Description

(for a presentation with images, see: Presentation )

What is Petrologistics?

• Petrologistics is an MLP containing a single asset: a facility in Texas that is exclusively used for converting propane into propylene. Currently, this facility is the largest such plant in the United States.
• Petrologistics was taken public in May of 2012 for $17.00/share by the private equity firm Lindsay Goldberg, which continues to hold a ~51% stake in the partnership. Another ~12% stake is owned by the hedge fund York Capital.

What’s the Bull Case?

• The argument for why Petrologistics (“PDH”) is an attractive investment opportunity goes as follows:
  • Propylene has historically been created as a by-product from a) oil refiners, and b) ethylene “crackers”. Depending on the feedstocks used, more or less propylene is produced, with heavier feedstocks producing more propylene.
  • The rise of cheap and plentiful shale gas has led to an increase in the amount of available lighter feedstocks, such as ethane. (It has also led to increased production of propane, which is also important to this story.)
  • As refineries have moved over to lighter feedstocks, the amount of propylene that is produced as a by-product has declined, despite relatively stable demand for propylene, which is primarily used to make polypropylene, a common type of plastic.
  • But propylene can also be produced directly (i.e., not as a by-product) by the dehydrogenation of propane, and since there should be an increasing supply of propane, the economics of this process are compelling.

So What?

• This argument, which is convincingly made by PDH’s management, does in fact have some merit. So what’s the problem?
• The problem is that, although the underlying story is reasonable, the company is also benefiting hugely from some unusual and likely temporary factors. When these factors subside, the true earnings power of PDH is unlikely to produce sufficient cash flow to pay the distributions that unit holders are expecting.
• It is also my contention that the owners of PDH, who were not expecting the windfall profits they are currently enjoying, will be in a hurry to unload their shares when their lock-up expires on 10/30/2012.

The Set Up

• Although the chemistry can sound complicated to a non-specialist, the economics of PDH are in fact extremely straightforward. Indeed, since it operates a single facility, with a single commodity input that it converts to a single commodity output, both of which are transacted at market prices, PDH is among the most transparent companies in the public markets.
• Essentially all of PDH’s gross profit can be calculated by multiplying the volume of propylene sold by the “propane-to-propylene spread”. There is some downtime for maintenance (both planned and un-planned), and some cost for replacing the catalyst material, and expenses such as salaries, utilities and insurance, but the basic economics are driven overwhelmingly by this spread.
• Indeed, given that this spread fluctuates constantly as the two commodity prices move around, it seems almost perverse to base an MLP on such a business, since the distributable cash flow per quarter is likely to be very unstable.

The Twist

• The single biggest reason why PDH is currently “over-earning” is very simple: propane prices are currently artificially low because of the unseasonably warm winter last year. In fact, according the NOAA, last winter was the 4^th warmest winter going back to 1869.
• Roughly 50%of propane demand in the US comes from heating, primarily in the North East. Amusingly, although PDH’s management gives an incredibly detailed explanation of the drivers of their business and the reasons why they are so bullish, they never once mention the words “weather” or “winter” on their earnings call.
• The freakishly warm weather led to a huge buildup in propane inventories, which pushed prices down to artificially low levels (from $1.20/gallon to under $0.80/gallon), as illustrated by the following excerpts from public company earnings calls:
  • “Results for the second quarter of fiscal 2012 were significantly affected by record warm temperatures across most of the country, and in particular, our service territories. In fact, the period from January through March 2012 was reported by NOAA as being the warmest on record in the contiguous United States, capped off by the warmest March on record. These record warm temperatures follow the considerably warmer-than-normal temperatures experienced in the fiscal 2012 first quarter, making the fiscal 2012 heating season one of the most challenging six month periods faced by the industry.” (Suburban Propane, 5/3/2012)
  • “Our financial performance was not at levels we are capable of achieving due principally to the very warm spring weather we encountered in our business units. Rolling 12 month records for warmth continue to be set this quarter. In fact, only Michael Phelps has set more records this past year than the winter has.” (Amerigas Partners, 8/7/2012)
  • “Inflated propane inventories as a result of a very warm winter put downward pressure on propane and ethane prices…” (Enterprise Products, 8/1/2012)
• What about the other side of the spread, namely propylene? Although prices have since fallen significantly to about $0.50/lb as of 8/15/2012 for polymer-grade propylene (Source: DeWitt & Company), prices were highly elevated earlier in the year, reaching almost $0.78/lb in March.
• Needless to say, PDH has been enjoying an anomalously high propane-to-propylene spread. Thus, it is hardly surprising that the owners of the plant elected to take the company public in May of 2012.
• It is not entirely clear what led to the elevated propylene prices in early 2012. According to PDH’s management, this was a predictable consequence of the declining propylene production that is attributable to the move to lighter feedstocks from refiners and crackers— something which they predict will continue in the coming years, implying that higher propylene prices are sustainable.
• Again, while the underlying observation is technically true, it is also misleading. According to the 2/20/2012 issue of PlasticNews:

“The February move resulted from tightness in propylene supply caused by a number of refinery maintenance turnarounds…Refineries temporarily out of production for maintenance included Exxon Mobil Chemical's unit in Baytown, Texas, and Dow Chemical's St. Charles unit in Hahnville, La. A refinery operated by Flint Hills Resources in Port Arthur, Texas, also was down because of a power outage.”

• So the bigger reason for the surging prices was a series of outages (at least one of which was unplanned) at some major refineries. This would partly explain why propylene prices have come back down so rapidly. The truth is probably somewhere in the middle– the shift to lighter feedstocks left the propylene market vulnerable to relatively small supply disruptions.

Basic Economics

• The other reason that propylene prices have declined since March of 2012 is because of lower demand. As mentioned earlier, most propylene is used to produce polypropylene (“PP”). According* to ICIS, “PP goes into packaging, fiber and durables, including automotive, pipe and conduit, and wire and cable.”

* (Source: “Polypropylene market squeezed by feedstocks”, 4/4/2011)

• There are many applications where polyethylene (“PE”) plastic can be substituted for PP. Since PE is derived from ethylene, which is in abundant supply because of the rise of shale gas, this substitution can lead to cost savings. One should note that, according to ICIS, “There is no substitution option in packaging film, however, or with applications that require heat resistance such as under-the-hood automotive applications.”
• An interesting twist is that, because of the completely unrelated surge in cotton prices, PE demand was elevated at the end of 2011 because of its use in textile fibers. This might explain why there wasn’t more substitution of PP to PE. Another reason, according to ICIS, is that “[PP] Producers have kept prices competitive despite high propylene prices, so they haven't lost much share to other materials yet…But how much longer producers can keep this up before they concede some markets is unknown...”
• There is good reason to believe that if propylene prices were to remain at elevated levels (say, the $0.75/lb seen in early 2012) for an extended period of time, there would in fact be real demand destruction. This is because PP producers would eventually need to impose price hikes, and there is a fairly high elasticity of demand for PP on the margin because it is readily substitutable for other kinds of plastics, at least for some major applications. Since PP is by far the largest use for propylene, this would directly impact the price of propylene.
• This is not merely theoretical speculation. On January 13, 2011, Pinnacle Polymers, a producer of PP, posted the following “Market Comment” on its website: “We are looking at increases in feedstock prices for January and February 2011 that are unprecedented in magnitude and which will bring propylene prices within 10 cents of the all time highs reached in 2008. As we have indicated in the past, we are at risk of destroying American manufacturing demand for polypropylene in a permanent fashion. This is very troubling for us and our polypropylene customers, because high prices such as these make it very hard, if not impossible, to maintain sufficient margins. Our margins have already been declining for the last several years.”
• So far, we have discussed the supply and demand for propane, and the demand for propylene. But probably even more important to the financial health of PDH’s operations is the supply outlook for propylene.
• The fact is that propylene is a commodity. The technology to produce propylene from propane (or from methanol/coal) is out there and available to anyone who wants to build a plant. Basic economic theory dictates that if the returns on capital are highly attractive, additional supply will come online until the market is in equilibrium.
• Since there are few barriers to entry (at least among established, well capitalized firms), and there is no “economic moat” or patented technology that is unavailable to competitors, the returns from such a business should not be particularly compelling in the intermediate to long term.

Management’s Rebuttal

• On their first and only earnings call on 7/26/2012, PDH’s management makes the following argument for why they are confident in the future of their business:
  • “...let me tell you why we are unguardedly optimistic about the longer-term prospects for our business. By now you are all well versed in the thesis that has emerged surrounding the very favorable impact of the shale gas development on the US petrochemical industry. I'll repeat the well-worn cliché that it is a game changer, because it truly is.”
  • “We could not be in a better position to benefit from this still-emerging trend as the first and only propane dehydrogenation facility operating in the US today.”
  • “Not surprisingly, others have caught on to the idea and have announced intentions to build PDH facilities as well. We can't predict how many of those facilities will actually get built, but two points are worth noting in that regard. First, any new propylene capacity from PDH facilities will largely be replacing propylene production lost by the continued lightening up of feed slates of existing ethylene crackers. The lightening of the US steam cracker feed slates is well underway and will continue.”
  • “Second, no new PDH facility will be operational prior to the 2015-2016 time period at the earliest. So our first-mover status is one we'll exclusively enjoy for several years to come.”
• There are several problems with this argument, which combines elements of the truth along with some tenuous and misleading logic.
• Shale gas may in fact be a “game changer,” but it doesn’t change the basic laws of economics. An appeal to a large, secular change in the economy is a typical rhetorical device to convince investors to ignore glaring issues with a business model (e.g., the internet bubble).
• The crux of their argument is that they are the only game in town for now. And if there does end up being competition (notice how they imply that some of the announced plants won’t even get built), that competition is years away, so there is no need to worry about it now.
• This argument rings hollow. As we will see, there are several similar (and larger) plants now under construction from highly credible and well capitalized players (e.g., DOW Chemical, Williams, Enterprise Partners, etc.), and one of these plants is scheduled to open in late 2014—about 2 years from now. At the very least, it is hard to see how this argument would lead a reasonable person to be “…unguardedly optimistic about the longer-term prospects…” for PDH.
• To really see why management’s argument is not sensible, we need to understand the underlying economics of constructing a propane dehydrogenization facility. To that end, let’s look at an important table that was included in the prospectus for PDH (this version is from the 8^th amendment to the Form S-1, filed on 5/2/2012):

• First, observe just how sensitive PDH’s earning power is to the propane-to-propylene spread— it doesn’t take much of a move to wipe out their ability to make cash distributions out of operating cash flow. As of PDH’s 7/26/2012 earnings call, the Q2 average spread was about $0.38/lb, and according to management, the then-current spread was $0.27/lb.
• Now, let’s take a look at the implied returns on capital from this table.
• PDH did not construct their facility from scratch. Instead, they purchased a former olefins production site from ExxonMobil in December of 2006—not the depths of the financial crisis for a bargain price, but rather at the height of the credit bubble—and invested capital to convert the plant to produce propylene.
• As of June 30^th, 2012, the carrying value of PDH’s total “property, plant, and equipment, net,” was $596mm, and their inventories were carried at $17mm, a total of $613mm. Annualized depreciation and amortization expense was ~$67mm. Assuming that PDH could earn the forecasted EBITDA for the 12 months ending June, 2013 of $346mm would imply operating income of about $280mm. This would amount to an absurdly high return on capital of 280/613 = ~46%.
• What about the economics for a newly built plant? Williams Companies announced in July that they are going to build a propane dehydrogenization plant with a 1 billion lbs/year capacity (compare to PDH’s facility, which has capacity of 1.2 billion lbs/year). News reports have placed the cost of this facility at between $600mm and $800mm, which suggests that PDH’s carrying value of its plant is not far from its true replacement cost as a newly built facility.

Simple Argument

I believe one of two things will happen:

1. The propane-to-propylene spread will contract to a lower level, causing PDH’s earnings to fall sharply.
2. The spread will persist for a time, but the overwhelmingly attractive returns on capital will quickly lead to a glut of similar capacity within 3 years at most, and this will lead to a sharp contraction of the spread.

Either way, it appears that the best possible outcome for PDH is that they enjoy 3 or maybe 4 years of windfall profits, and then the income will fall sharply as competition comes online.

Thus it is not sensible to value PDH by applying a multiple or yield to their current level of earnings or cash flow. Rather, the steady-state earnings power should be capitalized and added to the NPV of the 3-4 years worth of “excess profits”.

Also, observe that there is also significant short term downside risk to PDH— all it would take is a fairly cold winter to cause the price of propane to surge. Indeed, similar plants in Europe are known to shut down during the winter months because they can’t compete with the heating uses for propane.

• I would go further and suggest that it is far from clear that PDH could sustain this elevated level of earnings even for the 3 or 4 years it takes for the competition to come online. This is because any sustained increase in the price of propylene will likely lead to substitution to alternative inputs.
• Now let’s take a closer look at the competitive situation. As mentioned before, Williams is building a facility in Canada, with ready access to the same markets as PDH via rail (according to Williams management on their 8/2/2012 earnings call, “We do rail, today, a tremendous amount of propylene out of Redwater already today. This would be just additive…we do think the situation is very favorable and very supportive of that project”).
• In addition, Enterprise Products has announced a 1.65 billion lbs/year propylene facility near PDH’s facility. It is important to point out that Enterprise is the largest supplier of propane in the US, and would have a competitive advantage to PDH because of its size and scale (Enterprise has a market cap of almost $50b) as well as strategic access to propane. According to Enterprise’s management on their 8/1/2012 earnings call, “…we think the returns are going to be very nice for us.”
• That’s not all– Dow Chemical, PDH’s largest customer, representing almost half of PDH’s revenues, has announced not one but two propane dehydrogenization plants of exactly the same kind as PDH’s, located in the same region as PDH’s plant. The first of these is scheduled to open in 2015.
• It is hardly surprising that more and more projects are coming out of the woodwork, inspired by the juicy returns to be had in a commodity conversion business. According to a 5/25/2012 article in ICIS (“Tight US propylene may lead to two more PDH plants”):

“These new plants would join the sole operating PDH plant in the US, PetroLogistics's 544,000 tonnes/year unit. Meanwhile, LyondellBasell is expanding the capacity of an existing metathesis unit, allowing it to consume an additional 500m bbl/year (227,000 tonnes/year) of ethylene to produce propylene.

Even with these latest projects, at least two additional companies are considering PDH plants, Bauman said. Another producer is considering a methane-to-propylene (MTP) plant, which could add at least 500,000 tonnes/year, he said. Fasullo expects that the derivatives produced from all of this new propylene will be targeted for export. “ I don't think our domestic demand can absorb all of this," he said.”

Valuation

• Let’s now take a look at the valuation of PDH as of 9/5/2012. With a market cap of $1.85b, and $343mm of debt and $43mm of cash, the enterprise value of PDH is ~$2.15 billion.
• The replacement cost for PDH’s facility is almost certainly $1 billion or less. Thus, one way to think about the situation is that you are paying about $1.1 billion for 3 or 4 years of excess profits. At a 12% unlevered return, such a facility would still be a relatively attractive capital project. This would imply steady-state operating profit of ~$120mm/yr.
• According to the sensitivity table given in PDH’s S-1 filing, this ~$120mm/yr level of operating profit would be consistent with a $0.27/lb spread—coincidentally, the then-current spread as of their 7/26/2012 earnings call. So, even in an optimistic scenario for PDH, where they can earn $280mm in operating profit, this would imply “excess profit” of $160mm. On an undiscounted basis, 4 years of this would be worth only $640mm, almost half of what is implied by the current price.
• Obviously, if the spread were to revert sooner to even the $150mm/yr level, then PDH would be trading for ~14 times EBIT, an absurdly high valuation for a commodity business with no barriers to entry.
• So, what is a more reasonable valuation for PDH? There are a few ways to approach this, but the most straightforward way is to say that the value is the sum of the replacement cost plus 4 years of excess profits.
• Since the excess profits can vary widely, it makes sense to calculate a low and a high valuation. For the high valuation, excess operating profit of $200mm/yr would seem to be extremely optimistic, and would correspond to a propane-to-propylene spread of $0.43/lb  using the company’s own sensitivity table.
• For the low valuation, $50mm/yr of excess operating profit, corresponding to a spread of ~$0.31/lb, seems reasonable—especially considering that the spot spread as of 7/26/2012 was just $0.27/lb.
• Using a 10% discount rate, the present value of the excess profits is approximately $700mm in the high case and $175mm in the low case. As for the replacement cost, if we scale up the $700mm midpoint cost estimate for the Williams plant by 20% to reflect the additional capacity in PDH’s plant, this gives a reasonable low valuation of $840mm. For the high valuation, we can use a more conservative $1 billion estimate.
• This leads to a total high value of $1.7 billion, corresponding to a price of just over $10/share, and a low value of $840mm + $175mm = $1,105mm, which implies a share price of just $5.77— less than half of the current market price for PDH.

Share Overhang

• Ultimately, I don’t believe that we will need to wait 4 years for the competition to come online and destroy the attractive margin structure of PDH’s only facility—the market is likely to discount this scenario before it actually happens.
• More importantly, I would suggest that PDH’s savvy private equity backers, holding over 60% of the stock, will move to aggressively sell down their holdings when their lock-up expires at the end of October, 2012. They are under no obligation to retain their stake, and the risk/return of holding on to it is not favorable. Put differently, after hitting an unexpected jackpot, they are unlikely to push their luck even further.
• Also remember that, as a single-facility business, PDH is exposed to a lot more risk than the threat of competition from larger and more strategic players. PDH faces real threats from unplanned downtime for repairs (indeed, the plant has experienced multiple unplanned outages since it started operating, one happening as recently as last quarter), not to mentioned the risk of natural disaster in the hurricane prone gulf region.
• Finally, the spread could also contract if there were to be a rally in natural gas prices. Since gas prices are now below the cost of production for many producers, this scenario is not so improbable in the next couple years.

Risks/Issues

• In the short term, it is possible that the spread could expand again, which would cause PDH to earn large windfall profits in the near term. If the market improperly valued these earnings, it could cause the share price to increase.
• Since the majority of PDH shares are tied up in the lock-up arrangement for the time being, the liquidity for the shares is not particularly high at the moment, at least relative to the market cap of the company.
• Because PDH is an MLP, it might present some issues in terms of borrowing shares to sell short. This could be addressed by transacting the short in swap form. I have heard that borrows are available at GS.
• There was a news story on 9/17/2012 on Bloomberg about PDH applying for permits to add more capacity to their existing plant. According to the article, the company has not decided on anything. I am under the impression that the time required to add this additional capacity would be significant, and thus any contribution would be at the tail end of the "over-earning" period. Also, the company would need to fund these additions, probably by issuing additional units.

Catalyst