How I Found High Yields Over Lunch

My friend Barbara phoned and invited me to lunch a few weeks ago. When she offered to pay, I knew something was up.

Barbara talked about her workout routine, her daughter’s job search, and her upcoming vacation to Panama. After asking me a cursory question or two, she finally got to the point.

“I’m bullish on oil,” she said. “Oil stocks have had great recoveries in 2009. But I’m not sure about how much further they’ll go up this year.” I nodded and waited for the punch line.

“What I want is to find stocks that offer capital gains as oil continues to rise, but also throw off high income while I wait. I can’t find oil stocks that offer the kind of yields I want. I’ve checked.”

Barbara is right. Most of the major oil producers like ExxonMobil (NYSE: XOM) offer low yields. BP (NYSE: BP) is the highest-yielding of the bunch, but its yield is still only 6%.

So if you’re bullish on crude, where can you also find a high yield?

No doubt about it, the 2010 outlook for crude oil is positive. Not wildly bullish, but constructive enough to make stocks in this sector worth looking at.

According to a panel of 28 analysts polled by Forbes, crude will average an estimated $75.40 per barrel in 2010, up from about $60.90 per barrel in 2009. The analysts are hardly going out on a limb, given that oil for February delivery is currently above $75 per barrel.

But if the analysts are right, oil companies will receive around +24% ($75.40/$60.90) more in 2010 versus 2009 for the same (unhedged) production volumes. Simply by standing still and producing the same volumes, earnings should rise. Companies with rising production should, in general, fare even better.

#-ad_banner-#But the Forbes consensus figure may be conservative. Earlier in 2009, Morgan Stanley forecasted an average oil price of $85 in 2010 and $95 in 2011. And Sanford C. Bernstein & Co. analysts think we could see triple-digit oil prices by late 2010 or early 2011.

While few expect to see the $147 a barrel peak of July 2008 any time soon, two big tailwinds are behind these bullish projections.

Demand is increasing in emerging markets, like China, as the global economy recovers. In the United States, which together with China consumes an estimated 33% of global oil, demand is also picking up. Worldwide consumption is forecast to rise nearly +2% to 86.2 million barrels a day in 2010, according to a monthly report from the International Energy Agency.

Also, a weak dollar should benefit oil, which is purchased as an inflation hedge. The massive increase in debt issued by the U.S. government has raised the specter of inflation, which could continue to put upward pressure on commodities like gold and oil.

But as my friend Barbara pointed out, you simply can’t find high yields by looking at the “majors.” Even independent oil and gas companies like Anadarko (NYSE: APC), Devon Energy (NYSE: DVN), or Pioneer Natural Resources (NYSE: PXD) leave much to be desired in the yield category.

But if the majors and larger independents aren’t the place to be, what about small and micro-cap stocks — those with market caps below $2 billion?

When I ran a small-cap screen, I struck pay dirt. I found numerous oil and gas stocks with yields of 8%, 9%, 10% and higher. Barbara’s problem was solved. For example, MVO Oil Trust (NYSE: MVO) pays a mouth-watering 9% and is expected to grow earnings per share +20% this year — not too shabby.

And the exciting thing is there are a number of similar small-cap oil plays that will pay you a strong yield while also benefiting from strong oil prices. In fact, I approached this topic in a recent issue of High-Yield Investing, pinpointing four small-cap oil plays that yielded up to 17%.

So if you’re hunting for a way to lock in high yields from oil, the key might be to simply think smaller.