Refiners Prepare for the Worst … With MLPs

The petroleum refining sector has been on a wild ride for the past year. The situation for companies in the downstream sector earlier in 2012 was pretty grim, with higher crude oil prices putting severe pressure on refiners’ margins, causing many of them to struggle. Energy industry pariahs, many integrated firms began spinning off their refining operations into separately managed stocks and companies.

Those spin-offs now seem to be getting the last laugh on many of their former parents. Crude prices have drifted relatively lower from their peaks, and the glut of natural gas is helping to not only alleviate higher feedstock costs but also lower refiners’ energy bills as well. Not to the mention the sector’s newfound love affair with exporting record amounts of gasoline.

As a result, refiners like Marathon Petroleum (NYSE:MPC) have seen their share prices surge as the new reality has emerged. Overall, the downstream players finally appear back on surer footing.

With refiners now on the winning side of the equation, their boards certainly aren’t going to let them go back to the dark side, even if that means spinning off assets from a spin-off.

Doing the Regulation Dance

While the refining industry has enjoyed higher profit margins over the recent months as the cost of U.S. crude has fallen below the global standard Brent crude prices, President Obama’s reelection has many top refinery CEOs scared. The reason? Future regulations and taxes.

First, refining insiders believe Obama’s second term will usher in a new wave of rules that will have direct ill effects on the downstream sector. Speaking at Deloitte’s annual Oil & Gas Conference in November, Marathon Petroleum CEO Gary Heminger said new and expanded federal regulations, such as the Renewable Fuel Standard and the Corporate Average Fuel Economy (CAFE) standards — have cost the refiners billions over the last few years while cutting use of their products. Phillips 66 (NYSE:PSX) CEO Greg Garland echoed Heminger’s sentiment.

Overall, the numbers of federal rules that seek to cut emissions and increase biofuel use were greatly expanded during Obama’s first term. More stringent rules on emissions have already been discussed, and another four years of policies that will reduce demand for refineries’ petroleum-based fuels could be at hand.

The American Petroleum Institute (API), an industry lobbying group, estimates that EPA rules now in the works, such as a Tier 3 gasoline standard and greenhouse gas rules, could put several U.S. refiners out of business and place others at a significant disadvantage to foreign rivals. The API argues that the EPA’s new particulate matter standards will increase costs and potentially wreck any hiring in the industry.

Those higher costs could come at a time when taxes for the industry will also likely be going up. The whole fiscal cliff mess has thrown corporations for a loop. That uncertainty has created the notion of “save what we can now” before Congress takes away any breaks.

For refiners, the one-two punch of increased regulatory costs plus potentially higher taxes has many now looking for ways to cut any likely liabilities and future taxes.

Great News for Investors

This brings us to the spin-offs of a spin-off.

Many refiners have been drawn to master limited partnerships (MLP) as a way to create tax efficiencies. By placing refining assets and chemical plants, as well as pipelines that feed these facilities into an MLP, the sponsoring firms help avoid taxes and receive back generous distribution payments.

The fiscal cliff also creates a sense of urgency to use the structure as any deficit-cutting deal could limit or prevent firms from creating new MLP subsidiaries in the future.

Already, we’ve seen smaller refiner Alon USA Energy (NYSE:ALJ) spin off Alon USA Partners (NASDAQ:ALDW) as an MLP as well as Marathon doing the same with MPLX (NASDAQ:MPLX). Phillips 66 has now thrown its hand into the MLP ring and will spin-off some assets to investors in the first half of 2013.

While more regulations and taxes aren’t necessarily good from an investing point of view, if they help create more MLP opportunities, I’m all for them.

These refining MLPs are a great way for investors to score some high and tax-advantaged dividends. At the same time, the partnership benefits from “drop-down” transactions with its parent firm. These drop-downs generally are immediately accretive to the MLP’s distributable cash flow and are used to boost cash distributions to unit holders.

Future tax hikes could result in more drop-downs and ultimately be a big boost to shareholders.

Firms like Tesoro Logistics (NASDAQ:TLLP) or the pending Phillips 66 spin-off could actually be better long-term buys than their parent companies because they avoid taxes and serve as just pass-through entities. Plus, the MLP isn’t responsible for meeting EPA regulations; that duty falls to the general partner or sponsoring firm.

For investors, the time could be right to bet on the spin-offs of the spin-offs.

As of this writing, Aaron Levitt didn’t own any securities mentioned here.

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