Description

Panhandle Royalty Company (PHX) owns oil/gas mineral and royalty interests in several states with the majority of oil and gas production from wells located in Oklahoma. With 85% of production and reserves in natural gas, a potential investor must have the belief that natural gas prices will not decline dramatically from the current price level for an extended period of time.

I believe that Panhandle is an attractive holding based on its structure, stability, and history of solid financial performance.

Structure

PHX is not an operator of wells so there is no operational risk for investors. I like the fact that the company can generate revenues of over 37 million dollars with 16 employees. Investors get upside potential on high commodity prices and more exposure to additional reserves and production as the higher price environment translates into more drilling proposals on the Company’s properties by other parties.

The average working interest was 3% in ’04. In a shift of strategy, PHX plans to increase its working interest in new wells so that the average reaches 8-9%. In the past, PHX primarily leased their mineral rights. They would not pay any of the costs of the drilling and get a lease bonus and a small royalty interest. With the new strategy, PHX will share the cost of the drilling and get a much higher percentage of the revenue from the production. PHX is very excited about this new approach and believes it will be more profitable than its previous way of doing business.

The company has an inside track on important information about who’s interested in drilling, where they want to drill, and what prospects are in the area. The more optimistic that PHX is about an area the more they negotiate to receive a higher working interest in an area. Some working interest are as high as 30-40%.

Stability

PHX holds relatively small interests in wells in several states thereby providing it exposure to a number of different plays.

Independently proved reserves of Oil and Gas were up 10% to 34.3 BCFE for the Fiscal year ended Sept 30^th.

Oklahoma is PHX’s largest mineral rights acreage state. This is significant because Oklahoma has “forced pooling” regulations. Wells are relatively easy to drill and can be drilled within a short time after geologic and economic data are evaluated. In many other states if someone owns say 40 acres of a 640 tract they can block any drilling. In Oklahoma any party wishing to drill can “force pool” others even if they disagree to the viability of a project. Since PHX does not operate any wells, if it is “forced pooled” and does not like the prospects of the area, they can just lease its interest and collect a lease bonus and royalty from any successful production. If PHX is excited about an area it will obviously choose to go with more of a working interest arrangement.

Financial Performance

Cash flow from operating activities increased 38% over last year to $2.80 per share. That cash flow number is double what it was in 2003. Earnings per share were roughly flat at $1.25.  This number was distorted due to extraordinary lease bonus revenue in the 3^rd quarter of ’05 and an impairment charge of 2.8 million in the 4^th quarter of ’06.

PHX used a portion of  its cash flow to cut its debt in half in fiscal ’05 to just over 5 million dollars. During ’06 PHX continued to reduce its debt levels.

PHX has hedged roughly 1/3 of its natural gas production in ‘07 between $6.00 and $9.50. It may also hedge some of the remaining 2/3rds.

PHX currently pays a quarterly dividend of .04 per share.

With its new strategy of increasing its working interests in new wells drilled I could easily see cash flow growing by 25% in the current fiscal year to $3.50. One example of where this increased cash flow will come from is the Woodford Shale area in S.E. Oklahoma. Five years ago this area was not very active. With recent activity picking up significantly in this area, the new working interest strategy could start paying off.

At around 5.5 times cash flow I see PHX as a good value.

There have been several insider purchases over the past several months with the vast majority of shares being purchased by Robert Robotti. Robotti owns over 6.5% of the shares outstanding. Here is a quote from Robotti about PHX:

“Minerals are clearly a scarce resource in the oil and gas business. This ownership interest uniquely positions PHX to participate in exploration opportunities that others won’t get the chance to see. Most other oil and gas companies have to conduct their own exploration, which means those companies have to develop exploration leads and secure land before they can begin to explore. Our minerals bring the best explorers to us.”

Risks

While PHX is not an operator on any of its or other’s properties, the usual operating risks of an energy company does not apply. Competition is less of a risk factor because of its mineral interests.

The primary risk of PHX is the future price of gas. If prices were to decline and remain at a low level for any lengthy period, the loss of participation opportunities and the lower dollar value of reserves would have an impact on PHX and its stock price.

Catalyst