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Arbitrage Opportunities in the Oil Patch

A potentially fruitful area of the market is a form of arbitrage in the land of pipelines. Due to
an 80's era tax law, energy related infrastructure entities are allowed be formed as master
limited partnerships or MLP's.

An MLP is not much different from a REIT or an S-Corp. MLP's pay no corporate taxes, taxes
instead are the responsibility of the unitholders. While MLP's are not required to pay out a
certain percentage of their distributable cash flow, they are highly cash generative
enterprises with somewhat limited reinvestment opportunities. As a result, MLP's distribute
a large percentage of their cash flows to shareholders.

One nuance of an MLP, is that there is often a general partner or GP that manages the
operations. The GP usually takes a 2% cut of the cash flow before it is distributed to LP unit
holders. Plus, as we discussed in last week's post, GP's usually hold incentive distribution
rights (IDRs), which entitles them to an increasing cut of the cash flow depending on the LP
per unit distributions.

Here's an example from Buckeye:

As you can see in the attached chart, Buckeye's GP Holdings BGH is entitled to nearly 46%
of the distributable cash flows if LP distributions reach at least: $0.5251. Something to
watch for as a GP owner is the sustainability of the distribution as the IDRs work both
directions (i.e. if LP per unit distributions fall, GP distributions fall at an increasing rate).

Many GP's are publically traded, including the GPs of Buckeye BGH, NuStar NSH, Enterprise
Products EPE, Energy Transfer EPE, and Magellan MGG, to name a few. Because of IDRs,
GP's should trade at premium. In other words, the distribution yield should be lower for a
GP then the corresponding LP--as long as you believe that cash flows will rise over time.
Therefore, when this relationship is violated, you maybe presented with an arbitrage
opportunity: buy the GP, and short the LP.

As you can see below, there's not a large price discrepancy between the 5 pairs shown
below.
On Wednesday morning, the Magellan complex took matters into their own hands and
announced that they were rolling their GP Magellan Midstream Holdings MGG into the LP
Magellan Midstream Partners MMP. The transaction is an all-unit offering at a 25% premium
based on Tuesday's close. The 25% premium coincidentally is the same premium MarkWest
Energy Partners MWE paid to roll up its GP last year.

The transaction is beneficial to the LP as it eliminates incentive distributions, which will have
the dual impacts of reducing MMP's cash cost of capital and increasing the rate at which
MMP can raise quarterly distributions over time. It also reduces duplicative overhead
expenses from operating two different entities. We would also note it helps remove any
uncertainty surrounding the carried interest debate.

Jason's favorite name to execute a similar transaction is the NuStar complex--NSH and NS.
The key factors being:

1) Strong distribution coverage ratio of 1.25x. Because the LP will likely be issuing
shares to consummate such a deal, having sufficient cash flow to pay the additional
distributions is critical.
2) There's no debt at the GP level--NSH. At first glance, Energy Transfer looks like
an even more likely candidate to eradicate the discount of its GP shares--ETE--given
ETE trades at a discount to ETP. However, ETE has a load of debt that would either
have to be assumed by ETP or paid off. The debt can't be assumed because it would
limit ETP's distributable cash flow, and it can't be paid off because ETP doesn't have
the cash lying around. The clean balance sheet of NSH thus makes a takeout more
feasible.
3) Chairman Bill Greehey is notorious for taking advantaged of mispriced assets. For
example, as CEO of Valero VLO he rolled up small independent refineries during the
dog days of the 1990s. He initiated the spin off of NuStar from its former parent
Valero. We don’t think this is a large driver of a takeout, but adds to our confidence.

We view this trade as relatively low risk, and having medium reward. As long as
distributions are not cut, your cash carry is simply the yield spread between the GP and LP
units—about 1% (for purposes of structuring this transaction, you'll short NS and long NSH
at equal dollar amounts). However, you must also account for the opportunity cost of your
capital. If you plan to park your money in a money market fund, the opportunity cost of
your capital is relatively low, at maybe 1% to 2%. However, if you see other attractive
opportunities in the market, this cost can be very high. For simplicity’s sake, let’s just call it
10%, the theoretical “long run” return profile of the stock market. Therefore, the total cost
to you in this case is about 10% + 1% = 11%. The return profile is also relatively simple. If
future transactions follow the Magellan Midstream MGG model, you stand to gain 25%. The
sooner any potential transaction happens, the higher the annualized returns. If the deal
happens in exactly one year, at a 25% premium, the annualized return would be 25% -
11% = 14%; if it happens in 3 months, the annualized return is 56%. This is not a hit-it-
out-of-the-park number, but it’s not bad at all for a low-risk transaction.

Investors considering this trade should also be mindful of the tax implications. As mentioned
above, MLP investors are responsible for the taxes based on the income they receive. An
investor's taxable income however is usually only a small fraction of their gross income as
they are entitled to a share of the depreciation tax shield. The depreciation shield is greatest
in the early years of your investment. Given the anticipated shorter holding period of this
investment, we don't believe tax carrying costs will be significant.

You'll also receive some tax benefit from paying out the distributions on the LP units that
you are short. The distributions are treated as investment interest expense, but you must
itemize your deductions on your taxes and have the short open at least 46 days to realize
this benefit. The tax issues may be enough to keep some readers away.

Warren Buffet in a shareholder letter 20 years ago mentioned he uses, "…arbitrage as an


alternative to holding short-term cash equivalents…At such times, arbitrage sometimes
promises much greater returns than Treasury Bills and equally important, cools any
temptation we may have to relax our standards for long-term investments." Given the
uncertainty in the market and near 0% short-term interest rates, we think this opportunity
is not a bad place to park some cash.