Another Huge Dividend Play

I highlighted CVR Energy Partners (NYSE: UAN) for Fool.com readers a few months ago. Since then, the stock climbed as much as 69% before settling back during the recent market malaise. Still, it continues to be up a solid 17% (plus 10% more today) while the market is really hurting. The stock has held up so well because of its huge yield, which I peg at more than 9%, and I think it still has plenty of upside, too.

Today, I'm back to find another stock just like it. A fat dividend that drives the stock price higher is one of my favorite kinds of special situation. Get ready to meet the latest such candidate I've discovered.

I like big dividends and I cannot lie
The company is Eagle Rock Energy Partners LP (Nasdaq: EROC), a U.S.-based partnership engaged in transporting natural gas and natural gas liquids (the midstream business) and developing and acquiring interests in oil and gas properties (the upstream business). The company's stated goal is to grow its business in order to increase cash distributions to its unitholders. (That's what owners of publicly traded partnerships are called.)

The midstream business is located in five significant natural-gas-producing areas around Texas, Louisiana, and the Gulf of Mexico. Its system here includes 5,482 miles of pipeline and 737 million cubic feet per day of processing capacity. The midstream segment provides Eagle Rock with relatively stable volumes, plus cash flows with the potential for growth.

The upstream business has long-lived properties in Alabama and Texas, including 273 operated wells and 137 non-operated wells, with about 5,000 barrels of oil equivalent a day, and proved reserves of 38.4 billion cubic feet of natural gas and 8.7 million barrels of crude oil. With commodities as volatile as they are -- particularly in the upstream business -- the company locks in higher prices when it can to escape the brunt of declining prices in the future, and stabilize its cash flows going forward.

As for its growth plans, the company tries to leverage its existing midstream infrastructure, but also looks for opportunities in brand-new projects outside its infrastructure. Eagle Rock is expanding its plant in the Granite Wash play -- one of the most active drilling sites in the U.S. -- from its current 50 million cubic feet per day capacity to 80 million, and it should be completed by the end of the year.

In the upstream business, the company relies on infill drilling -- tapping the spaces between existing well sites to eke out overlooked pockets of gas and oil -- and recompletion -- repairing and restoring wells to get them back in production -- to drive organic growth. It's also looking for smart acquisitions. In its most recent quarter, Eagle Rock acquired Tulsa-based natural gas producer Crow Creek Energy, helping to boost its natural gas segment's operating income by 102% in the second quarter. The company targets a rate of return of 18% and 20% on its midstream and upstream operations, respectively.

Eagle Rock's senior management team has an average of about 20 years of related experience, and those managers own significant stakes in the company.

And then there's that distribution...
Eagle Rock upped its distribution by 25% between its first and second quarters, to $0.1875, or $0.75 annualized. At Eagle Rock's current price, that implies a yield of 7.2%, a figure that sits comfortably above some of its peers in the publicly traded partnership space:

Source: Capital IQ, a division of Standard & Poor's.

These comps suggest that an average yield might be 6.4% in the partnership space, about in line with what I've shown and read elsewhere. Either way, the stock's upside on this year's yield could roughly range from 6% at minimum to as much as 24%.

I'm more interested in management's intention to up the dividend later this year, and on into 2012. Eagle Rock has suggested that annualized distributions could reach $1.00 per share by the close of next year. Using multiples like those above would put the stock's upside at 42% to 66%. If the company can deliver on its expectation, the stock could be in for a good run.

I'm also encouraged to see that the top three company insiders have added to their stakes since March 31, with each now holding more than 200,000 shares.

And then there are the risks...
Like any investment, this one isn't without its perils. My thesis hinges on Eagle Rock increasing, or at least maintaining, its dividend. That means Eagle Rock needs to tread carefully in the volatile energy market. While the company has about 80% of its oil hedged at $75 a barrel, and almost 100% of gas at $5.96 for the rest of 2011, it still does rely on high prices to keep the cash flowing in. It has hedged more than 70% of 2012 production at still higher prices.

Liquid capital markets are also vital for Eagle Rock, since it must finance strategic transactions through either stock or debt issuance. The company has already stated that it needs "substantial new capital" in order to realize its growth plans. Any seize-up in the markets could leave Eagle Rock unable to raise funds and boost its payouts.

Also, Eagle Rock uses hydraulic fracturing, or "fracking," in its natural gas drilling program. The process is controversial because of potential environmental damage, and many states and the federal government could more stringently regulate the process, increasing its costs. Other investments to meet environmental compliance could also lessen distributable cash.

Last, because Eagle Rock is a limited partnership, some investors want to avoid the more complicated tax calculations that its status creates. For investors who don't mind, that just spells greater opportunity and a fatter distribution.

Foolish bottom line
With a yield that's about 7.2% at current prices, Eagle Rock shares seem to have room to run in order to reach yields that are more comparable to its peers'. But given the nature of its volatile business, Eagle Rock might not be for everyone, especially income investors who need absolutely unquestionable and growing dividends quarter after quarter.

For those who demand such stable payouts, I invite you to take a look at 13 other dividend stocks in a free report from The Motley Fool called "13 High-Yielding Stocks to Buy Today." Hundreds of thousands have requested access to this special free report, and now you can access it today at no cost. To get instant access to the names of these 13 high yielders, simply click here -- it's free.