3 Companies Taking Advantage of Distorted Oil Prices

The spread between West Texas Intermediate and Brent, the two most widely used crude oil benchmarks, have consistently remained over $15 per barrel since July. Following the reversal of the Seaway pipeline, many analysts predicted that the historical parity between the two benchmarks would soon be restored. However, that hasn't been the case.

A prophecy gone haywire
While the discount did narrow down to below $10 a barrel for a few days, this just seemed to be a flash in the pan. It gradually became evident that there's no way a single pipeline reversal, with a transfer capacity of 150,000 barrels per day, can reduce the huge glut at Cushing, Okla. -- the delivery point and storage hub of WTI. In fact, the last three months have seen the spread widening. The graph below gives a clearer picture:

Source: Energy Information Administration; author's calculations

What's causing this disparity?
The Mid-Continent region houses the country's hottest oil shale plays. Most of the oil produced in this region, which is of the WTI grade, is then shipped to the storage hub at Cushing. The problem lies with the fact that there isn't enough capacity to transfer these massive amounts of crude oil to the Gulf coast, where a large number of refineries are located. As a result, with inventories piling up, the WTI trades at a considerable discount to the internationally tracked Brent.

The U.S. Energy Information Administration, however, expects this discount to narrow down to $9 per barrel by the end of 2013. Obviously, the biggest assumption here is that crude oil transport and delivery infrastructure (read: pipelines) will improve considerably by then. Even if things are to work out as planned, it's still quite a long way off before parity between the two benchmarks is restored. Careful investors can actually exploit this situation to their advantage by investing in the right companies.

Opportunities beckon
For starters, refining companies with easy access to the cheaper WTI should see their gross margins flourish. These companies have most of their refineries (if not all) located at places to which crude oil can be easily moved from Cushing through existing pipelines. In other words, with access to cheaper feedstock (raw material), input costs are much less than those refiners that use Brent or Light Louisiana Sweet as feedstock. Here are two such refiners who are excellently placed to exploit this strategic advantage.

1. HollyFrontier (NYSE: HFC  )
A favorite of mine since early this year, HollyFrontier hasn't looked back since the "merger of equals" between Holly and Frontier in July 2011. Its five refineries are located near Cushing and either source the WTI or the heavy Canadian crude oil (which is again cheaper than Brent) for their refining operations. Despite the stock being up a solid 65% this year, the refiner's valuations are still attractive. With a trailing P/E of 5.9 and a forward P/E of 8.0, it's still among the cheapest in the industry. Additionally, HollyFrontier has a 44% stake in Holly Energy Partners which owns and operates crude oil pipelines and terminals and loading rack facilities that support HollyFrontier's refining and marketing operations. Fools should also watch out for companies operating in the midstream segment.

2. Marathon Petroleum (NYSE: MPC  )
Here is a refiner that has the same set of advantages as those of HollyFrontier. This dividend-paying company is currently in expansion mode. For more details, you can check out this article detailing its operational and financial soundness.

But refiners aren't the only ones
Next up is an exploration and production company that has proved its operating prowess in the last 18 months. Bakken player Kodiak Oil & Gas (NYSE: KOG  ) doesn't seem to have an obvious connection with this situation, you might say. However, if you look carefully, crude oil from the Bakken region sells at a premium to WTI. And this premium has just widened to $5.5 per barrel. The reason is simple: Bakken crude is not only in demand, but efficient transport facilities have ensured that a bottleneck doesn't arise.

The reason why is that earlier this month Tesoro (NYSE: TSO  ) received its first load of Bakken crude at its new 50,000-barrel-a-day terminal in Washington. Sunoco's Philadelphia refinery is once again reviving operations in a joint venture with the private equity firm, Carlyle Group. Accordingly, an unloading terminal that will receive 140,000 barrels a day of Bakken oil is being built. Similarly, Canada-based Irving Oil is expecting another 70,000 barrels of Bakken and Canadian crude from this month near its Saint John refinery in New Brunswick. Demand for Bakken crude is currently at an all-time high.

3. Kodiak Oil & Gas
Right now, Kodiak seems to be the best bet among growth companies operating in this region. The company is expecting to reach production volumes of 27,000 barrels of oil equivalent per day (BOE/D) by the end of this year. Compare this with a production of 10,000 BOE/D at the end of 2011. You can do the math. Without a doubt, Kodiak looks well-positioned to take advantage of the entire situation. The valuations, too, are getting attractive. In March, Kodiak was trading 53 times its trailing-12-month earnings. Back then, I wrote that investors shouldn't be fooled by this figure. The growth prospects looked immense. Thanks to a couple of excellent quarters, the trailing P/E has already fallen to 26. This is an excellent opportunity for long-term investors.

The Foolish bottom line
Fool Morgan Housel rightly points out that the increasing crude oil production in the U.S., which is currently the highest in 15 years, has been among the most unappreciated developments in recent times. In hindsight, this has been a very positive development, paving the way toward the nation's energy independence. Accordingly, many more oil and gas companies will benefit. Click here to gain access to "The One Energy Stock You Must Own Before 2014," a free report on a company that will profit greatly from domestic energy production. Click here to gain access immediately.

Fool contributor Isac Simon does not own shares of any of the companies mentioned in this article. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.  


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