Cheapest Crude Marks Path to Profits

In this week’s issue of The Energy Letter we discussed the basics of oil refining and covered some of the important factors that influence a refiner’s profitability.

To review, the profitability of a refinery can be predicted on the basis of the difference between the crude oil it purchases and the finished products sold and is expressed in terms of the “crack spread.”

Although a barrel of oil is refined into many finished products, the crack spread typically refers to only crude oil input and the output of gasoline and distillate. The most widely used crack spread for US refineries is called the 3:2:1, which signifies 3 barrels of oil being converted into 2 barrels of gasoline and 1 barrel of distillate (diesel, jet fuel and fuel oil).

Over the past few years, certain refiners in the US have had access to discounted crudes which they then turn into finished products priced on the basis of the more expensive crudes, which tend to be light, sweet and waterborne. Thus, a refiner that can buy a Bakken crude, for example, at a $20 per barrel discount to Brent crude has the potential for big profits, so long as the the refinery is configured to process the discounted crude.

Light, sweet crudes with access to waterborne transportation are highly sought after, and are therefore generally the most expensive. Examples include Brent and Louisiana Light Sweet (which has actually traded at premium to Brent). Geographically disadvantaged crudes and heavy, sour crudes will trade at a discount (as shown in the following graphic). Over the past few years as US oil production has ramped up, West Texas Intermediate (WTI) has traded at a discount to the waterborne crudes like Brent.

Crude pricing graphic
Source: Valero UBS Conference Presentation (although “F” — the Bakken symbol — is for some reason showing in Minnesota).

Crudes from the Bakken area are more geographically disadvantaged than WTI, and typically trade at a $2-per-barrel discount to WTI (although that differential has ranged from a $25-per-barrel discount to WTI in early 2012 to a $5-per-barrel premium in September 2012). The heavy crudes in Alberta, Canada such as Western Canadian Select (WCS) are even more disadvantaged than Bakken crudes, and typically trade at a $20-$30/bbl discount to WTI.

Geography is not the only factor that influences the price of crude oil. Heavy crudes require additional processing where they are cracked into smaller molecules. Sour crudes — that is sulfur-containing crudes — require hydrotreaters to remove sulfur. The presence of metals in the crude oil will require further processing. The more processing that is required, the more complex — and costly — the refinery.

At present, the perfect refinery for investors would have the following characteristics:
  • Access to geographically disadvantaged crudes

  • The complexity to process heavy, sour crudes

  • Access to waterborne markets for finished products

While no company fully meets this ideal, some are better positioned than others. Below, I review the major players and single out those best-placed to continue profiting from the current landscape.

Valero (NYSE: VLO) is the largest independent refiner in the world. Its 16 refineries can process 2.8 million barrels per day (bpd) of crude oil, and its 10 ethanol plants make Valero one of the largest ethanol producers in the US.

Valero’s refineries are concentrated on the Gulf Coast, with another two in California along the Pacific Coast. On the first-quarter earnings conference call, management noted that an increase in margins for diesel and jet fuel and deeper discounts on purchased crude oil yielded higher margins in the US Gulf Coast, Mid-Continent, and North Atlantic regions. West Coast operations, however, suffered reduced margins.

Valero operations graphic
Source: Valero 2012 Annual Report

Uniquely among US refiners, Valero bought ethanol plants in response to the ethanol blending mandate under the Renewable Fuel Standard. In 2009 the company purchased seven ethanol plants from bankrupt ethanol producer VeraSun Energy, instantly making Valero one of the country’s largest ethanol producers and enabling it to comply with the ethanol mandates from in-house production.

Valero crushed analysts’ first-quarter profit estimates, delivering 59 percent more than expected. The stock has risen 86 percent in the past year, and the company should continue to post strong profits well into the foreseeable future.

One of the knocks on Valero is that its refineries are not quite as advantageously situated as those of some competitors. The West Coast refineries, for example, have been a recent drag on profits. However, the following graphic shows how Valero plans to address this by shipping cheaper crudes into those refineries. (The graphic is also an excellent representation of shipping costs by rail and pipeline from different regions.)

crude shipping costs graphic

The other knock on Valero is that its ethanol operations are frequently a drag on profitability. In fact, this operating segment suffered a loss in 2012. On the other hand, by producing its own ethanol Valero is afforded a measure of insurance against a spike in ethanol prices.

Valero has an enterprise value (EV) of nearly $27 billion and a trailing twelve months (ttm) Enterprise Value/EBITDA of 3.8. (EBITDA stands for earnings before interest, taxes, depreciation and amortization.) Valero has a profit margin of 2.3 percent and a return on assets of 8.2 percent for the trailing twelve months. For the most recent quarter (mrq), its total debt/asset ratio stood at 15.1 percent.

While Valero has a lot going for it, other US refiners have stronger fundamentals.

Phillips 66
Phillips 66 (NYSE: PSX) was formed when ConocoPhillips (NYSE: COP) spun off its refining and some of its midstream and chemical assets in May 2012. The divestiture happened just as refining conditions for mid-continent refiners were reaching their best point in years, and PSX shares took off, returning 105 percent over the past 12 months.

Full disclosure: I worked for ConocoPhillips from 2002 to 2008, joining Conoco just before it merged with Phillips. I worked at two of the current Phillips’ refinery locations — Ponca City, OK and Billings, MT — before transferring to Aberdeen, Scotland to manage engineers working on oil and gas extraction in the North Sea. As a result of my participation in ConocoPhillips’ 401k plan, I own shares of COP, and was issued shares of PSX when it was spun off. I continue to hold both stocks.

Phillips 66 is a larger and more geographically diverse company than Valero, with comparable refining assets. PSX has 11 refineries scattered across all five US Petroleum Administration for Defense Districts (PADDs), and owns or has a stake in three European refineries and one in southeast Asia. The company has a global refining capacity of 2.8 million barrels per day, as well as 7.2 billion cubic feet per day of natural gas processing capacity.

Phillips 66 also has significant midstream access and expertise enabling it to move economically disadvantaged crudes to coastal refineries. Valero’s graphic shows an estimated cost of $9/bbl to rail crude from the Bakken to Washington state. Given the $10-$20/bbl discount on the Bakken crude  relative to Brent, the Phillips 66 refinery in Ferndale, Washington is well-positioned for future profitability as Bakken production continues to grow.

Last year the company signed a five-year deal with Global Partners (NYSE: GLP) to transport 50,000 bbl/day of oil from the Bakken Shale its Bayway refinery in New Jersey — the largest on the East Coast. Rail costs from the Bakken to the East Coast are higher than those to the West Coast, but if Bakken trades at a $20/bbl discount to Brent then the Bayway refinery should be in a strong competitive position.

Phillips 66 has an enterprise value of $43 billion and an EV/EBITDA (ttm) of 6.7. PSX has a profit margin (ttm) of 3 percent, a return on assets of 6.5 percent (ttm), and a total debt/asset ratio of 13.6 percent.

However, as much as I like Phillips 66 as a company, the stock’s extraordinary run over the past 12 months gives me pause. Further, some of the company’s refining assets — notably those in Europe — are not particularly well-placed. I wouldn’t be a buyer at current prices, especially since there are more fairly valued refiners out there.

Marathon Petroleum

Marathon Petroleum (NYSE: MPC) was created in the summer of 2011 when Marathon Oil (NYSE: MRO) spun off its refining operations to shareholders. Marathon’s refining and marketing segment income had fallen far from its $2.8 billion peak in 2006 and, just as ConocoPhillips would do the following year, Marathon spun off what it probably felt would be an underperforming asset.

A little more than three months after the spinoff Marathon looked to have made a wise move, with MPC shares dropping 30 percent as the European financial crisis and the US debt ceiling fiasco fueled fears of a recession. But riding to the rescue was a growing surplus of cheap crude from the North American shale drilling boom, in locations advantageous to Marathon.

The discount on all this crude without an affordable route to Gulf Coast refineries boosted MPC’s profit fourfold in 2011. And in the 2012 fiscal year just reported by the company, refining income from operations was up another 42 percent, thanks to the widening spread between the cost of making gasoline and its wholesale price, as well as the persistent discount on domestic crude.

Marathon Petroleum has seven refineries, as well as marketing and transportation operations that are concentrated primarily in the Midwest, Gulf Coast and Southeast regions of the US. Total daily capacity of MPC’s refineries is 1.7 million bpd, which is nearly 10 percent of the US total.

The most recent acquisition for MPC was the former BP (NYSE: BP) Texas City refinery, with a capacity of 450,000 bpd of crude oil throughput. In 2012 the company formed MPLX LP (NYSE: MPLX), a midstream master limited partnership that is currently valued at $2.8 billion.

We added MPC to the Aggressive Portfolio as a Buy in January of this year, and after an initial surge in performance we lowered the rating to a Hold. The change in rating was a result of the significant advance in the share price and some developing concern about declining margins as the Brent-WTI differential sank.

MPC remains one of the more attractive refiners, but we would prefer to see either improving margins or a pullback in the share price before changing the rating back to a Buy.


HollyFrontier (NYSE: HFC) was formed in 2011 by the merger of Holly and Frontier. The company owns five refineries in Wyoming, Kansas, New Mexico, Oklahoma and Utah. These are configured to process 443,000 bpd of heavy, sour crudes.

These refineries are all located near sources of growing production basins pumping crude that generally trades at a discount to WTI. The Tulsa, Oklahoma plant is near the major crude storage nexus in Cushing, OK. HFC’s refineries receive crude from the Bakken formation, the Niobrara Shale, the Permian Basin and the Unita Basin. As such, HollyFrontier is ideally positioned to benefit from the growth of crude oil production across the US Mid-Continent.

HollyFrontier also owns a 39% interest in, and is the general partner for, Holly Energy Partners LP (NYSE: HEP). Holly Energy Partners is a master limited partnership that owns and operates pipelines, terminals and tankage across the mid-continent.

HollyFrontier’s financial performance has been outstanding, leading peers in several categories. Its return on invested capital (ROIC) was best in class for the most recent five-year period, and the 2012 ROIC of 26.5 percent trailed only Western Refining’s (NYSE: WNR) 28.3 percent.

HFC is also the only company in the refining group to meet famed value investor Benjamin Graham’s investment criteria. These are described in Chapter 14 of Graham’s classic “The Intelligent Investor,” and focus on a company’s financial strength, history of dividend payments and valuation.

HollyFrontier has an enterprise value of $8.3 billion and an EV/EBITDA (ttm) of 2.5. HFC’s most recent annual profit margin was 9.2 percent, its return on assets was 18.4 percent, and the total debt/asset ratio is at 12.9 percent. The company’s fundamentals are stronger in nearly every category than those of Valero, and yet it trades at a discount to peers.

Igor has more on the investment case for HollyFrontier in the following article, but suffice it to say that its extraordinarily strong financial condition and strategic positioning that should fuel growth for years to come. We are adding HollyFrontier to our Growth Portfolio this week. Buy HFC up to $57.


Tesoro (NYSE: TSO) owns and operates seven refineries in the western United States — including one in Alaska. An eighth plant in Hawaii is being converted into a logistics terminal. Following the recently completed acquisition of the big Carson, California refinery from BP, the total capacity of Tesoro’s refineries is about 845,000 bpd of crude oil throughput.

When I joined The Energy Strategist, Tesoro was listed as a “Sell” in the Energy Watch List, while Valero was called a “Buy.” I was puzzled by this, because in many ways Tesoro seemed to be in a stronger position, so my first order of business was to change the Tesoro recommendation to a “Buy.” If you acted promptly on that recommendation you are sitting on a 48 percent gain even after the recent correction. (Valero gained 30 percent over the same time period.)

Conditions for US refiners have deteriorated somewhat since that initial recommendation, but Tesoro is still in a relatively strong position, with several refineries set to benefit from the Midwestern crude glut. For example, the one in Anacortes, Washington has been running mostly the deeply discounted Bakken and Canadian Light Sweet crudes. Tesoro also has a refinery in North Dakota that is ideally positioned to access Bakken’s growing bounty.

While the share price was relatively flat from 2008 to 2012, since mid-2012 it has been on a steep climb. Between 2009 and 2012, Tesoro’s annual revenue nearly doubled, while a loss of 66 cents a share in 2009 gave way to a profit of $6.47 a share in 2012. This year is off to a good start, with first-quarter revenue and profits both up over the first quarter of 2012. Read on for more on the investment case for Tesoro. Buy TSO up to $66.

Western Refining
Western Refining (NYSE: WNR) is much smaller than the other companies we have examined. It owns and operates just two refineries, with a total crude oil capacity of 150,000 bpd. The largest is a 128,000 bpd plant in El Paso, Texas. Western Refining also runs a much smaller refinery near Gallup, New Mexico.

WNR’s refineries are not particularly complex, nor are they in a good position to access a wide variety of disadvantaged crudes. The company does have good access to Permian Basin crude, which means it will perform well when the Brent-WTI spread is wide, as it was for most of 2012. WNR’s stock advanced more than 115 percent in 2012, but the share price has lagged that of other refiners so far in 2013 because of the shrinking Brent-WTI spread.

Brent-WTI spread chart

Thus, WNR is a riskier play than rivals with access to multiple sources of disadvantaged crude.

Western Refining has an enterprise value (EV) of $3 billion and an EV/EBITDA (ttm) of 3.0. The most recent annual profit margin was 5.7 percent, and the favorable Brent-WTI spread in 2012 produced a best-in-class return on assets of 22.8 percent. WNR is more leveraged than peers, with a total debt/asset ratio of 26.9 percent.

Key Peformance Indicators for US Refiners

Refiners key stats table

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