Growing foreign demand for U.S. crude oil and refined products has created a significant build-out opportunity for midstream providers linking supply with export points along the U.S. Gulf Coast. One of the most important links in the energy value chain facilitating volume growth is the storage and terminaling connections that provide staging capability for further distribution both locally and abroad. From our perspective at BP Capital, expanding linkage associated with foreign demand should drive economic growth and enhanced midstream operating scale, and in the process, provide investors with attractive return potential for these largely downstream or ‘demand-pull’ midstream assets (storage and terminals.) We note, however, that the many midstream companies comprising the energy infrastructure MLP universe do not own or operate downstream assets of notable scale; thus, this enhances the importance of investing in the MLPs/midstream companies who have exposure to demand-pull assets.

Given the significance of “where we see the puck headed” with respect to foreign demand pull exports and how it is driving midstream company growth, we thought it timely to highlight recent deal activity and barriers to entry across the midstream universe. In our opinion, these deals and resultant barriers to entry underscore the value potential to both incumbents and new entrants that come from expansion or acquisition of these high-quality storage and terminaling projects. Before we do, let’s review some basics.

Why is marine storage and terminaling so important?

With a significant uptick in petroleum products being ‘put on the water’ over the last five years, the competition vying to win a larger share of these growth opportunities in major import/export ports and harbors is very intense. This competition not only involves many publicly traded MLPs, midstream companies and refiners, but also international marine storage providers and processing facilities with marine storage assets and capabilities (e.g., petchem or condensate splitting.)

Why is the incumbent advantage so important?

Many of the scale petroleum and petroleum products terminals along the Houston Ship Channel (“HSC”) have been built up and retrofitted over many, many years (we use the HSC as our case study.) Therefore, for the larger incumbent marine storage players on the HSC, it is not uncommon for these terminals to be connected to a grid of over ten or more different pipelines taking and receiving product from a multitude of supply and demand locations.

What’s the incumbent value proposition?

Based on experience and several project economic assessments, for a new entrant to grab market share in any major marine storage hub you must offer the connectivity; yet, this is often the most expensive and tricky part of the commercialization effort. Why? Incumbents often do not want new entrants into the marine terminal market, and, therefore, will strategically hold back offering a connection to a new site unless it is a Federal Energy Regulatory Commission (“FERC”) regulated, open-access line. Further, the sheer Engineering, Procurement and Construction (“EPC”) costs of installing new under-ground pressurized pipelines is very expensive and time consuming to build, especially in congested pipeline corridors up and down the HSC. The pipeline connection costs, as well as any dock work or new dock additions, oftentimes will push the project cost so high that the storage rates required to recoup the terminal investment keep the new entrant out of the market—often by a large margin (with storage rates quoted often in $/Bbl of storage capacity/month.) Further, the State and Federal permitting and regulatory bodies make major expansions and pressurized connections a very formal and lengthy approval process even for the scale incumbents.

To drive home this point of connectivity creating high downstream barriers to entry, we extracted a Q&A piece from the Enterprise Products Partners LP (NYSE: EPD) 2Q 2017 earnings call where the CEO, AJ “Jim” Teague, is queried about EPD’s focus on downstream. For emphasis, we note that EPD is one of the most integrated and connected downstream-facing midstream companies in the publicly-traded midstream universe, with an unparalleled basket of storage and terminaling assets in the world; thus, we believe the EPD statement is as credible as it gets. The Q&A:

Question from unnamed analyst:

“Okay. And just a quick follow-up. I think we’re all very aware of what the risk picture looks like as midstream players go closer to the wellhead. You guys are obviously doing more going downstream and going further away. Could you give us a little bit of color around sort of what the different risks are as we move that direction versus towards the wellhead?”

A.J. “Jim” Teague – Enterprise Products Partners LP:

“What we’re doing costs more money and it’s harder to duplicate, pure and simple. We think that from a – Brent, maybe want to chime in on this. But the easiest thing to do is build a gathering system and get a dedication and call yourself a midstream company. What we’re seeing is producers and we’ll use the Permian as an example. The producer is going to dictate what that gather would does for him, and he is going to dictate whether or not he wants – what kind of segregations he wants. So we’re going to fill this pipeline up and we will build out into certain basins, we will do things, like buying the Eagle Ford system from Pioneer, but our focus is, we like things that have a high barrier to entry, and we like things that add to our downstream value chain. Brent?”

Which companies stand to reap the benefits of incumbency?

Given the barriers to entry, we understand the incumbent advantage in these high-demand marine storage markets. We believe the long-term market share winners in this space will be companies that currently possess scale, connectivity, and defensibility around these asset types.

As an example, we cite the Kinder Morgan (NYSE: KMI) Pasadena, TX terminal listed below with almost 19 million barrels of storage; however, note KMI also operates another scale facility nearby in Galena Park and a large condensate splitter on the HSC for British Petroleum. See the KMI Pasadena layout below. We highlight the sheer number of receiving and injecting connections that make this terminal, in our view, almost impossible to duplicate.

Overall, the KMI Storage and Terminaling segment is one of the industry’s largest in the U.S., along with Buckeye Partners LP (NYSE: BPL), ITC (Intercontinental Terminals Co. – Japanese owned), Magellan Partners LP (NYSE: MMP; reference below), and EPD. Also, most of the domestic refiners themselves operate large scale storage and terminaling operations both around their refineries and also in major ports and distribution hubs. Further, the Partnerships like ANDX, VLP, PSXP, MPLX, PBFX, DKL and HEP, which are owned and controlled by the refiners, maintain sizeable storage and terminaling assets coast to coast. We acknowledge there are smaller pure play storage and terminaling names (e.g., Sprague Resources LP; NYSE: SRLP), but many of their terminals are inland and/or in less robust demand centers and import/export marine locales.

What have we seen in recent deal activity and organic growth project announcements?

For reference and perspective on the TX and HSC region, per EIA, as of January 2016, the 29 petroleum refineries in Texas had a capacity of over 5.4 million barrels of crude oil per day and accounted for 30% of total U.S. refining capacity. The majority of this capacity is located on the HSC; therefore, we would expect much of the capital invested into the HSC region to support the sheer magnitude of refining and industrial capacity growth needs.

On the HSC if we just examine the major players for refined products storage and terminaling (although this same assessment can be done for crude, NGLs, and chemicals) we quickly find scale, existing terminals which have almost all been expanded in some form in the last several years, with some very recent expansions as well. We cite some examples below:

  • KMI Pasadena and Galena Park have been expanded several times over the last 5 years (KMI Pasadena used as an example earlier.) In 2014, KMI invested $240 million to expand capacity and dock capabilities for refined products.
  • MMP Pasadena and Galena Park and MMP/LBC JV are major storage hubs. Note, here we are ignoring the scale MMP crude assets along the HSC such as MMP East Houston, which are their own physical assets. Notably, on September 14, 2017 MMP and VLO announced a 50/50 JV to develop MMP’s Pasadena expansion terminal (see illustration in Appendix).
    • The Pasadena facility is planning to handle petroleum products, grades of gasoline, diesel and jet fuel, and even biofuels, will be owned 50/50 by Magellan and Valero, and will include 5 million barrels of storage, truck loading facilities, and 2 proprietary ship docks. Additional phases are already planned and announced.
    • Connectivity: After completion of this expansion, the Pasadena facility will be connected via pipeline to VLO’s refineries in Houston and Texas City, Texas and to the Colonial and Explorer pipelines, in addition to the already planned connection to MMP’s Galena Park terminal facility. BPCFA notes that MMP’s Connectivity is very likely the reason why VLO decided to not only commit but also take an equity stake in the new, expanded facility. Please see the MMP terminal illustrations in the appendix to review their Connectivity listings for each asset.
    • All terminal phases are estimated to cost approximately $820 million. Notably, both phases are fully contracted with long-term customer commitments.
  • SemGroup Corp.’s (NYSE: SEMG) HFOTCO (Houston Fuel Oil and Terminaling Co.), which boasts almost 17 million of storage capacity, was recently purchased by SEMG from PE-firm Alinda Capital Partners for $1.5 billion as announced on June 6, 2017.
  • KMI and TransMontaigne Partners LP (NYSE: TLP) both own near 50% of BOSTCO (Battleground Oil Specialty Terminal Company) with a third small equity owner. BOSTCO first became operational in 2013 and operates nearly 7 million barrels of capacity on the HSC.
  • Major refiners like Valero, MPC, LYB, Shell Deer Park, XOM, etc. operate several storage terminals along the HSC mainly supporting their own refining and logistics needs.

The common thread in analyzing the capabilities of these scale terminals is connectivity: Connectivity to a handful of FERC-regulated pipelines, 3rd party private pipelines, other refineries, and multiple storage locales, along with adequate dock access and dock time. Further, many of these facilities can send product on to major takeaway pipelines to other U.S. demand centers, such as Explorer Pipeline taking product north to Chicago, or Colonial Pipeline sending product to the Northeast. MMP’s expansion is a clear reflection of providing takeaway to other demand centers, as their two take-away lines are some of the most strategic connections to which the HSC terminal would favor access.

BPCFA Conclusions and Take-Aways

As we’ve written in the past, midstream assets situated near key end users or markets generally offer a more stable volume throughput profile when compared to assets situated more closely to the source of supply. For the midstream company, this linkage of assets to this end user ‘demand-pull’ typically translates to a more stable revenue and cash flow stream, and the benefits of lower volatility in operating and financial results. Further, BPCFA believes the barriers to entry and difficulty in replicating most of these scale storage operations gives a handful of companies a long-term advantage for future volume growth, and potential global market share advances as well. When it comes to the sustainability and economic value of the downstream facing or ‘demand-pull’ subsector of the midstream value chain, we believe it’s wise to heed the views of the CEO of perhaps the most well-run midstream name in EPD.

Disclaimer: This material is for informational purposes only and does not constitute an offer or a solicitation to buy, hold, or sell an interest in any investment or any other security, including any investment with BP Capital Fund Advisors, LLC (“BPCFA”) or any of its affiliates or any other related investment advisory services. This material does not constitute legal, tax, or investment advice, nor is it a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional adviser. In preparing this material BPCFA has relied upon data supplied by third parties. BPCFA does not undertake any obligation to update the information contained herein in light of later circumstances or events. BPCFA does not represent the information herein is accurate, true or complete, makes no warranty, express or implied, regarding the information herein, and shall not be liable for any losses, damages, costs or expenses relating to its adequacy, accuracy, truth, completeness or use. This material is subject to a more complete description and does not contain all of the information necessary to make any investment decision, including, but not limited to, the risks, fees and investment strategies of an investment.