Refining the Refined Products MLP Model

Refined products MLPs collect tariffs to transport crude or products a given distance, akin to toll-booth operators. Storage and blending services are also fee-based, allowing the MLPs to avoid taking title of the products and associated commodity exposure. One unique feature of crude oil and refined products pipelines is the Federal Energy Regulatory Commission's (FERC) regulatory price indexing, which allows interstate pipelines to change rates each July according to an index--currently Producer Price Index plus 1.3%. The FERC also prevents new interstate pipelines from being built unless deemed economically necessary, creating monopolies in some cases. Together, these traits make for a wide-moat business. Across our coverage, refined products limited partnerships have averaged 10% annual distribution growth since inception, while general partnerships--juiced by incentive distribution rights--have averaged 15%.

Volume Growth Flat to Declining
So what's the catch? Well, according to Energy Information Administration (EIA) data, total U.S. liquid fuels demand has been declining since 2005. What's more, the EIA doesn't expect demand to reach 2005 levels again until 2025, and only then with steady growth in demand for biofuels. Excluding biofuels, the EIA projects refined petroleum products volumes to remain at today's lower level of around 19 million barrels per day through 2030. While a wide range of outcomes is possible, we think this outlook seems reasonable. Looking forward for the next few years, we expect legislation, conservation, new technologies, and higher prices to keep demand in check, resulting in flat to declining domestic refined products volumes. For instance, more stringent CAFE standards aim to boost fuel efficiency; as drivers move to more fuel-efficient vehicles and stress conservation, demand decreases; and plug-in hybrids and electric vehicles are likely to further decrease demand for gasoline.

How to Grow with Flat Volumes?
With refineries being idled or shut down rather than added, it appears that there will continue to be little or no need for major new pipelines. As such, we expect refined products MLPs to continue allocating capital to terminals, which provide storage and blending services that enhance the value of an MLP's entire network. With the flexibility to store and blend greater volumes across a wider variety of geographies, refined products MLPs can better respond to market dynamics such as the recent steep contango environment or price discrepancies among different grades of crude. Greater storage capacity allows the MLP to simultaneously lock in purchases and sales of physical product at one or more delivery points on its system, capturing margin or pure arbitrage in the process.  NuStar Energy's recently released 2010 outlook illustrates the ongoing focus on storage, with over 70% of its $300 million-plus capital program in 2010 going to storage build-outs. As long as products prices remain relatively high and/or volatile, we expect demand for storage to remain strong, as we're seeing today with higher contract renewal prices and longer terms. While it's hard to say how long such an investment cycle could last, we think, judging by anecdotes of project backlogs, that it could go on for several years, particularly for MLPs with well-established networks that lend themselves to bolt-on organic growth projects.

Another growth driver in recent years has been horizontal integration. One example is NuStar, which purchased all of CITGO's asphalt refineries in 2006. While such a move has added margin-based volatility to NuStar's business model, it has thus far paid off handsomely through the ups and downs and will probably contribute meaningfully to growth in coming years. Also,  Buckeye Partners' purchase of the Lodi natural gas storage assets in California represented a significant deviation from its core pipelines and terminals operations, but one that provided similar attractive fee-based economics. The growing need for natural gas infrastructure associated with shale development could create further opportunities for refined products MLPs to diversify their operations in pursuit of growth.

Finally, we think refined products MLPs could see additional growth opportunities from asset sales, particularly from majors and refiners looking to monetize their midstream assets. For instance, Buckeye has a pending $47.5 million acquisition of two pipelines and three terminals in the Chicago and St. Louis areas from  ConocoPhillips . Recently, Conoco announced its long-term goal to focus on exploration and production, which it plans to accomplish in part by divesting its midstream assets--an array of products pipelines and terminals that generate annual EBITDA around $800 million. While these assets alone should make a considerable splash in the MLP space, a similar move by other majors or refiners could shake up the space in a big way.

Investment Implications and Our Favorite Refined Products MLP
Normally, flat or slightly declining volumes in both the short term and long term would be a hindrance to growth and a major red flag for an investor. While this issue isn't to be taken lightly for refined products MLPs, we think structural advantages inherent to this industry, persistent demand for storage, and other emerging growth media will continue to support attractive risk-adjusted total returns for several years. Like other MLPs, refined products MLPs provide healthy tax-advantaged yields, but uniquely, refined products MLPs enjoy an annual PPI-plus tariff adjustment that can help hedge a portfolio against inflation without taking on significant commodity exposure. We think this combination, which could stretch growth for income-oriented portfolios or reduce volatility for growth-oriented portfolios, merits consideration of refined product MLPs for most portfolios.

While none of the refined products MLPs we cover are currently below our Consider Buying price, one that is close and offers a particularly compelling value proposition, in our view, is Magellan Midstream Partners.

Magellan operates the longest petroleum products pipeline system, which stretches 9,400 miles along the middle third of the U.S., along with 85 terminals that can store over 60 million barrels. This massive network touches more than 40% of the refining capacity in the continental U.S., and marine terminals allow Magellan to receive imports too, giving Magellan perhaps the most diversified access to supply of any refined products MLP. Such a network lends itself to abundant organic growth projects, which have been Magellan's primary growth driver since 2004 and remain its preferred mode of growth since they offer the best project returns. We also respect Magellan's conservative management team and feel it has demonstrated a disciplined capital allocation approach over the years, executing low-risk projects that consistently generate returns on invested capital above the partnership's cost of capital. One other trait that differentiates Magellan is its lack of a general partner following the limited partnership's recent stock-for-stock buyout of former general partner Magellan Midstream Holdings. Thanks to this transaction, Magellan no longer pays incentive distributions, which lowers its cash cost of equity relative to its peers'. The lower effective cost of capital will make Magellan more competitive when bidding for assets or acquisitions, and the lack of a general partner burden will allow the partnership to grow its distribution more quickly over the long term.