Item 1A. Risk Factors
ITEM 1A.
RISK FACTORS
Although risk factors are described elsewhere in this Annual Report on Form 10-K, the following is a
summary of the principal risks associated with an investment in Units of the Trust.
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BUSINESS AND OPERATING RISKS
Oil and gas prices fluctuate due to a number of factors, and lower prices will reduce net proceeds to the Trust and distributions to Unit Holders.
The Trusts monthly distributions are highly dependent upon the prices realized from the sale of gas and, to a lesser extent,
oil. Oil and gas prices can fluctuate widely in response to a variety of factors that are beyond the control of the Trust and Hilcorp. Factors that contribute to price fluctuation include, among others:
worldwide and regional economic conditions impacting the global supply of and demand for oil and natural gas;
the price and quantity of foreign imports and U.S. exports of oil and natural gas;
political conditions in major oil producing regions, especially in the Middle East and Russia, including the
conflicts between Russia and Ukraine and Israel and Hamas;
the effects of armed conflict throughout the world on global oil and gas producing regions, countries, sea lanes,
thoroughfares and the oil and gas markets;
expectations about future prices of, or the supply of and demand for oil and natural gas;
public health concerns, such as COVID-19;
technological advances affecting energy consumption, energy storage and energy supply;
the price and availability of alternative fuels;
the proximity, capacity, cost and availability of gathering, processing and transportation facilities;
U.S. federal, state and local governmental regulation and taxation;
government regulations, such as regulation of natural gas transportation and price controls;
energy conservation and environmental measures; and
acts of force majeure.
Lower oil and gas prices may reduce the amount of oil and gas that is economic to produce and reduce Net Proceeds to the Trust. The volatility
of energy prices reduces the predictability of future cash distributions to Unit Holders.
Trust reserve estimates depend on many assumptions that
may prove to be inaccurate, which could cause both estimated reserves and estimated future revenues to be too high.
The value of
the Units of the Trust depends upon, among other things, the amount of reserves attributable to the Royalty and the estimated future value of the reserves. Estimating reserves is inherently uncertain. Ultimately, actual production, revenues and
expenditures for the properties underlying the Subject Interests will vary from estimates and those variations could be material. Petroleum engineers consider many factors and make assumptions in estimating reserves. Those factors and assumptions
may include:
historical production from the area compared with production rates from similar producing areas;
the assumed effect of governmental regulation; and
assumptions about future commodity price adjustments, production and development costs, severance and excise
taxes, and capital expenditures.
Changes in these assumptions can materially change reserve estimates. The reserve data
included herein are estimates only and are subject to many uncertainties. Actual quantities of oil and natural gas may differ considerably from the amounts set forth herein. In addition, different reserve engineers may make different estimates of
reserve quantities and cash flows based upon the same available data.
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Operating risks for Hilcorp and other operators of the properties underlying the Subject Interests can
adversely affect Trust distributions.
Royalty Income payable to the Trust is derived from the sale of natural gas and oil
production following the gathering and processing of those minerals. These operations are subject to risk inherent in such activities, such as blowouts, cratering, explosions, uncontrollable flows of oil, gas or well fluids, fires, pollution and
other environmental risks and litigation concerning routine and extraordinary business activities and events. These risks could result in substantial losses which are deducted in calculating the net proceeds paid to the Trust due to injury and loss
of life, severe damage to and destruction of property and equipment, pollution and other environmental damage and suspension of operations.
Pandemics and other public health concerns, including a COVID-19 pandemic resurgence or emergence of new COVID-19 variants, are possible and could adversely affect global demand for oil and gas, the operators of the properties underlying the Subject Interests, the Royalty and the cash available for distribution to Unit
Holders.
It is not possible to predict the impact a resurgence of COVID-19, the emergence
of new strains or variants of COVID-19, or the occurrence of other pandemics or public health concerns may have on global demand for oil and gas. If prices are negatively impacted in the future, it is possible
Hilcorp or any third-party operator of the properties underlying the Subject Interests could shut in or curtail production from wells on the properties underlying the Subject Interests or plug and abandon marginal wells that otherwise may have been
allowed to continue to produce for a longer period under conditions of higher prices, without the consent of the Trust or the Trust Unit Holders. Substantial declines in and extended periods of decreased economic activity and depressed oil and
natural gas prices have previously resulted in and may in future periods result in reductions in the amount of oil and natural gas that is economic to produce from the properties underlying the Subject Interests, reduced net proceeds to which the
Trust is entitled, and elimination of cash available for distribution to Trust Unit Holders for an unknown period of time.
To the extent COVID-19, other health concerns, or mitigation efforts related thereto adversely affect production from the properties underlying the Subject Interests or the business, results of operations and financial condition
of the operators of the properties underlying the Subject Interests, it may also have the effect of heightening many of the other risks described in this Form 10-K.
A bankruptcy of Hilcorp or any third-party operator could adversely affect the operation of the wells and the development of the proved undeveloped
reserves and interrupt or decrease distributions to Trust Unit Holders.
The value of the Royalty and the Trusts ultimate
cash available for distribution are highly dependent on Hilcorps financial condition. The bankruptcy of Hilcorp or any third-party operator of the properties underlying the Subject Interests could impede the operation of the wells and the
development of the proved undeveloped reserves and decrease distributions to the Trust Unit Holders. The ability to develop and operate the properties underlying the Subject Interests depends on Hilcorps future financial condition and economic
performance and access to capital, which in turn will depend upon the supply of and demand for oil and natural gas, prevailing economic conditions and financial, business and other factors, many of which are beyond the control of Hilcorp. Further,
Hilcorp is not a reporting company and is not required to file periodic reports with the SEC pursuant to the Exchange Act. Therefore, Trust Unit Holders do not have access to financial information about Hilcorp.
FINANCIAL RISKS
Mineral properties, such as the
properties underlying the Subject Interests, are depleting assets and, if Hilcorp or other operators of the properties underlying the Subject Interests do not perform additional development projects, the assets may deplete faster than expected.
The Royalty Income payable to the Trust is derived from the sale of depleting assets. Accordingly, the portion of the
distributions to Unit Holders (to the extent of depletion taken) may be considered a return of
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capital. The reduction in proved reserve quantities is a common measure of depletion. Future maintenance and development projects on the properties underlying the Subject Interests will affect
the quantity of proved reserves. The timing and size of these projects will depend primarily on the market prices of natural gas. If Hilcorp does not implement additional maintenance and development projects, the future rate of production decline of
proved reserves may be higher than the rate currently expected by the Trust.
Increased costs of production and development will result in decreased
Trust distributions.
Production and development costs attributable to the properties underlying the Subject Interests are deducted
in the calculation of net proceeds. Accordingly, higher production and development costs, without concurrent increases in revenues, decrease the share of net proceeds paid to the Trust as Royalty Income. If development and production costs of the
properties underlying the Subject Interests exceed the proceeds of production from the properties underlying the Subject Interests, such excess costs are carried forward and the Trust will not receive a share of net proceeds for the properties
underlying the Subject Interests until future net proceeds from production from such properties exceed the total of the excess costs. Development activities may not generate sufficient additional revenue to repay the costs; however, the Trust is not
obligated to repay the excess costs except through future production.
War, military invasions, terrorism and continued geopolitical hostilities
could adversely affect the Trusts distributions to its Unit Holders or the market price of its Units.
The outbreak of war,
military invasions, terrorist attacks and the threat of such violence, whether domestic or foreign, as well as military or other actions taken in response to such attacks or threats, could cause instability in the global financial, oil and natural
gas markets. Such geopolitical hostilities could adversely affect the Trusts distributions to its Unit Holders or the market price of its Units in unpredictable ways, including through the disruption of oil and natural gas supplies and
markets, increased volatility in oil and natural gas prices, or the possibility that the infrastructure on which the operators of the properties underlying the Subject Interests rely could be a direct target or an indirect casualty of such violence.
RISKS RELATED TO THE STRUCTURE OF THE TRUST
The
Royalty can be sold and the Trust can be terminated in certain circumstances.
The Trust will be terminated and the Trustee must
sell the Royalty if holders of at least 75% of the Units approve the sale or vote to terminate the Trust, or if the Trusts gross revenue for each of two successive years is less than $1,000,000 per year. Following any such termination and
liquidation, the net proceeds of any sale will be distributed to the Unit Holders and Unit Holders will receive no further distributions from the Trust. The Trustee cannot provide assurances that any such sale will be on terms acceptable to all Unit
Holders.
None of the Trustee, the Trust nor the Unit Holders control the operation or development of the properties underlying the Subject
Interests.
Neither the Trustee nor the Unit Holders can influence or control the operation or future development of the properties
underlying the Subject Interests. The properties underlying the Subject Interests are owned by Hilcorp and Hilcorp operates the majority of such properties and handles the calculation of the net proceeds attributable to the Royalty and the payment
of Royalty Income to the Trust.
Unit Holders have limited voting rights.
Voting rights as a Unit Holder are more limited than those of stockholders of most public corporations. For example, there is no requirement
for annual meetings of Unit Holders or for an annual or other periodic re-election of the Trustee. Unlike corporations, which are generally governed by boards of directors elected by their equity holders, the
Trust is administered by a corporate trustee in accordance with the Indenture and other organizational documents. The Trustee has extremely limited discretion in its administration of the Trust.
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RISKS RELATED TO OWNERSHIP OF THE TRUST UNITS
If the Trust cannot meet the New York Stock Exchange continued listing requirements, the NYSE may delist the Trust Units.
Under the continued listing requirements of the NYSE, a company will be considered to be out of compliance with the exchanges minimum
price requirement if the companys average closing price over a consecutive 30 trading day period (Average Closing Price) is less than $1.00 (the Minimum Price Requirement). Under NYSE rules, a company that is out of
compliance with the Minimum Price Requirement has a cure period of six months to regain compliance if it notifies the NYSE within 10 business days of receiving a deficiency notice of its intention to cure the deficiency. A company may regain
compliance if on the last trading day of any calendar month during the cure period the company has a closing share price of at least $1.00 and an average closing share price of at least $1.00 over the 30-trading-day period ending on the last trading day of that month. If at the expiration of the cure period, both a $1.00 closing share price on the last trading day of the cure period and a $1.00 average
closing share price over the 30-trading-day period ending on the last trading day of the cure period are not attained, the NYSE will commence suspension and delisting
procedures. If delisted by the NYSE, a companys shares may be transferred to the over-the-counter (OTC) market, a significantly more limited market
than the NYSE, which could affect the market price, trading volume, liquidity and resale price of such shares. Securities that trade on the OTC markets also typically experience more volatility compared to securities that trade on a national
securities exchange. During the cure period, the companys shares would continue to trade on the NYSE, subject to compliance with other continued listing requirements.
The market price for the Trust Units may not reflect the value of the Royalty held by the Trust.
The trading price for publicly traded securities similar to the Trust Units tends to be tied to recent and expected levels of cash
distributions as well as oil and natural gas prices. The amounts available for distribution by the Trust vary in response to numerous factors outside the control of the Trust, including prevailing prices for sales of oil and natural gas production
from the properties underlying the Subject Interests and the timing and amount of direct operating expenses and development expenses. Consequently, the market price for the Trust Units may not necessarily be indicative of the value that the Trust
would realize if it sold the Royalty to a third-party buyer. In addition, such market price may not necessarily reflect the fact that, since the assets of the Trust are depleting assets, a portion of each cash distribution paid with respect to the
Trust Units should be considered by investors as a return of capital, with the remainder being considered as a return on investment. As a result, distributions made to a Trust Unit Holder over the life of these depleting assets may not equal or
exceed the purchase price paid by the Trust Unit Holder.
The limited liability of Trust Unit Holders is uncertain.
The Trust Unit Holders are not protected from the liabilities of the Trust to the same extent that a shareholder would be protected from a
corporations liabilities. The structure of the Trust does not include the interposition of a limited liability entity such as a corporation or limited partnership which would provide further limited liability protection to Trust Unit Holders.
While the Trustee is liable for any excess liabilities incurred if the Trustee fails to ensure that such liabilities are to be satisfied only out of Trust assets, under the laws of Texas, which are unsettled on this point, a Unit Holder may be
jointly and severally liable for any liability of the Trust if the satisfaction of such liability was not contractually limited to the assets of the Trust and the assets of the Trust and the Trustee are not adequate to satisfy such liability. As a
result, Trust Unit Holders may be exposed to personal liability.
LEGAL, ENVIRONMENTAL, AND REGULATORY RISKS
The operators of the properties underlying the Subject Interests are subject to extensive governmental regulation.
Oil and gas operations have been, and in the future will be, affected by federal, state and local laws and regulations and other political
developments, such as price or gathering rate controls and environmental protection regulations. Also, climate change laws and regulations may, in the future, have an increasing impact on oil and natural gas production, gathering, marketing and
transportation.
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Government action, policies or regulations designed to discourage production, reduce demand for, or
promote alternatives to oil and natural gas could impact the price of oil and natural gas produced on the properties underlying the Trusts Subject Interests, directly as intended or through unintended consequences.
Governments around the world are considering actions intended to reduce greenhouse gas emissions by decreasing both the supply of and the
demand for oil and natural gas products or the promotion of alternative energy sources. These include the adoption of cap and trade regimes, carbon taxes, trade tariffs, minimum renewable usage requirements, restrictive permitting, increased mileage
and other efficiency standards, mandates for sales of electric vehicles, mandates for use of specific fuels or technologies, and other incentives or mandates designed to support transitioning to lower-emission energy sources. Political and other
actors and their agents also increasingly seek to advance climate change objectives indirectly, such as by seeking to reduce the availability or increase the cost of financing and investment in the oil and gas sector.
On January 20, 2021, President Biden signed an executive order that reversed the United States withdrawal from the Paris Agreement,
and the United States formally rejoined the Paris Agreement on February 19, 2021. At the federal regulatory level, both the EPA and the Bureau of Land Management (BLM) have adopted regulations for the control of methane emissions,
which also include leak detection and repair requirements, from the oil and gas industry. Additionally, President Biden has issued an executive order seeking to adopt new regulations and policies to address climate change and suspend, revise or
rescind prior agency actions that are identified as conflicting with the Biden Administrations climate policies. In addition, President Biden has declared that he supports federal government efforts to limit or prohibit hydraulic fracturing
and banning new leases for production of minerals on federal properties, including onshore lands. Any of these actions could require Hilcorp to increase capital expenditures for the Subject Interests, decrease demand for natural gas and oil
production, or limit the Subject Interests ability to produce natural gas or oil production. The Trust is unable to determine what, if any, the effects of such actions will have on the Subject Interests ability to produce natural gas and
oil, and Hilcorps ability to pay Royalty Income to the Trust.
Hilcorp has informed the Trust that it does not believe that actions
undertaken by President Bidens administration to curtail future leases for natural gas and oil drilling on federally owned land will impact the Subject Interests because, at the present time, they do not impact current leases.
The Biden administration announced in September 2023 that it has moved to shut down future development of oil, gas and mining activity on
approximately 4,200 acres in Sandoval County, New Mexico for the next 50 years. Hilcorp has informed the Trust that the proposed tracts are not within the production area of the Subject Interests or part of any future proposed development plans.
Depending on how policies are formulated and applied, such policies could impact the ability and costs of the operators of the properties
underlying the Trusts Subject Interest to supply products, demand for their products, or the competitiveness of hydrocarbon-based products, which in turn, could reduce net proceeds to the Trust. Any policy that increases the costs for
operators of the properties underlying the Subject Interests or decreased market prices could have a material impact on the distributable income of the Trust.
Federal and state legislative and regulatory initiatives relating to hydraulic fracturing could result in Hilcorp incurring increased costs, additional
operating restrictions or delays and fewer potential drilling locations.
In
recent years there has been increased public concern regarding an alleged potential for hydraulic fracturing to adversely affect drinking water supplies and to induce seismic events. As a result, from time to time, legislation has been introduced,
but not enacted, in Congress to provide for federal regulation of hydraulic fracturing and to require disclosure of the chemicals used in the hydraulic fracturing process. In the event that new federal restrictions relating to the hydraulic
fracturing process are adopted in areas where the properties underlying the Subject Interests are located, Hilcorp and outside operators may incur additional costs or permitting requirements to comply with such federal requirements that may be
significant and that could result in
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added delays or curtailment in the pursuit of exploration, development or production activities, which would in turn reduce the oil and natural gas produced from the properties underlying the
Subject Interests.
Increased regulation and attention given to the hydraulic fracturing process could lead to greater opposition to, and
litigation concerning, oil and natural gas production activities using hydraulic fracturing techniques. Additional legislation or regulation could also lead to operational delays or increased operating costs for operators in the production of oil
and natural, including from the developing shale plays, or could make it more difficult for Hilcorp and outside operators to perform hydraulic fracturing. The adoption of any federal, state or local laws or the implementation of regulations
regarding hydraulic fracturing could potentially cause a decrease in Hilcorps completion of new oil and natural gas wells on the properties underlying the Subject Interests and an associated decrease in the cash distributable to Trust Unit
Holders.
CYBERSECURITY RISKS
The Trustee may be
subject to attempted cybersecurity disruptions from a variety of sources.
The Trustee maintains robust cybersecurity protocols
including, but not limited to technological capabilities that prevent and detect disruptions; computer workstations and programs protected with passwords and passphrases, as well as employee training throughout the year on cybersecurity followed up
by testing of that knowledge. Other, non-technical protocols include securing of documents and work areas that could contain
personal, non-public information and independent verification of information changes by outside vendors. If the measures taken to protect against cybersecurity disruptions prove to be insufficient or
if proprietary data is otherwise not protected, the Trustee could be adversely affected. The Trust is also exposed to potential harm from cybersecurity events that may affect the operations of third parties, including suppliers, service providers
(including providers of cloud-hosting services for data or applications), and customers. Cybersecurity disruptions could cause physical harm to people or the environment, damage or destroy assets; compromise business systems; result in proprietary
information being altered, lost, or stolen; result in employee, customer, or third-party information being compromised; or otherwise disrupt business operations. The Trust could incur significant costs to remedy the effects of a major cybersecurity
disruption in addition to costs in connection with resulting regulatory actions, litigations, or reputational harm.
TAX RISKS RELATED TO THE TRUST UNITS
Trust Unit Holders are required to pay U.S. federal income taxes on their share of the Trusts income, even if they do not receive any cash
distributions from the Trust.
Trust Unit Holders are treated as if they own the Trusts assets and receive the Trusts
income and are directly taxable thereon as though the Trust were not in existence. Because the Trust generates taxable income that can be different in amount than the cash the Trust distributes, Trust Unit Holders are required to pay any U.S.
federal income taxes and, in some cases, state and local income taxes, on their share of the Trusts taxable income even if they receive no cash distributions from the Trust. Trust Unit Holders may not receive cash distributions from the Trust
equal to their share of the Trusts taxable income or even equal to the actual tax liability that results from that income.
Unit
Holders should consult their own tax advisor regarding state tax requirements, if any, applicable to ownership of Trust Units.
The tax treatment of
an investment in Trust Units could be affected by recent and potential legislative changes, possibly on a retroactive basis.
U.S.
federal tax reform legislation informally known as the Tax Cuts and Jobs Act (TCJA) was enacted December 22, 2017, and made significant changes to the federal income tax rules applicable to both individuals and entities, including changes to
the effective tax rate on a Trust Unit Holders allocable share of certain income
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from the Trust. The TCJA is complex and Unit Holders should consult their tax advisor regarding the TCJA and its effect on an investment in Trust Units. In addition, the current administration
has generally proposed repealing fossil fuel tax subsidies, which could impact certain tax benefits available to Trust Unit Holders.
Any
modification to the U.S. federal income tax laws or interpretations thereof may be applied retroactively and could adversely affect the Trusts business, financial condition or results of operations. The Trust is unable to predict whether any
changes or other proposals will ultimately be enacted, or whether any adverse interpretations will be used. Any such changes or interpretations could negatively impact the value of an investment in the Trust Units.
A portion of any gain recognized on the disposition of the Trust Units could be taxed as ordinary income.
A Trust Unit Holder who sells his Trust Units will recognize a gain or loss equal to the difference between the amount realized and the Trust
Unit Holders adjusted tax basis in those Trust Units. A substantial portion of any gain recognized may be taxed as ordinary income due to potential recapture items, including depletion recapture.
The Trust generally allocates its items of income, gain, loss and deduction between transferors and transferees of the Trust Units based upon the
monthly record date. The IRS may challenge this treatment.
The Trust generally allocates its items of income, gain, loss and
deduction between transferors and transferees of the Trust Units each month based upon the ownership of the Trust Units on the monthly record date, instead of the date a particular Trust Unit is transferred. The IRS could disagree with this
allocation method and could assert that income and deductions of the Trust should be determined and allocated on a daily or prorated basis, which could require adjustments to the tax returns of the affected Trust Unit Holders and result in an
increase in the administrative expense of the Trust in subsequent periods.
The Trust has not requested a ruling from the IRS regarding the tax
treatment of the Trust. If the IRS were to determine (and be sustained in that determination) that the Trust is not a grantor trust for U.S. federal income tax purposes, the Trust could be subject to more complex and costly tax reporting
requirements that could reduce the amount of cash available for distribution to Trust Unit Holders.
If the Trust were not treated
as a grantor trust for U.S. federal income tax purposes, the Trust should be treated as a partnership for such purposes. Although the Trust would not become subject to U.S. federal income taxation at the entity level as a result of treatment as a
partnership, and items of income, gain, loss and deduction would flow through to the Trust Unit Holders, the Trusts tax reporting requirements would be more complex and costly to implement and maintain, and its distributions to Trust Unit
Holders could be reduced as a result.
If the Trust were treated for U.S. federal income tax purposes as a partnership, it would likely be
subject to new audit rules that alter the procedures for auditing large partnerships and assessing and collecting income taxes due (including applicable penalties and interest) as a result of an audit. These rules effectively would impose an entity
level tax on the Trust, and Trust Unit Holders might have to bear the expense of the adjustment even if they were not Trust Unit Holders during the audited taxable year.
Neither Hilcorp nor the Trustee has requested a ruling from the IRS regarding the tax status of the Trust, and neither Hilcorp nor the Trust
can assure you that such a ruling would be granted if requested or that the IRS will not challenge these positions on audit.
Trust Unit
Holders should be aware of any possible state tax implications of owning Trust Units.