A High-Quality Baby Bond Yielding +9% - NuStar - NuStar Energy L.P. (NYSE:NS)

As US oil continues to expand NuStar Energy LP (NS) is well positioned to grow with it.

The market has provided an opportunity to gain the extra security of being at the debt level of the capital.

At High Dividend Opportunities, we set out in 2019 with a few specific goals. We want to increase our exposure to fixed-income investments, we want to lock in high-yields for an extended period of time, and we want exposure to industries that are counter-cyclical and/or recession resistant.

We love to pick up high-yield investments in a sector that is going through some temporary distress. Often, Mr. Market runs in panic from temporary headwinds, creating a situation where an entire sector is oversold.

While there is often a kernel of truth underlying the fear, Mr. Market usually overreacts to the low-side as well as the high-side. Everyone says "buy low, sell high", but so many in the market do the exact opposite. Running from industries in a downswing into allegedly "safe" investments. Then when those "safe" investments fall they run to the next "safe" investment, constantly running into the next momentum stock, buying high and selling into a loss to buy another pick that is high.

The best deals are often found in sectors that are out of favor, the sectors that everyone is running away from. Buying when fear is prevalent can be psychologically difficult, especially since finding absolute bottom requires more than a little luck. Sectors out of favor will often continue to trend down before things get better.

By focusing on the fundamentals, we can identify the safer options in a distressed sector. Picking those that are most likely to maintain their dividends, locking in a high-yield before the share prices recover.

The MLP sector is one sector that is currently out of favor. Specifically, US-based energy infrastructure has struggled for about 4-years. Looking at WTI Crude prices, that shouldn't be a surprise.

When crude prices collapsed in 2015, it created a shock through MLPs. With prices remaining depressed, the pressure built, causing many MLPs to reduce their distributions. Another issue was that MLPs assumed they would always have high share prices to issue equity. Being forced to issue equity at rock bottom prices created further distress for these companies. Falling share prices, declining distributions and no clear catalyst for a return of $100+ oil took its toll on the entire sector.

We can see that the Alerian MLP ETF (AMLP) was heavily impacted by the decline of oil.

From 2010-2014, MLPs were hot. They were a go-to place for "safe" cash-flow, with many MLPs yielding in the mid-single digits. When the prices for oil, natural gas, and other byproducts collapsed, the market took a wild downward swing.

While the sector has recovered from its deepest lows, share prices continue to struggle. When we look at the fundamentals, we see improvements that have yet to be recognized by Mr. Market.

This has allowed us to make investments at very attractive yields in MLPs like Sunoco LP (SUN), Global Partners LP (GLP) and Targa Resources Corp (TRGP) which are trading with yields in the 9-10% range.

In addition to common units in MLPs, overstated fear has also created some great opportunities higher up the food chain. Today we look at a baby bond that is yielding over 9%.

NuStar Energy LP (NS) is an MLP that operates in 3 segments: Pipelines, Storage, and Fuels Marketing. They have assets spread across the United States.

NS has approximately 9,800 miles of pipeline and a total storage capacity of 88 MMbbls.

NS is particularly bullish on their ability to continue delivering strong numbers from their Permian Basin assets. The Permian Basin accounts for more than half of active US oil rigs.

Production growth in the Permian Basin continues, primarily due to growth in shale production.

The Permian Basin has already experienced significant growth and that is expected to continue. While the decline in oil prices has been painful, one of the benefits is that it has forced more efficiency and US oil is able to be profitable at lower prices.Source:NuStar Investor Presentation

NS has already experienced significant growth in the Permian Basin over the last two years, and they expect that growth to continue. This activity will help their direct Permian assets, and they also expect that it will help improve their assets in Corpus Christie, TX, through rising demand for exports.

The US has become the world's largest oil producer andcontinues to grow oil production faster than any other country. At 12.3 million barrels per day (BPD) of oil, the US accounts for over 16% of global oil production. The US now matches Saudi Arabia at 12.3 million BPD and exceeds Russian production of 11.4 million BPD.

US production took a step back when oil prices first collapsed, however, growth has returned as more efficient producers have learned to be competitive at the current prices.

As US production continues to increase, demand for infrastructure to transport and store oil, chemicals, and byproducts will continue to increase. This puts MLP's like NS in a great position to receive consistent and growing cash flows.

The US oil market is making up for low prices through higher volume, NS stands to benefit from the growing volume, with the potential to benefit even more if prices increase.

Despite this potential, Mr. Market remains overly pessimistic, oil is a growth industry in the US and the US is going to increasingly become the dominant oil producer in the world.

The specific investment opportunity we are recommending is NuStar Logistics L.P., 7.625% Fixed-to-Floating Rate Subor Notes due 1/15/2043 (NSS). These are "baby bonds" which float in the capital structure below the senior debt and above preferred equity.

NSS pays a floating interest rate. In general, we are not fans of floating rate bonds because we believe that rates are generally headed down. However, there is an exception to every rule. The floating rate is calculated as 3-month LIBOR + 673.4. That means that the interest will always exceed 6.7% and at current LIBOR rates is over 9%. Even if rates drop to near 0, the return is very generous.

NSS does not mature until 2043, so if interest rates increase in the future, the floating rate could improve returns. NSS is trading post-call date, so the company has the right to redeem at par value ($25) plus any accrued and unpaid interest.

In total, NS has $3.3 billion in debt and $1.3 billion in preferred shares. NSS is the "NuStar Logistics Sub Notes", it ranks above the preferred equity, equal to the "GO Zone Bonds" and is subordinated to the senior notes and the credit facility.

NS currently has a debt to EBITDA ratio of 4.1x and is likely to remain in that range in the near future.

NS has some significant maturities coming up in 2020.

Since the end of the quarter,NS issued $500 million in new 6% Notes, due 2026. These bonds will be used in part to pay down their debt maturing in 2020. The bonds were priced at 100% par, which is a positive indicator of their ability to roll their debt maturing 2020-2022.

Additionally, NS has an agreement to sell their St. Eustatius facility for $250 million. They expect to use proceeds from that sale to pay down their revolver.

We do not believe that NS will have any difficulty in rolling their remaining debt.

2019 Adjusted EBITDA guidance is for $665-715 million. That implies interest coverage of 3.75-4.0x. NS has plenty of cash flow to service their debt. In fact, they are currently paying over $95 million/quarter in preferred and common dividends- that is more than twice their interest expense. There is plenty of cushion if NS encounters unexpected difficulties for them to reduce equity distributions.

NS made significant progress reducing debt in 2018, from $3.7 billion to $3.3 billion. With the sale of St. Eustatius, we expect they will deleverage even more. Additionally, NS is experiencing growth in the Permian Basin and expects to increase their export business in Corpus Christie throughout the year. NS will likely keep distributions flat and direct all proceeds to reducing debt as improving their credit ratings is going to be a top priority for them.

The efforts are paying off as Moody’s finally changed its tune last month and moved theiroutlook on NS debt to stable.

As stated above, we expect NS to continue deleveraging as their cash-flow improves and through strategic dispositions. Since NSS is trading post-call, and has a higher interest rate than other debt, that raises the risk that NS calls NSS.

So far, NS has not shown an inclination to start redeeming NSS. We believe the primary reason is that in the prospectus, there is a provision that allows NS to defer paying interest for up to 5-years as long as the time does not exceed the maturity date. While the interest would continue to accumulate, this provides NS the option to suspend payments for a period, much like they might suspend a cumulative preferred, without triggering a default and potentially forcing a bankruptcy.

For NSS holders, this creates the risk that the company exercises this option, though they are unlikely to do so unless their financial situation is dire. Oddly, it also creates a bit of protection from the security being called.

From the company standpoint, the flexibility is something that could potentially save the company. For any senior debt, they would have to negotiate to avoid default if they needed to suspend payments. The extra flexibility that provision provides makes NSS more attractive to NS, even if the interest rate is somewhat higher.

Therefore, we believe that the company will remain biased toward reducing the more senior debt first. NSS is unlikely to be replaced until and unless NS is able to issue another baby bond or preferred equity at materially better interest rates.

Oil prices are not directly correlated with broader market. They march to the beat of a different drum. The collapse in late 2014 and into 2015 was a huge blow to the US oil market and by extension, the MLPs that service it.

For the last 4-years, oil has remained depressed but production started picking back up as US producers adapted from a $100+ price environment to a $50-$60 price environment. Natural Gas production has remained on a steady track up for the whole time and did not even pause when oil prices.went down.

Through increasing efficiencies, the market is now at a place where the US oil industry can grow profitably at prices in the $50s, while at the same time oil prices have shown indications of climbing higher. This should be very bullish for US oil production.

MLPs like NS absorbed the blow with the oil producers, and continue to trade at long-term lows as a pessimistic market has gotten used to them underperforming. This has created an opportunity where we can take advantage by investing in MLPs at very high yields, just as their performance starts to improve and they transform from investments with regular dividend cuts to investments with regular dividend increases.

While Mr. Market is still fearful, the underlying fundamentals are looking positive for US-based MLPs as production increases and the US extends its lead as the world's largest oil producer. NS is one of the MLPs that is particularly well positioned to benefit.

NSS is an investment that allows us to get a debt position that currently yields over 9%. A yield that is actually higher than the common distribution and is close to the yield from the preferred shares. While in other MLPs, we have targeted the common units, this opportunity to be at the debt level instead of the equity level for similar yields is one we cannot pass up.

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Disclosure: I am/we are long NSS, GLP, TRGP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Seekingalpha.com

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