Analysts at Jefferies on Monday initiated coverage on four independent oil refiners and their affiliated logistics master limited partnerships (MLPs). After a period of high crack spreads in the year following the collapse of crude prices in the latter half of 2014, refiners have fallen on some tough times as domestic inventories have swollen. Crack spreads have tightened and refiners may be forced to cut production runs.

Jefferies initiated coverage on the following firms, listed here with their rating, Monday closing price and price target:

• Marathon Petroleum Corp. (NYSE: MPC): Buy; $41.10; $48
• MPLX L.P. (NYSE: MPLX): Hold; $33.60; $35
• Phillips 66 (NYSE: PSX): Hold; $76.97; $72
• Phillips 66 Partners L.P. (NYSE: PSXP): Hold; $48.91; $54
• Tesoro Corp. (NYSE: TSO): Buy; $74.42; $101
• Tesoro Logistics L.P. (NYSE: TLLP): Hold; $46.11; $49
• Valero Energy Corp. (NYSE: VLO): Buy; $54.43; $66
• Valero Energy Partners L.P. (NYSE: VLP): Buy; $41.62; $53

In their general comments on refiners, Jefferies analysts see “potential for planned maintenance downtime and economic run cuts” to help draw down the swollen inventories. They also expect “ongoing investment in the midstream space in an effort to diversify exposure & promote stability in underlying cash flows.”

Concerning the MLPs, Jefferies expects to see cash-rich refiners move to make more acquisitions in the logistics space. Calling the MLPs a “multiple step up in valuation” due to “well articulated growth backlog, open capital market access, and volume agnostic contractual arrangements,” the “refining affiliated MLP model is now taking on a new life.”

We include here some of the analysts’ comments on each of the refiners and MLPs on which they are initiating coverage:

Marathon Petroleum

• The largest refinery operator in PADD 2
• Most levered to [General Partner Incentive Distribution Rights] relative to refining peers
• Owns & operates one of most profitable C-stores in country
• Strong vertical integration from refining to marketing
• Has made several large midstream acquisitions in last year (MWE merger, 9% stake in [Dakota Access Pipeline])

MPLX

• The largest processor and fractionator in Marcellus & Utica thus direct volume exposure to natural gas & NGLs from northeast producers
• Strong backlog of additional northeast dedicated midstream projects through 2017
• Potential to acquire interest in Mariner East 2 with MPC support
• Large inventory of drop-down assets from MPC

Phillips 66

• Most diversified portfolio of assets
• Best performer vs peer group YTD (-2% vs -25%)
• High quality midstream infrastructure projects ([Dakota Access Pipeline], Freeport, etc)
• Diversity yields internal hedge support (i.e. long ethane & ethylene)
• Berkshire Hathaway owns 15% of outstanding shares
• In late innings of world-scale ethylene cracker completion

Phillips 66 Partners

• Large and highly attractive list of drop-down assets from [investment grade] parent
• In-flight growth projects expected to contribute to EBITDA in 2017
• Has raised ~$1B of equity in last 2 quarters
• Mgmt targeting ~20-25% distribution growth in 2017 & 2018 as it targets a 30% CAGR since 4Q13 IPO
• Strong downstream support for midstream projects via PSX

Tesoro

• One of the largest refining operators in PADD 5
• Refining is the smallest operating segment as a % of [cash flow] contribution
• Exhibiting largest discount to Sum-of-the-Parts
• We expect support will be needed by TLLP in the form of attractive drop-down multiples
• Goal of attaining Investment Grade credit rating

Tesoro Logistics

• Large presence in the Midcontinent and Williston basin thus creating volume exposure to crude, natgas & NGLs from Bakken producers
• Large inventory of drop-down assets from TSO although we expect parent support on at least one of the drop-down transactions
• Stated goal of retaining [investment grade] and hitting $1B EBITDA in 2017
• Deep in 50% [incentive distribution rights] splits making growth more difficult vs peers

Valero

• Largest independent refiner in world with largest presence in PADD 3
• Refining is the largest operating segment as a % of [cash flow] contribution
• Largest discount to peers on almost every metric
• Environmental costs remains an issue – currently in litigation with EPA
• Spun off retail business in 2013 decidedly making VLO a merchant refiner

Valero Energy Partners

• Fastest rate of distribution growth under MLP coverage
• Robust coverage and healthy balance sheet provides cushion of support not shared by peers
• Stated goal from mgmt to grow distribution by 25% in 2017 & 2018
• Large inventory of drop-down assets from VLO
• Don’t expect to see a MPLX type transaction

For the near term, the Jefferies analysts conclude:

Refining margins remain under pressure and, we believe, intermediate-term utilization rates will decline on the back of maintenance downtimes & economic run cuts. Accordingly, we have seen a material slowdown in refining directed capex and, instead, a pivot by US refiner[s] to enhancing their individual midstream capabilities. We believe significant organic midstream investment and M&A will be completed by US refiners in the coming years and the logistic MLPs first created to simply provide financial flexibility will be large enough to support significant cash flow generation back to the parent sponsors. Therefore, while we do not expect the same magnitude of structural separation as was seen with the diversified E&P companies like El Paso, Williams, & QEP earlier this decade, we believe the time will come for refiners to monetize portions of their MLP positions to provide valuation markers, similar to the actions of Anadarko & EQT with Western & EQGP, respectively. By that time, however, we believe crude markets will have rebalanced and, following the structural move away from streamlined midstream GPs (Kinder, Targa, & Plains), we think refiners’ GP structures may be both unique and valuable to external investors.

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