A Focus On The Old Energy Trusts Like Hugoton, Mesa, And San Juan Basin

| About: San Juan (SJT)
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Summary

Energy trusts are a small-cap retail-owned sector almost completely unfollowed by Wall Street.

After eight down years, natural gas fundamentals finally look attractive on a supply vs. demand basis.

The old style energy trusts have no debt thus avoid existence risk many energy companies have faced in last eight years.

Hugoton, Mesa, and San Juan Basin are the only pure natural gas trusts.

The yields in the sector are unusually high at the moment and should move towards long-term averages; lower yield = higher price.

There are a handful of surviving USA energy trusts that are little-known because of their size and low trading volumes. Names in the category include BP Prudhoe Bay (NYSE:BPT), Hugoton (NYSE:HGT), Permian Basin (NYSE:PBT), Mesa (NYSE:MTR), San Juan Basin (NYSE:SJT), and Sabine (NYSE:SBR). Each is very unique and has its own story to tell which would take pages. Thus, I am going to try and do just a quick overview given sharp price action in some of them recently.

Energy trusts were just an alternative way for large energy companies in the past to raise new cash without having to issue stock, debt or outright selling of assets. What was done simply is somebody like Exxon (NYSE:XOM) would take certain acreage they owned with mature existing oil & gas wells and sell into a trust which would then be IPO'ed to the public and the proceeds go to Exxon. Exxon would continue to operate the assets thus the trust had zero employees and simply had a trustee who would review the monthly oil & gas production, revenue from its sales less the costs of production and the difference sent out in distribution checks. The trusts do pay certain state taxes/fees but tend to be small and thus the income would flow through to shareholders who would get taxed at their own rates.

The above is remarkably similar to how most REITs operate and thus many referred to the sector as 'energy REITs'. Most of these companies came public back in the 1980s and 1990s. A similar sector existed in Canada (the old Canadian Royalty Trusts) until it was largely shut down when tax laws for trusts were terminated there about a decade ago.

What made US energy trusts unique from Canada was the absence of employees and absence of debt. The operator of the assets would (on their own call) perform improvements to the existing wells if it made economic sense to do so, which would hurt distributions while work was done, but neither debt nor new shares were ever issued to fund the work.

As expected, distributions rose as oil & gas rose and fell the same way. Given these trusts are heavily retail-owned, the greatest price movements always took place at times dividends took big swings (recently MTR's dividend is up 40+% and stock up 20%) and thus the trusts tend to overshoot to both downside and upside.

A newer breed of trusts in recent years issued right before energy crash tarnished the entire sector. 'Rental trusts' like MV Oil Trust (NYSE:MVO), and VOC Energy Trust (NYSE:VOC) were sold to the public who, I observed in many cases, had no clue they were trusts that existed solely for a given amount of production and thereafter shut down/stock worthless. Dividend yields in these names often looked like 20-30% but did not reflect the temporary nature of these trusts. The rental trusts at least involved the temporary transfer of mature oil/gas wells to a trust such that one could calculate expected returns at different oil/gas price levels with accuracy. The last trusts created were the infamous SandRidge trio, SDT, SDR and ECT, spun-off from SandRidge Energy (NYSE:SD) where raw acreage was put in a trust and sold to public with an attractive reserves number attached. None of the trusts produced anywhere close to expected levels once drilled and they famously crashed.

These newer trusts burned many people and with many upstream MLP blowing up after energy prices crashed, many believed all trusts connected to energy were scams and certainly institutional ownership of the original trusts has dwindled to near nothing. To make matters worse for the natural gas oriented trusts such as Hugoton, San Juan Basin, and Mesa, the price of nat gas languished since 2008 and kept falling even after oil rebounded off the low in recent years. The prices of all these trusts crashed to lifetime lows in late 2015/early 2016 dating back well into 1980s.

This is when I did my homework and began accumulating. All three of these nat gas trusts were priced for $1.50 to $2.00 natural gas forever and had wildly overshot to downside (as is typical with retail-owned stocks that have zero Street sponsorship). Even as natural gas hit lows of $1.50 in 2016 and now climbed, these trusts, for the most part, remained priced to $1-2 nat gas.

I am well aware of the naysayers in these names who attack them with DCF analysis which I concede rarely looks positive. The problem with that analysis is that nat gas reserves at these names are a moving target. As gas price goes up, so do reserves and same the other way and it's not always a linear move. In addition, I have seen trusts where proved reserves in a 10K today are no different than 10 years ago. Keep in mind these trusts have no employees and nobody is really being a stickler for accuracy of numbers. Again, I am not ignoring their analysis. I am simply pointing out it's more applicable to somebody who is going to buy trust and hold to maturity. Oh, and by the way, many of these DCF analyses assume that when assets deplete to zero and the trust terminates that the value goes to zero, but in reality, that acreage gets liquidated and proceeds go to the shareholders. There could easily be technology by this date making these assets very valuable to a new producer and it's a bad bet to assume the land value at liquidation is zero. In fact, I have read a report that San Juan Basin acreage may, in fact, have shale gas on its acreage that was not even known about when spun off in 1980 that could have tremendous value when acreage gets liquidated in future (or possibly when the operator opts to exploit them).

Another confusing aspect of these trusts is that their monthly dividend reflects production from 2+ months ago. Thus, as natural gas prices rose recently, expectations for a big pop in the dividend built a few months ago despite it being obvious to the more informed the dividend pop would come later, and with no analysts following them to explain, confusion and despair saw trusts like San Juan gap from $4 to $7 ½ in Q2 of 2016 as nat gas prices firmed up, only to fall back to mid-$5s as dividend didn't explode higher.

Today, with Mesa's dividend jumping 40+% from previous month and at two-year highs, we have hit 'the turning point'. Mesa's stock price jumped 20% and San Juan's jumped 10% (and it does not announce until tomorrow). Retail suddenly 'rediscovered' these ancient names with massive jumps in volume. Ironically, none of the names are even at 52-week highs and most are 50% below their price the last time they posted dividends this high. Clearly, the argument can be made they have room to go higher and if nat gas prices hit $4 as I can build a case for, all three of these nat gas names have 100% or more upside if (so long as UST yields remain in the 1-2% area and junk bonds in the 4-5% range).

I will caution all three of these names have their warts and wrinkles. Take a look at the last few 10-Q and 10-K and read them to understand some of the external risks. Some have outstanding litigation (Hugoton). Others suffer from disputes between the operator and the trustee over production costs or amounts that were attributed to trust assets vs. other operator assets.

On the positive side, you have 15-20-30 years of production data/history that you can input to spreadsheets to very intelligently estimate production declines and what reworks did to boost production along the way.

So what other ways to value vs. DCF of estimated reserves? The best that I know of is to assess the yield have these trusts tended to migrate to historically. Having tracked them since late 1990s, I can tell you the range has generally been 6-9% distribution yield. In recent years, that yield fell to 3-5% as distributions fell with low prices received for the nat gas and the trust prices fell to lifetime lows. In fact, Hugoton began skipping its distribution in early 2016 as revenues were below costs and San Juan did same in mid-2015 briefly. These sorts of actions lead to retail panic that the trust will close and panic dumping occurs, which is precisely when one wants to provide liquidity.

So where are these trust yields today (1/19/17) after huge jumps?

SJT: 10 3/8% with divvy announced tomorrow

MTR: 15 5/8% with a big divvy announced today and now fourth strong divvies in a row

HGT: 3 ½% but there was a divvy whiff last month that could see reversed hard

Clearly, Mesa and San Juan are well above historical trading yields and have room to see higher price to reflect this. Do keep in mind Mesa trades by appointment and that San Juan is the only name with real volume, so I give the nod to San Juan's lower yield given the liquidity. Hugoton is liquid, but at $2 big boys can't accumulate much size and will skip. I don't know about you but I love plays that institutions can't get involved in, which means it's only retail investors I am competing with.

I was asked by some followers why I wasn't buying some of the nat gas oriented big energy plays. My answer is all of them are loaded with debt and many barely survived the recent energy sector crisis. Now with rates climbing, I have no interest in the risk of these debt-filled plays just now.

I reiterate that these old energy trusts have zero debt. They will never have a worry about rolling over debt or hedgies snapping up the debt to push company into bankruptcy. This is why in a world still starved for yield, I believe yields of 5-7% over long run are fair when you consider that HYG (the best known junk ETF) has a yield in the 4-5% area.

I will close by suggesting you look hard at recent DOE nat gas data. We saw a 243 bcf draw today despite a heating degrees number that was far from impressive. We are seeing increased amounts of nat gas sold to private industrial sector in USA as well as exported to Mexico and at same time, the drilling rig count is down 90% from 2008 peak and production has clearly come off peak. Today's draw dropped inventory by almost 8% and we are now just 17% above last year's low inventory point and it's mid-January. Probably, the only thing that can hurt nat gas is the US dollar soaring.

Thanks for having a read on my first piece for Seeking Alpha.

Disclosure: I am/we are long SJT HGT MTR.

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.