Description

CITGO Petroleum Corp (CITPET) – 6.375% Notes due 2026

Executive Summary:

CITGO owns and operates three large-scale, highly complex petroleum refineries with 769 mbpd of total processing capacity:

CITGO’s refining operations are supported by an extensive distribution network. The company has ownership stakes in 40 refined storage and transfer terminals across 21 states with total product storage capacity of 12 million barrels. CIGO also has a retail network of over 4,500 independently owned and operated CITGO-branded retail outlets located east of the Rocky Mountains. The company and its predecessors have had a presence in the United States for over 100 years.

The company is owned by Petroleos de Venezuela (“PDVSA”), the Venezuelan national oil company. We believe that the company’s bonds trade wider than their intrinsic credit risk due to this ownership overhang. CITGO is prohibited from paying out dividends due to sanctions on Venezuela, which is a major credit positive. Following strong earnings in 2022 and YTD-2023, CITGO’s cash balance of $3.46 billion exceeded its debt balance by $215 million as of March 31, 2023. The company is expected to continue to generate cash due to a healthy refining market supply/demand balance.

The company’s 6.375%% senior secured bonds due June 2026 trade at 96.5c, which represents a 7.7% yield to maturity and approximately +360 bps spread to risk-free interest rates. With the balance sheet completely de-risked and no way to pay dividends, we expect CITGO to redeem its notes prior to maturity rather than running a negative spread on its balance sheet. Returns to an early call are:

• December 2023 @ 103.188 = 18.7%
• June 2024 @ 101.594 = 11.6%
• June 2025 @ 100.000 = 8.3%

Furthermore, various creditors of Venezuela have been seeking to recover on their claims by forcing a sale of PDV Holding’s shares in CITGO Holding Inc, the company’s parent. Were these lawsuits to be successful, we believe that would likely be a credit positive and cause the bonds to trade up to par, as most potential acquirers are large, investment-grade companies. Also, there is a covenant in the indenture which requires the company to repurchase bonds at 101c if the company’s credit ratings (B3/B+) are not confirmed within 90 days following a change of control, which protects bondholders from a re-leveraging transaction.

Business Description:

CITGO is the 5^th largest refiner in the US, behind Marathon, Valero, Phillips 66 and PBF Energy. The company has an advantaged crude slate, as it has two deepwater ports and is able to process a majority of its products by using heavy crude oil. For example, it processed crude from 32 suppliers in 9 countries, without any supply coming from Venezuela. Furthermore, CITGO also benefits from lower prices on natural gas (a key input cost) relative to European refineries, enabling it to earn economic rent.

Pre-COVID, the company’s utilization averaged ~90% and EBITDA ranged from $1.2 billion to $1.9 billion. When COVID hit, utilization dropped and EBITDA plunged into negative territory at -$0.5 billion in 2020. The company has had a strong recovery since then, generating $0.5 billion in 2021, $4.4 billion in 2022, and $1.35 billion in Q1 2023. Capital expenditures have historically averaged $250 million per year. With midcycle EBITDA of ~$1.5 billion, the implied enterprise value of CITGO is approximately $6 billion (based on a ~4x multiple, a 2-3x discount to trading multiples for MPC, VLO, and PSX).

Investment Thesis:

• Low risk way to make 8-18% IRR over the next 6-36 months
  • With the company’s debt more than covered by cash and cash trapped, the credit is fully de-risked
  • Very tight range of outcomes
• Excess spread relative to intrinsic credit risk
  • At a +358 bps credit spread, CITGO’s bonds are priced ~120bps wide to the average US BB 3-year corporate bond, despite having a better credit profile
  • We believe this excess spread is due to the company’s ownership overhang
• Margin of safety
  • Assuming a $6 billion EV for the refining operations (20% unlevered FCF yield based on midcycle earnings), the bonds represent an LTV of just 23% (based on a numerator of $1.9 billion of opco debt, and a denominator of $6 billion EV plus $2.1 billion of cash excluding the CITGO Holdings 2024 bond maturity)

Key Risks:

• Duration risk
  • The company could choose to leave the debt outstanding to maturity, and interest rates could rise further, resulting in a mark to market hit and potential opportunity cost of owning these bonds
  • Mitigant: even in that case, bonds generate a modest premium over risk-free, for relatively little risk
• Dividend payments
  • If sanctions on Venezuela were to be lifted, the company could potentially re-lever by paying out its cash pile as a dividend
  • Mitigant: seems highly unlikely under the current administration
• Refining cycle
  • Refining is a highly cyclical business, and the current level of earnings are unsustainable in the long-run. If we were to get another pandemic-type shock that caused cash flow to go negative, the margin of safety could be eroded.
  • Mitigant: even if the cash balance shrunk, there is ample EV to cover the debt load and support a refinancing.

Catalyst

Catalysts:

• Early debt redemption
  • Would enhance IRRs
• Resolution of parent lawsuits
  • Could result in a sale of the company and possible change of control offer
• Ratings upgrades
  • The company’s credit profile merits a BB following its strong deleveraging