A Small-Cap Energy Play with a 13% Yield

Income investors looking to cash in on rising oil and natural gas prices may be hard pressed to find traditional companies that pay a hefty yield. Exxon (NYSE: XOM), for example, yields 2.4% and Chesapeake Energy (NYSE: CHK), the largest producer of natural gas in the United States, yields 1.2%.

That's why I've been researching small-cap energy companies that pay double-digit yields. One company I found is Whiting USA Trust I (NYSE: WHX). WHX is a royalty trust spun off by Whiting Petroleum Corp (NYSE: WLL) to receive royalties on revenue from oil and natural gas producing properties. The company yields 13.2% and has a market cap of $278 million.

The trust receives 90% of revenue derived from the production and sale of oil and natural gas from its properties located in Rocky Mountain, Mid-Continent, Permian Basin, and Gulf Coast regions. Reserves are about 56% oil and 44% natural gas.

The trust passes along these royalties as quarterly distributions to shareholders. The first distribution of 2010 was $0.66 per share, paid in February. Distributions for the past four quarters totaled $2.55 for a stratospheric trailing yield of more than 13%. While the trust only made three distributions in 2008, as its shares began trading in April, the average quarterly distribution in for the year was $1.37 compared to an average distribution of $0.67 in 2009.

For the full year 2009, revenues fell -38% while income (net of expenses) declined -34% from 2008. Conveyance of the trust's royalties didn't start until April of 2008, so the 2008 numbers only include nine months of sales and production. Revenues and profits were down for one simple reason: commodity prices.

Oil and gas prices plummeted during the financial crisis from record levels in 2008. Average oil sales prices were $102.04 per barrel in 2008 and just $48.29 per barrel in 2009. Natural gas sales prices averaged $8.94 per Mcf (thousand cubic feet) in 2008 and $4.13 in 2009. The trust does hedge its portfolio, and realized prices net of hedging were $62.50 per barrel for oil and $5.39 per Mcf of natural gas in 2009.

But, things have been continually improving since the first half of 2009. The daily average NYMEX price per barrel of oil rose throughout the year from $43.21 per barrel in the first quarter to $76.17 in the fourth quarter. Today oil is over $80 per barrel. NYMEX natural gas prices averaged $3.99 per Mcf in 2009 and the price is at about $4.30 per Mcf today.

The prognosis for prices going forward is excellent. As economies throughout the world continue to recover, the International Energy Agency (IEA) expects worldwide oil demand to rise from about 85 million barrels per day in 2009 to 86.5 million in 2010. Just last month, Goldman Sachs (NYSE: GS) estimated that oil prices will rise to between $85 and $95 per barrel in 2010, and analysts from both Goldman Sachs and Morgan Stanley (NYSE: MS) estimated that oil will average $100 per barrel in 2011. As well, the Henry Hub spot price forecast for natural gas prices averages $5.17 per MMBtu in 2010 and $5.65 per MMBtu in 2011.

The cost of producing oil and natural gas is roughly the same regardless of prices. Higher prices of oil and gas make higher profits and distributions and vice versa.

That said, the properties from which the trust earns royalties are depleting assets. The trust terminates when 9.11 million barrels of oil equivalent (MMBOE) have been produced and sold from the properties. A revised reserve report estimates (as of December 31st) that the reserve balance is 6.0 MMBOE, which is expected to be produced through 2017. According to the trust, oil and gas production is estimated to decline at an average annual rate of -14.6% from 2010 through 2017.

But with oil prices on the rise, distributions are likely to increase. In the near term, the trust is a pure play on rising oil and gas price in the recovery.

P.S. If you're looking for both high yields and enormous capital gains potential, then you need to learn more about our "Income Security of the Month" for April 2010. This booming oil & gas firm has returned +196% in the past year alone.