This company is a post reorganization NOL vehicle designed to acquire energy related assets and make use of significant tax assets. So far management has successfully turned around their largest operating segment, which is also profiting from the falling oil price. Add on acquisitions have already created value for shareholders. Efficiency gains in the future should further strengthen profitability. In addition to that, Sam Zell, an investor with a quite lot of experience in turnaround and NOL investments is the largest shareholder in the company.
Par Petroleum (PARR) was created through the reorganization of Delta Petroleum in August 2012. The reorganization converted USD 265 m of unsecured debt to equity and allowed the company to preserve significant tax attributes.
PARR is currently operating three segments:
- refining, distribution and marketing;
- natural gas and oil production;
- commodity marketing and logistics.
Ad 1. The refining, distribution and marketing segment consists of a refinery in Kapolei, Hawaii, refined products terminals, pipelines, a single-point mooring and retail outlets which distribute gasoline and diesel throughout Hawaii.
The refinery produces ultra-low sulfur diesel, gasoline, jet fuel, marine fuel, and other associated refined products primarily for consumption in Hawaii. The refinery is configured significantly differently than most other US refineries. The refinery has been designed to maximize jet fuel (due to high jet demands), and residual fuel yield to supply required fuel for power generation and ship bunkering. Roughly 24% of total throughput consists of fuel oil compared to below 4% for the U.S. refineries as a whole. Reason for this relatively high portion compared to other refineries is that electricity on Hawaii is mostly generated by burning fuel oil. In 2013, Hawaii relied on oil for 70% and on coal for 14% of its electricity generation. Nevertheless, management has shifted product mix from fuel oil to higher yielding distillates over the last quarters.
The refinery is located about 20 miles west of Honolulu. Crude oil is received into the refinery tank farm, which consists of 2.4 m barrels of total crude storage. Refined products can be stored within the refinery’s 2.5 m barrels of refined product tankage. In addition to that, the company provides critical energy infrastructure to the state of Hawaii. From the refinery gate, they distribute refined products through the network throughout the Island of Oahu as well the neighbouring islands of Maui, Hawaii and Kauai.
The refinery is rated at 94,000 barrels per day throughput. Utilization during the first half of 2015 was at 83% with 78% of total throughput sold on-island and the rest being exported to the West coast of the US and Asia. Management focuses on on-island sales given higher margins. Production is not limited by capacity but by on-island demand, which is currently roughly 130,000 barrels per day. With the acquisition of Mid Pac Petroleum which was completed during the second quarter 2015, management made another significant step towards increasing on-island sales. Mid Cap adds 84 outlets to the company’s retail segment bringing the total number of retail sites to 146. As a consequence of the acquisition, the refinery is now supplying Mid Pac with 4,000 barrels per day leading to an increase in the refinery’s utilization rate. In addition to that, the company distributes its products through wholesale and bulk. While their wholesale distribution efforts focus on jobbers and other non-end users, bulk distribution primarily serves utilities, airports, military bases, marine vessels, industrial end-users and exports.
There are a variety of factors that make a Hawaii refinery relatively more costly to operate than refineries on the mainland. Hawaii refineries are significantly smaller than the average US refiner with a much lower degree of complexity. These disadvantages cause Hawaii refineries to have higher average crude oil costs than larger, more sophisticated refineries. Fuel specifications reducing sulphur content in fuels require Hawaii refineries to process sweeter crude (more expensive) than average US refineries. Additionally, freight costs to Hawaii are more expensive per barrel than freight to an average US refinery due to distance and relatively smaller size of shipment vessels.
Hawaii’s only other refinery is smaller in seize than PARR’s refinery with a throughput capacity of 54,000 barrels per day and has been put up for sale by its owner Chevron as the company is not satisfied with the financial performance due to the reasons mentioned above. It is all but certain that a buyer of the refinery will continue operation as the requalification to an import terminal might be more profitable in the future.
Already, that Hawaii is an island market serves to emphasize the possibility of market power in an industry with only two producers and high entry costs. Interestingly, 17 years ago, the Hawaiian state attorney general filed suit against the two refinery owners (Chevron and Tesoro) alleging anticompetitive behaviour. Therefore, it will be interesting to watch what will happen to PARR’s competitive position should Chevron decide to sell to a potentially less professional market player or shut down the refinery.
Ad 2. PARR’s natural gas and oil assets are non-operated and are concentrated in the 32.4% ownership of Piceance Energy, a joint venture entity operated by Laramie Energy and focused on producing natural gas in Garfield and Mesa Counties, Colorado. Piceance Energy was formed as part of the company’s reorganization and resulted from the contribution of properties located in the Piceance Basin in Colorado by PARR and by Laramie. In addition, PARR holds a 6% interest in Arguello Point Offshore unit off the coast of Santa Barbara, undeveloped acreage in Mancos and Niobrara fields and a 5% interest of a well program where Encana is the majority owner.
Ad 3. PARR operates an integrated sourcing, marketing, transportation, and distribution business focused on crude oil. They use a variety of transportation modes, which are generally leased, to transport products, including river barges, pipelines and a fleet of approximately 150 railcars. They purchase and resell crude oil primarily from the Western United States and Canada to customers in the Midwest, Gulf Coast, and East Coast regions of the U.S. and deliver the crude oil via rail, pipeline, and barge. They also have pipeline positions on lines moving Canadian crude oil south. They sell crude oil primarily to end users (refiners and their suppliers).
In the last conference call, management mentioned that they evaluate a “separate reporting” for this segment and a potential listing as master limited partnerships (MLP).
Enhanced profitability of refining business
The refining business is currently the company’s most important segment. PARR bought the refining, distribution, and marketing segment just two years ago from Tesoro for a total consideration of USD 325 m. This included the acquisition price of USD 75 m in cash, plus net working capital and inventories, certain contingent earn-out payments of up to USD 40 m, and the funding of certain start-up expenses and overhaul costs prior to closing.
For Tesoro the refinery was an inefficient part of their business and therefore it had been undermanaged for a couple of years. Consequently, PARR was able to acquire these assets at a very low valuation compared to reconstruction value. Over the last two years the refinery went first through a sales process, and then a five months shutdown followed by a long start-up. Hence, at the beginning focus hasn’t been really operations excellence, but rather normalizing ongoing operations. Since the takeover management has successfully increased throughput, terminated a transition services agreement with Tesoro, reduced the reliance on third-party service providers and entered into a new supply and offtake agreement with J Aron.
Currently, management is working on improving crude sourcing leading to a more balanced supply of crude oil from different regions in the world. As a consequence, the gradual increase of the usage in cost advantaged crudes should also drive a meaningful margin uplift.
In April 2015, the USD 107 m Mid Pac acquisition was closed. Management estimates an annual contribution of approx. USD 17 m of EBITDA from its operations. On top of that roughly USD 5 m of synergies will be generated mainly on the logistic side. In addition, the refinery benefits from the Mid Pac supply agreement through increased on-island sales. Mid Pac’s added gasoline volume is also increasing the company’s on-island gasoline sales and decreases the refinery’s requirement to export gasoline range materials. Historically, management estimates that each exported barrel of refined product costs the company between USD 6 and USD 10 per barrel (including shipping costs, lost product value and other costs). Management expects the supply agreement to add another USD 5 m to USD 10 m of EBITDA coming from the refinery side just by selling more barrels on the island, instead of putting them in export. Consequently, the Mid Pac transaction delivers roughly USD 30 m of incremental EBITDA resulting in a very modest acquisition multiple paid.
A refinery becomes most profitable at a utilization rate between 90% and 95% or 85,000 to 89,000 barrels per day in the case of PARR. So this is where management wants to get to. After the restart of the refinery management has continuously increased throughput. Including the Mid Pac supply agreement, the company sold 75,000 barrels per day therof 62,000 on-island in the second quarter 2015.
However, refinery throughput is still below the most efficient level. Therefore, going forward management wants to further increase on-island sales. The Mid Pac acquisition was only the first step in this direction. For instance, management also sees potential in jet fuel where Hawaii is short off and needs to import roughly 25% of total demand or 10,000 barrels per day. In addition, PAR continues to make asphalt for the local market and repositions the refinery in the local propane business to maximize on-island sales.
As a result of the recent efforts, the refineries economics have progressed well over the last quarters as can be seen in the table below:
After the successful turnaround, management sees the profitability of the refinery business being a function of the difference between crude oil prices and wholesale petroleum product prices (mostly gasoline and distillate fuels). In the industry this difference is called crack spread. The crack spread is a good approximation of the margin a refinery earns. Market demand and individual factors can boost or reduce the average crack spread of a refiner. Configuration, crude diet and location relative to markets can have the biggest impact on the crack spread.
From a market perspective the profitability of PARR’s refinery business is mostly influenced by crack spreads in both the Singapore and the US West Coast markets. These markets reflect the closest, liquid market alternatives to source refined products for Hawaii. Management sees about an 80% sensitivity coming from the Singapore market and a 20% sensitivity for PARR’s products to the US West Coast.
Based on the refinery’s configuration and competition, management believes the Singapore 4-1-2-1 crack spread (or four barrels of Brent converted into one barrel of gasoline, two barrels of distillate (gasoil and jet fuel), and one barrel of fuel oil) best reflects a market indicator for the segment’s operations.
Management has provided its opinion about potential mid-cycle profitability: Looking at the historic 4-1-2-1 crack spreads, USD 8.0 a barrel seems to be a realistic assumption. In addition to that, the discount to Brent on the crude differential side (Mid Pacific blend differential) has to be taken into account. This is another USD 0.2 a barrel. Hence, management regards USD 8.2 benchmark margin per barrel as a good approximation of mid-cycle profitability. In the second quarter of 2015 the benchmark stood above USD 11 per barrel indicating that we are currently in relatively robust market.
Based on this guidance, management views the refining, distribution and marketing segment at USD 100 m EBITDA per year in a mid-cycle environment.
Apart from demand and supply, the refinery’s profitability is also affected by the movement of the oil price. During a rapidly declining crude market, refineries tend to benefit from expanding crack spreads as changes in refined product prices tend to lag crude prices. The majority of PARR’s contracts typically price at least one week in arrears and some of the utility customer contracts have at least a one month lag in the price setting mechanism. For instance, during the fourth quarter 2014 PARR substantially benefited from these prior week or prior month average pricing mechanisms in the contracts as crude oil lost USD 37 per barrel. Recently, PARR changed the sales mix by selling less fuel oil to the utilities leading to a significant reduction in exposure to the time lag effect going forward.
Unlike most other refineries, PARR is burning fuel instead of gas. They burn about 840,000 barrels a year of fuel oil. As a consequence, the cost of crude is a significant driver in operating costs. The recent price decline in oil leads to significant cost savings in the future. Currently, hedges are in place for 75% of the internally consumed fuel at around USD 55 to USD 60 per barrel until March of 2016, with annual cost savings of approximately USD 20 m at 2014 crude price environment.
Potential risks from regulation
The current energy product supply mix in Hawaii might change in the near future. This might be due to a number of regulations stemming from Federal EPA (United States Environmental Protection Agency) requirements on refiners and/or utilities, and some from Hawaii based initiatives such as the Hawaii Clean Energy Initiative (HCEI), Hawaii greenhouse gas (GHG) requirements from stationary sources and the potential development of LNG imports in Hawaii. A number of these regulations and initiatives may lead to a reduced demand for Hawaii refinery supply, potentially requiring the refineries to reduce processing throughput or export the specific product that becomes “long” to other markets. In addition, new regulation might increase the need for capital expenditures.
While these policies are focused on displacing petroleum based fossil fuels with cheaper and/or more environmentally friendly fuels, the two existing refineries operated by PARR and Chevron still provide more than 90% of Hawaii’s fuel needs. So from my perspective, it will take a long time if at all before refining capacity in Hawaii will be obsolete as the investments to be made in substitutes like renewable energy and natural gas are substantial.
In addition, I believe that a closure of Chevron’s refinery might be a likely outcome in the near term due to its low throughput capacity and a lack of hydrotreating capacity to adapt to new gasoline standards. For instance, while Chevron may have difficulties meeting the EPA Tier 3 gasoline requirements, PARR’s refinery with a significant amount of hydroprocessing should have a greater ability to meet the standard, especially since the refinery also processes light sweet crude. With low sulfur levels in crude and significant removal of sulfur from refinery streams via hydroprocessing, PARR should have very low cost to meet the Tier 3 regulation. In the case of the rival’s disappearance, PARR’s refinery should profit from an enhanced competitive position in Hawaii despite a restrictive regulatory environment.
Major shareholders and capital structure
PARR was created through the reorganization of Delta Petroleum in 2012. The reorganization converted USD 265 m of unsecured debt to equity and allowed the company to preserve significant tax attributes. Based upon the plan as confirmed by the bankruptcy court, Delta’s creditors were issued 147.7 million shares of common stock, and Delta’s former stockholders received no consideration under the Plan. At the closing, Piceance Energy entered into a new credit agreement, borrowed USD 100 m under that agreement, and distributed approximately USD 72.6 m net of settlements to PARR and approx. USD 24.9 m to Laramie. PARR used its distribution to pay bankruptcy expenses and to repay its secured debt. PARR itself also entered into a new credit facility and borrowed USD 13 m under that facility at closing, and used those funds primarily to pay bankruptcy claims and expenses.
To finance the acquisition of the Hawaiian assets, in September 2013, PARR completed a private placement transaction and issued approx. 144 m shares of common stock resulting in net proceeds of approx. USD 199.2 m.
In January 2014, PARR implemented a one-for-ten reverse stock split of the outstanding common stock.
In August 2014, PARR issued approximately 6.4 million shares of common stock resulting in net proceeds of approx. USD 101.5 m to finance the Mid-Pac acquisition.
The Zell Credit Opportunities Master Fund, an affiliate of Sam Zell’s Equity Group Investments, and Whitebox Advisors played a leading role in the restructuring / investment process and are currently the two largest equity holders in PARR holding approx. 32.8% and 24.1% of outstanding shares. Sam Zell is a well known investor. He has been involved in a number of turnaround situations often making use of large NOLs. For instance, he invested in Covanta, Anixter and currently he is participating in a small company called Signature Group Holdings. Whitebox Advisors is led by Andy Redleaf who was one of the market participants predicting at the end of 2006 the crash in US credit markets and who is now concerned again.
As of August 2015, PARR has a market cap of 713 m and a cash balance of USD 121 m. Total debt stands at USD 171 m. Roughly USD 93 m of total debt outstanding belongs to a term loan PARR entered into with certain equity holders including Zell Credit Opportunities Master Fund. This term loan requires the company to pay relatively high interest in-kind at 12% of outstanding debt. With the ongoing improvement in balance sheet strength and accelerating cash generation, I expect management to explore more economic ways to finance the company’s capital needs going forward.
PARR owns significant tax assets
As of yearend 2014 the company had roughly USD 1.4 bn of net operating loss tax carryforwards (NOLs). The NOLs will expire in various amounts between 2027 through 2033. As the company has this very valuable asset in place, management is sourcing new potential acquisitions to make use of the NOLs in the future.
For instance, the acquisition of Mid Pac generated a USD 19 m tax gain from the release of the valuation allowance because management expects to use a portion of the NOLs to offset the future taxable income of Mid Pac. This tax gain will translate into cash when the NOLs will offset the future profits for Mid Pac.
In order to pursue the acquisition strategy and fund these acquisitions, PARR is expected to issue new shares. Rights offerings create an efficient way for the controlling shareholders to maintain their ownership percentage which is key to the NOL eligibility.
For the refining segment including marketing and distribution, management targets a mid cycle EBITDA of USD 100 m per annum.
Currently, US listed refineries are trading for an average mid cycle multiple of 8.0x assuming that the last cycle went from 2010 to 2014:
All of the peers listed above do have a number of different refineries in place. Hence, they are not dependent on only one site as it is the case for PARR. Therefore, it seems to be appropriate to use a discount when ascribing a multiple to PARR’s refinery segment. Let’s use a 6.8 times multiple or a 15% discount leading to an enterprise value of USD 680 m.
The 32.4% investment in Piceance Energy is accounted for with the at-equity method. The current asset value in the balance sheet is USD 127 m. While this is generally only a rough approximation of intrinsic value, in this case it might not be that far off. According to the second quarter financials subsequent to June 30, an unaffiliated third-party invested an aggregate of USD 19 m in Piceance Energy for a 4.7% share. Consequently, this values PARR’s share in Piceance Energy with an equity value of USD 131 m.
The sourcing, marketing, transportation, and distribution business called Texadian Energy, was acquired from SEACOR for USD 14 m plus estimated net working capital of approx. USD 4 m. Hence, I will apply USD 18 m as the value for this segment.
As of December 2014 the company has total NOLs of USD 1.4 bn. At a tax rate of 35% and a discount of 20% to apply for the probability that PARR can generate sufficient taxable income in the future to utilize the NOLs leads to a valuation of USD 392 m.
Taking into account net debt of USD 50 m, fleads to an equity value of USD 1,170 m or USD 31.4 per share (current share price is USD 19.1). As a consequence, PARR is currently trading at a 39% discount to my estimation of NAV.
There are three thigs I do not like about this investment. First, there is some uncertainty regarding the regulatory impact on the refinery business. Second, the current interest rate on the term loan appears to be exceptionally high and not in line with the company’s solid balance sheet. Third, it is difficult to make any assumptions about the future of Piceance Energy which seems to be a good growth asset in the E&P sector, but faces headwinds from the current market environment in the commodities sector.
That said, I believe that these issues are more than sufficiently reflected in the current stock price. With the Mid-Pac acquisition, management proved that it has a valid strategy in place to increase value for shareholders not only stemming from tax assets but also from synergies. Two exogenous factors, the falling oil price and the potential loss of a competitor are also helping. Apart from that, more than 50% of the shares are held by capable investors, who achieved very good results from similar situations in the past.
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