the trust) related to the Fankhouser settlement. The settlement deduction caused costs to exceed revenues by $27,235,464 ($21,788,371 net to the trust) on properties underlying the Oklahoma net profits interests and by $6,225,126 ($4,980,101 net to the trust) on properties underlying the Kansas net profits interests. However, these excess costs did not reduce net proceeds from the remaining conveyance. XTO advised the trustee in October 2012 that it partially recovered $3,342,186 ($2,673,749 net to the trust) of excess costs. Remaining excess costs at December 31, 2012 were $24,027,648 ($19,222,118 net to the trust) on properties underlying the Oklahoma net profits interests and $6,090,756 ($4,872,605 net to the trust) on properties underlying the Kansas net profits interests (Note 9). The excess costs claimed underlying the Kansas and Oklahoma net profits interests are the subject of pending arbitration described more fully under (Note 9).

Should XTO be fully successful in this arbitration, the trust will have to bear their remaining share of the settlement, which is roughly $24 million ($30,118,090 from excess costs in the above table times 80% interest). The settlement also changed the way that certain op costs are calculated on the subject properties. From the 10-K:

XTO Energy has advised the trustee it believes that the terms of the conveyances covering the trust's net profits interests require the trust to bear its 80% interest in the settlement, or approximately $28.5 million, of which $23.4 million will affect the net proceeds from Oklahoma and $5.1 million will affect the net proceeds from Kansas. If so, this will adversely affect the net proceeds of the trust from Oklahoma and Kansas and will result in costs exceeding revenues on these properties. XTO Energy began deducting the settlement amount with the September 2012 distribution. Based on the revised settlement allocation between Oklahoma and Kansas and recent revenue and expense levels, the deductions XTO Energy has made, and will resume making if the Tribunal ultimately rules in XTO Energy's favor, will cause costs to exceed revenues for approximately 12 months on properties underlying the Oklahoma net profits interests and by approximately 7 years on properties underlying the Kansas net profits interests; however, changes in oil or natural gas prices or expenses could cause the time period to increase or decrease correspondingly. The net profits interest from Wyoming is unaffected and payments will continue to be made from those properties to the extent revenues exceed costs on such properties. XTO Energy has advised the trustee that the settlement would decrease the amount of net profits going forward for the Oklahoma and Kansas properties due to changes in the way costs (such as gathering, compression and fuel) associated with operating the properties will be allocated, resulting in a net gain to the royalty interest owners. XTO Energy has advised the trustee that this expected net upward revision for the royalty interest owners would reduce applicable net profits to XTO Energy and, correspondingly, to the trust. For 2012 the revision would have reduced trust net proceeds by approximately $272,000 (which amount would have been reflected in the June 2012 through December 2012 distributions).

So not only are net proceeds of the trust lowered going forward due to a new formula regarding op costs, costs will exceed revenues in the Oklahoma interest for a year and the Kansas properties for seven years!

The gross production breakdown for the underlying properties is roughly as follows:

  • 15,000 MCFD / 58 BOPD from the Hugoton Area (KS & OK)
  • 25,500 MCFD / 539 BOPD from the Anadarko Basin (OK)
  • 15,200 MCFD / 28 BOPD from the Green River Basin (WY)

If XTO is correct in saying that Kansas and Oklahoma will not generate net proceeds for a year (longer for Kansas), the trust will be dependent on the Wyoming properties for distributions. Using the trust's 80% interest and a generous $105/oil and $4/MCF, gives a monthly revenue net to the trust from the Wyoming properties of around $1.53 million. This is before any operational costs, taxes, development costs, overhead, or administrative costs. With 40 million units outstanding, this revenue comes out to less $0.04 per unit. Once you add in the various costs, distributions will likely be less than $0.03 a month even at $4 gas.

At the end of the day, it appears that HGT is grossly overvalued regardless of the outcome of the arbitration. Even with a 5% discount factor, it is roughly 30% overvalued and with the more commonly used 10% discount factor it is 45% overvalued compared to NPV. If the arbitration goes against the trust, the NPV will be reduced even further. Not to mention that distributions will be heavily depressed for at least a year.

As always, do your own research and make your own decisions regarding on whether or not to invest in a certain stock.

Disclosure: I am short HGT. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.