A Familiar Pattern

By David Dittman • April 20, 2012

What to Buy: QR Energy LP (NYSE: QRE)

Why Now: QR Energy LP (NYSE: QRE) is a North American producer of oil and natural gas that’s organized as a master limited partnership (MLP) to maximize cash distributions to unit holders.

The company has consistently grown its production with a combination of drilling on its lands and adding properties with acquisitions. The latest of these is the purchase of Prize Petroleum LLC, announced Mar. 19, 2012, which induced management to lift its output target for 2012 as well as its quarterly distribution to $0.4875 per unit. The boost was the second in the last 12 months, raising the quarterly payout by a total of 18.2 percent over year-ago levels.

Nonetheless, QR’s unit price has plunged since mid-March, from nearly $24 per unit to the current level of $19 and change. This decline coincides with weakness in natural gas prices and concern about the future of oil prices as well as a secondary equity offering that will raise a total of $162.6 million–after the underwriters exercised their full option to buy additional units–to pay down debt used to fund the recent expansion.

Equity offerings in the past have almost always triggered selloffs in even the strongest MLPs. And these selloffs are almost invariably followed by strong recoveries.

That’s our expectation for QR Energy, which now yields more than 10 percent. Buy under USD21.

The Story

Investors’ ardor for high yields has cooled a bit in recent weeks, as some old bogeymen have resurfaced for the market. As a result the yield gap between dividend-paying investments deemed safest and those considered riskier has widened.

One manifestation of the trend is that selling of stocks has tended to encourage more selling, as investors make the usually incorrect assumption that there’s fire where there’s smoke. This month’s opportunity appears to come from that trend, as investors try to sort out what energy companies are most vulnerable to the 35 percent plunge in natural gas prices this year.

Ironically, that’s not really a big concern for QR Energy, as it has 90 percent of expected 2012 production hedged, expects big production gains this year and is more than half weighted toward liquids by output and 76 percent by revenue.

But guilt by association has created a great buying opportunity in that rare animal: a 10 percent plus yielder that’s also growing distribution by more than 10 percent a year.

David: It’s that time again to review what’s happened to these super-yielding picks we’ve had in Big Yield Hunting.

Roger: This may come as a surprise to you, but I’m actually somewhat encouraged by most of these stocks.

Superior Plus Corp (TSX: SPB, OTC: SUUIF) has really come back from the dead. Taking part profits in PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF) and OneSteel Ltd (ASX: OST, OTC: OSTLF, ADR: OSTLY) looks like it was the right move.

And despite how scared people have gotten about falling natural gas prices, Breitburn Energy Partners LP (NSDQ: BBEP) raised its dividend again this week. Someday people are going to give it some credit.

And I think the same is true about this month’s pick, which is another energy producing limited partnership that may have even better creds.

David: I’ll give you that. But before you gloss over the rest of the open positions, I think it’s clear there’s been a widening out of that yield spread you keep talking about.

That’s hurt our position in some of these stocks, including Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF).

Roger: You’re absolutely right to bring that up.

Just to clarify to the readers, nothing has changed at Capstone. We’re still waiting on the terms of its new Cardinal power plant contract and for management to set what it’s billed as a “sustainable” dividend policy. But the stock has ticked back just a bit from where we entered it this month.

I think it brings up one of the disadvantages of coming up with a new pick on or about a fixed date every month. The available fare is always shifting, and you do sometimes find yourself recommending high-yielding stocks when investors are more willing to pay up for them and prices are higher.

I do think though that we’re still very much in the game for all of these stocks. That even includes France Telecom (France: FTE, NYSE: FTE) and Telefónica (SM: TEF, NYSE: TEF), which have held their dividends but still have lost ground as concerns about the European credit markets have continued to swirl. Again, we’re not recommending safeties here, far from it.

We’re trying to buy stocks where expectations are so low that beating them is close to a cinch, which in turn is going to give us a nice capital gain. We ride out volatility–and even sometimes dividend cuts–in search of that payoff.

These aren’t stocks where the conservative should be looking. That’s for our other advisories.

David: All good points. But what about AvenEx Enegy Corp (TSX: AVF, OTC: AVNDF). They had great fourth-quarter results, and distributable cash flow was twice the dividend.

But they still cut their dividend from CAD0.045 to CAD0.035 per month. Didn’t that surprise you?

Roger: Unfortunately, I have to admit that it did.

I thought this company had the wherewithal to hold their distribution on their liquids output and the strong performance at the services operation. As it turned out, though, two things happened.

First, natural gas prices have fallen a lot further than I thought they would–in fact they were recently well below $2 per million British thermal units in some parts of Alberta.

Second, the company’s hedges were coming off this month, and management acted very proactively to ensure it has the cash to keep the liquids development program on track. Some investors took this as a sign things were worse than they appeared at AvenEx, and I can’t blame them for bailing.

The fact of the matter is that when a company reports fourth-quarter earnings on Mar. 30, it’s very hard to infer anything from the numbers that can give you confidence after a dividend cut. The stock has stabilized a bit, which is a good sign. But I think the right thing to do here is to make AvenEx a hold rather than a buy, at least until we get a better feel of what numbers look like with gas prices this low.

Once again, they’re going to make us wait to get them. It looks like the announcement date will be somewhere around Jun. 11. Really the only reason I’m willing to wait around is that this has been a very well managed company over the years. But that’s only as a speculation.

David: So QR is also an energy producer yielding over 10 percent. What makes it so different you’re willing to jump in there?

Roger: I’m glad you got back around to this month’s pick. One reason is just the contrast in fourth-quarter results.

QR didn’t get them out a lot earlier than AvenEx. But output was up 147 percent, proven reserves were up by a like amount and the distribution coverage ratio was 1.5. That’s superior, and it’s also a nice cushion for the dividend with gas prices dropping in the first quarter.

Another reason is the dividend increase this month, which is the second this year and it puts the payout up around 18 percent from what it paid last year.

David: You’re not concerned cash flow is going to plunge this year, after gas prices have fallen so far?

Roger: They’re something like 90 percent hedged on their oil and natural gas sales this year.

Sure, realized prices for gas will come down some, if for no other reason than even prices for hedges have dropped. But it’s going to be far less than it was for AvenEx, which was basically going to be out of hedges this spring.

Also, QR got 76 percent of revenue from liquids in the fourth quarter. That percentage is likely to rise this year, which will further proof cash flows and balance sheet against the impact of falling gas in future years, when all those hedges are at even lower prices.

David: I like the fact that they have a $1.5 billion credit line that was only $500 million drawn at the end of 2011 and that doesn’t mature until April 2017.

Roger: Cash is key to developing resources, and this company–unlike many others–has a lot to tap.

Also, it just did a very successful equity offering (for proceeds of $162 million) that the underwriters exercised their option on. That will pay for a big chunk of the $230 million purchase of Prize Petroleum without running up debt.

And Prize is going to add a lot of oil for QR, which is better priced and safeguards the dividend as well. In fact, Prize is pretty much an all-oil deal as far as revenue goes; it’s 93 percent liquids by volume.

David: There were some accounting weaknesses associated with the initial public offering, which was only a bit more than a year ago. I saw that “material weaknesses” were reduced from 10 to two as of the most recent 10-K filing. But this is clearly not Exxon Mobil (NYSE: XOM).

Roger: The other risk here is this is still a relatively small producer, even with the Prize acquisition, with only 13,000 to 14,000 barrels of oil equivalent per day of output.

Small producers have a lot less margin for error than big ones like Exxon Mobil. But then again, that’s why this one yields more than 10 percent.

There are uncertainties that will only be resolved if this company continues to grow successfully. There was also some talk that QR was paying too much for Prize. That seems unlikely, particularly in an era where $100 oil is still holding. But if we did get a real “Black Swan” event here–like a plunge in oil back to, say, $70–you can bet there will be a lot more second-guessing of management.

David: On the other hand, the places where QR is drilling are hardly high-risk. The Permian Basin is a pretty well worn track, and the company got more than half its fourth quarter output from there.

Roger: That’s always good for revenue stability, as the possibility of dry holes is much less and exploration costs aren’t such a big deal. This we should point out is the basic model exploration and production master limited partnerships have been following as they gain scale, including the most successful ones like Linn Energy LLC (NSDQ: LINE).

David: Are you suggesting QR could be another Linn?

Roger: That would certainly make this an extremely profitable trade. Let’s not forget that Linn was also pretty volatile in its early years, even though it had hedged out production for several years in advance.

Investors still associate small producers with large risks, and the AvenEx experience certainly doesn’t do anything to change that perception.

David: One thing you haven’t mentioned is that production costs have been falling at QR. Fourth-quarter costs were higher than what some people expected, but they were still well off what happened in the third quarter.

Roger: That, again, is what happens when a producer starts to gain scale.

This one has a long way to go to get to the size of even a Linn Energy. But this Prize deal is certainly a step in the right direction. These properties’ proved developing producing reserves–the surest measure for development–is 88 percent, and the decline rate is less than 5 percent a year. Reserve life at current production rates is better than 30 years and QR–following its strategy–has already heavily hedged the output from these properties through 2017.

David: That’s pretty far out in the future. I see these properties are forecast to be accretive by $0.15 or better in the next three years. That’s better coverage for the distribution and probably comes as close to locking in dividend growth as is possible for a producer.

Roger: I would definitely agree.

And QR is an MLP. That means a good chunk of its dividend is going to be tax-advantaged as return of capital. You don’t pay a tax the year you receive the income. Instead it comes off the cost basis and you pay the tax as a capital gain when you sell.

That advantage can really add up if you’re in a high tax bracket, especially considering how high the yield is already.

David: It always astounds me how so many investors don’t understand return of capital. I guess that shows what a nerd I am. But so many people assume that “return of capital” means management is selling the furniture to pay a dividend, when it’s anything but the case.

Roger: Yeah, that’s one I answer all the time for new MLP Profits readers. There are investments where return of capital is indeed piecing off the business as distributions. But I think we’ve made pretty clear here that ROC is an accounting distinction for QR and other producer MLPs.

They’re most definitely growing enterprises.

David: One last thing. I’d like to talk a little about what can go wrong here.

Definitely a big drop in oil prices would hurt, though I guess the hedging will limit the pain for the next few years at least. Obviously, management could overpay for an acquisition, and debt is always something to watch with a small company.

This is also a very new company–the initial public offering was in December 2010–so there’s a limited track record for this enterprise.

And QR has to execute its development plans. That means not only operating existing fields safely and efficiently but also being able to find and acquire new properties to keep dividends growing.

Roger: I think you’ve pretty much summed it up.

The only concern I’d add would be the threat of tough new rules on drilling for oil and gas in the US. That’s certainly what the Sierra Club is campaigning on. That seems to me less of a concern in an election year when the president’s party is being accused of causing high gasoline prices.

But it could well resurface after the vote, depending on who wins.

David: Are these risks priced in? Is the bar so low that QR just showing up will be enough to hurdle it?

Roger: I think anytime a stock yields more than 10 percent there’s a lot of risk priced in.

In fact, it’s pretty clear that despite the dividend increase a lot of investors are still expecting a dividend cut. Do I think QR will have an easy time beating those kinds of expectations? You bet.

On the other hand, there are definitely risks and this is not one for the most conservative investors.

David: More like a BreitBurn?

Roger: Maybe more like PetroBakken if we’re lucky.

By the way, I would not pay more than 21 for this one.

David: Got it. Looks like a wrap.

This month’s high-yield selection, QR Energy LP, is a buy up to USD21.

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