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The fascinating aspect of the energy industry is how what may seem like a small event can have such a large impact on companies. Today, there's one small trend that resulted in Exxonmobil (NYSE: XOM ) having a tragic quarter, while others like Devon Energy (NYSE: DVN ) crushed earnings estimates: the Brent-WTI spread. Let's take a look at what the spread means, and who wins and loses as the spread narrows, as it has done in recent months.
The spread that isn't set by Vegas
Contrary to what many may think, oil is not a universal product. Granted, the price for oil is much more global than its hydrocarbon counterpart natural gas, but there are some regional discrepancies in the price of oil. In the U.S., the two most important oil price benchmarks are the foreign Brent, and the domestic West Texas Intermediate -- also known as WTI.
For several years until 2011, the spread between WTI and Brent was marginal, and the effects of pricing had little to no effect. Then, all of a sudden, U.S. oil production started to take off, and the cost for local crude became much less expensive than imported crude.
There are lots of reasons why this happened, but increased U.S. production, and a lack of infrastructure to move crude to markets, were the largest culprits of this trend. Today, though, increases in pipeline capacity, with the addition of rail shipments, has made the movement of oil across the country much more fluid, and the price of domestic crudes are increasing. At the same time, the price for international crude has slipped, thanks to the U.S. using less of it, as well as a weak economy in Europe and slowing growth in the Asia Pacific region.
What is important about this trend for investors, though, is the realized prices for oil each company can attain. A company like Exxon, which has a greater exposure to international crude, will suffer in relation to more domestic-minded producers like Devon. Compared to last quarter, Exxon's upstream earnings took a $300-million hit thanks to lower realized prices on the crudes that it produced, whereas Devon's increased production and higher-price realization on domestic crudes resulted in an earnings beat of almost 30%.
Both Devon and Exxon are clear examples of companies that benefit from the narrowing spread between regional oil prices, and we have seen several exploration and production companies adjust for this. ConocoPhillips (NYSE: COP ) has been reshuffling its assets so that it has a much larger exposure to domestic oil production versus foreign crude. This past quarter, Conoco increased production from the Permian, Bakken, and Eagle Ford formations by 47% year over year, and it has put assets in Nigeria, Trinidad and Tobago, and Canada this year alone.
But exploration and production companies are not the only ones that have been affected. The narrowing of the spread between WTI and Brent has meant that U.S. refiners are not getting the deep discounts on crude that they were seeing only a couple of quarters ago. The most directly affected are refiners in the Mid-continent region. CVR Refining (NYSE: CVRR ) saw its refining margin reduced by 29% year over year because the realized price it paid on crude feedstocks- -- a majority of which are domesitcally priced -- was 39% higher than it was last year.
The oil price between the two benchmarks is getting so narrow that refiners with easy access to ports are switching back to foreign crudes. Phillips 66 (NYSE: PSX ) has reduced its shipments from the North Dakota region because the cost of the oil, plus shipment, is now greater than what the company can pay for foreign crudes from Nigeria. These small changes can mean a lot for Phillips 66. For every dollar change in the companies' refining margin, the company stands to gain or lose $440 million in net income.
Those deliveries that were intended for Phillips 66's refineries were slated to happen via rail, which is yet another sector that has been negatively affected by the narrowing of the WTI-Brent spread. The reason rail had emerged in the U.S. was because the lack of pipeline, and the large spread between domestic and foreign oil prices, combined to make oil via rail viable, even though it's more expensive than moving via pipe. Now that the spread has narrowed, oil via rail shipments are dropping. Both Canadian Pacific and Union Pacific have recently stated that certain segments of the oil-via-rail business is falling away, like intrastate Texas, the oil prices are not there to support the premium to move via rail.
What a Fool Believes
Of course, the Brent-WTI spread is always in flux, and some refiners and railroad companies are expecting the spread to widen again. The biggest reason to support this case is that the production rate in the U.S. is likely to outpace its pipeline infrastrucutre...again, which will result in lower prices, as companies fight for space on pipelines and rail cars. As long as oil production in the U.S. remains at its current pace, it is very likely that this back and forth between the WTI-Brent spread will continue.
America is going through some growing pains as it figures out how to handle all this new oil and gas production, and investors who can get a pulse on this fast-moving environment could find some spectacular opportunities. For this reason, we have put together a comprehensive look at three energy companies set to soar during this transformation in the energy industry. Let us help you discover three companies that are spreading their wings by checking out our special report, "3 Stocks for the American Energy Bonanza." Simply click here to get free access to this valuable report.