This article is part of our Rising Star Portfolios series.
What do you do when within two days, the share price for one of your companies drops 22%? Me, I take a real close look at what caused that drop and, if my investing thesis still holds, buy some more shares.
Last Wednesday, shares of Western Refining (NYSE: WNR ) fell 13.5% and then fell another 9.8% on Thursday. This fall was for two related reasons (though Thursday's was helped along by an analyst downgrade).
First, ConocoPhillips (NYSE: COP ) announced that it was selling its 50% ownership stake in the Seaway Crude Pipeline Co. to Enbridge (NYSE: ENB ) for $1.15 billion. Normally, this wouldn't matter one whit to Western Refining. However, Enbridge and Enterprise Products Partners (NYSE: EPD ) , the owner of the other half of the pipeline, then announced that they are planning to reverse the flow of oil in the pipeline so that, instead of moving oil from the Gulf Coast to Cushing, Okla., oil in the pipe will now go the other direction.
One way or the other, what's the big deal?
The big deal is that it will help relieve the oversupply of oil at Cushing, which was contributing to something called the Brent-WTI spread. That spread is the difference in price between Brent North Sea crude oil and Midwest "West Texas Intermediate" crude. All this year, Brent has been quite a bit more expensive than WTI, by as much as $28 last month (see the graph, below). Refiners who were buying WTI crude but selling the refined products at prices influenced more by Brent were sitting in a sweet spot. It had climbed so dramatically this year that one analyst predicted a spread of $40 before too long.
The announcement by Enbridge and Enterprise, however, indicated that the supply pressure at Cushing was going to be relieved, at least somewhat. That led to a drop in the spread, down to about $9. This was enough to whack the share prices of Western Refining, Marathon Petroleum (NYSE: MPC ) , HollyFrontier (NYSE: HFC ) , and Valero (NYSE: VLO ) , all of which were taking advantage of that spread.
Sources: U.S. Energy Information Administration and Intercontinental Exchange.
It's not all about the spread
The interesting point to notice, however, is that the spread was no longer at $28 and no longer climbing. In fact, it had been falling since mid-October, dropping to about $13, half of what it had been, before the Seaway news. No $40 spread for speculators. The announcement about Seaway probably put the nail in the coffin for speculators who were betting that refiners would continue to profit indefinitely from a wide Brent-WTI spread. I believe that as they realized the wide spread was doomed, they closed out their positions and the share prices dropped.
Fundamentally, Western Refining is still the same company it was the week before this news broke. As you can see, most of the time over the past several years, the spread has bounced around either side of $0 and Western Refining (along with the others) has managed to turn an operating profit.
With gasoline prices well above $3 per gallon and likely to remain so given oil prices of $90 to $100 per barrel, refiner profitability is unlikely to disappear. Heating oil and diesel are also expected to remain expensive, again helping refiner margins.
At Friday's closing price of $12.51, the market is expecting free cash flow of Western Refining to drop by 18% per year for five years, 9% annually for another five, and then never grow again (at my usual 15% hurdle rate to discount). Given that the company's actually managed to grow FCF by 34.3% per year over the past five years, that expectation seems a bit low. Plus, the company's balance sheet has gotten significantly stronger, with net debt now at just $663 million, down from $1.23 billion in the summer of 2010.
Sure, there could be a dip in the margins over the next couple of quarters as the Brent-WTI spread seems to be returning to a more normal level. But to expect the total collapse of the ability to generate free cash flow over the next decade is taking things a bit too far, in my opinion. Consequently, the Messed-Up Expectations portfolio will buy some more shares at this low price, expanding the energy part of the portfolio.
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