Swimming in Gasoline
In the most recent monthly web chat for subscribers of The Energy Strategist and MLP Profits, I was asked whether it is too early to start moving back into the refiners. So today I want to review the sector.
First, a quick primer. The oil and gas industry can be broadly split into three segments. Large, integrated companies like ExxonMobil (NYSE: XOM) and Chevron (NYSE: CVX) encompass all three.
“Upstream” refers to the extraction of oil and gas. An upstream company can be predominantly an oil producer or a natural gas producer, but generally will produce both. Major upstream companies operating in the U.S. include ConocoPhillips (NYSE: COP), EOG Resources (NYSE: EOG), Continental Resources (NYSE: CLR), and Apache (NYSE: APA). There are also a number of service companies that are closely related to the upstream sector, such as hydraulic fracturing sand provider U.S. Silica (NYSE: SLCA) and water and environmental services specialist Cypress Energy Partners (NYSE: CELP).
“Midstream” businesses are those that move oil and gas from the site of production to processing plants, storage facilities, and end customers. Midstream consists largely of the oil and gas pipelines that crisscross North America. Many midstream companies are organized as master limited partnerships (MLPs). Midstream companies generally act as toll collectors, charging for the use of storage tanks, pipelines, and oil and gas gathering infrastructure. The major midstream players include MLPs Enterprise Products Partners (NYSE: EPD), Magellan Midstream (NYSE: MMP), Plains All American (NYSE: PAA), and the incorporated Kinder Morgan (NYSE: KMI).
“Downstream” is the business of refining, marketing and distributing the products made from oil and natural gas. This group includes major U.S. refiners like Valero (NYSE: VLO), Tesoro (NYSE: TSO), and Phillips 66 (NYSE: PSX), and fuel distributors such as Global Partners (NYSE: GLP).
The oil and gas industry is cyclical, but its upstream and downstream segments typically trade out of sync. The downstream segment, for instance, does well when oil prices are falling, because gasoline prices don’t fall as quickly. This means that a refiner’s margins — that is the difference between the price of oil and the price of the finished products made from that oil — will swell when oil prices fall and contract when they rise.
As oil prices crashed in mid-2014, the refiners soared. Even though 2015 was a miserable year overall in the oil and gas industry, the downstream segment did quite well. By September, we thought there was a significant risk that oil prices would rise in coming months, and so we purged the portfolios of refiners. And, as I wrote in A Blast From the Past, it was a timely move because all of the refining stocks fell significantly soon after.
To further illustrate, let’s look at the best and worst performing MLPs from last year. In 2015, even though the refiners had begun to sell off by the end of the year, they were still the performance leaders among MLPs. (See Refiners Shine in Ugly Year for MLPs). The worst performers? Upstream — the oil and gas producers.
But 2016 is a different story. The upstream sector has bounced back strongly (albeit many upstream MLPs didn’t survive). But the three worst-performing MLPs in 2016 are all refiners: Calumet Specialty Products Partners (NASDAQ: CLMT), CVR Refining (NYSE: CVRR), and Alon USA Partners (NYSE: ALDW). These three MLPs are down 72%, 64%, and 60% year-to-date. This is performance reminiscent of the upstream sector in 2014 and 2015.
Timing these sector shifts accurately can bring huge profits, but the risk is significant. If you bought the average upstream MLP at the end of 2014 after the group had fallen sharply, you would have suffered even bigger losses in 2015.
But is it too early to jump back in?
Several signs point to “Yes.” Margins are less than half of what they were a year ago, which is why the refiners have sold off. And even though demand for gasoline in the U.S. is at an all-time record high, the output from refiners has been even greater, leading to a huge increase in gasoline inventories. This situation doesn’t look like it is going to resolve itself any time soon. I also don’t believe there will be a return to the low $30s for oil prices, which would help refiners regain some footing.
So for now, I would keep your powder dry on the refiners. Unlike the situation with oil prices, I can’t yet see conditions improving on the horizon for refiners. But when we detect that first glimmer of hope, we will bring the news to you in The Energy Strategist and MLP Profits. Consider subscribing for our frequent detailed analyses on the refiners, as well as on the entire energy sector.