Hugoton Royalty Trust Is Still A Bad Investment

Includes: HGT
by: Richard Shaw

We wrote a negative article about Hugoton Royalty Trust (NYSE:HGT) in September 2011, after receiving multiple inquiries from clients who wondered if we should be capturing the yield and positioning for a natural gas price recovery. Our view remains negative.

Kurt Wulff of McDep provides lots of useful data that you might want to evaluate.

Favorable Arguments:

The price of natural gas was $3.79 on September 28, 2011. The price today is $1.95.

It has a logical price perhaps in the $6.00 to $9.00 range (about 10% of the price of oil).

Oil may have a replacement cost of $60 to $90; has a 10-year moving average of about $67; and has a higher natural price to support the welfare state in Saudi Arabia and Venezuela, and to keep Russia afloat). In any event, natural gas can be view as eventually going up a lot.

The 10-year and 20-year moving average ratio of the price of natural gas to the price of West Texas oil is shown by this chart to be about 10%. Plenty of upside.

According to Kurt Wulff, the 6-year futures on natural gas are in the $4.00 area (more than double the current price). That sound like opportunity.

Wulff's website reports a 5% yield on HGT. Yahoo reports 7.3%. Fidelity reports an "annualized yield" of 10.57%.

Wullf's McDep ratio (mkt-cap and debt to net present value of oil, gas and other businesses) of 0.88. That would suggest a 12% discount is available.

HGT has no "other businesses" and no debt so the McDep ratio can be simply stated as "market-cap to net present value of oil and gas reserves.

Thompson Reuters StarMine (amalgamated ratings of best analyst for that security) is at 7.7 out of 10 (Bullish). The Street price target for 12-months ahead is positive 17%.

Unfavorable Arguments:

Wulff's EV/EBITDA of 16.8 is the highest in the "bottom line payers", which range from 7.3 to 16.8.

The 2011 10-k says the standardized net present value of future cash flows is $334,953,000 while the market cap today is $498,800,000.

That suggests that the trust is worth 23% less than the price. But that was based on price assumptions twice as high as today's gas price (and pretty close to today's oil price).

The standardized discount model uses a 10% discount factor, and the month-end average oil and gas prices for the preceding 12 months. That average was in the $4.00 range for gas, and about $97 for oil.

In our September 2011 article, we reported a 12.9 year useful life (based on the 2010 data) for the trust. That means a yield of about 8% was needed then, just to get your money back, unless technology or prices extended the useful life of reserves).

The distribution for 2011 was $1.30 (based on an average gas price around $4 versus about $2 now). So, we should not expect too much of a distribution yield this year. Average yield in 2011 was about 7%. That could suggest a 2012 distribution of 3% to 4%.

If you were looking for above average yield (say 7%), then you would seek about 15% distributions (8% for return OF your money back and 7% for return ON your money). It's nowhere near that level today.

Actually, the yield hasn't been that high much in the past decade. Here is a table of the average yield for each year from 2002-2011:

Year Average Yield
2002 10.53%
2003 15.83%
2004 13.42%
2005 10.96%
2006 13.59%
2007 10.59%
2008 22.45%
2009 5.34%
2010 8.18%
2011 7.01%

Here is a chart of distributions each year and average share price each year:

You can see from the yield table and the graph that there was a nice bargain as a result of the 2008 crash, but not now.

This chart tells a similar story. In the upper panel it shows five-year monthly price performance of HGT (black line), natural gas (red line) and oil (gold line). In the middle panel, it shows the ratio of the price of HGT to the price of natural gas (blue line). In the bottom panel, it shows the ratio of the price of natural gas to the price of West Texas oil (green line).

It certainly suggests that gas has a lot of price upside, but some of that is apparently already anticipated by the price of HGT. Gas is down 75% over five years, while HGT is down only 32%.

This chart shows HGT refusing to go down with the price of natural gas, perhaps in part due to hope for a natural gas recovery, and perhaps in part due to investors being attracted to the distribution yield without realizing it is virtually all return of capital (and prospectively not full return of capital).

Maybe we're missing something, and maybe there is value here, but it seems you'd have to twist your data like a pretzel to clearly demonstrate long-term gain opportunity.

A trading opportunity? Perhaps. A long-term income play? No.

Disclosure: QVM does not own HGT as of the creation date of this article (April 19, 2012).

General 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.