I highlighted master limited partnerships (MLP) in the Nov. 22, 2006, issue of The Energy Strategist, Leading Income, and discussed the group again at length in the Oct. 3, 2007, issue The Partnerships.

Traditionally, MLPs and other publicly traded partnerships (PTP) have been involved in the so-called midstream energy business—basically owning pipelines, storage and processing facilities. But in early 2006, Wildcatters Portfolio holding Linn Energy (NSDQ: LINE) listed on Nasdaq and became the first PTP in more than a decade to focus on the upstream business—the actual production of oil and natural gas. Since then, several more upstream PTPs have listed, including fellow Wildcatters Portfolio holding Eagle Rock Energy Partners (NSDQ: EROC).

These upstream-focused PTPs have been hit since the credit crunch kicked off last summer. Now Linn Energy offers a tax-advantaged yield of more than 13 percent, and Eagle Rock is paying around 11.

Typically, when I see yields that high, I wonder if they’re sustainable. In this case, however, I see the selling as primarily artificial and not based on fundamental value; I believe that the current distributions for both PTPs are not only sustainable but have room for upside.

The fear in the market is that both Linn and Eagle Rock have been growing primarily via acquisitions. Those acquisitions were financed via a combination of debt and so-called PIPE deals. PIPE refers to private investment in public equity; this involves raising capital by selling additional partnership units (shares) to institutional investors. Many of the upstream PTPs—including Linn and Eagle Rock—ended up having their ownership concentrated in the hands of a few institutional shareholders.

As the market weakened and the credit crunch widened, many of these institutional shareholders sought to raise cash. They sold down their stakes. This created an artificial overhang of selling pressure.

However, the assets that these PTPs purchased with the capital raised via PIPEs are good; these are real producing oil and gas properties with low-risk profiles. In the end, I believe that the upstream PTPs will reflect the value of their properties and their ability to keep paying generous distributions.

Short-term weakness aside, my buy recommendations for Linn and Eagle Rock remain unchanged. Here’s a brief rundown of their recent conference calls:

Linn Energy reported a solid fourth quarter, earning 66 cents in distributable cash flow, comfortably above the 63 cents in distributions the PTP paid for the quarter.

One of the most common concerns voiced by analysts in recent quarters is that Linn is too dependent on acquisitions for growth. Management effectively addressed that issue in the conference call—focusing its attention on the PTP’s ability to grow organically—by drilling new wells, improving infrastructure and potentially exploiting exciting new fields.

Linn has identified 5,500 potential drilling locations on its properties; many of these locations are in the acreage it purchased last year from Dominion Resources (NYSE: D). These aren’t high-risk drilling prospects but wells that could be sited near existing known, producing wells within well-understood fields. For 2008, management expects it can drill roughly 300 wells. Linn currently has 16 drilling rigs working.

By simply working on its existing inventory of identified drilling locations, management believes it can grow production by 3 to 5 percent annually long term. This growth estimate doesn’t include any potential acquisitions. It’s pure growth via modest, low-risk drilling projects.

In addition, Linn announced that it has significant acreage in two hot gas plays: the Woodford Shale of Oklahoma and the Marcellus Shale in Appalachia. These shale plays are known as unconventional gas reserves, meaning they can’t be produced using traditional technologies but instead require special drilling techniques. I highlighted the growth potential in these plays in the Feb. 20 issue Growing Unconventionally.

Linn has no immediate plans to drill its shale plays. However, management hinted that it would evaluate these plays on an ongoing basis; it’s likely that Linn will choose to develop these plays as a joint venture with one of the experienced producers in the region.

The most important point: Linn isn’t assuming any production from these shales in its guidance. Unconventional reserves represent meaningful production upside potential for Linn.

The company’s comments regarding its hedging policies were also of interest. One common comment I hear is that Linn doesn’t benefit from improving gas prices because it’s fully hedged production for 2008-09. That’s not true. Take Linn’s 2008 hedge book as an example.

For 2008, Linn is fully hedged on natural gas and oil at a weighted average price of $8.39 per thousand cubic feet and $77.96 per barrel, respectively. But 18 percent of its 2008 natural gas hedge book and 41 percent of its oil book is put options. Put options provide a floor price; in other words, if the price of oil and gas drop below these prices, Linn’s hedges will protect the firm’s cash flows.

But puts don’t overly limit Linn’s upside. If gas and oil prices continue to rise, Linn will still participate in the upside.

Puts are 20 percent of Linn’s gas position for 2009 and 30 percent for 2010. Based on the midpoint of Linn’s guidance for production this year, the PTP will cover its planned 2008 distributions 1.13 times with distributable cash flow. That leaves essentially no danger that Linn will have to cut its payout. In fact, given the potential upside for production outlined above, there’s room for Linn to boost its distributions this year without compromising its coverage.

Eagle Rock operates in both the upstream and downstream business. The company is far smaller than Linn Energy but also made a series of acquisitions last year; in total, distributable cash flow grew 486 percent over the fourth quarter of 2006. Most of that growth came via acquisitions.

However, I see room for organic growth. The company’s midstream business consists mainly of gas gathering lines and a gas processing facility. These are stable assets, and rates charged for moving gas have no relation to commodity prices.

Management reported significant drilling activity near its core gathering systems in Texas; this drilling activity is what ultimately drives volumes and fees for Eagle Rock. With gas prices recovering, I see significant upside for drilling activity in the US.

As for the upstream segment, Eagle Rock should be able to maintain its current production of 33 million to 35 million cubic feet of gas equivalent per day this year. Eagle Rock’s production is roughly one-third crude oil and natural gas liquids and two-thirds natural gas. Much of that production is hedged, and there’s upside to volumes because Eagle Rock has plans for a modest drilling program on its existing properties this year.

In the process of an internal audit, Eagle Rock did uncover a few potential accounting control lapses and delayed the release of its 10-K annual filing with the Securities and Exchange Commission. But management stated that it doesn’t expect the audit to result in any material restatements. I don’t see this as a long-term problem.

All told, Eagle Rock covered its distributions nearly 1.2 times in the fourth quarter. That’s a healthy coverage.