Since the start of the second quarter, units of Penn Virginia Resource Partners LP (NYSE: PVR) have returned almost 15 percent, making the stock one of the top-performing names in my Best Buys List–an impressive performance in such a challenging market.  

Penn Virginia Resource Partners historically has derived the majority of its cash flow by leasing its substantial coal reserves to miners. As we explained in Coal: Outlook and Opportunities, demand for North American steam coal has been hit hard by a combination of ultra-depressed natural gas prices, the extraordinarily warm 2011-12 winter that pressured electricity demand and rising mining costs in Central Appalachia.

Based on Penn Virginia Resource Partners’ focus on coal, investors might expect the stock to trade sharply lower. That’s certainly the case for many other coal-focused master limited partnerships (MLP) such as Oxford Resource Partners LP (NYSE: OXF) and Rhino Resource Partners LP (NYSE: RNO), two sell-rated MLPs in the Energy Watch List.

What sets Penn Virginia Resource Partners from its peers? The MLP is in the midst of a transformation that will dramatically reduce its dependence on coal royalties while boosting its exposure to fee-generating midstream natural gas assets. Management estimates that the latter business will account for about 70 percent of the MLP’s cash flow in 2013–up from less than 50 percent at the end of the first quarter.

Penn Virginia Resource Partners’ midstream business consists primarily of natural gas gathering and processing capacity in Texas, Oklahoma and Appalachia’s Marcellus Shale, a low-cost basin where drilling activity has remained relatively resilient.

At the end of the first quarter, Penn Virginia Resource Partners’ gathering pipelines in the Marcellus Shale handled 211 million cubic feet per day of natural gas.

The MLP began building these midstream assets in 2010 and continues to expand these systems to meet demand. Like most MLPs, Penn Virginia Resource Partners won’t undertake a major construction project without securing capacity commitments from customers that guarantee some cash flowregardless of whether the pipeline is fully utilized.

For example, Penn Virginia Resource Partners’ Lycoming West gathering pipeline in North-Central Pennsylvania includes capacity reservation agreements with Range Resources Corp (NYSE: RRC), Southwestern Energy (NYSE: SWN) and integrated energy giant Royal Dutch Shell (LSE: RDSA, NYSE: RDS A).

The company is also expanding Lycoming West to allow for additional connections with the Tennessee interstate pipeline to the north and the Transco pipeline to the south. Upon completion, the system will have a nameplate capacity of 850 million cubic feet per day.

In additiona, the MLP has formed a joint venture with Aqua America (NYSE: WTR) that will deliver water–a critical component in hydraulic fracturing–to gas producers in the Pennsylvania portion of the Marcellus Shale.

Besides these organic expansion projects, Penn Virginia Resource Partners doubled its midstream volumes in the Marcellus Shale with the May 17 acquisition of Chief Gathering LLC from the privately held Chief E&D Holdings LP for $1 billion. We expect the integration of these assets to proceed without a hitch because of their proximity to Penn Virginia Resource Partners’ existing gathering networks.

Better still, capacity on these newly acquired pipelines is reserved by long-term, take-or-pay commitments with major producers such as Anadarko Petroleum Corp (NYSE: APC), Chesapeake Energy Corp (NYSE: CHK), Chevron Corp (NYSE: CVX), Enerplus Corp (NYSE: ERF), ExxonMobil Corp (NYSE: XOM) and Statoil (NYSE: STO). These contracts require customers to pay a minimum fee regardless of usage.

Although much of Penn Virginia Resource Partners’ midstream growth will occur in the Marcellus Shale, investors shouldn’t overlook the MLP’s roughly 2,000 miles of gathering pipelines in the Texas panhandle and Oklahoma, the heart of the liquids-rich Granite Wash. This system also includes 340 million cubic feet per day of gas processing capacity.

Drilling activity in this play has remained robust, as producers shift their focus from basins that primarily produce natural gas to those that also yield higher-value natural gas liquids (NGL). To meet demand, Penn Virginia Resources Partners will bring online another 60 million cubic feet per day of processing capacity by midyear.

All told, Penn Virginia Resource Partners’ midstream volumes are slated to increase to as much as 1.5 billion cubic feet per day in 2013 from about 650 million cubic feet per day at the end of the first quarter. At the same time, fee-based agreements will cover about 80 percent of the MLP’s total midstream throughput, up from about 30 percent in 2011.

In short, Penn Virginia Resource Partners’ midstream business has more than doubled while becoming less dependent on commodity prices and drilling activity.

Although the North American market for steam coal faces significant headwinds, Penn Virginia Resource Partners’ royalty business is relatively well-positioned to weather the storm. About 80 percent of these contracts guarantee the MLP the higher of a fixed percentage of the gross sales price of coal produced on its properties or a fixed fee per ton mined.

This structure limits Penn Virginia Resource Partners’ direct exposure to rising mining and environmental costs associated with mining in Central Appalachia, a region that accounts for three-quarters of Penn-Virginia’s coal-related royalty streams. Contracts with lessees have an average life of 10 to 15 years, which limits near-term risk. 

In the first quarter, Penn Virginia Resource Partners’ coal royalties per ton mined increased slightly to $4.09 from $3.94. However, lessees reduced output in response to lower coal prices. In the first three months of the year, the MLP received royalties on 8.1 million tons, compared to 9.9 million in the same quarter one year ago.

The resulting $5 million hit to the segment’s operating income smarts, but this shortfall is relatively insignificant for a firm that’s expected to generate about $500 million in earnings before interest, taxation, depreciation and amortization in 2013.

We expect weakness in Penn Virginia Resources’ coal business to be more than offset by the expansion of its midstream asset base.

The MLP disbursed $0.52 per unit in May, up from $0.51 in the prior quarter and equivalent to a yield of 8.8 percent. The partnership is targeting distribution coverage of between 105 and 115 percent. Based on growth in fee-based midstream cash flows over the next 18 months, Penn Virginia Resource Partners has the scope to grow its distribution at an annualized pace of 7 percent to 8 percent.

MLPs that own gathering and processing assets usually offer a distribution yield of about 7 percent, which suggests that investors have yet to recognize Penn Virginia Resource Partners’ transformation from a coal-focused business to a midstream operator.