Description

Thesis Summary

Par Pacific Holdings, Inc. (“Par” or “the Company”) operates refineries and related logistics assets in Hawaii, Wyoming and Washington state, as well as gasoline stations in Hawaii, Washington and Idaho. Per the 10K, the Company’s stated strategy is “to acquire and develop energy and infrastructure businesses in logistically-complex markets.” We tested this strategy against the core assets in our diligence.

The Hawaii refinery historically operated with below adequate returns as the island operated in an oversupply dynamic on most refined products. This forced the on-island refineries to export product, which incurred a significant cost of shipping and reduced profitability to below acceptable returns. With the recent shutdown of Par’s only competitor on-island and Par’s subsequent consolidation of certain of their assets, the dynamics for Hawaii should change going forward. We expect the island to move to “import parity” on the major higher value refined products, meaning that the marginal price will be set by imports. This price could be as much as $8 per barrel higher than the price of an exported barrel. Given Hawaii’s physical separation from Asia, the U.S. and other markets, and Par’s new position as the sole operator on-island (with a valuable logistics and retail network to boot), we believe the Hawaii refinery meets the objectives of management’s stated strategy. This isolated location is also supported by a cost advantage in shipping crude (≈$0.022 per barrel per day) versus shipping refined product (≈$0.045). We expect materially higher profitability out of this asset in the coming years.

The Wyoming refinery is an inland refinery that largely serves the needs of the nearby Rapid City, South Dakota market. Our homework indicates that Par has a protected position in this market, as the closest refineries have more economic options to send their product to the Salt Lake City and Denver markets, and there is little incentive for the operator of the sole pipeline into Rapid City to make Rapid City a more attractive option for refiners versus these much larger markets. Par’s Wyoming facility also has access to inland crude from the nearby Powder River Basin. While we do not expect the Wyoming facility’s economics to improve much from where they are, our homework indicates this is a high-quality asset whose profitability should be sustainable. We therefore conclude that the Wyoming refinery also meets the objectives of management’s stated strategy.

The Washington refinery operates in Tacoma and competes with four other refineries in the Puget Sound. Par’s Washington refinery has access to crude oil from Canada, which trades at a substantial discount to Brent, the benchmark waterborne crude, and to crude oil from the Bakken area of North Dakota, which also usually trades at a discount to Brent. The other refineries in the area have less access to these crudes and instead must buy a large portion of their supply at or near benchmark prices. While differentials persist, Par’s refinery should have a relative advantage. Our homework indicates these differentials are likely to last for at least a year or two, though it is inherently a more difficult exercise to handicap. We therefore do not consider Par’s advantage in the Washington refinery to be predictably sustainable. That being said, the Company also controls related logistics assets in the area. Their truck rack (where trucks come to load up with refined products) is particularly valuable, given its convenient location. We would therefore consider the Washington logistics assets to meet the objectives of management’s stated strategy, while the refinery assets are less certain.

Overall, our analysis shows that Par’s assets largely reflect management’s strategy, with advantages stemming from logistical complexity that should persist.

Par is heavily influenced by legendary investor Sam Zell, whose entities own 26.5% of the stock, and is run by Bill Pate, a longtime lieutenant of Zell’s. We have been impressed with Pate as a capital allocator, operator and leader, and only wish he owned a bit more stock to better align his interests with ours.

The inflection point happening in Hawaii, which we discuss in more detail below, gives us an opportunity to acquire shares at a price that we do not believe reflects these changing dynamics or the quality of the assets and management team. The stock trades at around 5.5x our projection of mid-cycle EBITDA (giving no value to the Company’s $1.5 billion in federal NOLs), and around 4.5x our projection of mid-cycle free cash flow (which assumes nominal cash taxes). We expect an IRR on the stock in the mid-teens to low-20s over a five-year hold, assuming no real change to the multiple. A rerating that reflects the higher quality of Par’s geographically advantaged refining assets, their typically higher multiple logistics and retail businesses, a better balance sheet and a top-notch management team represents additional upside potential.  

The main risks around Par relate to its leverage, which is not insubstantial at around 2.6x mid-cycle EBITDA and 40% of assets, and around the exposures to complex local and global hydrocarbon commodities (including the risk of declining use of petroleum products for use in transportation, such as gasoline fueled cars) and environmental concerns that typify investing in the refining industry. Our homework indicates that Par’s logistical advantages mitigate some of these risks. Furthermore, the Company should produce substantial free cash flow in the near-term, which likely will be used to reduce leverage.

Business Description

Par’s business is organized into three primary operating segments:

1. Refining - They own and operate three refineries with total crude oil throughput capacity of over 200 thousand barrels per day (“Mbpd”). Their refinery in Kapolei, Hawaii, produces ultralow sulfur diesel (“ULSD”), gasoline, jet fuel, marine fuel, low sulfur fuel oil (“LSFO”), and other associated refined products, primarily for consumption in Hawaii. Their refinery in Newcastle, Wyoming, produces gasoline, ULSD, jet fuel, and other associated refined products that are primarily marketed in Wyoming and South Dakota. Their refinery in Tacoma, Washington, produces distillate, gasoline, asphalt, and other associated refined products that are primarily marketed in the Pacific Northwest.

2. Retail - Par operates 124 retail outlets in Hawaii, Washington, and Idaho. Their retail outlets in Hawaii sell gasoline, diesel, and retail merchandise throughout the islands of Oahu, Maui, Hawaii, and Kauai. Their Hawaii retail network includes Hele® and 76® branded retail sites, company operated convenience stores, 7- Eleven operated convenience stores, other sites operated by third parties, and unattended cardlock stations. During 2018, Par completed the rebranding of 24 of their 34 company-operated convenience stores in Hawaii to “nomnom,” a new proprietary brand. Their retail outlets in Washington and Idaho sell gasoline, diesel, and retail merchandise and operate under the “Cenex®” and “Zip Trip®” brand names.

3. Logistics - Par operates an extensive, multimodal logistics network spanning the Pacific, the Northwest, and the Rockies. They own and operate terminals, pipelines, a single-point mooring (“SPM”), and trucking operations to distribute refined products throughout the islands of Oahu, Maui, Hawaii, Molokai, and Kauai. They also own and operate a crude oil pipeline gathering system, a refined products pipeline, storage facilities, and loading racks in Wyoming and a jet fuel storage facility and pipeline that serve Ellsworth Air Force Base in South Dakota. In Washington, they own and operate a marine terminal, a unit train-capable rail loading terminal, storage facilities, a truck rack, and a proprietary pipeline that serves McChord Air Force Base.

In addition to these three primary segments, Par also owns a 46.0% equity ownership in Laramie Energy, LLC (“Laramie”), a joint venture focused on producing natural gas from the Piceance Basin in Garfield, Mesa, and Rio Blanco Counties, Colorado.

Refining is a complex industry. For a good background, we recommend the Deutsche Bank analysis that can be found here: https://www.wallstreetoasis.com/files/DEUTSCHEBANK-AGUIDETOTHEOIL%EF%BC%86GASINDUSTRY-130125.pdf

The changing dynamics at the Hawaii facility drive the bulk of the investment opportunity at Par, so we will focus our write-up there. We have researched the other facilities as well and are happy to discuss them in more detail in the Q&A if there is interest.

Hawaii Refinery

Par’s Hawaii refinery is in Kapolei, Hawaii, on the island of Oahu and is rated at 148 Mbpd throughput capacity with a Nelson Complexity Index of 4.0. The Hawaii refinery’s major processing units include crude distillation, vacuum distillation, visbreaking, hydrocracking, naphtha hydrotreating, and reforming units, which produce ULSD, gasoline, jet fuel, marine fuel, LSFO, and other associated refined products. The co-located refinery has two facility locations that are approximately two miles from one another:

• Par East – Par’s legacy refinery assets, which they have owned and operated since the acquisition in 2013 from Tesoro (which changed its name to Andeavor prior to being purchased by Marathon in October 2018).

• Par West – The recently-acquired assets from Island Energy Services (IES).

Par sources crude oil for the Hawaii refinery from North America, Asia, Latin America, Africa, the Middle East, and other sources. Crude oil is transported to Hawaii in tankers then discharged through Par’s single-point mooring (SPM) or third-party logistics networks. Par’s three underwater pipelines from the SPM allow crude oil and refined products to be transferred to and from the Hawaii refinery.

Crude oil is received into the Hawaii refinery tank farm, which includes 2.4 MMbbls of total owned crude oil storage, and/or third-party crude oil storage. Par processes the crude oil through various refining units into products and stores them in the Hawaii refinery’s owned 2.5 MMbbls of refined and additional third-party product storage.

Here are some basic stats from the 10K:

An important characteristic of this asset relative to many other refineries is its high working capital. Hawaii has no local crude source. As such, all the islands’ oil demand must be imported. To effectively run a refinery that relies on imports requires storing many days’ worth of crude. This refinery needs about 30 days of supply on hand, or about 3.3 million barrels (given daily throughput of around 110 Mbpd), to run. The prior owner funded the inventory investment entirely with its own capital. When Par acquired the refinery, management instead chose to utilize the lower cost capital of a financial institution, in this case J. Aron (a subsidiary of Goldman Sachs).

To appreciate why Tesoro struggled so much with this refinery, it is important to understand the competitive dynamics at the time. The Hawaii refinery was one of two refineries on Hawaii at the time of Par’s purchase, with Chevron owning a smaller refinery with capacity of 54 Mbpd. Chevron was trying to sell its refinery at the time, with reports claiming that it took them six years to close a deal due to the challenging dynamics of oversupply in Hawaii between the two refineries. According to Par’s former CEO (and current head of refining) Joe Israel at a 3/3/16 Company presentation, “The fact that Chevron may shut it down or sell it, even to a third party, it’s probably 90% of the benefit that we’re expecting in the Hawaiian market, because no one else will be able to dump product with a large system sort of like Chevron does.” We have studied manuscript cargo and trips data files supplied by the US Army Corps of Engineers (“USACE”). The data shows that Chevron increased gasoline imports around the time Par purchased Tesoro’s assets, lending support to Par’s claim that Chevron was dumping gasoline into a market that was already in oversupply. It would appear like Chevron was trying to muscle Par out of the business in an expensive game of chicken.

Chevron finally sold its Hawaii refinery (and related retail and logistics assets) in November 2016 to Island Energy Service (IES), a subsidiary of investor group One Rock Capital Partners. The on-island excess capacity continued to create challenging economics for both refineries, both before and after the Chevron-IES deal, which can be seen in the financial results during many of the years of Par’s ownership of the Hawaiian asset. However, the transfer to a private equity firm created a real possibility that the smaller IES refinery would be shut down, leaving only one player (Par) standing.

In August of 2018, that possibility became reality when IES announced its intention to cease refining operations in Hawaii. Simultaneously, Par announced the acquisition of certain IES refining units for $45 million in cash and stock. Par also entered into an agreement to supply products to IES, permitting them to satisfy several utility fuel contracts after they ceased operations.

As shown here, Par historically exported a significant amount of refined product from the island:

We can see the impact on exports of IES announcing its shutdown in August in the 2018 numbers. Management speaks cautiously about Hawaii, rightly saying the market has yet to prove its potential. But if money talks, this slide says a lot:

With the IES transaction, Par’s mix and profitability will change. Par projected the following increases in throughput and refined products:

The investments and acquisition will dramatically alter the product mix that Par Hawaii produces, as seen here:

With the acquired assets of IES, the Company should solidify its position as the lowest cost (and only) refinery operations on Hawaii, a market that provides a logistical advantage given the high cost of shipping product to the island from refineries located in other regions. The Company believes that many more of their refinery barrels will be sold on-island, as shown in the chart above. This is a critical change to the go-forward economics, enabling Par to earn a reasonable return on its assets. The closure of IES should result in a shortage of distillate and gasoline capacity in Hawaii, which means the marginal price of refined products should be set by the imported barrel:

Using disclosures provided by management over the past few quarters, we can project production as follows (which assumes a stable yield in line with historical averages):

We have verified the above suppositions utilizing data available from the EIA, USACE and Hawaii’s government sites, though we need to take the data and conclusions as directional rather than scientific. Here are links to some of the better sites for data:

http://files.hawaii.gov/dbedt/economic/data_reports/reports-studies/energy-data-trend-2017.pdf

https://www.eia.gov/petroleum/data.php#imports

http://cwbi-ndc-nav.s3-website-us-east-1.amazonaws.com/files/wcsc/webpub/#/report-landing/year/2017/region/4/location/4457

Several observations come out of that analysis, most notably that after the shutdown of IES:

1. Hawaii will be short gasoline on-island, after years of oversupply

2. Hawaii will continue to be short distillates (jet fuel and diesel) on-island, as it has been prior to the IES shutdown

3. Hawaii will be roughly in-balance on-island with regards to LFSO and HFSO

4. Par plans to grow product where the market is short, but won’t completely close the gap

Par’s on-island go-forward sales should benefit from “import parity” in the refined products where insufficient on-island capacity exists. This means that the price of these products will be set by the marginal barrel, which will be an imported barrel. As such, the price will have to include the transportation cost of an imported barrel.

Bloomberg shows a cost to ship clean product on a typical MR tanker from Singapore to Los Angeles (which we can use as a proxy for shipping costs to Hawaii) is around ~$4 per barrel. Since the company would capture this $4 twice when a product flips from export parity to import parity, we would expect up to a roughly $8 spread could be captured today on barrels that flip from export to import parity.

Furthermore, crude is shipped in much larger shipments than clean product. For instance, Par imports about a million barrels of crude at a time using a Suezmax tanker. The typical refined product tanker, in comparison, is the 300k ton MR. Data shows MR clean tanker rates of around $13.5k per day vs $22.0k per day for a Suezmax. This would imply a cost of 4.5 cents per barrel of refined product for the MR ($13,500 / 300,000) vs.2.2 cents per barrel of crude for the Suezmax ($22,000 / 1,000,000). So, all else being equal, there are logistical advantages in the ability to drive down the cost of freight on a per barrel basis of shipping crude versus distilled product. Obviously, the supply and demand of these tankers at any time defines the magnitude of the changes in freight cost.

What this all means for Par’s economics is complicated, but our calculations indicate that Par could earn EBITDA per barrel of $3.50-$4.00 in the Hawaii refining operations by 2021 (after the naphtha hydrotreater is completed), assuming mid-cycle 4-1-2-1 Singapore crack spreads and production costs of $3.15 per barrel. This would work out to EBITDA of $160 million, a considerable increase from 2018’s $47 million. When we combine the Hawaii refinery with the rest of the operations, we calculate 2021 EBITDA of over $300 million and EPS approaching $3 per share. Maintenance capex runs about $50-$55 million, which is well below D&A of close to $100 million, so free cash flow exceeds earnings by quite a bit. We calculate 2021 free cash flow per share of around $4.75. This compares to today’s stock price of around $20.

Other Areas of Interest

Comp

The Company recently put in place a new executive compensation plan that encourages stock ownership. The CEO and CFO also recently bought shares in the open market, each at around $500k.

Washington Acquisition

Management bought the Washington refinery and logistics assets for $358 million, plus net working capital, in January 2019. This works out to a 3.8x multiple of trailing adj. EBITDA and a 4.8x multiple of management’s estimate of mid-cycle EBITDA.

When management bought these assets, we believe they were primarily interested in the logistics assets, and really viewed the deal as a fair price for logistics plus a call option on the refiner. The refinery has significant optionality while the WTI to Brent spread persists. If the spread collapses, management could shut down the refiner and run it as a profitable logistics terminal. There is a good data point to support the valuation of the logistics asset. Arclight recently purchased a smaller logistics asset in the region for about $160 million from Targa. We have heard this asset sold for over 10x EBITDA. At a 10x multiple, the logistics assets of Par’s Washington purchase would be about $200-$250 million. Management thinks they have much more valuable assets than Targa: more rail capability, more storage capacity and nearly 3-4x the land. At the higher 12x EBITDA multiple, the logistics value would be $240-$300 million.

Par purchased the assets with $250 million of debt and freed up the majority of the rest of the capital from their own balance sheet for a total purchase price of $327 million. So, they effectively paid $75 million dollars for the refiner, or about 1x the $71 million of adjusted EBITDA we calculate they made last year. With the existing spreads on crude and the expectation these will be sustained for a few years, they can utilize the refiner to deleverage the borrowed money and capture this value for the equity holders, leaving any remaining value in the refinery as a call option.

Buybacks

Historically, the Company has issued shares as opposed to repurchasing. However, we believe that management would like to have the flexibility to buy back shares when they think they are cheap (like today). Currently, the Company’s debt agreements restrict them from doing so. We suspect as the leverage rapidly comes down with strong near-term performance from Hawaii and Washington, management might look to repurchase some stock. Limited liquidity and concentrated share ownership are two factors that might preclude large buybacks.

Disclosures

The information contained herein has been derived from public information believed to be reliable but the information is not guaranteed as to accuracy and does not purport to be a complete analysis of any security, company or industry involved.  All data and analysis are unaudited and should not be used as the basis for any investment decisions. Neither the advisor, nor any of its officers, directors, partners, contributors, employees or consultants, accept any liability whatsoever for any direct or consequential loss arising from any use of information in this analysis.  The user of the information assumes the entire risk of any use it may make or permit to be made of the information.

Neither the advisor nor any of its employees holds a position with the issuer such as employment, directorship, or consultancy.

The adviser, through a partnership that it advises, holds an investment in the issuer's securities.

Catalyst

Improved performance in Hawaii, including growth capex projects

Deleveraging and possible buyback