Second-quarter earnings season is underway, and many master limited partnerships (MLP) yet to report results have pre-announced distributions.

Overall, the news is positive. Of our 17 Portfolio recommendations, nine have indicated planned distributions for the quarter, and seven of those have announced sequential hikes in their payouts. Looking at the sector as a whole, 77 percent of the MLPs that have announced their latest distribution plans will pay unitholders more than they did a year ago, while 67 percent have increased payouts from the preceding quarter. Only one MLP reduced its distribution.

The steady stream of positive news has pushed the Alerian MLP Index steadily higher in recent weeks; on a total-return basis, the Alerian is up 21 percent in 2010, compared to a less than 1 percent gain for the S&P 500. And unlike the S&P 500, most MLPs have rallied beyond their April 2010 highs.

The term “earnings” season is a bit of a misnomer when it comes to MLPs; traditional earnings measures used to value common stocks are next to meaningless for most partnerships. Earnings are an accounting construct and include several charges that don’t represent actual cash flowing into or out of a business.

One of the largest such charges is depreciation, essentially a means of spreading the cost of an asset over multiple years. Depreciation charges reduce reported earnings per share over time even, though they don’t represent actual cash charges. This is a particularly significant issue for energy-focused MLPs, a group that operates asset-intensive businesses such as pipelines, storage caverns and gas-processing plants. These assets require significant up-front capital to build and then are depreciated over a period of years, generating a steady stream of non-cash charges.

For partnerships involved in actual oil and gas production–such as Aggressive Portfolio holdings Linn Energy LLC (NasdaqGS: LINE), Legacy Reserves LP (NasdaqGS: LGCY), EV Energy Partners LP (NasdaqGS: EVEP) and Encore Energy Partners LP (NYSE: ENP)–mark-to-market accounting on hedges is another issue.

MLPs that produce oil and natural gas typically use options, swaps and other derivatives to lock in oil and gas prices for future production and limit exposure to volatile commodity prices. Linn, for example, hedges essentially 100 percent of its planned production for two to three years into the future and a smaller percentage of planned production for subsequent years.

But according to generally accepted accounting principles (GAAP), the value of these hedges must be marked to market each quarter. If oil prices rise in a particular quarter, the value of future hedges would, by definition, fall. Under US accounting rules, this would mean a paper loss on all hedges the partnership has in place, regardless of which year’s production they cover. Fret not. These hedges are structured so that the MLP owes no additional margin or deposit, regardless of what happens to commodity prices in the interim years.

Nevertheless, because of this accounting quirk, relatively small rallies in oil or gas prices can produce mythical losses; these paper losses don’t affect the cash the MLP receives from selling its oil or gas production in any particular quarter. MLPs aren’t trading oil and gas hedges in an effort to predict swings in oil and gas prices; for the most part, management teams rely on these instruments to lock in a fixed price for future production.

The more an MLP hedges production, the less sensitive cash flows are to near-term shifts in commodity prices. Unfortunately, the larger the hedge book, the bigger these phantom swings in the value of mark-to-market hedges.

Instead of looking at earnings, the key metric for MLPs is a non-GAAP measure called distributable cash flow (DCF). DCF is calculated by adding non-cash charges like depreciation, mark-to-market hedge adjustments and depletion back to earnings. A charge known as maintenance capital spending (CAPEX)–a measure of the spending needed to maintain assets in good working order and sustain cash flows–is subtracted from that adjusted earnings figure to obtain DCF.

To ensure a steady stream of income, investors should monitor the health of each MLP’s DCF over time, bearing in mind that each MLP calculates this figure in slightly different ways. We always look beyond the reported results to determine if these numbers make sense and are consistent over time and with industry peers.

This caveat aside, DCF is the figure we watch most carefully when evaluating results, and it’s also the most widely watched metric by institutional investors.

A word of caution: All MLPs must report earnings per unit (the equivalent of earnings per share) when they release quarterly results, and most Wall Street analysts publish earnings estimates by convention. Accordingly, many financial websites and news services will report these misleading earnings figures in headlines and state that a particular MLP has missed or beaten expectations; because computers automatically generate some of these headlines, this should come as no real surprise.

Investors have learned to ignore these headlines, though an individual name will sometimes react to bullish or bearish MLP “earnings” headlines in the wake of quarterly results; this knee-jerk reaction can provide an opportunity for nimble investors. We will always issue a Flash Alert if news or results from one of our recommended MLPs changes our opinion of the company or its ability to sustain distributions. 

In addition to looking at reported DCF figures and changes in quarterly distributions, the conference calls that follow each quarterly release are instructive. Conference calls help to highlight businesses showing relative strength and weakness within the MLP industry.

Two Conservative Portfolio recommendations have reported earnings results to date, Kinder Morgan Energy Partners LP (NYSE: KMP) and Enterprise Products Partners LP (NYSE: EPD). These two firms are among the first to release results and are bellwethers for the rest of the group; both Kinder and Enterprise are large MLPs involved in a number of businesses and, as such, provide bird’s-eye view of key trends. Here’s a review of both firms’ results.

Kinder Morgan Energy Partners raised its quarterly distribution from $1.07 per unit in the first quarter to $1.09 in the second, marking the 37th quarterly increase in the past 13 years. For full- year 2010, management expects to meet its target for a total distribution of $4.40 per unit, implying that it will increase its payout over the next two quarters.

Kinder Morgan Energy Partners’ adjusted distributable cash flow (DCF) was $1.06 per unit in the second quarter and $2.24 per unit in the first half. The partnership didn’t fully cover its distribution for the second quarter but managed to cover its first-half payout by roughly 1.04 times.

Normally, we’d be concerned about an MLP that fails to cover its payout in any single quarter, and 1.04 is a tight coverage ratio, even for a large, well-diversified operator such as Kinder Morgan Energy Partners. But in this case the MLP’s lack of coverage isn’t a major concern; the outfit’s underlying businesses continue to perform, and additional cash flows will kick in the in latter half of the year. In addition, Kinder Morgan Energy Partners’ second-quarter DCF excludes some one-time benefits the MLP received from its general partner; the MLP’s actual coverage is a lot better than it first appears.

One of the most important projects Kinder has underway in the near term is KinderHawk Field Services, a joint venture (JV) with one of the largest  and best-positioned exploration and production firms in the Haynesville Shale, Petrohawk Energy Corp (NYSE: HK). To form the JV, Kinder Morgan Energy Partners acquired a 50 percent interest in Petrohawk’s gas gathering and treating facilities in the Haynesville for a little over $900 million and plans to expand these assets aggressively.

Gathering lines are small-diameter pipelines that connect individual wells to the pipeline network. Treating plants remove naturally occurring carbon dioxide from natural gas. The Haynesville Shale is attractive for two interrelated reasons: Prolific wells and a low-cost of production. In fact, many operators remain profitable even with gas prices at depressed levels.

That’s why activity in the play has continued to pick up over the past year despite weak gas prices and a slowdown in production from conventional gas plays; more drilling means more wells that need to be hooked up to gathering pipelines.

The Haynesville is located deep underground and contains “dry” gas that’s devoid of natural gas liquids (NGL). However, Haynesville gas tends to be relatively high in carbon dioxide; increased production from the region will require additional gas treating capacity.   

KinderHawk contributed cash flows to Kinder Morgan Energy Partners in the second quarter, but the amount was modest because the JV had existed for a little over a month. Management estimates that a throughput of roughly 800 million cubic feet per day of gas by the end of 2010. Over the long term, the partners are targeting a throughput 2 billion cubic feet of gas per day.

Management also noted that the firm is ahead of plan on pipeline volumes, thanks to robust demand from third-party producers. This news sets the stage for KinderHawk to record significantly higher distributable cash flows later in the year, supporting an increase in distributions.

And last quarter the MLP’s general partner (GP) once again demonstrated its support for the limited partner. As we’ve explained in prior issues, the GP manages an MLP’s assets, receiving a fee known as an incentive distribution right (IDR) for its services. These IDRs are typically based on the distributions paid to MLP unitholders; as distributions reach certain threshold tiers, the general partners’ IDRs rise. This structure incentivizes distribution growth.

As part of the financing for the KinderHawk deal, Kinder Morgan Energy Partners’ GP agreed to forego a significant portion of the IDRs it would normally receive from the JV until after 2011. By foregoing IDRs, the GP will effectively increase Kinder Morgan Partners’ DCF over the next six quarters, giving the project plenty of time to ramp up toward full capacity.

Another case in point: Kinder Morgan Energy Partners’ $206 million settlement in the second quarter. For several quarters, Kinder has negotiated a rate case with a group of shippers on one of its refined products pipelines; some of the cases involved date back to the early 1990s. The company paid out $206 million to finally settle these claims. However, that cash isn’t coming out of your pocket; the GP covered the cost of the settlement by accepting lower IDRs.

Also note that payments to the LP as a result of the resolution of this rate case are not included in management’s DCF calculation.

The startup of the KinderHawk JV garnered much of the attention in the quarter but away from the limelight, Kinder’s other major businesses also appear on track. Its refined products pipeline business reported an uptick in volumes transported, suggesting that the recovery in US oil demand is for real.

California increased its mandatory ethanol blend rate to 10 percent, and Kinder Morgan Energy Partners is a major player in that state; ethanol volumes soared 58 percent over the same quarter one year ago. But even if we adjust for the new mandate, refined-products volumes were up a 0.5 percent from a year ago–the first increase in refined-products volumes since the third quarter of 2007. Management also indicated that July volumes are on course to top last year.

Diesel volumes were particularly strong in California, up 5 percent from a year ago, suggesting that the economic recovery continues.

And don’t forget the associated ethanol business. As I noted earlier, the jump in California’s blend mandates pushed volumes sharply higher; it’s impressive how quickly this business has grown for Kinder Morgan Energy Partners. The company was quick to invest in terminals and other infrastructure needed to blend and transport the fuel; management estimates that the firm handles roughly one-third of all ethanol volumes used in the US.

The bulk terminals business also exceeded management’s expectations. Terminals handle the import and export of dry-bulk cargoes such as steel and coal. Management noted an increase in steel volumes for the quarter, benefitting from a jump in capacity utilization (the percentage of plants in operation) at US steel plants. Capacity utilization stands at 75 percent, up from less than 50 percent at the same time in 2009.

Coal was another highlight of the second-quarter conference call. Coal exports from its Gulf Coast and West Coast terminals increased significantly, a sign that international coal demand remains strong.

One business line that showed real weakness was the carbon-dioxide segment. Kinder Morgan Energy Partners transports carbon dioxide for use in enhanced oil-recovery projects, where operators pump the gas into mature oilfields to aid production.

As part of this business, the outfit produces some crude oil and is exposed to fluctuations in the price of the commodity. Kinder Morgan Energy Partners mitigates this exposure in two ways: The commodity-sensitive business is a small portion of the firm’s total revenues, and management uses hedges to lock in oil prices.

Nonetheless, Kinder isn’t fully hedged, and the MLP’s plan at the beginning of the year called for oil prices to average around $84 a barrel. Every $1 per barrel deviation from that average price results in a roughly $6 million hit to the bottom line. That’s not much when you consider that Kinder’s distributable cash flow was north of $600 million in the first half of the year, but it’s still meaningful.

But oil prices have firmed up after briefly dipping below $70 a barrel in late May. With US demand recovering, oil inventories beginning to normalize and Asian demand still strong, I see considerable upside for crude into the back half of the year. Any upside for prices would be a nice tailwind for Kinder Morgan Energy Paqrtners’ carbon-dioxide business, reversing any second quarter shortfall.

And Kinder has a number of major projects slated for completion in 2011 and 2012, which bodes well for distribution growth.

The company has formed a JV with Copano Energy LLC (NasdaqGS: CPNO) in the Eagle Ford Shale of south Texas. This shale play is red hot right now because it’s cheap to produce, and portions of the field are rich in crude oil and/or NGLs. The JV includes an 85-mile pipeline and processing assets and is due to commence operations in summer 2011; Kinder Morgan Energy Partners already has signed agreements covering 200 million cubic feet per day of throughput.

Kinder completed a non-binding open season for a NGL pipeline in the Marcellus region of Appalachia. A non-binding open season is essentially a way for Kinder to propose a new pipeline and allow potential shippers to express interest in contracting for capacity. Apparently, the demand warranted a 230-mile pipeline from the Marcellus to Sarnia, Ontario; the firm started to apply for permitting on the pipeline and is working to sign up commitments. If permitting goes according to plan, the new pipeline could be up and running by the third quarter of 2012.

The Fayetteville Express Pipeline is capable of transporting 2 billion cubic feet of gas per day from Arkansas’ Fayetteville Shale, another low-cost play. This pipe is ahead of schedule and under budget; management noted that the pipeline should be operational before year-end.

All told, Kinder Morgan Energy Partners is a large, well-diversified MLP with an attractive slate of near-term and longer-term organic expansion projects. Management has been quick to enter key shale-gas fields such as the Haynesville and Eagle Ford, either through JVs or by building new pipelines to leverage its existing assets. Disappointing DCF isn’t likely to persist, and management signaled its confidence by sticking with its full-year distribution targets. Kinder Morgan Energy Partners LP remains a buy in our Conservative Portfolio under 70.

Looking to hold Kinder Morgan Energy Partners in an IRA or add exposure to this outfit over time? Consider buying Kinder Morgan Management (NYSE: KMR), whose only assets are units in Kinder Morgan Energy Partners. But whereas Kinder Morgan Energy Partners pays a cash distribution, Kinder Morgan Management offers additional units–a sort of automatic distribution reinvestment plan. 

Enterprise Products Partners reported a rock-solid second quarter and announced its 24th consecutive quarterly distribution increase, to $0.575 per unit. DCF of nearly $0.75 per unit covered that payout 1.3 times–a high coverage ratio for a midstream MLP. Management has retained about $256 million in excess DCF to fund expansion projects.

The partnership’s overall results were expected to be positive, but some analysts had worried about the outlook for the company’s NGL-related businesses. Enterprise Products Partners owns NGL pipelines, processing capacity for separating NGLs from raw natural gas, and fractionation capacity for separating NGLs into various components. Analysts were concerned because a barrel of NGLs typically hovers around 60 percent of the cost of a barrel of crude oil, and NGLs prices tend to follow crude oil over time. But check out the graph below.

Source: Bloomberg

This graph tracks the price of a typical mixture of ethane, propane, butane and natural gasoline. Despite the long-term correlation between oil and NGL prices over the long term, the value of these two commodities have diverge over the past two months; NGL prices have trended slightly lower, while oil prices have rallied towards $80 a barrel.

The price of NGLs and crude oil sometimes diverge over short periods, but some observers worry that this trend stems from weaker demand. And higher inventories of ethane have fueled concerns that prolific NGL production from shale-gas sets the stage for a chronic oversupply of NGLs and a structural decline in NGLs prices relative to crude.

As many of Enterprise Products Partners’ processing and NGL transport businesses are fee-based, a long-term decline in NGL prices wouldn’t be catastrophic and likely wouldn’t necessitate a cut in distributions. However, a shift in NGL pricing and demand could negatively impact what has been an important growth business for Enterprise and many other MLPs in recent quarters.

Enterprise’s management team obviously knows about these lingering fears and was quick to address them during prepared remarks and during the question and answer period. Management remains extremely bullish about the NGL business and noted that demand remains red hot amid a structural change in the US and global petrochemical industries.

Ethylene is the basic building block for most types of plastic and is one of the most important petrochemicals. To produce ethylene, chemical companies have two basic options for raw material: naphtha derived from crude oil or ethane or propane processed from raw natural gas. As one would expect, relative prices drive this input decision.

Because of high oil prices and prolific NGL production from many of North America’s shale fields, there’s no contest anymore: Any petrochemical processor capable of using ethane and propane will favor these hydrocarbons over naphtha. In the second quarter, a whopping 82 percent of ethylene production capacity used NGLs as an input. The growing use of NGLs as a petrochemical feedstock is an important source of incremental demand.

Enterprise Products Partners regards this situation as sustainable and doesn’t anticipate demand to weaken. Management noted that profit margins available to chemicals producers for ethylene and propylene production were at the highest point since 2005, when hurricanes Katrina and Rita temporarily disrupted production capacity and sent prices sharply higher.

To capture these attractive margins, petrochemicals plants in the US are running at 91 percent of nameplate capacity–an extraordinarily high utilization rate.

For most of the quarter, US ethylene supplies were tight, pushing up prices and margins. Toward the end of the quarter, that situation eased slightly; ethylene production facilities that were shut down for maintenance came back online. However, Enterprise Products Partners noted that the ethylene market continues to be undersupplied. In fact, when a major production facility was stopped temporarily in early July, ethylene prices jumped immediately.

With existing capacity running at close to full utilization, management also highlighted mounting evidence that producers are planning new petrochemicals production capacity. Examples include a US vinyl producer announcing a capacity expansion earlier this year, Eastman Chemical’s (NYSE: EMN) decision to restart an ethylene plant that’s been shut down since late 2008, and informal discussions Enterprise Products Partners has held with producers looking to expand capacity.

Ethane and propane are the preferred feedstock for these expansion projects; NGL demand should increase further. Over time producers that still use uncompetitive naphtha feedstock could convert to NGLs, another source of incremental demand.

Exports are another potential release valve for US NGLs. Enterprise Products Partners announced that its NGL exports averaged 93,000 barrels per day in the second quarter–close to triple the average in second quarter 2009.

And management noted that several pipeline projects aim to move NGLs from the US to petrochemicals plants in Canada, an astounding shift; traditionally, Canadian plants have used local NGLs and even exported some excess to the US. Examples of the latter trend includes Kinder Morgan Energy Partners’ planned NGLs pipeline for moving gas from the Marcellus Shale to Sarnia, Ontario.

Why, then, did NGL prices decline in June? Enterprise Products Partners attributed the bout of weakness to the seasonal shutdown of US ethylene capacity for maintenance. The firm estimates that stopping these plants reduced ethane demand by 6.6 million barrels, elevating ethane inventories toward the end of the quarter.

With those plants now back online, management expects ethane inventories to decline through the balance of 2010, pushing prices higher.  Enterprise Products Partners is a major player in NGLs, and management doesn’t make such predictions lightly; this is good news for the company and Targa Resources Partners LP (NYSE: NGLS).

In addition to management’s comments on NGLs, the conference call yielded two other key points.

Enterprise Products Partners continues to see expansion opportunities in US shale plays. These comments echoed statements from Kinder Morgan Energy Partners. In particular, Enterprise Products Partners continues to build its footprint in the liquids-rich Eagle Ford Shale and currently feeds around 200 million cubic feet of gas per day into its system, up from essentially nothing one year ago.

In addition, the outfit’s Haynesville extension pipeline project is on track for completion next year.

The Obama administration’s moratorium on deepwater drilling in the Gulf of Mexico affected Enterprise Products Partners only modestly. The firm is one of the only MLPs with direct exposure to the deepwater Gulf, though it’s an almost negligible percentage of total revenues and will have no significant impact on the partnership’s distribution.

Throughput volume at its offshore Independence Hub fell from 891 billion BTUs in the second quarter of 2009 to 635 billion this year. Management expects full-year volumes of 500 to 600 billion BTUs per day for the remainder of the year.

Many of the wells hooked up to the Independence Hub are older and require ongoing maintenance, or “workovers” in industry parlance, to maintain production. Although the US drilling moratorium doesn’t prohibit all workovers, it has created a great deal of uncertainty, delaying permit approvals and sparking an exodus of personnel and equipment from the region. Amid this upheaval, many workovers weren’t completed.

One well connected to the hub also watered out–that is, the amount of water produced with oil and gas volumes sharply increased to the point that the well became unproductive. Normally, it might be possible to remedy the situation, but the moratorium has disrupted operations in the region.

None of this is a particular concern for Enterprise Products Partners, but it’s interesting from a macro perspective, as it demonstrates that the moratorium continues to have a material effect on US oil and gas production from the Gulf.

Enterprise Products Partners LP continues to execute; however, the recent rally has put the stock beyond our buy target. Buy Enterprise Products Partners LP when it dips below 38.