Friday’s market drop reminds me of Robert Duvall in Apocalypse Now, when he says, “I love the smell of napalm in the morning.”  It’s not that I like getting flamed by the market but, I must admit that, after the market closes and the damage is done, there’s nothing quite like smelling the residue of an attractive stock opportunity the next morning amongst the burning rubble of Wall Street.

Usually a good place to catch a whiff of a bargain is in the carnage of the small and lightly-traded stocks, which cannot take the heat of indiscriminate selling. A good case in point is Eagle Rock Energy Warrants (EROCW). These warrants are good for one unit of Eagle Rock Energy Limited Partners (EROC) at a $6 strike price until May 2012.

On Thursday, Eagle Rock units dropped hard. EROC shares — or more properly “units” in limited partnership lingo — dropped 7.3% on blanket selling of the Master Limited Partnership ETFs, which include EROC units.  However, the much less liquid, leveraged warrants dropped by 15.7%, but in neither case did the underlying intrinsic value of the Eagle Rock units drop by more than a percent or two, if at all. Once again, illiquidity is the enemy of the hasty, but the friend of the patient.

Recently, Eagle Rock announced its second quarter earnings and increased its distribution rate to .1875 a quarter. More importantly, it reaffirmed the company’s previously announced intention to increase the annual distribution rate from 60 cents earlier this year, to $1 by year end 2012. Currently, the annualized distribution is 75 cents a unit. At $10.13/unit, the yield is currently 7.4% — up from 6.8% the day before. So much for the efficient market theory.

In a world where the 10-year bond is under 3%, Eagle Rock’s yield is bound to bring in new money from yield-hungry investors.  By year end 2012, when the one dollar distribution rate is in place, a 7% yield will imply a unit price of $14, or a 40% increase in unit prices.  Not bad, but on the leveraged warrants, a $4 increase in the unit price will generate a 100% gain on the warrants.

Granted, Eagle Rock does have some risks; it’s not a guaranteed bond. But short-term crude fluctuations don’t really hurt Eagle Rock, because the company hedges its future production for two to three years out to ensure consistent distributions.  Also, the company did give a heads up on a $40 million environmental compliance capital requirement likely to occur in 2013. At 25% of its capital budget, this expense is likely to impact the company’s ability to increase significantly in 2013.

Another place to breathe in some opportunity is my old favorite, Nicholas Financial (NICK), a microcap subprime lender whose conservative use of leverage let it escape through the 2008 financial crisis without a losing quarter. Nicholas doesn’t lend to the unemployed, so stagnant unemployment is not a problem for Nicholas — but a rising rate is. If you envision unemployment quickly climbing to 12%, you will want to run from this recommendation; but, otherwise, you might find its 15% cash flow yield attractive. I certainly do.

While we wait to see how the post-Congressional Euro bank malaise plays out in the stock market, tune into your inner Robert Duvall, turn up the Wagner, and keep investing.

Disclosure: Of course, Doug owns EROCW and NICK. The day he finds a stock attractive enough to write about, but not attractive enough to have already bought, will be a first.

Follow us on Twitter @CompleteGrowth.

When I was new at the investing game, I ran from any company with a bankruptcy in its history.  Hey, if it goes under once, why won’t it go under again?

Seems logical doesn’t it? I mean, really, who doesn’t think we will never see another airline go under?  After all, there are certain industries — especially the cyclical and the leveraged — that just attract bankruptcies.

Yet, other industries really don’t have many bankruptcies. You can put a lot of debt on a stable company, and it will continue to pay its bills, even in the worst economies.  I don’t care how hard times get; Americans aren’t going to give up their TV, electricity, or beer.  They might cut back, but they aren’t going to go cold turkey — so you can put a fair bit of debt on your business if you’re a cable company, power producer, or brewery, and still pay your creditors in a downturn.

You’d figure that a gas pipeline operator would fall right in line with these safe examples, because people like living in a warm house in the winter.  And you’d be right unless the pipeline company’s management did something really stupid.

Granted, pipeline companies that take custody of the gas in their gathering system assume a small amount of commodity risk, but that can generally be hedged. If the company hedges a little and the hedges don’t work out, the company will lose a little money. When the company hedges a lot, however, and not for the purpose of offsetting what they own, but because they are riverboat gamblers and they lose, the company will go bankrupt. Case in point, SemGroup® Corporation (SEMG) of Tulsa, OK, and its 2008 bankruptcy filing.

The nice thing about a bankruptcy is that you get a fresh start, and that’s what SemGroup got in November 2009. It emerged 95% owned by the creditors, who put in a new management team that is dull, boring, and does not gamble. Last fall, it resumed operations as a public company with a listing on the New York Stock Exchange with ticker, SEMG.

The new SemGroup emerged as a smaller company, and with some debt, but also with some nice large energy infrastructure assets that generate cash.  Normally, a company like SemGroup would be structured as a Master Limited Partnership (MLP) to maximize the value of the depreciation of the long-lived assets, and increase cash payouts to shareholders. But, as a practical matter, one doesn’t exit bankruptcy as a partnership, but as a corporation.  Had it tried to leave as an MLP, it would probably still be in court today explaining the differences between an MLP and a C Corporation.  As for myself, I will just refer you to Wikipedia.

Not surprisingly, SemGroup is investigating converting to an MLP format. It is promising an answer on conversion plans by June 30, 2011.  The answer will be “yes,” as the real question isn’t if it will convert and start sending out those MLP distributions, but when. At that point, it will also start showing up on the list of top paying dividend stocks, so that brokers will sell this stock to yield hogs and generate capital gains for me.

Besides the MLP conversion, another catalyst for SemGroup is that it’s in the process of refinancing its post-bankruptcy debt of $310 million @ 9% with a more competitive rate. Management is expecting its new debt and revolver terms to drop its financing charges in half.

So what is SemGroup worth?

On the most recent quarter conference call, management made an earnings before interest, taxes, depreciation, and amortization (EBITDA) projection of $120 to $140 million for next year.  Now, in general, I hate companies that spout EBITDA numbers to me, because ignoring depreciation is like ignoring management’s options package — but pipelines are different.

A pipeline in the right market should be good for 40 years, and the cost of maintenance capital is infinitesimal compared to the accounting department’s depreciation calculations. With a market cap at $1 billion, and an enterprise value (EV) of $1.2 billion, EV/EBITDA would be 10. For a corporation, a pre-tax ratio of 10 isn’t bad, but it doesn’t get me too excited. However, for an entity like an MLP that doesn’t pay corporate income taxes and isn’t overly leveraged, a post-tax ratio of 10 implies that the future could support healthy cash distributions to its owners.

The size of distributable cash for an MLP is roughly its EBITDA minus maintenance capital, or about $100 million in the case of SemGroup.  Maybe that’s too simplistic but, frankly, $10 million in either direction doesn’t really matter. If my investments require precision, I find new investments.

I will, however, be excluding the not unsubstantial $80 million for new capital expenditures. Almost all MLPs fund their new projects with sales of new partnership units, and I would expect SemGroup to do the same.  Since the new investments should, in theory, have a stable projected return over the cost of capital, this should increase the partnership’s value.

At $100 million, if SemGroup were an MLP, it would need to distribute about $2.40 per share on the 42 million shares outstanding. That’s a 9.6% yield on today’s $25/share price. Once this gets known, Mr. Market will probably choose something closer to 7.5%, which implies $32/share. But I’ve used low estimates and ignored the growth prospects, so the potential for more is good.

Furthermore, the downside protection is strong, as there are many MLPs with low cost capital that would be happy to buy this cash flow below their 6% to 7% cost of capital, so we should be fairly well covered on the downside, as well.

Fire away and let me know what you think.

Disclosure: I have a position in SEMG.

Sometimes it’s better to be lucky than to be good, and our position in Eagle Rock Warrants (EROCW) makes a good case in point. The warrants, you’ll remember, give us the option to buy one unit of Eagle Rock Partners (EROC) for $6 by May 2012.  We bought ours for $2.96 back in January when the units were still selling around $9.

Our catalyst was the announced, but not yet implemented, reinstatement of the distribution to an annual rate of sixty cents in February, and seventy-five cents by year-end. And, like bees to honey, yield-hungry investors and MLPs bought in as soon as the higher payouts began. Just last week, Eagle Rock was selling for $10.30, and the warrants were going for $4 with a forward yield of 5.8% on the sixty cent rate, and at 7.2% on the seventy-five cent rate, which the company had announced it would be paying by year end.

The market was still undervaluing the seventy five-cent rate when it priced the warrants at $4. The warrants could reasonably sell for $11 to $12 at full value, implying that our warrants would be worth $5 to $6 — or an additional 25% to 50%. Based on skill, I was expecting another 25% to 50% over the course of a year. But based on luck, we’re doing much better.

Without an inkling that something might develop, Eagle Rock Partners announced that its general partner was facilitating an acquisition of privately-held Crow Creek Partners by Eagle Rock Energy Partners, which would double Eagle Rock’s oil and gas production. Eagle Rock also announced that, with the acquisition, it would be advancing the 75-cent annual distribution rate to the next quarter, and raising the distribution to $1 by the end of 2012. A 6.5% yield on a $1 distribution implies a $15.40 unit price, or a $9.40 warrant. Anyone want to guess who is holding on for more?

So what’s the catch? The biggest one is that interest rates could go up. While 6.5% for an oil-producing MLP sounds good when the 10-year bond is below 4%, if the 10-year bond goes to 4.5%, I would expect the price to settle around $13.30/unit so that the $1 payout would yield 7.5%

Next on the worry list is if oil prices crater for a prolonged stretch. Eagle Rock hedges its production, so the effect of falling prices would not be seen right away, but eventually, lower oil prices would result in lower distributions.

Finally, bad things can happen to any business. Last November, a gas processing plant that services Eagle Rock production had an explosion, and Eagle Rock was unable to sell a portion of its production for several months. Insurance covered some, but not all, of the lost revenue.

Never invest based on everything coming up roses because, sometimes, everything comes up thorns.

Disclosure: Doug owns EROCW in his personal account.

Contango Oil & Gas (MCF)
If you would have told me a year ago that there would be a nuclear accident in Japan and revolution in the Middle East and North Africa, yet natural gas would still be at $4/mcf, I would be buying you a beer. And I would have also set a lower value on Contango, something more like the $60/share where it trades today than a more optimistic $75 of a year ago. With a glut of shale gas geographically stranded in North America, Contango at $60 is on my chopping block as a source of funds.

Eagle Rock Energy Partners Warrants (EROCW)
The dividend restoration story is in full play, and our warrants are up 33% in two months, but I think we can make a little bit more, because the typical MLP is yielding about 6% and Eagle Rock Partners will be yielding 7.4% on its 75-cent/share distribution rate by year end. However long you hold them, don’t forget to sell them before May 2012, when they turn into pumpkins.

Nicholas Financial (NICK)
Nicholas, our micro-cap subprime is benefitting from low interest rates, an improving economy, and the fact that Americans will give up their houses before they give up their cars. Our easy money gain of 50% is over, but with a ROE of 20%, we don’t have much incentive to sell, especially since management received an unsolicited offer in February.

Penn-Miller (PMIC)
Our sleeping agri-business microcap insurer is still selling at 65% of book. I’d like it to sell for 90% of book and pocket the difference. The catch is that while the agri-business line of insurance is a lion, its general commercial line is a dog. Recently, the company started closing down the worst parts of the commercial line, but can they do it soon enough without collateral damage? We’ll just have to wait and see, as downside is low.

Rosetta Resources (ROSE)
Rosetta Resources is a free option on its Alberta Bakken play because, at $45/share, the company is selling for the value of its liquid-rich Eagle Ford gas field alone.  Rosetta has proven that significant oil exists on its Montana and Alberta Bakken Leases, but it’s trapped in tight shale rock. Figuring out how to cost-effectively produce it might take a little time and a lot of capital but, with oil prices rising, I expect them to figure out how to do it sooner rather than later.

TerraNova Royalty Corp. (TTT)
No one has ever gone broke going long what China is short, and the demand for iron ore is certainly not abating. We got into Terra Nova for the KHD Humboldt spinoff play, which finally distributed its last shares in January. I am game to hold on to my iron ore a little longer with commodity inflation on the rise, while I wait and see what CEO Michael Smith concocts in the meantime.

I’m a value guy, but people can certainly make money using growth or momentum styles, too. So how come serious investors don’t use all three approaches simultaneously? The more methods at your disposal, the more flexibility you’ll have to find good stocks in all markets, right?

No!

Investing is just applied decision making. All that you know about a company doesn’t matter if you can’t pull the trigger to buy or sell the stock when you need to. The race doesn’t go to the one who knows the most but, rather, to the one who knows when to act. It’s not the number of methods at your disposal that makes the difference, but how well you execute on those ideas you have.

While using more methods will give you a larger pool of stocks from which to select, it doesn’t help you make better buying and selling decisions, and that’s where the money is made. I would rather follow 30 stocks and know them intimately, and find only five of them worth holding at any given time, than work with a list of 300 stocks by using multiple investing styles and have only mild confidence on the best to buy or sell.

Yes, we would all like the best of both worlds. We would like to know hundreds of stocks that we could confidently buy or sell; but if you have to choose between breadth and confidence, I’ll take confidence every time. This is why mixing styles works so poorly for most investors. It will give you more ideas, but it doesn’t help you obtain more certainty in them.

Above-average returns do not come to those who know the most, but to those who execute on what they know the best. You need mastery of your domain in order to allocate your capital among all your investing ideas most optimally, and you’re not going to get it by trying to learn all fields.

Value investing works for me because the concepts of margin of safety, intrinsic value, and loss avoidance resonate with my personality. But if growth investing works for you, that’s wonderful, too. I think we’ve all seen the web ad where the guy with the cell phone glued to his head bought Marvel at 10 cents and is up a few thousand percent. But whatever your approach, you need to buy when you need to buy, and sell when you need to sell.

Talk is cheap. Acting when it matters is what counts. But action is hard. This is why day-traders fail. Who can possibly make so many good decisions?  Who can possibly be right more often than not, 25 times in a day, 250 times in a year?

No one can. Eventually, a few really bad trades out of a hundred thousand will sink even the most successful day trader.

What you need for long-term success is a framework that allows you to reduce the number of decisions you need to make. This will give you the time to increase the certainty in each decision you do make. That’s why we only hold 12 stocks in the VF portfolio.

This past week, we finally unloaded the last of our KHD Humboldt (KHDHF) shares after the hassle of getting our broker to register them in a saleable format. KHD appears to be no worse for wear from the rights dilution I railed about earlier this year, but I still think management has shown its true colors, and will no longer get my capital.

Eagle Rock Energy Partners (EROC), the company underlying our position in the Eagle Rock Energy Warrants (EROCW), issued an as expected earnings report this past week. Its distributions are still on target to increase from 60 cents to 75 cents a year by next February. Because income is why people buy the company, we’re in good shape as long as the distributions increase. Also, with the rise in oil prices increasing future prices, the company’s new hedges are set for higher prices, ensuring more good news in the future.

Rosetta Resources (ROSE) announced earnings earlier in the month. The liquid rich Eagle Ford shale is working out as planned, and the company is successfully selling off non-core fields in California and Colorado to fund its development. However, my interest with ROSE is in its Montana and Alberta Bakken shale prospects. The company is remaining coy, because it has little to gain by announcing good news while it’s still acquiring leases, but the company confirmed it’s drilling five vertical wells to delineate the field, so stay tuned. We’ll get either feast or famine.

Kirkland’s (KIRK) reported 4^th quarter and 2010 annual results last week. Pre-tax operating margins were 10.1% as compared to 11.6% last year. The “guidance” for fiscal 2011 is for flat to slightly negative same store sales (SSS) and slightly lower operating margins. (I really, really hate the practice of earnings guidance.)

At 20.5 million fully-diluted shares outstanding, KIRK’s equity is valued at $297.25 million. Accounting for $91.2 million in cash, KIRK’s 2010 pre-tax operating earnings of $41.97 million are being valued at a multiple of about 4.9. I’ll post some more thoughts on the Forum once I’ve had a chance to listen to the conference call.

Did you by any chance miss Jason’s 2010 portfolio review? No worries, because he didn’t actually write it until this past week. It may be a bit tardy, but it’s an excellent exercise in portfolio management to do it in March of the following year.

If the conventional wisdom on investing is seemingly always wrong, why do so many follow it?

It’s not like this advice was sourced from the distilled knowledge of millions of investors collaborating jointly for the benefit of their fellow man. Rather, these homilies and not so true-isms mostly come straight from the financial industry itself, and basically tell potential investors what they want to hear, not what they need to hear.

When was the last time you saw an advertisement for a brokerage that said, “Our clients lost money last year?” When was the last time you read a mutual fund ad that mentioned that your fund manager does not invest in the fund he manages?  Don’t rack your brain too hard trying to answer the question, because it’s never happened and never will.

While the financial industry’s top priority is wealth creation, it’s the creation of their wealth, not yours, that takes the top rung. The key metric for measuring a financial management company’s value is its assets under management (AUM).  Since financial managers charge a percentage of AUM, the larger the asset base, the more they collect.  It makes a nice story to say that the fund and the customers are aligned, because growing assets mean growing fees. That’s the angle that gets all the print, but that’s not the only way to read it.

For the managers, this source of revenue is like an annuity. Every day that the money stays at the firm, the firm gets a little bit richer. Likewise, any day that a customer removes his money, the firm gets a little poorer. The top goal, then, is not necessarily to make money for the customers, but rather not to lose any customers. Making money for them comes second.

If you’re new to the investing world, you can be forgiven if you think the best way to avoid losing customers is to make them money. But, in reality, the best way to avoid losing customers is to avoid big losses. Outside of CGI readers, few customers really care if their investment didn’t do as well as it could have, as long as it went up. But almost all customers get really upset when they lose money. It follows, then, that the easiest way for a fund to maintain assets under management is to avoid doing substantially worse than the competition at any given time.

But wouldn’t it be better for the fund company to please its customers by just making them more money than the benchmark?

Well, you know how Warren Buffett says he’d rather make a lumpy 15% return than a steady 12%?  He can say that because he doesn’t manage a fund; he runs a real company, and Berkshire Hathaway’s earnings aren’t dependent on what his shareholders think.  If Warren buys Burlington Northern at 20 times earnings and makes shareholders mad, he just waits them out. Two years later, when the shareholders realize that he only paid 10 times 2011 earnings, he just smiles. A fund manager who played that game would lose all his customers — and his paycheck — before he could be proven right.

There’s great comfort in staying with the crowd and not venturing out, but your comfort should come from within when investing and not from what others say.  Like my favorite Benjamin Graham quote, “You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.”

True wisdom is not conventional, but timeless.

Last week, I talked about Master Limited Partnerships (MLPs). Today we’ll look at one in particular.

VF portfolio holding Eagle Rock Energy Partners (EROC) makes a point to hedge 80% of its production and processing gas for two years into the future to ensure predictability. This makes it easy to project the future, but it also means that currently, Eagle Rock is receiving below market prices for oil, though slightly above market prices for gas.

Why not hedge 100%? Because if you did, and then you didn’t actually produce the volume of product you thought you were going to, you’d be on the hook for the difference. This is more commonly called speculation or gambling.

For example, Eagle Rock Energy’s East Texas oil and gas production is currently shut in, due to a third party processor’s plant fire, which led to a multi-month plant refurbishment. As a result of lost production, it is effectively hedging about 96% of its actual production until the plant is back on-line in mid-February. Since oil currently sells for a higher price than when the hedges were put in place, hedging based on 100% production would have required Eagle Rock to make up the difference in the market at a higher, more painful price.

Why is Eagle Rock attractive now after getting hammered by falling commodity prices and liquidity squeezes in 2008, and nearly going bankrupt?

Well, time heals all wounds that can be fixed by slashing your dividend from $1.60/year to 10 cents/year for nearly two years. In addition, the partnership sold producing assets, issued a rights offering, and bought out its general partner.

Yes, it was grim, but by withholding distributions and selling more equity to pay off immediate borrowings, there is no longer any question about its survival. It is also on course to raise its distributions from two-and-a-half cents a quarter to 19 cents by year end 2011.

On January 27, 2011, the new distribution policy was reaffirmed when the partnership announced a $0.15 distribution rate for the February 14^th payment.

Because Eagle Rock, at $9.00/unit, is currently only yielding about 1% on its 10 cents/unit distribution, few yield-hungry investors are attracted to it. However, at 75-cents/unit distribution, the yield will climb to 8.3%, which isn’t bad at all when 10-year Treasuries yield half that amount, and other comparable limited partnerships yield 6% to 7%. If Eagle Rock’s yield settled to 7%, on a 75-cent distribution, the implied unit price would be $10.71/unit. Adding in 60 to 75 cents of dividends, we would get a return of 25%.

For me, a more attractive option is to purchase the Eagle Rock Energy warrants (EROCW). These permit their owner to buy one unit of EROC at $6 until May 2012. By purchasing the warrant, we won’t collect any distributions, but our anticipated return will be $1.71 divided by $3, or 57%.

The warrants provide a leveraged return over the next 16 months, when I expect the largest capital appreciation.  Long-term income investors may prefer to buy the partnership units directly and maximize the tax deferral aspects of MLP ownership. I recommend that income-oriented investors take this approach with an interstate pipeline oriented MLP rather than one like Eagle Rock, which operates with relatively shorter-lived assets.

Disclosure: Doug owns EROCW in his personal account.

I’ve finally visited the new Steak ‘n Shake in Katy, TX.  It’s been open more than a month, but every time the family goes out to give it a try, the line is out the door, so we’ve gone elsewhere. Tonight we went early and got the last table available without waiting.

The location is excellent with great visibility, and the large glass windows surround three quarters of the restaurant, making the dining experience look appealing from the outside.

Guess what was the first thing I saw as I entered the door?  Yup, Sardar Biglari’s smiling face on a promotional poster welcoming me. I didn’t really need to see it, because I figured his smile had something to do with his compensation package. But maybe I’m just paranoid.

My wife and I found the whole dining experience a little bit underwhelming — think Sonic with chairs — but my six-year old and nine-year old both loved the place. My older one wore the Steak ‘n Shake grill hat in the car all the way home, so you better believe we’ll be back.

I was impressed with the staff — very upbeat and professional — but was disappointed to see that it must take about 10 employees in the kitchen just to keep the place running. I sat near a window on the drive-through side, and can report that the line at the drive-through was long, but slow. This is a new restaurant, but they need to speed that line up.

This location is on my daily commute, so I’ll let you know if its business dies down once novelty expires. For now, Sardar’s looking like a genius at Westgreen and I-10 and deserves his smile.

We received Terra Nova Royalty Corp’s (TTT) first cash dividend today. Terra Nova’s primary source of income is from iron ore royalties.  Iron ore prices are up this year, which is good for now, but it gives me pause for the long-term. Nothing attracts new competition like high prices, and the time to buy a commodity producer is before the rise and not after.  On the other hand, the long-term success of Terra Nova is not tied to iron-ore, but rather to how the iron-ore royalties are reinvested. On this ground, we’re likely to do well with Mr. Michael Smith at the helm.

Nicholas Financial (NICK) reported fantastic earnings last week. Per share diluted net earnings increased 52% to $0.38, as compared to $0.25 for the three months ended December 31, 2009. Revenues were only up 11%, the rest of the gain is attributable to a sharp decline in credit losses, with charge-offs down by one third. Nicholas also announced acquiring sites for new branch offices in Chicago and St. Louis to be opened by Q4. This little engine that can is still chugging along with its P/E of 9, with plenty more track to run.

Publicly-traded energy-related Master Limited Partnerships (MLPs) are odd creatures. Structured as partnerships and not as corporations, they don’t pay taxes or dividends. Rather, they simply pass through their free cash flow, as well as the obligation to pay taxes on it, to each of their partners, and the income is taxed only once when it hits your form 1040.

Even better — since they also pass through the large depreciation expense on their assets to the partners, the distributions of cash from the partnership can be treated as a return of capital and not a taxable event. When the shares are finally sold, taxes are due, but that could be years later.

So why isn’t every company set up this way to avoid corporate taxation?

First, Congress has restricted MLPs to the energy industry since 1986. Second, the trick of deferring income taxes only works when depreciation is higher than income. This occurs with expensive, but long-lived, assets such as pipelines.

The second, purely theoretical, concern was that operating a debt-laden business as a partnership that passed through its earnings rather than retain them for a rainy day, would be a poor business structure for a liquidity crisis. Because there hadn’t been a financial panic in the U.S. since the Depression, everyone was willing to overlook this issue.

This last theory proved to be correct in the fall of 2008, when every last energy-related MLP got decimated.  A combination of years of unfettered expansion by the industry, a 60% drop in natural gas prices, the extinction of all liquidity for refinancing debt-heavy energy infrastructure providers, and the bankruptcy of Lehman Brothers, the then-undisputed king of MLP investment banking, led to a total bloodbath in the market for MLPs, and to sweaty palms amongst worried CFOs.

MLPs live on debt, and we all know to be leery of debt. If there’s ever a safe place for it, you’d think a billion-dollar pipeline serving a critical public need under long-term contracts set by government tariffs, which eliminate competition, is about as safe a place as any. However, if you’re in the middle of a financial panic, and your investment banker goes bankrupt, it just doesn’t really matter how good your business is if you need cash to rollover a debt and can’t get it.

While all got hit, the actual level of disaster was a function of the MLP’s risk profile. The first MLPs to come to market years ago were boring and safe companies that owned product pipelines filled with gas, diesel, or aviation fuel. The product remained owned by third parties during transit, and the use of the pipeline was governed by long-term contracts. Later came the more adventurous pipeline companies, those that might actually take ownership of the product and hedge out the commodity risk, but who still operated in a pretty steady-eddy environment of sound customers with solid contracts.

Now, I think you know where this is going. Eventually some MLPs were formed without regard to whether the assets were really stable and long-term enough to fit the debt schedule and distribution-paying requirements should a downturn in the business occur. The poster children for this segment were MLPs that assumed full commodity risks and weak customers. The riskiest group included members like Highland, CrossTex Energy (XTEX), Atlas Energy (ATLS), and Eagle Rock Energy Partners (EROC), and operated gas gathering systems.

All about gathering systems

These partnerships focused not on large stable interstate pipelines, but on the collection of small pipelines in a producing region, which connect individual gas wells or fields to the larger pipeline. This network is called a gathering system.

But unlike an interstate pipeline with a 50-year life and many diverse customers along its path, a gathering system pipeline serves a much more limited customer base. The pipeline that is physically built between a major pipeline hub and a gas well has no alternate use once the gas well is depleted and goes dry.

Gathering systems process the raw gas, as well. Most gas wells produce not just methane, the simplest hydrocarbon gas, but also heavier components, such as ethane, propane, and butane, which sell at prices more closely related to oil. By separating out these more valuable components, the total sales realized from a gas well is significantly increased.

Because a small time delay occurs between when the gas is received and when the components are sold, the processor is normally taking on a little commodity risk in this operation. This, however, can be hedged out easily enough. However, should gas prices decline significantly and quickly like they did in the fall of 2008, this small risk can become substantially larger. Another risk is that the customers who use component gas for feedstock may shut-in for an extended period after receiving damage from a hurricane or fire.

In addition, some gathering and processing LPs also include producing oil and gas fields into their asset mix.  But, unlike an interstate pipeline with a 60-year useful life, the remaining life of an oil and gas field bought by an MLP may be only 10 more years, during which time its production is declining each year.

The natural decline of an oil and gas field can only be arrested by making new capital investments for new production. Therefore, I question putting these depleting assets in an income investment where investors expect stable, if not rising, distributions. It doesn’t take a rocket scientist to know that the longer life and minimal capital requirements of the pipeline over the oil field make the former a much more attractive asset for an MLP to own.

You know how Warren Buffett likes to say that he’d rather earn a lumpy 15% than a steady 13%?  Well, Warren isn’t an MLP investor. They belong to the camp that prefers a steady 13% return. MLP operators, therefore, need to offer consistent, steady distributions to attract and retain them. As a result, all MLPs hedge their commodity exposure to varying degrees in a trade of maximum possible gain for stability.

Next week: A look at how this affects VF Portfolio holding Eagle Rock Energy.