Mesa Royalty Trust: Form 10-Q for the period ended Mar 31, 2024

The following review of the financial condition and results of operations of Mesa Royalty Trust (the “Trust”) should be read in conjunction with the financial statements and notes thereto. The discussion of net production attributable to the Hugoton Royalty Properties and San Juan Basin Royalty Properties (as each is defined below) represents production volumes that are to a large extent hypothetical as the Trust does not own and is not entitled to any specific production volumes. Any discussion of “actual” production volumes represents the hydrocarbons that were produced from the properties in which the Trust has an overriding royalty interest. See Note 7 to the financial statements in the Trust’s Annual Report on Form 10-K for the year ended December 31, 2023.

The Trust was created on November 1, 1979 and is now governed by the Mesa Royalty Trust Indenture (as amended, the “Trust Indenture”). Through a series of conveyances, assignments, and acquisitions, the

Trust currently owns an overriding royalty interest (the “Royalty”) equal to 11.44% of 90% of the Net Proceeds (as defined and described in an Overriding Royalty Conveyance dated as of November 1, 1979 (the “Conveyance”)) attributable to the specified interest in certain producing oil and gas properties located in the:

Hugoton field of Kansas (the “Hugoton Royalty Properties”);

San Juan Basin field of New Mexico (the “San Juan Basin — New Mexico Properties”); and

San Juan Basin field of Colorado (the “San Juan Basin — Colorado Properties”, and together with the San Juan Basin — New Mexico Properties, the “San Juan Basin Royalty Properties”, and together with the Hugoton Royalty Properties, the “Royalty Properties”).

Pursuant to past conveyances, Scout, Hilcorp, Simcoe and Red Willow are the operators of certain portions of the Hugoton Royalty Properties and San Juan Basin Royalty Properties (each of Scout, Hilcorp, Simcoe, and Red Willow being a “Working Interest Owner”, and together, the “Working Interest Owners”). As used in this report, Scout refers to the current operator of the Hugoton Royalty Properties, Hilcorp refers to the current operator of the San Juan Basin — New Mexico Properties, and Simcoe and Red Willow refer to the current co-operators of certain tracts of land included in the San Juan Basin — Colorado Properties, unless otherwise indicated.

The Trust is a passive entity whose purposes are limited to: (1) converting the Royalties to cash, either by retaining them and collecting the proceeds of production (until production has ceased or the Royalties are otherwise terminated) or by selling or otherwise disposing of the Royalties; and (2) distributing such cash, net of amounts for payments of liabilities to the Trust, to the unitholders. The Trust has no sources of liquidity or capital resources other than the revenues, if any, attributable to the Royalties and interest on cash held by the Trustee as a reserve for liabilities or for distribution. The Trust does not undertake or control any capital projects or make capital expenditures. While the Trust’s Royalty income is net of capital expenditures, these capital expenditures are controlled and paid by the Working Interests Owners, and the Trust receives Royalty income net of these expenses. In addition, the Trust does not have any off-balance sheet arrangements or other contingent obligations.

Note Regarding Forward-Looking Statements

This Form 10-Q includes “forward-looking statements” about the Trust and other matters discussed herein that are subject to risks and uncertainties that are intended to qualify for the safe harbor from liability established by the Private Securities Litigation Reform Act of 1995 and Section 21E of the Securities Exchange Act of 1934, as amended. All statements other than statements of historical fact included in this document, including, without limitation, statements under “Trustee’s Discussion and Analysis of Financial Condition and Results of Operations,” including the Trust’s or any Working Interest Owner’s future financial position, status in any insolvency proceeding, business strategy, budgets, projected costs, political and regulatory matters, such as tax and environmental policy, climate regulations, expected market conditions and commodity pricing, interest rates, prices received by Working Interest Owners, plans and objectives, oil and natural gas prices, information relating to future distributions, statements regarding reconciliation and adjustment of estimated versus actual revenue and expense amounts, statements pertaining to future exploration and development activities and costs, estimates regarding production costs and expenses, estimates of cash flows, statements regarding the number of wells to be drilled and producing in future periods, and estimates regarding production and reserves, are forward-looking statements. Actual outcomes and results, which are substantially all outside of the Trust’s control, may differ materially from those projected. Forward-looking statements are generally accompanied by words such as “estimate,” “project,” “predict,”

“future,” “believe,” “expect,” “anticipate,” “potential,” “possibly,” “could,” “may,” “can,” “foresee,” “plan,” “goal,” “forecast,” “assume,” “target,” “should,” “intend” or other words that convey the uncertainty of future events or outcomes. These statements are based on certain assumptions made by the Trust in light of its experience and perception of historical trends, current conditions and expected future developments, as well as other factors the Trustee believes are appropriate under the circumstances. The Trustee relies on the Working Interest Owners for information regarding the Subject Interests (as defined in “Note 1 — Trust Organization and Provisions”), the Royalty, and the Working Interest Owners themselves.

Although the information provided by the Working Interest Owners provides a reasonable basis for the forward-looking statements contained herein, no assurance can be given that such expectations will prove to be correct. The Working Interest Owners alone control historical operating data, and handle receipt and payment of funds relating to the royalty properties and payments to the Trust for the related royalty. The Trustee cannot assure that errors or adjustments or expenses accrued by the Working Interest Owners, whether historical or future, will not affect future royalty income and distributions by the Trust. However, whether actual results and developments will conform with such expectations and predictions is subject to a number of risks and uncertainties, including the risk factors discussed in Part I, Item 1A of the Trust’s Annual Report on Form 10-K for the year ended December 31, 2023 and those set forth from time to time in the Trust’s filings with the Securities and Exchange Commission (the “SEC”), which could affect the future results of the energy industry in general, and the Trust and Working Interest Owners in particular, and could cause those results to differ materially from those expressed in such forward-looking statements. The actual results or developments anticipated may not be realized or, even if substantially realized, they may not have the expected consequences to or effects on the Working Interest Owners’ businesses and the Trust. Such statements are expressly qualified in their entirety by the risks and other factors discussed and are not guarantees of future performance. Actual results or developments may differ materially from those projected in such forward-looking statements. The Trust undertakes no obligation to publicly update or revise any forward-looking statements, except as required by applicable law.

SUMMARY OF ROYALTY INCOME, PRODUCTION AND AVERAGE PRICES

(Unaudited)

Royalty income is computed after deducting the Trust’s proportionate share of capital costs, operating costs and interest on any cost carryforward from the Trust’s proportionate share of “Gross Proceeds,” as defined in the Conveyance.

The Trust’s Royalty income from the Royalty Properties and its distributions to unitholders are heavily influenced by commodity prices received by Working Interest Owners. Commodity prices may fluctuate widely in response to (i) relatively minor changes in the supply of and demand for oil and natural gas, (ii) market uncertainty and (iii) a variety of additional factors that are beyond the Trustee’s control. Royalty Income may be based upon spot market prices or on prices determined by contract.

The following summary illustrates the net effect of the components of the actual Royalty computation for the periods indicated.

(1)

Gross Proceeds from natural gas liquids attributable to each of the Hugoton Royalty Properties and San Juan Basin Royalty Properties are reported by the Working Interest Owners net of a volumetric in-kind processing fee retained by Scout and Hilcorp, respectively.

(2)

Royalty income is computed after deducting the Trust’s proportionate share of capital costs, operating costs and interest on any cost carryforward from the Trust’s proportionate share of Gross Proceeds. As a result of excess production costs incurred in one monthly operating period and then recovered in a subsequent monthly operating period, the Royalty income paid to the Trust may not agree to the Trust’s Royalty interest in the Net Proceeds (as defined in the Conveyance). The excess production costs are recoverable by the Working Interest Owners before any distribution of Royalty income will be made to the Trust. See “Note 5 — Excess Production Costs” in the Notes to Financial Statements contained in Item 1 of this Form 10-Q.

Also, as a result of Royalty income reported by the Working Interest Owners in one quarterly operating period and received by the Trustee in a subsequent quarterly operating period, the Royalty income paid to the Trust may not agree to the Trust’s Royalty interest in the Net Proceeds.

(3)

Average production costs attributable to the Royalty are calculated as stated capital costs plus operating costs, divided by stated net production volumes attributable to the Royalty paid. As noted above in footnote (2), production costs may be incurred in one operating period and then recovered in a subsequent operating period, which may cause Royalty income paid to the Trust not to agree to the Trust’s Royalty interest in the Net Proceeds.

(4)

Net production volumes attributable to the Royalty are determined by dividing Royalty income by the average sales price received. Any differences noted are due to rounding.

(5)

Subject to adjustments to actual current production and costs to account for historical monthly reconciliations as they are completed. See Trustee’s Discussion and Analysis of Financial Condition and Results of Operations — Operational Overview — San Juan Basin Royalty Properties of this Form 10-Q.

Three Months Ended March 31, 2024 and 2023

Financial Review

Royalty and Interest Income. The Trust’s Royalty income was $183,657 for the quarter ended March 31, 2024, as compared to $845,417 for the quarter ended March 31, 2023. All of the Royalty income received in the quarter ended March 31, 2024 and the majority of the Royalty income received in the quarter ended March 31, 2023 was from Hilcorp. The decrease in Royalty income was primarily a result of decreases in pricing reported and net production for natural gas, natural gas liquids and oil and condensate, increases in operating expenses for natural gas liquids and oil and condensate and increases in capital expenses for natural gas, natural gas liquids and oil and condensate, offset in part by decreases in operating expenses for natural gas for Hilcorp in the quarter ended March 31, 2024 as compared to the quarter ended March 31, 2023.

The Trust’s Interest income for the quarters ended March 31, 2024 and 2023 was $24,228 and $20,087, respectively. In accordance with the Trust Indenture and as explained below, interest on cash on hand was paid at a rate equivalent to a 7.00% annualized return from January 1, 2024 through March 31, 2024.

General and Administrative Expense. General and administrative expense was $46,192 and $66,074 for the three months ended March 31, 2024 and 2023, respectively. The Trustee’s fees are included in general and administrative expense.

For the quarter ended March 31, 2024, the Trustee was due $118,750 for its services. The Trust paid $108,288 of this amount to the Trustee, and $10,462 was allocated to offset against interest due to the Trust under the Trust Indenture. The Trust Indenture requires that cash being held by the Trustee earn interest at 1.5% below the prime rate, which would have yielded the Trust a 7.00% annualized return from January 1, 2024 through March 31, 2024. However, due to the current interest rate environment, the Trustee was unable to obtain an account in which such an interest rate was available. In the event such an interest rate is unavailable in the future, the Trustee intends to allocate certain of its fees due to the Trust to meet the minimum interest rate payable under the Trust Indenture. In future periods the Trustee will continue to allocate a portion of the fees earned for its services to the Trust until all remaining interest due to the Trust is fully offset.

Unreimbursed Expenses and the Contingent Reserve. The Working Interest Owners partially reimburse the Trust each quarter for amounts paid in connection with the Trustee’s services. For the quarter ended March 31, 2024, the Trustee’s fees were $108,288 and the Working Interest Owners reimbursed a sum of $95,897 to the Trustee, which was the same amount reimbursed for the quarter ended March 31, 2023. As of each of the quarters ended March 31, 2024 and 2023, there were $0 of unreimbursed expenses.

The terms of the Trust Indenture provide, among other things, that the Trustee may establish cash reserves and borrow funds to pay liabilities of the Trust, and may pledge assets of the Trust to secure payment of the borrowings in accordance with the Trust Indenture. At any given time, the amount reserved for such future unknown contingent liabilities and expenses (such cumulative withholding being the “Contingent Reserve”) is included in cash and short-term investments. The Trustee utilizes the Contingent Reserve in its discretion in accordance with the Conveyance, and adjusts the balance of the Contingent Reserve as necessary when funds are added or removed. The net effects of such adjustments for the three months ended March 31, 2024 and 2023 resulted in the balance of the Contingent Reserve being equal to $1,407,705 as of March 31, 2023 and equal to $1,762,256 as of March 31, 2024. The Trustee intends to increase the Contingent Reserve to a total of $2.0 million.

Distributable Income Available for Distribution. The portion of the Trust’s distributable income available for distribution each period includes the Royalty income received from the Working Interest Owners during such period, plus interest income earned to the date of distribution (if any) and increases or withdrawals from the Contingent Reserve (if any). Distributable income available for distribution for the quarter ended March 31, 2024 was $114,987, representing $0.0617 per unit, as compared to $688,892, representing $0.3697 per unit, for the quarter ended March 31, 2023. Based on 1,863,590 units outstanding for the quarters ended March 31, 2024 and 2023, respectively, the per unit distributions for each month in such periods were as follows:

Operational Review

Global Oil Market Impact in 2024

Ongoing uncertainty around production from Russia and actions of OPEC create volatility that continues to affect the oil and gas industry and market prices. Oil prices have been impacted by certain actions by OPEC+, uneven global supply and demand trends, Russia’s invasion into Ukraine and hostilities and heightened geopolitical risks in the Middle East, among other factors. Global and domestic natural gas markets have experienced volatility due to macroeconomic conditions, infrastructure and logistical constraints, weather, and geopolitical issues, among other factors. If commodity prices for crude oil and natural gas fall or remain volatile, monthly distributions to unitholders could be substantially reduced or there may be no distributions in future periods. While inflationary pressures in the United States’ economy have begun to subside, high interest rates and global supply disruptions continue to affect the cost of labor and supplies. In addition, changes in economic conditions, including relatively high interest rates and lower global economic activity, could result in additional shifts in demand and supply for future periods. High levels of inflation and interest rates coupled with shipping and supply chain disruptions are expected to increase expenses for Working Interest Owners and are expected to have an adverse impact on Royalty income during 2024.

Hugoton Royalty Properties

Natural gas and natural gas liquids production attributable to the Hugoton Royalty Properties accounted for none of the Royalty income of the Trust during the first quarter of 2024 or 2023.

Royalty Income. Royalty income attributable to the Hugoton Royalty Properties was $0 in both the first quarter of 2024 and the first quarter of 2023. The lack of Royalty income was primarily a result of actual expenses being greater than actual revenues for the three months ended March 31, 2024 and 2023, as reported by Scout. The Trustee is in ongoing discussions with Scout regarding financial and operational information required to be delivered to the Trustee for purposes of timely disclosures by the Trust and is engaged with Scout in reviewing the amount of Net Proceeds in past and current periods.

Operating Costs and Capital Expenditures. Operating costs were $550,033 in the first quarter of 2024, as compared to $564,156 in the first quarter of 2023, a decrease of approximately 2.5%. Capital expenditures attributable to the Hugoton Royalty Properties were $155 in the first quarter of 2024 as compared to $46,757 in the first quarter of 2023. As reported by Scout, the higher capital expenditures in Q1 2023 were primarily due to stronger pricing in Q1 2023 which provided more opportunities for capital investment. With lower pricing in Q1 2024, Scout has not pursued those same investments.

Average Sales Price. Average sales prices per thousand cubic feet (“Mcf”) of natural gas and barrel (“Bbl”) for natural gas liquids for the Hugoton Royalty Properties are directly dependent on the prices Scout realizes for natural gas sold under short-term and multi-month contracts to multiple purchasers. Overall sales prices reported for natural gas from Hugoton Royalty Properties were lower for the three months ended March 31, 2024 as compared to the three months ended March 31, 2023.

San Juan Basin Royalty Properties

Royalty income from the San Juan Basin Royalty Properties is calculated and paid to the Trust on a state-by-state basis depending upon whether the property is situated in Colorado or New Mexico. The majority of the Royalty income from the San Juan Basin Royalty Properties is attributable to the San Juan Basin — New Mexico Properties.

San Juan Basin — Colorado Properties

Royalty Income. Royalty income from the San Juan Basin — Colorado Royalty Properties was $0 during the first quarter of 2024, as compared to $57,492 during the first quarter of 2023. The lack of Royalty income for the three months ended March 31, 2024 was primarily a result of prior period adjustments reported by Simcoe in 2021 that were recovered by Simcoe by withholding the Net Proceeds that would otherwise be payable to the Trust in the quarter ended March 31, 2024. In March 2023, Simcoe informed the Trustee that Simcoe performed a true-up of its production for the periods of 2020 through 2022, and a true-up report was received by the Trustee. Net Proceeds from the San Juan Basin — Colorado Properties operated by Simcoe were received by the Trust in the first quarter of 2023, indicating that the Trust was no longer in a deficit position with Simcoe at that time. In June 2023, Simcoe informed the Trustee that the true-up previously performed by Simcoe included revenues only and did not include any true-up for joint interest billing amounts. The result is that the Trust remains in a deficit position with Simcoe as of the quarter ended March 31, 2024. Because of these adjustments reported by Simcoe, the amounts of Net Proceeds reported during the three months ended March 31, 2024 for the San Juan Basin — Colorado Properties operated by Simcoe may not be representative of Net Proceeds that will be received in future quarters. In addition, with the assistance of a third party consultant, the Trust plans to commence a review of certain of Simcoe’s financial and operational statements and the Net Proceeds payable by Simcoe to the Trust.

Operating Costs. Operating costs as reported by Simcoe and Red Willow on these properties were $44,491 in the first quarter of 2024, as compared to $91,045 in the first quarter of 2023, a decrease of approximately 51.1%. The decrease in the first quarter of 2024 was primarily the result of the 2023 true-up Simcoe performed to its production revenues and expenses that Simcoe asserted it was entitled to deduct under the Conveyance. If not for the true-up, Simcoe’s operating costs for the quarter ended March 31, 2023 would have been $22,432.

Capital expenditures attributable to the San Juan Basin — Colorado Properties were $0 in both the first quarter of 2024 and in the first quarter of 2023.

San Juan Basin — New Mexico Properties

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Royalty Income. Royalty income from the San Juan Basin — New Mexico Properties was $183,657 during the first quarter of 2024, as compared to $787,925 during the first quarter of 2023, a decrease of approximately 77%. The decrease in Royalty income was primarily a result of decreases in pricing reported and net production for natural gas, natural gas liquids and oil and condensate, increases in operating expenses for natural gas liquids and oil and condensate and increases in capital expenses for natural gas, natural gas liquids and oil and condensate, offset in part by decreases in operating expenses for natural gas in the quarter ended March 31, 2024 as compared to the quarter ended March 31, 2023.

Operating Costs and Capital Expenditures. Operating costs were $258,275 in the first quarter of 2024, a decrease of approximately 16% as compared to $308,438 in the first quarter of 2023. Capital expenditures on these properties were $65,046 in the first quarter of 2024, an increase of $46,234 as compared to $18,812 in the first quarter of 2023. The increase was due primarily to the general increase in activity in the first quarter of 2024, as there were three major recomplete projects in the three months ended March 31, 2024 as compared to one major recomplete project in the three months ended March 31, 2023.

In past periods, Hilcorp used estimates for revenues and expenses and made payments to the Trust based on those estimates. Hilcorp subsequently performed true-up reconciliations of those revenue and expense amounts which resulted in either charges to or credits for the Trust. The Trust recognized these amounts in accordance with the Trust’s modified cash basis of accounting. The Trust is engaged with Hilcorp in reviewing the amount of Net Proceeds in past and current periods.

Pursuant to the Trust Indenture, the Trust is not required to pay to Hilcorp any amounts that could be owed if the estimated revenue exceeded actual revenue amounts or estimated expenses were less than actual expense amounts in past periods. However, Hilcorp may recover such amounts by withholding a portion or all of the Net Proceeds that would otherwise be payable to the Trust in subsequent periods. This could result in a decrease in Net Proceeds paid to the Trust and could result in future material reductions in distributions to the Trust’s unitholders.

Liquidity and Capital Resources

The Trustee, acting pursuant to the Trust Indenture, may withhold Royalty income for future unknown contingent liabilities and expenses, such cumulative withholding referred to as the Contingent Reserve. The Trustee reserves the right to determine whether or not to increase or release cash reserves in future periods with respect to any reimbursement expenses. At any given time, the Contingent Reserve is included in cash and short-term investments.

The Trustee may establish and increase cash reserves as permitted by the Trust Indenture. The Trustee has recently evaluated the adequacy of the Contingent Reserve based on the likelihood of future regular receipts of Royalty income from the Royalty Properties, volatility in commodity prices and other market conditions affecting Royalty income, and the anticipated costs and expenses related to the future termination of the Trust. On the basis of this evaluation, the Trustee intends to increase the Contingent Reserve to a total of $2.0 million, which will reduce Net Proceeds available to the Trust and distributions to Trust unitholders. The amount and timing of the addition to the Contingent Reserve will be determined by the Trustee on a monthly basis and is expected to vary in future periods depending on circumstances at the time. The Trustee intends to continue to evaluate the adequacy of the Contingent Reserve and may at any time, without notice to the unitholders, increase or decrease the amount of the Contingent Reserve based on this ongoing evaluation. Future filings by the Trust with the SEC will include information regarding the Trustee’s evaluation of cash reserves and funding of the Contingent Reserve.

In recent periods, substantial accumulated excess production costs have decreased Trust income and distributions, and in some months resulted in no Trust distributions. There can be no assurance that the Trust will receive additional Royalty income adequate to fund the Contingent Reserve and to provide sufficient liquidity for the Trust.

The Trust may be unable to pay future distributions to unitholders if future Royalty income is less than the amount required to fund the increase in the Contingent Reserve. Even if the Trust receives payments for the Royalty during 2024 and beyond, unitholders may not receive any material distributions during such periods, because the Trust would need to withhold funds to first add to the cash reserve before making distributions to unitholders.

See Note 6 to the Financial Statements (Unaudited) in Item 1 for a discussion of the Contingent Reserve.

Evaluation of Disclosure Controls and Procedures. The Trustee maintains disclosure controls and procedures designed to ensure that information required to be disclosed by the Trust in the reports that it files or submits under the Exchange Act, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and regulations. Disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed by the Trust in the reports that it files or submits under the Exchange Act is accumulated and communicated by the Working Interest Owners to The Bank of New York Mellon Trust Company, N.A., as Trustee of the Trust, and its employees who participate in the preparation of the Trust’s periodic reports as appropriate to allow timely decisions regarding required disclosure.

As of the end of the period covered by this report, the Trust officer acting on behalf of the Trustee responsible for the administration of the Trust conducted an evaluation of the Trustee’s disclosure controls and procedures. The officer acting on behalf of the Trustee concluded that the Trust’s disclosure controls and procedures were effective with respect to the Trustee and its employees.

Due to the contractual arrangements of (i) the Trust Indenture and (ii) the rights of the Trust under the Conveyance regarding information furnished by the Working Interest Owners, the Trustee relies on information provided by the Working Interest Owners, including (i) the status of litigation, (ii) historical operating data, plans for future operating and capital expenditures and reserve information, (iii) information relating to projected production, and (iv) conclusions regarding reserves by their internal reserve engineers or other experts in good faith. See Part II Item 1A. “Other Information — Risk Factors — Trust unitholders and the Trustee have no control over the operation or development of the Royalty Properties” and “The Trustee relies upon the Working Interest Owners for information regarding the Royalty Properties” in the Trust’s Annual Report on Form 10-K for the year ended December 31, 2023 for a description of certain risks relating to these arrangements and reliance, including filings such as this filing outside the time periods specified notwithstanding effective disclosure controls and procedures, of the Trustee regarding information under its control.

The officer acting on behalf of the Trustee has not conducted a separate evaluation of the disclosure controls and procedures with respect to information furnished by the Working Interest Owners. The Trustee notes that it is conducting an ongoing review of certain information and calculations by the Working Interest Owners. See “Trustee’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources” under Part II, Item 7 of the Trust’s Annual Report on Form 10-K for the year ended December 31, 2023 for information concerning controls and procedures with respect to the Royalty and information related to the Trustee’s review of certain information and calculations by the Working Interest Owners.

Changes in Internal Control over Financial Reporting. In connection with the evaluation by the Trustee of changes in internal control over financial reporting of the Trust that occurred during the Trust’s last fiscal quarter, no change in the Trust’s internal control over financial reporting was identified that has materially affected, or is reasonably likely to materially affect, the Trust’s internal control over financial reporting. The Trustee notes for purposes of clarification that it has no authority over, has not evaluated and makes no statement concerning the internal control over financial reporting of the Working Interest Owners.

For a discussion of the Trust’s potential risks and uncertainties, please see “Risk Factors” in Part I, Item 1A of the Trust’s Annual Report on Form 10-K for the year ended December 31, 2023. During the quarter ended March 31, 2024, there was no material change in such risk factors.