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CAPScall of the Week: QR Energy

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For years, satirical late-night TV host Stephen Colbert has been running a series on his show called "Better Know a District," which highlights one of the 435 U.S. congressional districts and its representative. While I am no Stephen Colbert, I am brutally inquisitive when it comes to the 5,000-plus listed companies on the U.S. stock exchanges.

That's why I've made it a weekly tradition to examine one seldom-followed company within the Motley Fool CAPS database, and make a CAPScall of outperform or underperform on that company.

For this week's round of "Better Know a Stock," I'm going to take a closer look at QR Energy (UNKNOWN: QRE.DL  ) .

What QR Energy does
QR Energy is an upstream master limited partnership that has interests in thousands of oil, natural gas liquids, and natural gas wells in eight U.S. states. According to QR Energy's operations website, the majority of its proved reserves and production come from the Permian Basin, which is primarily in Texas, and Ark-La-Tex, which, unsurprisingly, is located in Arkansas, Louisiana, and Texas. These two geographic regions account for 89% of proved reserves and 86% of production.  

QR Energy's most recent earnings report came in early November when it recorded a 1% increase in barrels of oil equivalent produced per day (14,620) and reported a 16% decrease in distributable cash flow due to higher cash interest expense and management incentive fees. It ended the third quarter with a production mix of 43% oil, 42% natural gas, and 15% natural gas liquids. 

Whom it competes against
As you might imagine, the onshore oil and gas exploration and production space is very crowded. When acquiring working interests in wells, QR Energy is forced to go up against industry titans. Occidental Petroleum (NYSE: OXY  ) , for instance, owns twice as much acreage as its closest competitor in the Permian Basin and produced nearly three times as much oil-equivalent barrels as Kinder Morgan, the No. 2 in the region, in 2012. Good luck finding additional working interests there, right?

QR Energy is also forced to overcome negative industry sentiment surrounding the tax status of MLP's and the dividends they pay out. MLP's struggled for most of 2012 under the presumption that the fiscal cliff would necessitate a boost in the way their payouts were treated. Although the fiscal cliff is now a distant memory, the threat of tax hikes on dividends always remains a concern.

The longevity and sustainability of QR Energy's dividend payments is another factor that will greatly influence its price. With natural gas accounting for 42% of total production in the third quarter, stable or rising prices are needed to sustain its distributable cash flow. Investors also need to feel confident that the amount of dividends yet to be received is higher than the current stock price. Given the "newness" of QR Energy (debuting in 2010) I'd say this is quite feasible. This wasn't the case for San Juan Basin Royalty Trust (NYSE: SJT  ) or BP Prudhoe Bay Royalty Trust (NYSE: BPT  ) which were both heavily criticized for being overvalued relative to the remaining life of their dividend payouts. Unless oil prices rise significantly, both San Juan and BP Prudhoe Bay could see production and payouts dip to a point where it's unprofitable for shareholders to purchase these royalty trusts.

The call
After carefully reviewing the prospects for QR Energy, I've decided to make a CAPScall of outperform on the company.

There were three main components that went into my outperform CAPScall. First, QR Energy hedges its oil and natural gas (it does not hedge natural gas liquids) to a greater extent than its peers. Having 95% of QR Energy's 2013 oil and gas production hedged versus its peers' average of 94% in 2013 isn't out of the ordinary; however, by 2017, there's a marked difference with 60% of its oil and gas hedged compared to the industry average of just 13%. More hedging will lead to more stable cash flow and consistent payouts for investors. 

Second, QR Energy's prime production location is conducive to receiving top-dollar prices for its oil. As I highlighted recently with EOG Resources (NYSE: EOG  ) , an oil and gas driller operating out of the Bakken Shale, the allure of spending a bit more to ship its oil by rail past Cushing, Okla., to Louisiana can often result in a significant premium to crude oil sale prices. With 91% of its proved reserves south of Cushing, QR Energy makes for a geographically attractive oil and gas MLP that can easily utilize Louisiana's terminals.

Finally, the expected length of dividend payments makes QR Energy appear undervalued. Based on the company's prospectus in 2010 prior to its debut, it projected a reserve to production ratio of 16 years. Even if oil and natural gas prices remain similar to where they are now, QR Energy will produce a yield in the neighborhood of 8%-12% annually and churn out (as my best guess) a cumulative $25-$32 per share in dividends over the next 16 years. And let's just say that I'm betting on natural gas and oil prices to rise over that same period!

Is this the best oil and gas company worth owning?
It's easy to forget the necessity of midstream operators that seamlessly transport oil and gas throughout the United States. Kinder Morgan is one of these operators, and one that investors should commit to memory due to its sheer size – it's the fourth-largest energy company in the U.S. – not to mention its enormous potential for profits. In The Motley Fool's new premium research report on Kinder Morgan, our top energy analyst breaks down the company's growing opportunity, as well as the risks to watch out for, in order to uncover whether it's a buy or a sell. To determine whether this dividend giant is right for your portfolio, simply click here now to claim your copy of this invaluable investor's resource. As an added bonus, you'll receive a full year of key updates and guidance as news develops, so don't miss out!

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