The commentary below is adapted from remarks made by Kevin McCarthy, CEO and President of KYN, KYE and KED, during the KED earnings conference call for the quarter ended August 31, 2009.  The conference call took place on October 7, 2009.

MARKET COMMENTARY

It’s been a very interesting quarter for companies in the energy industry.  There were many positive signs, including continued strength in Master Limited Partnership (MLP) prices, substantially stronger bond prices, and continued recovery of crude oil and natural gas liquids (NGL) prices.  On the other hand, stock prices tend to reflect future expectations, and operating conditions in the energy sector remain difficult.  We believe that energy companies have had the same experience as other companies across a broad range of industries – the recovery may be coming, but it’s not here yet.

The MLP market has continued to perform very well in 2009, with the Alerian MLP index gaining 4.9% during the fiscal quarter ending August 31, 2009.  The strong performance continues as the MLP index is now up 41.6% year to date through October 5, 2009 compared to a 15.2% increase for the S&P 500 index.  All of this supports our belief that MLPs were oversold in 2008 due to the technical factors that we discussed in previous earnings conference calls.  We also believe the characteristics of MLPs that we’ve extolled for many years – attractive cash distributions and stable, fee-based cash flows – are proving to be very appealing to retail investors in this low interest rate environment.

Certain of the MLPs, namely the gathering and processing MLPs, have also benefited from continued improvements in certain commodity prices.   It’s been a difficult period for natural gas and coal, but prices for crude oil and NGLs have strengthened throughout the year.  The prices for NGLs are up almost 60% from the beginning of the year.  As a result, gathering and processing MLPs, which produce NGLs, have recovered from a disastrous 2008 and are up over 100% year-to-date through October 5, 2009.

In terms of the broader energy market, energy stocks were essentially flat for the quarter, but have performed very well year-to-date.   As of October 5, 2009 share prices for exploration and production (E&P) companies were up 31%, oil services companies were up 55%, and coal companies were up 68% year-to-date.

While energy stock prices have performed well, certain of the commodity markets are still very weak, especially for domestic energy commodities like coal and natural gas.  The recession has reduced industrial demand for electricity, resulting in lower demand for both natural gas and coal.  The recession has also caused fewer goods to be shipped, and fewer miles to be driven, so demand for gasoline, diesel and jet fuel has declined.  As a result, natural gas storage is nearing full capacity for the first time ever, diesel inventories are at their highest level over 25 years, and coal inventories at utilities are at all-time record levels.

This put further pressure on natural gas prices during the quarter, eventually pushing them down to eight-year lows in early September 2009.  With prices below $4.00 per MMBtu during most of the quarter, many producers delayed drilling, delayed completions or even shut in production.  Prices per ton for steam coal traded down to the mid-$40’s which is below the mining cost for most Appalachian coal producers.  And finally, refining margins, especially for economically-sensitive refined products like diesel and jet fuel, remain well below historical levels.

The good news is that signs are pointing to a recovery in 2010.  Supplies of both natural gas and oil are expected to decline because drilling activity is currently at half the levels we saw last year.  Likewise, expectations are that demand will slowly improve during 2010 as the overall economy improves, both here and globally.  These expectations are reflected in the futures markets, with 2010 natural gas prices trading in the mid $6.00 per MMBtu range, compared to less than $3.00 per MMBtu less than a month previously.  Coal prices and oil prices are also in steep contango, with prices for 2010 delivery about 10% higher than current spot prices.

The outlook for MLPs is positive.  We are very encouraged by MLPs’ access to the capital markets since the beginning of the year. Capital raising activity has grown with each successive quarter in 2009, and has reached levels far higher than what we expected at the beginning of the year.  So far this year, through October 5, there have been 36 follow-on offerings for a total of almost $5 billion.  The debt markets have also been very strong, with over $9.5 billion raised year-to-date.  More importantly, we’ve seen a tremendous tightening in credit spreads which serves to lower the cost of capital for MLPs.  The rates for investment grade deals have fallen from over 9% to under 6%.  For non-investment grade names, rates have fallen from over 12% to under 9%.  This is very important for MLPs, because access to capital at reasonable rates is critical for financing both internal projects and acquisitions that may ultimately lead to distribution increases.

The question we get asked most frequently is whether there is still upside in MLP valuations given the strong performance so far this year.  We believe that MLPs are still attractively valued even with the recent price gains.  On an absolute basis, MLP yields are almost 100 basis points above the five-year averages, and the spread over the 10-year Treasury is almost 200 basis points wider than historical levels. 
           
With regard to MLP distributions, we believe that the worst is behind us.  Distribution growth began to show improvement during the quarter ended August 31, 2009 as MLPs were able to access capital to finance both organic growth projects and acquisitions.  Distribution cuts have slowed significantly – only two MLPs cut their distributions this quarter compared to six last quarter – and no cuts are expected for next quarter.  We expect more MLPs to focus on distribution growth this coming quarter as the recession eases and as their management teams become more comfortable with the stability of the capital markets.