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Investors in this volatile market can still find 8.2% distribution yields and the potential for significant capital gains. I am referring to the exploration and production master limited partnerships. They offer high distribution yields and proven capital gain performance. In this article I will highlight Vanguard Natural Resource (NASDAQ:VNR) and my rationale for owning this partnership.

Overview

Vanguard Natural Resources is involved in the acquisition and development of oil and natural gas properties. The key locations are in southern Appalachian Basin, south east Kentucky and north east Tennessee, the Permian Basin, and west Texas.

Vanguard Natural Resource extracts oil, natural gas and natural gas liquids from geographically diversified properties in the U.S. On December 1st, 2011, Vanguard Natural Resource merged with Encore Energy Partners and more than doubled its reserves to 79.3 MMBoe with 57% oil, 34% natural gas and 9% natural gas liquids, valued at roughly $1.5 billion. Daily production is approximately 13,310 Boe.

Business Strategy

Vanguard Natural Resource has an active management team that is closely aligned with unit holders. The company has high quality, long lived reserves, an asset base that generates stable cash flow, a multi year hedging program to mitigate commodity risk, and an active focus on increasing proved reserves and daily production - to increase distributable cash to unit holders. The company has increased average daily production from 1,931 Boe in 2007 to 13,310 Boe in 2011 and increased reserves from 11.2 MMBoe in 2007 to 79.3 MMBoe in 2011. Vanguard Natural Resource focuses on maintaining robust financials so it can easily tap into debt and equity capital markets to fuel its growth and acquisitions.

The company has an emphasized focus upon oil and natural gas liquids, as presented in a recent March 1st presentation:

Financials

For fiscal 2011, Vanguard Natural Resource reported revenue of $319.6 million, up 243% over 2010, operating income of $122.4 million, up 245% from 2010, and net income of $62 million, up 184% from 2010. Full year earnings per share were $1.95. The company held $2.9 million in cash, $1.7 billion in total assets, $771 million in long term debt and $844 million as unit holders' equity.

Vanguard Natural Resources has hedges in place for both oil and natural gas. The years 2012 and 2013 are heavily hedged against any commodity swings. This will ensure the company's distribution can remain robust at a current 8.2% distribution yield.

Distributions

Vanguard Natural Resources has consistently increased quarterly distributions, from 42.5 cents in 2008 to 58.75 cents for its fourth quarter ended December 2011. Vanguard Natural Resources distributed a total of $2.31 per unit in fiscal 2011 which was 5.7% higher than in 2010. Vanguard had a distribution yield of 8.2% as of March 14th.

Vanguard Natural Resources reported, on March 1st, a solid fourth quarter adjusted net income to unit holders. The amount was $27.6 million in the fourth quarter of 2011 or $0.76 per basic unit. This is significantly higher than the year over year comparison of $11.8 million or $0.45 per basic unit, in the fourth quarter of 2010.

Units

Units traded from $21.86 to $33.67 over a 52-week period and were off from earlier highs, trading at the $28.39 level as of March 14th. The company has a market capitalization of about $840 million, slightly below book value.

Peer Group

Vanguard Natural Resource's peers include similar sized upstream oil and natural gas producers such as Linn Energy, LLC (NASDAQ:LINE), and EV Energy Partners, L.P. (NASDAQ:EVEP). Vanguard has a distribution yield that is slightly higher than its peers.

Linn Energy, LLC

Linn Energy is an upstream exploration and production master limited partnership. The company seeks to find long lasting oil and natural gas reserves. Management has hedged oill and natural gas production at favorable prices through 2015.

Here is a December hedge update provided to unit holders:

Management has been active on the acquisition front. On March 9th, management paid $175 million for oil and natural gas properties in East Texas. The deal should close by May 1st.

On February 27th, Linn Energy management made an agreement to purchase Hugoton Basin properties, in Kansas, from BP America Production Company for a contract price of $1.2 billion. Management has stated the deal will be accretive to Linn Energy's free cash flow. This could provide a catalyst for a distribution increase.

Action

I recommend investors buy Linn Energy on price weakness. The yield is a compelling one at 7.2% with most of the production hedged for the next 3 years.

EV Energy Partners, L.P.

EV Energy Partners is an upstream operator that is engaged in the pursuit of oil and gas production.

The general partnership is structured with Enervest and Management owning 76.25% and Encap owning the remaining 23.75%. The company has close to a $4 billion enterprise value. The yield is low, at 4.1% as of March 14th, but the partnership has extensive organic growth initiatives.

The partnership has a joint purchase with Enervest Institutional Partnerships in the Barnett Shale area; a $74 million acquisition in late 2011 and early 2012 in the Mid-Continent Region; and a $31 million Ohio drop down acquisition in the late summer of 2011.

The partnership has a significant joint venture with Chesapeake (NYSE:CHK). Natural gas has excellent price hedges for volume in 2012 through 2013. Gas prices are hedged through 2015 at prices ranging from $4.85 to $5.97 per MMbtu. Oil has excellent hedged prices through 2015. Investors are focused upon natural gas due to the recent weak term pricing of the abundant U.S. energy source.

Action

I really like EV Energy Partners' growth prospects. The company has established established partners and is aggressively moving forward to monetize its assets. I recommend buying EV Energy Partners' near the $70 price range.

Summary

With shares trading at close to book value, in the middle of its 52-week range and with a reasonable distribution yield, Vanguard Natural Resource units look attractive. Its recent Encore acquisition may result in higher near term operating expenses but should result in better profits and distributions in the future.

I recommend unit holders purchase shares in Vanguard Natural Resources due to the growth prospects and the organic projects within the business model. An 8.2% distribution yield is significant when compared to contrasting investment yields and opportunities.

Source: Vanguard's High Annual Yield 8.2% Is Protected By Commodity Hedges