MTR

Mesa Royalty Trust (MTR) - 2021 Annual Report Summary

Business Context and Reporting Period

Mesa Royalty Trust is a passive entity created in 1979 under Texas law, holding an overriding royalty interest equal to 11.44% of 90% of the Net Proceeds from specific oil and gas properties. The Trust has no employees; administrative functions are performed by The Bank of New York Mellon Trust Company, N.A. The reporting period covers the fiscal year ended December 31, 2021. The Trust's assets consist of interests in the Hugoton field (Kansas) and the San Juan Basin (New Mexico and Colorado), operated by third-party Working Interest Owners (Scout, Hilcorp, Simcoe, and Red Willow).

Key Financial Metrics

Note: The Trust operates on a modified cash basis of accounting. Net Proceeds are calculated after deducting production and capital costs. If costs exceed revenues, the excess is recovered from future proceeds before distributions are made.

Material Changes vs. Prior Period

• Income Increase: Royalty income increased by approximately 9% year-over-year, primarily driven by higher commodity prices and the recovery of excess production costs by Working Interest Owners (specifically Hilcorp and Scout) that were withheld in prior periods.
• Regional Performance:
  • Hugoton: Royalty income dropped to $0 in 2021 from $248,445 in 2020. While production occurred, revenues were insufficient to cover costs, and remaining excess costs were recovered by withholding proceeds.
  • San Juan Basin (Colorado): Royalty income surged to $630,687 from $191,448, largely due to unusually high pricing in early 2021 caused by extreme winter weather. However, significant prior period expense adjustments are expected to be recovered in future periods.
  • San Juan Basin (New Mexico): Royalty income decreased to $277,472 from $392,256 due to the recovery of historical excess costs and a system conversion delay by Hilcorp that required the use of estimated payments for several months.
• Reserve Estimates: Proved reserves increased significantly in 2021 compared to 2020, with total proved gas reserves rising to 8,141,000 Mcf and natural gas liquids to 439,000 Bbls, driven by revisions to previous estimates and price changes.

Outlook, Risks, and Contingencies

• Excess Production Costs: A material risk remains regarding outstanding excess production costs totaling $403,785. Working Interest Owners are entitled to recover these costs from future Net Proceeds before any distribution is made to the Trust. This includes $341,707 related to Simcoe (Colorado) and $29,184 related to Hilcorp (New Mexico).
• Contingent Reserve: The Trustee intends to increase the Contingent Reserve from $1.025 million to $2.0 million to cover future liabilities. This increase will reduce Net Proceeds available for distribution to unitholders.
• Commodity Price Volatility: Distributions are highly sensitive to natural gas prices. While prices improved in 2021, the Trust notes that recent increases may not be sustained. Fixed-price contracts held by some operators may prevent the Trust from benefiting fully from spot price increases.
• Operator Reliance: The Trustee has no control over operations and relies entirely on Working Interest Owners for data. Errors or adjustments in operator reporting (as seen with Hilcorp's system conversion and Simcoe's expense adjustments) can materially impact reported income and future distributions.
• Termination Risk: The Trust will terminate if royalty income falls below $250,000 for two successive years. While 2021 income was well above this threshold, the Hugoton properties currently generate no distributable income.

Investor Verification Checklist

• Excess Cost Recovery Status: Verify the current balance of excess production costs owed by Simcoe, Hilcorp, and Scout, as these directly reduce future distributions.
• Contingent Reserve Adjustments: Monitor quarterly reports for the timing and amount of the planned increase to the $2.0 million Contingent Reserve.
• Operator Reconciliations: Review updates on Hilcorp's system conversion true-up and Simcoe's expense adjustments to understand potential future downward revisions to income.
• Hugoton Viability: Assess the long-term economic viability of the Hugoton properties, which generated zero royalty income in 2021 due to cost carryforwards.
• Commodity Price Exposure: Evaluate the mix of fixed-price versus spot-market contracts held by the Working Interest Owners to gauge sensitivity to natural gas price fluctuations.