Blue Dolphin Energy Company (BDCO)

[Enterprising Investor]

Refiners Can Keep Floating on Cheap Oil (7/21/15)

Refining stocks have been the star energy performers this year, mostly due to cheap oil. That should continue in the second half, despite looming risks.

By Liam Denning

The U.S. refining sector resembles a surfer cruising along in the sunshine—but with the shadow of a massive wave creeping up behind. With some nimble maneuvering, and outside help, though, investors can keep riding the swell.

Even as the exploration-and-production and oil-field-services sectors have slumped again, stocks of refiners such as Valero Energy, Marathon Petroleum and Western Refining are up by 25% or more this year.

Refiners’ ideal environment is one in which excess oil supply depresses the price but also encourages drivers to fill up their tanks with refined products like gasoline. That pretty much sums up the first half of 2015. Analysts recently have rushed to upgrade forecasts ahead of second-quarter results.

But refining, being notoriously cyclical, rarely lets investors rest easy. One issue is valuation; it isn’t a red light yet but has turned yellow. Refining stocks usually run up over the summer driving season and this year have no doubt gotten a boost from investors rotating out of exploration-and-production shares.



Valero, one of refining’s heavyweights, now trades around 9.6 times earnings, above its 15-year average of about 8.5 times. That average is actually overstated by wild swings in 2009 and 2010 in the aftermath of the financial crisis. Take those out, and the average is just eight times, with the current multiple more than one standard deviation above that.

The other worry is that the glut of crude oil is morphing into a glut of refined products. U.S. commercial inventories of crude peaked in April and have since dropped by 29.5 million barrels. In the same period, though, stocks of refined products have increased by 57 million barrels to hit their highest level on record. And with Labor Day rapidly approaching, the seasonal boost to gasoline demand will wane.

Even as pricing of refined products starts to come under pressure, though, refiners may get further relief on the cost side. Crude-oil prices have now given back most of the rebound that took hold in late March as U.S. supply has proved more resilient than some expected. The prospect of sanctions on Iranian oil being lifted has depressed prices further.

From U.S. refiners’ perspective, the most promising development is the rising premium of the global Brent benchmark over the local West Texas Intermediate crude-oil price. A higher premium tends to make U.S. refiners more competitive, bolstering margins. One month ago, the spread implied by futures prices for the third quarter was less than $4.20 a barrel, down 36% from a year earlier. Now, it is above $6, on par with last year.

Implied spreads are up through the first quarter of 2016. One signpost on crude’s direction, as Edward Westlake at Credit Suisse wrote recently, will be exploration-and-production earnings season, when producers give updates on drilling budgets. Any signs of expansion will weigh on crude futures to the benefit of refiners. That, in turn, may discourage investors selling refining stocks to rotate back into exploration and production, according to Mr. Westlake.

Refiners also have more capacity to help themselves these days. Valero, for example, just approved an additional $2.5 billion buyback program, helped by a strong balance sheet. Valero has had net debt of less than 0.4 times trailing earnings before interest, taxes, depreciation and amortization for the past three quarters. Prior to this, leverage hadn’t been so low since the final quarter of 2007.

Several refiners have also used the fascination with high-yielding stocks in a low interest-rate environment to create master limited partnerships, effectively reducing their cost of capital. Witness the recent acquisition of MarkWest Energy by MPLX, a partnership controlled by Marathon Petroleum. Marathon, due to its general partner interest in the combined entity, stands to gain the most from the deal.

By the time 2016 comes around, the growing glut in refined products, especially diesel, may simply be too large for even the most optimistic investor to ignore. For now, though, it is still summer.

http://www.wsj.com/articles/refiners-can-keep-floating-on-cheap-oil-1437495278