Now that you have a better understanding of the real financial challenges plaguing Philadelphia Energy Solutions (PES), you might be surprised to find that many of the challenges stressing PES were known and anticipated by its investors. And, reasonably, these investors sacrificed PES for the benefit of their more profitable investments.
The Known Knowns. It is clear that in 2012, the PES investors had certain information at their disposal. As reviewed in the first blog of this series, investors knew the PES asset was distressed and in need of capital investment. Investors knew there would be escalating Renewable Fuel Standard (RFS) compliance requirements; as a merchant refinery they could potentially face certain disadvantages on RFS compliance options (e.g. RIN market price volatility); and as a large refinery it would generate significant RFS compliance obligations. They also knew cheap domestic oil production from the Bakken was ramping up; crude-by-rail movement was starting to increase; and PES equity investors required significant payments as part of the acquisition deal.
The Unknown Knowns. Here is where it gets interesting. In July 2012, Energy Transfer Partners (ETP) began efforts at FERC to proceed with conversion of its natural gas Trunkline pipeline with an eye towards moving Canadian and Bakken crude to the Gulf Coast. The resultant ETCO pipeline project enabled crude to move from Illinois to Sunoco’s petroleum terminal in Nederland, Texas. A newly constructed Dakota Access pipeline (DAPL) would be needed move Bakken crude from North Dakota to ETCO in Illinois. DAPL’s initial open season began in March 2014 and came into service in June 2017.
The combination of ETP’s ETCO and DAPL projects, collectively the “Bakken Pipeline,” enabled Bakken crude to move to the Gulf Coast, largely shutting out the East Coast refineries from cheaper WTI-priced crude. As mentioned, both ETCO and Dakota Access are part-owned by ETP, who acquired Sunoco in April 2012. ETP/Sunoco own 32.5% of PES, and the Bakken Pipeline terminates at Sunoco’s terminal.
In other words, ETP owns a part of PES, yet invested billions of dollars in more profitable infrastructure that rendered PES uncompetitive.
Furthermore, when Carlyle and ETP/Sunoco made the decision to acquire the refinery in June 2012, they were aware of the larger Bakken Pipeline vision that began its regulatory path in July 2012. PES had at least a 4-year heads up from its own parent company that it might be getting squeezed out of WTI-priced feedstock. The only unknown was whether or not the full Bakken Pipeline could be realized.
In 2012, PES didn’t know what the cost of RINs (the credits used to comply with the RFS) would be in the future. But, by the end of 2013, they knew compliance costs were much higher than expected when the refinery asset was purchased in June 2012.
Some other merchant refineries, like PBF Energy and Valero, have acquired or strategically partnered with blending terminal facilities in order to reduce exposure to RIN costs and secondary market volatility. PES has right of first offer to purchase Sunoco’s (SXL’s) Belmont Rack at fair market value, if Sunoco chooses to sell the asset. (SEC 163)
When PES was profitable in 2014 and higher RIN costs were known, it would have been an ideal time to exercise this option, or develop a strategic partnership. But it seems no action was taken even when increasing RIN costs were known.
In June 2015, a one-year agreement (with term extension options) was developed where PES would sell ethanol to Sunoco, and Sunoco agreed to sell PES 8 million RINs per month, at prevailing market prices. (F-32) Back of the envelope, this quantity of RINs would cover only about 5% of PES’ monthly D6 RIN obligation.* Prior to June 2015, PES and Sunoco also had a contract for RFS obligations that was structured more like an integrated company, but limited details of this contract have been disclosed. (F-32)
The Unknown Unknowns. PES investors could not have predicted the actions of OPEC, namely the organization’s failure to cut production in the face of low oil prices in a deliberate effort to squeeze out U.S. shale-oil producers. Similarly, PES could not have predicted that in December 2015, congress and president Obama would pass a law lifting the decades-old ban on oil exports. Together, these actions increased competition for a reduced volume of cheap domestic crude, disadvantaging PES.
The Hedge and the Option
The sophisticated energy investors in PES knew the ultra-high refinery margins in 2012 would be temporary, especially as they were heavily investing in pipeline infrastructure responding to the domestic shale-oil glut. Furthermore, these investors—namely ETP/Sunoco—knew if their primary investment, the Bakken Pipeline, panned out it could cripple the PES refinery.
On the other hand, if the pipeline project didn’t work out, the refinery could continue to access discounted WTI crude and could provide a nice profit, upon initial public offering. Perhaps a hedge or silver lining, in case ETP’s larger Bakken Pipeline project didn’t pan out?
The refinery venture was risky, but that is just what private equity companies like Carlyle Group take bets on (plus, Carlyle negotiated attractive payouts, sweetening the PES prospect). PES could also be seen as an option, in the event a large-diameter natural gas pipeline was built into Southeastern PA, creating a lucrative opportunity for conversion to petrochemical refining.
PES filed IPO registration for its logistics operation in late 2014 and for its refining segment in early 2015. Turns out, PES launched its IPO efforts a little too late. By that time public and private investors saw the writing on the wall. PES ended its bids to go public in September 2016.
And, the gas pipeline into Philly didn’t work out either, so the prospect of a petrochemical energy hub in Philadelphia waned.
Failure to Act
Given what PES investors and management knew and when they knew it, perhaps PES should have been focusing on what they could control? Specifically, better managing their approach to RFS compliance. However, it seems investors prioritized their larger and more lucrative investments over PES. Specifically, the Bakken Pipeline project and Sunoco's operations.
The next blog in the series will explore the future of PES, assuming the company can successfully emerge from Ch. 11 restructuring.
* PES has a 335,000 barrel of oil per day capacity and an approximate capacity utilization of 81% (typical for East Coast refineries). Assuming one barrel of oil converts to 20.3 gallons of gasoline, PES would yield about 165,250,000 gallons of gasoline in a 30-day month. Meaning the new agreement with Sunoco for 8 million RINs per month at market price would cover about 4.8% of the refinery’s ethanol (D6) RIN requirements.
Note: A more detailed publication on the Philadelphia Energy Solutions bankruptcy is in development.