In the second quarter, the Alerian MLP Index declined by 0.65 percent–the benchmark’s first quarterly loss since the final three months of 2008. Despite this modest pullback, the benchmark is still up 5.2 percent from the beginning of 2011 to the end of June.

More important, our outlook for our favorites and the group as a whole remains sanguine.

The three Portfolio holdings which have announced their second-quarter distributions will disburse a higher payout than they did in the first three months of 2011. Meanwhile, the average MLP that has announced its second-quarter distribution hiked its payout by 1.8 percent from the first quarter. If their peers can keep up this pace, the second quarter would market the strongest three months of distribution growth since 2007.

Averaged together, the returns posted by the three model Portfolios lagged the Alerian MLP Index by about 1.4 percent in the first half of 2011. The Conservative Portfolio has been the standout performer so far in 2011, returning an average of 5.6 percent and besting the Alerian MLP Index by 0.37 percent. But a strong showing from this defensive basket of stocks didn’t offset weaker returns from the Aggressive Portfolio (up 2.3 percent) and the Growth Portfolio (up 2.7 percent).


Source: MLP Profits

Although we’re not pleased that the model Portfolios underperformed the Alerian MLP Index, our goal is to outperform the benchmark on an annual basis. We also remain sanguine about our favorite MLPs’ long-term growth prospects and regard recent weakness in the broader market as a stellar opportunity to buy our top picks.

Led by our Aggressive Portfolio holdings, the model Portfolios also outperformed the Alerian MLP Index and the S&P 500 handily in 2009 and 2010. In 2010 the Aggressive Portfolio returned 45.4 percent, besting the benchmark’s gains by almost 10 percent. Although all our Conservative Portfolio holdings boosted their payout at least once in 2010, these plays lagged our Aggressive picks.

But the Conservative Portfolio’s relative strength in the second quarter wasn’t a surprise. As Roger Conrad explained in Big Profits from Pipelines, the Conservative Portfolio consists primarily of MLPs that earn fee-based income from long-term contracts with major oil and gas producers. These revenue streams are largely insulated from economic weakness or a pullback in energy prices–two headwinds that buffeted our Aggressive and Growth Portfolio holdings in recent months. Our Aggressive and Growth Portfolio holdings were also vulnerable to profit-taking after outperforming substantially over the past two years.

In the June 20, 2011, issue Buy the Correction, we profiled a handful of Portfolio holdings that underperformed when the broader market pulled back, and advised investors to buy the dip. This call proved prescient: The Alerian MLP Index bottomed on June 16, and several of our erstwhile laggards have roared back in recent weeks.

For example, Encore Energy Partners LP’s stock (NYSE: ENP) has surged 10.7 percent since June 16, reflecting Vanguard Energy Resources LLC’s sweetened takeover offer for the MLP. Meanwhile, units of Teekay LNG Partners LP (NYSE: TGP) have soared 9.6 percent over the same period.

Shale Boom Driving Infrastructure Demand

On July 15, Australian energy and mining behemoth BHP Billiton (ASX: BHP, NYSE: BHP) announced it will acquire US-based independent oil and gas producer Petrohawk Energy Corp (NYSE: HK) in a USD12.1 billion all-cash deal that also includes the assumption of around USD3 billion in net debt. The blockbuster deal was BHP Billiton’s largest acquisition to date, and the purchase price represented a 65 percent premium to Petrohawk Energy’s closing price on July 14.

Like many North American independent oil and gas producers, Petrohawk Energy focuses on unconventional oil and gas plays. Broadly speaking, an unconventional or nonconventional field refers to any play that can’t be produced economically using traditional well technologies.

By drilling horizontally through unconventional rock formations, producers can expose more of their well to productive zones. Increasingly effective hydraulic fracturing techniques improve the permeability of unconventional fields, making it easier for gas in a reservoir to flow into a well.

Petrohawk Energy is a major player in two of the largest unconventional fields in the US: the Haynesville Shale, a dry-gas field in Louisiana that produces little to no natural gas liquids (NGL), and the Eagle Ford Shale, which produces natural gas, NGLs and oil in different parts of the play.

BHP Billiton isn’t the first large-capitalization name to enter the shale gas fray by acquiring an independent producer. In fact, the Australian mining giant in February purchased Chesapeake Energy Corp’s (NYSE: CHK) assets in Arkansas’ Fayetteville Shale for USD4.75 billion.

Other major shale energy deals include US-based energy giant Chevron Corp’s (NYSE: CVX) $4.3 billion acquisition of Atlas Energy–a major player in Appalachia’s Marcellus Shale–and ExxonMobil Corp’s (NYSE: XOM) purchase of XTO Energy in an all-stock deal worth more than $40 billion.

As we wrote in the Dec. 18, 2009, issue Shale Infrastructure, ExxonMobil is considered one of the shrewdest investors in the energy patch; the company’s big bet on XTO energy indicates that its management regards US onshore shale oil and gas fields as world-class plays. As we predicted, the deal has become a blueprint for a host of major oil and gas firms to enter US unconventional plays.

BHP Billiton’s big acquisition flew in the face a series of stories published by The New York Times that questioned the sustainability of the shale gas revolution. These pieces suggested that shale gas producers have overstated the productivity of their wells and that shale gas fields are unprofitable in the current pricing environment.

These articles undoubtedly had their intended effect, mobilizing both critics and supporters of shale gas development and stimulating a vociferous debate. Although arguments that the emperor has no clothes always attract plenty of eyeballs–the primary motivation of many media outfits–readers must evaluate the logic underpinning these claims and distinguish the rational from the sensational.

The New York Times is correct that some shale gas fields are uneconomic in the current pricing environment, which explains why drilling activity has declined in the natural gas-rich Barnett Shale and Haynesville Shale.

But the articles largely ignore the economics of the Eagle Ford Shale and other unconventional fields that produce large amounts of high-value oil, condensate and natural gas liquids such as butane, ethane and propane. In general, exploration and production firms have shifted production from dry-gas fields to liquids-rich plays that offer superior profitability.

As we explain in the March 15, 2011, issue The Saudi Arabia of Natural Gas Liquids, NGLs can dramatically increase the profitability of some of America’s largest shale fields.

Processing and transporting NGLs is big business for many MLPs, including Conservative Portfolio stalwart Enterprise Products Partners LP (NYSE: EPD) and Growth Portfolio pick Targa Resources Partners LP (NYSE: NGLS). Both MLPs have reported strong NGL demand from US-based petrochemicals producers and are building significant processing and pipeline infrastructure to meet that demand. NGL exports represent an emerging opportunity for both Enterprise Products Partners and Targa Natural Resources Partners.

Moreover, the shale gas industry has undeniably changed the domestic energy mix in recent years: Natural gas production from US unconventional fields has soared to about one-quarter of total domestic gas output, up from only 4 percent a half-decade ago.

This production boom has enabled the US to overtake Russia as the world’s leading producer of natural gas, while the resulting supply overhang and closed domestic market has ensured that the country enjoys natural gas prices that are far lower than anywhere else in the world. That hardly sounds like a Ponzi scheme in the making.

A subsequent opi piece published in The New York Times—Clashing Views on the Future of Natural Gas–highlighted some of the inaccuracies, distortions and exaggerations evident in the paper’s late June series on shale gas fields. The article also criticizes the stories for their reliance on anonymous sources and individuals who are known opponents of the shale gas industry.

But mergers and acquisition activity provides the best refutation of The New York Times’ articles on shale gas. From Chevron and ExxonMobil to Total (Paris: FP, NYSE: TOT) and Royal Dutch Shell (NYSE: RDS.A), some of the world’s largest and most-respected energy companies have invested billions of dollars to add exposure to US shale oil and gas field.

These firms employ veritable armies of geologists, petroleum engineers and experienced oilfield workers to evaluate the productivity of these unconventional fields. I have more faith in the Super Oils’ take on the economics of shale oil and gas fields than I do in the slapdash reporting of a journalist.

The shale oil and gas revolution remains one of the most compelling growth opportunities for the MLPs in our coverage universe. Most MLPs are involved processing, transporting and storing natural gas and NGLs, activities that limit exposure to commodity prices. Producers book capacity on these assets under long-term contracts that guarantee minimum cash flows to the MLP. These agreements are usually inked long before the MLP begins construction on a new infrastructure project.

Investors should cheer the entry of major integrated oil companies into US unconventional plays; these deep-pocketed firms have the capital needed to drill aggressively in shale oil and gas fields with a long-term view on commodity prices. For example, ExxonMobil is unlikely to change its drilling plans significantly if gas prices gap lower this year. In contrast, smaller independent operators often adjust their drilling plans based on short-term gyrations in commodity prices. In short, the majors are better counterparties for MLPs that own and operate midstream assets.

Investors continue to underestimate the need for pipeline, storage and processing infrastructure to support the growth of North America’s unconventional fields. The Energy Information Administration’s (EIA) Annual Energy Outlook 2011 (AEO) estimates US natural gas production and consumption out to the year 2035. The AEO contains high-quality data and analysis, but it appears to be overly bearish on the prospects for natural gas production and consumption. In particular, the latest AEO calls for US gas production to rise from 21.3 trillion cubic feet (tcf) in 2010 to only 26.3 tcf in 2035. The same report envisions US gas consumption rising just 12 percent over the next 25 years, to 26.6 tcf.

In contrast, ExxonMobil has a bullish outlook for natural gas production and demand. A recent comprehensive report issued by the Interstate Natural gas Association of America (INGAA), a trade group for the pipeline industry, echoed this sentiment.

Although one should question the independence of the INGAA’s analysis, the trade group’s assumptions for US natural gas consumption aren’t unreasonable; the INGAA assumes US power demand will expand at an annualized rate of 1.3 percent through 2035.

The INGAA report also doesn’t make aggressive assumptions about new sources of demand for natural gas. For example, the report assumes that gas doesn’t gain widespread acceptance as a transportation fuel. Although the report acknowledges that some bus and taxi fleets will run on natural gas in 2035, the release doesn’t factor in the use of gas in passenger cars or commercial trucks. Moreover, while the INGAA report assumes that the Kitimat liquefied natural gas (LNG) plant in western Canada will begin operations, the analysis avoids projections about additional LNG export capacity. If either LNG exports or natural gas-powered vehicles gain greater acceptance, the INGAA’s demand assumptions would be overly conservative.

The INGAA forecasts that natural gas will win market share among electric utilities and that these gains will account for three-quarters of the projected increase in natural gas consumption. This prediction makes sense: Stringent regulations will gradually increase the cost of coal-fired power, prompting US utilities to shift to natural gas, the cleanest-burning fossil fuel. Natural gas-fired plants are also comparatively easy to site and build and tend to engender less public opposition.

At the same time, alternative energy sources such as solar and wind power can’t compete with coal and natural gas on price or practicality. These inherently intermittent sources of power–the sun doesn’t always shine and the wind doesn’t always blow–can’t offset the need for reliable, baseload electricity. In fact, the more solar and wind power farms the world builds, the more thermal or nuclear power plants are required to compensate for any power shortfalls.

ExxonMobil’s The Outlook for Energy: A View to 2030 makes similar arguments in favor of natural gas. The energy giant expects natural gas to overtake coal as the world’s second-largest source of electricity by 2030. ExxonMobil projects annual global growth in gas demand of about 2.0 percent–almost three times the 0.7 percent projected annual growth in oil demand.

Meanwhile, the INGAA’s report calls for a 1.6 percent annualized increase in North American gas consumption, with about 90 percent of that increased consumption supplied by gas produced from unconventional shale fields.

According to the INGAA, building the infrastructure to meet production growth will require roughly $8.2 billion (2010 dollars) in investment per year through 2035–a total of more than $200 billion worth of new projects.

Source: Interstate Natural Gas Association of America

MLPs are the dominant builders and owners of natural gas pipeline, processing and gathering infrastructure in the US; the group will take a leading role in enabling the shale gas revolution to continue.  

Although $8.2 billion per year might not seem like a huge amount in the context of the massive $14 trillion US economy, consider that the entire combined market capitalization of all MLPs in the Alerian MLP Index currently stands at just over $150 billion. The need to build out natural gas infrastructure will be a huge tailwind for MLPs in coming years.

The pie graph above applies only to natural gas-related infrastructure. The INGAA estimates that if we include the need to build out oil pipelines and NGL transmission lines, the annual required capital outlay jumps to $10 billion. Because many MLPs also operate oil-related infrastructure, they stand to benefit handsomely from this spending.

Second Quarter Reports

The MLPs in our coverage universe will be reporting second-quarter results over the next month, providing a full slate of catalysts. We expect our picks to post solid results, supported by continued strength in NGL prices and the announcement of several pipeline and processing plant construction projects over the past few weeks.

Enterprise Products Partners, Genesis Energy LP (NYSE: GEL) and Targa Natural Resources Partners announced plans to boost their payouts from first-quarter levels. We’ll cover second- quarter results from each of our picks in the coming weeks. Here’s a rundown of the planned second-quarter release dates for all of our recommendations.

Aggressive Portfolio

Encore Energy Partners LP (NYSE: ENP)–08/05/2011 (estimated)

Penn-Virginia Resource Partners LP (NYSE: PVR)–07/27/2011 (confirmed)

Legacy Reserves LP (NSDQ: LGCY)–08/04/2011 (estimated)

Linn Energy LLC (NSDQ: LINE)–07/29/2011 (estimated)

Navios Maritime Partners LP (NYSE: NMM)–07/26/2011 (estimated)

Regency Energy Partners LP (NSDQ: RGNC)–08/09/2011 (estimated)

Conservative Portfolio

Enterprise Products Partners LP (NYSE: EPD)–08/09/2011 (confirmed)

Genesis Energy LP (NYSE: GEL)–08/05/2011 (estimated)

Kinder Morgan Energy Partners LP (NYSE: KMP)–07/20/2011 (confirmed)

Magellan Midstream Partners LP (NYSE: MMP)–08/03/2011 (confirmed)

Sunoco Logistics Partners LP (NYSE: SXL)–07/27/2011 (estimated)

Spectra Energy Partners LP (NYSE: SEP)–08/05/2011 (estimated)

Growth Portfolio

DCP Midstream Partners LP (NYSE: DCP)–08/05/2011 (estimated)

Energy Transfer Partners LP (NYSE: ETP)–08/09/2011 (estimated)

Inergy LP (NSDQ: NRGY)–08/09/2011 (estimated)

Targa Natural Resources Partners LP (NYSE: NGLS)–08/08/2011 (confirmed)

Teekay LNG Partners LP (NYSE: TGP)–08/11/2011 (estimated)