Getting North American Crude Production to Market

With 3.8 million Bpd of refining capacity and more than 3.5 million Bpd of oil supply either from within PADD II, or from near by Canada, PADD II refiners (ex Marathon (“MPC”), Phillips 66 (“PSX”), and BP (“BP”) are geographically well positioned to absorb much of the increasing oil production from the oil sands in Western Canada, and the Bakken and Utica formations.

This said, over the next 10-20 years, total oil production from these regions is expected to more than double, with the great majority of this increased production being heavy oil from the oil sands. To take advantage of this, many of the PADD II refiners who have low average Nelson Complexity ratings, are retooling some of their refineries to be able to handle some of the cheaper heavier grades of crude. The Nelson Complexity Index measures a refinery’s ability to process inferior quality crude or heavy sour crudes. It also measures a refinery’s ability to produce a high percentage of LPG, light distillates and middle distillates and low percentage of heavies and fuel oil.To date, three PADD II refiners have announced capital plans which will allow them to take advantage the price differential between the cheaper heavier crudes which come from Canada and the lighter crudes which these refineries had been importing from PADD III. Even if PADD II refiners displace all of the crude oil they currently import from PADD III, Western Canadian producers will still have to find buyers for this incremental production. With over 9 million Bpd of refining capacity and the ability to process heavier crude oils like the oil produced by the Canadian oil sands, the PADD III refineries on the USGC would seem to an optimal home for this incremental North American oil production.

In order for Canadian oil producers to be able to take advantage of the 9 million Bpd refining market in PADD III, there needs to be sufficient cross border pipeline to import the oil into the US. Additionally, there needs to be sufficient north to south pipeline connectivity to bring the crude from the upper Midwest to the USGC.
With just 2.5 million Bpd of current oil imports from Canada and 3.8 million Bpd of current Canada-US pipeline capacity in operation, over 1 million Bpd of excess cross boarder capacity would seem to be sufficient. However, with Canadian production expected to double, and with the long lead times which are often needed to build a pipeline, it’s important keep ahead of this production increase to keep as much of the oil in North America as possible. Regardless of this sentiment, three pipeline expansions totaling nearly 1.5 million Bpd of capacity are in development.The TransCanada’s Keystone XL pipeline is intended to service the USGC and upper Midwestern refinery markets. The Canadian oil producers are especially excited about the Enbridge (“ENB”) and Kinder Morgan (“KMI”) pipelines as they are largely intended to create a second market for Canadian crude by servicing Asia’s growing demand. Having a second buyer for its crude is likely to benefit Canadian oil producers by introducing some price competition for Canadian crude.

Southbound Crude Pipelines

In addition to needing cross border pipeline connectivity, selling crude to the USGC will require an enhancement of the North south capacity from Midwest/Cushing to USGC. Lack of north to south pipeline capacity south of Cushing has been causing oil inventories in Cushing to pile up.

• To date, the reversal of Enterprise Products (“EPD”)/Enbridge Seaway pipeline has increased the Cushing to USGC capacity by 150k Bpd. This is hardly sufficient to keep up with the increase production, but Seaway is due to increase its capacity to 400k Bpd by early 2013 and to 850k Bpd by 2014.
• While the cross boarder portion of Keystone XL is still waiting approval, Keystone’s Cushing MarketLink pipeline is due to be completed in 2013. This will bring an additional 500k Bpd of crude south from Cushing to the UGCC.
• Finally, according to a FERC regulatory filing, Energy Transfer (“ETP”) is in the process of getting FERC approval to reverse the flow and change the service of one of the three parallel pipelines of its Trunkline gas pipeline system. Once approved, using an existing and contiguous pipeline should allow ETP to begin shipping oil south from Tucola, Illinois to connect with Sunoco Logistics’ crude oil system in the Buna, Texas region by early 2014. Without entering into a partnership with a Bakken or Canadian crude gather, not having direct access to Canadian crude may hinder ETP vis-à-vis Enbridge and TransCanada as ETP’s two competitors will be able to offer a one stop shop to get crude from Canada to the USGC.

When all three of these southbound pipelines enter service, they should bring an additional 1.6 million Bpd of oil to the USGC. This should be sufficient to keep up with production increases for the next few years, but may be insufficient in the medium to longer term.

PADD I Market Potential

An additional but much smaller market, for some of the growing North American oil production could be PADD I refineries on the east coast. These refineries have never had very good terrestrial crude oil access to the rest of the country. As a result, they have imported a lot of oil from North and West Africa. Because these refiners have not spent capital to upgrade their ability to refine heavier and cheaper grades of crude, they would not be able to take advantage of much of the new heavy oil production from Canada. Rather, they will be forced to buy from the Bakken and once its up and running, from the Utica. They will also be able to take advantage of some of the lighter crudes which are being displaced for heavier crudes in PADD II. All this said, PADD I refiners will probably the most eager buyers of domestic crude as they currently have to pay for premium seaborne crudes which are priced at a premium to North American crudes.

Marathon Petroleum’s Pipes… A Value Creating Opportunity?

The Background section of Sunoco’s proxy statement for its acquisition by Energy Transfer Partners (“ETP”) mentions that “Company A,” a large petroleum refiner, marketer, and transporter, was also interested in a merger with Sunoco (“SUN”). The universe of possibilities for Company A’s true identity is rather limited, and includes companies such as:

1. Delek (“DK”)
2. Marathon Petroleum (“MPC”)
3. Murphy Oil (“MUR”)
4. Phillips 66 (“PSX”)
5. Tesoro (“TSO”)
6. Western Refining (“WNR”)
7. Valero (“VLO”)

Chevron (“CVX”) and ExxonMobil (“XOM”) could also be included in this list, but these giants have been focusing more of their efforts and capital on their upstream businesses.

Though refiners with some marketing and logistics assets, DK, TSO, VLO, and WNR would seem to have little to offer in the way of operational synergies due to their regional focuses on either the southwest or west.

This leaves PSX and MPC. With 10,000 marketing locations and 15,000 miles of pipeline, Sunoco’s assets 5,000 marketing locations and nearly 8,000 miles of pipeline would seem to fit nicely with those of PSX. However, PSX seems to be focusing more of its efforts and capital on its Chemicals and Midstream businesses as they offer higher returns than Refining and Marketing. This leaves MPC as being the last potential “Company A” for Sunoco.

With highly cyclical results and market prescribed EV/EBITDA multiples in the 3-5x range, it is not surprising that a refiner such as MPC would be limited in the premium it could pay for an acquisition, as the proxy suggests. And thus, it is not surprising that a company with much more stability in its results, and with an EV/EBITDA in the 10-12x range, would win the auction for SUN. This however, does not mean that some of SUN’s assets would not be a good fit and offer good synergy opportunities for a company such as MPC. In fact, MPC was correct to be interested in SUN, and a correctly structured deal for some, rather than all, of SUN’s assets may offer a company such as MPC the opportunity to monetize some of its highly value, non core, assets (ex. pipelines) for which the market gives it little valuation credit, while continuing to add heft to one of its core business (ex. retail).

With Pipeline EBITDA accounting for just 4.5% of MPC’s total EBITDA, and Refining and Marketing EBITDA accounting for 87.3% of MPC’s total EBITDA, it certainly seems as if MPC’s pipeline assets can be viewed as non-core. When one compares the valuation premium which the market puts on many pipelines, (12x EBITDA) relative to to refiners (3-5x EBITDA) and convenience store operators (6-8x EBITDA), the argument for doing something to monetize the value of MPC’s pipelines becomes that much more obvious, and it seems that even MPC’s management has realized that its pipeline business is hidden within MPC as a whole. To this end, MPC has made the effort to highlight its pipeline business by filing to take taking part of it public through an MLP structure.

Another possible way to realize the value of MPC’s pipelines while bolstering a core business might be a swap of MPC’s pipelines for SUN’s retail business.

Because MPC’s Pipeline business and SUN’s retail business, generate relatively the same amount of EBITDA, a transaction of this type would allow MPC to keep its EBITDA relatively flat by bulking up its second largest business, while crystallizing some of its pipeline’s valuation premium by picking up either cash or SUN/ETP units as consideration. Under this scenario, where the assets would be exchanged at market multiples, MPC would trade ownership of its pipeline business for SUN’s retail business plus $1 Billion of consideration. This consideration could take the form of either cash or shares/units in SUN/ETP.

MPC Pros

• Asset exchange could be done on a tax-free basis. As a tax paying entity, prudent tax planning is likely to be important to MPC too avoid value leakage. If a reverse Morris Trust structure is used, it is likely this MPC and SUN could exchange their assets (and additional consideration) in a tax-free manner.
• Improve an under-performer. Relative to MPC’s Speedway branded retail presence, SUN’s retail outlets are under-performers. It is likely MPC’s retail management team could improve the operation of SUN’s retail assets and bring their performance more in like with Speedway’s.
  • Speedway’s Light Product Margin Per Store Per Month is nearly $8,000 better than its peer group average, including SUN’s retail business
  • Speedway’s Merchandise Margin per Store Per Month is nearly $21,000 better than its peer group average, including SUN’s retail business
• Move away from wholesale and spot gasoline markets. Based on current refinery gasoline yields, MPC sells ~60% of the gasoline produced at its refineries to assured markets (ex controlled retail chains and long term wholesalers). A greater retail presence would allow MPC to sell a greater portion of its gasoline production to the higher margin assured market vs the wholesale or spot markets.

MPC Cons

• Less Control. On the face of things, selling its pipelines would give Marathon less control over the operations and strategic direction said pipelines. However, MPC will have long-term contracts to use these pipelines. In fact, in anticipation of the spinoff of its pipelines into an MLP, MPC has already entered into long-term contracts with its pipeline subsidiary.
  • MPC’s pipelines are already common carrier and as such, open to all users under tariffed rates.
  • Contracts will allow MPC to continue to use the pipelines.
• Leakage in Value Creation. Pipelines are often not operated in an optimally commercial manner when they are captive to an E&P company or a refiner vs a 3rd party. If MPC’s pipelines are sold/exchanged, MPC may be able to capture some of the upside/growth derived by a 3rd party owner if it takes units rather than cash as consideration.
  • Taking units may also help MPC to keep some control over its pipelines, and MPC may even be able to get board representation in the pipeline’s acquirer.

SUN/ETP Pros

• Retail Divestiture. ETP has indicated it would eventually sell SUN’s retail business. In addition to being not logistics oriented, there are some questions about whether or not the retail assets would be MLP qualifying.
• Synergies Between Pipeline Networks. A Combination of the MPC and SUN pipeline networks is likely to result in numerous synergies as new crude oil pipelines and refined product pipelines will be able to share rights of way with existing pipelines. The combined networks could create a best in class crude oil and refined products pipeline network which service most of the refineries and major markets in the North East and Ohio River Valley.
  • A combined network and their rights of way would simplify the construction of a crude oil pipeline which could more easily get crude oil from the Bakken to the stranded refineries on the east coast.

ETP Cons

• Possible High Pipeline Valuation. MPC does not appear to be an eager seller of its pipelines, and this may lead to having to pay a higher than desired price/valuation
• Complicated Organization. ETP restructuring could make it more difficult to realize operational synergies with Sunoco Logistics pipelines.

Other Possible Impediments

• Possible Anti Trust on Retail/Marketing. In the US, there are over 115,000 convenience stores which sell fuel, with 59,000+ convenience stores in the Midwest and south-east. A combination of the SUN and MPC retail businesses would total ~10,000 stores, not an overwhelming proportion of the total convenience store market.
  • PSX currently has ~10,000 stores on its own. A combined MPC/SUN retail would come close to rivaling PSX’s retail presence.
• Possible Anti Trust on Pipelines. There could be some antitrust concerns as two liquid pipeline systems are brought together. However, there is minimal overlap of services between the two networks.
  • SUN’s pipeline system in North East is predominantly a refined products pipeline network
  •  Any overlap SUN and MPC may have would seem to be for refined products in northern Ohio. However, SUN’s pipeline is an east to west pipeline while MPC’s pipelines are mostly south to north.

Chevron’s Non-Core Pipelines

With a preponderance of its refinery capacity in the west (625,000 Bpd), and with one just refinery in Mississippi (330,000 Bpd), Chevron (“CVX”) may not have much strategic use for its minority interests in three mid-western pipelines. As a result, it may be able to redeploy some capital by selling these non-core interests.

Chevron Pipeline Interests

Explorer Pipeline (refined products) – CVX owns 16.6% of the Explorer Pipeline. The other owners of the Explorer Pipeline are American Capital (6.8% ownership), Phillips 66 (“PSX”; 13.8%), Marathon Petroleum (“MPC”; 17.4%), Shell (“RDS-A”; 36%), and Sunoco Logistics (“SXL”; 9.4%). joint venture that owns approximately 1,900 miles of common carrier refined products pipelines. The system, which is operated by Explorer employees, originates from the refining centers of Lake Charles, Louisiana and Beaumont, Port Arthur and Houston, Texas, and extends to Chicago, Illinois, with delivery points in the Houston, Dallas/Fort Worth, Tulsa, St. Louis, and Chicago areas.

Mid-Valley Pipeline (crude oil) – CVX owns 9% of the Mid-Valley Pipeline. The other owner of the Mid-Valley Pipeline is SXL. SXL is also the operator of the Mid-Valley Pipeline. The Mid-Valley Pipeline owns approximately 1,000 miles of crude oil pipelines, which originate in Longview, Texas and terminate in Samaria, Michigan. Mid-Valley provides crude oil to a number of refineries, primarily in the midwest United States, including PBF’s Toledo, Ohio refinery. Based on the last sale of an interest in the Mid-Valley pipeline in May 2010, the pipeline was valued at $182 million.

The Mid-Valley Pipeline does not appear to service any of CVX’s refineries, and thus, would seem to be of limited strategic benefit to CVX.

West Texas Gulf Pipeline (crude oil) – CVX owns 28.3% of the West Texas Gulf Pipeline. The other owners of West Texas Gulf are SXL (60.3%) and PDVSA (11.4%). West Texas Gulf owns and operates approximately 600 miles of common carrier crude oil pipelines which originates from the West Texas oil fields at Colorado City and the SXL’s Nederland terminal, and extends to Longview, Texas where deliveries are made to several pipelines, including Mid-Valley. Based on the last sale of an interest in West Texas Gulf in August 2010, the pipeline was valued at $352 million.

Though it is possible that CVX’s Mississippi refinery processes crude which is produced in the Permian Basin and which is shipped east on the West Texas Gulf Pipeline, this crude oil will have to travel through another pipeline for the final leg of its trip from Long View, TX to Mississippi. Because West Texas Gulf is a common carrier pipeline, it is likely that CVX could free up some capital while maintaining its level of service by selling its interest in West Texas Gulf.

Though it is unlikely that CVX will be able to divest itself of these minority interests at a valuation equal to the 11 – 15x EBITDA multiple which most public the public pipeline companies garner, it is likely these interests could be sold at EBITDA multiples which are  a sigvificant premium to CVX’s 4.0 – 4.3x EBITDA multiple.