A Windfall Squeezed From Shale
The function of an oil refiner is to process crude oil into finished products like diesel, gasoline, and jet fuel. That sounds simple enough, but in reality there are a lot of different processes that go on within a refinery. Water, salt, and metals have to be removed from the crude oil, and the different fractions have to be separated (e.g., diesel-length hydrocarbons have a different boiling point range than gasoline-length hydrocarbons and are thus separated by distillation). There is also a great deal of chemistry taking place within a refinery. Sulfur has to be removed to a very low level, and long hydrocarbons chains are cracked and reformed into shorter chains.
Refineries have groups whose responsibility is to make sure the refinery is operating at the most economical level. I worked in one such group for two years. Basically you are balancing the cost of the crude oil inputs — and that cost can vary greatly depending on the crude oil quality — against the demand and the margins for various products. In the fall, for instance, demand for diesel is higher as farmers work to bring in harvests. Refineries then adjust the crude slates they purchase (some crudes naturally produce more diesel than others) and they tweak the refinery to produce a bit more diesel.
But ultimately, all the optimization that goes in within a refinery amounts to a few percentage points of profit either way. What really moves the profit needle is the difference between the price of crude oil and the price of finished products.
The refiner earns money on the difference between the crude oil purchased and the products sold. This difference is referred to as the crack spread, and has many different iterations. One of the most common is called the 3:2:1 crack spread, which refers to three barrels of oil input, and outputs of two barrels of gasoline and one barrel of diesel. While this is not an exact measure of refiners’ margins, the rise and fall of the crack spreads provides an indicator of the industry’s ever-changing fortunes.
Over the past few years, the differential between the price of West Texas Intermediate (WTI) and Brent crude oil had become a proxy of sorts for the profitability of many refiners. Because the U.S. maintains a ban on exports of crude oil, surging domestic production put downward pressure on the price of WTI.
Many refineries have made major capital investments over the years to process heavier (and cheaper) crudes, but the oil coming out of the shale oil fields is much lighter. Many refiners preferred to continue maximizing the throughput of heavy crudes, because those heavy crudes generally provide the refiner with the highest margins. Further, there is a limit to just how much light oil can be fed to these refineries that have been reconfigured to process heavier crudes from places like Venezuela. This was especially true for coastal refineries, which make up more than half of U.S. refining capacity:
Source: American Fuel and Petrochemical Manufacturers
The surge of new domestic light crudes outstripped the infrastructure needed to get it to market. New pipeline and rail options were (and continue to be) developed, but the result was that WTI began to trade at a discount to crudes like Brent that are traded globally.
This discount proved to be a windfall for refiners in the U.S., because while there is a crude oil export ban, there isn’t a ban on finished product exports. For the refiners, these discounted crudes are referred to as “advantaged crudes”, but for oil producers they are most certainly disadvantaged. So even though the U.S. remains a net crude oil importer, exports of finished products (primarily distillates like diesel) tripled over the course of five years:
Source: U.S. Energy Information Administration
The primary beneficiaries of this surge in finished product exports were the crude oil refiners who were purchasing discounted crude and selling the products at higher world market prices. These finished product prices are more influenced by the price of Brent crude, hence the reason the WTI-Brent spread became a proxy for refiner profitability. In the past year or so, the spread between Brent and Light Louisiana Sweet (LLS) has became a more important measure of refiner profitability as the flood of domestic U.S. crude oil production finally reached the Gulf Coast.
The four largest pure refiners (i.e., those that don’t produce oil like ExxonMobil) in the U.S. are Valero Energy (NYSE: VLO), Marathon Petroleum (NYSE: MPC), Phillips 66 (NYSE: PSX), and Tesoro (NYSE: TSO). Each of them has more than doubled the performance of the S&P 500 over the past three years (although PSX wasn’t spun off from ConocoPhillips (NYSE: COP) until May 2012):
The star of this group of stars was Tesoro, which more than quadrupled the return of the S&P 500 over the past three years. Tesoro is the fourth largest refiner in the U.S. by volume, operating six refineries in the western U.S. with a total capacity of 850,000 bpd. The company operates the only refinery in North Dakota — the heart of the Bakken shale formation — and owns the first plant on the West Coast to have received crude oil from the Bakken by rail.
Valero is the largest refiner in the world that doesn’t also produce crude, with 15 petroleum refineries with a combined global capacity of 2.9 million bpd. The company also has 11 ethanol plants with a combined production capacity of 1.3 billion gallons per year, a 50-megawatt wind farm, and more than 7,400 filling station outlets. Unlike most refiners who have to purchase ethanol to meet their mandate under the Renewable Fuel Standard, Valero went out and purchased its own ethanol plants. The share price has risen 173% over the past three years, more than triple the gain of the S&P 500.
The third leading performer over the past three years is the third largest refiner, Marathon Petroleum, with a gain of 146%. Marathon has seven refineries in the Midwest and Gulf Coast with a total capacity of 1.7 million bpd. The company also has 5,400 Marathon retail locations and 2,740 Speedway convenience stores. In addition, it operates 81 light product and asphalt terminals and 8,300 miles of pipeline, including 2,900 miles owned by MPLX (NYSE: MPLX), an affiliated master limited partnership.
The “laggard” of this group over the past three years is Phillips 66 with a gain of 133%. To be fair, it hasn’t quite been three years since the company was spun off from ConocoPhillips. Phillips 66 is the nation’s second largest refiner with a capacity of 2.2 million bpd (technically ExxonMobil is second, but they are a fully integrated oil company). PSX also has substantial chemical manufacturing capabilities and midstream interests.
Each of these refiners has sponsored a subsidiary logistics MLP to purchase their midstream assets and unlock shareholder value. Phillips 66 Partners (NYSE: PSXP) went public in August 2013, and the unit price doubled in less than a year (after PSX itself doubled less than two years after its spinoff). MPLX, PSXP, and Valero Energy Partners (NYSE: VLP) have total returns respectively of 67%, 56%, and 45% over the past 12 months, while Tesoro Logistics (NYSE: TLLP) has lost 7%.
All four refiners reported strong earnings in 2014.
Valero posted net income from continuing operations of $1.2 billion, or $2.22 per share, in the fourth quarter of 2014, compared with $1.3 billion, or $2.38 per share, a year earlier. For all of 2014, net income from continuing operations was $3.7 billion, or $6.97 per share, compared with $2.7 billion, or $4.96 per share, in 2013. In 2014, Valero returned $1.9 billion to stockholders, or 50 percent of net income from continuing operations, including $554 million in dividends and $1.3 billion in stock buybacks. In January, Valero announced a 45% increase in its quarterly dividend from $0.275 per share to $0.40 per share. This translates to an annualized yield of 2.6%.
Phillips 66 reported fourth-quarter earnings of $1.1 billion, compared with earnings of $826 million in the fourth quarter of 2013. Phillips 66’s full-year 2014 earnings were $4.8 billion or $8.33 per share. This compares with $3.7 billion or $6.02 per share in 2013. The company generated $3.5 billion in cash from operations during 2014 and returned $4.7 billion of capital to shareholders. Phillips 66 paid $1.1 billion in dividends and repurchased 29.1 million shares of common stock totaling $2.3 billion. The company announced a dividend following the quarter of $0.50/share, which equates to a 2.5% annualized yield at the current share price.
Marathon Petroleum reported 2014 fourth-quarter earnings of $798 million, or $2.86 per diluted share, compared with $626 million, or $2.07 per diluted share, in the fourth quarter of 2013. Full-year 2014 earnings were $2.52 billion, or $8.78 per diluted share, compared with $2.11 billion, or $6.64 per diluted share, in 2013. Through share buy-back programs and dividends, MPC returned a total of $2.7 billion of capital to shareholders in 2014, including $820 million during the fourth quarter. Following the fourth quarter MPC announced a quarterly dividend of $0.50 per share, which equates to a 1.9% yield at the current share price.
Tesoro reported fourth quarter 2014 net earnings of $145 million or $1.13 per diluted share versus last year’s $7 million loss. Full-year 2014 net earnings were $843 million or $6.44 per diluted share, up 105% over 2013 net earnings of $412 million. Overall gross margin for the quarter was $11.08/bbl, compared to $9.45/bbl for Q4 2013. During the fourth quarter, Tesoro returned about $187 million to shareholders through the purchase of nearly 2.2 million shares for $150 million and its regular quarterly dividend of $37 million. Following the quarter Tesoro announced a 40% increase to the quarterly dividend to $0.425 per share, which equates to a 1.8% annualized yield at the current share price.
Here are some of the key performance indicators for these four refiners:
Key Performance Metrics for the Four Largest Pure U.S. Refiners in Order of Market Cap
EV = Enterprise value
EBITDA = Earnings before interest, depreciation, and amortization
ROE = Return on equity
So what risks might these refiners face in the years ahead? The single biggest risk is the possibility of losing their discounted crude slate. Consider the profitability of North American refiners versus the rest of the world:
Source: U.S. Energy Information Administration
Prior to 2010, the profits of U.S. refiners were largely in line with those of overseas competitors. The shale oil boom changed that picture as rapidly expanding supplies drove down U.S. crude prices. For the past three years, margins for U.S. refiners have been $6/bbl or more above those for their European counterparts.
The refiners benefit enormously from the crude oil export ban, and as a consequence have fought the effort by oil producers to abolish it. 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 currently enjoy would deflate if U.S. oil producers could sell their crude at world market prices.
A secondary threat is that of rising oil prices generally. The refining industry tends to fare best when oil prices are falling. In that environment, its margins tend to expand as fuel buyers become less price-conscious. Demand also tends to increase as oil prices decline. This explains the excellent fourth-quarter results reported by many refiners. 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.
I believe a repeal of the crude oil export ban or a sharp upward move in oil prices is unlikely over the next couple of years. That should leave the refiners as one of the bright spots in the energy sector.
(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)
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