The U.S. Refining Industry is a Cash Cow
In the aftermath of Hurricane Harvey, refinery outages led to gasoline shortages across Texas and in areas serviced by the Colonial Pipeline.
What wasn’t as widely reported is those refinery outages in Texas also created a serious gasoline supply crunch in Mexico. Because it just so happens that Mexico has become the largest foreign buyer of gasoline produced in Texas.
Foreign markets have become a major cash cow for U.S. refiners. The development of these markets is just the latest change in an industry that’s been evolving since it began.
The History of U.S. Refining
The oil and gas industry has three major divisions:
- Upstream refers to oil and gas production
- Midstream refers to the transportation and storage of oil and gas
- Downstream refers to the conversion of oil and gas into finished products and the marketing and distribution of those products
The history of downstream, which we commonly know as the refining industry, is as old as the oil industry itself. Early refiners simply boiled off fuel oil for lamps, often discarding the rest.
Then mass adoption of automobiles created a market for gasoline that has been growing for over 100 years. Refineries were forced to become more complex to squeeze more gasoline from a barrel of oil.
As some of the early oil fields depleted, the quality of available crude oils declined. Crudes became progressively heavier and sourer (meaning they contain longer, more complex hydrocarbon molecules as well as more sulfur).
Globally, heavy crude production increased in places like Canada, Venezuela, and Nigeria. A wide price differential developed between heavy, sour crudes and light sweet crudes like West Texas Intermediate (WTI) and Brent.
This required refiners to make a choice. Either they paid a premium for light, sweet crudes, or they made major capital investments to be able to process heavy, sour crudes.
Because heavy, sour crudes can produce about the same amount of finished products as lighter, sweeter crudes, refiners had a strong financial incentive to make the necessary investments required to process the discounted crudes.
Many refiners had already made these investments when the U.S. shale oil boom delivered a windfall of new barrels of light, sweet crude oil to U.S. markets.
Profiting From the Crude Export Ban
Due to a crude oil export ban that had been enacted following the 1973 OPEC oil embargo, the ability to export the growing supply of oil to any country besides Canada was severely restricted. And because refiners had made major investments in equipment to process heavy, sour crudes, they weren’t as interested in paying premium prices for the premium oil that was being pumped from the shale plays.
This caused the price of WTI to start trading at a discount to Brent. But refiners were happy to buy domestic crudes at a discount, refine them into finished products, and then export the refined products (since the export ban didn’t apply to refined products).
That’s just what they did. Following more than two decades of relatively stable finished product exports, the shale boom turned into a boon for refiners. Finished product export volumes quadrupled in a decade, and continued to grow even as U.S. oil production flattened (and after the crude oil export ban was repealed in late 2015):
Refiners Outperform Broader Markets
Refiners are historically cyclical, with margins eroding when oil prices are rising. Refiners tend to do well when oil prices are flat or falling, and that has undoubtedly been the case over the past three years.
Since the start of the energy bear market in mid-2014, the refining group has outperformed not only the rest of the energy sector but the broader market indices as well. Consider that over the past five years, the NASDAQ is up 110%, while Valero (NYSE: VLO), the largest pure refiner in the world, rose 144% and increased its dividend by 300%.
Simply put, refiners with export capabilities like Valero, Marathon Petroleum (NYSE: MPC), Phillips 66 (NYSE: PSX), and Andeavor (NYSE: ANDV) have become cash-generating machines. All of these companies have more than doubled in value in the past five years, and last week shares of each of these refiners were trading near 52-week highs.
Warren Buffett recognizes this, as Berkshire Hathaway Inc. (NYSE: BRK.B) owns nearly a 16% stake in Phillips 66. It is the 8th largest holding in the Berkshire portfolio, and notably the only energy company in the portfolio.
This most recent evolution of the refining sector has helped diversify the sector’s markets. Low gasoline prices and the growth of the export market is driving an increase in profits at the major refiners, and boosting the sector to new all-time highs.
So if you have shunned the energy sector because of the softness in oil and natural gas prices, keep in mind that these are exactly the conditions that benefit refiners.
Just ask Warren Buffett.