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Why This Refining Stock Could See Further Gains

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The U.S. Gulf Coast is about to be inundated with oil. But not foreign oil, as was often the case in the past. I'm talking about light, sweet crude oil produced right here in America. The reason?

A number of pipeline projects -- some already in service and others expected to come on line this year -- will provide a substantial boost to takeaway capacity from the Eagle Ford and the Permian Basin, both major oil plays located in Texas. When the crude oil deluge hits the Gulf Coast, analysts expect the regional benchmark price -- Louisiana Light Sweet, or LLS -- to fall substantially.

At the same time, the expansion of the Seaway pipeline and the start-up of the Keystone XL Gulf Coast extension project are expected to lead to a narrower spread between the main domestic oil benchmark -- West Texas Intermediate, or WTI) -- and the global crude oil benchmark, Brent.

These are both major changes with some major implications for different refiners. Let's first look at the broad impacts on mid-continent and Gulf Coast refiners and then examine one refining stock that appears best positioned to capitalize on these trends.

Impact on mid-continent refiners
Over the past couple of years, mid-continent refiners with access to cheap WTI have enjoyed remarkable profits and soaring stock prices. As a whole, their net operating margins averaged $18.59 last year, significantly higher than margins in 2011.  

For instance, HollyFrontier (NYSE: HFC  ) , which operates five refining facilities in the mid-continent, southwestern, and Rocky Mountain regions, benefited tremendously from its access to crude oil flowing from North Dakota's Bakken shale and Texas' Permian Basin. In the fourth quarter, the company's overall refining margins jumped to $24 a barrel, up from $15.32 a barrel in the year-earlier  period.

This favorable refining environment, along with an increase in production, contributed to the company's record 2012 earnings. In the fourth quarter, HollyFrontier posted a profit of $391.6 million, or $1.92 a share, representing a whopping 75% increase over the year-earlier period.

Similarly, Western Refining (NYSE: WNR  ) , a company that struggled for years with heavy debt and poor refining margins, has also reaped the rewards stemming from its highly advantageous geographic position. The company's 128,000-barrel-per-day refinery in El Paso, Texas, has capitalized on cheap crude flowing from the nearby Permian Basin, which has boosted overall margins and allowed the company to reduce its debt load and even raise its dividend.

Going forward, however, if the spread between WTI and Brent narrows significantly, it would lead to weaker refining margins for these companies. But for reasons I discussed in a separate article, I think there's a good chance that this is unlikely and that the WTI-Brent spread will remain wide throughout the year.

Impact on Gulf Coast refiners
On the other hand, I'm more convinced that LLS prices will fall, which would be good news for Gulf Coast refiners. Analysts at Tudor Pickering, an integrated energy investment and merchant bank, summed it up well in a note released earlier this year:

"The early stages of the U.S. crude supply renaissance benefited a minority of U.S. refining capacity in the middle portion of the U.S. ... However, midstream bottleneck alleviation is quickly bringing this crude to the coasts, particularly the Gulf Coast, where 9 million b/d of capacity awaits."

With respect to this coming deluge of crude oil to the Gulf Coast, there is one point worth noting, however. Refiners in the region are generally better equipped to process heavier crudes, as opposed to the primarily light, sweet crudes that will soon be flowing to them.

Over the past few years, many have invested heavily in catalytic crackers, hydrocrackers, and coking units, which are designed to convert heavy crudes into lighter refined products. While these refineries do have the ability to process light crudes, doing so can lead to major imbalances.

For instance, it might underload cracking units designed to handle heavy crude components, while overloading units designed to process lighter components. This can lead to a poor utilization of their available capacity.

1 stock to consider
Whether Gulf Coast refiners as a whole will be able to handle the coming flood of light, sweet crude remains to be seen. But I think one company is particularly well poised to profit from the influx of cheaper light oil -- Valero (NYSE: VLO  ) .

The world's largest independent refiner, it boasts a total refining capacity of 2.8 million barrels a day, of which two-thirds is located in the Gulf Coast. At its refineries in Memphis, Tenn., and the Gulf Coast region, the transition toward using cheap domestic crude allowed the company to more than double its fourth-quarter refining margins from the year-earlier quarter.

In fact, the company recently announced that is has stopped buying light, sweet oil from abroad, after making significant progress in switching over to domestic crudes. Valero has also drastically reduced its consumption of heavier crudes, with domestic light, sweet crude currently accounting for half of its feedstock, up from a third not too long ago.

Similarly, Phillips 66 (NYSE: PSX  ) , the nation's biggest independent refiner by revenue, also recently announced that its plants in the Gulf Coast region will no longer need to import light, sweet crude oil from overseas, reflecting a positive trend sweeping the Gulf Coast refining industry. Like Valero, Phillips also posted strong fourth-quarter earnings that were boosted by its increased access to cheap domestic oil.

In fact, Valero's access to discounted crudes contributed to fourth-quarter earnings that were the highest in seven years, coming in at $1.01 billion, or $1.82 a share, as compared with $45 million, or $0.08 a share, in the year-earlier quarter.  

Going forward, I suspect that Valero should continue to outperform as the LLS price falls, especially considering its relatively robust light oil processing capacity; three of its seven refineries along the Gulf Coast are equipped to process light oil. Though the stock has seen a meteoric rise over the past year, I think it may have even more room to run, thanks to these favorable developments.

While mid-continent and Gulf Coast refiners are well positioned to profit from growing volumes of cheap domestic crude, don't forget about the midstream companies that transport the stuff. Kinder Morgan is one of these operators, and one that investors should commit to memory because of its sheer size -- it's the fourth largest energy company in the U.S. -- not to mention its enormous potential for profits. In The Motley Fool's new premium research report on Kinder Morgan, our top energy analyst breaks down the company's growing opportunity, as well as the risks to watch out for, in order to uncover whether it's a buy or a sell. To determine whether this dividend giant is right for your portfolio, simply click here now to claim your copy of this invaluable investor's resource.

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9/26/2016 9:40 AM
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