CROSS TIMBERS ROYALTY TRUST - Quarter Report: 2008 June (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

For the quarterly period ended June 30, 2008

OR

Commission File Number: 1-10982

Cross Timbers Royalty Trust

(Exact name of registrant as specified in its charter)

(877) 228-5084

(Registrant’s telephone number, including area code)

NONE

(Former name, former address and former fiscal year, if change 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  x    No  ¨

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

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

Indicate the number of units of beneficial interest outstanding, as of the latest practicable date:

Outstanding as of July 1, 2008

6,000,000

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CROSS TIMBERS ROYALTY TRUST

FORM 10-Q FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2008

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CROSS TIMBERS ROYALTY TRUST

GLOSSARY OF TERMS

The following are definitions of significant terms used in this Form 10-Q:

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CROSS TIMBERS ROYALTY TRUST

PART I - FINANCIAL INFORMATION

The condensed financial statements included herein are presented, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in annual financial statements have been condensed or omitted pursuant to such rules and regulations, although the trustee believes that the disclosures are adequate to make the information presented not misleading. These condensed financial statements should be read in conjunction with the financial statements and the notes thereto included in the trust’s latest Annual Report on Form 10-K. In the opinion of the trustee, all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the assets, liabilities and trust corpus of the Cross Timbers Royalty Trust at June 30, 2008, and the distributable income and changes in trust corpus for the three- and six-month periods ended June 30, 2008 and 2007, have been included. Distributable income for such interim periods is not necessarily indicative of distributable income for the full year.

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

Bank of America, N.A., as Trustee

  for the Cross Timbers Royalty Trust:

We have reviewed the accompanying condensed statement of assets, liabilities and trust corpus of the Cross Timbers Royalty Trust as of June 30, 2008 and the related condensed statements of distributable income and changes in trust corpus for the three- and six-month periods ended June 30, 2008 and 2007. These condensed financial statements are the responsibility of the trustee.

We conducted our review in accordance with standards established by the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

The accompanying condensed financial statements are prepared on a modified cash basis as described in Note 1 which is a comprehensive basis of accounting other than accounting principles generally accepted in the United States of America.

Based on our review, we are not aware of any material modifications that should be made to the condensed financial statements referred to above for them to be in conformity with the basis of accounting described in Note 1.

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the statement of assets, liabilities and trust corpus of the Cross Timbers Royalty Trust as of December 31, 2007, and the related statements of distributable income and changes in trust corpus for the year then ended (not presented herein), included in the trust’s 2007 Annual Report on Form 10-K, and in our report dated February 25, 2008, we expressed an unqualified opinion on those financial statements. In our opinion, the information set forth in the accompanying condensed statement of assets, liabilities and trust corpus as of December 31, 2007 is fairly stated, in all material respects, in relation to the statement of assets, liabilities and trust corpus included in the trust’s 2007 Annual Report on Form 10-K from which it has been derived.

KPMG LLP

Fort Worth, Texas

July 21, 2008

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CROSS TIMBERS ROYALTY TRUST

Condensed Statements of Assets, Liabilities and Trust Corpus

The accompanying notes to condensed financial statements are an integral part of these statements.

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CROSS TIMBERS ROYALTY TRUST

Condensed Statements of Distributable Income (Unaudited)

The accompanying notes to condensed financial statements are an integral part of these statements.

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CROSS TIMBERS ROYALTY TRUST

Condensed Statements of Changes in Trust Corpus (Unaudited)

The accompanying notes to condensed financial statements are an integral part of these statements.

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CROSS TIMBERS ROYALTY TRUST

Notes to Condensed Financial Statements (Unaudited)

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

Costs deducted in the calculation of net proceeds for the 90% net profits interests generally include applicable taxes, transportation, marketing and legal costs, and do not include production expense or development costs. For the 75% net profits interests, costs deducted in the calculation of net proceeds include production expense, development costs, applicable taxes, transportation, marketing and legal costs, operating charges and other costs.

The financial statements of the trust differ from those prepared in conformity with U.S. GAAP because revenues are recognized when received rather than accrued in the month of production, expenses are recognized when paid rather than when incurred, and certain cash reserves may be established for contingencies which would not be accrued under U.S. GAAP. This comprehensive basis of accounting other than U.S. GAAP corresponds to the accounting permitted for royalty trusts by the U.S. Securities and Exchange Commission, as specified by Staff Accounting Bulletin Topic 12:E, Financial Statements of Royalty Trusts.

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Most accounting pronouncements apply to entities whose financial statements are prepared in accordance with U.S. 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.

The initial carrying value of the net profits interests of $61,100,449 represents XTO Energy’s historical net book value on February 12, 1991, the creation date of the trust. Amortization of the net profits interests is calculated on a unit-of-production basis and is charged directly to trust corpus. Accumulated amortization was $43,269,560 as of June 30, 2008 and $42,712,697 as of December 31, 2007.

Several states have enacted legislation to require state income tax withholding from nonresident recipients of oil and gas proceeds. After consultation with its state tax counsel, XTO Energy has advised the trustee that it believes the trust is not subject to these withholding requirements. However, regulations are subject to change by the various states, which could change this conclusion. Should the trust be required to withhold state taxes, distributions to the unitholders would be reduced by the required amount, subject to the unitholder’s right to file a state tax return to claim any refund due.

Certain of the properties underlying the 90% net profits interests were subject to a reversion agreement between XTO Energy and an unrelated party. The agreement called for XTO Energy to transfer 25% of its interest in those properties to the third party when net amounts received by XTO Energy from the properties subject to the agreement equal the purchase price of the properties plus a 1% per month return on the unrecouped purchase price, known as payout. At the time payout occurred, net proceeds payable to the trust and trust distributions to unitholders were reduced. XTO Energy informed the trustee that payout occurred effective with the July 2007 distribution, which was paid on August 14, 2007, thereby reducing the July 2007 distribution and all future distributions by approximately 5%.

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From time-to-time, XTO Energy receives net proceeds for the underlying properties related to significant lawsuit settlements, including related interest income. Because of the size and nature of these settlements, XTO Energy has informed the trustee that it believes these should be considered one-time, or nonrecurring, events. Since most of the properties in the trust are nonoperated, these adjustments are generally not known to XTO Energy until reported by the purchaser. These settlements are included and reported in net profits income in the month received by the trust, which is generally the month following receipt by XTO Energy.

In first quarter 2008, the calculation of net profits income included a lawsuit settlement of $827,446 related to underpayment of royalties on underlying properties in the San Juan Basin. Included in this settlement was interest of $212,654 and additional gas revenue of $614,792. The total settlement, net to the trust, was $744,702, or $0.12 per unit. Based on additional information received by XTO Energy in April 2008, the amount allocated to interest income was increased by $136,262 in second quarter 2008. This reallocation did not change the total lawsuit settlement.

In second quarter 2008, the calculation of net profits income included another lawsuit settlement of $1,602,880 related to underpayment of royalties on underlying properties in the San Juan Basin. Included in this settlement was interest of $675,899 and additional gas revenue of $926,981. The total settlement, net to the trust, was $1,442,592 or $0.24 per unit.

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The following discussion should be read in conjunction with the trustee’s discussion and analysis contained in the trust’s 2007 annual report, as well as the condensed financial statements and notes thereto included in this Quarterly Report on Form 10-Q. The trust’s Annual Report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports are available on the trust’s web site at www.crosstimberstrust.com.

Distributable Income

Quarter

For the quarter ended June 30, 2008, net profits income was $8,528,354 compared to $5,222,836 for second quarter 2007. This 63% increase in net profits income is the result of higher oil and gas prices and lawsuit settlement proceeds included in second quarter 2008, partially offset by decreased oil and gas sales volumes. See “Net Profits Income” and “Other Proceeds” below.

After considering interest income of $4,556 and administration expense of $152,596, distributable income for the quarter ended June 30, 2008 was $8,380,314, or $1.396719 per unit of beneficial interest. For second quarter 2007, distributable income was $5,076,960, or $0.846160 per unit. Distributions to unitholders for the quarter ended June 30, 2008 were:

Six Months

For the six months ended June 30, 2008, net profits income was $15,414,208 compared to $9,922,022 for the same 2007 period. This 55% increase in net profits income is the result of higher oil and gas prices and lawsuit settlement proceeds included in the first six months of 2008, partially offset by decreased oil and gas sales volumes. See “Net Profits Income” and “Other Proceeds” below.

After considering interest income of $11,034 and administration expense of $278,650, distributable income for the six months ended June 30, 2008 was $15,146,592, or $2.524432 per unit of beneficial interest. Administrative expense for the six months ended June 30, 2008 decreased 12% from the prior year six-month period primarily because of the timing of expenditures. For the six months ended June 30, 2007, distributable income was $9,625,410, or $1.604235 per unit.

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Net Profits Income

Net profits income is recorded when received by the trust, which is the month following receipt by XTO Energy and generally two months after oil production and three months after gas production. Net profits income is generally affected by three major factors:

Because properties underlying the 90% net profits interests are royalty and overriding royalty interests, they generally bear no costs other than production and property taxes, related legal costs, and marketing and transportation charges. In addition to these costs, the 75% net profits interests are subject to production expense and development costs, since the properties underlying the 75% net profits interests are working interests.

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The following is a summary of the calculation of net profits income received by the trust:

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The following are explanations of significant variances on the underlying properties from second quarter 2007 to second quarter 2008 and from the first six months of 2007 to the comparable period in 2008:

Sales Volumes

Oil

Oil sales volumes decreased 12% for second quarter 2008 and the first six months of 2008 as compared with the same 2007 periods. Decreased oil sales volumes for the quarter are primarily because of payout occurring under the reversion agreement and natural production decline, partially offset by the timing of cash receipts. Decreased oil sales volumes for the six-month period are primarily because of payout occurring under the reversion agreement, natural production decline and the timing of cash receipts. See “Reversion Agreement” below.

Gas

Gas sales volumes decreased 13% for second quarter 2008 and 15% for the first six months of 2008 as compared with the same 2007 periods primarily because of payout occurring under the reversion agreement, natural production decline and the timing of cash receipts. See “Reversion Agreement” below.

Sales Prices

Oil

The average oil price increased 70% to $94.30 per Bbl for the second quarter and 68% to $90.00 per Bbl for the six-month period. Oil prices have risen primarily because of increasing global demand and supply shortage concerns, inadequate sour crude refining capacity and political instability. In the last few months of 2007 and first half of 2008, continued tension in the Middle East, weakness in the U.S. dollar and strong demand caused prices to reach record levels of above $147.00 per Bbl. Oil prices are expected to remain volatile. The second quarter 2008 oil price is primarily related to production from February through April 2008, when the average NYMEX price was $104.21 per Bbl. The average NYMEX price for May and June 2008 was $130.14 per Bbl. At July 15, 2008, the average NYMEX futures price for the following twelve months was $140.40 per Bbl. Recent trust oil prices have averaged approximately 6% lower than the NYMEX price.

Gas

Gas prices for the second quarter increased 49% to $11.67 per Mcf and for the six-month period increased 46% to $11.13 per Mcf. Excluding the effects of the lawsuit settlement in first and second quarters 2008, the average gas price was $10.23 per Mcf in second quarter 2008 and $9.80 per Mcf for the first six months of 2008. See “Other Proceeds” below. Although the U.S. entered winter with above average gas in storage, a normal winter and lower liquified natural gas imports led to normal gas storage levels. As a result of tighter storage levels and higher oil prices, recent gas prices have reached as high as $13.00 per MMBtu. Prices will continue to be affected by weather, oil prices, the U.S. economy, the level of North American production and import levels of liquified natural gas. Natural gas prices are expected to remain volatile. The second quarter 2008 gas price is primarily related to production from January through March 2008, when the average NYMEX price was $8.03 per MMBtu. The average NYMEX price for May and June 2008 was $11.60 per MMBtu. At July 15, 2008, the average NYMEX futures price for the following twelve months was $11.64 per MMBtu. Recent trust gas prices have been approximately 40% higher than the NYMEX price.

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Costs

Taxes, Transportation and Other

Taxes, transportation and other increased 12% for the second quarter and 10% for the six-month period primarily because of increased production taxes related to higher oil and gas revenues, partially offset by lower property taxes.

Production Expense

Production expense was 32% higher for the second quarter and 16% higher for the six-month period primarily because of increased power, fuel and labor costs as well as the timing of cash disbursements, partially offset by decreased maintenance costs.

Development

Development costs decreased 29% for the second quarter and 27% for the six-month period primarily because of decreased activity and costs related to Texas and Oklahoma properties underlying the 75% net profits interests.

Contingencies

Several states have enacted legislation to require state income tax withholding from nonresident recipients of oil and gas proceeds. After consultation with its state tax counsel, XTO Energy has advised the trustee that it believes the trust is not subject to these withholding requirements. However, regulations are subject to change by the various states, which could change this conclusion. Should the trust be required to withhold state taxes, distributions to the unitholders would be reduced by the required amount, subject to the unitholder’s right to file a state tax return to claim any refund due.

Reversion Agreement

Certain of the properties underlying the 90% net profits interests were subject to a reversion agreement between XTO Energy and an unrelated party. The agreement called for XTO Energy to transfer 25% of its interest in those properties to the third party when net amounts received by XTO Energy from the properties subject to the agreement equal the purchase price of the properties plus a 1% per month return on the unrecouped purchase price, known as payout. At the time payout occurred, net proceeds payable to the trust and trust distributions to unitholders were reduced. XTO Energy informed the trustee that payout occurred effective with the July 2007 distribution, which was paid on August 14, 2007, thereby reducing the July 2007 distribution and all future distributions by approximately 5%.

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Other Proceeds

In first quarter 2008, the calculation of net profits income included a lawsuit settlement of $827,446 related to underpayment of royalties on underlying properties in the San Juan Basin. Included in this settlement was interest of $212,654 and additional gas revenue of $614,792. The total settlement, net to the trust, was $744,702, or $0.12 per unit. Based on additional information received by XTO Energy in April 2008, the amount allocated to interest income was increased by $136,262 in second quarter 2008. This reallocation did not change the total lawsuit settlement.

In second quarter 2008, the calculation of net profits income included another lawsuit settlement of $1,602,880 related to underpayment of royalties on underlying properties in the San Juan Basin. Included in this settlement was interest of $675,899 and additional gas revenue of $926,981. The total settlement, net to the trust, was $1,442,592, or $0.24 per unit.

Forward-Looking Statements

This report on Form 10-Q includes “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. All statements other than statements of historical fact included in this Form 10-Q including, without limitation, statements regarding the net profits interests, underlying properties, development activities, development, production and other costs and expenses, oil and gas prices and differentials to NYMEX prices, supply shortages, distributions to unitholders, the impact on future payments as a result of the reversion of properties under the reversion agreement and industry and market conditions, are forward-looking statements that are subject to risks and uncertainties which are detailed in Part I, Item 1A of the trust’s Annual Report on Form 10-K for the year ended December 31, 2007, which is incorporated by this reference as though fully set forth herein. Although XTO Energy and the trustee believe that the expectations reflected in such forward-looking statements are reasonable, neither XTO Energy nor the trustee can give any assurance that such expectations will prove to be correct.

There have been no material changes in the trust’s market risks, as disclosed in Part II, Item 7A of the trust’s Annual Report on Form 10-K for the year ended December 31, 2007.

As of the end of the period covered by this report, the trustee carried out an evaluation of the effectiveness of the trust’s disclosure controls and procedures pursuant to Exchange Act Rules 13a-15 and 15d-15. Based upon that evaluation, the trustee concluded that the trust’s disclosure controls and procedures are effective to ensure that information required to be disclosed in reports filed with the Securities and Exchange Commission is recorded, processed, summarized and reported within the periods required and that this information is accumulated and communicated to allow timely decisions regarding required disclosures. In its evaluation of disclosure controls and procedures, the trustee has relied, to the extent considered reasonable, on information provided by XTO Energy. There has not been any change in the trust’s internal control over financial reporting during the period covered by this report that has materially affected, or is reasonably likely to materially affect, the trust’s internal control over financial reporting.

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PART II - OTHER INFORMATION

Not applicable.

There have been no material changes in the risk factors disclosed under Part I, Item 1A of the trust’s Annual Report on Form 10-K for the year ended December 31, 2007.

Items 2 through 5.

Not applicable.

(a) Exhibits.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.

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