Merger and acquisitions (M&A) activity continues to heat up worldwide, a trend underscored by heavy-machinery giant Caterpillar’s (NYSE: CAT) recently announced acquisition of Wildcatters Portfolio holding Bucyrus International (NasdaqGS: BUCY).

In last week’s installment of The Energy Letter, I sold Bucyrus from the model Portfolios for a roughly 150 percent gain and explained why Joy Global (NasdaqGS: JOYG)–Bucyrus’ closest competitor and replacement in the model Portfolios–could also become takeover fodder. I also promised to share my top 10 takeover plays for 2011; here are the remaining nine stocks. For more details on the 10th pick, Joy Global, check out M&A Boom: The Next Takeover Targets in the Energy Sector.

In picking potential takeover targets, I examined recent deals and sought names that fit within overarching, bigger-picture themes–mergers and acquisitions often come in bunches. All of the picks in this issue are small enough that the heavyweights in their industry groups won’t be scared off by integration risks.

Of course, you should never buy a stock solely because it could be a takeover target; all 10 of my picks have what it takes to generate robust returns for shareholders on their own.

In This Issue

The Stories

The oil services and equipment industries have been a hotbed of M&A activity over the past few years, a trend that should continue into 2011.  Three of my top 10 takeover plays hail from this part of the energy patch. See Oil Services and Equipment.

A trend has emerged in a recent wave of deals among energy-focused master limited partnerships. In all of these instances, limited partners have acquired their general partners, eliminating the burden of incentive distribution rights. The few remaining publicly-traded general partners are potential buyout candidates. See General Partners: Endangered Species.

The investment thesis is simple: China, India and other emerging markets are driving rapid demand growth for coal, and nearby Australia happens to be world’s largest exporter of both steam and met coal. Get ready for deals to get done down under. See Coal for Sale.

The global agricultural challenge is every bit as acute as meeting exploding demand for energy. Here are two ag companies that are ripe for the picking. See Harvesting Profits.

Want to know which stocks to buy now? Check out the updated Fresh Money Buys list. See Fresh Money Buys.

The Stocks

Core Laboratories (NYSE: CLB)–Buy < 95
Dresser-Rand (NYSE: DRC)–Buy < 40
Dril-Quip (NYSE: DRQ)–Buy in Energy Watch List
Alliance Holdings GP LP (NasdaqGS: AHGP)–Buy < 48.50
NuStar GP Holdings (NYSE: NSH)–Buy < 37.50 in Energy Watch List
NuStar Energy LP (NYSE: NS)–Buy < 68
Energy Transfer Equity LP (NYSE: ETE)–Buy in Energy Watch List
Joy Global (NasdaqGS: JOYG)–Buy < 85
Macarthur Coal (ASX: MCC)–Buy < AUD13.50 in Energy Watch List
Intrepid Potash (NYSE: IPI)–Buy < 34 in Energy Watch List
AGCO Corp (NYSE: AGCO)–Buy < 47.50 in Energy Watch List

Oil Services and Equipment

The oil services and equipment industries have been a hotbed of M&A activity over the past few years, a trend that should continue into 2011.   

Recent blockbuster deals include Wildcatters Portfolio holding Schlumberger’s (NYSE: SLB) acquisition of Smith International in late February in an all-stock deal worth $12 billion and Baker Hughes’ (NYSE: BHI) takeover of BJ Services in a cash-and-stock deal worth about $7 billion.

With a market capitalization of more than $100 billion, Schlumberger is roughly three times the size of Halliburton (NYSE: HAL), the second-largest pure-play services name. Given its size and strong balance sheet, Schlumberger should add to the dozens of deals acquisitions it’s closed over the past few years.

But Schlumberger’s buyout of Smith International removed the most prominent takeover target among the leading international oil services companies. Schlumberger has the scope to digest fellow Wildcatters Portfolio holding Weatherford International (NYSE: WFT), the smallest of the Big Four oil services outfits, but such a deal is unlikely because of the business overlap. At this point, regulators could also make the case that further consolidation among the Big Four is anti-competitive.   

Netherlands-based Core Laboratories (NYSE: CLB) is one leading takeover target for the Big Four. Not only does the firm have a market capitalization of just USD4 billion, but its core business of reservoir description should also grow substantially over the next few years. And Core Labs is one of a few smaller services firms that focus on oil-related projects and boast an international business footprint.

Oil and gas don’t occur in giant underground caverns or lakes; instead, hydrocarbons are locked in the pores of rocks. The quality of the reservoir rock largely determines how a particular field should be produced and its ultimate output. Two of the most basic measures of reservoir quality are porosity and permeability.

Porosity is the amount of pore space found in a particular rock; the more pores, the more hydrocarbons that rock can contain. Permeability is a measure of how easily fluids and gases can flow through a rock. In other words, for oil or gas to flow through a reservoir and into a well, the pores of the rock must be connected.

Major US unconventional fields such as Louisiana’s Haynesville Shale and North Dakota’s Bakken Shale contain plenty of hydrocarbons, but the dense and impermeable reservoir rock inhibits the flow of oil and natural gas into the well.

Hydraulic fracturing (fracking) addresses this problem by increasing a field’s permeability. This technique involves pumping a liquid into the formation at such high pressures that the reservoir rock fissures, creating pathways through which the hydrocarbons can flow.  

To assess a play’s porosity and permeability, Core Labs analyzes samples from reservoir rock, scrutinizing both the characteristics of the rock itself and the oil, water and natural gas contained in the field. The company is a market leader in this particular business.

The primary goal of reservoir description is to increase the recovery factor. Original oil in place (OOIP) refers to the amount of oil that’ physically present in a given field; the recovery factor is the percentage of OOIP that’s economically recoverable. Although the average recovery factor is about 35 to 40 percent, this measure varies widely from field to field. And slight variations in the recovery factor can make a big difference in overall output and economics. Measures that increase a recovery factor by 1 or 2 percent can translate into millions of barrels of additional crude oil over time.

The data Core Labs collects and analyzes not only helps to estimate a field’s OOIP but is integral to designing a production program that maximizes recovery factors while minimizing damage. This information and analysis is invaluable in plays that require water flooding or hydraulic fracturing.

Water flooding is a simple concept–pumping water into a mature oil field increases underground pressure and sweeps oil through the reservoir and into producing wells–but designing an optimal water flooding program is extraordinarily complex. This isn’t factory work. Producers must have a clear understanding of how fluids and gases move through a particular field. Core Labs also assists in designing enhanced oil recovery programs that involve carbon dioxide and nitrogen flooding or natural gas reinjection.

Hydraulic fracturing of individual wells occurs in multiple stages, each of which involves the fracking of a specific section of well. As the shale oil and gas revolution has progressed, producers have found that increasing the number of fracking stages often yields the best results. Core Labs’ data and expert analysis are used to determine the best approach for fracturing a particular well.

Roughly 70 percent of Core Labs’ profit and revenue comes from international markets, which explains the company’s bias toward oil-centric projects. In fact, during a conference call to discuss third-quarter results, management noted that it will continue to expand internationally rather than add to its capacity to support US unconventional drilling.

The stock took a hit after the company reported third-quarter earnings that beat analysts’ expectations. Revenue that fell slightly short of Wall Street estimates and management’s conservative comments about the sustainability of US drilling activity appear to be the culprits behind the stock’s decline.

But Core Lab’s shares have turned in a strong performance this year, returning about 50 percent through Dec. 1; the post-earnings dip likely stems from traders taking profits off the table, not long-term concerns about the company’s business and fundamentals. The dip offers a great opportunity to buy the stock.

Core Laboratories, the latest addition to the Wildcatters Portfolio, is a buy under 95.

The oil equipment industry is an even more fruitful hunting ground for buyout candidates. Two of the most likely targets are Wildcatters Portfolio holding Dresser-Rand (NYSE: DRC) and Dril-Quip (NYSE: DRQ).

Dresser-Rand, a leader in the manufacture and after-market maintenance of compressors and turbines, generates about 90 percent of its revenue from the oil and gas infrastructure spending.

Operators use Dresser-Rand’s centrifugal compressors to reinject natural gas and carbon dioxide back into oil fields to maintain pressures and enhance production. Compressors also feature prominently in gas pipelines as well as liquefaction, refining and processing facilities.  

The company also manufactures turbines, though this is a smaller business line. These products are used in a wide range of industrial end markets, including refining, oil and gas production, chemicals and manufacturing. Dresser-Rand is also the exclusive turbine supplier to the US Navy, primarily for power generation and propulsion on aircraft carriers and other vessels.

The pie graph below breaks down the firm’s key end markets.

Source: Dresser-Rand

The prominence of the refining industry in the company’s revenue mix might give investors pause; refining margins in the US and developed Europe continue to suffer ill effects from the 2007-09 economic downturn. Refiners are shuttering smaller and less-efficient operations to reduce capacity and boost margins.

Here’s the rest of the story. While the US addresses its overcapacity, some developing markets will expand their refining capabilities to meet growing demand for gasoline, diesel and other refined products. At the same time, equipment at remaining US facilities will need to be maintained a replaced. This struck me last year when I visited Chevron’s (NYSE: CVX) refinery in Richmond, Calif., a facility that’s been expanded and upgraded so many times that it’s essentially been rebuilt multiple times. Dresser-Rand’s business with refineries should continue to thrive over the long term.

Elevated oil prices should support orders from oil and gas producers. Meanwhile, the rapid development of more than a dozen unconventional plays has prompted US operators to build new pipelines and storage facilities, slowly rationalizing an increasingly outdated system. This construction boom should continue as the shale gas revolution rolls on.

Finally, though cyclical, the chemicals business is in the midst of an uptrend. Output from liquids-rich gas plays such as the Eagle Ford Shale in south Texas have dramatically increased the supply of propane and ethane, natural gas liquids (NGLs) used as feedstock to produce ethylene, the base chemical in most plastics. These NGLs are a welcome alternative to naphtha, which is produced from crude oil; an abundance of these relatively inexpensive hydrocarbons gives US chemicals producers a considerable competitive advantage.

Dresser-Rand’s third-quarter earnings fell slightly short of consensus expectations, and management lowered its full-year guidance. Although the stock sold off sharply after the announcement, it has since recovered, partly because management unveiled a series of growth initiatives at an analyst day in mid-November.

A new environmental solutions unit will serve companies working on innovations such as compressed-air energy storage, a technology that can fill in for intermittent power sources such as wind and solar energy. By using electricity to pressure pump air into underground chambers, the operator can generate electricity during downtimes by releasing the air to drive a turbine.

The new business segment will also target opportunities in carbon capture and sequestration, a process that involves culling carbon dioxide from power plant emissions and injecting it into permanent underground storage facilities. Compressors and turbines–Dresser-Rand’s bread and butter–are essential components in such  a system.

With a market capitalization of about $3 billion, Dresser-Rand would be just the right size for a larger equipment provider such as National Oilwell Varco (NYSE: NOV) or fellow Wildcatters Portfolio holding Cameron International (NYSE: CAM). Dresser-Rand is now a buy up to 40. 

Dril-Quip manufactures a wide range of offshore drilling and production equipment. Here’s a quick rundown of some of the company’s main product lines.

Subsea wellheads are installed directly on the seafloor during deepwater drilling operations. Strings of casing–lengths of a thick metal pipe that line wells–are suspended from the wellhead, which is designed to withstand the extreme pressure exerted by hydrocarbons located in deepwater fields. Specialty connectors are used to connect strings of casing.

Subsea production trees are the valves and equipment installed on top of a producing well to control the flow of hydrocarbons. In deepwater fields, trees are installed directly on the seafloor, directly above the well. Operators use subsea control systems to monitor and manipulate the trees’ functions.

Subsea manifolds are a series of valves and connectors that collect and control the flow of oil and gas produced from multiple wells. Oil and gas travels from wells through subsea pipelines and manifolds on the way to surface-based production platforms.

Most of these apparatuses have been used in land-based wells for some time. However, the subsea equipment Dril-Quip produces is significantly more complex and must be designed to withstand the rigors of unforgiving deepwater environments, where extremes of pressure and temperature are a constant challenge.

Dril-Quip’s biggest competitors in the offshore drilling space include Cameron International, FMC Technologies (NYSE: FTI) and General Electric’s (NYSE: GE) oil services and equipment division. The latter name might surprise readers. But Wellstream (LSE: WSM), a British producer of flexible pipeline that boasts a production facility in Brazil, in October rejected a takeover bid from General Electric. Over the past two years the conglomerate has made a big effort to expand its presence in the oil and gas industry.

With a market capitalization of $3 billion, Dril-Quip is much smaller than these competitors and could be a target.

Dril-Quip’s story is simple: Deepwater drilling is among the fastest-growing segments of the energy business, and the company benefits directly from this uptick in activity and development.  As I explained in the Nov. 3, 2010, issue, Riding the Services Cycle, the Macondo spill and subsequent drilling moratorium imposed by the Obama administration slowed activity in the Gulf of Mexico–for the time being. But drilling in key deepwater regions outside the US, including Brazil and offshore West Africa, continues apace.  

Although Dril-Quip has been named in some lawsuits regarding the Macondo blowout, it’s highly unlikely that the firm will be found in any way liable for the spill. The market appears to agree with this assessment; the stock hasn’t reacted much in recent news flow about the oil spill and BP’s (NYSE: BP) liability.

Moreover, Dril-Quip’s shares have rallied since the company reported third-quarter earnings that beat expectations. Orders for new equipment hit $227 million and the backlog reached $625 million, new records on both counts. Dril-Quip continues to add capacity, a sign that management expects business to remain robust.

Despite the company’s compelling growth prospects, valuation is a bit of a concern. The stock trades at about 25 times 2011 earnings estimates, a substantial premium to shares of Cameron International, which go for 18 times next year’s earnings. Given its strong upward momentum in recent weeks, the stock could suffer a bout of profit-taking at the hint of bad news or market correction. Dril-Quip rates a buy in the Energy Watch List. The stock won’t graduate to the model Portfolios for two reasons: Current Wildcatters Portfolio holding provides exposure to similar markets, and the valuation is a bit rich at this time.

General Partners: Endangered Species

I’ve explained the relationship between general partners (GP) and limited partners (LP) in previous issues of The Energy Strategist, but this concept is crucial to understanding the recent wave of deals among energy-focused master limited partnerships (MLP). In all of these instances, LPs have acquired their GPs, eliminating the burden of incentive distribution rights (IDR). The few remaining publicly-traded GPs are potential buyout candidates.

Every MLP is a combination of two companies, an LP and a GP. When you purchase an MLP, you’re typically buying a stake in the LP, which entitles you to a share of the MLP’s cash flow.

The GP is best thought of as part manager and part parent. The GP manages the MLP’s assets and makes major business decisions–for example, the acquisition of certain assets or the construction of new pipeline projects.

The best GPs seek to grow the MLP’s cash flow. In some cases this involves asset drop-downs, or deals where the GP holder sells assets to the MLP. These transactions are usually priced so that they’re immediately accretive to cash flows and allow the LP to increase its distributions. GPs can also help to finance acquisitions, provide direct financial support during periods of market weakness or simply by providing high-quality management.

As you might imagine, the GP doesn’t perform these functions out of the goodness of its heart. The exact relationship between GP and LP is governed by the partnership agreement–the basic document drawn up when an MLP is formed–which also establishes the fees that the LP pays to the GP in exchange for its services.

Typically these fees take the form of quarterly IDR payments that are based on the size of the quarterly distribution made to LP unitholders. IDRs are tiered such that the GP gets a larger percentage cut of cash flows when the LP increases its distribution, a structure that should incentivize the GP to make decisions that grow the MLP’s cash flow.

The GP-LP relationship is among the most important fundamental considerations when investing in an MLP. One of the most common questions I receive from subscribers is to explain exactly how much the GP is charging LP unitholders to manage the business. To answer this question, it’s important to understand how a tiered IDR system works.

Let’s use Proven Reserves Portfolio holding Penn Virginia Resource Partners LP (NYSE: PVR), a coal and natural resource property manager, as an example. The company has a four-tiered structure for calculating IDRs based on the distributions paid to LP holders:

• Tier 1: 98 percent to PVR holders and 2 percent to the GP, up to a quarterly distribution of $0.275 per unit;

• Tier 2: 85 percent to PVR holders and 15 percent to the GP, up to a quarterly distribution of $0.325;

• Tier 3: 75 percent to PVR holders and 25 percent to the GP, up to a quarterly distribution of $0.375; and

• Tier 4: 50 percent to PVR holders and 50 percent to the GP for all quarterly distributions above $0.375

In mid-November Penn Virginia Resource Partners paid a quarterly distribution of $0.47 to unitholders, placing it in the fourth tier of the distribution structure outlined above. Once the MLP exceeded a quarterly payout of $0.47, it was in the highest tier of IDRs–the “high splits” in industry parlance.

Note that just because Penn Virginia Resource partners is in the fourth tier of its IDR structure does not mean that it’s paying out 50 percent of its cash flow to the GP as an IDR fee. Second, not that you can’t accurately gauge the GP’s fees by looking solely at the maximum high-splits percentage in the IDR tier structure. 

The only way to gauge the true IDR fees is to calculate what the GP received in the most recent quarter. Here’s how the calculation works for Penn Virginia Natural Resources:

• Tier 1: The first 27.5 cents paid to the LP unitholder represents 98 percent of the total distribution. In other words, the total Tier 1 payout is 28.06 cents (27.5 cents divided by 0.98). This consists of 27.5 cents for LP holders and a little over half of a cent for the GP.

• Tier 2: The next 5 cents (32.5 cents minus 27.5 cents) paid to the LP is 85 percent of the total distribution. That means the total payout is 5.88 cents (5 cents divided by 0.85). That’s 5 cents to the LP holders and about 0.88 of a cent to the GP.

• Tier 3: The next 5 cents (37.5 cents minus 32.5 cents) paid to the LP is 75 percent of the total distribution. Therefore, 6.67 cents (5 cents divided by 0.75) is paid out–5 cents to the LP and 1.67 cents to the GP.

• Tier 4: The next 9.5 cents of the distribution (47 cents minus 37.5 cents) is half of the total. The total payout is 19 cents, of which 9.5 cents goes to the LP and 9.5 cents goes to the GP.

Summing all of these figures shows that unitholders received 47 cents per unit in mid-November, while the partnership’s GP received about 12.6 cents per unit. Penn-Virginia paid out a total of 59.6 cents, of which the GP received about one-fifth.

These figures match up well with those in Penn Virginia Resource Partners’ 2009 10-K. That year the LP paid $124,009 in distribution, of which $24,140 was paid to GP holders as IDRs–roughly one-fifth of the total distributions made. Again, if you look at the maximum high split, it does not provide a meaningful measure of the GP’s take; you must scrutinize the IDR structure carefully.

The structure of the IDRs is the key to determining distribution growth potential and sustainability. In the case of Penn Virginia Resource Partners, imagine a situation where the MLP is able to grow its distributable cash flow (DCF) by 15 cents per unit, and the GP decides to pay out 10 cents per unit as additional distributions and hold back 5 cents per unit as a reserve cushion.

Given the structure of Penn Virginia Resource Partners’ IDRs, a 10-cent increase in total distributions does not mean a 10-cent increase in the payout to unitholders. Rather, the MLP could boost its payout to LP holders by about 5 cents from the current 47 cents per unit to 52 cents per unit. The remainder of 5 cents would go to the GP as an additional IDR.

In other words, as an MLP progresses through its tier structure, it becomes more difficult to grow LP distributions. A larger percentage of each dollar of DCF would go to the GP.

This also effectively raises an MLP’s cost of capital, as money paid out as IDRs can’t be used to grow the business or disburse higher distributions. Over the years several MLPs, including Portfolio holdings Enterprise Products Partners LP (NYSE: EPD) and Sunoco Logistics Partners LP (NYSE: SXL), have taken steps to alter their IDR tier structure, moves that have reduced IDRs while facilitating the growth of the LP’s underlying business.

The latest trend: Deals in which the LP buys the GP and eliminates IDRs.

In March 2009 Magellan Midstream Partners LP (NYSE: MMP) announced a deal to acquire Magellan Midstream Holdings, its publicly traded GP, in a deal worth $2.5 billion. The all-stock transaction finally closed at the end of September 2010. The downside was that Magellan Midstream Partners issued about 40 million units (the MLP equivalent of shares), boosting its unit count from 67 to 106.6 million. The stock initially sold off after the new issue, as investors reacted to having their stakes diluted.

But if you bought the stock on the day the deal was announced, you would now be sitting on a total return of more than 118 percent. MLPs have performed well since early March 2009, but Magellan Midstream Partners has outperformed the benchmark Alerian MLP Index’s of 79 percent.

The deal was good for investors despite the immediate dilution caused by the creation of all those new units. That’s because Magellan eliminated its IDRs entirely as part of the deal, allowing it to free up cash each quarter to fund growth and pay distributions to LP holders.

Since then, several other MLPs have followed this example. Buckeye Partners LP (NYSE: BPL) acquired Buckeye GP Holdings, paying 0.705 LP units of for each GP unit in a $3 billion deal that closed in late November. In early November propane-focused Inergy LP (NYSE: NRGY) completed an all-stock deal worth $3.1 billion to buy its GP, Inergy Holdings.

Finally, Proven Reserves Portfolio holdings Enterprise Products Partners and Penn Virginia Resource Partners are involved in similar transactions. On Nov. 23, 2010, Enterprise Products Partners completed the $10 billion purchase of its GP, Enterprise GP Holdings, while Penn Virginia Resources’ all-stock acquisition of Penn Virginia GP Holdings LP (NYSE: PVG) should close early in the new year. Once the latter deal is completed, the IDR structure I outlined will be eliminated; the LP will no longer need to pay out 20 percent of its cash flow in IDRs.

These deals are a win-win for both parties. Investors who own the GPs earn their profits quickly, as the LPs normally buy out the GPs at a significant premium. Over the long term, LPs benefit because they no longer have to pay out IDRs each quarter.

I’ve received questions from several subscribers who have been contacted by law firms about a lawsuit against Enterprise Products Partners concerning the acquisition of its GP. These lawsuits are primarily designed to earn fees for the lawyers and have little merit; I like the deal, and the performance of Enterprise Products Partners’ units over the past few months suggests that a large number of investors agree with me.

There are now just three publicly traded pure-play GPs that look like potential buyout candidates: Alliance Holdings GP LP (NasdaqGS: AHGP), NuStar GP Holdings LLC (NYSE: NSH) and Energy Transfer Equity LP (NYSE: ETE).

Alliance Holdings is the general partner for Alliance Resource Partners LP (NasdaqGS: ARLP), an MLP that focuses on coal production. In total, Alliance Holding GP has nearly 650 million tons of coal reserves and produces upwards of 25 million tons per annum. I highlighted the coal-mining industry at great length in the most recent issue of The Energy Strategist, Buy Coal-Related Stocks This Holiday Season.

The price of US thermal coal–the variety used in power plants–has been weak this year because of elevated stockpiles at utilities, an overhang from the severe economic downturn of 2007-09, when electricity demand declined substantially. The price of metallurgical (met) coal–the variety used in steelmaking–remains robust thanks to a rebound in global steel production and strong demand from abroad.

There are also some key geographical points to keep in mind. Coal production from Central Appalachia (CAPP) remains troubled because coal seams in the region have been heavily exploited over the years, making it difficult to increase production. In addition, coal mining in Appalachia is dangerous. Although the US coal mining industry is safe compared to what goes on in China, a series of high-profile accidents have resulted in more onerous regulations.

It’s far easier to produce coal in the Illinois Basin, and regulations aren’t quite as burdensome in this region as they are in the CAPP. But coal from the Illinois Basin usually contains larger percentages of sulfur. That’s less of an obstacle now that a growing percentage of US coal facilities now have installed advanced scrubbers that bring emissions in line with regulatory expectations. As the percentage of utilities with scrubbers grows, demand for easier-to-produce coal from the Illinois Basin has grown.

Mines in the Illinois Basin accounted for about 80 percent of Alliance Resource Partners’ output in 2009. This distinguishes the LP from Penn Virginia Resource Partners, a stock discussed at length in the Nov. 17 issue. Exposure to growing demand for coal from the Illinois Basin should be a tailwind for Alliance Resource Partners.

On the downside, most of the MLP’s coal production is steam coal; prices for steam coal have been weak relative to met coal because of the supply overhang. But this isn’t a near-term concern because the company has already locked in prices for 90 percent of its 2011 production. By the end of 2011, the glut of coal at US utilities should decline, making for a more salutary pricing environment.

The nature of Alliance Resource Partners’ business also sets it apart from other coal-focused MLPs: Rather than collecting royalties based on the value of coal produced from its properties, Alliance mines its own coal. In fact, the outfit is the nation’s fifth-largest coal producer.

The LP’s growth opportunities are also attractive. Alliance Resource Partners is expanding its existing mines and recently opened up a new one in the Illinois Basin. This positions the firm to benefit from a recovery in prices for coal hailing from this region.

Through the end of the third quarter, Alliance Resource Partners has covered its distributions by a lofty 1.9 times. This margin of safety is one reason that the LP’s units yield considerably less than Proven Reserves Portfolio holdings Penn Virginia Resource Partners and Natural Resource Partners LP (NYSE: NRP).

But investors should set their sights on the general partner, Alliance Holdings. The GP owns the LP’s IDRs, so its cash flow is based on the distributions paid to the LP. As in the example I outlined previously, the GP’s take rises at a faster pace as the LP pays out higher distributions. This means that the GP’s distributions grow more rapidly than the LP’s payout; over the past year, the LP has boosted its distributions by about 8.5 percent, while the GP’s payout is up almost 13 percent.

The GP’s units yield less than the LP’s stock–about 4.3 percent, compared to 5.2 percent for the LP–but the faster distribution growth compensates for the slightly lower yield.

In this case, the GP owns a more than 40 percent stake in the LP, which may complicate any attempt by the LP to acquire the GP. But the MLP’s mining business is in fine shape, and the GP’s distributions should continue to grow at a double-digit rate in the coming year. In fact, given its high distribution coverage so far in 2010, distribution growth could accelerate in 2011. If there’s no deal between the LP and GP, the MLP is still on solid footing. If the two entities merge and eliminate the IDRs, expect the GP to command a substantial premium.

Alliance Holdings GP LP, a new addition to the Gushers Portfolio, is a buy up to 48.50. Because the stock is thinly traded, readers should use a limit order to avoid overpaying. Also note that Alliance Holdings GP is itself an MLP and reports distributions on a standard K-1 form.

NuStar GP Holdings is the GP of Proven Reserves Portfolio holding NuStar Energy LP (NYSE: NS). Formerly named after the refining giant Valero Energy Corp (NYSE: VLO), NuStar Energy originally operated fuel terminals as well as crude oil and refined-products pipelines. The latter are one of the steadiest and lowest-risk businesses for an MLP; tariffs on these pipelines are locked in under long-term contracts and aren’t sensitive to economic conditions. 

But in 2008 NuStar Energy purchased Citgo’s asphalt refineries and storage facilities, entering a much more cyclical business. The LP reduces some of these risks by only paying out a portion of the cash flow it generates from the asphalt side of the business.

These days supply trends in the asphalt business are favorable. Many US refineries that used to produce asphalt have been upgraded to produce gasoline and other higher-value products, reducing the supply of asphalt. But supply is only part of the equation. Weak demand for asphalt continues to weigh on prices, though that should improve as the economy recovers.

Nevertheless, NuStar Energy has managed to grow its distribution, boosting its third-quarter payout to $1.075 per unit from $1.065–a testament to the sustainability of its business model.

Management recently commented that it sees no economic reason to buy its GP at this time. But a turnaround in the asphalt business might change that sentiment. Investors looking to buy NuStar Energy should consider buying its GP, NuStar Holdings, as an alternative. Although the latter offers a lower yield, the GP is likely to grow its distributions at a much faster pace than the LP.

NuStar Holdings GP LLC rates a buy under 37.50 and will be tracked in the Energy Watch List. NuStar Energy LP is a buy up to 68.

Finally, Energy Transfer Equity is the GP of Energy Transfer Partners LP (NYSE: ETP), an operator of natural gas pipelines that hasn’t increased its quarterly distribution since August 2008. That situation appears set to change as new growth projects come online.

The company’s Fayetteville Express Pipeline and Tiger Pipeline will begin generating cash flows this month. The former is a joint venture with Proven Reserves Portfolio holding Kinder Morgan Energy Partners LP (NYSE: KMP) that’s designed to transport gas from the Fayetteville Shale in Arkansas. The latter is designed to serve the Haynesville Shale play in Louisiana and East Texas. Management has noted that both projects were completed ahead of schedule and below budget. As cash flows are locked in under long-term contracts, these fee-based businesses that should begin generating additional DCF immediately.

The company also has two smaller projects underway in the Eagle Ford Shale. As I explained in the Oct. 20, 2010, issue, Rough Guide to Shale Oil, this liquids-rich area is one of the hottest shale plays in the US because the coproduction of NGLs, condensate and oil ensure superior returns.

Energy Transfer Equity also recently acquired the GP of another MLP, Regency Energy Partners LP (NasdaqGS: RGNC), a smaller, faster-growing MLP with an attractive pipeline that services the Haynesville Shale. Energy Transfer Equity LP rates a buy and will be tracked in the Energy Watch List.

Coal for Sale

The most recent installment of The Energy Strategist, Buy Coal-Related Stocks This Holiday Season, emphasized the huge growth potential of Australia’s leading coal producers. The investment thesis is simple: China, India and other emerging markets are driving rapid demand growth for coal, and nearby Australia happens to be world’s largest exporter of both steam and met coal.

That’s why I added Joy Global to the Gushers Portfolio as a buy under 85. (See M&A Boom: The Next Takeover Targets in the Energy Sector).

Macarthur Coal (ASX: MCC) is another likely takeover target. Subscribers may recall that Wildcatters Portfolio holding Peabody Energy Corp (NYSE: BTU) tried to acquire Macarthur Coal, only to have the deal scuttle amid uncertainty surrounding Australia’s proposed resource super profits tax.

The coal mining industry remains the subject of plenty of M&A activity. Vallar (LSE: VAA), a mining investment fund controlled by Nathaniel Rothschild, in November invested USD3 billion to create a mining company composed of the assets of Vallar and two Indonesian mining firms. Indonesia rivals Australia as the world’s largest exporter of thermal coal. The new company, to be listed in London, will be called Bumi.

And in October Australia’s Whitehaven Coal (ASX: WHC) put itself up for sale, while Coal India (Bombay: 533278) announced that it to make up to USD1.2 billion worth of overseas acquisitions between now and next March.

These developments suggest that Macarthur could be in play again.

There are basically two ways to make steel: in blast furnaces or in electric arc furnaces. To use electric arc furnaces, a steel producer must have access to scrap steel; electric arc furnaces are common in the US and other developed countries where scrap is available in abundance.

A lack of scrap, coupled with strong demand for steel, forces China and other emerging Asian economies to rely primarily on blast furnaces, which require the use of a high-quality met coal. Peabody Energy’s Australian operations produce both met and thermal coal. Macarthur, on the other hand, focuses primarily on an altogether different variety, pulverized coal injection (PCI) coal.

PCI coal is crushed and injected into steel blast furnaces as a replacement for expensive metallurgical coal. Macarthur’s mines produce roughly one-third of Australia’s exports of PCI-grade coal, and the company is the world’s largest producer of PCI coal.

Output comes from two mines in the Bowen Basin of Queensland, Australia: the Coppabella and Moorvale. Coppabella is 73.3 percent owned by Macarthur, with China CITIC Bank Corp (Hong Kong: 0998) and a number of Japanese steelmakers accounting for the remaining interest. The mine produces about 2.9 million metric tons of coal per annum. Moorvale produces about 2 million metric tons and is also 73.3 percent owned by Macarthur.

Macarthur’s next big expansion project will be the Middlemount Mine, slated to come online by the end of 2011 and produce roughly 2 million tons per annum. Management is already evaluating a second expansion phase that could ratchet up the mine’s output to as much as 5.4 million tons. This project likely wouldn’t be completed until 2012-13.

More important, Middlemount produces a combination of PCI coal (30 percent of output) and higher-value met coal (70 percent of output), ensuring better returns and diversifying the company’s business.

Gloucester Coal (ASX: GCL) owns a 25 percent plus stake in the mine as well as options that would allow it to increase its interest to 50 percent. Those options are likely to be exercised, so Macarthur would end up owning half of this promising project.

There are some complications. Access to Australia’s export ports is becoming increasingly difficult; MacArthur will need to make further arrangements to ensure there are no bottlenecks to exporting its fast-growing coal production.  

In addition, any acquirer would need to secure the approval of three large shareholders–China CITIC Bank Corp, ArcelorMittal (NYSE: MT) and POSCO (NYSE: PKX)–that own nearly half of Macarthur. These stakeholders won’t sell for cheap. As part of its initial bid, Peabody Energy proposed a transaction that would allow this troika to maintain its stake; Peabody would simply take control of the majority share and delist the stock from the public market.

Despite these challenges, Macarthur’s assets are too attractive to ignore. If coal prices remain elevated, some bidder will emerge and offer terms that tempt the three shareholders to sell.

Final clarity on Australia’s mining tax policy could be another catalyst for a deal. New Prime Minister Julia Gillard revised the tax proposal last summer after wresting leadership of the Labor Party from Kevin Rudd. Her changes, made in concert with the industry, softened the blow of the tax.

Subsequently, however, Gillard barely retained control of government after a general election. To stay in charge, she was forced to form a coalition government with Australia’s Green Party; the Greens want to adopt a more severe tax that’s in line with what Rudd proposed in the spring. This is unlikely to occur, though the Greens may make a few changes to the law. At any rate, this uncertainty should be resolved next year.

Macarthur Coal rates a buy under AUD13.50 and will be tracked in the Energy Watch List for now.

Harvesting Profits

BHP Billiton’s (NYSE: BHP) $43 billion offer for Potash Corporation of Saskatchewan (NYSE: POT) has officially fallen through after the Canadian government blocked the deal. But that doesn’t change the fact that the agriculture industry is in the middle of a multiyear boom.  Prices for corn, soybeans, palm oil and other agricultural commodities have soared this year amid strong demand growth and low stocks of crops.

According to the United Nations, the world’s population will increase by more than 50 percent between 2000 and 2050, from 6.1 to 9.2 billion people.

Feeding people is already a major challenge. But contrary to popular belief, the biggest challenge isn’t more mouths to feed but dietary shifts.

Economic growth in developing nations is driving an epic transformation in eating habits, the likes of which the world hasn’t seen since the Agricultural Revolution of the 18th and 19th centuries. As consumers’ disposable incomes rise, their diets tend to become more diverse and meat consumption tends to increase.

The average Chinese consumer’s daily calorie intake has risen gradually since 1965. However, the more dramatic trend visible is the change in the composition of these calories. The intake of basic cereals such as rice has declined, while meat, fruits and vegetables have all become vital components of the Chinese diet.

From an agricultural standpoint, this shift presents a problem. Meat, fruits and vegetables are far more agriculturally intensive products to grow than rice and other cereals.

It takes 7 kilograms (15.4 pounds) of feed grain to produce 1 kg (2.2 lb) of beef; 4 kg (8.8 lb) of grain to produce 1 kg of pork; and 2 kg (4.4 lb) of grain to make 1 kg of poultry. As consumers eat more meat, demand for producing grains for feed goes up by a multiple of the increase in meat consumption.

According to estimates by the US Dept of Agriculture and other international agricultural organizations, total global demand for grains is likely to triple from its 1960 level by 2020. Much of that jump is due to indirect grain consumption as a livestock feed.

Supply is also a major issue. As countries such as China develop and urban areas grow, less land is available for cultivation. A growing shortage of water also has an impact. For example, parts of China once suitable for cultivating crops are now little more than deserts with insufficient water to support much plant life.

According to estimates by the Food & Agriculture Organization of the United Nations, there was more than 0.5 hectare (1.24 acres) of arable land per person globally in 1950. Today the figure is closer to 0.22 hectare; by 2020 it’s going to fall to 0.2 hectare, less than half its 1950 level.

Simply put, the world’s farmers will need to grow more food to feed more people using less land. The global agricultural challenge is every bit as acute as meeting exploding demand for energy.

Agriculture is no longer the low-tech activity it was 20 years ago. Meeting the global boom in demand will require the adoption of best-practice farming methods worldwide and increasing use of advanced gene technologies to boost yields per acre and protect against crop failure.

To make the widespread adoption of advanced farming technologies economically feasible, the prices for all sorts of agricultural commodities will continue to rise.

The Big Three

Crops remove certain nutrients from soil over time; if that process goes unchecked, yields per acre will drop precipitously. Farmers fertilize their soil to replace these nutrients. The amount and types of fertilizer used depend to a great extent on varying soil conditions in different parts of the world as well as the type of crops being cultivated.

There are three main types of fertilizer at use in the world today: potassium chloride (potash), phosphate and nitrogen.

Potassium chloride is mined from ore deposits created when oceans and seas dried up millions of years ago. With the passage of time, most of the world’s ores have been covered by earth and are now located deep underground.

To create potash that’s used for crops, the potassium chloride is separated from impurities such as salt and then dried and prepared into either solid pellets or a liquid product.

The largest producers of potash in the world, based in Canada, Russia and Belarus, account for about two-thirds of total global output. Because there are only a handful of global producers, about 80 percent of global potash supply is traded across international borders.

Fruits and vegetables account for nearly one-quarter of global potash consumption. Corn and rice are also big potash consumers, accounting for a further 28 percent of the global market combined.

Phosphate is also mined from underground ore bodies created from ancient sea life. Typically, phosphate fertilizer is combined with ammonia to produce solid fertilizers known as DAP and MAP. Sulfur mainly derived from oil refining and natural gas processing is a key raw material for converting phosphate rock into usable fertilizer.

As with potash, production of phosphate is concentrated in a handful of countries. China is the largest producer, followed by the US and Morocco. The latter is the largest exporter in the world because the US and China consume most of their phosphate production domestically.

Because the big producers of phosphate also tend to be big consumers, only 20 percent of global phosphate supplies move across international borders.

Nitrogen is the most common element in the air; however, plants rarely make direct use of atmospheric nitrogen. Nitrogen-based fertilizer is made from ammonia synthesized from natural gas. In fact, natural gas accounts for as much as 90 percent of the cost of making ammonia.

Urea is the most common form of nitrogen fertilizer, accounting for about half the world market. And most nitrogen fertilizer isn’t traded but is used near where it’s produced. The biggest crops for nitrogen fertilizer are corn, rice, and wheat, which account for half of total global nitrogen use worldwide.

Given soaring demand for agricultural commodities and the need to grow more crops on less land, farmers the world over are focused on yield, the amount of crop they can grow per acre of land. Because proper fertilization is among the most important factors determining yield, demand for all three types of fertilizer has been on the rise in recent years. That trend is likely to continue.

It can take as long as seven years to bring a potash production plant onstream, and building a mining and processing facility costs upward of USD2.6 billion. As demand for potash rises, supply can only adjust gradually to that demand.

For a USD2.6 billion investment in a plant to be worthwhile, potash prices would have to remain relatively high and stable. Although phosphate and nitrogen fertilizers are a bit less intensive in terms of investment and time, it’s not a simple matter to increase fertilizer output quickly to meet demand.

I recommend two big fertilizer producers–Mosaic (NYSE: MOS) and Potash Corp–in my biofuels field bet. But a more likely takeover target is Intrepid Potash (NYSE: IPI), the largest US potash producer.

One advantage Intrepid has over other potash producers is that its mines are located closer to the Midwest Corn Belt, cutting down on transport costs. Rail freight costs have become more expensive in recent years, so this can be an enormous advantage. And Intrepid’s royalty and tax costs are also lower than its Canadian peers.

In addition, Intrepid has historically sold most of its production under spot contracts rather than fixed-price deals, so it benefits more during periods of rising potash prices.

Going forward, Intrepid is working on ways to expand production from its existing mines and plans to open an old mine that had been mothballed; these efforts will allow it to take full advantage of rising potash prices.

Intrepid is tiny compared to Potash Corp; with a market capitalization of just over $2 billion, it would be an easier target. And because its mines are located in the US, there isn’t much chance of the government blocking an attempt to buy Intrepid. Intrepid Potash rates a buy under 34 and will be tracked in the Energy Watch List.

My final takeover play is machinery producer AGCO Corp (NYSE: AGCO), the firm behind brands such as Challenger, Fendt, Massey Ferguson and Valtra. The largest producers of agricultural machinery in the world are Deere (NYSE: DE), CNH Global (NYSE: CNH) and AGCO. With a market capitalization of around $4 billion, AGCO is just over one-tenth the size of Deere and by far the smallest of the three.

AGCO’s generates only 22 percent of its revenue in North America, compared to nearly two-thirds of sales for Deere and nearly 40 percent for CNH Global. AGCO is estimated to have just a 10 percent share of the US market for agricultural machinery such as tractors and combines.

The company’s real strength lies abroad. The firm generates 28 percent of sales from South America and 46 percent from Europe, Africa and the Middle East (EAME). In fact, AGCO has leading market shares in Brazil and Argentina, key breadbaskets for the rest of the world.

Sales of agricultural machinery are leveraged to farm income. With soybeans and corn–two of the most important cash crops–trading close to all-time record prices, farmers are making, and spending, money. Orders for new machinery have picked up measurably. The Association of Equipment Manufacturers releases monthly data on farm equipment sales in the US. In October sales of large farm equipment soared 37 percent from year-ago-levels, while sales for all farm equipment was up about 15 percent.

Fresh Money Buys

The stocks recommended in the three model Portfolios represent my favorite picks. The three Portfolios are designed to target different levels of risk: Proven Reserves is the most conservative the Wildcatters names entail a bit more volatility; and Gushers are the riskier plays but have the most potential upside.

I realize that this long list of stocks can be confusing; subscribers often ask what they should buy now or where they should start. To answer that question, I’ve compiled a list of 15 Fresh Money Buys that includes 13 names and two hedges.

I’ve classified each recommendation by risk level–high, low or moderate–and included a brief rationale for buying each stock. Conservative investors should focus the majority of their assets in low- and moderate-risk plays, while aggressive investors should layer in exposure to my riskier and higher-potential plays. Hedges are appropriate for investors looking to offset exposure to energy stocks.

Also note that stocks that exceed my buy target for more than two consecutive issues will either be removed from the list or the buy target will be increased. Here’s the list, followed by a short update on company-specific developments.

Source: The Energy Strategist

Fresh News

Seadrill (NYSE: SDRL) announced strong quarterly results and boosted its dividend to $0.65 per share. The company is without a doubt the best-positioned deepwater contract drilling, and I expect a quarterly dividend of 70 to 75 cents per share by the third quarter of next year.

In the 10 weeks since I added Afren (LSE: AFR) to the Fresh Money Buys list, the stock is up 20.5 percent– compared to a 17.5 percent gain for the S&P 500 Energy Index.  I still like the stock and it will remain in the Gushers Portfolio. However, I’m swapping it out of the Fresh Money Buys list in favor of Core Laboratories (NYSE: CLB).

See You at the Summit

Advertisers would have you believe that what happens in Vegas stays in Vegas. That also goes for the presentations and one-on-one conversations that occur at KCI Investing’s 2011 Wealth Summit at the luxurious Mandarin Oriental in the new CityCenter arts complex.

Guests will have the opportunity to listen to some of the investing community’s brightest minds share their top ideas and trades. Don’t miss out on this unique opportunity to hear Elliott Gue, Roger Conrad, Yiannis Mostrous and Benjamin Shepherd share their latest insights on the markets and economy.

Special guests include Jim Fink, senior editor of Investing Daily, who will discuss the ins and outs of options, and executives from Linn Energy LLC and Vermilion Energy. This year’s conference focuses on the unprecedented growth of Asian economies and the game-changing investment strategies you need to protect and grow your portfolio in the 21st century.

The two-day event gets underway on April 1, 2011. Get smart on April Fools’ Day. Pre-register for the Wealth Summit at InvestingSummit.com.