OVERVIEW
You should read the following discussion in conjunction with Part II, Item 8.
"Financial Statements and Supplementary Data" and Part I, Items 1. and 2.
"Business and Properties" of this Form 10-K. 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 Notes to
Financial Statements located in Part II, Item 8. "Financial Statements and
Supplementary Data" of this Form 10-K. A glossary of definitions for some of the
oil and gas industry terms used in this Form 10-K is provided beginning on page
2 . Additionally, please refer to the section above entitled "Forward-Looking
Statements" in this Form 10-K. The information below has been furnished to the
Trustee by Highlander Oil & Gas Assets LLC (HOGA).
Market Conditions Update
The COVID-19 pandemic and related economic repercussions have created
significant volatility, uncertainty, and turmoil in the oil and natural gas
industry. As the global economy continues to recover from the effects of the
COVID-19 pandemic, economic indicators have continued to strengthen. However,
the economy has begun to experience elevated inflation levels as a result of
global supply and demand imbalances and current geopolitical events.
Inflationary pressures and labor shortages could result in increases to the
Royalty Trust's operating costs and the current increase in natural gas prices
may not be sustained for any significant period of 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 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 each
of McMoRan's 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 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
Oil & Gas LLC (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 expenses as
provided for in the Royalty Trust Agreement, (c) its
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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 or HOGA, and (g) its cash distributions to Royalty Trust
unitholders, if any, 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.
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 Highlander Oil & Gas Assets LLC (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. HOGA is the operator of the
Highlander subject interests.
The Royalty Trust has no ability to direct or influence the exploration or
development of the subject interests. In addition, none of FCX, McMoRan or HOGA
is under any obligation to fund or to commit any other resources to the
exploration or development of the subject interests. To the extent that HOGA
does not fund further exploration and development of the onshore Highlander
subject interest, or if for any other reason sufficient production from the
onshore Highlander subject interest is not maintained in commercial quantities,
Royalty Trust unitholders will not realize any additional value from their
investment in the Royalty Trust units.
The Royalty Trust units are quoted on the OTC Pink tier of the OTC markets. The
OTC Pink is a significantly more limited market than the national securities
exchanges, which could adversely affect the market price, trading volume,
liquidity and resale price of the Royalty Trust units.
For information regarding the OTC Pink, see Part I, Item IA. "Risk Factors -
There is a limited public market for the Royalty Trust units, which could affect
the market price, trading volume and resale price of the Royalty Trust units" of
this Form 10-K.
OPERATIONAL ACTIVITIES
Status of the Onshore Highlander Subject Interest
On January 19, 2023, the sole well producing from the onshore Highlander subject
interest experienced an operational issue, resulting in substantial amounts of
water entering the well, which caused a shut in of the well before production
resumed at significantly reduced levels. Following an evaluation by HOGA's field
operations team, HOGA determined that it would be necessary to commence
operations to control the water production, in expectation of eventually
initiating "kill" operations on the well. HOGA has informed the Trustee this
process is ongoing, during which time the well may only operate intermittently,
with significantly reduced production, or none at all.
The onshore Highlander subject interest is the only subject interest that has
established commercial production. Accordingly, shutting in the well for an
extended period of time will eliminate any production from the onshore
Highlander subject interest during such period, which will also eliminate any
proceeds to which the Royalty Trust would be entitled pursuant to its overriding
royalty interest during the same period. Therefore, while the well continues to
produce at significantly reduced levels, the Royalty Trust may not receive
income attributable to its overriding royalty interest; further, unless the
operational issues with the well can be rectified, the well is redrilled or
another well is drilled on the onshore Highlander subject interest, the Royalty
Trust does not expect to receive any income attributable to its overriding
royalty interests and accordingly, does not expect to have any cash available to
distribute to Royalty Trust unitholders in future periods.
Oil and Gas Activities
For additional information regarding McMoRan's and HOGA's current oil and gas
activities in relation to the subject interests, see Part I, Items 1. and 2.
"Business and Properties - The Subject Interests - Exploratory and Development
Drilling" and Part I, Item 1A. "Risk Factors" of this Form 10-K.
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Production
For information regarding McMoRan's and HOGA's production, see "Results of
Operations" in this section of this Form 10-K.
Acreage Position
For information regarding McMoRan's and HOGA's acreage position, see Part I,
Items 1. and 2. "Business and Properties - The Subject Interests - Acreage" of
this Form 10-K.
RESULTS OF OPERATIONS
Royalty Income. The onshore Highlander subject interest began commercial
production on February 25, 2015. Prior to this date there had been no commercial
production of hydrocarbons from any of the subject interests. During the year
ended December 31, 2022, the Royalty Trust received royalties of $2,472,908 from
HOGA related to 429,000 Mcf of natural gas production attributable to the
onshore Highlander subject interest with average post-production costs of $0.43
per Mcf and an average receipt price of $6.19 per Mcf. During the year ended
December 31, 2021, the Royalty Trust received royalties of $1,181,093 from
McMoRan and HOGA related to 384,421 Mcf of natural gas production attributable
to the onshore Highlander subject interest with average post-production costs of
$0.40 per Mcf and an average receipt price of $3.47 per Mcf. Royalty income was
higher during the year ended December 31, 2022, as compared to the year ended
December 31, 2021 due to higher natural gas prices and higher production.
Administrative Expenses. For the years ended December 31, 2022 and 2021, the
Royalty Trust paid administrative expenses of $604,361 and $564,787,
respectively. Administrative expenses, which consisted primarily of audit, legal
and trustee expenses incurred in connection with the administration of the
Royalty Trust, were higher in 2022 as compared to 2021 primarily due to
inflation and the timing of payments for professional services.
LIQUIDITY AND CAPITAL RESOURCES
Pursuant to the Royalty Trust Agreement, FCX has agreed to pay annual trust
expenses up to $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 were made during the years ended December 31, 2022 or
2021. 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. 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 will receive any distributions. No loans or repayments were
made during the years ended December 31, 2022 or 2021.
Pursuant to the Royalty Trust Agreement, FCX also 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 has
provided $1.0 million in the form of a reserve fund cash account to the Royalty
Trust. As of December 31, 2022, 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.
Royalties are paid to the Royalty Trust on the last day of the month following
the month in which production payments are received by McMoRan or HOGA in
accordance with the terms of the master conveyance. In accordance with the
master conveyance, the Royalty Trust received royalties from HOGA of $2,472,908
and $1,181,093 during the years ended December 31, 2022 and 2021, respectively,
due 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
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--------------------------------------------------------------------------------December 31, 2022. As of December 31, 2022, the Trustee has established a
minimum cash reserve of $293,750. 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 minimum cash
reserve.
Commencing with the distribution to Royalty Trust unitholders in the first
quarter of 2022, the Royalty Trust is withholding, and in the future intends to
withhold, $8,750 from the funds otherwise available for distribution each
quarter to gradually build a cash reserve of approximately $350,000. This cash
is reserved for the payment of future known, anticipated or contingent expenses
or liabilities of the Trust. 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 Royalty Trust 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 Royalty
Trust unitholders, together with interest earned on the funds.
Distributable income totaled $1,842,816 and $607,591 for the years ended
December 31, 2022 and 2021, respectively. On January 13, 2023, the Royalty Trust
declared a cash distribution of $0.002702 per unit paid on February 10, 2023, to
Royalty Trust unitholders of record on January 31, 2023. 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. See Part I, Item 1A. "Risk Factors" of
this Form 10-K for more information.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The financial statements of the Royalty Trust are prepared on the modified cash
basis of accounting and are not intended to present the Royalty Trust's
financial position and results of operations in conformity with GAAP. This other
comprehensive basis of accounting corresponds to the accounting permitted for
royalty trusts by the SEC.
The carrying value of the Royalty Trust's overriding royalty interests in the
subject interests (defined in Note 2 in the Notes to Financial Statements
located in Part II, Item 8. "Financial Statements and Supplementary Data" of
this Form 10-K) is amortized using the units of production method based on
estimated proved reserves, on an individual subject interest basis, once
production has been achieved for the respective subject interests. Such non-cash
amortization is charged directly to the Trust Corpus as royalties are received,
and does not affect distributable cash or the determination of distributable
cash per Royalty Trust unit.
The Royalty Trust evaluates the carrying values of the overriding royalty
interests in the subject interests for impairment if conditions indicate that
potential uncertainty exists regarding the Royalty Trust's ability to recover
its recorded amounts related to the overriding royalty interests. Indications of
potential impairment with respect to the overriding royalty interests can
include, among other things, subject interest lease expirations, reductions in
estimated reserve quantities or resource potential, changes in estimated future
oil and gas prices, exploration costs, and/or drilling plans, and other matters
that arise that could negatively impact the carrying values of the overriding
royalty interests. If an impairment event occurs and it is determined that the
carrying value of the Royalty Trust's overriding royalty interests in the
subject interests may not be recoverable, an impairment will be recognized as
measured by the amount by which the carrying amount of the overriding royalty
interests in the subject interests exceeds the fair value of these assets, which
would be measured by discounting projected cash flows. The related impairment
amounts are recorded as a reduction to the overriding royalty interests with an
offsetting reduction to the Trust Corpus in the period such impairment is
determined, see Note 3 in the Notes to Financial Statements located in Part II,
Item 8. "Financial Statements and Supplementary Data" of this Form 10-K. No
impairment charges were recorded during the years ended December 31, 2022 and
2021.
NEW ACCOUNTING STANDARDSThe Royalty Trust does not expect recently issued accounting standards to have a
significant impact on its future financial statements and disclosures.
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