Why Now: LRR Energy (NYSE: LRE) posted a distribution coverage ratio of just 0.85 times for the fourth quarter of 2012. But the full-year figure for 2012 was 1.03 times.

Production numbers suffered in comparison to the third quarter due to volatility associated with newly drilled wells as well as an unexpected equipment failure. But January and February results suggest this small oil and gas producer will meet its output targets for 2013.

And LRR just announced its second consecutive quarterly distribution increase, a modest boost from USD0.4775 per unit per quarter to USD0.48. That’s a good sign this master limited partnership (MLP), which completed its initial public offering on the New York Stock Exchange in November 2011, is confident in its ability to grow output, manage its hedge book and control costs.

A recent follow-up offering of 6 million units has taken the unit price down from a mid-February peak above USD19. The stock traded as high as USD20.84 a little more than a year ago and as low as USD12.34 in June 2012. In mid-November, when the broader market had sold off as well, the MLP hit USD16.05 on a closing basis.

That’s probably the short-term potential downside. The medium-term potential upside is near USD20. Couple that with the USD0.48 quarterly distribution–which will tick higher if management executes–and we’re looking at a solid Big Yield Hunting candidate.

Buy LRR Energy under USD18.

The Story

The market feels frothy after a 15 percent rally off the mid-November near-term low. But traditional valuation metrics suggest, still, that this now four-year rally off the March 2009 Great Financial Crisis nadir is still very much un-loved, with high yield stocks being viewed with particular skepticism.

Hunting for big yields in this environment is definitely treacherous. The types of stocks we identify in this service–high-risk, high-reward–are the first and greatest sufferers when, for example, the market goes overboard reacting to news from Cyprus’ troubled banking sector and the potential impact on the European Union.

And once tagged “vulnerable,” it’s very hard to get off the deck.

We have, however, focused on an oil and gas exploration and production master limited partnership (MLP) whose double-digit yield is the function of a generous payout rate, the sale of a large block of units by its sponsor and a mildly disappointing earnings report that was driven by factors well within the ability of management to correct in 2013.

David: I guess it’s a horrible sort of disclaimer to say right at the top that I don’t feel particularly great about anything that’s trading with a yield in the double-digit range, or even close to it, right now.

Roger: I know what you mean. We’ve seen enough dividend cuts lately from a range of sectors that any stock that shows signs of vulnerability is going to attract that much more attention.

Stocks with yields as high as 10 percent–or even close to it, as you say–are already under some scrutiny, with the expectation that a dividend cut is soon to come.

I’ve been particularly impressed by the high levels of shorting of big-yield stocks. That’s not to say these guys are any better informed than investors on the long side. But there is a certain logic to it from a trading point of view.

Mainly, whenever a company cuts a dividend, its stock is going to get dumped en masse. In fact there’s going to be selling across the sector. Even if you guess wrong on the individual company you short, you can have an opportunity to cash out at a profit.

And let’s not forget that the significant rally since mid-November means expectations have risen as well. Even if a company is sound, its stock will be punished if there’s a misstep, and hard.

David: Yeah, that’s a good point: The market–“the market” being the S&P 500–is up about 15 percent since Nov. 15, 2012, but there are still a lot of stocks with high yields out there. That gives us a lot of targets, sure, but a lot of them–too many of them–have significant flaws that I just can’t look past.

Even this up-leg in what’s now a four-year rally couldn’t carry them.

At the same time, however, the S&P’s valuation at these levels is well within a reasonable range. There’s a lot of bullish sentiment–in fact January in-flows for equity funds was the highest it’s been in years. The USD20 billion surge still pales in light of the USD600 billion that flowed out during the six years through 2012.

Bearish sentiment is also remarkably high. People are still looking over their shoulders at 2008-09, and people are still suspicious about the Fed’s “quantitative easing” and what it’s doing to equity valuations.

But Bloomberg reported on Monday that, even after US stocks have more than doubled since March 2009, the S&P is cheaper than at any record high since 1980, trading at 15.4 times reported profit. That compares to an average of 19.9 in bull markets since 1962.

And, not for nothing, the Conference Board’s Index of Leading Indicators posted another solid reading, and the four-month moving average is trending upward, so it appears we’re heading away from as opposed to into another recession.

I feel like I’m trying to talk myself out of my relative pessimism.

Roger: Stocks, including those of high yielding companies, have basically been tracking the economy’s ups and downs since this bull market began back in March 2009. So there is reason for some optimism that stronger economic growth this year could push them higher.

Ironically, it’s been robust economic growth that’s ended past bull markets. That’s because it gets harder to grow profits when all the slack in the labor and commodity markets is soaked up and when the velocity of money pushes up its cost, i.e. interest rates.

I don’t think we’re there yet. But the more things improve with the economy, the closer that day will come.

On the bright side, fewer concerns about the economy will almost certainly mean a lift for the kind of high yielding stocks we recommend in this service. But this does provide us an opportunity to reiterate once again–or make a disclaimer–about what we’re doing here, and that is making high-risk, high-potential-reward bets.

Big Yield Hunting is not for the risk-averse. In fact, although I wouldn’t go so far as to say it’s for thrill-seekers, I would say that anybody who doesn’t have a solid, diversified portfolio of essential-service utilities, MLPs that derive cash flow from fee-based operations, Australian and Canadian companies with clearly identifiable revenue and cash flow steams–and all of these with strong balance sheets–has no business here.

The positions we recommend, in other words, are for your speculative money.

David: I agree, although I think younger investors, early-career professionals who are contributing to 401Ks and IRAs, also have the long-term earnings horizon that means they can take on more risk.

Roger: That’s a good point. But, at any rate, it boils down to understanding what kind of investor you are and having a good grasp on your financial goals. We don’t want anyone building their retirement plan or trying to fund their child’s education on Big Yield Hunting.

David: Alright, having said all that, I do like LRR Energy LP’s (NYSE: LRE) medium- and long-term prospects, even if I am skittish about the possibility of a meaningful–read: double-digit-plus–correction for the broader market in the short term.

Roger: I was impressed by the fact that management just boosted the distribution. I also like the recent acquisition, and the units are trading lower this week after a new offering of 6 million units by it and the MLP’s sponsor, Lime Rock Resources. And let’s not forget this is one of those companies that hasn’t rallied much precisely because of concerns about the economy.

I don’t know if I would go so far as to call LRR countercyclical–its fortunes are clearly tied to energy prices and, by extension, the economy, and that’s pretty much the classic definition of a cyclical stock.

But it does have the potential to do much better when the economy does roll back, and I think it’s one high yielder that will soar then no matter what happens to interest rates.

David: This is another small oil and gas producer: LRR reported full-year 2012 average production of 6,303 barrels of oil equivalent per day (boe/d) and fourth- quarter output of 5,935 boe/d. The former was in line with guidance, while the latter, though down 11 percent sequentially, was “generally consistent,” in management’s words, with internal forecasts.

Most of that decline was expected and due to the “flush production” decline of its Red Lake wells drilled during 2012. “Flush production,” or “transient flow,” happens during the early life of a well, when the reservoir boundaries haven’t been felt, and the reservoir is said to be “infinite-acting.”

In other words, they just haven’t defined the long-term production potential yet.

Fourth-quarter distributable cash flow (DCF) was USD9.2 million and distribution coverage was 0.85 times. For 2012 DCF was USD44.1 million and distribution coverage was 1.03 times.

An effective hedging program helped LRR realize an average natural gas price of USD5.14 per million British thermal units (MMBtu) versus an average Henry Hub price of USD3.40. The average realized oil price was USD90.60 per barrel, compared to an average New York Mercantile Exchange price of USD88.17.

Roger: Those are pretty solid numbers for what amounts to a start-up. But it’s pretty easy to see why the unit price has been so volatile over its very brief history. People are still trying to figure out what LRR is worth.

One benchmark we can keep an eye on is management’s plan to spend USD50 million to USD100 million on acquisitions during 2013. That’s aggressive for a company with a market capitalization right now of just USD436 million.

If they succeed, they think they’ll push their distribution coverage to “at least” 1.2 times, and that should mean more quarterly growth. If not, well, that will be the time to reassess this trade.

The good news is in January LRR closed on the USD21 million purchase of oil and natural gas assets in the Mid-Continent region of Oklahoma from Lime Rock–a so-called drop-down acquisition. The MLP also acquired in-the-money hedges worth approximately USD1.8 million as of the closing date. The company made USD88 million of acquisition announcements during 2012. That’s a nice record of success. And given the turmoil in the energy patch now, the company should be able to find targets.

As for the distribution, it was raised to USD0.48 per unit per quarter, or USD1.92 on an annualized basis, from USD0.4775, or USD1.91. It’s a modest boost, but every little bit counts. And I think management has sent a nice signal with its second quarterly boost–the best possible sign of management’s confidence in its ability to execute on its growth plans.

David: And the recent Oklahoma purchase should help smooth out the production blip we saw in the fourth quarter, no?

Roger: Let’s wait and see. That would certainly help the stock price around about May 7, which is when Bloomberg expects them to report first-quarter results. But this exposes one of the problems of dealing with small oil and gas producers: Work–or, as it were, lack thereof–at one project can really put a dent in overall operating and financial numbers.

The Red Lake project, which included 15 wells drilled and completed in August 2012, produced at a higher-than-expected initial rate. But it also showed faster-than-expected decline rates, which, along with a planned drilling slowdown as well as an unplanned compressor failure at another field, made overall fourth-quarter output come in 2 percent below forecast. Failure to get decline rates under control at key projects has doomed more than a few smaller producers.

David: The fourth-quarter production mix was 56 percent natural gas, 31 percent oil and 13 percent natural gas liquids (NGLs). Liquids were the focus of the 2012 development plan, and fourth-quarter oil and NGLs output was up from 35 percent of the total from the year-ago quarter.

Management expects that, based on its 2013 capital program and projects for natural gas prices, its mix will tilt even further to liquids through 2013.

Roger: The greater reliance on gas is a real difference with some of the other Big Yield Hunting energy producers we’ve featured here, such as BreitBurn Energy Partners LP (NSDQ: BBEP).

Frankly, I’d like to see more oil output right now, as it’s a global commodity. And as you know, low NGLs prices have laid a big hurt on Bonavista Energy Corp (TSX: BNP, OTC: BNPUF), for example, though price differentials–the difference between prices Canadian crude gets on the open market versus what US crude fetches–have had at least as much of an impact there.

We’re still up in that trade, and I think LRR is actually a bit better positioned. As of Dec. 31, 2012, LRR’s estimated net proved reserves were 27.9 million boe, 85 percent of which were classified as “proved developed.” Sixty-one percent are located in the Permian Basin, 27 percent are in the Mid-Continent and 12 percent are in the Gulf Coast region.

Forty-seven percent were liquids. Based on fourth-quarter average daily production the company’s production-to-proved reserves life is 12.9 years.

Based on standardized measurements the value of these reserves was USD325 million at year-end 2012. LRR has a market cap, as of March 22, of USD435.2 market cap

David: Fourth-quarter lease operating expenses decreased 21 percent sequentially to USD5.5 million, or USD10.05 per barrel of oil equivalent (boe), from USD6.9 million, or USD11.29 per boe.

So that’s a positive trend, and the raw figure looks good as well.

As for first-quarter 2013 production, estimated output for February averaged 5,900 boe/d. January and February production were hurt by the previously noted compressor failure. According to management, this compressor failure will take a 109 boe/d bite out of production.

But the overall lost output is less than 1 percent of expected 2013 revenue. And management is “still confident” in its 2013 production guidance of 6,200 to 6,500 boe/d.

The forecast for operating expenses is between USD10 and USD10.50 per boe

Management noted at the end of the presentation portion of its fourth-quarter and full-year 2012 conference call that it has USD205 million outstanding on its revolving credit facility and USD50 million outstanding under a term-loan facility. There’s USD45 million available to support CAPEX and the distribution.

Roger: The real key here is what happens to production and if our assumptions it will recovery prove accurate. And I think that’s going to depend heavily on how effectively LRR executes on its acquisitions and, just as important, how it finances them.

Incidentally, I am encouraged that the unit price has bounced back a bit from where it priced the equity offering this week. That’s always a good sign.

David: LRR has four “buy” recommendations and five “holds” on Wall Street, with no “sell” recommendations. The average 12-month target price, based on forecasts from six of the nine analysts who cover the stock and also provide such a figure, is USD19.83, with a high of USD24 and a low of USD18.

The MLP was changing hands at USD17.05 when I wrote this. The implied price-only upside from here based on the average target for March 2014 is about 16 percent.

If you include four distributions at the current rate of USD0.48 per we’re talking about a 27.5 percent 12-month total return.

Roger: Well, that’s reasonably conservative, but again I want to caution people that it all goes out the window if energy prices take a dive this year or management’s plans to boost production flounder. Analyst sentiment is a useful tool, and certain among them sometimes offer compelling insights. And a line of 4-5-0 is not at all bad for a small energy producer in this environment, given the many crackups we’ve seen already. But even these guys can miss things. Let’s not hang our hat on that rack.

And most analysts are primarily focused on capital appreciation and don’t necessarily have the same focus on dividend sustainability and growth that is our bread and butter.

But this is encouraging. Despite its relatively short track record, the No. 1 thing that sticks out to me is the January distribution increase.

David: What would you say are the benchmarks we should be looking at for first-quarter 2013 reporting season?

Roger: Like I said, production needs to approach the full-year 2013 guidance range, and I want to see that in the first quarter. I’d also like to see costs within forecast. And I’d like to see progress getting the distribution coverage ratio back above 1-to-1.

Of course, one or two more accretive acquisitions would be a giant step toward all those things. But as I don’t sit on LRR’s board, I’m going to have to wait to see what happens on that score.

David: That’s what we’ll be looking for, then, on or about May 7, when LRR should post results. LRR Energy–yielding 11.2 percent at these levels–is a buy under USD18.

Roger: I think it’s a good shot, which is what we’re looking for in this service. Before we close, let’s take a brief look at the other open positions.

I was happy with the earnings report from PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF), which again affirmed management’s commitment to the current dividend rate.

The company also appears to be dealing as well as could be hoped with the challenge of oil-price differentials in Canada, and it’s getting more efficient with production–though the rate of growth in 2013 will be somewhat less than last year at 8 percent to 12 percent.

We’ve had at least some of the wind taken out of our sails by the slump in the Canadian dollar. That’s always the risk when you go outside the country for yield. But I think we’ve gotten back into this one at a good price.

David: There are still a lot of bearish voices on this one, with most of the critique stemming from the idea management should use its cash to pay down debt rather than pay such a big dividend.

But I though management did a good job during the call of explaining why the payout is really not such a burden in terms of cash outlay.

Like you said, it really does all boil down to energy prices. But barring a big drop this one looks set to maintain its dividend, and when the market mood lifts a bit we should get that capital gain we’re looking for.

You mentioned BreitBurn earlier in our conversation. We’ve had that position open a long time for this service, since November 2011. The stock is up a bit but what’s impressed me is the 11 consecutive quarterly dividend increases.

Roger: Yeah, they’re doing a lot right in rough environment.

I’ve heard a lot of readers talk about California oil and gas as a good play given the geographic isolation, and the stock may be outperforming its sector precisely for that reason.

What’s important for use is the 7 percent production boost in the fourth quarter, the way the company topped its acquisition targets in 2012 (USD600 million-plus) and its ability to secure stable prices for output.

That’s a formula for more dividend growth. And while this is really not a long-term service, I think we need to stick with BreitBurn.

David: So buy up to USD20 for Breitburn and USD10 for PetroBakken. What about QR Energy LP (NYSE: QRE)?

Roger: It’s tough to tell if distribution growth has stalled at this master limited partnership or not, and I think that’s what’s weighed on the unit price lately.

Again, fourth-quarter results were solid, and guidance for 2013 was pretty much on. They boosted reserves 22 percent in 2012, and oil by 43 percent.

Full-year output growth wasn’t exciting at 5 percent but still steady and, more important, distributable cash flow covered the dividend by a solid 1.2-to-1 ratio.

Debt doesn’t seem to be a problem, and the company was able to do almost USD600 million in accretive acquisitions last year.

A lot boils down to price, but I think we’re OK here.

David: So keep the buy on QR Energy at USD21.

We talked briefly about Bonavista earlier. My thought is we should keep it for now. It’s been wacked by lower NGLs prices, but it has a great reserve base, the dividend is in no danger, there’s no real balance-sheet pressure, and we really did get it at the bottom.

Roger: Agreed.

Shifting gears a bit, I think we should cash out of our longest-held recommendation, Capital Products Partners LP (NSDQ: CPLP).

The unit price is below our initial entry but is well above our buy target, and we have a total return of about 15 percent.

More important, I’m just not all that sanguine on this business in the near term.

It hasn’t raised its distribution since late 2010, and everything you read about the company is about “supporting” the distribution, not raising it.

The conference call this week was predictably upbeat, with management even promising distribution growth “as the underlying market recovers.” But it has nine tankers coming up for renewals in the next few months. They may get good rates for all of them, and the recent acquisition is a positive.

But let’s take our money off the table for now. If they don’t re-contract well, we all know what will happen to the distribution and unit price.

David: OK, so sell Capital Product Partners.

I’ve been thinking the same thing about Tabcorp Holdings Ltd (ASX: TAH, OTC: TABCF). I can’t help thinking how I should have pulled the trigger in August 2012 when it was above USD3.50. It’s now at USD3.30, but isn’t necessarily showing any signs of breakdown.

Roger: It’s a solid company to be sure. But it’s also well above our buy target, and the Australian dollar has just recently surged. Now that we have a 20 percent-plus profit again, why don’t we take what the market gives us? If you’re right about the trading range, we will almost certainly have another opportunity to play.

David: I hate that advice, but it is my instinct. Sell Tabcorp Holdings.

It also makes me think of the paper profit we had in Aditya Birla Minerals Ltd (ASX: ABY, OTC: ABWAF) last month. Now that company is shutting in one of its higher-cost copper mines to wait for better pricing. I should have gotten out.

Roger: Well, we did counsel people not to buy more at that price at least.

Look, copper production is a very volatile business. This is a good company, and looking at the chart we’re going to have another shot to take a profit. No hair-shirts here.

It looks like we’re something of a net breakeven on our two coal plays. Natural Resource Partners LP (NYSE: NRP) is up while Rhino Resource Partners LP (NYSE: RNO) is down a bit. There’s no change to either’s distribution since we’ve held them.

My sense though is the fact that Rhino did cut is holding down its price. I think we got both of these cheap. I have to say, coal market conditions haven’t improved, and there’s a risk they won’t in 2013 either, unless gas can push up another buck or so from here.

David: It really does boil down to maintaining distributions. But so long as we’re selling stocks here, why don’t we get rid of the softy and keep the harder target.

Roger: I assume you mean unloading Rhino and sticking with National Resource Partners. I agree with that. I think this was a good idea last year, and we did get them at a low price.

But if the coal market stays on its back for most of this year, I think we definitely want to be with the stronger play.

David: So sell Rhino Resource Partners.

Just two more to talk about here. Cushing MLP Total Return Fund (NYSE: SRV) is up a bit since we got in Nov. 15, 2012. It’s also above our buy target slightly.

What makes me a bit nervous is that we haven’t seen a much bigger gain given the kind of rally we’ve seen for MLPs in general. The Alerian MLP Index, for example, is up 18.7 percent over that time. That’s three times the gain in a fund that’s supposed to be leveraged.

The expense ratio is up to 4.3 percent, and the fund is selling for a premium of 14.1 percent to its net asset value.

Roger: Those numbers are all worse than what we saw when we entered this trade. On top of that, most of the fund’s top 10 holdings as of Dec. 31 have raised dividends since, and the fund’s payout remains the same as when we bought in. We had a bigger profit last month, but I think we should take what we have.

David: Discretion is always the better part of valor. Sell Cushing MLP Total Return.

I assume you’re going to want to stick with Windstream Corp (NYSE: WIN)?

Roger: One should never assume anything when it comes to high-yield stocks.

But yes, I think we need to let this one run a while.

There’s been no hard news since we recommended it last month. But there’s been plenty of hand-wringing, and short interest is astounding at 12 percent of float, with 6.8 days to cover based on average daily trading.

Look, there are no sure bets here. But this one is really pretty simple. The bears are betting heavily that Windstream will have to follow the lead of CenturyLink Inc (NYSE: CTL) and the other wireline companies that have had to cut dividends due to eroding revenue.

Our bet is that the company’s revenue picture will improve, as broadband rises from its current level of 70 percent of revenue, and that will enable stable free cash flow coverage of dividends.

Windstream’s fourth-quarter revenue was down about 1 percent year over year. But management’s made a pretty good case for why that will turn stable or even positive in 2013 and decisively so for 2014. Making that benchmark is the key to maintaining the dividend.

By contrast, CenturyLink’s fourth-quarter revenue was off 1.7 percent, and the rapidly eroding traditional phone business is still more than half of overall sales.

My point is again no guarantees, but we are starting from a much better point with Windstream.

This is not the same kind of company as CenturyLink. It can still fail to perform and cut the dividend. But if so, it will flounder for different reasons.

David: Well put. And that’s a rap.

• December 16, 2010: Capital Product Partners LP (NSDQ: CPLP)–SELL
• November 18, 2011: BreitBurn Energy Partners LP (NSDQ: BBEP)–Buy < USD20
• April 20, 2012: QR Energy LP (NYSE: QRE)–Buy < USD21
• May 17, 2012: Tabcorp Holdings Ltd (ASX: TAH, OTC: TABCF, ADR: TACBY)–SELL
• August 24, 2012: Natural Resource Partners LP (NYSE: NRP)–Buy < USD22
• September 21, 2012: Rhino Resource Partners LP (NYSE: RNO)–SELL
• October 19, 2012: Aditya Birla Minerals Ltd (ASX: ABY, OTC: ABWAF)–Buy < USD0.50
• November 16, 2012: Cushing MLP Total Return Fund (NYSE: SRV)–SELL
• December 20, 2012: Bonavista Energy Corp (TSX: BNP, OTC: BNPUF)–Buy < USD15
• January 17, 2013: PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF)–Buy < USD10
• February 22, 2013: Windstream Corp (NYSE: WIN)–Buy < USD11
• March 22, 2013: LRR Energy LP (NYSE: LRE)–Buy < USD18

• August 19, 2010: New Flyer Industries (TSX: NFI-U, OTC: NFYIF)–SELL (06/16/11)
• September 16, 2010: Avenex Energy Corp (TSX: AVF, OTC: AVNDF)–SELL (06/22/12)
• October 22, 2010: Otelco (NYSE: OTT)–SELL (09/21/12)
• November 18, 2010: Telstra Corp Ltd (Australia: TLS, OTC: TLSYY)–SELL (06/16/11)
• January 20, 2011: Cellcom Israel Ltd (Israel: CEL, NYSE: CEL)–SELL (08/18/11)
• February 22, 2011: DUET Group (Australia: DUE, OTC: DUETF)–SELL (08/18/11)
• March 17, 2011: Chorus Aviation Inc (TSX: CHR/A, OTC: CHRVF)–SELL (12/16/11)
• May 19, 2011: The DATA Group Income Fund (TSX: DGI-U, OTC: DGPIF)–SELL (03/23/12)
• June 16, 2011: FP Newspapers Inc (TSX: FP, OTC: FPNUF)–SELL (12/16/11)
• August 31, 2011: Zargon Oil & Gas Ltd (TSX: ZAR, OTC: ZARFF)–SELL (12/16/11)
• September 15, 2011: Alaska Communications (NSDQ: ALSK)–SELL (12/16/11)
• October 21, 2011: PetroBakken Energy Ltd (TSX: PBN, OTC: PBKEF)–SELL (09/21/12)
• December 16, 2011: Telefonica SA (NYSE: TEF)–SELL (09/21/12)
• January 23, 2012: Inergy LP (NYSE: NRGY)–SELL (06/22/12)
• February 16, 2012: Arrium Ltd (ASX: ARI, OTC: ARRMF)–SELL (09/21/12)
• March 23, 2012: Capstone Infrastructure Corp (TSX: CSE, OTC: MCQPF)–SELL (06/22/12)
• April 21, 2011: Superior Plus Corp (TSX: SPB, OTC: SUUIF)–SELL (11/16/12)
• July 22, 2011: France Telecom (France: FTE, NYSE: FTE)–SELL (11/16/12)
• June 22, 2012: Data Group Inc (TSX: DGI, OTC: DGPIF)–SELL (11/16/12)
• July 20, 2012: CSR Ltd (ASX: CSR, OTC: CSRLF)–SELL (11/16/12)