Our coverage universe is off to a solid start in 2010; the industry benchmark Alerian MLP Index is up a little over 2 percent, and our Aggressive Portfolio picks are up by roughly twice that amount.  

There are three main drivers of upside to date, and all are likely to remain tailwinds throughout the year: improving conditions in capital markets, rising interest in natural gas and the potential for significant distribution increases this year. Here’s a look at each as it applies to recommendations in our Aggressive Portfolio.

Capital Markets

Probably the most important factor behind MLPs’ record gains in 2009 was a dramatic and steady improvement in equity and credit market conditions over the course of the year.

Early in 2009, even the largest and best-capitalized MLPs had trouble raising cash to fund new pipeline construction or acquisitions at reasonable rates. With MLP equities trading at depressed valuations, companies were reluctant to issue new units to raise capital; issuing stock when the broader market is in free fall would have disastrous consequences for unit prices.

And with banks licking their wounds from tremendous losses in 2008, most were focused on cutting credit lines and reducing risk on their balance sheets rather than extending new credit.

What a difference a year makes.

Source: Bloomberg

This graph tracks the spread between the yield on a 10-year US Treasury bond and a 10-year bond issued by a company that Standard & Poor’s rates “BBB”–the lowest rating a company can have and still be considered investment grade.

The higher the spread the more expensive it is to raise debt capital by issuing bonds or taking on new credit lines. As you can see, the cost of credit has steadily declined since last spring.

And the credit market for MLPs has broadened significantly over the past year; even MLPs without investment-grade credit ratings have managed to raise debt capital at reasonable prices. The graph below provides a closer look.

Source: Bloomberg

None of these five issuers have investment grade credit ratings, but all issued bonds at some point in 2009. The column labeled “Yield to Maturity” shows the current yield on these bonds, and the column “Yield at Issue” shows the yield at the time the bond first started trading.

The decline in yields is dramatic for some of these names. Consider, for example, that when Linn Energy (NSDQ: LINE) issued bonds in June, those notes yielded over 11.9 percent. Now, those same bonds have rallied so much in price that they only yield about 8.5 percent. That represents a huge drop in Linn’s cost of debt capital over the past seven months.

In last week’s Growth MLP Spotlight, A Virtuous Cycle, Roger Conrad highlighted several recommended MLPs that have sold additional units (stock) to raise cash. As we’ve highlighted on several occasions over the past year, this typically results in an immediate drop in the MLP’s unit price–when a company issues additional stock, it dilutes the value of existing unitholders’ stake.

However, these issues are not a negative for the MLPs over the longer term. Partnerships typically use the cash raised to pay down higher-cost credit lines, make acquisitions or fund organic expansion projects. In other words, MLPs typically use the cash raised to fund projects that ultimately result in higher distributions. In every case we highlighted last year, the short-term dips that followed new unit issuance turned out to be an outstanding buying opportunity.

The latest example is Aggressive Portfolio holding Legacy Reserves (NSDQ: LGCY), which announced on January 12 that it had priced an offering of 4.25 million new units at a price of $20.42 per unit.  Ultimately, we suspect the partnership will also price their additional 637,000 unit over-allotment option.  The offering should raise around $100 million for Legacy; the partnership plans to use this cash to fund part of its $130 million acquisition of 13 existing oilfields in the Big Horn and Wind River Basins of Wyoming from St. Mary Land & Exploration (NYSE: SM).

This deal represents a significant departure from Legacy’s existing core region of operation, the Permian Basin of Texas. Nonetheless, the assets are a good fit strategically; much like its existing properties, oil accounts for over 90 percent of the acreages production and these mature fields are well-explored and proven. Legacy should be able to employ the same basic techniques and strategies it has honed in Texas to produce these fields. And management has admitted that it views the deal as a springboard for future acquisitions that will allow it to diversify geographically.

The acquisition is also notable for its size. Legacy’s existing production base is around 9,000 barrels of oil equivalent per day; the St. Mary deal will add almost 1,500 barrels per day to that base. And Legacy was able to immediately enter into swaps transactions that enabled it to lock in attractive economics for production from its new fields.

Finally, the St. Mary deal is significant because it highlights a potential new avenue of growth for Legacy and other production-oriented MLPs, including Portfolio holdings EV Energy Partners (NSDQ: EVEP) and Linn Energy.

St. Mary is selling these mature fields to generate cash it can reinvest in its faster-growing unconventional natural gas plays, such as its acreage in the Haynesville and Marcellus shale.

Typically, traditional exploration and production (E&P) companies like St. Mary are valued on their ability to grow production. The plays that offer the most production growth are unconventional fields. Meanwhile, producing MLPs are focused on stable, predictable production that backs up their distributions–mature, well-proven fields are the best fit. This fundamental difference means that there is the potential for traditional E&P corporations to sell mature assets to MLPs, generating value for both sides.

Natural Gas

For much of 2009, natural gas was the ugly stepchild of the energy patch. Conventional wisdom was that strong production from US shale plays and depressed demand due to the recession would keep prices low for the foreseeable future.

Weakness in natural gas prices had the most dramatic impact partnerships with heavy exposure to gathering and processing (G&P), a business we explained at length in the Nov. 9, 2009, article, Commodity Tailwinds, and in the October 9 article, Upside for G&P MLPs. Gathering pipelines collect gas from individual wells and transport it to processing facilities; a big drop-off in gas drilling activity meant falling production and less demand for gathering services. Weak gas processing margins early in 2009 were also a major headwind.

But as we look forward into 2010, the natural gas market is rapidly improving; MLPs with heavy exposure to G&P operations have significant growth potential.

In recent weeks, near-record low temperatures across much of North America have been an important support for natural gas prices. The cold weather has increased demand for heating fuel, driving higher-than-normal drawdowns in natural gas inventories. The latest drawdown, reported Jan. 14, 2010, was just a few billion cubic feet shy of an all-time record draw. The graph below demonstrates what a huge difference a few weeks of cold winter weather can make to the gas market.

Source: EIA

Just three months ago, natural gas traders were fretting that the US might exhaust its storage capacity; many pundits assumed that US gas inventories would remain glutted for the foreseeable future.

But as of the most recent report, inventories are just 121 billion cubic feet above the five-year average. In the week ended Jan. 8, 2010, US gas inventories fell 266 billion cubic feet, roughly 130 billion cubic feet above the average for that week. In other words, the US natural gas market is now just one cold week away from below-average inventories. With weeks of winter weather ahead of us, it’s not at all unreasonable to expect gas inventories will end the heating season in March near “average” levels.

The improvement in market fundamentals has prompted gas producers to increase their drilling activity once again. As I noted in the Dec. 18, 2009, article, Shale Infrastructure, most of the recovery in drilling activity will likely come from low-cost unconventional shale plays such as the Haynesville and Marcellus. Here’s a graph tracking the US active gas rig count, a measure of the total number of rigs actively drilling for natural gas in the US.

Source: Bloomberg

The jump in US natural gas drilling will benefit MLPs with gathering and processing infrastructure strategically located near key shale plays. An example is Regency Energy Partners (NSDQ: RGNC) and its Haynesville expansion project in Louisiana.

On Jan. 12, 2010, Regency announced that the project had been fully completed and cost less than management had anticipated. The pipeline system is now in a testing phase, and service is expected to ramp up through the remainder of January. Strong drilling activity in the Haynesville Shale spells continued strong volumes for this project. In addition, Regency will likely have opportunities to add new capacity and facilities around its Haynesville project.

Another company that’s well-placed to take advantage of a snap-back in drilling activity is Williams Energy Partners (NYSE: WPZ). The company will benefit from the return of volumes through its gathering systems as well as solid gas processing margins.

Gas processing margins are a function of the price of natural gas liquids (NGLs) relative to the cost of gas itself. The value of a barrel of NGLs has traditionally tracked the price of oil, but this relationship broke down in the first half of 2009. Now NGLs appear to be gaining value faster than crude, a trend that makes processing services all the more valuable.

Distribution Growth

Although only a handful of MLPs in our coverage universe actually cut distributions in 2009, some names that had boosted their payouts aggressively in prior years stopped or slowed that growth.  But improving fundamentals for natural gas gathering and processing, a pick-up in the pace of acquisitions and an easier funding environment make it increasingly likely that 2010 will be the year in which distribution growth resumes with a vengeance.

Growing confidence in distribution growth explains a good bit of the recent run-up in MLPs as a group.

Navios Maritime Partners (NYSE: NMM) is another MLP that’s likely to increase its distribution this year. Navios owns a fleet of dry-bulk ships that carry commodities such as steel, coal and grains; demand for these ships has been driven largely by rapidly rising import demand from emerging markets such as China and India.

This month, Navios announced two new acquisitions: the Navios Hyperion, a 75,700 dead-weight ton Panamax ship, and the Navios Sagittarius, a slightly smaller Panamax ship. For those unfamiliar with the term, Panamax is the largest class of dry-bulk carrier capable of fitting through the Panama Canal. Navios funded the purchase using existing credit lines and the proceeds from its offering of new units late in 2009, an event that we discussed in a Flash Alert issued Nov. 19, 2009.

Because both deals should be immediately accretive to distributable cash flow, Navios likely will be in a position to boost its payout from the current annual rate of $1.62 per unit to as much as $1.80 per unit. If the LP does boost its payout, Navios could still offer yields as high as 11 percent in 2010.

Market conditions and distribution growth potential look bright for our Aggressive Portfolio favorites. However, due to the recent run-up in price, several have now surpassed our recommended buy under prices, despite the fact that we have boosted these targets on several occasions over the past few months to reflect improving conditions.

We intend to remain conservative and prudent about boosting targets further.  There’s a distinct possibility that some MLPs could see a buy-the-rumor-sell-the-news reaction in coming weeks; the group has run up in anticipation of distribution hikes, but we may see some profit-taking when those increases are actually announced. For now, we recommend buying only MLPs that trade under our targets. Investors should also look to buy more extended names on short-term dips; be sure to check the website often as we review targets frequently.