What some may see as an average domestic refinery play is actually an opportunity to own the single most valuable nitrogen fertilizer asset in North America at a deep discount to intrinsic value – we believe CVI is worth somewhere between $25 and $55 per share (implying more than 150% upside from current levels). In an uncertain economy, CVI is a scarce and valuable inflation protected resource with hard assets and significant, yet overlooked FCF generation potential.  Furthermore, any spike in natural gas prices or a multiple re-rating in the currently undervalued refinery sector would create meaningful upside to our valuation targets.  Perhaps most importantly, the first critical catalyst for realizing this value is imminent – the Company has already legally separated out its extremely profitable, yet heretofore overlooked and underappreciated fertilizer segment into a tax advantaged MLP structure and plans a public flotation within the next 6-9 months.  Until the MLP offering occurs, CVI falls through the cracks as energy investors don’t know how to value the fertilizer assets and vice versa.  In effect, there is currently no natural shareholder base, a situation which has temporarily obscured what we believe is tremendous underlying value.

 

What follows is an overview of the primary refining assets, then a look at the unique fertilizer assets (the real value driver here), followed by a detailed valuation analysis that supports our $55 potential price target.  There simply isn’t enough room in this posting to cover many of the interesting details here (but we’ve tried to at least briefly touch on them), so we would refer you to the Company’s extremely helpful S-1 that was filed in October.

 

 

 

 

Supply is Shrinking – No new refinery has been built in the US in over 30 years due largely to environmental regulatory requirements, high capital costs and historical excess capacity.  In fact, domestic refinery capacity has decreased by 7% since 1981 even as domestic consumption has increased dramatically during that same time period.  More than 175 small, unsophisticated refineries were shut down as they were unable to economically process heavy crude (a competitive advantage that CVI possesses and even continues to improve upon).  Strict US fuel specifications and rising foreign demand for refined products also limit the threat of further refined product imports (which currently account for approximately 12% of US consumption).  The implementation of federal Tier II low sulfur fuel regulations is expected to only further reduce existing domestic refinery capacity as well as import suitability.  As a result of these supply-side shifts, average domestic refinery utilization increased from 69% in 1981 to 93% by 2004.

 

Scarce Asset – Because of the supply situation described above (no new domestic greenfield refinery in 3 decades), there is actually no real market by which to gauge true replacement costs today, however, there are recent US expansion projects that can give us a sense for underlying asset values as well as greenfield projects abroad we can look to (where environmental regulations are often less stringent).  Domestically, recent expansions have occurred in the range of $15,000 to $25,000 per barrel of refining capacity.  Abroad, the current newbuilds are expected to come in at or above the high end of this range.  We will cover the implications of these data points in detail in the valuation section below, but for now, suffice it to say that high quality domestic refining assets are scarce resources, new projects are virtually impossible to greenfield and expansions are extremely expensive (with construction cost estimates continually on the rise).  In general, it is our view that the public market valuations of the refining sector are currently underestimating this scarcity value (many are now trading below their estimated replacement cost) and we believe that there is a strong possibility of a significant sector re-rating as we remain in an environment of sustained high utilization rates (a scenario which would be incrementally positive to our valuation analysis).

 

Demand is Growing – Projections from the federal Energy Information Administration (EIA) indicate that US demand for refined product will continue to outstrip increases in domestic refining capacity for the next 20 years (1.5% per year vs. 1.3% per year).  Approximately 83% of this demand growth is expected to come from increased consumption of light refined products, which are more difficult and costly to produce, disproportionately benefiting the more complex refineries such as CVI.  As a result of continued anticipated demand strength (and extremely limited supply response), the EIA projects that domestic refinery utilization levels will remain between 92% and 95% for the next 20 years.

 

Regional Shortages Equal Higher Profitability – Demand in CVI’s region (Midwest PADD II) currently outstrips supply by 22%, providing strong support to regional utilization rates.  Local refiners also generally earn higher margins on product sales than those who must rely on pipelines for supply.  As a result, CVI has generated refining margins (2-1-1 crack spread) that have exceeded US Gulf Coast margins by $1.74/barrel on average for the last four years (and this is prior to the major investments and improvements that have recently been implemented, discussed below).

Location is Key – CVI is located just 100 miles from Cushing, OK, one of the largest crude oil trading and storage hubs in the US, served by pipelines from the US Gulf as well as Canada.  As a result, the refinery will continue to benefit from convenient access to increasing supplies of much cheaper heavy crudes from the Canadian Oil Sands, increasing its refining margins versus peers more reliant on light sweet crudes.

 

Significant Recent Investments – Over the last 3 years, CVI has implemented a sweeping $673 million capital improvement plan (fully 30% of the Company’s entire current enterprise value) that has increased overall refinery throughput, enhanced yields of favorably priced distillates, diversified the crude feedstock variety (lowering raw material costs) and improved plant operations (increasing efficiency, reliability, flexibility and environmental and safety compliance).

Improving Long-term Profitability – Although refining margins can be volatile during short time periods due to seasonality of demand, refinery outages, adverse weather conditions and inventory levels, long-term average profits have been increasing for more than a decade as a result of the improving supply/demand fundamentals within the industry.  The following data from Platts illustrates this with a rolling average of the NYMEX based 2-1-1 crack spread from 1994 through the first half of this year:

 

Increasing Complexity – CVI’s complexity allows it to optimize the yields of higher value transportation fuels, which currently account for 93% of their liquid production output.  Furthermore, as a result of the recent investments described above, this complexity has increased significantly (from a Solomon score of around 9.0 to the most recently reported 11.1).

 

Now is the Time to Buy Refiners – As much as we are fundamental research-driven value investors, we cannot help but point out the strong technical pattern that this sector’s securities have exhibited over the past two decades.  As the chart below shows, shares of publicly traded refiners have generated a positive return for the 6 months from December to May in 17 of the last 18 years and have bested their performance during the other 6 months of the year in 15 of those 18 years.

 

Aligned Incentives – Goldman Sachs and Kelso (private equity firm) remain the 2 largest shareholders in the Company, with a combined 77% ownership.  They did not sell a single share in the CVI IPO.  We believe that this is because they recognize the value that remains to be unlocked when the fertilizer segment begins to trade publicly in mid to late 2008.

 

Experienced Management Team – Senior management team averages 28 years of experience each.  CEO has 35 years and has run a refinery nearly 5 times this size (at El Paso and Coastal) as well as a multi-plant fertilizer system.  COO has 33 years and was in charge of one of the largest fertilizer systems in the US.  CFO has 18 years and has been the CFO for 2 fertilizer manufacturers.

 

 

 

 

Unique Lowest Cost Producer – Literally the ONLY operation in North America that utilizes a revolutionary coke gasification process to produce ammonia, making it the LOWEST cost producer of ammonia and UAN on the continent.  As a result of this technology (which utilizes a low-value petroleum coke byproduct from the refinery), CVI requires only 1% of the high cost natural gas that all other nitrogen fertilizer producers depend upon for the production of ammonia.  CVI estimates that its production cost advantage is sustainable at natural gas prices as low as $2.50/mmBtu equivalent (66% below current market levels based on today’s spot price of $7.45).  The plant is also the newest fertilizer plant in North America (built in 2000 and expanded during a full scheduled turnaround in 2006).

 

INVERSE Exposure to Natural Gas Prices – Because natural gas is the primary cost component in manufacturing ammonia, fertilizer prices generally increase with natural gas prices.  As a result, CVI actually BENEFITS from higher natural gas prices not only because its cost structure is unaffected versus its competitors, but also because the price for its output increases right along with everyone else’s in the market, having a dramatic impact on margins in a tight supply/demand environment.  The current natural gas futures market runs through September 2011 and shows that current market expectations for natural gas during that time period fluctuate between $7.58 and $9.12 per mmBtu (2% to 22% above the current spot price), with an expected 4 year average price of $8.18 (10% high than current).  In other words, rising natural gas prices should be a significant benefit to CVI for years to come.

 

Although we have not included the following upside scenario in our valuation, there is a strong argument to be made that natural gas prices are headed much higher than this forward curve would indicate, and/or that prices are vulnerable to short-term spikes (either of which would obviously be extremely lucrative for CVI’s fertilizer operations).  The drivers that may cause such a situation to play out include interruptions as a result of hurricanes or other severe weather, rapidly rising exploration and productions costs both domestically and abroad, declining production curves, continued delays in LNG gasification projects and a lack of LNG imports due to sustained increases in foreign demand.

 

Strong Market Fundamentals – Nitrogen accounts for approximately 60% of worldwide fertilizer consumption and there are no substitutes for nitrogen fertilizers in the cultivation of high-yield crops such as corn.  A growing world population, increases in disposable income and associated improvements in diet (higher incomes = more beef = more feed corn) are all driving increasing high value food supply demands (particularly in India, Latin America and Russia) that are benefiting the nitrogen fertilizer industry.  The expanded use of corn for production of ethanol is also driving demand (2007 corn acreage exceeded 2006 levels by 19%).  As a result of these influences, over the past 45 years, growth in nitrogen fertilizer demand has outstripped growth in global fertilizer demand (by an annual rate of 4.8% vs. 3.7%).

 

Current strong industry fundamentals include US producer UAN inventories that are lower than they were during the prior year, a tight US import market which contracted sharply in late 2006 and nitrogen fertilizer global capacity utilization which is projected to be near 85% through 2010.  These fundamentals have been driven, in part, by increased US corn plantings and increasing worldwide natural gas prices.

 

There is certainly a debate about whether the recent increases in ethanol production (and therefore corn plantings) are sustainable and a significant amount of froth has come out of some ethanol related equities over the last year or so.  We believe that the best metric to consider when determining future fertilizer pricing (aside from future natural gas prices) is to go straight to the primary driver – the price of corn.  Farmers don’t care whether their produce is going to feed cattle or to produce ethanol – they just care how much a bushel of corn can sell for and this drives their planting decision, which directly determines their use of nitrogen fertilizer (roughly 100-160 pounds of nitrogen for each acre of plantings).  Therefore, we believe the best indicator to determine the future health of the nitrogen fertilizer industry is to look at the futures market for corn.  The following table illustrates that the market expects corn prices to remain elevated and in fact to rise as much as 25% from current levels over the next 3 years.  This is also consistent with long-term USDA forecasts.

Location is Key – Because shipping ammonia requires refrigerated or pressurized containers and UAN is more than 65% water, transportation cost is substantial for ammonia and UAN producers.  CVI’s fertilizer assets are located directly in the corn belt, creating a geographic advantage to supply products in this significant region without incurring intermediate transfer, storage, barge or pipeline freight charges.  This substantial cost benefit only further widens CVI’s structural competitive advantage over all other nitrogen fertilizer producers.

 

Upcoming Expansion – CVI is now embarking on a $50m fertilizer plant expansion, which could increase the plant’s capacity to upgrade ammonia into higher margin UAN by 50% to more than 1 million tons per year.  We estimate that this project could generate an incremental $36 million in annual EBITDA at expected market prices (based on independent pricing estimates as per fertilizer experts Blue, Johnson).

Secure Raw Material Source – Refinery byproducts provide 80% of the feedstock necessary for fertilizer production.  A recent 20 year inter-company supply agreement ensures that this will remain the case even after the separation.

 

Upcoming MLP Spin-Out – CVI has already separated the nitrogen assets into a separate legal entity structured as a tax advantaged Master Limited Partnership (MLP) – this was done in conjunction with the CVI IPO.  We believe that this structure will attract yield focused investors and garner a higher valuation as a result – the MLP universe, on average, tends to trade in the range of 15x forward EBITDA.  Management has indicated that they expect to complete this transaction within the next 6-9 months.

 

 

 

 

The bottom line is that we think CVI is worth somewhere between $25 and $55 per share (as much as 155% upside) over the next 2 years.  The table below summarizes our valuation analysis and what follows is a more detailed look at some of our key assumptions: 

To avoid getting too much into the weeds here, it is worth referring you to a July 23, 2007, UBS research report initiating coverage on the US refiners that does an excellent job of providing an explanation of some of the various metrics by which to value refinery assets.  A good starting point (although it ignores profitability per barrel, which would likely favor CVI in this analysis) is to look at a refinery’s enterprise value per equivalent distillation capacity (a formula that effectively adjusts for varying complexities among refineries that impact their product mix).  The analyst provides the current market metrics for the key US refineries and shows that, at the time of the report, the most comparable assets (Valero, Tesoro, Sunoco and Frontier) were trading at a range of between $1,200 and $2,400 per equivalent barrel.  Because the CVI refinery assets are of fairly average complexity within this group (see the chart above), we have chosen a fairly conservative range in the bottom two-thirds of this spectrum for our valuation ($1,400 to $2,000 per equivalent barrel).  We ran our valuation on the demonstrated peak capacity after the improvements made in conjunction with the recent flood-related rebuilding (119,000 barrels per day).  The result is an implied enterprise value of $1.8 to $2.6 billion for the refinery assets alone.  Recall that we mentioned earlier that recent domestic expansion projects have been completing in the range of $15,000 to $25,000 per barrel (and even higher for newbuilds abroad).  For comparison purposes, our equivalent barrel valuation above translates into an implied value per barrel of roughly $15,000 (low case) to $22,000 (high case), entirely consistent (and perhaps conservative) with recent actual examples.

 

We believe the real hidden value in CVI lies within the fertilizer assets, which in our estimation could actually be worth as much or even more than the refinery itself – especially considering the separate public MLP structure that Goldman and Kelso intend to pursue for these assets during the first half of 2008.  The table below shows our analysis of the potential earnings power of the fertilizer assets during 2006 (these pro forma figures were provided in the Company’s recent S-1); in their current form under prevailing market prices (2008 column); and once the anticipated gasification expansion is fully completed (2010 column).  All projections utilize current independent Blue, Johnson average corn belt pricing estimates for both ammonia and UAN.

  

The ammonia capacity in 2006 was lower than true capacity (or historical reality) due to that year’s scheduled turnaround and a one-time hydrogen diversion.  For 2008 and beyond, it is management’s expectation that its on-stream factor should return to the nearly 97% utilization seen in 2005 (in addition to a further 6,500 tons as a result of spare gasifier improvements).  The end result is that CVI should be able to produce 660k tons of UAN next year by upgrading two-thirds of its ammonia production (just as it does now) and then nearly 1 million tons of UAN by the beginning of 2010 when the gasifier expansion project is completed.  Our cost assumptions increase by a 3% CAGR each year from the actual levels seen in 2006.  Due to the literally 99% fixed cost nature of the direct expense cost structure, the impact of anticipated fertilizer market pricing combined with the expected capacity improvements will result in a step-function increase in earnings power for the segment beginning as early as 2008 and improving going forward.

 

As mentioned, the pricing assumptions are straight from an October 2007 report from the pre-eminent independent source for fertilizer and agricultural chemical pricing analysis (Blue, Johnson).  Their current long-term UAN forecast is as follows:

 Finally, we apply a market multiple on the expected fertilizer segment EBITDA.  The pure play public fertilizer comps (POT, MOS, AGU, CF, TRA, TNH) currently trade at a wide forward EBITDA multiple range from about 5.5x to 16x.  We believe that the combination of factors described above (primarily the positive profitability correlation with natural gas prices) and the fact that the fertilizer segment will be spun out in a tax advantaged MLP structure (an analysis of public MLPs shows that they trade at an average implied forward EBITDA multiple of around 15x) gives us confidence that CVI’s fertilizer segment should command a market multiple at or above the high end of the current peer range.  However, we have capped the valuation range in our analysis at 15x and showed scenarios all the way down to what we feel is a very unrealistic 6x multiple to illustrate just how compelling the CVI valuation is at any of these levels.  The result is that we believe that the fertilizer segment alone is worth between $1.0 and $2.7 billion in enterprise value.

There are a number of adjustments to enterprise value other than the relatively straightforward calculations (pro forma debt, cash and minority interest).  These are broken out in the detailed valuation table above.  In short, we have endeavored to be as conservative as possible by essentially charging the equity with the full current value of the flood reconstruction costs, the crude spill remediation efforts, the back payments owed to J. Aron related to the cash flow swap agreement and most importantly, the current market value of completely eliminating the remainder of the dilutive swap agreement (something that management has indicated it does not believe makes economic sense at current levels).  We are treating the valuation as if these payments are all made today, even though no cash has left the Company for any of them yet (as of the last published pro forma balance sheet used herein).  More details on each of these issues is available in the Company’s S-1.  We believe that all of these items together represent a negative adjustment of approximately $780-$790 million.