Management's Discussion of Results of Operations (Excerpts)
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On a scale of 0 to 5, 5 being best, Zenith rates this company's Management's Discussion as a 5.
Overview The Trust is an express trust created under the laws of the state of Texas by the San Juan Basin Royalty Trust Indenture entered into on November 1, 1980 between Southland Royalty Company (“Southland”) and The Fort Worth National Bank. Effective as of September 30, 2002, the original indenture was amended and restated and, effective as of December 12, 2007, the restated indenture was amended and restated, which we refer to as the “Indenture.” As a result of a series of mergers and other transactions, the current Trustee of the Trust is Compass Bank, which is a wholly-owned subsidiary of Banco Bilbao Vizcaya Argentaira, S.A. The Conveyance and the Royalty Pursuant to the Net Overriding Royalty Conveyance (the “Conveyance”) effective November 1, 1980, Southland conveyed to the Trust a 75% net overriding royalty interest (the “Royalty”) that burdens certain of Southland’s oil and natural gas interests (the “Subject Interests”) in properties located in the San Juan Basin of northwestern New Mexico. Subsequent to the Conveyance of the Royalty, through a series of assignments and mergers, Southland’s successor became Burlington Resources Oil & Gas Company LP (“Burlington”), which is an indirect wholly-owned subsidiary of ConocoPhillips. The Royalty constitutes the principal asset of the Trust. The beneficial interest in the Royalty is divided into 46,608,796 units (the “Units”) representing undivided fractional interests in the beneficial interest of the Trust equal to the number of shares of the common stock of Southland outstanding as of the close of business on November 3, 1980. Each stockholder of Southland of record at the close of business on November 3, 1980 received one freely tradable Unit for each share of the common stock of Southland then held. Holders of Units are referred to herein as “Unit Holders.” The Trustee The primary function of the Trustee is to collect Royalty Income, to pay all expenses and charges of the Trust and distribute the remaining available income to the Unit Holders. The amount of income distributable to Unit Holders, which we refer to as “Distributable Income,” depends on the amount of Royalty Income and interest received by the Trust, as well as the amount of expenses paid by the Trust and any change in cash reserves. The Trust has no employees, officers or directors. All administrative functions of the Trust are performed by the Trustee. ConocoPhillips Affiliates of ConocoPhillips are the principal operators of the majority of the Subject Interests. Burlington also is responsible, subject to the terms of an agreement with the Trust, for marketing the production from such properties, either under existing sales contracts or under future arrangements, at the best prices and on the best terms it shall deem reasonably obtainable in the circumstances. A very high percentage of the Royalty Income is attributable to the production and sale by Burlington of natural gas from the Subject Interests. Accordingly, the market price for natural gas produced and sold from the San Juan Basin heavily influences the amount of Royalty Income distributed by the Trust and, by extension, the price of the Units. Sale of Burlington’s Interest in the San Juan Basin In a July 31, 2017 news release, ConocoPhillips announced that the sale of its San Juan Basin assets to Hilcorp, which includes the Subject Interests, closed on July 31, 2017. ConocoPhillips informed the Trust that the last production month that ConocoPhillips is responsible for is July 2017. Results of Operations – Three and Six Months Ended June 30, 2017 and 2016 Royalty Income Royalty Income consists of monthly net proceeds attributable to the Royalty. Royalty Income for the three and six months ended June 30, 2017 The Royalty Income distributed to the Trust for the three and six months ended June 30, 2017 was higher than that distributed during the same periods of 2016 primarily due to higher natural gas prices. The average natural gas price increased from $1.43 per Mcf and $1.61 per Mcf for the three and six months ended June 30, 2016, respectively, to $2.63 per Mcf and $2.78 per Mcf for the three and six months ended June 30, 2017, respectively. Gross Proceeds from Subject Interests. Gross proceeds increased $7.0 million or 70% for the three months ended June 30, 2017 compared to the three months ended June 30, 2016 and increased $13.7 million or 59% for the six months ended June 30, 2017 compared to the six months ended June 30, 2016. Such increases for these periods were primarily attributable to higher natural gas and oil prices offset by lower production volumes. Capital Expenditures. Capital expenditures decreased $0.19 million or 71% for the three months ended June 30, 2017 compared to the three months ended June 30, 2016 and decreased $0.6 million or 68% for the six months ended June 30, 2017 compared to the six months ended June 30, 2016. Such decreases for these periods were primarily attributable to the challenging price environment for natural gas and natural gas liquids along with fewer maintenance and facility projects. Severance Taxes. Aggregate severance taxes increased $0.7 million or 61% for the three months ended June 30, 2017 compared to the three months ended June 30, 2016 and increased $1.3 million or 54% for the six months ended June 30, 2017 compared to the six months ended June 30, 2016. Such increases were primarily attributable to higher gross proceeds during these periods. Severance taxes represented 10.3% of gross proceeds for the three months ended June 30, 2017 compared to 10.9% for the same period of 2016. Severance taxes represented 10.3% of gross proceeds for the six months ended June 30, 2017 compared to 10.6% for the same period of 2016. Lease Operating Expenses and Property Taxes. Lease operating expenses and property taxes increased $0.03 million or 0.04% for the three months ended June 30, 2017 compared to the three months ended June 30, 2016 and decreased $1.1 million or 8% for the six months ended June 30, 2017 compared to the six months ended June 30, 2016. Lease operating expenses increased slightly during the second quarter of 2017 compared to second quarter of 2016. The decrease in lease operating expenses over the six month period of 2017 compared to the same period in 2016 was primarily attributable to 1) Burlington’s efforts to reduce contracted maintenance and repair costs; and 2) Burlington’s efforts to reduce costs on compression equipment. Property taxes decreased $41,277 in the second quarter of 2017 compared to the second quarter of 2016 and decreased $243,188 in the first half of 2017 compared to the first half of 2016 because actual taxes for 2016 were less than accrued, which resulted in a decrease in the current accruals based on a new estimate of ad valorem taxes for 2017. Monthly lease operating expenses of the Subject Interests, including property taxes, in second quarter 2017 averaged approximately $2.2 million, as compared to $2.2 million in the second quarter of 2016. Monthly lease operating expenses of the Subject Interests, including property taxes, in the first half of 2017 averaged approximately $2.1 million, as compared to $2.3 million in the first half of 2016. Distributable Income Distributable Income. Distributable Income increased by approximately $5.6 million or 1,287% to $6 million ($0.128333 per Unit) for the three months ended June 30, 2017 from $0.4 million ($0.009251 per Unit) for the three months ended June 30, 2016. Distributable income increased $11.9 million or 537% to $14.1 million ($0.303129 per Unit) for the six months ended June 30, 2017 from $2.2 million ($0.047586 per Unit) for the six months ended June 30, 2016. Such increases in Distributable Income were primarily attributable to an increase in Royalty Income over these periods and decreased general and administrative expenses directly related to audit and legal costs incurred in the 2014 Litigation. Interest Income. Interest income was higher for the three and six months ended June 30, 2017 as compared to the three and six month periods ended June 30, 2016 primarily due to increased funds available for investment. General & Administrative Expenses. General and administrative expenses decreased $0.4 million or 47% for the three months ended June 30, 2017 compared to the three months ended June 30, 2016 and decreased $1.0 million or 51% for the six months ended June 30, 2017 compared to the six months ended June 30, 2016. Such decreases were primarily due to decreased audit costs and legal costs incurred related to the 2014 Litigation. Cash Reserves. Total cash reserves for litigation expenses were $1.0 million as of June 30, 2017. The Trustee did not increase the cash reserves during the first half of 2017 and does not anticipate any increases in 2017. Liquidity and Capital Resources The Trust’s principal source of liquidity and capital is Royalty Income. The Trust’s distribution of income to Unit Holders is funded by Royalty Income after payment of Trust expenses. The Trust is not liable for any production costs or liabilities attributable to the Royalty. If at any time the Trust receives more than the amount due under the Royalty, it is not obligated to return such overpayment, but the amounts payable to it for any subsequent period are reduced by such amount, plus interest, at a rate specified in the Conveyance. If the Trustee determines that the Trust does not have sufficient funds to pay its liabilities, the Trustee may borrow funds on behalf of the Trust, in which case no distributions will be made to Unit Holders until such borrowings are repaid in full. The Trustee may not sell or dispose of any part of the assets of the Trust without the affirmative vote the Unit Holders of 75% of all of the Units outstanding; however, the Trustee may sell up to 1% of the value of the Royalty (as determined pursuant to the Indenture) during any 12-month period without the consent of the Unit Holders. 2017 Capital Expenditure Budget Burlington has informed the Trust that its 2017 budget for capital expenditures for the Subject Interests is estimated to be $1.7 million. Burlington reports that, based on its actual capital requirements, the pace of regulatory approvals, the mix of projects and swings in the price of natural gas, the actual capital expenditures for 2017 are subject to change. Burlington’s announced 2017 capital plan for the Subject Interests anticipates capital expenditures of $1.7 million, of which $0.64 million is allocated to 10 maintenance and facilities projects, $0.42 million is allocated to three well recompletions, and $0.64 million is allocated to 10 facilities projects attributable to the budgets for prior years. Primarily due to depressed pricing for natural gas, Burlington has not allocated any capital expenditures for 2017 to its drilling program in the San Juan Basin. Existing wells will continue to be operated. Following the sale to Hilcorp, the budget for capital expenditures for the Subject Interests for the remainder of 2017 is subject to change, which could include increases to capital expenditures and that may adversely affect Distributable Income. Oil and Natural Gas Production Royalty Income for the quarter ended June 30, 2017 is associated with actual oil and natural gas production during February 2017 through April 2017 from the Subject Interests. Royalty Income for the six months ended June 30, 2017 is associated with actual gas and oil production during November 2016 through April 2017 from the Subject Interests. The Trust recognizes production during the month in which the related net proceeds attributable to the Royalty are paid to the Trust. Royalty Income for a calendar year is based on the actual natural gas and oil production during the period beginning with November of the preceding calendar year through October of the current calendar year. Sales volumes attributable to the Royalty are determined by dividing the net profits by the Trust from the sale of oil and natural gas, respectively, by the prices received for sales of such volumes from the Subject Interests, taking into consideration production taxes attributable to the Subject Interests. Because the oil and natural gas sales attributable to the Royalty are based upon an allocation formula dependent on such factors as price and cost, including capital expenditures, the aggregate sales amounts from the Subject Interests may not provide a meaningful comparison to sales attributable to the Royalty. The fluctuations in natural gas production that have occurred during the three-month and six-month periods ended June 30, 2017 and 2016, respectively, generally resulted from changes in the demand for natural gas during that time, market conditions, and variances in capital spending to generate production from new and existing wells, as offset by the natural production decline curve. Also, production from the Subject Interests is influenced by the line pressure of the natural gas gathering systems in the San Juan Basin. As noted above, oil and natural gas sales attributable to the Royalty are based on an allocation formula dependent on many factors, including oil and natural gas prices and capital expenditures. Marketing There were no changes to the contracts pursuant to which ConocoPhillips sells production from the Subject Interests and for the gathering and processing of production during the first half of 2017. Off-Balance Sheet Arrangements None. ConocoPhillips Information As a holder of a net overriding royalty interest, the Trust relies on ConocoPhillips for information regarding ConocoPhillips and its affiliates, including Burlington; the Subject Interests, including the operations, acreage, well and completion count, working interests, production volumes, sales revenues, capital expenditures, operating expenses, reserves, drilling plans, drilling results and leasehold terms related to the Subject Interests, and factors and circumstances that have or may affect the foregoing. In a July 31, 2017 news release, ConocoPhillips announced that the sale of its San Juan Basin assets to Hilcorp, which includes the Subject Interests, closed on July 31, 2017. ConocoPhillips informed the Trust that the last production month that ConocoPhillips is responsible for is July 2017 and therefore the last monthly distribution report that the Trust will receive from ConocoPhillips will be in September 2017. Commencing in October 2017, the Trust will receive distribution reports from Hilcorp (relating to August 2017 production). Hilcorp’s reporting of revenue and expenses may differ from ConocoPhillips’ reporting. Controls and Procedures. The Trust maintains a system of disclosure controls and procedures that is designed to ensure that information required to be disclosed in the Trust’s filings under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms. Due to the pass-through nature of the Trust, ConocoPhillips provides much of the information disclosed in this Form 10-Q and the other periodic reports filed by the Trust with the SEC. Consequently, the Trust’s ability to timely disclose relevant information in its periodic reports is dependent upon ConocoPhillips’s delivery of such information. Accordingly, the Trust maintains disclosure controls and procedures designed to ensure that ConocoPhillips accurately and timely accumulates and delivers such relevant information to the Trustee and those who participate in the preparation of the Trust’s periodic reports to allow for the preparation of such periodic reports and any decisions regarding disclosure. The Indenture does not require Burlington to update or provide information to the Trust. However, the Conveyance transferring the Royalty to the Trust obligates Burlington to provide the Trust with certain information, including information concerning calculations of net proceeds owed to the Trust. Pursuant to the settlement of litigation in 1996 between the Trust and Burlington, Burlington agreed to newer, more formal financial reporting and audit procedures as compared to those provided in the Conveyance. In connection with the Hilcorp transaction, the Trust and its third party compliance auditors have been coordinating with Hilcorp to transition these controls and procedures. In order to help ensure the accuracy and completeness of the information required to be disclosed in the Trust’s periodic reports, the Trust engages independent public accountants, compliance auditors, marketing consultants, attorneys and petroleum engineers. These outside professionals advise the Trustee in its review and compilation of this information for inclusion in this Form 10-Q and the other periodic reports provided by the Trust to the SEC. The Trustee has evaluated the Trust’s disclosure controls and procedures as of June 30, 2017 and has concluded that such disclosure controls and procedures are effective, at the “reasonable assurance” level (as such term is used in Rule 13a-15(f) of the Exchange Act), to ensure that material information related to the Trust is gathered on a timely basis to be included in the Trust’s periodic reports and recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. In reaching its conclusion, the Trustee has considered the Trust’s dependence on ConocoPhillips to deliver timely and accurate information to the Trust. Additionally, during the quarter ended June 30, 2017 there were no changes in the Trust’s internal control over financial reporting (as such term is used in Rule 13a-15(f) of the Exchange Act) that materially affected, or are reasonably likely to materially affect, the Trust’s internal control over financial reporting. Because the Trust does not have, nor does the Indenture provide for, officers, a board of directors or an independent audit committee, the Trustee has reviewed neither the Trust’s disclosure controls and procedures nor the Trust’s internal control over financial reporting in concert with management, a board of directors or an independent audit committee. Risk Factors. Hilcorp completed its acquisition of the Subject Interests from ConocoPhillips, which may result in certain administrative disruptions for the Trust, may increase costs and expenses or may adversely affect Distributable Income. Prior to July 31, 2017, Burlington, a wholly-owned subsidiary of ConocoPhillips, was the principal operator of the Subject Interests. On July 31, 2017, Hilcorp announced that it completed its acquisition of the Subject Interests from ConocoPhillips, and as a result, Hilcorp or its affiliate(s) will replace Burlington as the principal operator of the Subject Interests. Although ConocoPhillips, on behalf of Burlington, must require Hilcorp to assume Burlington’s obligations with respect to the Subject Interests, the Hilcorp acquisition may not necessarily be in the best interests of the Trust and the Unit Holders. The Subject Interests will continue to be subject to the Royalty following the Hilcorp transaction, but the Distributable Income will now be calculated and paid by Hilcorp. The Trust is in the process of transitioning certain reporting processes and procedures to Hilcorp, which transition could result in administrative disruptions for the Trust. Hilcorp may lack Burlington’s experience in the Subject Interests or its creditworthiness. Furthermore, the Hilcorp acquisition may increase the Trust’s general and administrative expenses in the form of increased accounting, audit, legal, and administrative costs. Hilcorp may also increase the budget for capital expenditures for the Subject Interests, which may adversely affect Distributable Income.