Royalty Trust Wealth Destruction And Opportunity Update

by: Josh Young

After meaningful moves in the trusts and stocks discussed, it seems timely to revisit the article Royalty Trust Wealth Destruction and Opportunity. Since the time of that article, Whiting Trust I (NYSE:WHX) collapsed, Hugoton Royalty Trust (NYSE:HGT) is down a little more, and even Gale Force Petroleum (OTCQX:GFPMF) is down considerably.

As discussed in the previous article, HGT was down because a legal settlement will prevent dividend distributions for at least the next 18 months. And I predicted that WHX could decline significantly because it would only pay ~$7 in distributions until it expired worthless in 2.5 years, versus a then-unit price of $17. It has since traded down to $9, much closer to its intrinsic value.

The big surprise so far has been Gale Force Petroleum, which is down 20% from the time the article was written. This is surprising because Gale Force announced a substantial hedging gain recently, is on the cusp of announcing drilling results (which will very likely be positive, as they are drilling proved undeveloped reserves in proven fields), and is proceeding with its plan to spin off a royalty trust in the next year.

I think one reason Gale Force is down since May is that other Canadian traded E&P companies also traded down, many as much as 50% or more. So Gale Force may have actually outperformed some of its peers despite being down 20%. However, many of those peers' stocks have recovered significantly, such as Guide Exploration (OTC:GLNYF), which used to be named Galleon Energy, which has risen from a low of $1.30 to a current price of $2.11, up 62%. Gale Force has not yet participated in that junior Canadian E&P stock price recovery.

Another reason Gale Force stock is down is that it has been months since the company issued an operations update, and the investor presentation on the website is from February and is out of date. I think that when the new investor presentation comes out (hopefully soon), when the company announces its likely success from its drilling and recompletion program, and when it more explicitly illustrates the royalty trust plan, the stock could recover like Guide did and could outperform.

And when the market starts to price in a royalty trust valuation [$250,000 per boepd for trusts like Pacific Coast Trust (NYSE:ROYT), Sandridge Permian Trust (NYSE:PER) and Sandridge Mississippian Trust (NYSE:SDT)] versus Gale Force's current valuation (~$25,000 per boepd, based on exit rate guidance for 2012), or a $2 stock versus the current price of $0.22, Gale Force could be one of the best performing stocks in the market.

Here is a little more detail around how this transition to a royalty trust could play out: Gale Force could "drop down" 1000 boepd of production (the anticipated level by early 2012) into a wholly owned subsidiary LLC. It would also make a commitment to that LLC to maintain that production level for the next 3 or so years, and would hedge the production to lock in cash flows for that time period. It would then do an offering where it issued ~50% of the units in the LLC to the public, likely at a $250 million valuation. It would raise $125 million through this process, which it could use to buy back stock, pay out a dividend or drill more wells. It would then dividend out most of its remaining ownership of the LLC to its existing shareholders, retaining enough units to fund the capital requirement. It should be able to distribute more than $200 million to shareholders via a combination of cash and LLC unit dividends and stock buybacks, or almost $2 per share, versus a current $0.22 stock price. And it would retain enough cash to acquire and develop new fields and potentially issue another royalty trust in the future.

So far, WHX and HGT played out as described in the previous article, and Gale Force hasn't yet. Two for three isn't bad, but three for three is obviously better, and the third seems likely to come with an updated presentation and an operations update, with a further uplift next year from the royalty trust.

Disclosure: I am long OTCQX:GFPMF.

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