Despite the buoyant stock market, all was not well in summer 2007. A rising tide of mortgage defaults touched off a selloff in the broader market, with the S&P 500 giving up 10 percent from July to August. Credit markets also reflected this contagion. Yields on lower-quality corporate bonds spiked relative to Treasuries, and global interbank lending markets showed the first signs of unease. This was just the opening salvo of a vicious financial crisis that besieged global markets through much of 2008 and early 2009.

Since these dark days, equity and bond markets have staged a credible recovery. The S&P 500 ended 2010 with a more than 15 percent gain and was up almost 90 percent from its nadir in March 2009.  Nevertheless, the S&P 500 remains more than 300 points shy of the record set in 2007.

The Alerian MLP Index is a different story altogether. Including reinvested distributions, the index surpassed its 2007 high over one year ago. Excluding distributions, the Alerian MLP Index hit a new record on Oct. 5, 2010, on its way to a 35.9 percent total return that year.

MLP Profits’ model Portfolios fared even better, recording an average gain of 37.6 percent in 2010. This performance outstripped the Alerian MLP Index by 3 percent and the S&P 500 more than 23 percent. The table below summarizes the 2010 returns for each Portfolio holding.

Source: Bloomberg

With credit markets regaining their health and commodity prices continuing to strengthen, names levered to energy prices were the stars in 2010. The Aggressive Portfolio soared more than 45 percent, topping the Alerian MLP Index by 10 percentage points.

At the same time, our Conservative Portfolio, which targets names with only limited exposure to commodity prices, also turned in a solid performance. Despite its lower risk profile, this Portfolio segment came close to matching the gains posted by the industry’s benchmark index.

The Alerian MLP Index and most of our favorite MLPs finished the year at new highs, raising questions about whether the group has become overvalued. Although a correction could be in the cards–since mid-2009, the group has pulled back 5 to 10 percent on a handful of occasions–the security class isn’t overvalued. In fact, MLPs are cheaper today than they were in 2007. Check out the graph below.

Source: Bloomberg

This graph tracks the Alerian MLP Index’s indicated yield since mid-2006. Throughout most of 2006 and early 2007, the index’s indicated yield fell, touching a low near 5.3 percent over the summer. Although most MLPs raised their distributions over this period, unit prices rose at a far faster pace than payouts.

Today, the Alerian MLP Index trades well above its 2007 high, but the benchmark index still yields 6.1 percent. In other words, distribution growth has outstripped price appreciation in recent years.

Consider the two largest MLPs, Conservative Portfolio stalwart Enterprise Products Partners LP (NYSE: EPD), which increased has increased its payout 21 percent since summer 2007, and Kinder Morgan Energy Partners LP (NYSE: KMP), which has upped its payout 31 percent.

The Alerian MLP Index yields considerably less than it did at the height of the financial crisis, when even the best-capitalized names offered double-digit yields. Nevertheless, the average MLP yields far more today than it did in 2006-07; on a yield basis, the index is cheaper today than in 2007.

Relative yields likewise suggest that MLPs aren’t overvalued.

Source: Bloomberg

This graph compares the yield offered by the Alerian MLP Index and the Bloomberg REIT Index. Real estate investment trusts (REIT) are a staple of income-oriented portfolios, vying with MLPs and other dividend-paying securities for investors’ attention.

When MLPs reached a then-record high in 2007, the Alerian MLP Index yielded less than 1 percent more than the Bloomberg REIT Index. Today, MLPs yield about 3 percent more than REITs and this spread remains above its 10-year average.

MLPs outperformed in 2010, but these gains reflected rising distributable cash flow (DCF) and accelerating distribution growth.

MLP IPOs

In the Dec. 20, 2010, issue The Power of Equity, we explained how many MLPs have taken advantage of strong equity and debt markets to obtain capital at attractive rates. Most of the MLPs we recommend announced at least one secondary issuance of new units (the MLP equivalent of shares) in 2010.

The best in the business are putting that capital to work either by making accretive acquisitions or by funding new organic growth projects, setting the stage for faster distribution growth in the year ahead. 

This general strength has translated into strong demand for initial public offerings (IPO) within the sector.

Source: Bloomberg

This graph tracks the total proceeds raised by newly listed MLPs in each of the past 10 years. As you can see, the market for MLP IPOs was strong from 2005-07, primarily because the US stock market was performing well and investors’ demand for energy and dividend-paying equities was at a high.

The strongest year for MLP IPOs was 2006, when a total of 16 new partnerships raised more than $3.3 billion by going public. In any industry, the quality of IPOs tends to declines during boom markets. For example, ill-fated companies such as Pets.com went public at the height of the tech boom to cash in on the frenzy. That wasn’t the case with MLP IPOs in 2006; the class of ’06 includes Portfolio holdings Linn Energy LLC (NasdaqGS: LINE), Regency Energy Partners LP (NasdaqGS: RGNC) and EV Energy Partners LP (NasdaqGS: EVEP).

The number of IPOs dwindled during the 2008-09 financial crisis. No new MLPs went public in 2009, and those that listed in 2008 did so in the first half of the year, when energy prices were still rising.

But the cycle has turned, and interest in MLP IPOs is on the rise. Six new MLPs went public in 2010, raising nearly $1.6 billion–the best showing since 2007. All six of these names traded above their offering price at the end of 2010, leaving little doubt that we’ll see more MLPs list their shares in 2011.

In December refining giant Tesoro Corp (NYSE: TSO) announced plans to spin off its midstream assets–pipelines and storage tanks associated with its refineries–into a separately traded MLP. The list of assets would include a crude-oil gathering system located in North Dakota’s Bakken Shale, a fast-growing oil-producing region. Rising production in the Bakken will necessitate building new pipelines and facilities to transport oil from the area.

Pipeline capacity in the region is in such short supply that EOG Resources (NYSE: EOG), a major producer in the Bakken, has opted to transport a good portion of its oil out of the area via rail.

Tesoro has yet to file an S-1 Registration statement with the Securities and Exchange Commission to detail which assets it plans to contribute to the new MLP. But this could be a hot IPO in 2011. We’ll share any new details as soon as they come available.

In MLP Profits, we add all new IPOs to our How They Rate coverage universe and assign each name a buy, hold or sell rating based on our analysis of each company’s business and fundamentals. Investors should closely examine any new MLPs that plan to go public; partnerships often grow their distributions rapidly in their first two years as a public company.

For example, in its first two years as a publicly traded partnership, Williams Partners LP (NYSE: WPZ) firm boosted its quarterly payout to $0.575 per unit from $0.35 per unit. This growth was fueled by 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.

Conservative Portfolio recommendation Sunoco Logistics Partners LP (NYSE: SXL) enjoyed a similar pop. The refined products pipeline giant increased its payout 23 percent in its first eight quarters as a public company, and the stock gained 100 percent. There’s nothing like rapid distribution growth to attract investors’ attention.

The three largest MLP IPOs in 2010 were offerings from Chesapeake Midstream Partners LP (NYSE: CHKM), Niska Gas Storage Partners LLC (NYSE: NKA) and PAA Natural Gas Storage LP (NYSE: PNG). We analyzed all three in the Sept. 24, 2010, issue IPOs for Growth and added them to our How They Rate coverage universe. Today, we’ll profile the remaining three MLP IPOs from 2010.

New MLPs on the Block

Oxford Resource Partners LP (NYSE: OXF) holds nearly 92 million tons of coal reserves in the Illinois Basin and Northern Appalachia (NAPP), much of which contains higher levels of sulfur than output from Central Appalachia (CAPP) or the Poweder River Basin. The company primarily produces thermal coal, the type that’s burned in power plants.

The only coal-focused name in the model Portfolios is Penn Virginia GP Holdings LP (NYSE: PVG), a stock we highlighted in the Nov. 10, 2010, issue Higher Distributions Justify Higher Buy Targets. Penn Virginia GP Holdings doesn’t produce coal but leases its properties out to coal mining firms in exchange for royalty fees. These royalties typically involve a guaranteed minimum of some sort, plus an amount tied to the value of coal mined on the partnership’s properties.

In contrast, Oxford Resource Partners operates a hybrid model, mining some coal and leasing out a handful of its properties in exchange for royalties. Oxford operates 17 surface mines, the majority of which are located in Ohio. These operations produce more than 7 million tons of thermal coal each year. The largest of the partnership’s mines accounts for less than 13 percent of total output, and this diversification reduces the negative impact of any temporary problems at an individual mine.

In addition, roughly one-third of the company’s reserves aren’t accessible using surface-based mining techniques. The company leases these properties under royalty agreements similar to those used by Penn Virginia GP Holdings and other coal-focused MLPs.

Oxford’s focus on thermal coal will weigh on results in the near term. The US market for thermal coal is slowly recovering from its post-recession hangover. In 2007-09, demand for electricity collapsed and US utilities’ coal inventories ballooned to glutted levels, sending the price of thermal coal tumbling.

But conditions are beginning to improve. An unusually cold 2009-10 winter and abnormally hot summer drove stronger seasonal demand for electricity, reducing utilities’ coal inventories. In addition, the US economic recovery has led to an uptick in power demand.

Coal markets have also been aided by an unlikely source: the US government. New environmental and safety regulations have raised the cost of mining coal and delayed planned mine expansions, particularly in CAPP. That’s driven out many smaller producers, reducing production and normalizing coal stockpiles.

US thermal coal prices remain weak and are likely to recover only gradually through the first half of 2011. But as inventories normalize and electricity demand recovers, the latter half of the year is shaping up to be a much more hospitable market for producers of thermal coal. Over the long term the US could become an important exporter of thermal coal to Europe and Asia, where supplies are much tighter and prices are far more favorable.

The outlook for metallurgical (met) coal, the variety used in steelmaking, is completely different. Met coal prices have soared, as global steel output has bounced back from its recessionary nadir. In particular, imports to China, India and other emerging economies have surged amid increasing demand. Meanwhile, in the second half of 2010, heavy rains in Australia and Indonesia hampered exports from these key markets, further tightening global supplies and pushing up prices. Exports of met coal from the US have helped to fill that supply gap.

Met coal has a much higher per-ton value than thermal coal, and the US is already a major exporter. US met coal prices reflect strong global demand; thermal coal prices hinge on domestic supply and demand.

But Oxford’s focus on thermal coal is offset by long-term sales contracts that cover all of the partnership’s 2011 production. This provides a degree of protection against weakness in the spot market. In 2012, 81 percent of the MLP’s output has been pre-sold, while that proportion declines to 51 percent in 2013. By that point, US inventories of thermal coal will have normalized and spot prices will improve.

Oxford also wins points for its exposure to NAPP and the Illinois Basin. New environmental and safety regulations have increased production costs in the CAPP, accelerating the long-term decline in output from this mature region.

Expect increased output from NAPP and the Illinois Basin, where mining costs are lower and environmental obstacles are less onerous, to offset waning CAPP production. Oxford enjoys a lower cost of production because many of all of its operated properties are surface mines.

Traditionally, utilities have preferred CAPP coal because it contains less sulfur. When burned in a power plant, the sulfur that occurs naturally in coal binds with oxygen in the air to form sulfur dioxide, a pollutant that causes acid rain and has other negative environmental consequences. Regulations limiting sulfur dioxide emissions will continue to become more stringent. Burning coals that contain less sulfur is one way to comply with air-quality regulations.

But many power plants are installing advanced scrubbers capable of removing most sulfur from emissions, enabling these facilities to burn a variety of coals. The majority of utilities in Oxford’s markets–Illinois, Indiana, Kentucky, Ohio, Pennsylvania and West Virginia–will have implemented these emissions-control systems over the next few years. This transition effectively expands the market for Oxford’s high-sulfur coal.

Major US coal-mining firms such as Arch Coal (NYSE: ACI) and Peabody Energy Corp (NYSE: BTU) have picked up on this trend and have made or are contemplating investments in additional Illinois Basin production. You can bet that these industry giants wouldn’t invest in this region if they didn’t expect the market for high-sulfur coals to expand.

Oxford’s units began trading on the New York Stock Exchange at roughly $18 per share and have rallied into the mid-$20s as the outlook for US coal producers improves.

The firm disbursed a prorated third-quarter distribution of $0.352 per unit in late October, but the actual quarterly dividend will be $0.4375 per unit. Assuming that the MLP manages to pay its intended distributions, the units yield 7.2 percent at current prices. Fellow coal-focused MLPs Penn Virginia GP Holdings and Natural Resource Partners LP (NYSE: NRP) yield roughly 6.8 percent, while Alliance Resource Partners LP (NasdaqGS: NRLP) yields 5.1 percent.

Oxford’s third-quarter earnings report included a lot of moving parts, and results suffered from a handful of temporary issues, including a slight delay in receiving a mine permit, a heavy maintenance schedule for equipment and some one-off production issues at its leased underground mines. All of these challenges meant that the MLP’s third-quarter DCF failed to cover its distribution.

Oxford should manage to pay its minimum quarterly distributions in 2011and could make up for any minor shortfalls by dipping into available cash or tapping its credit lines.

According to the company’s schedule of incentive distribution rights, the general partner (GP) will receive 2 percent of quarterly distributions until the MLP pays out more than $0.5031 per unit. This gives the GP every incentive to grow distributions above that hurdle as soon as possible; payouts could reach this level sometime in 2012 if the market for thermal coal continues to improve.

Nevertheless, Oxford will need to post stronger results before we upgrade the stock to a buy in our How They Rate coverage universe. In particular, the partnership must prove that its existing long-term sales contracts are sufficient to allow the firm to fully cover its $1.75 annualized payout with DCF. This uncertainty is the main reason that Oxford offers a higher yield than its coal-focused peers.

For now, we’re adding Oxford Resource Partners LP to the How They Rate coverage universe as a hold. We’ll revisit this name after its reports its fourth-quarter earnings.

Units of coal-focused Rhino Resource Partners LP (NYSE: RNO) hit the New York Stock Exchange on Sept. 30, 2010. Like Oxford, Rhino generates cash flow by producing coal. The partnership boasts a portfolio of six underground mines and five surface plays in CAPP, NAPP and the Illinois Basin. Thermal coal represents 95 percent of the firm’s output.

In 2009 the MLP’s CAPP properties accounted for roughly half of its coal production, with the remainder coming from NAPP. This production mix should shift over the next two years, as the MLP recently received permits for its Taylorville mine in the Illinois Basin, a play that contains 110 million tons of provable and probable reserves. Until this project comes online, Rhino will focus on securing sales commitments for the mine’s future output, guaranteeing a certain level of revenue and cash flow.

Rhino also manages a joint-venture project in which it holds a 51 percent stake. Located in West Virginia, this mine primarily produces met coal, a variety that commands a higher price in the current market.  

In 2009 Rhino produced 4.7 million tons of coal and purchased and sold an additional 2 million tons. Of these 6.7 billion tons, about 350,000 tons were metallurgical coal. Last year the company scaled back thermal-coal production at some of its higher-cost CAPP mines, so output has decline in recent quarters.

Rhino has more exposure to coal prices than Oxford. At the time of its IPO, the firm had sales contracts in place for about for about 69 percent of its planned production for the year ended Sept. 30, 2011–a cause for concern. In the four quarters after its IPO, Rhino will need to sell about 1.25 million tons of thermal coal in a weak pricing environment. The firm’s 400,000 tons of uncommitted met coal isn’t a liability because of strong demand for this variety.

Although Rhino’s prospectus makes no mention of sales contracts for 2012 and 2013, it’s a safe bet less than 69 percent of expected production has been pre-sold.

The firm’s exposure to CAPP is another challenge. Although the new mine in the Illinois Basin is a promising development, the MLP currently generates about half of its output from a region that’s plagued by higher production costs as well as significant regulatory and geologic risks.

Rhino’s met coal production somewhat counterbalances this weakness; management expects its output of met coal to increase significantly in 2011.

The MLP has targeted an annual distribution of $1.78 per unit in its first 12 months as a public company, an achievable goal. At current prices, Rhino’s units yield about 7.6 percent, roughly 1.5 percent more than the average partnership in the Alerian MLP Index. This above-average yield reflects Rhino’s above-average commodity price risk.

Over the past year the firm would have covered about 93.7 percent of its total minimum distribution. When you consider how weak the US market for thermal coal has been, that’s not a bad showing.

Management estimates that the MLP will generate DCF that will cover its payout 1.7 times. But this guidance hinges on Rhino’s ability to sell its uncommitted thermal coal at a premium to the current spot price. The projection also assumes that Rhino will restart much of its idled CAPP production as coal prices recover. This outlook more or less reflects our current market outlook but does entail meaningful commodity risk.

Rhino is a commodity-sensitive MLP that would be an appropriate play for aggressive investors interested in playing a rebound in US thermal coal prices. Until Rhino Resource Partners LP demonstrates that it can comfortably cover its distribution, the MLP will rate a hold in our How They Rate coverage universe.

QR Energy LP (NYSE: QRE) became a publicly traded MLP on Dec. 17, 2010. QR Energy owns upstream assets from which it produces oil and natural gas. Oil and natural gas liquids account for about 70 percent of the outfit’s reserves (29.7 million barrels of oil equivalent) and production (5,184 barrels of oil equivalent per day).

Operations in the Permian Basin, a mature oil-producing region in west Texas and New Mexico, account for 60 percent of QR Energy’s reserves and nearly half of its output. In recent years producers have achieved impressive success in certain parts of the Permian by drilling horizontal wells or using hydraulic fracturing techniques.

A horizontal well branches off laterally from an initial vertical drill hole, exposing more of the productive layer to the well. Fracturing, or stimulation, increases the permeability of the reservoir rock, allowing natural gas to flow from the reserve rock into the well. This process involves pumping large quantities of water and a small percentage of chemicals into the rock formation at high pressure, producing a network of cracks. The inclusion of a proppant–typically sand, sand coated with ceramic material or ceramic material–ensures that these passages remain open.

The Permian is also a hot area for upstream-focused MLPs. Aggressive Portfolio holdings Linn Energy and Legacy Reserves LP (NasdaqGS: LGCY) have operations in the same region.

In addition to the Permian, QR Energy has operations in the Mid-Continent region (Oklahoma and northern Texas), the Ark-La-Tex region straddling the borders of Texas, Arkansas and Louisiana and the Gulf Coast. All of these areas appeal to upstream MLPs because the fields are mature and the underlying geology is well-understood. Also, these areas boast modest decline rates and offer predictable output, attractive attributes for an MLP.

Like all upstream MLPs, QR Energy has exposure to oil and natural gas prices; prospective investors should understand the MLP’s hedge book and potential production growth before adding the stock to their portfolios.

QR Energy’s prospectus states that management intends to keep 65 to 85 percent of its total oil and gas production hedged three to five years into the future. At present, the MLP has hedged 80 percent of its 2011 production, 71 percent of its 2012 production, 68 percent of its 2013 production, 65 percent of its 2014 production and 47 percent of its 2015 production.

These large hedge positions shelter QR Energy from near-term volatility in oil and gas prices, though the MLP has more exposure to commodity prices than Linn Energy, which has hedged nearly all of its production for years into the future. Investors should demand a higher yield to compensate for this risk.

QR Energy’s most likely growth strategy is to acquire new producing oil or gas fields, potentially through drop-down transactions from its parent and GP, which is controlled by Quantum Resource Fund.

In a drop-down transaction, the MLP’s GP sells some of its assets to the MLP, usually at a price that ensures the deal is immediately accretive to DCF and allows the limited partner to boost distributions. Growth Portfolio holding Targa Resources Partners LP (NYSE: NGLS) and several other MLPs have used drop-down transactions as their primary avenue of growth.

QR Energy’s GP is controlled by a private-equity firm that owns reserves totaling 56.4 million barrels of oil equivalent–almost double the MLP’s current reserve base. These properties would be a good fit for QR Energy’s portfolio, and the fund intends to drop down some of these assets to the MLP. Note that the fund has an incentive to foster QR Energy’s growth because it owns more than 47 percent of the outstanding units and receives a management incentive fee that increases as the MLP’s cash flow and distribution grow.

QR Energy has targeted a minimum quarterly distribution of $0.4125, equal to $1.65 on an annualized basis. Assuming that the MLP pays its minimum distributions, its units currently yield more than 8.2 percent.

Management expects the MLP to generate enough DCF to cover its distribution 1.07 to 1.08 times. These estimates assume that the MLP’s production will decline 3 percent, oil prices will average $80 per barrel, and natural gas prices will average $4 per million British thermal units.

With oil prices already above $90 per barrel, management’s forecast for this commodity appears conservative. Moreover, QR Energy has already hedged 78 percent of its 2011 oil production at about $85 per barrel, so the company could still achieve an average price of $80 per barrel even if crude prices tumbled considerably.

Management’s price forecast price realization for natural gas also appears conservative; 84 percent of the MLP’s 2011 output is hedged at an average price of $7.26 per million British thermal units.

Forecasted cash flows aren’t particularly sensitive to commodity prices, thanks to the large 2011 hedge book. That being said, a significant production miss (on the order of 10 percent) would endanger the MLP’s distribution coverage ratio.

QR Energy is a high-risk play because of its commodity exposure and an unproven operating history. But it does offer a considerable yield premium to the average upstream MLP and benefits from strong exposure to crude oil. Appropriate for aggressive investors, QR Energy is a buy in our How They Rate coverage universe. Please note that we’re adding this MLP to our coverage universe, not to the model Portfolios.