Given that the Hugoton Royalty Trust (NYSE:HGT) is currently unprofitable (it pays dividends of $0 and runs at a deficit), there has been speculation regarding when the Trust might terminate. For example, The Forensic Accountant wrote an article titled, "Will Your Oil And Gas Trust Survive To See Higher Prices?" (published on Dec. 28, 2015). The author's conclusion about Hugoton was that if current prices are sustained through 2017, the Trust will dissolve and will have paid out $0 in dividends in the meantime.
I think the article presents some really good analysis, and I agree with the author's assessment that SandRidge Permian Trust (NYSE:PER) is by far the best oil trust. However, I believe the author made two mistakes with respect to Hugoton, both of which you or I could easily have made ourselves. (While I agree that PER is better than most, I still haven't felt comfortable enough to open up a position in it, nor have I verified any of the author's results with my own calculations.)
There are two ways in which Hugoton Royalty Trust might terminate: by shareholder vote, or automatically by failing to make enough money over a certain time period. Specifically, quoting from the Trust's website:
The Trust does not have a specific end date. There are, however, some events that could cause the Trust to terminate: (1) If the Royalties fail to generate net revenue for the Trust of at least $1,000,000 per year over any consecutive two-year period, (2) A unitholder vote of 75% or more.
The question then is: What is the definition of "net revenue"? According to 8-K SEC filings, two of the Trust's three conveyances (Kansas and Wyoming) are unprofitable, leaving only the third conveyance (Oklahoma) to pay dividends. The Oklahoma property generated a profit of only $15,000 in January and $65,000 in February, of which the Trust had an 80% share of $12,000 and $52,000, respectively. Neither of these was enough to cover the Trust's operating expenses for January ($139,000) and February ($95,000). Thus, not only is the drilling operation across the three properties operating at a deficit, but the Trust itself is also running at a deficit.
Does this mean the Trust will terminate? As a matter of fact, it does not. While the Trust's "revenue" with respect to its expenses has been small - certainly small enough to trigger the less-than-one-million-dollars criteria if it persists for two years - this is not the value that is used. Instead, it is the Trust's revenue across all the properties before expenses. To double check, I emailed Nancy Willis at Southwest Bank, VP of Royalty Trust Management. An excerpt from her response shows exactly what figures are being looked at when checking for termination:
The termination of the trust is based on the revenue factor of 'if it fails to generate gross proceeds from the underlying properties of at least $1,000,000 per year over any consecutive two-year period…'
This is before the expenses deducted to come to the Net Profits Income, of which 80% is transferred to the trust. As a point of reference, if you look on page 8 of the third quarter report (click here), you will see that gross proceeds for the underlying properties for the nine months ended Sept. 30, 2015, was $39,993,116. This is well above the threshold of $1,000,000 for one year.
On a final note, if the Trust were to terminate, it is not as suggested in The Forensic Accountant's article that the Trust will become worthless. Who knows what the three properties' profit interests could be sold for. To quote from another segment of VP Willis' email:
Finally, if termination proceedings were to be initiated, either by the revenue test or by a vote of holders of 80% of the units (the other key triggering factor for termination of the trust), the net profits interests would be sold for cash and any cash obtained from that sale (plus any cash on hand), less administrative expenses, would be distributed to the unitholders of record at that time. (Before making a comment, I do not know why she quotes an 80% threshold in her email, but the Trust's website cites a 75% threshold.)
To conclude, both the drilling operation as well as the physical Hugoton Royalty Trust are operating at losses. While the future remains uncertain, we can be certain that it will be many years before revenues fall low enough to trigger an automatic termination of the Trust. Because the drilling operation and the Trust both individually cost much more than $1,000,000 a year to run, the Trust will almost certainly be ended by unitholder vote. This could happen tomorrow, or it could happen a decade from now - but it will not happen automatically if two years pass without profit.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.
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