OVERVIEW
You should read the following discussion in conjunction with the financial
statements of Gulf Coast Ultra Deep Royalty Trust (the Royalty Trust) and the
related Trustee's Discussion and Analysis of Financial Condition and Results of
Operations and the discussion of its Business and Properties in the Royalty
Trust's Annual Report on Form 10-K for the year ended December 31, 2020 (2020
Form 10-K), filed with the United States (U.S.) Securities and Exchange
Commission (SEC). The results of operations reported and summarized below are
not necessarily indicative of future operating results. Unless otherwise
specified, all references to "Notes" refer to the Notes to Financial Statements
located in Part I, Item I. "Financial Statements" of this Form 10-Q. Also see
the 2020 Form 10-K for a glossary of definitions for some of the oil and gas
industry terms used in this Form 10-Q. Additionally, please refer to the section
entitled "Cautionary Statement" on page 12 of this Form 10-Q. The information
below has been furnished to the Trustee by Highlander Oil & Gas Assets LLC
(HOGA).
COVID-19 Pandemic and Market Conditions Update
In March 2020, the World Health Organization designated the outbreak of the
novel coronavirus known as COVID-19 as a pandemic. The COVID-19 pandemic and
related economic repercussions have created significant volatility, uncertainty,
and turmoil in the oil and natural gas industry. If there is a resurgence of the
virus across the U.S. and other locations around the world, the extent of these
impacts on the oil and natural gas industry and further effects on the Royalty
Trust cannot be reasonably predicted at this time.
Business Overview
On June 3, 2013, Freeport-McMoRan Inc. (FCX) and McMoRan Exploration Co. (MMR)
completed the transactions contemplated by the Agreement and Plan of Merger,
dated as of December 5, 2012 (the merger agreement), by and among MMR, FCX, and
INAVN Corp., a Delaware corporation and indirect wholly owned subsidiary of FCX
(Merger Sub). Pursuant to the merger agreement, Merger Sub merged with and into
MMR, with MMR surviving the merger as an indirect wholly owned subsidiary of FCX
(the merger).
FCX's oil and gas assets are held through its wholly owned subsidiary, FCX Oil &
Gas LLC (FM O&G). As a result of the merger, MMR and McMoRan Oil & Gas LLC
(McMoRan) are both indirect wholly owned subsidiaries of FM O&G.
The Royalty Trust is a statutory trust created as contemplated by the merger
agreement by FCX under the Delaware Statutory Trust Act pursuant to a trust
agreement entered into on December 18, 2012 (inception), by and among FCX, as
depositor, Wilmington Trust, National Association, as Delaware trustee, and
certain officers of FCX, as regular trustees. On May 29, 2013, Wilmington Trust,
National Association, was replaced by BNY Trust of Delaware, as Delaware trustee
(the Delaware Trustee), through an action of the depositor. Effective June 3,
2013, the regular trustees were replaced by The Bank of New York Mellon Trust
Company, N.A., a national banking association, as trustee (the Trustee).
The Royalty Trust was created to hold a 5% gross overriding royalty interest
(collectively, the overriding royalty interests) in future production from
specified Inboard Lower Tertiary/Cretaceous exploration prospects located in the
shallow waters of the Gulf of Mexico and onshore in South Louisiana that existed
as of December 5, 2012, the date of the merger agreement (collectively, the
subject interests). The subject interests were "carved out" of the mineral
interests that were acquired by FCX pursuant to the merger and were not
considered part of FCX's purchase consideration of MMR. McMoRan has informed the
Trustee that it has no plans to pursue, has relinquished, has allowed to expire
or has sold all of its subject interests.
In connection with the merger, on June 3, 2013, (1) FCX, as depositor, McMoRan,
as grantor, the Trustee and the Delaware Trustee entered into the amended and
restated royalty trust agreement to govern the Royalty Trust and the respective
rights and obligations of FCX, the Trustee, the Delaware Trustee, and the
Royalty Trust unitholders with respect to the Royalty Trust (the royalty trust
agreement); and (2) McMoRan, as grantor, and the Royalty Trust, as grantee,
entered into the master conveyance of overriding royalty interests (the master
conveyance) pursuant to which McMoRan conveyed to the Royalty Trust the
overriding royalty interests in future production from the subject interests.
Other than (a) its formation, (b) its receipt of contributions and loans from
FCX for administrative and other
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expenses as provided for in the royalty trust agreement, (c) its payment of such
administrative and other expenses, (d) its repayment of loans from FCX, (e) its
receipt of the conveyance of the overriding royalty interests from McMoRan
pursuant to the master conveyance, (f) its receipt of royalties from McMoRan and
HOGA, and (g) its cash distributions to Royalty Trust unitholders, the Royalty
Trust has not conducted any activities. The Trustee has no involvement with,
control over, or responsibility for, any aspect of any operations on or relating
to the subject interests.
The Trustee receives annual compensation of $200,000. Additionally, the Trustee
receives reimbursement for its reasonable out-of-pocket expenses incurred in
connection with the administration of the Royalty Trust. The Trustee's
compensation is paid out of the Royalty Trust's assets. The Trustee has a lien
on the Royalty Trust's assets to secure payment of its compensation and any
indemnification expenses and other amounts to which it is entitled under the
royalty trust agreement.
As of September 30, 2021, only the onshore Highlander subject interest had
established commercial production. On February 5, 2019, McMoRan completed the
sale of all of its rights, title and interest in and to the onshore Highlander
subject interest pursuant to a purchase and sale agreement with HOGA (the
Highlander Sale). The onshore Highlander subject interest was sold subject to
the overriding royalty interest in future production held by the Royalty Trust.
As a result of the Highlander Sale, HOGA has a 72 percent working interest and
an approximate 48 percent net revenue interest in the onshore Highlander subject
interest. The Royalty Trust continues to hold a 3.6 percent overriding royalty
interest in the onshore Highlander subject interest. McMoRan was the operator of
the onshore Highlander subject interest through May 31, 2019. HOGA qualified and
was designated as the operator on June 1, 2019. McMoRan has informed the Trustee
that it has no plans to pursue, has relinquished, has allowed to expire or has
sold all of its subject interests.
In connection with the Highlander Sale, McMoRan sold its interests in
substantially all of its oil and gas leases associated with the Highlander
subject interest to HOGA. At September 30, 2021, HOGA owned interests in
approximately 131 gas leases onshore in South Louisiana, covering approximately
9,000 gross acres (6,476 acres net to HOGA's interest) associated with the
onshore Highlander subject interest. McMoRan has informed the Trustee that it
has no plans to pursue, has relinquished, has allowed to expire or has sold all
of its subject interests. Whether or not HOGA maintains the acreage associated
with the onshore Highlander subject interest is determined by HOGA's current and
future plans, over which the Royalty Trust has no control.
LIQUIDITY AND CAPITAL RESOURCES
Pursuant to the royalty trust agreement, FCX has agreed to pay annual trust
expenses up to a maximum amount of $350,000, with no right of repayment or
interest due, to the extent the Royalty Trust lacks sufficient funds to pay
administrative expenses. No such contributions by FCX were made during the
three- and nine-month periods ended September 30, 2021 or 2020. In addition to
such annual contributions, FCX has agreed to lend money, on an unsecured,
interest-free basis, to the Royalty Trust to fund the Royalty Trust's ordinary
administrative expenses as set forth in the royalty trust agreement. No loans
were outstanding as of September 30, 2021, or December 31, 2020. All funds the
Trustee borrows to cover expenses or liabilities, whether from FCX or from any
other source, must be repaid before the Royalty Trust unitholders receive any
distributions.
Pursuant to the royalty trust agreement, FCX agreed to provide and maintain a
$1.0 million stand-by reserve account or an equivalent letter of credit for the
benefit of the Royalty Trust to enable the Trustee to draw on such reserve
account or letter of credit to pay obligations of the Royalty Trust if its funds
are inadequate to pay its obligations at any time. Currently, with the consent
of the Trustee, FCX may reduce the reserve account or substitute a letter of
credit with a different face amount for the original letter of credit or any
substitute letter of credit. In connection with this arrangement, FCX provided
$1.0 million to the Royalty Trust. The $1.0 million, plus interest collected
thereon, is held in reserve fund cash. As of September 30, 2021, the Royalty
Trust had not drawn any funds from the reserve account, and FCX had not
requested a reduction of such reserve account.
In connection with the completion of the Highlander Sale, HOGA assumed all
administrative and reporting responsibilities with respect to the Royalty Trust,
including those described in Article III of the royalty trust agreement.
In accordance with the terms of the master conveyance, royalties are paid to the
Royalty Trust on the last day of the month following the month in which
production payments are received by HOGA. As of September 30, 2021, only the
onshore Highlander subject interest had established commercial production. The
Royalty Trust received
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royalties of $134,631 and $586,196 during the three- and nine-month periods
ended September 30, 2021, respectively, and $163,604 and $597,667 during the
three- and nine-month periods ended September 30, 2020, respectively, relating
to production from the onshore Highlander subject interest.
Royalties received by the Royalty Trust must first be used to (i) satisfy
Royalty Trust administrative expenses and (ii) reduce Royalty Trust
indebtedness. The Royalty Trust had no indebtedness outstanding as of
September 30, 2021. Additionally, the Trustee has established a minimum cash
reserve of $250,000. As a result, distributions will be made to Royalty Trust
unitholders only when royalties received less administrative expenses incurred
and repayment of any indebtedness exceeds the $250,000 minimum cash reserve.
In November 2021, the Trustee notified HOGA that the Trustee intends to withhold
a portion of the funds otherwise available for distribution each quarter to
gradually build a cash reserve for the payment of future known, anticipated or
contingent expenses or liabilities, commencing with the distribution payable in
the first quarter of 2022. The Trustee may increase or decrease the targeted
cash reserve amount at any time, and may increase or decrease the rate at which
it is withholding funds to build the cash reserve at any time, without advance
notice to the unitholders. Cash held in reserve will be invested as required by
the royalty trust agreement. Any cash reserved in excess of the amount necessary
to pay or provide for the payment of future known, anticipated or contingent
expenses or liabilities eventually will be distributed to unitholders, together
with interest earned on the funds.
Distributable income totaled $29,304 and $109,892 during the three- and
nine-month periods ended September 30, 2021, respectively, and $25,391 and
$103,912 during the three- and nine-month periods ended September 30, 2020,
respectively. On October 15, 2021, the Royalty Trust declared a cash
distribution of $0.000127 per unit payable on November 12, 2021, to Royalty
Trust unitholders of record on October 29, 2021. These distributions are not
necessarily indicative of future distributions. The Royalty Trust's only other
sources of liquidity are mandatory annual contributions, any loans and the
required standby reserve account or letter of credit from FCX. As a result, any
material adverse change in FCX's, McMoRan's or HOGA's financial condition or
results of operations could materially and adversely affect the Royalty Trust
and the underlying royalty trust units.
OFF-BALANCE SHEET ARRANGEMENTS
The Royalty Trust has no off-balance sheet arrangements. The Royalty Trust has
not guaranteed the debt of any other party, nor does the Royalty Trust have any
other arrangements or relationships with other entities that could potentially
result in unconsolidated debt, losses or contingent obligations.
RESULTS OF OPERATIONS
Royalty Income. As of September 30, 2021, only the onshore Highlander subject
interest had established commercial production. In accordance with the terms of
the master conveyance, during the three-month period ended September 30, 2021,
the Royalty Trust received royalties of $134,631 related to 52,667 thousand
cubic feet ("Mcf") of natural gas production attributable to the onshore
Highlander subject interest with average post-production costs of $0.45 per Mcf
and an average sales price of $3.01 per Mcf. During the three-month period ended
September 30, 2020, the Royalty Trust received royalties of $163,604 related to
130,604 Mcf of natural gas production attributable to the onshore Highlander
subject interest with average post-production costs of $0.34 per Mcf and an
average sales price of $1.59 per Mcf.
During the nine-month period ended September 30, 2021, the Royalty Trust
received royalties of $586,196 related to 240,857 Mcf of natural gas production
attributable to the onshore Highlander subject interest with average
post-production costs of $0.42 per Mcf and an average sales price of $2.85 per
Mcf. During the nine-month period ended September 30, 2020, the Royalty Trust
received royalties of $597,667 related to 400,463 Mcf of natural gas production
attributable to the onshore Highlander subject interest with average
post-production costs of $0.34 per Mcf and an average sales price of $1.83 per
Mcf.
Royalty income was lower during the three- and nine-month periods ended
September 30, 2021, as compared to the corresponding 2020 periods primarily due
to lower production, partially offset by higher natural gas prices.
Administrative Expenses. Administrative expenses consist primarily of audit,
legal and trustee expenses incurred in connection with the administration of the
Royalty Trust. During the three-month periods ended September 30, 2021 and 2020,
the Royalty Trust paid administrative expenses of $105,335 and $138,236,
respectively. During the nine-month periods ended September 30, 2021 and 2020,
the Royalty Trust paid administrative expenses of $476,328
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and $495,600, respectively. Administrative expenses were lower for the three-
and nine-month periods ended September 30, 2021 as compared to the corresponding
2020 periods, primarily because of the timing of payments for professional fees.
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NEW ACCOUNTING STANDARDS
None.
CAUTIONARY STATEMENT
This Quarterly Report on Form 10-Q contains forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange
Act"). Forward-looking statements are all statements other than statements of
historical facts, such as any statements regarding the future financial
condition of the Royalty Trust or the trading market for the royalty trust
units, all statements regarding the respective plans of McMoRan or HOGA for the
subject interests, the potential results of any drilling on the subject
interests by the applicable operator, anticipated interests of McMoRan or HOGA
and the Royalty Trust in any of the subject interests, HOGA's geologic models
and the nature of the geologic trend onshore in South Louisiana discussed in
this Form 10-Q, the amount and date of quarterly distributions to Royalty Trust
unitholders, the potential impact of a resurgence of COVID-19 on the oil and gas
industry and on the Royalty Trust, and all statements regarding any belief or
understanding of the nature or potential of the subject interests. The words
"anticipates," "may," "can," "plans," "believes," "estimates," "expects,"
"projects," "intends," "likely," "will," "should," "to be," "potential," and any
similar expressions and/or statements that are not historical facts are intended
to identify those assertions as forward-looking statements.
Forward-looking statements are not guarantees or assurances of future
performance and actual results may differ materially from those anticipated,
projected or assumed in the forward-looking statements. Important factors that
may cause actual results to differ materially from those anticipated by the
forward-looking statements include, but are not limited to, the future plans of
FCX and HOGA for their remaining oil and gas properties; the risk that the
subject interests will not produce additional hydrocarbons; general economic and
business conditions; variations in the market demand for, and prices of, oil and
natural gas; drilling results; changes in oil and natural gas reserve
expectations; the potential adoption of new governmental regulations; decisions
by FCX, McMoRan or HOGA not to develop and/or transfer the subject interests;
any inability of FCX, McMoRan or HOGA to develop the subject interests; damages
to facilities resulting from natural disasters or accidents; fluctuations in the
market price, volume and frequency of the trading market for the royalty trust
units; the amount of cash received or expected to be received by the Trustee
from the underlying subject interests on or prior to a record date for a
quarterly cash distributions; the economic effects of the COVID-19 pandemic and
federal, state and local governmental actions in response to the pandemic; and
other factors described in Part I, Item 1A. "Risk Factors" in the 2020 Form
10-K, as updated by the Royalty Trust's subsequent filings with the SEC. Any
differences in actual cash receipts by the Royalty Trust could affect the amount
of quarterly cash distributions.
Investors are cautioned that current production rates may not be indicative of
future production rates or of the amounts of hydrocarbons that a well may
produce, and that many of the assumptions upon which forward-looking statements
are based are likely to change after such forward-looking statements are made,
which the Royalty Trust cannot control. The Royalty Trust cautions investors
that it does not intend to update its forward-looking statements,
notwithstanding any changes in assumptions, changes in business plans, actual
experience, or other changes, and the Royalty Trust undertakes no obligation to
update any forward-looking statements except as required by law.
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