Now Is the Time to Buy This Fast Growing Refiner

The refining industry’s margins have been battered by the compression of the WTI/Brent spread. With the Energy Information Administration predicting that the spread has bottomed and is poised to rebound substantially over the next two years, patient investors have a ticket to ride a gravy train of increasing profits as well as a high and growing yield.

Adam Galas
Adam Galas
Apr 16, 2014 at 1:03PM
Energy, Materials, and Utilities

The energy industry has always been a cyclical one. For patient investors this can serve as a catalyst for long-term, market-beating returns. One need but wait for a cyclical industry bottom to purchase shares of quality companies and ride the results all the way to the bank. 

The refining industry is now in a trough of such a cycle due to two key factors. The first is the severe compression of the WTI/Brent oil spread. This has been caused by the new Marketlink pipeline coming online in Cushing Oklahoma that is decreasing the oil glut where West Texas Intermediate oil is priced. Enterprise Products Partners' plan to double the capacity of its Seaway pipeline (which exports from Cushing to the Gulf) is also partly responsible. The second cause of the trough is a surge in the cost of renewable energy credits (RINs). The Energy Information Agency, (EIA) is predicting that the WTI/Brent spread compression is soon to reverse and new EPA regulations have caused a plunge in the cost of RINs. These two positive factors likely signal a bottom to the refining market.

For long-term investors the following MLP offers additional growth catalysts that should result in market outperformance over the long term (and a safe double-digit yield).

Calumet Specialty Product Partners (NASDAQ:CLMT) is a specialty refiner whose diversified product mix of 6,000 specialty petroleum products are sold around the world. Its specialty products include solvents, waxes, and lubricants. It also produces conventional-oil products such as diesel, gasoline, jet fuel, asphalt, and heavy fuel oil. Its total capacity is 163,000 bpd (barrels/day) from its 13 facilities (which are located to take advantage of cheap oil from oil fracking regions such as Texas, Montana, Oklahoma, North Dakota, Canada, and the Gulf Coast). 

Recently the unit price has been hammered due to margin compression resulting from the same WTI/Brent spread narrowing that is affecting the entire domestic refining industry. In addition, the partnership had to perform scheduled maintenance on three of its refineries in 2013. When combined with the trough in industry margins and increased renewable energy (ethanol mixing) credit costs, the maintenance downtime and cost resulted in a large decline in distributable cash flow. The distribution coverage ratio dropped to just .09 during the fourth quarter of 2013.

Understandably the market panicked, expecting a distribution cut to be imminent. However, there are five catalysts that are likely to protect the distribution and even grow it in the future.

The first of these is an increase in the WTI/Brent spread. This will increase refining margins. The EIA is anticipating that the spread will average $9 in 2014 and $11 in 2015 (it recently hit a low of $0.86). 

Second, the Renewable Energy tax credits (RINs) that spiked in price from $0.02/credit in 2012 to $1.18/credit in 2013, have dropped to $0.5/credit due to the EPA relaxing regulations on ethanol mixing volumes. 

Third, management has $500 million-$550 million in expansion projects coming online through the first quarter of 2016 that will increase Adjusted EBITDA by $190 million-$215 million (a 79%-89% increase over 2013 levels). Each of these projects is predicted to have an internal rate of return (IRR) of 25% (meaning it is expected to pay for itself in four years or less).

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Even at today's cyclically low margins, the additional DCF provided by this cash flow should be enough to permanently secure the distribution.When margins improve, the distribution will likely begin growing again. 

Forth, the partnership continues expanding through acquisitions, such as its recent purchase of Bel-Ray (seller of 2,500+ specialty products in 100+ countries). Management expects to use this global supply chain to increase sales abroad. 

In addition, Calumet recently purchased Anchor Drilling, a leading provider of fracking oils and fluids. Not only is this a fast growing company (20% EBITDA growth in 2013), but management made the purchase at a great price -- just 7.4 times EBITDA.

Finally Calumet has been extremely successful raising capital. At the beginning of 2014 the partnership had $593 million in liquidity. In the last five months they have sold $1.25 billion in unsecured debt ($600 million used to refinance more expensive loans). Also, the company has authorized a three-year $300 million "At The Market" (ATM) unit issuance program. This gives the option (but not the obligation) to raise equity capital without the need for a secondary offering, which dumps a large number of units on the market at a discount. Instead management can sell units when prices are favorable, a little at a time, increasing price stability and minimizing dilution of existing investors. 

The combination of the debt and equity results in over $1 billion in liquidity. This is sufficient to pay for acquisitions, management's expansion programs, and cover the distribution until cash flows from organic investment projects arrive. 

From 2008 through 2013 Calumet grew Adjusted EBITDA by 13.7% CAGR. This exceptional growth is due to management's track record of well executed, disciplined acquisitions, and organic investments. As Calumet becomes larger and gains access to new markets (international sales and new industries such as fracking), there is every reason to believe that the partnership, its unit price, and most importantly the distribution will continue to grow. 

Foolish takeaway
With the refining industry reeling from severe margin compression, now is the time for patient, long-term investors to purchase quality refining companies (and partnerships). In Calumet Specialty Product Partners investors have an opportunity to buy into one of the best managed refiners in the country while it's sporting a safe 10.4% yield. With the partnership's aggressive investment growth plans this distribution is not likely to becut. Rather it will probably increase at a strong rate in the future, once key projects come online in 2015 and 2016.