A New Partnership

Rise of MLPs to accelerate consolidation of convenience and fuel marketing.

Samantha Oller, Senior Editor/Fuels, CSP

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Risk Factor

Nearly a dozen investment institutions and holding companies interviewed by CSP have embraced MLPs as a low-risk, highly accretive investment that prom­ises companies greater capitalization and fluidity, and consistent dividends for its investors—a win-win in the otherwise high-risk financial markets.

But a small chorus of financial experts is warning of a canary in a coal mine. It’s not that MLPs don’t have a strong upside; they do. But, these dissenters argue, the investment vehicle is evolving, with new forms and players. And, as with any investment, there is risk. And their fear is that effusive optimism is drowning out inherent risks.

“The trend has clearly been pushing the IRS envelope in terms of what gets approved and what they say is qualifying income for an MLP,” says Hinds Howard, an Austin, Texas-based asset manager and investment banker for Guzman Invest­ment Strategies who specializes in MLPs. “On the upstream, downstream, oil-field services—anything/everything is going into an MLP.”

While Howard acknowledges it cre­ates an opportunity for specialists such as himself to sift through the MLPs for investors, “It also creates a risk of a lot of investors buying something based on an idealistic view of what an MLP is: These are all safe, high-yield pipeline assets. But here’s one that will give you 19% yield. Those things don’t match up in a world where you go to a bank and can’t get 0.5% yield.”

Trinder agrees that the evolution from MLPs based in stable, conservative upstream and midstream assets into new downstream entrants has introduced new questions.

“A pipeline is a really good type of asset to have in an MLP because people will deliver product into that pipeline over a long-term contract,” he says. “That long-line asset with large corporate cus­tomers is a much different risk profile than Susser.”

Trinder cites Susser’s foray into MLP as a risky investment. For one, it is brand new, and he views any new MLP IPO as inherently riskier for the first year of its publicly traded history because it has not yet proven it can maintain and grow its distributions.

Second, “It’s a little different: It’s wholesale fuel distribution and some rental income from actually having real estate for some locations, and that is just different, and different to me is always riskier.”

Trinder is careful to say he sees no fundamental flaws in Susser’s business operations and praises what he—and many others—say is a top-notch execu­tive team. That said, he contends that SUSP’s IPO would have been attractive to him at a unit price of $17 to $18, maybe $20. But not $23, which is where it ulti­mately opened.

“Clearly,” he says, “the management team did a great job on the road show, and underwriters did a great job of get­ting them in front of potential investors for this IPO, and must have done a great job also on focusing on just the yield— ignoring the tax-deferred portion.”

Another fundamental concern of MLPs, Trinder says, is the business structure. Typically, a general partner (GP) has a 2% ownership stake in the partnership and can receive an incen­tive distribution through ownership of the MLP’s incentive distribution rights (IDR). In the case of SUSP, the general partner’s interest will be 0%, or “non-economic.”

“I would prefer to see that 2% equity in there down the road,” he says. “If you look at the history of larger MLPs, GPs have been putting 2% in over 20 years— that adds up to a lot of money.”

An official at Wells Fargo, who spoke on condition of anonymity, echoed the same concern. Though the official said he generally supports the expansion of MLPs into non-traditional sectors, notably the convenience and petroleum channels, he acknowledged what he considers a “conflict of interest with the general partner.”

Specifically, it is the same manage­ment team that controls both the MLP and the parent company. So, taking Susser as an example, in theory a conflict could arise about the proper price in a sale between assets moving to and from Susser Holdings and Susser Petroleum.

Huhndorff of Raymond James isn’t concerned. “I’ve seen this concern raised before, and the response is pretty simple,” he says. “If someone could provide a tangible example of a prec­edent where this issue has negatively impacted the MLP value, then it would be a more credible risk. I’m not aware of any.”

Generally speaking, Huhndorff says he understands the fear of conflict of interest, but IDR upsides and other benefits are “greatly mitigated by the GP’s ownership of common and subunits.”

“The GP is highly incentivized to not do anything (dilute cash flow per share, overpay for an acquisition, cut distributions, pay excessive management comp, etc.) that would negatively impact the value of the common units,” he says. MLPs should clearly define in the partnership agreement transfer of assets, he says, and most MLPs require third-party fairness opinions to confirm transfer valuations.

Howard of Guzman Investment Strategies says he sees potential in the wholesale-fuel-based MLPs.

“The Susser and Lehigh cases—I think those can work in an MLP just fine and can grow over time by adding other sources of distribution, or eventually buying other companies,” he says. He cites the example of Global Partners LP, an MLP formed in 2002 based on terminal assets and a wholesale fuel distribution busi­ness, and the acquirer of large wholesale distributor and c-store operator Alliance Energy earlier this year.

“That’s a traditional MLP structure, in terms of having a minimum quarterly distribution,” says Howard. “This sector is so much about management and being conservative with all of these levers you can pull to make your distributions do whatever you want. So management is supremely important. Almost any asset can be an MLP and be successful if they have good management teams.”

Variable Rewards and Risks

Because of the seasonality and cyclical nature of certain energy businesses, the variable-distribution MLP has become a popular structure to assume for operators who want an MLP’s tax advantages but are not able to pay out a minimum quarterly distribution. Instead, the MLP distributes all of its available cash generated in a particular quarter.

While this format had previously attracted nitrogen-fertilizer manufacturers, the new players in this format are refiners, who play in the higher reward/higher risk world of commodities and volatile margins.

In July, Northern Tier Energy LP (NTI) formed as a variable-rate MLP whose assets are a St. Paul Park, Minn., refinery and a 17% pipeline interest. Its parent company, Northern Tier Energy, was formed by Acon Investments and TPG Capital after they acquired Marathon Oil’s downstream assets—including 166 SuperAmerica locations—in 2010.

(SuperAmerica now exists in a C corporation subsidiary along with SuperMom’s Bakery, a baked-goods operation that supplies the c-store chain. After-tax income from the retail operations is distributed to the MLP.)

“If you look at the refining industry, there has been a lot of shareholder activism,” says Maria Testani, director of planning and strategy for Northern Tier Energy LLC, Ridgefield, Conn., citing Marathon Petroleum’s change of heart regarding forming an MLP with its midstream assets. “Investors have demanded they get their money back, and the refiners save cash for a rainy day. We said, ‘Why don’t we distribute the cash back?’ We’ll make a promise to distribute it back every quarter.

“If we need the cash for growth projects, we’ll come to the market and ask for it. If we’ve performed well, [the] market will give it to us. If we haven’t, then the market won’t.”

This latest evolution of MLPs makes some analysts nervous, for various reasons.

“If you’re a refiner, you’re exposed to the crack spread, which, when it’s good, it’s really good,” says Trinder. “When it’s bad, you lose money with every barrel of input you put into the refinery. You lose cash flow. That’s really bad if you have to distribute all of your cash flow for the quarter.”

“The refinery MLPs are scary to invest in,” says Howard. “They will have a high yield and investors will jump on them; we’ve just never seen the down cycle for these variable-distribution MLPs.”

Testani acknowledges that variable-distribution MLPs are not for every inves­tor. “If you’re looking for a minimum quarterly distribution, stable income like a pipeline company, it will undoubtedly be more risky,” she says. “That’s why these companies demand a higher yield. We traded at a much higher yield than a tra­ditional distribution pipeline company within an MLP structure.

“But if you look at it compared to a refining C corporation,” she continues, “it’s definitely less risky because we’re distrib­uting cash every quarter. What we make we’ll go ahead and pay out, and you’ll get that cash. If we need money back, we will come to market and ask for it.”

Although it was hoping to price at $19 to $21 per unit, Northern Tier Energy LP’s IPO of 16.25 million units priced at $14 a share. Investors’ initial trepidation “surprised us,” Testani admits, but she believes two factors were at play. First, it was four days into a down market. “Inves­tors felt they weren’t willing to pay a cer­tain price given the market conditions of that time,” she says, “and they knew they could demand a lower price.”

Secondly, another variable MLP that debuted about a week prior was trading at only half its price. “They were unsure of the variable MLPs at the time,” she says. “I think now they’re getting more comfortable with it; when we start dis­tributing our cash, they’ll get more com­fortable.” In fact, as of press time, NTI was trading at $21.20.

Adding to investors’ confidence is the fact that NTI beat its own projections on adjusted EBITDA, projecting $220 million to $240 million and ultimately reporting $246.5 million in its second-quarter 2012 earnings report. “Investors are becoming more comfortable with our story and the fact that we’re exposed to crack spreads in the upper Midwest, and sourcing crude from the Bakken [Oil Formation] and Western Canadian oil sands, so they’re getting more comfort­able with the fact that we’re a pure-play, mid-continent refiner who will distribute cash on a quarterly basis,” says Testani.

“When I’m looking at an MLP, I like to see a story about how they will grow,” says Howard, who cites Tesoro Logis­tics, which started as an MLP with a very small pool of assets and then grew them by investing in production of oil at the Bakken Oil Formation and aiming to fix bottlenecks. “That’s a great story. But with the variable distribution MLP, you’re buying a single asset—let’s say it’s a refinery. It might have great cost advan­tages; you can buy cheaper crude and have higher margins than other refineries. That’s OK, but beyond that, there’s no story, no growth.

“That’s what worries me about these things: There’s never been a variable-dis­tribution MLP that’s issued equity after its IPO. It’s a prerequisite for growth, to enable them to find new equity capital to fund future growth.”

Because of the small size of the invest­ment class, there is concern that the fail­ure or poor performance of one MLP will reflect poorly on all and scare away investors. In its online edition, the Wall Street Journal warned that MLPs may be heading toward a bubble, citing an announcement from Alon USA that it plans to put its Big Spring, Texas, refinery into a variable-distribution MLP.

“Such expansion of what goes into MLPs comes amid other clues that the sec­tor is overheating,” the Journal article says, citing a report from CreditSights analyst Andy DeVries that a jump in acquisition multiples, several new MLP funds and the “strange resilience this year of several MLP stocks exposed to slumping ethane prices” are signs of a pending collapse.

There is also concern that it will prod the government into cracking down again on which types of assets can be included in the business structure—similar to what happened in the 1980s, when even the Boston Celtics formed an MLP to enjoy its tax savings.

“I worry about regulatory risk,” says Howard. “If the whole S&P 500 energy portion goes into an MLP, then we have a real problem with the MLP structure going away entirely.”

Johns of BMO Capital Markets is not as dire, though he does raise some yellow flags: “We’ve had all sorts of bubbles— the tech bubble, the real-estate bubble. Humans tend to get carried away, and that’s our nature.

“The early stages in an investment opportunity is harder to determine win­ners and losers,” he says. “But investors will buy and sell, and with MLPs you only need one winner to reap your reward.”

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