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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-Q

 

 

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2017

OR

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number: 1-10476

 

 

Hugoton Royalty Trust

(Exact name of registrant as specified in its charter)

 

 

 

Texas   58-6379215

(State or other jurisdiction

of incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

Southwest Bank

Trustee

P.O. Box 962020, Fort Worth, Texas

  76162-2020
(Address of principal executive offices)   (Zip Code)

(855) 588-7839

(Registrant’s telephone number, including area code)

NONE

(Former name, former address and former fiscal year, if change since last report)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☑    No  ☐

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ☐    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act (check one):

 

Large accelerated filer      Accelerated filer  
Non-accelerated filer   ☐  (Do not check if a smaller reporting company)    Smaller reporting company  
     Emerging growth company  

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).    Yes  ☐    No  ☑

Indicate the number of units of beneficial interest outstanding, as of the latest practicable date:

Outstanding as of November 1, 2017

40,000,000

 

 

 

 


Table of Contents

HUGOTON ROYALTY TRUST

FORM 10-Q FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2017

 

 

TABLE OF CONTENTS

  
         Page  
 

Glossary of Terms

     3  
PART I.  

FINANCIAL INFORMATION

  
    Item 1.  

Financial Statements (Unaudited)

     4  
 

Report of Independent Registered Public Accounting Firm

     5  
 

Condensed Statements of Assets, Liabilities and Trust Corpus at September 30, 2017 and December 31, 2016

     6  
 

Condensed Statements of Distributable Income for the Three and Nine Months Ended September 30, 2017 and 2016

     7  
 

Condensed Statements of Changes in Trust Corpus for the Three and Nine Months Ended September 30, 2017 and 2016

     8  
 

Notes to Condensed Financial Statements

     9  
    Item 2.  

Trustee’s Discussion and Analysis

     14  
    Item 3.  

Quantitative and Qualitative Disclosures about Market Risk

     19  
    Item 4.  

Controls and Procedures

     19  
PART II.  

OTHER INFORMATION

  
    Item 1.  

Legal Proceedings

     20  
    Item 1A.  

Risk Factors

     20  
    Item 6.  

Exhibits

     20  
 

Signatures

     21  

 

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HUGOTON ROYALTY TRUST

GLOSSARY OF TERMS

The following are definitions of significant terms used in this Form 10-Q:

 

Bbl    Barrel (of oil)
Mcf    Thousand cubic feet (of natural gas)
MMBtu    One million British Thermal Units, a common energy measurement
net proceeds    Gross proceeds received by XTO Energy from sale of production from the underlying properties, less applicable costs, as defined in the net profits interest conveyances
net profits income    Net proceeds multiplied by the net profits percentage of 80%, which is paid to the Trust by XTO Energy. “Net profits income” is referred to as “royalty income” for income tax purposes.
net profits interest    An interest in an oil and gas property measured by net profits from the sale of production, rather than a specific portion of production. The following defined net profits interests were conveyed to the Trust from the underlying properties:
   80% net profits interests—interests that entitle the Trust to receive 80% of the net proceeds from the underlying properties.
underlying properties    XTO Energy’s interest in certain oil and gas properties from which the net profits interests were conveyed. The underlying properties include working interests in predominantly gas-producing properties located in Kansas, Oklahoma and Wyoming.
working interest    An operating interest in an oil and gas property that provides the owner a specified share of production that is subject to all production expense and development costs

 

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HUGOTON ROYALTY TRUST

PART I - FINANCIAL INFORMATION

 

Item 1. Financial Statements.

The condensed financial statements included herein are presented, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in annual financial statements have been condensed or omitted pursuant to such rules and regulations, although the Trustee believes that the disclosures are adequate to make the information presented not misleading. These condensed financial statements should be read in conjunction with the financial statements and the notes thereto included in the Trust’s latest Annual Report on Form 10-K. In the opinion of the Trustee, all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of the assets, liabilities and trust corpus of the Hugoton Royalty Trust at September 30, 2017 and the distributable income and changes in trust corpus for the three- and nine-month periods ended September 30, 2017 and 2016 have been included. Distributable income for such interim periods is not necessarily indicative of the distributable income for the full year. The condensed financial statements as of September 30, 2017, and for the three-month and nine-month periods ended September 30, 2017 and 2016 have been subjected to a review by PricewaterhouseCoopers LLP, the Trust’s independent registered public accounting firm, whose report is included herein.

 

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Report of Independent Registered Public Accounting Firm

To the Unitholders of Hugoton Royalty Trust and

Southwest Bank, Trustee

We have reviewed the accompanying condensed statement of assets, liabilities and trust corpus of Hugoton Royalty Trust (the “Trust”) as of September 30, 2017, and the related condensed statements of distributable income and changes in trust corpus for the three-month and nine-month periods ended September 30, 2017 and 2016. These interim financial statements are the responsibility of the Trustee.

We conducted our review in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

As described in Note 1, these interim financial statements were prepared on the modified cash basis of accounting, which is a comprehensive basis of accounting other than accounting principles generally accepted in the United States of America.

Based on our review, we are not aware of any material modifications that should be made to the accompanying condensed interim financial statements for them to be in conformity with the basis of accounting described in Note 1.

We previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the statement of assets, liabilities and trust corpus as of December 31, 2016, and the related statements of distributable income and changes in trust corpus for the year then ended (not presented herein), and in our report dated March 10, 2017, we expressed an unqualified opinion on those financial statements. In our opinion, the information set forth in the accompanying condensed statement of assets, liabilities and trust corpus as of December 31, 2016 is fairly stated, in all material respects, in relation to the statement of assets, liabilities and trust corpus from which it has been derived.

/s/ PricewaterhouseCoopers LLP

Dallas, TX

November 6, 2017

 

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HUGOTON ROYALTY TRUST

 

Condensed Statements of Assets, Liabilities and Trust Corpus (Unaudited)

 

     September 30,
2017
     December 31,
2016
 

ASSETS

     

Cash and short-term investments

   $ 1,150,720      $ 1,257,800  

Net profits interests in oil and gas properties—net (Note 1)

     18,582,882        26,885,503  
  

 

 

    

 

 

 
   $ 19,733,602      $ 28,143,303  
  

 

 

    

 

 

 

LIABILITIES AND TRUST CORPUS

     

Distribution payable to unitholders

   $ 150,720      $ 257,800  

Expense reserve (a)

     1,000,000        1,000,000  

Trust corpus (40,000,000 units of beneficial interest authorized and outstanding)

     18,582,882        26,885,503  
  

 

 

    

 

 

 
   $ 19,733,602      $ 28,143,303  
  

 

 

    

 

 

 

 

(a) The expense reserve allows the Trustee to pay its obligations should it be unable to pay them out of the net profits income. As of September 30, 2017, the reserve currently established by the Trustee is fully funded at $1,000,000.

The accompanying notes to condensed financial statements are an integral part of these statements.

 

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HUGOTON ROYALTY TRUST

 

Condensed Statements of Distributable Income (Unaudited)

 

     Three Months Ended
September 30
     Nine Months Ended
September 30
 
     2017      2016      2017      2016  

Net profits income

   $ 688,252      $ 1,253,498      $ 4,236,724      $ 1,516,605  

Interest income

     2,091        289        4,616        544  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total income

     690,343        1,253,787        4,241,340        1,517,149  

Administration expense

     193,023        187,892        707,060        725,229  

Cash reserves withheld (used) for Trust expenses

     —          273,975        —          —    
  

 

 

    

 

 

    

 

 

    

 

 

 

Distributable income

   $ 497,320      $ 791,920      $ 3,534,280      $ 791,920  
  

 

 

    

 

 

    

 

 

    

 

 

 

Distributable income per unit (40,000,000 units)

   $ 0.012433      $ 0.019798      $ 0.088357      $ 0.019798  
  

 

 

    

 

 

    

 

 

    

 

 

 

The accompanying notes to condensed financial statements are an integral part of these statements.

 

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HUGOTON ROYALTY TRUST

 

Condensed Statements of Changes in Trust Corpus (Unaudited)

 

     Three Months Ended
September 30
    Nine Months Ended
September 30
 
     2017     2016     2017     2016  

Trust corpus, beginning of period

   $ 20,063,091     $ 28,801,000     $ 26,885,503     $ 86,900,231  

Amortization of net profits interests

     (1,480,209     (1,142,565     (8,302,621     (1,935,269

Impairment of net profits interest (Note 1)

     —         —         —         (57,306,527

Distributable income

     497,320       791,920       3,534,280       791,920  

Distributions declared

     (497,320     (791,920     (3,534,280     (791,920
  

 

 

   

 

 

   

 

 

   

 

 

 

Trust corpus, end of period

   $ 18,582,882     $ 27,658,435     $ 18,582,882     $ 27,658,435  
  

 

 

   

 

 

   

 

 

   

 

 

 

The accompanying notes to condensed financial statements are an integral part of these statements.

 

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HUGOTON ROYALTY TRUST

 

Notes to Condensed Financial Statements (Unaudited)

 

1. Basis of Accounting

The financial statements of Hugoton Royalty Trust (the “Trust”) are prepared on the following basis and are not intended to present financial position and results of operations in conformity with U.S. generally accepted accounting principles (“GAAP”):

 

    Net profits income recorded for a month is the amount computed and paid by XTO Energy Inc., the owner of the underlying properties, to Southwest Bank, as trustee (“Trustee”) for the Trust. XTO Energy is a wholly owned subsidiary of Exxon Mobil Corporation. Net profits income consists of net proceeds received by XTO Energy from the underlying properties in the prior month, multiplied by a net profits percentage of 80%.

Costs deducted in the calculation of net proceeds for the 80% net profits interests generally include applicable taxes, transportation, marketing and legal costs, production expense, development costs, operating charges and other costs.

 

    Net profits income is computed separately for each of the three conveyances under which the net profits interests were conveyed to the Trust. If monthly costs exceed revenues for any conveyance, such excess costs must be recovered, with accrued interest, from future net proceeds of that conveyance and cannot reduce net proceeds from the other conveyances.

 

    Interest income and distribution payable to unitholders include interest earned on the previous month’s investment.

 

    Trust expenses are recorded based on liabilities paid and cash reserves established by the Trustee for liabilities and contingencies.

 

    Distributions to unitholders are recorded when declared by the Trustee.

The Trust’s financial statements differ from those prepared in conformity with U.S. GAAP because revenues are recognized when received rather than accrued in the month of production, expenses are recognized when paid rather than when incurred and certain cash reserves may be established by the Trustee for contingencies which would not be recorded under U.S. GAAP. This comprehensive basis of accounting other than U.S. GAAP corresponds to the accounting permitted for royalty trusts by the U.S. Securities and Exchange Commission, as specified by Staff Accounting Bulletin Topic 12:E, Financial Statements of Royalty Trusts.

Most accounting pronouncements apply to entities whose financial statements are prepared in accordance with U.S. GAAP, directing such entities to accrue or defer revenues and expenses in a period other than when such revenues were received or expenses were paid. Because the Trust’s financial statements are prepared on the modified cash basis, as described above, most accounting pronouncements are not applicable to the Trust’s financial statements.

 

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Impairment of Net Profits Interest

The Trustee reviews the Trust’s net profits interests (“NPI”) in oil and gas properties for impairment whenever events or circumstances indicate that the carrying value of the NPI may not be recoverable. In general, the Trustee does not view temporarily low prices as an indication of impairment. The markets for crude oil and natural gas have a history of significant price volatility and though prices will occasionally drop significantly, industry prices over the long term will continue to be driven by market supply and demand. If events and circumstances indicated that the carrying value may not be recoverable, the Trustee would use the estimated undiscounted future net cash flows from the NPI to evaluate the recoverability of the Trust assets. If the undiscounted future net cash flows from the NPI are less than the NPI carrying value, the Trust would recognize an impairment loss for the difference between the NPI carrying value and the estimated fair value of the NPI. The determination as to whether the NPI is impaired requires a significant amount of judgment by the Trustee and is based on the best information available to the Trustee at the time of the evaluation.

In light of lower long term prices used to develop projections of future cash flows, continued excess costs on two conveyances and zero distributions to unitholders for the quarter ended June 30, 2016, the Trustee concluded in the second quarter of 2016 that the events or circumstances indicated the carrying value may not be recoverable and an assessment of the forecasted net cash flows was performed for the NPI. The fair value of the NPI was developed using estimates for future oil and gas production attributable to the Trust, future crude oil and natural gas commodity prices published by third-party industry experts (adjusted for basis differentials), estimated taxes, development and operating expenses, and a risk-adjusted discount rate. The result of the assessment indicated that the estimated undiscounted future net cash flows from the NPI were below the carrying value of the NPI. The NPI was written down to its fair value of $28.8 million, resulting in a $57.3 million impairment charged directly to trust corpus, which did not affect distributable income.

There was no impairment of the NPI during the quarter ended September 30, 2017.

Net profits interests in oil and gas properties

The initial carrying value of the net profits interests of $247,066,951 represents XTO Energy’s historical net book value for the interests on December 1, 1998, the date of the transfer to the Trust. During the second quarter 2016, the carrying value of the NPI was written down to its fair value of $28,801,000, resulting in an impairment of $57,306,527 charged directly to Trust corpus. Amortization of the net profits interests is calculated on a unit-of-production basis and charged directly to Trust corpus. Accumulated amortization was $171,177,542 as of September 30, 2017 and $162,874,921 as of December 31, 2016.

 

2. Development Costs

The following summarizes actual development costs, budgeted development costs deducted in the calculation of net profits income, and the cumulative actual costs compared to the amount deducted for the underlying properties:

 

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     Three Months Ended
September 30
     Nine Months Ended
September 30
 
     2017      2016      2017      2016  

Cumulative actual costs under (over) the amount deducted—beginning of period

   $ (83,055    $ 438,751      $ 56,243      $ 239,528  

Actual costs

     (434,911      (502,300      (1,774,209      (1,228,077

Budgeted costs deducted

     760,000        150,000        1,960,000        1,075,000  
  

 

 

    

 

 

    

 

 

    

 

 

 

Cumulative actual costs under (over) the amount deducted—end of period

   $ 242,034      $ 86,451      $ 242,034      $ 86,451  
  

 

 

    

 

 

    

 

 

    

 

 

 

The monthly deduction is based on the current level of development expenditures, budgeted future development costs and the cumulative actual costs under (over) previous deductions. XTO Energy has advised the Trustee that 2017 budgeted development costs for the underlying properties are between $2 million and $4 million. The 2017 budget year generally coincides with the Trust distribution months from April 2017 through March 2018. XTO Energy has advised the Trustee that due to increased non-operated development activity on properties underlying the Oklahoma net profits interests, it increased the monthly development cost deduction from $200,000 to $280,000 beginning with the August 2017 distribution. Changes in oil or natural gas prices could impact future development plans on the underlying properties. XTO Energy has advised the Trustee that this monthly deduction will continue to be evaluated and revised as necessary.

 

3. Income Taxes

For federal income tax purposes, the Trust constitutes a fixed investment trust that is taxed as a grantor trust. A grantor trust is not subject to tax at the trust level. Accordingly, no provision for income taxes has been made in the financial statements. The unitholders are considered to own the Trust’s income and principal as though no trust were in existence. The income of the Trust is deemed to have been received or accrued by each unitholder at the time such income is received or accrued by the Trust and not when distributed by the Trust. Impairments recorded for book purposes will not result in a loss for tax purposes for the unitholders until the loss is recognized.

All revenues from the Trust are from sources within Kansas, Oklahoma or Wyoming. Because it distributes all of its net income to unitholders, the Trust has not been taxed at the trust level in Kansas or Oklahoma. While the Trust has not owed tax, the Trustee is required to file an Oklahoma income tax return reflecting the income and deductions of the Trust attributable to properties located in the state, along with a schedule that includes information regarding distributions to unitholders. The Trust does not expect to file a Kansas income tax return for the 2017 tax year because it expects to have no revenues, income or deductions in 2017 attributable to properties located in Kansas. The Trust did not file a return with Kansas for the 2016 and 2015 tax years for the same reason.

Wyoming does not impose a state income tax.

Each unitholder should consult his or her own tax advisor regarding income tax requirements, if any, applicable to such person’s ownership of Trust units.

Unitholders should consult the Trust’s latest annual report on Form 10-K for a more detailed discussion of federal and state tax matters.

 

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4. Contingencies

In December 2010, a royalty class action lawsuit was filed against XTO Energy styled Chieftain Royalty Company v. XTO Energy Inc. in Coal County District Court, Oklahoma. XTO Energy removed the case to federal court in the Eastern District of Oklahoma. The plaintiffs allege that XTO Energy wrongfully deducted fees from royalty payments on Oklahoma wells, failed to make diligent efforts to secure the best terms available for the sale of gas and its constituents, and demand an accounting to determine whether they have been fully and fairly paid gas royalty interests. The case was certified as a class action in April 2012; however, on appeal in June 2012, the 10th Circuit Court of Appeals reversed the certification of the class and remanded the case back to the trial court for further proceedings. XTO Energy has informed the Trustee that it has reached a tentative settlement for the matter and continues to negotiate the final settlement agreement. The Trustee has requested the settlement amount from XTO Energy and has been informed that at this time, the amount that XTO Energy believes should be charged to the Trust has not been determined. XTO Energy has advised the Trustee that the settlement will be allocated to all of XTO Energy’s Oklahoma wells, the majority of which are not properties in which the Trust owns an underlying net profits interest.

The Trustee has informed XTO Energy that it intends to review any claimed reductions in payment to the Trust based on the facts and circumstances of such settlement. In light of a 2014 arbitration decision in which a three panel tribunal decided that the settlement in Fankhouser v. XTO Energy, Inc., including a new royalty calculation for future royalty payments, could not be charged to the Trust, to the extent that the claims in Chieftain are similar to those in Fankhouser the Trustee would likely object to such claimed reductions. Should there be a disagreement as to whether the Trust should bear its share of a settlement or judgment, the matter will be resolved by binding arbitration through the American Arbitration Association under the terms of the Indenture creating the Trust. XTO Energy has informed the Trustee that, although the amount of any reduction in net proceeds is not presently determinable, in its management’s opinion, the amount is not currently expected to be material to the Trust’s financial position or liquidity though it could be material to the Trust’s annual distributable income. Additionally, XTO Energy has advised the Trustee that any reductions would result in costs exceeding revenues on the properties underlying the net profits interests of the case, as applicable, for several monthly distributions, depending on the size of the settlement, if any, and the net proceeds being paid at that time, which would result in the net profits interest being limited until such time that the revenues exceed the costs for those net profit interests.

Certain of the underlying properties are involved in various other lawsuits and governmental proceedings arising in the ordinary course of business. XTO Energy has advised the Trustee that it does not believe that the ultimate resolution of these claims will have a material effect on the financial position or liquidity of the Trust, but may have an effect on annual distributable income.

Other

Several states have enacted legislation requiring state income tax withholding from payments made to nonresident recipients of oil and gas proceeds. After consultation with its tax counsel, the Trustee believes that it is not required to withhold on payments made to the unitholders. However, regulations are subject to change by the various states, which could change this conclusion. Should amounts be withheld on payments made to the Trust or the unitholders, distributions to the unitholders would be reduced by the required amount, subject to the filing of a claim for refund by the Trust or unitholders for such amount.

 

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5. Excess Costs

If monthly costs exceed revenues for any of the three conveyances (one for each of the states of Kansas, Oklahoma and Wyoming), such excess costs must be recovered, with accrued interest, from future net proceeds of that conveyance and cannot reduce net proceeds from other conveyances.

The following summarizes excess costs activity, cumulative excess costs balance and accrued interest to be recovered by conveyance:

 

     Underlying  
     KS      WY      Total  

Cumulative excess costs remaining at 12/31/16

   $ 1,049,601      $ 1,158,205      $ 2,207,806  

Net excess costs (recovery) for the quarter ended 3/31/17

     (76,669      (686,923      (763,592

Net excess costs (recovery) for the quarter ended 6/30/17

     10,426        44,584        55,010  

Net excess costs (recovery) for the quarter ended 9/30/17

     (125,539      (403,898      (529,437
  

 

 

    

 

 

    

 

 

 

Cumulative excess costs remaining at 9/30/17

     857,819        111,968        969,787  

Accrued interest at 9/30/17

     102,255        72,387        174,642  
  

 

 

    

 

 

    

 

 

 

Total remaining to be recovered at 9/30/17

   $ 960,074      $ 184,355      $ 1,144,429  
  

 

 

    

 

 

    

 

 

 

 

     NPI  
     KS      WY      Total  

Cumulative excess costs remaining at 12/31/16

   $ 839,681      $ 926,564      $ 1,766,245  

Net excess costs (recovery) for the quarter ended 3/31/17

     (61,335      (549,538      (610,873

Net excess costs (recovery) for the quarter ended 6/30/17

     8,341        35,667        44,008  

Net excess costs (recovery) for the quarter ended 9/30/17

     (100,431      (323,118      (423,549
  

 

 

    

 

 

    

 

 

 

Cumulative excess costs remaining at 9/30/17

     686,256        89,575        775,831  

Accrued interest at 9/30/17

     81,803        57,909        139,712  
  

 

 

    

 

 

    

 

 

 

Total remaining to be recovered at 9/30/17

   $ 768,059      $ 147,484      $ 915,543  
  

 

 

    

 

 

    

 

 

 

Improved gas prices in relation to costs resulted in the partial recovery of excess costs on properties underlying the Kansas and Wyoming net profits interests for the quarter ended September 30, 2017.

Underlying cumulative excess costs for the Kansas and Wyoming conveyances remaining as of September 30, 2017 totaled $1.1 million, including accrued interest of $0.2 million.

 

6. Operated Overhead

XTO Energy advised the Trustee that the August 2016 distribution included a one-time reimbursement to the Trust of approximately $450,000 related to operated overhead corrections for the period of January 2014 through May 2016. This reimbursement affected the net profits income under the Oklahoma conveyance.

XTO Energy advised the Trustee that the May 2016 distribution included a one-time reimbursement to the Trust of approximately $788,000 related to operated overhead corrections for the period of January 2014 through February 2016. The reimbursement affected the net profits income under the Kansas, Oklahoma and Wyoming conveyances by approximately $186,000, $320,000 and $282,000 respectively.

 

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7. Taxes, Transportation and Other Deductions

XTO Energy advised the Trustee that net profits income for August 2016 included a deduction of approximately $500,000 in additional gathering fees for the period of December 2015 through May 2016 related to a renegotiated gas purchase contract that included production from properties underlying the Oklahoma conveyance. The current contract term is December 1, 2015 until November 30, 2017.

 

8. Subsequent Event

Effective October 19, 2017, Simmons First National Corporation (“SFNC”) completed its acquisition of First Texas BHC, Inc., the parent company of Southwest Bank, the Trustee of the Trust. SFNC is the parent of Simmons Bank. SFNC has announced that it intends to operate Southwest Bank as a separate bank subsidiary for an interim period, after which it intends to merge it into Simmons Bank. The Trustee does not anticipate any material impact to the Trust as a result of the acquisition.

 

Item 2. Trustee’s Discussion and Analysis.

The following discussion should be read in conjunction with the Trustee’s discussion and analysis contained in the Trust’s 2016 Annual Report on Form 10-K, as well as the condensed financial statements and notes thereto included in this Quarterly Report on Form 10-Q. The Trust’s Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports are available on the Trust’s web site at www.hgt-hugoton.com.

Distributable Income

Quarter

For the quarter ended September 30, 2017, net profits income was $688,252, as compared to $1,253,498 for third quarter 2016. This 45% decrease in net profits income is primarily the result of lower gas and oil production ($0.7 million), net excess costs activity ($0.6 million), increased production expense ($0.6 million), higher overhead ($0.5 million) and increased development costs ($0.5 million), partially offset by higher gas and oil prices ($2.1 million) and decreased taxes, transportation and other costs ($0.2 million). See “Net Profits Income” below.

After adding interest income of $2,091 and deducting administration expense of $193,023, distributable income for the quarter ended September 30, 2017 was $497,320, or $0.012433 per unit of beneficial interest. Administration expense for the quarter increased $5,131 as compared to the prior year quarter, primarily related to the timing of receipt and payment of Trust expenses and terms of professional services. Changes in interest income are attributable to fluctuations in net profits income and interest rates. For third quarter 2016, distributable income was $791,920, or $0.019798 per unit.

 

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Distributions to unitholders for the quarter ended September 30, 2017 were:

 

Record Date

   Payment Date    Distribution
per Unit
 

July 31, 2017

   August 14, 2017    $ 0.002573  

August 31, 2017

   September 15, 2017      0.006092  

September 29, 2017

   October 16, 2017      0.003768  
     

 

 

 
          $0.012433  
     

 

 

 

Nine Months

For the nine months ended September 30, 2017, net profits income was $4,236,724 compared with $1,516,605 for the same 2016 period. This 179% increase in net profits income is primarily the result of higher gas and oil prices ($10.6 million), partially offset by decreased gas and oil production ($2.5 million), net excess costs activity ($2.2 million), increased taxes, transportation and other costs ($1.3 million), higher overhead ($1.0 million), increased development costs ($0.7 million) and higher production expense ($0.2 million). See “Net Profits Income” below.

After adding interest income of $4,616 and deducting administration expense of $707,060, distributable income for the nine months ended September 30, 2017 was $3,534,280, or $0.088357 per unit of beneficial interest. Administration expense for the nine months ended September 30, 2017 decreased $18,169 as compared to the same 2016 period, primarily related to the timing of receipt and payment of Trust expenses and terms of professional services. Changes in interest income are attributable to fluctuations in net profits income and interest rates. For the nine months ended September 30, 2016, distributable income was $791,920, or $0.019798 per unit.

Net Profits Income

Net profits income is recorded when received by the Trust, which is the month following receipt by XTO Energy, and generally two months after oil and gas production. Net profits income is generally affected by three major factors:

 

    oil and gas sales volumes,

 

    oil and gas sales prices, and

 

    costs deducted in the calculation of net profits income.

 

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The following is a summary of the calculation of net profits income received by the Trust:

 

     Three Months Ended
September 30
(a)
    Increase
(Decrease)
     Nine Months Ended
September 30
(a)
    Increase
(Decrease)
 
     2017      2016        2017      2016    

Sales Volumes

               

Gas (Mcf) (b)

               

Underlying properties

     3,557,852        3,806,576       (7%)        10,497,894        11,263,950       (7%)  

Average per day

     38,672        41,376       (7%)        38,454        41,109       (6%)  

Net profits interests

     229,435        574,688       (60%)        1,286,934        706,835       82%  

Oil (Bbls) (b)

               

Underlying properties

     40,990        44,718       (8%)        119,291        139,353       (14%)  

Average per day

     446        486       (8%)        437        509       (14%)  

Net profits interests

     4,000        9,883       (60%)        21,221        12,205       74%  

Average Sales Prices

               

Gas (per Mcf)

     $2.81        $2.12       33%        $2.94        $1.88       56%  

Oil (per Bbl)

     $43.96        $42.94       2%        $46.29        $36.02       29%  

Revenues

               

Gas sales

   $ 10,006,965      $ 8,078,025       24%      $ 30,827,132      $ 21,199,655       45%  

Oil sales

     1,801,955        1,920,303       (6%)        5,521,410        5,019,621       10%  
  

 

 

    

 

 

      

 

 

    

 

 

   

Total Revenues

     11,808,920        9,998,328       18%        36,348,542        26,219,276       39%  
  

 

 

    

 

 

      

 

 

    

 

 

   

Costs

               

Taxes, transportation and other

     2,079,613        2,333,558       (11%)        6,269,314        4,644,267       35%  

Production expense

     4,618,468        3,908,973       18%        12,934,692        12,626,547       2%  

Development costs (c)

     760,000        150,000       407%        1,960,000        1,075,000       82%  

Overhead (d)

     2,961,087        2,302,504       29%        8,650,612        7,466,646       16%  

Excess costs (e)

     529,437        (263,579     N/A        1,238,019        (1,488,940     N/A  
  

 

 

    

 

 

      

 

 

    

 

 

   

Total Costs

     10,948,605        8,431,456       30%        31,052,637        24,323,520       28%  
  

 

 

    

 

 

      

 

 

    

 

 

   

Net Proceeds

     860,315        1,566,872       (45%)        5,295,905        1,895,756       179%  

Net Profits Percentage

     80%        80%          80%        80%    
  

 

 

    

 

 

      

 

 

    

 

 

   

Net Profits Income

   $ 688,252      $ 1,253,498       (45%)      $ 4,236,724      $ 1,516,605       179%  
  

 

 

    

 

 

      

 

 

    

 

 

   

 

(a) Because of the two-month interval between time of production and receipt of net profits income by the Trust, (1) gas and oil sales for the quarter ended September 30 generally represent production for the period May through July and (2) gas and oil sales for the nine months ended September 30 generally represent production for the period November through July.

 

(b) Gas and oil sales volumes are allocated to the net profits interests by dividing Trust net cash inflows by average sales prices. As gas and oil prices change, the Trust’s allocated production volumes are impacted as the quantity of production necessary to cover expenses changes inversely with price. As such, the underlying property production volume changes may not correlate with the Trust’s allocated production volumes in any given period. Therefore, comparative discussion of gas and oil sales volumes is based on the underlying properties.

 

(c) See Note 2 to Condensed Financial Statements.

 

(d) See Note 6 to Condensed Financial Statements.

 

(e) See Note 5 to Condensed Financial Statements.

 

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The following are explanations of significant variances on the underlying properties from third quarter 2016 to third quarter 2017 and from the first nine months of 2016 to the comparable period in 2017:

Sales Volumes

Gas

Gas sales volumes decreased 7% for both the third quarter and for the nine-month period primarily because of natural production decline.

Oil

Oil sales volumes decreased 8% for third quarter and 14% for the nine-month period primarily because of natural production decline and the timing of cash receipts.

The estimated rate of natural production decline on the underlying oil and gas properties is approximately 6% to 8% a year.

Sales Prices

Gas

The third quarter 2017 average gas price was $2.81 per Mcf, a 33% increase from the third quarter 2016 average gas price of $2.12 per Mcf. For the nine-month period, the average gas price increased 56% to $2.94 per Mcf in 2017 from $1.88 per Mcf in 2016. The third quarter 2017 gas price is primarily related to production from May through July 2017, when the average NYMEX price was $3.15 per MMBtu.

Oil

The third quarter 2017 average oil price was $43.96 per Bbl, a 2% increase from the third quarter 2016 average oil price of $42.94 per Bbl. For the nine-month period, the average oil price increased 29% to $46.29 per Bbl in 2017 from $36.02 per Bbl in 2016. The third quarter 2017 oil price is primarily related to production from May through July 2017, when the average NYMEX price was $46.81 per Bbl.

Costs

Taxes, Transportation and Other

Taxes, transportation and other costs decreased 11% for the third quarter primarily because of decreased gas deductions related to additional gathering fees included in third quarter 2016, partially offset by increased production taxes related to higher gas revenues. For further information on additional gathering fees included in third quarter 2016, see Note 7 to Condensed Financial Statements. Taxes, transportation and other costs increased 35% for the nine-month period primarily because of increased production taxes related to higher gas and oil revenues, increased gas deductions related to higher gathering fees and increased property taxes.

Production Expense

Production expense increased 18% for the third quarter primarily because of increased salt water disposal, environmental costs, and other field goods and services. Production expense increased 2% for the nine-month period primarily because of increased salt water disposal and environmental costs, partially offset by decreased labor and other field goods and services.

 

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Development Costs

Development costs deducted are based on the current level of development expenditures, budgeted future development costs and the cumulative actual costs under (over) previous deductions. These development costs increased 407% for the third quarter and 82% for the nine-month period. The monthly development cost deduction will be reevaluated by XTO Energy and revised as necessary. For further information on development costs, see Note 2 to Condensed Financial Statements.

Overhead

Overhead increased 29% for the third quarter and 16% for the nine-month period primarily because of one-time reimbursements related to operated overhead corrections in 2016. For further information on overhead corrections, see Note 6 to Condensed Financial Statements.

Excess Costs

If monthly costs exceed revenues for any conveyance, these excess costs must be recovered, with accrued interest, from future net proceeds of that conveyance and cannot reduce net profits income from another conveyance. Underlying cumulative excess costs for the Kansas and Wyoming conveyances remaining as of September 30, 2017 totaled $1.1 million, including accrued interest of $0.2 million. Cumulative excess costs for the NPI remaining as of September 30, 2017 totaled $0.9 million, including accrued interest of $0.1 million. For further information on excess costs, including the excess cost balance and accrued interest by conveyance, see Note 5 to Condensed Financial Statements.

Impairment of Net Profits Interest

In light of lower long term prices used to develop projections of future cash flows, continued excess costs on two conveyances and zero distributions to unitholders for the quarter ended June 30, 2016, the Trustee concluded in the second quarter of 2016 that the events or circumstances indicated the carrying value may not be recoverable and an assessment of the forecasted net cash flows was performed for the NPI. The fair value of the NPI was developed using estimates for future oil and gas production attributable to the Trust, future crude oil and natural gas commodity prices published by third-party industry experts (adjusted for basis differentials), estimated taxes, development and operating expenses, and a risk-adjusted discount rate. The result of the assessment indicated that the estimated undiscounted future net cash flows from the NPI were below the carrying value of the NPI. The NPI was written down to its fair value of $28.8 million, resulting in a $57.3 million impairment charged directly to trust corpus, which did not affect distributable income. There was no impairment of the NPI during the quarter ended September 30, 2017.

Marketing

XTO Energy has advised the Trustee that, effective April 1, 2017, Cross Timbers Energy Services, Inc. (“CTES”), a wholly owned marketing subsidiary of XTO Energy, has assigned all gas sales contracts for production from the underlying properties to XTO Energy. XTO Energy will directly market and sell the gas to third parties. XTO Energy has advised the Trustee that there are no changes to the terms of the contracts related to the assignment and no impact on Trust distributions.

For further information regarding natural gas sales from the underlying properties to affiliates of XTO Energy, see Significant Properties, under Item 2, Properties and Note 7 to the Financial Statements under Item 8, Financial Statements and Supplementary Data of the Trust’s Annual Report on Form 10-K for the year ended December 31, 2016.

 

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Contingencies

For information on contingencies, see Note 4 to Condensed Financial Statements.

Forward-Looking Statements

Statements in this report relating to future plans, predictions, events or conditions are forward-looking statements. All statements other than statements of historical fact included in this Form 10-Q, including, without limitation, statements regarding the net profits interests, underlying properties, development activities, annual and monthly development, production and other costs and expenses, monthly development cost deductions, oil and gas prices and differentials to NYMEX prices, supply levels, future drilling, workover and restimulation plans, the outcome of litigation and impact on Trust proceeds, distributions to unitholders, and industry and market conditions, are forward-looking statements that are subject to risks and uncertainties which are detailed in Part I, Item 1A of the Trust’s Annual Report on Form 10-K for the year ended December 31, 2016, which is incorporated by this reference as though fully set forth herein. XTO Energy and the Trustee assume no duty to update these statements as of any future date.

 

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

There have been no material changes in the Trust’s market risks from the information disclosed in Part II, Item 7A of the Trust’s Annual Report on Form 10-K for the year ended December 31, 2016.

 

Item 4. Controls and Procedures.

As of the end of the period covered by this report, the Trustee carried out an evaluation of the effectiveness of the Trust’s disclosure controls and procedures pursuant to Exchange Act Rules 13a-15 and 15d-15. Based upon that evaluation, the Trustee concluded that the Trust’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Trust in the reports that it files or submits under the Securities Exchange Act of 1934 and are effective in ensuring that information required to be disclosed by the Trust in the reports that it files or submits under the Securities Exchange Act of 1934 is accumulated and communicated to the Trustee to allow timely decisions regarding required disclosure. In its evaluation of disclosure controls and procedures, the Trustee has relied, to the extent considered reasonable, on information provided by XTO Energy. There has not been any change in the Trust’s internal control over financial reporting during the period covered by this report that has materially affected, or is reasonably likely to materially affect, the Trust’s internal control over financial reporting.

 

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PART II—OTHER INFORMATION

 

Item 1. Legal Proceedings.

Refer to Note 4 of this Quarterly Report on Form 10-Q for information on legal proceedings.

 

Item 1A. Risk Factors.

There have been no material changes in the risk factors disclosed under Part I, Item 1A of the Trust’s Annual Report on Form 10-K for the year ended December 31, 2016.

 

Item 6. Exhibits.

 

(31)    Rule 13a-14(a)/15d-14(a) Certification
(32)    Section 1350 Certification
(99)    Items 1A, 7 and 7A to the Annual Report on Form 10-K for Hugoton Royalty Trust filed with the Securities and Exchange Commission on March 10, 2017 (incorporated herein by reference)

 

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.

 

    HUGOTON ROYALTY TRUST
    By SOUTHWEST BANK, TRUSTEE
    By  

/s/ LEE ANN ANDERSON

      Lee Ann Anderson
      Senior Vice President
    EXXON MOBIL CORPORATION
Date: November 6, 2017     By  

/s/ DAVID LEVY

      David Levy
      Vice President—Upstream Business Services

 

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