North American refiners are in the catbird seat as unconventional energy discoveries expand in the US and Canada observes Elliott Gue of Energy and Income Advisor.
Widening differentials between inland oil prices in the US and global oil benchmarks have driven the refining industry's second Golden Age. In short, the most recent up cycle isn't a global phenomenon, but applies primarily to a handful of advantaged regions in the North American market.
The 3-2-1 crack spread assumes that a refiner purchases WTI crude oil as feedstock and sells gasoline and heating oil. As we explained in Mind the Differentials, rapid production growth in the Bakken Shale and other unconventional oil fields has overwhelmed takeaway capacity at the hub in Cushing, Oklahoma, the delivery point for WTI.
Refiners with facilities in the Midwest can purchase WTI at favorable prices and sell their output at prices that reflect global supply and demand conditions. On the other hand, refineries on the West Coast or the Gulf Coast lack sufficient access to WTI, forcing them to run Brent or Light Louisiana Sweet crude oil-higher-priced waterborne varietals that constrain profitability relative to their inland peers.
In 2011, more than 16.5 million barrels of refined products-equivalent to almost one-fifth of global demand-traded across international borders. Because gasoline and distillates are globally traded commodities, the prices of these products usually track Brent crude oil, a key international benchmark.
That's great news for inland refiners in North American that can purchase WTI crude oil at a local discount and sell gasoline and diesel fuel at prices that reflect global supply and demand conditions.
Regional refining margins historically have moved in lockstep throughout the world. However, the profit margins enjoyed by downstream operators in North America have soared because of the widening price spread between inland crude oils such as WTI and Western Canada Select (WCS) and other international benchmarks.
Not surprisingly, the boom in refining margins has also resulted in the initial public offerings (IPO) of several master limited partnerships seeking to take advantage of the sector's bullish outlook and investors' insatiable demand for securities that offer above-average yields.
Alon USA Partners (ALDW) debuted on the New York Stock Exchange on November 20. The MLP had planned an IPO of 16 million units at a price of $19 to $21 each, but ultimately downsized the issue to 10 million units at a price of $16 each, likely because of a lack of demand. Nevertheless, the stock has rallied to almost $24 per unit-well above the high end of the MLP's original price range.
This downstream operator's primary asset is a single refinery in western Texas that boasts a nameplate capacity of 70,000 barrels per day and a Nelson Complexity Index rating of 10.2, indicating that the facility can handle a broad slate of heavy-sour crude oils.
In 2011, the company took full advantage of these capabilities. More than 80% of the feedstock Alon USA Partners processed was West Texas Sour (WTS) crude oil, a light crude oil that's high in sulfur content and currently trades at less than $72 per barrel-a significant discount to WTI, and an almost $40 discount to Brent. The official delivery point for WTS, Midland, Texas, is only a few miles down the road from Big Spring refinery.
|pagebreak|Oil produced in West Texas historically has found its way to Cushing, but oversupply at that hub makes the WTI delivery point a less-than-ideal destination. Moreover, the Permian Basin in West Texas has experienced a boom in drilling and oil production, as producers use horizontal drilling and hydraulic fracturing to exploit new reserves. There isn't enough takeaway capacity in the area to handle this growing output, oversupplying the local market and depressing prices even further.
Although these constraints pose a challenge for producers in this market, the Big Spring refinery should enjoy below-average feedstock costs for the foreseeable future. New pipeline capacity is on the way, but output continues to rise unabated; this bottleneck will take some time to resolve.
Meanwhile, in the first nine months of 2012, Big Spring earned a profit margin of about $22.88 per barrel of crude oil processed, and ran at a capacity utilization rate of 97.3%. By comparison, the facility operated at a utilization rate of 90.8% and generated a profit margin of $20.89 per barrel in 2011. The year prior to this, profitability was a mere $7.64 per barrel, and the utilization rate came in at 68.2%.
This wide variation in profit margins per barrel and utilization rates illustrates the inherent cyclicality of the refining business. These statistics also reflect arguably the most important point about Alon USA Partners: This nontraditional MLP doesn't aim to pay a minimum quarterly distribution and gradually boost these disbursements over time.
Alon USA Partners' prospectus makes this clear: The MLP will disburse 100% of
available cash each quarter to unitholders and will hold little cash in reserve
beyond requirements for basic maintenance. The partnership agreement also lacks
the subordinated-unit structure that many MLPs use to protect the quarterly
distribution from temporary shortfalls in cash flow.
In short, investors
should expect the payout to vary with trends in refining margins.
Alon USA Partners could offer an impressive distribution yield in a strong market for refiners. In the prospectus, the MLP estimates its distributions for the year ended September 30, 2013, at $5.20 per common unit. At the MLP's offering price of $16 per unit, this payout equates to a yield of 32.5%. Based on the current quote and assuming the MLP delivers on this forecast, the units now yield 21.7%.
However, investors shouldn't put too much stock in this forward estimate. Most partnerships lowball their forecast quarterly distributions in order to surprise to the upside. Alon US Partners, on the other hand, has assumed that the Big Spring refinery will run at close to full capacity and that the favorable price differentials for WTS feedstock will continue in 2013. Given the volatility of commodity prices and refining margins, these factors can change quickly.
Investors should also consider the potential downside during periods when refining margins are less sanguine. In 2010, the MLP generated earnings before interest, taxation, depreciation, and amortization of $31.574 million-enough to support an annual distribution of about 42 cents per unit.
In terms of future upside potential, the MLP could also benefit from drop-down transactions from its sponsor, Alon USA Energy (ALJ), which owns other downstream assets that would be suitable in this structure. With an 84% equity stake in the MLP and ownership of its general partner, the parent has ample incentive to pursue strategies that enable Alon USA Partners to grow its distributable cash flow. At the same time, the general partner's take doesn't include incentive distribution rights, a feature that frees up more cash for distribution to investors.
Alon USA Partners represents a solid play on strong refining margins, but investors should regard the stock as a short-term trading vehicle, not a long-term investment like many of our favorite MLPs. We rate Alon USA Partners a buy for investors who understand the risks associated with this nontraditional MLP.
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