The vast majority of MLPs operate midstream oil and gas businesses. Midstream refers to the segment of the oil and gas industry that moves produced oil and gas (which is “upstream”) to processing facilities (downstream). Midstream business lines function largely as logistics companies that charge fees to move oil and gas along their distribution routes, most commonly via pipeline. These businesses tend to be stable and fairly insulated from commodity risk. As such, they have attracted a large following among conservative investors looking for stable income.

There are MLPs that operate outside the midstream oil and gas business. In fact, some, like StoneMor Partners (NYSE: STON) — an owner/operator of cemeteries, and Cedar Fair (NYSE: FUN) — an amusement-resort operator, are far removed from the oil and gas industry. But the overwhelming majority of MLP offerings continue to be in oil and gas.

These include a growing number of upstream and downstream MLPs complementing the many midstream offerings. These MLPs have very different operating models and risk factors than those of their midstream counterparts.

Upstream MLPs like BreitBurn Energy Partners (Nasdaq: BBEP) and Memorial Production Partners (Nasdaq: MEMP) are sensitive to commodity pricing. As such, these MLPs generally hedge some portion of their production. This provides some protection against falling oil and gas prices, but also provides some resistance to appreciation if oil and gas prices are strongly advancing.

Downstream MLP offerings like CVR Refining (NYSE: CVRR) and Northern Tier Energy (NYSE: NTI) are affected by the differential between the price of oil and the price of finished products (the crack spread). As a result, they can perform well when the price of oil is falling, as long as it isn’t falling faster than the price of finished products. This is contrary to the performance of upstream MLPs, which will suffer (depending on the amount of hedging) when oil and gas prices are falling.

It is important to understand the differences in the types of MLPs. Most MLPs strive for stable, growing distributions. As such, you will see conventional midstream MLPs like Kinder Morgan Energy Partners (NYSE: KMP) with a long track record of growing distributions, and a defined minimum quarterly distribution. That’s what you can expect out of well-managed midstream MLPs.

It gets a little trickier with upstream MLPs, but historically most of them have managed to grow distributions through acquisitions and development of new properties. Most managed similar performance to the midstream MLPs — growing distributions over time, although the distributions were not necessarily as stable.

The refiners are different. Refining is a highly cyclical business, and as a result they will sometimes have enough cash to pay very rich distributions, and at other times they may not have enough money to make a distribution at all. Chances are when you see an MLP sporting a 15 or 20 percent yield, it is a refiner fresh off a very good quarter. It is also likely to be a variable-rate MLP, which is the model many refiners — and their distant cousins the fertilizer producers — have adopted. These variable distribution models simply pay out the available cash to unit holders after each quarter, and as a result the unit price can be volatile depending on business conditions.

Following the third quarter of this year, six MLPs cut their distributions. We have been warning for months that refiners were going to fare poorly, and that turned out to be the case as half of the MLPs that cut distributions were refiners. Fertilizer manufacturers like Rentech Nitrogen Partners (NYSE: RNF) suffered from higher natural gas costs and also found themselves relatively cash poor for the quarter and needing to cut their distributions.

Of the six MLPs that cut their Q3 distribution, five were refiners or fertilizer manufacturers with variable distribution policies. It is fully expected that at times these businesses will have to cut distributions, and investors should understand what they are getting with these variable-rate MLPs. In the case of the refiners, the drop most of them suffered after announcing the Q3 distribution was probably a buying opportunity as opposed to a reason to sell. The reason is that refining conditions for Q4 are looking much better than they were in Q3, and distributions will likely be increased for the variable rate MLPs.

However, one of the MLPs that cut its distribution was an upstream MLP, and it was the second time it has cut its distribution in the past five years. Eagle Rock Energy Partners (Nasdaq: EROC) is primarily an upstream partnership involved in the production of crude oil, natural gas, and natural gas liquids in Texas, southern Alabama and Oklahoma. In the entire MLP universe, it was the only one other than the downstream MLPs forced to cut its distribution for Q3. That is a flashing red light for EROC investors, and is much more significant than the distribution cuts of the variable-rate downstream MLPs.

EROC is certainly not the first conventional MLP to have to cut its distribution, but the fact of it does point to some fundamental issues with the partnership. EROC is highly leveraged, which is especially risky given the near-term outlook for oil and gas prices. And the fact that this is the second distribution cut in five years is probably the most worrisome sign that EROC management may not be up to the task of executing like competitors. Investors have punished EROC this year, driving the unit price down 37 percent year-to-date and giving it the distinction of being one of the worst performing MLPs this year.

So, when should you worry about a distribution cut? When there isn’t supposed to be a distribution cut. In the case of the refiners and the fertilizer manufacturers, cuts were expected since conditions were poor in Q3, and further because the distribution agreement spells out for investors that distributions will vary.

In the case of EROC, it is expected that,

1) That it will spend money wisely to acquire and develop properties that allow the partnership to expand production and grow distributions; and

2) That it will be hedged against falling oil and gas prices to protect that distribution. The failure now — twice — to execute this strategy means that investors should proceed with utmost caution.

On the other hand, many feel that EROC units are oversold, and may present a buying opportunity. It may indeed be the case, but I would point out that many were making this argument about EROC six months ago when units were still north of $8. Today they are at $5.49. Is this the bottom? It could be, but trying to catch EROC at the bottom is not the kind of game most MLP investors should be playing.

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)

Portfolio Update

Energy Transfer Surfs LNG Wave

There may be no more hopeful story in the energy field now than LNG. Liquefied natural gas is, like crude, part of the bounty currently getting pumped from various domestic shales. Unlike crude, it can be exported overseas with a government permit. This has set off a rush of such export projects, including Energy Transfer Equity’s (NYSE: ETE) plan to export LNG from a current import terminal at Lake Charles, Louisiana.

Until very recently, project specifics beyond the 2019 likely export date were scarce. We knew that Energy Transfer had signed a long-term tolling agreement with the UK’s BG Group (NYSE: BG) to export all of the LNG processed at Lake Charles. And we knew that the development arm of the venture, Energy Transfer LNG Export, LLC, was 60-percent owned by ETE and 40-percent by its main operating affiliate, Energy Transfer Partners (NYSE: ETP).

Now Energy Transfer has come up with a new ownership plan for the current import terminal and associated storage assets at Lake Charles, currently held by ETP’s previously acquired subsidiary Southern Union Company. Ahead of its analyst meeting last week, Energy Transfer announced that ETP will transfer the regasification and storage facilities to ETE for approximately $1 billion in ETP units as well as $330 million in future management fees and subsidies tied to the facility. In exchange, it will get assets that will form the core of a new LNG-specific MLP, Energy Transfer’s answer to Cheniere Energy Partners (NYSE: CQP), the asset holding affiliate of Cheniere Energy (NYSE: LNG), whose rival LNG export project is set to come online in 2016.

Energy Transfer will detail its LNG MLP plans early next year, but plans to use the proceeds to finance part of the $1.6 billion equity portion of development costs expected to total $11 billion. The LNG-specific IPO will allow Energy Transfer to lay off a lot of the project risk onto the investing public, while retaining much of the upside attached to the special payment-in-kind units and the incentive distribution rights it plans to keep.

How much upside? Using some plausible math, Energy Transfer estimated the value of the expected Lake Charles cash flows after financing costs from 2020 onwards at more than 100 percent of ETE’s current market capitalization and 43 percent of ETPs. These cash flows are backed by BG’s take-or-pay commitments running through at least 2044 and extendable for 20 years thereafter.

And in the meantime and presumably based on expectations of next year’s IPO, the transfer of the current Lake Charles assets to ETE is expected to be immediately accretive to its cash flow as well as ETP’s, so that no short-term sacrifice is being sought to secure the promised long-term upside.

The market loved the news. ETE’s price jumped 11 percent over two days, topping our very recently increased buy-below target of $74. ETP appreciated a relatively modest 2 percent over the same span, such that it’s almost reached our recently set buying threshold. In addition to its potential to profit from next year’s LNG IPO, ETP will benefit as the exclusive shipper of natural gas to Lake Charles.

This is a smart step by Energy Transfer to cash in on current optimism about LNG exports while retaining much of the upside from its project. It appears to be setting the stage for additional acquisitions by ETP, while establishing ETE as the fast-growing general partner. I will have more on ETE and ETP in next week’s issue of MLP Profits. For now, continue buying ETE on dips below $74 and ETP below $55.

— Igor Greenwald