Editor’s Note: A few weeks ago we ran an excerpt from The Rise of the State: Profitable Investing and Geopolitics in the 21st Century, a book Elliott co-wrote with David Dittman and Yiannis Mostrous, in The Energy Letter. David and Elliott will host a book signing at the San Francisco MoneyShow. This event will occur at Booth 120 on Friday, Aug. 20 at 3:30 pm PST. Elliott and David look forward to meeting you.

Also note that readers who are unable to make the event will be able to ask me any questions about the book, energy markets or specific stocks during the next Live Chat on Thursday, Aug. 19 at 2:30 EST. Click here to sign up for an email reminder about the chat.

Each quarter I scrutinize dozens earnings reports and conference calls to get a sense of company-specific and broader-market trends. At least one sector always surprises me; it’s incredible how much can change in a single quarter.

I’ve favored coal for over a year and recommend several names in the model Portfolios. Whereas coal still appears to be king, the purported heir to the throne, alternative energy, appears a ways off from being a contender; second-quarter results were decent, but 2011 is shaping up to be an absolute disaster for the former market darling.  

The lesson from this tale of two industries: Buy coal-levered names and short overhyped alternative-energy stocks.

In This Issue

The Stories

Comments during key second-quarter conference calls validate my bullish stance on names with exposure to Asian coal demand. See Coal: Still King.

Most investors associate master limited partnerships with energy-related infrastructure. Here are two high-yielding picks that offer exposure to improving fundamentals in coal markets and limited downside risk. See Coal MLPs.

Seasonal weakness for natural gas prices could weigh on two of my favorite shale-gas stocks, but their long-term growth prospects remain strong. See US Natural Gas.

Our two short plays have panned out well thus far and should benefit from further downside. See Still Shorts Season.

The Stocks

Bucyrus International (NasdaqGS: BUCY)–Buy < 77
Peabody Energy Corp (NYSE: BTU)–Buy < 52
Penn Virginia Resource Partners LP (NYSE: PVR)–Buy < 24
Penn Virginia GP Holdings (NYSE: PVG)–Buy < 21
Natural Resource Partners LP (NYSE: NRP)–Buy < 27
Petrohawk Energy Corp (NYSE: HK)–Buy < 30
Range Resources Corp (NYSE: RRC)–Buy < 60
Cabot Oil & Gas Corp (NYSE: COG)–Sell in Energy Watch List
First Solar (NasdaqGS: FSLR)–Sell Short > 110
Diamond Offshore (NYSE: DO)–Sell Short > 60
Seadrill (NYSE: SDRL)–Buy < 29

Coal: Still King

Bucyrus International (NasdaqGS: BUCY)

Key Takeaways:

• Adjusting for one-off charges related to the acquisition of Terex Corp’s (NYSE: TEX) mining equipment business, Bucyrus beat earnings expectations by a significant margin.
• Sales were down, but quotations, backlog and new orders indicate that demand is accelerating in all markets, with the exception US thermal coal.
• The Terex mining acquisition is a big positive for Bucyrus, allowing the firm to cross-sell new products into its existing markets.
• Once the Export-Import Bank financing deal for the Reliance Power (India: 532939) plant closes, expect management to raise its guidance.

Coal-mining equipment giant Bucyrus International (NasdaqGS: BUCY) reported second-quarter earnings of $0.89 per share, compared to consensus estimates of about $0.94. At first blush, Bucyrus substantially underperformed analysts’ expectations, but in this case the headline number and consensus forecast don’t make for an apples-to-apples comparison.

Chief among these discrepancies were one-off integration costs related to the outfit’s acquisition of Terex Mining, formerly a division of Terex Corp (NYSE: TEX), on Feb. 19. Bucyrus’ market capitalization is less than $5 billion, and the transaction amounted to roughly $1.3 billion in cash and stock; given the size and scope of the deal, which adds several new business lines to Bucyrus’ operations, these initial integration costs weren’t a shock.

Factoring out these costs and some related inventory write-downs, Bucyrus’ adjusted earnings per share were $1.04, considerably above analysts’ consensus forecasts. Despite several misleading headlines about the company failing to meet estimates, the stock popped after the firm reported its results; investors paid more attention to adjusted earnings than the headline number.

Sales were better than expected across the firm’s legacy operations, but a quarter’s worth of contributions from the Terex business lines accounted for much of the bump. Excluding the effects of the acquisition, sales of new surface mining equipment fell 1 percent from a year ago, while sales of aftermarket parts and services on existing equipment were down 13 percent. Underground mining, a smaller business line, also posted lower year-over-year revenue.

But management and the market expected these declines because sales are a lagging indicator; that is, sales from the first half of 2009 likely represent orders and contracts booked in 2008, when commodity prices skyrocketed and sales of mining equipment boomed. This trend held particularly true in international coal markets.

New quotes, orders and backlog provide a better picture of future sales. Quotes are simply an indication of interest in new equipment or parts; booked contracts and backlogs represent locked-in future sales. As the market is a forward-looking mechanism, these metrics are what counts.

News was extremely positive on this front. Excluding the Terex operations, Bucyrus received about $790 million in new orders, double the second quarter of 2009 and up more than 40 percent from the prior quarter. Management also noted robust demand for quotes in Eastern Europe, Russia and China–some of these markets were hard hit in late 2008 and early 2009 as commodity prices collapsed. Now these markets appear to be enjoying a V-shaped recovery.

Management also described India as a “very active” market. As I’ve written in previous issues, the Indian government has ambitious plans to expand the country’s coal-fired generation capacity in an effort to keep pace with electricity demand.

India is also taking steps to improve basic electricity infrastructure; inferior facilities had been a major impediment to growth. The bottom line: India is likely to become the world’s fastest-growing importer of coal over the next few years, and the nation will also look to boost domestic production. Both trends spell rising demand for mining equipment.

Management also noted that quote requests ticked up in Australia and Brazil.

Australia is the world’s largest exporter of metallurgical (met) coal used in steelmaking and thermal coal used in power plants. Much of these supplies are destined for Asia. A jump in quote requests suggests confidence that Asian demand will continue to grow.

And although coal mining is Bucyrus’ largest end market, the firm also sells equipment to miners targeting copper, iron ore and other commodities. Management’s comments about Brazil probably relate to mining giant Vale (NYSE: VALE) and demand for iron ore.

The company reported weakness in only one market: North American thermal coal. Despite the world’s largest coal reserves, the US market is somewhat insular; domestic supplies largely meet domestic demand. US coal prices, production, and equipment demand depend heavily on inventories of thermal coal and electricity consumption.

There are reasons to be optimistic about the US market for thermal coal. Electricity demand has recovered from the depressed levels that prevailed in the 2007-09 recession, and power consumption has been robust thanks to a hot and humid summer. US coal miners have also helped their cause by reducing production in response to high inventories at power plants.

With supply dropping and demand on the rise, these stockpiles are beginning to diminish. In May, the most recent month for which the US Energy Information Administration (EIA) provides detailed data, inventories were off 3 percent from a year ago. And the EIA projects further declines.

As you can see, coal inventories (“stocks”) moved from extremely lean levels in 2005 and 2006 to an outright glut in 2009. Going into 2011, the EIA expects stockpiles to decline gradually to “average” levels. This forecast appears at least directionally correct and should put a floor under US thermal coal prices going forward.

But a modest improvement in the domestic price of thermal coal isn’t enough to generate strong sales growth for Bucyrus. Here’s how CEO Tim Sullivan put it during the company’s second-quarter conference call:

Until we really get some traction with our overall economic situation in the United States, I really don’t see a significant rebounding of the thermal coal market in the United States, and that could be next year at this time or it could even be beyond next year at this time.

Don’t fret. This weakness isn’t a major problem for a company that generates more than 70 percent of its revenues from outside the US. And US met coal markets are in far better shape; domestic steel production has rebounded from recessionary lows, and international demand remains strong. In sort, a weak US market for thermal coal would impact less than 30 percent of Bucyrus’ revenues. Strong international growth prospects continue to drive the stock price.

However, management’s comments underline yet again the importance of selectivity. Investors should favor names with heavy exposure to international coal markets and, in particular, companies with exposure to China and India. Coal firms with meaningful exposure to the US met coal also have attractive growth prospects. And when it comes to US thermal coal, it pays to focus on companies with little or no exposure to the Central Appalachian region. I can’t emphasize this enough (hence the bold text) and will explain my rationale later in this issue.

The Terex acquisition looks like a major long-term positive for Bucyrus. The company had planned to rationalize the new product lines over the next few quarters, eliminating redundant products and reshuffling manufacturing capacity for maximum efficiency.

But the company is postponing these changes because of a welcome problem: Demand for Terex’s equipment is so strong that management can’t slow down any of its manufacturing operations. Needless to say, demand is solid when a company can’t afford to rein in production to cut costs.

The acquisition gives Bucyrus arguably the most-complete line of mining equipment in the industry, a position that opens up plenty of opportunities. The firm’s recent sale of trucks and hydraulic excavators to Brazilian mining giant Vale is a case in point. Here’s how the CEO described the firm’s opportunities during the second-quarter conference call:

I think our relationship with the Big Five is obviously enhanced with the fact now that we’ve got the largest portfolio of mining machinery for them.

And I think with that, I think they want to support us, I think they want to make sure that they have that diversity. But they’re willing to give us that business and give us a shot, which is, again, very pleasing and gratifying from our standpoint. And with the leverage of the installed base that we have, we have opportunities to make sure that as our volume with these customers’ increases, we’re also able to pass on discounts. So it’s all the above. And I think we’re out of the blocks well with a lot of our traditional customers and we expect that to continue.

“Big Five” refers to multinational mining giants BHP Billiton (Australia: BHP, NYSE: BHP), Rio Tinto (London: RIO, NYSE: RTP), Anglo American (London: AAL, OTC: AAUKY), Vale (NYSE: VALE) and Xstrata (London: XTA; OTC: XSRAY).

Whereas Bucyrus enjoys a long-standing relationship with the Big Five, Terex was never particularly successful selling their products to these behemoths; Bucyrus now has the opportunity to cross-sell Terex products to these and other clients in bundles.

A few analysts on the conference call expressed surprise that Bucyrus was able to realize this sort of a deal so soon after the acquiring Terex. Although Bucyrus issued nearly six million shares to finance the acquisition, management expects the deal to be neutral to slightly accretive this year; going forward, cross-selling and bundling opportunities will be a significant tailwind.

Despite signs of improvement, management held fast to its full-year earnings and revenue guidance–a conservative move that likely reflects lingering uncertainty about a deal with India’s Reliance Power (India: 532939).

Here’s the skinny. Reliance is building a coal-fired power plant in India and will open mines to supply coal to the facility; Bucyrus would supply around $300 million worth of equipment.

The US Export-Import (Ex-Im) Bank, funded by Congress, is set up to provide loan guarantees to projects that promote US exports. The bank denied the guarantees for Reliance, citing environmental concerns; the bank has adopted a policy of not supporting projects that would increase global carbon emissions.

At first, it appeared as though Reliance turn to a different supplier–for example, one in China. But a negative public reaction–losing the reliance deal would affect more than 1,000 manufacturing jobs in Wisconsin–prompted the Ex-Im Bank to reverse its decision. It gets more complicated. The approval process has dragged on since last November, preventing Bucyrus from booking the revenue.

I won’t take a stand on the politics of this deal, the existence of a state-sponsored Ex-Im Bank or the appropriateness of the bank’s policies on climate change. Suffice it to say that I expect the deal to go through over the next few months; no administration would be keen on exporting manufacturing jobs from the Midwest in the middle of an election year, especially with the US unemployment rate near multi-decade highs. Once that deal is booked, I expect Bucyrus to boost its earnings forecast.

Given the firm’s strong second-quarter results and management’s upbeat comments, Bucyrus International remains a buy under 77.  

In fact, the stock, and the coal sector in general, is one of my favorite groups for the back half of 2010. This has been a consistent theme in The Energy Strategist this year; I highlighted coal as one of my favorite investments in the Jan. 6, 2010, issue, The Crystal Ball.

A Word about Buy Tactics

Investors who bought Bucyrus on my recommendation late in 2009 are sitting on gains of more than 60 percent and are likely anxious to protect their return against a potential market correction in the fall.

Put options insurance, a technique I explained at some length in the special report The ABCs of Options to Hedge Risk, is one way for investors to accomplish this.

In this case, I’d recommend buying one October $55 put option (BUCY101016P00055000) for every 100 shares of Bucyrus you own. This put currently trades for around $330 per contract.

Bottom line: You pay about 5.5 percent to insure your Bucyrus position against losses below $55 per share between now and Oct. 15, 2010.

Remember, the best thing that can happen in this case is that you lose the entire investment in the puts, which would mean that the stock continued to rally.

As an aside, investors often ask me if it’s too late to invest Bucyrus International, Enterprise Products Partners LP (NYSE: EPD) or Sunoco Logistics Partners LP (NYSE: SXL) given how well these names have done in recent months. Others worry about buying now for fear of a short-term market correction in the seasonally weak months of September and October.

It’s not too late to enter any recommended stock as long as it trades under the price in my buy advice.

Investors worried about a near-term correction should consider a staggering their purchase.

For example, assume you have $12,000 you’d like to invest in Bucyrus or another Portfolio recommendation. Instead of investing all of your capital in a single transaction, consider buying $4,000 worth of shares now and allocating the two remaining $4,000 chunks over the next two to three months.

This way, if autumn doesn’t bring a correction, you’ll have some upside exposure to Bucyrus at low prices. And if a pullback does materialize, you’ll be able to get into the position at a lower average price. This staggered strategy reduces anxiety about “missing out” on upside and reduces the near-term pain of any broader market correction.

Peabody Energy Corp (NYSE: BTU)

Key Takeaways:

• Peabody reported second-quarter earnings that beat analysts’ expectations, and the stock enjoyed a subsequent pop.
• Peabody’s Australian operations once again led the way, benefiting from Asia’s strong demand for thermal and met coal. Management believes this demand is sustainable and is focusing capital spending and growth plans in the region.
• Contrary to some reports, met coal prices remain firm; any weakness is concentrated in lesser-grade coal.
• The US market for thermal coal is slowly recovering; the Powder River Basin (PRB) and Illinois Basin have the best near-term prospects. Management foresees export opportunities for PRB coal over the long term.

Peabody Energy Corp (NYSE: BTU) beat analysts’ expectations in the second quarter, and management was upbeat about business conditions in all of its major markets during the conference call. The company reported second-quarter earnings from continuing operations of $0.69 per share, up from $0.32 per share one year ago and considerably more than consensus forecasts of $0.63. Revenue of $1.661 billion was roughly in line with anaysts’ expectations. Shares of Peabody have responded favorably to the news, outperforming the broader market averages.

Management also boosted guidance, targeting earnings before interest, taxation, depreciation and amortization (EBITDA) of $1.7 to $1.9 billion for 2010 and earnings per share (EPS) of $2.60 to $3.15. This compares to prior guidance of $1.6 to $1.9 billion and EPS of $2.45 to $3.15. Management expects results in the second half of the year to be even stronger.

Peabody’s largest markets are the US and Australia, though the latter drives growth; the company’s revenue increased 24 percent in the second quarter, whereas its Australian sales soared 93 percent.

Five years ago Peabody was a US-centric business, but management spun off its East Coast operations into Patriot Coal Corp (NYSE: PCX) and completed a number of Australian acquisitions. Given planned mine expansions in Australia, the focus will shift even more heavily in favor of Australia over the next few years.

Exports, primarily to Asia, drive Australian coal demand, and management sees no signs of flagging demand. CEO Gregory H. Boyce and his team highlighted a litany of statistics demonstrating that China and Asia’s demand will continue to grow. Here are some examples:

• Chinese electricity generation is up 19 percent in the first six months of 2010, compared to the same period one year ago;
• Vehicle sales in China are up 48 percent this year, and steel production is up 22 percent;
• China’s steel intensity–steel use per capita–is at half or less than that of Japan, South Korea and the US, but will ultimately be higher than in the US because Chinese cities are growing up (high-rise, steel structures) rather than out (suburbs);
• Coal exports to India soared 22 percent in the first half of 2010 and are expected to be up 15 to 20 percent for the full year; and
• Japanese steel production is up 20 percent this year, and imports of thermal coal have increased 13 percent through May–both signs of a recovery from the 2007-09 recession.

Boyce also expects total Chinese coal imports–thermal and met coal–to reach 125 to 135 tons this year, adding that the actual number may trump his estimate. Although the CEO noted that it was too early to gauge demand for 2011, he doubts that overall Chinese imports would go down compared to 2010 totals. Management projects that thermal coal imports in the Pacific region will increase more than 10 percent this year, while imports of met coal will be up 30 percent.

Smart investors listen to Boyce; the scope of the company’s operations provides him unique insight into global coal markets. For example, in early 2009 Peabody’s management was among the first to note a rebound in Chinese demand. This year Boyce shares my view that the Chinese authorities will successfully engineer a soft landing for its economy while setting the foundation for gross domestic product to grow at an average annual rate of 8 to 10 percent over the long term.

Some analysts have noted that slowing production among Chinese steelmakers has softened demand for met coal, a scenario that would lead to lower prices. This chatter is another sign that many still fear a sharp decline in China’s economy.

Management’s comments on this score were instructive: Boyce and his team have yet to see across-the-board softness in demand for met coal. Rather, the weakness appears to be concentrated in lower grades of coal, which makes sense given circumstances earlier this year. With steel production soaring and prices for met coal heading higher, some firms opted for lower-quality coal that lacks the energy content of superior grades. Many steel producers seek to improve input costs by mixing the lower- and higher-grade coals.

But this strategy hasn’t worked for some producers, many of which have stepped up their purchases of higher-grade met coal. Better-quality met coal always commands a premium, but this gap appears to be on the rise. The bottom line: Rumors of softening demand for top-quality met coal don’t reflect market reality.

Given Asia’s high and growing demand for coal, Peabody plans to expand its Australian production substantially over the next few years. Management expects the firm to produce 27 to 29 million tons of coal in Australia this year. Peabody produced 12.6 million tons in the first half of 2010; management’s forecast implies significant growth in the final two quarters. Expanded capacity at the Port of Newcastle is a big part of this export growth.

Management has targeted production of 35 to 40 million tons by 2014. Because Peabody has closed a number of acquisitions in Australia, I wouldn’t be surprised if the company’s output surpasses this goal, assuming demand growth keeps pace.

Peabody’s management was more upbeat about the US market than their peers at Bucyrus International–likely because of the company’s focus on the Powder River (PRB) and Illinois Basins rather than Central Appalachia (CAPP).

During the second-quarter conference call, management emphasized that West Coast producers have maintained their production discipline despite the improvement in thermal coal prices. The following passage from Boyce’s prepared remarks is instructive:

Now in the U.S., economic activity has yet to fully recover, with much more upside potential in the future. But even so coal supply/demand fundamentals are solid in 2010. On the demand side, goal is gaining market share for power generation, and coal consumption by generators is up 6 percent this year. Power plants are running at high utilization rates with cooling degree days 30 percent above the average and 49 percent above last year.

Meanwhile, U.S. coal production is down some 3 percent, driven by a 12 percent decrease in Appalachia. Coal stockpiles have declined below prior year levels. The stockpile draw over the past 5 weeks has been nearly 15 million tons and that is 8 million tons more than normal. So as a result, PRB and Illinois basin inventories will be at near-normal levels by year-end. So you can see why coal prices have marched up in the quarter and continue to set post-recession highs in the Powder River and Illinois basins particularly.

Cooling degree days are a measure of summer heat. Whereas summer 2009 was much milder than average, summer 2010 has been much hotter; the number of cooling degree days is up nearly 50 percent from last year. Higher temperatures increase demand for electricity, and utilities are working through excess inventories.

US production of thermal coal is down 3 percent from a year ago, primarily because of a 12 percent decline in CAPP output. As a result, utilities’ stockpiles declined at twice the normal rate in July.

Pabody’s management also pointed out a big difference between overall US coal inventories and stockpiles at utilities that burn coal from the PRB and Illinois Basin, noting that the latter supplies would near normal levels by the end of 2010. As I noted before, overall stockpiles are forecast to decline but aren’t expected to reach average levels. This explains why PRB coal has commanded higher prices thus far in 2010.

Source: Bloomberg

This graph tracks the prices for two benchmark grades of US thermal coal: PRB 8800 BTU coal and a CSX grade of CAPP coal. PRB coal’s inferior energy content is inferior to the CAPP coal; this grade of PRB coal contains 8,800 British thermal nits (BTU) per short ton, compared to 12,000 to 13,000 BTUs per for most grades of CAPP coal. That being said, PRB coal tends to contain less sulfur, reducing the need for scrubbers to remove sulfur dioxide emissions. PRB coal always trades at a lower per ton price, which is why the graph features two scales.

As you can see, however, the price of PRB coal has jumped from around $8 per ton at the beginning of 2010 to more than $15 per ton. PRB coal has returned to prices that prevailed in early 2008, while CAPP prices remain well off their 2008 highs. CAPP prices have improved, but the gains are modest.

Costs are another challenge for operators in the CAPP, the oldest coal-producing region in the US. Much of the easy-to-produce coal is gone, and many producers are returning to older mines to extract smaller pockets of coal that had been missed. In contrast, PRB coal is located near the surface, and deposits are still thick, reducing the costs and potential dangers.

The US coal mining industry is extremely safe by historical standards and in comparison to China and other big coal producers. But a series of highly publicized mine accidents, primarily in CAPP, have resulted in a series of new safety regulations. Meeting these standards takes time and considerable investment; in many cases, low coal prices mean that the returns just aren’t attractive. These factors have weighed on output.

Meanwhile, the government has cracked down on mountaintop mining, and delays in new permitting may make this controversial practice totally uneconomic.

Coal mining in CAPP will never disappear. But I expect regional operators to focus on met coal: The margins are superior, and CAPP is still home to some of the highest grades of met coal found anywhere in the world.

Peabody’s management has long maintained that the long-term opportunity for the US coal industry resides in the seaborne market. The US does export coal, particularly met coal, but the actual tonnage is rather small compared to the size of the country’s reserves. Peabody continues to work on a plan to export some of it PRB and Illinois Basin production from the West Coast to Asia. Such an operation would be major growth driver for Peabody.

Industry chatter has also focused on the possibility of exporting coal from the Gulf Coast and around Africa to coal-hungry India. A wider Panama Canal could also offer the opportunity to ship coal to Asia.

Exports are the future, but Peabody’s outlook for its US operations remains conservative despite improvements in the market for PRB coal. Much of its US output has been priced and contracted for 2011. But the firm could ramp up production at its big mines if demand surprises to the upside next year.

Meanwhile, more than two-thirds of its Australian output hasn’t been priced for next year: It’s clear where Peabody’s near-term opportunities reside.

The company’s efforts to control costs at its US operations are also encouraging and should keep US margins healthy.

Peabody’s outlook backs up my strategy: Focus on firms leveraged to foreign demand, and avoid companies with major exposure to CAPP thermal coal production. When it comes to US operators, investors should favor names with heavy exposure to the PRB and Illinois Basin. But don’t forget that Asia is the real driver of near-term growth.

Peabody Energy Corp rates a strong buy under 52. Investors considering the stock may want to scale into the position to avoid being caught if the market corrects in the fall.

Coal MLPs

Bucyrus International and Peabody Energy Corp are great growth plays. But the gradual improvement in US coal markets also offers significant opportunities for income-oriented investors.

The Wildcatters Portfolio includes two coal-focused master limited partnerships (MLP) that yield over 8 percent: Penn Virginia Resource Partners LP (NYSE: PVR) and Natural Resource Partners LP (NYSE: NRP).

And because distributions paid by MLPs are taxed differently than normal corporate dividends, a good chunk of the income you receive will be tax-deferred. This makes MLPs one of the only income-oriented sectors that won’t see an immediate impact from the likely tax hike in 2011.

In Oil Services: In the Sweet Spot, I pointed out that earnings per share aren’t the best performance indicator for MLPs; distributable cash flow (DCF), the amount of cash generated by the business after expenses, is a far more meaningful metric.

MLPs involved in coal mining take a relatively low-risk approach that protects revenue streams in volatile and unpredictable markets.

Coal MLPs don’t mine an ounce of the black gold; these firms simply collect royalties. MLPs own property in coal-producing regions and lease this land to mining firms under long-term contracts. The beauty of this arrangement is that the MLPs don’t incur any operating costs associated with the mines–a distinct advantage in the wake of new safety regulations.

A typical lease agreement provides several potential revenue sources for the MLP. First and foremost is a guaranteed minimum fee that the partnership collects regardless of whether the mines operate. This ensures that the MLP receives a base level of cash flow in weak markets.

On top of these contract minimums, coal leases generally provide for a fixed fee per ton sold and a percentage of the gross sales. Such an arrangement offers the coal MLP multiple layers of protection.

First, per-ton fees are based on volumes of coal mined, not the value of the coal; fluctuations in coal prices don’t necessarily impact an MLP’s cash flows. However, the percentage of sales royalties offers the MLP an upside bonus in periods of high coal prices. In effect, the MLP takes on relatively limited downside in exchange for significant upside potential.

Of course, weak coal prices and demand spell lower output from mines, reducing volume-based fees. However, most mining firms sign multiyear deals with utilities. These contracts typically force the utility to accept delivery of some coal each year, regardless of current mining conditions; the nature of the coal contracting business helps to mitigate the risks of fluctuating coal output.

That being said, it’s important to note that these factors mitigate but do not eliminate risk; coal MLPs still carry significantly more commodity and economic risk than MLPs that own and operate pipelines.

But coal MLPs compensate for this risk with significantly higher yields–on average, roughly 200 basis points more than the benchmark Alerian MLP Index. And if my forecast for a gradual improvement in US coal prices and demand pans out, these names could offer plenty of growth potential. Remember: Dividend-paying stocks can also offer growth potential.

Also bear in mind that high yields do not equate to low risk: One must closely scrutinize the underlying business and determine whether operations will generate sufficient cash flow to support the payout. Here’s a look at my two MLP recommendations and their recent results.

Penn Virginia Resource Partners LP (NYSE: PVR)

Key Takeaways:

• Penn Virginia operates a hybrid business that includes coal royalties and midstream natural gas assets.
• Coal royalties are on the rise. The price of thermal coal is recovering from 2009 lows, and metallurgical coal prices are strong. Management raised its forecast for the coal business.
• Long-term contracts with a heavy fee-based component shelter the MLP’s cash flow from volatile coal prices.
• The midstream business suffered from lower throughput and weaker processing margins. But volumes are on the rise, and margins are stabilizing.
• Growth projects, particularly in the Marcellus Shale, position the MLP for a potential distribution increase in 2011.

Penn Virginia Resource Partners LP (NYSE: PVR) operates a hybrid business model that includes coal royalties and natural gas gathering and processing infrastructure. This diversification positions the MLP to benefit from growing natural gas and natural gas liquids (NGL) production from US shale plays and long-term prospects for US coal demand and exports.

Penn Virginia Resource Partners LP’s DCF of 30.24 million failed to meet its second-quarter distribution of 30.24, a coverage ratio of 97 percent.

But this weakness doesn’t reflect underlying business conditions; the MLP took a one-time charge of $5 million related to the separation of its general partner Penn Virginia GP Holdings (NYSE: PVG) from its former sponsor, Penn Virginia Corp (NYSE: PVA). Without unraveling the complexities of this transaction, suffice it to say that the move will provide Penn Virginia Resource Partners LP with greater independence to pursue growth.

Investors should note that when this charge is excluded, the company’s DCF covered the second quarter payout. And over the first six months of 2010 Penn Virginia Resource Partners LP covered its distribution 1.09 times.

Management’s guidance for the remainder of 2010 also suggests that the coverage ratio should be significantly higher on average in the back half of the year.

Bottom line: Penn Virginia Resource Partners LP’s distribution looks safe. A more important question is when the MLP might be able to increase its payout.

The partnership’s coal business has improved steadily, performing better than management expected at the beginning of 2010. The MLP owns 829 million tons of proven and probable reserves, the majority of which is located in the CAPP, but the outfit also boasts significant exposure to Northern Appalachia, the Illinois Basin and the San Juan Basin.

This recommendation seemingly flouts my caveat to avoid coal-levered names with substantial exposure to the CAPP. The warning still stands but applies primarily to corporations.

Penn Virginia Resource Partners LP generates 82 percent of its coal revenue from contracts that provide for royalties based on the higher of a fixed rate or a percentage of the lessee’s gross coal sales. The remaining contracts consist of fixed royalties that escalate automatically each year. As these contracts are usually long-term agreements, shifts in CAPP pricing over the course of a quarter have less of an impact on the MLP than they would on a mining firm.

In addition, the partnership’s coal reserves–a combination of met and steam coal–tend to be high in energy content and low in sulfur. Strong demand and pricing for met coal, coupled with an improvement in the price of CAPP steam coal, are pushing Penn Virginia Resource Partners LP’s royalty margins higher. In the second quarter the MLP’s royalty rate per ton jumped $0.50 to $3.93, compared to $3.43 a year ago. Production from the partnership’s mines was up only marginally; the majority of the 16 percent year-over-year jump in royalty revenue stemmed from higher margins.

These positive developments prompted management to boost its full-year guidance for production and royalties. The MLP is now looking for total production of 32.4 to 33.5 million tons, up from 31 to 32 million, and margins of $3.50 to $3.60, up from $3.30 to $3.40.  

The midstream side of Penn Virginia Resource Partners LP’s business lagged expectations slightly, though management has implemented some promising growth initiatives. The firm is involved in gas gathering and processing, so cash flow depends on two basic fundamentals: gas throughput and processing margins.

Gathering volumes declined to 320 million cubic feet per day from 344 million a year ago. Management attributed the weakness to delays in hooking up new wells to the system; drilling activity in the hottest shale-gas plays continues apace, but a lack of fracturing equipment and personnel has cut into well completions. (Fracturing is the process of pumping a liquid into a gas well under tremendous pressure to physically crack the reservoir rock and enhance production.)

A decline in drilling activity would be a concern, but Penn Virginia Resource Partners LP operates in Appalachia’s Marcellus Shale, the Texas Panhandle and the Granite Wash area of Oklahoma and Texas. Gas from these plays is relatively cheap to produce and contains considerable quantities of NGLs, higher-priced commodities that boost profit margins considerably. I explained the NGLs business at some length in Oil Services: In the Sweet Spot.

During the firm’s second-quarter conference call, management indicated that as of late July Penn’s systems were handling more than 350 million cubic feet per day of gas–a considerable jump. Management forecast that its systems would gather 340 to 350 million cubic feet per day in 2010, suggesting that throughput would increase to roughly 370 million cubic feet for day in the back half of the year.

Bottom line: Gas volumes aren’t a problem for Penn Virginia Resource Partners LP. The Marcellus Shale offers plenty of growth potential. Initial gas volumes–about 10 million cubic feet per day–have begun to flow through te MLP’s system–and the producer has a number of wells that need only be fractured. Once these wells are hooked up, gas throughput should ramp up to 30 million cubic feet per day.

A gathering system that the MLP is building with Wildcatter Portfolio holding Range Resources Corp (NYSE: RRC), a leading producer in the Marcellus, offers long-term upside. Although all of the equipment and pipes are in place, the partners are waiting for Pennsylvania to approve certain permits. Environmental studies that had delayed the project appear to be OK; if all goes according to plan, Penn Virginia Resource Partners LP will begin receiving throughput on Dec. 1. Given Range Resources’ aggressive drilling plans, the system could prove quite lucrative in 2011.  

Lower processing margins related to a decline in NGLs prices also weighed on Penn Virginia Resource Partners LP’s second-quarter results. In the previous issue, I highlighted comments from Portfolio bellwether Enterprise Products Partners LP concerning the intermediate to long-term outlook for the NGLs and processing. Enterprise’s management noted strong demand among petrochemicals processors fir NGLs and suggested that chemicals firms are increasingly using NGLs to make basic chemicals.

Second-quarter refining margins were off because the price of a barrel of NGLs has declined since the end of March. The graph below offers an updated look at this relationship.

Source: Bloomberg

As you can see, the price of a barrel of NGLs has trended lower since early 2010. Some of this weakness stems from seasonal plant maintenance. But the relationship between NGLs and crude oil prices appears to be stabilizing; a barrel of NGLs is worth around 55 percent of a barrel of crude, roughly in line with where it has been since mid-June. In other words, NGLs are no longer underperforming oil prices.

One of the analysts on the call asked why units of Penn Virginia Resource Partners LP have an above-average yield–another way of asking why the stock is undervalued relative to other MLPs.

Management attributed this weak valuation to the MLP’s failure to boost its payout over the past two years. Given the weak coal and NGLs-processing markets of late 2008 and early 2009, it’s impressive that the MLP never cut its distributions; however, investors tend to pay more for MLPs that consistently increase payouts over time.

Accordingly, a higher distribution would be a key catalyst for the stock. If the coal markets continue to recover as expected and the company brings its new midstream operations on-stream by early next year, the MLP could up its payout by the second quarter of 2011. In that event, investors might value the MLP more in-line with the rest of the industry, implying upside to around $30 per unit.

This combination of yield and a potential growth kicker makes for a compelling investment. Even the worst-case scenario–that the partnership simply maintains its current payout–wouldn’t be the end of the world. Buy Penn Virginia Resource Partners LP under 24.

For investors looking to put new money to work, the MLP’s general partner (GP), Penn Virginia GP Holdings, offers exposure to the same story, with a bonus. The GP makes money in two ways: distributions from Penn Virginia Resource Partners LP and incentive distribution rights (IDR), a sort of management fee that the limited partner pays to the general partner.

The size of the IDRs is related to the size of distributions paid to LP unitholders. In other words, the more holders of Penn Virginia Resource Partners LP receive in quarterly distributions, the more holders of Penn Virginia GP Holdings receive in IDRs. And it’s not a linear scale: IDRs increase faster than the rise in distributions. If you’re still confused, check out my detailed explanation, with examples, in the June 23 issue, A Full Tank of Oil.

GPs usually offer a lower yield than LPs because they grow distributions at a faster pace. That’s not the case with Penn Virginia GP Holdings; its yield is roughly equal to that of the LP despite its superior prospects for distribution growth. And Penn Virginia GP Holdings offers the same basic tax advantages as Penn Virginia Resource Partners LP.

I won’t add the GP to the model Portfolios because it would of redundancy, but Penn Virginia GP Holdings is a buy up to 21 for those who don’t already hold Penn Virginia Resource Partners LP.

Natural Resource Partners LP (NYSE: NRP)

Key Takeaways:

• Natural Resource Partners has more exposure to met coal than most of its peers.
• The MLP’s growing exposure to the Illinois Basin is a positive; demand for the coal is expected to rise as more utilities install scrubbers.
• The MLP covered its second-quarter distribution by 1.18 times and recently boosted guidance for full-year DCF.
• Efforts to diversify into new businesses such as minerals and aggregates follow the same basic fee-based royalty structure as coal.

Natural Resource Partners LP (NYSE: NRP) is a purer play on the coal business than Penn Virginia Resource Partners LP; roughly three-quarters of its revenue comes from royalties on coal-related properties.

And the MLP boasts higher exposure to met coal than its peers, a key distinction because this market has recovered more quickly than the price of thermal coal. Although met coal accounts for 22 percent of its reserves, this varietal accounts for one-third of production and 40 percent of coal-related royalties thus far in 2010.

Like most coal-focused MLPs, much of Natural Resource Partners’ production hails from the CAPP. Growing exposure to the Illinois Basin is a plus, as mining costs are generally lower than in mature markets. The area’s relative proximity to the East Coast, home to many coal-fired plants, provides an advantage over production from Wyoming, Montana and Colorado. That being said, coal from this region tends to contain larger amounts of sulfur.

But sulfur content is becoming less of an issue. When the government first began regulating sulfur dioxide emissions, many utilities shifted to low-sulfur coal to cut emissions. Oddly, stricter regulations require utilities to install advanced scrubbers even if they burn low-sulfur coal. Changing fuel alone is no longer sufficient to meet regulations.

Demand for high-sulfur coal is rising. For utilities with scrubbers to remove sulfur, it doesn’t really matter if they’re burning low or high sulfur coal–the more scrubbers are installed, the larger the addressable market for coal from the Illinois Basin. In 2005 Illinois Basin coal represented just 5 percent of Natural Resource Partners’ production; now the region accounts for nearly 15 percent of the total. New acquisitions should push that share higher still. With economics improving in the play, it’s wise for the MLP to beef up its exposure to the area.

Like Penn Virginia Resource Partners, Natural Resources Partners benefited from rising steam and met coal prices in the second quarter. The MLP’s DCF soared 30 percent from a year ago–enough to cover the MLP’s distributions by around 1.18 times. In light of these improvements, management boosted its full-year DCF forecast to $190 to $210 million, a substantial increase from prior projections of $150 to $185 million.

The MLP continues to grow via acquisitions, both in the coal market and in new business lines. In the second quarter the MLP issued about 4.6 million units, garnering $112.5 million in proceeds. Management deployed more than $70 million of this cash into new acquisitions.

Coal-related infrastructure and other minerals are two areas where Natural Resource Partners has expanded operations. The MLP’s assets include five coal-preparation plants in Appalachia, a coal barge loading facility and two rail loops. The firm also recently formed a joint venture with International Paper (NYSE: IP) to manage about 7 million acres of mineral-producing properties. This land produces everything from aggregates (rocks) to timber, precious and industrial metals.

Non-coal assets represent a small portion of the MLP’s assets but feature a similar fee-based royalty structure.

Natural Resource Partners has some sensitivity to coal prices and demand and, like Penn Virginia Partners, hasn’t hiked its distributions since February 2009. This lack of growth, coupled with the perception of commodity exposure, explain the MLP’s 8.4 percent yield.

But with conditions in coal markets on the mend, this high yield is more than adequate compensation for the additional risks. If coal markets continue to improve as expected, Natural Resource Partners could raise its payout early next year–a significant upside catalyst for the stock. Buy Natural Resource Partners LP under 27.

US Natural Gas

Above-average temperatures this summer and storms in the Gulf of Mexico have produced some spikes in North American natural gas prices over the past three months, but generally speaking, the market remains depressed. Natural gas has averaged $4.50 per million British thermal units since the end of the first quarter.

But US gas storage levels have increased at a slower pace.

Source: Energy Information Administration

This graph tracks weekly gas storage statistics compared to the five-year average. Negative numbers indicate gas in storage is either falling at a faster-than-normal pace or rising at a slower-than-average rate.

As you can see, the cold winter of 2009-10 drove above-average gas consumption for heating and pushed storage levels sharply lower. But any gains made during the winter months were immediately reversed during the spring shoulder season, a period of weak gas demand.

US gas production has increased throughout the year, but abnormally cold winter weather masked this growth; as soon spring sprung, excess production began to show up in the weekly storage statistics once again.

This summer has yielded consistently bullish storage statistics, returning inventories to normal levels.

Source: Energy Information Administration

In this graph the blue line represents the five-year minimum storage level; the red line represents the five-year maximum; and the green line is the current path of storage. As you can see, starting in April–shoulder season–US gas in storage set new seasonal records up through July 1. Around this time–just when Americans are firing up air-conditioning units–the green line begins to trend toward normal levels; storage is about 7.9 percent above the five-year average but 5 percent below the level in 2009.

Here’s the short-term concern for gas: Summer weather will keep demand high for a few more weeks, but the fall shoulder season presents problems. In 2009 natural gas prices were extremely weak in September; front-month futures prices dipped under $3 per million British thermal units in late August and early September. As Americans turned off their air-conditioning units, the amount of gas in storage exploded–many analysts worried the country would max out its storage capabilities.

In some ways, the situation last year was worse: A cool summer meant that gas inventories were bloated heading into the fall. This year concern centers on an elevated US gas-directed rig count, the total number of rigs targeting natural gas.

As I’ve explained in previous issues, many of these “gas-directed” drillers aren’t targeting NGL, condensate and crude oil that occur naturally with gas in many shale plays; prices for these liquids are much healthier than prices for natural gas alone. In this scenario, natural gas is almost a by-product.

At the beginning of the year, I opined that this could be a better year for natural gas than 2009. This forecast didn’t call for gas prices to rally above $10 per million British thermal units; my investment thesis focused on producers with exposure to attractive shale plays such as the Marcellus, Haynesville or Eagle Ford. I argued that these producers would prosper for two reasons: low production costs and the value of the liquids produced alongside gas.

Thus far the market action in shares of Range Resources Corp, a play on the Haynesville, and Petrohawk Energy Corp (NYSE: HK), a play on the Marcellus, hasn’t borne out my predictions. Both names have grown production and continue to benefit from attractive economics, but the stock prices don’t reflect these fundamentals.

Production costs–particularly those related to fracturing–have increased, but both outfits have implemented measures to reduce the amount of time, and money, it takes to complete a well.

For example, Petrohawk has enjoyed success choking back output from its wells in the Haynesville; by preventing the wells from producing at the maximum rate, reservoir pressure is maintained over a longer period.

In a normal Haynesville well, initial production rates are sky-high, often north of 20 million cubic feet per day. But production falls 80 percent in the year after the well is completed. Choking back these wells lowers initial production but also limits the decline rate to as low as 25 percent. Management indicated that this strategy increases the wells’ ultimate output.

By reducing costs and focusing on liquids-rich plays, the best producers should enjoy solid profitability. That being said, shares of Range Resources and Petrohawk haven’t been able to shake the negative sentiment stemming from weak natural gas prices, especially as the shoulder period approaches. If natural gas inventories pop again in September and October, the stocks could face further seasonal weakness.

That being said, the long-term prospects for both firms appear rosy; current valuations represent an attractive entry point. Petrohawk Energy Corp is a buy up to 30, while Range Resources Corp is a buy under 60.

Given my forecast for natural gas prices and the potential for a fall correction, I’m examining potential short plays among gas-levered names. Most of the candidates are firms with exposure to less attractive fields and/or a higher cost base.

Cabot Oil & Gas Corp (NYSE: COG) is one potential option. Despite its name, natural gas accounts for 95 percent of the firm’s production. The company has exposure to the Marcellus and Haynesville, but its acreage isn’t the best. And although Cabot will ramp up production in the back half of this year, particularly in Marcellus, I doubt the market will reward the firm for these efforts. For now I’ll track Cabot Oil & Gas Corp as a sell in the Energy Watch List; I’ll issue a Flash Alert if I decide to recommend shorting the stock.

Investors looking to commit new money to the producers should focus on my oil-levered recommendations such as Occidental Petroleum Corp (NYSE: OXY), EOG Resources (NYSE: EOG) and Suncor Energy (NYSE: SU).

Still Shorts Season

Finally, shares of First Solar (NasdaqGS: FSLR) and Diamond Offshore (NYSE: DO) are underperforming the broader market and the energy sector–good news for our shorts.

First Solar reported a decent second quarter because German demand for solar-power equipment was strong ahead of the July 1 reduction in the country’s generous subsidies. Companies completing projects by this date locked in higher prices for solar power generated over next 20 years.

But solar subsidies in Germany will decline 16 percent this year–3 percent on July 1 and a further 3 percent at the end of the third quarter. Many in Germany’s legislature have pushed for even larger cuts in an effort to improve fiscal conditions. Cuts to subsidies have also been proposed or passed in Spain, Italy and other EU nations. Another wave of EU subsidy cuts is slated for the end of 2010 or early 2011.

Meanwhile, a US cap-and-trade bill is dead for at least 2010.

These headwinds are beginning to show up in First Solar’s results; profit margins weakened, and management’s guidance disappointed many investors. All of this precipitated a $10 drop in the stock on the day the company reported earnings. I expect the stock to fall under $100 per share over the next few months as sentiment continues to sour. Short First Solar above 110.

Diamond Offshore is in real trouble. The company’s heavy exposure to contract drilling in the Gulf of Mexico is a major negative because of the moratorium. And once the government lifts the ban, strict new requirements could leave many of Diamond’s aging fleet on the sidelines. And drilling activity won’t return to previous levels as smaller producers exit the region.

Most investors buy shares of Diamond for the high yield, a combination of regular quarterly and special dividends. However, income investors will exit the stock gradually as the payouts wane.

In contrast, Seadrill (NYSE: SDRL) boasts a fleet of new rigs and minimal exposure to the Gulf of Mexico. Even better, the company has boosted its dividends and offers a mouth-watering 10.3 percent yield. The company has the scope to increase the quarterly payout from $0.60 per share to $0.70 to $0.75 in a year’s time. Expect income investors to switch horses. Short Diamond Offshore above 60 and buy Seadrill under 29.