Hugoton Royalty Trust (HGTXU): Beware Of The High Risk Of The 21% Distribution Yield

Hugoton Royalty Trust (OTCQB:HGTXU) has enjoyed an exceptionally favorable business landscape over the last 12 months. Thanks to the sanctions of the U.S. and Europe on Russia, the global natural gas market became extremely tight last year and thus the price of U.S. natural gas rallied to a 13-year high. As a result, Hugoton has offered an 8-year high distribution over the last 12 months. As this distribution corresponds to an annualized yield of 21% and the sanctions are not likely to be withdrawn anytime soon, Hugoton is likely to entice many income-oriented investors. However, investors should be aware of the high risk of the trust.

Business overview

Hugoton Royalty Trust was created by XTO Energy in late 1998. The trust has 80% net profit interests in certain primarily gas-producing properties in Kansas, Oklahoma and Wyoming. Its assets are static, i.e., Hugoton cannot add new properties to its asset portfolio. Its net profits are calculated by deducting production costs, development costs and labor costs from the revenues generated by the properties.

In 2021, Hugoton produced 88% natural gas and only 12% oil. Therefore, the distributions of Hugoton are largely determined by the underlying price of natural gas and the operating costs of the trust. This is a striking difference from most oil and gas trusts, which are significantly affected by the price of oil as well.

Hugoton is currently thriving thanks to the exceptionally favorable conditions prevailing in the global gas market. Before the onset of the Ukrainian crisis, almost a year ago, Russia used to provide about one-third of natural gas consumed in Europe. Due to the sanctions of Europe on Russia, the former began to import a record number of LNG cargos from the U.S. Consequently, the U.S. gas market became extremely tight and thus the price of natural gas rallied to a 13-year high last year.

Hugoton greatly benefited from the rally of the price of natural gas. In 2022, the trust offered 8-year high total distributions per unit of $0.35, which correspond to a 21% yield at the current stock price.

However, just like all the oil and gas trusts, Hugoton offers a different distribution every month. The distribution is determined primarily by the sold volumes of the trust and its average realized gas prices. As the global gas market has finally absorbed the impact of the war in Ukraine, the price of U.S. natural gas has plunged 65% off its peak in the summer and is currently trading below its level just before the onset of the Ukrainian crisis.

The current price of gas is probably sufficient for Hugoton to keep offering a high distribution yield to its unitholders, though the forward yield of the trust is likely to prove much lower than the aforementioned 21% yield. However, the slump of the price of natural gas below its level just before the war is a bearish signal, as it indicates that the market has absorbed the impact of the war. Furthermore, due to the global energy crisis caused by the 13-year high prices of oil and gas last year, most countries are investing in renewable energy projects at a record pace. These clean energy projects, which will come online within the next 2-5 years, are likely to take their toll on the price of natural gas. As a result, Hugoton is likely to face a major downturn in its business in the upcoming years.

Vulnerability to downturns

The oil and gas industry is infamous for its high cyclicality, which is caused by the dramatic swings of the prices of oil and gas. Therefore, it is unreasonable and highly risky to assume that gas prices will remain favorable for Hugoton for the next several years. As experience has shown, a severe downturn in the gas market will show up sooner or later. It is thus of paramount importance to examine the resilience of Hugoton to downturns.

Unfortunately, Hugoton has proved one of the most vulnerable oil and gas trusts to downturns. To be sure, the trust suspended its distributions for 2.5 years, between April-2018 and October-2020, primarily due to low gas prices, which caused the costs of the trust to exceed its revenues. Even worse, when the price of natural gas began to recover from the pandemic, in late 2020, Hugoton did not reinstate its distributions, as it had to offset its past losses first.

Despite the sustained recovery of the price of natural gas, things got even worse later. On July 2nd, 2021, Hugoton reported that it had agreed to be acquired by XTO Energy at a price of $0.165 per unit in cash. That price was more than 90% lower than the price of the trust in 2016-2017. It would thus cause devastating losses to the unitholders. Fortunately, the acquisition was rejected by unitholders in late 2021 and the trust reinstated its distributions in August-2022.

Thanks to the rejection of the above deal, unitholders avoided devastating losses at the last minute. However, the above events are stern reminders of the excessive risk of Hugoton, which may return to the brink of dissolving whenever the next severe downturn of the oil and gas industry shows up. In addition, the suspension of distributions for nearly 4.5 years is certainly intolerable for all the income-oriented investors. There is no other oil and gas trust (to my knowledge) that has suspended its distributions for such a long period.

To cut a long story short, Hugoton is thriving right now and thus it is offering an above-average distribution yield but it is extremely sensitive to the cycles of its business. While there are no clouds in the oil and gas industry right now and the sanctions of western countries on Russia are not likely to loosen anytime soon, investors should be taught by history that downturns in this business show up suddenly and almost always catch most investors off-guard.

In 2020, the prices of oil and gas collapsed due to the onset of the pandemic, with the price of oil diving to negative levels for the first time in history. Analysts were calling “the end of oil as we knew it” at that time. However, the prices of oil and gas bottomed in the spring of 2020 and began to recover. Just one year later, these prices rallied to 13-year highs thanks to the Ukrainian crisis. These wild swings are just reminders of the dramatic cyclicality of the business of Hugoton.

Final thoughts

The price of natural gas has slumped 65% off its peak in the summer but it remains at levels that are probably sufficient for Hugoton to keep offering an above-average distribution yield. As long as gas prices remain around current levels, the trust will probably continue rewarding its unitholders. However, whenever the next downturn of the gas market shows up, Hugoton is likely to come under great pressure and suspend its distributions. Only the investors with high risk tolerance and deep knowledge of the cycles of the natural gas market may consider purchasing this high-risk trust.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.