Paying off the credit card feels great, doesn't it? Maybe not quite as good as winning the Powerball lottery, but there's still something wonderfully satisfying about being debt-free...at least until the next credit card bill comes due next month.
Energy industry player NuStar Energy (NS 0.07%), which operates a network of oil, gas, and ammonia pipelines across the Midwest, is probably feeling good after paying off its debt -- at least temporarily -- in Q2. Investors are probably feeling good thanks to the company's 14%-plus yield and high coverage ratio, both of which are superior to those of major industry players like Magellan Midstream Partners (MMP -0.33%).
But just because things are good for now doesn't mean they'll be good forever. And indeed, NuStar seems to be betting the farm (er, the pipelines) on a single play. Here's why you should be wary of this master limited partnership (MLP) despite its high yield and good coverage.
Getting the house in order
NuStar's balance sheet was in pretty bad shape in late 2017. Thanks in part to its $1.5 billion acquisition of Navigator Energy Services LLC, NuStar was so loaded up with debt that the ratings agencies Moody's and Fitch Ratings had downgraded its rating to BB/Ba2: junk status. The company wasn't able to cover its distribution -- MLP-speak for dividend -- with cash from operations, so it was falling further into debt as it made up the difference. While many MLPs are heavily indebted, there are plenty -- including Magellan -- that sport investment-grade debt ratings.
Finally, NuStar made the unpopular but necessary move of cutting its quarterly distribution from $1.095/unit to just $0.60/unit. That caused an immediate drop in the unit price, but put the company on a much sounder financial footing.
Then, in Q2, management used its revolving credit line to pay off $350 million in unsecured notes that matured in April, which means that the partnership now has no major outstanding debt coming due prior to 2020. Coupled with its high distribution coverage ratio of 1.2 times to 1.3 times and its big yield, the partnership would seem to be worth a closer look.
The right place at the right time
When NuStar purchased Navigator -- a fellow pipeline operator with an extensive Permian Basin gathering pipeline network -- in May 2017, the Permian oil and gas boom was already well underway. But NuStar's EBITDA from those Permian operations has increased by 400% in the months since, from $7 million in Q2 2017 to an estimated $28 million in Q3 2018. The amount of crude oil the system transports has risen by 164%.
But all that is just a drop in the bucket for NuStar. Of the company's 9,700 miles of pipeline, only about 720 are located in the Permian Basin, and that's a gathering network as opposed to a single long-haul pipeline. That's a small — and disconnected — portion of the company's operations to shoulder the heavy lifting of earnings growth. And with companywide quarterly EBITDA of $155.7 million in Q2 2018, Permian operations make up only about 18% of that total. Plus, don't forget, the company ponied up $1.5 billion for the Permian assets, which will need to pay for themselves (with interest) for the company to actually turn a profit on the purchase.
It's also worth noting that although NuStar now has pipelines and terminals within the Permian, and has some crude oil assets around Corpus Christi, it doesn't own any assets in between, and has no plans to build or acquire any -- meaning its customers will have to rely on third parties (rail or pipeline) to ultimately get the Permian crude roughly 500 miles to the coast.
The other shoe
NuStar may not have any debt coming due until 2020, but boy will 2020 be a doozy. Currently, more than $1.5 billion of NuStar's debt matures that year. That includes just over $1 billion on its revolver and $450 million in unsecured notes. Meanwhile the company expects to issue up to $500 million in new senior unsecured notes by the end of 2018. And with its debt rating currently at junk status, it's going to have to offer that new debt on very favorable terms to its creditors, which isn't good for the company.
In other words, within the next two years, NuStar needs to start cranking cash out of its operations so it can cover its obligations.
Investing heavily in the company's Permian infrastructure through capital spending seems like a logical move, and indeed, NuStar is planning to devote about half of its 2018 capital spending to its Permian system this year ($190 million out of total capital expenditures of $360 million to $390 million).
But other companies are going on a Permian spending spree as well to capitalize on the massive production boom. For example, Magellan just announced it will construct a new 30-inch crude pipeline from the Permian to the Houston area that will be operational in mid-2020, as well as increasing capacity at its Seabrook Logistics marine terminal in Houston.
On its Q2 earnings call, NuStar CEO Brad Barron stated that the company is "evaluating" connecting its Permian system to Plains All American Pipeline's Sunrise pipeline, which runs to Wichita Falls, TX, and that NuStar is in "discussions" with third-party long-haul pipeline operators about connecting its Permian system and its Corpus Christi terminal to one of three Permian-to-Corpus Christi pipelines currently under development. However, nothing appears to be set in stone just yet.
Threading the needle
So, given that NuStar is a very small fish in a very big pond, a lot has to go exactly right in order for its Permian strategy to work:
- The production boom in the Permian needs to continue unabated through 2020. This seems likely, but transportation bottlenecks could cause producers to scale back their operations.
- Sufficient third-party pipeline capacity needs to be built to Corpus Christi as opposed to Houston, so NuStar's Corpus Christi marine terminal can benefit, but third-party terminal capacity in Corpus needs to remain limited enough that competition doesn't eat into profits.
- Third parties need to be willing to allow NuStar to connect its gathering network and its terminal to their pipelines. But third parties may have their own networks of pipelines and terminals they wish to optimize, and even those that don't will likely be entertaining multiple bids from producers and other gathering companies looking to lock in volumes in a constrained system.
- Rail needs to remain a viable means of shipping Permian barrels to allow NuStar's Permian rail terminals to continue to generate income even as pipeline capacity increases.
- Crude oil exports must continue to rise, keeping NuStar's marine terminal busy.
What's most concerning is that so much of this is outside of the company's control. I have no doubt that NuStar's Permian network will continue to be a bright spot for the company, but whether it can drive substantial growth and debt reduction for the company will be more dependent on market conditions and the decisions of other companies than NuStar's execution.
With that in mind, investors should be wary of investing in this company for the long haul.