Description

Investment Thesis:

PBF Energy engages in refining of petroleum products and is the fifth largest independent refinery in the US with two refineries located on the East Coast and one refinery in the Mid-Continent region. PBF is a highly compelling investment candidate as i) the Company is run by a highly experienced and capable management team that have made their careers by buying failing refineries and turning them around, ii) multiple avenues to increase EBITDA in the near future due to expansion of railroad project, other ongoing turnaround and new projects, resolution on RFS by EPA in 2014, spin-off of the logistic business to form a MLP, and the future advantage from being located in the proximity of the Utica shale basin, and iii) shares trade at extremely attractive levels – approx.. 3.0x 2015 estimated EBITDA and approx. 6.6x my worst case EBITDA (worst case scenario multiple is in line with the higher end of current peer trading multiple).

Industry:

Crude refining is a margin based business as both the feedstock and the final refined petroleum product trade as commodities with fluctuating prices which makes managing and valuing the refining business extremely complicated. The key to higher operating margin is simple, i) minimize cost of feedstock and operating expenses, and ii) maximize the yield of high value end product.

The location of the refineries dictates the ability and cost to source the feedstock and deliver the final product. There are currently about 137 refineries in the US with most of the refineries (approx. 50%) based on the gulf coast, where crude is predominantly explored in the US. The refineries on the Gulf Coast are also in an advantageous position to receive the international crude oil transported by sea tanker vessels via the Atlantic. This skewed geographical location of the refineries has created a supply –demand gap among the PADD regions. The East Coast has approx. one-third of the US demand but only one-tenth of the refining capacity. Similarly, demand and production exceeds the refining capacity tin he Mid-Continent region.

The recent US shale boom (thanks to hydraulic fracking and horizontal drilling) is changing the dynamics of the oil industry. With the increased production of oil in the Eagle Ford and Permian region, US refineries now rely less on international crude feedstock. Similarly, with the increase in production in the North (ie. Bakken and Western Canada), refineries located in the Mid-Continent and East Coast now have an alternative to Brent from the Gulf Coast and International seas.

Oil production in the Bakken region has now exceeded 1mm bpd vs. 0.8mm at the end of 2012 and 0.27mm bpd in Jan 2011. Supply transportation infrastructure in the North has yet to catch up with the boom in the oil production resulting in the Bakken and the Canadian Heavy oil trading at a discount to Brent from the Gulf Coast / International and WTI from Cushing region. As the rail infrastructure builds up in the North, the refineries in the Mid-Continent and East Coast regions are well positioned to take advantage of the low cost high yielding WTI crude.

Company:

PBF was founded in 2008 to pursue acquisition of US refineries. The Company was founded by the refinery veteran Thomas O’Malley along with Blackstone and First Reserve as sponsors.  PBF bought three refineries (Delaware City and Paulsboro refinery on the East Coast, and Toledo in the Mid Continent) between 2010 and 2011 for about $1,100 mm in aggregate. The economic downturn and low refining margins provided PBF the opportunity to buy good value-dislocated assets at extremely attractive valuations. Since the acquisitions, PBF has invested in turnaround and new projects reducing operating cost, increasing feedstock options and crude slate flexibility.

1)      Delaware City Refinery: PBF acquired the then closed down Delaware City in June 2010 from Valero for $200mm. Valero had shut down the refinery in Q4 2009 as it was losing about $1mm a day due to high operating expenses. PBF opportunistically acquired the asset at a highly attractive price and as a part of the deal to get the facility operational, PBF was able to negotiate tough cost cuts and long-term contracts with the unions and also obtain concessions from the Delaware state government. Highlights of the refinery:

• Production capacity of 190,000 bpd
• Locate in PADD 1 area; 5000 acre site on Delaware River
• Nelson Complexity Index of 11.3 implying one of the most complex refineries on the east coast and the ability to process heavy crude which equates to higher refining margins.
• Coker facility with capacity to process 25% of crude

PBF restarted the Delaware facility in Oct 2011 and since its acquisition PBF has spent over $500 mm in turnaround and new projects. The turnaround projects (decommissioning of the gassifier unit, converting electric generation unit to use natural gas, and increase hydro-cracker production capacity) have reduced operating expenses by approx. $200mm per year bringing the operating cost below $4.50 per bbl from $7.50 per bbl at the time Valero was running the operations.

2)      Paulsboro: PBF acquired Paulsboro refinery from Valero soon after the acquisition of Delaware City for $357.7 mm. With a Nelson Complexity Index of 13.2 this is one of the most complex refineries on the east coast. Paulsboro also has a coker facility and together with the Delaware City refinery make 100% of the coking capacity on the East Coast. The two East Coast refineries are approx. 30 miles apart making transfer of feedstock and end products from one refinery to another highly economical. Current Delaware crude rail unloading facility allows to transfer up to 45k bpd to the Paulsboro facility providing additional flexibility to refine light sweet WTI crude at cost-advantaged rate.

3)      Toledo Refinery: Toledo is the goose that currently lays the golden eggs for PBF. PBF acquired the facility from Sunoco in March 2011 at an extremely attractive price as Sunoco wanted to exit the refinery business; $575 mm including $125 mm of additional payments paid based on performance of the refinery. At $575 mm, the acquisition cost is less than 1x its current EBITDA. The refinery only processes light/medium and sweet crude and gets most of its WTI crude through pipeline from Canada, the Mid- Continent, the Bakken region and the U.S. Gulf Coast. The refinery is strategically very well located to receive the discounted high quality crude due to the oil production boom in the Bakken and Western Canadian region and to distribute the final product in the Mid-Continent region, region with a huge supply-demand gap. Also, the refinery is merely 100miles from the Utica Shale Basin – a source of cost advantageous feedstock if the shale region plays out in the future.

Summary: 

PBF has been continuously been investing in turnaround and new projects. To improve margins of the east coast refineries, PBF has been investing in i) rail infrastructure to take advantage of the production boom in the Bakken and Canadian Region, and ii) increasing the efficiencies and flexibilities on the refineries to change of crude slate mix – increase yield of high value products. Similarly, PBF has been investing on projects to improve efficiency of the Mid-continent refinery. 

The East Coast refineries have historically received most of the crude oil (mainly Brent) through sea tanker vessels from the International Seas and the Gulf Coast.  The transportation cost of seaborne crude from the Gulf Coast to the East Coast refineries is approx. $4.00 per barrel. As exploration and production in the North have increased in the recent years, PBF has been quick to increase its rail capacity to take advantage of the high yielding WTI crude that has been trading at steep discount to Brent making it more economical from all perspectives. PBF can currently transport WTI from the Bakken for approx. $12.0 per barrel (well below $16.0-$18.0 per barrel other refiners on the East Coast) making it more advantageous to discharge WTI crude when WTI – Brent spread is in low teens or more. Similarly, PBF can discharge Canadian Heavy oil from Western Canada for approx. $18.0 per barrel. With the new rail car facility coming up and expected to complete by the end of 2014, the Company anticipates the transportation cost of Canadian Heavy to drop to $16.50 per barrel.  In 2012, PBF spent about $57mm in expanding and improving existing railroad infrastructure and unloading facility to bring its rail discharging capacity to 110k bpd; 70k from Bakken; 40k of Canadian Heavy crude.  Due to the higher operating efficiency, the discharge capacity has increased to 100k of Bakken, raising current capacity to 140k bpd. In 2013, Board also approved the expansion a third rail crude offloading project to add an additional 40k bpd and bring the total rail crude unloading capacity to 180k. The expansion that was initially estimated to be completed by Q2 2014 but has recently noticed some delays pushing the current expected completion to Q4 2014.

PBF is also working towards reclassifying its crude slate at the East Coast facilities. When PBF restarted the facility in Oct 2011, most of the crude slate was waterborne Brent from the Atlantic. Brent being the most expensive and relatively low yielding crude, PBF had little margins to work from. Currently, with the buildup of the rail infrastructure and operational changes, PBF has the capacity to have a mix approx. 50%, 35%, and 15% of International Brent, Bakken, and Canadian Heavy oil, respectively. After completion of the rail expansion project by the end of 2014, PBF is expected to have capacity to use 1/3^rd of each crude oil.

PBF is currently spending about $85mm in capex on a series of projects to improve the efficiency and flexibility of the Toledo refinery. According to the Company’s estimate, when the projects completes in 2014, the company should achieve additional EBITDA of approx. $70 – 80mm per yr.

Source: Company presentation.

Along with devoloping strategies to source feedstock in most economical manner, the Management has also been highly focused on cost cutting and improving efficiencies at its refineries. Management has not been shy to invest large sums of capital on turnaround and new projects to improve refining margins. The below list shows the capex use and expected returns:  

Valuation:

We valued the Company based on an EV / EBITDA basis using sum-of-parts of the East Coast refineries and Mid-continent refineries to calculate EBITDA. EBITDA is estimated two ways i) expected EBITDA for 2015 based on completion of ongoing turnaround and expansion projects, and ii) worst case EBITDA – no advantage to discharging WTI crude from Bakken and Western Canada; no discounts between WTI and Brent feedstock; narrower crack spreads. The stock is currently trading at below 3x 2015 expected EBITDA implying substantial room for the stock price to improve as and when the projects play out. Assuming worst case scenario, the stock is trading at 6.6x EBITDA which is still within the band where peers are trading, implying sufficient margin of safety if things go drastically wrong for either the Company or the sector/economy in general.

A conservative 4.0 to 4.5x EBITDA on 2015 expected number would imply a stock price of approx. $40 - $45, an upside of 33% - 50%.

Other additional avenues for value expansion:

1. Renewable Fuel Standards (RFS): In 2005, EPA created a program to ensure that transportation fuel sold in the US contained a minimum amount of renewable fuel to lower the amount of greenhouse gases emitted. The program required renewable fuel to be blended into transportation fuel – 9 bln gallons in 2008 gradually increasing to 36bln gallons by 2022. Each refinery is to be allocated a quote of renewable fuel to be blend based on the amount of fuel it sells in the US.

The program has been a disaster as the minimum blend amount quotas had been projected based on the estimated gasoline demand projected in 2008 when the economy was doing great and demand was high. Unfortunately, demand has not caught up with the 2008 estimates and refiners are forced to blend more biofuels into their production mix. The amount of biofuels that can be blended into gasoline is also currently capped at 10% (90/10 fuel) creating a “blend wall”. Last year, the RFS quota was 13.2bln gallons of biofuel but according to the EIA, US consumed 133bln gallons of gasoline, which meant 13.3 bln gallon of biofuel had to be blended into the mix making it unfeasible. This year the situation is worse off given higher blend requirements. Refineries that cannot blend the required quota of biofuel can buy credits in the market via Renewable Identification Number (RIN). The prices of RIN have fluctuated drastically based on the expected blend requirement gap. This year, RIN prices skyrocketed from 10 cents in Jan to more than $1.0 per credit making it highly expensive for refineries to meet the EPA requirement. PBF incurred approx. $112 mm on RIN expense during the first 9 months this year vs. $33 mm for the first 9 months last year in 2012.

EPA is aware of the problem and is getting a lot of backlash from players in the refinery sector and the media in general. O’Malley has especially been very vocal on this topic with his views clearly stated during the quarterly earning calls. Things are finally looking bright for the refineries as in early December EPA came out saying that it would more or less scrap the program in 2014. The elimination of the program will increase EBITDA meaningfully for small refineries like PBF.

1. PBF logistics LP: In August 2013, PBF Logistics, an indirect sub of PBF Energy, confidentially filed with the SEC to IPO its logistics business under the MLP structure. Currently street estimates a minimum of $100mm of EBITDA from the logistics business. A multiple expansion from the current 3x to 7x EBITDA would imply value creation of $400mm or approx. $4.00 per share for PBF.

Management:

Thomas O’Malley, Executive chairman of the Board of Directors, founded the Company with sponsorship from Blackstone and First Reserve and is the man you can bet your money on to create value at PBF given his knowledge about the industry and vision for the Company. He has over 30 years of refinery industry experience, mostly leading turnaround of failing refineries selling them later reaping huge profits for shareholders. O’Malley’s brief history:

• 1963: Started career in the oil industry in the mailroom of Philipp Bros and then went on to become an oil trader and then ultimately CEO of Salomon / Philbro. He brought approx. 26% of Tosco during the 1987 market crash and ultimately ended up being the Chairman and CEO of Tosco. 
• In 2001 sold Tosco to Phillips Petroleum (now Conoco Phillips) for $7.4bln reaping huge profits.
• From 2002 – 2005, Chairman and CEO of Premcor: Soon after O’Malley sold Tosco, he was asked by Blackstone to run Premcor, a struggling Company at the time. In 2004, Premcor bought Delaware City refinery for $900mm (same asset that PBF bought in 2010 for $200mm plus $500mm of turnaround cost), turned it around and sold the Company to Valero for $8.0bln in 2005.
• 2006 – 2011, Chairman of the Board and CEO of Petroplus: O’Malley was again brought in by Blackstone to run the European refinery. Though Blackstone was able to get out of the investment early on, other investors were not lucky enough as the Company got hit in 2008 by debt burden, economic crisis, and weakness in oil prices resulting in eventual bankruptcy in 2012. O’Malley had quit the firm in 2010 to focus on PBF.

The other key person on the team is Thomas Nimbley (“Tom”), CEO, with more than 40years of experience in the refining industry. Tom and O’Malley have previously worked together and so form a good team. Tom has previously worked at Tosco Corp, Phillips Petroleum, and at Conoco Phillips. From 2005 to 2010, Tom operated his own refining consulting firm.

Catalyst