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Building a Wide Moat With Pipelines

Thu, 10 Nov 2011

Magellan Midstream Partners' CFO John Chandler discusses how his firm can earn a good return on capital by focusing on organic investments instead of expensive acquisitions.

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Video Transcript

Avi Feinberg: Hi, I'm Avi Feinberg, equity analyst with Morningstar, covering oil and gas pipelines. Today I'm at Morningstar's Management Behind the Moat Conference, and I'm pleased to be joined by John Chandler, the CFO of Magellan Midstream Partners.

John, thanks for joining me.

John Chandler: I appreciate the opportunity to tell our story.

Feinberg: John, Magellan has had very strong distribution growth. You've averaged 11% annual growth since your IPO and also have pretty strong distribution coverage over that time. I was wondering, if you could explain a little bit about the contract structures and the commodity exposure of your underlying cash flows?

Chandler: I think, obviously, what you're trying to get to is the reliability and the stability of our cash flow stream, and we really have two fundamental different businesses within our organization. We have a refined products pipeline system that's really a demand-driven system. Now, we can talk about contracts. We do have several contracts within the pipeline system, but that system is more about demand than it is about the contract structure.

Then we have also a storage business, and it is very much driven by the contract structure.

Our pipeline system serves markets throughout the mid-continent, such as Des Moines, Iowa, Kansas City, Kan., and Sioux Falls, S.D. And in those markets, while contracts are important, what's more important is the demand in the markets that we serve. There are very few pipes that serve in the mid-continent part of the United States, and to the extent there are pipes that are serving those markets, they were all fairly, substantially utilized.

So, as long as demand is growing in those markets, we're going to get our fair share of that growth. So, we do have volume-incentive contracts. We do have market-share-commitment contracts and various other forms of contract in the pipe. But again, that pipe is driven by fundamental solid demand for refined products usage in the mid-continent.

Now, the storage side or storage business is very much driven by market volatility. When prices really became volatile several years ago, there was this tremendous peak in demand for storage. Obviously, traders and marketers make money when there's volatility in the market. But in order to make money, they've got to have storage and an ability to actually store product. And so, when that volatility picked up, there was a tremendous demand for us to increase our storage capacity, both along our pipeline system and at our terminals. And of course, we don't do that unless we can receive a long-term contract. So, a substantial portion of our storage business is backed by long-term contracts.

Feinberg: You mentioned the refined products pipeline network. We like that it's not only one of the largest in the nation, but also one of the best-connected. You're connected to about 40% or more of refining capacity in the continental U.S. I'm just wondering, how that scale and connectivity translates to an economic moat, or in other words, to sustained competitive advantages?

Chandler: Well, again it is a demand-driven system and not all pipelines are like ours. A lot of people don't understand that. In a lot of cases, pipelines are delivery sources out of one, two or maybe three refineries. In our case, our pipelines are connected to 40% of the United States refining capacity.

So, we can deliver product out of the Gulf Coast. We can deliver product out of refineries in the mid-continent. We can deliver out of refineries out of Chicago. And so to the extent there are refinery issues, it really doesn't have a meaningful impact to us. In fact, to the extent we have refining issues in the mid-continent, we tend to bring product out of the Gulf Coast, and we earn a larger tariff for doing that. So, our profits tend to go up.

So if you think about marketers that are serving 50-some-odd markets that our pipeline serves and the multiple supply sources into our system, I think we have an obvious competitive advantage in that they would rather have those multiple supply sources. They are available on our system as opposed to being tied to a system. That's really at the mercy of one, two, or three refineries and that has helped us in the long term. It really does, I think, make our assets very attractive.

<TRANSCRIPT>

Feinberg: When we think about economic moats from the quantitative side, we like to look at the return on invested capital metric, and Magellan, by our calculations, has earned about low- to mid-teens-type returns consistently over the past decade, which is among the best-in-class and also well above your cost of capital. Are there any other key factors you think have contributed to these excess returns?

Chandler: Yeah, I think there are a couple of key reasons that are driving that. Probably, the first and probably the most powerful is, a substantial percentage of our capital spending is for organic capital. So it's projects that we're building upon assets that we already have in-house. As you can imagine, when you're doing that, when you're building upon assets you already have, there are a lot of fundamental investments you don't have to make. We already have pumps in place. We already have existing pipelines, in place.

So, those projects tend to be lower-risk, smaller in size, and built upon existing infrastructure, and as a result, the returns tend to be higher on organic capital projects. Now, that’s not unique to us. You're talking about how we compare versus others, and a lot of our peers have organic capital, too. But I think as a percentage of investment, our organic capital investment is probably larger as a percentage than others relative to acquisitions.

So, kind of moving to the acquisition front, we're very active in looking at acquisitions as a company. We're very interested in pursuing acquisitions. But I think those that follow us know is we're a very conservative company. We have a tremendously strong underlying business. We have a growing business. We have tremendous organic capital projects that support our business.

So we don't feel pressured to pursue acquisitions at all costs, and as a result, we've stayed away from overpaying for assets in our opinion. Many of our peers may not be in the same exact situation as us and have closed on acquisitions that fundamentally we believe are priced too high. Today, with the cheap cost of equity and the cheap cost of debt, you're seeing acquisitions close at very high prices and as a consequence, I think when you blend those acquisitions in with other people's returns, it draws down the overall average return on the invested capital on their part relative to our part.

Feinberg: Turning to big picture a little bit here, it's no a secret that refined products demand has been gradually declining for the past five years or so. Looking ahead, forecast from the Energy Information Administration and others, call for pretty much flat demand or even slightly declining demand over the next couple of decades. On the other hand, you have the regulated annual-rate tariff increase from the Federal Energy Regulatory Commission each July, currently at Producer Price Index plus 2.65%. When you put all this together, how do you think about volumes and cash flows on the refined products system during the next few years, what those might look like?

Chandler: I mean obviously you're keying in on the two key things that drive our base business growth, which is volumes of refined products demand and our tariff-rate increases. We don't have any unique crystal ball or view into the future of what refined products demand is going to be. We, just as you, look to the EIA and the government predictions for refined products demand, and if you look at those, I think there is a general belief that diesel demand is going to increase as the economy recovers. But offsetting that, gasoline demand is probably going to decline, just partly because of the increased efficiency standards that are being placed on vehicles.

And so, over the long term, I think the EIA predicts, and we support that prediction, that demand is going to be generally flat for refined products. That doesn't mean though as you're pointing out here that our profits are going to be flat relative to the pipeline system because of the right opportunities available to us. Our rates are lightly regulated by the FERC, which allows us at least in our index markets to raise our rates equal to the Producer Price Index plus 2.65% at least for the next five years.

So, if you use even a tame prediction of PPI of around 2%, you're talking an area of 5% increase in annual rates on our pipeline system. If you apply that to the fact that we have a tariff that's slightly north of a $1 per barrel shipped and if you look at the fact that we will ship, by the end of the year, more than 400 million barrels, that's $20 million alone of revenue increases incrementally year over year just from tariff-rate increases, and a lot of that falls to the bottom line.

So you can see that even with a fairly tame demand growth on volume, we should continue to see some pretty nice revenue increases on the pipeline system.

Feinberg: Your other businesses have really picked up the slack in terms of growth, in terms of what might have been lacking on the refined products side. You had very strong growth from terminals lately, of building new storage, and some pipeline projects on the crude oil side as well. Can you talk about some of the drivers here and how you expect those to be playing out over the next few years, as well?

Chandler: Sure. Just to kind of take it back in time a little bit, starting in 2004 when we really began to grow in a meaningful way, we acquired some refined products pipelines in Texas from Shell. And one of the things that we found, and it's not surprising, when majors own assets even though they are broadly available to the market, generally those majors control those assets for their proprietary refinery and marketing needs. And so when an independent service provider like us could step in and acquire those assets, there is tremendous pent-up demand in the market by others who want to use those assets for their own needs. And we saw that.

So, following our acquisition of those pipelines in 2004 from Shell, we pursued several years, a number of growth projects around those pipeline assets. That took us really through 2005 to 2006. About that time, volatility really picked up in commodity prices, and we saw a huge pickup in demand for storage. And so for the next several years, we've pursued significant growth in building out storage on our pipeline system and our marine terminals.

Now the next growth wave we see is in the crude oil space with new drilling technologies where the producers are finding opportunities to drill production that they once thought wasn't available. So, we're seeing tremendous growth in production in West Texas in the Permian Basin, and we're seeing it in South-Central Texas in the Eagle Ford Shale. We're seeing it in the northern part of the U.S., the Bakken shale. All that crude oil is the locations that need logistics infrastructure to get that crude to the market

And so we saw that wave coming, and the last year, we acquired some logistics and storage assets from BP for crude oil. That really moved us from a very small presence in the crude oil space to a reasonably large logistics player in that one transaction. Now, today we have storage in Cushing, Okla. We're the third-largest storage provider in Cushing for crude oil. We have very strategic pipeline assets in the Houston area that allow for crude delivery to the refineries, and we're doing some development work around those assets that are going to make them very strategic. And we're launching a reversal of a refined products pipeline that we had that goes from Houston to El Paso, Texas, to take West Texas Permian crude from the Odessa, Texas, area back to Houston. And so, we are seeing tremendous logistics opportunities in the crude space, and we expect to continue to see that going forward as these new fields really increase their production.

Feinberg: You mentioned acquisitions from the integrated oil players as kind of a driver. We've been seeing that happen in the space over the last few years, but at the same time it seems like they continue to focus even more and more on their upstream portfolios, such as divesting midstream and downstream assets, spinning off entities, and so forth. Where do you think we are in that life cycle, and do you think there are more acquisitions to come?

Chandler: I do. I think there are still several integrated oil and gas companies that haven't really divested of their midstream assets at this point in time. We are excited about our opportunities when they come. We're not capital-constrained. We have strong demand for our equity. We have strong demand for our debt. So, we feel like we're in a position to perform well if those acquisitions come to market.

We think of things like ConocoPhillips which really hasn't meaningfully moved any midstream assets to market. ExxonMobil hasn't moved any meaningful assets to the market. Also, CITGO still has tremendous amount of storage assets, and even if you just drop down to the kind of the next level, not major integrated, but the kind of midsize integrated companies like Marathon, there is tremendous logistics assets in those companies, as well. So we see no end to this. We think there are going to be several acquisition opportunities for the years to come, and we stand ready and are excited about our opportunities of having our fair shot at some of those.

Feinberg: John, I want to thank you again for coming in to discuss Magellan's economic moat and your growth opportunities.

Chandler: We appreciate our opportunity to come and tell our story. Thank you.

Feinberg: I'm Avi Feinberg for Morningstar. Thank you for watching.


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