High-Yield Oil Stocks: Is Vanguard Natural Resources' 8.9% Yield Too Good to be True?

By Markets Fool.com

Vanguard Natural Resources (NASDAQ: VNR) is a favorite among high-yield income investors for its generous monthly distribution. However, back in February the oil crash forced the MLP to slash its payout 44%, and investors are understandably nervous about the sustainability the new distribution is in a world of lower energy prices. To answer that question we need to look at three factors: Vanguard's latest distribution coverage ratio, recent changes to its hedging portfolio, and its two most recent acquisitions.

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Latest quarter's results: distribution finally sustainable

Metric Q1 2015 Q2 2014 Percentage Change
Total production (billion cubic feet/day gas equivalent) 35.5 24.1 47%
Distributable cash flow $32.4 million $41.8 million (22.5%)
Common units outstanding 84.5 million 79.9 million 5.8%
Common unit distribution coverage ratio 1.09 0.83 31.3%

Source: Vanguard Q1 earnings release.

Vanguard's first quarter results were actually pretty good. Thanks to a solid hedging portfolio, much higher production, and lower distribution, the MLP's distribution coverage ratio soared to a thoroughly sustainable level,despite a 51%, 47%, and 66% decline in the average price of oil, natural gas, and natural gas liquids, respectively.

New hedging portfolio
To help it protect the new, lower payout, Vanguard is conserving cash by reducing 2015's capital expenditures by 20%, all of which is designed to simply maintain production at current levels.

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In addition, in January management reshuffled its hedges, to better smooth out and protect future cash flows from energy volatility. The new hedging portfolio became:

Source: Vanguard Q1 earnings release

As this table shows, Vanguard's new hedges provide excellent protection for 2015, but starting in 2016 the MLP's exposure to oil prices rises drastically. Luckily for investors, Vanguard's latest two acquisitions -- the $614 million purchase of Eagle Rock Energy Partners (NASDAQ: EROC) and the $539 million acquisition of LRR Energy (NYSE: LRE) -- improves Vanguard's hedging positions even further.

Source: Eagle Rock merger investor presentation.

Merger mania: Deals make sense BUT there's a catch
Speaking of Vanguard's latest big acquisitions, let's look at whether they make sense for Vanguard investors and might help it better sustain its new distribution or even grow it in the future.

The first thing to know about these purchases is that they are funded entirely by common units and debt assumption.

  • Eagle Rock investors get 0.185 Vanguard units for each unit of Eagle Rock they now own, which will create 27.6 million new Vanguard units.
  • LR Energy investors get 0.55 Vanguard units for each unit of LR Energy they currently hold, which will create 15.4 million new Vanguard units.

All told, these acquisitions will increase Vanguard's unit count by 43 million, or 51%.

On the other hand, the new, larger Vanguard will boast 26%, 31%, and 47% greater reserves, production, and revenue, respectively, and management believes that these purchases will be neutral to distributable cash flow per unit in 2015, despite the large dilution, and accretive to DCF per unit beginning in 2016.

In other words the short-term effects of these latest purchases are neutral in terms of distribution safety. Barring a sharp energy price recovery in 2015, investors shouldn't expect a possible distribution increase until 2016, when the accretive nature of the acquisitions take effect.

Bottom line:Vanguard's new payout is safe but don't expect short-term payout growth
Vanguard has an impressive track record of growing reserves, production, and revenue through acquisitions. In fact since 2008 it's closed 25 deals worth a total of $4.8 billion.However, while the current payout appears sustainable, because these two most recent deals create so much unit dilution Vanguard investors need to be patient and realize that distribution growth is still likely a few quarters away -- assuming energy prices don't decline from their current levels.

The article High-Yield Oil Stocks: Is Vanguard Natural Resources' 8.9% Yield Too Good to be True? originally appeared on Fool.com.

Adam Galas has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.