Many investors mistakenly assume that collapsing commodity prices were the biggest challenge master limited partnerships (MLP) faced in fall 2008 and early 2008.

Some MLPs have exposure to the price of oil, natural gas and natural gas liquids (NGL) and a handful of smaller names had to cut their distributions when energy prices plunged.

But these firms represent the exceptions rather than the rule. Most MLPs have only modest exposure to economic conditions and commodity prices, thanks to a combination of hedges and long-term, fee-based contracts. Although the Great Recession and plummeting commodity prices were an undeniable hindrance, the vast majority of MLPs did not cut their payouts during the 2007-09 swoon.

In fact, frozen credit markets presented the biggest challenge to energy-focused MLPs at the height of the financial meltdown. New pipelines, processing plants and storage facilities require significant up-front investment to build. MLPs usually raise capital to fund these projects by issuing secondary units or tapping the credit markets; the credit crunch prevented MLPs from making these investments and growing their distributions.

To worsen matters, many MLPs relied on credit lines that needed to be rolled over frequently and were subject to periodic redeterminations. In some instances, the interest rates on these loans were indexed to the London Interbank Offered rate (LIBOR), which soared when the credit crunch hit.

Some MLPs relied on private investment in public equity (PIPE) deals in which the MLP would raise cash by selling shares of restricted stock to a hedge fund or other institutional investor. Desperate for liquidity at the height of the credit crunch, many of these investors dumped their MLP units to raise cash.

Although some MLPs still rely on credit lines, most have taken advantage of robust investor demand for additional units and ultra-low cost of capital available in the corporate bond market.

For example, Aggressive Portfolio holding Linn Energy LLC (NSDQ: LINE), which formerly relied on PIPE deals and credit lines to finance its growth projects, has replaced these funding sources with 10-year bonds. Unlike credit lines, these bonds don’t have to be rolled over frequently and carry fixed rates.

Now the company tends to use its $1.5 billion credit line to fund deals and then repays the balance by issuing new units or selling bonds. As we pointed out in the July 29 issue, Linn Energy has also announced a “continuous equity offering,” under which it will sell $500 million in units over a period of time. This is another easy and relatively inexpensive way for Linn Energy to raise capital without exposing itself to short-term financing risks.

In other words, most MLPs have restructured their finances, reducing their vulnerability in the event of another global credit crunch.

Reading the sensationalist headlines in the mainstream media, you might think that the EU’s ongoing sovereign-debt crisis had already shut down credit markets. But the TED spread–the three-month LIBOR minus the yield on a three-month Treasury note–continues to hover at levels that are well below those that prevailed in summer 2010, when Greece’s fiscal crisis first sent investors scurrying for the exit. When the Ted spread spikes, confidence in the banking system has eroded.

The past few weeks have brought a modest bifurcation in the corporate bond market. Investors have piled into the safest investment-grade names, depressing yields. Meanwhile, high-yield fare has come under modest selling pressure. Consider that the yield on Linn Energy’s 10-year bonds–rated B by Standard & Poor’s–has ticked up to about 7.5 percent in recent weeks. Nevertheless, this is a fraction of the almost 12 percent it paid to borrow money in early 2009.

With access to capital at relatively low costs, most of our favorite MLPs have no problem funding growth projects that will ultimately lead to higher distributions.

As we pointed out in a handful of Flash Alerts issued over the past two weeks, the recent selloff reflects weakness in the broader market; the group’s fundamentals remain intact. Although the stock market’s downdrafts can be terrifying, investors should regard these pullbacks as an opportunity lock in higher yields on our favorite MLPs.

Conservative Portfolio stalwart Enterprise Products Partners LP boosted its distribution for the 29th consecutive quarter, to $0.605 per unit from $0.595. That’s a 5.2 percent increase from year-ago levels.

The master limited partnership (MLP) generated second-quarter distributable cash flow (DCF) of $778 million, which covered its new payout by 1.6 times. If you exclude a one-time gain of $166 million related to the sale of the firm’s stake in Energy Transfer Equity LP (NYSE: ETE), Enterprise Products Partners still covered its payout by a comfortable 1.2 times.

Although some yield-hungry investors might grouse about Enterprise Products Partners’ conservative management and safety-first approach, the almost $500 million in DCF that the MLP has retained in 2011 reduces its need to issue additional units or sell bonds to fund expansion projects.

Arguably the steadiest and most dependable MLP in our coverage universe, Enterprise Products Partners turned in another solid performance in the second quarter. We closely scrutinize the MLP’s results and conference calls because management’s strategic decisions and capital expenditures often reveal emerging trends for the industry as a whole.

Although Enterprise Products Partners is involved in a number of midstream businesses, the booming market for natural gas liquids (NGL) remains one of the firm’s most exciting growth prospects. We covered this market at length in the March 25, 2011, issue, The Saudi Arabia of Natural Gas Liquids.

Here’s a primer for the uninitiated. Raw natural gas doesn’t consist solely of pipeline-ready methane, a hydrocarbon consisting of one carbon atom bound to four hydrogen atoms (CH4). The output from the wellhead often includes a variety of heavier hydrocarbons (NGLs) such as ethane (C2H6), propane (C3H8) and butane (C4H10).

Petrochemical producers use ethane, propane and butane as feedstock for ethylene, propylene or butadiene–the basic building blocks of three-quarters of all chemicals, plastics and man-made fibers.

Ethylene is a colorless gas used to synthesize polyethylene, polyvinyl chloride and polystyrene, plastics used in everything from food packaging to waterproof garments and synthetic fibers. Meanwhile, propylene is used to make polypropylene, a plastic used in electronics, automobile bumpers and consumer packaging. Synthetic rubber tires, latex gloves and nylon fibers wouldn’t exist without butadiene.

But NGLs aren’t the only feedstock used to produce these synthetic materials. For example, the American Chemistry Council estimates that Western Europe produces 70 percent of its ethylene from petroleum derivatives such as naphtha or gas oil.

As the petrochemicals industry regards these NGLs as an alternative to those derived from crude oil, the price of a barrel of NGLs tends to trade at a discount to crude oil but exhibits similar price trends. Despite weak natural gas prices in North America, NGL prices have followed oil prices significantly higher.

A revolution in the US NGL market has completely changed the dynamics of the global petrochemicals industry.

Over the past five years, oil and gas producers have developed a host of shale gas and oil fields in earnest. The Barnett Shale of north Texas was one of the first major tight-gas plays to enter commercial production, while drilling activity in 2011 has ramped up dramatically in the Eagle Ford Shale of south Texas and the Pennsylvania portion of the Marcellus Shale. The glut of natural gas from these and other prolific unconventional fields continues to depress US natural gas prices.

To improve profitability, producers have shifted their drilling activity from dry-gas fields such as Louisiana’s Haynesville Shale to NGL-rich plays such as the Eagle Ford. Meanwhile, the oil-laden Bakken Shale of North Dakota and the Permian Basin of west Texas also contain significant volumes of NGLs.

The Energy Information Administration (EIA) estimated US proved reserves of wet-gas at 284 trillion cubic feet at the end of 2009, up from 175 trillion a decade earlier. Since 2009, producers have developed and booked trillions of cubic feet worth of wet gas reserves in emerging shale plays.

Although exploration and production (E&P) names garner the most media attention for the shale gas revolution, energy-focused MLPs that build, own and operate the supporting midstream infrastructure arguably deserve just as many kudos. As production from emerging shale fields booms, demand for facilities to process this output and transfer it to markets also increases. Check out this map of the major shale oil and gas plays in the continental US.

Source: Energy Information Administration

Ten years ago, only a couple of these fields produced significant quantities of oil or natural gas. Three years ago, E&P outfits didn’t even discuss the Eagle Ford for fear of being elbowed out of the best acreage. With all of these discoveries and development, massive investments in new processing facilities and pipelines are needed to bring this oil, gas and NGLs to market.

Whereas US demand growth hasn’t offset the oversupply of natural gas, the petrochemical industry has welcomed the surge in NGL production. For the first time in decades, Dow Chemical (NYSE: DOW) and other firms are restarting shuttered ethane cracking facilities or contemplating the construction of new production plants. With an ample supply of NGLs, US manufacturers can produce many plastics and petrochemicals at a lower cost than international rivals which depend on naphtha and other petroleum derivatives as a feedstock. This development represents an absolute sea change from a few years ago.

NGL exports also ensure that supply doesn’t overwhelm demand–a release valve that the domestic market for natural gas currently lacks. For example, in 2010 chemical exports from the Port of New Orleans jumped by 34 percent. Enterprise Products Partners and a handful of other MLPs have invested in projects that will expand the nation’s NGL export capacity.

Enterprise Products Partners’ second-quarter earnings and management’s comments during an Aug. 9 conference call suggest that the supply and demand picture for NGLs remains bullish. The MLP”s NGL pipeline and services unit contributed $498 million to the firm’s overall gross operating margin (GOM), up 13 percent from a year ago. This was by far the largest single contributor to GOM.

Within this operating segment, the processing and marketing business–separating the NGLs from the dry gas and selling the products to chemicals companies–posted a $35 million increase in GOM from year-ago levels. These gains reflected strong demand for NGLs and an uptick in processing volumes over the past year. A series of new projects and contracts signed with producers in the NGL-rich Eagle Ford should boost Enterprise Products Partners’ fee-based revenue over the coming year.

Enterprise Products Partners gravitates toward contracts that charge a fixed, volume-based fee for its processing capacity, ensuring a reliable stream of revenue. That’s in contrast to percent-of-proceeds (POP) contracts in which the processor receives a percentage from the sale of the natural gas or liquids. In a keep-whole arrangement, the processor retains and sells the NGLs separated from the gas in exchange for compensating the producer for the energy lost when the liquids were removed. Both POP and keep-whole deals expose the processor to prevailing energy prices..

When energy prices collapsed in late 2008 and early 2009, several smaller MLPs sank into financial duress because of their penchant for inking processing deals that included exposure to commodity prices.

Enterprise Products Partners’ focus on fee-based revenue limits its exposure to volatile commodity prices and locks in reliable revenue streams, supporting steady distribution growth and making its one of the top picks in our Conservative Portfolio.

During the MLPs conference call to discuss second-quarter earnings, Chief Operating Officer Jim Teague also indicated that producers prefer to sign fee-based contracts with processors, most of which rely on high-value NGLs to boost well economics: “You couldn’t get a keep-whole contract right now if your life depended on it. The producer wants that exposure, which is fine with us because with it gives us certainty.”

Enterprise Products Partners’ NGL pipeline and storage division produced GOM of $143 million, up about $4 million from one year ago. Not only did the total volume of NGLs increase by roughly 3 percent to 2.3 million barrels per day, but the firm also exported about 10 million barrels of propane–18 percent more than in the second quarter of 2010.

The MLP also plans to take advantage of growing demand for midstream infrastructure in emerging NGL-rich fields. In the second quarter, the MLP held an open season to gauge interest in an expansion of its Mid-America NGLs pipeline system in the Rocky Mountains, home to the Niobrara and Unita plays.

Since the conclusion of the open season, the MLP has received long-term commitments for 50,000 barrels per day of capacity. Management expects shippers to exercise options to increase their total capacity to the full 85,000 barrels per day by the end of 2011. The expanded pipeline should come onstream in the third quarter.

This process reflects Enterprise Products Partners’ long-standing commitment to sustainable growth. Before the MLP breaks ground on a new project or allocates capital, management gauges its customers’ interest in the project by offering 10-year deals that guarantee it a minimum amount of cash flow.

The MLP is also working to roughly double its export operation on the Gulf Coast. Management noted that all of the firm’s export capacity for propane is booked through the end of 2012. Meanwhile, management is already in discussions that would book its additional capacity once the project is completed in 2012. All these multiyear deals charge preset fees that are independent of commodity prices.

Enterprise Products Partners’ NGL fractionation division posted GOM of $54 million in the second quarter, up over 50 percent from the prior year. Fractionators separate raw NGLs into discrete products for shipment to end-markets. The opening of a fourth fractionation facility at the MLP’s massive Mont Belvieu, Texas complex drove this huge jump in gross operating margin. With a fifth unit slated to come online by the end of 2011 and a sixth facility under construction, the fractionation capacity at Mont Belvieu will reach 450,000 barrels per day by the end of 2013.

This rapid expansion reflects rising demand from producers in the prolific Eagle Ford Shale, arguably the nation’s hottest unconventional play. Management noted that 180 rigs currently operate in the region and 1,100 wells have been sunk. An additional 400 wells have been drilled and await completion. With midstream constraints forcing Enterprise Products Partners to run a fleet of 125 trucks that shuttle crude oil from the Eagle Ford to Gulf Coast refineries, producers are eager to sign multiyear deals that guarantee access to pipeline, processing and fractionation capacity.

Over time, Enterprise Products Partners and other MLPs will build enough pipeline capacity to take these trucks off the road, but production from the Eagle Ford has overwhelmed the region’s existing midstream infrastructure.

Accordingly, growth projects in the Eagle Ford shale will account for a significant portion of the MLP’s capital budget over the next five years. In addition to expanding its fractionation facilities at Mont Belvieu, the firm plans to build about 300 miles of natural gas pipelines in the region, a 127-mile NGL pipeline and up to 900 million cubic feet of gas processing capacity. Also in the works are 220 miles of oil pipelines and a storage facility capable of holding 5 million barrels of crude.

Management is also contemplating a pipeline that would transport ethane volumes from the Marcellus Shale in Appalachia to the Gulf Coast, where many petrochemical plants are based. The project makes sense. Ethane production has ramped up quickly in the Marcellus Shale, and a recent outlet that transports 30,000 to 40,000 barrels per day to Sarnia, Ontario isn’t enough to handle the current output. This proposal would make extensive use of Enterprise Products Partners’ existing pipelines, limiting new construction to about 30 percent. Such an approach would reduce the time and cost involved in the project.

Although the firm’s NGL-related businesses led the way in the second quarter, its other operating segments also performed well. Bolstered by an uptick in fee-based revenue from its Texas pipeline network and San Juan gas-gathering system, the natural gas pipelines and services unit generated GOM of $54 million–an increase of more than 50 percent from the prior year.

Enterprise Products Partners is also working on a network of gas pipelines and treatment facilities to support the Haynesville Shale. Drilling activity has moderated in the Haynesville, as E&P firms have shifted their emphasis from dry-gas fields to liquids-rich plays that offer superior profitability. But the MLP’s cash flow won’t take a hit from diminished drilling in the Hayneville; the projects are backed by 10-year commitments that provide a guaranteed stream of fees, regardless of the utilization rate.

Rising output from the Eagle Ford and Barnett Shale fueled a 161 percent surge in Enterprise Products Partners’ oil pipeline business. The lone weak point in the MLP’s portfolio was the Seaway pipeline, which transports oil from the Gulf Coast to Cushing, Okla., the delivery point for West Texas Intermediate (WTI) crude.

WTI generally commands a slight premium to Brent crude oil, but that relationship has reversed over the past 12 months. Local supply conditions at the physical delivery point in Cushing are the culprit: Rising US imports of Canadian oil, higher domestic output from shale oil fields and an uptick in ethanol production have prompted pipeline operators to add new lines or reverse the flow of existing lines to carry crude south to Cushing and other refinery centers.

This shift has not only glutted storage facilities at Cushing, but the reversed pipelines have limited flows out of the hub. When an influx of crude oil overwhelms refining capacity, stockpiles build, and the price of WTI declines. This logistical logjam can only be resolved by the construction of new pipelines to move crude oil from Cushing to the Gulf Coast. At this point, no producer is looking to move oil to Cushing from the Gulf Coast.

The MLP sought to convince ConocoPhillips (NYSE: COP)–its partner on the Seaway pipeline–to reverse the flow from north to south, but the oil and gas giant rejected the idea. Now, Enterprise Products Partners plans to build a new pipeline that will transport oil from Cushing to the Gulf Coast. The firm is currently seeking commitments from customers before making a final investment decision.

The company’s offshore operations in the Gulf of Mexico also continued to struggle, posting a $19 million decline in GOM during the second quarter. Fortunately, the lingering aftereffects of the Obama administration’s moratorium on deepwater drilling should reverse as permitting picks up next year. Meanwhile, the firm only took a 2 percent hit to its overall GOM from its operations in the Gulf of Mexico.  

Enterprise’s fee-based revenue stream, track record of distribution growth and lineup of organic expansion projects make it one of the safest MLPs in our coverage universe.

As we pointed out in the Aug. 8 Flash Alert, Four Ways to Capitalize on the Selloff, strong fundamentals can’t protect units of our favorite MLPs when panic selling rules the day. But Enterprise Products Partners’ reliable cash flow insulates it from broader economic conditions and commodity prices; these short-lived selloffs mark an outstanding opportunity to pick up units on the cheap.

Magellan Midstream Partners LP (NYSE: MMP)

Owning pipelines that transport oil and refined products is one of the safest and steadiest businesses for an MLP. Even during a severe economic downturn, throughput declines by only a modest amount. In addition, many of these pipeline operators charge government-regulated tariffs that include annual adjustments for inflation.

One of the largest and best-capitalized MLPs, Magellan Midstream Partners LP owns almost 10,000 miles of pipelines and more than 50 crude oil and refined-product terminals.

In the second quarter, Magellan Midstream Partners reported DCF of $117.6 million–up about 17 percent from year ago levels–and boosted its quarterly distribution  by 7 percent from year-ago levels to $0.785. The firm’s cash flow covered this distribution an impressive 1.33 times.

Magellan Midstream Partners also evaluates the performance of its individual business segments by based on gross operating margin. On that basis, the refined-products and crude-oil pipelines groups accounted for the majority of the firm’s GOM. Much of the MLP’s year-over-year growth in GOM stemmed from the acquisition of BP’s (LSE: BP, NYSE: BP) in September 2010. Excluding these operations, the firm still managed to grow oil and refined-product throughput by 5 percent from year-ago levels.

In addition to pipelines, Magellan Midstream Partners owns storage facilities that hold oil and refined products and provide fuel blending and other ancillary services. This segment’s GOM increased 1 percent from the prior year, though these gains would have been far higher if not for a $6.4 billion fine levied by the Environmental Protection Agency (EPA) for excess air emissions at its Houston terminals.

Management indicated that modifications to the terminals in 2010 should ensure that additional charges won’t be forthcoming.

The MLP plans to invest about $240 million in organic-growth projects this year, including the ongoing expansion of its storage capacity at the Cushing terminal it acquired from BP last year. The firm brought 2.5 million barrels of capacity online early this year, while another 1.75 million barrels of storage will be available by the end of October.

Demand for storage at Cushing continues to grow as Canadian oil and output from the Bakken Shale overwhelms existing capacity. Management noted that all of these expansion projects are supported by long-term contracts of at least five years.

Management is also pushing a plan to reverse the flow of the Longhorn Pipeline, which stretches from Houston to El Paso, Texas. This change should enable the pipeline to take advantage of rising demand for takeaway capacity from the Permian Basin in west Texas to Houston. Although this mature field has a long history of oil and gas production, modern directional drilling and hydraulic fracturing technologies have given the field a new lease on life.

During a conference call to discuss second-quarter results, management indicated the MLP is awaiting firm commitments from customers before it decides whether to reverse the direction in which the Longhorn pipeline flows. A definitive announcement should be forthcoming over the next few weeks.

Magellan Midstream Partners is also soliciting shipping commitments for a proposed pipeline that would transport volumes from the Eagle Ford to Corpus Christie, Texas. This project is likely to go ahead, though the timing is less certain.

Finally, management is investigating the feasibility of building a pipeline to transmit crude oil from Cushing to the Gulf Coast, a project that would rely extensively on the MLP’s existing infrastructure. The pipeline would be capable of handling 60,000 to 70,000 barrels of crude oil per day.

The company also indicated that US demand for refined products has weakened because of higher prices and a softening economy. But these headwinds should be offset by expansion plans and a 6.9 percent hike in government-regulated tariffs to reflect inflation. In fact, management increased its DCF guidance slightly to $440 to $445 million. Magellan Midstream Partners has targeted annualized distribution growth of 7 percent in 2011 and a coverage ratio of 1.2 times. The MLP is on track to meet or exceed that guidance.

Magellan Midstream Partners’ emphasis on fee-based revenues and high distribution coverage provide plenty of protection in a challenging macroeconomic environment. A handful of low-risk growth projects should enable the MLP to grow its payout at an annualized rate of 5 to 7 percent over the next few years. Buy Magellan Midstream Partners under 58 and regard any pullbacks to the low 50s as an outstanding buying opportunity.

Legacy Reserves LP (NSDQ: LGCY)

Legacy Reserves produces oil, natural gas and NGLs. Although the firm inherently has some exposure to commodity prices, the MLP hedges extensively to ensure favorable commodity prices and guarantee minimum cash flows over time.

But unlike fellow Aggressive Portfolio holding Linn Energy, Legacy Reserves doesn’t fully hedge its output for years into the future, preferring to maintain some exposure to oil prices.

For example, in the second quarter, Legacy hedged about three-quarters of its total output, providing a welcome tailwind when oil prices remain elevated. The MLP has hedged about 70 percent of its production over the remainder of 2011 and 55 to 60 percent of its 2012 output. Thereafter, the size of its hedge book declines significantly.

Legacy Reserves hasn’t suffered inordinately from weak WTI prices; its average oil hedge for the remainder of the year amounts to about $90 per barrel. Only a precipitous drop (probably to less than $60 per barrel) in oil prices in the short term, or a decline that persists through to 2013, would imperil the company’s distribution. Neither of these scenarios is likely.

When energy prices cratered in late 2008 and early 2009, producers’ hedging strategies faced an unprecedented stress test. Legacy Reserves managed to maintain its payout at the nadir of the bust, overcoming the toughest operating environment E&P firms have faced for some time.

Check out these two graphs from the MLP’s May 26 presentation at the National Association of Publicly Traded Partnerships’ 2011 MLP Conference.

Source: Legacy Reserves LP

Although the MLP’s revenue plunged in 2009, the firm’s hedged revenue continued to increase throughout the crisis. This protection enabled Legacy Reserves to obtain credit from banks and maintain its quarterly distribution.

The MLP passed another stress test with its second-quarter results. Some investors had worried that weather-related disruptions in the first quarter and a series of outages at older gas-processing facilities would lead to higher operating costs in the second quarter and continue to constrain production. But the MLP increased its output by 18 percent from the first quarter and 40 percent from year-ago levels.

The company’s earnings before interest taxation and depreciation (EBITDA) jumped 27 percent sequentially, while DCF surged 33 percent to $0.72 per unit. Legacy Reserves calculates DCF differently than many of its peers. Most MLPs add non-cash charges such as depreciation to net income and subtract any capital spending to maintain existing assets in working order.

Legacy Reserves, on the other hand, doesn’t differentiate between capital expenditures on growth and maintenance. The firm also subtracts all cash flows when calculating DCF. This conservative accounting yields a lower DCF estimate than the standard approach. Nevertheless, the MLP covered its second-quarter distribution more than 1.3 times after hiking its payout by to $0.54 from $0.51. This marked the third consecutive quarter in which the firm had hiked its distribution. 

Barring an outright collapse in oil prices, we expect the MLP grow its distribution at a similar pace over the next year. If oil prices average $100 per barrel in 2012, Legacy Reserves could accelerate the pace of its distribution increases.

Legacy Reserves now operates more than 5,500 wells and produces 13,363 barrels of oil equivalent per day. Roughly 70 percent of its reserves are high-value oil and NGLs and about 70 percent of its proved reserves are in the Permian Basin. On average, the company realized prices about 40 percent higher than the widely quoted Henry Hub gas price for its production. Even with with gas prices languishing near $4.25 per million British thermal units (BTU), Legacy Reserves earns almost $6 per million BTUs thanks to the value of those NGLs.

In the near term, the MLP’s growth strategy focuses on low-risk acquisitions and an exciting drilling plan in the Wolfberry Trend region of the Permian Basin. Management has allocated about half the capital budget to its operations in the Wolfberry, where the firm’s solitary rig completes a new well roughly every three weeks. Thus far, drilling results have exceeded expectations.

Both the Permian and Wolfberry have been in production for decades, but E&P outfits have squeezed additional output from the fields through directional drilling and hydraulic fracturing. As the firm gains experience applying these techniques, its costs and output have improved. With an extensive drilling inventory, Legacy Reserves should be able to maintain a growing production base that focuses on oil and wet gas.

Legacy Reserves has completed about $93 million worth of acquisitions thus far in 2011 and targets an annual run rate of $200 million. Most of these deals are smaller, bolt-on transactions. But the firm could opt for a transformational acquisition over the next year or two; management recent acknowledged they have bid on a few “multi-hundred million type” opportunities. Buy Legacy Reserves under 32. During last week’s selloff, investors could have picked up the stock for as low as $22. Regard any dips to the mid-$20s as a gift.

Encore Energy Partners LP (NYSE: ENP)

Vanguard Natural Resources LLC’s (NYSE: VNR) acquisition of Aggressive Portfolio holding Encore Energy Partners should close in the fourth quarter of 2011. For each unit of Encore Energy Partners in their portfolio, investors will receive 0.75 units of Vanguard Natural Resources. We regard the deal as a positive for both companies and recommend that investors hold Encore Energy Partners and accept units of Vanguard Natural Resources.

Encore Energy Partners produced 8,534 barrels of oil equivalent per day in the second quarter–roughly the same amount as in the first three months of 2011 and down 3 percent year over year. That the MLP has managed to maintain its output over the past year, especially because the firm’s current general partner has underinvested in these fields.

Encore Energy Partners’ capital expenditures amounted to $1.5 billion in the second quarter, while the firm plans to invest $8 million in the third quarter. Most of this spending will support drilling activity in the Montana and Wyoming’s Big Horn Basin, where the company plans to sink eight wells after completing its first well at the end of the second quarter. The MLP owns a 67 percent stake in these wells; ExxonMobil Corp (NYSE: XOM) holds the remaining stake.

Encore Energy Partners cut its second-quarter distribution to $0.47 from $0.49, though the move wasn’t unexpected. The MLP pays a variable distribution that takes into account planned capital spending; money spent on drilling reduces the cash available for distribution to unitholders.

With Vanguard Natural Resources’ acquisition of Encore Energy Partners expected to close in the fourth quarter, investors should focus on the purchaser’s distribution policy and growth prospects. In the second quarter, Vanguard Natural Resources hiked its payout to $0.575 per unit from $0.57 and generated enough cash flow to cover this distribution almost 1.5 times.

Vanguard Natural Resources plans to ramp up capital spending in the back half of 2011. Even with these investments, management believes the MLP will be able to cover its distribution by 1.4 to 1.45 times for the full year. This elevated coverage ratio reflects the firm’s exposure to commodity prices.

Nevertheless, the MLP could have the scope to increase its distribution over the next few quarters. Management indicated that its adjusted EBITDA–a measure of cash flows–surpassed $74 million in the first half of the year, implying that the MLP exceeded the top end of its year-end guidance of $140 to $147 million in EBITDA. This should give the firm enough wiggle room to push through a modest distribution increase.

Vanguard Natural Resources’ organic growth potential is centered on three plays: Parker Creek in Mississippi, its Bone Springs acreage in the Permian Basin, and the Sunt TSH field in south Texas. In 2011 the MLP’s capital expenditures focused on Parker Creek, an investment that has paid off. Not only did near-perfect execution limit drilling costs, but the two wells also yielded initial production rates of 441 and 171 barrels per day, respectively. In short, drilling costs on these 53 percent-owned wells came in $700,000 under budget and results met expectations.

The MLP’s next big project is a 100 percent-owned well in the Bone Springs portion of the Permian Basin. This complex well will include an 11,250-foot vertical shaft and a 5,000-foot lateral segment. A nine-stage fracturing job will complete the well. These advanced drilling techniques push the total cost to $6.5 million, but results from other producers in the region suggest that the well is a low-risk bet. Management has pegged the initial production rate at 300 to 400 barrels per day and has identified dour additional drilling locations if the first well is a success.

Combined, Encore Energy Partners and Vanguard Natural Resources boast potential organic growth potential and its operations in the Permian Basin offer plenty of opportunity for bolt-on acquisitions.

In the Aug. 9 Flash Alert, Profiting from a Pricing Anomaly, we noted that weakness in the broader market gives investors the opportunity to buy units of Encore Energy Partners at a discount of 8 to 10 percent of its takeover value. Buy Encore Energy Partners LP under 24.

Regency Energy Partners LP (NYSE: RGP)

On Aug. 9, Aggressive Portfolio holding Regency Energy Partners LP shifted its listing from the NASDAQ to the New York Stock Exchange and changed its ticker to “RGP” from “RGNC.”

This MLP owns gathering and processing (G&P) infrastructure and has gradually added more fee-based contracts to its revenue base, reducing its exposure to commodity prices.

Gathering pipelines collect oil or gas from individual wells. Typically, the gathering business is sensitive to drilling activity: The more wells that are drilled, the more volumes flow into these lines. In turn, drilling activity ebbs and flows with commodity prices because producers drill more aggressively when oil and gas prices are relatively high.

In the second quarter, the US active rig count was up 22 percent from year-ago levels–a welcome tailwind for firms that own G&P assets. However, location is everything when it comes to evaluating a G&P firm’s growth prospects. Producers continue to shift rigs from the Haynesville Shale and other dry-gas fields to the Eagle Ford and other liquids-rich plays.

Fortunately, Regency Energy Partners’ assets are located in regions where producers are ramping up activity. The firm’s overall throughput increased by 6 percent from the second quarter of 2010, thanks to robust demand in south and west Texas. Volumes gathered and processed by the firm’s south Texas system, which serves the Eagle Ford shale, rose to 28,000 barrels per day in the second quarter, a sequential increase of 3,000 barrels per day. Overall volumes were up about 27 percent on a year-over-year basis.

Regency Energy Partners’ NGL-focused assets in west Texas serve the Permian Basin enjoyed a 10 percent increase in throughput. Management expects these volumes to climb into the back half of the year.

Although the MLP’s Midcontinent system lacks exposure to liquids-rich field, this capacity is booked under fee-based contracts that provide stable cash flows.

The firm’s Lone Star joint venture (JV) with Growth Portfolio holding Energy Transfer Partners LP (NYSE: ETP) also offers considerable upside. The two MLPs also share the same general partner, Energy Transfer Equity (NYSE: ETE).

Regency Energy Partners holds a 30 percent stake in JV and is responsible for a similar percentage of the capital budget. The biggest projects announced to date include a fractionation facility at Mont Belvieu with a capacity of 100,000 barrels per day and a 530-mile NGL gathering system that will come online in the first quarter of 2013. Both of these assets will serve the Permian Basin and Barnett Shale. 

In the second quarter, Regency covered its distribution by 1.03 times–a marked improvement from the first quarter when the MLP failed to cover its payout. Rising throughput at its Texas G&P systems and new cash flow from the Lone Star JV should bolster DCF considerably to 1.1 or 1.2 times its quarterly distribution.

Meanwhile, the MLP’s exposure to commodity prices continues to dwindle. Management estimates that a $10 decline in oil prices that precipitates a similar percentage change in NGL pricing would reduce the firm’s DCF by only $3 million. Meanwhile, if natural-gas prices were to decline by another $1 per million BTU, the firm’s cash flow would take a $1-million hit. Buy Regency Energy Partners LP under 29.