Magellan Midstream: Competitive Advantage Analyzed

Summary

• Magellan Midstream is in the business of the transportation, storage, and distribution of refined petroleum products and crude oil.
• In this article, I review its business model for the refined products, crude oil, and marine storage segments.
• I analyzed its competitive advantage using Michael Porter's five force framework, setting the stage for an in-depth look at the company.
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The business

Magellan Midstream Partners, L.P. (NYSE:MMP), a spin-off of The Williams Companies (WMB) in 2001, is in the business of the transportation, storage, and distribution of refined petroleum products and crude oil.

Refined products. The refined products segment has the longest refined petroleum products pipeline system in the U.S., primarily transporting gasoline and diesel fuel with a 9,700-mile pipeline system, 53 terminals, and 45 MMbbl of storage; it owns 25 independent terminals with 6 MMbbl storage mainly in the southeastern U.S. and connected to third-party common carrier interstate pipelines, including the Colonial and Plantation pipelines; it also has a 1,100-mile ammonia pipeline system, which it plans to divest (Fig. 1).

• The refined products segment generates revenue from (1) transportation tariffs on volumes shipped on the refined products pipeline system; (2) providing services such as terminalling, ethanol and biodiesel unloading and loading, additive injection, custom blending, laboratory testing and data services to shippers; and (3) charging fees based on the amount of product delivered through the facilities and from ancillary services such as additive injections and ethanol blending.

Fig. 1. The assets of Magellan Midstream Partners, modified from the MLP & Energy Infrastructure Conference May 2019 presentation.

Crude oil. Its crude oil segment is comprised of 2,200 miles of crude oil pipelines (1,000 miles 100%; 1,200 miles JVs) and 33 MMbo of storage, serving crude oil producers in the Permian Basin, Rocky Mountain, Midcontinent, and Gulf Coast markets. It is one of the largest storage providers in Cushing, OK, and has a growing Gulf Coast storage position.

• The crude oil segment generates revenue through transportation tariffs on our crude oil pipelines, storage fees from the crude oil terminals, tolling fees from the condensate splitter, and ancillary services including terminal throughput fees.

Marine storage. Its marine storage segment consists of five wholly-owned and one JV marine terminals located along coastal waterways with a total storage capacity of 27 MMbbl.

• The marine storage segment generates revenue by providing storage services for customers.

Segment contributions. As of 2018, the refined products segment - with 49% of the total assets - pulled in 72% of the total revenue and contributed 57% of the operating margin; the crude oil segment - with 39% of the total assets - generated 22% of the sales and contributed 32% of the operating margin; and the marine storage segment - with 12% of the total assets - generated 7% of the sales and contributed 10% of the operating margin (Table 1).

Table 1. The contribution of the business segments of Magellan Midstream to its consolidated revenue, operating margin, and total assets. Here, operating margin represents operating profit before depreciation, amortization, and impairment expense and general & administrative costs, but excludes unrealized mark-to-market and other commodity-related adjustments. Source: Laurentian Research.

Competitive strategy: Five forces

Competitive rivalry. For the refined products segment of Magellan, the intensity of competition varies from an area to another. Approximately 40% of refined products tariff revenue is deemed by FERC as "less competitive" and 60% is deemed "workably competitive" by the FERC (Fig. 2).

Fig. 2. Competitive vs. less competitive refined product pipeline markets of Magellan. Source: Magellan Midstream 2018 Analyst Day presentation.

The workably competitive markets are under state regulations and follow annually determined rate changes, while the less competitive markets are subject to the indexation methodology approved by the FERC and follow the mid-year FERC index (see below).

The majority of Magellan's crude oil pipeline tariffs are established by negotiated rates that generally provide for annual adjustments in line with the FERC index, subject to certain modifications, including tariffs held flat if the index is negative.

Barriers to entry. The economic barriers to entry are the fixed cost that has to be incurred by a new entrant into a market, which the incumbents have not had to incur.

Due to the capital-intensive and long lead time nature of midstream projects, customers in a local market are typically locked into long-term commitments or take-or-pay contracts, which thus erects considerable barriers to entry. Joint ventures can substantially reduce financial commitment and enable entry into an attractive market; Magellan has eight JVs as of the 1Q2019 (Table 1).

Table. 1. Magellan investments in non-controlled entities as of March 31, 2019. Source.

Buyer's bargaining power. The pricing power of Magellan in refined products is regulated by the FERC or states. The FERC indexation methodology, first instituted in 1995 to allow pipelines to raise rates to recover actual cost increases while earning a reasonable return without a complicated cost-of-service filing, is reviewed every five years. Effective July 2016, the FERC index formula is calculated as "the change in PPI + 1.23%".

• The tariff increases roughly 4.0% yearly on average (Fig. 3).
• The tariff increased by 4.4% on July 1, 2018, and is expected to see an adjustment of around 4.3% in mid-2019.

Fig. 3. FERC index history and market-based tariff, modified from the Magellan Midstream 2018 Analyst Day presentation.

As of 2018, Magellan charged $1.556/bbl of refined products shipped, which has consistently increased by 2.88% per year since 2009 (Fig. 4).

Fig. 4. Transportation revenue per barrel of refined products or crude oil shipped. Source: Laurentian Research.

The company expects fee-based activities to comprise over 85% of the operating margin going forward (Fig. 5), which is supposed to lower the risk associated with commodity price volatility.

Fig. 5. The composition of 2018 operating margin in terms of revenue types. Source: MLP & Energy Infrastructure Conference May 2019 presentation.

Magellan charged $1.208/bbl of crude oil shipped as of 1Q2019, which is lower than on refined products and which, in the seven years from 2010 to 2017, more than quadrupled (Fig. 4). Company management was able to perfectly time its exposure to the rapidly increasing crude oil production in the Rocky Mountains and Permian Basin.

However, by 1Q2019, a great amount of investment has been attracted to egress from the Permian Basin, which has resulted in a hyper-competitive market and led to erosion of the pricing power of the midstream players, as evidenced by signs of pricing weakness (Fig. 4). So, management decided to sell a minority (35%) stake in the Longhorn crude pipeline to raise as much as $2 billion for investment in new projects elsewhere with higher returns (see here) and to scrap a proposed pipeline from the Permian Basin to the Gulf Coast (see here).

Supplier bargaining power. As of end-2018, Magellan hired 1,868 employees. Approximately 24% of the 948 employees in the refined products segment are represented by the United Steel Workers; about 14% of the 201 employees in the marine storage segment are represented by the International Union of Operating Engineers; the 160 employees in the crude oil segment are not covered by a collective bargaining agreement. The low percentage (14%) of the employee unionization and wide geographical distribution of the assets, I believe, are not conducive to a strong bargaining power for the labor.

The relatively stable fee-based revenue, largely free from commodity price volatility, leads to a low cost of capital for the midstream players. According to a previous article by yours truly, a select group of 40 midstream and downstream companies have a weighted average cost of capital (or WACC) of 7.51%; Magellan enjoys an even lower WACC at 6.52% as of April 2019.

The pipeline right of way easement costs is supposed to appreciate (see here). Pipe steel price follows a generally appreciating trend in spite of the wild fluctuation from one year to the next (Fig. 6). These rising costs necessitate a perennial increase in tariffs, which is fortunately the case (Fig. 3).

Fig. 6. Producer Price Index of iron and steel pipe and tube, purchased iron and steel, with the index set at 100 for June 1982 and not seasonally adjusted. Source.

The threat of substitution. In the long run, refined petroleum products and crude oil face the threat of substitution by electricity and renewable energy, thanks to government subsidization of renewable energy and the rising market share of electrified vehicles, as well as eroded market share of internal combustion engines (aka ICEs) (Fig. 7). Even the majors such as Royal Dutch Shell (RDS.A) are taking steps to hedge their reliance on petroleum ahead of potential disruption by investing in EV charging infrastructure and technology (see here).

Fig. 7. Projection of future electricity generation from natural gas and renewables, as compared with the shares of nuclear and coal generation. Source: EIA Annual Energy Outlook 2019.

On the other hand, renewable energy is reportedly struggling to stay economically viable in competition with much cheaper fossil fuel and amidst electricity oversupply. The projected future market share of ICEs varies too, e.g., from 50% to 75% (Fig. 8). New vehicle fuel economy improvement will continue to help ICE keep its dominance (see EIA Annual Energy Outlook 2019 pdf linked above). Therefore, the threat of substitution does exist, but it may be still distant.

Fig. 8. Projection of alternative and electric vehicles market share. Source: EIA Annual Energy Outlook 2019.

Investor takeaways

From the analysis above, I believe Magellan commands a sustainable competitive advantage in its core business of the transportation, storage, and distribution of refined petroleum products.

Its segments of crude oil and marine storage also have some competitive advantage (Fig. 9), but the recent investment spurs in the egress from the Permian Basin may have started to cause medium-term oversupply of transportation capacity, prompting company management to halt a proposed crude oil pipeline and to sell a minority interest in the Longhorn pipeline.

Fig. 9. Michael Porter's five force analysis of Magellan Midstream. Source: Laurentian Research.

Disclosure: I am/we are long MMP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.