Mesa Royalty Trust still very cheap
Mesa Royalty Trust still very cheap
Cheap stock that also qualifies as special situation
Still trading at a 20-30% forward yield and a sizable discount to SJT
Overal natural gas supply and takeaway situation looks better than in 2016
Trades at significantly lower valuation compared to previous crash in 2016
Catalyst in form of increased dividends by end of this year
I wrote an article on Mesa Royalty Trust (MTR) last year when it was trading at about $4 per share. Now it trades at $5.9 per share, but I am still holding a large position. Natural gas prices are at roughly $4/mcf, higher than what I estimated them to be. Current forward yield seems to still be around 20-30% if gas stays between $3-4. In the 4 years between 2015 and 2020 MTR has generated 44% of its market cap with just their SJ acreage for an average yield of 11% per year with average natural gas prices of only $2.8/mcf (source). This compares to 32% for the San Juan Trust (SJT). Including income from MTR’s Hugoton acreage, it generated 72% of its market cap in those 4 years. Hugoton has break even costs of around $2.6/mcf so it is more of an option on gas prices that you are getting for free here.
The reason for the discount is that MTR is currently paying out much lower distributions than SJT due to a ~$1 million charge by their New Mexico SJ producer, Hilcorp (as I mentioned in my last article would likely happen) due to overpayment. As of Q1 there was about $750k left to work off. And their New Mexico acreage generated about $1m per year in 2017 and 2018 when gas was about $3/mcf. Currently the futures curve is hanging around $4/mcf well into 2022.
Furthermore due to the record low prices in 2020 (nat gas averaged only $2.03/mcf), MTR’s Hugoton acreage still had a deficit of $390k to work off as of Q1 this year. To get a better idea of break even costs for the Hugoton field, see also the Hugoton Trust (HGTXU). In 2017 and 2018, MTR’s Hugoton acreage generated about $1.4m and $700k respectively.
Natural gas supply situation
So in order to gain some conviction here, at least a general view on natural gas is needed. To get a general idea of what a commodity market will do, you need to know how cyclical capex spend is. For copper, the capex cycle is very long because a very large amount is invested up front in a mine that will last for decades with a low decline rate. So once supply comes online, it won’t easily go away. Since capex will be low and cash costs are far more relevant than full cycle costs. Oil and gas used to be similar until the shale revolution, which largely reversed this, especially for natural gas. Shale well production generally declines by about 50% and 80% after 1 and 5 years respectively. So new wells need to be drilled constantly (which means more constant capex) to keep production steady. Since most of North American gas is now produced from shale wells, this creates very volatile and short cycles. If no new gas wells are drilled, then overall production will decline by about 30% in one year (source).
This means average annual natural gas prices will more closely track the marginal cost of production over a several year period. And that over and under supply situations are generally more quickly resolved. Which makes it a relatively attractive commodity to invest in as a value investor. As you are less likely to get trapped in a multi year commodity bear market. All you need to really focus on is valuation and that production costs are significantly below marginal cost of production. For natural gas the marginal cost of production is about $3/mcf. And most of the larger shale producers need gas to be between $2.2-2.7/mcf to break even. For example, EQT, one of the largest and most efficient shale gas producers, has breakeven EBIT of around $2.3/mcf.
MTR’s SJ acreage seems to have breakeven cost below $2/mcf.
And interestingly now that the general sentiment is more negative towards oil and gas stocks than even in 2016, the industry is much more focussed on making a profit, rather than mindlessly growing production. This means there will likely be a greater lag between rising prices and rising production. Gas rig counts are moving up slower now compared to the last time gas prices recovered from a large drop in early 2016 (source):
Even though North American production in 2016 was 77 Bcf and will likely be 90 Bcf in 2021! And valuations are actually attractive this time around. The last time MTR was trading this cheaply, gas was at $2/mcf. And by the time gas had recovered to $4/mcf at the end of 2016, MTR was trading at $11, vs $5.9 currently (as nat gas price is now $4/mcf as well). Even though there is now far more shareholder imposed discipline now among gas producers compared to 5 years ago.
Additionally what is relevant is takeaway capacity. If there is a lack of pipelines it means large discounts for your gas. This was a problem until recently for SJ producers due to Permian oil producers not having enough pipeline capacity for their associated gas. This caused producers in San Juan to also sell their gas at a discount to Henry Hub pricing since the SJ field is near the Permian.
This shows correlation between SJ discounts to Henry Hub (HH) prices (up until July 2021):
And pipeline constraints in the Permian (Source):
Looks like there will be plenty of space in those pipelines for years to come. Although this has not yet fully shown up in pricing differentials.
So in conclusion I quite like the setup here. The upcoming dividend increase will show this at the top of every dividend screener before the end of this year, providing a strong catalyst. Long MTR at an average price of $5.29 per share. And I may sell it at any time so DYOW.