The past few months have been painful for most market sectors, including energy. But there’s a silver lining: Income-oriented investors now have a once-in-a-decade opportunity to grab companies with little or no exposure to an economic slowdown or weak energy prices and lock in tax-advantaged yields of 8 to 15 percent.

Master Limited Partnerships (MLP) have long been a favorite income-producing group within The Energy Strategist. These stocks have been bloodied in recent months due mainly to forced liquidations on the part of hedge funds and other institutional investors. Meanwhile, the vast majority are actually increasing their distribution payouts.

In this issue, I’ll take a closer look at the sector and the reasons I think the recent turn to the upside is the beginning of a longer trend.

I explore MLPs and explain why now is the best buying opportunity for income-oriented investors. I also delve into the pipeline transportation business, which offers steady, dependable cash flows that don’t change based on commodity prices. See Master Limited Partnerships.

MLPs currently offer high-yield potential for investors, which is the big advantage of this asset class. In addition, MLPs are partnerships, not corporations, so these firms pay no corporate-level tax whatsoever. See Tax and Yield Advantages.

It’s no surprise that MLPs haven’t been immune to the market selloff that’s infected the broader averages over the past year. Much of the selloff was due to forced liquidations on the part of hedge funds, private equity firms and closed-end, MLP-focused funds. But there is a silver lining. See Why the Fall?

I provide a table of all of my current MLP recommendations across all three TES portfolios and a rundown of each. I’m also adding a new MLP to the Portfolio as of this issue. See MLP Favorites.

I’m recommending or reiterating my recommendation in the following stocks:

• Duncan Energy Partners (NYSE: DEP)
• Enterprise Products Partners (NYSE: EPD)
  
• Kinder Morgan Energy Partners (NYSE: KMP)
• Kinder Morgan Management (NYSE: KMR)
• Sunoco Logistics (NYSE: SXL)
• Tortoise Energy Infrastructure (NYSE: TYG)

In last week’s flash alert Master Limited Partnerships Regaining Their Defensive Mojo, I highlighted what I consider the best buying opportunity of the decade for income-oriented investors. For those unfamiliar with this class of security, I recommend rereading the Nov. 22, 2006, issue of TES, Leading Income, which is available in the archives; the issue offers a detailed guide to the group.

To summarize, MLPs are stocks and trade on the major exchanges just like IBM, General Electric or Schlumberger. You shouldn’t incur any additional commissions or fees from your broker relating to the purchase of these securities. In fact, close to 90 percent of the MLPs I follow trade on the New York Stock Exchange (NYSE).

Most MLPs are involved in the midstream energy business. Typically, the term upstream refers to the actual production of oil, natural gas or other energy-related commodities, while downstream suggests refining and the actual marketing of oil and gas products to consumers and industrial users.

Therefore, midstream energy companies own the assets that connect producers with refiners and, ultimately, consumers. This would include pipelines, tankers, storage, terminal facilities and plants used to process natural gas.

It’s impossible to generalize completely; however, the midstream business typically has little or no real exposure to commodity prices. For example, the most common assets owned by MLPs are oil and gas pipelines. Pipeline operators generally offer two basic types of transportation contract: firm or interruptible; the latter contract is sometimes called an “as available” contract.

Firm contracts typically consist of two types of fee: a demand (reservation) charge and a commodity charge. The former is a fee paid for reserving capacity on the pipeline; the demand charge must be paid whether the shipper actually puts gas through the line or chooses not to. Firm contracts also establish a particular firm’s maximum daily quantity (MDQ)–the maximum amount a given shipper is allowed to ship per day. 

A commodity charge is an amount paid based on the volume of oil or gas transported on a given day. It’s extremely important to note that this fee has absolutely nothing to do with the value of oil or natural gas shipped over the pipeline. The pipeline operator doesn’t take possession of the commodities that are transported through its lines. The pipeline operator doesn’t care whether the natural gas that travels through its system trades at $6 per million British thermal units (MMBtu) or $20 per MMBtu. The only point that matters is how much gas is pushed through the pipe.

Interruptible contracts typically carry no demand charge. Rather, pipeline operators receive a commodity charge that’s based on supply and demand for service on a particular day. Just as with firm contracts, the fee pipeline operators charge has nothing to do with commodity prices. These are volume-based fees. 

As you might expect, pipeline capacity is allocated on a given day according to priority. Shippers with firm contracts are allocated their guaranteed capacity first; the only time this would likely be reduced would be because of pipeline damage or a weather-related issue such as a hurricane. After all firm contracts are satisfied, the pipeline owner can allocate capacity to firms wishing to ship gas under interruptible contracts.

One more point to note: There’s a difference between interstate and intrastate pipelines. Interstate pipes that cross state boundaries are subject to regulation from the Federal Energy Regulatory Commission (FERC). FERC regulators regulate the fees that an interstate pipeline operator can charge for its services; the process is fairly complex, but these fees are normally set to allow the operator to recover expenses incurred in building the pipeline and receive a reasonable utility-like return on their business. Fee determination also involves both the pipeline operator and major shippers on a given system.

Intrastate pipelines are regulated by individual states; for example, intrastate pipelines in Texas are regulated by the Texas Railroad Commission (TRC). The amount of regulation varies by state, but as general rule, states impose less-stringent regulation on rates and fees charged.

Most MLPs only build pipelines when they receive enough firm capacity commitments at acceptable rates to back up their construction costs. A pipeline operator will often propose a new pipe and then ask potential shippers for commitments. If it attracts enough interest and firm commitment, the MLP would go ahead with the pipe. If not, the project is canceled. 

The bottom line: The pipeline transportation business offers steady, dependable cash flows that don’t change based on commodity prices. This is one of the steadiest, most cash flow positive businesses you’ll encounter.

Of course, pipelines are just one of many types of assets commonly owned by MLPs. But it’s fair to say that these firms typically concentrate on owning physical infrastructure that generates high, free cash flow and has relatively low exposure to commodity prices.

The big advantage of MLPs is yield potential. MLPs are required to pay out the majority of their earnings as distributions. The sector currently offers high-yield potential for investors. Also helping in this regard is the fact that MLPs are partnerships, not corporations; these firms pay no corporate-level tax whatsoever. Freedom from the traditional double-taxation structure offers more cash available for distribution to unitholders (the MLP equivalent of shareholders).

Consider the industry benchmark index, the Alerian MLP Index. At this time, the Alerian Index pays an average yield of 10.9 percent; within the index, yields range from 6.5 to 21.3 percent. In addition, 24 of the 50 index components offer yields greater than 10 percent.

But sky-high yields won’t do investors any favors unless those payouts are sustainable. In the case of most MLPs and all of the MLPs I recommend in TES, I believe dividends are not only sustainable but have considerable scope to actually rise in coming quarters.

MLPs aren’t some newfangled investment class that’s been cooked up by Wall Street over the past few years in an era of easy credit. Some of these companies have been around for more than a decade. And those that have been around for a long time have established an outstanding track record of dividend growth over time. Check out the chart below for a closer look.

This chart shows the quarterly dividends investors would have received from a 500-share investment in Proven Reserves Portfolio member Enterprise Products Partners (NYSE: EPD) at the end of October 1998. Back then, that investment would have cost you $8,312.50; in the first year, those 500 shares paid about $900 in distributions for a yield of 10.8 percent. This is similar to the yields available from Enterprise during the recent market turmoil.

But what’s even more impressive is Enterprise’s record of boosting distributions over time. Consider that same 500-share investment in 1998 now generates a quarterly payout of $522.50. Based on the original investment of $8,312.50, you would now be earning nearly $2,100 per year. That’s a yield of more than 25 percent based on the initial investment.

Also impressive is that Enterprise hasn’t once cut its yield over this time period. In fact, in 26 out of the past 39 quarters, Enterprise has raised its payout. Few income-producing securities have offered that degree of security and sustainability over the long term.

And recent history also shows no sign of distress. As I noted in last week’s flash alert, every single one of the MLPs I recommend has boosted distributions paid to investors at least once over the past 12 months, and several have already declared increases in their payout for this quarter. Despite that fact, each one has equivalent or better distribution coverage than one year ago.

More broadly, there are currently 50 MLPs in the Alerian MLP Index. Of that total, 48 have announced an increase in their distributions at some point over the past 12 months. That’s 96 percent of the total.

To date, a total of 36 of the 50 MLPs in the Alerian Index have officially announced dividends for the third quarter. Of those, 75 percent have announced an increase in their quarterly payout.

And MLPs are currently offering attractive yields relative to other income-producing securities. Consider the chart below.

Source: Bloomberg

This chart shows the spreads between US 10-year Treasury Bond yields and three major income-oriented industry groups: MLPs, utilities and REITs. When this spread is positive, it means that the stocks offer a dividend yield higher than the yield on the 10-year.

As you can see, prior to the summer of 2007, the spreads were reasonably stable. Over the past decade, the spread between the yield of the Alerian MLP Index and the 10-year bond has averaged 2.86 percent; in 2006 and early 2007, the spread was much tighter, averaging less than 2 percent.

You can also see that prior to the summer of 2007, utility stocks as measured by the Philadelphia Utility Index (UTY) offered a smaller yield than the 10-year. Finally, the yield on the FTSE REIT Index was close to–or slightly less than–the yield on the 10-year.

There’s an obvious change in character starting around July 2007. The spread between the yield on US Treasuries and just about every imaginable income-producing stock or sector exploded. By October of this year, the spread between the yield of the Alerian MLP Index and the 10-year soared to more than 9 percent intraday. This is a record high. REITs also saw a huge yield spike in October as the credit crunch intensified. Yield spreads spiked to more than 7 percent intraday.

The move in utility yields is also apparent, but the spike is nowhere near the same order of magnitude. At the heart of the crunch, utilities yielded close to 2 percent more than the 10-year Treasury bond; although the spike is certainly not as massive, this does represent a multi-year high for this spread.

At this point, you might be wondering why these spreads are relevant at all. First, it’s important to note that the yield on the Alerian Index can increase for two reasons: falling stock prices or rising distributions. To explain this, let’s assume you own an MLP trading at $10 per unit that pays $1 in annual distributions–a 10 percent yield. If the price of the MLP drops to $5, the yield is now 20 percent ($1 divided by $5 equals 20 percent). Alternatively, the yield could rise if the MLP decided to boost its distribution. In this case, the yields for MLPs rose for both reasons. The average MLP has boosted its distributions by roughly 8 percent over the past year, but most stocks in the group have fallen in price, albeit at a slower pace than the broader market.

To make a long story short, we can look at yield spreads as a measure of risk or, at least, risk appetite. The 10-year US government bond yield is what’s known as a risk-free return. It’s assumed that there’s no risk that the US government would fail to repay the interest and principal on these bonds. When industry group spreads rise, it means that investors are effectively demanding a higher yield relative to the risk-free rate in order to compensate them for higher risks.

I’m not arguing that these spreads should have remained at early 2007 levels throughout the recent credit crunch. On the contrary, utilities, MLPs and REITs are all reliant to some extent on debt to finance expansion projects and growth; deteriorating credit conditions is certainly a key risk for these firms.

However, the explosion in spreads to record levels is indicative of the panic selling across all sectors that gripped the markets in October. In the case of the MLPs, this dramatic increase in risk premiums makes no sense. As noted above, most MLPs continued to raise their distributions even as credit conditions deteriorated. Moreover, as I’ll discuss at more length in today’s issue below, most of the MLPs I follow have ample debt capital available to fund their near-term expansion plans without having to sell more bonds or take out new credit lines with banks.

Furthermore, it stands to reason that, as the credit crisis continues to ease, these spreads should revert to levels closer to their long-term averages. As I explained at length in the Oct. 1, 2008, issue of TES, Energy Stocks Watch Washington, my favorite measure of credit market health is the TED spread. See the chart below for a closer look.

Source: Bloomberg

Although the TED spread remains elevated, it continues to decline sharply. This is due primarily to a major fall in the London Interbank Offered Rate (LIBOR), the interest rate banks charge to loan money to one another. Falling LIBOR rates indicate a looser credit market and easier access to capital for companies.

My final point about yield spreads is that the yield spreads for both REITs and MLPs exploded by about the same magnitude during the current crisis. This also makes absolutely no fundamental sense; in my view, the MLP industry carries less risk that the REIT industry in the current market environment.

Specifically, it’s likely that commercial and retail property valuations are declining alongside residential real estate. Moreover, shopping mall-focused REITs rely on retailers for their cash flows (rent payments), while residential REITs take rent money from consumers. To make a long story short: I’d rather have a firm commitment for fees from a company such as Chevron, BP or Chesapeake Energy than from a retailer or consumer. I suspect we’ll continue to see yield spreads for MLPs return to more normal levels faster than for REITs.

The bottom line: MLPs are offering sky-high yields that are at historically stretched levels. That makes this an outstanding time to buy into well-positioned MLPs and lock in double-digit or near double-digit yields.

In addition to yield, MLPs offer myriad tax advantages for investors. I explain these advantages at some length in the Nov. 22, 2006, issue, Leading Income. To summarize, MLPs pay no corporate-level taxation and simply pass through their profits to unitholders. This is why you’ll sometimes hear MLPs called pass-through securities.

The distributions passed through to unitholders are reported on a standard K-1 partnership form at tax time, not a 1099 like dividends from regular corporations. The distributions aren’t taxed as dividends; instead, part of each distribution is taxed as a return of capital (ROC), while the remainder is taxed as regular income and will be taxed at normal income tax rates.

The key to the MLP tax advantage is the ROC payments. For most MLPs, somewhere between 80 and 100 percent of the distributions you receive will be taxed as ROC payments. This portion of the distribution isn’t immediately taxable. Instead, ROC payments serve to reduce your cost basis on the MLP and aren’t taxable until that MLP is sold.

For example, let’s assume you buy an MLP for $10 and receive $1 in annual distributions. Ninety percent of that $1 is taxed as return of capital, and the remaining 10 cents is taxed as normal income. You’d be taxed at your full income tax rate on only 10 cents of the $1 in annual distributions. The remaining 90 cents would reduce your taxable cost basis from $10 to $9.10. You’d use this lower cost basis to calculate your tax liability when you sell the MLP. Effectively, thanks to return of capital payments, you can defer paying taxes on most of your distributions from MLPs for many years, if not indefinitely.

All of the information you need to account for all of this is contained on the K-1 forms you’ll receive from each MLP you own. Typically, these documents will hit your mailbox in February or March.

Dealing with K-1 forms will complicate your tax filings somewhat. However, it’s long been my view that the extra effort required is worthwhile given the tax deferral advantages MLPs offer. And the process is becoming easier. Many MLPs allow you to import all of the necessary K-1 information directly from their Web sites into electronic tax preparation software. And, of course, any tax accountant can handle K-1 forms with little additional effort. 

One caveat: It’s best to hold MLPs in taxable accounts rather than IRA or 401(k) accounts. The reason has to do with a quirky tax issue called unrelated business taxable income (UBTI). If you do want to hold MLPs in an IRA or tax-advantaged account, there are two ways to accomplish this while avoiding UBTI issues: Buy closed-end funds focused on MLPs or purchase i-unit MLPs that pay distributions in the form of additional shares rather than cash. 

My favorite closed-end MLP fund is Proven Reserves recommendation Tortoise Energy Infrastructure (NYSE: TYG) and my favorite i-unit is Kinder Morgan Management (NYSE: KMR), a stock I’ll explain at greater length below.

Finally, last night’s election results further increase the attraction of MLPs. Without delving into political commentary, I believe it’s fair to say that dividend taxation is more likely to go up under an Obama presidency than it would have been under a McCain administration. This is a negative for dividend-paying stocks because higher taxation means a lower after-tax yield. However, MLPs don’t pay dividends, and changes in dividend tax policy would have no bearing on the way MLPs are taxed. This makes the tax deferral advantage of MLPs all the more attractive.

You might also be wondering about the potential for there to be a change in tax regulations surrounding MLPs, particularly with Obama as president. Of course, you can never rule out such a change completely. However, recent actions appear to be moving in exactly the opposite direction.

For example, the so-called “bailout” bill that passed Congress and was signed into law by President Bush last month included a provision that actually broadened the definition of MLPs to allow them to participate in renewable fuels industries. This provision was designed to provide tax advantages to encourage renewable fuels development.

Moreover, there was a good deal of misleading reporting going on surrounding bills introduced before Congress over the past year. There were even a few headlines proclaiming that the government aimed to tax publicly-traded energy MLPs.

The reality: The legislation these articles referred to was targeting hedge funds and private equity firms that have listed as limited partnerships. This legislation made the distinction between traditional energy-related MLPs and the non-energy MLPs. I suspect the latter group is particularly vulnerable to new taxes in coming years, while the chance that there will be changes to MLP taxation generally is low.

Why the Fall?

As I noted in last week’s flash alert, MLPs haven’t been immune to the market selloff that’s infected the broader averages over the past year. This is despite the fundamentally defensive characteristics of the midstream energy business that’s the bread and butter for most MLPs.

Over the past 12 months, the S&P 500 has declined 31.4 percent, while the Alerian MLP Index is off roughly 20 percent. Although that certainly does represent significant outperformance, it’s cold comfort given that both indexes are trading lower.

There are several reasons for this. One is that, in sharp downtrends such as those we’ve witnessed over the past year, almost all sectors and stocks get caught up in the selling to at least some extent. In fact, not one of the 10 official economic sectors within the S&P 500 has traded higher over the past 12 months. Here’s a rundown of the sectors.

Source: Bloomberg

As you can see, the best performing group is the consumer staples sector, which includes food, soft drink, alcoholic drinks and tobacco. This sector is still down more than 10 percent despite its fundamentally recession-resistant characteristics. Health care and energy are also down less than the market at large but more than the Alerian Index.

As I noted in last week’s flash alert, most of the selloff in the MLPs was due to forced liquidations on the part of hedge funds, private equity firms and closed-end, MLP-focused funds.

The driver of these liquidations hasn’t been the fundamentals of the sector but rather it’s a need to raise cash. These institutional investors have needed cash for several key reasons. First, many purchased their portfolios relying at least to some extent on borrowed money. When the credit crunch hit in the summer of 2007, gaining access to this capital became much harder.

More recently, the problem for many closed-end funds has been that the value of their portfolios declined to the point that they risked violating their leverage restrictions. To bring the fund back into compliance, they were required to sell their portfolios off to raise cash. In addition, some closed-end MLP funds sold additional fund shares to raise capital and bring their leverage back into compliance.

Finally, of course, most hedge funds have seen vicious redemptions from investors amid the market turmoil. When investors ask for their money back, fund managers must sell off their portfolios to raise cash and fund those redemptions. Unfortunately, redemptions tend to rise when the market is weak, forcing managers to sell stocks at the most inopportune time.

The pattern of forced liquidations is apparent on the charts of even the most fundamentally stable and secure MLPs, such as Enterprise Products Partners. Check out this intraday chart for Enterprise.

Source: StockCharts.com

This chart clearly shows the panicky selling in Enterprise in several days in early October. Notice in particular the quick whoosh lower in the stock on Oct. 8 amid heavy volume. This was due to several orders to sell large blocks of the stock right at the open. This is rumored to be volume from one of the large closed-end fund companies.

But amid all this seemingly dark news is a silver lining. First, historically, big selloffs in MLPs–such as those we’ve seen over the past year–have proved to be outstanding buying opportunities for the group. And as I highlighted above, MLPs haven’t been this attractive on a fundamental or yield basis in more than a decade.

Even better, we’re seeing some concrete signs that forced liquidations in the industry are easing. Chief among those: The group has begun to outperform once again amid weak broader market conditions. Consider that the Alerian Index is actually trading up nearly 2 percent since the end of September compared to a near 14 percent decline for the S&P 500 over the same time period.

Also note the sharp recoveries in Enterprise stock following those sharp opening drops Oct. 8 and 10. The stock dipped to $16 intraday and then recovered to close higher. This indicates that some investors saw dips in Enterprise to these distressed levels as a buying opportunity. Value-oriented funds and investors appear to be viewing forced liquidations as an opportunity to buy; as those liquidations come to an end, I suspect the sector will continue to recover quickly.

Finally, there are some legitimate concerns that MLPs would have trouble growing amid a credit crunch that starves the group of capital to grow. As noted above, the improvement in credit conditions since mid-October should begin to ease those fears. In addition, most of my favorite MLPs have adequate capital to fund current expansion plans, at least through the end of 2009. I’ll discuss this at length below.

MLP Favorites

Without further introduction, here’s a table of all of my current MLP recommendations across all three TES portfolios. I’m also adding a new MLP to the portfolio as of this issue: Kinder Morgan Energy Partners (NYSE: KMP).

Here’s a quick review and update for the MLPs I recommend that have released quarterly earnings so far. I’ll offer updates for the remainder via flash alerts and future issues as they report results.

My focus in discussing each MLP will be centered on one major point: the MLP’s ability to sustain and grow its dividends. If the yield is sustainable and the underlying business is sound and defensive, this will ultimately drive solid performance for the MLP.

Duncan Energy Partners (NYSE: DEP)–Duncan Energy Partners was formed by Enterprise Products Partners, one of the largest and oldest MLPs. Enterprise acts as Duncan’s general partner (GP), meaning that Enterprise manages the day-to-day operations of Duncan. This is a good thing. Enterprise’s management team is among the most respected in the business. In addition, Dan Duncan controls Enterprise Products and TEPPCO Partners; it’s safe to say he’s one of the wealthiest and best-regarded players in the energy business. If you haven’t already guessed, Duncan Energy Partners is named after Dan Duncan.

Duncan Energy owns a 66 percent stake in a number of assets, with Enterprise itself owning the remaining minority stake. The list of assets includes a series of natural gas storage facilities, 1,000 miles of natural gas pipelines and 600 miles of natural gas liquids (NGL) pipes. For those unfamiliar with the term NGLs, these are hydrocarbons found naturally occurring with natural gas (primarily methane). Examples include propane, butane and natural gasoline.

Because of its location along the Gulf Coast of Texas and Louisiana, Duncan’s operations did see significant disruption from hurricanes during the third quarter. Management estimates the hurricanes cost Duncan about $1.2 million in distributable cash flow (DCF). I explain the concept of DCF at some length in the Nov. 22, 2006, issue of TES, Leading Income. Suffice it to say that earnings are next to meaningless for MLPs because they include a large number of non-cash charges such as depreciation. DCF is the widely accepted measure of an MLP’s earnings power.

These disruptions account for why Duncan only covered its third quarter distribution 0.9 times. However, if we exclude the effects of the storms, Duncan earned $0.433 in DCF for the quarter, covering its $0.42 quarterly distribution by about 1.04 times. This is considered relatively tight distribution coverage, but over the past three quarters–even including the effects of the hurricanes–Duncan’s coverage is a far healthier 1.1 times. This is acceptable given the stable cash flows generated by Duncan’s assets.

As of the end of September, Duncan had about $100 million available in unrestricted cash flow and undrawn credit lines. The company’s credit facility is a $300 million line of credit with JP Morgan and Citibank heading the list of participants. This line doesn’t need to be rolled over until 2011, so I don’t see much near-term funding risk.

Duncan’s maintenance capital spending—the amount of cash it needs to maintain its assets in good working order—stands at about $12.5 million per year. Therefore, I see the company’s $100 million in liquidity as ample to continue operating its existing assets.

As for growth spending, when Duncan was formed in early 2007, the primary avenue of growth was thought to be drop-downs. Basically, these are would-be sales of assets from Enterprise Products to Duncan. For Enterprise Products, sales into Duncan would represent another way of raising cash to fund organic growth projects. For Duncan, drop-downs represented a chance to buy assets at relatively favorable prices.

There’s been a problem with this plan. Tighter capital markets will make it difficult for Duncan to borrow money to fund drop-downs. A continued loosening in credit conditions could change this, and Duncan could still manage some smaller deals using existing credit lines. But there’s some uncertainty as to exactly when the drop-down growth story will kick off in earnest again.

Bottom line: Duncan owns stable assets and doesn’t need to access the capital markets near term to maintain those assets. However, I’m not looking for huge distribution growth near term due to credit market constrains; Duncan will probably manage to boost its distributions by 2 to 5 percent over the coming 12 months through simple organic projects and small acquisitions. Distribution growth should accelerate in 2010 assuming credit markets stabilize and Duncan can begin drop-downs again.

I’m not going to bet against Dan Duncan. With a yield approaching 11 percent, Duncan Energy Partners is a compelling value even with relatively slow distribution growth. And, it’s possible Enterprise and Duncan will put together a drop-down deal to re-energize growth a good deal sooner than the market expects. Buy Duncan Energy Partners.

Enterprise Products Partners (NYSE: EPD)–Enterprise Products Partners is one of the largest and oldest MLPs in the US. The MLP focuses primarily on the ownership of assets related to natural gas. Some of Enterprise’s key assets include onshore and offshore gas pipelines, a series of floating production platforms in the Gulf of Mexico, natural gas processing and fractionating facilities for removing NGLs from the gas stream and NGL pipelines.

In its recent quarterly release, Enterprise reported DCF of $316 million. Like Duncan, Enterprise’s Gulf Coast operations were negatively impacted by Hurricanes Ike and Gustav to the tune of about $64 million in the quarter.

However, despite that one-off issue, Enterprise still covered its distribution 1.2 times; excluding hurricane-related charges coverage was closer to 1.5 times. This is considered a heavy distribution coverage ratio for an MLP and is particularly impressive in light of the fact that Enterprise has boosted its distributions by 6.6 percent over the past year.

Generally, all of Enterprise’s assets performed well in the quarter, and the company doesn’t have much exposure to natural gas prices. Enterprise does have some slight exposure to gas processing margins; processing revenues tends to rise when oil is expensive relative to gas as has been the case over the past few quarters. And Enterprise does tend to see better volumes through its small diameter gas gathering pipelines when gas prices are higher. But these effects are extremely modest by any measure.

Enterprise’s main growth angle is organic: the building of new pipelines and other assets. And Enterprise does have some impressive and attractive organic growth projects under way that will add to DCF in coming quarters.

The company’s two largest projects to be completed near term are the Meeker gas processing facility and the Sherman extension pipeline. The former is a gas processing facility located in Colorado; gas processing capacity in the Rocky Mountains isn’t sufficient to meet demand because the region has seen strong gas production growth in recent years. Therefore, this facility is in high demand and has deals in place with several major local gas producers.

The Sherman Extension pipeline is located in Texas near a prolific gas-producing unconventional play known as the Barnett Shale. For those unfamiliar with this region, check out the Sept. 3, 2008, issue of TES, Unlocking Shale. This pipe is scheduled for completion ahead of schedule in the first quarter and is largely secured by transportation agreements with major producers.

Longer-term, Enterprise has several other projects in the offing including an offshore oil imports facility that it is building in conjunction with TEPPCO Partners, another big MLP.

I like the conservative tone of Enterprise’s recent conference call. Management hinted that it would seek to retain more cash rather than paying it out as distributions; this won’t mean a cut in distributions but rather a slower rate of growth.

Specifically, barring a major improvement in capital market conditions over the next 12 months, I’d expect Enterprise to grow its distributions by roughly 5.5 to 6.5 percent year-over-year in 2009. This move makes sense to me because by retaining more cash, Enterprise can afford to undertake highly attractive expansion projects without taking on more debt or issuing units. This is a flexibility that few MLPs can match. And with a sky-high coverage ratio, Enterprise’s distribution is absolutely secure even in the event the recession in the US is a lot longer and deeper than anyone is currently projecting.

Enterprise appears to have also scaled back its growth capital spending program. In recent years, the company has been spending roughly $1.5 billion to $2 billion per year on growth projects; currently, it’s agreed to only $700 million to $800 million for 2009. The MLP is focusing only on the most profitable and assured prospects that it can finance without issuing more bonds or stock.

With $800 million in cash and available credit lines plus retained distributable cash, Enterprise has little real exposure to credit market conditions at least into early 2010. Due to the stock’s defensive characteristics, Enterprise offers a slightly lower-than-average yield of 8.5 to 9 percent. But its unblemished record of boosting distributions, attractive financing position and ongoing organic projects, Enterprise Products Partners is a buy.

Kinder Morgan Energy Partners (NYSE: KMP)–As of this issue, I’m adding Kinder Morgan Energy Partners to the Proven Reserves Portfolio. Kinder and Enterprise are the largest MLPs in the US and both have a long record of consistently boosting distributions over time.

Kinder has an impressive slate of assets, including refined petroleum products pipelines, natural gas lines, crude oil terminals and gas processing facilities. Just as with most midstream operations, these are primarily fee-based businesses; most of Kinder’s pipelines and storage facilities are also backed by long-term capacity agreements in which shippers pay Kinder a demand charge–described earlier in today’s report–whether or not they actually use their capacity.

Kinder Morgan Energy’s carbon dioxide (CO₂) business is basically a series of pipelines to transport carbon dioxide to mature oilfields where it’s used in enhanced oil recovery. Enhanced oil recovery is simply the process of injecting CO₂ into an old oilfield to help repressurize the field and produce more oil.

As part of this business, Kinder Morgan Energy owns a significant stake in two mature oilfields that are being produced using this method. This is the only part of Kinder’s business that has any leverage whatsoever to commodity prices. And the company’s CO₂ business makes up less than 9 percent of revenues. Even better, Kinder hedges its exposure to oil to all but eliminate any commodity exposure.

Like Enterprise, Kinder also relies heavily on organic expansion projects for growth. Two of its most promising organic growth deals are the Rockies Express (REX) and MidContinent Express Pipelines.

REX is a pipeline that’s designed to carry gas from the prolific Rocky Mountain region eastward. Natural gas production in the Rockies has grown significantly in recent years, but there’s little local consumption; most of the core gas-producing region is sparsely populated. At the same time, pipeline capacity to carry gas out of the Rockies to key consuming markets such as the East Coast is extremely limited.

What tends to happen is that natural gas gluts develop in the Rockies, particularly during the summer months. When that happens, local gas prices plummet. Currently, natural gas at the Henry Hub in Louisiana trades at close to $7 per MMBtu compared to $3.40 per MMBtu at the Opal Hub in Wyoming. If you’re a producer in the Rockies, this is a big problem as you likely aren’t happy about selling your gas at half price.

REX partly solves this problem. Producers can produce gas in the Rockies and then ship this gas east, where prices are typically far more favorable. As you can imagine, the pipeline is extremely popular, and producers were quick to reserve capacity on REX. In fact, Kinder is already exploring plans to add capacity to the line; producers are willing to pay guaranteed fees to reserve that new capacity.

Kinder Morgan’s Midcontinent Express pipeline is a 50/50 joint venture between Kinder and Energy Transfer Partners. This pipe extends from southeast Oklahoma across northern Texas, northern Louisiana, central Mississippi and into Alabama. This pipe passes adjacent to at least four major unconventional plays, including the Texas Barnett, Oklahoma Woodford, Arkansas Fayetteville and Louisiana Haynesville. These shale plays are all highlighted in the Sept. 3, issue, Unlocking Shale. All of these plays are in desperate need of pipeline capacity to handle expanding production.

The Midcontinent Express was originally designed with a capacity of 1.5 billion cubic feet per day (bcf/d); however, Kinder Morgan announced it’s received considerable interest in a plan to boost capacity all the way up to 1.8 bcf/d. This could be accomplished relatively inexpensively simply by adding additional compression (more pressure) to the pipe. Even better, Kinder Morgan is open to expanding the line even further; there seems to be interest in an even bigger pipe.

Thanks primarily to its slate of organic expansion projects, Kinder recently announced it’s boosted its quarterly distribution to $1.02 per quarter, up a whopping 16 percent over the same quarter one year ago. Kinder is targeting a further increase to at least $1.04 and likely higher for the fourth quarter. In the current quarter, Kinder covered its distribution about 1.07 times.

This distribution looks tight, but you have to consider the fact that many of Kinder’s key projects weren’t completed until late in the quarter. It didn’t get the full benefit of those revenues for the entire quarter. Looking at 2008 on a year-to-date basis, Kinder has generated nearly $100 million in excess DCF above and beyond what was actually paid in distributions. This is a comfortable cushion.

Kinder appears to have ample liquidity to fund growth projects to which it’s already committed for 2009. And Kinder has decided to partner with other MLPs of a few of its more recently announced projects; by spreading the costs, the firm reduces its need to raise capital.

However, the most important point to emerge from Kinder’s recent conference call was the firm support from its general partner, Knight Inc. Knight is controlled by the Chairman and CEO of Kinder Morgan, Richard Kinder. Somewhat like Dan Duncan over at Enterprise, Kinder isn’t a man you see on CNBC everyday, but he’s definitely a legend in the energy business. According to Forbes, he’s the 130th richest man in the world.

In an interesting twist, Kinder was once President of the infamous Enron. He left the firm in 1996 because he wasn’t on board with Ken Lay’s “asset-light” strategy. In other words, Kinder wants to own real cash-producing assets such as pipelines. At the time, many pundits thought that was a dumb move; however, I don’t have to tell you how it worked out in the end.

At any rate, Kinder stated that he and Knight stand behind Kinder Morgan. Knight has access to a credit line and cash reserves totaling between $750 million and $800 million. Knight stands ready to invest that cash as needed in equity or debt securities to support Kinder Morgan Energy Partner’s expansion projects. With a yield around 8 percent, Kinder Morgan Energy Partners rates a buy under 65 and is a new addition to the Proven Reserves Portfolio.

For investors interested in exposure to Kinder inside a retirement or tax-advantaged account, consider buying Kinder Morgan Management (NYSE: KMR) instead of Kinder Morgan Energy Partners.

Kinder Morgan Management is exactly the same firm as Kinder Morgan Energy Partners. However, instead of paying out distributions in cash, Kinder Morgan Management pays holders in the form of additional units. In a sense, Kinder Morgan Management represents a sort of automatic dividend reinvestment plan. The benefit of this is that Kinder Morgan Management eliminates concerns about UBTI, which I explained earlier in today’s report.

Sunoco Logistics (NYSE: SXL)–Sunoco Logistics owns a series of refined products pipelines and crude oil terminals. These are among the most stable businesses an MLP can own.

Refined products pipelines carry petroleum products like gasoline and jet fuel; like all pipelines, revenues are based on volumes transported, not prices. Of course, the volume of refined products transported in and around the US has been falling in recent quarters due to the recession.

Although you might assume that lower volumes means lower revenues, that’s not necessarily the case; Sunoco is actually increasing the tariffs it charges enough to offset any volume declines. This seems to be the case across much of the industry; most refined products pipeline companies reset their tariffs annually by an amount equal to inflation–measured by producer price inflation–plus an additional margin.

Sunoco is also seeing even stronger growth in its terminals segment. The company has some older contracts coming up for renewal. These contracts are seeing huge price increases as they’re renewed. And terminals are generally seeing high demand for ancillary services such as mixing ethanol and other additives to gasoline.

Sunoco has two major growth projects in the hopper at this time. The first is tank facilities and a pipeline to connect its existing Nederland terminal in Texas to the Massive Motiva Port Arthur refinery. That refinery is undergoing an expansion, so this infrastructure is crucial.

The second is Sunoco Logistics’ acquisition of a refined products pipeline in Texas from integrated oil giant ExxonMobil. Not only will that that purchase add directly to cash flow, but there are myriad opportunities for Sunoco to add tank capacity and other ancillary infrastructure around this asset.

There are two main reasons I can see that Sunoco is a must-own MLP. First, the company ranks at the bottom of its industry group in terms of debt burden. It has a lot less exposure to weak credit markets that its peer group. In addition, Sunoco has $400 million in undrawn credit facilities and unrestricted cash. That compares favorably to is $125 million or so of growth and maintenance capital expenditure needs for 2008. Bottom line: Sunoco Logistics doesn’t need access to the capital markets this year or next.

Second, Sunoco has a long history of grinding out consistent distribution increases over time from its low-risk asset base. Year-over-year in the most recent quarter, Sunoco boosted distributions by 13.5 percent. And management has reaffirmed its guidance to boost distributions by a further 10 percent in 2009 despite the weak credit market conditions. Buy Sunoco Logistics.

Tortoise Energy Infrastructure (NYSE: TYG)–Tortoise Energy Infrastructure fund is a fund that specializes in investing in MLPs. The fund offers the benefit of broad diversification in the MLP industry. In addition, Tortoise issues a form 1099 at tax time rather than a K-1; this simplifies taxes and allows investors to hold the fund inside a tax-advantaged account with no UBTI difficulties.

I firmly believe that investors will generally perform better owning individual securities than by owning a fund. However, Tortoise is a worthy addition to any portfolio.

Tortoise, like most closed-end funds, has seen its share of difficulties in recent months. As I alluded to earlier in today’s report, closed-end funds have leverage restrictions. The Investment Company Act of 1940 states that if the fund pays distributions, it must have $2 in assets for every $1 in leverage (debt plus preferred shares).

Like most closed-end funds, the value of Tortoise’s portfolio declined with the broader MLP industry. The fund’s portfolio represents its assets; therefore, as the value of those assets declines, the fund is forced to sell down holdings and use that cash to pay down debt. This is the only way a fund can bring down leverage to meet the 1940 Act.

However, the situation is improving. Last month, Tortoise offered more fund units for sale to raise cash and used that cash to pay down debt and preferred shares. At the same time, a recovery in the company’s portfolio since mid-month has improved the asset side of its balance sheet. The result: Tortoise is now comfortably under the debt limits imposed by the 1940 Act. This should eliminate the need to sell off portfolio holdings at fire-sale prices. Tortoise Energy Infrastructure rates a buy.

Fall is the perfect time to enjoy Washington, DC’s outdoor treasures and catch a glimpse of nature’s splendor. And this year you can enjoy the immediate aftermath of the Presidential election in the seat of the federal government.

Join me and my colleagues Neil George and Roger Conrad for the DC Money Show, Nov. 6-8, 2008, at The Wardman Park Marriott.

Go to www.moneyshow.com or call 800-970-4355 and refer to priority code 011361 to register as our guest.

We also have a special invitation for our readers. KCI Communications, Inc., is organizing an exciting 11-day investment cruise Dec. 1-12 through the Caribbean and Panama Canal. Participants will have the opportunity to meet and chat with me and my colleagues Roger Conrad, Gregg Early and Neil George.

This will be a unique opportunity to step away from your daily routines, relax in one of the most beautiful parts of the world and share analysts’ knowledge and passion for the markets. During the sail, you’ll not only explore the cerulean splendor of the Caribbean, but you’ll also delve deep into current markets in search of the most profitable opportunities for your portfolios. You’ll also have the rare chance to sail through one of the world’s engineering marvels, the Panama Canal.

It’s always a special treat to meet and talk with subscribers in person, and we couldn’t have picked a better setting than aboard the six-star Crystal Serenity. This is sure to be an especially memorable experience. We hope you’ll join us.

For more information, please click here or call 877-238-1270.

The Rebound: Investors are now desperately scouring the headlines and the Internet daily for any sign of a bounce. We can save you the trouble. My fellow KCI Communications editors and I will present a breaking news conference Nov. 6, 2008 at 1 pm ET. Join us for “Election Results, Recession Fears and What Investors Should Do Next” by registering here or calling 800-832-2330.

In the meantime, please check out our latest insights into the markets on our blog, At These Levels.