Hugoton Royalty Trust (
) had a rather tumultuous 2012. Having traded between $20 and $24,
the units dropped to the $14 - $16 range in the beginning of 2012
after a sharp decline in realized and forward natural gas prices in
association with the anomalously warm 2011 / 2012 winter. The units
dropped from $14 to $7 in May 2012 after a 10-Q filing mentioning a
$28.5 million litigation settlement charge, helped by a concerted
(and successful!) effort by short sellers to create panic. The unit
price has recovered somewhat but is still significantly below
Several developments since last spring have dramatically
improved the HGT valuation outlook. First of all, the settlement
charge is being rightfully disputed by the trustee and the dispute
is tentatively scheduled for arbitration on October 7, 2013. $4.4
million towards the settlement was already deducted from the 7/12
and 8/12 distributions and will be returned if the resolution is
favorable to the unit holders. Even if the outcome of the
arbitration is negative, the present value of the remaining charge
is only about $0.50. Obviously, that hardly justifies the
difference between where the units were trading before the
announcement and where they are now.
In addition, the natural gas pricing environment has changed
dramatically since the spring of 2012. A climatologically normal
winter of 2012/2013 combined with a massive reduction in the
natural gas rig count has resulted in a much tighter natural gas
market. This is evidenced by the fact that storage will end the
withdrawal season close to the mid-point of the historical range.
As a result, Henry Hub physical gas prices have moved from sub
$2.00 / MMbtu to close to $4.00 / MMbtu. The current forward curve
through January 2015 is above where it was as of 3/1/2012. Yet HGT
is trading at $8.19 now but was $14 as of 3/1/2012.
As the chart below shows, monthly distributions have climbed
back close to $0.07/unit and will reach $0.10/unit by January 2014,
assuming realized gas prices are similar to what the current
forward curve suggests. HGT has recovered a bit, with two notable
breakout attempts in November 2012 and January 2013.
(click to enlarge)
Below is a snapshot of our DCF valuation model for HGT:
(click to enlarge)
We believe that a 6% discount rate is appropriate for the
current interest rate environment and is commensurate with other
instruments with a similar tenor and risk profile. Keeping in mind
that the valuation is sensitive to this and other assumptions
(production decline rates, gas/oil revenue ratio, etc.), we are
confident that HGT is worth between $12 and $13, even after taking
into account the remaining settlement charge. In other words, the
current $8.20 level represents an approximately 12% IRR.
1. The May 2012 price drop was a clear overreaction, albeit not
surprising in an environment of multi-year low natural gas prices
and panic fanned by short sellers. Even if the arbitration decision
is detrimental to the unit holders, the present value of the
remaining settlement payment is only about 50 cents / unit.
2. HGT is one of the few "pure play" instruments that allow
investors to take a long position in unhedged natural gas reserves.
The commodity is currently traded for $19 / MMbtu in Japan, $12 in
Europe, and $4 in the US.
3. There is a significant potential for a short squeeze
- At the present natural gas curve, the monthly distributions
will increase to 0.10 / unit by January 2014 and therefore will
continue to attract more yield-minded investors.
- There is a strong possibility that the arbitration will be
resolved favorably for the trust. Such an announcement will be a
4. Using forward natural gas and oil prices as of 3/20/2013,
discounted at 6%, and even assuming a negative dispute resolution,
the trust units are worth between $12 and $13.
I am long [[HGT]]. I wrote this article myself, and it expresses my
own opinions. I am not receiving compensation for it. I have no
business relationship with any company whose stock is mentioned in
Thermo Fisher Scientific, Inc., Life Technologies
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