HOLLY ENERGY PARTNERS LP - Quarter Report: 2007 March (Form 10-Q)

 

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2007

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES ACT OF 1934

For the transition period from                      to                     .

HOLLY ENERGY PARTNERS, L.P.

(Exact name of registrant as specified in its charter)

Delaware		20-0833098
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

100 Crescent Court, Suite 1600
Dallas, Texas 75201-6915

(214) 871-3555

None

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).

Yes o No þ

The number of the registrant’s outstanding common units at April 25, 2007 was 8,170,000.

 

 

HOLLY ENERGY PARTNERS, L.P.
INDEX

PART I. FINANCIAL INFORMATION			3
FORWARD-LOOKING STATEMENTS			3
Item 1. Financial Statements (Unaudited, except December 31, 2006 Balance Sheet)			4
Consolidated Balance Sheets			4
Consolidated Statements of Income			5
Consolidated Statements of Cash Flows			6
Consolidated Statement of Partners’ Equity (Deficit)			7
Notes to Consolidated Financial Statements			8
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			21
Item 3. Quantitative and Qualitative Disclosures About Market Risks			32
Item 4. Controls and Procedures			32
PART II. OTHER INFORMATION			33
Item 1. Legal Proceedings			33
Item 2. Unregistered Sales of Securities and Use of Proceeds			33
Item 6. Exhibits			33
SIGNATURES			34
Computation of Ratio of Earnings to Fixed Charges
Certification of CEO under Section 302
Certification of CFO under Section 302
Certification of CEO under Section 906
Certification of CFO under Section 906

PART I. FINANCIAL INFORMATION

FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q contains certain “forward-looking statements” within the meaning of the federal securities laws. All statements, other than statements of historical fact included in this Form 10-Q, including, but not limited to, those under “Results of Operations” and “Liquidity and Capital Resources” in Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Part I are forward-looking statements. These statements are based on management’s beliefs and assumptions using currently available information and expectations as of the date hereof, are not guarantees of future performance, and involve certain risks and uncertainties. Although we believe that the expectations reflected in these forward-looking statements are reasonable, we cannot assure you that our expectations will prove correct. Therefore, actual outcomes and results could differ materially from what is expressed, implied or forecast in these statements. Any differences could be caused by a number of factors, including, but not limited to:

	•		Risks and uncertainties with respect to the actual quantities of petroleum products shipped on our pipelines and/or terminalled in our terminals;
	•		The economic viability of Holly Corporation, Alon USA, Inc. and our other customers;
	•		The demand for refined petroleum products in markets we serve;
	•		Our ability to successfully purchase and integrate any future acquired operations;
	•		The availability and cost of our financing;
	•		The possibility of reductions in production or shutdowns at refineries utilizing our pipeline and terminal facilities;
	•		The effects of current and future government regulations and policies;
	•		Our operational efficiency in carrying out routine operations and capital construction projects;
	•		The possibility of terrorist attacks and the consequences of any such attacks;
	•		General economic conditions; and
	•		Other financial, operations and legal risks and uncertainties detailed from time to time in our Securities and Exchange Commission filings.

Cautionary statements identifying important factors that could cause actual results to differ materially from our expectations are set forth in this Form 10-Q, including without limitation, in conjunction with the forward-looking statements included in this Form 10-Q that are referred to above. When considering forward-looking statements, you should keep in mind the risk factors and other cautionary statements set forth in our Annual Report on Form 10-K for the year ended December 31, 2006 in “Risk Factors,” and in this Form 10-Q in “Management’s Discussion and Analysis of Financial Condition and Results of Operations”. All forward-looking statements included in this Form 10-Q and all subsequent written or oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. The forward-looking statements speak only as of the date made and, other than as required by law, we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Item 1. Financial Statements

Holly Energy Partners, L.P.

		March 31, 2007				December 31,
		(Unaudited)				2006
		(In thousands, except unit data)
ASSETS
Current assets:
Cash and cash equivalents		$	11,100			$	11,555
Accounts receivable:
Trade			5,571				7,339
Affiliates			1,866				3,518
			7,437				10,857
Prepaid and other current assets			821				1,212
Total current assets			19,358				23,624
Properties and equipment, net			158,324				160,484
Transportation agreements, net			55,801				56,821
Other assets			2,470				2,644
Total assets		$	235,953			$	243,573
LIABILITIES AND PARTNERS’ EQUITY
Current liabilities:
Accounts payable		$	2,117			$	3,781
Accrued interest			988				2,941
Deferred revenue			6,392				5,486
Accrued property taxes			508				868
Other current liabilities			730				1,098
Total current liabilities			10,735				14,174
Commitments and contingencies			—				—
Long-term debt			181,048				180,660
Other long-term liabilities			1,264				1,550
Minority interest			11,390				10,963
Partners’ equity (deficit):
Common unitholders (8,170,000 units issued and outstanding)			174,197				176,844
Subordinated unitholders (7,000,000 units issued and outstanding)			(71,769	)			(70,022	)
Class B subordinated unitholders (937,500 units issued and outstanding)			23,235				23,469
General partner interest (2% interest)			(94,147	)			(94,065	)
Total partners’ equity			31,516				36,226
Total liabilities and partners’ equity		$	235,953			$	243,573

See accompanying notes.

Holly Energy Partners, L.P.

		Three Months Ended March 31,
		2007				2006
		(In thousands, except per unit data)
Revenues:
Affiliates		$	13,790			$	12,482
Third parties			10,082				9,956
			23,872				22,438
Operating costs and expenses:
Operations			7,777				7,109
Depreciation and amortization			4,071				3,793
General and administrative			1,287				1,224
			13,135				12,126
Operating income			10,737				10,312
Other income (expense):
Interest income			185				243
Interest expense			(3,358	)			(3,175	)
Gain on sale of assets			297				—
			(2,876	)			(2,932	)
Income before minority interest			7,861				7,380
Minority interest in Rio Grande Pipeline Company			(427	)			(245	)
Net income			7,434				7,135
Less general partner interest in net income			580				327
Limited partners’ interest in net income		$	6,854			$	6,808
Net income per limited partner unit - basic and diluted		$	0.43			$	0.42
Weighted average limited partners’ units outstanding			16,108				16,108

See accompanying notes.

Holly Energy Partners, L.P.

		Three Months Ended March 31,
		2007				2006
		(In thousands)
Cash flows from operating activities
Net income		$	7,434			$	7,135
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization			4,071				3,793
Minority interest in Rio Grande Pipeline Company			427				245
Amortization of restricted and performance units			302				143
Gain on sale of assets			(297	)			—
(Increase) decrease in current assets:
Accounts receivable – trade			1,768				(283	)
Accounts receivable – affiliates			1,652				86
Prepaid and other current assets			391				(172	)
Increase (decrease) in current liabilities:
Accounts payable			(1,664	)			(481	)
Accrued interest			(1,953	)			(1,932	)
Deferred revenue			906				484
Accrued property tax			(360	)			(385	)
Other current liabilities			(368	)			(197	)
Other, net			284				126
Net cash provided by operating activities			12,593				8,562
Cash flows from investing activities
Additions to properties and equipment			(912	)			(817	)
Proceeds from sale of assets			325				—
Net cash used for investing activities			(587	)			(817	)
Cash flows from financing activities
Distributions to partners			(11,538	)			(10,461	)
Purchase of units for restricted grants			(908	)			—
Cash distributions to minority interest			—				(600	)
Other			(15	)			—
Net cash used for financing activities			(12,461	)			(11,061	)
Cash and cash equivalents
Decrease for period			(455	)			(3,316	)
Beginning of period			11,555				20,583
End of period		$	11,100			$	17,267

See accompanying notes.

Holly Energy Partners, L.P.

										Class B
		Common				Subordinated				Subordinated				General Partner
		Units				Units				Units				Interest				Total
		(In thousands)
Balance December 31, 2006		$	176,844			$	(70,022	)		$	23,469			$	(94,065	)		$	36,226
Distributions to partners			(5,518	)			(4,725	)			(633	)			(662	)			(11,538	)
Purchase of units for restricted grants			(908	)			—				—				—				(908	)
Amortization of restricted and performance units			302				—				—				—				302
Net income			3,477				2,978				399				580				7,434
Balance March 31, 2007		$	174,197			$	(71,769	)		$	23,235			$	(94,147	)		$	31,516

See accompanying notes.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 1: Description of Business and Presentation of Financial Statements

Holly Energy Partners, L.P. (“HEP”) together with its consolidated subsidiaries, is a publicly held master limited partnership, currently 45% owned by Holly Corporation and its subsidiaries (collectively “Holly”). HEP commenced operations July 13, 2004 upon the completion of its initial public offering. In this document, the words “we”, “our”, “ours” and “us” refer to HEP unless the context otherwise indicates.

We operate in one business segment — the operation of petroleum pipelines and terminal facilities.

One of Holly’s wholly-owned subsidiaries owns a refinery in Artesia, New Mexico, which Holly operates in conjunction with crude, vacuum distillation and other facilities situated in Lovington, New Mexico (collectively, the “Navajo Refinery”). In July 2005, we acquired the two parallel intermediate feedstock pipelines, which connect the Lovington, New Mexico and Artesia, New Mexico refining facilities. The Navajo Refinery produces high-value refined products such as gasoline, diesel fuel and jet fuel and serves markets in the southwestern United States and northern Mexico. In conjunction with Holly’s operation of the Navajo Refinery, we operate refined product pipelines as part of the product distribution network of the Navajo Refinery. Our terminal operations serving the Navajo Refinery include a truck rack at the Navajo Refinery and five integrated refined product terminals located in New Mexico, Texas and Arizona.

Another of Holly’s wholly-owned subsidiaries owns a refinery located near Salt Lake City, Utah (the “Woods Cross Refinery”). Our operations serving the Woods Cross Refinery include a truck rack at the Woods Cross Refinery, a refined product terminal in Spokane, Washington and a 50% non-operating interest in product terminals in Boise and Burley, Idaho.

In February 2005, we acquired from Alon USA, Inc. and several of its wholly-owned subsidiaries (collectively, “Alon”) four refined products pipelines, an associated tank farm and two refined products terminals. These pipelines and terminals are located primarily in Texas and transport and terminal light refined products for Alon’s refinery in Big Spring, Texas.

Additionally, we own a refined product terminal in Mountain Home, Idaho, and a 70% interest in Rio Grande Pipeline Company (“Rio Grande”), which provides transportation of liquid petroleum gases to northern Mexico.

The consolidated financial statements for the three months ended March 31, 2007 and 2006 included herein have been prepared without audit, pursuant to the rules and regulations of the United States Securities and Exchange Commission (the “SEC”). The interim financial statements reflect all adjustments which are, in the opinion of management, necessary for a fair presentation of our results for the interim periods. Such adjustments are considered to be of a normal recurring nature. Although certain notes and other information required by accounting principles generally accepted in the United States of America have been condensed or omitted, we believe that the disclosures in these consolidated financial statements are adequate to make the information presented not misleading. These consolidated financial statements should be read in conjunction with our Form 10-K for the year ended December 31, 2006. Results of operations for interim periods are not necessarily indicative of the results of operations that will be realized for the year ending December 31, 2007. Certain reclassifications have been made to prior reported amounts to conform to current classifications.

Recent Accounting Pronouncements

Interpretation No. 48 “Accounting for Uncertainty in Income Taxes”

In June 2006, the FASB issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes. This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements by prescribing a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.

This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. We adopted this standard effective January 1, 2007. The adoption of this standard did not have a material impact on our financial condition, results of operations and cash flows.

Note 2: Properties and Equipment

		March 31,				December 31,
		2007				2006
		(In thousands)
Pipelines and terminals		$	194,152			$	194,008
Land and right of way			22,458				22,486
Other			6,947				6,947
Construction in progress			2,451				1,539
			226,008				224,980
Less accumulated depreciation			67,684				64,496
		$	158,324			$	160,484

During the three months ended March 31, 2007 and 2006, we did not capitalize any interest related to major construction projects.

Note 3: Transportation Agreements

The costs of two transportation agreements are recorded on our consolidated balance sheets at March 31, 2007:

•		Costs incurred by Rio Grande in constructing certain pipeline and terminal facilities located in Mexico, which were then contributed to an affiliate of Pemex, the national oil company of Mexico. In exchange, Rio Grande received a 10-year transportation agreement from BP plc (“BP”) expiring in April 2007. This asset is being amortized over the 10-year term of the agreement.
•		A portion of the total purchase price of the Alon assets was allocated to the transportation agreement asset based on the fair value appraisal provided by an independent firm. This asset is being amortized over 30 years ending 2035, the 15-year initial term of the Alon PTA plus the expected 15-year extension period.

The carrying amounts of the transportation agreements are as follows:

		March 31,				December 31,
		2007				2006
		(In thousands)
Rio Grande transportation agreement		$	20,836			$	20,836
Alon transportation agreement			59,933				59,933
			80,769				80,769
Less accumulated amortization			24,968				23,948
		$	55,801			$	56,821

Note 4: Debt

Credit Agreement

In conjunction with our initial public offering on July 13, 2004, we entered into a four-year, $100.0 million senior secured revolving credit agreement (the “Credit Agreement”) expiring in July 2008. Union Bank of California, N.A. is one of the lenders and serves as administrative agent under this agreement. As of March 31, 2007 and December 31, 2006, we had no amounts outstanding under the Credit Agreement.

The Credit Agreement is available to fund capital expenditures, acquisitions, and working capital and for general partnership purposes. Advances under the Credit Agreement that are designated for working capital are short-term liabilities. Other advances under the Credit Agreement are classified as long-term liabilities. In addition, the Credit Agreement is available to fund letters of credit up to a $50.0 million sub-limit. Up to $5.0 million is available to fund distributions to unitholders.

We have the right to request an increase in the maximum amount of the Credit Agreement, up to $175.0 million. Such request will become effective if (a) certain conditions specified in the Credit Agreement are met and (b) existing lenders under the Credit Agreement or other financial institutions reasonably acceptable to the administrative agent commit to lend such increased amounts under the agreement.

Our obligations under the Credit Agreement are secured by substantially all of our assets. Indebtedness under the Credit Agreement is recourse to HEP Logistics Holdings, L.P., our general partner, and guaranteed by our wholly-owned subsidiaries.

We may prepay all loans at any time without penalty. We are required to reduce all working capital borrowings under the Credit Agreement to zero for a period of at least 15 consecutive days once each twelve-month period prior to the maturity date of the agreement.

Indebtedness under the Credit Agreement bears interest, at our option, at either (a) the base rate as announced by the administrative agent plus an applicable margin (ranging from 0.25% to 1.00%) or (b) at a rate equal to the London Interbank Offered Rate (“LIBOR”) plus an applicable margin (ranging from 1.50% to 2.25%). In each case, the applicable margin is based upon the ratio of our funded debt (as defined in the agreement) to EBITDA (earnings before interest, taxes, depreciation and amortization, as defined in the Credit Agreement). We incur a commitment fee on the unused portion of the Credit Agreement at a rate of 0.375% or 0.500% based upon the ratio of our funded debt to EBITDA for the four most recently completed fiscal quarters. At March 31, 2007, we are subject to the 0.500% rate on the $100.0 million of the unused commitment on the Credit Agreement. The agreement matures in July 2008. At that time, the agreement will terminate and all outstanding amounts thereunder will be due and payable.

The Credit Agreement imposes certain requirements, including: a prohibition against distribution to unitholders if, before or after the distribution, a potential default or an event of default as defined in the agreement would occur; limitations on our ability to incur debt, make loans, acquire other companies, change the nature of our business, enter a merger or consolidation, or sell assets; and covenants that require maintenance of EBITDA to interest expense ratio and debt to EBITDA ratio. If an event of default exists under the agreement, the lenders will be able to accelerate the maturity of the debt and exercise other rights and remedies.

Senior Notes Due 2015

Our senior notes maturing March 1, 2015 are registered with the SEC and bear interest at 6.25% (“Senior Notes”). The Senior Notes are unsecured and impose certain restrictive covenants, including limitations on our ability to incur additional indebtedness, make investments, sell assets, incur certain liens, pay distributions, enter into transactions with affiliates, and enter into mergers. At any time when the Senior Notes are rated investment grade by both Moody’s and Standard & Poor’s and no default or event of default exists, we will not be subject to many of the foregoing covenants. Additionally, we have certain redemption rights under the Senior Notes.

The $185.0 million principal amount of Senior Notes is recorded at $181.0 million on our consolidated balance sheets at March 31, 2007. The difference of $4.0 million is due to $3.0 million of unamortized discount and $1.0 million relating to the fair value of the interest rate swap contract discussed below.

Interest Rate Risk Management

We have entered into an interest rate swap contract to effectively convert the interest expense associated with $60.0 million of our 6.25% Senior Notes from a fixed rate to a variable rate. The interest rate on the $60.0 million notional amount is equal to three-month LIBOR plus an applicable margin of 1.1575%, which equaled an effective interest rate of 6.52% on $60.0 million of the debt during the quarter ended March 31, 2007. The maturity of the swap contract is March 1, 2015, matching the maturity of the Senior Notes.

This interest rate swap has been designated as a fair value hedge as defined by SFAS No. 133. Our interest rate swap meets the conditions required to assume no ineffectiveness under SFAS No. 133 and, therefore, we have used the “shortcut” method of accounting prescribed for fair value hedges by SFAS No. 133. Accordingly, we adjust the carrying value of the swap to its fair value each quarter, with an offsetting entry to adjust the carrying value of the debt securities whose fair value is being hedged. We record interest expense equal to the variable rate payments under the swap.

The fair value of our interest rate swap of $1.0 million and $1.2 million is included in “Other long-term liabilities” in our consolidated balance sheets at March 31, 2007 and December 31, 2006, respectively. The offsetting entry to adjust the carrying value of the debt securities whose fair value is being hedged is recognized as a reduction of “Long-term debt” on our consolidated balance sheets at March 31, 2007 and December 31, 2006.

Other Debt Information

		Three Months Ended
		March 31,
		2007				2006
		(In thousands)
Interest on outstanding debt:
Senior Notes, net of interest rate swap		$	2,932			$	2,810
Credit Agreement			—				—
Amortization of discount and deferred issuance costs			303				242
Commitment fees			123				123
Net interest expense		$	3,358			$	3,175
Cash paid for interest(1)		$	5,135			$	4,865

We estimate that the fair value of our Senior Notes was $176.7 million at March 31, 2007, based on a determination by a third-party investment firm.

Note 5: Employees, Retirement and Benefit Plans

Employees who provide direct services to us are employed by Holly Logistic Services, L.L.C., a Holly subsidiary. Their costs, including salaries, bonuses, payroll taxes, benefits, and other direct costs, are charged to us monthly in accordance with a three-year omnibus agreement we entered into with Holly in July 2004 (the “Omnibus Agreement”).

These employees participate in the retirement and benefit plans of Holly. Our share of retirement and benefits costs was $0.4 million and 0.2 million for the three months ended March 31, 2007 and 2006, respectively.

We have adopted a Long-Term Incentive Plan for employees, consultants and directors who perform services for us. The Long-Term Incentive Plan consists of four components: restricted units, performance units, unit options and unit appreciation rights.

On March 31, 2007, we had two types of equity-based compensation, which are described below. The compensation cost charged against income for these plans was $0.3 million and $0.2 million for the three months ended March 31, 2007 and 2006, respectively. It is currently our policy to purchase units in the open market instead of issuing new units for settlement of restricted unit grants. At March 31, 2007, 350,000 units were authorized to be granted under the equity-based compensation plans, of which 253,255 had not yet been granted.

Restricted Units

Under our Long-Term Incentive Plan, we grant restricted units to selected employees, consultants and directors who perform services for us, with vesting generally over a period of one to five years. Although full ownership of the units does not transfer to the recipients until the units vest, the recipients have distribution and voting rights on these units from the date of grant. The vesting for certain key executives is contingent upon certain earnings per unit targets being realized. The fair value of each unit of restricted unit awards was measured at the market price as of the date of grant and is being amortized over the vesting period, including the units issued to the key executives, as we expect those units to fully vest.

A summary of restricted unit activity as of March 31, 2007, and changes during the three months ended March 31, 2007, is presented below:

										Weighted-
						Weighted-				Average				Aggregate
						Average				Remaining				Intrinsic
						Grant-Date				Contractual				Value
Restricted Units		Grants				Fair Value				Term				($000)
Outstanding January 1, 2007 (not vested)			36,597				40.21
Granted			19,687				46.12
Forfeited			—				—
Vesting and transfer of full ownership to recipients			(4,170	)			39.45
Outstanding at March 31, 2007 (not vested)			52,114			$	42.50			1.4 years				$	2,429

There were 4,170 units vested and transferred to recipients during the three months ended March 31, 2007. As of March 31, 2007, there was $1.1 million of total unrecognized compensation costs related to nonvested restricted unit grants. That cost is expected to be recognized over a weighted-average period of 1.4 years.

Performance Units

Under our Long-Term Incentive Plan, we grant performance units to selected executives and employees who perform services for us. These performance units are payable upon meeting the performance criteria over a service period, and generally vest over a period of three years. The amount payable under the initial performance grant of 1,514 units in 2005 is based upon our unit price and upon our total unitholder return during the requisite period as compared to the total unitholder return of a selected peer group of partnerships. The amount payable under all other performance unit grants is based upon the growth in distributions per limited partner unit during the requisite period.

We granted 12,321 performance units to certain officers in February 2007. These units will vest over a three-year performance period ending December 31, 2009, and are payable in HEP common units. The number of units actually earned will be based on the growth of distributions to limited partners over the performance period, and can range from 50% to 150% of the number of performance units issued. The fair value of these performance units is based on the grant date closing unit price of $46.12 and will apply to the number of units ultimately awarded.

A summary of performance units activity as of March 31, 2007 and changes during the three months ended March 31, 2007 is presented below:

		Payable
Performance Units		In Units
Outstanding at January 1, 2007 (not vested)			14,015
Vesting and payment of cash benefit to recipients			—
Granted			12,321
Forfeited			—
Outstanding at March 31, 2007 (not vested)			26,336

There were no payments for performance units vesting during the three months ended March 31, 2007. Based on the weighted average fair value at March 31, 2007 of $47.62, there was $0.8 million of total unrecognized compensation cost related to nonvested performance units. That cost is expected to be recognized over a weighted-average period of 2.2 years.

Note 6: Significant Customers

All revenues are domestic revenues, of which over 90% are currently generated from our three largest customers: Holly, Alon and BP. The major concentration of our petroleum products pipeline system’s revenues is derived from activities conducted in the southwest United States. The following table presents the percentage of total revenues generated by each of these three customers:

		Three Months Ended
		March 31,
		2007				2006
Holly			58	%			56	%
Alon			26	%			31	%
BP			13	%			11	%

Note 7: Related Party Transactions

Holly

We serve Holly’s refineries in New Mexico and Utah under two 15-year pipeline and terminal agreements. One of these agreements relates to the pipelines and terminals contributed by Holly to us at the time of our initial public offering and expires in 2019 (“Holly PTA”). Our other agreement with Holly relates to the Intermediate Pipelines acquired from Holly in July 2005 and expires in 2020 (“Holly IPA”). The substantial majority of our business is devoted to providing transportation and terminalling services to Holly. The minimum revenue commitments under the Holly PTA and the Holly IPA increase each year at a rate equal to the percentage change in the producer price index (“PPI”), but will not decrease as a result of a decrease in the PPI.

Following the July 1, 2006 PPI rate adjustment, the volume commitments by Holly under the Holly PTA will produce at least $38.5 million of revenue for the twelve months ending June 30, 2007. Under the Holly IPA, Holly agreed to transport volumes of intermediate products on the Intermediate Pipelines that following the July 1, 2006 PPI rate adjustment, will result in minimum funds to us of $12.4 million for the twelve months ended June 30, 2007.

If Holly fails to meet its minimum revenue commitments in any quarter, it is required to pay us in cash the amount of any shortfall by the last day of the month following the end of the quarter. A shortfall payment may be applied as a credit in the following four quarters after Holly’s minimum obligations are met.

Under the Omnibus Agreement expiring in 2019 that we entered with Holly in July 2004, we pay Holly an annual administrative fee, currently in the amount of $2.0 million, for the provision by Holly or its affiliates of various general and administrative services to us for three years following the closing of our initial

public offering. This fee does not include the salaries of pipeline and terminal personnel or the cost of their employee benefits, such as 401(k), pension and health insurance benefits, which are separately charged to us by Holly. We also reimburse Holly and its affiliates for direct expenses they incur on our behalf.

•		Pipeline and terminal revenues received from Holly were $13.8 million and $12.5 million for the three months ended March 31, 2007 and 2006, respectively. These amounts include the revenues received under the Holly PTA and Holly IPA.
•		Holly charged general and administrative services under the Omnibus Agreement of $0.5 million for the three months ended March 31, 2007 and 2006.
•		We reimbursed Holly for costs of employees supporting our operations of $2.3 million and $1.9 million for the three months ended March 31, 2007 and 2006, respectively.
•		Holly reimbursed $74,000 and $56,000 to us for certain costs paid on their behalf for the three months ended March 31, 2007 and 2006, respectively.
•		In the three months ended March 31, 2007 and 2006, we distributed $5.4 million and $4.8 million, respectively, to Holly as regular distributions on its subordinated units, common units and general partner interest.
•		Our net accounts receivable from Holly were $1.9 million and $3.5 million at March 31, 2007 and December 31, 2006, respectively.
•		Holly has failed to meet its minimum revenue commitment for each of the first seven quarters of the Holly IPA. We have charged Holly $4.0 million for these shortfalls to date, $0.6 million and $0.2 million of which are included in affiliate accounts receivable at March 31, 2007 and December 31, 2006, respectively.
		We recognized $0.5 million of shortfalls billed under the Holly IPA in 2006 as additional revenues in the first quarter of 2007, as Holly did not exceed its minimum revenue obligation in any of the subsequent four quarters. Deferred revenue in the consolidated balance sheets at March 31, 2007 and December 31, includes $2.5 million and $2.4 million, respectively, relating to the Holly IPA. It is possible that Holly may not exceed its minimum obligations under the Holly IPA to allow Holly to receive credit for any of the $2.5 million deferred at March 31, 2007.

BP

We have a 70% ownership interest in Rio Grande and BP owns the other 30%. Due to the ownership interest and resulting consolidation, BP is a related party to us.

•		BP is the sole customer of Rio Grande. BP’s agreement to ship on the Rio Grande pipeline expires in April 2007, and will continue year-to-year thereafter unless cancelled by either party prior to the beginning of the previous contract year. We recorded revenues from them of $3.0 million and $2.4 million in the three months ended March 31, 2007 and 2006, respectively.
•		Rio Grande paid distributions to BP of $0.6 million in the three months ended March 31, 2006.
•		Included in our accounts receivable – trade at March 31, 2007 and December 31, 2006 were $1.2 million and $2.1 million, respectively, which represented the receivable balance of Rio Grande from BP.

Alon

We have a 15-year pipelines and terminals agreement with Alon (the “Alon PTA”), expiring in 2020, under which Alon has agreed to transport on our pipelines and throughput through our terminals volumes of refined products that results in a minimum level of annual revenue. The agreed upon tariffs are increased

or decreased annually at a rate equal to the percentage change in PPI, but not below the initial tariff rate. The total annual commitment for 2007, including the effect of the March 1, 2007 PPI adjustment, is $20.8 million.

Alon became a related party when it acquired all of our Class B subordinated units in connection with our acquisition of assets from them on February 28, 2005.

•		We recognized $4.4 million and $5.1 million of revenues for pipeline transportation and terminalling services under the Alon PTA and $1.8 million and $1.7 million under a pipeline capacity lease for the three months ended March 31, 2007 and 2006, respectively. The capacity lease agreements have remaining terms from less than a year up to three and one-quarter years.
•		We paid $0.6 million to Alon for distributions on our Class B subordinated units for the three months ended March 31, 2007 and 2006.
•		Included in our accounts receivable – trade at March 31, 2007 and December 31, 2006 were $4.5 million and $5.0 million, respectively, which represented the receivable balance from Alon.
•		“Deferred revenue” includes $3.9 million and $3.1 million of minimum revenue commitments under the Alon PTA at March 31, 2007 and December 31, 2006, respectively.

Note 8: Partners’ Equity and Cash Distributions

Issuances of units

Holly currently holds 7,000,000 of our subordinated units and 70,000 of our common units, which constitutes a 45% ownership interest in us, including the 2% general partner interest.

Holly’s subordinated units have the right to receive distributions of available cash from operating surplus in an amount equal to the minimum quarterly distribution of $0.50 per quarter, plus any arrearages in the payment of the minimum quarterly distribution on the common units from prior quarters, before any distributions of available cash from operating surplus may be made on the subordinated units. The purpose of the subordinated units is to increase the likelihood that cash is available for common unit distributions during the subordination period. The subordination period will extend until the first day of any quarter beginning after June 30, 2009 that each of the following tests are met: distributions of available cash from operating surplus on each of the outstanding common units and subordinated units equaled or exceeded the minimum quarterly distribution for each of the three consecutive, non-overlapping four-quarter periods immediately preceding that date; the “adjusted operating surplus” (as defined in its partnership agreement) generated during each of the three consecutive, non-overlapping four-quarter periods immediately preceding that date equaled or exceeded the sum of the minimum quarterly distributions on all of the outstanding common units and subordinated units during those periods on a fully diluted basis and the related distribution on the 2% general partner interest during those periods; and there are no arrearages in payment of the minimum quarterly distribution on the common units. If the unitholders remove the general partner without cause, the subordination period may end before June 30, 2009. The Holly subordinated units may convert to common units on a one-for-one basis when certain conditions are met. The partnership agreement sets forth the calculation to be used to determine the amount and priority of cash distributions that the common unitholders, subordinated unitholders and general partner will receive.

Under our registration statement filed with the SEC using a “shelf” registration process, we may offer from time to time up to $800.0 million of our securities, through one or more prospectus supplements that would describe, among other things, the specific amounts, prices and terms of any securities offered and how the proceeds would be used. Any proceeds from the sale of securities would be used for general business purposes, which may include, among other things, funding acquisitions of assets or businesses, working capital, capital expenditures, investments in subsidiaries, the retirement of existing debt and/or the repurchase of common units or other securities.

Allocations of Net Income

Net income is allocated between limited partners and the general partner interest in accordance with the provisions of the partnership agreement. Net income allocated to the general partner includes any incentive distributions declared in the period. After the amount of incentive distributions is allocated to the general partner, the remaining net income for the period is generally allocated to the partners based on their weighted average ownership percentage during the period.

Cash Distributions

We consider regular cash distributions to unitholders on a quarterly basis, although there is no assurance as to the future cash distributions since they are dependent upon future earnings, cash flows, capital requirements, financial condition and other factors. Our Credit Agreement prohibits us from making cash distributions if any potential default or event of default, as defined in the Credit Agreement, occurs or would result from the cash distribution.

Within 45 days after the end of each quarter, we will distribute all of our available cash (as defined in our partnership agreement) to unitholders of record on the applicable record date. The amount of available cash generally is all cash on hand at the end of the quarter; less the amount of cash reserves established by our general partner to provide for the proper conduct of our business, comply with applicable law, any of our debt instruments, or other agreements; or provide funds for distributions to our unitholders and to our general partner for any one or more of the next four quarters; plus all cash on hand on the date of determination of available cash for the quarter resulting from working capital borrowings made after the end of the quarter. Working capital borrowings are generally borrowings that are made under our revolving Credit Agreement and in all cases are used solely for working capital purposes or to pay distributions to partners.

We make distributions of available cash from operating surplus for any quarter during any subordination period in the following manner: firstly, 98% to the common unitholders, pro rata, and 2% to the general partner, until we distribute for each outstanding common unit an amount equal to the minimum quarterly distribution for that quarter; secondly, 98% to the common unitholders, pro rata, and 2% to the general partner, until we distribute for each outstanding common unit an amount equal to any arrearages in payment of the minimum quarterly distribution on the common units for any prior quarters during the subordination period; thirdly, 98% to the subordinated unitholders, pro rata, and 2% to the general partner, until we distribute for each subordinated unit an amount equal to the minimum quarterly distribution for that quarter; and thereafter, cash in excess of the minimum quarterly distributions is distributed to the unitholders and the general partner based on the percentages below.

The general partner, HEP Logistics Holdings, L.P., is entitled to incentive distributions if the amount we distribute with respect to any quarter exceeds specified target levels shown below:

				Marginal Percentage Interest in
		Total Quarterly Distribution		Distributions
		Target Amount		Unitholders		General Partner
Minimum Quarterly Distribution		$0.50		98%			2	%
First Target Distribution		Up to $0.55		98%			2	%
Second Target Distribution		above $0.55 up to $0.625		85%			15	%
Third Target distribution		above $0.625 up to $0.75		75%			25	%
Thereafter		Above $0.75		50%			50	%

The following table presents the allocation of our regular quarterly cash distributions to the general and limited partners for each period in which declared.

		Three Months Ended March 31,
		2007				2006
		(In thousands, except per unit data)
General partner interest		$	222			$	205
General partner incentive distribution			440				189
Total general partner distribution			662				394
Limited partner distribution			10,876				10,067
Total regular quarterly cash distribution		$	11,538			$	10,461
Cash distribution per unit applicable to limited partners		$	0.675			$	0.625

On April 27, 2007, we announced a cash distribution for the first quarter of 2007 of $0.69 per unit. The distribution is payable on all common, subordinated, and general partner units and will be paid May 15, 2007 to all unitholders of record on May 7, 2007. The aggregate amount of the distribution will be $11.9 million, including $0.5 million paid to the general partner as an incentive distribution.

As a master limited partnership, we distribute our available cash, which exceeds our net income because depreciation and amortization expense represents a non-cash charge against income. The result is a decline in partners’ equity since our regular quarterly distributions exceed our quarterly net income.

Note 9: Supplemental Guarantor/Non-Guarantor Financial Information

Obligations of Holly Energy Partners, L.P. (“Parent”) under the 6.25% Senior Notes have been jointly and severally guaranteed by each of its direct and indirect wholly-owned subsidiaries (“Guarantor Subsidiaries”). These guarantees are full and unconditional. Rio Grande (“Non-Guarantor”), in which we have a 70% ownership interest, is the only subsidiary which has not guaranteed these obligations.

The following financial information presents condensed consolidating balance sheets, statements of income, and statements of cash flows of the Parent, the Guarantor Subsidiaries and the Non-Guarantor. The information has been presented as if the Parent accounted for its ownership in the Guarantor Subsidiaries, and the Guarantor Subsidiaries accounted for the ownership of the Non-Guarantor, using the equity method of accounting.

Condensed Consolidating Balance Sheet
						Guarantor				Non-
March 31, 2007		Parent				Subsidiaries				Guarantor				Eliminations				Consolidated
		(in thousands)
ASSETS
Current assets:
Cash and cash equivalents		$	2			$	6,287			$	4,811			$	—			$	11,100
Accounts receivable			—				6,277				1,160				—				7,437
Intercompany accounts receivable (payable)			(96,799	)			97,027				(228	)			—				—
Prepaid and other current assets			105				716				—				—				821
Total current assets			(96,692	)			110,307				5,743				—				19,358
Properties and equipment, net			—				125,520				32,804				—				158,324
Investment in subsidiaries			310,137				26,579				—				(336,716	)			—
Transportation agreements, net			—				55,771				30				—				55,801
Other assets			1,415				1,055				—				—				2,470
Total assets		$	214,860			$	319,232			$	38,577			$	(336,716	)		$	235,953
LIABILITIES AND PARTNERS’ EQUITY
Current liabilities:
Accounts payable		$	—			$	1,761			$	356			$	—			$	2,117
Accrued interest			988				—				—				—				988
Deferred revenue			—				6,392				—				—				6,392
Accrued property taxes			—				464				44				—				508
Other current liabilities			365				157				208				—				730
Total current liabilities			1,353				8,774				608				—				10,735
Long-term debt			181,048				—				—				—				181,048
Other long-term liabilities			943				321				—				—				1,264
Minority interest			—				—				—				11,390				11,390
Partners’ equity			31,516				310,137				37,969				(348,106	)			31,516
Total liabilities and partners’ equity		$	214,860			$	319,232			$	38,577			$	(336,716	)		$	235,953

Condensed Consolidating Balance Sheet
						Guarantor				Non-
December 31, 2006		Parent				Subsidiaries				Guarantor				Eliminations				Consolidated
		(in thousands)
ASSETS
Current assets:
Cash and cash equivalents		$	2			$	9,819			$	1,734			$	—			$	11,555
Accounts receivable			—				8,772				2,085				—				10,857
Intercompany accounts receivable (payable)			(78,952	)			79,144				(192	)			—				—
Prepaid and other current assets			203				1,009				—				—				1,212
Total current assets			(78,747	)			98,744				3,627				—				23,624
Properties and equipment, net			—				127,357				33,127				—				160,484
Investment in subsidiaries			298,872				25,581				—				(324,453	)			—
Transportation agreements, net			—				56,271				550				—				56,821
Other assets			1,453				1,191				—				—				2,644
Total assets		$	221,578			$	309,144			$	37,304			$	(324,453	)		$	243,573
LIABILITIES AND PARTNERS’ EQUITY
Current liabilities:
Accounts payable		$	—			$	3,356			$	425			$	—			$	3,781
Accrued interest			2,941				—				—				—				2,941
Deferred revenue			—				5,486				—				—				5,486
Accrued property taxes			—				726				142				—				868
Other current liabilities			516				389				193				—				1,098
Total current liabilities			3,457				9,957				760				—				14,174
Long-term debt			180,660				—				—				—				180,660
Other long-term liabilities			1,235				315				—				—				1,550
Minority interest			—				—				—				10,963				10,963
Partners’ equity			36,226				298,872				36,544				(335,416	)			36,226
Total liabilities and partners’ equity		$	221,578			$	309,144			$	37,304			$	(324,453	)		$	243,573

Condensed Consolidating Statement of Income
						Guarantor				Non-
Three months ended March 31, 2007		Parent				Subsidiaries				Guarantor				Eliminations				Consolidated
		(in thousands)
Revenues:
Affiliates		$	—			$	13,790			$	—			$	—			$	13,790
Third parties			—				7,349				3,026				(293	)			10,082
			—				21,139				3,026				(293	)			23,872
Operating costs and expenses:
Operations			—				7,277				793				(293	)			7,777
Depreciation and amortization			—				3,223				848				—				4,071
General and administrative			766				520				1				—				1,287
			766				11,020				1,642				(293	)			13,135
Operating income (loss)			(766	)			10,119				1,384				—				10,737
Equity in earnings of subsidiaries			11,264				997				—				(12,261	)			—
Interest income (expense)			(3,064	)			(149	)			40				—				(3,173	)
Gain on sale of assets			—				297				—				—				297
Minority interest			—				—				—				(427	)			(427	)
Net income		$	7,434			$	11,264			$	1,424			$	(12,688	)		$	7,434

Condensed Consolidating Statement of Income
						Guarantor				Non-
Three months ended March 31, 2006		Parent				Subsidiaries				Guarantor				Eliminations				Consolidated
		(in thousands)
Revenues:
Affiliates		$	—			$	12,482			$	—			$	—			$	12,482
Third parties			—				7,881				2,369				(294	)			9,956
			—				20,363				2,369				(294	)			22,438
Operating costs and expenses:
Operations			—				6,670				733				(294	)			7,109
Depreciation and amortization			—				2,949				844				—				3,793
General and administrative			712				511				1				—				1,224
			712				10,130				1,578				(294	)			12,126
Operating income (loss)			(712	)			10,233				791				—				10,312
Equity in earnings of subsidiaries			10,789				572				—				(11,361	)			—
Interest income (expense)			(2,942	)			(16	)			26				—				(2,932	)
Minority interest			—				—				—				(245	)			(245	)
Net income		$	7,135			$	10,789			$	817			$	(11,606	)		$	7,135

Condensed Consolidating Statement of Cash Flows
						Guarantor				Non-
Three months ended March 31, 2007		Parent				Subsidiaries				Guarantor				Eliminations				Consolidated
		(in thousands)
Cash flows from operating activities		$	12,446			$	(2,934	)		$	3,081			$	—			$	12,593
Cash flows from investing activities
Additions to properties and equipment			—				(908	)			(4	)			—				(912	)
Proceeds from sale of assets			—				325				—				—				325
			—				(583	)			(4	)			—				(587	)
Cash flows from financing activities
Distributions to partners			(11,538	)			—				—				—				(11,538	)
Purchase of units for restricted grants			(908	)			—				—				—				(908	)
Other			—				(15	)			—				—				(15	)
			(12,446	)			(15	)			—				—				(12,461	)
Cash and cash equivalents
Increase (decrease) for the period			—				(3,532	)			3,077				—				(455	)
Beginning of period			2				9,819				1,734				—				11,555
End of period		$	2			$	6,287			$	4,811			$	—			$	11,100

Condensed Consolidating Statement of Cash Flows
						Guarantor				Non-
Three months ended March 31, 2006		Parent				Subsidiaries				Guarantor				Eliminations				Consolidated
		(in thousands)
Cash flows from operating activities		$	10,461			$	(1,959	)		$	1,460			$	(1,400	)		$	8,562
Cash flows from investing activities – additions to properties and equipment			—				(782	)			(35	)			—				(817	)
Cash flows from financing activities
Distributions to partners			(10,461	)			—				(2,000	)			2,000				(10,461	)
Cash distribution to minority interest			—				—				—				(600	)			(600	)
			(10,461	)			—				(2,000	)			1,400				(11,061	)
Cash and cash equivalents
Decrease for the period			—				(2,741	)			(575	)			—				(3,316	)
Beginning of period			2				17,770				2,811				—				20,583
End of period		$	2			$	15,029			$	2,236			$	—			$	17,267

Note 10: Investment in Joint Venture

In February 2007, the HLS board of directors authorized a letter of intent with Plains All American Pipeline, L.P. (“Plains”) for HEP to acquire a 25% joint venture interest in a new 95-mile intrastate pipeline system, now being constructed by Plains, for the shipment of up to 120,000 bpd of crude oil into the Salt Lake City area. The pipeline would be owned by a new joint venture company which would be owned 75% by Plains and 25% by HEP. Subject to the actual construction cost, HEP would purchase its interest for between $22.0 and $25.5 million in the first quarter of 2008, when the new pipeline system is expected to become fully operational.

HOLLY ENERGY PARTNERS, L.P.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This Item 2, including but not limited to the sections on “Results of Operations” and “Liquidity and Capital Resources”, contains forward-looking statements. See “Forward-Looking Statements” at the beginning of Part I.

OVERVIEW

Holly Energy Partners, L.P. (“HEP”) is a Delaware limited partnership formed by Holly Corporation (“Holly”) and was initially formed to acquire, own and operate substantially all of the refined product pipeline and terminalling assets that support Holly’s refining and marketing operations in west Texas, New Mexico, Utah and Arizona and a 70% interest in Rio Grande Pipeline Company (“Rio Grande”). HEP commenced operations July 13, 2004 upon the completion of its initial public offering and is currently 45% owned by Holly.

We operate a system of petroleum product pipelines in Texas, New Mexico and Oklahoma, and distribution terminals in Texas, New Mexico, Arizona, Utah, Idaho, and Washington. We generate revenues by charging tariffs for transporting petroleum products through our pipelines and by charging fees for terminalling refined products and other hydrocarbons, and storing and providing other services at our terminals. We do not take ownership of products that we transport or terminal; therefore, we are not directly exposed to changes in commodity prices.

Our revenues for the three months ended March 31, 2007 were $23.9 million and our net income for the three months ended March 31, 2007 was $7.4 million. Our revenues and net income for the three months ended March 31, 2006 were $22.4 million and $7.1 million, respectively. Our total operating costs and expenses for the three months ended March 31, 2007 were $13.1 million, as compared to $12.1 million for the three months ended March 31, 2006.

Agreements with Holly Corporation

We serve Holly’s refineries in New Mexico and Utah under two 15-year pipeline and terminal agreements. One of these agreements relates to the pipelines and terminals contributed by Holly to us at the time of our initial public offering and expires in 2019 (“Holly PTA”). Our other agreement with Holly relates to the Intermediate Pipelines acquired from Holly in July 2005 and expires in 2020 (“Holly IPA”). The substantial majority of our business is devoted to providing transportation and terminalling services to Holly. Following the July 1, 2006 rate adjustment for the increased producer price index (“PPI”), the volume commitments by Holly under the Holly PTA will produce at least $38.5 million of revenue for the twelve months ending June 30, 2007. Under the Holly IPA, Holly agreed to transport volumes of intermediate products on the Intermediate Pipelines that following the July 1, 2006 PPI adjustment, will result in minimum funds to us of $12.4 million for the twelve months ended June 30, 2007. If Holly fails to meet its minimum revenue commitments in any quarter, it will be required to pay us in cash the amount of any shortfall by the last day of the month following the end of the quarter. A shortfall payment may be applied as a credit in the following four quarters after Holly’s minimum obligations are met.

Under an omnibus agreement expiring in 2019 that we entered with Holly in July 2004 (the “Omnibus Agreement”), we pay Holly an annual administrative fee, currently in the amount of $2.0 million, for the provision by Holly or its affiliates of various general and administrative services to us for three years following the closing of our initial public offering. This fee does not include the salaries of pipeline and terminal personnel or the cost of their employee benefits, such as 401(k), pension and health insurance benefits, which are separately charged to us by Holly. We also reimburse Holly and its affiliates for direct expenses they incur on our behalf.

RESULTS OF OPERATIONS (Unaudited)

Income, Distributable Cash Flow and Volumes

The following tables present income, distributable cash flow and volume information for the three months ended March 31, 2007 and 2006.

		Three Months Ended
		March 31,
		2007				2006
		(In thousands, except per unit data)
Revenues
Pipelines:
Affiliates – refined product pipelines		$	8,239			$	7,323
Affiliates – intermediate pipelines			3,009				2,473
Third parties			8,790				8,777
			20,038				18,573
Terminals and truck loading racks:
Affiliates			2,542				2,686
Third parties			1,292				1,179
			3,834				3,865
Total revenues			23,872				22,438
Operating costs and expenses
Operations			7,777				7,109
Depreciation and amortization			4,071				3,793
General and administrative			1,287				1,224
			13,135				12,126
Operating income			10,737				10,312
Interest income			185				243
Interest expense, including amortization			(3,358	)			(3,175	)
Gain on sale of assets			297				—
Minority interest in Rio Grande			(427	)			(245	)
Net income			7,434				7,135
Less general partner interest in net income, including incentive distributions (1)			580				327
Limited partners’ interest in net income		$	6,854			$	6,808
Net income per limited partner unit — basic and diluted (1)		$	0.43			$	0.42
Weighted average limited partners’ units outstanding			16,108				16,108
EBITDA (2)		$	14,678			$	13,860
Distributable cash flow (3)		$	12,594			$	11,214
Volumes (bpd)
Pipelines:
Affiliates – refined product pipelines			72,361				66,570
Affiliates – intermediate pipelines			59,474				61,052
Third parties			65,187				77,338
			197,022				204,960
Terminals and truck loading racks:
Affiliates			120,186				119,168
Third parties			46,846				47,056
			167,032				166,224
Total for pipelines and terminal assets (bpd)			364,054				371,184