The MLP Profits Portfolios are off to strong start, returning an average of roughly 6 percent in the first quarter–about 0.50 percent more than the Alerian MLP Index. Check out the table below, which runs down how the three Portfolios fared and how each holding performed in the first three months of 2011.

Source: Bloomberg, MLP Profits

Note that we sold former Aggressive Portfolio holding EV Energy Partners LP (NSDQ: EVEP) in the Jan. 14, 2011, issue Forecasts and Answers. Meanwhile, Penn Virginia Resource LP (NYSE: PVR) replaced Penn Virginia GP Holdings LP (NYSE: PVG) in the Aggressive Portfolio after acquiring its general partner on March 10, 2011. (See New-Money Buys and Earnings.)

Commodity Tailwind

The first quarter brought a significant increase in the price of crude oil, natural gas and natural gas liquids (NGL). Oil prices surged in response to the ongoing civil war in Libya, a conflict that has reduced the nation’s oil output from 1.6 million barrels per day at the end of 2010 to less than 400,000 barrels per day in March.

In oil services giant Halliburton’s conference call to discuss first-quarter earnings, management indicated that the firm was unlikely to resume normal operations in Libya for some time. Even if the combatants agree to a ceasefire, damage sustained by the Libya’s energy infrastructure will prevent the country from bringing new production online in a timely fashion.

In the March 15, 2011, issue The Saudi Arabia of Natural Gas Liquids, we explained the importance of NGLs such as ethane, propane and butane to the growth prospects for a long list of MLPs. The petrochemicals industry uses NGLs extensively, and a surging domestic supply provides US-based chemicals producers with a significant cost advantage over competitors in the Middle East.  

In the roughly one month that’s transpired since we published that issue, NGL prices have continued to rise.

Source: Bloomberg

Westlake Chemical Corp (NYSE: WLK) is the latest major chemicals producer to announce plans to boost its output of ethylene, a key building block in many plastics. Management attributed this decision to the abundance of US NGL supplies and the attendant cost advantages.

Rising demand for NGLs continues to drive demand for pipelines, processing plants and storage facilities. MLPs build and own the majority of these infrastructure assets; a favorable outlook for the US NGL industry is a major growth driver for the group.

US natural gas prices have also ticked up in recent weeks, moving in sympathy with international gas prices after the devastating earthquake that hit Japan in March.

Source: Bloomberg

The 9.0-magnitude earthquake forced Japan to close several nuclear power plants, taking as much as 10 to 15 percent of the country’s generation capacity offline. Some of that capacity will never be restored. To offset these losses, Japan plans to burn more natural gas, most of which will be imported in the form of liquefied natural gas (LNG). Anticipation of this demand has boosted LNG prices in Asia.

Meanwhile, Germany announced that it will shutter seven of its 17 nuclear reactors. The country also canceled plans to extend the operating lives of its remaining 10 plants. Barring a change to the current policy, all of Germany’s nuclear capacity will be shuttered by 2022. With a strong anti-nuclear power sentiment in the country, many analysts speculate that the nation’s seven oldest reactors will be closed permanently. In recent years, nuclear power accounted for more than a quarter of Germany’s electricity generation; the loss of that capacity should increase the country’s reliance on natural gas.

Most European countries source a significant portion of their natural gas supply from Russia, often through contracts that are indexed to oil prices–a major challenge when oil prices take off. With oil prices on the ascendant, LNG imports from the Middle East and North Africa became an attractive alternative for European nations. But surging Asian demand for LNG has pushed European prices to levels comparable to those in oil-indexed contracts.

North America is isolated from Asian and European markets for natural gas; the US and Canada produce more than enough gas to satisfy domestic demand, limiting LNG imports to negligible levels. The recent uptick in US natural gas prices–which pales in comparison to the jump in UK gas prices–stems largely from traders’ psychology, as opposed to improving fundamentals. Robust production from shale gas fields should ensure that US and Canadian natural gas markets remain glutted in the near term.

In January, we sold EV Energy Partners from the Aggressive Portfolio, citing the firm’s exposure to natural gas production. Although the MLP’s outstanding track record and extensive hedges have limited its exposure to depressed natural gas prices, oil-levered names such as Linn Energy LLC (NSDQ: LINE), Encore Energy Partners LP (NYSE: ENP) and Legacy Reserves LP (NSDQ: LGCY) offer more upside and outperformed in the first quarter.

But the majority of MLPs own midstream infrastructure such as pipelines and storage facilities, limiting their exposure to weak natural gas prices. Not only do these energy assets generate volume-based fees that remain the same regardless of gas prices, but most MLPs also sign contracts that guarantee a certain level of revenue whether or not the producers use their allotted capacity. These agreements are usually worked out before an MLP breaks ground on a new project. As we explained in The Saudi Arabia of Natural Gas Liquids, gas processors often benefit when natural gas prices lag the prices of NGLs.

Given the strength in energy prices, MLPs with exposure to this upside outperformed. Not surprisingly, the average return in the Growth and Aggressive Portfolios trumped the average return posted by our Conservative Portfolio holdings. Standout performers during the quarter include Teekay LNG Partners LP (NYSE: TGP), a partnership that owns tankers which transport LNG.

With demand for LNG on the rise, Teekay LNG should have ample opportunity to acquire or build tankers and lease those ships under generous long-term contracts. The company also announced plans to focus on building out its portfolio of floating storage and re-gasification units (FSRU)–vessels that transform LNG into gas for injection into a pipeline network. FSRUs provide a flexible alternative to capital-intensive onshore, an ideal solution for countries looking to quickly ramp up LNG imports. Teekay LNG Partners LP rates a buy up to 41.

A Question of Values

MLPs have performed well over the past two years, with the Alerian MLP Index surging 76.4 percent in 2009 and 35.9 percent in 2010. Since the publication’s inception, the MLP Profits Portfolios have outperformed the broader index by a comfortable margin.

Given the group’s recent strength, subscribers often ask whether MLPs are overvalued. As you can see in the graph below, MLPs remain attractive relative to real estate investment trusts (REIT) and US corporate bonds with a triple-B rating.

Source: Bloomberg

The Alerian MLP Index yields 6.11 percent, about 2.57 percent more than the yield offered by the MSCI US REIT Index. Over the past five years, the yield spread between these two security classes has averaged almost 2.55 percent. In other words, the Alerian MLP Index continues to offer a historically attractive yield relative to REITs, a popular security class for investors seeking income.

According to data from Bloomberg, the average 10-year US corporate bond rated BBB by Standard and Poor’s currently yields about 5.31 percent–roughly 0.80 percent less than the yield on the Alerian MLP Index. The five-year average spread is closer to 1 percent; MLPs presently offer a lower-than-average yield relative to triple-B rated bonds.

When MLP Profits launched in spring 2009, about one-quarter of the names in our coverage universe yielded more than 10 percent. MLPs also traded at low valuations relative to most income-oriented groups, including REITs and corporate bonds. Although the Alerian MLP Index’s strong performance over the past two years has reduced the number of screaming bargains, this uptrend doesn’t mean that the group is overvalued.

MLPs still offer historically high yields relative to REITs and other income-producing stocks. More important, strong fundamentals should enable our favorite MLPs continue to grow their distributions–something the fixed-income market doesn’t offer. When MLPs hike their distributions, the units also tend to appreciate in value and outperform the broader market.

That’s good news for investors following our model Portfolios; we expect more of our picks to boost their distributions than in any year since 2007.

Strong commodity prices are part of this trend, but the recovery of the capital markets is also an important factor.

This table lists all secondary unit offerings announced by MLP Profits Portfolio holdings thus far in 2011. In a secondary unit offering, an MLP sells additional units (shares) to raise capital; our picks have raised more than $2 billion worth of capital via new issues alone.

Units of MLPs typically sell off sharply after management announces a secondary offering, as the new units dilute the stakes of existing holders. For example, if an MLP has 100 million units outstanding and issues 10 million new units, the stake of existing holders declines by about 10 percent.

But investors in well-run MLPs needn’t worry about the temporary dilution that occurs when a partnership issues new units; MLPs typically use the proceeds to fund organic growth projects or to acquire other companies or promising assets, which generate additional distributable cash flow and set the stage for higher disbursements to unitholders. Historically, MLPs increase their distributions within a quarter or two of completing a secondary offering to fund expansion.

Over the past two years, we’ve consistently reminded subscribers to buy our favorite MLPs in the downdraft that typically occurs when a partnership issues new units–provided that the proceeds will be invested in growth initiatives. In each case, our Portfolio holdings have eclipsed their pre-offering price within three months.

Units of Teekay LNG Partners, Navios Maritime Partners LP (NYSE: NMM), and Energy Transfer Partners LP (NYSE: ETP)–all of which have completed secondary offerings since the end of March–have pulled back to attractive levels. Investors should regard these dips as a buying opportunity.  

This latest flurry of new issues demonstrates that MLPs enjoy ready access to relatively inexpensive capital. As the six Portfolio holdings that have issued new units deploy the roughly $2 billion worth of capital, the pace of distribution increases should pick up, sending unit prices higher.

Strong capital markets have also led to an influx of MLP initial public offerings (IPO) in recent quarters. MLP Profits strives to cover the entire universe of publicly traded partnerships, a goal that requires us to track IPOs and add them to our How They Rate coverage universe. For example, we scrutinized the 2010 crop of IPOs in the Jan. 5, 2011, issue Strong 2010 Encourages MLP IPOs and in the Sept. 24, 2010, issue IPOs for Growth.

But there’s another reason to pay attention to MLP IPOs. In many cases, MLPs grow distributions at a faster rate during their first two years as a public company, driving price appreciation and total returns.

For example, in Williams Partners LP’s (NYSE: WPZ) first two years as a public company, the firm boosted its quarterly payout from $0.35 to $0.575, thanks to a series of asset drop-downs from its general partner, Williams Companies (NYSE: WMB). These deals helped the stock soar 80 percent from the close on its first full day of trading. Units of Conservative Portfolio holding Sunoco Logistics Partners LP (NYSE: SXL) enjoyed a similar pop. The owner of refined products pipelines increased its payout by 23 percent in its first eight quarters as a public company, and the stock soared 100 percent.

But these success stories don’t mean that investors should blindly sink money into every MLP IPO. Plenty of IPOs launched during the strong market of 2005-07 expanded too quickly or took on too much debt, leading to a number of blow-ups. The key is to examine the MLP’s business prospects and opportunities for growth.

For the record, QR Energy LP (NYSE: QRE) and Chesapeake Midstream Partners LP (NSDQ: CHKM)–the two fledgling MLPs to which we assigned a “buy” rating in How They Rate–have outperformed the Alerian MLP Index by an average of 2.6 percent since the close on their first day of trading. Niska Gas Storage Partners LLC (NYSE: NKA), PAA Natural Gas Storage LP (NYSE: PNG), Oxford Resource Partners LP (NYSE: OXF) and Rhino Resource Partners LP (NYSE: RNO)–all of which earned a “hold” rating–have underperformed the industry benchmark by an average of 1.82 percent since their IPOs in 2010.

2011 Debutants

Golar LNG Partners LP (NSDQ: GMLP) began trading on NASDAQ on April 7, 2011. The Bermuda-based partnership was formed by Golar LNG Limited (NSDQ: GLNG) and owns LNG carriers and FSRUs.  

When natural gas is cooled to minus 260 degrees Fahrenheit at a liquefaction facility, it condenses into a liquid that’s roughly 1/600th of its original size. In this form, large volumes of natural gas can be safely transported overseas in specially designed ships. Regasification terminals return LNG to its gaseous state before pipelines transmit the product to end users.

FSRUs are a substitute for onshore, fixed LNG regasification units. Many FSRUs are converted LNG carriers that add the capacity to regasify LNG.

At present, Golar LNG Partners has four main assets:

• The Golar Spirit was originally an LNG carrier constructed in 1981. In 2007 this carrier was retrofitted and converted into an FSRU. It’s currently booked on a long-term contract to Brazilian national oil company Petrobras (NYSE: PBR). This agreement expires in 2018.
• The Golar Winter is also an FSRU conversion project. The original LNG carrier was built in 2004 and retrofitted in 2008. The partnership has leased this vessel to Petrobras under a long-term time charter that expires in 2019.
• The Methane Princess is an LNG carrier built in 2003 and leased under a long-term time charter to British energy giant BG Group (London: BG, OTC: BRGYY). This agreement expires in 2024.
• A 60 percent stake in the Golar Mazo, an LNG carrier built in 2000 that’s under a time charter with Indonesian state-owned oil giant PT Pertamina. This contract expires in 2017. Chinese Petroleum Corp owns a 40 percent interest in this carrier.

All of Golar LNG Partners’ carriers and FSRUs are booked under time charter contracts that lock in fixed rates over multi-year period, ensuring that the MLP will receive the contracted rates for the duration of its contracts, regardless of the supply of LNG carriers and the price of natural gas.

For the duration of these time charters, Golar LNG Partners effectively operates a fee-based business with no significant commodity exposure. In addition, Golar’s counterparties on all four assets are solid: Three of its four carriers and FSRUs are leased to fully or partly state-owned energy firms that boast solid credit ratings.

The fourth is contracted to BG Group, an $82 billion company that owns gas reserves, liquefaction capacity, LNG carriers and LNG regasification facilities.

As Golar’s charter rates are fixed under long-term contracts for years into the future, acquisitions offer the best opportunity for growth, especially potential drop-down transactions from its parent, Golar LNG Limited. Such deals usually involve favorable terms and enable the MLP to boost its distribution immediately. Golar LNG Partners has the right to purchase the Golar Freeze and the Khannnur in drop-down transactions over the next 24 months.

The Golar Freeze is an FSRU that was recently retrofitted from an LNG carrier originally built in 1977. The FSRU is currently booked under a long-term contract to Dubai’s main natural gas supplier.

The Khannur is an LNG carrier built in 1977 that’s slated to be converted into an FSRU next in 2012. Two Indonesian energy companies, PT Pertamina and PT Perushaan Gas Negra (Indonesia: PGAS), are in line to book this vessel under an 11-year contract.

Although there’s no guarantee that Golar LNG Partners will acquire either asset, these transactions are likely as long as the firm’s access to the capital markets remains unconstrained.

Golar LNG Partners will likely enjoy new expansion opportunities as global demand for LNG accelerates. Over the past few years, a number of LNG export projects have come onstream, but rising demand for natural gas in Asia and the EU–particularly Germany. LNG won’t become an important part of the North American gas supply picture, but it will be crucial in many parts of the world. That should drive demand for LNG carrier ships and FSRUs.

Another positive for Golar LNG Partners is that its parent and general partner (GP) is controlled by Norwegian billionaire John Fredrikson. Income-oriented investors should be familiar with Norway’s richest man; he’s chairman or president of a long list of companies, including deepwater contract driller Seadrill (NYSE: SDRL), tanker giant Frontline (NYSE: FRO) and Golar LNG Limited. Fredrikson is one of the most experienced players in the tanker and drilling businesses and has a long history of shareholder-friendly activities.

Frontline has suffered in recent years because of a weak market for oil tankers, but its stock was one of the leaders during the tanker bull market of 2003-08. Seadrill has been the best-performing deepwater driller in recent quarters and continues to grow earnings and dividends rapidly.

Fredrikson’s experience is an undeniable asset for Golar LNG Partners. For example, the partnership can save on ship repair and maintenance costs by bundling its needs with those of its larger parent.

Golar LNG Partners’ F-1 Registration statement outlines the company’s planned distributions. The partnership’s minimum distribution per unit is $0.3850 per quarter, equivalent to an annual payout of $1.54. Given the firm’s fixed-rate time charters and fee-based income streams, Golar LNG Partners will likely pay at least $1.54 per unit in its first full year as a public company– equivalent to a yield of about 6.2 percent at current prices. Because Golar LNG Partners won’t disburse its first quarterly distribution for another three months or so, Yahoo Finance, Google Finance and most brokers’ sites list the stock’s yield as zero percent.

Golar LNG Partners pays an incentive distribution right (IDR) to its GP that’s based on the size of distributions paid to unitholders. When the quarterly payout is $0.4428 per unit or less, the GP’s receives an IDR that amounts to 2 percent of the total distribution. Above this threshold, the IDR increases gradually to a maximum of 48 percent.

New subscribers unfamiliar with the relationship between general and limited partners should consult the June 28, 2010, issue from a detailed primer on how IDRs are calculated.

If Golar LNG Partners acquires the Golar Freeze and the Khannur, the MLP’s quarterly distributions would likely approach $0.4428 per unit. Typically, MLP IPOs are structured so that initial thresholds for IDR growth are low, encouraging the GP to pursue initiatives that will enable the MLP to increase its distributable cash flow. With a quarterly distribution of $0.4428 per unit, the MLP’s units would yield almost 7.1 percent.

Golar LNG Partners is also taxed differently than most other MLPs. Like Aggressive Portfolio holding Navios Maritime Partners, Golar LNG Partners is technically an MLP but has elected to be taxed as a C corporation for US federal income tax purposes. Headquartered in Bermuda, the MLP has no US assets and earns no revenue in the US, exempting it from US corporate income taxes.

As a C-corp, Golar LNG Partners reports its distributions on a standard form 1099, not a form K-1. In addition, Golar LNG Partners doesn’t generate unrelated business taxable income, making this security suitable for an IRA or 401(k) account. Although Golar LNG Partners offers investors some of the benefits of a corporation in terms of tax filings, some of the tax advantages of the MLP structure also apply. Roughly 70 percent of the MLP’s distribution is classified as a dividend; the remainder is a non-dividend distribution that the Internal Revenue Service treats as a return of capital. Return of capital payments from Golar LNG Partners aren’t immediately taxable but do reduce your cost basis.

Golar LNG Partners should benefit from growing international demand for LNG and its focus on long-term, fee-based contracts. The MLP could grow distributable cash flow rapidly over the next 12 to 14 months through asset drop-downs from its parent.

Growth Portfolio holding Teekay LNG Partners already offers exposure to the global LNG market, though the MLP is unlikely to grow distributions as quickly as Golar LNG Partners over the next couple of years because it’s a larger firm and its stock already yields 6.7 percent. As we already have exposure to this trend, we will track Golar LNG Partners LP as a “buy” in our How They Rate coverage universe.

CVR Partners LP (NYSE: UAN) produces nitrogen-based fertilizer from a plant located in Coffeyville, Kan. The company’s GP, CVR Energy (NYSE: CVI), owns a refinery adjacent to CVR Partner’s fertilizer production facilities.

Farmers primarily use three types of fertilizer: potassium chloride (potash), phosphate and nitrogen.

Potassium chloride is mined from ore deposits created when oceans and seas dried up millions of years ago. With the passage of time, most of the world’s ores have been covered by earth and are now located deep underground.

To create potash, the potassium chloride is separated from salt and other impurities and then dried and prepared into either pellets or a liquid.

Phosphate is also mined from underground ores created from ancient sea life. Typically, phosphate fertilizer is combined with ammonia to produce solid fertilizers known as DAP (diammonium phosphate) and MAP (monoammonium phosphate). Sulfur mainly derived from the refining and processing of oil and natural gas is a key raw material for converting phosphate rock into usable fertilizer.

Nitrogen is the most common element in the air; however, plants rarely make direct use of atmospheric nitrogen. Nitrogen-based fertilizer is made from ammonia, a compound that comprises nitrogen and hydrogen. The most common fertilizer made from ammonia is what’s known as urea ammonium nitrate (UAN), a liquid solution of ammonia and nitrate. As you might guess from CVR Partner’s ticker symbol “UAN,” the company’s main focus is on the production of urea ammonium nitrate (UAN).

The growth story for fertilizer is compelling, driven by rising demand for basic crops such as corn, sugar, soybeans and wheat across the emerging markets. The main driver isn’t that people in emerging markets are consumer more calories, but that their diets are changing.

Take China as an example. Between 1987 and 2007, per capita calorie consumption rose 15 percent; over the same 20 year period, meat consumption soared 125 percent. This trend isn’t unique to China. As household incomes increase, consumers eat more meat, processed foods and fats, while their intake of basic staples and grains falls.

This dietary shift translates into rapidly growing demand for agricultural commodities. It takes 7 kilograms (15.4 pounds) of feed grain to produce 1 kg (2.2 lbs.) of beef; 4 kg (8.8 lbs.) of grain to produce 1 kg of pork; and 2 kg (4.4 lbs.) of grain to produce 1 kg of poultry.

In fact, China is so concerned about demand for agricultural commodities that the government recently introduced curbs on the use of corn by industrial processors. The government aims to free up as much corn as possible for the livestock industry. That’s a sign that the nation is growing increasingly concerned about its dependence on corn imports to meet demand.

Increasing yields–the amount of corn, wheat and other commodities produced per acre of land–is essential to feeding the world’s growing population. Proper application of fertilizers is a big part of the solution. According to the Food and Agricultural Organization of the UN, global fertilizer demand is set to jump by about 45 percent between 2005 and 2030.

Rising demand for fertilizer, coupled with only modest growth in fertilizer production, has pushed up prices in recent years, with the exception of a severe but brief slump during the financial crisis of late 2008 and early 2009.

Unlike most MLPs in our coverage universe, CVR Partners has significant exposure to commodity prices–in particular, the price of UAN and ammonia. The firm can’t hedge its prices, and its distributable cash flow will ebb and flow with the prospects of the global fertilizer industry.

Although we’re bullish on agricultural commodities and fertilizer in the long term, seasonal price gyrations and those related to global supply and demand conditions are a given. Management has indicated that it will disburse all of the distributable cash flow generated each quarter; none will be set aside to invest in the business or to meet future distributions.

For these reasons, CVR Partners is one of the riskiest MLPs in our coverage universe. Most MLPs are set up to generate predictable, fee-based cash flows that support a steady distribution. Over time, MLPs look to buy or build new fee-generating assets that allow them to grow their payout. The group’s traditional modus operandi has been to avoid distribution cuts at all costs and gradually increase payouts over time.

CVR Partners’ strategy represents a departure from this pattern. In the MLP’s S-1 registration acknowledges this difference, stating: “Investors who are looking for an investment that will pay regular and predictable quarterly distributions should not invest in our common units.” This approach doesn’t necessarily make CVR partners a bad investment; however, prospective investors must understand how this MLP differs from its peers and the above-average risk involved.

CVR Partners competes with several major ammonia-based and UAN fertilizer producers, but the MLP’s production process distinguishes it from the pack. The outfit is the only US producer that uses petroleum (pet) coke–a product derived from oil refining–to produce ammonia and UAN. Its competitors use natural gas as a feedstock.

With oil prices near three-year highs and natural gas prices near multiyear lows, one would assume that natural gas offers a significant cost advantage over oil as a feedstock. But the opposite is true: CVR enjoys a significant and durable cost advantage over its competitors, thanks to a 20-year supply contract it signed with its GP in 2007.

Under the terms of the deal, CVR Energy sells all of the pet coke it produces at its refinery to CVR Partners. CVR Partners pays the lower of a price based on an index of pet coke prices or a price based on prevailing market prices of UAN fertilizer. Since 2007, CVR has paid an average of $25 per ton of pet coke, while the cost of pet coke sourced from third parties has averaged about $41 per ton. Pet coke supplied under this deal represents more than 70 percent of CVR Partners’ feedstock.

CVR Partners’ location sweetens this cost advantage. Most US producers of ammonia-based and UAN fertilizer operate along the Gulf Cost, a region with plentiful supplies of natural gas. But CVR Partners is located in the Midwest–the nation’s breadbasket–limiting transportation costs.

Roughly 80 percent of CVR Partners’ production costs are fixed, while the typical fertilizer producer contends with a cost structure that’s 80 to 90 percent variable. Much of this variability stems from natural gas prices.

There are plenty of risks to CVR Partners’ story. Ultra-low natural gas prices have allowed other US-based fertilizer producers to close the price gap, though CVR Partners’ management estimates that it retains a slight cost advantage even with natural gas prices at about $4 per million British thermal units.

Moreover, CVR Energy supplies about 70 percent of the MLP’s demand for pet coke; a major jump in pet coke prices would boost production costs. However, CVR Partners’ management reckons that a 10 percent jump in pet coke prices reduces distributable cash flow by about $1.9 million, or roughly $0.06 per unit.

CVR Partners’ main near-term growth prospect is a $135 million expansion it plans to fund with the proceeds from its IPO. This expansion will allow the MLP to convert all of its ammonia into UAN. In many market environments, UAN offers higher profit margins than ammonia, so it’s useful to have the flexibility to produce either product. 

Beyond that, the firm’s growth prospects appear limited. The company could expand its ammonia production, but that would require additional feedstock purchases from third parties.

Calculating a sensible estimate of CVR Partners’ annual distribution is a challenge, as it depends on the price of ammonia, UAN and pet coke. Management has estimated that the MLP could pay out $1.92 per unit during the fiscal year ended March 31, 2011. Based on current prices, that adds up to a mouth-watering yield of almost 11 percent.

Management’s estimates are based on a 52 percent jump in ammonia prices and a 56 percent increase in UAN prices from average levels in 2010. Though this target seems aggressive, current spot prices for fertilizers and strong demand suggest that the MLP could achieve this goal. CVR Partners’ forecast also prices in pet coke prices that are more than two times what it paid in 2010.

But CVR’s distributable cash flow is at the whim of the commodity markets. If fertilizer prices remain where they were in 2010, the MLP would generate enough cash flow to support an annual distribution of $0.42 percent–a paltry 2.5 percent yield at current prices.

Conservative investors should avoid this MLP altogether. However, risk-tolerant investors looking to profit from potentially massive yields during bull markets for agricultural commodities should consider the stock. We’ll track CVR Energy as a “buy” in our How They Rate coverage universe.

Tesoro Logistics LP (NYSE: TLLP), the largest of the three MLP IPOs thus far in 2011, began trading today. Backed by Tesoro Corp (NYSE: TRO), the second-largest independent refiner in the US, Tesoro Logistics operates two businesses: an oil gathering system in the Bakken Shale/Williston Basin area of North Dakota and Montana, and a system of eight refined products terminals and a storage facility in the western US.  

Tesoro Corp retained a majority ownership stake in Tesoro Logistics after the IPO and will continue to control its GP interests, entitling it to receive incentive distribution rights from the LP.

The Bakken Shale region of North Dakota and Montana is one of the hottest unconventional oil plays in the US right now.

What makes an oil or natural gas play unconventional? Hydrocarbons don’t occur in giant underground pools but are trapped in the pores and cracks of a reservoir rock. Conventional reservoir rocks such as sandstone feature high porosity and permeability. That is, they have many pores capable of holding hydrocarbons as well as fissures and interconnections trough which the oil or gas can travel. When a producer drills a well in a conventional field, oil and gas flow through the reservoir rock and into the well, powered mainly by geologic pressure.

Shale fields and other unconventional plays aren’t particularly permeable. In other words, these deposits contain plenty of hydrocarbons but lack channels through which the oil or gas can travel. Even in shale fields where there’s plenty of geologic pressure, the hydrocarbons are essentially locked in place.

Producers have developed and refined two major technologies in recent years to unlock the natural gas and oil trapped in shale deposits–horizontal drilling and fracturing. Horizontal wells are drilled down and sideways to expose more of the well to productive reservoir layers.

Fracturing is a process whereby producers pump a liquid into a shale reservoir under such tremendous pressure that it cracks the reservoir rock. This creates channels through which hydrocarbons can travel, improving permeability. Over the past several years US producers have perfected these techniques in a number of prolific shale gas plays. Now more and more of these exploration and production firms are applying the same techniques to a handful of established and emerging shale oil plays.

Producers are increasingly finding that long horizontal wells–“long laterals” in industry parlance–and huge multistage fracturing jobs maximize output from shale deposits. For example, in the Bakken producers routinely drill laterals that exceed 10,000 feet in length, a distance of nearly two miles. Plenty of producers do fracturing jobs in more than 30 stages, and a few are contemplating fracturing projects of 42 stages or more. As technology and drilling techniques evolve, output and efficiency continue to improve.

The results explain why exploration and production outfits have rushed to secure acreage in the most promising plays. Not only do these fields produce crude that’s often of better quality than West Texas Intermediate (the US standard that’s the basis for futures traded on the New York Mercantile Exchange), but break-even costs are also far lower than in the deepwater.

In the core of the Bakken, for example, producers need oil prices in the $35 to $40 range to earn solid returns on their drilling programs. At current oil prices, some producers enjoy internal rates of return in excess of 100 percent.

Oil production from the Bakken region has surged in recent years. Less than five years ago, North Dakota and Montana combined produced less than 150,000 barrels of oil per day. Today that number is closer to 400,000 barrels per day. The region’s output could eclipse 750,000 barrels per day by mid-decade.

The biggest problem producers in the Bakken face isn’t getting oil out of the ground but moving that crude to market. North Dakota and Montana are sparsely populated states, so the local market is negligible. Because the region historically hasn’t been an important center of US oil production, there’s limited pipeline capacity to move oil, NGLs and other products out of the region to population centers.

Tesoro Logistics’ High Plains gathering system offers one outlet. The company has the capacity to gather about 23,000 barrels per day from the region using trucks. Tesoro Logistics also owns a 700-mile pipeline gathering system in the region that collects production from individual oil wells. All told, the MLP’s gathering system is set up to deliver up 70,000 barrels per day of oil crude to Tesoro Corp’s refinery in Mandan, N.D. The Mandan facility is one of Tesoro Corp’s smaller refineries, but the company is expanding the operation to accommodate all of the MLP’s gathering capacity. These additions are slated for completion in 2012.

The terminals and storage business is closely tied to Tesoro Corp’s refineries in the western US. Terminals typically hold refined products such as gasoline and diesel fuel and often provide fuel blending and other ancillary services. Conservative Portfolio holding Sunoco Logistics Partners also owns an extensive collection of terminal assets.

Tesoro Logistics’ cash flows are all supported by long-term contracts with Tesoro Corp. These agreements establish a minimum monthly throughput for the MLP’s gathering system and terminals, guaranteeing a certain level of cash flow that’s independent of utilization rates. For the gathering and storage infrastructure, the contract sets an inflation-indexed fee schedule that protects the MLP from rising labor and raw material costs. These contracts will be valid for 10 years from Tesoro Logistics’ IPO, though the agreements governing the crude oil trucking operation in the Bakken are good for two years.

Tesoro Logistics growth story hinges on organic expansion and asset drop-downs from its GP. Tesoro Corp contributed almost $200 million worth of terminals and logistics assets to Tesoro Logistics, but the IPO prospectus estimates that the parent company owns another $240 million worth of assets that would be suitable for the MLP. In fact, Tesoro Corp has granted Tesoro Logistics the right of first refusal on any of these assets it might like to purchase.

Over the next 12 to 24 months, Tesoro Logistics will likely raise additional capital and announce a series of drop-downs from its parent. These transactions should boost to distributions immediately.

Tesoro Logistics also has ample opportunity to grow organically. For example, Tesoro Logistics has discussed the feasibility of a rail terminal at its North Dakota refinery that would accept additional oil production from the Bakken and transport that oil to the Gulf Coast by rail. Several major producers in the Bakken already use trains to ship oil out of the region.

Tesoro Logistics’ contracts with its GP should enable the MLP to achieve its minimum quarterly distribution of $0.3375 per unit. Investors should expect the second-quarter distribution to be prorated; the MLP went public 20 days into the quarter.

Based on Tesoro Logistics’ minimum payout and the stock’s closing price on its first day of trading, the stock yields 5.7 percent. That’s in-line with the average US-traded MLP and reflects the low-risk nature of the MLP’s business.

Tesoro Logistics’ IDR structure is set up such that fees paid to the GP begin to increase gradually once the limited partners’ quarterly distributions exceed $0.388125 per unit. Given the likelihood of drop-down transactions, the payout should exceed that level over the next 12 to 24 months, a respectable rate of distribution growth for a low-risk MLP.