SJT San Juan Basin Royalty Trust

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

for the Quarterly Period Ended September 30, 2021

or

for the transition period from                      to                     

Commission File No. 001-08032

SAN JUAN BASIN ROYALTY TRUST

(Exact name of registrant as specified in the Amended and Restated San Juan Basin Royalty Trust Indenture)

PNC Bank, National Association

PNC Asset Management Group

2200 Post Oak Blvd., Floor 18

Houston, TX 77056

(Address of principal executive offices) (Zip Code)

(866) 809-4553

(Registrant’s telephone number, including area code)

BBVA USA, Trust Department

2200 Post Oak Blvd., Floor 18

Houston, TX 77056

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ☐    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer, a smaller reporting company or an emerging growth company. See definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company” or “emerging growth company” in Rule 12b-2 of the Exchange Act. (Check one):

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ☐    No  ☒

Number of Units of beneficial interest outstanding at November 15, 2021: 46,608,796

Table of Contents

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SAN JUAN BASIN ROYALTY TRUST

These Condensed Financial Statements should be read in conjunction with the accompanying

Notes to Condensed Financial Statements included herein.

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1. Basis of Presentation

The preceding condensed statement of assets, liabilities and trust corpus as of December 31, 2020, which has been derived from audited financial statements, and the unaudited interim condensed financial statements included herein have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). These condensed financial statements should be read in conjunction with the financial statements and the notes thereto included in San Juan Basin Royalty Trust (the “Trust”) Annual Report on Form 10-K for the year ended December 31, 2020. In the opinion of PNC Bank, National Association, the trustee of the Trust (“PNC Bank” or the “Trustee”), and based upon information provided to the Trust by Hilcorp San Juan L.P. (“Hilcorp”), the present owner of certain oil and gas interests (the “Subject Interests”) originally owned by Southland Royalty Company (“Southland”) in properties located in the San Juan Basin of northwestern New Mexico, all adjustments, consisting only of normal recurring adjustments, have been included that are necessary to fairly present the assets, liabilities and trust corpus of the Trust at September 30, 2021, and the distributable income and changes in trust corpus for the three-month and nine-month periods ended September 30, 2021 and 2020. The distributable income for such interim periods is not necessarily indicative of the distributable income for the full year.

The financial statements of the Trust are prepared on the following basis and are not intended to present the financial position and results of operations of the Trust in conformity with U.S. generally accepted accounting principles (“GAAP”):

The financial statements of the Trust differ from financial statements prepared in accordance with GAAP because revenues are not accrued in the month of production; certain cash reserves may be established for liabilities and contingencies which would not be accrued in financial statements prepared in accordance with GAAP; expenses are recorded when paid instead of when incurred; and amortization of the Royalty calculated on a unit-of-production basis is charged directly to trust corpus instead of as an expense. Most accounting pronouncements apply to entities whose financial statements are prepared in accordance with GAAP, directing such entities to accrue or defer revenues and expenses in a period other than when such revenues were received or expenses were paid. Because the Trust’s financial statements are prepared on the modified cash basis, as described above, most accounting pronouncements are not applicable to the Trust’s financial statements. This comprehensive basis of accounting corresponds to the accounting permitted for royalty trusts by the SEC, as specified by Staff Accounting Bulletin Topic 12:E, Financial Statements of Royalty Trusts.

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The Trustee routinely reviews the Trust’s royalty interests in oil and natural gas properties for impairment whenever events or circumstances indicate that the carrying amount of an asset may not be recoverable. If an impairment event occurs and it is determined that the carrying value of the Trust’s royalty interests may not be recoverable, an impairment will be recognized as measured by the amount by which the carrying amount of the royalty interests exceeds the fair value of these assets, which would likely be measured by discounting projected cash flows and is charged directly to trust corpus instead of as an expense. There was no impairment of the Trust’s assets as of September 30, 2021.

2. Federal Income Taxes

For federal income tax purposes, the Trust constitutes a fixed investment trust that is taxed as a grantor trust. A grantor trust is not subject to tax at the trust level. The Unit Holders are considered to own the Trust’s income and principal as though no trust were in existence. The income of the Trust is deemed to have been received or accrued by each Unit Holder at the time such income is received or accrued by the Trust rather than when distributed by the Trust.

The Trust is a widely held fixed investment trust (“WHFIT”) classified as a non-mortgage widely held fixed investment trust (“NMWHFIT”) for federal income tax purposes. The Trustee is the representative of the Trust that will provide tax information in accordance with the applicable U.S. Treasury Regulations governing the information reporting requirements of the Trust as a WHFIT and a NMWHFIT.

The Royalty constitutes an “economic interest” in oil and natural gas properties for federal income tax purposes. Unit Holders must report their share of the production revenues of the Trust as ordinary income from oil and natural gas royalties and are entitled to claim depletion with respect to such income. The Royalty is treated as a single property for depletion purposes. The Trust has on file technical advice memoranda confirming such tax treatment.

The classification of the Trust’s income for purposes of the passive loss rules may be important to a Unit Holder. Royalty income such as that derived through the Trust will generally be treated as portfolio income that may not be offset or reduced by passive losses.

Tax positions taken by the Trust related to the Trust’s pass-through status and state tax positions have been reviewed, and the Trustee is of the opinion that the material tax positions it has taken would more likely than not be sustained by examination. As of September 30, 2021, the Trust’s tax years 2017 and thereafter remain subject to examination.

Each Unit Holder should consult his or her own tax advisor regarding tax compliance matters related to such Unit Holder’s interest in the Trust.

3. Commitments and Contingencies

Contingencies related to the Subject Interests that are unfavorably resolved would generally be reflected by the Trust as reductions to future Royalty Income payments to the Trust with corresponding reductions to cash distributions to Unit Holders. See Note 1 Basis of Presentation, for a summary of the terms of the Conveyance with respect to recovery of costs.

Covid-19 Pandemic. The Trust continues to request periodic updates from Hilcorp as to its production and financial expectations with respect to the Subject Interests due to any effects caused by the ongoing Covid-19 pandemic and the recent fluctuations in oil and gas pricing. Hilcorp has informed the Trust that, given the current natural gas pricing environment, Hilcorp does not anticipate materially reducing any of the Subject Interests’ production or taking any of the Subject Interests’ wells offline; however, both the Trust and Hilcorp continue to monitor the impact that Covid-19 may have on production, including as it relates to personnel availability in New Mexico and other Subject Interest areas. Hilcorp further informed the Trust that Covid-19 has not had, nor does it anticipate that Covid-19 will have any material impact on its operation of the Subject Interests or on its payments of Royalty Income to the Trust. However, the continuing impact of the ongoing Covid-19 pandemic, including additional surges or variants and required or recommended pandemic mitigation efforts, on Hilcorp and the Subject Interests remains unknown and any such impact could result in actual results being different from Hilcorp’s expectations, despite the lack of a materially adverse impact to-date of the pandemic.

Gross Proceeds and Production Cost Estimates. Hilcorp has advised the Trust that for certain months (since the closing of its purchase of the assets), it has reported estimates of cash revenues and expenses based on the best information available to it at the time, instead of reporting actual amounts. Hilcorp further has informed the Trust that it believes that its estimates have been prepared in accordance with the Conveyance, and the Trust and its advisors continue to review such estimates for compliance with the Conveyance.

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4. Settlements and Litigation

None

5. Subsequent Events

PNC Succession as the Trustee

On June 1, 2021, The PNC Financial Services Group, Inc. (“PNC”) announced that it had completed the purchase of BBVA USA Bancshares, Inc., a financial holding company, including its U.S. banking subsidiary, BBVA USA, an Alabama-chartered bank and trustee of the Trust (“BBVA USA”). On October 8, 2021, PNC Bank, an indirect wholly owned subsidiary of PNC, succeeded BBVA USA as the trustee of the Trust following BBVA USA’s merger with and into PNC Bank.

October Distribution

On October 19, 2021, the Trust announced a cash distribution of $3,155,671 or $0.067705 per Unit, based primarily upon the reported production during the month of August 2021, which was paid on November 15, 2021.

Hilcorp Meeting and Reimbursements to the Trust

On November 11, 2021, Hilcorp met with the Trust (the “November 2021 Meeting”) to discuss several material issues that the Trust had raised with respect to Hilcorp’s estimates of gross proceeds and severance taxes, as well as the Trust’s audit of Hilcorp’s reported revenues and expenses. During the November 2021 Meeting, Hilcorp informed the Trust that it had completed its actualization and validation of January, February, and March 2021 with respect to the gross proceeds and severance tax estimates attributable to the Royalty Interests owned by the Trust. Based on such review, Hilcorp informed the Trust that it had determined that it owes the Trust an additional $448,780 for these time periods, along with $63,496 in interest in accordance with the terms of the Conveyance.

Also, during the November 2021 Meeting, Hilcorp informed the Trust that it had discovered errors made in the setup of a few of its general ledger accounts during its SAP conversion process. Specifically, Hilcorp stated that these accounts had been mislabeled as billable, including three of the Trust’s general ledger accounts. As a result, Hilcorp notified the Trust that it will reimburse the Trust $2,681,521 for the erroneous billed labels for January through July 2021 production months, along with $72,667 in interest in accordance with the Conveyance. Hilcorp believes that it has now corrected its accounting internal control systems.

Hilcorp intends to include the payments for these actualizations and adjustments, together with the related interest, in the November reporting and distribution to the Trust. Hilcorp also confirmed that it continues to work on its actualization and accounting of the operated revenue and severance tax computations for the production month of April 2021 and will notify the Trust promptly upon completion of such actualization and accounting.

The Trustee continues to engage with Hilcorp regarding its ongoing accounting and reporting to the Trust, and the Trust’s third-party compliance auditors continue to audit all payments made by Hilcorp to the Trust, including adjustments, true-ups, and recoupments. The Trustee continues to consult with outside counsel to review the rights of the Trust with respect to these matters and to evaluate any available potential legal remedies.

The Trustee

The primary function of the Trustee is to collect Royalty Income, to pay all expenses and charges of the Trust and distribute the remaining available income to the Unit Holders. The amount of income distributable to Unit Holders, which we refer to as “Distributable Income,” depends on the amount of Royalty Income and interest received by the Trust, as well as the amount of expenses paid by the Trust and any change in cash reserves. The Trust has no employees, officers or directors. The Trustee performs all administrative functions of the Trust.

Hilcorp

Hilcorp is the principal operator of the majority of the Subject Interests and is responsible, subject to the terms of a prior agreement with the Trust, for marketing the oil and natural gas production from such properties, either under existing sales contracts or under future arrangements, at the best prices and on the best terms it shall deem reasonably obtainable under the circumstances. A very high percentage of the Royalty Income is attributable to the production and sale by Hilcorp of natural gas from the Subject Interests. Accordingly, the market price and demand for natural gas produced and sold from the San Juan Basin heavily influences the amount of Royalty Income distributed by the Trust and, by extension, the price of the Units.

The sale of San Juan Basin assets, including the Subject Interests, from Burlington to Hilcorp closed on July 31, 2017. Under the terms of the sale, Hilcorp is required to make payments to Burlington if natural gas prices are above a certain price. Hilcorp has confirmed that in accordance with the Conveyance, Hilcorp will not charge the Trust any portion of such payments.

Gross Proceeds and Severance Tax Estimates. Hilcorp has advised the Trust that for certain months (since the closing of its purchase of the assets), it has reported estimates of cash revenues and expenses based on the best information available to it at the time, instead of reporting actual amounts. Hilcorp further has informed the Trust that it believes that its estimates have been prepared in accordance with the Conveyance, and the Trust and its advisors continue to review such estimates for compliance with the Conveyance.

Hilcorp’s process of reconciling actual revenue and severance taxes to previously reported estimates (which the Trust refers to as “true-ups”) are still occurring and being reported in 2021. In addition, Hilcorp informed the Trust that due to Hilcorp’s transition to a new accounting system beginning in March 2021, revenue and severance tax categories for the February through May 2021 production months were based on estimates utilizing historical trends. Revenue and severance tax for the May, June and July production months were trued-up in August and September 2021.

During the November 2021 Meeting, Hilcorp informed the Trust that it had completed its actualization and validation of January, February, and March 2021 with respect to the gross proceeds and severance tax estimates attributable to the Royalty Interests owned by the Trust. Based on such review, Hilcorp informed the Trust that it had determined that it owes the Trust an additional $448,780 for these time periods, along with $63,496 in interest in accordance with the terms of the Conveyance. Hilcorp intends to include the payments for these actualizations and adjustments, together with the related interest, in the November reporting and distribution to the Trust.

Lease operating expenses and capital costs for the January through April 2021 production months were based on estimates, but the lease operating expenses and capital costs for May 2021 were based on actual costs. Both Lease operating expense and capital costs for the January through May 2021 production months were trued-up in July 2021. However, due to excess production costs for the June production month (which corresponds with the Trust’s August distribution month), there was no cash distribution made in August 2021. These true-up corrections resulted in no distribution payment declared for the August 2021 reporting month.

Hilcorp also confirmed that it continues to work on its actualization and accounting of the operated revenue and severance tax computations for the production month of April 2021 (the remaining 2021 production month that was based on estimates) and will notify the Trust promptly upon completion of such actualization and accounting by the end of 2021. Hilcorp further informed the Trust that it believes that the April 2021 true-up and adjustment may result in changes to future distributions of net proceeds to the Trust that reflect such rebooking and true-ups plus interest on such amounts (as required by the Conveyance) to the extent an underpayment to the Trust has occurred. Hilcorp has confirmed that it will continue to waive interest to the extent there were any overpayments to the Trust based on true-ups in 2021.

The Trustee continues to engage with Hilcorp regarding its ongoing accounting and reporting to the Trust, and the Trust’s third-party compliance auditors continue to audit all payments made by Hilcorp to the Trust, including adjustments, true-ups, and recoupments. The Trustee continues to consult with outside counsel to review the rights of the Trust with respect to these matters and to evaluate any available potential legal remedies.

Commodity Prices. The Trust’s income and monthly distributions from the Subject Interests are heavily influenced by the price of oil and natural gas. These prices may fluctuate widely in response to relatively minor changes in the supply of and demand for oil and natural gas based on market uncertainty or a variety of additional factors that are beyond the Trustee’s control.

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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 Environmental Protection Agency (“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. President Biden’s executive orders require the adoption of new regulations and policies to address climate change and suspend, revise or rescind prior agency actions that are identified as conflicting with the Biden Administration’s climate policies. In addition, federal government efforts to limit or prohibit hydraulic fracturing and additional prohibitions on new leases for production of minerals on federal properties, including onshore lands could affect the Subject Interests and the Trust in several ways. For example, Hilcorp could be required to increase its capital expenditures for the Subject Interests, the market could suffer a decreased demand for natural gas and oil production, or various agencies could limit the Subject Interests’ ability to produce natural gas or oil. 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 Hilcorp’s ability to pay royalty income to the Trust.

Hilcorp previously informed the Trust that it does not believe that recent actions undertaken by the Biden’s administration to curtail future leases for natural gas and oil drilling on federally owned land will affect the Subject Interests because as currently enacted, they do not affect current leases.

Results of Operations – for the Three and Nine Months Ended September 30, 2021 and 2020

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The Royalty Income distributed to the Trust for both the three and nine months ended September 30, 2021 was higher than that distributed during the same period of 2020 due primarily to higher natural gas prices. There was no Royalty Income distributed to the Trust in the three months ended September 30, 2020 due to excess production costs from the April 2020 production month. The average natural gas price increased from $1.46 per Mcf for the three months ended September 30, 2020 to $2.74 per Mcf for the three months ended September 30, 2021, and the average natural gas price increased from $1.47 Mcf for the nine months ended September 30, 2020 to $2.72 per Mcf for the nine months ended September 30, 2021. Production of natural gas from the Subject Interests increased from 5,786,304 Mcf for the three months ended September 30, 2020 to 6,410,955 Mcf for the three months ended September 30, 2021, and increased slightly from 19,521,825 Mcf for the nine months ended September 30, 2020 to 19,631,861 Mcf for the nine months ended September 30, 2021.

Gross Proceeds from Subject Interests. Total Gross proceeds increased approximately $11 million, or 136%, for the three months ended September 30, 2021 compared to the three months ended September 30, 2020, and increased approximately $27.6 million, or 96%, for the nine months ended September 30, 2021 compared to the nine months ended September 30, 2020. The increase was due primarily to higher natural gas prices.

Capital Expenditures. Capital expenditures by Hilcorp decreased approximately $166,000 for the three months ended September 30, 2021 compared to the three months ended September 30, 2020. The decrease is due primarily to a credit as a result of true-ups for the January through April 2021 production months. Hilcorp’s capital expenditures increased approximately $159,000 for the nine months ended September 30, 2021 compared to the nine months ended September 30, 2020. The increase was primarily due to differences in timing in the payment of these expenditures along with capital expenditures attributable to the prior year’s budget.

Severance Taxes. Aggregate severance taxes increased approximately $1.1 million for the three months ended September 30, 2021 compared to the three months ended September 30, 2020, and increased approximately $4.3 million for the nine months ended September 30, 2021 compared to the nine months ended September 30, 2020. The increase in severance taxes was primarily attributable to higher gross proceeds during those periods. Severance taxes represented approximately 13% of gross proceeds for the three months ended September 30, 2021, compared to approximately 18% for the same period of 2020. Severance taxes represented approximately 13% of gross proceeds for the nine months ended September 30, 2021, compared to approximately 10% for the same period of 2020. The distributions in 2020 included true ups of previous production months which resulted in fluctuations of severance taxes.

Lease Operating Expenses and Property Taxes. Lease operating expenses and property taxes increased $3.5 million, or 69%, for the three months ended September 30, 2021 compared to the three months ended September 30, 2020, and increased $2 million, or 11%, for the nine months ended September 30, 2021 compared to the nine months ended September 30, 2020. The increase is primarily due to true-ups and corrections for the January through May 2021 production months, as well as to increased activity at the Subject Interests by Hilcorp.

Monthly lease operating expenses of the Subject Interests, including property taxes, for the three months ended September 30, 2021 averaged approximately $2.9 million, compared to $1.7 million for the three months ended September 30, 2020. Monthly lease operating expenses of the Subject Interests, including property taxes, for the nine months ended September 30, 2021 averaged $2.2 million, compared to an average of $2 million for the nine months ended September 30, 2020.

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Distributable Income. Distributable Income for the three months ended September 30, 2021 was $5.7 million ($0.121735 per Unit). There was no Distributable Income during the three months ended September 30, 2020. Distributable Income increased by approximately $15.4 million, or 296%, to $20.6 million ($0.441787 per Unit) for the nine months ended September 30, 2021 from $5.2 million ($0.111642 per Unit) for the nine months ended September 30, 2020. The increase in Distributable Income was primarily attributable to higher natural gas prices.

Based on 46,608,796 Units outstanding, the per-Unit distributions during the third quarter of 2021 were as follows:

Due to excess production costs for the June production month (which corresponds with the Trust’s August distribution month), there was no cash distribution made in August.

Interest Income. Interest income was lower for the three months ended September 30, 2021 as compared to the same period in 2020 due primarily to lower yields on short-term investments.

General & Administrative Expenses. General and administrative expenses increased approximately 33%, for the three months ended September 30, 2021 compared to the three months ended September 30, 2020, and increased 0.7%, for the nine months ended September 30, 2021 compared to the nine months ended September 30, 2020. The increase in general and administrative expenses was primarily attributable to differences in timing in the receipt and payment of certain expenses by the Trust, and increased legal expenses during the transition from BBVA to PNC Bank as the Trustee.

Cash Reserves. Total cash reserves were $1.0 million as of September 30, 2021. The primary purpose of the cash reserves is to have sufficient funds to cover monthly general and administrative expenses in the event that there is insufficient Royalty Income to cover such expenses. The Trustee does not anticipate any increases to the cash reserve above a level of $1.0 million in 2021, although it cannot guarantee that the Trustee will not increase such cash reserves in the future.

Liquidity and Capital Resources

The Trust’s principal source of liquidity and capital is Royalty Income. The Trust’s distribution of income to Unit Holders is funded by Royalty Income after payment of Trust expenses. The Trust is not liable for any production costs or liabilities attributable to the Royalty. If at any time the Trust receives more than the amount due under the Royalty, it is not obligated to return such overpayment, but the amounts payable to it for any subsequent period are reduced by such amount, plus interest, at a rate specified in the Conveyance. If the Trustee determines that the Trust does not have sufficient funds to pay the Trust’s liabilities, the Trustee may borrow funds on behalf of the Trust, in which case no distributions will be made to Unit Holders until such borrowings are repaid in full. The Trustee may not sell or dispose of any part of the assets of the Trust without the affirmative vote of 75% of all of the Units outstanding; however, the Trustee may sell up to 1% of the value of the Royalty (as determined pursuant to the Indenture) during any 12-month period without the consent of the Unit Holders.

Due to excess production costs in June 2021, the Trust did not declare a distribution in August 2021. The cash required for monthly expenses was funded by the cash reserve. The amount taken from the cash reserve was replenished in September 2021.

In the event the Trust does not receive sufficient net cash payments from Hilcorp, the Trust believes it has sufficient capacity to draw upon the cash reserve amount or borrow funds against the Royalty to cover the Trust’s operating expenses until its cash reserve can be replenished from net cash payments from Hilcorp.

Oil and Natural Gas Production

The natural gas volumes reported to the Trust by Hilcorp are based on plant residue gas volumes plus equivalent volumes for natural gas liquids. Hilcorp converts one barrel of natural gas liquids to six Mcf of natural gas using industry standards.

Royalty Income for the three months ended September 30, 2021 is associated with oil and natural gas production during May through July 2021 from the Subject Interests. Production of oil and natural gas and related average sales prices attributable to each of the Subject Interests and the Royalty for the three months ended September 30, 2021 and 2020 were as follows:

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Production of oil and natural gas and related average sales prices attributable to each of the Subject Interests and the Royalty for the nine months ended September 30, 2021 and 2020 were as follows:

The Trust recognizes production during the month in which the related net proceeds attributable to the Royalty are paid to the Trust. Royalty Income for a calendar year is based on the actual natural gas and oil production during the period beginning with November of the preceding calendar year through October of the current calendar year. However, for 2021, non-operated revenue has been based on estimated natural gas and oil production. Sales volumes attributable to the Royalty are determined by dividing the net profits by the Trust from the sale of oil and natural gas, respectively, by the prices received by Hilcorp for sales of such volumes from the Subject Interests, taking into consideration production taxes attributable to the Subject Interests. Because the oil and natural gas sales attributable to the Royalty are based upon an allocation formula dependent on such factors as price and cost, including Hilcorp’s capital expenditures and the timing of Hilcorp’s true-ups of prior reported estimated oil and natural gas production data, the aggregate sales amounts from the Subject Interests may not provide a meaningful comparison to sales attributable to the Royalty. Future true-ups will impact future royalty proceeds, but will not change the reported amounts due to the accounting basis used.

The fluctuations in natural gas production that have occurred during the three-month period ended September 30, 2021 and 2020, respectively, generally resulted from changes in the demand for natural gas during that time, market conditions, and variances in capital spending to generate production from new and existing wells, as offset by the natural production decline curve. Also, production from the Subject Interests is influenced by the line pressure of the natural gas gathering systems in the San Juan Basin. As noted above, oil and natural gas sales attributable to the Royalty are based on an allocation formula dependent on many factors, including oil and natural gas prices and capital expenditures.

Marketing

There were no changes to the contracts pursuant to which Hilcorp sells production from the Subject Interests and for the gathering and processing of production during the three months ended September 30, 2021.

Off-Balance Sheet Arrangements

None.

Critical Accounting Policies and Estimates

For a discussion of significant accounting policies and estimates that impact the Trust’s financial statements, see Part I, Item 1. Unaudited Financial Statements, Note 1 Basis of Presentation and Part II, Item 8. Financial Statements and Supplemental Data contained in the Trust’s Annual Report on Form 10-K for the year ended December 31, 2020.

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Information Regarding Forward-Looking Information

Certain information included in this Quarterly Report on Form 10-Q contains, and other materials filed or to be filed by the Trust with the SEC (as well as information included in oral statements or other written statements made or to be made by the Trust) may contain or include, forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and Section 27A of the Securities Act of 1933, as amended. Such forward-looking statements may involve or may concern, among other things, the amount and variability in capital expenditures by Hilcorp, drilling activity, development activities, production efforts and volumes, hydrocarbon prices, estimated future net revenues, estimates of reserves, the results of the Trust’s activities, the differences between Hilcorp’s estimated revenue and actual revenue, and regulatory matters. Such forward-looking statements generally are accompanied by words such as “may,” “will,” “based,” “estimate,” “expect,” “predict,” “project,” “anticipate,” “believe,” “plan,” “intend,” or other words that convey the uncertainty of future events or outcomes. Such statements are based on certain assumptions of the Trustee and by Hilcorp, with respect to future events; are based on an assessment of, and are subject to, a variety of factors deemed relevant by the Trustee and Hilcorp; and involve risks and uncertainties. However, whether actual results and developments will conform with such expectations and predictions is subject to a number of risks and uncertainties which could affect the future results of the energy industry in general, and the Trust and Hilcorp 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 Hilcorp’s business and the Trust. Such statements are not guarantees of future performance and 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.

Hilcorp Information

As a holder of a net overriding royalty interest, the Trust’s reporting of financial information is reliant upon Hilcorp to accurately and timely report information regarding Hilcorp and its affiliates; the Subject Interests, including the operations, acreage, well and completion count, working interests, production volumes, sales revenues, capital expenditures, operating expenses, reserves, drilling plans, drilling results and leasehold terms related to the Subject Interests, and factors and circumstances that have or may affect the foregoing. See Part I, Item 4. Controls and Procedures.

For information on the Trust’s exposure to market risk, please see Part II, Item 7A, “Quantitative and Qualitative Disclosures About Market Risk” contained in the Trust’s Annual Report on Form 10-K for the year ended December 31, 2020.

Lease operating expenses and capital costs for the January through April 2021 production months were based on estimates, but the lease operating expenses and capital costs for May 2021 were based on actual costs. Both Lease operating expense and capital costs for the January through May 2021 production months were trued-up in July 2021. Due to excess production costs in June 2021, the Trust did not declare a distribution in August 2021.

Hilcorp also confirmed that it continues to work on its actualization and accounting of the operated revenue and severance tax computations for the production month of April 2021 (the remaining 2021 production month that was based on estimates) and will notify the Trust promptly upon completion of such actualization and accounting by the end of 2021. Hilcorp further informed the Trust that it believes that the April 2021 true-up and adjustment may result in changes to future distributions of net proceeds to the Trust that reflect such rebooking and true-ups plus interest on such amounts (as required by the Conveyance) to the extent an underpayment to the Trust has occurred. Hilcorp has confirmed that it will continue to waive interest to the extent there were any overpayments to the Trust based on true-ups in 2021.

The Trustee continues to engage with Hilcorp regarding its ongoing accounting and reporting to the Trust, and the Trust’s third-party compliance auditors continue to audit all payments made by Hilcorp to the Trust, including adjustments, true-ups, and recoupments. The Trustee continues to consult with outside counsel to review the rights of the Trust with respect to these matters and to evaluate any available potential legal remedies.

The Trustee has evaluated the Trust’s internal disclosure controls and procedures as of September 30, 2021, and has concluded that such disclosure controls and procedures are effective, at the “reasonable assurance” level (as such term is used in Rule 13a-15(f) of the Exchange Act), to ensure that material information received from Hilcorp is gathered on a timely basis to be included in the Trust’s periodic reports and recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.

Additionally, during the three months ended September 30, 2021, there were no changes in the Trust’s internal control over financial reporting (as such term is used in Rule 13a-15(f) of the Exchange Act) that materially affected, or are reasonably likely to materially affect, the Trust’s internal control over financial reporting. Because the Trust does not have, nor does the Indenture provide for, officers, a board of directors or an independent audit committee, the Trustee has reviewed neither the Trust’s disclosure controls and procedures nor the Trust’s internal control over financial reporting in concert with management, a board of directors or an independent audit committee.