On Track

Coal fuels 50 percent of the nation’s electricity generators, and it is the fuel of which the United States has the most reserves. One cloud over the industry has been its safety record. We had the collapse in Utah and Sago in 2006. But the safety record was pretty clean in 2005. The MLP space was severely hit in early August. We had not expected that. The reason for the hit was due to the credit crunch.

About Natural Resource Partners, L.P. (NRP): This firm is unique among both master limited partnerships (MLPs) and coal companies as the only pure coal-royalty play. As such, it provides investors with an opportunity to participate in the commodity price of coal in a tax-advantaged vehicle without being subject to operational, regulatory, or environmental expenses.

While NRP does not have any financial hedges in place to lock in the price of coal, most of its lessees do have long-term contracts that are as effective as hedging in capturing today’s high prices for the long term. As coal prices continue to remain high and contract terms continue to lengthen and benefit the producer, the higher realized sales prices should mean higher revenues and earnings for NRP.

The firm owns or controls 2.0 billion tons of coal reserves that it leases to third-party operators, which, in turn, mine the coal and pay NRP a royalty.

Although the partnership does assume some commodity price risk, it avoids or mitigates most of the operational and environmental challenges that most coal companies must manage. The result is that it has one of the highest earnings before interest, taxes, depreciation and amortizations, net margins, and cash flows of not only all coal companies, but of most MLPs as well.

The partnership is actively seeking acquisitions in a number of coal basins. We believe its increased presence in the Illinois Basin, while lowering their overall per-ton royalty rate, will continue to benefit unit holders through increased distributable cash flow.

Natural Resource Partners continues to perform well and make solid acquisitions. We still see liquidity as a potential problem for investors. And while we believe that the recently executed 2-for-1 unit split and the conversion of the remaining NSP units to NRP in November will help, it remains a thinly traded partnership. Nonetheless, we believe it will continue to be a stellar performer. We are maintaining our buy rating and increasing our 12-month price target to $41 per unit from $37 per unit.

oooooooo

Samuel BrothwellWachovia Capital Markets. [email protected]

Area of coverage: Utilities

Sector outlook: With a few exceptions, second-quarter earnings were generally in line to better than expected. Against shaky broader markets, credit concerns, and recession fears, it would seem that this sector’s defensive characteristics would kick in at some point, though there remain a number of issues to be concerned about.

KKR and Texas Pacific Group’s planned leveraged buyout of TXU Corp. has survived despite escalating concerns over credit. But it should be abundantly clear by now that the fount of private equity money that buoyed sector valuations earlier this year has probably dried up. Australian fund manager Macquarie, which acquired Pittsburgh-based Duquesne Light on May 31, has reportedly suffered a 25 percent drop in one of its big real estate funds. As Montana’s flat rejection of Babcock & Brown’s bid for Northwestern Corp. has shown, regulators pose another challenge.

With private equity pulling in its horns, the door could open wider for strategic buyers, particularly those from outside the U.S. given their size and currency advantage. Indeed, if the TXU deal were to break, we would expect to see interest from European players, who have consolidated their continent about as far as they can. But here again, regulators could be a major hurdle, and not just at the state level; ownership of nuclear assets could pose a major challenge to any non-U.S. buyout proposal.

The initial fear that sparked the sell off in interest rates several weeks ago may be reversing itself as investors flock to Treasuries. On that note, the relatively defensive nature of the utility sector could kick in as yields become more attractive.

Near term, we expect natural gas to remain under pressure with full storage at this stage of the cycle. At the margin, Japan’s nuclear woes will likely drive increased demand for liquefied natural gas, which could slow volumes into the U.S. We also believe that staunch opposition to coal and a sense that the much-heralded nuclear renaissance will take longer and cost more than previously thought will force the U.S. to re-embrace natural gas for power generation. While our core natural gas-exposed names (which includes Questar) will likely trade in sympathy with the commodity, we believe they are well-protected by hedging and are underpinned by long term fundamentals.

About Questar Corp (STR): Questar is an integrated natural gas company with its core operations located in the Rocky Mountains. Through its market resources division, STR conducts gas and oil exploration, production, gathering, energy marketing, trading, and risk management services. STR also provides gas transmission, storage, and distribution services through its regulated services division.

STR’s primary value driver is its accelerating production and cash flow from its prolific natural gas reserves in the Rockies. Rocky Mountain natural gas will be increasingly called upon to meet projected U.S. natural gas demand. This should create complementary expansion opportunities for STR’s midstream operations. Regulated operations should provide a stable source of earnings to support the dividend.

The second quarter was good with adjusted earnings of $0.68 a unit versus our estimate of $0.58 and the consensus of $0.60. Key drivers for the quarter included strong hedged natural gas realized prices (something that continues to be underappreciated), solid production growth and stronger than expected midstream results, offset by slightly weaker regulated segments.

—

Clifton Linton is a Bay Area-based writer specializing in energy.