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Oil Crash Showcasing Refiners

By Chad Fraser

As with any big economic shift, the oil-price plunge has left winners and losers in its wake.

On the winning side are US consumers, who, despite a recent rise, are still paying an average of $2.46 a gallon at the pumps, down more than a dollar from around $3.53 at this time last year, according to the American Automobile Association.

At the other end of the spectrum are oil and gas producers, who’ve chopped a combined $86.4 billion from their 2015 capital budgets, according to a February 18 report from RBC Capital Markets. The reductions come as RBC forecasts a 32% decline (or about $140 billion) in the industry’s operating cash flow this year as low prices take their toll.

But even with the capex cuts, non-OPEC production is forecast to slow, but not contract, in 2015: according to just-released figures from OPEC, countries outside the cartel will still produce 850,000 barrels a day (bpd) more in 2015 than they did last year.

RBC also sees the capex cuts falling disproportionately on companies that focus solely on exploration and production (a 31% cut, or $52 billion), versus integrated oils (13%, or $34.4 billion). The latter also refine petroleum and distribute the finished product—two businesses that tend to benefit when oil prices are falling.

Let’s take a closer look at refining.

Why Refining Stocks Are Prospering Now

In a recent issue of our Energy Strategist advisory, analysts Igor Greenwald and Robert Rapier took a close look at the US refining business.

“When your suppliers are desperate and your customers are flush, that’s when you can really make some money,” the pair wrote in a February 28 article. “Which certainly describes the happy place US refiners currently occupy, between a glut of domestic crude and customers using more fuel in response to lower prices.”

That latter point was borne out by figures released by the Federal Highway Administration earlier this month. According to the agency, US motorists logged a total of 251.4 billion miles in December, up 5% from last year. That capped off 10 straight months of year-over-year growth and was the fastest increase the FHWA has seen since 2001.

Newer figures from Texas suggest motorists have kept their hands on the wheel into the new year: last week, the state, which accounts for 10% of US gasoline sales and 13% of diesel sales, reported that it had collected $284 million in fuel taxes in February, compared to $269 million in the same month last year.

Refiners make money on what’s known as the “crack spread,” which refers to the difference between what they pay for the crude they process and the selling prices for finished products like gasoline, diesel and jet fuel.

Over the past few years, the differential between the price of W&T Offshore, Inc. (NYSE:WTI) and Brent crude has become a proxy of sorts for the profitability of many refiners. That’s because the prices of the fuels they produce are more influenced by the higher international Brent price.

Meanwhile, because the US bans crude exports, surging shale production at home has put downward pressure on WTI, as US producers can only sell their oil to American refiners.

“With the export ban in place the way it is … the US refiners have a crude cost advantage,” Kevin Lindemer, managing director at consulting firm IHS, told the Wall Street Journal last fall.

The Brent-WTI spread has fluctuated widely so far in 2015; right now, it stands at around $8.00, compared to around $2.66 at the start of the year. In late February, it ranged as high as $13.74.

Refining Stocks: Not Without Risk

Of course, any number of factors could come along and upset the refiners’ happy situation. One would be the end of the export ban—something producers have been advocating for years.

“The refiners benefit enormously from the crude oil export ban, and as a consequence have fought the effort by oil producers to abolish it,” writes Rapier. “It will be an uphill fight for those seeking an end to the ban, but should it happen, the refiners will be hit hard. The high margins they enjoy would deflate if US oil producers could sell their crude at world market prices.”

In addition, a spike in domestic oil prices is always a possibility:

“Should oil prices make a sharp upward move, it would hurt refiners as consumers once again looked for the lowest gas prices and cut back on some of their discretionary fuel consumption,” Rapier adds.

One for the Road

Nonetheless, Rapier feels the export ban is unlikely to meet its demise in the next couple of years, and while refiners’ higher margins won’t last forever, the continued—albeit slower—growth in US crude output means they may stick around for a while.

As such, the advisory has recently added two refiners to its portfolios to go along with its existing holdings in the sector, which include Valero Energy Corporation (NYSE:VLO), the largest refiner in the US that doesn’t also produce oil.

Valero’s stock has gained 59% since the Energy Strategist first recommended it on October 24, 2013 (not including dividends), nearly tripling the S&P 500’s rise.

The company operates 15 refineries with a combined capacity of 2.9 million bpd. It also has 11 ethanol plants with a total capacity of 1.3 billion gallons a year and a 50-megawatt wind farm. On the distribution side, the company operates 7,400 filling stations under such banners as Diamond Shamrock, Ultramar and Beacon.

Valero benefits from its strong presence on the Texas Gulf Coast, close to the Eagle Ford shale play. The company plans to spend $750 million to add a total of 185,000 bpd of light crude processing capacity in the state by the first half of 2016.

Like the three other leading pure refiners in the US, Valero recently reported strong 2014 earnings.

For 2014, the company’s adjusted net income from continuing operations was $3.5 billion, or $6.98 a share, up sharply from $2.4 billion, or $4.41, in 2013. Fourth quarter adjusted earnings came in at $952 million, down from $963 million last year, though earnings per share rose slightly, to $1.83 from $1.78, on fewer shares outstanding.

Both the fourth-quarter and full-year results were well ahead of analysts’ expectations.

The company returned $1.9 billion to stockholders in 2014, including $554 million in dividends and $1.3 billion in buybacks. In January, Valero announced a 45% dividend hike, to a quarterly rate of $0.40 a share, for a 2.6% annualized yield.

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