Description

Blueknight Energy Partners

Blueknight Energy Partners (“Blueknight” or the “Partnership”) is a publicly-traded master limited partnership which owns and operates crude oil terminals and pipelines and asphalt storage facilities in some key strategic locations across the United States.  As will be explained later, prior to the autumn of 2010, Blueknight was known as Semgroup Energy Partners, LP (or “SGLP”).  There are two securities in Blueknight that we will discuss:

(i)                  the common limited partnership units which trade on the NASDAQ under the ticker BKEP (the “Common LP Units”); and

(ii)                the 11% convertible preferred stock which trades on the NASDAQ under “BKEPP” (the “Series A Preferred”). 

Background and History

SGLP was formed in 2007 as an affiliated master limited partnership of SemGroup, LP (“SemGroup” or the “Former Parent”).  VIC readers may be familiar with the bankruptcy of privately-owned SemGroup in the summer of 2008 after it lost $2 billion trading in oil derivatives.  Because SemGroup was SGLP’s largest customer at the time, the bankruptcy disrupted SGLP’s operations while it had to find new customers, but the ultimate quality of SGLP’s underlying assets endured.  After SemGroup’s bankruptcy, SGLP became independent of its Former Parent, and it is now known as Blueknight Energy Partners.   The Partnership never filed for bankruptcy, and there were no material liabilities related to the SemGroup bankruptcy or trading activities at Blueknight.   

During the Partnership’s transitional period after SemGroup’s bankruptcy, it suspended payment of distributions on its publicly-traded Common LP Units.  A majority of Blueknight’s revenues had accrued from storage and transportation contracts with its Former Parent, and the Partnership had to stabilize the overall business.  Blueknight owns high quality fee-based assets, and this stabilization occurred over the last few years as it has contracted with new customers (at similar rates to that which its Former Parent had paid) and recapitalized its balance sheet to substantially lower its total leverage, which now stands at approximately 3x EBITDA. 

As part of SemGroup’s bankruptcy, Elliott Management gained control of the general partnership interest in Blueknight.  Elliott subsequently sold the general partnership interest to Vitol, a privately-owned major global energy marketing and trading firm.  Vitol then teamed with Charlesbank, a well-known Boston-based private equity firm, to recapitalize Blueknight in 2010-2011.  Currently, Vitol and Charlesbank each own 50% of Blueknight’s general partner.  As part of this recapitalization:

• Vitol and Charlesbank invested $125 million through Series A Preferred;
• the subordinated MLP units of Blueknight that were held by the general partner were cancelled;
• the distribution on the Common LP Units was reinstated at a minimum level of 11 cents per quarter  (minimum quarterly distribution or “MQD”);
• a rights offering for the convertible preferred (the Series A Preferred) was held for the common LP unitholders; and
• the distribution schedule for the general partner incentive distribution rights (IDRs) was reset

It is important to note that there was a well-documented dispute between Vitol/Charlesbank and major holders of the LP units from 2010-2011 as part of the negotiation of the recapitalization of the Partnership.  Rather than dedicate this write-up to retelling that story, Blueknight’s 10-K and other public filings (such as the proxy dated July 28, 2011) provide a detailed summary of the history of that issue.  Ultimately, the final recapitalization proposal was supported by the major holders of the Common LP Units, and the rights offering of Series A Preferred in October 2011 to such holders was significantly oversubscribed.  The unit-holder vote and rights offering ended the dispute, allowing Blueknight to finalize its recapitalization and move forward under a business plan to continue improving its existing assets and pursue new growth opportunities.

Business Overview and Key Assets

Today, Blueknight continues to own and operate a collection of desirable midstream fee-based assets in some key locations.  

• Crude storage and terminals – 7.8 million barrels of crude terminalling faclilities and storage tanks, including 34 storage tanks with approximately 6.6 million barrels of capacity at its terminals in Cushing, OK.  In addition to the Cushing operations, there are 430,000 barrels of capacity at the Partnership’s Longview, TX terminal and 787,000 barrels of storage at various points along Blueknight’s pipeline and gathering system.
• Crude pipelines – 1,289 miles of crude oil pipeline primarily in Oklahoma and Texas, including and the 820 mile Mid-Continent Mainline System, the 139 mile Eagle North Pipeline System, and over 300 miles of pipeline related to the Longview System.
• Producer field and Crude oil transport services – Approximately 130 producer field service trucks and 150 tanker truck.  
• Asphalt storage – 44 terminals across 22 states providing 7.2 million barrels of asphalt and residential fuel oil storage capacity.  43 of these 44 terminals are under long-term contract through 2016. 
• Expansion Opportunities – So far this year, the Partnership has announced $47 million of growth projects that will increase free cash once they are completed in mid-2013.  These include the recently announced $37 million Arbuckle pipeline in TX/OK under long-term agreement with XTO (Exxon-Mobil).  Blueknight is also working on opportunities to extend other pipelines to support key customers and has approximately 10 acres of land at Cushing, OK that could support additional storage capacity of 1 million barrels. 

Importantly, Blueknight does not engage in marketing and does not take title to products that it moves; it therefore has minimal direct commodity price exposure. 

Valuation

The Partnership’s fee-based assets generate reliable free cash flow with low capital expenditure requirements on a normalized basis.  Using management’s stated 2012 estimates, the free cash flow profile is:

Note: 2012 has higher than normal maintenance capex due to some deferred maintenance during the Partnership’s transitional period after SemGroup’s bankruptcy.  The “As-Converted” column illustrates the dilutive effect of the convertible preferred using the “Normalized” cash flow.

The partnership estimated that it may generate approximately $68 million of EBITDA this year.  Maintenance capex in 2012 will be elevated (due to some deferred capex from the last two years) at approximately $17 million.  Typically, the partnership might expect maintenance capex of about $12.5 million per year.  In addition, the Arbuckle project, described earlier, may contribute approximately $5-6 million of EBITDA and 6-10 cents of additional cash flow per unit by the time it is on line, based on the published estimates of one research analyst and the Partnership’s general comments about the financial parameters of the project.  (This will come on-line in mid-2013 and is not included in the cash flow estimates set forth above.)  We would also note that the Partnership, with essentially the same set of assets, generated over $100 million of annualized EBITDA before the former Parent’s bankruptcy in 2008, so the $68 million of baseline operating earnings could reasonably have some additional upside as deferred capex is addressed and operations continue to be turned around. 

BKEP Common LP Units – the Partnership is currently paying a dividend to the holders of these units at the minimum quarterly distribution rate of $0.11 per quarter.  These units are currently trading at ~$6.42, implying a current yield of 6.9%.  It is important to understand that Blueknight now has among the lowest total leverage of any publicly-traded MLP with Net Debt/EBITDA of approximately 3.1x EBITDA, while having one of the highest LP unit yields in the same universe (other mid-stream crude MLPs have sub 5% yields despite lower potential distribution growth profiles).  Meanwhile, the Partnership may generate distributable cash flow in 2012 of $15.6 million, or $0.69 per unit, (after the 11% dividend on the convertible preferred), based on the estimates from management.    Accordingly, the coverage ratio on the common dividend is 1.6x, which is astounding for an MLP with these type of quality assets.  Typically, this ratio would be 1.05-1.20x, at the high end, suggesting the Partnership is under-distributing currently.  On a fully-diluted as-converted basis, we believe this partnership has numerous levers (such as increasing the payout ratio, normalizing free cash flow, and new projects) to grow its common unit distributions by 56% to over 17 cents per quarter based on the Partnership’s current earnings power.  Indeed, the IDR’s establish the incentive for the general partner to raise the distribution to 18.25 cents per quarter over the next 2-3 years.  As shown below, we calculate the Partnership’s illustrative near-term distribution power using the following assumptions:

• Maintenance capex normalizes around $12.5 million per year.
• An estimated contribution from the Arbuckle pipeline project slated for completion in mid-2013
• Raising the payout ratio but still allowing for 1.15x distribution coverage (which would still be in the upper range of comparable companies)
• No contribution from Growth Capex beyond the $50 million in 2012.  The Partnership is targeting mid-teens returns on future growth projects.
• Accounts for revised IDR splits, which results in Common LP Units receiving approximately 90% of the earnings power at this distribution rate.

In the July 2011 Proxy, the Partnership offered the following longer-range forecasts assuming its long-term business plan:

Both current earnings power and management’s business plan suggest that there is ample opportunity for significant increases in distributions to the Common LP Units.

BKEP Series A Convertible Preferred Units – The Series A Preferred securities convert into the Common LP Units at a price of $6.50 per unit and pay a coupon of 11% per year.  These are the same securities that Vitol and Charlesbank, who jointly own the general partner, own via their investment of $125 million in the recapitalization described earlier. If Vitol and Charlesbank convert to common, they would bring along the rest of the holders.  Also, the preferred convert after October 2015 if the common price is at least 130% of the conversion price.  Despite the conversion option of these securities being at the money (and, at various times during the past year, meaningfully in-the-money), they trade at $8.60 which offers an 8.3% yield.  The total enterprise value through the convertible preferred is only 6.1x.  Particularly considering the quality of the underlying assets, we believe the risk-reward for these securities is extremely attractive. 

There is scant research coverage and liquidity can be limited, but we believe both securities offer compelling investments.

Risks

Potential conflicting interests with GP, Customer relationship with Vitol, declines in storage/terminal rates, and interest rate risk.

Disclaimer

We now own any of the securities discussed above, and may decide to buy or sell such securities at any time of our choosing without providing an update.

Catalyst