USD Partners - Massive Contract Win, Yet No Reaction (MB 22 Dec 2019)

12/23/2019 USD Partners: Massive Contract Win, Yet No Reaction - USD Partners LP (NYSE:USDP) | Seeking Alpha
USD Partners: Massive Contract Win, Yet No Reaction

Dec. 22, 2019 8:59 PM ET2 comments
by: Michael Boyd
Summary
Prior to recent news, I viewed USD Partners as one of the most

compelling short opportunities in midstream heading into 2020.
Crude by rail is, in my opinion, a disadvantaged asset destined for poor

margins. Management pulled off a heck of a move recently to combat
that.
For those bearish on Canadian pipeline capacity for the very long term,
this might be worth a look as a buy. I view it as fairly valued now.
The midstream subsector is wholly out of favor and arguably deeply oversold. Yet, even
within the most beaten-down areas of the market, there are extreme avoid or outright
short selling opportunities. Just a few days ago, my opinion was that USD Partners
(USDP) faced a high likelihood of extreme downside in its earnings power over the next
few years. While currently propped up by a Canadian crude market characterized by an
extreme lack of takeaway capacity, that dynamic appeared unlikely to persist in the long
term. As a firm believer in the pipeline value proposition, it has been hard to see a long-
term viability case for crude by rail, a market predicated upon demand for a less efficient,
higher-cost service. With some recent weak execution - including a completely blown
acquisition that will soon be generating zero EBITDA in the interim – USD Partners
continued to trade at 8x forward EBITDA at what I believed to be a cyclical top. As another
headwind, USD Partners had not yet been an adopter of “MLP 2.0” with the incentive
distribution rights remaining outstanding. With distribution hikes occurring even in the face
of falling earnings and near 1.0x coverage, I saw a risk of limited partners being diluted at
the top of the market. Yet, quite amazingly, the partnership released ground-breaking
news that fundamentally changed the investment, but the name barely budged. It has
been incredibly interesting to observe the trading action in this firm in recent days.
History Of USD Partners and Crude By Rail

USD Partners is a fee-based, growth-oriented MLP that held its IPO late in 2014. The
corporate sponsor, US Development Group, was founded by crude by rail (“CBR”) tycoon
Dan Borgen, a pioneer behind many of the technologies that have made CBR loading
more viable. While many other larger entities have made significant strides in this niche
market, US Development Group has long held the leading edge. No question that being
backed by Goldman Sachs (NYSE:GS), who bought a 50% stake in US Development
https://seekingalpha.com/article/4313752-usd-partners-massive-contract-win-yet-no-reaction?isDirectRoadblock=false&utm_medium=email&utm… 1/8
Group back in 2007, helped nurture that market reputation. Within the industry, Borgen
developed a bit of a reputation as one heck of a market timer, selling more than a dozen
CBR terminals to some of the big names in midstream like Plains All American (PAA) and
Kinder Morgan (KMI) early on in the decade. Readers here are likely aware, or perhaps
just not surprised to learn, that the United States crude by rail market peaked in 2014.
Why? Crude by rail rates are, in general, about twice as expensive (or more) than
shipping by pipeline in nearly all situations while being more accident-prone. Given the
massive investment in domestic pipelines over the past five years, crude by rail volumes
fell by 70% from 2014 to 2019, even though production is up 40% over the same
timeframe. Borgen and USD Development succeeded in exiting much of their crude by
rail exposure in the United States at precisely the right time.
That is just a history lesson for context; USD Partners has little to do with CBR serving
domestic crude. Admittedly a bit of a rush job, the IPO for USD Partners did not occur until
its foundational asset, the Hardisty Rail Terminal (“USD Hardisty”), was completed about
eighteen months after construction began. USD Hardisty remains the only unit train
capable facility – a train in which all cars carry the same product from origination to
destination without interruption – that ties Hardisty, the largest Canadian crude oil hub, to
the lower Americas. Over the past six years, USD Hardisty has loaded more than 1,000
trains carrying 60mm cumulative barrels of Canadian crude destined for Cushing and the
Gulf Coast. While there was initial skepticism on the value of investing in these assets in
Canada, Dan Borgen appears to have pulled a rabbit out of his hat yet again. Just as the
market for crude by rail failed in the United States, demand skyrocketed in Canada to
provide an outlet for tar sands production as pipelines continue to face delays. The
correlation in the unit price of USD Partners and the Canadian crude by rail industry is
crystal clear:
*Source: Author Calculations.
USD Hardisty, alongside completed expansion project Hardisty South, remains the
primary drivers of EBITDA at USD Partners: 63% of current adjusted EBITDA as of Q3. In
addition to USD Hardisty, the firm also owns the Stroud Terminal, a crude oil destination
terminal in Oklahoma near the Cushing storage hub. Inbound product to Stroud is
delivered via the Stillwater Central Rail (via BNSF and Union Pacific rail) and sent
outbound via the seventeen-mile SCT Pipeline (USD Partners owned) to the Cushing
storage hub. The final material asset is the Casper Terminal, another railcar terminal
located in Wyoming which interconnects the Express Pipeline from Western Canada with
American markets. The value proposition and overall strategy for USD Partners are very
clear when looking at them on a map: help facilitate the flow of oil sands produced crude
oil into American markets to the south, primarily ending up in refiner storage tanks to be
processed into refined products.
*Source: USD Partners, August 2019 Investor Presentation, Slide 5
With the exception of Casper – which sees quite poor utilization – these assets are
currently highly contracted under take or pay contracts, an obviously appealing structure
to investors. So long as Western Canadian Select (“WCS”) continues to trade at a major
discount to both Brent and West Texas Intermediate (“WTI”) benchmarks and
apportionment on export pipelines like the Enbridge Mainline continues, frustrating
Canadian exploration and production (“E&P”) firms, there will be significant incentives to
shipping crude via alternative means: by rail, by truck, and by ship. What has been a
headwind to nearly the entire Canadian energy complex has been a tailwind to USD
Partners, leading to the small cap outperforming the Alerian MLP Index over most
timeframes since its IPO – and that is ignoring significant small-cap underperformance
versus large caps.
But will this bullish Canadian situation always be the case? There is massive economic
incentive for pipelines to be built. Midstream investors have been talking about the Line 3
Replacement (Enbridge (ENB)), Keystone XL (TC Energy (TRP)), and the Trans Mountain
Expansion (prior Kinder Morgan (KMI) and now government-owned) projects for many
years. All three are key projects that would, in concert, open up nearly 1,900kbpd of
additional export capacity, a near doubling of Western Canadian export capacity. However,
these proposed projects have faced multi-year delays and regulatory challenges and
consensus on which lines, if any, will be eventually completed continues to be quite mixed.
Readers that look through my old work will note that I have been very bearish on the
likelihood that the WCS/WTI differential would persist. They have, and they will through
2020 as well. Beyond that, the bearish outlook begins to ease.
Trans Mountain Expansion finally broke ground in the past few days, with first pipe likely to
be in the ground by Christmas. Contractors have already been hard at work at the
Westridge Marine Terminal in Burnaby, British Columbia, where a lot of the new volumes
will find themselves loaded onto ships for export. There are still several regulatory hurdles
to overcome, particularly additional challenges to try to disrupt past permits next month.
Recently, Enbridge placed the Canadian side of its Line 3 Project back into service. While
owner/operator Enbridge continues to face delays and challenges in Minnesota on the
construction work to replace aging assets on this side of the border, the improvements on
the Canadian side will allow 100kbpd to flow by the end of the year. The slowest of the
three, TC Energy, perhaps wisely, is holding off on pre-construction work on the massive
830kbpd Keystone XL Pipeline while a judge considers challenges by several
environmentalist groups. In my view, the expectation is for Line 3 to be in-service by late
2020, with Keystone XL and Trans Mountain Expansion in 2022 – the latter to be the
earlier completion. So long as those projects are not in place, more than 250kbpd of
Canadian crude will flow down to North America via the more expensive option: rail. But
what about when they are in-service?
Casper Terminal Case Study, Contract Structure

The glaring weakness for crude by rail is the contract structure. Shippers will never agree
to long-term contracts when there is the possibility of a pipeline reaching in-service as an
alternative. This leads to significant boom-and-bust cycles, some of which have impacted
USD Partners already in its short public history. In October of 2015, USD
Partners purchased the Casper Terminal from Stonepeak Infrastructure Partners and
other owners for $225mm. The acquisition was lauded as one that would be a highly
accretive acquisition that would provide a base for growth while also taking out a key
competitor. Because Casper is tied directly into Express Pipeline which has tariff rates
much lower than barrels shipped via Hardisty to Cushing via train, there was a cost
advantage. If you can’t beat ‘em, buy ‘em.
The reality has been much different. As of the last quarterly presentation, Casper
Terminal generated just 14% of 2019 EBITDA: a $7mm run rate. Per management, the
August 2019 contract – the only one at Casper that was fixed for a percentage of overall
capacity – rolled off in August without renewal (from the Q3 conference call): “lower
revenue at the Casper terminal resulting from the conclusion of customer agreements at
the end of 2018 and in August of 2019 offset the higher revenue at Hardisty during the
quarter.” Casper is now, in my opinion, barely generating positive EBITDA. What
happened? How can an asset go from generating $26mm in EBITDA to nothing?
Remember that Casper, Wyoming, is being fed by the Express Pipeline, a 280kbpd
pipeline flowing Canadian crude oil from Hardisty, and incremental barrels being produced
in the Powder River Basin and Bighorn Basins shale plays. The Express Pipeline, like
many out of Canada, it is at full capacity, going as far as to use drag reducing agents in
order to incrementally bump up flows. Gathering and processing (“G&P”) out of the
Powder River Basin is also near its limits. This should be a great setup for any asset
predicated upon moving product from one location to another.
Simply put, pipelines are in place. The Platte Pipeline, among others like Wood River and
the Rocky Mountain Pipelines, provides all the takeaway capacity that the region needs.
Proposed projects, such as the Liberty Pipeline, would potentially move 350kbpd from
Guernsey, just one hundred miles to the east, to Cushing, easing the shortfalls in capacity
out of the Powder River Basin. The Guernsey Hub, less than one hundred miles away,
which has pipeline connections to Hardisty, has outbound connections to PADD II
refineries, Salt Lake City, Wood River and the Rocky Mountain Pipelines, and West Coast
access. Contracts are not being renewed at Casper because it is no longer an economical
choice. This is not an atypical result of crude by rail. While there is a plan to help address
this via a new connection, tying into a nearby storage hub at USD Partners’ expense of
$15mm, it is tough to see the value prop. Guernsey already provides connectivity to PADD
II refineries, the Gulf Coast, Salt Lake City, and the Rocky Mountain Pipeline, as well as
connectivity to the Western corridor. Why would anyone agree to significant capacity in the
long term? It’s a stopgap for flexibility and insurance for shipping, nothing more.
What are these assets worth? Not much when orphaned. In 2017, USD Partners acquired
the Stroud Terminal, an asset built by EOG Resources (NYSE:EOG) that commenced
commercial operations in 2010. EOG Resources built the Hawthorne Pipeline to connect
the terminal to Cushing. Stroud was not viable and had no contracts in place. However,
concurrent with the purchase, the partnership entered into a multi-year, take-or-pay
agreement with a customer for 50% of the capacity, ending in June 2020. This was a
$10mm per year EBITDA contract, worth $28mm over its life. USD Partners paid $25mm
for the asset, meaning there was little to no value ascribed to the value of the
assets beyond the current contracts. While Stroud has since picked up two more
contracts for 10% of the capacity (expiring June 2020) and 31% of capacity (expiring June
2024), long-term prospects look shaky. As more Permian crude finds way directly to the
Gulf Coast via new pipelines (Wink to Webster, Gray Oak, Wink to Webster, Cactus II),
supply currently flowing into Cushing in a roundabout way (Permian to Cushing to other
markets) seems set to moderate. See “Basin Differentials And Implications For Midstream”
for more discussion on this topic. Meanwhile, there are new pipelines on the way to
facilitate flows out of the hub: Phillips 66 (PSX) and Plains All American are partnering on
Red Oak and the expansion of Seaway, an Enterprise Products Partners (EPD) joint
project with Enbridge, are two such examples. That is no favorable setup for crude by rail
serving Cushing.
What about growth to offset? Development projects at USD Development Group

frequently make their way into USD Partners presentations: the Texas Deepwater
Partners joint venture on the Houston Ship Channel, Deer Park Rail Terminal, potential
refined product terminals in Mexico. Unfortunately, those projects are just not economical
to be dropped down. While there is $168mm of stated liquidity on the Revolver, the firm
trades at 3.8x net debt/EBITDA. There is no borrowing capacity beyond 4.5x debt to
EBITDA, meaning there is actually just $40mm of capacity on the Revolver.
I have held a negative perception of USD Partners for quite some time. The partnership
owns assets with little value other than the contracts that it holds – contracts that have
nearly always had short lives. Half of all USD Partners contracts would have expired by
2022. Heading into that recontracting, USD Partners was facing a high likelihood that the
Line 3 Replacement would (hopefully) be in place, freeing up capacity out of Canada.
Either Keystone XL or Trans Mountain would have been right around the corner in 2022.
In Stroud, which is driven by nearby Cushing economics, the Seaway Pipeline expansion
will be providing 200kbpd of outflow capacity from Cushing by 2022, Red Oak will double
that by early 2021. It was not a favorable situation… yet perhaps USD Partners and Dan
Borgen have another rabbit in their hat.
December 2019 Announcement: Yet Another Rabbit
*Source: USD Partners, DRU Announcement Presentation, Slide 3
In a bit of a bombshell press release in my opinion, US Development Group, in

partnership with Gibson Energy, will construct a diluent recovery unit (“DRU”) near USD
Hardisty. To explain a little more, the DRU separates diluent from bitumen, a product that
makes crude oil non-flammable and more dense, improving both safety and the value
proposition for crude by rail. ConocoPhillips (COP), a core customer, will contract out the
DRU unit, but most importantly it will extend its contracts on substantially longer terms at
the unit train terminals. The benefits for USD Partners are obvious: it will not pay for this
DRU unit out of pocket yet it will immensely benefit USD Hardisty post completion.
Via the new contract, 33% of USD Hardisty capacity has now been extended through
2031 “at rates consistent with current rates.” On top of that, ConocoPhillips took over
100% of the contracted business at Stroud. While contract terms were not disclosed on
the Stroud assets, it seems likely that since this is a linked asset – ConocoPhillips is
shipping oil sands oil via USD Hardisty to Stroud as a destination facility – that contract
there is likely to be on similarly lengthy terms. Even assuming Stroud is just extended
through 2027, these contracts had a total value of $180mm. At an 8% discount rate,
those cash flows are worth $136mm or $5.00/unit. While I think it was clear the base
case of the market was not a zero, I don’t think the expectation was (or should have been)
a straight up extension either. Given the interest from ConocoPhillips, I don’t think it would
be unusual to see USD Hardisty fully contracted out as well. This deal changed the entire
investment thesis. The fact that there was so little movement on the announcement – just
5% - was surprising.
Takeaways
My entire view on USD Partners shifted based on the most release contract news. The
lack of a reaction or volume has been perplexing to me. While I contemplated a position,
especially via options as a late news reaction play, it just does not exist here. I don’t know
if an outright common position makes sense, at least from an opportunity cost perspective.
While I’m not an owner, I think the position could make quite a lot of sense, particularly for
those that have large exposure to Canadian crude via upstream E&Ps or other plays that
will be harmed by low netbacks caused by wide WCS differentials.

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12/23/2019 USD Partners: Massive Contract Win, Yet No Reaction - USD Partners LP (NYSE:USDP) | Seeking Alpha

USD Partners: Massive Contract Win, Yet No Reaction

Prior to recent news, I viewed USD Partners as one of the most

Crude by rail is, in my opinion, a disadvantaged asset destined for poor

History Of USD Partners and Crude By Rail

*Source: Author Calculations.

*Source: USD Partners, August 2019 Investor Presentation, Slide 5

Casper Terminal Case Study, Contract Structure

What about growth to offset? Development projects at USD Development Group

December 2019 Announcement: Yet Another Rabbit

*Source: USD Partners, DRU Announcement Presentation, Slide 3

In a bit of a bombshell press release in my opinion, US Development Group, in

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