Steadily growing, tax-advantaged distributions are the raison d’être for Master Limited Partnerships (MLPs). That’s why the most conservative names usually own midstream energy assets–pipelines and storage facilities–that generate reliable fee-based cash flows and are relatively insulated from commodity prices and economic conditions.

At first blush, the upstream energy business–oil and gas production–would appear to be ill-suited to the MLP structure. After all, the exploration and production (E&P) industry is rightly known for its volatility, exploration risks and sensitivity to commodity prices.

But not all E&P plays are inherently risky. A handful of partnerships have carved out profitable and surprisingly steady businesses. Better still, the average E&P-focused MLP in our coverage universe yields over 11 percent, a significant premium to the average 8.5 percent yield offered by the Alerian MLP Index.

And the best upstream partnerships are well positioned to grow distributions. Improvements in credit markets have made it easier for companies to finance acquisitions. Meanwhile, the drop in oil and natural gas prices mean that well-capitalized MLPs have an opportunity to buy up prime producing properties at cut-rate prices. Because acquisitions produce immediate cash flows, upstream MLPs have traditionally relied on deals to grow distributions.

That said, swimming upstream can be dangerous; it pays to be selective when picking your spots.

Consider the cautionary tale of Constellation Energy Partners (NYSE: CEP), an upstream MLP that owns properties in the Black Warrior Basin of Alabama and Cherokee Basin of Kansas and Oklahoma, as well as a smaller interest in Oklahoma’s Woodford Shale.

Constellation is primarily a play on coal-bed methane (CBM), natural gas reserves located in underground coal seams. Most US gas wells aren’t profitable at current gas prices, and CBM wells often have higher-then-average production costs. Although Constellation has locked in favorable prices on about 90 percent of its 2009 production, the partnership has fewer hedges covering 2010 and 2011 production. That means it’s exposed to still-depressed gas prices.

To make matters worse, at the end of June the company’s lenders cut its borrowing base from $265 million to just $225 million as part of its regular semiannual debt review. Constellation’s borrowing agreements state that if it utilizes over 90 percent of its credit facility, the partnership must suspend distributions. With its credit facility 98 percent drawn, Constellation discontinued its payout.

Even assuming a modest uptick in gas prices, it will take at least a few quarters for Constellation to pay down its credit facility and resume its distribution payouts. Moreover, the credit line resets twice annually and expires next year; Constellation likely won’t be able pay a distribution until it rolls over its credit facility. We’ve rated Constellation Energy Partners a Sell in How They Rate since we launched MLP Profits.

In contrast, Aggressive Portfolio bellwether Linn Energy (NSDQ: LINE) finds itself in an enviable position. First, Linn has hedges covering all of its production through the end of 2011 and smaller percentages through 2014. Because the company set most of those hedges last year, it’s locked in sky-high prices for both its oil and gas production.

Second, Linn’s production profile is a balanced mixture of natural gas, natural gas liquids (NGLs) and crude oil. Although current natural gas prices are depressed, crude oil and NGL prices have improved markedly this year.

The graph below will help me to explain how Linn and other partnerships hedge against lower commodity prices.

Source: Bloomberg

This chart show crude oil futures prices out through the end of 2017. As the curve illustrates, oil for delivery in September of this year trades at roughly USD70 a barrel. But futures expiring two years from now trade command north of USD80 a barrel. Producers can lock in oil prices in the USD75 to USD90 range for several years into the future given this curve. That means they’ll be able to earn a solid profit on their production regardless of economic conditions and commodity prices at the time that oil is produced.

Consider Linn’s recent purchase of oil-producing properties in the Permian Basin, highlighted in a recent alert. Linn’s acquired fields produce around 1,350 barrels of oil each day, equivalent to around half a million barrels annually. At USD80 per barrel, that annual production is worth roughly USD40 million in revenues each year.

Linn purchases properties with existing production and locks in guaranteed high prices for its oil for years into the future. With this strategy, the partnership can quickly earn a solid return from its acquisitions.

Bottom line: Acquisition economics are favorable right now, and Linn is well-placed to take advantage. Given the company’s strong hedge position, Linn shouldn’t experience problems rolling over its credit lines. Linn remains a Buy under USD25 in our Aggressive Portfolio.

We’re also adding in two new high-yielding upstream MLPs to the portfolio: EV Energy Partners (NSDQ: EVEP) and Legacy Reserves (NSDQ: LGCY).

Like Linn, EV Energy has avoided a payout cut this year. In fact, it’s boosted its distribution every quarter since going public in 2006–an impressive record when you consider the volatility in commodity prices over that period. And with a current yield of more than 15 percent, EV is among the highest-yielding partnerships in our coverage universe.

EV has a well-diversified asset base centered in two regions: Appalachia and the Mid-Continent of Texas, Oklahoma and New Mexico. In total, EV owns reserves estimated to contain the equivalent of 359 billion cubic feet of gas. About 74 percent of its reserve base is natural gas. In total, EV produces around 70 million cubic feet of natural gas per day.

We like EV Energy Partners for three reasons: a significant hedge book, a strong distribution coverage ratio and the partnership’s acquisition strategy.

As to the first point, EV hasn’t hedged all its future gas production to the extent that Linn has; the MLP has a degree of exposure to depressed natural gas prices. But EV has hedged roughly 85 to 90 percent of its total planned production for the remainder of 2009 and roughly three-quarters for 2010.

EV periodically adds to its hedges, and management announced recently announced that the partnership has added hedges for the years 2014 and 2015. (Although gas prices are depressed now, prices five years from now are much more favorable). Investors should note that because EV’s credit agreement prevents the partnership from hedging more than 90 percent of its production in a given year, it will never be as fully hedged as Linn.

But EV makes up for its slightly more aggressive hedging policy by reserving more cash to pay future distributions. For example, EV covered its second quarter distribution 1.44 times compared to around 1.21 times for Linn. In other word, EV usually sets aside cash for the proverbial rainy day.

EV’s growth potential sets it apart from the competition. Although EV’s fields are located in the US, the partnership is managed by Canadian investment management firm EnerVest.  This association is a major advantage for EV; the firm can partner with its parent on new deals, reducing its reliance on financing and enhancing access to capital.  

By partnering with other firms and EnerVest, EV can take small stakes in attractive projects without having to pay out large sums up front. And EV has been doing just that in recent months, announcing a series of bolt-on acquisitions near its existing operating areas. EV Energy Partners is a new addition to the Aggressive Growth Portfolio as a Buy under 23.

Legacy Reserves has a far more oil-focused production profile than either Linn or EV Energy. Crude oil and natural gas liquids (NGLs) account for three-quarters of its annual production. The company operates primarily in the Permian Basin of West Texas, an ideal area of operation that’s relatively uncomplicated to produce.

And because there are literally thousands of small producers in this area, Legacy enjoys a steady buffet of small bolt-on acquisitions.

In its quarterly conference call, management remarked that capital markets are improving and that its bankers are “in better moods,” suggesting that Legacy’s lenders also understand the economics of buying oil properties and immediately hedging a good part of that production at prices round USD80 a barrel.

Based on second-quarter production rates, Legacy is roughly 50 percent hedged for the remainder of 2009 and a bit less than 50 percent hedged for 2010. In both years its average hedge price is USD82 a barrel, not far from crude oil’s current price. Legacy leaves a significant proportion of its production volume unhedged to gain exposure to rising commodity prices.

To offset this risk-taking, Legacy maintains high distribution coverage–in the second quarter, the partnership covered its payout 1.34 times. Bottom line: Oil prices would need to fall back to USD40 per barrel for a lengthy period of time before Legacy would be vulnerable to a distribution cut. That’s a low-probability event in our view.

Legacy’s near 13.5 percent yield compensates investors for oil price exposure. And the market hasn’t priced in Legacy’s potential to grow production in the Permian Basin via acquisitions. Legacy Reserves is a new addition to Aggressive Growth Portfolio as a Buy under 18.