Hugoton Royalty Trust: How To Buy 60 Cents For A Dollar

| About: Hugoton Royalty (HGT)
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Hugoton Royalty Trust (NYSE:HGT), which closed on Friday at $12.94, is a company I initially investigated during my search for a reasonably-priced call option on natural gas price improvement. Hugoton's heavy emphasis on natural gas production (with only a relatively limited oil production), combined with the recent decline in dividend payout and steady price decline since November 2011, implied that there may be value to be found there. To make a short story shorter, suffice to say I found nothing of the sort.

For some background, Hugoton Royalty Trust has an 80% net interest in certain oil- and gas-producing (primarily natural gas) properties in Kansas, Oklahoma, and Wyoming. Net proceeds are paid to unit holders on a monthly basis. The remaining 20% interest belongs to XTO energy (acquired by Exxon Mobil (NYSE:XOM)), who operates the properties.

Here's where it gets interesting: this disclosure on the fifth page of the 2011 annual statement (located here):

Estimated future net cash flows from proved reserves of the net profits interests at December 31, 2011 were $658 million. Using an annual discount factor of 10%, the present value of estimated future net cash flows at December 31, 2011 was $335 million. Proved reserve estimates and related future net cash flows have been determined based on a 12-month average gas price of $4.67 per Mcf and a 12-month average oil price of $92.92 per Bbl. (emphasis added).

The company has no unproven (probable or possible) reserves, so the expected cash flow figures referenced here are the entire amounts expected by the independent engineers who conducted the reserve study.

The entire current market cap for HGT is $517.6 million as of Friday's close. Using average realized 2011 natural gas and oil prices, a current HGT unit holder would receive total estimated cash payments, over the course of the entire useful lifetimes of the properties from which HGT receives royalties, of 127% of the current market cap, spread over a decade+ lifetime. Not a good time-weighted return, even at $4.67 per Mcf prices - substantially above where natural gas prices are trading today.

The expected lifetime payout is lower today, considering the fact that current natural gas prices are no higher than $2.74/MMBtu, according to energy price data from Bloomberg. In 2011, 82% of revenues came from royalties on natural gas (the remaining 18% from oil royalties). Current natural gas prices are approximately 58.7% of 2011 realized values ($2.74 vs. $4.67), and oil prices are little changed (down approximately 1.5%). After readjusting the 'future net cash flows' figure from the annual statement (see earlier quote) to account for the ~42.3% decline in natural gas prices yields a new total gross cash flow figure of $433.2 million - less than 84% of HGT's current market cap. Quite literally, unless natural gas prices stage a rally, a current HGT unit-holder can expect to receive total cash flows of less than the current share price. This is like paying a dollar now to receive 84 cents total, in irregular amounts at regular intervals, over the next decade plus.

A dollar paid at some point in the future is worth less than a dollar in hand now, so we need to apply some sort of discount rate to the future payouts in order to estimate a fair value for HGT units at the current time. I very roughly estimated the discount that should be via a simple NPV function in excel, assuming straight-line depletion over a period of 14 years (in line with HGT's expectations of 6-8% annual production declines, and below the actual 10% annual gas production declines from 2009 to 2011, though oil declines have been more moderated). Applying even a low discount rate of 6% indicates that the NPV of future cash flows from HGT should be worth 76% of 'future net cash flow' amount - or under $330 Million at current natural gas prices. This implies a 'fair value' price for HGT of $8.25/share (which equates to the price at which unit holders can expect to make a 6% annual return on investment without any changes to natural gas or oil prices). And $8.25 is about 40% below the current stock price.

To be perfectly fair, I expect there to be changes to the natural gas price over HGT's lifetime. I initially began looking into HGT as a potential 'call-option' play on a medium-term, moderately-sized rebound in natural gas prices. However, natural gas prices can be reasonably hedged through other publicly-traded instruments. Given the premium that HGT is trading at, with respect to the total cash disbursements a unit-holder can expect to receive over the total investment lifetime, I would recommend a short position in HGT common stock, with offsetting long natural gas hedges. Properly hedged against updrafts in natural gas prices, HGT is a relatively low-risk short. Though I generally dislike shorting dividend-paying stocks, it is helpful in this case to realize that [more than] the entire dividend is a return of capital, rather than a return on capital.

After taking into consideration even a low discount rate, purchasing HGT units at current prices is like buying 60 cents for a dollar.

Other considerations: There has not been any considerable aggregate drilling activity on the properties underlying HGT's profit interests. According to the 2011 annual statement, 1.5 net well was drilled in 2011, 2.7 net wells were drilled in 2010, and 6.1 net wells were drilled in 2009. Compare this to 1268 gross wells in place as of year-end 2011, and these marginal drilling activities hardly move the needle. Furthermore, incentive alignment between the operator [XTO] and HGT is mediocre at best; XTO owns only a 20% operating interest and while obligated to manage the properties prudently, one should not expect XTO to conduct massive well-enhancement projects when for the same effort, they could upgrade properties on which they possess a substantially higher interest. Per page 39 of the indenture, the Trust cannot acquire additional assets for the trust (excluding short-term investments)-the physical assets from which HGT currently generates royalty income are the entirety of what the trust will possess until commercial production runs out, so there is no risk of additional asset acquisition.

Pre-Disclosure: Author is still seeking fairly-valued natural-gas-centric entities to purchase as natural gas call options. Any direction readers could provide would be appreciated.

Disclosure: I am short HGT.