The Alerian MLP Index declined by almost 7 percent in the third quarter of 2011, its worst quarterly performance since the fourth quarter of 2008. After this correction, the index was down 2.1 percent for the year through Sept. 30.  

Although we’re never pleased when our coverage universe posts a negative quarterly return, MLPs handily outperformed the S&P 500, which gave up 13.9 percent in the third quarter. These energy-related stocks also outperformed the S&P 500 Energy Index, a cyclical group that declined by more than 20 percent in the third quarter.

The table below tracks how our Portfolio holdings fared during this difficult quarter.

Source: Bloomberg, MLP Profits

With investors fretting about the potential for a US recession and global credit crunch, the defensive names in the Conservative Portfolio outperformed the Growth and Aggressive Portfolios. Four of our six Conservative holdings posted a gain during the first nine months of the year, enabling this segment of the model Portfolio to beat the Alerian MLP Index by 3.75 percent.

On the other hand, our Growth Portfolio and Aggressive Portfolio holdings tend to have more exposure to commodity prices and economic conditions. As we explained in the Sept. 22, 2011, issue, MLPs and the EU Sovereign Debt Crisis, several of our more aggressive holdings are rated sub-investment grade, making them vulnerable to weakness in global credit markets.

But most MLPs still enjoy ready access to capital and continue borrow money at favorable rates. That’s particularly true of investment-grade issuers such as Conservative Portfolio holding Enterprise Products Partners LP (NYSE: EPD); the MLP’s bonds yield less today than they did six months ago.

Access to debt capital also enabled Kinder Morgan Inc (NYSE: KMI) to acquire El Paso Corp (NYSE: EP) for $38 billion. We shared our initial take on this deal in a Flash Alert issued on Oct. 21, 2011, and will analyze the implications of this transaction in greater detail later in this issue.

But credit conditions have tightened for high-yield issuers and companies with less-established credit histories. 

MLPs in our coverage universe depend less on short-term lines of credit and bank loans than in late 2008, when Lehman Brothers’ bankruptcy froze global credit markets. Most MLPs have replaced credit lines and private financing deals with bonds that have longer maturities. The group has also taken advantage of the post-crisis rally in the stock market to raise capital by issuing new units.

Credit lines usually feature a variable interest rate indexed to the London Interbank Offered Rate (LIBOR), the percentage that banks charge one another for shorter-term loans. Bonds, on the other hand, have fixed borrowing rates.

These efforts to shore up their balance sheets have reduced the group’s vulnerability to a spike in LIBOR. Most of our favorite MLPs have already raised significant capital and have little near-term refinancing needs, putting them in a great position to ride out any short-term credit market instability. 

Nevertheless, the trauma of the financial crisis is fresh in many investors’ minds; units of MLPs with smaller market capitalizations or more exposure to commodity prices tend to sell off at any hint of a credit contagion, no matter how illusory. Although the Growth Portfolio and Aggressive Portfolio outperformed the S&P 500 in the third quarter, both Portfolios underperformed the Alerian MLP Index.

But there’s a silver lining to market volatility: Investors have an opportunity to pick up our favorite names at a discount and lock in higher yields.

Regulations restrict institutions’ MLP holdings to a percentage of their investable assets; most MLPs have an ownership base that skews toward individual investors. Units of smaller MLPs also trade in relatively light volumes, exacerbating the upswings and downswings in bull and bear markets.

Many individual investors also continue to use stop-loss and trailing stop-loss orders on their MLP holdings. A stop-loss order instructs your broker to sell a specific position if the stock reaches a predetermined price. Many investors regard these orders as a risk-reduction tool because they can limit your losses if a stock plummets.

Investors usually use trailing stop-loss orders to lock in profits over time. In this instance, the threshold that would trigger the sell order increases as the stock appreciates in value. Some brokers offer tools that automatically set the stop a certain percentage below the stock’s highest closing price.

Stop-loss and trailing stop-loss orders have proved extraordinarily costly for many MLP investors. Consider the price history of Aggressive Portfolio holding Linn Energy LLC (NSDQ: LINE).

Source: Stockcharts.com

The low price circled on this graph occurred on May 6, 2010, a day when the Dow Jones Industrial Average plummeted by 9.2 percent before recovering quickly. During this flash crash, Linn Energy tumbled to a low of $12.60 per unit from its previous close of more than $25 per unit. The stock remained at depressed levels for less than 10 minutes before bouncing back to finish the trading day at $23.69.

Stop-loss orders intensified the selling pressure on Linn Energy’s units. Investors who were stopped out of the stock that day undoubtedly sold at unfavorable prices only to watch the stock rebound once again into the close.

Investors should never place a stop-loss or trailing stop-loss order on the MLPs in our model Portfolios. Although the May 2010 flash crash is admittedly an extreme example, units of Linn Energy and other MLPs occasionally sell off inexplicably over a one- to three-day period before quickly recovering.

Rather than setting stops that are likely to get picked off by savvy institutional traders, use these indiscriminate sell-offs as an opportunity to buy some of our favored names at bargain-basement prices and lock in much higher yields on your investment.

For example, in the Aug. 8, 2011, Flash Alert, Four Ways to Capitalize on the Selloff, we highlighted four Portfolio holdings whose units represented an outstanding buying opportunity: Linn Energy, Genesis Energy LP (NYSE: GEL), Teekay LNG Partners LP (NYSE: TGP) and Navios Maritime Partners LP (NYSE: NMM). If you purchased these units at their closing price on Aug. 8, you’d be up an average of 26.2 percent–more than double the Alerian MLP Index’s return over the same period holding period.

Another panic-driven selloff at the end of the third quarter skewed the performance of our Portfolio holdings and the Alerian MLP Index. MLPs rallied in the first two weeks of October and many have inched back into positive territory on the year. Some of the Portfolios’ worst performed in the third quarter have posted the biggest gains thus far in the fourth quarter. Units of Navios Maritim Partners and Penn Virginia Resource Partners LP (NYSE: PVR)–profiled in the Sept. 30, 2011, issue, Behind the Biggest Yields—have rebounded 26 percent and 10 percent, respectively.

Favorable Valuations

Although the Alerian MLP Index has rebounded substantially since the end of the third quarter, the group continues to trade at a favorable valuation.

Investors buy MLPs to lock in tax-advantaged income streams; one of the best valuation metrics for the group is the spread between the yield on the Alerian MLP Index and the yield on the 10-year Treasury bond. When the yield on the Alerian MLP Index is elevated compared to the yield on 10-year Treasuries, investors can earn an above-average yield for accepting the risk of owning MLPs.

Source: Bloomberg

The yield spread between the Alerian MLP Index and the 10-year Treasury bond spiked to record levels in late 2008 and early 2009. At the height of the credit crunch, investors shunned risky assets and fled to the safety of Treasuries. At times in late 2008, the short-term Treasury notes offered negative yields; investors were effectively paying interest for the right to lend money to the US government–a sign of extreme risk aversion.

The underlying fundamentals for MLPs also deteriorated somewhat in late 2008. Most MLPs have little or no exposure to oil and natural gas prices, though some firms involved in oil and gas production, gathering and processing suffered a decline in cash flow when commodity prices plummeted. Producers curtailed drilling, limiting the number of new wells hooked up to gathering systems and reducing throughput on processing systems.

But the credit crunch was an even bigger challenge for MLPs. Banks ceased lending money and the implosion in the stock and bond markets prevented many well-capitalized MLPs from issuing new units or selling bonds.

It’s testament to MLPs’ stability and defensive qualities that only a handful cut their distributions during the worst financial crisis since the Great Depression. Nonetheless, investors still punished the group; the yield on the Alerien MLP Index skyrocketed to as much as 1,000 basis points (10 percent) over the yield on the 10-year Treasury bond.

In late September 2011, the yield on one-month Treasuries slumped into negative territory once again, as investors sold stocks en masse and piled money into safe havens.

The yield spread between the Alerian MLP Index jumped to more than 5 percent at the end of September. Although MLPs have rallied substantially since mid-2009, these stocks are dirt cheap by any historical measure. The recent upswing in the stock market has lowered this yield spread somewhat, but the Alerian MLP Index still offers an attractive yield margin for income-oriented investors relative to government bonds.

Of course, valuation alone is never ample justification to buy a stock or industry group. Some stocks are cheap for a good reason. But business conditions remain sanguine for our favorite MLPs.

In the Sept. 22, 2011, issue, MLPs and the EU Sovereign-Debt Crisis, we examined conditions in global credit markets and concluded that most MLPs still have cheap access to credit despite the turmoil in the EU.  In the Sept. 30, 2011, issue, Behind the Biggest Yields, we examined the fundamentals of the highest-yielding MLPs and concluded that our favorites remained on solid footing.

Demand for energy commodities is also much healthier.

Source: Bloomberg

This graph tracks the prices of West Texas Intermediate (WTI) crude oil, Brent crude oil and a mixed barrel of natural gas liquids (NGLs) that includes ethane, propane, butane and iso-butane.

The last time the yield spread between the Alerian MLP Index and 10-year Treasury bonds was this elevated, oil prices had collapsed from a high of almost $150 per barrel to less than $40 per barrel. This year, oil prices have pulled back from their springtime high but remain elevated.

The pullback in the price of WTI crude oil has been more pronounced because of the oversupply of oil the delivery point in Cushing, Okla. Nevertheless, WTI crude oil barely dipped under $80 per barrel in September and is still up on a year-over-year basis.

The price of Brent crude oil has receded only modestly this year, an indication that global supply and demand conditions remain tight. Despite the sensationalist headlines about plummeting energy prices, Brent crude oil currently trades for well over $110 per barrel and never dipped under $100 per barrel during the September selloff. The price of Brent crude oil has increased by almost one-third on a year-over-year basis.

Earlier this year, the growth scare prompted concerns that an oversupply of ethane and propane would weigh on NGL prices. However, NGL prices have held up even better than crude oil in recent months.

Although US natural gas prices remain depressed, strong NGL and oil prices continue to incentivize aggressive drilling activity in liquids-rich fields. Check out this graph of the US active rig count.

Source: Bloomberg

In late 2008 and early 2009, producers slashed their drilling budgets in response to tumbling energy prices, pushing the rig count well under 1,000 by mid-2009.

Today, the US rig count has swelled since the first quarter of 2011 and has continued to rise even after oil prices pulled back in the third quarter. More than 2,000 rigs are actively drilling for oil and gas in the US, compared to 887 rigs at one point in mid-2009. All this drilling activity is a boon for MLPs involved in gas gathering and processing

Within the model Portfolios, Targa Resources Partners LP (NYSE: NGLS) has the most direct exposure to gathering and processing. The stock has returned roughly 9 percent in 2011, making it one of the top performers in our coverage universe.

There is a major disconnect between MLPs’ stock valuations and business conditions. Investors’ panic and risk-aversion offers investors an attractive opportunity to buy our favorite names at a discount. 

The Deal

Commodity- and energy-related industries have been a hotbed of merger and acquisition (M&A) activity in recent years, and 2011 is no exception. Thus far, mining companies have announced a total of 933 mergers and acquisitions, or $70 billion in deals. Even more impressive, oil and gas companies have inked 658 deals worth more than $132 billion in total value.

Kinder Morgan Inc.’s proposed acquisition of El Paso Corp for $37.57 billion is the single largest deal announced in the energy industry since ExxonMobil Corp’s (NYSE: XOM) $41.3 billion takeover of XTO Energy announced in late 2009. The acquisition is also the second-largest purchase announced across all industry groups so in 2011, trailing only AT&T’s (NYSE: T) proposed buyout of T-Mobile USA.

Investors always sit up and take notice when a deal this big goes down; acquisitions of this size often serve as a template for additional M&A activity. For example, ExxonMobil’s (NYSE: XOM) buyout of XTO Energy two years ago was just the first in a series of acquisitions that involved large, international oil and gas producers snapping up stakes in US producers with acreage in shale fields. The latest examples include BHP Billiton’s (NYSE: BHP) purchase of Petrohawk Energy this summer and Statoil’s (NYSE: STO) proposed buyout of Brigham Exploration (NSDQ: BEXP) this month.

Kinder Morgan Inc.’s acquisition of El Paso could prompt larger MLPs to pursue a wave of similar deals.

Under the terms of the proposed acquisition, El Paso’s shareholders have the option to receive either $25.91 in cash for each share held, 0.9635 shares of Kinder Morgan Inc. per share held, or $14.65 in cash and 0.4187 shares of Kinder Morgan Inc. All shareholders will also receive 0.64 warrants on shares of Kinder Morgan Inc. per share of El Paso, giving the holder the holder the right–but not the obligation–to purchase Kinder Morgan Inc. stock for $40 at any time over a five-year period.

Kinder Morgan Inc. is a corporation that went public in February and shouldn’t be confused with Conservative Portfolio holding Kinder Morgan Energy Partners LP (NYSE: KMP). Once the deal closes, Kinder Morgan Inc. will become the general partner (GP) for El Paso Pipeline Partners LP (NYSE: EPB). The firm already holds a GP interest in Kinder Morgan Energy Partners. This deal is a major positive for Kinder Morgan Energy Partners and El Paso Pipeline Partners and should fuel future distribution growth for both master limited partnerships.

El Paso Corp is involved in two distinct business lines: a midstream energy business and exploration and production (E&P). The company’s upstream E&P business primarily targets unconventional onshore oil and gas fields in the US. Over the past few years, El Paso has sold off older, mature fields and plowed the proceeds back into ramping up production in its most promising plays. The company has also expanded its production of oil and NGLs. 

El Paso’s has focused its drilling activity on four core opportunities: the Haynesville Shale, Eagle Ford Shale, the Altamont tight sands play and the Wolfcamp Shale. All of these unconventional fields require hydraulic fracturing and horizontal drilling.  Investors unfamiliar with these innovations and the major US unconventional oil and gas plays should check out the Dec. 18, 2009, issue, Shale Infrastructure, and the Aug. 18, 2011, issue, Opportunity Knocks. 

Some believe the Haynesville Shale in Louisiana and east Texas may prove to be the largest gas field in the US. The field contains scant NGLs, but the wells are prolific and costs are low. El Paso has 46,000 net acres in the Haynesville and produces about 143 million cubic feet of gas per day from the play.

Drilling activity in the Eagle Ford Shale in south Texas continues to accelerate. The play comprises three distinct zones: a northern window that primarily produces oil; a middle window that produces NGL-rich gas; and a dry gas window to the south. Given high oil and NGL prices, most of the drilling activity takes place in the field’s liquids-rich zones. Roughly 60 percent of El Paso’s Eagle Ford acreage is located in these desirable portions of the play. Management has noted that the low production costs and high liquids output from this area yields fat profits.

The Wolfcamp Shale is located in the Permian Basin, one of the oldest oil-producing plays in the US. Linn Energy and Legacy Reserves LP (NSDQ: LGCY) are also active in this part of Texas and New Mexico. Although the Permian has been in production for decades, producers have found several smaller sub-regions within this play that respond well to hydraulic fracturing and horizontal drilling. Over the past year and a half, El Paso has acquired acreage aggressively in this play, boosting its holdings to 138,000 acres.

Finally, El Paso holds 190,000 net acres in Utah’s Altamont tight-sands play, a prolific gas field that also boasts relatively low production costs.

El Paso also has operations in Brazil and Egypt. In Brazil, the firm has 137,000 net acres of offshore properties primarily operated in conjunction with Petrobras (NYSE: PBR). In Egypt, the firm has 1.1 million acres of exploratory properties in the Western Desert.

El Paso’s E&P assets don’t fit well with Kinder Morgan Inc.’s portfolio of midstream assets.

The economics of E&P and midstream assets differ greatly. E&P valuations usually hinge on prevailing commodity prices and the company’s ability to grow its oil and gas output. In contrast, midstream assets such as pipelines typically require large up-front capital investments and generate reliable cash flows that have little to do with commodity prices. In most cases, pipelines are backed by long-term contracts that guarantee the owner a reasonable return on its capital investment–regardless of demand for or pricing of oil and natural gas.

For these reasons, Kinder Morgan Inc. will divest El Paso’s E&P business in coming months. Kinder has a commitment letter from Barclays (NYSE: BCS) for the $11.5 billion in cash it will need to complete this transaction. Kinder Morgan Inc. will also issue about $9.6 billion in units and assume in El Paso’s $16.7 billion in debt. The beauty of this deal is that the proceeds from the sale of these E&P assets will allow Kinder Morgan to retire some of this acquired debt quickly.

International oil companies have forked over considerable sums to take over or form joint ventures with US independent producers with exposure to shale oil and gas fields. In July, Petrohawk Energy was acquired by BHP Billiton for $18 billion–a roughly 60 percent premium. And this month, Norway’s Statoil announced the acquisition of Brigham Exploration, a small exploration and production company with significant oil-producing assets in the Bakken Shale of North Dakota and Montana, for $4.4 billion. Based recent deals , we expect Kinder Morgan Inc. to find plenty of potential buyers for El Paso’s exploration and production portfolio and estimate the value will be north of $8 billion. 

Even better, there are some major tax advantages for this transaction. El Paso has considerable net loss carry-forwards in its E&P business, and Kinder Morgan Inc.’s management team believes it will not owe any taxes related to the sale.