The market turmoil resulting from the threat of covid-19 and the drop in crude oil prices hasn’t changed my investment thesis on Vertex Energy (VTNR) even though the company’s margins are tied to fuel prices.
The used motor oil (UMO) re-refiner reported an impressive recovery for the 2019 fourth quarter and full year on March 4th – yet to no avail. The market had bigger issues to reconcile. Still, Vertex Energy is as well-positioned financially, as well-partnered, as well-hedged and as well-prepared as it has been in years.
Vertex Energy’s History
Vertex announced the acquisition of Omega Holdings in March 2014. The transaction included three facilities – Marrero (Louisiana), Myrtle Grove (Louisiana) and Bango (Nevada). Prior to the acquisition, Vertex Energy had a re-refining capacity of less than 30 million gallons of UMO. Omega added capacity of over 80 million gallons to create a combined capacity of nearly 110 million gallons. In June 2014, Vertex executed a $17 million private placement to enable expansion. By mid-2014, Vertex Energy owed over $40 million and faced a June 30, 2015 maturity date for $9.1 million of the total with Goldman Sachs (GS). Crude oil prices were more than $100 per barrel at the time and the company seemed well-positioned to handle the obligation.
But, crude oil prices tumbled and were cut in half by early 2015. Things were looking a bit bleak for Vertex Energy. But, the tumble in price enabled the re-refining industry to transition to a service fee model for the collection of UMO. The EPA had set used oil management standards and required tracking used oil for any business point that handles shipments of more than 55 gallons. It was reasonable for this regulated service to be performed for a fee, especially when the value of UMO was so low. When the value of UMO is high, local generators expect to be paid rather than to have to pay.
In June, 2015, Vertex was able to raise $25 million by issuing approximately 8.1 million shares of Series B preferred stock. The proceeds were used to pay down $15.1 million of its debt. By the end of the 2015 third quarter, Vertex had slashed long-term debt to $27.44 million.
In February, 2016, it announced the sale of the Bango base plant in Nevada to Safety-Kleen Systems, a subsidiary of Clean Harbors (CLH) for $35 million. It used approximately $16 million of the proceeds to further pay down long-term debt. Its debt obligation to Goldman was down to around $7 million.
In May, 2016, the company announced a private placement of preferred stock and raised approximately $19.3 million. The first use of the proceeds was to repurchase and retire $11.2 million worth of the Series B preferred stock issued in June 2015. The remainder of the proceeds, approximately $8.1 million, was used to pay down debt and for working capital needs. The outstanding balance due Goldman was down to $6.4 million.
In twelve months, Vertex had decreased its total outstanding debt by two-third from $43.5 million to $14.2 million. Yet, of the $14.2 million in long-term debt outstanding, $8.9 million would mature in 2016. In January, 2016, Vertex Energy had provided a promissory note to Fox Encore for $5.15 million with a due date of July 31, 2016. The note did have three extension options which extended the maturity date by six months each at a fee. By third quarter reporting in November, 2016, the company’s long-term debt registered just over $15 million.
In February 2017, Vertex entered into a term loan and a revolving note with Encina Business Capital and closed out previous agreements. Both Encina credit agreements were to mature in February 2020.
Vertex was working on a new financing solution by March 2018 and expected it to close by summer of 2018. When that date came and went, the company all but promised a closing by calendar year-end. In March 2019, it reassured a solution was in the works. In May 2019, the completion date was moved yet again.
But, refinancing its debt was not the only financing struggle for Vertex Energy. Raising capital to increase production capacity had also been a focus all through 2018. In an interview with the Houston Business Journal, the total need was estimated at approximately $87 million for three unfinished projects – Myrtle Grove, Louisiana, Houston (Baytown), Texas and Columbus (Heartland), Ohio.
The cash infusion and a twelve month extension on the debt’s maturity date resulting from the Tensile partnership significantly improved Vertex’ liquidity position. With third quarter reporting in November, 2019, Vertex Energy did still owe $18.95 million. Completion of the pilot project by calendar year-end was to transform the company’s balance sheet.
Assuming receipt of the $13.5 million, we will move from a net debt to a net cash-positive by year-end or shortly thereafter.
We view the successful completion of the pilot test related to a phase 2 closing with Tensile Capital as a liquidity event that has the potential to transform our business, both reducing net leverage and by providing capital for long-term growth.
On January 10, 2020, the companies announced completion of the pilot. Tensile retained a right of first refusal to fully develop high-purity base oils at the Myrtle Grove facility in exchange for $50 million in project capital.
Successful completion of the pilot then triggered a second phase where another SPV was formed for the assets at Vertex’ Heartland facility. This transaction closed January 22, 2020. The Heartland refinery is now owned jointly by Vertex Energy and Tensile, with a 35% interest and 65% interest respectively.
On March 4th, Vertex reported 2019 fourth quarter and full-year results. In the quarter, while operating its Marrero and Heartland facilities at 100% and 103% capacity, revenue, adjusted EBITDA and net income all improved year-over-year.
Vertex’ street collections increased over 19% in the quarter compared to the previous year. When Vertex acquires its feedstock through street collections rather than from third-party suppliers, its expenses are less. For all of 2019, Vertex grew its volume of street collections by 21% from 30.6% in 2018 to 37% in 2019.
Additionally, product spreads were at a near-record level in the quarter.
The Impact of Product Spreads
Used motor oil is typically priced similarly to HSFO (High Sulfur Fuel Oil), also known as Gulf Coast #6 fuel oil, heavy fuel oil or marine fuel. Vertex purchases its feedstock at a price discounted from HSFO as the base.
The International Maritime Organization’s IMO 2020 global regulation changed the limit on sulfur content in marine fuel. The cap was lowered from 3.5% mass/mass (m/m) to 0.5%. With the implementation of IMO 2020 on January 1, 2020, demand for HSFO was expected to dramatically decrease and its price to fall. HSFO will still be used in the power, cement and road-building industries. As scrubbing technology continues to be developed and adopted, some demand is expected to resume in the transportation industry after 2020.Source
As a result, Vertex expected the implementation of IMO 2020 to lower its feedstock costs. At the same time, demand was to drive prices for IMO 2020-compliant marine fuel higher.
Fuel prices were initially expected to increase in 2020. So, as prices increased, sales revenue for Vertex Energy was projected to increase. In August 2019, Vertex projected the spread between WTI (West Texas Intermediate) crude and HSFO.Source
As already mentioned, the spread between Vertex’ input costs and its product pricing did dramatically increase as demand for HSFO declined in the last months of 2019. From August to November, the spread between WTI crude and HSFO was wider than projected.Source
The same trend carried through December and January.Source
But, global challenges brought significant deterioration.
During the first quarter 2020, product spreads narrowed from near-record fourth quarter levels as global trade slowed in reaction to concerns around a novel coronavirus strain.
The spread between WTI crude and HSFO is now well below $5.
The prices for Vertex Energy’s re-refined outputs track alongside the price of diesel. In 2018, Goldman Sachs’ (GS) investment research suggested the differential between diesel and Fuel Oil would widen to historic levels.Source
Although the transition to IMO 2020 proceeded as projected relative to diesel prices, the positive impact was short-lived. Previously unanticipated factors impacted diesel prices negatively. A senior manager at Breakthrough.com detailed the changes.
Growing international diesel inventories and the prospects of the coronavirus further disrupting the movement of freight internationally resulted in the lowest diesel premiums since June 30, 2017. At just 38.4¢ per gallon, the diesel crack on February 3, 2020, marked the first time the premium for diesel fuel from crude oil had fallen below 40.0¢ per gallon in a year-and-a-half. This was hardly the anticipated outcome expected during the IMO transition.
Since February 3rd, diesel fuel prices have fallen another 25%.Source
So, once again, the market seems to think the view is a bit bleak for Vertex Energy. The market has chopped its share price as much as 77% from a high of $1.95 on January 22nd, when the second Tensile SPV closed, to a low of $0.45 on March 19th.
Factors That Matter
There are, however, pertinent factors to recognize offering optimism. First, Vertex Energy signed a strategic agreement with Bunker One USA, a physical fuel supply network with global operations, in January. Bunker One has the exclusive right to purchase 100% of the marine fuel produced at Vertex’ Marrero refinery through December 2029.
This relationship not only ensures a long-term sales and marketing channel for 100% of our current marine fuel production at fair market prices, it also provides us surety of off-take for incremental marine fuel production in future years, while allowing us to participate as a minority partner in Bunker One’s entire North American marine fuel bunkering business.
In the fourth quarter release, CEO Ben Cowart reiterated benefits of the agreement.
Importantly, we have hedges in place to protect some of our product margins, which we expect will serve to offset part of the recent volatility evident in the market. Even as refining margins are expected to revert back toward long-term averages, contributions from the Bunker One agreement, together with strong demand for high-purity base oils, support our positive outlook for the full-year 2020.
And, in the earnings call, he applauded the company’s hedging strategy against volatility and assured the company is “not in any type of panic mode”.
Had we been exposed in the first quarter when this market turned upside down, we would have got beat up pretty good. (emphasis added)
Secondly, Vertex Energy’s liquidity position has significantly improved since the calendar year began. Its debt obligations now total only $6 million. Interest expense in 2019 was just over $3 million. At an average rate of 8%, interest expense in 2020 should be but a fraction of that number.
Third, Vertex Energy expects to continue to organically grow its self-collection business. Historically, it has grown this segment by 15% to 20%. While it does not have an aggressive plan for 2020, it still expects to see positive momentum.
Most importantly, management assured its 2020 guidance for adjusted EBITDA offered in November 2019 was conservative. The company expected 2019 adjusted EBITDA in a range of $4 to $6 million. The outperformance of the fourth quarter resulted in adjusted EBITDA of $7.4 million. Off the 2019 estimate, it projected adjusted EBITDA for 2020 in a range of $15 million to $20 million. Although the spread has been under pressure as the first quarter comes to an end, the company’s guidance is actually not at risk.
What we used as the benchmark for spread was $8 below WTI for high sulfur fuel.
Finally, a successful completion of the Tensile SPV at Heartland will transform the facility’s production regarding product as well as capacity. The first Tensile SPV was a pilot test at Myrtle Grove proving higher-purity Group III base oils could be produced. Not only was the pilot successful, but it is pertinent to remember Heartland has already been producing higher-purity base oils. The goal of the second SPV is to fully develop the facility to produce Group III base oils as validated by the pilot.
By 2023, Vertex Energy expects adjusted EBITDA, based solely on the Heartland facility, to increase 8X to 11X compared to the 2018 benchmark of $2 million. This is above and beyond the adjusted EBITDA guidance offered for 2020.Source
The need to re-refine UMO is not likely to diminish. According to the EPA, re-refining used oil takes only about one-third the energy of refining crude oil to lubricant quality. It takes 42 gallons of crude oil, but only one gallon of used oil, to produce 2-½ quarts of new, high-quality lubricating oil.
Vertex Energy spent a majority of the last decade positioning its business for the industry’s transformation to usage of higher-purity base oils and IMO 2020-compliant fuel. It has already weathered one downturn in crude oil prices. Between its hedging strategy, its improved liquidity, its decreasing costs, its partnerships and the completion of proof-of-concept projects, the company is much better positioned to weather the current crisis.
While the market is distracted, building a position in Vertex Energy would cost an investor very little. The risk is low while the potential reward is attractive.
Disclosure: I am/we are long VTNR. 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.
Additional disclosure: I belong to an investment club that owns shares in VTNR
Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.