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A 6% Yielding Bet on Oil and Gas Prices

- By Ben Reynolds

(Published by Bob Ciura on June 2)

Royalty trusts can be a good place to look for investors focused primarily on high dividend yields. Many royalty trusts pay dividends each month.

Hugoton Royalty Trust (HGT) is no exception - the company has a high dividend yield of 6.4% using its trailing 12-month dividends.

You can see the full list of established 5%-plus yielding stocks by clicking here.

In addition, it pays a monthly dividend that allows investors to compound their dividends more frequently than quarterly or semiannual dividends.

Monthly dividend stocks are a rare breed. There are just 21 stocks that make monthly dividend payouts.

You can see the entire list by clicking here.

This is a difficult time for oil and gas royalty trusts, due to the steep decline in oil prices over the past few years. As a result, they are exposed to the risk of a continued decline in commodity prices.

That said, they are worth exploring further for investors interested in high current income. And they offer potential for growth, if commodity prices increase moving forward.

This article will discuss Hugoton Royalty Trust's business model and its dividend.

Business overview

Hugoton was created on Dec. 1, 1998 by XTO Energy, which is now a subsidiary of ExxonMobil (XOM).

At that time, XTO created the trust with an 80% interest in primarily gas-producing properties, located in Kansas, Oklahoma and Wyoming.

Hugoton makes money by collecting income from its 80% interest. Income is calculated and paid by XTO Energy and is based on the proceeds from the underlying properties.

The trust then calculates dividend payments to investors of record on the last day of each month.

Hugoton will continue operating and paying dividends as long as the oil and gas fields are producing. The trust does not have a specified end date but will terminate if royalty revenue falls below $1 million per year over any consecutive two-year period.

It should come as no surprise that Hugoton has struggled mightily over the past three years. Crashing oil and gas prices caused the trust's income to collapse in tandem.

HGT Financial

Source: 2016 Annual Report, page 3

Distributable income fell from $43.8 million in 2014 to $7.75 million in 2015. Last year, distributable income fell to $1.85 million.

Lower distributable profit was the result of weak commodity prices and falling production, partially offset by lower costs of production.

Natural gas prices averaged $2.09 per thousand cubic feet for 2016, a 23% drop from 2015, when gas prices averaged $2.72. Realized oil prices fell 25% in 2016 to $37.59 per barrel.

Gas sales volumes for 2016 fell 6% from 2015 while oil sales volumes declined 8% for the year.

As of the end of 2016, Hugoton's estimated proved reserves were 92.5 billion cubic feet of natural gas and 1.1 million barrels of oil.

Growth prospects

Going forward, Hugoton's income growth will be virtually entirely reliant on the next direction commodity prices take.

Higher prices are critical for royalty trusts since their oil and gas fields deplete over time. Hugoton's estimated rate of natural production decline on its underlying oil and gas properties is approximately 6% to 8% per year.

Business conditions improved considerably to start 2017. Net profits income soared to $2.22 million in the first quarter, up from just $63,562 in the same quarter last year.

HGT First Quarter

Source: First Quarter Report, page 2

Higher commodity prices boosted net profits by $4.3 million last quarter.

This allowed Hugoton to resume distribution payments on its 40 million units.

As expected, sales volumes continued to decline. Gas and oil sales volumes declined by 6% and 18% for the first quarter.

But higher commodity prices more than made up for this.

Hugoton's average gas price rose 66% from the first quarter of 2016 to $3.16 per thousand cubic feet. Its average oil price was 40% higher year over year.

Commodity prices right now are close to the average levels from the first quarter. For example, Hugoton's average realized oil price was $46.56 per barrel last quarter.

Oil currently trades near $47 per barrel. Therefore, Hugoton's financial results in the second quarter should remain at least comparable to its first-quarter totals.

Dividend analysis

As a royalty trust, Hugoton's dividends are classified as royalty income. As such, the distributions are considered ordinary income and are taxed at the individual's marginal tax rate.

Hugoton's dividend is entirely based on whether the trust is generating income. When commodity prices rise, so do Hugoton's cash flow and dividends.

When commodity prices fall, Hugoton's dividend is reduced.

Hugoton's distribution history is volatile:

  • 2016 distributions of 4.6385 cents per unit.
  • 2015 distributions of 19.3831 cents per unit.
  • 2014 distributions of $1.095242 per unit.
  • 2013 distributions of 86.2682 cents per unit.
  • 2012 distributions of 58.1823 cents per unit.

As you can see, Hugoton's distributions can fluctuate wildly from year to year or cease altogether for extended periods.

Distributions are highly tied to commodity prices.

2014 was a great year for Hugoton; oil and gas prices were near their peaks. But as commodity prices declined, distributions dried up.

In 2016 Hugoton paid no distributions from January to June. It resumed making distributions in July and August but only at miniscule amounts (0.0942 cents and 0.6639 cents per unit).

For 2016 Hugoton distributed 4.6385 cents per unit for the full year. This comes out to a 2.62% yield based on the unit price of $1.77.

Distributions have picked up in 2017 as commodity prices recovered over the first half of the year. Hugoton has already distributed 6.5828 cents per unit through the first five months of 2017.

Hugoton's dividend yield based on trailing 12-month distributions is 6.4%.

If oil and gas prices stabilize or trend higher over the remainder of 2017, Hugoton's distributions will likely accelerate to end the year.

But the opposite scenario would play out if commodity prices head lower. This is the major risk investors should consider before buying units.

Final thoughts

There are several considerations investors should take into account before investing in royalty trusts. Hugoton carries unique tax implications for investors.

It is also a microcap with a market capitalization of just $73 million. As a result, it is thinly traded and receives virtually no analyst coverage.

Disclosure: I am long ExxonMobil.

This article first appeared on GuruFocus.