Investors should take advantage of the ongoing correction in the stock market to pick up units of our favorite master limited partnerships–particularly those that operate in the upstream space–at favorable valuations.

Since the end of 2007, the Alerian MLP Index has generated a total return of 66.6 percent, about 32 percent of which came from price appreciation. The S&P 500, on the other hand, lost 1.55 percent over the same period.

This outperformance reflects strong fundamentals, particularly for master limited partnerships (MLP) that own and operate midstream infrastructure for processing and transporting oil, natural gas and natural gas liquids (NGL).

For one, midstream operators stand to benefit over the next several years from rising demand for takeaway capacity in the nation’s prolific shale oil and gas plays.

Surging activity in the Bakken Shale in North Dakota, the Eagle Ford Shale in South Texas and other plays has enabled the US to grow it annual oil output for the first time in decades. Even more impressive, this increase in overall oil volumes has occurred despite a sharp decline in production offshore Alaska and in the Gulf of Mexico.

Meanwhile, frenzied drilling in the nation’s shale plays enabled the US to surpass Russia as the world’s leading producer of natural gas and has dramatically depressed gas prices in the closed North American market. Despite gas prices that continue to hover near record lows, US output has continued to grow. Exploration and production firms have shifted their emphasis from dry-gas fields to fields such as the Marcellus Shale and Eagle Ford Shale that also produce large amounts of higher-value NGLs that improve wellhead economics.

This upsurge in onshore oil and gas output has occurred in many regions that lack legacy takeaway and processing capacity, while even the Permian Basin in west Texas–an area that’s produced oil since the 1920s–requires additional infrastructure to handle growing volumes.

In a comprehensive report on this subject, the Interstate Natural Gas Association of America (INGAA) estimates that the US and Canada will need to spend $83.8 billion to build and expand enough midstream infrastructure to support the surge in onshore production. Although a trade organization that represents pipeline owners produced this report, many of the pricing and production assumptions underlying the INGAA’s estimates appear reasonable.

Demand for these midstream assets will be met by MLPs, setting the stage for the best-positioned names to grow their cash flow and quarterly distributions to unitholders. Rising cash flow and quarterly payouts inevitably add up to rising stock prices.

In addition to rising demand for midstream infrastructure, MLPs continue to reap the rewards from an extraordinarily low cost of capital. Because MLPs are pass-through entities that disburse the majority of their cash flow to their investors, publicly traded partnerships rely on the debt and equity markets to fund acquisitions or organic growth projects.

With many of our favorite MLPs raising inexpensive debt and equity capital to fund growth projects in the nation’s burgeoning shale plays, we expect the coming distribution growth to fuel additional price appreciation.

Moreover, the current market environment should combine with investor psychology and demographics to increase investment in the group.

For one, despite the Alerian MLP Index’s recent rally, the group still offers superior yields to an overbought bond market and traditional income-oriented securities such as real estate investment trusts.

Many income-seeking investors also remain scarred by the stock market implosion that accompanied the global credit crunch and Great Recession, a period that reminded investors of the risk involved in investing in higher-yielding fare. Few will forget the panic that ensued when corporate titans such as General Electric (NYSE: GE) and Bank of America Corp (NYSE: BAC) were forced to slash their dividends after the credit bubble burst.

In contrast, many energy-related MLPs managed to maintain their distributions throughout this turbulent period, overcoming frozen capital markets and plummeting oil and gas prices. MLPs that own midstream assets such as pipelines proved the most resilient; these names tend to garner much of their cash flow from fees and are relatively insulated from fluctuations in commodity prices.

At the same time, uncertainty surrounding the EU sovereign-debt crisis and global economic growth should ensure that volatility once again rules the stock market through at least 2012. With shell-shocked investors seeking reliable income and growing dividends to offset losses incurred by panicked selling and a flat stock market, expect inflows to the MLP sector to continue apace.

Besides investor psychology, demographic trends also bode well for energy-related MLPs. The US Census Bureau estimates that the number of elderly American will increase by 36 percent in 2020 and 79 percent in 2030. To meet the needs of this wave of retiring baby boomers, financial planners continue to shift their focus from the best strategies for accruing assets to turning accumulated savings into a lifelong income stream. Not surprisingly, the sustainable yields offered by MLPs hold a great deal of appeal for investors whose bodies are becoming less reliability.

Retirees will also gravitate toward the tax advantages offered by MLPs. The Tax Reform Act of 1986 sought to encourage investment in energy infrastructure by exempting the MLP structure from corporate taxes. Similar to real estate investment trusts, MLPs are pass-through entities that transfer any profit or losses to individual unitholders who pay taxes at their ordinary income rate.

Because of depreciation allowances, 80 to 90 percent of the distribution you receive from a typical MLP is considered a return of capital by the Internal Revenue Service. You don’t pay taxes immediately on this portion of the distribution.

Instead, return of capital payments serve to reduce your cost basis in the MLP. You’re not taxed on the return of capital until you sell the units.

In other words, 80 to 90 percent of the distribution you receive from the MLP is tax-deferred. The remaining piece of each distribution is taxed at normal income tax rates, not the special dividend tax rate. But the piece taxed at full income tax rates is only 10 to 20 percent of the total distribution; there’s still a huge deferred tax shield for unitholders.

An example can provide a useful illustration. Assume you own an MLP purchased for $50 and receive $5 in annual distribution payments, $4.50 of which is considered a return of capital. After one year, your cost basis on the MLP would drop to $45.50 ($50 minus $4.50); no income tax is paid on that $4.50. You’d pay normal income tax rates on the remaining 50 cents.

When you finally sell the units or the cost basis drops to zero dollars, a portion of the capital gains are taxed at the special long-term capital gains tax rate. The remainder is taxed at your full income tax rate. But in most cases, MLPs should be held for long periods to get the full benefit of distributions. You’re likely to be deferring 80 to 90 percent of your taxes for several years or perhaps indefinitely–a tremendous benefit, especially for older investors.

Older investors can also rest easy that when their MLP holdings pass on to their heirs. The cost basis of an MLP is reset to the initial cost basis (purchase price) when an investor dies. MLPs can be a valuable component of your estate plan, allowing you to pass along an income-paying asset without owing tax on shielded income.

Not surprisingly, financial institutions have been quick to capitalize on rising demand for MLPs, rolling out 41 funds that provide one-stop exposure to the group.

Not only does this trend raise investors’ awareness of the benefits of MLPs, but the added liquidity should also boost unit prices within the sector and increase the correlation between this security class and the S&P 500.

Investors will eke out better returns over the long run by purchasing units of individual MLPs. The funds pushed by the various investment houses eliminate some of the headaches with figuring out tax liabilities on individual MLPs, but many of these funds expose investors to the double taxation that individual holdings avoid. Also, these funds’ portfolios often include a number of marginal names in addition to the sector’s top performers.

Around the Portfolios

Upstream MLP Legacy Reserves LP (NSDQ: LGCY) enjoyed a solid first quarter, growing production by about 5 percent sequentially, to 14,400 barrels of oil equivalent per day. Much of this uptick in production stemmed from elevated initial production rates on recently completed wells and a full quarter of output from $28 million in acreage acquired in November 2011. Improved takeaway capacity also bolstered natural gas output from the MLP’s acreage in New Mexico.

Legacy Reserves in the first quarter realized an average of $70.51 per barrel of oil equivalent per day, compared to $68.10 per barrel of oil equivalent per day in the fourth quarter of 2011. The firm’s outsized exposure to oil and higher price realizations for this commodity offset a 14 percent decline in the price of natural gas and a 13 percent drop in the price of NGLs.  

Higher production and average price realizations, coupled with management’s decision to limit capital expenditures in the first quarter, enabled Legacy Reserves to generate record-high DCF in the quarter and cover its distribution by 1.37 times. This coverage ratio is even more impressive when you consider that the MLP’s secondary offering in November 2011 increased the number of outstanding units.

The MLP’s conservative approach to calculating distributable cash flow–management doesn’t distinguish between capital expenditures for maintenance and those for growth–suggests that the publicly traded partnership should have no problem sustaining its distribution. Moreover, Legacy Reserves has hedged about 67 percent of its expected production in 2012, providing a buffer against the recent decline in oil prices.

Although management warned that second-quarter production would likely fall slightly short of the MLP’s output in the first three months of the year, the firm’s largest acquisition since December 2010 should prove accretive to cash flow in the third quarter.

The $88 million in acquisitions that the firm announced in the first quarter consisted of acreage in two distinct regions: the Rockies and Legacy Reserves’ traditional stronghold, the Permian Basin in west Texas.

The MLP paid $70.8 million to an undisclosed seller for oil-producing properties in Montana and North Dakota, with a current net output of 776 barrels of oil equivalent per day. All the acreage is proved, developed and producing, and management estimates the reserve life at about 11 years.

Not only does the deal diversify Legacy Reserves’ geographic footprint, but the acquisition also reflects the rising cost of acreage in the Permian Basin. CEO Cary Brown alluded to this challenge during a recent conference call to discuss first-quarter results:

One of the things that feels good is the Permian Basin right now is really hot and being able to buy in the Rockies because of the outstanding group we have up there and in some of these other basins really opens up the opportunities. As I’ve told guys around here, it’s nice to have multiple places to shop when you’re looking for acquisitions.

During the quarter, Legacy Reserves also announced $17.3 billion in bolt-on acquisitions, 74 percent of which are in Wyoming and 26 percent of which were in the Permian Basin. Management estimated production from these fields at 157 barrels of oil equivalent per day.

Finally, Cary and his team indicated that the MLP will drill its first horizontal wells in the Bone Springs and Yeso areas of the Permian Basin. Other operators in this vicinity have delivered impressive well results.

With plenty of opportunity to increase production in coming years and an oil-weighted production profile, Legacy Reserves is a solid bet to continue growing its distribution. Offering a distribution yield of almost 9 percent after the recent pullback, units of Legacy Reserves LP are a buy up to 32 and a bargain at current prices. With the market likely to remain volatile in the coming months, investors should consider easing into this position to take advantage of any further correction in the stock price.

Linn Energy LLC (NSDQ: LINE) reported its first quarter profits in time for the previous issue of MLP Profits and is highlighted there. The positive message was further reinforced at the MLP Conference by CEO Mark Ellis.

Not surprisingly, the unit price has been knocked around by volatile energy prices, despite the fact cash flow is wholly protected from gas price swings until 2018 and oil price volatility through 2015. Linn continues to find opportunities to expand using its locked in cash flows, which should fuel future growth in distributions. Meantime, it’s a solid buy up to 40.

We added Mid-Con Energy Partners LP (NSDQ: MCEP) to the Aggressive Portfolio about two months after its initial public offering. With a market capitalization of only $362.9 million and an average daily trading volume of about 66,000 units, the stock has endured significant volatility over the past few months but has still returned 0.17 percent.

With the EU sovereign-debt crisis roiling the stock market and another growth scare weighing on oil prices, investors should expect the unit price of Mid-Con Energy Partners to fluctuate in coming months. That being said, results from Mid-Con Energy Partners’ first full quarter as a publicly traded firm reaffirmed our confidence in the upstream MLP’s growth story and suggest that the stock will reward investors who stick it out for the long term.

Mid-Con Energy Partners owns about 10 million barrels of oil-equivalent reserves in the Midcontinent region, 69 percent of which are proved and developed. Crude oil accounts for about 96 percent of the firm’s reserves, a favorable mix in the current price environment. Like many upstream MLPs, the firm operates in established plays that feature limited drilling risk and predictable decline rates.

In fact, management estimates that about 90 percent of the outfit’s wells have been in production since 1982 or earlier. Mid-Con Energy Partners specializes in water-flooding, an enhanced recovery technique that involves injecting large volumes of water into a mature field to restore well pressure and bolster output. So-called primary production recovers only 10 percent to 25 percent of the hydrocarbons in a field, while water-flooding and other secondary techniques can extract another 10 percent to 20 percent of these resources.

More than 90 percent of Mid-Con Energy Partners’ producing wells employ water flooding to improve production rates. Six to 18 months of water injections are required to increase production, but the technique works. The MLP’s acreage in southern Oklahoma (about 55 percent of total reserves), which is still in the early stages of water-flooding, flowed about 220 barrels of oil equivalent per day in September 2006 and in December 2011 yielded 2,492 barrels of oil equivalent per day.

During the first quarter, Mid-Con Energy Partners extracted 1,703 barrels of oil equivalent per day–150,000 barrels of oil and 31 million cubic feet of natural gas–up 15 percent sequentially. Excluding derivatives related to hedging, the MLP’s hydrocarbon sales totaled $15.5 million, while the firm’s adjusted earnings before interest, taxes, depreciation and amortization came in at $11.8 million. More important, Mid-Con Energy Partners generated distributable cash flow of $0.556 per unit, enough to cover the quarterly payout by 1.17 times. Over the long term, the MLP targets a payout ratio of between 1.15 and 1.20 times.

With management expecting daily production to average 1,850 barrels of oil equivalent per in 2012 and 75 percent of this output hedged at favorable prices, we expect the recent weakness in oil prices to have only a modest effect on the MLP’s near-term fortunes.

Moreover, Mid-Con Energy Partners’ long-term growth story remains intact. In April, the company increased its borrowing base to $100 million, an amount that management told analysts would “cover any potential acquisitions for the year, but not [include] any unused availability that [the firm] wouldn’t need.”

CEO Jeffrey Olmstead also indicated that the pipeline of potential acquisitions and joint ventures appears strong, with many exploration and production companies seeking to divest mature assets to fund drilling in shale basins and other emerging plays:

As far as opportunities arise, our deal flow really in the last six months has been as good as it has ever been. We’ve looked at more water-flood opportunities–…from grass roots [opportunities] that our people have put together themselves and gone out and found, to companies that maybe have come across some water-floods and some acquisitions they had that [weren’t] their core competency…[Some companies] have talked about divesting [these properties] and that other people talk to us about joint venturing with them. So, we’re very positive on the outlook in the deal flow that we’ve seen and hope to continue to grow with it.

Even if Mid-Con Energy Partners doesn’t close an acquisition in 2012, management reaffirmed that 2013 will likely bring a drop-down transaction from the firm’s general partner, private-equity outfit Yorkville Partners.

Mid-Con Energy Partners’ parent, which has about $3 billion in assets under management, has invested in a number of oil- and gas-producing properties that might be a good fit for Mid-Con Energy Partners. Private affiliate Mid-Con Energy III focuses on water-flood opportunities that fit the MLP’s business model, while Mid-Con Energy IV targets primary production opportunities over a broader geographic range. Management indicated that any drop-down transactions in the near-term would likely come from Mid-Con Energy III.

By dropping down a new water-flooding project to Mid-Con Energy Partners, Yorktown Partners would monetize this asset and shield ongoing revenue from the field from corporate taxation. Meanwhile, rising production and cash flow from the dropped-down asset would enable Mid-Con Energy Partners to grow its distribution. With an almost 50 percent stake in Mid-Con Energy Partners’ outstanding units, Yorktown Partners has ample incentive to pursue strategies that will foster the MLP’s growth.

Prospective investors should also note that management reviews Mid-Con Energy Partners’ distribution policy every third quarter, so the payout will likely increase once annually rather than in incrementally in each quarter.

Yielding more than 9.5 percent, Mid-Con Energy Partners’ oil-weighted production mix and solid pipeline of growth opportunities makes the stock a buy under 26.50. Investors who can stomach the volatility should jump at any chance to acquire the stock for less than $19 per unit.