Description

Opportunity

Hugoton Royalty Trust (HGTXU) is effectively an option on a primarily natural gas royalty business facing legal uncertainty in a depressed natural gas price environment. In terms of stock price outcomes, there is a chance of significant upside, but there is also the possibility of a loss (i.e. the legal uncertainty). This idea is meant for small accounts due to the small market capitalization. Given the legal uncertainty, the time horizon is several years.

Additional details can be found in the excellent and profitable short recommendation posted on VIC in 2012 by yellowhouse.

Corporate Description

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 94% natural gas and NGLs (trust does not break out liquids). Since 2011, production has declined from 59,433 Mcf per day (2011) to 38,091 Mcf per day (2017). Run-rate decline is around 7% per year. According to the reserve report, at $2.40 per Mcf for gas and $47.91 oil, the PV-10 is $0.62/unit (50% above the current price), with a 10-year reserve life.

Recent Developments

Hugoton currently trades at $0.40, down from its 52-week high of $1.90 for multiple reasons:

1)   Depressed natural gas prices

2)   XTO’s increased development budget which caused the trust to discontinue distributions

3)   XTO Energy’s lawsuit settlement with Chieftain, where it is attempting to pass $20 million of settlement costs onto HGTXU

4)   HGTs recent delisting from the NYSE 

Discontinued distributions, lawsuits and the NYSE delisting have been significant negatives for HGTXU’s primarily retail shareholder base.

Issues facing HGTXU

HGTXU is facing numerous issues:

1) Development costs – Increased costs in Oklahoma

Over the next few years, XTO will be drilling more wells in Oklahoma resulting in increased operating costs ($30 million to $35 million) and thus reduced payments to HGTXU. Oklahoma represents the largest production of the three different states. Given current natural gas prices and development costs, it is unlikely that HGTXU will receive royalties from Oklahoma for a significant period of time. However, XTO has chosen to spend money on the Oklahoma acreage in the belief that such expenditures will be profitable. Please note that the Wyoming and Kansas operations are smaller and unless natural gas prices rise significantly, any royalties received will essentially offset the trust’s operating costs. Also note, that costs related to each of the conveyances (Wyoming, Kansas and Oklahoma) are independent of each other.

2) Chieftain lawsuit: HGTXU may or may not have to bear the lawsuit settlement costs

The Chieftain Royalty Company sued XTO Energy, alleging that XTO underpaid them over a number of years. Recently, both sides settled for $80 million. XTO has used part of the lawsuit settlement (around $20 million) as operating costs to reduce the royalties paid to HGTXU from the Oklahoma operations. HGTXU believes that the lawsuit settlement costs are not operating costs and should not be used to reduce royalty payments.

The Chieftain lawsuit may be similar to the Fankhouser lawsuit. In the case of Fankhouser, XTO Energy tried to pass on certain costs as operating costs. In the end, an arbitration panel ruled that XTO could not pass on such costs to HGTXU.

Please note that HGTXU pays its own legal costs which would be recoverable from XTO in the case of an HGTXU win.

3) Hugoton wins its $5 million lawsuit against XTO Energy

Hugoton is currently suing XTO Energy in the amount of $5 million, alleging that it was underpaid from 2014 to 2016. The lawsuit is similar to the Chieftain lawsuit (underpayment from 2002 to 2010), so a settlement is certainly possible, but it is difficult to say with certainty what the final outcome will be.

However, as the Chieftain class action lawsuit was resolved in 2018 after 8 years, a settlement may not be reached quickly.

If HGT wins its $5 million lawsuit, this would represent a one-time upside of $0.125 per unit, representing approximately 30% of today’s share price of $0.40. This amount could, however, be offset by development costs.

4) Optionality on the price of natural gas 

It is difficult to determine when the price of natural gas could rise, but HGTXU would be a beneficiary of a rising natural gas price environment.

Valuation

In 2017, at $2.90 MMBtu natural gas price and $46 oil, HGTXU paid $0.11 per unit. Assuming legal and development cost success, and a similar production and energy pricing environment as 2017, HGTXU may be able to resume distributions at the 2017 level in the next few years. Assuming a 10% yield, HGTXU could trade at $1.10.

There is also some comfort that the PV-10 is $0.62 per unit versus the current stock price of $0.40. The PV-10 has not been adjusted for the potential Chieftain lawsuit costs.

Risks

-       HGT is forced to absorb its share of the Chieftain lawsuit costs

-       XTO’s development costs in Oklahoma don’t result in significant production

-       Both of these would result in essentially no distributions for a significant period of time

Conclusion

HGTXU represents an option on a recovery in the natural gas pricing environment mixed in with legal uncertainty but with historical precedent on its side. Assuming a similar natural gas and oil pricing environment as 2017 and with a 10% yield, HGTXU’s potential $0.11 distribution (its distribution level in 2017) could result in a $1.10 stock price.

Catalyst

- Lawsuit Resolution

- Rising Natural Gas Prices

- Successful Drilling in Oklahoma