Description

OCI Partners L.P. (OCIP-US)

This might be one of the best upside/downside opportunity I have seen this year. The investment thesis basically boils down to this:

1. OCIP is trading at 7x my 2017 FCF estimate, less than 5.5x FCF if some of management’s cost savings estimates are to be believed. I see a wide valuation range between $3.75 to $20+.

2. This busted MLP pays all its distributable cash so you will receive this real FCF. No IDRs GP splits or any of that non-sense. This will serve as a hard catalyst.

3. Opportunity exists because of a confluence of negative developments: a) MLP cost of capital advantage, drop down potential etc. didn’t work out as planned, b) IRS suggests methanol not MLP’able c) debottlenecking capital blowout, d) methanol and ammonia prices were at trough or close to trough leading to distribution cut to zero, e) sell-side drops coverage g) proposed CF acquisition of OCI (sponsor) scrapped h) OCIP warned in 3Q16 of imminent debt covenant breaches potentially leading to default

4. However, Egyptian billionaire Sawiris Nassef (biggest holder of OCI NV, sponsor) arranged for $200 mln intercompany loan to fix it and continues to aggressively buy OCIP personally. Downside is therefore protected by Nassef, underlying asset value and ultimately Methanex would buy OCIP if discrepancy is unreasonable between intrinsic value and quoted unit price

Background

I have followed Methanex for a long time and continue to underappreciate how well it is run despite it being in a commodity business – I would guess VIC agrees with this as Methanex has been written up 7 times. I also was in search for any other busted MLPs the market is mispricing, inspired by the great writeups such as PTXP and WPZ. This is how I stumbled upon OCIP – a busted MLP that hasn’t re-rated yet.

History

Sawiris Nassef (https://en.wikipedia.org/wiki/Nassef_Sawiris) is the richest Egyptian with an estimated net worth of > US$5 bln according to Forbes. Without going into too much detail, Nassef owns about half of OCI NV which is a producer of natural gas based chemicals including nitrogen based fertilizers and methanol.

Due to high natural gas prices (before the shale boom), many chemical plants using natural gas as a feedstock shutdown in the US. Nassef decided in 2011 to be a contrarian investor and bought 50% of Eastman’s plant in Beaumont, Texas for $26.5 mln (shutdown since 2004). Shortly after, Nassef bought out the other 50% and refurbished/restarted the plant for an additional $300 mln – it uses natural gas as a feedstock and produces methanol and ammonia.

http://www.ocipartnerslp.com/content.php?page=about-oci-beaumont

At the time MLPs were all the rage so Nassef decided to form OCIP to take advantage. The OCIP MLP structure was different than the typical MLP in 2 aspects: 1) no GP IDR or other special incentives, 2) no minimum quarterly distribution, just pay 100% of distributable cash which is virtually a FCF calculation using maintenance capex and a minor capex reserve amount. The plan was to spend some capital to debottleneck and increase both methanol and ammonia production capacity by ~25% and dropdown sponsor OCI’s assets into OCIP when they are complete.

With an 2013 IPO price of $18, things went as planned with sell-side coverage and analysts expecting close to $3 per unit in future distributions per unit (and $30+ price targets). Things went well for a while as OCIP traded in the mid $20s, in anticipation of a ~$150 mln debottlenecking project that would increase production of methanol and ammonia. Keep in mind, methanol and ammonia prices were quite high. For methanol, this was driven by high oil prices (as it relates to methanol’s energy related demand). For ammonia, this was driven by robust farmer economics and high marginal cost of ammonia coming out of a disadvantaged Ukraine (gas costs at the mercy of the Russians).

Soon after, everything that could go wrong went wrong for OCIP:

1. Debottleneck Project – Instead of $150 mln, OCIP ends up spending $384 mln. It seems like a lot of the cost overrun had to do with additional environmental equipment considerations. It is important to note that the sponsor OCI backstopped the capital cost overruns by buying addition OCIP units, the injections were $60 mln for 3 mln units and $40 mln for 3.5 mln units. This took OCI’s interest in OCIP up to 80% today

2. Operational mishaps – Related or unrelated to the debottlenecking, OCIP ran into operational issues that hurt production

3. IRS – IRS announces methanol will likely not be considered qualifying income. However, since OCIP got private letter ruling, they will not be taxed for 10 years, meaning probably tax free until 2023.

4. Methanol and ammonia prices tumble. Methanol prices was likely dragged down by oil prices and slowing Chinese demand while ammonia prices dropped due to lower crop prices etc. Going through the transcripts you can see management’s distributable cash guidance steadily dropped from > $2 per unit to a low of $0.24 per unit in 1Q16 before being scrapped completely due to the pricing environment and debt covenant concerns

5. Throughout this time, OCIP had to seek numerous amendments to avoid breaching debt covenants.

6. OCIP units reached a low when it freaked the market out by coming out suggesting they will likely breach debt covenants by December 31, 2016

As of September 30, 2016, the Partnership was in compliance with all these covenants. Due primarily to decreases in average sales prices, management believes we may not be in compliance with certain covenants as of December 31, 2016 and thereafter. We expect to explore multiple options to prevent or remediate such noncompliance, including refinancing the credit facilities and/or seeking waivers or amendments to the credit facilities.

It is important to note for 3Q16, OCIP realized $216/mt for methanol and $235/mt for ammonia.

That sounds terrible, why is now the time to buy OCIP?

Let’s be honest, I probably missed the bottom on this one but there was a real chance minority unitholders of OCIP get massively diluted if they were to do a massive rights offering or some sort of advantageous equity deal with OCI to cure the expected debt covenant breach. The actions since 3Q16 results convince me minority unitholders will not get hosed because:

1. Nassef has arranged a $200 mln intercompany loan from OCI

http://ocipartnerslp.investorroom.com/2016-11-21-OCI-Partners-LP-Receives-Lender-Consent-to-Amend-Its-Term-Loan

2. Nassef has continued to personally buy OCIP units

3. Methanol prices has since rebounded a lot making distributions resumption highly likely – we will touch on that in the valuation section.

4. I am sorry I didn’t finish this writeup one day earlier but OCIP just got the amendment they need for its Term Loan:

http://ocipartnerslp.investorroom.com/2016-11-30-OCI-Partners-LP-Announces-Closing-of-Term-Loan-Amendment

The above developments are huge because I could see various scenarios where minority unitholders get mistreated but the fact Nassef arranges for an intercompany loan, gets the covenant relief/amendment and just buys units in the open market himself speaks volumes to treating unitholders at least somewhat fairly. Also for someone with a $5 bln net worth and a 40% effective stake in OCIP (50% of OCI which owns 80% of OCIP), OCIP must be pretty darn undervalued for Nassef to be personally buying OCIP in the market separately.

Understanding the Business and Valuation

The business is very easy to understand which makes valuation a pretty straightforward task. The trouble, as always with commodity businesses, is forecasting methanol and ammonia prices. In this particular case I will lay out some scenarios that show the risk/reward is very asymmetric without the need to be correct on the commodity call with any level of precision.

Readers can get up to speed on methanol by looking at this highly rated write-up: https://www.valueinvestorsclub.com/idea/METHANEX_CORP/136060

For ammonia, please check out some nitrogen fertilizer producer write-ups such as this one:

https://www.valueinvestorsclub.com/idea/CF_INDUSTRIES_HOLDINGS_INC/138130

(I’m not being lazy here but it is just too hard to forecast methanol prices, I would have thought for instance that the Asia methanol price is set by coal producers there and US and Europe prices would be at a premium to the Asian price. The irony is US methanol prices traded at a discount to that because of inventory and new production coming on. And now there is a coal shortage (imagine that) in China apparently raising the methanol cost curve. At the same time you have Trinidad gas issues and now OPEC appears to be cooperating and that helps. Rest assured I thought about the commodities exhaustively, I just don’t think precise forecasts matter much here)

Back to the business. For OCIP, they own a facility that basically uses natural gas as a feedstock and adds steam and out comes methanol and ammonia.

Key numbers:

• Annual methanol capacity 912,500 mt

• Annual ammonia capacity 331,000 mt

• Natural gas usage 110,000 to 120,000 mmbtu per day

• Maintenance capex $12 mln (debottlenecking done, including additional maintenance reserve for major turnaround in 2018)

• Interest cost $40 mln

• Units outstanding 87 mln

• Net debt 452 mln

Starting with the Downside Case

I would frame the downside by saying probably 3Q16 prices are pretty close to trough - $214/mt methanol and $235/ammonia. I could be wrong but at least methanol prices are significantly higher currently.

At any rate, plugging in $3.35/mmbtu gas $214/mt methanol and $235/ammonia, I get a negative FCF number but in this draconian scenario, I am inclined to give partial credit for the cost savings management outlined during the call (see below).

Over the last several months we've taken various steps to reduce both our fixed and variable costs, and our capital expenditure for 2017. As a result we anticipate approximately $30 million of savings compared to the cost incurred during 2016. This concludes our business update. I will now hand over to Fady who will provide a (inaudible) of our financial performance.

Putting in $20 mln in cost savings, I get FCF of $0.19. I don’t know how much one should pay for a trough FCF yield. I would take a stab and say 5%? In that case downside is $3.75.

Another way to frame the downside is to look at what OCIP has put into the facility since inception. $25 mln (initial 50% stake) + $300 mln (remainder + restart) + $384 mln (debottleneck project). That works out to $3 per unit after taking out the debt.

Base Case

The problem with the downside case is that it is completely unreasonable because methanol prices are significantly higher. In fact Methanex just posted its December price at $366/mt

https://www.methanex.com/sites/default/files/methanol-price/Mx-Price-Sheet%20-%20Nov%2029%2C%202016.pdf

With OCIP getting a 15-20% discount to posted prices, one can assume a $300/mt realized price.

Putting $300/mt methanol, $235/ammonia and no cost savings. I get FCF of $0.84 per unit putting OCIP at 7x FCF. Give them $20 mln in cost savings I get FCF $1.6 per unit or 5.5x FCF.

I don’t know what a FCF multiple you would put here but I think OCIP could easily be worth north of $10 per unit.

Upside Case

We do not have to resort to recent peak prices (i.e. $500/mt methanol) to get a lot of upside in OCIP. In fact, the latest Methanex write-up author suggested a mid-cycle $350/mt realized methanol price – I do not disagree.

Put in $350/mt realized methanol, $300/mt ammonia, $20 mln cost savings and you get some crazy FCF numbers - $1.8 per unit. This has OCIP trading at 3x FCF. I see OCIP potentially worth > $20 per unit under this scenario.

Other valuation yardsticks

• I understand OCIP’s facility is insured for $1 bln. Obviously OCIP may over or under insure – who knows. As a check, net of debt, that pegs OCIP equity value in the facility at $6.30

• Replacement cost – just from following Methanex I understand greenfield projects are ~ $1000/mt. I think CF and others cancelled nitrogen/ammonia projects because capex was north of that per mt. Plugging in 1,000/mt gets OCIP units at $14/unit

A note on cost savings. While OCI doesn’t have IDRs on OCIP, they are probably a bit generous on the reimbursable G&A costs. I’m guessing there is a bit of fat to trim based on a scan of executive compensation – seems to be an awful lot of “all other compensation”, for instance.

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Potential for Methanex Takeout

The usual argument for a takeout is just from a valuation perspective, which I discussed above. I think there are 3 additional considerations that make an acquisition of OCIP, especially if it continues to languish, attractive for Methanex:

1. Methanex already knows the asset well, being one of the top 3 customers for OCIP’s methanol. As well Methanex publishes and manages the non-discounted reference methanol prices for the industry (which probably helps them realize prices higher than if everything ran at spot prices). However, Methanex only commands around 15% market share, and that includes the methanol they purchase and resell. My guess is Methanex needs to keep up a certain level of market share to continue to set prices for the industry and indirectly influence industry discipline.

2. Methanex can add value by setting up a natural gas price sharing contract with a natural gas supplier/producer. OCIP currently runs unhedged and pays spot natural gas prices – making distributable cash particularly volatile. Having a long-term contract with a base natural gas price plus methanol price sharing helps make the operations more manageable.

3. For the last 15 years, Methanex likely learned its lesson the competitive advantage is not via building plants where natural gas costs are theoretically low but by having facilities in jurisdiction with gas supply certainty. For instance, Methanex’s Chilean plants never got enough gas and they had to move a plant and run at below capacity. Same with its plant in Egypt that theoretically has access to very low cost gas. And even Trinidad is experiencing gas supply interruptions. It is reasonable to think Methanex will continue to add North American capacity and especially if OCIP represents an opportunity to have immediate production at less than $1,000/mt greenfield.

Who’s on the Other Side of the Trade?

I’m guessing there is a healthy amount of tax loss selling and investors who bought OCIP for its “yield” – possibly retail investors but I can’t be sure. It is amazing how Methanex has reacted to the methanol prices rebound whereas OCIP has completely ignored the commodity price move (perhaps for some of the reasons discussed in the write-up and also the sell side has abandoned coverage on OCIP).

Disclaimer: The write-up is only intended for VIC members and not for dissemination (especially to the issuer).

Not investment advice, no warranties expressed or implied, subject to material and potentially egregious errors. Basically, do your own homework.

Catalyst

Debt covenant breach risk removed

OCIP realizes current methanol prices