• Dresser-Rand (NYSE: DRC)
• Enterprise Products Partners (NYSE: EPD)
• Linn Energy (NSDQ: LINE)
• Natural Resource LP (NYSE: NRP)
• Penn Virginia (NYSE: PVR)
• Sunoco Logistics (NYSE: SXL)
• Teekay LNG (NYSE: TGP)
• Tortoise Energy Infrastructure Corp (NYSE: TYG)
• Valero LP (NYSE: VLI)
• Williams LP (NYSE: WPZ)

Income And Growth

Utilities, real estate investment trusts (REITs) and even bonds have long been the mainstay of most income-oriented portfolios. All of these asset classes can be solid high-yielding investments at times. But MLPs are the most-overlooked income play out there. I’m continually amazed at just how few investors own these publicly traded partnerships despite their myriad advantages.

The case for investing in MLPs is clear; the numbers speak for themselves. Since 2000, the Alerian MLP index–an index of most publicly traded MLPs–has returned an annualized 24.1 percent including dividends and capital gains. In the same time period, the S&P 500–the benchmark for most mutual funds–is down more than 13.7 percent; that’s nearly negative 2.5 percent annualized.


Source: Bloomberg

Granted, these figures are skewed by the 2000-02 bear market in the US stock market. But even if we measure returns from the S&P 500’s low in 2003, MLPs totally outshine the broader market. Since the 2003 lows, the Alerian MLP index is up more than 21.6 percent annualized against just 14.9 percent for the S&P.

Better still, the MLP index is less than half as volatile as the S&P 500; superior gains with less risk and volatility is the raison d’etre for every investment manager. And those figures are just for the broad MLP index. A modicum of selectivity can vastly improve performance.

Too many investors believe that MLPs are simply ultra-safe, slow-growing companies that own crude oil or gas pipelines. Nothing could be further from the truth.

In the past decade, there’s been an explosion in the number of partnerships publicly traded on the US and Canadian exchanges. MLPs are now surprisingly flexible, allowing investors to play trends as diverse as liquefied natural gas (LNG), refining, coal and even oil and gas production. MLPs offer investors a chance to play some of the hottest energy themes while receiving a growing, reliable income stream.

Bottom line: MLPs are far and away my favorite income-oriented idea in The Energy Strategist; I’ve long recommended several in the model Portfolios. I also featured MLPs in the Oct. 26, 2005 issue of TES, The Next Big Income Investment and the Aug. 9, 2006 issue, Playing Defense. But in this week’s issue, I offer an even-more-detailed look at MLPs, how they’re traded and managed, and my favorite plays in the group.

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The Case For MLPs

The value proposition for MLPs is simple: yields of 5 to 8 percent coupled with distribution growth in the 5 to 15 percent range. In other words, the best MLPs offer a combination of high current income and the potential for that income to grow rapidly over time. As the chart below illustrates, that compares favorably with most other traditional income investments.


Source: Bloomberg, The Energy Strategist

To calculate the figures in this chart, I used the Bloomberg REIT Index, which contains close to 150 publicly traded REITs across all segments of the industry–residential, retail and office. The index currently yields about 3.8 percent, and the largest 15 REITs in the US have boosted their dividends by an average of 4.4 percent annually in the past five years.

For the utility stocks, I used the Philadelphia Utility Index; the average ute yields 3.3 percent and has grown distributions by a little more than 3 percent annualized in the past five years.

Finally, the 10-year Treasury bond yields about 4.6 percent at the time of this writing; most money market funds currently yield between 4 to 5 percent.

These figures are dwarfed by MLPs. The average MLP in the Alerian Index currently yields 5.9 percent and has managed distribution growth of more than 9 percent annualized in the past five years.

And that 5.9 percent is based on trailing dividend yields; looking at indicated yields (declared distributions for the coming year), the average is nearly a full percentage point higher at 6.8 percent. Therefore, MLPs have offered higher yields and higher income growth than any of these alternative income investments.

I don’t illustrate these statistics to say that Treasuries, utes and REITs are bad investments. My point is that MLPs, even ignoring their tax advantages, have to be considered a highly attractive asset class for income-seeking investors. MLPs, as a group, offer not only high dividends but the potential for growth in distributions and capital appreciation.

The importance of the income growth potential is what makes MLPs so attractive. Although you can certainly find plenty of stocks and bonds yielding more than 5.9 percent, you’d be hard-pressed to find many investments that can grow distributions by 9 percent annualized. And remember, that’s just an average; some of the MLPs I cover are seeing distribution growth well in excess of 15 percent annualized.

But consider the case of Enterprise Products Partners, one of my longest-standing MLP recommendations. Check out the chart below.


Source: Bloomberg

Assume you put $25,000 in Enterprise Products Partners at the end of 1999. The chart shows what your quarterly distributions–the MLP equivalent of dividends–would have been in every quarter since January 2000.

In 2000, your annualized distributions totaled $2,779; by 2006, total distributions on your holding would top $4,860, a close to 75 percent increase in income in just six years. And that’s all on top of the more than $50,000 worth of capital gains in Enterprise during the same time period.

When you factor in current yield and the potential for income growth, better-placed MLPs have the potential to offer relatively steady annualized total returns in the 12 to 15 percent range.

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What Are MLPs?

MLPs are limited partnerships (LPs) that trade on the major exchanges just like any stock. Most of the MLPs I follow trade on the New York Stock Exchange (NYSE); MLPs can be purchased easily through any discount or full-service broker at the same commissions you’d pay to buy any stock.

Unlike regular corporations, MLPs don’t pay any corporate-level tax. Instead, these partnerships pass through the majority of their income to investors in the form of regular (typically quarterly) distributions.

MLPs raise capital by issuing units–the rough equivalent of shares in a common stock. When you buy an MLP, you’re known as an LP unitholder.

To qualify for MLP status, a partnership must receive at least 90 percent of its income from what the IRS calls “qualifying” sources; these include all sorts of activities related to the production, processing or transportation of natural resources like oil, natural gas and coal.

MLPs consist of two basic entities: LPs and a general partner (GP). As an LP unitholder, this entitles you to cash distributions that come from the basic operation of the partnership business–basically, the cash flows received from running the business. But LPs don’t actively manage or control the assets of the partnership.

The actual day-to-day management of an MLP is a task performed by the GP. GPs typically are compensated for their services in two ways.

First, most GPs also own LP units and receive cash flows just like any other unitholder. Second, GPs earn what’s known as an incentive distribution–a sort of management fee that escalates based on a pre-set performance formula.

Incentive distributions are typically based on the quarterly distribution paid to LP unitholders. The exact formula differs from MLP to MLP. For instance, with Enterprise Products Partners, the incentives paid to the GP are based on the following formula applied to each quarterly distribution:

• Tier 1: 2 percent of each quarterly distribution under 25.3 cents.
• Tier 2: 15 percent of each quarterly distribution of between 25.3 cents and 30.85 cents.
• Tier 3: 25 percent of each quarterly distribution totaling more than 30.85 cents per unit.

Because Enterprise Products Partners pays out 46 cents per quarter in distributions at this time, its incentive distributions exceed the Tier 3 level; Enterprise pays what’s known as the high split to its GP.

Although the exact computations are complex, the most-recent quarterly distribution from Enterprise is a useful example of an incentive distribution at work. Each LP unitholder received 46 cents in distributions, while the GP received a little more than 6.5 cents per outstanding unit in incentive distributions this quarter.

The effect of the incentive distribution formula is that the higher the quarterly distributions paid to LP unitholders (investors in the MLP), the higher the management fee paid to the GP. The idea behind this is that the GP has an incentive to try to boost distributions; there’s an incentive to pursue income-accretive acquisitions and organic growth projects.

The effect of this is also that relatively new “young” MLPs pay little or no incentive distribution to GPs. As cash flows and distributions rise over time, incentive distributions rise as well.

Incentive distributions are an important consideration when investing in MLPs; each MLP has a different formula for calculating splits. For example, while Enterprise has a maximum split of 25 percent, it’s common for GPs to demand a 50 percent high split.

Obviously, the higher the split, the less cash there is to pay distributions to investors in the MLP. High splits also reduce the amount of cash available to service debt, make acquisitions and for general capital expenditures. High splits to GPs can make it more expensive for an MLP to borrow money to fund expansion.

Meanwhile, some younger MLPs structure their incentive distributions so that incentive distributions will be small for the first few years of the MLP’s existence. This gives the MLP room to grow.

Others start taking a higher cut earlier on. The structure of incentive distributions can make a big difference for unitholders.

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Taxation

As I highlighted above, MLPs don’t pay any tax at the corporate level, provided their activities are considered qualified. Instead, quarterly distributions are passed directly to unitholders (investors); investors pay individual tax on their distributions. But MLP distributions are highly tax-advantaged and offer a significant tax shield for investors.

Because MLP distributions aren’t dividends, MLP unitholders don’t get a Form 1099 at tax time. Instead, unitholders receive a form K-1–a standard partnership form that’s typically mailed to unitholders in February or earlier.

But there are some big tax benefits to owning MLPs. Because of depreciation allowance, 80 to 90 percent of the distribution you receive from a typical MLP is considered a return of capital by the IRS. You don’t pay taxes immediately on this portion of the distribution.

Instead, return of capital payments serve to reduce your cost basis in the MLP. You’re not taxed on the return of capital until you sell the units.

In other words, 80 to 90 percent of the distribution you receive from the MLP is tax-deferred. The remaining piece of each distribution is taxed at normal income tax rates, not the “qualified” 15 percent dividend tax rate. But the piece taxed at full income tax rates is only 10 to 20 percent of the total distribution; there’s still a huge deferred tax shield for unitholders.

An example can provide a useful illustration. Assume you own an MLP purchased for $50 and receive $5 in annual distribution payments, $4.50 of which is considered a return of capital. After one year, your cost basis on the MLP would drop to $45.50 ($50 minus $4.50); no income tax is paid on that $4.50. You’d pay normal income tax rates on the remaining 50 cents.

When you finally sell the units or the cost basis drops to $0, a portion of the capital gains are taxed at the special long-term capital gains tax rate. The remainder is taxed at your full income tax rate.

But, in most cases, MLPs should be held for long periods to get the full benefit of distributions. You’re likely to be deferring 80 to 90 percent of your taxes for several years–a tremendous benefit for most investors.

MLPs do add a level of complication to annual tax returns. The form K-1 details the split between regular income distributions and return of capital distributions. Form K-1 and accompanying documentation have become clearer in recent years, but they do require filing additional forms with your annual return and keeping records of your cost basis.

However, the benefits of tax deferral coupled with high current income outweigh these complications. And many find it easier to simply consult a tax professional; any good accountant can easily handle MLPs.

Alternatively, there are two ways to invest in MLPs and completely avoid these tax considerations. First, there are a handful of closed-end funds trading on the major exchanges (typically the NYSE) that invest exclusively in MLPs. The benefit of buying these funds is that all of the K-1 forms and cost-basis calculations are handled by the fund manager; fund holders simply receive a form 1099 at tax time.

In other words, all the income passed through from the MLPs held in the fund is considered dividend income. You pay taxes on these distributions as you would for any other dividends.

I’ll be discussing the specifics of a few closed-end MLP funds below. But a word of warning: You should be very careful when selecting an MLP fund; they aren’t all the same. Some MLPs closed-end funds charge expense ratios of less than 1 percent while others charge 1.5 to 2 percent.

It’s also important to pay careful attention to the actual MLPs that are held in these funds. Some managers are creative in taking advantage of new MLP issues and getting in on new initial public and bond offerings, while others are basically a proxy for the Alerian index.

In addition, a portion of distributions from MLPs are often subject to what’s known as unrelated business tax income (UBTI). UBTI only matters if you hold the MLP in a tax-advantaged account, such as an IRA.

Inside an IRA, any UBTI distributions of more than $1,000 are taxed as income; they’re taxed even though they’re held in an IRA account. This reduces the tax benefits of investing in MLPs. This doesn’t apply to taxable accounts.

But income received from closed-end MLP funds isn’t subject to UBTI. Therefore, you can hold closed-end MLP funds in IRA accounts without worrying about this tax complication.

Second, there are two publicly traded US MLPs known as i-units. I-units don’t pay cash distributions to shareholders. Instead, these units pay distributions in the form of additional units.

For example, Kinder Morgan Energy Partners LP (NYSE: KMP) is a normal MLP that pays cash distributions. But there’s another LP known as Kinder Morgan Management LLC (NYSE: KMR). KMR owns roughly 26 percent of the outstanding units of KMP; this is KMR’s only asset. Therefore, KMR receives distributions from KMP as if it were any other unitholder.

Instead of passing through the cash distributions, however, KMR simply pays unitholders in the form of additional shares of KMR. It’s in many ways equivalent to a dividend reinvestment program (DRIP plan).

To use an example, last quarter KMP declared a quarterly cash distribution of 81 cents per unit. Shareholders of KMR will receive 81 cents worth of additional KMR shares for every unit of KMR they hold to reflect this distribution.

Although this might seem a rather pointless arrangement, it’s not. KMR doesn’t issue a K-1 form for unitholders, and the share distributions don’t generate UBTI. Therefore, i-shares like KMR can be held in tax-advantaged accounts and offer a more simplified tax structure.

Of course, if you hold the i-shares long enough, your capital gains will be taxed at the long-term capital gains tax rate. Moreover, you don’t get any actual cash income until you sell the units. The fact that there are only two traded i-units also limits your choices considerably.

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Other Catalysts

In addition to the potential for high tax-advantaged income and distribution growth, there are other reasons to be excited about MLPs. First, they’re in a rapidly growing asset class that’s only recently been opened up to institutional investors; there’s a wave of institutional money going into the MLP market.

Mutual funds must derive 90 percent of their income from certain sources to qualify as “regulated investment companies.” Until 2004, this didn’t include MLPs; funds could place no more than 10 percent of their respective total assets in MLPs.

The American Jobs Creation Act of 2004 changed all that. The act specifically allows funds to put up to a quarter of their assets into MLPs provided a single MLP accounts for no more than 10 percent of total assets. And closed-end funds aren’t considered regulated investment companies; they’re not subject to this 25 percent restriction at all.

Investors are increasingly looking for income. This trend is driven by several factors, including demographics. The massive baby-boomer generation is looking for income to fund retirement. A proliferation of yield-hungry investors is one reason that mutual funds, a rising number of closed-end and even hedge funds are investing in MLPs.

Bottom line: MLPs were long considered a retail investor’s game. Now institutional money is just starting to pour into the industry. This is one reason that MLPs have been performing so well in recent years.

And the MLP market is also becoming bigger in other ways. In 1995, there were fewer than a dozen publicly traded MLPs in the US; the total market value was only a few billion. Choice was limited, as most of the MLPs were involved almost exclusively in the pipeline business.

Now, there are more than 50 MLPs and publicly traded partnerships in the US alone; more than a dozen have been brought to market in just the past three years. Total market capitalization now approaches $100 billion.

And that’s only the tip of the iceberg. It’s likely we’ll see another strong calendar of MLP initial public offerings scheduled for the next few years.

In addition, MLPs aren’t exclusively in the pipeline business any longer. You can now buy MLPs to play mature oil and gas reserves, the refining business, offshore oil and gas platforms and all sorts of tanker ship.

Companies are finding that by listing as an MLP, they can attract more capital than listing as a traditional corporation. The structure is also more efficient from a tax standpoint. Bottom line: MLPs are becoming an increasingly flexible asset for investors.

Finally, so-called spin-downs are becoming increasingly popular. Oil and natural gas exploration and production (E&P) companies often own gas storage facilities, pipelines and gas processing plants; these assets are key to the energy business. Infrastructure assets tend to generate copious free cash flows but little in the way of revenue growth. They’re highly profitable, slow-growing assets.

Slow-growing assets aren’t desirable for E&P companies. Such firms are typically valued based on their ability to find new reserves and boost their production of hydrocarbons. Investors are looking for growth, not cash. Most of these firms pay little in the way of dividends; they keep most of their cash to fund growth projects.

But MLPs are ideally suited for holding highly cash-generative, slow-growing assets. That’s because partnerships are valued on their ability to generate cash that can be distributed to unitholders.

In a spin-down, the GP sells slow-growing assets to the LP. This allows the GP to realize an immediate cash gain; that cash can be used for expansion and the funding of future growth. The GP also picks up a stream of cash flows from its ownership interest in the MLP and ongoing incentive distribution payments.

Meanwhile, the LP picks up another rich source of cash flow that backs up distribution boosts. Moreover, the MLP doesn’t pay any corporate-level tax. Therefore, a non-taxable MLP can afford to pay more than a taxable corporation to buy new assets–new cash-generating pipelines and storage facilities. The MLP tax advantage frees up more capital for investment in mature assets.

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Dresser-Rand

Dresser-Rand has long been a recommendation within the Wildcatters Portfolio. I first mentioned the stock in the Sept. 29, 2005 issue, Energy Infrastructure. It’s been one of the most-disappointing recommendations in the newsletter and continues to trade more or less in line with my original recommendation.

But I’m not changing my buy recommendation. The company’s recent third quarter earnings report looks like a potential catalyst for upside.

Dresser manufactures compressors of several different types. Compressors are used in just about every aspect of energy production, distribution and processing. The company sells compressors almost entirely into energy-related markets.

Dressers largest single business is compressors for refineries. Compressors are used extensively in the refining process, particularly when it comes to processing heavy and sour grades of crude.

Similar equipment is used to separate gas, water and oil on floating production, storage and offloading platforms (FPSOs); FPSOs are typically used to produce deepwater oil and gas reserves. And compressors are also key to the natural gas market, as they’re used to move natural gas along pipelines and to convert natural gas into liquefied natural gas (LNG) for transport.

Dresser focuses on large, custom-made compressors designed for a specific project. These are high-power compressors tailored to a particular customer’s needs.

Although Dresser certainly has plenty of competitors in the compressor market, much of its competition makes smaller, cheaper commodity compressors. When it comes to large projects, Dresser has a commanding market share globally, and its compressors are widely recognized as some of the most technically advanced in the industry.

All this sounds great, but it begs the question: Why hasn’t Dresser performed well for us in the Portfolio?

I see a couple of headwinds that have been holding Dresser back in the past year. Topping the list is the inherent lumpiness of the company’s revenues.

Dresser tends to book revenues from huge, complex projects such as refinery upgrades and offshore developments. Although these are highly attractive projects to work on, they’re prone to periodic short delays. Just a few days’ delay can be enough to cause shift recognized revenues from one quarter to another.

For example, in the company’s third quarter report released last week, Dresser actually came with revenues slightly under most Wall Street estimates and under second quarter levels. But the delay was because some revenues due to be recognized in late September got pushed into early October. It wasn’t a sign of weakening demand or slowing orders growth.

Management highlighted that it delivered compressors on an FPSO just before the quarter’s end. But because the FPSO wasn’t prepared to install the compressors, the equipment wasn’t finally fitted until October. This meant that the revenues were recognized in the fourth quarter instead of the third quarter.

On the new order bookings front, Dresser reported a solid quarter. But two huge contracts were booked just after the quarter’s end. If those bookings had come a few days earlier, the picture would have appeared very different indeed.

This lumpiness isn’t unusual for manufacturing companies, particularly those that do a good deal of large custom work, as Dresser does. But the problem is compounded by the fact that the company is relatively new to the public markets.

Dresser has a long history operating as a private firm but wasn’t listed until the summer of 2005. This makes it harder for analysts to estimate earnings. Because investors aren’t truly familiar with the nature of Dresser’s business, this has made the company’s order lumpiness all the more unpalatable.

Given that the stock actually rose smartly following the release of its earnings last week despite the revenue “miss”, it seems that investors are gaining a comfort level with Dresser’s lumpiness. I’m also encouraged by several other developments that its management team highlighted during the call.

First, it seems that Dresser’s profit margins continue to improve. The company’s total backlog currently stands at a record $1.2 billion.

But this backlog consists of a mix of older and newer projects of different types. Legacy projects signed two years ago don’t carry profit margins that are anything close to current levels for new contracts. Therefore, as these older contracts are flushed out of the system, overall pricing improves, which aids margins.

This is why management margins have been improving so much in the past year. Management sounded an upbeat tone for margin expansion during the next two years as well.

Dresser has also been experiencing some considerable success in signing new customers and new projects. The company recently negotiated a “preffered supplier” deal with integrated giant Shell. Although it’s unclear exactly how much business that could mean, it looks likely that Dresser will get most of Shell’s compressor orders for new refineries and other projects for at least the next five years, covered by the contract.

Finally, growth in what Dresser calls the “applied technology” segment is phenomenal. Revenues from this segment were up 175 percent in the first nine months of 2006 against 2005 levels. Applied technology initiatives involve the company retrofitting competitors’ equipment with its own technology to improve performance and reliability.

Although this growth is coming from a small base, it’s encouraging that so many operators are willing to ask Dresser to fix their competitors’ equipment. This strikes me as an endorsement of the superiority of its products. Dresser remains a buy under 30, with a stop at 18.

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Political Talk

I’m sure that most subscribers are sick of hearing about politics in the wake of the midterm elections. And it’s a bit early yet to make any wide-ranging predictions about the effects the Democrats’ takeover of both the House of Representatives and the Senate will have on the energy markets.

However, to say the very least, energy is a politically charged industry, so it can’t be ignored; a few points bear careful watching. This is particularly true given that Democrats have been traditionally viewed as less friendly than Republicans toward the oil and gas business. And certainly, the rhetoric from the Democratic Party leading into the elections has been negative for traditional oil and gas companies.

That said, it’s worth pointing out that the Democrats don’t have enough of a majority to override a presidential veto in the Senate; any particularly onerous legislation can be defeated. However, the shift in majority gives the Dems power over key congressional committees and will allow them to control the course of debate on the floor.

Therefore, they’ll be able to introduce policies and conduct investigations even if such policies have no hope of actually becoming law or leading to any real changes. This power of the “bully pulpit” will result in rhetoric that will likely move the energy markets at least short term.

I suspect we’ll hear more talk of a special “windfall tax” on big energy companies. This has long been a plan put forth by the Democrats; the basic idea is that there would be a tax on the big energy firms (perhaps limited to just the largest integrated firms) and that cash would be used to pay for research into alternative energies.

Any talk of a windfall profits tax is bad for big, integrated energy stocks, including Portfolio recommendations ExxonMobil and Chevron, though I see the main effect to sentiment, not policy. I fully expect Congress to drag the big oil company executives back up to Capitol Hill and ask them to explain why they’re making so much money. This will get plenty of news coverage–as it always does–and lead to negative headlines.

However, I doubt any windfall profits tax will get passed; President Bush is likely to put his foot down on any such policy and veto it. More-moderate Democrats also will probably oppose more-extreme windfall profits tax legislation on big energy firms.

The fact that these companies rallied even after the election suggests that the market is already aware that this windfall profits tax is unlikely to be enacted. I tend to see any headline-induced selloff in the big oils as an opportunity to buy.

However, if such a tax were imposed, it will probably lead to higher energy prices (oil and gas) and greater dependence on imports from abroad. The effect could be minor or quite severe depending on how exactly the legislation gets framed and how many companies it affects.

If such a tax were imposed, I suspect the big oil companies would cut their exploration and development budgets or, at the very least, cut back on growth in these budgets. This would likely curb activity, particularly in high-cost resources like oil sands and oil shale.

If smaller producers in the US are affected, such a tax could hit domestic production severely, particularly for natural gas. Natural gas strip prices in at least the $6 to $8 range are prerequisites for a continuation of some of the higher-cost drilling projects at work in the US and Canada.

It’s interesting that a California proposal–Proposition 87–to tax oil extraction in the state was defeated last week by a vote of 55 percent. The funds from this tax were to be used to fund alternate energy. The fact that this proposition was defeated in California adds credence to the belief that a national windfall tax would befall a similar fate.

The Democrat win will likely step up chatter concerning a wide range of alternative energy technologies. For example, the current chairman of the House Resources Committee is Richard Pombo (R-Calif.), who lost his seat to Democrat Jerry McNerney by a 53-to-47-percent margin.

Pombo has been a major advocate for opening up additional US waters for oil and gas drilling. In contrast, McNerney runs a small alternative energy company in California; it’s clear that the momentum in this committee will shift toward alternatives.

The likely head of the Resources Committee will be Nick Rahall (D-W.Va.). He’s a big supporter of investment in coal-to-liquids (CTL) technology; West Virginia is, of course, a big coal-producing state. Montana Gov. Brian Schweitzer, a Democrat, is another big CTL proponent.

Many also believe that the Democrats will push for the regulation of carbon dioxide and other “greenhouse” gases. This would likely be accomplished through an emissions trading scheme similar to what the US currently has in place for sulphur dioxide and nitrous oxide. A carbon trading system is already in place in Europe.

Most interesting, the Republicans, including President Bush, broadly support alternative energies, including CTL, wind and ethanol/biodiesel. Although there are clearly some differences on how the two parties wish to handle alternative energy policy, I suspect there are areas of broad agreement.

It’s not hard to see a case where the president and Congress unite behind some sort of alternative energy policy, perhaps as part of a broader energy compromise. I see this as another potential catalyst for the biofuels plays I outlined in the September 20 issue of TES, Fueled By Food.

The big winner when it comes to carbon trading will be nuclear power. The IEA just published a study encouraging governments to expand nuclear power as the only viable means of reducing carbon-dioxide emissions. While I suspect we won’t see a carbon trading scheme anytime soon, any global warming rhetoric is a positive for the uranium stocks.

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Assets Owned By MLPs

MLPs are typically far less volatile than the energy sector at large. I calculated the beta of all US-traded MLPs using the Philadelphia Oil Services Index (OSX) as my reference point.

Beta is simply a measure of relative volatility. If a particular MLP has a beta of +2 relative to the OSX, that means that a 1 percent move in the oil services index typically leads to a 2 percent swing in the MLP. Betas of less than 1 mean that an MLP is less volatile than the index, while betas of more than 1 indicate it’s more volatile than the OSX.

The average beta for the 50 MLPs I analyzed is 0.21. In other words, a 1 percent move in the OSX typically leads to only a 0.21 percent move in the average MLP. The most-volatile MLP I studied has a beta of just 0.56 to the OSX.

With that said, some types of assets expose partnerships to more commodity risk than others. A careful analysis of the assets owned is the only way to evaluate a particular MLP’s exposure to the ups and downs of the broader energy markets and commodity prices. Although it’s impossible to generalize completely, here’s a brief rundown of some of the more common MLP assets and the risk/growth opportunities of each asset type:

Gathering Pipelines

Gathering pipelines are small diameter pipes that connect a single well or a group of wells to processing facilities and eventually the national interstate pipeline grid. Gathering lines “gather” hydrocarbons from wells; it’s the first step in the process of moving gas from wellhead to consumer.

Companies that own pipelines charge a fee based on the volume of gas gathered. Gathering pipelines aren’t regulated by the government; they’re in a competitive business, and rates charged for transporting gas are set by overall supply and demand conditions.

Gathering lines have exposure to drilling activity. When drilling activity is strong, producers are constantly drilling new wells that need to be hooked up to gathering lines. That spells a steady stream of new business for the owners of gathering lines.

Also, a typical US gas (or oil) well has a fairly steep decline curve; production per day drops off rapidly in the first years of operation. Therefore, to keep revenues growing, an MLP needs to constantly be hooking up new gathering lines.

Location is key in the gathering business, especially when it comes to natural gas. Most new drilling activity in the US targets gas, not oil. Drilling activity has been extraordinarily strong during the past few years; it’s still a rapidly growing business, despite the drop in gas prices.

This has been a favorable tailwind for the gathering industry. But it’s also a highly regional business.

Unconventional gas reserves in Texas and the Rockies have been particularly hot of late. These wells offer highly attractive economics at current gas prices, and that spells continued strength for well-positioned gathering line volumes. In contrast, shallow-water Gulf of Mexico drilling for gas and coal-bed methane wells have weakened of late; gathering lines focused on these markets are less attractive.

Gathering lines have significant growth potential. Some exploration and production (E&P) companies own extensive gathering line networks; depending on location, these lines have superior spin-down potential. And there’s also the potential for organic growth in hot markets as an MLP can continue to hook up new wells.

Gas Processing/Fractionating

When natural gas is first produced, it’s called wet or rich natural gas. Wet gas is composed primarily of methane, but it also contains a number of other hydrocarbons known as natural gas liquids (NGLs). Examples of NGLs include propane, ethane and butane.

Natural gas must meet certain specifications before it can be put into the nation’s pipeline network. Specifications include a certain heat or energy content measured in millions of British Thermal Units (Btus) per million cubic feet.

There are other specifications that detail how much NGL content can be in the natural gas stream. Once NGLs are separated from the natural gas stream, the remaining gas is called dry natural gas. Dry natural gas is then injected into the pipeline system for transport to consumers or power plants.

The removal of NGLs from the gas is known as natural gas processing.
The various hydrocarbons in NGLs can also be separated in a process known as fractionation.

NGLs such a propane, butane and ethane often have more value as separate products than they would simply as a component of natural gas. They can be sold separately for more money than if they’re simply burned in a power plant.

NGLs are priced more or less like liquid hydrocarbons; price tends to closely track the price of crude oil. When crude oil is expensive relative to natural gas, processing operators are busy. They’re removing the NGLs from relatively cheap natural gas to be sold at high oil-like prices.

In contrast, when gas is expensive, the value of NGLs is low and producers tend to do less processing. Therefore, the economics of processing and fractionating will, to an extent, track the gas/oil relationship.

But some MLPs involved in processing are more exposed than others to the gas/oil relationship. You must also consider the nature of processing contracts. Under some contracts known as keep-whole contracts, the processor actually takes ownership of the NGLs in the gas stream. Profitability swings wildly with the value of the NGLs.

In other contracts called percent of liquids or percent of proceeds, processors are compensated with both a mixture of fixed volume-based fees and some fees tied to the value of the NGLs removed. These contracts involve less exposure to the gas/oil relationship. Less risky still are fee-based contracts that simply pay a fee for volume.

A decade ago, keep-whole contracts were the norm. But nowadays, most MLPs do little or no keep-whole contracting; contracts on percent of liquids or a fee basis are more common. This has greatly reduced the risk profile of the processing business for MLPs.

Refined Product Pipelines

Refined product pipelines carry petroleum-based products like gasoline, diesel and jet fuel from refineries to terminals for distribution. Typically, pipeline owners charge a fee based on the volume of product that travels through their lines. Oftentimes, however, refined product pipelines are dedicated for a particular refinery; refiners often agree to a minimum fee regardless of how much gasoline ships across the lines.

Refined product pipelines are typically a very stable, cash-generative asset. Commodity prices have little or no impact on fees. And because demand for refined products is relatively stable over time, volumes don’t fluctuate a great deal.

That said, there’s little room for growth. No new refineries have been built in the US since 1976; there isn’t much room for expansion. And because most refined product lines are already held by MLPs, there’s not much room for acquisitions.

Gas and Crude Storage

Gas storage facilities charge a competitive fee based on the volume of gas stored. Alternatively, sometimes, MLPs owning storage facilities will lease out a portion of their capacity for pre-set fixed fee on a longer-term basis.

While natural gas demand has risen quickly in the US during the last decade, available storage capacity hasn’t expanded quickly enough to keep pace with that demand. Storage capacity is, therefore, an extraordinarily valuable asset.

Storage demand is particularly acute in certain regions of the country. For example, the building of liquefied natural gas (LNG) facilities along the Gulf Coast will eventually mean much-higher imports of gas that need to be stored near coastal import facilities. Companies with storage facilities located near these regions should benefit from all that imported LNG.

In addition, demand for storage has been very high lately. Last winter’s warm weather has meant that larger-than-normal stocks of gas have built up in storage. And because natural gas prices for delivery in a few months’ time are much higher than prices for immediate “spot” delivery, producers can store natural gas to try to take advantage of those higher futures prices.

Finally, gas prices aren’t identical in all parts of the country. MLPs with flexible storage and pipeline infrastructure can store gas and move it to the most-favorable markets.

Crude storage facilities charge a fee in much the same way as gas facilities, and the economics are similar. Crude oil storage terminals that offer other services, such as blending fuels and mixing gasoline to meet environmental regulations, can earn higher profit margins. And just like gas storage facilities, location is key; crude and refined product storage facilities near key supply-short markets like the Midwest are particularly valuable.

There are still plenty of gas and crude oil pipelines held by major E&P companies and integrated oil firms. These assets are ideal acquisition targets for MLPs: There’s the potential for growth via acquisitions of storage facilities.

Coal Properties

Of all the MLPs, coal MLPs are the most volatile and commodity sensitive. MLPs own coal-producing lands but don’t actually mine for coal. The land is leased out to miners that pay a royalty fee based on the value of coal they produce.

These royalty fees aren’t regulated and do vary with the price of coal: When coal prices are high, coal MLPs can demand larger royalty fees. Of course, royalty fees are often negotiated on a longer term basis. Royalty rates adjust only slowly to changes in coal prices.

In addition, royalties are based on coal production. Just as with coal miners, the quality of mines is very important. Older underground mines in the Central Appalachian coal-producing region tend to carry high mining costs and are often subject to production shortfalls; these mines are difficult to produce efficiently, and the coal seams being exploited are increasingly thin.

Production shortfalls from poor mining conditions can also affect royalty payments. The best coal MLPs have exposure to basins outside of Central Appalachia, such as the Illinois and Powder River basins. Production from these regions is cheaper and more reliable.

But although coal MLPs are the most volatile of the MLP sectors, these partnerships still don’t carry the volatility of traditional coal-mining firms. Coal prices have dropped this year, but they’re still far higher than two or three years ago. Coal MLPs are still signing royalty contracts at relatively attractive rates.

Interstate Pipelines

Interstate pipelines are heavily regulated by the government. Tariffs are set to allow pipeline operators to recoup their capital and maintenance costs plus a reasonable rate of return. Interstate pipelines offer stable regulated returns. But because fees are based on volume, profitability varies with demand for oil or gas transport.

Location is important. Gas pipelines that serve fast-growing production centers, such as the Barnett shale in Texas, enjoy strong volume growth. And oil pipelines connected to regions where production is growing, such as western Canada (oil sands) or the deepwater Gulf, similarly benefit from growing volumes.

In addition, pipelines that serve regions such as the Northeast and Midwest are valuable; these key consumption centers rely on constant flows of crude oil from the Gulf Coast to meet local demand.

Finally, MLPs typically own more than one type of asset. MLPs that have exposure to more than one type of asset carry less risk that heavily focused MLPs.

For example, processing facilities benefit from high crude oil prices and relatively cheap natural gas. But when natural gas is expensive, operators of gas gathering lines tend to see higher profits; drilling activity accelerates when gas prices are high.

This offers diversified MLPs a sort of innate hedge: Processing facilities are effectively “short” gas, while gathering lines are long gas. This adds a measure of stability to profitability.

To properly gauge risk, you should take care to evaluate an MLP’s mix of businesses and the geographic location of those assets.

Back To In This Issue


How To Play It

I tend to classify MLPs into two broad categories: slow-growing MLPs with higher current yields and MLPs with lower yields but more growth potential. I recommend holding some exposure to both types of partnership; this strategy offers the potential for high current yield and dividend growth potential.

In the table below, I list key data for all 49 MLPs I cover in The Energy Strategist. Here’s a brief rundown of the meaning and interpretation of each column of the table:

Enterprise Value–Enterprise value is defined as an MLP’s total market value (market capitalization) plus the value of outstanding debt net of cash holdings. Enterprise value is a measure of an MLP’s size. Smaller partnerships typically have more opportunity for rapid distribution growth.

Even relatively small acquisitions can create a huge jump to cash flows and distribution potential for smaller MLPs. There are a multitude of smaller gathering systems and storage facilities that are too small to provide much of a boost in cash flow for an MLP the size of Enterprise Products Partners or Kinder Morgan.

But even a relatively minor acquisition can be a big boost for a small, newly formed MLP. In addition, oftentimes, smaller MLPs are early in their lifecycle–relatively new partnerships that aren’t paying high-incentive distributions to GPs.

Current Yield–To calculate this column, I annualize an MLP’s most-recent distribution. Don’t be tempted to buy MLPs just because they sport a high yield. Some MLPs offer high yields because business conditions are poor and there’s risk they’ll be forced to cut distributions. Others offer high yields but little or no opportunity for distribution growth over time.

2005 Payout Ratio–The key metric for evaluating an MLP’s ability to make distribution payments is called distributable cash flow (DCF). DCF is a measure of the amount of free cash an MLP generates after making all capital expenditures needed to maintain its basic assets. Maintenance capital expenditure includes items such as pipeline maintenance and processing plant repairs; it’s the minimum capital required for an MLP to continue its existing operations.

DCF doesn’t include any accounting charges like depreciation or amortization. For MLPs, DCF is a more-accepted measure than earnings; non-case accounting charges included in earnings figures don’t reflect an MLP’s cash flow potential.

To calculate the 2005 payout ratios, I simply divided total distributions in 2005 by 2005 DCF. Ratios of less than 100 percent mean that the MLP paid out less than its available DCF; the MLP retained some cash as a reserve.

Ratios of more than 100 aren’t sustainable; partnerships can’t continually pay out more cash than they earn. Lower ratios are typically desirable, though partnerships with low-risk assets like refined products pipelines can afford to carry higher-than-average payout ratios.

Not all MLPs report DCF directly, and as it’s a non-GAAP measure, there’s no standard calculation or formula. Some MLPs provide more-complete accounting data than others. I took a conservative estimate of each MLP’s DCF when calculating payouts.

Year-To-Date Payout Ratio–Identical to the 2005 payout ratio, except I calculated DCF and payouts for the first nine months of 2006.

Historical Distribution Growth–This is the annualized growth in distributions paid to partners on a trailing five-year basis. If the MLP hasn’t been around for five years, I used three-year annualized figures instead. Clearly, higher distribution growth is preferable.

Consensus Distribution Growth 2007–The consensus analyst estimates for the growth in distributions from 2007 compared to 2006.

Consensus Three-Year Annualized–The consensus analyst estimates for distribution growth during the next three calendar years. Although analyst estimates certainly aren’t flawless, this column offers an indication of a particular MLP’s growth potential. Because MLP cash flows are relatively predictable, analyst estimates are more reliable than for most other industries.

Alerian MLP and OSX Betas–I explained the OSX beta above. Basically, it’s a measure of how volatile an MLP is with reference to the OSX. Higher figures typically represent higher risk. The Alerian MLP beta compares each MLP’s volatility to that of the Alerian MLP Index; again, figures under 1 represent lower-than-average volatility.

Asset Risk–I rated each MLP in terms of their exposure to commodity prices and volatility in the energy markets. This rating is based on the MLP’s payout ratios and both beta calculations. This isn’t a totally quantitative measure; I also took into account qualitative factors, such as an analysis of each MLP’s asset base and regional exposure.

Partnership (Symbol)	Current Yield	2005 Payout Ratio	YTD Payout Ratio	Historic Dist. Growth	Consensus 3 Year Ann.	Asset Risk	Alerian MLP Beta	OSX Beta
Natural Gas Pipelines/Processing
Atlas Pipeline Part. (APL)	7.2	76	90	6.3	8.1	High	0.97	0.23
Boardwalk Pipeline Part. (BWP)	5.3	N/A	64	11	8	Low	0.8	0.18
Copano Energy (CPNO)	5.1	52.6	39	64	13.5	High	0.94	0.23
Crosstex Energy (XTEX)	5.9	79.3	95.6	32.63	15.5	High	1.11	0.30
DCP Midstream (DPM)	5	N/A	46.9	N/A	13	Medium	0.53	0.07
Energy Transfer Part. (ETP)	5.7	75.2	60	16.1	18	Medium	0.8	0.18
Enterprise Prod. Part. (EPD)	6.5	77.5	85.5	9.2	8	Medium	1.14	0.23
Hiland Partners LP (HLND)	5.6	N/A	125	120.8	15	High	0.88	0.27
Markwest Energy Part. (MWE)	7.1	54.3	66.7	15.6	11	High	0.61	0.14
ONEOK Part. (OKS)	6.4	77.5	86.2	3.8	8.5	Medium	0.96	0.16
Regency Energy Part. (RGNC)	5.7	N/A	N/A	N/A	10.5	High	0.62	0.09
Williams Partners LP (WPZ)	4.5	78.7	57.1	N/A	25	Medium	1.01	0.13
Refined Products Pipelines/Terminals
Valero LP (VLI)	6.6	84	91	26.31	5.5	Low	0.95	0.19
Buckeye Part. (BPL)	6.9	91.4	98	4.3	6	Medium	0.8	0.22
Holly Energy Part. (HEP)	6.2	89.3	93.5	16.2	7	Medium	0.84	0.21
Magellan Midstream Partners (MMP)	6.2	83.3	77	26.12	9.5	Medium	Stock Talk Comments Comments Guidelines Our Stock Talk section is reserved for productive dialogue pertaining to the content and portfolio recommendations of this service. We reserve the right to remove any comments we feel do not benefit other readers. If you have a personal question about your subscription or need technical help, please contact our customer service team. If you have any success stories to share with our analysts, they’re always happy to hear them. Note that we may use your kind words in our promotional materials. Thank you. Add New Comments You must be logged in to post to Stock Talk OR create an account