May 3, 2018
Executives
Michael N. Mears - Magellan Midstream Partners LP Aaron L.
Milford - Magellan Midstream Partners LP
Analysts
Theresa Chen - Barclays Capital, Inc. Jeremy Bryan Tonet - JPMorgan Securities LLC Dennis P.
Coleman - Bank of America Merrill Lynch Barrett Blaschke - MUFG Securities America, Inc.
Operator
Good day and welcome to the Magellan Midstream Partners First Quarter 2018 Earnings Results Conference Call. Today's conference is being recorded.
At this time, I would like to turn the conference over to Chief Executive Officer, Mike Mears.
Michael N. Mears - Magellan Midstream Partners LP
All right. Well, thank you for joining us today.
I'd like to start by thanking those of you who had the opportunity to attend our Analyst Day. We hope you received some valuable detail about our company and found the event to be a good use of your time.
Before we dive into first quarter earnings, I'll remind you that management will be making forward-looking statements as defined by the SEC. Such statements are based on our current judgments regarding the factors that could impact the future performance of Magellan.
You should review the risk factors and other information discussed in our filings with the SEC and form your own opinions about Magellan's future performance. We announced solid first quarter financial results this morning for a good start to the year, setting aside the onetime pension correction and mark-to-market on our open futures contracts, we exceeded our guidance by $0.10 per unit, primarily related to stronger than expected refined products and crude oil transportation revenues during the quarter.
Our core fee-based activities continue to generate solid results, emphasizing the stability and consistency of our business model. Our CFO, Aaron Milford, will now review Magellan's first quarter financial results in more detail.
Then, I'll be back to discuss our outlook for the rest of the year, and the status of the few of our larger expansion projects before opening the call to your questions.
Aaron L. Milford - Magellan Midstream Partners LP
Thank you, Mike. During my comments today, I will be making references to certain non-GAAP financial metrics, including operating margin and distributable cash flow.
We've included exhibits to our earnings release that reconcile these metrics to their nearest GAAP measure. Earlier this morning, we reported first quarter net income of $210.9 million or $0.92 per unit on a diluted basis, which was lower than the $222.7 million or $0.98 per diluted unit reported for the first quarter of 2017.
Excluding the impact of mark-to-market futures contract activity in the current quarter, adjusted diluted earnings per unit of $0.98 exceeded our guidance of $0.95 provided on a similar basis back in February. Distributable cash flow of $258.9 million for the first quarter of 2018 was almost 14% higher than the $227.6 million reported in the first quarter of 2017.
As mentioned in our earnings release, both our reported net income and distributable cash flow were negatively impacted by a $16 million onetime correction of pension expense due to estimation errors made by our third-party actuary in calculating our pension benefit obligations dating back to 2010. We rely on the expertise of our third-party actuary to estimate our pension liabilities.
These liability estimates also impact the amount of pension expense we recognize annually and our pension funding decisions. In essence, the error is made by our actuary in estimating our liabilities since 2010, resulted in us not recognizing as much pension expense as we otherwise would have for the periods between 2010 and 2017.
The correction made in the first quarter represents the cumulative amount of expense we needed to recognize to catch up. It's important to note that the errors did not result in us being out of compliance with any minimum pension funding requirements nor will they require any significant change to our pension funding plans for 2018.
Finally, the estimation errors made by the actuary were not material to any of our historical financial results, especially considering the fact that this correction is cumulative for a seven-year period of time. If we adjust our first quarter results for this pension correction and unrealized mark-to-market impacts, our net income for the quarter would have been $226.9 million or $1.05 per unit on a diluted basis.
Our distributable cash flow for the quarter would have been $274.9 million. Fundamentally, 2018 is off to a good start, and as Mike will talk more about in a moment, our outlook for the remainder of the year is positive.
I will now move to a brief discussion of the operating margin performance of each of our business segments. Our refined products segment generated $211.4 million of operating margin in the first quarter of 2018 compared to $221.3 million for the same period in 2017.
This decline in operating margin between periods primarily resulted from the impact of mark-to-market valuations of our exchange-traded futures contracts used to hedge our commodity exposure. Transportation and terminals revenues increased $18.5 million or almost 8% compared to the 2017 quarter.
This increase was driven by 13% higher distillate volumes as fuel demand in the crude oil producing regions we serve continues to increase, as well as 2% higher gasoline volumes and higher jet fuel demand in our Denver and Little Rock market. Operating expenses were essentially flat compared to the first quarter of 2017, with higher personnel costs and higher power costs due to higher volumes being mostly offset by lower environmental and other expenses.
Of note, the higher personnel costs for the quarter included $4.1 million of expense related to the pension correction mentioned earlier. Product margin decreased by $30 million compared to the first quarter of 2017 as a result of lower unrealized gains associated with our hedging program and lower butane blending volumes.
Ignoring mark-to-market impacts, our cash margins were also lower in the first quarter of 2018 compared to the first quarter of 2017 as we had anticipated in the guidance we provided back in February. For our crude oil segment, operating margin of $127.7 million was $25.7 million higher in the first quarter of last year.
Transportation and terminals revenue increased by approximately $21 million, mostly due to contributions from our Corpus Christi splitter, which began operations in June of last year, as well as higher average rates on our Longhorn pipeline. Further, volumes on our Houston distribution system increased significantly compared to last year.
These higher volumes on the Houston distribution system, which move at substantially lower rates than our Longhorn volumes, caused our average crude oil transportation rate to decline quarter-over-quarter while our overall revenue increased substantially. Segment operating expenses increased $6.2 million as a result of higher operating expenses associated with our condensate splitter, which was not operational in the first quarter of 2017, as well as higher power costs and slightly higher personnel costs.
Our personnel costs increased primarily as a result of recognizing $0.7 million of expense related to the pension correction made in the quarter. For the quarter, volumes on our Longhorn pipeline averaged approximately 265,000 barrels per day compared with 270,000 barrels per day in the first quarter of 2017.
Of note, the current quarter volume was higher than our previous annual guidance of 260,000 barrels per day. Equity earnings from our various joint ventures increased $11 million compared to the first quarter of 2017.
This increase is primarily attributable to higher volumes in the BridgeTex pipeline from new commitments, which started in the first quarter of 2018, as well as Eaglebine originated volumes and higher spot shipments. Volumes on the Saddlehorn pipeline were also higher as a result of the contractual step-up in committed volumes in September of 2017.
BridgeTex's volumes averaged approximately 315,000 barrels per day during the first quarter of 2018 compared to approximately 210,000 barrels per day in the first quarter of 2017. Saddlehorn pipeline averaged approximately 65,000 barrels per day during the current quarter compared to approximately 45,000 barrels per day during the first quarter of 2017.
Finishing up my discussion of our segment performance, our marine segment generated approximately $30 million of operating margin in the current quarter compared to $34.5 million in the first quarter of 2017. Revenues were essentially flat period-over-period with higher storage rates offsetting lower utilization as we continue to complete the work necessary to bring tanks damaged last year by Hurricane Harvey back online and complete other tank maintenance that was delayed as a result of the storm.
Operating expenses increased $5.3 million compared to the 2017 quarter due to lower product overages which, as you may recall, act to reduce our operating expenses and higher personnel costs. Personnel costs were negatively impacted by approximately $0.9 million related to the pension correction.
Now, moving to other net income variances to last year's quarter, our G&A expenses were $6.3 million higher than the 2017 quarter as a result of higher personnel costs. $3.4 million of higher personnel costs were attributable to the pension correction and the balance of the increase was related to higher head count as we continue to grow.
Depreciation and amortization increased as a result of new assets placed into service and other expense increased $7.6 million. Approximately $6.9 million of the increase in other expense was attributable to the pension correction made in the quarter.
Net interest expense increased by $4.7 million due to higher outstanding borrowings used to finance growth capital. I will now move to discussion regarding our balance sheet and liquidity position.
We had $4.6 billion of long-term debt outstanding as of March 31, 2018, and our average interest rate was approximately 4.8% with an average tenure of approximately 15 years. Our leverage ratio was about 3.3 times debt-to-EBITDA.
We continue to maintain the credit facility totaling $1 billion, which also backstops our commercial paper program. At quarter-end, we did not have any outstanding borrowings on this facility or under our commercial paper program and had about $74 million of cash on hand.
We also have a $750 million at-the-market equity program available, but did not issue any units under this program during the quarter and have not issued any units under this program since it has been in place. We continue to expect that we will be able to fund our current slate of growth projects underway without exceeding our long-term, our long-standing maximum leverage ratio target of 4 times.
As we progress through the year, we expect our leverage ratio to rise, but also remain below our targeted maximum. I'll now turn the call back over to Mike to discuss our updated guidance for the balance of the year as well as some of our significant growth projects underway.
Michael N. Mears - Magellan Midstream Partners LP
Thank you, Aaron. Based on our solid start to 2018 and our expectations for the remainder of the year, we have increased our annual DCF guidance by $30 million to $1.08 billion for 2018.
A number of industry dynamics moved in our favor since the time we initially provided guidance earlier this year. For one, the crude oil pricing differential between the Permian Basin and Houston has been favorable of late, climbing to over $12 per barrel as of yesterday.
The current tariff for spot shipments on both the Longhorn and BridgeTex pipelines is close to $4 per barrel, so shippers can easily justify moving spot barrels in this pricing environment. We are indeed seeing interest in spot shipments currently and have assumed spot barrels continue to flow, especially in the uncommitted space on BridgeTex, at least for the next few months.
The outlook for butane blending margins has also improved since we provided guidance earlier this year, primarily due to a softening of butane prices, which favorably impacts our blending process. We've continued to hedge our expected fall blending activities and now have about three quarters of fall blending margins locked in at this point.
Earlier this year, we expected average margins of around $0.30 per gallon for the year. With hedges we put into place so far and using the forward curve for the remaining sales volume, we currently expect our average butane blending margins to be closer to $0.40 per gallon for the year.
I know that the upcoming Longhorn recontracting is on your mind, so I'd like to briefly hit on where we are. As we mentioned on our Analyst Day, almost all existing Longhorn customers now have extended their contracts under current terms for an additional two years as allowed by the agreements that expire on September 30.
Hopefully, these extensions removes some of the uncertainty related to these expiring contracts and we believe their willingness to roll the current contracts emphasizes the strong demand for space on Longhorn, especially with the current differential environment. In saying that, Magellan always prefers contract length when possible, so we remain in active discussions with these shippers to extend the duration of these contracts.
Pricing for long-term commitments on crude oil pipelines originating from the Permian still remains quite competitive, with new capacity expected to come online over the next few years at lower rates, and that is really the rate we are competing against. As a result, we continue to assume in our DCF guidance that average tariff rates on Longhorn will likely be lower beginning in the fourth quarter of 2018 as we still prefer additional length to those commitments, even if that means a rate reduction for that longer-term surety.
So wrapping up 2018 guidance, if you remember the fact that the $16 million one-time pension adjustment reduced our DCF for the year, our increased guidance to $1.08 billion clearly shows that our company is generating strong results this year, allowing us to overcome this unexpected item and still boost our expectations for the year. With regards to distributions, we raised our quarterly cash distribution to $0.9375 per unit for the first quarter, which was a $0.0175 increase over the last quarter.
We remain committed to our stated goal of increasing annual distributions by 8% during 2018 with the intention of bumping the quarterly payout by $0.02 per quarter for the remainder of the year to get us there. Based on our updated guidance, we still expect distribution coverage of 1.2 times, while generating excess cash of nearly $200 million for the year.
Looking further ahead, we continue to target annual DCF growth in the range of 5% to 8% for both 2019 and 2020, and we've indicated our intentions to manage distribution growth consistent with DCF growth expectations for the foreseeable future. We also plan to maintain annual distribution of 1.2 times for these out-years, which will result in annual distribution growth of 5% to 8% for 2019 and 2020 as well.
Moving to expansion capital, we continue to develop incremental investment opportunities expected to generate attractive returns for our investors. Based on the projects currently under construction, we now expect to spend $950 million in 2018, with an additional $425 million in 2019 to complete the expansion projects now in progress.
This spending profile is $100 million higher than previously discussed, mainly due to a recently launched project to construct a new transmix fractionator in Frost, Texas. This new fractionator is expected to be operational in late-2019, and will be needed as we handle more and more refined products volume in the Texas market, especially once our East Houston-to-Hearne pipeline comes online that year.
Expansion of our Seabrook Logistics joint venture is nearing completion and is expected to commence operations in early third quarter. As a reminder, the second phase of this crude oil export facility includes 1.7 million barrels of storage and connectivity to our Houston distribution system.
Demand for this storage appears quite strong to the industry's increased interest in crude oil export capabilities. We also continue to make great strides at our Pasadena joint venture marine terminal with tank construction in full swing.
The first 1 million barrels of storage should be operational by January of 2019, with the remaining 4 million barrels of storage projected to come online by January of 2020. For our large scale pipeline projects, the pipeline steel has been ordered, and permit and right-of-way work are in progress for the Delaware Basin crude oil and East Houston-to-Hearne refined products pipeline, with both expected to be operational in mid-2019.
As we indicated during our recent Analyst Day, we are currently evaluating optimization of the Delaware Basin project with third-parties due to the competitive landscape and our commitment to maintain capital discipline. Pending the outcome of these optimization efforts, our current spending estimates continue to include the entire $150 million spend for this project.
We also continue to evaluate other potential expansion opportunities, still totaling well in excess of $500 million. Active discussions with potential customers continue to further develop our Pasadena and Seabrook Logistics joint ventures.
Discussions also continue regarding new infrastructure investments in West Texas and other regions of Texas for both crude oil and refined products services. An open season is currently underway to assess customer interest for the potential expansion of the western leg all of our refined products system in Texas.
Significant interest has been expressed from potential shippers for this proposed pipeline expansion, with the open season recently extended by one week to May 16 to provide interested shippers additional time to finalize their commitments. And that concludes our prepared remarks.
So, operator, we can now turn it over for questions.
Operator
Yes, sir. Our first question comes from Theresa Chen, Barclays.
Theresa Chen - Barclays Capital, Inc.
Good afternoon. Mike, in light of the announcements of new Permian pipelines moving forward, Gray Oak in particular, how does that change the competitive dynamics for you in terms of signing up customers for your Wink to Crane project, as well as for Longhorn recontracting?
Michael N. Mears - Magellan Midstream Partners LP
Well, I think the situation hasn't changed dramatically. I mean, the market, the fact that Gray Oak announced that their proceeding hasn't changed the fact that Gray Oka, as well as many other participants have been actively trying to secure commitments for the last year-and-a-half.
And so, we've been working on recontracting Longhorn and developing the Wink to Crane pipeline in that environment. So, the fact that one pipeline has announced their proceeding really hasn't changed the dynamic nature or the situation we're in with regards to recontracting.
I guess another way to phrase that is, everyone that is a Longhorn shipper fully expected another pipeline was going to be built out of the Permian at some point. And so, that's not new news to them.
I mean, who the party was that actually won the race at least for the – at this point may have been in some doubt, but there wasn't any doubt in anyone's mind that somebody was going to win the race and another pipeline was going to be built.
Theresa Chen - Barclays Capital, Inc.
Okay. So, what do you think Magellan can offer that is differentiated at this point?
Is it mainly downstream related to your Houston distribution system?
Michael N. Mears - Magellan Midstream Partners LP
Well, it depends on which element of the value chain you're talking about. If you're talking about Longhorn specifically and our efforts to recontract Longhorn, obviously, our distribution system in Houston is a critical component of what we have to offer and access to all of the demand points in Houston and crude oil export capabilities.
The other item that I think it's pretty self-evident with regards to recontracting Longhorn today at lower rates is that the differentials are high now and are likely going to be high until the next pipeline gets built. So, to the extent that someone can contract or negotiate a lower fee on Longhorn today that would apply for the next two years, during this high priced environment, I think it would be attractive and is attractive to the shippers.
Theresa Chen - Barclays Capital, Inc.
Got it. And turning to the open season for the expansion of the western leg of your Texas refined products system, is the cost still expected to be around $300 million and what kind of multiple do you expect such a project would generate, would it be similar to your East Houston-to-Hearne project, like around 8 times?
Michael N. Mears - Magellan Midstream Partners LP
We are expecting around an 8 times multiple and the capital is still expected to be around $300 million.
Theresa Chen - Barclays Capital, Inc.
Okay. And lastly, I understand you are very focused on the Houston exports options via some of your projects down there, but in terms of the potential Corpus Christi expansion, can you give an update on how that's going, and especially in light of competitors focusing on the ability to partially or fully (00:23:09) in that area?
And given the position of your land, it's pretty deep in the channel, seems that that would be difficult. Would you be willing to partner with one of the projects on the north side of the bay or perhaps with the port itself via the Harbor Island project?
Michael N. Mears - Magellan Midstream Partners LP
Absolutely. And I think we've publicly talked about our willingness to partner with the port or other parties to have a viable project in Corpus.
Theresa Chen - Barclays Capital, Inc.
Thank you.
Michael N. Mears - Magellan Midstream Partners LP
Okay.
Operator
Our next question comes from Jeremy Tonet, JPMorgan.
Jeremy Bryan Tonet - JPMorgan Securities LLC
Good afternoon.
Michael N. Mears - Magellan Midstream Partners LP
Hi, Jeremy.
Jeremy Bryan Tonet - JPMorgan Securities LLC
Just want to – thanks, want to circle back to the discussion with regards to kind of rate versus tenure on contract, and appreciate you're not going to want to give away inside information how you're negotiating here, but just wondering how you see that trade-off? What do you think is realistically the longest type of tenor you can get in this situation?
I mean, given where differentials are right now and presumably it could be tight like this for quite some time, just wondering if you could expand a bit more as far as your philosophy in the trade-off in rate versus contract tenor?
Michael N. Mears - Magellan Midstream Partners LP
Well, the negotiations we're having now are long-term contracts. So, we – active negotiations are contracts anywhere from 5 years to 10 years.
So, that's the range we're looking at.
Jeremy Bryan Tonet - JPMorgan Securities LLC
Got you.
Michael N. Mears - Magellan Midstream Partners LP
And clearly, a 10-year agreement would command a lower rate than a five-year agreement. And so, those are kind of the balance of what the negotiations are.
Jeremy Bryan Tonet - JPMorgan Securities LLC
Okay. Thanks for that.
And then, equity earnings within the crude oil segment, I think 1Q results were a bit lower than 4Q 2017. Just wondering – maybe I missed it, if you could provide a little bit more color on the drivers there?
Michael N. Mears - Magellan Midstream Partners LP
Well, most of that's probably due to BridgeTex. And if you recall back in the fourth quarter, if you look at the – let me back up, spot movements on BridgeTex are obviously highly dependent on what the Midland to Houston differential is.
And if you look at the fourth quarter last year, the differential was high and there was a lot of spot movements moving on BridgeTex. If you look at the first quarter this year, it got pretty weak in the early part in the first quarter, and so that we didn't have significant spot movements on BridgeTex.
That changed in late-March and April, and the differential, as everyone knows, has started to blow out. So, we're back in the mode of at least at this point in time with significant spot shipments.
So, if you're comparing the fourth quarter to the first quarter, it all had to do with the fact that the margin did compress quite a bit in January and February.
Jeremy Bryan Tonet - JPMorgan Securities LLC
That's helpful color. That's it for me.
Thanks.
Michael N. Mears - Magellan Midstream Partners LP
Sure.
Operator
Our next question comes from Dennis Coleman, Bank of America.
Dennis P. Coleman - Bank of America Merrill Lynch
Good afternoon. Thanks very much.
Just if I can go back to the Longhorn question a little bit. And I wonder if you might talk a little bit how – what the outcomes you think will be?
Will it be sort of all the shippers will go towards one type of contract? Will there be some kind of laddering?
Is that desirable for you to have some kind of laddering in terms of not having sort of all the contracts come due at the same time?
Michael N. Mears - Magellan Midstream Partners LP
Well, I can tell you that probably my preference and given the nature of – the conservative nature of our company, I preferred to have 10-year contracts from everybody, that's not likely. What will be likely is hard to predict at this point.
I think we'll have a mix of terms. I think it is possible that we will have shippers that don't sign a longer-term agreement and then just stick with the higher rate for two years.
But what the precise mix of that will be is I can't predict right now. And unfortunately, given the nature of the extension rights that the shippers have and the fact that they've signed the two-year extensions that don't kick in, I mean the base contract doesn't expire till September 30, it's possible we could be negotiating these extensions through the summer and into the early fall before someone actually signs, and hopefully that's not the case and we're able to get some of these secured sooner rather than later.
But since everyone's got at least the next two years secured and that potential for not having certainty on this for a few more months is present. So, unfortunately I can't guess and I don't really want to guess as to what that mix will look like.
But I can tell you in our guidance we've assumed that essentially all of the shippers sign long-term extensions and reduced the rate. So, to the extent that doesn't happen, there is upside to our current year guidance.
Dennis P. Coleman - Bank of America Merrill Lynch
Okay. That's helpful.
Clearly, the preference is for longer, but interesting to hear that there could be some that choose none or to stick with the two-year. With regard to the spot shipments, changing topic a little bit, it seems you're sort of saying you think that spot shipments continue to the third quarter, but I guess you could maybe build an argument that that differential holds out for perhaps longer.
Any sort of logic behind the third quarter guidance?
Michael N. Mears - Magellan Midstream Partners LP
We decided to be conservative in our guidance. If the margin stays high through the rest of the year, then our guidance is low.
Dennis P. Coleman - Bank of America Merrill Lynch
Okay. That's perfect.
A couple just quick ones, with regard to the pension issue, you've given some good detailed numbers, the impact at various businesses. Is this something that will cause operating expenses to be higher on in future years as well, should we think about a higher run rate?
Aaron L. Milford - Magellan Midstream Partners LP
No. This is Aaron.
This isn't going to impact our cost structure going forward. It really was just a cumulative catch up to where we needed to be for the error that our actuary made.
So, it's not going to have any future cost structure impact.
Dennis P. Coleman - Bank of America Merrill Lynch
Great. Perfect.
And then just one last one for me, the commodity hedges. I think I know the answer to this, but you had some impact from mark-to-market, presumably that unwind in future periods as you realize the actual sales against those positions, is (00:30:54) right?
Michael N. Mears - Magellan Midstream Partners LP
Yes.
Dennis P. Coleman - Bank of America Merrill Lynch
Okay. That's it for me.
Thanks.
Michael N. Mears - Magellan Midstream Partners LP
All right. Thank you.
Operator
Our next question comes from Barrett Blaschke, MUFG Securities.
Barrett Blaschke - MUFG Securities America, Inc.
Hey, guys. As far as the guidance update, can you give us a little color around sensitivity as far as the differential, and if it widens, how much more spot shipments you could see?
And is there any way you can quantify it a little?
Michael N. Mears - Magellan Midstream Partners LP
Well, we've assumed at least for the next few months that it's pretty well full on spot shipments, with not – I mean that we pretty much filled the pipeline up with spot shipments. So, there is really no upside to our forecast for the next few months.
But again, we've assumed this only lasting for the next few months and not into the fourth quarter. And so, there is upside there, but not – I mean, we've – pretty much of our guidance assume we fill up the pipe over the next few months.
Barrett Blaschke - MUFG Securities America, Inc.
Okay. Thank you.
Michael N. Mears - Magellan Midstream Partners LP
Okay.
Operator
We have no further questions in the queue. I'd like to turn the call back over to Mr.
Mears.
Michael N. Mears - Magellan Midstream Partners LP
All right. Well, thank you for your time today, and we appreciate everyone's continued interest and investment in Magellan.
Have a good afternoon.
Operator
Thank you. Ladies and gentlemen, this concludes today's teleconference.
You may now disconnect.