The 2013 third quarter came as a shock for many investors in full cash-flow but variable payout refinery master limited partnerships. The three refining MLPs are all fairly new companies, with IPOs that occurred within the last five quarters. All three came out the gate during a period of very high refinery profitability, rewarding investors with very large distributions. However, a shift in the refinery profitability business will separate the competitors and Northern Tier Energy LP (NYSE:NTI) offers the best profit potential for the group.
Note: MLP companies such as Northern Tier Energy have units and pay distributions. The words stock, shares and dividends may be used here with the understanding that the rules of MLP units apply including the tax consequences of investing in MLP units.
Crack Spreads and Dividends Disappear in Q3
The finances of a crude oil refinery boil down to what is called the crack spread, which is the market price of fuels that can be produced minus the cost of a barrel of crude. For example, a 3-2-1 crack spread would be the cost of 3 barrels of crude minus 2 barrels - 84 gallons - of gasoline minus 42 gallons/1 barrel of diesel fuel. The refining companies typically call their actual results the refining margin per barrel.
For the refinery MLPs, the refining margin produces a gross profit. Out of the gross profit comes the expenses to operate the refinery, pay the interest on any debt, money set aside for capital expenditures, and to pay for the next turn-around or overhaul of the refinery. The left over cash becomes the distributable cash flow, all of which will be paid out as distributions to the owners of the limited partnership units.
If oil prices move higher and gas and diesel do not move up as much, the crack spread and profits of the refineries get squeezed. This scenario as played out to date in 2013, especially in the third quarter. To illustrate, here are the reported refining margins, adjusted EBITDA and dividend for the first three quarters of this year for each of the three refinery MLPs:
- 2013 Q1: Refining margin: $28.76 per barrel; EBITDA: $161 million; Dividend: $1.48
- 2013 Q2: Margin: $16.21 per barrel; EBITDA: $66 million; Dividend: $0.71
- 2013 Q3: Margin: $6.46 per barrel; EBITDA: $7 million; Dividend: $ZERO
- Q1: Refining margin: $26.71; EBITDA: $310 million; Dividend: $1.76 pro-rata
- Q2: Margin: $20.56 per barrel; EBITDA: $251 million; Dividend: $1.35
- Q3: Margin: $11.89 per barrel; EBITDA: $34 million; Dividend: $0.30
Northern Tier Energy LP press releases
- Q1: Margin: $25.81 per barrel: EBITDA: $$157 million; Dividend: $1.23
- Q2: Margin: $23.92 per barrel; EBITDA: $86 million; Dividend: $0.68
- Q3: Margin: $11.84 per barrel; EBITDA: $51 million; Dividend: $0.31
The point of these numbers is to show that profit margins for these refineries can vary significantly from quarter to quarter. For Northern Tier Energy, throughput was reduced by 32% for the second quarter when the refinery went through a month long turnaround. In the third quarter a fire in one of the crude units reduced throughput by 7% for the quarter.
What Sets Northern Tier Energy Apart?
While the refiners are at the whim of energy prices, there are some factors that can set them ahead of or behind their peers. A major difference can be if the refiner can purchase crude at a significant discount to the benchmark prices - in this case West Texas Intermediate - and be able to sell gas and other fuels at a close to market price. The refineries of both Alon USA and CVR Refining are closely located with oil production regions and have historically picked up some transport cost advantages and extra spread by processing different, local grades of crude. Unfortunately, the historical advantages pretty much evaporated during the third quarter and refining margins were below the benchmark crack spreads for both refiners.
The refining margin for Northern Tier Energy also dropped below the benchmark used by the company in the third quarter. However, this is an area where Northern Tier should have a cost advantage in most market conditions. The company sources crude from the Bakken play in North Dakota, synthetic crude from Canada, and also heavy crude from north of the border. The refinery is flexible concerning what grades of crude it refines and this combined with three crude sources that typically cost significantly less what WTI should allow Northern Tier to have a cost price advantage the majority of the time. For example, in early October, Bakken crude was trading at a $12 discount to WTI.
Another advantage to Northern Tier is the company's chain of 200+ owned and franchised retail stores. The retail arm provides a steady customer for much of the refinery's production and chips in some profit to help out the bottom line.
Finally, the recent news that Western Refining, Inc. (NYSE:WNR) has purchased the general partner interest and 38.7% of the LP units from the private equity firm that set up the Northern Tier Energy IPO can only bring good things in the future. The Western Refining business has a similar profile to what Northern Tier is doing, just in a different part of the country.
Since the July 2012 IPO, Northern Tier Energy has paid 5 dividends ranging from a low of $0.31 up to $1.48. Unfortunately for early investors, the distributions have been trending down since the IPO. The share price has ranged from a low of about $18, reached soon after the Q2 dividend payment to a high of $33 back in the days when it looked like big crack spreads were here to stay. Recently, the NTI share price has rebounded, probably on a better crack spread outlook and the WNR investment news.
Over the last two quarters, the NTI results were affected by the turnaround in Q2 and the fire in Q3, which will also affect Q4 results. So far in the fourth quarter, oil prices have dropped, and the crack spread - using EIA spot price numbers - has widened by about $5 from September and is in a range close to the first two months of Q3. With a return to historical price discounts for the crude Northern Tier buys, I expect the company to put up an operating margin for Q4 in the $15 to $20 range. As a result, my dividend prediction is $0.50 to $0.80 per unit, putting roughly a 10% yield on the current $25 unit price.
From the historical results to date, under most conditions Northern Tier Energy should be able to pay a minimum quarterly distribution of 40 to 50 cents if the refinery runs at capacity for the full quarter. The high end for a good quarter is above $1.00. The long-term investment strategy would be to buy units when the price drops into the low $20s, which would give an investor a minimum yield of about 8%. The understanding must be that the potential is there for the operating margin to be squeezed to a point of negative profits, and then the share price would look like the low teens where ALDW currently trades. However, I believe that Northern Tier Energy's crude purchasing advantages should allow the company to post consistently profitable quarters in all but the most dire energy pricing scenarios.