Trunkline Conversion? A Sign Of The Times?

Recently, various news sources have reported rumblings of the potential conversion of one of Trunkline natural gas pipeline’s multiple parallel pipelines, or loops. Trunkline’s owner, Energy Transfer’s (“ETE”), hopes to convert one of Trunkline’s main loops from natural gas service to crude oil service. As part of this conversion, ETE would also like to reverse the flow of this pipeline loop to so it could transport crude oil from the upper mid-west to the US Gulf Coast. Once reversed, this 30 inch, 770 mile pipeline could ship as much as 400,000 Bpd of crude to the USGC.

As a first step in this conversion, Trunkline applied to FERC on July 26, 2012 to abandon and sell a section of its mainline to an affiliate. This affiliate has yet to be determined by Trunkline’s parent company, ETE. Too keep all of its liquids assets under one roof, and to take advantage of its low cost of capital, it seems likely that this affiliate will be one of Sunoco Logistic’s (“SXL”) subsidiaries.

Current Pipeline Utilization

Trunkline is currently transporting natural gas at well below its capacity. And, with the development of the Marcellus and Utica shale formations, transporting natural gas from the USGC to Michigan seems increasingly inefficient. Since Trunkline’s mainline is looped, with multiple parallel pipelines along its mainline, the conversion of one loop to oil service will still leave the remaining loops to continue providing gas service. According to the FERC application, after the conversion, it is expected that Trunkline’s mainline capacity would be reduced by 597,000 Dt/d (597 MMcfd), or 38%, to 958,000 Dt/d (~958 MMcfd).

Though Trunkline has asked that FERC approve its request by April 1, 2013 so the converted pipeline can go into service by April 2014, FERC has 90 days from Trunkline’s initial application to solicit comments, or to approve the application.

Opposition to the Conversion

The governor of Michigan has filed a protest against this conversion, claiming that the decrease in natural gas pipeline capacity to Michigan could adversely affect Michigan’s energy security. In addition to Trunkline, three other major gas pipelines deliver gas to Michigan: Texas Eastern (owned by Spectra, “SE”), ANR (owned by TransCanada, “TRP”), and Panhandle Eastern (owned by “ETE”).

Despite this protests, we believe the existing pipeline capacity to Michigan, as well as the development of more local sources of gas in the Utica (initial estimate of 38 tcf of gas reserves) and Marcellus (estimated 141 tcf of gas reserves) should allay any fears which FERC, or the governor of Michigan might have. We believe that FERC will approve this pipeline conversion.

Why Convert?

By converting an existing pipeline to crude oil service, ETE can not only save on construction costs, but it can bring its pipeline into service more quickly because it will not have to spend time to acquire rights of way, or to lay new pipe.

Though it is hard to determine without more details on the project, we estimate that a pipeline conversion could be done for 60-80% of the cost of a new pipeline, and that the conversion of one of Trunkline’s loops between the Chicago, IL area to the USGC could cost over $1 Billion. A conversion of Trunkline from the Woodriver/Petoka, IL area to the USGC would be less expensive, but could cost over $800 million.

If we use Seaway’s tariffs for light crude ($3.82/barrel) and heavy crude ($4.32/barrel), as a benchmark for Trunkline’s conversion, we believe once converted, this pipeline could $150-350 million of EBITDA.

Crude From the Chicago Area

If Trunkline’s crude conversion were to take delivery of crude oil in the Chicago area, it will be dependent on ENB’s mainline as its only source crude from either the Bakken, or from Canada. ENB’s Seaway and Spearhead pipelines also have takeaway capacity from Chicago and will be competitors to Trunkline’s crude conversion. As a result, it is unclear how helpful ENB would be in this endeavor. (Note: Though local to the mid-west, we believe it is likely that any and all crude produced in the Utica will be consumed by local refineries.)

Crude From Wood River/Petoka

Interconnecting with southbound crude pipelines in the Wood River/Petoka, IL area would seem to offer more options for potentially cooperative partners. The following pipelines carry Canadian and/or Bakken crude and terminate in the Wood River/Petoka area:

• Minnesota and Wood River Pipelines. The Minnesota Pipe  and the Wood River Pipeline are both owned by Koch. The Minnesota Pipeline delivers Canadian and Rockies crude oil, including Bakken, from the Enbridge system in Clearbrook, Minn., to refineries in the Twin Cities. This system can easily be expanded to accommodate the growing supply of these crudes. The 580-mile Wood River system receives crude oil at its terminal in Wood River, IL, from Midwest crude pipelines that source crude oil from major hubs and production points, including Cushing, OK, Patoka, IL, St. James, La., and the Rockies, and delivers this crude to refineries in the Twin Cities. North American crude oil production seems to indicate that Koch will eventually reverse the flow of its Wood River Pipeline.
• Express/Platte Pipelines. The Express and Platte pipeline systems are owned by Kinder Morgan (“KMI”) and two Canadian investors. This system currently has the capacity to transport up to 164,000 Bpd of Canadian crude to Wood River, IL. KMI has suggested that this pipeline’s capacity could be increased.
• Enbridge/Mustang/Capwood Pipelines. ENB’s mainline system has the capacity to transport up to 2.5 million Bpd of Canadian and Bakken crude to Chicago, IL. Its pipeline service to Wood River/Petoka, IL is more limited at 100,000-200,000 Bpd.
• Keystone. Trans Canada’s (“TRP”) Keystone pipeline currently has the ability to deliver 590,000 Bpd of Canadian crude oil to Petoka, IL. Keystone is working on building a pipeline from Cushing, OK to Texas, which is expected to come into service in late 2013.

Louisiana Terminus

Trunkline’s routing and ability to terminate its crude oil flow in Louisiana or Texas may make it the most desirable transportation alternative for many of the Louisiana and Mississippi River refineries (these refineries have over 4 million Bpd of refining capacity). The Keystone XL and Seaway pipelines will both terminate in Texas. To get crude from Texas to Louisiana shippers would have to contract with another pipeline for this last leg.

 Potential Competition

• Spearhead Pipeline. Spearhead is owned by ENB and transports Canadian and Bakken crude from Chicago, IL to Cushing, OK. Spearhead has 650,000 Bpd of current capacity.
• Seaway Pipeline. Seaway is owned by ENB and EPD. Seaway connects with the Spearhead Pipeline and transports Canadian and Bakken crude from Cushing, OK to the USGC. Current capacity of Seaway is 150,000 Bpd, but capacity is expected to be expanded to 400,000 Bpd in early 2013. Pipeline will be looped, increasing Seaway’s capacity by 450,000 Bpd, by mid 2014.
• Pegasus Pipeline. Pegasus is owned by ExxonMobil (“XOM”), and transports crude oil from Petoka, IL to Nederland, TX. Pegasus has the capacity to transport 90,000 Bpd of crude oil.
• Keystone XL. Keystone XL is being developed by TRP. TRP plans us Keystone to transport Canadian and Bakken crude to the USGC via Cushing, OK. As mentioned above, Keystone XL’s Gulf Coast access section is expected to have 500,000 Bpd of capacity by late 2013.
• Mid-Valley Pipeline Reversal. The Mid-Valley pipeline is currently flowing crude from south to north to service the many of the Ohio refineries with oil from the West Texas Pipeline and other third party pipelines in Beaumont/Nederland, TX. The Mid-Valley Pipeline is 91% owned by SXL and 9% by Chevron (“CVX”). Current pipeline capacity 240,000 Bpd. Increasing crude production from the Bakken and from Canada is decreasing the demand for oil from this pipeline and the flow of the Mid-Valley Pipeline could potentially be reversed.
• Capline Pipeline Reversal. Capline is currently flowing crude oil form south to north to service many of the PADD II refineries with crude from St. James, LA via Petoka, IL. Capline is owned by Plains All-American (“PAA”, 54%), Marathon Petroleum (“MPC”, 33%), and BP (“BP”, 13%). Current pipeline capacity 1,200,000 Bpd. As with the Mid-Valley Pipeline, increasing crude production from the Bakken and from Canada is decreasing the demand for oil from this pipeline, and the flow of the Capline Pipeline could potentially be reversed.

Closing of SUN Acquisition to Put Near Term Pressure on ETP Units?

Yesterday, Energy Transfer Partners (“ETP”) announced the cash consideration option for its pending purchase of Sunoco (“SUN”) was oversubscribed. According to the preliminary results of the elections made by SUN shareholders regarding the form of consideration to be received, almost 74 percent of SUN shareholders selected that choice.

Among other factors, it is possible this will likely lead to some near term pressure on ETP units as those holders of SUN shares which received, but did not want, ETP units sell the unwanted units as quickly as possible. We believe SUN shareholders behavior could unfold as follows:

• Unit Only Election. Out of a total of almost 105 million shares of SUN, only 4.2% of SUN owners elected to receive only units. These SUN shareholders will receive 1.049 ETP units and no cash for each SUN share, and this election was worth $44.27/SUN share based on Monday’s closing price. Once the deal closes on Friday, these holders will hold ~4.7 million units of ETP, and these holders are likely to hold onto their ETP units.
• Standard Election. 2.6% of SUN shareholders elected to receive the standard election of $25 cash and 0.5245 ETP units for each share of SUN. This election was worth $47.13 per SUN share based on Monday’s closing price, and these shareholders will receive ~1.4 million ETP units. Like the unit only group, once the deal closes on Friday, these holders are likely to hold onto their units.
• No Election. 19.2% of SUN shareholders made no election and will receive the standard election of $25 of cash and 0.5245 ETP units each SUN share they hold. Like the Standard Election, this election was worth $47.13 per SUN share based on Monday’s closing price. These shareholders will receive ~10.6 million ETP units. Like the Standard Election group, once the deal closes on Friday, these holders are likely to hold onto their ETP units.
• Cash Only Election. 73.9% of SUN shareholders elected to try to maximize their return and receive cash only. Unfortunately for these shareholders, while this would have been $50 of cash had this deal not been subject to proration, proration will adjust their compensation to be $26.44 of cash (more cash than the standard election as some SUN shareholders elected to take no cash) and 0.4944 ETP units for each SUN share. This election was worth $47.40 per SUN share based on Monday’s closing price. For any number of reasons (ex. Selling to lock in gains, selling because they are not mandated to hold MLP units, etc.), these holders are likely to try to sell their ETP units as quickly as possible. Total units given to holders who made the Cash Only Election are expected to be ~38.3 million units.
  • Prior to closing this deal, ETP had a total of ~245 million common units and ~55 million ETP units will be issued as consideration in this deal.
  • ETP’s recent trading volume has averaged ~1.5 million shares per day.
  • SUN shareholders who are able to short are likely to begin to short ETP units prior to the deal closing to get ahead of any selling pressure.

Note: Had ETP units been trading above $47.66 on Monday, the final Election day, the profit maximizing choice on Monday would have been the Unit Only Election.

Energy Infrastructure Valuation Comps – September 2012

This relative value analysis compares various valuation metrics for companies in the  large Energy Infrastructure universe, those companies with EVs of greater than $10 Billion (ex. KMI, EPD, WMB, ETE, OKE, SE, and MMP). To do this, it is best to compare the valuation of the various MLP GPs amongst them selves, as well as to compare the valuation of the MLPs w/o GPs. It can also useful to compare the relative values of the MLP GPs with their own MLPs.

1. Most Expensive
   1. EV/EBITDA
      1. OKE. Relative to the selected universe of OKE is by far the most expensive company in the universe. (EV/LTM EBITDA 14.1x, EV/2012E EBITDA 16.0x; EV/2013E EBITDA 12.9x). Regionally focused presence in the mid-continent. Growing presence in the Bakken via it’s MLP (“OKS”). Slow growing natural gas distribution business and a shrinking natural gas marketing business held in its GP (“OKE”). The great preponderance of OKE’s growth projects won’t begin to make significant a contribution to results until 2014.
      2. MPP. (EV/LTM EBITDA 19.4x, EV/2012E EBITDA 17.6x; EV/2013E EBITDA 16.1x). Single class of unit ownership, no GP, raises its unit cost of capital relative to GP units and lowers its unit cost of capital relative to two class MLP units. Tax treatment of LP units vs C Corp. shares raises the cost LP units relative to C Corp. shares (OKE and KMI).
      3. KMI. (EV/LTM EBITDA 18.0x, EV/2012E EBITDA 15.9x; EV/2013E EBITDA 14.6x). Premier company in the space with biggest, most diverse set of assets. Diversity of assets and an Enterprise Value of over $100 billion should give it the lowest cost of capital in the energy infrastructure universe.
   2. Yield
      1. OKE. Dividend yield of 2.6% is 24% lower than next lowest company, making OKE share’s 24% more expensive than its next most expensive peer, when measured by this metric. OKE’s assets and results would not seem to be 24% better than the next best company in the universe.
      2. WMB. 3.4% dividend yield. Large diverse asset base with strong position in the Marcellus and in the Canadian NGL market.
      3. KMI. 3.7% dividend yield. See above.
         SUN. 1.7% dividend yield. SUN has a low dividend, as this is deceptively expensive because prior to its agreement to be acquired by ETP, SUN was also returning cash to share holders through an aggressive share buyback program.
2. Most Reasonably Valued
   1. EV/EBITDA
      1. SUN. (EV/LTM EBITDA 9.1x, EV/2012E EBITDA 8.9x; EV/2013E EBITDA 7.9x). GP of a growing crude oil and refined products distribution business combined with a relatively stable retail convenience store business and minority interest in a restructuring refinery business. Low valuation was a result of the exit costs and valuations associated with SUN’s exit from its former chemicals and refining businesses.
      2. SE. (EV/LTM EBITDA 9.8x, EV/2012E EBITDA 8.9x). Large geographically diverse natural gas transportation and processing business with a significant stable natural gas distribution business.
      3. ETE. (EV/LTM Proforma EBITDA 12.4x, EV/2012 Proforma EBITDA 12.4x; EV/2013E Proforma EBITDA 10.8x). Stagnant distribution growth from a dominant intra-Texas natural gas transportation business due to lack of basis in natural gas, broad asset base from acquisition of Southern Union assets, growing scale in NGL processing and logistics. In process of acquiring undervalued SUN assets.
   2. Yield
      1. ETE. 5.5% distribution yield. Remembering that distributions are treated as a return of capital for tax purposes (vs dividends which are taxed). ETE is amassing control of an increasingly broad base of natural gas, NGL, crude oil, and refined products infrastructure assets. However, flat natural gas basis and a deferral of Incentive Distribution Rights have led to stagnant distribution growth.
      2. EPD. 4.7% distribution yield.Broadest NGL processing and distribution network. Historically strong management with track record of consistent growth.
      3. SE. 3.8% dividend yield. Please see above.
         

Note: EV for GPs includes the value of the GPS’ MLPs which are not held by the GP; EV for the MLPs is grossed up to include the value of the MLP’s GP.

Getting Oil Out of the Bakken…

As the Bakken’s oil production growth continues to exceed expectations, oil production is now expected to eventually double or even triple to 1.2 – 2.0 million Bpd. The Bakken’s rapid growth is, however, being constrained by an inability to cheaply and efficiently move the oil out of the region. To this end, we thought we’d take a look at some of the infrastructure alternatives, and see if there might be an intriguing opportunities. Generally, lighter crude oils such as those produced by the Bakken have the greatest demand in the east in  PADDs I and II. This is because many of the PADD I and Ohio refineries have less ability to process heavier oils, as measured by their lower Nelson Complexity Ratings. Generally, heavier oils will go south to the PADD III refineries on the USGC which have been upgraded to process heavier oils.

There are two main ways to transport oil out of the Bakken: (1) by train, and (2) by pipeline.

Currently, because the Dakotas were never a historically prolific oil producing region, oil pipeline capacity out of the Bakken is limited to Enbridge’s (“ENB”) 200,000 Bpd pipeline, and many shippers have had to resort to shipping their oil to the USGC, or even the USEC, by rail. However, there are at least three pipeline systems under construction, and by 2015, pipeline capacity is expected to carry nearly all of the oil production from the Bakken.

Rail vs Pipeline Costs

One might ask why rail, as the incumbent carrier, wouldn’t be able to keep its current share of oil transportation customers. The answer is cost. Transporting oil by rail is dramatically more expensive than transporting oil by pipeline. Though much more expensive than a pipeline on a per barrel basis, rail has one big advantage. Many rail systems are already in place and need a minimal amount of capital upgrades to begin transporting oil. That said, as the $10 differential between the rail cost to St. James and the pipeline cost to the USGC shows, once up and running, pipelines are a much cheaper, more efficient, and more reliable way of transporting oil. However, pipelines are expensive to build, and take a fair amount of time to get permitted and into service.

The $14/Barrel differential in rail pricing to USEC vs to pipeline pricing to Petoka, IL creates opportunity to bring oil into Ohio and to the USEC. Petoka is about the farthest east that one can transport Bakken oil by pipeline. As was mentioned above, the the lack of heavy oil processing capability makes the Ohio and the PADD I/east coast refinery markets an appealing 1.5 million Bpd opportunity for Bakken oil. This said, once up and producing in the next three to seven years, the oil production from the Utica could satisfy 300k of this demand. Nevertheless, a 1.2 million Bpd market should be more than sufficient to support the construction of a pipeline to the east coast from the Midwest.

Bakken to the Midwest

To get oil to the USEC and to Ohio, transiting through Cushing, OK seems unnecessary, adding additional distance and cost to the trip. That said, skipping Cushing will eliminate OneOK (“OKE”) and TransCanada’s (“TRP”) Keystone XL pipelines as potential carriers out of the Bakken. Skipping OKE and Keystone XL will leave ENB as the main pipeline alternative out of the Bakken.

If one takes either OKE’s or Keystone XL’s pipeline from the Bakken to Cushing, to get east, one will need to use ENB’s Ozark Pipeline to Wood River, IL or BP’s pipeline to get to Whiting, IL. Using either of these two alternatives does not seem like a cost effective alternative to using one of ENB’s pipelines the whole way from the Bakken. ENB’s mainline can get crude from the Bakken to Toledo, OH, or to either Chicago or Patoka, IL.

The High Prairie Pipeline, a yet to be built pipeline out of the Bakken is currently fighting with ENB to interconnect with ENB’s mainline at Clearbrook, MN. Another option for High Praire to move its crude south and/or east might be to interconnect with the Koch (Minnesota/Koch) pipeline system. Koch’s Minnesota Pipeline begins at Clearbrook, MN, and then interconnects with the Koch Pipeline in St. Paul, MN. The Koch Pipeline terminates at Wood River, IL. Because there are a lot of historical relationships between High Prairie’s management team and Koch, many members of High Prairie’s management team used to work at Koch, we feel like this could be a easier and better alternative than interconnecting with ENB.

Possible East Coast Pipeline Partners:

As oil production in the Utica ramps up, it is likely that local refiners in Ohio (Marathon, Husky, BP/Husky, and PBF) will absorb most of the 300k Bpd of light oil produced by this formation.This however, does not mean that there isn’t a need for pipeline infrastructure to get oil from Ohio to the PADD I refineries, most of which seem to be clustered in and around the  Philadelphia area. This pipeline need will play to companies who already service some or all of these refineries for either crude delivery or refined product take away capacity and to those companies who can aggregate disparate pipeline networks and rights of way. We see some possible players as being the following:

• Marathon Petroleum (“MPC”)
  • Has rights of way, and crude and refined products pipeline connections to terminals and refineries in Ohio.
  • Marathon Pipeline connects Petoka, IL to Marathon’s refineries in Ohio.
  • Does not have pipeline connectivity east of Ohio.
• Sunoco (“SUN/SXL”)
  • Has rights of way and pipeline connections from many of the Philadelphia area refineries to markets in Pennsylvania, Ohio, and Michigan.
  • Also controls the Inland Pipeline, a refined products pipeline which connects three refineries to eastern Ohio and western Pennsylvania markets.
  • Could be possible to use rights of way and underutilized/unused pipe to get crude from either Toledo or one of Inland’s Ohio refineries to Philadelphia.
• Buckeye (“BPL”)
  • Has rights of way and refined products connections to terminals and refineries in Pennsylvania, Ohio, New York, and New Jersey.
• Enterprise Products (“EPD”)
  

• EPD owns the interstate ATEX pipeline.
• Though it crosses Indiana, Ohio, and Pennsylvania, ATEX is primarily a NGL pipeline and does appear to connect to refineries.

Conclusion

ENB seems poised to be the dominant transporter of crude, not only from Canada, but also out of the Bakken. However, a good counter balance would seem to be a combination of the MPC pipeline network and either the SUN/SXL or BPL pipeline network. This combination would create a pipeline network which serves a thirsty but under-served region with 1.5+ million Bpd of light oil demand.

Marathon Petroleum to Purchase BP’s Texas City Refinery?

Today’s Financial Times reported that BP (“BP”) was in talks to sell its 475k Bpd Texas City refinery to Marathon Petroleum (“MPC”). Despite of having been in talks for months, the article stated that it was still unclear that a deal could be reached. With that in mind, we thought we’d consider some of the likely bidders for the Texas City might be. As BP is trying to raise cash to cover the cost of its Gulf of Mexico oil spill, a suitor who is able to pay cash would seem to be preferable to one who might pay a higher price with shares.

Based on the $1.175B which Tesoro (“TSRO”) agreed to pay for BP’s 266k Bpd Southern California refinery ($4,417 per barrel of refining capacity), we might expect a buyer could pay up to $2.1B for BP’s 475k Bpd Texas City refinery. The inventory associated with the Texas City refinery could add another $2.3B to the purchase price, depending on price and inventory level.

Because of the volatility in their results, refineries usually trade at low multiples and generally do not have a high amount of leverage. This being the case, a refinery as large as BP’s Texas City refinery would probably be too large for a private equity firm to take private, and a local refinery would seem to allow for the most opportunity to generate operating synergies. In addition to the BP refinery, there are four refineries in the Texas City/Houston area:

1. ExxonMobil (“XOM”)
   1. 584k Bpd capacity
   2. The XOM refinery is located in Baytown, TX and is not close to BP’s Texas City refinery.
2. Houston Refining
   1. Joint venture between Citgo and LyondellBasell
   2. 268k Bpd capacity
   3. Houston Refining’s refinery is located in Houston and is not close to BP’s Texas City refinery.
3. Marathon Petroleum (“MPC”)
   1. 80 Bpd capacity
   2. MPC’s refinery is located down the street from BP’s Texas City refinery.
   3. MPC’s EV/LTM EBITDA: 4.1x
   4. MPC’s Total Debt/LTM EBITDA: 0.7x
   5. MPC’s Net Debt/LTM EBITDA: 0.3x
4. Valero Energy (“VLO”)
   1. 405k Bpd capacity
   2. VLO’s refinery is loctaed down the street from BP’s Texas City refinery.
   3. VLO’s EV/LTM EBITDA: 4.3x
   4. VLO’s Total Debt/LTM EBITDA: 1.3x
   5. VLO’s Net Debt/LTM EBITDA: 1.1x

Based purely on location, the Houston Refining (Houston) and XOM (Bay City) refineries don’t seem as if they could generate any operating synergies with the BP refinery. On the other hand, a combination of the BP refinery and either the MPC and VLO refineries, both of which abut the BP refinery, would seem to offer the opportunity to generate substantial operating and/or capital synergies.

Though VLO’s slightly higher EV/EBITDA multiple might suggest that it could more easily raise cash through an equity offering, MPC’s lower total and net leverage give it the ability to raise $2.8-3.8B more debt. than VLO. This would seem to make it easier for MPC to purchase BP’s Texas City refinery.

Further, MPC could also raise additional capital by swapping its non-core pipeline business for Sunoco’s (“SUN”) convenience store business. Because a pipeline business is more highly valued than a convenience store business, and because MPC’s pipeline business and SUN’s retail businesses generate roughly the same amount of EBITDA, a transaction such as this would allow MPC to maintain its level of EBITDA and debt capacity, and also  receive an additional $1B of consideration. This additional consideration could used to help pay for BP’s Texas City refinery.

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.

Infrastructure SOS in the North East

Yesterday’s announcement of Carlyle’s (CG) acquisition of a majority interest in Sunoco’s (SUN) 330,000 barrel per day Philadelphia refinery and last month’s acquisition of Philips 66’s 185,000 bpd Trainer refinery by Delta Airlines highlight the need to revamp and repurpose some of the energy infrastructure in the North East.

Both of these facilities had been put on the chopping block in large part because of their reliance on imported crude oil as their base feedstock. Because the infrastructure (and until recently, the supply) has been unavailable for East Coast refiners to access domestic (ex Bakken) or Canadian crude oil production, the wide spread between imported crude oil and domestic crude oil has caused East Coast refineries to be unprofitable. Sunoco has stated it has lost over $1 Billion in its refinery business in the past three years.

The Bakken Crude Advantage

Bakken crude oil is currently priced at a discount of about $7 to $10 a barrel to benchmark West Texas Intermediate (WTI) crude oil. As of late, WTI crude oil has traded at a $12-15 discount to Brent crude oil, the benchmark for most crude produced in the Atlantic. Railroad freight charges to transport a barrel of oil from North Dakota, where the majority of Bakken crude oil is produced, to the East Coast are about $12-$15 per barrel. Transatlantic shipment of crude is currently about  $4.50-$7 per barrel. Doing a back of the envelope calculation, shipping Bakken crude via rail to Philadelphia would allow a refinery to benefit from a $11 per barrel decrease in input costs.

As a near term way to capture this input cost differential, part of Carlyle’s investment in Sunoco’s refinery will be the construction of a high speed train unloading facility at the refinery. This facility is expected to be completed by the end of this year, and will give the refinery the ability to off load up to 140,000 barrels of oil per day (~42% of the refinery’s capacity) of North American crude oil.

Rail is Suboptimal

Though certainly a good short-term solution, the shipment of crude oil from North Dakota to Philadelphia via train is not an optimal medium or long-term solution for the following reasons:

(1) Once in place, pipelines will always be more economic than trains. Shipping by rail costs $12-15 per barrel. This compares with an estimated $4-8 per barrel from Chicago or Toledo to Philadelphia or possibly $7-$11 from North Dakota to Philadelphia.

(2) Pipelines will always be more reliable than trains, especially trains that have to transit through Chicago. Trains carrying oil from the North Dakota to Philadelphia will always have to travel through Chicago, where over 1,200 trains transit per day. Though three additional unit trains per day would not seem to be a huge amount of incremental usage, it is widely known that Chicago’s train infrastructure is at its limits and trains are often subject to delays. If all three Delaware Valley refineries (Carlyle, Delta, and PBF/Blackstone) refineries all have the same idea and try to import crude from North Dakota, these three refineries could create a demand for up to 650,000 bpd of crude oil. This would necessitate the use of up to 14 unit trains (or 1,400 cars) per day. In addition to increasing Chicago’s burden, the impact of 14 unit trains on Philadelphia’s rail infrastructure is not likely to be insignificant.

(3) It is likely that pipeline companies will be able to leverage existing infrastructure to provide pipeline access from the North Dakota to Philadelphia.

• Enbridge (ENB) is one of the largest oil pipeline companies in North America with a large amount of pipeline capacity coming from Canada, through North Dakota to a hub in Chicago. ENB is currently increasing the capacity of its routes to Chicago and from Chicago to Toledo. These expansions which will add an incremental 150,000 bpd of capacity are likely to be operational by 2014.
• Sunoco Logistics (SXL), Buckeye Partners (BPL), and Marathon Petroleum (MPC) all seem to have assets which could be used as part of the final leg of pipeline transport of crude oil from Chicago (or Toledo) to Philadelphia.
• Sunoco Logistics (SXL) – Owns the last mile of piping and out of the Sunoco refinery which is being sold to Carlyle; Because of the close proximity or Delta’s refinery to the Carlyle refinery, SXL also would seem to own pipe within a few miles of Phillips 66 refinery which was sold to Delta; SXL also has an extensive pipeline network in New Jersey, Ohio, Michigan, and Illinois.
• Buckeye (BPL) – BPL has an extensive pipeline network in Ohio, New Jersey Indiana, Illinois, and Michigan.
• Marathon Petroleum (MPC) – MPC is an independent refiner with extensive pipeline assets in Ohio, Indiana, Illinois, Kentucky, and Michigan. MPC’s refineries would also benefit from pipeline access to Bakken and Canadian crude.

Bakken Alternatives

• Canadian Crude Oil A pipeline connection Enbridge or Keystone’s pipelines or to an Illinois pipeline hub in Chicago, Wood River, or Patoka would also give a shipper access to Canadian crudes once Keystone XL and Enbridge expansions come on line in 2014 and 2015.
• Utica Shale. Possible play on the oiliness of the Utica Shale. Though in a much earlier stage of development than the Bakken or the Marcellus shale formations, the Utica shale formation in Ohio, Pennsylvania and West Virginia is expected to be very prolific. Early drilling results from Anadarko and Chesapeake have been very promising. The possible medium term emergence of the more local source of oil in the Utica may prevent the development of a pipeline all of the way from Philadelphia to Chicago. It would probably not preclude the development of a pipeline to a meet me point in Ohio (ex Toledo, canton, or Lima).
• Marcellus Shale. Though the Marcellus formation is very close to Philadelphia, it is not very rich in oil. However, the refinery’s close proximity to the inexpensive gas from the Marcellus should be of benefit. Though the refinery had previously been using oil to power its production processes, it is likely that the refinery will switch to locally sourced natural gas to power its production processes. With a cost of less than ¼ of oil, on an energy equivalent basis, the refinery’s access to locally sourced gas is also likely to be beneficial to the refinery’s profitability. Further, locally sourced gas is also likely be an inexpensive source of hydrogen for use in the refinery’s newly announced hydrocracker. Depending in the size of the hydrocracker and the new hydrogen plant, the facility could use locally sourced, and low priced natural gas to get up to a 30% unit volume expansion on its feed stocks. Where one barrel of feed stock would normally yield one barrel of distliates, hydrogen cracking could increase the yield such that the refinery could produce up to 1.3 barrels of middle distillates such as gasoline, diesel, or jet fuel per barrel of feed stock.

Why didn’t their original owners make these changes?

• Until recently, North American, and specifically Bakken crude oil production was rather limited. In January 2010, the Bakken produced 165,000 bpd of crude oil. In April, 2012, Bakken production increased to 545,000 bpd of, a CAGR of over 65%. Some pundits expect Bakken crude oil production to increase to 800,000 to 900,000 bpd by 2025, with one of the biggest constraints on production being the ability to easily get the oil and gas to market.
• This transition in is likely to take time, and until the supporting infrastructure is fully developed, likely to continue to generate losses. As such, a transition like this is best done in private, without the scrutiny and earnings drag which comes with being a part of a public company.

Sunoco/Energy Transfer Partners and Marathon Petroleum, a Match Made in Heaven?

On April 30, 2012, Energy Transfer Partners (“ETP”) announced its intention to acquire Sunoco (“SUN”). SUN has spent the last few years rationalizing its business lines and has slimmed it self down to two main businesses: (1) Retail Gasoline Service Stations and (2) Oil and Products Pipelines.

Though consistently profitable, ETP has stated that SUN’s retail business is noncore, and as it works to simplify its story, it is likely ETP will look to monetize SUN’s retail business.

Though there are a number of possible buyers (ex. Alimentation Couche-Tard Inc., Casey’s, Pantry, Susser, Valero, etc.) for SUN’s retail business, a deal with Marathon Petroleum (“MPC”) would seem to be optimal for both SUN/ETP and MPC. In this potential SUN/ETP and MPC transaction, SUN/ETP would swap its retail business for MPC’s pipeline business.

 Benefits for MPC

• Increases MPC’s retail presence and decreases its exposure to wholesale gasoline sales
  • MPC has been acquiring retail outlets
• Ability to monetize a non core asset at premium valuation
  • Pipeline contributed ~4.1% of MPC’s EBITDA
  • Pipelines trade at 10-12x EBITDA vs 2.75x-4x for refiners and 6-8x for retailers
  • MPC has been shedding/selling/closing pipeline miles; MPC is definitely not growing its pipeline miles
  • As a captive pipeline business, it is likely that MPC is not utilizing its pipeline network in a commercially optimal fashion
• A tax free monetization of MPC’s pipeline assets might be possible
  • Reverse Morris Trust opportunity
• Synergy Opportunities
  • SUN retail locations seem to underperform those of MPC’s when measured by: Light Product Sales, Light Produce Margin, Merchandise Sales, and Merchandise Margin
  • Retail gasoline margins higher than wholesale gasoline margins
  • Ability to amortize marketing dollars over larger footprint

Cons for MPC

• Doubles size of retail business
  • More revenue volatility associated with gasoline prices and retail sales vs. pipelines
  • Possible anit-trust concerns, but combined retail businesses would have less than 9% national market share
• Decreases exposure to stable pipeline business
  • EBITDA ranged from $213-244MM in 2008-2012
• Marathon might view pipelines as being strategic
  • Can sign long term usage contracts with SUN/ETP which will preserve most of their rights on the pipelines, or keep stub ownership

 Benefits for SUN/ETP

• Decreased exposure to non-core asset
  • Possible issues around MLP qualified nature of retail assets’ cash flow
• Increased breadth and scope of growing oil, refined products and NGL pipelines in the midwest and northeast
• Tax free monetization of retail assets
  • Reverse Morris Trust opportunity
• Synergy Opportunity
  • Highly likely that MPC’s pipelines have not been operated in an optimally commercial fashion

Cons for SUN/ETP

• Even though the MPC’s pipeline business and SUN’s retail business generate similar levels of EBITDA, it is likely SUN will need to contribute $500MM to $1B of cash to bridge the valuation gap because pipelines trade at 10-12x EBITDA and retail businesses trade at 6-8x EBITDA
  • SUN can swap its retail assets for less than 100% (60-75%) ownership of MPC’s pipeline assets

• Dilutive equity might need to be raised to bridge the valuation gap
  • If SUN’s retail business is being contributed on an unlevered basis, the debt SUN (or MPC) would have to raise to bridge the $500MM to $1B is reasonable at only 2-4x MPC’s pipeline EBITDA