e10vq
Table of Contents

 
 
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
OR
     
o   TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES ACT OF 1934
For the transition period from                      to                     .
Commission File Number: 1-32225
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
(Address of principal executive offices)
(214) 871-3555
(Registrant’s telephone number, including area code)
None
(Former name, former address and former fiscal year, if changed since last report)
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.
     
Large accelerated filer o Accelerated filer þ Non-accelerated filer o
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
         
    3  
 
    3  
    4  
    4  
    5  
    6  
    7  
    8  
    21  
    32  
    32  
 
    33  
 
    33  
    33  
    33  
    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

-2-


Table of Contents

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.

-3-


Table of Contents

Item 1. Financial Statements
Holly Energy Partners, L.P.
Consolidated Balance Sheets
                 
    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.

-4-


Table of Contents

Holly Energy Partners, L.P.
Consolidated Statements of Income
(Unaudited)
                 
    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.

-5-


Table of Contents

Holly Energy Partners, L.P.
Consolidated Statements of Cash Flows
(Unaudited)
                 
    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.

-6-


Table of Contents

Holly Energy Partners, L.P.
Consolidated Statement of Partners’ Equity (Deficit)
(Unaudited)
                                         
                    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.

-7-


Table of Contents

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.

-8-


Table of Contents

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.

-9-


Table of Contents

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.

-10-


Table of Contents

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  
 
           
 
(1)  
Net of cash received under our interest rate swap agreement of $1.9 million in each of the quarters ended March 31, 2007 and 2006.
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.

-11-


Table of Contents

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.

-12-


Table of Contents

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

-13-


Table of Contents

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

-14-


Table of Contents

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.

-15-


Table of Contents

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 %

-16-


Table of Contents

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.

-17-


Table of Contents

                                         
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  
 
                             

-18-


Table of Contents

                                         
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  
 
                             

-19-


Table of Contents

                                         
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.

-20-


Table of Contents

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.

-21-


Table of Contents

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  
 
           

-22-


Table of Contents

 
(1)  
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. Incentive distributions of $0.4 million and $0.2 million were declared during the three months ended March 31, 2007 and 2006, respectively. The net income applicable to the limited partners is divided by the weighted average limited partner units outstanding in computing the net income per unit applicable to limited partners.
 
(2)  
Earnings before interest, taxes, depreciation and amortization (“EBITDA”) is calculated as net income plus (i) interest expense net of interest income and (ii) depreciation and amortization. EBITDA is not a calculation based upon U.S. generally accepted accounting principles (“U.S. GAAP”). However, the amounts included in the EBITDA calculation are derived from amounts included in our consolidated financial statements. EBITDA should not be considered as an alternative to net income or operating income, as an indication of our operating performance or as an alternative to operating cash flow as a measure of liquidity. EBITDA is not necessarily comparable to similarly titled measures of other companies. EBITDA is presented here because it is a widely used financial indicator used by investors and analysts to measure performance. EBITDA is also used by our management for internal analysis and as a basis for compliance with financial covenants.
 
   
Set forth below is our calculation of EBITDA.
                 
    Three Months Ended  
    March 31,  
    2007     2006  
    (In thousands)  
Net income
  $ 7,434     $ 7,135  
Add interest expense
    3,055       2,933  
Add amortization of discount and deferred debt issuance costs
    303       242  
Subtract interest income
    (185 )     (243 )
Add depreciation and amortization
    4,071       3,793  
 
           
 
               
EBITDA
  $ 14,678     $ 13,860  
 
           
(3)  
Distributable cash flow is not a calculation based upon U.S. GAAP. However, the amounts included in the calculation are derived from amounts separately presented in our consolidated financial statements, with the exception of maintenance capital expenditures. Distributable cash flow should not be considered in isolation or as an alternative to net income or operating income, as an indication of our operating performance or as an alternative to operating cash flow as a measure of liquidity. Distributable cash flow is not necessarily comparable to similarly titled measures of other companies. Distributable cash flow is presented here because it is a widely accepted financial indicator used by investors to compare partnership performance. We believe that this measure provides investors an enhanced perspective of the operating performance of our assets and the cash our business is generating.
 
   
Set forth below is our calculation of distributable cash flow.
                 
    Three Months Ended  
    March 31,  
    2007     2006  
    (In thousands)  
Net income
  $ 7,434     $ 7,135  
Add depreciation and amortization
    4,071       3,793  
Add amortization of discount and deferred debt issuance costs
    303       242  
Add increase in deferred revenue
    906       484  
Subtract maintenance capital expenditures*
    (120 )     (440 )
 
           
 
               
Distributable cash flow
  $ 12,594     $ 11,214  
 
           

-23-


Table of Contents

*  
Maintenance capital expenditures are capital expenditures made to replace partially or fully depreciated assets in order to maintain the existing operating capacity of our assets and to extend their useful lives.
                 
    March 31,   December 31,
    2007   2006
    (In thousands)
Balance Sheet Data
               
Cash and cash equivalents
  $ 11,100     $ 11,555  
Working capital
  $ 8,623     $ 9,450  
Total assets
  $ 235,953     $ 243,573  
Long-term debt
  $ 181,048     $ 180,660  
Partners’ equity
  $ 31,516     $ 36,226  
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.
Results of Operations – Three Months Ended March 31, 2007 Compared with Three Months Ended March 31, 2006
Summary
Net income was $7.4 million for the three months ended March 31, 2007, an increase of $0.3 million from $7.1 million for the three months ended March 31, 2006. The increase in overall earnings was principally due to the effects of annual tariff increases on our pipelines and the recognition of certain previously deferred revenue, offset by the effect of a net decrease in volumes transported on our pipeline systems combined with an increase in our operating costs and expenses. Approximately $1.4 million of revenue relating to deficiency payments associated with certain guaranteed shipping contracts was deferred during the first quarter. Such revenue will be recognized in future periods either as payment for shipments in excess of guaranteed levels or when shipping rights expire unused after a twelve month period.
Revenues
Revenues for the three months ended March 31, 2007 increased $1.5 million from the three months ended March 31, 2006. This increase resulted principally from the effects of annual tariff increases on our pipelines and the recognition of $0.5 million of certain previously deferred revenue.
Revenues from refined product pipelines increased by $0.9 million from $16.1 million for the three months ended March 31, 2006 to $17.0 million for the three months ended March 31, 2007. This increase in refined product pipeline revenue is principally due to the effect of the annual tariff increase on refined product shipments. This favorable factor was partially offset by the effect of a net decrease in volumes transported on our refined product pipeline systems. Shipments on the Partnership’s refined product pipelines averaged 137.6 thousand barrels per day (“mbpd”) for the three months ended March 31, 2007 as compared to 143.9 mbpd for the three months ended March 31, 2006. This decrease was due to a decline in third-party shipments, partially offset by an increase in shipments by our affiliates.
Revenues from the intermediate product pipelines were $3.0 million and $2.5 million for the three months ended March 31, 2007 and 2006, respectively. This increase in intermediate pipeline revenue is principally due to the recognition of $0.5 million of previously deferred revenue as the contractual period to provide certain pipeline services had expired. Shipments on the Partnership’s intermediate product pipelines averaged 59.5 mbpd for the three months ended March 31, 2007 as compared to 61.1 mbpd for the three months ended March 31, 2006. The effect of this small decrease in volumes shipped was offset by the annual increase in the intermediate pipeline tariff.

-24-


Table of Contents

Although net volumes shipped on our refined product and intermediate pipelines were below expectations for the quarter due to the impact of refinery problems of certain shippers, the effects on our distributable cash were mitigated due to the terms of certain pipeline agreements which commit those shippers to minimum shipment levels.
Revenues from terminal and truck loading rack service fees decreased slightly from $3.9 million for the three months ended March 31, 2006 to $3.8 million for the three months ended March 31, 2007. Refined products terminalled in our facilities were 167.0 mbpd for the three months ended March 31, 2007 as compared to 166.2 mbpd for the three months ended March 31, 2006.
Operating Costs
Operations expense increased by $0.7 million from the three months ended March 31, 2006 to the three months ended March 31, 2007. This increase in expense was principally due a $0.4 million increase in the cost of employees who perform services for us including the addition of two new senior level executives.
Depreciation and Amortization
Depreciation and amortization was $0.3 million higher for the three months ended March 31, 2007 as compared to the three months ended March 31, 2006, due principally to depreciation and amortization on fixed asset additions.
General and Administrative
General and administrative costs increased less than $0.1 million from the three months ended March 31, 2006 to the three months ended March 31, 2007.
Interest Expense
Interest expense for the three months ended March 31, 2007 totaled $3.4 million, an increase of $0.2 million from $3.2 million for the three months ended March 31, 2006. For the three months ended March 31, 2007, interest expense consisted of: $3.0 million of interest on our outstanding debt, net of the impact of the interest rate swap; $0.1 million of commitment fees on the unused portion of the credit facility; and $0.3 million of amortization of the discount on the senior notes and deferred debt issuance costs. For the three months ended March 31, 2006, interest expense consisted of: $2.8 million of interest on our outstanding debt, net of the impact of the interest rate swap; $0.1 million of commitment fees on the unused portion of the credit facility; and $0.3 million of amortization of the discount on the senior notes and deferred debt issuance costs.
Minority Interest in Earnings of Rio Grande
The minority interest related to the 30% of Rio Grande that we do not own reduced our income by $0.4 million for the three months ended March 31, 2007 as compared to $0.2 million for the three months ended March 31, 2006.
LIQUIDITY AND CAPITAL RESOURCES
Overview
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. The Credit Agreement is available to fund capital expenditures, acquisitions, and working capital and for general partnership purposes. As of March 31, 2007, we had no amounts outstanding under the Credit Agreement.

-25-


Table of Contents

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.
Under our “shelf” registration process, filed September 2, 2005, 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.
We believe our current cash balances, future internally-generated funds and funds available under our Credit Agreement will provide sufficient resources to meet our working capital liquidity needs for the foreseeable future. In February 2007, we paid a regular cash distribution for the fourth quarter of 2006 of $0.675 on all units, an aggregate amount of $11.5 million. Included in this distribution was $0.4 million paid to the general partner as an incentive distribution, as the distribution per unit exceeded $0.55.
Cash and cash equivalents decreased by $0.5 million during the quarter ended March 31, 2007. The cash flows used for financing activities of $12.5 million, in addition to cash flows used for investing activities of $0.6 million, exceeded cash flows generated from operating activities of $12.6 million. Working capital decreased during the quarter by $0.8 million to $8.6 million at March 31, 2007.
Cash Flows — Operating Activities
Cash flows from operating activities increased by $4.0 million from $8.6 million for the three months ended March 31, 2006 to $12.6 million for the three months ended March 31, 2007. This increase is mainly due to $3.9 million in additional cash collections from our major customers, resulting principally from increased revenues and shortfall billings. The remaining increase in cash flows from operating activities is due to miscellaneous year-over-year changes in collections and payments.
As discussed above, our major shippers are obligated to make deficiency payments to us if we do not receive certain minimum revenue payments. Certain of these shippers then have the right to recapture these amounts if future revenues exceed minimum levels. During the first three months of 2007, we received cash payments of approximately $1.3 million under these commitments. We billed $0.5 million in the first quarter of 2006 related to first quarter shortfalls, which expired without recapture and was recognized as revenue in the first quarter of 2007. Another $1.4 million is included in our accounts receivable at March 31, 2007 related to shortfalls produced in the first quarter of 2007.
Cash Flows — Investing Activities
Cash flows used for investing activities decreased by $0.2 million from $0.8 million for the first quarter of 2006 to $0.6 million for first quarter of 2007. Additions to properties and equipment for the quarter ended March 31, 2007 was $0.9 million, an increase of $0.1 million from $0.8 million for the quarter ended March 31, 2006. For the quarter ended March 31, 2007, we received cash proceeds of $0.3 million on the sale of certain assets.
Cash Flows — Financing Activities
Cash flows used for financing activities amounted to $12.5 million for the three months ended March 31, 2007. This compared to cash flows used for financing activities of $11.1 million in the three months ended March 31, 2006. In the first quarter of 2007, we paid cash distributions on all units and the general partner interest in the aggregate amount of $11.5 million, an increase of $1.0 million from $10.5 million in distributions paid in the first quarter of 2006. There were no distributions to the minority interest owner in

-26-


Table of Contents

Rio Grande for the quarter ended March 31, 2007, as compared to $0.6 million for the quarter ended March 31, 2006.
Capital Requirements
Our pipeline and terminalling operations are capital intensive, requiring investments to maintain, expand, upgrade or enhance existing operations and to meet environmental and operational regulations. Our capital requirements have consisted of, and are expected to continue to consist of, maintenance capital expenditures and expansion capital expenditures. Maintenance capital expenditures represent capital expenditures to replace partially or fully depreciated assets to maintain the operating capacity of existing assets. Maintenance capital expenditures include expenditures required to maintain equipment reliability, tankage and pipeline integrity, and safety and to address environmental regulations. Expansion capital expenditures represent capital expenditures to expand the operating capacity of existing or new assets, whether through construction or acquisition. Expansion capital expenditures include expenditures to acquire assets to grow our business and to expand existing facilities, such as projects that increase throughput capacity on our pipelines and in our terminals. Repair and maintenance expenses associated with existing assets that are minor in nature and do not extend the useful life of existing assets are charged to operating expenses as incurred.
Each year the HLS board of directors approves our annual capital budget, which specifies capital projects that our management is authorized to undertake. Additionally, at times when conditions warrant or as new opportunities arise, special projects may be approved. The funds allocated for a particular capital project may be expended over a period of years, depending on the time required to complete the project. Therefore, our planned capital expenditures for a given year consist of expenditures approved for capital projects included in the current year’s capital budget as well as, in certain cases, expenditures approved for capital projects in capital budgets for prior years.
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. The pipeline is being built to allow various refiners in the Salt Lake City area, including Holly’s Woods Cross Refinery, to ship crude oil into the Salt Lake City area from the Utah terminus of the Frontier Pipeline as well as crude oil from Wyoming and Utah, which is currently flowing on Plains’ Rocky Mountain Pipeline. Our investment in the project is subject to various conditions, including the negotiation and execution of mutually satisfactory definitive agreements. This investment is expected to take the place of a project that we had been considering to construct and operate a new pipeline called the Porcupine Ridge Pipeline to transport crude oil from the Utah terminus of the Frontier Pipeline to Salt Lake City.
We anticipate that our currently planned expenditures for sustaining and maintenance capital as well as expenditures for smaller capital development projects (including the investment in the Utah crude oil pipeline project as described in the preceding paragraph) will be funded with existing cash balances, cash generated by operations and advances under our Credit Agreement.
The HLS board of directors is also considering a project to construct a 12-inch pipeline from Salt Lake City to Las Vegas, with service also to the Cedar City, Utah area. The initial capacity of the pipeline would be approximately 62,000 bpd, and it is expected that the capacity could be later increased up to approximately 118,000 bpd by adding pump stations. The cost of the pipeline is expected to be approximately $235.0 million, and the total cost of the project including terminals is expected to be approximately $300.0 million. We are currently in the process of evaluating bids solicited through an “open season” that ended in March 2007, and we expect to make a final decision on whether to proceed with this project based on the level of commitment from shippers. Certain preliminary work has already been carried out on this project by Holly, but as of the date of this report we have not expended HEP funds or committed to do so with respect to the project. If we choose to carry out this project, our financing for the project would include reimbursement to Holly for previous expenditures and assumption of any commitments previously made by Holly with respect

-27-


Table of Contents

to the project, and might also involve an investment in the project by one or more other companies, making our investment proportionately less.
We are also studying several other projects which are in the early stages of analysis.
We expect to use the issuance of common units and/or debt securities as the principal means of financing large investments in major capital projects such as the proposed Salt Lake City to Las Vegas pipeline project described in the preceding paragraph.
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 expiring in July 2008. Union Bank of California, N.A. is a lender and serves as administrative agent under this 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. As of March 31, 2007, we had no amounts outstanding under the Credit Agreement.
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 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. 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
The Senior Notes mature on March 1, 2015 and bear interest at 6.25%. 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

-28-


Table of Contents

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 accompanying consolidated balance sheet at March 31, 2007. The difference is due to the $3.0 million unamortized discount and $1.0 million relating to the fair value of the interest rate swap contract as further discussed under “Risk Management.”
Impact of Inflation
Inflation in the United States has been relatively low in recent years and did not have a material impact on our results of operations for the quarters ended March 31, 2007 and 2006.
A substantial majority of our revenues are generated under long-term contracts that include the right to increase our rates and minimum revenue guarantees annually for increases in the PPI. Historically, the PPI has increased an average of 3.9% annually over the past 3 calendar years.
Environmental Matters
Our operation of pipelines, terminals, and associated facilities in connection with the storage and transportation of refined products is subject to stringent and complex federal, state, and local laws and regulations governing the discharge of materials into the environment, or otherwise relating to the protection of the environment. As with the industry generally, compliance with existing and anticipated laws and regulations increases our overall cost of business, including our capital costs to construct, maintain, and upgrade equipment and facilities. While these laws and regulations affect our maintenance capital expenditures and net income, we believe that they do not affect our competitive position in that the operations of our competitors are similarly affected. We believe that our operations are in substantial compliance with applicable environmental laws and regulations. However, these laws and regulations, and the interpretation or enforcement thereof, are subject to frequent change by regulatory authorities, and we are unable to predict the ongoing cost to us of complying with these laws and regulations or the future impact of these laws and regulations on our operations. Violation of environmental laws, regulations, and permits can result in the imposition of significant administrative, civil and criminal penalties, injunctions, and construction bans or delays. A discharge of hydrocarbons or hazardous substances into the environment could, to the extent the event is not insured, subject us to substantial expense, including both the cost to comply with applicable laws and regulations and claims made by employees, neighboring landowners and other third parties for personal injury and property damage.
We inspect our pipelines regularly using equipment rented from third-party suppliers. Third parties also assist us in interpreting the results of the inspections.
Holly has agreed to indemnify us in an aggregate amount not to exceed $15.0 million for ten years after the closing of our initial public offering on July 13, 2004 for environmental noncompliance and remediation liabilities associated with the assets initially transferred to us and occurring or existing before that date, and provide $2.5 million of additional indemnification for the Intermediate Pipelines acquired in July 2005. Additionally, we entered into an environmental agreement with Alon with respect to pre-closing environmental costs and liabilities relating to the pipelines and terminals acquired from Alon in February 2005, where Alon will indemnify us for ten years subject to a $100,000 deductible and a $20.0 million maximum liability cap.
Contamination resulting from spills of refined products and crude oil is not unusual within the petroleum pipeline industry. Historic spills along our existing pipelines and terminals as a result of past operations have resulted in contamination of the environment, including soils and groundwater. Site conditions, including soils and groundwater, are being evaluated at a few of our properties where operations may have resulted in releases of hydrocarbons and other wastes, none of which we believe will have a significant effect on our operations as they would be covered under an environmental indemnification agreement.

-29-


Table of Contents

An environmental remediation project is in progress currently at our El Paso terminal, the remaining costs of which are projected to be approximately $1.2 million over the next five years. Other parties are undertaking remediation projects at our Boise, Burley and Albuquerque terminals, and we are obligated to pay a portion of these costs at the Albuquerque terminal, but not at the Boise or Burley terminals. As of March 31, 2007, we estimate the total remaining remediation cost for the Albuquerque terminal to be insignificant. A remediation project is also under way in New Mexico concerning a leak on our refined product pipeline from Artesia, New Mexico to Orla, Texas. As of March 31, 2007, we estimate the remaining cost on this project to be $0.2 million, half of which will be incurred in 2007. Holly has agreed, subject to a $15.0 million limit, to indemnify us for environmental liabilities related to the assets transferred to us by Holly to the extent such liabilities existed or arose from operation of these assets prior to the closing of our initial public offering on July 13, 2004 and are asserted within 10 years after that date. The Holly indemnification will cover the costs associated with the remediation projects mentioned above, including assessment, monitoring, and remediation programs.
In the fourth quarter of 2005, we experienced a refined product release near Sweetwater, Texas. As of March 31, 2007, we estimate that the total remaining remediation cost for this incident to be insignificant. This occurrence is not subject to indemnification from Alon.
We may experience future releases into the environment from our pipelines and terminals, or discover historical releases that were previously unidentified or not assessed. Although we maintain an extensive inspection and audit program designed, as applicable, to prevent, detect and address these releases promptly, damages and liabilities incurred due to any future environmental releases from our assets nevertheless have the potential to substantially affect our business.
CRITICAL ACCOUNTING POLICIES
Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities as of the date of the financial statements. Actual results may differ from these estimates under different assumptions or conditions. We consider the following policies to be the most critical to understanding the judgments that are involved and the uncertainties that could impact our results of operations, financial condition and cash flows.
Our significant accounting policies are described in “Item 7. Management’s Discussion and Analysis of Financial Conditions and Operations – Critical Accounting Policies” in our Annual Report on Form 10-K for the year ended December 31, 2006. Certain critical accounting policies that materially affect the amounts recorded in our consolidated financial statements include revenue recognition, assessing the possible impairment of certain long-lived assets and assessing contingent liabilities for probable losses. There have been no changes to these policies in 2007.
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.

-30-


Table of Contents

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 variable rates. Under the swap agreement, we receive 6.25% fixed rate on the notional amount and pay a variable rate equal to three-month LIBOR plus an applicable margin of 1.1575%. The variable rate being paid on the notional amount at March 31, 2007 was 6.5175%, including the applicable margin. 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 swaps.
The fair value of the interest rate swap agreement of $1.0 million is included in “Other long-term liabilities” in our accompanying consolidated balance sheet at March 31, 2007. 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 accompanying consolidated balance sheet at March 31, 2007.
The market risk inherent in our debt instruments and positions is the potential change arising from increases or decreases in interest rates as discussed below.
At March 31, 2007, we had an outstanding principal balance on our unsecured Senior Notes of $185.0 million. By means of our interest rate swap contract, we have effectively converted $60.0 million of the Senior Notes from a fixed rate to variable rate. For the fixed rate debt portion of $125.0 million, changes in interest rates would generally affect the fair value of the debt, but not our earnings or cash flows. Conversely, for the variable rate debt portion of $60.0 million, changes in interest rates would generally not impact the fair value of the debt, but may affect our future earnings and cash flows. We estimate a hypothetical 10% change in the yield-to-maturity applicable to our fixed rate debt portion of $125.0 million as of March 31, 2006 would result in a change of approximately $5.0 million in the fair value of the debt. A hypothetical 10% change in the interest rate applicable to our variable rate debt portion of $60.0 million would not have a material effect on our earnings or cash flows.
At March 31, 2007, our cash and cash equivalents included highly liquid investments with a maturity of three months or less at the time of purchase. Due to the short-term nature of our cash and cash equivalents, a hypothetical 10% increase in interest rates would not have a material effect on the fair market value of our portfolio. Since we have the ability to liquidate this portfolio, we do not expect our operating results or cash flows to be materially affected to any significant degree by the effect of a sudden change in market interest rates on our investment portfolio.
Our operations are subject to normal hazards of operations, including fire, explosion and weather-related perils. We maintain various insurance coverages, including business interruption insurance, subject to certain deductibles. We are not fully insured against certain risks because such risks are not fully insurable, coverage is unavailable, or premium costs, in our judgment, do not justify such expenditures.

-31-


Table of Contents

Item 3. Quantitative and Qualitative Disclosures About Market Risks
Market risk is the risk of loss arising from adverse changes in market rates and prices. See “Risk Management” under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for a discussion of market risk exposures that we have with respect to our cash and cash equivalents and long-term debt. We utilize derivative instruments to hedge our interest rate exposure, also discussed under “Risk Management.”
Since we do not own products shipped on our pipelines or terminalled at our terminal facilities we do not have market risks associated with commodity prices.
Item 4. Controls and Procedures
(a) Evaluation of disclosure controls and procedures
Our principal executive officer and principal financial officer have evaluated, as required by Rule 13a-15(b) under the Securities Exchange Act of 1934 (the “Exchange Act”), our disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) as of the end of the period covered by this quarterly report on Form 10-Q. Based on that evaluation, the principal executive officer and principal financial officer concluded that the design and operation of our disclosure controls and procedures are effective in ensuring that information we are required to disclose in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms.
(b) Changes in internal control over financial reporting
There have been no changes in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) that occurred during our last fiscal quarter that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.

-32-


Table of Contents

PART II. OTHER INFORMATION
Item 1. Legal proceedings
We are a party to various legal and regulatory proceedings, none of which we believe will have a material adverse impact on our financial condition, results of operations or cash flows.
Item 2. Unregistered Sales of Securities and Use of Proceeds
(c) Common unit repurchases made in the quarter
In the first quarter of 2007, we paid $0.9 million for the purchase of 19,687 of our common units in the open market for the recipients of our February 2007 restricted unit grants.
                                 
                            Maximum Number
                    Total Number of   of Units that May
                    Units Purchased as   Yet Be Purchased
                    Part of Publicly   Under a Publicly
    Total Number of   Average Price   Announced Plan or   Announced Plan or
Period   Units Purchased   Paid Per Unit   Program   Program
January 2007
        $              
February 2007
        $              
March 2007
    19,687     $ 47.17              
 
                               
Total
    19,687     $ 47.17                
 
                               
Item 6. Exhibits
     
12.1*
  Computation of Ratio of Earnings to Fixed Charges
 
   
31.1*
  Certification of Chief Executive Officer under Section 302 of the Sarbanes-Oxley Act of 2002.
 
   
31.2*
  Certification of Chief Financial Officer under Section 302 of the Sarbanes-Oxley Act of 2002.
 
   
32.1*
  Certification of Chief Executive Officer under Section 906 of the Sarbanes-Oxley Act of 2002.
 
   
32.2*
  Certification of Chief Financial Officer under Section 906 of the Sarbanes-Oxley Act of 2002.
 
*  
Filed herewith

-33-


Table of Contents

HOLLY ENERGY PARTNERS, L.P.
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
         
 
  HOLLY ENERGY PARTNERS, L.P.    
 
  (Registrant)    
 
       
 
  By: HEP LOGISTICS HOLDINGS, L.P.    
 
  its General Partner    
 
       
 
  By: HOLLY LOGISTIC SERVICES, L.L.C.    
 
  its General Partner    
 
       
Date: May 4, 2007
  /s/ P. Dean Ridenour
 
P. Dean Ridenour
   
 
  Vice President and Chief Accounting Officer    
 
  and Director    
 
  (Principal Accounting Officer)    
 
       
 
  /s/ Stephen J. McDonnell
 
Stephen J. McDonnell
   
 
  Vice President and Chief Financial Officer
(Principal Financial Officer)
   

-34-