Why NuStar's Great Earnings Aren't That Great

The spike in oil and liquid natural gas demand has coaxed exploration and production companies to dig into every possible reserve, giving top-line enhancement opportunities to the midstream sector as well as energy transportation and storage companies. So when Texas-based NuStar Energy (NYS: NS) -- whose pipelines cover major shale oil plays of the mid-continent and Gulf Coast regions -- surpassed its guidance for the third quarter, the news was a bit obvious in coming.

What might seem unusual to investors was the mismatch in the growth of revenue and that of operating income and net income. Let's find out what happened.

Decoding data
The discrepancy lies in the fact that in spite of a 60% jump in revenue, NuStar could manage only a paltry 3% rise in operating income and net income. Sales increased mainly due to higher gasoline prices. But even though selling and general expenses went down by 34%, cost of product sales increased by a whopping 78%.

Two factors pinched costs the most -- increased prices of crude oil, which the company uses to produce asphalt and other refined products, and ineffective hedging. NuStar, in order to hedge price risks, enters into future commodity derivative instruments. However, when the hedge proves to be ineffective, the company incurs losses that are included in the cost of products sold. Market adjustments attached to derivatives have also pulled down distributable cash flows to limited partners by $4 million.

Industrywide trend
Such contingencies are not uncommon or specific to NuStar. Across the midstream industry, several players incurred such losses this year. Valero Energy (NYS: VLO) has been fighting higher crude oil prices and losses through commodity derivative instruments, losing $542 million ($352 million after taxes) on derivative contracts related to forward sales of refined products in the nine-month period ending in September 2011.

Production snapshots
In the transportation segment, volumes went down by 7.4% to 842,382 barrels per day primarily due to problems at customers' refineries. This occurred despite additional sales coming from the Eagle Ford shale projects. Further contribution from the Eagle Ford shale plays is expected next year with NuStar's management announcing new projects in the fourth quarter of 2011.

The storage segment, however, had an uptick of 7.2% in output volumes. This enhanced the top line by 8.2%. With construction underway on a 70,00-barrel-per-day crude oil offloading facility for independent oil and gas major EOG Resources (NYS: EOG) , the segment will reflect further positive growth a year from now.

NuStar's asphalt and fuel marketing segment profits were down due to lower demand for asphalt. The company intends to buy crude oil from Canada for its 2012 asphalt season. Canada provides crude oil at a cheaper rate and should provide the company a chance to better its gross margin.

Foolish bottom line
Energy is a sector that finds a place in one's portfolio pretty early and stays there. NuStar, a 12-year-old midstream company, has done well for itself. But with growth being more market-driven, management should vouch for more strategic initiatives to take the company to a more comfortable position. As of now, I will give a yellow sign to investors. For the long term, time will tell.

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At the time thisarticle was published Fool contributor Abantika Chatterjee doesn't own any shares of the companies mentioned above. Try any of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.

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