Description

Northern Tier Energy is a single asset variable-distribution MLP refiner located in the Mid-West (St Paul, MN).  Before discarding this write-up on the basis that it is a refiner, take note of the following.  Of all the refining assets across the globe, this one likely has the most sustainable and defensible earnings stream and trades at half the valuation of its peers.  It will generate meaningful FCF during the trough of the market and provide significant upside to the extent marginal cost producers experience rising margins.  NTI trades at 5.0x P/E v group at 8.0-10.0x and a ~20% dividend/distribution yield on 2014 estimates.  NTI can provide investors with 50-100% return without appreciation in the S&P or refining equities.  While I am well aware refiners are not exactly the most loved businesses, I will try to explain why this asset is superior to other refiners as well as the reason for this unique disconnect in the market.

1. What makes this a good asset
2. Company specific projects
3. Why is the stock mispriced
4. Valuation

What Makes this a Good Asset:

The refining industry has in many ways become a real estate play in the fact that the value is determined by location.  In the past several years, largely as a function of the significant growth in shale oil, crude prices now differ significantly by region.  For example, the price of crude in Europe today is $115/barrel, the US Gulf Coast is $112/barrel, Cushing, OK is $109/barrel, etc.  In a commoditized industry such as this, even a $1.00 per barrel advantage in crude costs is an enormous competitive advantage ($.36/share for NTI). 

NTI’s refinery is located in St. Paul, MN with capacity of ~92.5k bpd.  This location is analogous to Beverly Hills real estate because the refiner has direct access to crude oil that is cheaper than anywhere else in the world.  The company buys Bakken, Syncrude, & Western Canadian crude oil which are $13, $5, and $31/barrel below global prices.  The reason for this advantage is that the Minnesota refinery is located right outside of the Bakken shale and is geographically close to the Canadian Oil sands.  Because the cost to ship crude out of these regions to the global market is substantial, the refinery can realize this transportation cost advantage via lower crude price purchases as compared to its competition.  VLO has a great slide on its website regarding the marginal cost of transporting crude to and from various regions to the extent one is looking for greater detail.  Secondly, the company sells its refined product (gasoline, diesel, etc.) in a market that is short gasoline in the summer.  As a result, gasoline prices are actually higher in the Midwest to justify transportation cost from other regions.  Overall, similar to the ethylene business or the nitrogen fertilizer business, the cost curve is so steep that NTI can generate meaningful FCF when the rest of the global industry is selling at marginal cost. 

It is worth noting why a buyer of crude oil in the Bakken is likely to have access at a significant discount to the global market.  The Bakken area of North Dakota could be classified as the first major shale oil producer in the US.  Production in the region has increased from 240,000 bpd at the end of 2009 to upwards of 850,000 bpd today.  All existing infrastructure to pipe crude out of the region has been exhausted and permitting is extremely time consuming and cost prohibitive.  As a result, the marginal cost to ship crude out of the region is via rail.  Crude costs can run upwards of $15/barrel to ship to the gulf or east coast or can be in the high single digits to ship to Cushing, another discounted market.  Given pricing in the Bakken is effectively determined as global pricing less transportation cost, it is understandable why a refiner in the area has a cost structure advantage.  Additionally, crude oil production is likely to grow substantially over the next several years.  EOG, in their last earnings release, noted a ~50% improvement in the estimated recoverable oil per well in their Bakken acreage and the large producers in the region demonstrated accelerated production quarter over quarter (QEP 20%, CLR 14%, SM 12%, KOG 8%, WPX 7%, etc.).  Overall, it is my opinion that Bakken pricing over time will continue to be dictated by rail economics.   

Bakken Monthly Production Data -  https://www.dmr.nd.gov/oilgas/stats/historicaloilprodstats.pdf

Company Specific Projects:

2013 is a transition year where NTI has two quarters of significant downtime (Q2 & Q4).  The company is investing in its crude unit during these downtimes on projects that are enormously accretive and generate in excess of 100% IRR.  In total, the company is investing $50mm dollars to 1) debottleneck the plant and increase production by 10%, 2) Increase the mix of production towards higher value products, and 3) gain greater access to pipeline capacity and vertically integrate into trucking crude.  While the capacity increase is notable and easy to quantify, the substantial benefit of yield improvement is not immediately obvious to investors.  As we enter 2014, the company’s product mix should see a 3.7% increase in diesel, .50% increase in gasoline, and .9% increase in LPGs, largely at the expense of black oil.  Given diesel sells for $135/barrel v black oil at ~$90, the numbers can be quite meaningful.  Following 2013, the next major downtime for its refinery is expected to be in 2018-2019.  In total, I estimate the projects should add $100mm of additional EBITDA ($1.00/share), providing the company with meaningful FCF growth as we move into 2014.     

Why is the Stock Mispriced:    

1. 2013 is a messy year with two quarters (Q2 & Q4) impacted from significant crude unit downtimes.  This has materially depressed earnings and served as a deterrent to “get ahead” of these shortfalls.  The company does not have any downtime scheduled for 2014 and should experience significant earnings improvement from the capital projects noted above.
2. The company was publicly listed just over a year ago.  As a result, sell-side coverage is spotty and does not publish on the stock with the same kind of frequency as C-Corp refiners.  This is starting to change given the growing liquidity in the stock.
3. NTI just completed a secondary offering, which served as a significant overhang on the stock.  When taking into account this secondary occurred in a period of low volumes (August), I believe it had a large market impact.   
4. Due to the downtime in the second quarter, the distribution dropped considerably on a sequential basis.  It is likely retail ownership (Estimated ~70% of shares) has misinterpreted the decline in profitability as sustainable.
5. The refining industry has been under pressure the past several months as the WTI/Brent spread compressed.  While compression in crude spreads did have a negative impact on margins for NTI, the lack of coverage led to a misunderstanding of the sustainability in earnings. Additionally, the wide WTI/Brent spread experienced earlier this year inflated industry earnings, making it difficult for some investors to understand the value of NTI’s assets.  Now that the spread has narrowed, the superior earnings power should be more apparent. 

Valuation:

I expect NTI to earn $4.25/share in earnings next year based on future strip pricing.  At 8.0x earnings plus the distribution, I believe the stock is reasonably worth $37/share by year end 2014.  For comparative purposes, the group trades at 8.7x 2014 earnings and arguably has greater earnings risk.  In fact, under those same assumptions for HFC (bellwether in mid-con refining), the stock earns approximately the same as NTI, yet HFC is a $45 stock v NTI at $21.  I assume maintenance cap ex of $35mm and turnaround cap ex of $25mm (accrued) such that my distribution estimate for 2014 is approximately is $4/share.  It is also worth pointing out that NTI is well positioned from a liquidity perspective at .5x gross debt/EBITDA (ALDW is at 1.5x and also a variable rate MLP).  This provides the company with optionality of deploying capital into additional discretionary capital projects or possibly repurchasing shares.

Overall, I believe the combination of the heavy retail ownership, secondary offering during the slow month of August has created a unique investment opportunity in NTI.  While refiners are inherently volatile, the variable rate MLP space is subject to even greater non-fundamental fluctuations.  While it is difficult to specifically identify a catalyst (aside from delivering 2014 earnings), the fundamental disconnect both on an absolute and relative basis appears so large, it is difficult to see this stock not appreciably higher down the road.

Catalyst