More than three-quarters of the S&P 500 have released second-quarter results, of which over 76 percent surpassed earnings estimates and 61 percent beat revenue estimates.

Plenty of pundits repeat the refrain that few of the index’s components generated top-line growth, noting that most of the upside stems from cost-cutting. Though popular, this statement has little basis in fact. Year-over-year sales growth is positive for all 10 S&P 500 economic sectors; energy and materials led the way, growing revenue 23 percent, compared to 11 percent for the index as a whole.

And risks associated with many of the big-picture themes I’ve written about over the past four months are receding. US economic data appears to have stabilized; for example, the widely watched ISM Manufacturing and Services Indexes both trumped analysts’ expectations.

Meanwhile, the market is gaining confidence that European governments are taking the necessary steps to bring budget deficits under control. Credit spreads on bonds issues by the weakest EU economies have receded, and US and EU corporate bond issuance remains robust. The risk of a double-dip recession and/or global credit crunch continues to decline.

All of these factors have pushed the markets higher in recent weeks. I continue to regard the dip in stocks that started in April as a correction in a bull market, not the beginning of a new bear market.

Although the market could pull back again in autumn, investors should regard any such move as an opportunity to buy the names in the model Portfolios.

In This Issue

The Stories

With drilling activity increasing and profit margins expected to expand in the back half of the year, second-quarter earnings confirmed that Weatherford International (NYSE: WFT), Schlumberger (NYSE: SLB) and Baker Hughes (NYSE: BHI) are entering the sweet spot of their cycle. See Oil Services.

Master limited partnerships remain one of my favorite groups, especially names that stand to benefit from increased drilling activity in shale plays that are rich in natural gas liquids and condensates. See Master Limited Partnerships.

The Stocks

Weatherford International (NYSE: WFT)–Buy @ 26
Schlumberger (NYSE: SLB)–Buy @ 85
Baker Hughes (NYSE: BHI)–Buy @ 55
Kinder Morgan Energy Partners LP (NYSE: KMP)–Buy @ 70
Enterprise Products Partners LP (NYSE: EPD)–Buy @ 38

Oil Services

Longtime readers known that oil-services companies are among my favorite plays for long-term growth. My basic thesis is simple: The world isn’t running out of oil; it is, however, running out of easy and cheap-to-produce oil.

The recent spill in the Gulf of Mexico underscores this point. The Macondo is located in water nearly a mile deep, and the well itself was some 18,000 feet long. Such developments require an array of advanced equipment and technologies, including massive semisubmersible drilling rigs, subsea robots and devices designed to control underground well pressures. No producer would invest the time and money to produce a well of this sort if it could easily produce more oil from existing onshore fields.

That activity in these deepwater fields has picked up suggests producers must look to ever more complex and difficult-to-access fields to replace maturing fields.

Of course, it’s not just deepwater fields. Onshore fields are also becoming tougher to produce. Producers are targeting heavy oil fields that require more intensive drilling, while the unconventional oil and gas drilling boom in the US relies on technologies perfected over the past decade: horizontal drilling and fracturing.

Well complexity and service intensity go hand in hand. Each well drilled in a deepwater or unconventional field requires more work from services firms than a traditional conventional well. Services firms are the purest beneficiary of the end of easy oil.

Every quarter I pay particularly close attention to earnings releases from the Big 4 services names: Baker Hughes (NYSE: BHI), Halliburton (NYSE: HAL), Schlumberger (NYSE: SLB) and Weatherford International (NYSE: WFT).These multinational companies operate in every conceivable oil or gas-producing region of the world, putting them in a good position to offer a bird’s eye view of trends underway in the industry.

The business environment for services names continues to improve. Onshore activity in North America is much stronger than expected at the beginning of 2010, and activity in key international markets such as Russia, Africa and the Middle East should accelerate into the back half of the year. The moratorium on drilling in the deepwater Gulf of Mexico represents a key headwind and has longer-term ramifications for oil prices, but the financial impact is manageable for most of the major services firms. The drilling ban will not affect the group’s long-term prospects.

Here’s my take on second-quarter earnings and conference calls from Portfolio recommendations Weatherford International, Schlumberger and Baker Hughes.

Weatherford International (NYSE: WFT)

Key Takeaways:

• Weatherford surpassed second-quarter earnings and revenue expectations, its first significant beat in a year.
• North American operations turned in a strong performance, led by growth in unconventional oil and gas plays, particularly gas fields rich in natural gas liquids (NGL).
• Weatherford has less exposure to the Gulf of Mexico than its competitors, amounting to $0.01 per share in monthly earnings.
• The Latin America segment underperformed, primarily because scaled-back operations in Mexico. But investors expected this weakness, and its Mexican business should pick up heading into 2011.
• Eastern Hemisphere results were led by a strong showing in Russia. Although results in this region disappointed some analysts, the shortfall stemmed primarily from start-up and mobilization costs. The impact will decline as projects commence in the second half of the year, and visibility around new projects is improving.
• Weatherford’s operations are improving, and the stock is cheap relative to its peer group. Buy Weatherford International up to 26.

Weatherford International has been a frustrating name to own over the past nine months. The stock handily outperformed its larger peers and the Philadelphia Oil Services Index in the six months after the market bottomed in March 2009. But starting last autumn a succession of headwinds have buffeted the stock. Some of these challenges were within management’s control; others, such as Mexico’s abrupt about-face on development of the Chicontepec field, were simply bad luck.

Over the past few quarters the Weatherford missed earnings expectations, dimming the luster of its growth story.

We’ve stuck with Weatherford despite these challenges for a few simple reasons. First and foremost, the company’s business mix remains well positioned for long-term growth. In particular, Weatherford’s expertise in producing oil from mature fields should be a boon; as the world’s biggest oil plays age, producers are anxious to stem the tide of natural production declines.

Just a few years ago, North America accounted for much of Weatherford’s revenue. Although the company has expanded its international operations considerably, the firm’s deep roots in its home market and considerable experience offer plenty of opportunities to extract oil from the region’s mature fields.

Weatherford’s long history of operation in Canada also accounts for the company’s expertise in heavy oil production. Heavy oil includes production from Canada’s oil sands as well as some grades of oil produced in the US, Mexico and key foreign markets.

And because Weatherford is far smaller than its three main competitors, expanded overseas operations have the potential to generate superior earnings growth. Thus far the company’s strategy of establishing a foothold in new markets and aggressively selling its expertise and technologies has paid off, catapulting the firm into the ranks of the industry’s fastest-growing names. Keep in mind that it’s much harder for larger competitors, most of which are well-established internationally, to grow earnings at the same pace.

The market has punished the stock for Weatherford’s short-term challenges, ignoring the long-term positives and the potential for sector-leading earnings growth. These headwinds will pass.

The company’s second-quarter earnings release affirms my confidence in the stock and should restore investors’ confidence in the firm’s long-term story. Most important, many of the biggest headwinds facing Weatherford have passed or are abating. In addition, some of the company’s growth and expansion initiatives are beginning to bear fruit, and the firm should increase profit margins considerably as international activity picks up.

Weatherford reported quarterly earnings of $0.11 per share, trumping analysts’ estimates of $0.07. The company also beat on the top line, posting revenue of $2.44 billion, compared to consensus estimates of $2.38 billion. Earnings were up roughly $0.04 per share sequentially, and revenue increased $100 million from the prior quarter.

North America

North America was a bright spot this quarter, contributing around $0.02 of the sequential earnings increase. In a normal year Canadian activity declines in the second quarter relative to the first quarter, a phenomenon known as the break-up season. This year, however, Canadian seasonal declines were less pronounced despite heavy rains in some of the country’s main producing regions.

But the real story in North America was the stronger-than-expected performance of the US land market, led by activity in US shale-gas plays, particularly fields that also produce crude oil or NGLs. 

“Natural gas liquids” is a catch-all term that describes a mixture of hydrocarbons such as ethane, propane and butane that occur naturally in certain natural-gas fields. A barrel of NGLs historically has tracked the price of crude more closely than the price of natural gas. With oil trading over $81 a barrel, a standard barrel of mixed NGLs fetches closer to $42 a barrel. Slightly heavier hydrocarbons, known as condensate, command even more. (Note that may analysis of Enterprise Products Partners LP’s (NYSE: EPD) earnings covers this market in far greater detail).

With North American gas prices weak, one would expect US gas-focused drilling activity to decline; producers usually cut back production when prices don’t support comfortable margins. But many of the best shale plays are rich in NGLs and condensates; producers in these regions realize significantly higher prices for their output.

The Eagle Ford Shale of south Texas and the Marcellus Shale of Appalachia produce ample amounts of these liquids; activity has ramped up in both regions despite weak gas prices. And a few shale plays primarily produce oil–namely, the Bakken Shale and a swatch of the Eagle Ford play.

Strong drilling activity within these liquids-rich plays provided a welcome bump to the major services names, many of which are called in to produce these complex fields.

Horizontal drilling and fracturing (also called stimulation), crucial to the production of unconventional oil and gas fields, continue to evolve. Recently, producers have found that drilling longer horizontal segments boosts production rates. Fracturing involves pumping liquid into the reservoir rock under high pressure, producing cracks that enable the gas to flow into a well. Companies continue to experiment with multi-stage fracturing on larger areas.

In other words, not only are producers drilling more wells, but these wells are bigger and more complicated. And greater complexity usually means more work for Weatherford and other services outfits.

Management noted that capacity is tight for many key service lines related to unconventional oil and gas development. Many producers are signing long-term contracts to guarantee access to key services and related equipment–a sure sign of high and rising demand. In this environment services companies enjoy pricing power; in fact, North America was the only region where Weatherford was able to hike prices significantly.

In the second quarter the company upped prices an average 10 percent on about 40 percent of the services it offers in North America. Management indicated that the firm should be able to push through additional price increases over time.

Meanwhile, management indicated that interest in Canada’s oil sands also appears to be picking up. Activity had been subdued after 2008 commodity price collapse prompted many oil-sands and heavy-oil producers to cancel or delay expansion projects. But producers appear to be playing catch-up. All indications suggest that volumes and activity should strengthen in the back half of the year–great news for Weatherford, the oil-services major with the most exposure to Canada.

And because 80 percent of Weatherford’s business in the region is related to shale oil and gas or heavy oil, the company stands to benefit from growing demand as producers increasingly target these plays.

Finally, Weatherford is the least exposed of the major services firms to the deepwater Gulf of Mexico, an important near-term positive for Weatherford relative to its competition. Management stated that the moratorium costs the firm roughly $0.01 per quarter in earnings; the company will reassign its Gulf Coast personnel either to onshore North America or to international markets.

Overall, like most services companies, Weatherford expects US activity to remain flat. Demand for services remains strong in the major shale plays, but the rig count doesn’t have much headroom. The drilling moratorium in the Gulf also will offset some of these benefits. Canadian activity should also enjoy a seasonal bump. 

I believe management’s outlook for North America errs on the conservative side, leaving room for Weatherford to beat expectations in the back half of the year.

Latin America

Latin America is a tale of two markets for Weatherford. On a pure-growth basis, the region was Weatherford’s weakest; revenues were off on a sequential basis and compared to the year-ago quarter. But Mexico accounted for much of this weakness–hardly a surprise. Developments in Mexico have weighed heavily on the stock in recent months.

What’s wrong south of the border? Output from Cantarell, Mexico’s largest oilfield, continues to decline rapidly, along with the nation’s overall production. The most recent data from PEMEX, the national oil company, indicates that oil output has plummeted from close to 3.1 million barrels per day in 2007 to 2.5 million barrels per day.

To offset the decline in Cantarell, PEMEX decided to step up spending on Chicontepec, a massive onshore field that produces heavy oil. As with other fields of this type, Chicontepec requires aggressive drilling; PEMEX hired Weatherford and, to a lesser extent Schlumberger, to handle this complex job.

Weatherford rapidly scaled up its infrastructure in Mexico to support what was expected to be a major, multiyear deal. Although output increased and Weatherford met most of its targets in terms of drilling wells, the production gains weren’t as swift as decision-makers had hoped. Even worse, politicians decried the vast sums of cash PEMEX was spending to ramp up output.

Bowing to political pressure, policymaker cut PEMEX’s budget and sank most of the capital into developments around key offshore fields such as Cantarell and KMZ. Activity in Chincontepec and many of the nation’s other onshore fields ground to a halt.

Mexico’s policy shift wasn’t that big of a deal to Schlumberger’s overall revenue, but this about-face dealt a major blow Weatherford, which regarded the contract as entrée into a lucrative market given PEMEX’s efforts to replace declining production from formerly prolific fields.

And the damage was more than just strategic. In the fourth quarter Weatherford had 50 strings working in Mexico. (A string is a drilling rig along with all of the other equipment and labor needed to handle a drilling operation).

As activity wound down, Weatherford reduced the strings operating in the region to 10 by the end of the second quarter. Shifting 50 strings to a region only to reduce that number to 10 a few quarters later is bad enough, but the excess capacity hit profit margins and revenue hard.

Thankfully, this problem is now in the rearview mirror. Revenue from Mexico should continue to decline in the third quarter, but the firm has dismantled most of the operation; management indicated that the Mexican debacle shouldn’t erode earnings too much going forward.

One analyst on the second-quarter conference call asked about rumors that Pemex once again plans a 54 percent increase to its 2011 budget in an effort to boost output. Weatherford’s CEO Bernard Duroc-Danner responded rather cautiously:

I wouldn’t necessarily take the percentage requested and sort of bake it in a–in models and things like that, because there is a political process, and it’s really a balance between what PEMEX thinks it can legitimately demand and what the political constituency will give them. But I do think the direction is positive for 2011 and thereon…

Duroc-Danner warns that a big increase in PEMEX’s budget is unlikely; the same political dynamics are at play that prompted the government to shift the national oil company’s strategy at Chiconpetec. Not surprisingly, management appears cautious about scaling up operations in Mexcio.

But if PEMEX manages to eke out a budget increase, the win will be a modest positive for what remains of Weatherford’s operations in the country.

Aside from its Mexican misadventure, Weatherford’s Latin America segment performed well. Activity has picked up in Colombia, where national oil company Ecopetrol plans to spend as much as USD80 billion by 2020 to double its output. And Weatherford continue to expand its presence in Brazil, one of the few countries with legitimate plans to increase oil production significantly over the next decade. Brazil could become one of the company’s fastest-growing markets; the firm has around USD1.5 billion worth of new contracts to complete over the next four years.

Eastern Hemisphere

Weatherford’s Eastern Hemisphere operations comprise a long list of international markets, including Russia, Africa, the Middle East and Asia. Revenue from the region was up 9 percent sequentially, while the rig count was up only 3 percent.

Shorter-term swings in North America may have made Weatherford’s quarter, but its long-term potential lies in the East. And with margins steadily improving, management expects growth in the Eastern Hemisphere top all other regions in 2010. If these forecasts bear out, the East will account for more than half the company’s business for the first time in its history.

Russia was the standout performer in the second quarter. The nation was the world’s largest oil producer and the second-largest producer of natural gas in 2009; Russia is of huge strategic long-term importance. Weatherford has assembled an enviable position in Russia, a foothold that was greatly enhanced when it acquired the services operation of BP’s Russian joint venture, TNK-BP. The only other company that boasts a similar footprint in Russia is Schlumberger, king of the services realm.

Rising activity is one component of Weatherford’s improved performance in Russia, but the biggest contributor in the quarter was the integration of the TNK-BP operation with the company’s existing Russian operations. The company enjoyed particular success selling TNK-BP services to other companies in Russia. In addition, management believes that Weatherford’s increased scale and better local support infrastructure enables it to serve clients better and win business.

Drilling activity should continue to increase in Russia as operators gain confidence in the sustainability of high oil prices. Weatherford also noted that prices in the nation fell precipitously after the 2008 financial crisis and commodity bust weighed wreaked havoc on Russian operators. Management hinted that prices would normalize eventually.

But the more important factor for the near-term profitability of its Russian operations is the same as it is for the rest of the Eastern Hemisphere: absorption. Weatherford has significant fixed costs associated with its infrastructure in the region; as the level of activity rises, these costs will be spread out over a larger amount of business, improving profit margins.

Weatherford also highlighted strength in Sub-Saharan Africa, a much smaller market that offers the highest profit margins of any region in the Eastern Hemisphere. Management has targeted this region more aggressively after opening a regional office in Johannesburg.

If there was one region in the Eastern Hemisphere that disappointed, it was the Middle East. Management acknowledged that revenue in the region fell short of forecasts established at the beginning of the year. That being said, this weakness isn’t a major concern; the shortfall stemmed primarily from a ramp up in activity ahead of projects that will get underway over the next several quarters.

Specifically, Weatherford has a number of large-scale projects in Iraq and six other nations in the region. Before these contracts generate revenue, Weatherford has to move people and equipment into place; these start-up and mobilization costs depress margins until revenues begin to flow.

Although this was bad news for second-quarter margins, the good news is that high mobilization and start-up costs mean that Weatherford continues to book new business. When asked about this point during the conference call, management noted that visibility surround future demand in the region continues to improve.

In fact, management expects the Middle East to be a growth leader in the second half of the year. Once again, the driving factor is absorption; as new projects start up, mobilization costs decline and revenues begin to flow, increasing margins.

Despite improving operation trends and superior growth potential, Weatherford has underperformed the oil services group by a significant margin and trades at a substantial discount to its peer group.

The Mexican misadventure that’s plagued the stock since last autumn has passed, and its North American operations are in good shape thanks to Weatherford’s heavy exposure to onshore activity and the minimal impact of the Gulf moratorium. In the Eastern Hemisphere, projects start-ups will reduce the impact of costs and boost margins into the back half of the year.

In the most recent live chat, a subscriber asked whether I would buy Schlumberger or Weatherford if I could only choose one. My response was Weatherford; I see more near-term upside for the stock as it plays catch up with the group. Buy Weatherford International under 26.

Deepwater’s Future

Savvy investors know that evaluating a company’s prospects involves a great deal more than checking whether it beat or missed earnings expectations in the most recent quarter. Many managers offer extremely valuable qualitative and quantitative commentary about the industry and the impact of recent news events, analysis that has bearing on their own firm as well as the competition. Usually these discussions occur during the question and answer period that follows every conference call.

Weatherford CEO Bernard Duroc-Danner made offered some noteworthy comments on the impact of new regulations that will likely follow the Gulf oil spill:

It’ll be less important…the time to get the projects done will be longer, and the cost to do things will be greater. Also means that fewer people can play in that market. You understand all of this simply because liabilities are now essentially open-ended and so very few people can afford to play in that market.

So now you have fewer people. And so think of the process of selling properties and that sort of thing which will take place because some players simply can’t stay in that market. So much longer, more expensive. And by process of osmosis, it mean that some of the plays abroad will be impacted, to a lesser degree, but they will be.

So our view is that, all things being equal deepwater as a percentage of the oilfield services market will go down. Not only now because the Gulf of Mexico moratorium which is extreme, but on a secular basis will go down. And that therefore the land plays are going to have more important.

This is the most pessimistic outlook I’ve heard regarding the future of deepwater drilling from any of the major services and equipment companies. Duroc-Danner asserts that coming regulations will lock smaller companies of the market, as these firms won’t be able to accept the potential for unlimited liabilities. This realization will force the smaller players to divest assets and drive up costs across the industry.

A few points are worth noting. First, Weatherford is the smallest player in the deepwater space, and the company stands to reap the rewards if activity shifts onshore from the deepwater. The other side of coin is that Duroc-Danner can afford to speak openly about deepwater; the firm doesn’t have much deepwater business.

Still, there’s a kernel of truth to what Duroc-Danner says; regulations will increase costs, particularly in the US, and the liability issue could force smaller players to exit the Gulf. This scenario would mean higher oil prices and greater reliance on foreign oil for the US. Such an outcome would shift some activity and spending to onshore oil plays in North America.

However, I don’t buy Duroc-Danner’s argument for a secular decline in deepwater activity. Short-term disruptions aside, deepwater represents one of the few significant production growth in coming years. Over the long term, a renewed focus on onshore activity is unlikely to offset a major slowdown in deepwater production. Some of the largest oilfields discovered in the past 20 years are in the deep. Companies will continue to exploit these fields because they must.

And although regulation will shape US deepwater exploration and development, international projects will continue to go ahead. This will likely mean an up-tick in activity in places like West Africa.

I highlighted this quote not because I agree with Duroc-Danner but because investors must keep their eyes peeled for risks. Regulation of deepwater drilling that slows the industry’s growth both in the US and abroad is a key risk to monitor in coming quarters.

Schlumberger (NYSE: SLB)

Key Takeaways:

• Schlumberger largely met expectations for the quarter. Results weren’t quite as strong as Weatherford’s because Schlumberger has less exposure to North America.
• Results from North America and Russia were strong, while North Africa was a weak spot.
• Winding down the company’s operations in Mexico will be a drag on results.
• Management was bullish on growth in the Middle East and expects a gradual ramp-up in activity in all international markets into 2011.
• The Gulf moratorium has weighed results in the near term but won’t stunt long-term growth in global deepwater drilling.
• Schlumberger is in the sweet spot of the oil-services cycle, buy under 85.

With a market cap more than twice that of Halliburton, Schlumberger is the biggest oil services company, hands down. As such, the firm’s operations extend into just about every imaginable oil or gas-producing region of the world. CEO Andrew Gould routinely provides invaluable color and granularity about Schlumberger’s diverse business lines and geographic footprint.

The oil-services business is one of the most high-tech industries on the planet. Schlumberger has earned a deserved reputation for developing and commercializing some of the most-advanced technologies out there.

Investors should also remember that Schlumberger is generally associated with exploration more than than development. In other words, Schlumberger’s largest competitive advantages tend to lie in service functions related to exploring for new oil and gas fields.

That’s not to suggest that Schlumberger isn’t involved in development; rather, an uptick in exploration tends to provide more of an earnings boost.

This operational bias means that Schlumberger’s sweet spot occurs slightly later in the cycle; as commodity prices rise, companies first develop existing fields more aggressively and then focus on exploration. Bottom line: I consider Schlumberger to be a must-own energy stock for the long-term, as it will benefit from the secular trends toward greater oilfield complexity.

In the second quarter, Schlumberger basically met earnings expectations of $0.68 and beat slightly on the top line, generating revenue of $5.94 billion. The stock didn’t react as positively to the news, falling about 3 percent the day the company reported results.

Why did Schlumberger’s stock sink when shares of Weatherford and Halliburton headed higher after their earnings releases? Quite simply, its competitors roundly trumped earnings expectations, while Schlumberger finished roughly in-line with the consensus forecast. Viewed within this context, the company’s earnings suffered from less exposure to onshore activity in North America.  

Don’t mistake this near-term weakness as a strategic disadvantage over the long haul; as I explained in my discussion of Weatherford’s second quarter results and conference call, Russia and other markets in the Eastern Hemisphere should drive growth in the back half of the year.

A few days after the earnings release, shares of Schlumberger moved higher, possibly in recognition of this point.

From a regional perspective, Schlumberger’s results and management’s comments reflected the same trends reported by Weatherford.

Earnings in the company’s oilfield services division jumped 7 percent sequentially, while WesternGeco’s (seismic services) net income was up 1 percent. The growth in the oilfield services division came from the same drivers Weatherford highlighted: solid growth and better pricing in US onshore markets, and a stronger-than-normal seasonal rebound in Russia.

Schlumberger’s Mexican operations posted solid results this quarter; however, this strength stems from timing, as opposed to an advantage over Weatherford.

Management noted that revenue from projects in onshore Mexico will decline in the third quarter and through the remainder of the year, largely because integrated project management (IPM) deals–basically a contract to manage the development of a field–for onshore plays are drawing to a close. The company will take a charge in the third quarter to reflect lower activity in Mexico.

That being said, Schlumberger also has exposure to Mexico’s offshore operations, fields that are benefiting from the decision to reallocate resources from onshore projects.

Like Weatherford, Schlumberger also has a number of new projects slated to get underway in the Middle East. Management highlighted the Rumaila oilfield of Iraq as an example; the company has moved the first of three rigs into place and is preparing to drill. Activity in Iraq should ramp up through the remainder of the year.

Management noted that it’s more optimistic about the Middle East than it was at the end of the first quarter, a statement that bodes well for both Schlumberger and Weatherford. Schlumberger also is gaining ground due to superior technology; the company appears to have won six rig contracts away from competitors in the Middle East because it was able to drill the required wells faster.

As for areas of weakness outside Mexico, Schlumberger also noted a growing impact from the US Gulf of Mexico drilling moratorium. In the second quarter, the moratorium hit oilfield services earnings by $0.02 per share; management forecasts that this activity won’t return in 2010, lowering full-year earnings by $0.08 to $0.12 per share.

It will be tough to gauge the moratorium’s impact on Schlumberger’s WesternGeco subsidiary, a leading provider of seismic services. This service uses sound a pressure waves to map subsea rock formations, a key to identifying areas for potential exploration and maximizing the efficiency of well placement. Important lease sales are scheduled to take place in 2011, though many observers expect authorities to postpone the March bid.

Normally, producers would purchase databanks of seismic information from Schlumberger to decide which blocks to bid on and how much they’re willing to pay. But if sales in the deepwater Gulf of Mexico are canceled or postponed, revenue could suffer into 2011.

Despite Schlumberger’s exposure to the Gulf, the hit to the company’s bottom line shouldn’t be too dramatic, nor will it affect long-term growth prospects. At this valuation the stock already prices in these headwinds.

Business was also weak in North Africa after several IPM contracts in the region wound down and new projects were delayed. But management emphasized West African activity–mainly deepwater drilling–should remain robust in the back half of 2010.

All told, Schlumberger expects international activity to increase gradually in the latter half of 2010 and into 2011, expanding the company’s margins. Management also suggested that this growth will more than make up for the impact of the moratorium over the next few quarters.

Schlumberger appears to be approaching the sweet spot of the cycle; expanding margins and increasing activity tend to propel the stocks higher.

Much of what Schlumberger reported echoed comments from Weatherford’s management team. Consensus is fine, but investors should pay even closer attention to divergent statements. CEO Andrew Gould’s comments on deepwater drilling during Schlumberger’s second-quarter conference call are a case in point:

I think the first thing to say is in the last three years, somewhere between 40 and 50 percent of the new field discoveries have been in the deepwater; that deepwater production has been scheduled to become 10 million barrels per day by 2015 so that’s approaching 10 percent of world supply and it’s a bigger supplier than almost any country apart from three. So I think that it’s highly unlikely that apart from some delays caused by proper caution and control that there is any significant reduction in deepwater activity anywhere. And I find it extremely interesting that both Norway and the UK have permitted some of the deepest wells they’ve ever drilled since the Gulf of Mexico moratorium was put on, so I don’t think this is going to significantly slow deepwater in the medium to long term.

I do think that the issue of spill response is something the industry has to address…and in terms of ourselves, I feel extremely comfortable because as I pointed out in the press release, we have made a huge effort to understand the risks of what we do in deepwater and to specifically train our people to be aware of those risks and to react to them. So after a brief pause in the Gulf of Mexico, I don’t see any reason to change our strategy in deepwater.

As investors, we must cut through the hype and panic to identify the fundamental factors at work in an industry. 

Few news events have generated more hype and hysteria than the oil spill in the Gulf of Mexico. In the June 10 issue of The Energy Letter, Macondo and $100 Oil, I attempted to introduce some reason to the panicked discourse, recalling that the Gulf’s resilience in recovering from Ixtoc-1, a similar spill that occurred in 1979. In addition, I pointed out that hot weather breaks down oil quickly and that the Gulf contains bacteria that consume oil that naturally seeps into the water.

I didn’t write that issue to minimize the economic damage caused to industries such as tourism and fishing; my point was that the ultimate environmental impact would be somewhat less than the alarming headlines suggested.

Many investors overreacted to the hype, rushing to the conclusion that the problems in the US would extend to global deepwater drilling. As I noted in several issues of The Energy Strategist, these same headlines offered opportunities for rational investors to pick up names like Schlumberger and Seadrill (NYSE: SDRL) at attractive prices.

Andrew Gould’s comments reflect these realities. The Gulf spill is a tragedy, and it will take time and money to clean it all up. But deepwater drilling is just too important to the global oil production to be ignored. This is even more true in the US, where the deepwater Gulf was expected to be one of the only regions that would actually see real output growth in coming years; without this output, the US will need to import much larger quantities of foreign oil.

Although the drilling moratorium has halted activity in the Gulf and will hurts results for services companies in the region, the implications for international markets are far less profound. Management noted that deepwater activity outside the US hasn’t declined; deepwater isn’t dead and remains a solid long-term investment theme.

Recent news that BP (NYSE: BP) has more or less killed the Macondo well should also boost sentiment. And rumors continue to circulate that the government will announce that three-quarters of the oil spilled has either evaporated or been collected. Environmental issues and questions about BP’s liability will still be in play, but the headline risks associated with the spill are beginning to abate.

 As Weatherford CEO Bernard Duroc-Danner noted, the question of liability will determine the shape of future deepwater activity in the Gulf of Mexico. Schlumberger CEO Andrew Gould’s take was notably less pessimistic than that of his counterpart:

The market [in the Gulf of Mexico] is not going to be the 45 rigs that people were talking about as little as four or five months ago. I don’t know that it is going to be 15 to 20 because I don’t think you’re going to be able to define that until you actually know how the liability is going to be defined. There is a risk that you quit rightly point out that this becomes limited to the super majors and perhaps people with national government backing. But In think it’s too early to assume that. So for the moment, we are doing our best to get the Gulf of Mexico back to break even by lending our people and equipment. That’s going to be very tough in Q3 and after that we’ll look and see how it looks afterwards.

In the longer term, I think that people will adapt their deepwater programs to other theaters where perhaps they feel they have a more clement regulatory climate in which to drill. I don’t know whether you read the Financial Times piece yesterday, but there was a very good summary of all the reactions so far around the world in different regulatory bodies to this and there isn’t one yet that has taken–and obviously they don’t have the emotional problem the US does–has taken such a firm stance against deepwater, and I very much doubt they will.

Gould confirms that new liability limits passed by Congress could lock smaller operators out of the Gulf, resulting in a market dominated by a handful of super-majors and national oil companies. Smaller, independent operators may have to pick up their stakes and move elsewhere.

But Gould doesn’t foresee any impact on deepwater markets outside the US. In fact, activity may tick up in these markets because of new US deepwater drilling policy; smaller players in the US will simply shift their focus overseas where they won’t face the same liability risks. Based on what we’ve seen so far, it appears that the Gulf of Mexico spill won’t have a huge long-term impact on the profitability of deepwater-focused services companies.

One final point to note: Schlumberger has been bearish in prior calls about gas markets–mainly North America–relative to oil. This reflects, in part, Schlumberger’s relatively small exposure to this market. But in this quarter’s call, Gould threw in the towel, acknowledging that gas drilling activity in the US likely would remain robust through year-end.

Baker Hughes (NYSE: BHI)

Wildcatters recommendation Baker Hughes released results on the day I wrote this issue; my analysis will be a bit less comprehensive.

The stock suffered a hard hit after that day; the report was by far the weakest of the Big 4. And because the stock has outperformed, the miss proved more damaging to sentiment. The quarter also included a lot of noise, including charges related to the company’s acquisition of BJ Services (NYSE: BJS).

Generally speaking, Baker’s results were in-line with expectations. However, the company was way above expectations in North America, obfuscating a rather large shortfall outside the region. Baker benefited from the same trends in North America as Weatherford and Schlumberger, and the firm is well positioned to take advantage of these opportunities, especially with BJ Services’ expertise in shale plays.

International operations were weak mainly due to Latin America and Africa, two markets where Baker has invested heavily.

Baker has encountered problems in Mexico, though not as dire as those experienced by Weatherford. The company had ramped up operations to support the Alma Marine IPM deal with PEMEX but has failed to secure additional work in the area and will allow the contract to expire.

As with Schlumberger, North Africa was an area of weakness for Baker. Management noted that Libya cut its budget by 30 percent, and activity in Algeria is recovering slowly after a shakeup at its national oil company, Sonatrach.

Neither of these problems is company-specific, though Baker’s results are disappointing given the amount of capital the firm has invested in Mexico and Africa.

Results elsewhere were more or less in-line with results from Schlumberger and Weatherford. Russia, sub-Saharan Africa and parts of the Middle East were solid. Management believes that North Africa and West Africa will pick up again toward the end of the year.

The market has overreacted to a single weak quarter. I like the company’s new organizational structure, which organizes the business by geographical regions rather than product lines; this structure makes it easier for the firm to win contracts in international markets. And the rising tide of improving international demand should lift results later this year. Baker Hughes remains a buy under 55.

Master Limited Partnerships (MLP)

The term “earnings” season is a bit of a misnomer when it comes to MLPs; traditional earnings measures used to value common stocks are next to meaningless for most partnerships. Earnings are an accounting construct and include several charges that don’t represent actual cash flowing into or out of a business.

One of the largest such charges is depreciation, essentially a means of spreading the cost of an asset over multiple years. Depreciation charges reduce reported earnings per share over time even, though they don’t represent actual cash charges. This is a particularly significant issue for energy-focused MLPs, a group that operates asset-intensive businesses such as pipelines, storage caverns and gas-processing plants. These assets require significant up-front capital to build and then are depreciated over a period of years, generating a steady stream of non-cash charges.

For partnerships involved in actual oil and gas production–such as Wildcatters recommendation Linn Energy LLC (NasdaqGS: LINE)–mark-to-market accounting on hedges is another issue.

MLPs that produce oil and natural gas typically use options, swaps and other derivatives to lock in oil and gas prices for future production and limit exposure to volatile commodity prices. Linn, for example, hedges essentially 100 percent of its planned production for two to three years into the future and a smaller percentage of planned production for subsequent years.

But according to generally accepted accounting principles (GAAP), the value of these hedges must be marked to market each quarter. If oil prices rise in a particular quarter, the value of future hedges would, by definition, fall. Under US accounting rules, this would mean a paper loss on all hedges the partnership has in place, regardless of which year’s production they cover. Fret not. These hedges are structured so that the MLP owes no additional margin or deposit, regardless of what happens to commodity prices in the interim years.

Nevertheless, because of this accounting quirk, relatively small rallies in oil or gas prices can produce mythical losses; these paper losses don’t affect the cash the MLP receives from selling its oil or gas production in any particular quarter. MLPs aren’t trading oil and gas hedges in an effort to predict swings in oil and gas prices; for the most part, management teams rely on these instruments to lock in a fixed price for future production.

The more an MLP hedges production, the less sensitive cash flows are to near-term shifts in commodity prices. Unfortunately, the larger the hedge book, the bigger these phantom swings in the value of mark-to-market hedges.

Instead of looking at earnings, the key metric for MLPs is a non-GAAP measure called distributable cash flow (DCF). DCF is calculated by adding non-cash charges like depreciation, mark-to-market hedge adjustments and depletion back to earnings. A charge known as maintenance capital spending (CAPEX)–a measure of the spending needed to maintain assets in good working order and sustain cash flows–is subtracted from that adjusted earnings figure to obtain DCF.

To ensure a steady stream of income, investors should monitor the health of each MLP’s DCF over time, bearing in mind that each MLP calculates this figure in slightly different ways. We always look beyond the reported results to determine if these numbers make sense and are consistent over time and with industry peers.

This caveat aside, DCF is the figure we watch most carefully when evaluating results, and it’s also the most widely watched metric by institutional investors.

A word of caution: All MLPs must report earnings per unit (the equivalent of earnings per share) when they release quarterly results, and most Wall Street analysts publish earnings estimates by convention. Accordingly, many financial websites and news services will report these misleading earnings figures in headlines and state that a particular MLP has missed or beaten expectations; because computers automatically generate some of these headlines, this should come as no real surprise.

Investors have learned to ignore these headlines, though an individual name will sometimes react to bullish or bearish MLP “earnings” headlines in the wake of quarterly results; this knee-jerk reaction can provide an opportunity for nimble investors. We will always issue a Flash Alert if news or results from one of our recommended MLPs changes our opinion of the company or its ability to sustain distributions. 

In addition to looking at reported DCF figures and changes in quarterly distributions, the conference calls that follow each quarterly release are instructive. Conference calls help to highlight businesses showing relative strength and weakness within the MLP industry.

Kinder Morgan Energy Partners LP (NYSE: KMP) and Enterprise Products Partners LP (NYSE: EPD) are two MLPs I watch closely each quarter. These two firms are among the first to release results and are bellwethers for the rest of the group; both Kinder and Enterprise are large MLPs involved in a number of businesses and, as such, provide bird’s-eye view of key trends. Here’s a review of both firms’ results.

Kinder Morgan Energy Partners raised its quarterly distribution from $1.07 per unit in the first quarter to $1.09 in the second, marking the 37th quarterly increase in the past 13 years. For full- year 2010, management expects to meet its target for a total distribution of $4.40 per unit, implying that it will increase its payout over the next two quarters.

Kinder Morgan Energy Partners’ adjusted distributable cash flow (DCF) was $1.06 per unit in the second quarter and $2.24 per unit in the first half. The partnership didn’t fully cover its distribution for the second quarter but managed to cover its first-half payout by roughly 1.04 times.

Normally, we’d be concerned about an MLP that fails to cover its payout in any single quarter, and 1.04 is a tight coverage ratio, even for a large, well-diversified operator such as Kinder Morgan Energy Partners. But in this case the MLP’s lack of coverage isn’t a major concern; the outfit’s underlying businesses continue to perform, and additional cash flows will kick in the in latter half of the year. In addition, Kinder Morgan Energy Partners’ second-quarter DCF excludes some one-time benefits the MLP received from its general partner; the MLP’s actual coverage is a lot better than it first appears.

One of the most important projects Kinder has underway in the near term is KinderHawk Field Services, a joint venture (JV) with one of the largest  and best-positioned exploration and production firms in the Haynesville Shale, Petrohawk Energy Corp (NYSE: HK). To form the JV, Kinder Morgan Energy Partners acquired a 50 percent interest in Petrohawk’s gas gathering and treating facilities in the Haynesville for a little over $900 million and plans to expand these assets aggressively.

Gathering lines are small-diameter pipelines that connect individual wells to the pipeline network. Treating plants remove naturally occurring carbon dioxide from natural gas. The Haynesville Shale is attractive for two interrelated reasons: Prolific wells and a low-cost of production. In fact, many operators remain profitable even with gas prices at depressed levels.

That’s why activity in the play has continued to pick up over the past year despite weak gas prices and a slowdown in production from conventional gas plays; more drilling means more wells that need to be hooked up to gathering pipelines.

The Haynesville is located deep underground and contains “dry” gas that’s devoid of natural gas liquids (NGL). However, Haynesville gas tends to be relatively high in carbon dioxide; increased production from the region will require additional gas treating capacity.   

KinderHawk contributed cash flows to Kinder Morgan Energy Partners in the second quarter, but the amount was modest because the JV had existed for a little over a month. Management estimates that a throughput of roughly 800 million cubic feet per day of gas by the end of 2010. Over the long term, the partners are targeting a throughput 2 billion cubic feet of gas per day.

Management also noted that the firm is ahead of plan on pipeline volumes, thanks to robust demand from third-party producers. This news sets the stage for KinderHawk to record significantly higher distributable cash flows later in the year, supporting an increase in distributions.

And last quarter the MLP’s general partner (GP) once again demonstrated its support for the limited partner. As we’ve explained in prior issues, the GP manages an MLP’s assets, receiving a fee known as an incentive distribution right (IDR) for its services. These IDRs are typically based on the distributions paid to MLP unitholders; as distributions reach certain threshold tiers, the general partners’ IDRs rise. This structure incentivizes distribution growth.

As part of the financing for the KinderHawk deal, Kinder Morgan Energy Partners’ GP agreed to forego a significant portion of the IDRs it would normally receive from the JV until after 2011. By foregoing IDRs, the GP will effectively increase Kinder Morgan Partners’ DCF over the next six quarters, giving the project plenty of time to ramp up toward full capacity.

Another case in point: Kinder Morgan Energy Partners’ $206 million settlement in the second quarter. For several quarters, Kinder has negotiated a rate case with a group of shippers on one of its refined products pipelines; some of the cases involved date back to the early 1990s. The company paid out $206 million to finally settle these claims. However, that cash isn’t coming out of your pocket; the GP covered the cost of the settlement by accepting lower IDRs.

Also note that payments to the LP as a result of the resolution of this rate case are not included in management’s DCF calculation.

The startup of the KinderHawk JV garnered much of the attention in the quarter but away from the limelight, Kinder’s other major businesses also appear on track. Its refined products pipeline business reported an uptick in volumes transported, suggesting that the recovery in US oil demand is for real.

California increased its mandatory ethanol blend rate to 10 percent, and Kinder Morgan Energy Partners is a major player in that state; ethanol volumes soared 58 percent over the same quarter one year ago. But even if we adjust for the new mandate, refined-products volumes were up a 0.5 percent from a year ago–the first increase in refined-products volumes since the third quarter of 2007. Management also indicated that July volumes are on course to top last year.

Diesel volumes were particularly strong in California, up 5 percent from a year ago, suggesting that the economic recovery continues.

And don’t forget the associated ethanol business. As I noted earlier, the jump in California’s blend mandates pushed volumes sharply higher; it’s impressive how quickly this business has grown for Kinder Morgan Energy Partners. The company was quick to invest in terminals and other infrastructure needed to blend and transport the fuel; management estimates that the firm handles roughly one-third of all ethanol volumes used in the US.

The bulk terminals business also exceeded management’s expectations. Terminals handle the import and export of dry-bulk cargoes such as steel and coal. Management noted an increase in steel volumes for the quarter, benefitting from a jump in capacity utilization (the percentage of plants in operation) at US steel plants. Capacity utilization stands at 75 percent, up from less than 50 percent at the same time in 2009.

Coal was another highlight of the second-quarter conference call. Coal exports from its Gulf Coast and West Coast terminals increased significantly, a sign that international coal demand remains strong.

One business line that showed real weakness was the carbon-dioxide segment. Kinder Morgan Energy Partners transports carbon dioxide for use in enhanced oil-recovery projects, where operators pump the gas into mature oilfields to aid production.

As part of this business, the outfit produces some crude oil and is exposed to fluctuations in the price of the commodity. Kinder Morgan Energy Partners mitigates this exposure in two ways: The commodity-sensitive business is a small portion of the firm’s total revenues, and management uses hedges to lock in oil prices.

Nonetheless, Kinder isn’t fully hedged, and the MLP’s plan at the beginning of the year called for oil prices to average around $84 a barrel. Every $1 per barrel deviation from that average price results in a roughly $6 million hit to the bottom line. That’s not much when you consider that Kinder’s distributable cash flow was north of $600 million in the first half of the year, but it’s still meaningful.

But oil prices have firmed up after briefly dipping below $70 a barrel in late May. With US demand recovering, oil inventories beginning to normalize and Asian demand still strong, I see considerable upside for crude into the back half of the year. Any upside for prices would be a nice tailwind for Kinder Morgan Energy Paqrtners’ carbon-dioxide business, reversing any second quarter shortfall.

And Kinder has a number of major projects slated for completion in 2011 and 2012, which bodes well for distribution growth.

The company has formed a JV with Copano Energy LLC (NasdaqGS: CPNO) in the Eagle Ford Shale of south Texas. This shale play is red hot right now because it’s cheap to produce, and portions of the field are rich in crude oil and/or NGLs. The JV includes an 85-mile pipeline and processing assets and is due to commence operations in summer 2011; Kinder Morgan Energy Partners already has signed agreements covering 200 million cubic feet per day of throughput.

Kinder completed a non-binding open season for a NGL pipeline in the Marcellus region of Appalachia. A non-binding open season is essentially a way for Kinder to propose a new pipeline and allow potential shippers to express interest in contracting for capacity. Apparently, the demand warranted a 230-mile pipeline from the Marcellus to Sarnia, Ontario; the firm started to apply for permitting on the pipeline and is working to sign up commitments. If permitting goes according to plan, the new pipeline could be up and running by the third quarter of 2012.

The Fayetteville Express Pipeline is capable of transporting 2 billion cubic feet of gas per day from Arkansas’ Fayetteville Shale, another low-cost play. This pipe is ahead of schedule and under budget; management noted that the pipeline should be operational before year-end.

All told, Kinder Morgan Energy Partners is a large, well-diversified MLP with an attractive slate of near-term and longer-term organic expansion projects. Management has been quick to enter key shale-gas fields such as the Haynesville and Eagle Ford, either through JVs or by building new pipelines to leverage its existing assets. Disappointing DCF isn’t likely to persist, and management signaled its confidence by sticking with its full-year distribution targets. Kinder Morgan Energy Partners LP remains a buy under 70.

Looking to hold Kinder Morgan Energy Partners in an IRA or add exposure to this outfit over time? Consider buying Kinder Morgan Management (NYSE: KMR), whose only assets are units in Kinder Morgan Energy Partners. But whereas Kinder Morgan Energy Partners pays a cash distribution, Kinder Morgan Management offers additional units–a sort of automatic distribution reinvestment plan. 

Enterprise Products Partners reported a rock-solid second quarter and announced its 24th consecutive quarterly distribution increase, to $0.575 per unit. DCF of nearly $0.75 per unit covered that payout 1.3 times–a high coverage ratio for a midstream MLP. Management has retained about $256 million in excess DCF to fund expansion projects.

The partnership’s overall results were expected to be positive, but some analysts had worried about the outlook for the company’s NGL-related businesses. Enterprise Products Partners owns NGL pipelines, processing capacity for separating NGLs from raw natural gas, and fractionation capacity for separating NGLs into various components. Analysts were concerned because a barrel of NGLs typically hovers around 60 percent of the cost of a barrel of crude oil, and NGLs prices tend to follow crude oil over time. But check out the graph below.

Source: Bloomberg

This graph tracks the price of a typical mixture of ethane, propane, butane and natural gasoline. Despite the long-term correlation between oil and NGL prices over the long term, the value of these two commodities have diverge over the past two months; NGL prices have trended slightly lower, while oil prices have rallied towards $80 a barrel.

The price of NGLs and crude oil sometimes diverge over short periods, but some observers worry that this trend stems from weaker demand. And higher inventories of ethane have fueled concerns that prolific NGL production from shale-gas sets the stage for a chronic oversupply of NGLs and a structural decline in NGLs prices relative to crude.

As many of Enterprise Products Partners’ processing and NGL transport businesses are fee-based, a long-term decline in NGL prices wouldn’t be catastrophic and likely wouldn’t necessitate a cut in distributions. However, a shift in NGL pricing and demand could negatively impact what has been an important growth business for Enterprise and many other MLPs in recent quarters.

Enterprise’s management team obviously knows about these lingering fears and was quick to address them during prepared remarks and during the question and answer period. Management remains extremely bullish about the NGL business and noted that demand remains red hot amid a structural change in the US and global petrochemical industries.

Ethylene is the basic building block for most types of plastic and is one of the most important petrochemicals. To produce ethylene, chemical companies have two basic options for raw material: naphtha derived from crude oil or ethane or propane processed from raw natural gas. As one would expect, relative prices drive this input decision.

Because of high oil prices and prolific NGL production from many of North America’s shale fields, there’s no contest anymore: Any petrochemical processor capable of using ethane and propane will favor these hydrocarbons over naphtha. In the second quarter, a whopping 82 percent of ethylene production capacity used NGLs as an input. The growing use of NGLs as a petrochemical feedstock is an important source of incremental demand.

Enterprise Products Partners regards this situation as sustainable and doesn’t anticipate demand to weaken. Management noted that profit margins available to chemicals producers for ethylene and propylene production were at the highest point since 2005, when hurricanes Katrina and Rita temporarily disrupted production capacity and sent prices sharply higher.

To capture these attractive margins, petrochemicals plants in the US are running at 91 percent of nameplate capacity–an extraordinarily high utilization rate.

For most of the quarter, US ethylene supplies were tight, pushing up prices and margins. Toward the end of the quarter, that situation eased slightly; ethylene production facilities that were shut down for maintenance came back online. However, Enterprise Products Partners noted that the ethylene market continues to be undersupplied. In fact, when a major production facility was stopped temporarily in early July, ethylene prices jumped immediately.

With existing capacity running at close to full utilization, management also highlighted mounting evidence that producers are planning new petrochemicals production capacity. Examples include a US vinyl producer announcing a capacity expansion earlier this year, Eastman Chemical’s (NYSE: EMN) decision to restart an ethylene plant that’s been shut down since late 2008, and informal discussions Enterprise Products Partners has held with producers looking to expand capacity.

Ethane and propane are the preferred feedstock for these expansion projects; NGL demand should increase further. Over time producers that still use uncompetitive naphtha feedstock could convert to NGLs, another source of incremental demand.

Exports are another potential release valve for US NGLs. Enterprise Products Partners announced that its NGL exports averaged 93,000 barrels per day in the second quarter–close to triple the average in second quarter 2009.

And management noted that several pipeline projects aim to move NGLs from the US to petrochemicals plants in Canada, an astounding shift; traditionally, Canadian plants have used local NGLs and even exported some excess to the US. Examples of the latter trend includes Kinder Morgan Energy Partners’ planned NGLs pipeline for moving gas from the Marcellus Shale to Sarnia, Ontario.

Why, then, did NGL prices decline in June? Enterprise Products Partners attributed the bout of weakness to the seasonal shutdown of US ethylene capacity for maintenance. The firm estimates that stopping these plants reduced ethane demand by 6.6 million barrels, elevating ethane inventories toward the end of the quarter.

With those plants now back online, management expects ethane inventories to decline through the balance of 2010, pushing prices higher.  Enterprise Products Partners is a major player in NGLs, and management doesn’t make such predictions lightly; this is good news for the company and Targa Resources Partners LP (NYSE: NGLS).

In addition to management’s comments on NGLs, the conference call yielded two other key points.

Enterprise Products Partners continues to see expansion opportunities in US shale plays. These comments echoed statements from Kinder Morgan Energy Partners. In particular, Enterprise Products Partners continues to build its footprint in the liquids-rich Eagle Ford Shale and currently feeds around 200 million cubic feet of gas per day into its system, up from essentially nothing one year ago.

In addition, the outfit’s Haynesville extension pipeline project is on track for completion next year.

The Obama administration’s moratorium on deepwater drilling in the Gulf of Mexico affected Enterprise Products Partners only modestly. The firm is one of the only MLPs with direct exposure to the deepwater Gulf, though it’s an almost negligible percentage of total revenues and will have no significant impact on the partnership’s distribution.

Throughput volume at its offshore Independence Hub fell from 891 billion BTUs in the second quarter of 2009 to 635 billion this year. Management expects full-year volumes of 500 to 600 billion BTUs per day for the remainder of the year.

Many of the wells hooked up to the Independence Hub are older and require ongoing maintenance, or “workovers” in industry parlance, to maintain production. Although the US drilling moratorium doesn’t prohibit all workovers, it has created a great deal of uncertainty, delaying permit approvals and sparking an exodus of personnel and equipment from the region. Amid this upheaval, many workovers weren’t completed.

One well connected to the hub also watered out–that is, the amount of water produced with oil and gas volumes sharply increased to the point that the well became unproductive. Normally, it might be possible to remedy the situation, but the moratorium has disrupted operations in the region.

None of this is a particular concern for Enterprise Products Partners, but it’s interesting from a macro perspective, as it demonstrates that the moratorium continues to have a material effect on US oil and gas production from the Gulf.

Enterprise Products Partners LP continues to execute; however, the recent rally has put the stock beyond our buy target. Buy Enterprise Products Partners LP when it dips below 38.