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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 ______________________________________________________________________________________
FORM 10-Q
 ______________________________________________________________________________________
(Mark One)
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2020
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE 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)
 ______________________________________________________________________________________
Delaware20-0833098
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
2828 N. Harwood, Suite 1300
Dallas
Texas75201
(Address of principal executive offices) (Zip code)
(214) 871-3555
(Registrant’s telephone number, including area code)
________________________________________________________________
(Former name, former address and former fiscal year, if changed since last report)
Securities registered pursuant to 12(b) of the Securities Exchange Act of 1934:
Title of each classTrading Symbol(s)Name of each exchange on which registered
Common Limited Partner UnitsHEPNew York Stock Exchange
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      No  
Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).    Yes       No  
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth” company in Rule 12b-2 of the Exchange Act.
Large accelerated filerAccelerated filer
Non-accelerated filer
Smaller reporting company
Emerging growth company
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).    Yes   No  
The number of the registrant’s outstanding common units at October 29, 2020, was 105,440,201.


Table of 19,
HOLLY ENERGY PARTNERS, L.P.
INDEX
 
Item 1.
Item 2.
Item 3.
Item 4.
Item 1.
Item 1A.
Item 6.
- 2 -

Table of 19,

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, statements regarding funding of capital expenditures and distributions, distributable cash flow coverage and leverage targets, and statements 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. Forward-looking statements use words such as “anticipate,” “project,” “expect,” “plan,” “goal,” “forecast,” “intend,” “should,” “would,” “could,” “believe,” “may,” and similar expressions and statements regarding our plans and objectives for future operations are intended to identify forward-looking statements. These statements are based on our beliefs and assumptions and those of our general partner 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 and our general partner believe that such expectations reflected in such forward-looking statements are reasonable, neither we nor our general partner can give assurance that our expectations will prove to be correct. All statements concerning our expectations for future results of operations are based on forecasts for our existing operations and do not include the potential impact of any future acquisitions. Our forward-looking statements are subject to a variety of risks, uncertainties and assumptions. If one or more of these risks or uncertainties materialize, or if underlying assumptions prove incorrect, our actual results may vary materially from those anticipated, estimated, projected or expected. Certain factors could cause actual results to differ materially from results anticipated in the forward-looking statements. These factors include, but are not limited to:
the extraordinary market environment and effects of the COVID-19 pandemic, including the continuation of a material decline in demand for refined petroleum products in markets we serve;
risks and uncertainties with respect to the actual quantities of petroleum products and crude oil shipped on our pipelines and/or terminalled, stored or throughput in our terminals and refinery processing units;
the economic viability of HollyFrontier Corporation (“HFC”), our other customers and our joint ventures’ other customers, including any refusal or inability of our or our joint ventures’ customers or counterparties to perform their obligations under their contracts;
the demand for refined petroleum products in the markets we serve;
our ability to purchase and integrate future acquired operations;
our ability to complete previously announced or contemplated acquisitions;
the availability and cost of additional debt and equity financing;
the possibility of temporary or permanent reductions in production or shutdowns at refineries utilizing our pipelines, terminal facilities and refinery processing units, due to reasons such as infection in the workforce, in response to reductions in demand or lower gross margins due to economic impact of the COVID-19 pandemic, and any potential asset impairments resulting from such actions;
the effects of current and future government regulations and policies, including the effects of current and future restrictions on various commercial and economic activities in response to the COVID-19 pandemic;
delay by government authorities in issuing permits necessary for our business or our capital projects;
our and our joint venture partners’ ability to complete and maintain operational efficiency in carrying out routine operations and capital construction projects;
the possibility of terrorist or cyber attacks and the consequences of any such attacks;
general economic conditions, including uncertainty regarding the timing, pace and extent of an economic recovery in the United States;
the impact of recent or proposed changes in the tax laws and regulations that affect master limited partnerships; and
other financial, operational 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, the forward-looking statements that are referred to above. You should not put any undue reliance on any forward-looking statements. When considering forward-looking statements, you should keep in mind the known material risk factors and other cautionary statements set forth in our Annual Report on Form
- 3 -

Table of 19,
10-K for the year ended December 31, 2019 and in our Quarterly Report on Form 10-Q for the quarter ended March 31, 2020, and in this Quarterly Report on 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.
- 4 -

Table of 19,
PART I. FINANCIAL INFORMATION
Item 1.Financial Statements
HOLLY ENERGY PARTNERS, L.P.
CONSOLIDATED BALANCE SHEETS
(In thousands, except unit data)
September 30, 2020December 31, 2019
(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents (Cushing Connect VIEs: $9,288 and $6,842, respectively)
$18,091 $13,287 
Accounts receivable:
Trade (Cushing Connect VIEs: $712 and $79, respectively)
13,857 18,731 
Affiliates46,504 49,716 
60,361 68,447 
Prepaid and other current assets6,282 7,629 
Total current assets84,734 89,363 
Properties and equipment, net (Cushing Connect VIEs: $32,092 and $2,916, respectively)
1,447,924 1,467,099 
Operating lease right-of-use assets, net3,164 3,255 
Net investment in leases167,238 134,886 
Intangible assets, net90,817 101,322 
Goodwill234,684 270,336 
Equity method investments (Cushing Connect VIEs: $39,658 and $37,084, respectively)
122,046 120,071 
Other assets11,278 12,900 
Total assets$2,161,885 $2,199,232 
LIABILITIES AND EQUITY
Current liabilities:
Accounts payable:
Trade (Cushing Connect VIEs: $6,030 and $2,082, respectively)
$21,022 $17,818 
Affiliates6,922 16,737 
27,944 34,555 
Accrued interest4,691 13,206 
Deferred revenue11,020 10,390 
Accrued property taxes8,972 3,799 
Current operating lease liabilities1,199 1,126 
Current finance lease liabilities3,459 3,224 
Other current liabilities2,849 2,305 
Total current liabilities60,134 68,605 
Long-term debt 1,439,874 1,462,031 
Noncurrent operating lease liabilities2,333 2,482 
Noncurrent finance lease liabilities69,180 70,475 
Other long-term liabilities13,861 12,808 
Deferred revenue41,376 45,681 
Class B unit51,956 49,392 
Equity:
Partners’ equity:
Common unitholders (105,440 units issued and outstanding
    at September 30, 2020 and December 31, 2019)
364,821 381,103 
Noncontrolling interest118,350 106,655 
Total equity483,171 487,758 
Total liabilities and equity$2,161,885 $2,199,232 
See accompanying notes.

- 5 -

Table of 19,
HOLLY ENERGY PARTNERS, L.P.
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)
(In thousands, except per unit data)
Three Months Ended
September 30,
Nine Months Ended
September 30,
2020201920202019
Revenues:
Affiliates$100,992 $106,027 $297,983 $311,755 
Third parties26,739 29,868 72,409 89,388 
127,731 135,895 370,392 401,143 
Operating costs and expenses:
Operations (exclusive of depreciation and amortization)40,003 44,924 109,721 123,045 
Depreciation and amortization26,190 24,121 75,202 72,192 
General and administrative2,332 2,714 7,569 7,322 
Goodwill impairment35,653  35,653  
104,178 71,759 228,145 202,559 
Operating income23,553 64,136 142,247 198,584 
Other income (expense):
Equity in earnings of equity method investments1,316 1,334 5,186 5,217 
Interest expense
(14,104)(18,807)(45,650)(57,059)
Interest income2,803 2,243 7,834 3,322 
Gain on sales-type leases 35,166 33,834 35,166 
Loss on early extinguishment of debt  (25,915) 
Other income (loss)7,465 142 8,439 (57)
(2,520)20,078 (16,272)(13,411)
Income before income taxes21,033 84,214 125,975 185,173 
State income tax expense(34)(30)(110)(36)
Net income20,999 84,184 125,865 185,137 
Allocation of net income attributable to noncontrolling interests
(3,186)(1,839)(6,721)(5,920)
Net income attributable to the partners
17,813 82,345 119,144 179,217 
Limited partners’ per unit interest in earnings—basic and diluted
$0.17 $0.78 $1.13 $1.70 
Weighted average limited partners’ units outstanding105,440 105,440 105,440 105,440 


See accompanying notes.

- 6 -

Table of 19,
HOLLY ENERGY PARTNERS, L.P.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)
 
Nine Months Ended
September 30,
20202019
Cash flows from operating activities
Net income $125,865 $185,137 
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization75,202 72,192 
(Gain) loss on sale of assets(887)(19)
Loss on early extinguishment of debt25,915  
Gain on sales-type leases(33,834)(35,166)
Goodwill impairment35,653  
Amortization of deferred charges2,479 2,307 
Equity-based compensation expense1,547 1,774 
Equity in earnings of equity method investments, net of distributions(238)263 
(Increase) decrease in operating assets:
Accounts receivable—trade4,874 (3,850)
Accounts receivable—affiliates3,212 11,016 
Prepaid and other current assets1,885 1,694 
Increase (decrease) in operating liabilities:
Accounts payable—trade(2,258)2,622 
Accounts payable—affiliates(9,815)(7,475)
Accrued interest(8,515)(7,418)
Deferred revenue(3,675)413 
Accrued property taxes5,173 7,487 
Other current liabilities544 400 
Other, net1,913 (3,160)
Net cash provided by operating activities225,040 228,217 
Cash flows from investing activities
Additions to properties and equipment(38,642)(23,828)
Investment in Cushing Connect JV Terminal(2,438) 
Proceeds from sale of assets961 265 
Distributions in excess of equity in earnings of equity investments701 693 
Net cash used for investing activities(39,418)(22,870)
Cash flows from financing activities
Borrowings under credit agreement219,500 269,500 
Repayments of credit agreement borrowings(237,000)(257,000)
Redemption of senior notes(522,500) 
Proceeds from issuance of debt500,000  
Contributions from general partner611 182 
Contributions from noncontrolling interest15,382  
Distributions to HEP unitholders(137,437)(204,701)
Distributions to noncontrolling interest(7,845)(7,750)
Payments on finance leases(2,666)(780)
Deferred financing costs(8,714) 
Purchase of units for incentive grants (255)
Units withheld for tax withholding obligations(149)(119)
Net cash used by financing activities
(180,818)(200,923)
Cash and cash equivalents
Increase for the period4,804 4,424 
Beginning of period13,287 3,045 
End of period$18,091 $7,469 
See accompanying notes.
- 7 -

Table of 19,
HOLLY ENERGY PARTNERS, L.P.
CONSOLIDATED STATEMENTS OF EQUITY
(Unaudited)
(In thousands)
 
Common
Units
Noncontrolling InterestTotal Equity
 
Balance December 31, 2019$381,103 $106,655 $487,758 
Contributions from noncontrolling interest— 7,304 7,304 
Distributions to HEP unitholders(68,519)— (68,519)
Distributions to noncontrolling interest— (3,000)(3,000)
Equity-based compensation506 — 506 
Class B unit accretion(835)— (835)
   Other208 — 208 
Net income25,696 1,216 26,912 
Balance March 31, 2020$338,159 $112,175 $450,334 
Contributions from noncontrolling interest— 5,959 5,959 
Distributions to HEP unitholders(34,460)— (34,460)
Distributions to noncontrolling interest— (1,000)(1,000)
Equity-based compensation474 — 474 
Class B unit accretion(835)— (835)
   Other80 — 80 
Net income77,305 649 77,954 
Balance June 30, 2020$380,723 $117,783 $498,506 
Contributions from noncontrolling interest— 2,119 2,119 
Distributions to HEP unitholders(34,458)— (34,458)
Distributions to noncontrolling interest— (3,845)(3,845)
Equity-based compensation567 — 567 
Class B unit accretion(894)— (894)
Other177 — 177 
Net income18,706 2,293 20,999 
Balance September 30, 2020$364,821 $118,350 $483,171 

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Table of 19,
Common
Units
Noncontrolling InterestTotal Equity
 
Balance December 31, 2018$427,435 $88,126 $515,561 
Distributions to HEP unitholders(67,975)— (67,975)
Distributions to noncontrolling interest— (3,000)(3,000)
Equity-based compensation661 — 661 
Class B unit accretion(780)— (780)
Other814 — 814 
Net income51,962 1,832 53,794 
Balance March 31, 2019$412,117 $86,958 $499,075 
Distributions to HEP unitholders(68,232)— (68,232)
Distributions to noncontrolling interest— (2,250)(2,250)
Equity-based compensation585 — 585 
Class B unit accretion(781)— (781)
Other(138)— (138)
Net income46,471 688 47,159 
Balance June 30, 2019$390,022 $85,396 $475,418 
Distributions to HEP unitholders(68,493)— (68,493)
Distributions to noncontrolling interest— (2,500)(2,500)
Equity-based compensation528 — 528 
Class B unit accretion(835)— (835)
Other182 — 182 
Net income83,180 1,004 84,184 
Balance September 30, 2019$404,584 $83,900 $488,484 

See accompanying notes.


- 9 -

Table of 19,
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. As of September 30, 2020, HollyFrontier Corporation (“HFC”) and its subsidiaries own a 57% limited partner interest and the non-economic general partner interest in HEP. We commenced operations on July 13, 2004, upon the completion of our initial public offering. In these consolidated financial statements, the words “we,” “our,” “ours” and “us” refer to HEP unless the context otherwise indicates.

On October 31, 2017, we closed on an equity restructuring transaction with HEP Logistics Holdings, L.P. (“HEP Logistics”), a wholly-owned subsidiary of HFC and the general partner of HEP, pursuant to which the incentive distribution rights ("IDRs") held by HEP Logistics were canceled, and HEP Logistics' 2% general partner interest in HEP was converted into a non-economic general partner interest in HEP. In consideration, we issued 37,250,000 of our common units to HEP Logistics. In addition, HEP Logistics agreed to waive $2.5 million of limited partner cash distributions for each of twelve consecutive quarters beginning with the first quarter the units issued as consideration were eligible to receive distributions. As a result of this transaction, no distributions were made on the general partner interest after October 31, 2017. This waiver of limited partner cash distributions expired after the cash distribution for the second quarter of 2020, which was made during the third quarter of 2020.

We own and operate petroleum product and crude oil pipelines, terminal, tankage and loading rack facilities and refinery processing units that support refining and marketing operations of HFC and other refineries in the Mid-Continent, Southwest and Northwest regions of the United States. Additionally, we own a 75% interest in UNEV Pipeline, LLC (“UNEV”), a 50% interest in Osage Pipe Line Company, LLC (“Osage”), a 50% interest in Cheyenne Pipeline LLC, and a 50% interest in Cushing Connect Pipeline & Terminal LLC.

On June 1, 2020, HFC announced plans to permanently cease petroleum refining operations at its Cheyenne Refinery and to convert certain assets at that refinery to renewable diesel production. HFC subsequently began winding down petroleum refining operations at its Cheyenne Refinery on August 3, 2020. As of September 30, 2020, our throughput agreement with HFC required minimum annualized payments to us of approximately $17.6 million related to our Cheyenne assets. The net book value of our Cheyenne assets as of June 30, 2020 was approximately $88.5 million, including $28.1 million of long-lived assets and $68.7 million of goodwill. No impairment of our Cheyenne long-lived assets was required.

Our annual goodwill impairment testing was performed during the third quarter of 2020. The estimated fair value of our reporting units were derived using a combination of both income and market approaches. The income approach reflects expected future cash flows based on anticipated gross margins, operating costs, and capital expenditures. The market approach includes both the guideline public company and guideline transaction methods. Both market approach methods use pricing multiples derived from historical market transactions of other like-kind assets. These fair value measurements involve significant unobservable inputs (Level 3 inputs). See Note 5 for further discussion of Level 3 inputs.

Our testing of goodwill did not identify any impairments other than our Cheyenne reporting unit, which reported a goodwill impairment charge of $35.7 million.

Subsequent to the third quarter of 2020, HEP and HFC reached an agreement in principle to terminate the existing minimum volume commitments for HEP's Cheyenne assets and enter into new agreements on the following terms, in each case effective January 1, 2021: (1) a ten-year lease with two five-year renewal option periods for HFC’s use of certain HEP tank and rack assets in the Cheyenne Refinery to facilitate renewable diesel production with an annual lease payment of approximately $5 million, (2) a five-year contango service fee arrangement that will utilize HEP tank assets inside the Cheyenne Refinery where HFC will pay a base tariff to HEP for available crude oil storage and HFC and HEP will split any profits generated on crude oil contango opportunities and (3) a $10 million one-time cash payment from HFC to HEP for the termination of the existing minimum volume commitment.

We operate in two reportable segments, a Pipelines and Terminals segment and a Refinery Processing Unit segment. Disclosures around these segments are discussed in Note 15.

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We generate revenues by charging tariffs for transporting petroleum products and crude oil through our pipelines, by charging fees for terminalling and storing refined products and other hydrocarbons, providing other services at our storage tanks and terminals and by charging fees for processing hydrocarbon feedstocks through our refinery processing units. We do not take ownership of products that we transport, terminal, store or process, and therefore, we are not exposed directly to changes in commodity prices.

The consolidated financial statements 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, in the opinion of management, are 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 U.S. generally accepted accounting principles (“GAAP”) 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 Annual Report on Form 10-K for the year ended December 31, 2019. 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, 2020.

Principles of Consolidation and Common Control Transactions
The consolidated financial statements include our accounts and those of subsidiaries and joint ventures that we control. All significant intercompany transactions and balances have been eliminated.

Most of our acquisitions from HFC occurred while we were a consolidated variable interest entity (“VIE”) of HFC. Therefore, as an entity under common control with HFC, we recorded these acquisitions on our balance sheets at HFC's historical basis instead of our purchase price or fair value.

Accounting Pronouncements Adopted During the Periods Presented

Goodwill Impairment Testing
In January 2017, Accounting Standard Update (“ASU”) 2017-04, “Simplifying the Test for Goodwill Impairment,” was issued amending the testing for goodwill impairment by eliminating Step 2 from the goodwill impairment test. Step 2 measures a goodwill impairment loss by comparing the implied fair value of a reporting unit’s goodwill with the carrying amount of that goodwill. Under this standard, goodwill impairment is measured as the excess of the carrying amount of the reporting unit over the related fair value. We adopted this standard effective in the second quarter of 2019, and the adoption of this standard had no effect on our financial condition, results of operations or cash flows.

Leases
In February 2016, ASU No. 2016-02, “Leases” (“ASC 842”) was issued requiring leases to be measured and recognized as a lease liability, with a corresponding right-of-use asset on the balance sheet. We adopted this standard effective January 1, 2019, and we elected to adopt using the modified retrospective transition method, whereby comparative prior period financial information will not be restated and will continue to be reported under the lease accounting standard in effect during those periods. We also elected practical expedients provided by the new standard, including the package of practical expedients and the short-term lease recognition practical expedient, which allow an entity to not recognize on the balance sheet leases with a term of 12 months or less. Upon adoption of this standard, we recognized $78.4 million of lease liabilities and corresponding right-of-use assets on our consolidated balance sheet. Adoption of this standard did not have a material impact on our results of operations or cash flows. See Notes 3 and 4 for additional information on our lease policies.

Credit Losses Measurement
In June 2016, ASU 2016-13, “Measurement of Credit Losses on Financial Instruments,” was issued requiring measurement of all expected credit losses for certain types of financial instruments, including trade receivables, held at the reporting date based on historical experience, current conditions and reasonable and supportable forecasts. We adopted this standard effective January 1, 2020, and adoption of the standard did not have a material impact on our financial condition, results of operations or cash flows.


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Note 2:Investment in Joint Venture

On October 2, 2019, HEP Cushing LLC (“HEP Cushing”), a wholly-owned subsidiary of HEP, and Plains Marketing, L.P. (“PMLP”), a wholly-owned subsidiary of Plains All American Pipeline, L.P. (“Plains”), formed a 50/50 joint venture, Cushing Connect Pipeline & Terminal LLC (the “Cushing Connect Joint Venture”), for (i) the development and construction of a new 160,000 barrel per day common carrier crude oil pipeline (the “Cushing Connect Pipeline”) that will connect the Cushing, Oklahoma crude oil hub to the Tulsa, Oklahoma refining complex owned by a subsidiary of HFC and (ii) the ownership and operation of 1.5 million barrels of crude oil storage in Cushing, Oklahoma (the “Cushing Connect JV Terminal”). The Cushing Connect JV Terminal was fully in service beginning in April 2020. The Cushing Connect Pipeline is expected to be in service during the first quarter of 2021. Long-term commercial agreements have been entered into to support the Cushing Connect Joint Venture assets.

The Cushing Connect Joint Venture contracted with an affiliate of HEP to manage the construction and operation of the Cushing Connect Pipeline and with an affiliate of Plains to manage the operation of the Cushing Connect JV Terminal. The total Cushing Connect Joint Venture investment will be shared proportionately among the partners, and HEP estimates its share of the cost of the Cushing Connect JV Terminal contributed by Plains and Cushing Connect Pipeline construction costs will be approximately $65 million.

The Cushing Connect Joint Venture legal entities are variable interest entities ("VIEs") as defined under GAAP. A VIE is a legal entity if it has any one of the following characteristics: (i) the entity does not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support; (ii) the at risk equity holders, as a group, lack the characteristics of a controlling financial interest; or (iii) the entity is structured with non-substantive voting rights. The Cushing Connect Joint Venture legal entities do not have sufficient equity at risk to finance their activities without additional financial support. Since HEP is constructing and will operate the Cushing Connect Pipeline, HEP has more ability to direct the activities that most significantly impact the financial performance of the Cushing Connect Joint Venture and Cushing Connect Pipeline legal entities. Therefore, HEP consolidates those legal entities. We do not have the ability to direct the activities that most significantly impact the Cushing Connect JV Terminal legal entity, and therefore, we account for our interest in the Cushing Connect JV Terminal legal entity using the equity method of accounting.


Note 3:Revenues

Revenues are generally recognized as products are shipped through our pipelines and terminals, feedstocks are processed through our refinery processing units or other services are rendered. The majority of our contracts with customers meet the definition of a lease since (1) performance of the contracts is dependent on specified property, plant, or equipment and (2) it is remote that one or more parties other than the customer will take more than a minor amount of the output associated with the specified property, plant, or equipment. Prior to the adoption of the new lease standard (see Note 1), we bifurcated the consideration received between lease and service revenue. The new lease standard allows the election of a practical expedient whereby a lessor does not have to separate non-lease (service) components from lease components under certain conditions. The majority of our contracts meet these conditions, and we have made this election for those contracts. Under this practical expedient, we treat the combined components as a single performance obligation in accordance with Accounting Standards Codification (“ASC”) 606, which largely codified ASU 2014-09, if the non-lease (service) component is the dominant component. If the lease component is the dominant component, we treat the combined components as a lease in accordance with ASC 842, which largely codified ASU 2016-02.
Several of our contracts include incentive or reduced tariffs once a certain quarterly volume is met. Revenue from the variable element of these transactions is recognized based on the actual volumes shipped as it relates specifically to rendering the services during the applicable quarter.
The majority of our long-term transportation contracts specify minimum volume requirements, whereby, we bill a customer for a minimum level of shipments in the event a customer ships below their contractual requirements. If there are no future performance obligations, we will recognize these deficiency payments in revenue.
In certain of these throughput agreements, a customer may later utilize such shortfall billings as credit towards future volume shipments in excess of its minimum levels within its respective contractual shortfall make-up period. Such amounts represent an obligation to perform future services, which may be initially deferred and later recognized as revenue based on estimated future
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shipping levels, including the likelihood of a customer’s ability to utilize such amounts prior to the end of the contractual shortfall make-up period. We recognize the service portion of these deficiency payments in revenue when we do not expect we will be required to satisfy these performance obligations in the future based on the pattern of rights exercised by the customer. During the three and nine months ended September 30, 2020, we recognized $1.1 million and $13.8 million of these deficiency payments in revenue, of which $0.2 million and $0.7 million, respectively, related to deficiency payments billed in prior periods. As of September 30, 2020, deferred revenue reflected in our consolidated balance sheet related to shortfalls billed was $0.4 million.
A contract liability exists when an entity is obligated to perform future services for a customer for which the entity has received consideration. Since HEP may be required to perform future services for these deficiency payments received, the deferred revenues on our balance sheets were considered contract liabilities. A contract asset exists when an entity has a right to consideration in exchange for goods or services transferred to a customer. Our consolidated balance sheets included the contract assets and liabilities in the table below:
September 30,
2020
December 31,
2019
 (In thousands)
Contract assets$6,187 $5,675 
Contract liabilities$(400)$(650)

The contract assets and liabilities include both lease and service components. We did not recognize any revenue during the three months ended September 30, 2020, that was previously included in contract liability as of December 31, 2019, and we recognized $0.7 million of revenue during the nine months ended September 30, 2020, that was previously included in contract liability as of December 31, 2019. We did not recognize any revenue during the three months ended September 30, 2019, that was previously included in contract liability as of December 31, 2018, and we recognized $0.6 million of revenue during the nine months ended September 30, 2019, that was previously included in contract liability as of December 31, 2018. During the three and the nine months ended September 30, 2020, we also recognized $0.1 million and $0.5 million, respectively, of revenue included in contract assets at September 30, 2020.

As of September 30, 2020, we expect to recognize $2.2 billion in revenue related to our unfulfilled performance obligations under the terms of our long-term throughput agreements and leases expiring in 2021 through 2036. These agreements generally provide for changes in the minimum revenue guarantees annually for increases or decreases in the Producer Price Index (“PPI”) or Federal Energy Regulatory Commission (“FERC”) index, with certain contracts having provisions that limit the level of the rate increases or decreases. We expect to recognize revenue for these unfulfilled performance obligations as shown in the table below (amounts shown in table include both service and lease revenues):
Years Ending December 31,(In millions)
Remainder of 2020$92 
2021362 
2022332 
2023295 
2024255 
2025188 
Thereafter650 
Total$2,174 
Payment terms under our contracts with customers are consistent with industry norms and are typically payable within 10 to 30 days of the date of invoice.
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Disaggregated revenues were as follows:
Three Months Ended
September 30,
Nine Months Ended
September 30,
2020201920202019
(In thousands)
Pipelines$68,292 $73,163 $197,718 $220,526 
Terminals, tanks and loading racks39,036 42,454 112,814 119,121 
Refinery processing units20,403 20,278 59,860 61,496 
$127,731 $135,895 $370,392 $401,143 
During the three and nine months ended September 30, 2020, lease revenues amounted to $90.1 million and $269.9 million, respectively, and service revenues amounted to $37.7 million and $100.5 million, respectively. Both of these revenues were recorded within affiliates and third parties revenues on our consolidated statement of income.

Note 4:Leases

We adopted ASC 842 effective January 1, 2019, and elected to adopt using the modified retrospective transition method and practical expedients, both of which are provided as options by the standard and further defined in Note 1.

Lessee Accounting
At inception, we determine if an arrangement is or contains a lease. Right-of-use assets represent our right to use an underlying asset for the lease term, and lease liabilities represent our payment obligation under the leasing arrangement. Right-of-use assets and lease liabilities are recognized at the commencement date based on the present value of lease payments over the lease term. We use our estimated incremental borrowing rate (“IBR”) to determine the present value of lease payments as most of our leases do not contain an implicit rate. Our IBR represents the interest rate which we would pay to borrow, on a collateralized basis, an amount equal to the lease payments over a similar term in a similar economic environment. We use the implicit rate when readily determinable.

As a lessee, we lease land, buildings, pipelines, transportation and other equipment to support our operations. These leases can be categorized into operating and finance leases. Operating leases are recorded in operating lease right-of-use assets and current and noncurrent operating lease liabilities on our consolidated balance sheet. Finance leases are included in properties and equipment, current finance lease liabilities and noncurrent finance lease liabilities on our consolidated balance sheet.

When renewal options are defined in a lease, our lease term includes an option to extend the lease when it is reasonably certain we will exercise that option. Leases with a term of 12 months or less are not recorded on our balance sheet, and lease expense is accounted for on a straight-line basis. In addition, as a lessee, we separate non-lease components that are identifiable and exclude them from the determination of net present value of lease payment obligations.

Our leases have remaining terms of less than 1 year to 24 years, some of which include options to extend the leases for up to 10 years.

Finance Lease Obligations
We have finance lease obligations related to vehicle leases with initial terms of 33 to 48 months. The total cost of assets under finance leases was $6.6 million and $7.0 million as of September 30, 2020 and December 31, 2019, respectively, with accumulated depreciation of $3.4 million and $4.5 million as of September 30, 2020 and December 31, 2019, respectively. We include depreciation of finance leases in depreciation and amortization in our consolidated statements of income.

In addition, we have a finance lease obligation related to a pipeline lease with an initial term of 10 years with one remaining subsequent renewal option for an additional 10 years.

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Supplemental balance sheet information related to leases was as follows (in thousands, except for lease term and discount rate):
September 30, 2020December 31, 2019
Operating leases:
   Operating lease right-of-use assets, net$3,164 $3,255 
   Current operating lease liabilities 1,199 1,126 
   Noncurrent operating lease liabilities2,333 2,482 
      Total operating lease liabilities$3,532 $3,608 
Finance leases:
   Properties and equipment$6,554 $6,968 
   Accumulated amortization(3,354)(4,547)
      Properties and equipment, net$3,200 $2,421 
   Current finance lease liabilities $3,459 $3,224 
   Noncurrent finance lease liabilities69,180 70,475 
      Total finance lease liabilities$72,639 $73,699 
Weighted average remaining lease term (in years)
   Operating leases6.06.5
   Finance leases16.217.0
Weighted average discount rate
   Operating leases4.8%5.0%
   Finance leases5.6%6.0%


Supplemental cash flow and other information related to leases were as follows:
Nine Months Ended
September 30,
20202019
(In thousands)
Cash paid for amounts included in the measurement of lease liabilities:
Operating cash flows on operating leases$773 $5,467 
Operating cash flows on finance leases$3,241 $75 
Financing cash flows on finance leases$2,666 $780 
- 15 -


Maturities of lease liabilities were as follows:
September 30, 2020
OperatingFinance
(In thousands)
2020$257 $1,931 
2021906 7,403 
2022627 7,277 
2023607 7,320 
2024494 6,856 
2025 and thereafter1,179 80,313 
   Total lease payments4,070 111,100 
Less: Imputed interest(538)(38,461)
   Total lease obligations3,532 72,639 
Less: Current lease liabilities(1,199)(3,459)
   Noncurrent lease liabilities$2,333 $69,180 

The components of lease expense were as follows:
Three Months Ended
September 30,
Nine Months Ended
September 30,
2020201920202019
(In thousands)
Operating lease costs$242 $1,852 $745 $5,420 
Finance lease costs
   Amortization of assets251 213 766 711 
   Interest on lease liabilities1,032 24 3,108 75 
Variable lease cost64 41 159 112 
Total net lease cost$1,589 $2,130 $4,778 $6,318 

Lessor Accounting
As discussed in Note 3, the majority of our contracts with customers meet the definition of a lease. See Note 3 for further discussion of the impact of adoption of this standard on our activities as a lessor.

Customer contracts that contain leases are generally classified as either operating leases, direct finance leases or sales-type leases. We consider inputs such as the lease term, fair value of the underlying asset and residual value of the underlying assets when assessing the classification.

Substantially all of the assets supporting contracts meeting the definition of a lease have long useful lives, and we believe these assets will continue to have value when the current agreements expire due to our risk management strategy for protecting the residual fair value of the underlying assets by performing ongoing maintenance during the lease term. HFC generally has the option to purchase assets located within HFC refinery boundaries, including refinery tankage, truck racks and refinery processing units, at fair market value when the related agreements expire.

One of our throughput agreements with Delek was renewed during the three months ending June 30, 2020. Certain components of this agreement met the criteria of sales-type leases since the underlying assets are not expected to have an alternative use at the end of the lease term to anyone other than Delek. Under sales-type lease accounting, at the commencement date, the lessor recognizes a net investment in the lease, based on the estimated fair value of the underlying leased assets at contract inception, and derecognizes the underlying assets with the difference recorded as selling profit or loss arising from the lease. Therefore, we recognized a gain on sales-type leases during the nine months ended September 30, 2020 composed of the following:
- 16 -


(In thousands)
Net investment in leases$35,319 
Properties and equipment, net(1,485)
Gain on sales-type leases$33,834 

This sales-type lease transaction, including the related gain, was a non-cash transaction.

Lease income recognized was as follows:
Three Months Ended
September 30,
Nine Months Ended
September 30,
2020201920202019
(In thousands)
Operating lease revenues$87,125 $94,459 $262,518 $282,747 
Direct financing lease interest income525 539 1,572 1,558 
Gain on sales-type leases 35,166 33,834 35,166 
Sales-type lease interest income2,278 1,675 6,218 1,675 
Lease revenues relating to variable lease payments not included in measurement of the sales-type lease receivable 2,952 3,075 7,413 3,075 
For our sales-type leases, we included customer obligations related to minimum volume requirements in guaranteed minimum lease payments. Portions of our minimum guaranteed pipeline tariffs for assets subject to sales-type lease accounting are recorded as interest income with the remaining amounts recorded as a reduction in net investment in leases. We recognized any billings for throughput volumes in excess of minimum volume requirements as variable lease payments, and these variable lease payments were recorded in lease revenues.

Annual minimum undiscounted lease payments under our leases were as follows as of September 30, 2020:
OperatingFinanceSales-type
Years Ending December 31,(In thousands)
Remainder of 2020$77,568 $530 $3,114 
2021306,771 2,128 12,456 
2022304,315 2,145 12,456 
2023273,362 2,162 12,456 
2024235,280 2,179 12,456 
2025 and thereafter739,158 40,787 73,044 
Total$1,936,454 $49,931 $125,982 

Net investments in leases recorded on our balance sheet were composed of the following:
September 30, 2020December 31, 2019
Sales-type LeasesDirect Financing LeasesSales-type LeasesDirect Financing Leases
(In thousands)(In thousands)
Lease receivables (1)
$90,606 $16,469 $68,457 $16,511 
Unguaranteed residual assets63,718  52,933  
Net investment in leases$154,324 $16,469 $121,390 $16,511 

(1)    Current portion of lease receivables included in prepaid and other current assets on the balance sheet.
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Note 5:Fair Value Measurements

Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value measurements are derived using inputs (assumptions that market participants would use in pricing an asset or liability) including assumptions about risk. GAAP categorizes inputs used in fair value measurements into three broad levels as follows:
(Level 1) Quoted prices in active markets for identical assets or liabilities.
(Level 2) Observable inputs other than quoted prices included in Level 1, such as quoted prices for similar assets and liabilities in active markets, similar assets and liabilities in markets that are not active or can be corroborated by observable market data.
(Level 3) Unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. This includes valuation techniques that involve significant unobservable inputs.

Financial Instruments
Our financial instruments consist of cash and cash equivalents, accounts receivable, accounts payable, and debt. The carrying amounts of cash equivalents, accounts receivable and accounts payable approximate fair value due to the short-term maturity of these instruments. Debt consists of outstanding principal under our revolving credit agreement (which approximates fair value as interest rates are reset frequently at current interest rates) and our fixed interest rate senior notes.

The carrying amounts and estimated fair values of our senior notes were as follows:
 September 30, 2020December 31, 2019
Financial InstrumentFair Value Input LevelCarrying
Value
Fair ValueCarrying
Value
Fair Value
(In thousands)
Liabilities:
6% Senior Notes
Level 2  496,531 522,045 
5% Senior Notes
Level 2491,874 490,155   

Level 2 Financial Instruments
Our senior notes are measured at fair value using Level 2 inputs. The fair value of the senior notes is based on market values provided by a third-party bank, which were derived using market quotes for similar type debt instruments. See Note 9 for additional information.

Non-Recurring Fair Value Measurements
For gains on sales-type leases recognized during the third quarter of 2020, the estimated fair value of the underlying leased assets at contract inception and the present value of the estimated unguaranteed residual asset at the end of the lease term are used in determining the net investment in leases and related gain on sales-type leases recorded. The asset valuation estimates include Level 3 inputs based on a replacement cost valuation method.

During the three months ended September 30, 2020, we recognized goodwill impairment based on fair value measurements utilized during our goodwill testing (see Note 1). The fair value measurements were based on a combination of valuation methods including discounted cash flows, the guideline public company and guideline transaction methods and obsolescence adjusted replacement costs, all of which are Level 3 inputs.


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Note 6:Properties and Equipment 

The carrying amounts of our properties and equipment are as follows:
September 30,
2020
December 31,
2019
 (In thousands)
Pipelines, terminals and tankage$1,609,453 $1,602,231 
Refinery assets349,030 348,093 
Land and right of way87,076 86,190 
Construction in progress40,734 10,930 
Other9,266 14,110 
2,095,559 2,061,554 
Less accumulated depreciation647,635 594,455 
$1,447,924 $1,467,099 

Depreciation expense was $64.3 million and $61.7 million for the nine months ended September 30, 2020 and 2019, respectively, and includes depreciation of assets acquired under capital leases.


Note 7:Intangible Assets

Intangible assets include transportation agreements and customer relationships that represent a portion of the total purchase price of certain assets acquired from Delek in 2005, from HFC in 2008 prior to HEP becoming a consolidated VIE of HFC, from Plains in 2017, and from other minor acquisitions in 2018.

The carrying amounts of our intangible assets are as follows:
Useful LifeSeptember 30,
2020
December 31,
2019
 (In thousands)
Delek transportation agreement
30 years
$59,933 $59,933 
HFC transportation agreement
10-15 years
75,131 75,131 
Customer relationships10 years69,683 69,683 
Other50 50 
204,797 204,797 
Less accumulated amortization113,980 103,475 
$90,817 $101,322 

Amortization expense was $10.5 million for both of the nine months ended September 30, 2020 and 2019. We estimate amortization expense to be $14.0 million for each of the next two years, $9.9 million in 2023, and $9.1 million in 2024 and 2025.

We have additional transportation agreements with HFC resulting from historical transactions consisting of pipeline, terminal and tankage assets contributed to us or acquired from HFC. These transactions occurred while we were a consolidated variable interest entity of HFC; therefore, our basis in these agreements is zero and does not reflect a step-up in basis to fair value.


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Note 8:Employees, Retirement and Incentive Plans

Direct support for our operations is provided by Holly Logistic Services, L.L.C. (“HLS”), an HFC subsidiary, which utilizes personnel employed by HFC who are dedicated to performing services for us. Their costs, including salaries, bonuses, payroll taxes, benefits and other direct costs, are charged to us monthly in accordance with an omnibus agreement that we have with HFC (the “Omnibus Agreement”). These employees participate in the retirement and benefit plans of HFC. Our share of retirement and benefit plan costs was $1.9 million and $1.8 million for the three months ended September 30, 2020 and 2019, respectively, and $5.7 million and $5.4 million for the nine months ended September 30, 2020 and 2019, respectively.

Under HLS’s secondment agreement with HFC (the “Secondment Agreement”), certain employees of HFC are seconded to HLS to provide operational and maintenance services for certain of our processing, refining, pipeline and tankage assets, and HLS reimburses HFC for its prorated portion of the wages, benefits, and other costs related to these employees.
We have a Long-Term Incentive Plan for employees and non-employee directors who perform services for us. The Long-Term Incentive Plan consists of four components: restricted or phantom units, performance units, unit options and unit appreciation rights. Our accounting policy for the recognition of compensation expense for awards with pro-rata vesting (a significant proportion of our awards) is to expense the costs ratably over the vesting periods.

As of September 30, 2020, we had two types of incentive-based awards outstanding, which are described below. The compensation cost charged against income was $0.6 million and $0.5 million for the three months ended September 30, 2020 and 2019, respectively, and $1.5 million and $1.8 million for the nine months ended September 30, 2020 and 2019, respectively. We currently purchase units in the open market instead of issuing new units for settlement of all unit awards under our Long-Term Incentive Plan. As of September 30, 2020, 2,500,000 units were authorized to be granted under our Long-Term Incentive Plan, of which 1,122,230 were available to be granted, assuming no forfeitures of the unvested units and full achievement of goals for the unvested performance units.

Restricted and Phantom Units
Under our Long-Term Incentive Plan, as of September 30, 2020, we granted restricted units to non-employee directors and phantom units to selected employees who perform services for us, with most awards vesting over a period of one to three years. Although full ownership of the units does not transfer to the recipients until the units vest, the recipients have distribution rights on these units from the date of grant, and the recipients of the restricted units have voting rights on the restricted units from the date of grant.

The fair value of each restricted or phantom unit award is measured at the market price as of the date of grant and is amortized on a straight-line basis over the requisite service period for each separately vesting portion of the award.

A summary of restricted and phantom unit activity and changes during the nine months ended September 30, 2020, is presented below:
Restricted and Phantom UnitsUnitsWeighted Average Grant-Date Fair Value
Outstanding at January 1, 2020 (nonvested)145,205 $26.22 
Vesting and transfer of full ownership to recipients(5,646)29.94 
Forfeited(8,578)