October 28, 2011 - 6:43pm EST by
2011 2012
Price: 25.50 EPS $4.47 $4.59
Shares Out. (in M): 87 P/E 5.5x 5.5x
Market Cap (in $M): 2,200 P/FCF 5.5x 5.5x
Net Debt (in $M): -50 EBIT 690 819
TEV ($): 2,150 TEV/EBIT 3.1x 2.6x

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I believe a synthetic long position in CVI’s refining business (Long position in CVI and short UAN to hedge out CVI’s interests in the company) to be an extremely attractive investment at this time.  CVI was written up late last year and provides some additional background on the business.  Early 2011, CVR Energy (CVI) took public its fertilizer business (UAN) through an IPO.  The UAN IPO was structured as an MLP, but contrary to other MLP structures out there, also included 100% of the GP interest.  This offering turned out extremely successful and as investors gravitated towards the name for its attractive yield, tax free nature, and favorable dynamics in the nitrogen fertilizer business.  As we fast forward to today, UAN is up ~100% from its pre-IPO valuation (initial range was $12-$14), valuing the remaining CVI ownership at $1.3B or $15/CVI share.  Through this trade, you are creating the core CVI business at $10/share for a business earning >$4/EPS today.  The core CVI business is mid-continent refinery (pure comp to HFC), an asset that processes almost exclusively from WTI (benefits from WTI/Brent dislocation), sells its product at a substantial premium to the Gulf Coast, and presents an attractive acquisition candidate for refiners looking to gain exposure to this market. 

Many will argue that most of today’s earnings are driven by the large spread in Brent/WTI and therefore it is not appropriate to look at current eps as a proxy.  I couldn’t agree more with that statement.  Having said that, I do believe that “peak earnings” will continue until a new pipeline is built in mid 2013 (Wrangler) at which time earnings will correct.  This means in the next two years, this investment will generate FCF $7-$9/share, thereby valuing the core investment $1-$3/share.  Assuming a $1.00-$1.50 eps for the refining business thereafter, values this investment at $17-$24/share assuming a 10x P/E multiple.


Market Capitalization:            
CVI  Market Cap


  UAN Stock      $25.62
     Less CVI Value                 (1,305)   Shares Owned              50.9
Adj Mkt Cap                     931        CVI Ownership            1,305
Cash    $518   Implied Value/CVI Share  $14.86
Debt   $467   Implied CVI Price    $10.60
Other   $146          
Enterprise Value (Adj)                  1,025          
EV (Mid 2013)                     323          

CVI’s Refining Operation:

The company operates one plant of 115,000 bpd in Coffeyville, KS.  It has a complex refiner (12.9 Nelson Complexity) & operates right in the center of PADD2, roughly 100 miles from Cushing, OK.  The company processes mostly WTI crude coupled with some WCS exposure, both of which are currently discounted v LLS or Brent. 


Mid-Con Exposure:

I figured its worth walking through the structural cost advantage of Mid-Con refining assets to better explain the origin of the large the earnings power.  To oversimplify things, refiners operate in a global market whereby they process crude oil (raw material) and sell gasoline & distillates (revenue).  Refiners around the world can process many different crudes depending on the complexity of the refinery and the geographic location.  In Louisiana, refiners can process Louisiana Light crude (LLS) or Maya crude.  In Europe, they generally process Brent crude.  For the Mid-Con refiners, WTI crude is the standard. 

Historically, WTI crude (the price of crude oil in Cushing, OK) has traded a $1-$2 above the price of international crude.  This is largely a function of the fact that the US was set up as an importing nation.  We consume more than we produce and therefore require pricing high enough to incentivize crude to be imported into the Gulf of Mexico and shipped up into the Mid-Con via pipeline.  Because WTI historically has been linked to global crude, it has become the proxy for global oil prices in the US.  Over the course of the past nine months, WTI crude has de-linked from global crude prices and now sells for a $20/barrel discount v Brent Crude.  In the context of refining, where net margins are in the $2/barrel range globally, the ability to realize a $20 incremental cost advantage is a game changer.  Under the scenario whereby the marginal cost player sells its product at cash costs (ie.  breaks-even), a Mid-Con refiner tied to WTI crude, would post record margins.  This is crux of the bull-case for refiners with WTI crude exposure. 

Why has WTI/Brent Spread Blown Out:

Given that the US was built as an importing nation of crude, all the pipelines and logistic networks can transport oil from the Gulf Coast into the Mid-Con, but not the other way around.  In the last couple years we have seen 1) continued growth of Canadian crude moving into the US and 2) the emergence of unconventional oil.  The same way shale gas changed the S/D dynamics in the US gas market, shale oil in areas like the Bakken, ND and Eagle Ford are driving significant increases in domestic oil production without any pipeline to get product out of the area.   If you look at the various regions of oil growth, it is possible to see 300-400k bpd of incremental crude supply in the US per year for the next several years, equivalent to a world scale pipeline built each year.  Despite further storage construction in Cushing, OK (Hub for WTI crude), there is simply too much supply.  So the question remains, how is the market price set?  Like any commodity business, there are many market setting mechanisms.   I have listed below the four main drivers and estimated WTI/Brent spread under each scenario.  

  1. Oil undersupplied & imported from Gulf ($1-$2)/barrel
  2. Oil oversupplied and exported to gulf via Pipeline - $1-$4/barrel
  3. Oil oversupplied and exported to gulf via railroad - $7/barrel
  4. Oil oversupplied and exported to gulf via truck - $12-$15+/barrel
  5. Oil oversupplied w/no exporting options - WTI prices to decline to well shut-in levels $60+/barrel


It is clear from observing the projected S/D dynamics that over the next two years, the market setting price is likely to be option #4.  There are no major pipelines coming online until 2013.  Railroad capacity is fully utilized at the moment and while there is some incremental capacity coming online, it is unlikely to swing the market into balance over the next several years.  While I do believe the market does possess enough truck capacity to move incremental supply today, it may not be sufficient down the road.  The problem is that truck is highly inefficient when it comes to moving large amounts of oil.  You are talking about a 1,000 mile + route where each truck can only carry 180 barrels.  If one assumes it takes one week to make a round trip via truck, each incremental truck in service can only carry 9,360 barrels/year.  To soak up an additional 100k bpd of incremental capacity, an additional 3,900 trucks would need to be built.  I do not have the data to effectively analyze the true probability of option #5, but merely pointing out that is the dislocation of last resort (have seen a few sell-side notes that discuss the potential for a significantly larger blow-out of spreads).  I am not making the case that one should view this as a decade long disconnect, but rather one that lasts at least until new pipeline is constructed.  The Wrangler pipeline is expected to come online mid-2013 and carry 800k barrels of WTI to the gulf coast.  While this would certainly correct the market, it is not a certainty that it will come online.  The last large pipeline announcement to ship product from Cushing to the Gulf Coast over the summer did not garner enough interest and was subsequently cancelled (unclear what this is).  Over time, I believe the WTI spread will reflect pricing to earn an appropriate return on new pipeline construction.  Based on my analysis of new builds and the required rate of return, I believe this to be $4/barrel. 

To provide a framework of the sensitivity, every $5 move in WTI/Brent translates to $1.10-$1.30 in eps for CVI and if one believes we are at a $15-$20 spread in the next two years, CVI should earn $3.50-$4.50/yr from this competitive cost position alone (above core refining earnings of the business).  Additionally, Mid-Con refiners are advantaged v global refiners even without the WTI exposure.  This is driven by 1) higher product prices in its region (PADD 2) and 2) access to Canadian Heavy crude, a WTI linked crude that is even more discounted.  While CVI’s exposure to Canadian crude is limited, it does directly benefit from higher product prices. 

  1. There is actually a shortage of refined product in PADD2 (geographical area where Mid-con refiners assets run) such that gasoline is actually imported in from other areas of the county.  It is for this reason that gasoline sells for a higher price v other areas of the country.  This premium (historically about 3.5 cents/gallon) falls right into the coffers of the US refiners and translates to $.65 cents/year in additional eps v a gulf refiner. 
  2. Canadian Heavy (WCS) Access – The company currently processes 22% of its total output with Canadian Heavy crude.  To simplify the impact, Canadian Crude is the most profitable crude on the market because it 1) is linked to WTI and 2) sells at a substantial discount to WTI.  When considering that the WCS has historically traded at a significant discount to WTI over the past five years ($10-$25/barrel), anyone who has access to this inherently carries a significant cost advantage.  While it isn’t a one for one ratio, a $15 discount to WTI for WCS translates to $130mm/yr ($.90-$.95/share) of cost savings v other refiners w/out access to heavy crude.


Fact Check on Valuation:

If you look at HFC in the market today (closest comp), it currently trades at 16k/barrel of refining capacity.  If one were to apply this valuation to CVI’s refining business, we would derive a valuation of $1.85B, or roughly $20/share for CVI.  Additionally, given the FCF characteristics and competitive position, there is a very good argument to make that HFC is an attractive investment today.  Notwithstanding the fact that the permitting process would be near impossible, if one were to try to build a new refinery the costs to replicate CVI’s assets would be north of $25 per share.

Overall, I view this investment as attractive for a couple reasons.  1) The strong cash flow driven by a fundamental disconnect in WTI/Brent provides substantial downside protection (recovers the majority of the investment in two years).  2) In the event pricing corrects in 2013 this investment makes 17-24 from a base of 10, but if the dislocation persists longer – or even if at any point the market simply believes it will persist, the profit on this investment increases substantially.


Continued FCF driven by strong refining margins
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