Description

DISCLAIMER:  I currently hold short positions in Hugoton.  I may change my position at any time without posting an update.  The views expressed here are merely the opinion of the author.  This is not a recommendation to buy or sell any securities.

This is down a bit today, sorry I didn't get it out sooner. I still think there is good money to be made in pretty short order.

The Idea

I believe that Hugoton Royalty Trust is overvalued by +30%. A forthcoming 85% cut to the distribution related to a lawsuit settlement will likely cause the unit price to converge with the trust’s fair value, and possibly well below. My short thesis for HGT is based on this distribution cut and how I think the under-informed, income-oriented unitholder base will respond. The fact it is overvalued to begin with is my downside protection. I am short HGT stock and long November puts.

Class Action Settlement

The following is an excerpt from Hugoton Royalty Trust’s 10-Q, filed on April 27^th. Until the distribution announcement on May 18^th, there was no other mention of this impending settlement (no press release).

An amended petition for a class action lawsuit, Beer, et al. v. XTO Energy Inc., was filed in January 2006 in the District Court of Texas County, Oklahoma by certain royalty owners of natural gas wells in Oklahoma and Kansas. The plaintiffs allege that XTO Energy has not properly accounted to the plaintiffs for the royalties to which they are entitled and seek an accounting regarding the natural gas and other products produced from their wells and the prices paid for the natural gas and other products produced, and for payment of the monies allegedly owed since June 2002, with a certain limited number of plaintiffs claiming monies owed for additional time. XTO Energy removed the case to federal district court in Oklahoma City. In April 2010, new counsel and representative parties, Fankhouser and Goddard, filed a motion to intervene and prosecute the Beer class, now styled Fankhouser v. XTO Energy Inc. This motion was granted on July 13, 2010. The new plaintiffs and counsel filed an amended complaint asserting new causes of action for breach of fiduciary duties and unjust enrichment. On December 16, 2010, the court certified the class. Cross motions for summary judgment were filed by the parties and ruled on by the court. After consideration of the rulings by the court in March and April of 2012, some benefiting XTO Energy and some benefiting the plaintiffs, and with due regard to the vagaries of litigation and their uncertain outcomes, the parties entered settlement negotiations leading up to trial and reached a tentative settlement of $37million on April 23, 2012, which requires court approval. The hearing for formal court approval is scheduled for May 23, 2012. Assuming the court approves the settlement, a fairness hearing will be scheduled at a later date. The trust will bear its 80% interest in the settlement, or approximately $29.6 million. This will adversely affect the net proceeds of the trust from Oklahoma and Kansas and will result in costs exceeding revenues on these properties. Based on recent revenue and expense levels, it is expected that costs will exceed revenues for approximately 18 months; however, changes in oil or natural gas prices or expenses could cause the time period to increase or decrease correspondingly. The net profits interest from Wyoming is unaffected and payments will continue to be made from those properties. The settlement is expected to decrease the amount of net profits going forward for the Oklahoma and Kansas properties due to changes in the way costs (such as gathering, compression and fuel) associated with operating the properties will be allocated, resulting in a net gain to the royalty interest owners. This expected net upward revision for the royalty interest owners will reduce applicable net profits to XTO Energy and, correspondingly, to the trust.

I have spoken with the attorney for XTO (now owned by Exxon) regarding the case. On May 23^rd a judge will render an opinion on whether the settlement is fair. The attorney expressed confidence that this would not be an issue. Following, a letter will be sent out to members of the plaintiff class informing them of the settlement amount and allocations to each party. Parties in the class action suit will have 30 days to offer any objections. After a few procedural waiting periods XTO will make a lump sum settlement payment to Beer et al; after which HGT will begin repaying its 80% share of the settlement. The attorney estimated a payment would be made around 90 days from now (barring any unforeseen hurdle).

This means that starting sometime in the next three to six months the trust will stop making distributions related to its Oklahoma and Kansas oil and gas production for 12 to 20 months (depending on commodity prices). During this period the trust will only be permitted to make distributions related to its Wyoming production, which is about 15% of the total. Based on strip pricing, I believe the annual distribution will drop from an LTM rate of $1.21/unit to $0.11/unit. At its current $13 price this will be a 0.84% yield. Given the fact that the vast majority of this stock is held in yield-oriented instruments, I believe the cut will result in very significant forced selling.

Unitholder Base

I presume that readers do not need to be convinced that owners of a trust like this are not likely to be well read on the most recent 10-Q (the price actually went up the day it was released) or the trust’s fundamental value, but it is worthwhile to talk briefly about the ownership. Around 22% of the trust is held by institutions. A review of the holders suggests that the units are owned by retail investors, yield-oriented vehicles or “quant” funds (I’ve interviewed some managers of these funds and learned that the term gets used much more loosely than I expected; “guided dart throwing” would be a more appropriate term). Bank of America and Morgan Stanley are the only two institutions with more than 1% of the units outstanding and the only holder with greater than 1% of its assets in HGT is Corby Asset Management, who holds the position in their “Global Cash Flow Portfolio”, which is intended to be a portfolio for “investors who need current income to enjoy conservative potential for long term principal appreciation when cash flows are not being compounded” (per the firm’s website). While I do not intend to disparage the managers of this portfolio, I am willing to bet some dollars that they are not aware of the significant distribution cut that is approaching (I have calls in to speak with the company and will relay what I learn and whether I won the bet). Suffice to say, I believe that the vast majority of the trust’s owners either have so little of their portfolio invested in HGT that they won’t care what price it is when they sell it (because it violates their yield mandate) or they just don’t know what is coming and will likely hit the “panic sell” button (aka, “stop loss”).

Intrinsic Value

Hugoton Royalty Trust owns an 80% interest in producing oil and gas properties in Oklahoma, Kansas and Wyoming. The trust was formed in 1999 when it was spun out from XTO. On a volume basis, production is 93% natural gas and NGLs (trust does not break out liquids). Over the past twelve years production has declined from +100 mcf/d to 53 mcf/d. Run rate decline is around 7.5%/yr. Per the reserve report, at $4.67 gas and $92.92 oil the PV-10 is $8.37/unit (36% below the current price), with 14 years of reserves.

According to the annual report, substantially all of the acreage in the trust is developed and drilling has been limited to recompletions and a very small number of new wells. While Exxon (the operator of wells) has not been willing to give details on their future plans for drilling the trust acreage, the 2012 capital budget would suggest that any development activities will be limited (new wells are non-economic). I have reviewed the locations of the trust acreage and, with the exception of a small amount of land in Beckham County, Oklahoma (located in the Granite Wash) I do not anticipate that there is much, if any, exposure to developing plays (ie, I don’t think this is a potential Mississippian play).

On an LTM basis the trust has distributed $1.21/unit, implying a 9.3% yield. Distributions and trust accounting are on a two month lag from actual pricing and production. Using oil and gas prices for the past two months and the current strip, NTM distributions (ignoring the aforementioned settlement) will be in the neighborhood of $0.75/unit, implying a 5.7% yield.

There is some uncertainty in estimating distributions, but I think the factors at hand are a tailwind for the short. The trust does not break out gas liquids from dry gas production. I have attempted to get a breakdown from the trustee and XOM, but to no avail. Historically the realized pricing per mcf has been $0.40-$1.00 higher than the average gas spot rate. This is probably partially due to purchasing contract terms/basis differentials/transportation costs etc., but mostly attributable to the liquids component. As some of you may know, NGL prices, particularly at Conway (where most HGT production is priced), have been in a freefall. Year to date the Conway propane spot price has declined almost 40% from $1.15/gal to $0.71/gal. While some of the fall is due to the warmer than average winter, I believe pricing will continue to be weak (both in absolute terms and relative to Mt. Belvieu) thanks to the significant production growth coming out of the Mississippian and limited infrastructure.

E&P names that I have worked with in the area (most of the production is in western Oklahoma) have typically benchmarked their NGL pricing on propane. Historically, HGT realized gas prices have captured around 18% of the energy equivalent premium in the propane to natural gas comparison. The relationship has been fairly consistent, so I believe propane is not a bad proxy for pricing the liquids component. Using the current propane price, I estimate a range of annual distributions given varying oil and gas prices as follows.

Given that this trust is experiencing 7.5% annual production declines, I would think that a 10% yield on $3.50 gas / $95 oil is a very generous view of fair value. This would price the trust at $9.70/unit, 25% below the current price (and still 17% above PV-10). While I am well aware that HGT is not unique in the sense that it is an overvalued oil and gas trust, I do think that the distribution cut will provide a meaningful catalyst that could very well cause the price to drop well below its intrinsic value.

Risks

It is possible that I am wrong about the reaction. The distribution could come and go without anyone caring. Many believe that HGT and other natural gas trusts are the best way to play a long gas thesis (http://mobile.bloomberg.com/news/2012-04-19/gundlach-sees-natural-gas-like-1997-gold-poised-to-rise). While I disagree with this perspective (at $52k per boe/d with no undeveloped acreage even UNG is a better way to go long gas), it would not be the craziest thing to happen in the market.

Gas could go on a tear and HGT could get caught in a buying wave. Though I believe that the recent move from <$2/MCF to $2.55/MCF is likely to retreat, there is a chance that gas gets closer to $3/MCF as shorts cover and analysts soften their language regarding the likelihood of storage filling up. Even so, should prices move towards $3/MCF, I believe a significant amount of the excess demand coming in the form of coal to gas switching with abate, causing weekly injections to rise and rekindling fears of overfilling storage.

The settlement could be delayed. In the event that something holds up the settlement payment the catalyst could be pushed out longer than expected. Given that I believe the trust is currently overvalued, this would hopefully be a “tails I don’t win” outcome.

Catalyst