Thu, 8 Nov 2012
New crude projects should help Magellan continue to expand its distribution, says CFO John Chandler.
Josh Peters: Hello, I'm Josh Peters, Morningstar's director of equity-income strategy and editor of our Morningstar DividendInvestor newsletter.
Today, I really have an outstanding interview to show you. We are here with Magellan Midstream Partners and its chief financial officer, John Chandler, to talk about what makes this business tick--the set of competitive advantages that have yielded such good results for investors over the long term--and to see where we might go from here.
John, thanks so much for being here with us today.
John Chandler: Thanks, Josh.
Peters: Now, we here at Morningstar have traditionally thought of pipelines as really being fantastic businesses having wide economic moats, not facing a whole lot of direct competition. But before we talk about that, I want to talk about the demand picture. The company is still largely a carrier of refined petroleum products. With high energy prices and higher mileage standards, we have kind of a dim outlook for consumption of refined petroleum products even if prices stay relatively high. How is Magellan positioned against those trends?
Chandler: We for quite some time have acknowledged the fact that increasing vehicle fuel-efficiency was going to have a drag on demand for gasoline and other refined products, but at the same time, we believe that the growth in the economy will drive increases again in demand for diesel fuel, especially for the farming and transportation and railroad industries.
So, if you look at that entire picture, our view is that refined products demand at best will be flat going forward; that doesn't mean that we don't have attractive growth ahead of us. We've been in this environment for the last two or three years. We see growth coming in our business from tariff growth on our pipelines.
Peters: That's indexed to inflation.
Chandler: Which is indexed to inflation.
Chandler: We also see a lot of attractive organic investment opportunities along our pipe and terminal networks. I'll give you a couple of examples. With the crude price differentials today between WTI and Brent and WTI and LLS, the Mid-Continent refiners are finding themselves surprisingly advantaged versus the larger, more complex coastal refiners.
As a result, those refiners have significantly increased their capacity or their utilization levels of those refiners and are trying to find new markets for the refined products that they are producing. We saw that opportunity and are in the process of completing a project to reverse a segment of our line that runs from northern Texas to northern Oklahoma to actually make one of our pipes bidirectional and allow those northern Oklahoma refiners to actually push product back into the Texas markets. So there is an example. Even though refined products demand isn't growing, we're seeing very attractive investment opportunities--actually small investment opportunities with very attractive returns that help continue to grow Magellan's cash flow stream.
Another example would be the share volatility of refined products prices these days. With the growth of that volatility, we've seen a lot of demand from our customers--our shippers--to have storage available to them to take advantage of opportunities when market prices blow out. We saw that volatility coming several years ago and undertook a process of investing a lot of new storage along our pipe and along our terminal network. So, as a result of all those things, as we look forward, yeah, we agree that demand is going to be somewhat flat, but we still see a lot of exciting opportunities for growth coming from tariff rates and also from incremental investment opportunities that we expect these Mid-Continent refiners, as well as refiners in the coast, to come to us to pursue.
Peters: Again back to the competitive advantage: When you are looking at those newer projects, especially in some of the newer areas that you are entering in crude oil gathering, how do you extend your competitive advantage out to there? How do you make yourself the preferred transporter and partner for energy producers and consumers in the areas?
Chandler: In my mind, there's really two key components to being competitive. One is of course to have a competitive cost of capital--we've got to have that--and the other is to have the trust of our shippers. With the recent energy boom, it's created a lot of opportunities for new pipeline and storage infrastructure. We've got the development going on in the Bakken shale, we've got developments going on in the Permian Basin, in the Eagle Ford shale, as well as various other regions in the United States. As a result of those developments, there's a rush by logistics providers like us to put the infrastructure in place to help that crude find its way to the market.
So, to be successful, most of these investments are quite large in size and companies like us generally don't pursue those investments unless we have commitments--long-term commitments--from our shippers. To have those commitments in hand and to be able to win in the competition for putting that infrastructure in place, we've got to be first of all capable of providing a cost-efficient alternative for shippers. We can do that. Our cost of capital is lower or as low as any of our competitors.
The second is you've got to again have the trust of the shippers. We have a long-term history of being a very reliable operator of refined products and crude oil assets. Our operators trust our ability to operate these pipelines to get them in place quickly and to operate them efficiently, and because of those things, we are seeing opportunities to build a lot of new assets again out of the Permian. We are reversing a pipeline from Crane, Texas, to Houston to carry Permian crude. We are doing a lot of developments in Corpus Christi, Texas, for Eagle Ford production, and in fact, we are undergoing one of the largest expansions of new asset development in our history as a company. It's something we're very excited about at Magellan, our employees are excited about it, and certainly our investors are excited about that.
Peters: I want to key in on one thing you mentioned there, which is cost of capital. Most MLPs don't retain a lot of cash flow for internal reinvestment. It's really good for providing a lot income for unitholders, but it means that you have to go out and raise that new debt and new equity capital in order to fund these growth projects. How do you keep your cost of capital low? How do you separate yourself from those companies, the other partnerships that you are competing with for these investment opportunities?
Chandler: Sure. The way I view it, having a low cost of capital is reward in a way from your debt and equity investors and it's a response from those debt and equity investors to operating your assets appropriately. We have always been intentional about maintaining a low leverage ratio at our company, and we've done that that--that's attracted a lot of debt investors to us. We've also been very intentional about providing an attractive distribution growth for our investors. That's obviously attracted a lot of equity investors to us. And because of those two things, obviously that's why our yield trades low on the equity side, that's why our bond prices so attractively. Also along with that, we've been very intentional about sticking to what we do well: refined products transportation logistics with 85% of our profits coming from fee-based activities. It's that low-risk structure that attracts investors to us, and that's what I believe will keep us competitive going forward.
Peters: When I look forward a little bit, I've seen just outstanding distribution growth here--18% targeted here in 2012 alone. Of course, that's got an increase associated with some wider coverage that you had, that's not necessarily the underlying growth, but the underlying growth is still very strong. When you put all these things together, what's the plan going forward to continue raising that distribution--how fast you think you can do it?
Chandler: Well, I think, to get a feel for where we're going to go in the future, you have to look to our past. And first I'd say, we appreciate the fact that our investors want both reliability of the current distribution--which certainly we provide that with our low-risk business model--but they also want attractive growth, and we've always believed that we wanted Magellan to be viewed to be a growth MLP. And we think we've been quite successful at that. Since our IPO in 2001, we've had 42 separate quarterly distribution increases. We've had a compounded annual growth rate in our distribution of 12% over that timeframe, which is pretty impressive, in our opinion. And we've been able to do that by conservatively managing our business and keeping ourselves out of some of the trouble you may have seen others experience when the market fell apart several years ago. But it has also been by being very proactive and thoughtful about what's going to be coming in the future.
If you look back to 2005 and 2006, we noticed and sensed a big pickup in volatility of refined products prices--that's really when that started to pick up. Our customers were talking to us about that as well, and we sensed the need to develop a lot of additional storage both at marine terminals and along our pipeline system that allowed those shippers to take advantage of opportunities when prices blew out, and also protect themselves if prices blew out, that they had adequate supply to supply the retail outlets, and for traders to actually protect themselves to the extent there are price blowouts. And so, as a result of that, we actively began a program of investing in new storage along our pipeline and terminal networks, and over the last five years we have constructed 16 million barrels of new storage along our assets, all backed by long-term contracts, and we're kind of coming to the end of that. We've got about 5 million barrels of storage that we're completing now, kind of at the back end of that wave. So, you kind of fast-forward from that, that's obviously provided a lot of cash flow growth for us over the past.
In the 2007-08 timeframe, we started to sense the real pickup in the crude oil markets, the new developments we are starting to surface. Since that as a company we needed to try to find if we could extend what we do well--logistics and storage--out of refined products into other markets. It seemed like crude was a natural extension for us. So, we started making to shift that way, and as a result today as a company, we are undertaking again the most dynamic growth we've had in new asset development in our history.
We've got our Crane-to-Houston pipeline reversal, which will ship crude oil out of the Permian Basin; that's a $375 million project that will come on line next year and obviously provide many years of growth for us as crude production picks up in the Permian. To the extent we decided to move forward, we are in negotiations with the Oxy for a joint venture to build the BridgeTex Pipeline, the brand new pipeline out of the Permian Basin. That would have 300,000 barrels a day of capacity coming out of the Permian.
Our piece of that joint venture would be a $600 million investment for Magellan, that would be operational we believe in 2014, obviously still providing several years of growth for us. We've made a number of investments in the Houston market, around our crude pipe assets in the Houston market; in Corpus Christi, around our marine terminal in Corpus Christi to take advantage of Eagle Ford production; and in Cushing, where we we're the third-largest storage provider in Cushing to take advantage of crude opportunities there. Those projects are all going to be contributing to us nicely for the foreseeable future, but you're saying, what's beyond that when you look out even four or five years beyond?
Well, that's hard for me to say, what's going to happen. We don't sense any certain moves that we need to make now, but what I can say is Magellan is quite large in size. We have a very large asset footprint. We are a trusted service provider by the shippers that utilize our system. We access 40% of the refining capacity in United States. As shifts occur in refined products demand and in crude oil, we have great relationships with those shippers, and we think we're going to be a key part to their optimization of their businesses as they find new projects for ways to increase their profitability.
So, we're excited about our future. We think there's a lot of growth coming from these crude projects that we're pursuing, and we're confident that our shippers trust us as new projects surface in the future.
Peters: I have to tell you as a unitholder both personally and professionally, all I can say is keep up the good work. It's really outstanding to see a business like this that many people could think of as being kind of slow, kind of sleepy delivering that outstanding distribution, outstanding distribution growth. I really appreciate additional detail here about how you're working that for us here today.
Chandler: Thank you.
Peters: So, we are here today with chief financial officer of Magellan Midstream Partners, John Chandler. I want to thank him very much for talking about this very strong business. If you'd like to learn more about Magellan, you can visit Morningstar.com. If you're interested in Morningstar DividendInvestor, please visit mdi.morningstar.com.
Again, I'm Josh Peters, Morningstar's director of equity-income strategy and editor of its DividendInvestor newsletter. Thank you very much.