by Aaron Levitt | February 3, 2012 8:54 am
The refinery and downstream sector of the energy markets continue to disappoint. The shrinking spread between West Texas Intermediate (WTI) and Brent crude prices is stifling margins and wrecking earnings. That shouldn’t be too surprising, given that refineries have historically had some of the most volatile earnings patterns of any energy subsector and require a “Goldilocks” scenario to get things just right.
To that end, a variety of integrated oil firms have begun spinning out their refinery operations to unlock shareholder value. The latest of which was major oil firm ConocoPhillips (NYSE:COP). However, it seems that dwindling margins for the refiners have a few looking at spin-offs of their own.
When Marathon Oil (NYSE:MRO) spun off its refinery operations as Marathon Petroleum (NYSE:MPC) last year, the basic idea was that the lumpy refinery earnings were holding back the stronger exploration and production (E&P) division. Shares of the producer’s stock would trade at a higher multiple once the downstream segment was gone.
So far that’s been true. Earnings for the E&P side continue to rise, while the refinery side has begun to struggle over the last three or so months. As crude oil prices have risen over 10% during this time period, Marathon Petroleum has seen its profits plunge, recently reporting a $75 million loss for the fourth quarter. The loss amounted to 21 cents per share, widely missing Wall Street expectations of 6 cents.
However, shares of the refiner didn’t fall when on the poor earnings report. The stock actually rose about 9% in premarket trading. The reason: Marathon said it’s considering an IPO for a master limited partnership (MLP) for its pipeline and infrastructure operations. By spinning off its profitable midstream segment, Marathon would benefit by passing its pipeline tax burdens onto investors. On the flipside, investors would be able to buy into a company with a more reliable revenue stream.
Midstream operations, including pipelines, storage facilities and gathering systems, generally operate under long-term contracts priced independently of energy prices. Refineries, on the other hand, must sell gasoline and other distillates at prices that fluctuate daily. Once the midstream operations are spun off, the result is a security type that pays high stable dividends back to shareholders.
Marathon wouldn’t be alone in its decision to spin off assets. Philadelphia-based refiner, Sunoco (NYSE:SUN) has begun moves to make itself leaner. The firm announced plans to put its Philadelphia and Marcus Hook refineries up for sale, as a part of its initiatives to reduce losses and boost profitability. It recently spun off its coal mining operations as SunCoke Energy (NYSE:SXC) and floated some energy logistics assets as an MLP back in 2002. Sunoco maintains a 33.8% stake in Sunoco Logistics (NYSE:SXL) through a 31.8% interest in the limited partner units, and a 2% general partner interest.
By going with the partnership structure for its pipeline operations, Sunoco has managed to reduce its taxes, while still adding to its earnings from these assets. Refiner Tesoro (NYSE:TSO) also caught the bug in early 2011 and floated its logistic assets as Tesoro Logistics (NASDAQ:TLLP).
Given the high likelihood of Marathon going forward with its plans to issue an IPO for its pipeline assets, current and would-be investors have some decisions to make. Unlike Sunoco — which will emerge as a leading supplier of transportation fuels, once it rids itself of its refinery assets, and could unlock value from its nonrefining businesses — Marathon will still be straight refining stock. While the tax aspect of the spin-off will certainly help, Marathon will still be at the whims of crude oil and gasoline pricing.
To that end, the better bet might be in Marathon’s pipeline MLP. Consider Sunoco Logistics, which has significantly outperformed Sunoco by a wide margin. Since 2007, shares of the MLP would have returned around 100%, not including dividends. For investors in the refiner, their return is closer to a 40% loss. Tack on SXL’s continually growing 4.5% dividend yield, and the case for buying Marathon’s spin-off grows.
Before making any decision, I’d wait to see the conditions of the IPO, what assets will be placed in the structure, pricing, etc. But if history is any indication, the MLP will outperform the refiner by a wide margin. For investors, that could be the best bet.
As of this writing, Aaron Levitt doesn’t own any securities mentioned here.
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