“Signs of euphoria” have emerged in the market for master limited partnerships (MLP), writes one research house. If true, investors certainly have good reason for high spirits, considering the flurry of distribution increases and profitable merger activity.

On the merger front, as we noted in a January 19 Alert, Williams Companies (NYSE: WMB) is merging its two publicly traded MLPs. One is Aggressive Portfolio holding Williams Partners LP (NYSE: WPZ). The other is buy-rated and far more conservative pipeline owner Williams Pipeline Partners LP (NYSE: WMZ).

Under the terms of the deal, Williams Partners LP will be the surviving entity. Williams Companies will “drop down” substantially all of its remaining midstream assets into the combined MLP. That includes its 65 percent interest in the Northwest Pipeline, 24.5 percent of the Gulfstream pipeline, as well as a range of gas processing and fractionation plants.

On reflection, Williams Companies appears to be trying to accomplish what Conservative Holding Enterprise Products Partners LP (NYSE: EPD) did in late 2009, by merging with affiliated MLP TEPPCO Partners LP. That’s basically to create an entity with the scale and conservative financial profile to more easily access capital markets for growth. One promising area for investment is infrastructure serving the Marcellus Shale gas play in Appalachia.

The new Williams Partners will immediately become one of the largest energy MLPs in the US. The deal also dramatically changes the MLP’s character by adding a wide range of stable, fee-based assets to what had been a fairly volatile mix of assets focused on energy-price-sensitive gathering and processing (G&P). Fitch has already put Williams on credit watch for an upgrade, and other raters are certain to do the same.

As we said Tuesday, the deal has been immediately bullish for units of both MLPs as well as for Williams Companies itself. For our stake in Williams Partners, it immediately adds to distributable cash flow, and management has it will boost the quarterly payout to $0.6575 from $0.635 beginning with the mid-May payment. And more hikes are on the way.

If there is a problem with this deal for us, it’s that Williams Partners no longer fits the profile of an Aggressive Holding. Accordingly, we’re moving it to the Growth Holdings, which combine stable fee-based income from energy infrastructure with operations that are sensitive to commodity prices.

The yield of 7 percent is on the low side for this group. But given Williams Partners’ unique mix of assets and newfound scale, it’s likely to prove to be worth the higher price, particularly once this deal is completed (probably in March).

Buy Williams Partners LP–now a Growth Holding–up to our new target of 37.

Conservative Holdings

As for our Conservative Holdings, none stand out as obvious candidates for an MLP merger on the scale of Enterprise Products’ deal last year. Rather, the excitement is coming from distribution growth, which appears to be accelerating as the energy industry bounces back and MLPs buy and build more infrastructure assets, adding to cash flow.

The latter continue to be greatly aided by a steady stream of equity issues. Nine MLPs sold units during the first three weeks of January, versus just one a year ago. And with the markets so hospitable, more are certain to follow suit, taking advantage of the highest unit prices in many months.

These secondary offerings continue to take their toll on unit prices, as dilution-fearing investors back off. But their aftermath remains prime time to pick up units that have often become too expensive to be truly attractive. And with myriad opportunities to buy and build assets, they continue to fuel growth in distributable cash flow and distributions, sending unit prices higher as well.

That virtuous cycle is still very much in effect for each of the Conservative Holdings. Over the past four weeks, Enterprise Products Partners LP (NYSE: EPD, 5.9 percent 12-month dividend growth rate), Genesis Energy LP (NYSE: GEL, 9.1 percent) and Spectra Energy Partners LP (NYSE: SEP, 13.9 percent) have raised distributions. Enterprise has now upped its payout for 23 consecutive quarters, while Genesis has done so for 18 quarters and Spectra every quarter since its 2007 inception.

Management of Kinder Morgan Energy Partners LP (NYSE: KMP) projected a 4.8 percent distribution increase for 2010 after generating a 44 percent increase in fourth-quarter distributable cash flow over last year’s levels. Kinder also reported a full-year surplus of distributable cash flow over the payout, a sharp reversal from shortfalls that prevailed for most of the year.

That was a major accomplishment, considering a 2.5 percent drop in throughput volumes across all operations. Steel volumes at the MLP’s terminals division were “substantially below” management’s projections. Poor pricing for oil and natural gas liquids were strong headwinds at the carbon dioxide division, whose major customer is CO₂ injection for otherwise depleted oil wells. Moreover, the company encountered delays starting up two major natural gas pipeline projects.

Offsetting the weakness is what basically amounts to pretty good blocking and tackling on Kinder’s part. Costs were held under control, profits and margins maximized under difficult conditions, and debt expenses were cut. That set the stage for better results in 2010, as conditions improve and new assets are brought on line.

One big one is the Fayetteville Express pipeline project being brought on line by Growth Holding Energy Transfer Partners LP (NYSE: ETP) later this year. Another is a set of three ethanol terminals being acquired for $195 million to take advantage of rising ethanol content requirements in fuels that are kicking in this year.

Kinder is now on track to handle a third of the ethanol produced in the US through its energy transport network. This business is completely fee-based and focused on throughput, so the MLP has no exposure to changes in ethanol prices and a clear path to grow along with US government mandated usage of the fuel.

The ethanol connection is just another way Kinder management has been able to expand its reach in energy transportation, and in a low-risk way that’s stood up to the worst possible economic conditions. In fact, some 75 percent of its business is under “term contract,” and therefore not even subject to much throughput risk. That’s a model for growth in almost any environment.

The units have risen quite a long way for a Conservative Holding since we first added it to the Portfolio last May. That’s forced us to continually wrestle with the question of how much we’re willing to pay for its rising yield.

At this point, we’re content to keep our buy target for Kinder Morgan Energy Partners LP at a flat 65, a point where it will yield a little less than 7 percent after this year’s likely distribution increase. Should the unit price move much higher, though, we’d have to consider downgrading the MLP to a hold and possibly taking some money off the table.

That’s a challenge we increasingly face with all of our picks in this service. We’re higher than ever on their business prospects. In fact, the higher unit prices go, the more capital they can raise and the faster cash flow, distributions and share prices can and will likely go.

However, nothing is a bargain at any price. And while we’re still a long way from there, at some point the list of worthy projects will diminish and speculative building will commence.

The fact that some investors are apparently willing to ignore value and bid up prices of our favorites is certainly welcome to us. We’ll always take what the market gives us and it’s dished out quite a lot to us so far.

It’s entirely possible that fourth-quarter results and 2010 outlooks will be so positive that we’ll have to lift buy targets even more than we have to date. Until that happens, we urge readers in the strongest possible terms not to chase yield above our buy targets.

Rather, continue to target the MLPs that best meet your own investment strategy, and buy them with discipline. If you’re an income investor who can’t afford to take a risk on what energy prices will do, stick with the Conservative Holdings highlighted above. If you can take more risk, by all means look at our Growth and Aggressive picks.