Tempted By a Yield That's Over 8%? Read This First!

As an investor, you've likely found out the hard way that not all companies operating in the same sector offer similar risks or rewards. Sometimes your idea can be right, but you make the wrong stock selection, which can wreck your returns. That's why it's as important to pick the right stock not only to benefit from a long-term trend but also to fit within your risk tolerance. 

One sector where there is a diversity of risk profiles is in the upstream oil and gas MLP space. While known for their high yields, it's important that you don't judge an upstream MLP by yield alone. That's easy to do because as you can see from the chart below, these yields can vary significantly:

What's not obvious when looking at these yields is why there is any disparity at all. That's why it's important to drill down a little deeper into each company to see what sets them apart. Specifically, there are three important areas to look at in order to get a better idea of how safe and reliable those yields will be in the future. 

Reserve mix
An oil and gas MLP is only as good as the reserves it has in the ground. These reserves play a key role in how much future margin each company can capture as its reserves are produced. As you can see in the chart below, reserve mix does vary significantly from one company to another:

Sources: Company Investor Presentations and Author Calculations

What's pretty evident is that as an investor you have three choices. You could choose a liquids-focused company like QR Energy, balanced producers like LINN and BreitBurn, or the natural-gas-heavy names like Vanguard or EV Energy. If you are of the opinion that natural gas price will be heading higher in the future, then you would enjoy more potential upside by investing in those companies with larger natural gas reserves. On the other hand, if you like balance in your life, then investing in a company with a balanced reserve mix makes sense.

What's important to note here is that reserve mixes tend to shift over time as new assets are added into a company's portfolio. Vanguard, for example, has gone from 100% gas at its IPO, to just 35% gas a couple of years ago. Its natural gas reserves now constitute the majority of its portfolio as the company has taken advantage of the dip in natural gas prices to pick up cheap gas assets. On the other hand, both LINN and BreitBurn have been acquiring oil reserves, as both are looking to counterbalance lower natural gas prices with higher margin oil so today's mix might not be the same a year from now. 

Geographic diversity
The location of a company's reserves is the driving factor in determining whether those reserves are more oily or tend to be on the gassy side. The chart below shows two important differentiations – you'll get a good picture of how geographically diverse each company is, as well as see in which basins each is most levered.

Source: Company Investor Presentations and Author Calculations

The first thing that jumps out is how levered EV Energy is to the gassy Barnett Shale which explains why the company's reserves are so gas-heavy. The other thing you'll notice is how important the Mid-Continent region currently is to LINN Energy's reserves. In LINN's case it will greatly improve its geographic diversity once the company completes its deal for Berry Petroleum, which will add more geographical balance by adding to LINN's positions in California, the Rockies, and the Permian Basin. Finally, notice how geographically balanced both BreitBurn and Vanguard are right now with no one geographic area being more than a third of reserves. As an investor, geographic diversity is important from a risk management standpoint which is why you need to know whether your investment is diversified or concentrated.

Hedging policy
The final area to look at is the company's hedging policy. Do you want income certainty for the next few years? Then you'd want a company that's more hedged. On the other hand, if you are okay with exposing your income to volatility as long as you are open to upside, then leaving some production unhedged is a risk you'd be willing to take. So, how do our MLPs stack up?

Source: Company Investor Presentations and Author Calculations

As you can see both LINN and QR Energy are very well hedged, while some oil and gas production at BreitBurn and EV Energy are left unhedged to capture upside. Personally, I prefer a secure dividend, but that's because I take my risk elsewhere. If income security is important to you, then you need to make sure your company has a very robust hedging policy.

Final Foolish thoughts
As you compare these three core areas you can really see the differences between how each company currently operates. LINN Energy, for example, has balanced reserves and a more robust hedging program. EV Energy, on the other hand, offers much more upside, but that upside could carry more risk. So, while all five currently yield more than 8%, you have to dig deeper than just current yield to get the whole story.