I believe that the unit price for PetroLogistics (PDH) will decline by 30%+ over the next few months as a result of dramatically lower near-term distributions, and that the stock will likely continue to fall as the market realizes that the abnormal profits realized in 2013 are unlikely to be repeated in the foreseeable future. I believe that the full-year 2014 distribution will struggle to reach $1.05, representing a 35%+ decrease from the distributions paid last year. Based on comparable variable distribution MLPs and the company's own trading history, a 12.5% yield would price the units at $8.80, 23% below their current price. Should the current propane shortage worsen, causing prices to stay high into the spring and summer, the company's distribution could fall well below a dollar. The fund I work for is short shares of PDH.
Due to structural changes facing PetroLogistics associated with surging propane exports, rising propane prices and weak propylene prices, PetroLogistics will likely be forced to meaningfully reduce its first quarter distribution to levels far below what investors are expecting.
PetroLogistics is a single-asset company, whose sole business is operating a propane dehydrogenation facility in Houston, Texas. The company is organized as a variable distribution master limited partnership (MLP). Similar to other variable distribution MLPs such as Northern Tier (NTI) and Alon USA Partners (ALDW), PDH pays a quarterly distribution which varies based on distributable cash flow that was earned in the prior quarter. The calculation of PDH's distribution is straightforward, as it is based on three primary inputs: the price of propane, the price of propylene and the facility's utilization rate. The company's facility, which processes propane into propylene, is the largest "on-purpose" propane dehydrogenation plant in the country. The vast majority of propylene is produced as a refinery by-product from cracking crude oil into diesel and heating oil. With a nameplate capacity of 1.4 billion pounds of propylene, PDH accounts for roughly 4% of total US production.
Margin Expansion and Correction
PDH makes money by purchasing propane and processing it into propylene, which is a raw material input for making many plastics. While profitability is somewhat correlated with oil prices (high prices being a positive), the largest driver is the spread between the price of propane and propylene. Throughout much of 2012 and 2013, natural gas liquids (NGLS) departed from their correlation with oil, and PDH benefitted from historically low propane prices. Meanwhile, propylene prices rose with oil. This situation has reversed in dramatic fashion. As illustrated below, since July of last year, the price of propane has risen 92%, while propylene prices are up just 13%.
Low propane prices were the result of the ongoing oil and gas revolution. From 2010 through 2013, propane production increased by over 40%, from 1 million barrels per day to over 1.4 million. With no way to match demand with rising supplies over such a short time, propane prices were cut in half from $1.50/gal to under $0.75/gal. As a result of this decline, US propane became priced at a significant discount to the global market. In 2012 and 2013, the average propane price in the US was around $1.00/gal, while world prices averaged nearly $2.00/gal. There are a few companies that benefited more from depressed propane prices than PDH. Throughout 2013 the average propane-to-propylene spread was over $0.40 per pound of propylene, which is roughly 75% higher than current spreads. It is unlikely that the company will ever benefit from such a favorable spread again.
Energy infrastructure investment is driven by pricing differentials. Depressed US propane prices offered companies a very attractive opportunity to capitalize on this dislocation. Companies such as Targa and Enterprise moved quickly to increase propane export capacity. Over the past two years, propane exports from the US more than doubled, rising from 150 thousand barrels per day to over 400 thousand. The following chart illustrates just how dramatic the export growth has been.
Exports will continue to ramp as new projects are completed in the Gulf, as this chart illustrates.
Source: RBN Energy
The increase in exports, combined with a higher-than-average demand, has cause propane prices to rise over 30% the past three months. While prices will likely retreat as we move into the spring and summer, the structural oversupply of propane, and resulting discounted prices, is likely over for good. And as low propane prices fade into the rear-view mirror, so too will PDH's outsized profits and its status as a low-cost producer relative to its competitors outside of North America.
The spot propane and propylene prices paint a dire picture for PDH's first quarter distribution. On 2/10/14, the spot price for Mont Belvieu propane was $1.71/gal and polymer-grade propylene was priced at just over $0.70/lb. This implies a $0.21/lb spread for processing propylene. At current prices, PDH would distribute less than $0.05 over a full quarter. Even more troubling, conditions may get worse before they get better.
Just last week, the Federal Energy Regulatory Commission (FERC) elected to use their emergency powers for the very first time when they issued a directive requiring Enterprise Products Partners (EPD) to give high priority to propane shipments going to the Midwest and Northeast from Mont Belvieu. PDH purchases the majority of its propane from Enterprise, and it is very likely that it will be negatively impacted, as Enterprise is required to redirect propane from Mont Belvieu (where PDH purchases propane) to areas needing propane for heating purposes. Conway, the most frequently quoted Midwest pricing hub, is currently pricing propane at $2.25/gal. This $0.54 spread provides a great deal of room for Mont Belvieu prices to rise. If PDH's propane input costs were to increase just $0.08 from their current price, keeping propylene constant, then it would be in danger of reaching negative DCF territory. Should that scenario come to fruition, I believe the stock could decline much more than 30%.
Challenging Longer-Term Outlook
While the current propane shortage is going to materially impact near-term distributions, I also believe there are long-term challenges that could result in a materially lower unit price. At the end of the day, PDH produces an undifferentiated commodity, and over time, returns from this kind of business will approach the builder's cost of capital. There are several large-scale propane dehydrogenation projects currently in some stage of development. These facilities are being completed by the likes of Dow Chemical (DOW), Williams Companies (WMB) and PDH's largest supplier of propane - Enterprise Products. As these projects are built out, the margin earned from converting propane into propylene should decline. I think it is helpful to consider the future scenario by thinking about what these projects cost and what the cost of capital is for these companies.
Based on numbers provided by Williams and others proposing these projects, the cost for constructing a new propane dehydrogenation facility is around $800MM per one billion pounds of annual capacity. Using PDH's 1.4B pounds of capacity would imply a total cost of around $1.15B (PDH's actual cost was significantly lower, since this was a conversion of an existing plant). Note that this is significantly lower than its current enterprise value of $2B+. In general, large MLPs and industrial companies like Dow will target low double-digit expected returns on projects like this. A return of 12% on a hypothetical new-build project the size of PDH's facility would give you $135MM of cash flow, before G&A costs, interest expense and any income taxes. Using the company's current expense load and debt structure, that would leave roughly $88MM in distributable cash flow, or $0.63 per unit. At even a 10% yield, which would be low for a variable distribution MLP, the units would be priced at $6.30, or 45%+ below their current price.
Additional disclosure: The fund I work for currently maintains a short position in PetroLogistics. This report is not a recommendation to buy or sell any securities. The author and/or employer may buy or sell shares in any company mentioned, at any time, without notice. The information contained herein is believed to be accurate as of the posting date. Readers should conduct their own verification of any information or analyses contained in this report. The author undertakes no obligation to update this report based on any future events or information.