What is the Crack Spread and How Does It Affect Oil Prices?

Shareholders of 8point3 Energy Partners (CAFD) have had a rough week, with the company falling a whopping 15% overnight after one of the parent companies announced plans to leave the project.

In this week's episode of Industry Focus: Energy, Motley Fool analysts Sean O'Reilly and Taylor Muckerman explain the context behind the move, why the market reacted so strongly to it, and how reasonable the market reaction was, all things considered. Also, the hosts look at two other big stories from energy this past week: what the crack spread is, why the oil market should pay more attention to how it vacillates, and where investors might want to look for deepwater-drilling investments that aren't going belly-up.

Sean O'Reilly: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, April 6, 2017, so we're talking about energy, materials, and industrials. I'm your host, Sean O'Reilly, and joining me in studio today is Motley Fool Premium analyst and lover of Hawaiian pizza, Mr. Taylor Muckerman. What's up?

Taylor Muckerman: What's up?

O'Reilly: How's it going?

Muckerman: Good. As long as it has bacon on it, too.

O'Reilly: Oh, that's the qualifier.

Muckerman: I don't necessarily like ... the pineapple and the ham still have the same kind of slimy texture. I need some crunch.

O'Reilly: Ham and bacon would be a big thing in Hawaii, because a luau always has a pig, always.

Muckerman: For sure, either cooked on a spit or wrapped up in banana leaves and buried on top of some hot coals.

O'Reilly: Do you ever see them take it out of the sand thing? It's a big deal.

Muckerman: Yeah, it's no joke. Fall off the bone, you have the orange slices all over it, oh, jeez.

O'Reilly: I've seen it once, and yeah, everything fell off the bone immediately. Anyway, moving on to more pleasant things, today's show, we're discussing oil prices and how they've been affected by inventories, because we get a news story every day, I guess.

Muckerman: Yeah, higher inventories in the U.S., higher inventories with OPEC, although they seem to have some slowing or maybe negative growth in their inventories lately. 

O'Reilly: At least, especially offshore.

Muckerman: The last few months, yes. Surprising inventory growth on the oil front.

O'Reilly: And I just have to talk about, the last 24 hours have been fun for all the solar yieldcos, and 8point3 Energy Partners.

Muckerman: Yeah, I think you brought that to our attention a few months ago.

O'Reilly: We have to rap about that, because last night was fun. And we don't talk about them enough, but we're going to touch on deepwater offshore drillers before we head out.

Muckerman: Yeah, they have not had a good time of it lately. We've just left them to die.

O'Reilly: We need them to be there, because in Armageddon, those were the guys they went to to help them drill into the asteroid to blow it up. So we need to keep these people doing what they're doing.

Muckerman: Not all of them, apparently. [laughs] 

O'Reilly: We just need Ben Affleck.

Muckerman: Yeah, we need Ben Affleck and National Oilwell Varco, and maybe another driller or two.

O'Reilly: So, last couple shows, we chatted about oil price and inventories. Despite the drop in shale production over the past few years here domestically and OPEC's cuts or whatever, Cushing inventories are still high. And every week, you get a couple little builds in there, and it's like, what's going on here? However, as was first touched upon by Tyler Crowe a month or so ago, when I had him call in from Malawi, this week, we have a string of articles from places like Bloomberg that U.S. traders might be focusing on the wrong data. More specifically, there's a Bloomberg article, "Oil Traders Are Looking at the Wrong Inventory Data," and it was written by Jason Schenker. He's the president and founder of Prestige Economics LLC, and he talks about product inventories like gasoline. For the layman, this is, plus oil, is used for plastic.

Muckerman: Generally, I would say most everything you touch throughout the day, your Tupperware, your car tires, some of your clothes, the soles on your shoes, yeah.

O'Reilly: What do you know about my -- no, I'm kidding. He also in the article talks about something called the crack spread, which I hope you can add some light on. We haven't mentioned this much on the show, but what is a crack spread, Taylor?

Muckerman: It's getting down into the nitty-gritty. It's really important for people who are looking at refiners. Basically, to make it as simple as I can make it, it's the margin that refiners are going to make from the cost of a barrel of crude oil to the cost that it takes to produce oil.

O'Reilly: Why does that vacillate? I'm surprised that it changes, quite frankly.

Muckerman: The price of oil, obviously, fluctuates. When it's $100 a barrel, obviously, a refiner's costs were a lot higher. So they elevated the price of gasoline. You're basically trying to take the barrel of oil equivalent of gasoline, have that price set, and then have the price that they paid for that oil, subtract it so that you get the margin. Hopefully for the refiners, the cost that they're selling a barrel equivalent of oil or gasoline or refined product is higher than they're paying for a barrel of oil. And they call it the crack spread because you're basically cracking oil up, the individual hydrocarbons into their end uses as refined products.

O'Reilly: Why does this exist? I remember when oil prices were literally plummeting in late 2014, they were talking about how the oil majors that owned refineries, they're going to do OK -- "OK" being a relative term, compared to a straight-up producer -- because the crack spread was widening. Is that because oil prices, their base commodity that they're cracking into -- is it falling faster than the end products they're selling?

Muckerman: Yeah, I feel like if you've ever looked at oil prices rising and falling, it's kind of a lag before gasoline prices follow suit.

O'Reilly: Is that the cause of the crack spread?

Muckerman: The cause of the crack spread is the vacillation of prices at different times. There's a history there where you see the crack spread, in 2011 and 2012, the crack spread was a little positive for the Gulf conventional gasoline crack spread. But earlier on in February 2011, you saw negative crack spread. I think it's less important for long-term investors because it's cyclical, and it does change over time. But obviously, if you're looking for short-term investment in a refiner, you're going to want to know what the crack spread is, what the projections are.

O'Reilly: He basically says that crack spreads are on the rise, at their highest levels since early, a year ago, 2016. He basically implies that that's an incentive for refiners to go grab all the oil that's in inventory and make it into stuff.

Muckerman: You would imagine so, because you never know when prices are going to rise. If you listen to a few recent projections from investment bankers, BNP Paribas said they could see $70 oil by the end of this year.

O'Reilly: That'd be fun.

Muckerman: Another bank that escapes me said $60 oil within the next three months. It's these spikes that catch the refiners off guard. If you have sustained pricing, then they can plan a little bit better for it. But it's this uncertainty.

O'Reilly: And that's when the crack spread drops, I assume?

Muckerman: You become more profitable if you can sustain low oil prices, and then you can push out lowering gasoline prices. Eventually, though, your customers are going to be like, "Well, you're getting your input costs a little cheaper, so how about you hook us up with a little bit of that margin you've been benefiting from?" But we should mention, end product inventories are down, so refiners could be buyers in the short term, especially with the summer driving season coming up.

O'Reilly: Which is basically what he was talking about.

Muckerman: Yeah. It's just the less heralded inventory levels, because oil is the base cost, that's what gets it all started, so that's the headliner.

O'Reilly: Of course, at the end of the day, just focus on good companies.

Muckerman: Yeah, you can also focus on, if you look at where the refineries are getting their oil from. A lot of mid-con refiners here right along the Cushing area and the Gulf Coast generally getting some cheaper oil, and the lighter sweet crude oil, which is easier and less costly to refine. You look at you getting Gulf oil from out in the Middle East, or if you're getting Mexico oil or heavy oil sands oil from Canada, it costs a little bit more to refine.

O'Reilly: So it's cheaper?

Muckerman: The oil itself is cheaper, but the cost for the refiner is a lot higher, because it's a lot dirtier, and it necessitates more refining than the light sweet crude. Generally, the U.S. is producing light sweet crude, and everywhere we import it from is producing the heavier crude.

O'Reilly: For sure. Cool. So I've talked about this company before, but we have to rap about this for a sec. Yesterday, 8point3 Energy Partners, which literally owns and buys solar installation projects, they have 20- to 25-year lives and then sell the electricity to utility companies, and that's it. I think they have five employees. I'm joking, but you see the point.

Muckerman: Yeah. Revenue per employee should be all right.

O'Reilly: They reported earnings after the close. They were pretty good; they projected their dividend for the year; they actually one month ago had increased their quarterly dividend by 3%. Things are OK over there operationally. [laughs]

Muckerman: Are they? Or so they say?

O'Reilly: The cause of the ruckus is an announcement by one of their two parent companies.

Muckerman: What happened? Overnight, the stock was down 8%-10%? More?

O'Reilly: It was rough. It's down 7% right now. It was down 15% after hours, it was crazy. Was like, woah, guys.

Muckerman: Some knee-jerk reactions and a little bit more rationalization. But still negative. What happened?

O'Reilly: There's three companies involved in this. You have 8point3, which trades under the symbol CAFD, and its two solar installer parent companies, First Solar, and SunPower. You could even throw in a fourth company, which is French oil giant Total SA. Where's Tyler Crowe when you need him?

Muckerman: Yeah, seriously, that's his bag, baby.

O'Reilly: They own 56% of SunPower. So they control it. They might as well not even have a board, L-O-L. So 8point3 reports earnings, they're decent, it's fine, cash flow's OK, distributable cash flow was $25 million, which is where it needs to be, all good. Then First Solar announced that they were exploring strategic alternatives for its ownership in 8point3 Energy Partners, basically saying they want out. And the stock tanks. One of the selling points two years ago, when 8point3 was created was, "We'll have two parent companies, as opposed to one," as was the case with TerraForm Power and Global; they were the yieldcos for SunEdison that's now in Chapter 11. Things were not great.

Muckerman: These yieldcos, NRG Energy had a yieldco; that's really done poorly.

O'Reilly: 8point3 was created when that was hot. That's the thing.

Muckerman: That's why they were created, because it was hot.

O'Reilly: I did some digging; it was weird, because on Dec. 1, 8point3 closed on an acquisition of a 34% interest in, you guessed it, First Solar, the company that wants out. Three hundred-megawatt Stateline solar project located in San Bernardino County, Calif. Project had 20-year contract life, expected to generate approximately $32 million in annual cash distributions. They're making deals, it's fine, they were fulfilling on why they were created. So First Solar said in the statement, their CEO said, it could allow them to allocate more capital to the production of its next generation Series 6 panels, which Chief Executive Mark Widmar said has the potential to be a transformational product. I don't quite buy this, because First Solar has a crap ton of cash on the balance sheet. I'm pretty sure it's over $1 billion. I don't know. I think it sounds --

Muckerman: Compared to their market cap ... $1 billion in cash, versus a market cap of $2.75 billion, so that's a pretty decent sum, OK.

O'Reilly: Yeah. And to be fair, solar panels are, for lack of a better word, a commodity. If you don't have a more efficient solar panel, somebody overseas will mess you up. So to be fair, they do have to dig in and do some things. But yeah, they have cash and cash equivalents -- as of end of 2016, $1.347 billion and $608 million in short-term investments, which I assume is T-bills or something. This is some serious cash. And I know they're thinking, we really have to focus on this, and that's fine. But it really smells to me like they created this thing when it was hot two years ago, and now it's just not --

Muckerman: It's falling out of favor.

O'Reilly: Yeah, it's falling out of favor.

Muckerman: The herd mentality has taken over.

O'Reilly: Fool.com, we have a contributing solar writer, he knows everybody --

Muckerman: Travis Hoium?

O'Reilly: Travis Hoium, yeah.

Muckerman: Yeah, he's the truth when you're looking at solar.

O'Reilly: I was chatting with him last night at 10 p.m., because this was just hilarious in every way. He said, and I appreciated this, "I think the whole move is because neither sponsor is betting on project development the way they were two years ago. So if you can cash out now, why not?" It could go either way. This could actually be good, and Total, the other 56% owner of SunPower -- there's a lot of "powers" and "suns" in here; I apologize -- you could see them buying the stake in this. They love renewables. You have an oil company worth hundreds of billions of dollars that's trying to pivot to solar. It would be incestuous, but it would be fine. This doesn't affect its cash flows right now. At the end of the day, it just seems like everybody doesn't like uncertainty on Wall Street, so they're just selling out.

Muckerman: Yes. That's where they tell you, you can capitalize, it is on uncertainty, but yeah. I think the whole NRG Energy yieldco story really, really soured people on these. So any hint of some negative news, people are jumping for the exits.

O'Reilly: People are still burned from the SunEdison stuff. TerraForm Global and Power, it was like, what are these things worth?

Muckerman: Right, and they're so confusing when you really dive down into it.

O'Reilly: Yeah, you look at a chart of the ownership structures of all the stuff they own ...

Muckerman: That's right, Enron-esque in terms of how confusing it can get.

O'Reilly: You own 34% of this project over here, and blah blah blah ...

Muckerman: Yeah, and somebody else below them owns another ... yeah, crazy.

O'Reilly: Lots of fun. Before we head out, I want to wrap about deepwater offshore drilling. 

Muckerman: Or lack thereof? [laughs] 

O'Reilly: Or lack thereof. When it was all peak oil right before the financial crisis in 2007, if memory serves, this was going to be the savior. It was going to be, we'll find these huge fields, we'll keep producing, we'll be OK for a while because of these deepwater offshore projects.

Muckerman: Yeah, their long-tail projects. Very expensive, though.

O'Reilly: Then, I don't know, Iraq's production gets back up to 4 or 5 million barrels; shale comes into the picture.

Muckerman: And the bottom falls out.

O'Reilly: Is it game over? What's going on here?

Muckerman: It is for some companies. You've been seeing a lot of restructuring lately. Hercules Offshore --

O'Reilly: I remember them.

Muckerman: Yeah, they were predominantly shallow-water, jackup rigs.

O'Reilly: So this is like 100 miles off the coast of the Gulf?

Muckerman: I don't even know if it's that far. It's all jackup rigs. They're not floating, they're actually on the surface below the water. They can't go too deep. But then again, it wasn't as expensive as deepwater, so you would expect, maybe there's some leeway there. Unfortunately not. Hercules Offshore restructured in court. Shareholders obviously not doing so well.

O'Reilly: Did they just have too much debt?

Muckerman: I can't speak to Hercules, but the latest one, Seadrill Deepwater, all debt. I remember talking about this company back in the boom days in 2012 and 2013. Very wary then when oil was surging, and deepwater was the Mecca of oil for the next few decades, or so people thought. They were completely funding their dividend out of debt. They were free cash flow negative before dividend, so then you have to take on debt to pay the dividends, because they had one of the highest yields in the business. Obviously unsustainable now. We talked about it, myself and Joel South talked about it extensively back then.

O'Reilly: Oh, so I should go to YouTube and find these four-year-old videos. [laughs] 

Muckerman: Yeah, YouTube "Taylor Muckerman Seadrill," there's proof in the pudding right there. But now, Transocean has been selling rigs to the tune of billions of dollars lately as well.

O'Reilly: Their fleet age is dropping a lot, by the way. Have you seen that?

Muckerman: It is. For a while there, they had one of the oldest fleet ages. Seadrill and Ensco had some of the youngest, along with Noble. But now they're selling off their old rigs, some of their shallow water rigs.

O'Reilly: And retiring.

Muckerman: Yeah. Retiring, not even selling them all off. They did make a pretty big deal, I think, in the last couple weeks. But, a lot of restructuring going on. And as we all know, when a company restructures when bankruptcy is involved --

O'Reilly: Shareholders are last in line.

Muckerman: Equity shareholders are usually the tail end of the bread line. This bodes well if deepwater does come back in favor, you have less competition and you've weeded out the weaker players who've tried their darnedest to get in when the getting was good. They weren't secure in their balance sheet, they had too many rigs on order. You're going to see, the players who are going to survive are going to, if deepwater does come back, they're just going to have a field day. And that's companies like, Transocean, I don't think is going to go anywhere any time soon. Ensco, Noble, and if you're looking at the companies that supply them with equipment, National Oilwell Varco and ... what was the company they spun out?

O'Reilly: DistributionNOW. That's the parts, mostly.

Muckerman: Yeah, they've done a great job of standardizing a lot of the parts on these rigs. If you want some contrarian bets on the energy sector, I'm not saying go buy them now. I'm saying take a look at Ensco, Noble, Transocean, NOV and DNOW. If you want five contrarian bets, maybe take a look. And even Petrobras (NYSE: PBR), integrated oil company out in Brazil. Brazil, in the pre-salt formation has supposedly some of the most prolific oil reserves under the deepwater there, and Petrobras has first come first serve.

O'Reilly: Actually, over a year and a half ago now, Tyler Crowe and I talked to National Oilwell Varco CEO.

Muckerman: Yeah, it's great people down there.

O'Reilly: I had sat down and interviewed [Robert] Workman, the CEO of DNOW. To any of our listeners, if you want to see those interviews, if you're wondering what those guys were thinking back then, feel free to email us and I'd be more than happy to send those to you.

Muckerman: I interviewed --

O'Reilly: You talked to them a year before us. They're cool guys.

Muckerman: -- Pete Miller on camera a year before. Yeah, we went down there two years in a row to talk to them and a few other companies. That's a very well-run company. It just got hit by market forces.

O'Reilly: And that's how economics work.

Muckerman: That's exactly how economics work.

O'Reilly: Thanks for your thoughts, man!

Muckerman: Cheers, good show!

O'Reilly: Talk to you later. See you next week!

Muckerman: You got it.

O'Reilly: That is it for us, folks. Be sure to tune in tomorrow for the Technology show. If you're a loyal listener and have questions or comments, we would love to hear from you. Just email us at [email protected]. Once again, thanks to our producer, Austin Morgan. We love you. As always, people on this program may have interests in the stocks that they talk about, and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell anything based solely on what you hear on this program. For Taylor Muckerman, I am Sean O'Reilly. Thanks for listening, and Fool on!