Stock prices don’t move in straight lines; even the strongest bull markets are interrupted by periodic corrections.

Since MLP Profits launched, we’ve warned investors not to be alarmed by the group’s occasional retrenchments. In fact, we’ve often recommended that investors regard a pullback of 5 to 10 percent as an opportunity to add to existing positions or buy a Portfolio holding that’s traded above our buy targets for some time.

Although buying high-quality MLPs when the stock price dips has paid off over the past two years, even modest corrections can be unsettling when you have money on the line.

Over the past year the Alerian MLP Index–a good proxy for the group as a whole–has suffered five pullbacks of varying magnitude, including a 19 percent decline in April and May 2010.

The key to fortifying your courage during these anxious pullbacks is to monitor both company-specific and macro trends. For example, the 19 percent pullback in the Alerian MLP Index stemmed from turmoil in EU credit markets, fear of a global double-dip recession and the flash crash that occurred on May 6, 2010.

In a series of articles in spring 2010, including Time to Buy and a Flash Alert  issued on May 6, we explained why neither the Europe’s woes nor the flash crash would affect MLPs over the long term and recommended that readers take advantage of an attractive buying opportunity.

Investors who heeded this advice earned impressive returns; the group rallied to new highs in the second half of the year, and many of our favorites boosted their distributions.

But investors shouldn’t rely on stop-loss orders and trailing stops as a risk management tool. These orders instruct your broker to automatically sell a particular stock when it touches a predetermined level.

Although these tools can limit the potential downside in corrections, these orders invariably are executed at the worst possible times, turning paper losses into real ones. The May 6, 2010, flash crash demonstrates the dangers that these risk management tools pose: Investors who placed stops on MLPs sold their positions and booked substantial losses, missing out on the subsequent recovery later that day. Most MLPs haven’t come close to revisiting the lows hit during the flash crash.

Although stop-loss orders can work well for traders placing short-term bets, they’re not appropriate for the MLPs in our model Portfolios.

The Recent Correction

In January 2011, the Alerian MLP Index pulled back, though units of some MLPs suffered declines of a greater magnitude. The names that are most vulnerable to these periodic selloffs tend to have more exposure to commodity prices and economic conditions. We’ve placed our riskier picks in the Aggressive Portfolio and, to a lesser extent, the Growth Portfolio.

Here’s a look at the maximum decline for each of our recommendations in January, calculated by subtracting the stock’s late January low from its high earlier in the month. Note that these numbers are based on intraday prices, not where the stocks finished at the close; this number represents the change between the monthly high and monthly low.

Source: Bloomberg

The primary driver of the pullback was a classic case of profit-taking after a nice run-up. The Alerian MLP Index gained roughly 36 percent in 2010, one of its best single-year performances in history. It’s hardly surprising that investors sought to book gains after year-end.

When you consider that our Aggressive Portfolio recommendations beat the total return for the Alerian MLP Index by more than 10 percent in 2010, it’s also not a big surprise that these commodity-sensitive names saw the largest average pullbacks in January.  The average Aggressive Portfolio holding pulled back a bit over 10 percent from high to low in January. A modest correction in crude oil prices toward the end of month also hit these recommendations more than the average MLP.

However, investors shouldn’t fret about macro issues affecting the group: Commodity prices should continue to strengthen this year, and credit markets appear to have come to grips with the EU sovereign debt crisis.

Crude Oil

Supply and demand conditions should continue to support higher crude oil prices, despite the occasional correction. Global oil demand grew by 2.7 million barrels per day in 2010– the fastest pace since 2004–and is projected to increase by another 1.4 million barrels per day this year. Demand hit an all-time quarterly high in the third quarter of 2010 and a new annual high last year. In 2011 demand is expected to top 89 million barrels per day for the first time in history.

Global oil supplies aren’t growing fast enough to meet demand. Non-OPEC supply expanded by 1.1 million barrels per day in 2010 and is expected to decline by roughly half in 2011. Meanwhile, OPEC hasn’t changed its official production quotas in two years. Although some members are producing above their targets, OPEC still isn’t supplying enough oil to meet global demand growth. With rising demand and little supply growth, oil inventories have declined in the US and around the world.

Source: Energy Information Administration

This graph shows the total change in US oil and refined-product (gasoline, diesel and jet fuel) inventories between the end of August and the end of December for each year going back to 1990. In 2010 US inventories fell by just under 80 million barrels, the second-fastest pace in the past two decades. This reduction represents more than three times the five-year average pace of inventory drawdowns over this time period.

This trend points to two major forces at work in US oil markets: slumping imports and surging demand. The decline in imports likely reflects rising oil demand in emerging markets, coupled with tighter supplies in these regions–a combination that attracts additional imports. At the same time, an accelerating US economy also bolstered oil demand, further drawing down inventories.

Short-term corrections aside, the supply and demand picture should remain tight throughout 2011. Either OPEC will need to supply more oil or prices will rise to a level that cools demand growth.

OPEC appears to be comfortable with oil prices at $100 per barrel. If OPEC boosts output, its spare capacity–the amount of idled production that can be readily brought online–will fall by a commensurate amount. Such production increases historically have been bullish for prices, as investors fret about falling spare capacity.

Few MLPs operate businesses with direct exposure to oil prices. Midstream MLPs such as Conservative Portfolio holdings Sunoco Logistics Partners LP (NYSE: SXL) and Magellan Midstream Partners LP (NYSE: MMP) own pipelines that transport oil and refined products, but the fees they receive aren’t based on oil prices. The regulated tariffs charged by interstate pipelines provide a stream of steady, reliable cash flow regardless of oil prices and economic conditions.

Oil and natural gas producers such as Aggressive Portfolio holdings Encore Energy Partners LP (NYSE: ENP), Legacy Reserves LP (NasdaqGS: LGCY) and Linn Energy LLC (NSDQ: LINE) have some exposure to commodity prices. But most producers organized as partnerships use hedges to lock in prices for their production. For example, Linn Energy’s hedges cover almost all of its oil production over the next three years; a temporary dip in oil prices has no real impact on the firm’s cash flow.

That being said, a dip in oil prices sometimes prompts investors to sell their MLP holdings, even though a pullback in crude won’t the partnerships’ bottom line.

Natural Gas Liquids (NGL)

The prices of most natural gas liquids (NGL)–hydrocarbons such as ethane, propane and butane that are sometimes produced alongside natural gas–continue to track oil prices.

The petrochemical industry relies on NGLs as a feedstock for plastics and other products, while refiners use butane and isobutene. Propane is used primarily for heating or fuel.

Natural gas producers have ramped up activity in NGL-rich shale plays such as the Marcellus Shale and Eagle Ford Shale, substantially increasing the supply of these hydrocarbons and prompting some investors to worry that the glut could depress prices.

But that hasn’t happened.

Source: Bloomberg

As you can see, NGL prices tend to track the value of crude oil rather than natural gas. A barrel of mixed NGLs–a combination of ethane, propane and butane–currently trades at slightly more than $53 per barrel, or about 60 percent of the price that a barrel of West Texas Intermediate crude commands. Over the past three years, a barrel of mixed NGLs has fetched an average of 57 percent of the price of a barrel of oil; in today’s market, the value of NGLs relative to crude is above the recent average.

Ethane is the most common and least valuable NGL. Plentiful in many shale fields, ethane is at the biggest risk of oversupply. Unlike other oil and other NGLs, ethane has yet to eclipse its spring 2010 high. But a barrel of ethane currently goes for about 30 percent of the price of a barrel of oil–slightly less than the long-term average of 33 percent.

Linn Energy and other upstream operators that produce NGL often hedge this output to limit short-term fluctuations in distributable cash flow.

Meanwhile, Targa Resources Partners LP (NYSE: NGLS) and other MLPs that own gas processing (removing NGLs from natural gas) and fractionation (separating the NGLs into individual components) assets also have some exposure to NGL prices.

We explained this business at length in the March 15, 2010, issue MLPs and Natural Gas Liquids. These MLPs tend to benefit when NGLs are in demand and the price of these coproduced hydrocarbons are higher relative to natural gas. With solid NGL prices and depressed natural gas prices, MLPs that operate processing and fractionation facilities should continue to do well.

Natural Gas

Our outlook for natural gas prices hasn’t changed since the Sept. 7, 2010, issue The Natural Gas Equation. Although US demand for natural gas continues to pick up as the economy recovers, that’s only half the equation: A surge in natural gas output has swamped demand and kept a lid on prices.

Source: Bloomberg

This graph shows the US natural gas rig count, which measures the total number of land-based drilling rigs in the US actively drilling for gas. As you can see, the rig count soared through May 2010 despite depressed natural gas prices. Even with gas prices near a multiyear low, the rig count had declined only slightly at the end of 2010.

There are four primary reasons why the gas-directed rig count continued rise despite weak gas prices and excess production:

1. High-value liquids. Some producers targeted plays rich in wet gas, or gas that contains significant quantities of NGLs. A barrel of NGLs is typically worth about 55 to 65 percent of a barrel of oil, providing superior economics.
2. Leasehold contracts. Many leasing contracts contain clauses that force companies to produce gas from their leaseholds within a specific time frame or forfeit these claims. These terms prevent producers from sitting on leased land until gas prices are attractive. To secure leaseholds, producers have continued to drill even though the economics of gas production have deteriorated.
3. Experience. Producers have become more efficient at extracting natural gas from shale, lowering the cost of production and break-even prices.
4. Hedges. Many producers hedge at least a small percentage of their output, limiting exposure to spot or near-month gas prices. Hedges improve profitability.

The natural gas supply outlook is unlikely to improve in the first half of 2011; prices should remain below $5 per million British thermal units. The best measure of gas prices is the 12-month natural gas strip, or the average of the next 12 months’ worth of gas futures contracts. The strip has rallied from its October 2010 low of less than $4 per million British thermal units to about $4.60 per million British thermal units. But gas prices often enjoy a bump during the winter, reflecting optimism about strong heating demand.

This winter has brought above-average snowfall and colder-than-normal temperatures to much of the US, driving demand for natural gas. Although the cold weather has helped support prices, gas storage levels remain elevated and producers have yet to rein in production. Don’t expect natural gas prices to mount a sustainable recovery in the first half of 2011.

Several operators have indicated that their acreage in the Haynesville Shale and other plays will be held by production by midyear, allowing them to shift their rigs to oil- or NGL-rich fields. A number of producers also noted that they have fewer hedges covering their gas production in the back half of 2011.

These two factors suggest that the US natural gas rig count could decline significantly in the second half of 2011, particularly in dry-gas basins such as the Haynesville and higher-cost plays such as the Barnett Shale. Drilling activity should continue apace in the liquids-rich portions of Pennsylvania’s Marcellus Shale and the Eagle Ford Shale in south Texas.

Although gas prices won’t have much upside in 2011, a decline in the rig count would improve sentiment surrounding natural gas-levered stocks in the back half of 2011. The long-term outlook remains sanguine. Natural gas is the cleanest-burning fossil fuel and will be a major part of any successful attempt to reduce America’s dependence on foreign energy supplies. Gas is also a crucial part of any legitimate effort to reduce carbon dioxide emissions.

The good news is that MLPs generally have little negative exposure to natural gas prices. Most MLPs own midstream assets such as pipelines, storage facilities and processing plants.

Cash flows from pipelines and storage facilities don’t depend on gas prices. In fact, the oversupply from the nation’s prolific shale gas fields have increased demand for new pipelines and storage, a net positive for MLPs. In addition, many of the nation’s liquids-rich plays require new infrastructure to process and transport this new output. The majority of these projects are backed by long-term contracts with producers that guarantee attractive returns.

Producers, on the other hand, face the biggest challenges in this pricing environment. Of the names in the model Portfolios, EV Energy Partners LP (NasdaqGS: EVEP) faces the strongest headwinds from gas prices.

Linn Energy has hedged all of its gas production for the next five years, limiting its exposure to near-term pricing. Meanwhile, Legacy Reserves and Encore Energy Partners have production profiles that are heavily tilted toward oil and NGLs.

But natural gas accounts for about 72 percent of EV Energy Partners’ reserves and 69 percent of its third-quarter production. As we explained in the Dec. 8, 2010, issue Higher Oil Prices, More Upside, EV Energy Partners has hedged the majority of its 2011 and 2012 gas production and has delayed gas-focused projects that wouldn’t be profitable at current prices. Management has also focused its investment dollars on the oil- and liquids-rich plays in its portfolio.

Despite these moves, the company’s distribution growth has slowed to a crawl over the past few years. And EV Energy Partners only covered its third-quarter payout by 1.03 times, a razor-thin margin. This coverage ratio should increase over time, thanks to hedges and new projects. The partnership is also unlikely to cut its payout this year, even if a shortfall in distributable cash flow forces it to dip into cash reserves. We remain impressed with the company’s top-notch management team and blemish-free history of increasing distributions by at least a small amount each quarter.

For much of the past two years, we’ve rated EV Energy Partners as a buy because the MLP offered a higher yield than units of safer names such as Linn Energy. But EV Energy Partners’ units currently yield 7.1 percent–just 0.3 percent above Linn Energy’s 6.8 percent yield and less than the yields offered by Legacy Reserves and Encore Energy Partners. Given its gas exposure and valuation, we can’t justify holding EV Energy Partners in the model Portfolio.

That’s why we downgraded EV Energy Partners to a sell in the Jan. 14, 2011 issue Forecasts and Answers, booking a total return of 142.8 percent since we added the stock to the Portfolio in August 2009.

Plenty of Credit

MLPs typically raise money to fund growth by issuing new units or debt. When MLPs announce a secondary offering of units, the stock typically dips in reaction to the news–selling new shares dilutes the value of existing unitholders’ stakes.

That being said, MLPs usually use the cash raised from unit offerings to fund acquisitions or organic expansion, investments that eventually boost distributable cash flow and provide the scope for higher distributions. As Roger explained in the Dec. 20, 2010 issue The Power of Equity, any dip following a new unit issue has typically marked an excellent buying opportunity.

Few fundamental shocks can stop MLPs in their tracks faster than a credit freeze. In late 2008 even the best-capitalized MLPs struggled to access the capital markets and were forced to hoard cash. Many MLPs saw their credit lines cut during the crisis, as banks were reluctant to lend money.

But the credit faucet is back on, allowing MLPs to borrow money at record-low spreads over US Treasuries. For example, B-rated Linn Energy sold $1 billion in 10-year bonds in September 2010 that yielded a little more than 7 percent. These bonds have rallied sharply since issued, yielding less than 7 percent and just 3.5 percent more US 10-year Treasury notes. Meanwhile, BBB-rated Magellan Midstream Partners has 10-year bonds that yield about 1 percent more than comparable Treasuries.

The yield on the 10-year Treasury note soared by 100 basis points (1 percent) between mid-October and the end of 2010. Some have asked if the uptick in government bond yields represents a challenge for the MLPs. Generally, the answer is no.

Source: Bloomberg

This graph depicts the spread between an average 10-year corporate bond rated BBB by Standard & Poor’s and a 10-year Treasury note. The spread spiked as high as 5.3 percent at the height of the credit crunch, when panicked investors piled their money into US government bonds.

But the credit market is far more sanguine today. Ten-year bonds issued by BBB-rated companies yield an average of just 2 percent over Treasuries. This spread tightened by about 50 basis points between October and December of last year, when the yield on US government bonds spiked by 100 basis points. In other words, investors are now leaving the safe haven of government bonds and jumping back into stocks and lower-quality corporate bonds.

Given these attractive spreads, it’s no surprise that US companies deemed sub-investment grade have issued a record $303 billion in new bonds over the past year. That compares to just $162 billion in 2009, $66 billion in 2008 and about $150 billion in 2006 and 2007.

Despite ongoing concerns about European sovereign debt, US credit markets are stronger than ever.

Stock-Specific Issues

Although strong fundamentals for many MLPs suggest that the recent pullback stemmed from profit-taking, some names pulled back for stock-specific reasons.

Aggressive Portfolio holding Navios Maritime Partners LP (NYSE: NMM) suffered a larger correction than most of our other recommendations because of weakness in the dry-bulk shipping market, the bankruptcy of Korea Line Corporation (KLC) and downgrades from two prominent brokerage firms.

Navios owns a fleet of dry-bulk ships that transport commodities such as metals, coal and grain. Although demand for these vessels has been strong in recent years, a glut of new ships has raised concerns that the market may be oversupplied. Some estimate that the global fleet of dry-bulk ships will grow by as much as 15 percent in each of the next two years.

The massive flooding in Australia has also weighed on day rates. The deluge has idled coal mines and destroyed export-related infrastructure, particularly in Queensland province. And Australia’s rainy season continues for at least two more months. A number of dry-bulk ships that would normally transport Australian coal to India, China and other end markets are now without work. These disruptions have depressed rates.

KLC, Korea’s second-largest operator of dry bulk-ships, is a casualty of the weak market. The company leases the majority of its roughly 150 dry-bulk vessels under long-term contracts known as time charters. Unfortunately for KLC, the company signed many of its time charter deals before the 2008 financial crisis, when ships were in tight supply and rates touched hit a record high. For some classes of dry-bulk ships, these peak day rates were more than 20 times today’s going rate. Paying sky-high rates in a weak market forced KLC to declare bankruptcy.

This bankruptcy is bad news for KLC’s counterparties as well. Companies that chartered ships to KLC enjoyed rates that were many times what the current market would bear. But KLC’s bankruptcy means the firm will no longer be paying for these ships.

Eagle Bulk Shipping (NasdaqGS: EGLE) was among the hardest hit, as the company leased a relatively large number of ships to KLC and is likely the most exposed of the major operators in terms of revenue. Navios Maritime Partners also had leased one of its ships to KLC, and the stock sold off in response to the news.

But Navios Maritime Partners has no exposure to counterparty risk from KLC or any of its other major customers: The MLP insures the value of its long-term contracts against such risks. If KLC fails to pay under the terms specified in the charter, Navios Maritime Partners will receive an insurance payment to make up the difference; KLC’s bankruptcy won’t impact the MLP’s cash flow.

Moreover, management’s policy of booking all of its ships under relatively long-term, insured time charters protects the MLP from short-term weakness in dry-bulk rates. None of the firm’s ships will go off-contract in 2011, and only three of its existing time charters will expire in 2012–two in November 2012 and one in the summer.  

Of course, if charter rates remain depressed when Navios Maritime Partners’ long-term contracts expire, the firm could find itself in trouble. But the expansion of the global dry-bulk fleet should slow markedly by the end of 2012, strengthening the market.

The two brokerage firms that downgraded Navios Maritime Partners cited negative sentiment surrounding the dry-bulk industry and the stock’s strong performance in 2010–developments that make the stock vulnerable to profit-taking.

We expect Navios Maritime Partners to continue to outperform its peers because itslong-term time charters insulates it from the depressed rates plaguing the spot market.

The shipper posted solid fourth-quarter results released in late January and boosted its quarterly payout by a full penny to $0.43 per unit. Over the past few years, Navios has tended to boost its payout in half-penny increments; the most recent increase is a sign of strength.

The firm has continued to grow its distribution because of drop-down acquisitions from its parent company, Navios Maritime Holdings (NYSE: NM). In 2010 the MLP purchased five vessels from its parent and signed those vessels onto long-term contracts at rates that generate positive distributable cash flow. Roger outlined the details of some of the company’s most recent deals in The Power of Equity

With a yield of 9 percent and little near-term risk from depressed dry-bulk rates, Navios Maritime Partners LP remains a buy under 20.