Upstream master limited partnerships took a wholesale hit to the bottom line in July. The reason may be an immature-investor temper tantrum.

The 12-strong E&P MLP sector came “under siege” that first week, declared Robert W. Baird analyst Ethan Bellamy in a research note, a perfect storm of converging factors that stripped $3 billion in market capitalization (18%!) from the group. “The bear raid has created a four-standard deviation gap from normal upstream-to-midstream MLP spreads,” he reported.

Why? Fear mostly. Fear of a government inquiry on a pending merger, fear of a long delay in inking a deal, fear of overleveraging a deal, and fear of puts, collars and swaps—misinterpreted as a hedging three-cup-short con.

“We expect the whole upstream MLP sector to underperform in the short run,” said Bellamy. “We caution investors broadly on upstream MLP equity positions given the attention of short sellers.”

Raymond James analyst Kevin Smith also deemed the group under attack. “The first half of 2013 has not been kind to the upstream MLP space,” he said in a report.

“Despite a record number of announced acquisitions, the space has significantly underperformed the MLP index and the broader markets. What has surprised us is the amount of misinformation in the marketplace, as new investors look at the space for the first time with less-than rose-colored glasses.”

New investors. Investors seeking yield-oriented vehicles but maybe not familiar with oil and gas practices.

Unquestionably, the SEC’s revelation that it is going to review Linn Energy’s merger with Berry Petroleum—the first-ever acquisition of a C-Corp by an MLP—cast a pall across the space. Linn’s stock immediately plunged 32%, dragging others down with it by association. But the inquiry is neither unexpected nor a death knell, suggested Wunderlich Securities’ Jason Wangler. Rather, due diligence.

“While it’s nice to be a pioneer in theory, given the glory and honor bestowed upon a successful deal, behind the scenes there are many issues that have likely never been dealt with before. The fact that this deal has taken longer than expected is not a surprise, nor a concern, to us.”

Smith, similarly, is confident in Linn and the deal. “It will not take the SEC long to come to the same conclusion we did; which is the company’s accounting is in good order and represents the company’s overall health. We remain positive on the stock.” He rates Linn Outperform.

In another downward sector pull, EV Energy Partners entered the second quarter facing debt-covenant pressure and nine months overdue in announcing a long-anticipated Utica shale sale. A $350-million capital commitment to a midstream project over the next few years increased investor angst. In that time its stock sank 50%. “EV has to sell something,” said Bellamy.

Subsequently, the partnership sealed a deal for 4,000 acres in August, just 4% of the total 100,000 up for sale, for $56 million. But the near-$13,000-per-acre valuation and promise of more sales to come springs hope, not to mention relaxed debt covenants layered in. Bucking the laggard investor sentiment, two analysts give EV an Outperform rating.

Similarly, investors bolted after BreitBurn Energy Partners signed an $890-million acquisition solely using its revolver. Concerned that the company didn’t issue equity to retain liquidity, the stock lost 12% in a day. The “major strategic error” put a bullseye on BreitBurn, suggested Bellamy. Raymond James’ Smith, however, said the market was being overly sensitive to potential equity offerings, noting the company still has $350 million in liquidity. “We believe the market is underestimating Breit-Burn’s cash-flow growth potential.”

Short sellers, likewise, have made a lot of unnecessary noise about MLPs (in particular, Linn and BreitBurn) using “puts” in their hedging programs to limit commodity price volatility, and how the puts are accounted for on the balance sheet. “In our opinion, puts are a very useful tool to hedge a greater degree of production,” Smith instructed clients that might be spooked by the practice. “We believe the market has significantly overstated the industry’s use of puts.”

In lieu of the SEC wildcard, Bellamy slapped a Speculative rating on Linn, but noted, “We remain constructive on upstream MLPs as a group longer term, but risk-averse investors likely need more clarity to build positions in the current environment. Stepping in here is suitable for aggressive investors only.”

But all analysts monitored saw strength in the sector—and opportunity.

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