Master limited partnerships (MLP) are among my favorite income-oriented sectors. I wrote about the group at some length in the May 19, 2010, issue, The Big Picture: Energy Stocks and Europe’s Debt Crisis. The basic value proposition is simple: The average MLP offers a tax-advantaged yield of close to 7 percent, pays no corporate-level tax and has the potential to significantly boost distributions–the MLP equivalent of dividends–over the next 12 months.

Best of all, the most MLPs are own midstream energy assets such as pipelines, gas storage facilities and oil terminals. Cash flows generated from these midstream assets tend to be relatively stable and have little direct exposure to commodity prices or economic conditions. 

Despite that stability, the industry-benchmark Alerian MLP Index tumbled 36.8 percent in 2008–its worst performance since a 7.8 percent decline in 1999. Two years ago investors feared that the credit crunch would hamper MLPs’ access to capital and make it tough for the group to fund new projects or pursue accretive acquisitions.

Back in late 2008, I advised subscribers to buy the dip. Credit market conditions had already started to improve by the end of 2008, and investors had begun to differentiate between shaky firms involved in economy-sensitive businesses and strong MLPs involved in defensive sectors. The 2008 selloff proved to be an historic buying opportunity; the Alerian Index soared nearly 77 percent in 2009, its best single-year performance. The Alerian Total Return Index–which includes reinvested distributions–is now just off all-time highs logged earlier this year.

Although MLPs have been among the best-performing groups in the model Portfolios over the past 18 months, Eagle Rock Energy Partners LP (NasdaqGS: EROC) has been an exception.

Unlike most of my other recommended MLPs, Eagle Rock was unable to sustain its distribution in the face of falling commodity prices and weak demand for energy. The firm slashed its payout to a little over 2 cents per quarter, and the stock fell sharply and underperformed the Alerian Index, rallying just 36 percent in 2009.

But Eagle Rock is now in the process of restructuring its business, and I like the changes underway. The partnership has always owned good assets but had two major problems: too much debt and too much exposure to commodity prices. The restructuring addresses both problems, and I expect Eagle Rock to up its quarterly distributions significantly by the end of this year–a likely upside catalyst for the stock.

Eagle Rock traditionally has operated in three business lines: minerals, oil and gas production, and midstream operations in Texas and Louisiana. The midstream business has some sensitivity to commodity prices because Eagle Rock is mainly involved in gathering and processing. Gas gathering lines are small-diameter pipelines that connect individual oil and gas wells to processing facilities and the interstate pipeline system.

The fees generated by gathering assets aren’t based directly on commodity prices. However, when commodity prices weaken, drilling activity eventually follows, meaning lower volume for gathering pipelines and fewer fees related to the hook-up of new wells.

Processing involves removing natural gas liquids (NGL) from raw natural gas. NGLs include hydrocarbons such as ethane, propane and butane; a barrel of NGLs trades at roughly 60 percent of the price of a barrel of crude oil. Depending on how processing contracts are structured, the business can have significant exposure to oil and gas prices.

The fundamentals of gathering and processing are improving. US demand for NGLs is strong, mainly as a petrochemicals feedstock; processing and other NGL-related businesses are on solid footing.

And although gas prices remain low in the US, gas drilling activity has picked up markedly in 2010 for two reasons: high NGL content in many of the hottest shale gas plays and the falling cost of onshore drilling in shale plays. This is a big positive for gathering and for Eagle Rock in particular, which has exposure to the low-cost Haynesville Shale as well as several NGL-rich shale fields.

Weak commodity prices weigh on its upstream business, but Eagle Rock mitigates that impact by hedging much of its production years into the future. And with oil prices near current levels, the returns from the oil wells Eagle Rock typically targets are impressive.

Finally, Eagle Rock sold its minerals business as part of its restructuring plan, raising more than $171 million that it used to pay down debt. This move killed two birds with one stone, reducing its excessive debt burden and exiting a potentially commodity- and economy-sensitive business line.

As part of this restructuring Eagle Rock also purchased and canceled incentive distribution rights (IDR) from its general partner. To make a long story short, this frees up more cash for distributions to unitholders.

Eagle Rock’s management team has stated that it will boost its payout to an annualized rate of $0.40 to $0.60 per unit by the end of 2010. This implies a yield of between 7.6 and 11.5 percent. I expect management to establish a distribution near the low end of that range and then grow the payout to the top end over the ensuing 12 months.

Eagle Rock Energy Partners LP rates a buy under 6.

The Rights

The following discussion only applies to subscribers who owned units of Eagle Rock Energy Partners as of the end of May.

To fund all of the transactions related to its restructuring and to raise capital, Eagle Rock has done what’s known as a rights offering. As of late May, every existing holder of Eagle Rock should have received 0.35 rights for every unit of Eagle Rock held. That means that if you owned 100 units of Eagle Rock in late May you should now also own 35 rights.

Each whole right has two components:

The right to buy one unit of Eagle Rock Energy Partners at a price of $2.50 per unit. Because the units currently trade at a price well north of $5 per unit, this right is quite valuable.

A warrant that allows holders to purchase additional units at a price of $6 starting in August for a period of about two years. This warrant is basically a call option on the MLP. Options pricing is a complex topic, and I won’t bore you with a detailed rundown, but suffice it to say that this warrant has no intrinsic value right now because the units trade below this price. That being said, the MLP could trade above this level over the next two years.

These rights trade separately on the Nasdaq under the symbol “EROCR” and currently sell for around $3.26 each.  

The most important point to note is that you must act by the end of June or you will lose out on the rights deal.

You have two choices.

First, you can exercise your right to buy additional units of Eagle Rock Energy Partners at $2.50, giving you an instant profit; the units command more than $5 in the open market. If you do this, you would also want to hold on to the warrants, which provide exposure to upside in Eagle Rock Energy Partners.

Alternatively, you can simply sell your for $3.25 in cash proceeds per right sold. Note that this won’t impact your ownership of Eagle Rock Energy Partners The second option makes sense if you simply want to maintain your position in EROC and don’t want to make a more aggressive play.

Whichever option you choose, be sure to do it quickly to maximize value from this rights offering.