Extreme Drop in Fuel Demand, Oil Prices Clouds Magellan's Outlook
The coronavirus pandemic and oil-price war have weighed on the short-term outlook for Magellan Midstream Partners' (MMP) business.
The firm generates about 55% of its operating profits from transporting and storing refined petroleum products such as gasoline and diesel fuel.
This has long been a nice cash cow business because demand trends are stable and growth is low, providing consistent throughput while discouraging others from constructing rival pipelines.
Due to the predictability of fuel consumption, Magellan's refined products operations have never really been a contract-driven business.
Last year only about 40% of shipments on Magellan's pipeline system were subject to agreements with shippers dictating payment, volume, or term commitments. These deals only had an average remaining life of three years, too.
The firm generates about 55% of its operating profits from transporting and storing refined petroleum products such as gasoline and diesel fuel.
This has long been a nice cash cow business because demand trends are stable and growth is low, providing consistent throughput while discouraging others from constructing rival pipelines.
Due to the predictability of fuel consumption, Magellan's refined products operations have never really been a contract-driven business.
Last year only about 40% of shipments on Magellan's pipeline system were subject to agreements with shippers dictating payment, volume, or term commitments. These deals only had an average remaining life of three years, too.
The rest of the refined products business is driven by published tariff rates and volumes that shippers nominate up to a month in advance.
In March 2016, management commented on how the steady demand profile of this business allows it to be run with relatively few long-term commitments:
"So whatever the demand is within our segment from those parts of the pipeline, if a particular customer does not perform, the demand remains. It's there. It didn't evaporate. As long as people are still driving their trucks and their SUVs, the demand is there, and we're in a position to serve that demand. So if a particular customer doesn't perform, in all likelihood, another customer simply steps in.
So the credit rating of our particular customers in that segment is really irrelevant when you look at how the segment fundamentals operate. With that said, most of our customers in this segment are the refiners connected to the system."
Unfortunately, the coronavirus has resulted in an unprecedented situation where many people are no longer driving their trucks and SUVs. Fuel demand is evaporating as more people worldwide are told to stay home and avoid non-essential travel.
It's hard to say how long these restrictions will remain in place, but they have created a cloud of uncertainty over refineries (Magellan's main customer group).
On March 17, Reuters reported that "margins for producing transportation fuels turned negative in Europe and Asia, and briefly did the same in the United States."
Simply put, this rapid demand destruction is unprecedented and even worse than what America experienced following September 11th.
The lack of volume commitment in this historically stable business suggests that refiners could significantly reduce the amount of fuel they send through Magellan's infrastructure in the weeks or months ahead, dealing a major blow to cash flow until travel demand recovers.
Meanwhile, the unprecedented plunge in oil prices creates challenges for Magellan's crude oil segment (about 37% of operating income), which consists mostly of long-haul pipelines providing outlets for production in the Permian Basin.
Saudi Arabia and Russia are engaged in a price war that threatens to take market share from higher-cost U.S. shale producers and has put the Permian Basin in its crosshairs. We believe oil prices could remain at historically weak levels for at least a few quarters, if not for more than a year.
Unlike refined products, Magellan discloses that its oil pipeline assets are generally secured by long-term take-or-pay commitments.
The bad news is that some of those commitments were set to expire in late 2020, which would be very poor timing given the crash in prices. Earlier this year Magellan says it entered into a new long-term agreement for "a significant portion of this capacity" though the firm's assumption of full capacity this year may be a stretch.
Regardless, investors are worried about any company with heavy exposure to U.S. shale, and this is an important part of Magellan's business. Even if contractual demand remains for its pipelines as short-term production inevitably slows or declines, there's risk that weaker customers can't honor their obligations with oil prices this low.
Once again, this is a difficult risk factor to analyze. In 2016, management talked about the high bar Magellan maintained in terms of customers' financial health:
"So now let's break out the crude oil piece and talk about that specifically for just a moment. If you look at -- which is dominated by our long-haul pipelines, which we've built recently, and as a result, we have many long-dated contracts still remaining on those pipelines. 95% of the revenue in 2015 for that segment on the pipeline commitments is with investment-grade counterparties.
And in fact, it's heavily biased towards the higher end of investment grade, BBB+. So when you look at the two segments in our business that are most driven by contracts and, therefore, have the most counterparty risks, we're in very good shape, with very few concerns."
A lot has changed since then, but Magellan has always taken a conservative, long-term approach with its business. The firm's customers could struggle in this environment, but Magellan likely maintains one of the strongest customer bases compared to many of its peers.
It's anyone's guess how much damage these two headwinds will do to Magellan's results this year. These are two major unprecedented shocks happening at the same time.
In January 2020, Magellan issued guidance calling for distributable cash flow of $1.2 billion and 3% distribution growth, which was expected to result in 1.25x distribution coverage.
Assuming a 3% raise, Magellan's distribution costs about $960 million annually, leaving $240 million of excess cash flow available to help fund growth projects or share repurchases.
Expansion spending has slowed in recent years, and management indicated that growth capex would likely total $400 million in 2020, down from $1 billion in 2019.
In other words, Magellan would only need to issue around $160 million of debt to meet its original plans before the coronavirus outbreak and oil crash occurred.
Management hasn't commented on these developments, but it seems likely that all non-essential growth spending will be curtailed in light of the commodity price environment and lower demand from customers.
In that scenario, Magellan wouldn't need access to any capital if its cash flow held up. However, that seems unlikely given its lack of volume protection in refined products and the challenges facing shale oil producers.
The good news is that Magellan's distributable cash flow could fall by more than 20% this year and still cover its existing distribution. Until fundamentals improved, the firm's distribution coverage ratio would sit at 1.0x, below management's 1.2x target.
If the shock to cash flow was even more extreme, Magellan's balance sheet provides some flexibility. At the end of 2019 the firm's leverage was 2.8x, below Magellan's long-standing 4.0x limit.
All else equal (aside from scrapping almost all growth spending), a 30% fall in Magellan's EBITDA would be needed to push its leverage ratio up to 4.0x. Or if EBITDA remained stable, we estimate that Magellan could borrow more than $1 billion before approaching leverage of 4.0x.
The firm has $1 billion available under its multiyear credit facility as well to help ensure it has enough liquidity to ride out short-term shocks.
Overall, Magellan faces unprecedented challenges in the short term, especially in its refined products business. Fortunately, management has always taken a long-term approach in running the business and enters this sudden downturn in a reasonably strong financial position.
Barring unprecedented bankruptcies in the Permian Basin and a severe and prolonged downturn in fuel demand, Magellan appears to have the balance sheet, distribution coverage, and commitment to its payout to wait out better times.
We will continue monitoring the situation and provide updates as needed.
