NuStar Energy is a US based oil and natural gas midstream service provider. And despite the notion that its business is immune to energy price fluctuations (because of its long-term take or pay contracts) the recent crash in oil prices will inevitably have a significantly negative impact on NuStar because many of its customers are increasingly at risk of bankruptcy. In this report, we analyze the company’s business mix, income potential, its ability to meet financial obligations, and finally conclude with our opinion on whether the company’s common and preferred units offer an attractive balance between risks and rewards.

Overview:

NuStar is organized as a publicly trades Master Limited Partnership (“MLP”), and it provides midstream services which include transportation, storage, terminaling of petroleum products such as crude oil, natural gas liquids, and anhydrous ammonia. The company owns 9,960 miles of pipeline as well as 74 terminal and storage facilities with a storage capacity of 74 million barrels.

The company divides its operations into three segments:

Pipeline Operations: This segment includes revenue earned from transportation of products through its pipelines. The company earns revenue tariffs on a per barrel basis for crude oil products, and on a per ton basis for ammonia. The tariffs are regulated by federal authorities. Valero Energy (VLO), which was also the company’s parent before NuStar’s spinoff, is the largest customer accounting for 28% of the total segment revenue.

Storage Operations: The storage segment comprises of NuStar’s facilities which provide storage services pertaining to crude oil, specialty chemicals, and other petroleum products. Revenue is generated in the form of fees charged for quantity of products stored in the storage tanks and the period of storage. This segment also includes throughput terminal revenues. Valero Energy is the largest customer in this segment as well accounting for 25% of the segment revenue.

Fuels Marketing: This segment includes NuStar’s bunkering operations. Bunkering refers to transfer of oil to ships. The company earns a spread between the cost and selling price of bunker fuels and as a result while the segments account for 23% of the company revenue, its contribution to profit is just 4%. The customers include ship owners such as cruise ships.

Since the company provides midstream services, its revenue is partially immunized from the daily fluctuations in oil prices. The company enters into long term contracts with its clients which specifies fixed tariffs that NuStar can charge. 55% of the revenue is generated from investment grade customers, while 34% is generated from speculative grade. Further, Uninterruptible contracts in the pipeline and storage segments consist of contracts that contain take-or-pay minimum volume commitment clause i.e. if the customer does not meet the volume obligations, it must pay a deficiency fee for the shortfall. As of the end of 2019, NuStar had $900 million in contractually committed revenue in the next 2 years. On the other hand, the company’s customer concentration is unusually high. More than 25% of the revenue in its 2 core segments is earned from Valero Energy. While Valero is a refiner and therefore is less vulnerable to absolute levels of oil prices than a producer, still the high concentration concerns us.

Plummeting of oil prices due to COVID-19 outbreak taking a serious toll on the industry

Widespread outbreak of COVID-19 has created unprecedented pressure on the global energy and resources sectors. The economic contraction resulting from this outbreak has led to a substantial decline in demand for oil globally. The inability or desire of major oil producers to make drastic cuts to their production has led to demand-supply mismatch and consequently a substantial decline in oil prices. Since the beginning of this year, oil price has declined from $61.65 per barrel to $20 per barrel, which is a fall of 68% within a span of around 4 months. The Energy Information Administration (EIA) has forecasted demand to remain subdued for much of 2020 because of the widespread reduction in business activities. EIA estimates that demand for oil will fall over 1.25 million barrels per day in the US in 2020 before recovering in 2021.

Historic lows in oil prices are forcing oil producers to considerably reduce production levels and fixed costs. The EIA has forecasted that crude oil production levels in US will decline by around 4% this year.

Please note that, as a measure to control prices, oil-producing countries have made a historic deal to reduce global oil production by 10% in the coming months. We believe that although this will provide some support to the falling oil prices, a major improvement in prices is not expected anytime soon unless the producing nations announce further cuts, or the global economy shows signs of a sustainable recovery despite COVID-19 outbreak.

NuStar is not immune to industry disruptions

Any large fluctuations in the energy prices may not affect NuStar in the very near term to the same extent as an oil producer, but in the medium to long term, its performance will be adversely impacted in a sub $25-$30 oil world. While a large part of the company’s cash flows are fee-based, and a majority of the company’s pipeline volume is in the form of take or pay contracts, large scale bankruptcies in the customer base will impact company’s EBITDA generation over the next 12-24 month timeframe absent a swift recovery in energy markets.

The company’s storage operations however could see a temporary, near term tailwind as oversupply leads to lack of storage capacity in the country. Crude oil storage tanks are nearly 65% full and Plains All Pipeline, one of the largest midstream companies in the US has estimated that US oil storage would hit its limits by mid of May. Investors must note that once US oil production capacity exits take place on a large scale and the supply glut is cleared, the storage business will also see impact from the dislocation.

Unfavorable but still manageable debt maturities during economic crisis

Adding to difficulties in the operating environment are the upcoming debt obligations that the company needs to tackle over the near future. The company has $450 million due to be repaid in September 2020 and $300 million after just 5 months in February 2021. However, the company has been working on giving itself some breathing room by extending maturities and looking for new sources of funding.

As a step to boost liquidity, the company recently arranged a credit facility of $750 million with Oaktree Capital at a staggering 12% interest rate as compared to mid-single digit rate on its existing debt, signifying the stress in energy credit markets. NuStar also extended the $1 billion revolver facility which was maturing in 2021 to 2023. The undrawn amount of $521 million out of this revolver can be used by NuStar to meet its obligations. However, investors must note that the company’s ability to draw on this revolver will be restricted as the covenants of the revolver require the company’s Debt-to-EBITDA to be below 5.0x and the current Debt-to-EBITDA is at 3.9x. In the case of EBITDA declines, the borrowing power under the revolver also becomes limited.

Recent credit actions provide breathing room for the next 12 months however distribution cuts are likely

NuStar had $16 million in cash and cash equivalents at the end of 2019. In 2019, NuStar generated $509 million as cash flows from operations and incurred capital expenditures of $534 million (both growth and maintenance capex) bringing the free cash flow to -$25 million. We estimated NuStar’s sources and uses of cash assuming the low end of its guidance for 2020 given in February before the collapse in oil price as the best case and a 20% lower EBITDA than guided as a worst-case scenario. While in the optimistic case, the company will be able to refinance its debt and pay distributions, in the worst-case scenario, it will have a hard time paying distributions on common (and potentially preferred shares) while it is still able to take care of any maturities. Please note that if oil prices stay at under $25 for more than six months, there will be further downside next year due to structural dislocations in the energy space.

Source: NuStar Energy, LP, Blue Harbinger

As evident in the table below, the company has primarily funded its acquisitions as well as distribution payments to preferred and common stockholders via a combination of debt issuance as well as secondary equity issuances.

In a sub $25-$30 oil price level, the public market’s appetite for the company’s stock may be limited. Given the difficult operating environment, the company is unlikely to tap credit markets, even if they were welcoming, to raise money for paying distributions. As a result, in-all-likelihood, the company may need to temporarily suspend its common share distributions and defer its distributions on its cumulative preferred shares should oil prices remain depressed for a prolonged period. We have already seen a number of MLPs announce drastic cuts to common distributions, but most have maintained preferred distributions for now:

NuStar also has 4 sets of preferred shares outstanding. All the preferred shares are perpetual and the coupons are cumulative (i.e. the company has an option to not pay preferred distributions on the due date but at a later date, however, if the company wishes to pay dividends to common equity shareholders, it can do so only after paying the preferred dividend first). Given the seniority of preferred shares relative to common, the company may first move to cut common distributions, and if oil prices stay below $25 for a prolonged period, it may also choose to defer preferred dividends.

Additionally, the company has also issued units of preferred share Series D via private placement in 2018. These are convertible and cumulative with variable interest rates. The coupon rate for 2020 and 2021 is 9.75% and 10.75% respectively. They also have the same voting rights as the common equity unitholders.

Upside Risks

Supply coordination efforts: The OPEC+ countries have already come to terms with decreased production levels in the coming quarters and any further drastic reduction in production volumes across the world can provide some support to oil and lead to improvement.

A “V-shaped” economic recovery: A V-shaped recovery from the current global economic state can lead to a huge jump in demand for oil because of rising manufacturing and consumer activities globally. This may also lead to a significant improvement in oil prices as well as an increase in oil production levels, thereby creating additional demand for the company’s assets.

Conclusion

The challenges created by low oil prices are dramatic, and the risks NuStar faces are very real. However, given current market dynamics, and the attractiveness of NuStar’s assets, we do not see the company having solvency issues (i.e. NuStar can pay its debt obligations, and is in significantly stronger financial shape than many of its peers). Nonetheless, if the coronavirus shutdown continues, and energy prices remain depressed, the common unit distributions are at risk. However, if the company cuts the common distribution—that is actually a positive for the preferred shares (i.e. it frees up more cash flow to support the preferred distribution, which are cumulative).

We currently own NuStar Series C preferred units (NS-C), and we have no intention of selling. We view this position as one of our riskier holding, but also recognize it offers high potential rewards in terms of a big distribution yield and the potential for price appreciation. Further, we own the the preferred units as part of a more broadly diversified portfolio, that includes investment from across market sectors and styles. If you are an income investor looking for “opportunistic” higher yield, NuStar’s preferred shares are worth considering.

NuStar Preferreds Yield +15%: Real Risks, Big Rewards