With an oil and gas midstream company such as Magellan Midstream Partners (NYS: MMP) , you expect relatively consistent earnings. So why did Magellan's third-quarter revenue drop by more than 50% year over year? Simply put: futures contracts.

When hedging goes wrong
When a company engages in oil and gas futures contracts, it hedges against potential losses, which could come from a drop in energy prices. This quarter, though, those hedges backfired at Magellan and brought down what could be considered a productive quarter. Comparing year-over-year numbers for this quarter gives a compelling argument for investors to discount losses or gains from hedges. In Q3 2011, Magellan benefited from its hedges to the tune of more than $30 million; this quarter it lost more than $29 million.  After adjusting revenue for the $60 million in discrepancies, we see that Magellan actually increased its operational revenue for the quarter.

Looking purely at Magellan's operations, we see that they performed well in the quarter. Pipeline revenues increased from transporting higher volumes in its network, and operational cash flow for the entire company increased 7% year over year. Looking forward, the company has been busy working on a deal with Occidental Petroleum (NYS: OXY) concerning a joint venture on the potential BridgeTex pipeline, a 278,000-barrel-per-day pipeline . This $600 million project would  expand the capacity to deliver oil from central Texas to several refining facilities in the Houston area. This pipeline would be another valuable asset within the company's network.


Magellan hasn't been the only company to suffer from bad hedges this past quarter. In a more egregious case, Linn Energy (NAS: LINE) wiped out 93% of its operational revenue for the quarter through futures contracts. At first glance, big losses for the quarter could make the less patient investor sell, without really looking deep into why those losses occurred. What's important to note for investors is that while these hits can have a big impact during times of volatile oil and gas prices, it doesn't mean doom and gloom for the company as a whole.

What a Fool believes

Company

Dividend Yield

Payout Ratio

P/E

Magellan Midstream Partners

4.5%

81%

24.91

Enterprise Products Partners (NYS: EPD)

4.9%

93%

20.21

Energy Transfer Partners (NYS: ETP)

9.6%

78%

8.85

Source Yahoo! Finance.

Oil and gas prices may fluctuate, but the products are always in demand. That's what makes midstream companies such as Magellan, Enterprise Products Partners, and Energy Transfer Partners so attractive. Working as the toll roads for oil and gas, these companies have a distinct advantage within the space because they aren't as exposed to the high costs associated with exploration. These companies are generally stable investments with strong dividends. I'll be making an outperform call on CAPS for all three companies to keep me honest

Magellan Midstream Partners is one of several companies within the midstream oil and gas industry positioned to make big moves in the upcoming years. Some experts estimate that these companies look to spend up to $210 billion in natural gas infrastructure projects to meet rising demand and revamp much of the energy infrastructure in North America. These investments and other developments in the oil and gas sector means there are some great opportunities for investors. We at The Motley Fool have kept a keen eye on this sector, and our analysts have found The Only Energy Stock You'll Ever Need. We've put together a report on this company. To get a free copy, click here.

The article Don't Let Hedging Losses Overshadow This Midstream Company originally appeared on Fool.com.

Fool contributor Tyler Crowe owns shares of Linn Energy.  You can follow him at Fool.com under the handle TMFDirtyBird, on Google +, or on Twitter, @TylerCroweFool. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Enterprise Products Partners and Magellan Midstream Partners. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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