Knowing which stocks to avoid is just as important to your portfolio’s health as knowing what to buy.

This is particularly true for master limited partnerships (MLP). All too often, income-hungry investors are attracted to the MLPs offering the highest yields; unfortunately, those sky-high payouts usually carry above-average risk.

A recent cautionary tale is K-Sea Transportation Partners (NYSE: KSP), a tank barge and tugboat company operating in US coastal waters. We’ve consistently rated K-Sea a sell in the How They Rate table. Although a distribution cut was a distinct possibility, investors still found it hard to resist the MLP’s 16 percent yield.

When the MLP slashed its payout in late October, the units fell by over 50 percent in a matter of days, wiping out years’ worth of distribution payouts.  Don’t assume that MLPs are safe just because they tend to offer high yields; K-Sea illustrates what can happen when an income-focused stock suddenly slashes its payout to conserve cash.

We’re willing to accept a degree of commodity exposure and business risk, especially in our Aggressive Portfolio, assuming that risk offers a significantly higher-than-average yield and the likelihood of a distribution cut is low. In other words, MLP investors should expect to be paid handsomely for assuming greater business risk.

But despite their large yields, some MLPs just aren’t worth the risk–here’s a rundown of two popular MLPs that we rate as sells in How They Rate. One is a downright yield trap that could cut its payout at any time; the other is involved in a shaky business and doesn’t offer enough yield to justify its inferior growth prospects.

With a yield of 17.7 percent, Capital Products Partners (NSDQ: CPLP) is among the highest-yielding partnerships in our coverage universe and continues to attract investors. Don’t be blinded by the yield; exigencies will likely force the MLP to slash its distribution by the second half of 2010.

Capital Products Partners owns a fleet of 18 ocean-going tanker ships, 15 of which are designed to carry refined products such as gasoline, chemicals or even edible oils. The MLP also owns two smaller product carriers and a single Suezmax-class oil tanker.

There’s absolutely nothing wrong with Capital Products Partners’ fleet of ships; all are double-hull tankers and less than five years old.  In addition, nine of its product/chemical carriers are Ice Class vessels, allowing them to serve ports that experience icing during the winter months. In a healthy tanker market, Ice Class ships typically earn a higher return for ship-owners.

But weak tanker market puts Capital Products Partners’ distribution at risk. Companies wishing to transport petroleum products or crude can hire ships on a short-term or one-off basis at prevailing spot day-rates or lock in ships under multi-year fixed rate deals known as time-charter contracts.  

Yield is the main reason investors put their money into Capital Products Partners–or any MLP, for that matter. But the partnership must generate stable revenues and distributable cash flow to sustain that yield. For this reason, Capital Products Partners has the majority of its ships vessels locked into time-charter contracts guarantee a steady and reliable return.

But one of the partnership’s time-charter contracts expired last October, and charters covering eight additional ships are due to expire in 2010. One time-charter contract is scheduled to expire in January, two in March, one in May, two in June and two in August. Capital Products Partners will need to book half of its fleet on the spot market or find new long-term time-charter contracts for those ships. To make matters worse, the schedule of contract expirations is heavily weighted to the first half of this year, giving the partnership little time to maneuver.

With crude and product tanker markets hovering near multi-year lows, neither opportunity looks attractive. Check out the graph below.

Source: Bloomberg

This index of crude oil tanker rates encapsulates conditions in the tanker market. Although rates have doubled from 20-year lows set in October 2009, tanker rates are still near the low end of their long-term average; Capital Products Partners is unlikely to re-contract its ships at rates anywhere near the preceding terms.

And amid this weak market, a large number of new ships–about one-third of the current global fleet–are due to be delivered from shipyards over the next few years.  Although scrapping older ships will blunt some of the impact, the global tanker market will still need to absorb a great deal of supply.

Based on management’s comments in its most recent conference call, Capital Products Partners will lease its ships on the spot market. At present, few ships are finding long-term deals for two reasons: Ship-owners don’t want to lock in their vessels at depressed rates, and charterers can get lower rates on the spot market right now. That spells increased volatility in distributable cash flow and a high degree of uncertainty surrounding distributions.

Capital Products Partners is also highly leveraged and has loan covenants governing the ratio of its debt to the total value of its ships. Tankers are tough to value in the current market because there have been few transactions to use as benchmarks; if lenders get nervous they might decide to mark down the assumed value of the MLP’s ships. The partnership may need to renegotiate its loan agreements to remain in compliance.

A good contrast Aggressive Portfolio recommendation Navios Maritime Partners (NYSE: NMM), another Greece-based MLP that owns dry-bulk ships. Unlike Capital Products Partners, Navios has no ships coming off contract in 2010 and only a handful of ships due to see expirations each year after that. This staggered schedule makes it easier to renegotiate contracts.

And the market for dry-bulk carriers is much healthier. Rates are well off their 2007-08 highs but still around 10-year average levels and well above rates companies received in the 1990s. Even as contracts expire, Navios should be able to secure new charter deals with similar terms.

Sell Capital Products Partners. Buy Navios Maritime Partners when units dip below 17.

Units of Cheniere Energy Partners (NYSE: CQP) yield 11.6 percent, roughly 425 basis points (4.25 percent) higher than the average yield in the Alerian MLP Index. The partnership is also in an unusual business that tends to attract investors’ attention.

Cheniere Energy Partners owns and operates the Sabine Pass liquefied natural gas (LNG) receiving terminal in Louisiana. LNG is a super-cooled form of natural gas; at 260 degrees Fahrenheit below zero, natural gas condenses into a liquid. For point of reference, the amount of gas that would fill a beach ball compresses to roughly the size of a ping-pong ball when converted to LNG.

This allows natural gas produced isolated parts of the world to be transported in specialized LNG tankers. LNG frees natural gas from the constraints of regional pipeline networks. For producers, LNG makes isolated, distant gas reserves valuable; without LNG there would be no way to transport this gas to market.

When LNG arrives at the importing country it’s re-gasified at an LNG receiving terminal. Sabine Pass is the largest such terminal in the US with 4 billion cubic feet per day (bcf/day) of capacity. Cheniere Energy Partners doesn’t own the gas that moves through its terminal, but simply provides the infrastructure and related services. In addition, the MLP owns an LNG storage facility at Sabine Pass that can hold 16.9 bcf of gas.

The first problem with Cheniere is the LNG business itself. We’ve written about the rapid growth in US unconventional shale gas in MLP Profits on several occasions, most recently in the Dec. 18, 2009, issue, Shale Infrastructure. Just a few years ago, before unconventional gas production ramped up, most energy analysts would have told you that the US would need to import ever-larger quantities of LNG to compensate for declining US and Canadian gas production. But the emergence of relatively cheap-to-produce shale plays has changed that equation; the US has plenty of domestic gas to meet demand without importing any LNG.

This doesn’t mean that US LNG imports will be zero. The US has immense pipeline and natural gas storage infrastructure, and it’s the world’s largest gas consumer. When demand for gas is low globally, typically during the summer months, the US serves as a market of last resort; if there’s no room for gas to be stored abroad, it can likely find a market at some price in the US. The graph below tracks US LNG imports over the past few years.

Source: Energy Information Administration

Although there’s a seasonal bounce in volumes imported over the summer, the broader trends aren’t positive. US LNG imports in 2009 were likely higher than in 2008 but still well below their 2007 records.

Because natural gas prices generally have remained higher outside the US and supplies are less plentiful, there is little reason for LNG producers to send their gas into the US. This situation is likely to persist thanks to the relative abundance of gas in North America.

Of course, there are a large number of LNG liquefaction trains–LNG export facilities–due to start up in the next few years, and some of those volumes have been contracted to the US. But contracts are typically flexible and allow shipments to be diverted to areas where gas is in higher demand and prices are better. All this adds up to weak prospects for companies owning LNG import facilities.

Ironically, LNG export capacity would be valuable in the US market. Given the abundance of gas from unconventional plays plays such as the Haynesville shale, several US producers have expressed interest in exporting LNG from the US to gas-hungry markets in Europe and Asia. Unfortunately, the only operating LNG terminal in the US is in Alaska.

I am often asked if there’s a possibility for Cheniere Energy Partners to convert its facilities to export gas. The short answer is no; doing this would require that the partnership to obtain regulatory permission–hardly an easy task. And even if the MLP did secure regulatory approval, Cheniere would face a multi-year, multi-billion dollar project that would involve building a liquefaction facility from scratch.

Some web-based services disseminated incorrect information in this regard last summer. Cheniere Energy Partners did get approval to import foreign LNG, store it and re-export it at a later time–a trading operation designed to take advantage of weak demand for LNG over the summer months. But Cheniere Energy Partners did not get permission to export US gas as LNG, nor would its current facilities be capable of handling exports.

There isn’t much demand for LNG import capacity in the US, and these terminals usually remain idle in the current environment. As a result, we don’t see much opportunity for the MLP to expand its current operations, add to current capacity or make acquisitions–there’s no room for growth in the US LNG import business. 

Here’s where the story gets even more complex. Cheniere Energy Partners has long-term terminal use agreements (TUA) in place covering its entire 4 billion bcf/day of LNG import capacity. These TUA deals are similar to the capacity reservation deals common in the pipeline industry, and the contracts require a minimum monthly payment to reserve the capacity regardless of use.

Cheniere Energy Partners has three such deals:

• Paris-based Total (NYSE: TOT) has reserved 1 bcf/day of regasification capacity in exchange for minimum monthly payments that add up to $125 million per year. The contract commenced on April 1, 2009 and extends for 20 years.
• US integrated energy giant Chevron (NYSE: CVX) has reserved 1 bcf/day of capacity under a 20-year deal that commenced on July 1, 2009. Chevron will also pay $125 million per annum, broken down into monthly payments.
• Cheniere Marketing, a company backed by Cheniere Energy Partners’ parent, Cheniere Energy (AMEX: LNG), has reserved the final 2 bcf/day for a $250 million annual fee that’s paid in quarterly installments. This contract lasts through at least 2028.

The annual payments from these TUAs total $500 million per year. At the current distribution rate, Cheniere pays roughly $280 million per year to its common unitholders, subordinated unitholders and general partner. Even if we make some aggressive assumptions about the operating expenses and maintenance needed to maintain the terminal, this is more than enough money to allow the partnership to make its quarterly payments. In fact, if these TUAs were solid, Cheniere Partners would be in a position to boost its distributions significantly.

The TUA deals with Chevron and Total are solid as a rock. Both oil giants have plenty of cash and high-quality balance sheets; I don’t foresee either company running into financial trouble.

The third part of the puzzle is troublesome. Half the terminal’s capacity is reserved by Cheniere Energy (NYSE: LNG), the general partner (GP) of Cheniere Energy Partners. This TUA is shaky to say the least.

Cheniere Energy is in the business of owning and operating LNG terminals and, as I noted earlier, that business isn’t good right now–in fact, Cheniere Energy is losing money. Analysts peg last year’s losses at $3.94 per share and estimate that the company will lose $1.19 per share this year. Moreover, Cheniere Energy has a market capitalization of roughly $175 million, $87 million in cash and a whopping $3 billion in debt. It shouldn’t come as a huge surprise that Standard & Poor’s assigned Cheniere Energy a “CCC+” credit rating. According to S&P’s own definition a credit rating of CCC suggests that a company is “currently vulnerable and dependent on favorable business, financial and economic conditions to meet financial commitments.”

Without a significant improvement in the LNG business over the next year or two, Cheniere Energy will go bankrupt. This does not mean that Cheniere Energy Partners (the MLP) will go into bankruptcy–these are two separate companies even though Cheniere Energy ultimately controls the MLP.

And given cash on hand and continued receipts under the TUAs with Total and Chevron, it appears that Cheniere Energy Partners could continue to meet its current distributions until one of its bonds comes due in 2013. And depending on what numbers you factor into the equation for expenses, the MLP’s distribution coverage would be tight at best until 2013.

Even worse, there are bond covenants in place that would ultimately prohibit the MLP from making any distributions whatsoever if Cheniere Marketing stops making guaranteed payments under its TUA agreement.

In the event of bankruptcy, control of Cheniere Energy (the parent) would pass to its creditors and bondholders. Those lenders might decide to keep making the scheduled TUA payments to continue receiving scheduled distributions and general partner incentive distributions from Cheniere Energy Partners. However, bankruptcy is an unpredictable process–there are no guarantees.

Moreover, I can’t imagine a scenario where Cheniere Energy Partners’ units don’t sell off in sympathy when its parent goes bankrupt. I suspect investors won’t want to risk the lengthy and uncertain bankruptcy process even if Cheniere Energy Partners continues to make its payouts.

Cheniere Energy Partners currently yields 100 basis points more than Aggressive Portfolio holding Legacy Reserves (NSDQ: LGCY). Legacy has significant growth opportunities from acquisitions near its oil-producing properties in the Permian Basin and Rockies. As a producer, Legacy Reserves has some exposure to crude oil prices but hedges most of that risk and covers its distribution by a significant margin. In fact, the MLP is likely to increase its payout this year.

Meanwhile, Cheniere has no growth opportunities, barely covers its payout and might soon be exposed to real and headline risks involved in a drawn-out bankruptcy process. An extra percent of annual income hardly merits that level of risk. Buy Legacy Reserves under 21, and sell Cheniere Energy Partners.