Description

MLPs are among the most worst performing asset classes this year, with the Alerian MLP index down 50%. 

“Crossover” capital may be relatively scarce given the size of the industry (>$150 billion), the inability of most long-only mutual funds to participate due to K1s, the losses suffered by distressed funds (the crossover capital…) from the 2016 cycle, and the fact that most “knowledge” of the sector is resident with people that have lost a fortune. 

The handful of large, dedicated MLP funds that seem to own 5% of every issuer are likely facing redemptions after years of underperformance. Those MLP funds that remain are expanding their scope to include utilities and renewables to make themselves palatable to investors. Retail has justifiably thrown in the towel. In any case, they need to tax-loss harvest to support their Tesla gains.

With that backdrop of wreckage, what if I told you that you could own irreplaceable assets at 6.8x GAAP earnings? Is that something you might be interested in?

What about if these assets carried a near 13% distribution yield with only 1.8x net leverage? Is that something you might be interested in?

I can imagine what you are thinking: Don’t most  MLPs make a practice of misleading investors in various ways such as paying unsustainable distributions, utilizing too much leverage, investing in short-lived assets, benefiting from above-market contracts, and taking inappropriate “incentive” fees?

The answer is yes! Most MLPs have done exactly that and worse. That practice has given the industry a bad name and causes investors to lump all MLPs together in the same analytic bucket. What if, however, they are not all the same? 

I am recommending an investment in BP Midstream Partners LP (“BPMP”). 

BPMP is cheap because it acts (rather than looks) almost nothing like most MLPs:

1. The entity earns significantly more than it distributes, with the distribution covered 1.2x based on GAAP earnings

2. The entity is significantly under-leveraged at 1.8x net debt / EBITDA, with cost of debt at L+73bpsMinimal CapEx required (~1% of EBITDA), so sell-side EBITDA-based valuations inaccurate

3. No bogus accounting 

4. Limited sell-side coverage (five firms) with lukewarm consensus opinion (four “Holds”)   

5. No exposure to shale or stranded basins

6. Limited near-term commodity exposure (< 3% of EBITDA) and minimal long-term commodity exposure 

7. No contract cliffs, no tariff-repricing risk, no above-market contracts  

8. Assets anchoring among the most important global assets of a supermajor 

9. Ethical management

BP plc owns 54% of the units and thus has a strong interest in achieving fair value for the units to facilitate drop-down transactions. If the entity never achieves viability, you collect a near-certain 13+% distribution yield with optionality on BP buying it back in over time. I see 63% upside with conservative assumptions. 

History

BP seeded BPMP with among its best assets, hoping to gin up a valuation that would facilitate billions in subsequent drop-downs. In retrospect, this marked the near-top for MLPs, and BPMP’s share price has never sustained a valuation that would justify issuing equity capital to fund drop-downs. Investors, however, benefit from a simple, premier asset portfolio with highly visible cash flows. BPMP’s asset base can be broken down into two groups of pipelines – those serving the Whiting refinery in Indiana and those serving BP’s Gulf of Mexico developments. These two asset groups represent the crown jewels of BP’s portfolio. 

Whiting Pipelines (~50% of profits) 

BPMP’s pipelines deliver crude oil and take away refined products from BP’s Whiting, IN refinery. Though the pipelines have minimum volume contracts (and I expect BP to renew and extend these contracts imminently), I do not believe these are relevant to the investment case once you understand the local refining microeconomics. 

The Whiting refinery is the largest and most sophisticated refinery in the Midwest, a region that is already a net-importer of refined products. BP recently invested $4.2 billion to expand and upgrade the refinery, reflecting its importance to BP. The following table outlines PADD 2 refineries. 

Whiting is likely the lowest cost refinery in the region owing to its size, Nelson complexity, and the ability to process large amounts of historically discounted Canadian crude. Due to high fixed costs, refineries need to run fully utilized to generate reasonable returns. For Whiting to not run at or near nameplate capacity implies that smaller, less efficient neighboring refineries are suffering significant losses. This means that even in a scenario in which local refined product demand falls precipitously, PADD 2 imports would disappear first and then numerous competing refineries would shut down. In short, Whiting will be running at nameplate capacity – and thus BPMP’s pipeline volumes will be sustained – in almost any conceivable refined products demand environment. Despite the current weak demand environment for refined products, BPMP noted on its most recent call that Whiting is currently running at nameplate capacity. Over time I expect slightly growing cash flows from these assets as they benefit from PPI+-based FERC escalators. In short, investors in BPMP own the critical pipelines serving one of the most advantaged refineries in the country, with associated cash flows independent of commodity prices or long-term refined product demand. 

Offshore Pipelines (~50% of profits)

BPMP’s offshore pipelines serve as “corridor” pipelines for BP and Shell’s largest offshore developments. Approximately 50% of BPMP’s offshore EBITDA stems from the Mars pipeline (co-owned with Shell) and the other half stems from the Mardi Gras series of pipelines (also co-owned with Shell). I recommend reading the recent SHLX write-up for additional details on offshore pipes – the BPMP portfolio is in effect a high-graded version of what you get at SHLX. 

In addition to inflation escalators, no meaningful CapEx, and life of lease dedications, these pipelines benefit from tremendous forward cash-flow visibility. Major offshore projects require years of planning and billions in development capital. Moreover, since these projects represent among the very best projects for BP and Shell, we can be confident that changes in capital budgets are unlikely to meaningfully impact project viability. Shell provides the following projections for the Mars pipeline, which represents 25% of the consolidated cash flows for BPMP (Mars is a much smaller contributor to the larger SHLX). 

Moreover, Woodmac provides project development data which can be mapped to the associated pipelines (projections below). Notably, the Woodmac data only includes known projects and anticipated infill drilling. Said differently, these projections represent a very conservative view of the future. In reality, both BP and Shell are likely to drill infill wells near their largest developments for many, many years. Infill wells leverage a variety of central costs and thus generate higher IRRs relative to new developments.

The below DCF illustrates the NPV of the offshore pipes using very conservative assumptions, and then translates this NPV into a multiple of the trailing year’s NOPAT. As you can see, the projections translate into the economic equivalent of 7.5x current run-rate earnings. The more likely scenario is that the pipelines benefit from additional infill drilling and incremental new developments, so consider this a floor value with a very high degree of visibility. 

To give you a sense for the embedded conservatism in these projections, which do not even extend past 2040, Shell has publicly noted that they expect the Mars basin to extend “to 2050 or beyond.” Furthermore, BP recently disclosed in their investor day presentation that they expect their Gulf of Mexico liquids production to increase ~12% by 2025, supported by growth from new projects and continued infill drilling.

https://www.shell.us/energy-and-innovation/energy-from-deepwater/shell-deep-water-portfolio-in-the-gulf-of-mexico/mars-b-olympus.html

Conclusion

We see ~63% upside, using draconian assumptions for future offshore development. More realistic scenarios that incorporate normal infill drilling and new projects in the Gulf yield target prices of >$20 / share. 

The onshore pipelines represent an incredibly safe LSD-growth cash flow stream as Whiting will likely operate at nameplate capacity for the foreseeable future. For these assets we assume 16.0x NOPAT based on the approximate perpetuity-growth implied multiple assuming 1% growth and a 7% discount rate. This is probably even conservative considering the safety of the cash flows. We note there is potential for further upside as BP2 has ample capacity to receive additional volumes. 

For the offshore assets we conservatively utilize the 7.5x NOPAT multiple implied from the above DCF. As a reminder, the DCF incorporates limited infill drilling and no unannounced major projects. Will BP or Shell never drill another major Gulf of Mexico development? I doubt it. That’s all upside, though. 

Catalyst

Given the strong coverage and resilient earnings, I expect BPMP to resume the historical distribution increase of ~1c per quarter (10% annualized rate). At a 13% yield, the market clearly perceives there to be risk to the distribution. Increases in the distribution, along side consistent reported earnings, should allay these fears and distinguish BPMP from other high yielding MLPs that need to cut their distributions.