Time to Buy

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On May 6 the broader market averages were headed for a sizeable decline, but the selling was orderly.

What happened over the space of about 15 minutes was extraordinary: The Dow Jones Industrials Average plunged from about 350 points down to almost 1,000, and the S&P 500 sliced through a key support at 1,100, hitting a low of 1,065. Soon thereafter, the market recovered, rallying back to roughly where it was before the precipitous drop.

No one can say with any degree of certainty why this mini-crash occurred. The most common explanation is a so-called "fat finger trade"--that is, a trader keyed in a sell order denominated in billions rather than millions. Such a mistake tends to snowball; stop-loss orders are activated, and the quick selloff triggers institutional sell programs.


But regardless of the cause, one thing is certain: The quick selloff did not represent normal market trading behavior and had nothing to do with underlying market fundamentals or any piece of news. Liquidity dried up at the lows, and very few shares changed hands--even in prominent large-cap names.

Take the case of Procter & Gamble ( PG ), a safety-first stock that tends to be less volatile than the broader market. At the height of the selloff, P&G traded under $40 per share, down 37 percent from the prior day's close, even though no news came out that would have precipitated such a decline.

Only a little over 26,000 shares of P&G actually traded at between $39.37 and $43. That's next to nothing when you consider that P&G trades more than 11 million shares on average and traded nearly 29 million shares yesterday. In short, the market simply stopped functioning.

It's no surprise that a day which features extreme moves in a highly liquid stock like P&G would produce even more examples of aberrant trading in less-liquid and more thinly traded stocks. As I mentioned in yesterday's Flash Alert, many of the MLPs we recommend in this publication suffered from the anomaly.

For example, Aggressive Portfolio Holding Linn Energy LLC ( LINE ) tumbled to an intraday low of $12.60--down 50 percent from the prior day's close--before recovering most of those losses by the close. The graph below tracks this unusual price movement.


Source: Stockcharts.com

Linn's units dropped substantially at the height of the financial crisis, but that selling was orderly. Note that the intraday range for Linn on May 6 is the biggest gap in its history.

Just as P&G had no liquidity near those lows, scant trading occurred near Linn's lows. The MLP's units traded in 218 transactions at prices between $12.60 and $17 yesterday, a total volume of about 51,000 units. On a normal day roughly 1.6 million units of Linn change hands; yesterday the volume was closer to 7 million units.

When Linn traded at that level, the bid-ask spread--the difference between the price at which you can buy a stock and the price at which you can sell it--expanded to well over $1. In a normal trading environment, the bid-ask spread would be around 5 to 10 cents. Linn's units likely would have traded lower on May 6 in sympathy with the broader market, but a price of $12.60 suggests the market wasn't functioning properly.

Although the trading action in Linn and other MLPs was unrealistic and dysfunctional, this drop had real implications for some investors, particularly those who set stop orders or trailing stops. Stop orders instruct a broker to automatically liquidate a position once the stock breaches a certain price. In most cases, traders use stop market orders; as soon as the stop is activated your broker will execute a market sell order to get you out of a stock at whatever the prevailing price might be.

Undoubtedly, there were plenty of investors in Linn, P&G and a long list of other stocks that got stopped out on the vicious intraday decline on the May 6. To make matters worse, liquidity was at a premium at the height of the selloff; many stop orders would have been executed at extraordinarily depressed prices. Stop-related selling not only cost investors a lot of money yesterday but also contributed to the broader selloff.

Ownership of MLP units tends to be concentrated among individual investors rather than institutions. Because individuals are more likely to set stops, prices of MLP units dropped more than shares of other companies.

Since Roger and I started MLP Profits , we've advised subscribers not to use stop-loss orders or trailing stops for these companies. Roger reiterated this point in the April 2, 2010, Viewpoint Rating MLP Safety .

Although no one could have anticipated a 100 percent roundtrip move in Linn Energy's units in 15 minutes, several MLPs have experienced wild intraday action over the past few years. These gyrations were undoubtedly caused, to no small extent, by the activation of scores of stop loss orders at around roughly the same price levels. Invariably these quick selloffs and recoveries will result in investors getting knocked out of an MLP at the worst possible moment.

When trading stocks, stop losses can be an outstanding way to reduce risk--I recommend stops on some positions in The Energy Strategist , the sister publication to MLP Profits.  But stops don't make sense for MLPs.

Your best bet is to keep on top of the fundamentals underlying our favorite MLPs.

If a partnership's business is sound and its distribution secure, we'll continue recommending the MLP; if an MLP has fundamental problems, we issue a sell recommendation in an article or Flash Alert.

Whenever the market heads steadily higher, hosts of investors hope for a pullback as an opportunity to buy. But when the correction actually hits, these erstwhile dip-buyers often disappear; the panic and fear that drive every correction take over.

These panic-fueled bouts of volatility are an enormous opportunity. The current market environment offers plenty of chances to accumulate our buy-rated MLPs at attractive prices.

 The broader market selling has been driven by concerns over about Greece's sovereign debt. In the grand scheme of things, Greece's economic woes wouldn't have a huge impact on the global economy in isolation. But investors fear that the contagion could spread; Greece's credit woes have already impacted Portugal, Spain, Hungary and other countries on Europe's periphery, and some fear that it could spread to larger economies such as the UK or US.

Another fear is that sovereign credit woes will infect the interbank lending market, touching off another global credit crunch akin to what happened after Lehman Brothers declared bankruptcy.

Credit woes are a problem for MLPs because these companies use debt and credit lines to fund new projects and to make acquisitions. But the risk of a 2008-style credit collapse is remote. Check out the graph below.


Source: Bloomberg

This graph tracks the TED spread back to 2005. The TED spread is the London Interbank Offered Rate (LIBOR) minus the yield on a three-month US treasury bond. LIBOR is the rate banks charge to lend to one another, while the three-month US bond yield is considered a risk-free interest rate. The spread is typically measured in basis points, equal to 1/100 of a percent.

When LIBOR rises relative to government bond yields, it indicates stress in the interbank lending markets. In other words, high TED spread readings reflect a credit crunch.

As you can see, the TED spread soared in 2007 and 2008 as the credit crunch and financial crisis worsened. You can also clearly see the improvement in this market since early 2009; in fact, the TED spread was at record lows just a few months ago. This trend has enabled MLPs to raise significant capital for expansion--a huge tailwind for the group.

The TED spread has spiked a bit recently but still indicates that interbank credit markets are extremely healthy right now--the spread is at even lower levels than it was in 2005 and 2006.

Another severe credit crunch appears unlikely, but most of our favorite MLPs already have raised significant capital via debt and share issues, providing plenty of capital to fund current growth plans even if debt markets do constrict.

Against that backdrop, any weakness in our favorite MLPs is a great opportunity to jump in and buy.

Getting Specific

Although the market continues to focus on macro-level risks, we also keep a close eye on the financial performance of the individual MLPs we recommend.

As we noted in a Flash Alert earlier this week, units of Encore Energy Partners ( ENP ) were hit hard after the partnership trimmed it distribution and its general partner (GP) announced plans to sell its 46 percent stake in the firm. 

Encore Energy Partners was originally created by an exploration and production (E&P) company called Encore Acquisition as a vehicle to hold some of that company's mature oil and gas-producing properties. Encore Acquisition owned a 46 percent stake in the MLP and controlled its GP.

This type of arrangement isn't uncommon. In many cases, E&P firms are valued based on their ability to grow production, and mature fields don't generate much production growth. But mature fields do generate copious amounts of cash; steady cash flows make these fields ideal for the tax-advantaged MLP structure. By creating the MLP, Encore raised some capital and enhanced the value of its mature properties, which are worth more inside a high-yielding MLP than buried inside a corporation like Encore Acquisition.

On March 10, 2010, Denbury Resources ( DNR ) acquired Encore Acquisition in a $4.1 billion cash and stock deal. This meant that Denbury Resources also acquired Encore's stake in Encore Energy Partners and ownership of the GP.

Denbury's proposed sale of Encore Energy Partners has weighed on the MLP's unit price, as investors interpreted the announcement as a decision not to support MLP.

Bear in mind that Denbury didn't form Encore Energy but acquired it recently as part of its purchase of another company. It's not uncommon for an E&P firm making a major acquisition to rationalize its portfolio by selling off some of the properties owned by its target. In fact, I can't recall a single E&P acquisition in recent memory where the acquirer didn't do a strategic review of the target's properties and make at least a few sales.

In this case, three factors appear to be driving Denbury's decision to sell Encore Energy Partners.

For one, Denbury's focuses on tertiary oil recovery, or the use of carbon dioxide floods to produce oil from older fields. Most of the Encore Energy Partners' properties aren't appropriate for carbon dioxide flooding. The only exception identified during the first-quarter conference call was the MLP's Elk Basin field in Wyoming and Montana. This field might be amenable to carbon dioxide flood production, and Denbury might be interested in retaining control.

Second, in early April Denbury sold off about $900 million worth Encore Acquisition's properties. These were mature properties that Encore Acquisition's management had envisioned as drop-downs for the MLP. In a drop-down transaction the GP sells properties to the limited partner, usually at a price that allows the MLP to immediately boost its cash payout. After the sale of those properties, Denbury may have concluded it doesn't have many properties left that would be suitable for drop-down to Encore LP.

This makes sense because most of the properties Denbury buys would be fields appropriate for tertiary carbon dioxide flood production.  And carbon dioxide floods require a huge up-front capital commitment relating to the infrastructure needed to acquire carbon dioxide and transport it to the field in question. This sort of capital would probably be too much to bear for Encore Energy Partners; the large upfront costs and uncertain payback period would threaten distributions. 

Without potential drop-downs from its GP, Encore Energy Partners' growth opportunities would be limited.

Finally, Denbury is seeking to sell Encore Energy Partners because the MLP is likely to fetch a good price. Encore's oil-focused properties in regions like the Permian basin of Texas are ideal in the current environment of sky-high prices for oil and natural gas liquids.

Although the MLP isn't that valuable to Denbury because of its strategic focus and lack of drop-down potential, its assets are in areas that have seen a lot of acquisition activity in recent quarters.

MLP Profits recommendations Linn Energy and Legacy Reserves ( LGCY ) are just two examples of partnerships that have acquired properties in the regions where Encore Energy operates--it wouldn't be a big surprise if both Linn and Legacy made a bid for Encore.

Bottom line: The proposed sale of Encore Energy Partners likely isn't bad news and doesn't reflect some major problem with the partnership's asset base.

Encore Energy Partners also reported results this week. Broadly speaking, the distribution cut was a bit of a disappointment, though management did make it clear that it would adjust the payout to reflect commodity price realizations.

Although Encore Energy Partners is heavily hedged--100 percent for 2010 and 90 percent for 2011--some of the hedges that expired in the fourth quarter of 2009 were struck at much higher oil and gas prices. These were likely hedges likely date back to when oil and gas were hit their highs in 2008. The expiration of those hedges is why Encore LP had lower commodity price realizations for the quarter.

As for the decline in production the MLP reported, this was expected; the mature fields the partnership decline natural slowly and steadily over time.

Encore Energy Partners posted decent results, and the market has overreacted to the news that Denbury is looking to sell the MLP; we're upgrading the MLP to a buy under 19.

Conservative Portfolio holding Spectra Energy Partners (SEP) announced solid results on May 5. The MLP reported quarterly distributable cash flow of $0.67 per unit and boosted its distribution to $0.42, a solid coverage ratio of 1.55 times.

This payout represents a 13.5 percent increase over the $0.37 Spectra paid in the same quarter one year ago. Distributable cash flow was up 23 percent.

Spectra offered updates on a couple of major organic expansion projects currently underway. First, the MLP completed a deal with the Tennessee Valley Authority (TVA) to transport 150,000 dekatherms of natural gas per day to the TVA's new gas-fired power plant. The project involves a $135 million capital investment to expand Spectra's NET pipeline in Eastern Tennessee.

In addition, the MLP announced it won approval from Federal Energy Regulatory Commission (FERC) for the Phase V expansion of its Gulfstream pipeline. The project will go into service in May of 2011.

A focus on high-quality fee-based assets, low debt and extremely high distribution coverage make Spectra among the safest MLPs in our coverage universe. In addition, the partnership has myriad growth opportunities from organic expansion projects and the potential drop-downs transactions.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

Article Republished with permission from <a href="http://www.KCIinvesting.com" rel="nofollow">www.KCIinvesting.com</a> and <a href="http://www.rukeyser.com" rel="nofollow">www.rukeyser.com</a>


This article appears in: Investing , Stocks

Referenced Stocks: DNR , ENP , LGCY , LINE , PG

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