2 Attractive High Yield Energy Plays

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 |  Includes: EROC, KNOP
by: Bret Jensen

Summary

High yield sectors like real estate investment trusts have outperformed the market in the first half of 2014 as interest rates have declined.

The probability that interest rates rise in the second half of the year on faster economic growth is high and it is time to lighten up in these sectors.

High yield energy partnerships are an exception to this strategy given the amount of demand in the sector. Here are two high income plays that are still attractive.

I have jettisoned most of my high yield plays over the past month. Real estate investment trusts (REITs) and the like served my portfolio so well in the first half of the year as interest rates declined confounding most pundits who predicted the opposite.

Economic growth should accelerate in the second half of the year. Maybe we will finally get a few quarters of 3% GDP growth. Combined with the Federal Reserve finally ending more than five years of QE initiatives, means interest rates should shoot past the 3% level they began the year at on the ten year Treasury yield by the end of the year.

One high yield area I continue to invest in is energy partnerships that pay high distribution payouts. These entities are benefiting from the continued boom in domestic energy production which I believe is in the early innings in the United States. I also like the energy sector globally as increasing demand from emerging markets is a secular trend.

Here are two high yield energy partnership plays in the energy sector that currently reside in my portfolio.

Eagle Rock Energy Partners, L.P. (NASDAQ:EROC) is an under the radar play in this market right now. It currently pays no distributions and is probably not showing up on a lot of filters for those looking for yield. The entity suspended its payouts when the Federal Trade Commission held up its sale of its midstream business for some $1.3B pending further information.

The company supplied that information to the FTC and the government agency approved the sale yesterday. The will leave Eagle Rock free to reinstate its payouts. If reinstated at previous levels, the stock would yield 12%. I expect the entity to provide somewhat lower payouts in the six to nine percent range. More importantly, this divestiture leaves Eagle Rock a pure play upstream limited partnership that should be rewarded with a higher multiple by the market. The shares trade at under $5 a share. EROC traded above $6 a share to begin the year and before it got held up by the FTC.

KNOT Offshore Partners (NYSE:KNOP) is a U.K.-based company that owns and operates shuttle tankers that service major oil and gas companies engaged in offshore production primarily in the North Sea. This company just came public in April, but its parent company (Knutsen NYK) has been around for over 100 years.

I bought the shares recently when the shares declined some 7% the day it did a secondary. Secondaries in the energy partnership and REIT space are usually misunderstood by investors which tend to sell. However, given these entities have to distribute most of their cash flow as dividends to shareholders; this is the primary way these entities raise money to buy additional cash flow producing assets. As long as those assets have roughly the same return as the ones in the existing portfolio, the value of the entity should remain the same. In KNOT's case, it was raising money to buy two additional vessels and the recent decline appears to be a solid entry point.

The entity yields a healthy six percent. Revenues are tracking to better than 30% growth in FY2014 and analysts believe similar sales growth is in store for 2015. Earnings should post an over 60% year-over-gain this year and the stock sells at roughly 17 times forward earnings, in line with the overall market multiple. The entity should receive several drop downs from its parent in the coming year fueling growth.

Disclosure: The author is long EROC, KNOP. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.