Westlake Chemical Partners: It Is All About Ethylene

Summary

• This partnership has a main product of ethylene and some polyethylene.
• The parent company uses the ethylene to make and sell commodity products.
• The partnership itself has take or pay minimums to smooth out earnings volatility.
• The strength of the "take or pay" agreements depends upon the health of the parent company (which right now is pretty good).
• Finances are very conservative.
• This idea was discussed in more depth with members of my private investing community, Oil & Gas Value Research. Learn More »

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Westlake Chemical Partners (NYSE:WLKP) produces ethylene for Westlake Chemical Corporation (WLK). That makes this partnership unique and definitely not something you typically find when looking at midstream partnership companies. While a true midstream company is closer to an electric utility. A partnership that makes ethylene is probably a better gauge of economic health. Westlake Chemical has gone to some lengths to stabilize the finances of the partnership. That will prevent the brunt of the economic cycles hitting the partnership.

However, should Westlake Chemical endure an extended downturn, there would be some question as to how much ethylene would be needed in that situation as well as the ability of Westlake Chemical to continue to provide minimum payments. An interesting question is the stability of natural gas and oil transportation compared to the stability of ethylene demand in a downturn.

Source: Westlake Chemical Partners Fourth Quarter 2020, Earnings Conference Call Slides February 2021.

The products made are basic products for many industries. Therefore demand would definitely change during a downturn. The partnership, like many, does have a kind of "take or pay" agreement. So there would be payments for unused committed volumes. The demand for ethylene is a big reason for the bright future for natural gas. Ethane is a part of natural gas that is separated from natural gas production to produce ethylene.

As long as Westlake Chemical survives any economic downturn in decent shape, then the "take or pay" agreements will hold. That should be most of the time.

Finances

To compensate for the volatility, the finances are far more conservative than is typical for a midstream partnership.

Source: Westlake Chemical Partners Fourth Quarter 2020, Earnings Conference Call Slides February 2021.

Leverage here is extremely conservative even by industrial standards. This does provide some protection to the relatively high payout ratio. Most partnerships that I follow are run conservatively when they have a main customer. This one definitely leads that pack in conservatism. Debt here is definitely not a worry.

However, the distribution will depend upon the goals of management. Right now the distribution coverage goal is 1.1. That coverage is probably too low for Mr. Market. Therefore investors should expect an adjustment in that goal in the future.

This would be especially true if Westlake Chemical Partners needs to grow to supply a growing parent company. Many midstream companies now look at keeping anywhere from 20% to 50% of the cash flow to fund future growth and debt payments. Raising capital every time there is a need to grow is no longer acceptable to Mr. Market.

Source: Westlake Chemical Partners Fourth Quarter 2020, Earnings Conference Call Slides February 2021.

One risk here is the presence of IDRs. The parent company is currently very supportive of the partner by resetting the IDRs to more favorable terms. That is extremely rare in the midstream industry.

However that supportive attitude can change overnight. If that were to happen the partnership protections in the midstream industry have been shown in the past to be rather weak for common unit investors. At some point it would be better for investors to get rid of the IDRs entirely in the future.

Secondly, this company is heavily dependent upon dropdowns. Those dropdowns can be a profit killer. It is often far better for a partnership to build its own necessary capacity because this route is generally more profitable. Hopefully in the future, this partnership will eventually be large enough and stable enough to go that route.

This partnership is located in an area with a lot of natural gas production. Therefore there is probably an excessive supply of ethane available to supply partnership needs. That is a profit enhancing situation for the long term.

The other risk here is that somewhere in the corporate structure there is always a profit margin risk as raw material fluctuations cannot always be passed on. A typical midstream company has a flat transportation rate and a flat rate for any processing done. This partnership also has that flat rate for processing (although here there is no transportation as there is with many midstream companies).

But the partnership is also dependent upon a main customer whose product is a commodity product subject to the market forces of any commodity product that gets sold. Therefore a sustained product margin crunch from high raw material prices combined with low product sales prices will affect the organization. The partnership is insulated by the take or pay contracts. But those contracts are only as good as the financial strength of the parent company.

Source: Westlake Chemical Partners Fourth Quarter 2020, Earnings Conference Call Slides February 2021.

The existence of the partnership is usually to demonstrate the total value of the parent company. Sometimes, the partnership is also seen as a vehicle to finance a particular part of the manufacturing process. This financing reduces the needs of the parent company to finance growth. Therefore the partnership will be around as long as it meets the needs originally foreseen by the management at the time of setup.

This partnership is one of the most healthy partnerships that I follow. There clearly needs to be some adjustments in the future. But partnership health is the main concern for any income investor. That health means that any cyclical setbacks will be met with a relatively quick recovery. Also low leveraged companies rarely run into serious trouble while often getting second and third chances. Therefore the long term risk of capital loss is far lower.

In the meantime, the parent company has plans to grow in the cyclical industries noted. That is good news for this partnership. The short position of the parent company in ethylene (and related products like polyethylene) demonstrates that the partnership capacity should be fully used in good times and other times in the industry cycle.

I suspect on the risk scale that the dependence on a main customer whose products are commodities may be more risky than a typical midstream pipeline company that transports products with some added profit centers. Oil and gas is definitely needed during a downturn. Products made from ethylene have variable amounts of "necessity" levels. But I can also see different points of view here. The conservative financing definitely offsets any strategic risk due to the exposure to the commodity markets.

For those willing to look at a very atypical partnership, this one may be enticing for both the payout and the growth potential. The parent company appears to be very supportive at the current time.

Midstream is so out of favor that the current distribution is as much as many investors make in a total return long term. Any appreciation potential is "icing on the cake". This one appears to have a lot of icing.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.

Disclaimer: I am not an investment advisor, and this article is not meant to be a recommendation of the purchase or sale of stock. Investors are advised to review all company documents and press releases to see if the company fits their own investment qualifications.