3 Reasons Why This 10% Yield Is Heading Higher

While most income-seeking investors are familiar with MLP's these days, not as many know about the terrific yields found just upstream from a traditional midstream oil and gas transportation partnership. These upstream oil and gas producers have some of the best yields in the business -- the one I'm going to tell you about today yields nearly 10%.

The company, BreitBurn Energy Partners (BBEPQ), is one of a handful of oil and gas producers organized in a tax-efficient, MLP-type structure. While its peers like LINN Energy (LINEQ) and Vanguard Natural Resources (NASDAQ: VNR) offer similarly high yields, both are currently in the 8% range. While that's a great current yield, BrietBurn's growing 10% yield, is really compelling today.

Before we get to the yield, we have to understand the business. For that we turn to CEO and co-founder, Hal Washburn, who recently said that when he and his partner started the company they:

Had a theory, a thesis, that technology was going to allow us to increase recoveries of oil and gas and we thought that, it would work very well in the United States and that the exodus from United States by all the major oil companies in late 80's was a mistake. We felt that new technologies would allow us to continue to grow production here in United States and so we built the business on the back of that. We acquired interest in large oil and gas fields, embracing technology to increase the reserves, the production, the cash flow and therefore the value.

This basic business model is the same one embraced by both LINN and Vanguard. The idea is to build an income machine on the back of steadily increasing oil and gas production from conventional oil and gas fields in the U.S. To get there, BreitBurn has been buying low-decline assets with enough upside to grow production by investing just a minimal amount of capital. As you can see from the map, the company has assembled a vast portfolio:

Source: BreitBurn Investor Presentation

This creates the base for a stable distribution. From here BreitBurn can invest capital to grow the distribution. These are the three reasons why that will continue to happen in the future.

1. No exploration risk
Despite all the technology and data, oil and gas exploration puts capital at risk. BreitBurn would rather let others take that risk. That's why its watching peers like EnCana (OVV 0.25%) and Devon (DVN -0.89%) spend exploratory capital in the Utica Collingwood and A-1 Carbonate formations in Michigan. Because BreitBurn's acreage is already held by production it can watch as these two drill test wells. This is important because we've seen companies like Shell end up shelling out in excess of $5 billion to explore offshore in Alaska with nothing to show for it. When BreitBurn invests capital, and it's spending $261 million this year, it does so in a way that has an almost immediate payback to stabilize and grow its distribution.

2. Hedging with upside in mind
BreitBurn has a very simple hedging plan which is to hedge 80% of the current year's production and then taper that down to about 50% by year five. Most of its hedges are in fixed-price swaps meaning its locking in production margins. While BreitBurn isn't as hedged as its peers, the company is opening up some of its production to further upside as commodity prices rise. In a rising price environment BreitBurn will benefit by leaving some of its production unhedged as it has enough of a safety net to get it through rough patches.

3. Meaningfully accretive acquisitions
The real driver of future distribution increases is its ability to acquire mature production assets. BreitBurn is targeting to have best-in-class distribution growth of 5% annually and to hit that target the company needs to close $500 million in deals this year. However, these must be highly accretive deals which is where discipline comes into play. Last year the company screened 500 opportunities and only bid on 20 while closing just seven for $600 million. That amount is more than enough to move the needle as long as those assets meet its criteria. For example, $500 million in asset acquisitions that meet its criteria which are funded with a balance of debt and equity can yield meaningful accretion of $0.21 per unit in distributable cash flow. That's really the key to sending its 10% yield even higher. 

Foolish bottom line
The good news is that there is a robust acquisition market for the very assets that BreitBurn is seeking, which speaks well for its ability to succeed in its plan. With its capital budget designed to slowly grow its production, and its hedge book open to upside, it's easy to see why this 10% yield is heading higher.