The mainstream media has described recent action in stocks and commodities with classic sensationalist language.

But amid all the noise around falling stocks and plunging commodity prices, it’s easy to forget that the S&P 500 currently sits less than 3 percent from a multi-year high. Meanwhile, it’s hard to describe the nearly $18 rally in the per-barrel price of Brent crude price so far in 2011 as anything other than a powerful uptrend.

All bull markets experience periodic–and often violent–pullbacks and corrections; the recent decline in energy prices and related stocks is a classic example. The worst move you can make is to panic and sell out of your holdings at the first sign of trouble. Instead, look to buy the dip, as it may be the last great buying opportunity for energy-related stocks this year.

There are some legitimate signs that the US economy has hit a soft patch since early April, but calls for a major slowdown have no basis in economic data. In addition, fears that the scheduled June end to the US Federal Reserve’s second round of quantitative easing (QE2) will sink stocks are vastly overblown.

The Fed will continue to buy bonds long after Jun. 30 by reinvesting proceeds from maturing securities in its portfolio. And markets have had plenty of time to adjust because the central bank has telegraphed its intentions clearly over the past six months.

A more likely scenario: The end of QE2 is a “sell the rumor, buy the news” event. In other words, nervous traders who’ve been selling stocks in anticipation of the Fed’s exit will chase markets higher when QE2 docks and the world once again fails to come to an end.

In This Issue

The Stories

In the long term supply and demand will determine prices for crude oil and other commodities. It’s that simple. See A Question of Macroeconomics.

Data, in the hands of a creative storyteller, can be the basis of innumerable scary tales. Fortunately, a clear-eyed look at prevailing data suggests nothing more than a soft patch for the economy. See The Economic Landscape.

Softer commodity prices will ease pressure for US consumers at the pump, which will have positive knock-on effects for the broader economy. See Weakening Commodity Prices an Upside Catalyst.

Saudi Arabia holds the key to OPEC’s response to disruptions to Libya’s production. Here are realistic scenarios. See Oil’s Well.

I track many companies in The Energy Strategist and break down the Portfolio so there are recommendations suitable for all levels of risk tolerance. I make it even easier to get started, with the Fresh Money Buys list. Want to know where to make your initial energy investment? See Fresh Money Buys.

The Stocks

Enterprise Products Partners LP (NYSE: EPD)–Buy < 45

Penn-Virginia Resource Partners LP (NYSE: PVR)–Buy < 29

Seadrill (NSDQ: SDRL)–Buy < 38

A Question of Macroeconomics

Broader economic forces and market sentiment are driving energy prices and related stocks right now, trumping company-specific news and industry fundamentals. Some call this a “risk on/risk off” market.

When the economic data looks supportive, stocks and commodities rise as a group, and institutional investors worry about lagging the market. But when the data sours institutions sell down their holdings to protect profits and reduce risk. These rotations in and out of stocks can occur quickly, leading to breakneck day-to-day volatility. You simply can’t ignore the big picture and hope to make money in this environment.

The bad news is macro-driven markets can persist for some time. Be aware of risk of further downside over the next one to four weeks amid legitimate signs of deteriorating economic growth, particularly in the US. The good news is the current economic soft patch is likely to be short-lived, and whatever the ultimate shape of the resulting selloff it will offer subscribers a golden opportunity to buy into my favorites at attractive valuations.

Energy stocks led the S&P 500 higher in the first quarter; the S&P 500 Energy Index jumped 16.3 percent over the first 12 weeks of the year, besting the broader market by a nearly 3-to-1 margin. The group is the consummate play on global economic growth, and by the end of the quarter institutional investors and fund managers with heavy energy exposure had significant profits to protect.

It’s only natural that these investors would be eager to book gains at the first sign of trouble; energy stocks rose further and faster than other stocks during the first quarter, leaving them more exposed on weaker days for the broader market averages.

Many energy-related stocks have pulled back sharply over the past few weeks. Corrections like these are always frightening. However every great bull market in history has endured serious pullbacks in the context of the longer-term uptrend.  The Philadelphia Oil Services Index (OSX) jumped close to 300 percent from the beginning of 2004 through the middle of 2008.

Although the uptrend was steady, closer examination reveals roughly 10 corrections of between 10 and 25 percent. Last summer, amid concerns about an oil spill in the Gulf of Mexico and a double-dip recession, the OSX pulled back just over 30 percent from its late April high to an early July low. Since that July low, the index has returned more than 90 percent; if you bought energy stocks into that selloff you made your year’s return with a single decision.

As of this writing the S&P 500 Energy Index is 10.5 percent below its April high, while the OSX components are down about 15 percent, a perfectly normal correction after a big run-up. The equation is simple: If you believe the world economy is headed for a major recession or another 2008-style financial crisis in 2011, this retrenchment could be the beginning of a more meaningful bear market. 

But that’s not my conclusion. The weakness revealed by economic data over the past month and a half looks more like a temporary soft patch rather than the beginning of a slide into recession. I need to see much larger, more persistent weakness in the data before I’ll modify this view. I therefore recommend buying stocks leveraged to the most powerful growth trends in the energy industry.

My favorite investment themes to buy on this dip include: oil services and equipment names with exposure to international exploration and development spending; US onshore producers with exposure to oil and natural gas liquids-rich shale fields; companies with exposure to global liquefied natural gas (LNG) markets; and stocks leveraged to international coal markets, including US miners with significant exposure to metallurgical (“met”) coal and firms that benefit from strong exports of both thermal and met coal out of Australia.

The Economic Landscape

An old Wall Street saw holds that the bearish argument always sounds more intelligent and well informed than the bull case. That doesn’t mean, however, that the bear argument is correct.

There’s no shortage of doomsayers these days, and it’s easy to fall into the bears’ trap because there are plenty of powerful long-term headwinds facing the US economy. For example, household and government debt burdens in the US are way too high, crimping consumers’ ability to spend and threatening the long-term fiscal stability of the US. But I could have made exactly the same argument two years ago in the spring of 2009; had I heeded the conclusion begged and stayed out of the market, I would have missed out on one of the most powerful rallies in history. The bears may eventually be right–and I suspect they will be, at least on some points–but that time is not now.

A year ago I argued, correctly, as it turns out, that the US wouldn’t experience a double-dip recession but was instead in the midst of a temporary slowdown in growth. My view was based on a dispassionate interpretation of the economic data. There was certainly a weakening, beginning in late spring of 2010, but none of the key indicators I watch fell to levels that would suggest recession. This year I see the same pattern, although the data looks in some ways more upbeat than it did a year ago.

As I explained in Monday’s issue of TES Weekly, the two economic indicators that have me most worried right now are initial jobless claims and the non-manufacturing Purchasing Managers Index (PMI).

Source: Bloomberg

The PMI is based on a monthly survey of about 300 executives conducted by the Institute for Supply Management (ISM). The ISM asks these managers how they feel about business conditions in a number of key categories, including new orders, employment and inventories; responding managers describe conditions as “getting better,” “unchanged” or “getting worse.” The PMI is a diffusion index with a range from 0 to 100; levels above 50 indicate that more than half of managers surveyed believe conditions are getting better.

The PMI is rather simple, but it boasts an outstanding track record of flagging periods of strength and weakness for the broader economy. More important, it tends to be a leading indicator: It flags changes in economic conditions before they become apparent in other data. A general rule of thumb for interpreting the PMI is that readings between 46 and 47 are consistent with recession, particularly when sustained for more than a month. The PMI is also one of the freshest indicators we get each month, as manufacturing PMI is released on the first business day of each month, while non-manufacturing PMI is released on the third day.

Manufacturing PMI has been strong for much of the past three quarters. Levels above 60 on the manufacturing PMI are relatively rare, occurring in less than 10 percent of months since calculation began in 1948. Historically, manufacturing PMI above 60 is consistent with US economic growth closer to 4 percent rather than the anemic 1.8 percent growth logged in the first quarter.

Non-manufacturing PMI has been similarly strong since last summer–until April, when it abruptly tumbled to 52.8 from the upper 50s, its lowest level since mid-2010. Non-manufacturing PMI is a relatively new indicator, as the ISM only began calculating it in 1997. But it’s arguably more important because non-manufacturing service industries have become increasingly important to the US economy since the 1970s.

Non-manufacturing PMI can be volatile at times; a big drop such as we saw in April could be at least partly reversed in subsequent surveys. Moreover, a reading of 52.8 still indicates a modest rate of expansion for the US economy, especially when you couple that with the fact that manufacturing PMI remains at elevated levels. Nonetheless, the quick drop in the indicator is troubling and suggests at least a temporary softening for the economy.

There’s no perfect explanation for the recent divergence between manufacturing and non-manufacturing PMI. But non-manufacturing PMI is generally considered more leveraged to domestic US economic conditions, while manufacturing industries can benefit from strong global growth via higher exports. By extension, non-manufacturing PMI is often assumed to be more leveraged to the US consumer and swings in consumer confidence and energy prices.

A look inside the PMI Manufacturing data shows strength across the board.

Source: Bloomberg

The chart above shows the three sub-indexes of manufacturing PMI. First, note that managers are still bullish on export orders for manufactured goods; in fact, the export component actually surged in April. This is due to two major factors: Strong global growth is driving demand for exports, while the weak dollar makes US manufactured goods more attractive on a pure price basis.

Meanwhile, new orders for manufactured goods fell off recent highs in April, but that drop came from a high level. In addition, note that new orders are still above the average range set during the 2004-07 period–there’s no sign of slackening demand for manufactured goods. Perhaps most important, the manufacturing employment sub-index continues to hover near a seven-year high, a level that suggests continued gains in manufacturing employment in coming months.

A peek inside non-manufacturing PMI is more troubling.

Source: Bloomberg

The sharp drop in the new orders component of PMI is the most dramatic feature of this chart. The only positive spin I can put on that is that the fall came from multi-year record high levels, and the current reading remains consistent with expansion, albeit at a slower pace. Employment trends have also clearly weakened, although the index remains above the high-40s levels witnessed during the height of last summer’s double-dip recession scare.

There is a clear and meaningful deterioration in the non-manufacturing sector of the US economy, although exports and overseas demand growth remain robust. It’s important not to read too much into the data. There are a few pundits predicting a recession in 2011 and a major global slowdown. That’s definitely not the message I’m seeing in the PMI.

The trend in initial jobless claims has also weakened notably since the beginning of April. Initial jobless claims is a weekly measure of the number of people filing for first-time unemployment benefits around the US; it’s the most timely leading indicator of health in the labor market. Employment is the most important fundamental of all, as it drives wages, consumer spending and investment.

The economic expansion that started in the summer of 2009 has been anemic in terms of creating jobs. Although payrolls growth turned positive in 2010, monthly gains were insufficient to bring about a lasting decline in the unemployment rate. Only in late 2010 and early 2011 have we seen what approaches healthy monthly private payrolls growth.

Source: Bloomberg

The week-to-week data on initial claims is extraordinarily volatile, so it’s best to look at the four-week moving average. I see three key stages on this chart.

First, as the US economy emerged from recession in the middle of 2009 jobless claims dropped steadily. This simply meant that the pace of job losses declined, and by the end of 2010 the US actually started to show some consistent payroll gains, albeit at a snail’s pace.

Then, in early 2010, initial jobless claims data began to plateau at roughly the 450,000 to 475,000 level. This leveling of initial jobless claims turned out to be an outstanding indicator that the US would face a string of weaker-than-expected monthly employment reports. Weak jobs growth was one of the major factors that led some pundits to call for a double-dip recession a year ago.

But by the end of the summer of 2010 the picture for initial claims began to improve again. Claims steadily declined in the second half of the year and into early 2011. Not surprisingly, at the end of 2010 and early this year we began to see better private non-farm payrolls growth; the US economy added 268,000 private non-farm jobs in April, the strongest rate of growth since 2005.

What’s worrying is the final few weeks of data–the four-week moving average of has spiked from below 400,000 to around 430,000, roughly the level last seen in the fall of 2010. The risk is this deterioration will show up in the monthly employment data over the next few months in the form of weak non-farm payrolls growth.

The data isn’t as clear-cut as it might first appear. The US Dept of Labor highlighted a number of special factors that artificially inflated inflation jobless claims over the past month, many of which pertain to the seasonal adjustments used to make the data easier to interpret.

Seasonal adjustments involve looking for patterns in employment in the US over time. For example, initial jobless claims often fall during the holiday season, as some workers take on seasonal employment with retailers. There are also patterns in factory production and maintenance schedules that occur every year. Looking at raw data makes it tough to separate these normal seasonal trends with what we’re really interested in–changes in the supply and demand of labor due to economic conditions.

But seasonal adjustments are a double-edged sword. They may be useful for eliminating noise in the data, but they also can be misleading if seasonal patterns in a particular year are unusual.

The special factors identified by the Labor Dept include the fact that some automobile factories appear to have shifted their schedules due to auto parts component shortages in Japan. Another factor was the late Easter holiday this year and a shift in the spring break schedule for schools in New York. Last week the Labor Dept also cited the impact of severe storms and tornados that hit several southern US states this spring.

All of these special factors make some sense. But there’s a palpable fear that there’s more to the up-tick in claims than just poor seasonal adjustments. If these suspicions are true, these data are the precursor to a significant weakening in the US labor market and another string of weaker-than-expected monthly employment reports like we saw last summer.

My view is that the lion’s share of the deterioration is due to special factors. More particularly, I see the auto parts component shortages as a key driver.

Source: Bloomberg

The Federal Reserve’s monthly industrial production report shows total output from US factories broken down into various industry groups. The consensus expectations heading into the April report was that total US industrial production would increase roughly 0.4 percent. The Fed reported that industrial production was flat, a significant disappointment.

But there was a good reason for the weak IP data: Shortages of key automobile parts and equipment from Japan hit auto factory output hard. The chart above shows the automobile and parts component of IP; you can clearly see the sharp pullback from high levels.

Most economists expected component shortages to modestly affect April IP and to be more meaningful in the May data. In effect, component shortages began to impact auto output sooner than most expected, skewing the IP data.

As you can imagine, seasonal adjustments to weekly initial jobless claims data don’t take into account a massive earthquake and the consequent disruptions to the global auto supply chain. Given the rapid drop in IP for autos, I suspect the auto industry is a major component of the recent up-tick in initial jobless claims.

All that being said, it’s tough to argue that there’s been no deterioration in labor market conditions over the past few weeks. My take is that the initial jobless claims data suggest a modest decline in the pace of improvement in the employment market, not a major change of trend.

Weakening Commodity Prices an Upside Catalyst

Long-time readers know I’ve been consistently bullish on crude prices since the 2009 lows for the various grades. At the beginning of 2011 I predicted that crude would spike above $120 per barrel at some point this year; my prediction came true a lot earlier than I expected due to the interruption of 1.5 million barrels a day of Libyan output. 

To make matters worse, there’s a growing realization that Libyan production isn’t likely to return to normal for at least a year and likely much longer than that. Libya faces a protracted civil war and a lengthy period of unrest.

But, in the Mar. 2, 2011, issue, Oiling Up and Going Nuclear, as well as in subsequent issues, I flagged the risk of a short-term correction for oil prices. On such a pullback I saw Brent crude falling to as low as $95 to $100 per barrel. My short-term caution on oil prices was based on a few key points:

• The spike earlier this year was pricing in the risk that unrest in Egypt, Libya, and Bahrain would spread to the world’s swing supplier of crude oil, Saudi Arabia. These risks are vastly overplayed. Planned protests in the Dessert Kingdom fizzled, and the monarchy is spending as much as 25 percent of gross domestic product (GDP) on social and housing projects designed to keep the local population satisfied. The chances of a major destabilization of the House of Saud in the short to intermediate term are slim to none.
• Speculation isn’t the long-term driver of crude oil prices, but speculative flows can certainly have a profound impact on short-term moves. As oil prices soared early in the second quarter, data from the Commodity Futures Trading Commission (CFTC) showed that non-commercial traders in oil futures had dramatically increased their bets on further upside in prices. This is a contrary indicator: When everyone is bullish on oil, it doesn’t take much of a price wobble to spark a selling panic. This is exactly the dynamic that caused the 10 percent intraday drop in oil prices earlier this month.
• Evidence of demand destruction due to higher prices was likely to cool sentiment on crude oil prices. As I’ve written on several occasions, the impact of higher oil prices on consumer spending and the economy is often overplayed, particularly as it pertains to the US market. In the US the negative impact of higher gasoline prices has been tempered by low costs of other energy commodities, including natural gas and coal. Nonetheless, a quick spike to nearly $130 a barrel is enough to temper the outlook for crude oil demand growth. In fact, this is why I predicted a spike in crude at the beginning of 2011; I felt that a jump above $120 would be needed to cool the rapid pace of oil demand growth headed into 2011.

All three of these basic points proved on the mark, though I was early in calling for a pullback in prices. My take now is that crude oil is close to finding a bottom and will still average well north of $100 a barrel this year.

Based on support and resistance levels on the charts of crude oil, I look for West Texas Intermediate (WTI) crude to hold above the $87 to $92 per barrel range on any further correction, compared to a current quote of about $98. The equivalent support level for Brent crude is somewhere in the $100 to $105 per barrel range, compared to a current quote of $112 a barrel. I regard these support levels in the context of an aggressive scenario; unless we see significant further weakening in the economic data, crude is likely to hold well above the low end of these ranges.

If the slowdown in the economy of late is temporary, as I expect, oil prices could easily retest–or exceed–recent highs by the end of 2011. And in 2012 I fully expect to see crude retest 2008 highs.

Remember, too, the feedback loops that exist among oil prices, oil demand and the global economy. Had you asked economists a month ago to highlight the greatest risk to global growth this year the consensus would have said “rising energy prices,” or “rising inflationary pressures in oil, food and basic materials prices.” The April PMI report showed more than 80 percent of managers in the manufacturing industries and 70 percent in service industries looking for further inflation in the prices they expected to pay for raw materials.

But rising prices have worked their magic, cooling global demand for oil and other commodities and pushing down prices. Just as it took time for rising oil prices to show up in the economic data, it could take time for falling oil prices to become apparent in the form of rising global growth and a decline in inflationary pressures. Moderation in commodity prices removes what was considered a top risk to the global growth story just a few weeks ago.

One place to look for a boost from falling energy prices is the monthly retail sales numbers. In particular, I monitor US retail sales excluding automobiles, building materials and gasoline; this is a good measure of consumer spending on more discretionary items. In April this measure of retail sales increased just 0.2 percent month over month, down from 0.6 percent in March and 1.1 percent in February. At the same time, sales of gasoline soared, as higher prices pushed up the amount consumers must spend on energy.

Rising spending on energy seems to have gradually crowded out expenditures on other items in March and April. With oil and food prices now pulling back–just as the US enters summer driving season–I look for a gradual reversal of this trend and an increase in spending on more discretionary items. That would likely help firm up key economic indicators, such as non-manufacturing PMI.

The decline in energy and commodity prices is even better news in emerging markets like China and India. The primary concern facing these countries has been inflation. Monetary authorities in China, India, Australia and even the European Central Bank (ECB) have been tightening monetary conditions in an effort to tame above-target inflation. The biggest source of inflation has been food and energy prices.

Chinese inflation is still above the government’s target, though it has started to decline. As more moderate commodity prices help push down inflation even further over the next few months, Chinese authorities will be able to end their cycle of monetary tightening. This will be seen as a major upside catalyst for stocks in this market and a major boost to global growth prospects. This would obviate one of the most pervasive fears about future prospects for stocks, that Chinese authorities would tighten too much and push the local economy into a hard landing. 

Oil’s Well

Ever since I started following energy markets nearly 12 years ago, I’ve heard the same basic conspiracy theory repeated in the popular media every time oil prices spike higher. The general sentiment is that the fundamentals for oil don’t support higher prices, so the jump must be due to the nefarious machinations of a group of profiteering Wall Street speculators, fat cats at Big Oil companies, price gouging by local petrol stations or OPEC manipulations.

These arguments have, as always, no basis in reality.

Let’s start with the Big Oil myth. The three largest private integrated oil companies in the world by market capitalization are Exxon Mobil (NYSE: XOM), Royal Dutch Shell (NYSE: RDS/A) and PetroChina (NYSE: PTR). If we aggregate oil production from all three of these giants, the total is less than 8 percent of global production. The energy industry is a lot more fragmented than most suppose, and the largest players control only a tiny slice of global output–certainly not enough to “corner” the market or set prices.

My personal favorite zombie conspiracy places blame on local petrol station operators. The truth is that gasoline is a loss leader for petrol stations. The idea is to get motorists off the highway and into their stores, where station owners can sell soft drinks, beer, coffee and hot dogs. Consider that a 12-ounce Coke might set you back $0.75; if oil traded for the same price it would cost $336 per barrel.

Most local gasoline stations make less than a nickel on every gallon of gasoline they sell. When gasoline prices rise they tend to earn an even lower margin. Station owners don’t want to raise their gasoline prices because such moves tend to repel potential convenience-store customers.

I’ve written about speculators on many occasions. Clearly, buying and selling in the crude oil futures market can push prices up or down in the short term, but in the long run the financial futures markets are intimately related to the physical market for oil, gas and other commodities.

Consider that if speculators truly pushed crude oil way beyond its actual value, there would be consequences in the physical market. Higher prices would stifle demand and encourage oil producers to invest and maximize their output. The result would be a glut of crude oil on the world markets and a massive increase in the amount of oil in storage globally.

I’ve heard several pundits say the world has plenty of oil and that fundamentals don’t support current prices.

Source: Bloomberg

The US is in a relatively strong position when it comes to oil supply. Domestic production has actually perked up over the past couple of years thanks to output from unconventional oil plays like the Bakken and Eagle Ford shales. Neighboring Canada is a significant oil exporter, with plenty of growth potential in plays such as the oil sands. At times over the past few months there’s been a glut of oil at the key Cushing terminal in Oklahoma due to a new pipeline that delivers crude to that terminal from Canada.

The chart above shows the change in total US inventories of oil and refined products such as gasoline in the first four months of the year. I calculated this inventory change for every year going back to 2003 by looking at total US oil inventories in the first week of May compared to inventories in the last week of December.

As you can see, total US oil and product inventories are down by more than 16 million barrels since the end of 2011, the largest seasonal drawdown since 2007 and the third-largest in the past decade. If oil prices were truly “too high” this year I would expect to see a combination of weaker demand and rising production push inventories up.

This trend is even more visible on the global market, where the International Energy Agency (IEA) has reported a far faster than normal seasonal drawdown in inventories across the developed world this year. Although the IEA recently revised lower its projections for 2011 oil demand growth due to sustained higher prices, demand is still projected to rise by 1.3 million barrels a day. Meanwhile, non-OPEC supply is projected to increase just 800,000 barrels a day, leaving a 500,000 barrel-per-day gap.

OPEC has two choices: It can fill that gap, or it can allow global inventories to decline rapidly. If OPEC opts for the former strategy, Saudi Arabia will hike production enough to offset ongoing supply disruptions in Libya and accommodate the increase in global supply. This requires putting idled production–known as spare capacity–back on line. At less than 4 million barrels a day OPEC spare capacity is already as tight as it’s been since 2008. Further declines would send oil prices higher.

If OPEC opts for the latter route, Saudi Arabia and other OPEC members will only partially offset lost Libyan production. To meet global demand growth, developed countries will simply draw on their inventories of crude in storage–a subsequent rapid decline in inventories would also be bullish for oil.

I expect the Saudis to try and walk this tightrope. They want high oil prices because they need to invest in new field developments such as the massive offshore Manifa project, and they need to fund new social spending initiatives. At the same time, the Saudis don’t want $130 oil, as price spikes to that level destroy customer demand and ultimately hurt their profits. That’s exactly what happened when oil prices spiked in 2008.

In the end they’ll likely attempt to partially accommodate the increase in oil demand so that inventories don’t collapse. At the same time they’ll be reluctant to allow spare capacity to fall too far this year, so I don’t expect output to increase by enough to accommodate lost Libyan production and rising demand. This remains a fundamentally bullish scenario.

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 18 Fresh Money Buys that includes 16 stocks and two hedges.

I’ve classified each recommendation by risk level–high, low or moderate. 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.

Source: The Energy Strategist

Enterprise Products Partners LP (NYSE: EPD) and Penn-Virginia Resource Partners LP (NYSE: PVR) are both organized as master limited partnerships (MLP). MLPs are traded on the New York Stock Exchange (NYSE) and the Nasdaq, like any other stock, but they’re not organized as corporations and, therefore, pay no corporate level tax. Instead, MLPs pass through the majority of their income as distributions; individual shareholders (unitholders in MLP parlance) then pay taxes on their share of the profits.

The good news is that the vast majority of the distributions you receive are considered return of capital. That means that you can defer taxation on the distributions received until you sell the MLP.  I explain the tax treatment in more depth in an April 1, 2011, Special Report, MLPs and Taxation: A Quick Refresher for Tax Season.

In a May 5 Flash Alert, Tax Reform and MLPs, I explained that several of my recommended MLPs, including both Penn-Virginia and Enterprise Products–had seen some selling pressure as a result of rumors the US Treasury Dept was preparing a proposal that would change the tax structure of MLPs.

The proposal, uncovered by the National Association of Publicly Traded Partnerships (NAPTP), reportedly would call for all pass-through entities with gross receipts over $50 million to pay corporate tax. As I explain in the Flash Alert, this proposal differs from prior legislation regarding partnerships and the issue of “carried interest.” If passed, this sort of legislation would damage the attractiveness of the MLP structure.

Not surprisingly, talk of a new tax for MLPs brought back unpleasant memories of the “Halloween Massacre,” a reference to the day the Canadian government announced its intention to change the tax treatment of Canadian income trusts, causing a short-lived yet nasty downturn for the group. One of the most common questions posed to me at the recent Las Vegas Money Show was if a similar overnight massacre could befall MLPs. In a word, the answer to that question is a resounding “no.” 

There can be no overnight change in the tax code governing MLPs because any tax proposal from the Obama administration or Treasury would need to be formulated into legislation and pass Congress. Currently, the US Congress is gridlocked, with Republicans controlling the House of Representatives and Democrats controlling the Senate. A proposal to tax MLPs has next to no chance of passing a Republican-controlled House. In fact, the NAPTP posted an interesting quote from Dave Camp, a Michigan Republican in charge of the powerful House Ways and Means Committee. When asked about the proposal he stated: “It’s not something I’d be inclined to consider.” That alone means any MLP tax is dead on arrival.

In addition, it’s not clear to me that such a proposal has widespread support on the Democrats’ side of the aisle either. In the past several Democratic leaders have targeted partnerships for taxation, but most of the talk has surrounded financial partnerships and private equity funds; some legislation proposed would have explicitly exempted energy-related partnerships from any additional tax burdens.

But even when the Democrats did control both the House and Senate by significant margins they were unable to pass legislation to tax carried interest earned by financial partnerships. It doesn’t seem likely they’ll have much greater success in a gridlocked Washington. The Obama MLP tax scare is a red herring; regard any downside in the group as a buying opportunity.

Fundamentally both Enterprise Products and Penn-Virginia are on solid footing.

Enterprise boosted its quarterly distribution to $0.5975 per quarter, the company’s 27th consecutive quarterly distribution hike. Thanks to near-record volumes of oil, natural gas and natural gas liquids (NGL) flowing through the company’s pipeline, storage and processing systems, Enterprise reported record quarterly distributable cash flow of $694 million. That’s enough to cover its quarterly distribution by 1.4 times, historically a high level of coverage for Enterprise.

I continue to like Enterprise Products’ growth prospects, particularly in NGLs. Demand for NGLs is strong from domestic petrochemicals producers who are taking advantage of large domestic supply and favorable pricing. And, Enterprise’s NGLs export terminal has been running at full capacity as the US is not the world’s largest producer of NGLs and has the lowest prices.

The Eagle Ford Shale in southern Texas is a particularly attractive expansion opportunity for Enterprise. The company has 21 projects underway in the region representing a total of $2.5 billion in infrastructure investments. All of these deals are backed by long-term commitments from producers in the region that effectively guarantee Enterprise a steady return on their investments in the region.

Given high distribution coverage and attractive growth prospects, Enterprise will likely accelerate distribution growth in the coming year. Enterprise Products Partners rates a buy under 45.

Penn-Virginia Resources boosted its quarterly distribution by 1 cent to $0.48, the first increase in its quarterly distribution rate since November 2008. That’s a sign of growing management confidence in the underlying business and Penn-Virginia’s growth prospects.

The MLP reported total distributable cash flow of $36.9 million, enough to cover its now-raised quarterly distribution by just over 1.2 times. The biggest contributor to upside in distributable cash flows was its coal royalty segment. Penn-Virginia doesn’t actually mine and sell; it owns coal-producing properties in Appalachia and leases those reserves out to miners for a royalty fee. Typically, these royalties include a minimum amount plus an amount based on the volumes sold and the prevailing price of coal.

Coal royalties soared due to higher production from the company’s lands, higher prices, especially for metallurgical coal used in steelmaking and the firm’s January acquisition of 102 million tons of coal reserves.

Penn-Virginia’s natural gas midstream represents a more conservative and defensive business line as it’s backed by long-term fee-based arrangements that have little or no sensitivity to prevailing commodity prices. Volume of gas throughout is up by more than a third year-over-year and Penn-Virginia plans to spend $120 million on further expansion in the Marcellus Shale region of Appalachia this year. Buy Penn-Virginia Resources under 29.

Deepwater contract driller Seadrill (NSDQ: SDRL) has pulled back from early March highs but remains one of my top picks for long-term growth and income potential. Most of the pullback in the stock can be attributed to action in the broader energy markets and profit-taking after an impressive run-up over the past year.

The company did announce on Apr. 7 that it planned to call a convertible bond issued in 2007. Under the terms of that bond, holders had the right to convert their bonds into common stock; Seadrill issued just under 26 million new shares under the terms of this deal. While the issuance of new shares represents dilution, I don’t regard the amount as significant–Seadrill has approximately 470 million shares outstanding, so this deal represents just about a 6 percent dilution of existing holders.

The more important trend to watch with Seadrill is its continued strategy to upgrade its already modern fleet. In April management announced it was selling a shallow-water jackup rig and exercising an option to build a new, state-of-the-art, ultra-deepwater rig for $600 million that will be delivered in late 2013. The company has the most modern fleet of any deepwater contract driller, and such rigs trade at a significant premium to older rigs.

Based on the firm’s current backlog of rigs booked under long-term contract, I see more upside to the quarterly dividend of $0.675. I also see the potential for Seadrill to declare additional special cash dividends in coming quarters, as it did in the first quarter of 2011. Assuming the dividend rises to around $.70 to $0.75 per quarter by early next year and Seadrill pays an additional special dividend, I can see the stock trading into the mid-40s.