Magellan Midstream Partners (MMP) Q1 2018 Earnings Conference Call Transcript

Magellan Midstream Partners (MMP)
Q1 2018 Earnings Conference Call
May. 3, 2018 1:30 p.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants

Prepared Remarks:

Operator

Good day, and welcome to the Magellan Midstream Partners first-quarter 2018 earnings results conference call. Today's conference is being recorded. At this time, I would like to turn the conference over to Chief Executive Officer Mike Mears.

Michael N. Mears -- Chairman, President, and Chief Executive Officer

All right. Well, thank you for joining us today. I would like to start by thanking those of you who had the opportunity to attend our Analyst Day. We hope you received some valuable detail about our company and found the event to be a good use of your time.

Before we dive into first-quarter earnings, I'll remind you that management will be making forward-looking statements as defined by the SEC. Such statements are based on our current judgments regarding the factors that could impact the future performance of Magellan. You should review the risk factors and other information discussed in our filings with the SEC and form your own opinions about Magellan's future performance. We announced solid first-quarter financial results this morning for a good start to the year.

Setting aside the one-time pension correction and mark-to-market on our open futures contracts, we exceeded our guidance by $0.10 per unit, primarily related to stronger-than-expected refined products and crude oil transportation revenues during the quarter. Our core fee-based activities continued to generate solid results, emphasizing the stability and consistency of our business model. Our CFO, Aaron Milford, will now review Magellan's first-quarter financial results in more detail, then I'll be back to discuss our outlook for the rest of the year and the status of a few of our larger expansion projects before opening the call to your questions.

Aaron L. Milford -- Chief Financial Officer

Thank you, Mike. During my comments today, I will be making references to certain non-GAAP financial metrics, including operating margin and distributable cash flow. We have included exhibits to our earnings release that reconcile these metrics to the nearest GAAP measure.Earlier this morning, we reported first-quarter net income of $210.9 million, or $0.92 per unit on a diluted basis, which was lower than the $222.7 million, or $0.98 per diluted unit reported for the first quarter of 2017. Excluding the impact of mark-to-market futures contract activity in the current quarter, adjusted diluted earnings per unit of $0.98 exceeded our guidance of $0.95 provided on a similar basis back in February.

Distributable cash flow of $258.9 million for the first quarter of 2018 was almost 14% higher than the $227.6 million reported in the first quarter of 2017. As mentioned in our earnings release, both our reported net income and distributable cash flow were negatively impacted by a $16 million one-time correction of pension expense due to estimation errors made by our third-party actuary in calculating our pension benefit obligations dating back to 2010.We rely on the expertise of our third-party actuaries to estimate our pension liabilities. These liability estimates also impact the amount of pension expense we recognize annually and our pension funding decisions. In essence, the errors made by our actuary in estimating our liability since 2010 resulted in us not recognizing as much pension expense as we otherwise would have for the periods between 2010 and 2017.

The correction made in the first quarter represents the cumulative amount of expense we needed to recognize to catch up. It's important to note that the errors did not result in us being out of compliance with any minimum pension funding requirements, nor will they require any significant change to our pension funding plans for 2018. Finally, the estimation errors made by the actuary were not material to any of our historical financial results, especially considering the fact that this correction is cumulative for a seven-year period of time.If we adjust our first-quarter results for this pension correction and unrealized mark-to-market impacts, our net income for the quarter would have been $226.9 million, or $1.05 per unit on a diluted basis. Our distributable cash flow for the quarter would have been $274.9 million.

Fundamentally, 2018 is off to a good start. And as Michael will talk more about in a moment, our outlook for the remainder of the year is positive. I will now move to a brief discussion of the operating margin performance of each of our business segments.Our refined products segment generated $211.4 million of operating margin in the first quarter of 2018, compared to $221.3 million for the same period in 2017. This decline in operating margin between periods primarily resulted from the impact of mark-to-market valuations of our exchange-traded futures contracts used to hedge our commodity exposure.

Transportation and terminals revenues increased $18.5 million, or almost 8% compared to the 2017 quarter. This increase was driven by 13% higher distillate volumes, as fuel demand in the crude oil producing regions we serve continues to increase as well as 2% higher gasoline volumes and higher jet fuel demand in our Denver and Little Rock market. Operating expenses were essentially flat compared to the first quarter of 2017 with higher personnel costs and higher power costs due to higher volumes being mostly offset by lower environmental and other expenses. Of note, the higher personnel costs for the quarter included $4.1 million of expense related to the pension correction mentioned earlier.

Product margin decreased by $30 million compared to the first quarter of 2017, as a result of lower unrealized gains associated with our hedging program and lower butane blending volumes. Ignoring mark-to-market impacts, our cash margins were also lower in the first quarter of 2018 compared to the first quarter of 2017, as we had anticipated in the guidance we provided back in February.For our crude oil segment, operating margin of $127.7 million was $25.7 million higher than the first quarter of last year. Transportation and terminals revenue increased by approximately $21 million, mostly due to contributions from our Corpus Christi splitter, which began operations in June of last year as well as higher average rates on our Longhorn pipeline. Further, volumes on our Houston distribution system increased significantly compared to the last year.

These higher volumes on the Houston distribution system, which move at substantially lower rates than our Longhorn volumes, caused our average crude oil transportation rate to decline quarter over quarter, while our overall revenue increased substantially. Segment operating expenses increased $6.2 million as a result of higher operating expenses associated with our condensate splitter, which was not operational in the first quarter of 2017 as well as higher power costs and slightly higher personnel costs. Our personnel costs increased primarily, as a result of recognizing $0.7 million of expense related to the pension correction made in the quarter. For the quarter, volumes on our Longhorn pipeline averaged approximately 265,000 barrels per day, compared to 270,000 barrels per day in the first quarter of 2017.

Of note, the current-quarter volume was higher than our previous annual guidance of 260,000 barrels per day.Equity earnings from our various joint ventures increased $11 million compared to the first quarter of 2017. This increase is primarily attributable to higher volumes in the BridgeTex pipeline from new commitments, which started in the first quarter of 2018 as well as Eaglebine-originated volumes and higher spot shipments. Volumes on the Saddlehorn pipeline were also higher, as a result of the contractual step-up in committed volume in 2017 -- in September of 2017.BridgeTex volumes averaged approximately 315,000 barrels per day during the first quarter of 2018 compared to approximately 210,000 barrels per day in the first quarter of 2017. Saddlehorn pipeline averaged approximately 65,000 barrels per day during the current quarter, compared to approximately 45,000 barrels per day during the first quarter of 2017.

Finishing up my discussion of our segment performance, our Marine segment generated approximately $30 million of operating margin in the current quarter, compared to $34.5 million in the first quarter of 2017. Revenues were essentially flat period over period with higher storage rates offsetting lower utilization as we continue to complete the work necessary to bring tanks damaged last year by Hurricane Harvey back online and complete other tank maintenance that was delayed, as a result of the storm.Operating expenses increased $5.3 million compared to the 2017 quarter due to lower product overages, which, as you may recall, add to reduce our operating expenses and higher personnel costs. Personnel costs were negatively impacted by approximately $0.9 million related to the pension correction. Now moving to other net income variances to last year's quarter.

Our G&A expenses were $6.3 million higher than the 2017 quarter as a result of higher personnel costs. $3.4 million of higher personnel costs were attributable to the pension correction, and the balance of the increase was related to the higher headcount as we continue to grow. Depreciation and amortization increased as a result of new assets placed into service and other expense increased $7.6 million. Approximately $6.9 million of the increase in other expense was attributable to the pension correction made in the quarter.

Net interest expense increased by $4.7 million due to higher outstanding borrowings used to finance growth capital. I will now move to discussion regarding our balance sheet and liquidity position. We had $4.6 billion of long-term debt outstanding as of March 31, 2018, and our average interest rate was approximately 4.8% with an average tenor of approximately 15 years. Our leverage ratio was about 3.3 times debt to EBITDA.We continue to maintain a credit facility totaling $1 billion, which also backstops our commercial paper program.

At quarter-end, we did not have any outstanding borrowings on this facility or under our commercial paper program and had about $74 million of cash on hand. We also have a $750 million at-the-market equity program available but did not issue any units under this program during the quarter and have not issued any units under this program since it has been in place.We continue to expect that we will be able to fund our current slate of growth projects under way without exceeding our long-term -- our long-standing maximum leverage ratio target of four times. As we progress through the year, we expect our leverage ratio to rise, but also remain below our targeted maximum.I'll now turn the call back over to Mike to discuss our updated guidance for the balance of the year as well as some of our significant growth projects under way.

Michael N. Mears -- Chairman, President, and Chief Executive Officer

Thank you, Aaron. Based on our solid start to 2018 and our expectations for the remainder of the year, we have increased our annual DCF guidance by $30 million to $1.08 billion for 2018. A number of industry dynamics have moved in our favor since the time we initially provided guidance earlier this year. For one, the crude oil pricing differential between the Permian Basin and Houston has been favorable of late, climbing to over $12 per barrel as of yesterday.

The current tariff for spot shipment from both the Longhorn and BridgeTex pipelines is close to $4 per barrel, so shippers can easily justify moving spot barrels in this pricing environment. We are indeed seeing interest in spot shipments currently and have assumed spot barrels continue to flow especially in the uncommitted space on BridgeTex, at least for the next few months.The outlook for butane blending margins has also improved since we've provided guidance earlier this year, primarily due to a softening of butane prices, which favorably impacts our blending profit. We've continued to hedge our expected fall blending activities and now have about three quarters of fall blending margins locked in at this point. Earlier this year, we expected average margins of around $0.30 per gallon for the year.

With hedges we put into place so far and using the forward curve for the remaining sales volume, we currently expect our average butane blending margins to be closer to $0.40 per gallon for the year. I know that the upcoming Longhorn recontracting is on your mind, so I would like to briefly hit on where we are. As we mentioned on our Analyst Day, almost all existing Longhorn customers now have extended their contracts under current terms for an additional two years as allowed by the agreements that expire on September 30. Hopefully, these extensions remove some of the uncertainty related to these expiring contracts, and we believe their willingness to roll the current contracts emphasizes the strong demand for space on Longhorn, especially with the current differential environment.In saying that, Magellan always prefers contract length when possible, so we remain in active discussions with these shippers to extend the duration of these contracts.

Pricing for long-term commitments on crude oil pipelines originating from the Permian still remain quite competitive, with new capacity expected to come online over the next few years at lower rates, and that is really the rate we are competing against. As a result, we continue to assume in our DCF guidance that average tariff rates on Longhorn will likely be lower beginning in the fourth quarter of 2018, as we still prefer additional length to those commitments, even if that means a rate reduction for that longer-term surety. So wrapping up '18 guidance. If you remember the fact that the $16 million one-time pension adjustment reduced our DCF for the year, our increased guidance to $1.08 billion clearly shows that our company is generating strong results this year, allowing us to overcome this unexpected item and still boost our expectations for the year.

With regards to distributions, we raised our quarterly cash distribution to $0.9375 per unit for the first quarter, which was a $0.0175 increase over the last quarter. We remain committed to our stated goal of increasing annual distributions by 8% during 2018, with the intention of bumping the quarterly payout by $0.02 per quarter for the remainder of the year to get us there. Based on our updated guidance, we still expect distribution coverage of 1.2 times while generating excess cash of nearly $200 million for the year. Looking further ahead, we continue to target annual DCF growth in the range of 5% to 8% for both 2019 and 2020.

And we have indicated our intentions to manage distribution growth consistent with these DCF growth expectations for the foreseeable future. We also plan to maintain annual distribution of 1.2 times for these out-years, which will result in annual distribution growth of 5% to 8% for 2019 and 2020 as well. Moving to expansion capital, we continue to develop incremental investment opportunities, expected to generate attractive returns for our investors. Based on the projects currently under construction, we now expect to spend $950 million in 2018, with an additional $425 million in 2019 to complete the expansion projects now in progress.This spending profile is $100 million higher than previously discussed, mainly due to a recently launched project to construct a new transmix fractionator in Frost, Texas.

This new fractionator is expected to be operational in late 2019 and will be needed as we handle more and more refined products volume in the Texas market, especially once our East Houston-to-Hearne pipeline comes online that year.Expansion of our Seabrook Logistics joint venture is nearing completion and is expected to commence operations in early third quarter. As a reminder, the second phase of this crude oil export facility includes 1.7 million barrels of storage in connectivity to our Houston distribution system. Demand for this storage appears quite strong to the industry's increased interest in crude oil export capabilities.We also continue to make great strides at our Pasadena joint venture marine terminal with tank construction in full swing. The first 1 million barrels of storage should be operational by January of 2019, with the remaining 4 million barrels of storage projected to come online by January of 2020.

For our large-scale pipeline projects, the pipeline steel has been ordered and permit and right-of-way work are in progress for the Delaware Basin crude oil and East Houston-to-Hearne refined products pipeline, with both expected to be operational in mid-2019. As we indicated during our recent Analyst Day, we are currently evaluating optimization of the Delaware Basin project with third parties due to the competitive landscape and our commitment to maintain capital discipline. Pending the outcome of these authorization efforts, our current spending estimates continue to include the entire $150 million spend for this project. We also continue to evaluate other potential expansion opportunities, still totaling well in excess of $500 million.

Active discussions with potential customers continue to further develop our Pasadena and Seabrook Logistics joint ventures. Discussions also continue regarding new infrastructure investments in West Texas and other regions of Texas for both crude oil and refined product services.An open season is currently under way to assess customer interest for the potential expansion of the western leg of our refined products system in Texas. Significant interest has been expressed from potential shippers for this proposed pipeline expansion, with the open season recently extended by one week to May 16 to provide interested shippers additional time to finalize their commitments. And that concludes our prepared remarks.

So operator, we can now turn it over for questions.

Questions and Answers:

Operator

[Operator Instructions] Our first question comes from Theresa Chen, Barclays.

Theresa Chen -- Barclays -- Analyst

Mike, in light of the announcements of new Permian pipelines moving forward, Gray Oak in particular, how does that change the competitive dynamic for you in terms of setting up customers for your Wink-to-Crane project as well as for Longhorn recontracting?

Michael N. Mears -- Chairman, President, and Chief Executive Officer

Well, I think the situation hasn't changed dramatically. I mean, the market -- the fact that Gray Oak announced that they are proceeding hasn't changed the fact that Gray Oak, as well as many other participants, have been actively trying to secure commitments for the last year and a half. And so we've been working on recontracting Longhorn and developing the Wink-to-Crane pipeline in that environment. So the fact that one pipeline has announced they're proceeding really hasn't changed the dynamic nature of the situation we're in with regards to recontracting.

I guess, another way to phrase that is everyone that is a Longhorn shipper fully expect that another pipeline was going to be built out at the Permian at some point. And so that's not new news to them. I mean, who the party was that actually won the race at least for the -- at this point may have been in some doubt. But there wasn't any doubt in anyone's mind that somebody was going to win the race and another pipeline was going to be built.

Theresa Chen -- Barclays -- Analyst

OK. So what do you think Magellan can offer that is differentiated at this point? Is it mainly downstream, related to your Houston distribution system?

Michael N. Mears -- Chairman, President, and Chief Executive Officer

Well, it depends on which element of the value chain you're talking about. If you're talking about Longhorn specifically and our efforts to recontract Longhorn, obviously our distribution system in Houston is a critical component of what we have to offer and access to all of the demand points in Houston and crude oil export capabilities. The other item that I think it's pretty self-evident with regards to recontracting Longhorn today at lower rates is that the differentials are high now and are likely going to be high until the next pipeline gets built. So to the extent that someone can contract or negotiate a lower fee on Longhorn today that would apply for the next two years during this high price environment, I think, would be attractive and is attractive to the shippers.

Theresa Chen -- Barclays -- Analyst

Got it. And turning to the open season for the expansion of the western leg of your Texas refined-products system, is the cost still expected to be around $300 million? And what kind of multiple do you expect such project would generate, whether it's similar to your East Houston-to-Hearne project, like around eight times?

Michael N. Mears -- Chairman, President, and Chief Executive Officer

We are expecting around an eight times multiple and the capital is still expected to be around $300 million.

Theresa Chen -- Barclays -- Analyst

OK. And lastly, understand you are very focused on the Houston export options via some of your projects down there. But in terms of the potential Corpus Christi expansion, can you give an update on how that's going and -- especially in light of competitors focusing on the ability to partially or fully load of V in that area? And given the position of your land, it's pretty deep in the channel. It seems like that would be difficult.

Would you be willing to partner with one of the projects on the north side of the bay or perhaps with the port itself via the Harbor Island project?

Michael N. Mears -- Chairman, President, and Chief Executive Officer

Absolutely. And I think we've publicly talked about our willingness to partner with the port or other parties to have a viable project in Corpus.

Theresa Chen -- Barclays -- Analyst

Thank you.

Michael N. Mears -- Chairman, President, and Chief Executive Officer

Sure.

Operator

Our next question comes from Jeremy Tonet with J.P.Morgan.

Jeremy Tonet -- J.P.Morgan -- Analyst

Good afternoon. Just want to circle back to the discussion with regards to kind of rate versus tenor on contract. And appreciate you're not going to want to give away inside information how you're negotiating here. But just wondering how you see that trade-off.

What do you think is realistically the longest type of tenor you can get in the situation? I mean, given where the differentials are right now, and presumably to be tight like this for quite some time, just wondering if you could expand a bit more as far as your philosophy and the trade-off in rate versus contract tenor.

Michael N. Mears -- Chairman, President, and Chief Executive Officer

Well, the negotiations we're having now are long-term contracts. So we -- active negotiations are contracts anywhere from five to 10 years. So that's the range we're looking at.

Jeremy Tonet -- J.P.Morgan -- Analyst

Got you.

Michael N. Mears -- Chairman, President, and Chief Executive Officer

And clearly, a 10-year agreement would command a lower rate than a five-year agreement. So those are kind of the balance of where the negotiations are.

Jeremy Tonet -- J.P.Morgan -- Analyst

OK. Thanks for that. And then equity earnings within the crude oil segment, I think 1Q results were a bit lower than 4Q '17. Just wondering, maybe I missed it, if you could provide a little bit more color on the drivers there.

Michael N. Mears -- Chairman, President, and Chief Executive Officer

Well, most of that's probably due to BridgeTex. And if you recall, in the fourth quarter, if you look at the -- let me back up. Spot movements on BridgeTex are obviously highly dependent on what the Midland to Houston differential is. And if you look at the fourth quarter last year, the difference is high and there was a lot of spot movements moving on BridgeTex.

If you look at the first quarter of this year, it got pretty weak in the early part of the first quarter. And so we didn't have significant spot movements on BridgeTex. That changed late in March and April, and the differential, as everyone knows, has started to blow out. So we're back in the mode of, at least at this point in time, with significant spot shipment.

So if you're comparing the fourth quarter to the first quarter, it all had to do with the fact that the margin did compress quite a bit in January and February.

Jeremy Tonet -- J.P.Morgan -- Analyst

That's helpful color. That's it for me. Thanks.

Michael N. Mears -- Chairman, President, and Chief Executive Officer

Sure.

Operator

Our next question comes from Dennis Coleman, Bank of America.

Dennis Coleman -- Bank of America Merrill Lynch -- Analyst

Good afternoon. Thanks very much. Just to -- if I can go back to the Longhorn question a little bit, I wonder if you might talk a little bit how -- what the outcomes you think will be? Will it be sort of all the shippers will go toward one type of contract? Will there be some kind of laddering? Is that desirable for you to have some kind of laddering in terms of not having sort of all the contracts come due at the same time?

Michael N. Mears -- Chairman, President, and Chief Executive Officer

Well, I can tell you that probably my preference and given that the nature -- the conservative nature of our company, I prefer to have 10-year contracts from everybody. That's not likely. What will be likely is hard to predict at this point. I think we will have a mix of terms.

I think it is possible that we will have shippers that don't sign a longer-term agreement and then just stick with the higher rate for two years. But what the precise mix of that will be is -- I can't predict right now. And unfortunately, given the nature of the extension rights that the shippers have and the fact that they've signed the two-year extensions that don't kick in, I mean, the base contract doesn't expire on September 30, it's possible we could be negotiating these extensions through the summer and into the early fall before someone actually signs. Hopefully, that's not the case and we are able to get some of these secured sooner rather than later.

But since everyone has got at least the next two years secured, and that potential for not having certainty on this for a few more months is present. So, unfortunately, I can't guess, and I don't really want to guess as to what that mix will look like. But I can tell you in our guidance, we have assumed that essentially all of the shippers sign long-term extensions and reduce the rate. So to the extent that doesn't happen, there's upside to our current year guidance.

Dennis Coleman -- Bank of America Merrill Lynch -- Analyst

OK. That's helpful. Clearly, the preference is for longer, but interesting to hear that there could be some that choose none or to just stick with the two-year. With regard to the spot shipments, changing the topic a little bit, it seems you're sort of saying you think that spot shipments continue to the third quarter, but I guess, you could maybe build an argument that that differential holds out for perhaps longer.

Any sort of logic behind the third-quarter guidance?

Michael N. Mears -- Chairman, President, and Chief Executive Officer

We just like to be conservative in our guidance. If the margin stays high through the rest of the year, then our guidance is low.

Dennis Coleman -- Bank of America Merrill Lynch -- Analyst

OK. That's perfect. Couple of just quick ones. With regard to the pension issue, you've given some good detailed numbers, the impacts of the various businesses.

Is this something that will cause operating expenses to be higher on a -- in future years as well? Should we think about higher run rate?

Aaron L. Milford -- Chief Financial Officer

No, this is Aaron. This isn't going to impact our cost structure going forward. It really was just a cumulative catchup to where we needed to be for the error that our actuary made. So it's not going to have any future cost structure impact.

Dennis Coleman -- Bank of America Merrill Lynch -- Analyst

Great. Perfect. And then just one last one for me. The commodity hedges, I think I know the answer to this, but you had some impact from mark-to-market, presumably that unwind in future periods as you realize the actual sales against those positions.

Is that right?

Aaron L. Milford -- Chief Financial Officer

Yes.

Dennis Coleman -- Bank of America Merrill Lynch -- Analyst

OK. That's it for me. Thanks.

Operator

[Operator Instructions] Our next question comes from Barrett Blaschke, MUFG Securities.

Barrett Blaschke -- MUFG Securities -- Analyst

Hey, guys. As far as the guidance update, can you give us a little color around sensitivity as far as the differential? And if it widens, how much more spot shipments you could see? I mean, is there any way you can quantify it a little?

Michael N. Mears -- Chairman, President, and Chief Executive Officer

Well, we've assumed, at least for the next few months that it's pretty well full on spot shipments with not -- I mean, that we've pretty much filled the pipeline up with spot shipments. So there's really no upside to our forecast for the next few months. But again, we have assumed this only lasting for the next few months and not into the fourth quarter. And -- so there is upside there, but not -- pretty much of our guidance assumes we fill up the pipe over the next few months.

Barrett Blaschke -- MUFG Securities -- Analyst

OK. Thank you.

Michael N. Mears -- Chairman, President, and Chief Executive Officer

Sure.

Operator

We have no further questions in the queue. I would like to turn the call back over to Mr. Mears.

Michael N. Mears -- Chairman, President, and Chief Executive Officer

All right. Well, thank you for your time today, and we appreciate everyone's continued interest and investment in Magellan. Have a good afternoon.

Operator

[Operator signoff]

Duration: 33 minutes

Call Participants:

Michael N. Mears -- Chairman, President, and Chief Executive Officer

Aaron L. Milford -- Chief Financial Officer

Theresa Chen -- Barclays -- Analyst

Jeremy Tonet -- J.P.Morgan -- Analyst

Dennis Coleman -- Bank of America Merrill Lynch -- Analyst

Barrett Blaschke -- MUFG Securities -- Analyst

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