6 high-yield plays in energy

However, the big payouts come with some serious risks.

By InvestorPlace Feb 9, 2012 10:47AM

By Daniel Putnam


While the energy sector typically isn't viewed as a source of yield, there is no shortage of energy-related dividend plays to consider even after the strong gains of the past four months. But not all dividends are created equal. In some cases, investors need to look past the headline dividend number to see if there's more to the story.


With this in mind, here's a look at six of the highest-yielding plays in the energy sector.


Vanguard Natural Resources


Vanguard Natural Resources (VNR) is a lesser-known oil and gas driller with a $1.43 billion market cap. While classified by many data providers as an E&P company, VNR is organized as a partnership and therefore will involve a K-1 filing. But it also offers a high (8.7%) -- and growing -- dividend that places it in the upper reaches of its energy sector peers in terms of yield.


Vanguard is experiencing solid growth and rising earnings estimates, so the dividend is secure. As a kicker, there's room for capital appreciation: The mean analyst price target is $32.58, which is 20.5% above current levels. A measure of patience is in order, however, as Vanguard has been struggling to break out above a falling 200-day moving average. Put this under-followed name on your radar screen, but wait for the technicals to turn positive before making a move.


San Juan
Basin Royalty Trust and Hugoton Royalty Trust


San Juan Basin Royalty Trust (SJT) and Hugoton Royalty Trust (HGT) offer yields in the 7%-8% range based on trailing numbers. The trouble is, both adjust their distributions based on their earnings, which in turn are tied to the price of natural gas. Since natural gas prices have been falling, so too will these royalty trusts' distributions.


SJT and HGT aren't without their merits. Even with lower distributions, both will continue to provide superior yields relative to most other areas of the market. Also, they have fallen to extremely depressed levels that largely reflect the expected reduction in their distributions. As a result, there might be meaningful upside in these names if you're looking for total return -- just be aware that the dividend you see listed is not necessarily what you'll get.


YPF


Argentine energy giant YPF (YPF) looks like a great investment on the surface, with a favorable growth outlook, impressive shale properties and a yield (10.4%) that exceeds its forward price-to-earnings ratio (7.5). However, beneath these numbers lurk hidden political risks. The stock faces the three-pronged threat of government demands that the company increase its domestic production, the possibility that the government also could force the company to slash its dividend, and the potential that its assets could be nationalized (although this appears unlikely).


Absent the political risk, YPF could be a compelling dividend play. As it is, the potential for negative headlines is too high, and the dividend isn't entirely secure given the activist nature of the Argentine government. Keep an eye on this name for future opportunities down the road, but for now be very wary of the double-digit yield.


Transocean


Transocean (RIG) is a controversial dividend play. Its forward yield is 6.4% -- if the company can follow through on its plan to pay a 79-cent quarterly dividend. But there are questions about whether this yield can hold up because of RIG's poor track record of capital allocation and weak earnings results.


From a long-term standpoint, RIG represents an attractive turnaround play in an improving sector, especially now that there is more clarity on its exposure to the Gulf oil spill. Transocean also remains on the deep end of its historic valuation range -- in terms of price-to-book and price-to-sales -- even after its recent rally. However, with the stock up 28% from its December low, caution is warranted at this point. Watch Transocean closely through the remainder of the year to see if it can deliver strong enough results to support the high yield.


SeaDrill


Norway-based deepwater driller SeaDrill (SDRL) used to be a hidden gem in the energy sector, but investors seem to have discovered the stock during the past four months. From an October low of $25.88, SeaDrill has surged more than 50% to the mid-$38 range, and it closed Tuesday just a hair short of its 52-week high.


Despite this strong performance, SDRL shares continue to offer a yield of 8%. The dividend can fluctuate, as Jeff Reeves pointed out in November, but the company's rising free cash flow and strong growth -- it's on track for an earnings per share gain of 13.5% in 2012 -- provide solid support for the dividend to stay where it is or rise from current levels. The shares aren't particularly expensive after the recent rally, commanding just 12 times forward earnings, but SeaDrill has come so far, so quickly, that it likely will pay to wait for a pullback. Be ready to take advantage of any weakness to build a position in one of the top dividend stocks in the energy sector.


And if these are too risky for you, I suggest looking into the following energy ETFs with potential.


As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.


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