Vanguard Natural Resources: Under the Radar Energy Play

Includes: DUG, VNR
by: Leonard the Monkey

VNR is my under the radar way to play the energy sector in 2008. Vanguard Natural Resources pays huge dividends from owning mature natural gas and oil fields somewhat like an oil and gas trust, but they use hedges and expand their business through acquisitions. This high yielding way to get energy exposure just went public in late October at $19. VNR has yet to announce its first dividend so there does not show any yield currently on Bloomberg and Yahoo. On top of that the first dividend payment of .29 which they will pay in the beginning of February is prorated down from .425 as the 1st quarter as a public company is only about two months. With the turmoil in the markets and economy not only does this make me more comfortable to own a high yielder like VNR but I think this fact will also attract others to the name resulting in some nice share appreciation on top of the large dividends.

VNR declared when they went public that they would yield 1.70 per share per year paid quarterly. At the current quote that is an almost 12% yield. What about oil and natural gas prices? VNR is hedged for almost all of their nat. gas (90%) through 2009, 2008 at $9 and 2009 at 8.85.

Now VNR really doesn't have much oil exposure at the moment but they recently agreed to acquire a very large oil field with a touch of nat. gas from Apache. This is very significant in relation to the size of VNR. The market cap currently sits around 177M and this acquisition was about 76M so it really should "move the needle" for the company. This is evident as management has already stated that when this acquisition closes later this quarter it will be immediately accretive and they will discuss raising the dividend by a substantial amount. This investment comes with Oil hedges on 90% of the oil out to 2011 at the price of $87.29 a barrel.

Another reason VNR has not caught on may be because by looking at the numbers without understanding what is going on can be a little confusing. How can they pay this big dividend based on their recent earnings? Well digging a little deeper you will find that the first nine months included some big one time costs to setup for the future. These include 2.8 mil for terminating existing gas swaps, 2.5 mil for extinguishment of debt and 6.5 mil for put option derivative contracts. This sets VNR up with strong gas prices going forward and gets rid of a 13% interest rate on a 31 million dollar loan. These things are very positive as the company goes forward.

As the FED continues to lower interest rates high yields will become more attractive to more people, also VNR will save on it's interest expenses as they pay libor + 1 to 1.75 or a domestic bank rate plus 0 to .75 whichever is lower. I think VNR shares are very undervalued given the positives going for the company and expect the investment to yield at least 25% in 2008 from the current level. This while you sit around earning what I believe will soon be a 14%+ dividend when they raise it after this quarter due to the new immediately accretive acquisition.

You get to sit around for years and wait for the next thing to drive up oil and/or nat. gas so they can enter into new swaps at higher prices dramatically increasing the payouts to shareholders and resulting in share appreciation.

Looking at the latest SEC filings is also encouraging as Lehman Brothers (who was one of the lead underwriters of the IPO) and the insiders have both made recent open market purchases of the stock at levels slightly higher then where it is today. Typically after an IPO there is a lockup period where insiders can unload some of their shares to help diversify some of their holdings – buying after the IPO after the shares have been hit in an awful market by the people who know the most about the business is a big positive in my view.

The market is a very volatile place right now and with recession on top of everyone's mind a way you can hedge against falling energy prices in the short term are with some DUG calls. Longer term I believe that natural gas and oil will continue to rise in price.

Disclosure: I do have a long position in VNR and I am long DUG calls.