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Somewhere in the US, there is a refinery executive staring into a drink and longing for the days of 2012. Back then, domestic crude prices were trading at a deep discount to the international benchmarks thanks to big bottlenecks in infrastructure, and retail prices remained relatively high. These factors led to almost comical refining margins. Unfortunately, it was only a matter of time till enough infrastructure was in place to bring down the gap between these two prices.
For that wistful executive out there, I have good news for you. There may be another bottleneck building in US crude supply, but it's not an infrastructure one. Let's take a look at what is happening in the US oil markets that may bring back memories of 2012.
Unclogging the Pipes
Oil and gas producers learned their lesson; production can't outpace infrastrucutre. Luckily for them, that is becoming less and less of a problem. One of the largest bottlenecks in our energy infrastructure took place at the hub in Cushing, Oklahoma. Now, with the reversal of Enterprise Products Partners' Seaway pipeline and Transcanada's Gulf Coast project coming online, there will be an additional 1.1 million barrel per day capacity flowing from Cushing to the heart of America's refining capacity in the Gulf Coast. These projects, several other pipelines, and the addition of rail have essentially wiped out the difference in price between the domestic benchmark West Texas Intermediate and the foreign standard Brent.
For refiners, though, that spread in price led to very lucrative refining margins. As that spread has narrowed, so too has margins for refiners.
|Refining Margins||Q4 2012||Q2 2013|
|Valero (NYSE: VLO )||$12.27||$9.26|
|Phillips 66 (NYSE: PSX )||$13.67||$9.88|
|HollyFrontier (NYSE: HFC )||$24.00||$20.28|
|CVR Refining (NYSE: CVRR )||$28.08||$20.30|
Both HollyFrontier's and CVR's refining capacity are found in the mid-continent region of the country, whereas Phillips 66 and Valero has much more of its refining centered in the Gulf Coast Region. So when all of that oil was found in the mid-continent region, the local refiners were the only game in town. That simply isn't the case anymore, and producers can find more advantageous prices for their crudes by moving to any of the coastal regions of the US.
The New Bottleneck
Between all the additional pipeline capacity coming online and rails increasing role in moving oil. It's not very likely that any particular region will see pricing problems because of physical restraints. However, a new bottleneck is about to emerge: The United States itself. A recent study from Deutsche Bank estimates that the US will produce another 700,000 barrels of light, sweet oil per day within the next 12 months. This would actually be enough oil to meet all of the light, sweet capacity at US refiners. To compound that emerging trend, the US government bans the export of crude oil. This means that any additional production of light, sweet crude won't have anywhere to go unless we see some big upticks in light oil processing capacity.
If this were to happen and we don't see any major policy changes regarding oil exports, then it is very likely that we will see domestic oil prices sink. According to the Deutsche Bank report, producers in the Bakken could see prices slump to the $75-$80 a barrel range. This would be extremely discouraging for some of the smaller producers like Kodiak Oil & Gas (UNKNOWN: KOG.DL ) . The company is currently getting about $90 a barrel, and a potential 17% cut in prices could be a wet blanket for a company that is trying to grow faster than its current earnings dictate.
For refiner's though, it could mean a return to the glory days of 2012. Since America can export refined petroleum products but not crude, it would give refiners the ability to somewhat dictate the price of gasoline and crude at the same time. Since Valero, Phillips 66, and other major coastal refiners can send refined products overseas to get premium prices in markets like Europe and South America, it can keep prices high while being the gatekeeper for any oil production in the US.
What a Fool Believes
Production growth for oil and gas in the US has been so fast that we find ourselves running up against problems we couldn't have even conceived less than a decade ago. The next big hurdle in creating a more fluid oil market in the US will require us to revisit the current ban on crude exports. Since this decision will happen in Washington and not in a corporate board room, you can be assured that it will take much longer. In the meantime, refining executives may get a little sparkle in their eyes as they see light crude supply starts to outgrow our capacity to refine it.
More Compelling Companies
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