This 'Hated' Sector Offers Great Yields And Catalysts Galore

by: StreetAuthority

By David Sterman

When is the best time to focus on a particular industry? When it's deeply out of favor.

Every industry hits the occasional rough patch, which typically leads investors to focus their attention elsewhere. Yet when the rough patch ends, and the skies start to brighten, you have a chance to dig into the group before the crowd returns.

That's precisely the set up in place for a group of companies known as upstream MLPs. These master limited partnerships focus on mature energy fields. These firms don't focus on the early stage of energy exploration, and instead buy mature oil and gas fields that other firms have chosen to sell.

It's an industry known for a lot of deals, as the key players boost sales and replace existing assets that eventually start to post declining output. Nearly $2.5 billion in transactions were completed in 2010, rising to $5.8 billion in 2012, according to Credit Suisse. And investors were expecting even higher amounts of deal-making in 2013 -- until Linn Energy (LINE) spoiled the party.

One of the industry's most acquisitive firms, Linn has tended to utilize aggressive accounting measures to justify the economics of its deals to investors. That caught the eye of the Securities and Exchange Commission (SEC), which opened an investigation into the company's books in July.

That investigation led investors to flee from all upstream MLPs, and analysts have begun to look much more closely at the accounting practices of the whole industry. Analysts at UBS have given Linn's rivals a clean bill of health: "While difficult to predict the outcome of the informal SEC investigation, given the sell-off following the news as well as increased scrutiny over maintenance (capital expenditures) and hedging practices by the sell side, we believe it's mostly priced in for the group," they wrote in an Oct. 14 report.

To be sure, these upstream MLPs have moved out of favor for other reasons as well. The price of natural gas and natural gas liquids (or NGLs) have pulled back from their springtime highs, reducing these MLPs' near-term earning power. Also, pipeline bottlenecks have impeded the flow of these MLPs' production volumes. Yet both of these recently negative catalysts are set to become positive catalysts.

First, let's look at pricing and volume, which is what really drive cash flow for these firms. According to UBS' analysts, NGL prices appear to have bottomed out in the second quarter, and they expect this energy category (which includes fuels such as butane, propane and butane) to post steadily higher prices thanks to a rapid rise in NGL demand in industries such as chemicals and fertilizers.

Of course MLPs focused on oil have no qualms about the current pricing environment. What about natural gas? A recent rebound in pricing, from $3.25 per thousand cubic feet (or Mcf) to a recent $3.75 surely helps, but the futures market doesn't anticipate a move up to $4.50 until early 2017. Still, gas prices in the range of $3.75 to $4 spell respectable profits for the gas-focused upstream MLPs.

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The real story here is volume growth -- in all three energy categories. "As domestic shale plays continue to develop we expect to see an increasing inventory of assets as candidates for upstream MLPs," note the UBS analysts. Translation: The growth-through-acquisition business model remains firmly in place for upstream MLPs, and is likely to resume at a strong pace in 2014 (as the Linn-induced industry clouds begin to recede).

Meanwhile, the recent troubles have pushed share prices down, and dividend yield up to very enticing levels. Here are three double-digit-yielding upstream MLPs to focus on right now.

1. Breitburn Energy Partners (BBEP)

Yield: 10.4%

Half of Breitburn's production output is natural gas, though that is set to change. Management plans to focus future acquisitions on oil-intensive energy fields, and expects that 60% of its output will come from oil in 2014.

A key virtue: Breitburn is known for the industry's most accretive acquisitions, which means that each deal generates above-average returns. A small caveat: Breitburn will likely need to raise more capital to fund recent deals, which could pressure shares. Still, that double-digit yield more than compensates for such risk.

2. LRR Energy (LRE)

Yield 11.4%

This MLP has what we call a "Rich Parent." Privately held Lime Rock Energy buys and develops energy fields, and once they are producing at strong rates, these fields are "dropped down" to LRR Energy. So unlike other upstream MLPs, LRE doesn't need to go out and find other firms' assets in a competitive bid process. Instead, it is assured of getting solid productive assets at a fair price.

The structure of the relationship between LRE and Lime Rock means that LRE is unlikely to deliver much dividend growth. Indeed investors should expect the dividend to grow just a few percentage points per year. That's why this yield is so high. Still, a double-digit yield that is backed up by a large and stable parent makes this MLP quite appealing.

3. QR Energy (QRE)

Yield: 11.7%

Worried about a drop in oil and gas prices? Then focus on this MLP, which has locked in current prices for 88% of its oil output through 2016 and 97% of its natural gas production. Of course, hedging output at current prices means that QR wouldn't benefit as much as peers if energy prices rise. Investors seeking the potential for growth and income are focusing elsewhere, which is why this is among the highest yielders in the group.

Equally important, QR will likely be supporting its robust dividends for many years to come. Management estimates that its current energy properties are extremely long-lived, capable of sustaining current output for more than 16 years. That's among the highest projected production lives of any upstream MLP.

Risks to Consider: These upstream MLPs must continually replace their base of assets as current wells start to deplete, so they will always be pursuing deals -- which, as we've seen with Linn Energy, heightens risk.

It's been a brutal stretch for these MLPs, which has created a great opportunity for investors willing to wade in while the current SEC investigation of Linn Energy persists. For that matter, Linn Energy also sports a double-digit dividend yield, though it may be advisable to await the outcome of the SEC investigation. Unfortunately, by waiting for the dust to settle around Linn, you may miss out on a quick pop in the stock if the SEC decides not to take any further action.

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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.