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By Avi Feinberg | 11-10-2011 10:00 AM

Building a Wide Moat With Pipelines

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.

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.

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