Are Oil Refiners Too Risky to Buy?

For several months earlier this year, the publicly traded oil refiner stocks could do no wrong. Companies including Phillips 66 (NYSE: PSX  ) , Marathon Petroleum (NYSE: MPC  ) , HollyFrontier (NYSE: HFC  ) , and Valero Energy  (NYSE: VLO  ) saw their profits (and by extension, stock prices) rise as they benefited from wide operating spreads.

Fast forward to today, and the situation is vastly different for the nation's biggest oil refiners. Narrowing spreads and margins are putting a serious dent in refiner profitability. Furthermore, a cascade of analyst downgrades is raining on the industry. As a result, should investors avoid oil refiners entirely?

Downgrades across the board amid worsening fundamentals
Analysts with Oppenheimer recently downgraded refiners including, but not limited to, Phillips 66, Marathon Petroleum, HollyFrontier, and Valero. This is squarely the result of a deteriorating earnings outlook, due to a number of factors such as lower spreads, higher crude acquisition costs, and therefore lower margins. The Oppenheimer downgrade is only the latest in a series of analyst downgrades for the sector in recent weeks.

Judging by results from refiners themselves, it seems that there's plenty of merit for pessimistic outlooks. Phillips 66 saw its second-quarter adjusted earnings fall by a full third. Weakness was apparent in its refining business, its biggest segment, where profits fell by nearly half.

Marathon's margins narrowed and served as the primary culprit for its own lackluster performance. Marathon Petroleum realized a gross margin of $11.13 per barrel in the second quarter of 2012, which fell to $6.18 per barrel in the second quarter of 2013. This resulted in a 23% drop in quarterly earnings, year over year.

HollyFrontier and Valero are performing more or less in-line with the industry, both struggling to deal with falling margins. HollyFrontier reported a 46% drop in second-quarter profits, and it's not hard to see why. Refinery gross margins were $20.28 per produced barrel, down 26% from $27.43 per barrel realized in the same quarter one year ago. Furthermore, expenses per barrel clocked in at $6.09, up 21% from $5 per barrel year over year.

Valero's second quarter profits fell by 43% as it realized lower production volumes and was adversely affected by higher maintenance expenses at four of the company's major refining facilities.

With all this going on, most investors would be understandably tempted to believe there's simply no light at the end of the tunnel for refiners and, consequently, no reason to invest.

Is there any reason for optimism?
Of course, commodities are cyclical, and there's always the chance that oil prices will soon become favorable to refiners once again. Plus, by taking cues from management, we can infer a certain sense of optimism among the companies themselves. For instance, each of these stocks has ratcheted up the amount of cash they're deploying to shareholders, even amid broad analyst pessimism.

Phillips 66, for example, recently upped its dividend by 25%, and since being spun off in 2012, the company has nearly doubled its dividend in that time. This represents the third dividend increase since the spinoff.

Marathon Petroleum is busy giving its investors a double-dose of cash returns. The company recently increased its dividend by 20%, raising its payout for the third time in the last two years. In addition, Marathon Petroleum also authorized an additional $2 billion for share buybacks, on top of the remaining $1.34 billion it had in its existing share repurchase program.

HollyFrontier is also throwing cash at shareholders to boost investor morale in a tough operating climate. Along with its quarterly results, the company announced both a special dividend of $0.50 per share in addition to its regular common stock dividend of $0.30 per share.

Valero bumped up its own payout by 12.5% recently, marking the second time this year the company has increased its dividend. Chairman and CEO Bill Klesse made specific mention to the fact that the company increased its dividend twice because management maintains a positive outlook for Valero, even in a tough time for refiners.

The Foolish bottom line
Deteriorating fundamentals are rarely an encouraging sign, and a heap of analyst downgrades only makes an investment decision that much tougher. There's no denying the fact that this is a hard time for oil refiners, as margins are being squeezed. At the same time, an old investing adage remains true: the best time to buy is usually when nobody else wants to.

While it's impossible to know for sure whether the operating environment for refiners will improve sooner rather than later, I have confidence that these well-run businesses will prosper once their margins become favorable once again. Plus, the increasing amount of cash they're heaping on their shareholders is a great sign that management teams of each of these companies are optimistic about what the future holds.

More from The Motley Fool
Imagine a company that rents a very specific and valuable piece of machinery for $41,000… per hour (that’s almost as much as the average American makes in a year!). And Warren Buffett is so confident in this company’s can’t-live-without-it business model, he just loaded up on 8.8 million shares. An exclusive, brand-new Motley Fool report reveals the company we’re calling OPEC’s Worst Nightmare. Just click HERE to uncover the name of this industry-leading stock… and join Buffett in his quest for a veritable LANDSLIDE of profits!

Read/Post Comments (2) | Recommend This Article (1)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 14, 2013, at 12:48 PM, AnsgarJohn wrote:

    Do the math Bob. What do you calculate Hollyfrontiers intrinsic value to be?

  • Report this Comment On October 15, 2013, at 2:51 AM, Jojojo53 wrote:

    MPC should not buy back $2B of stock.

    The shareholders of MPC would be better served spending this $2B on debt reduction and higher dividend. Debt reduction increases earning per share, as does a stock buyback, but by decreasing expenses. Debt reduction may also increase the P/E by creating a lower risk, lower debt/equity company.

    A higher dividend benefits all shareholders.

Add your comment.

Compare Brokers

Fool Disclosure

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 2680632, ~/Articles/ArticleHandler.aspx, 9/30/2016 8:27:47 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated Moments ago Sponsored by:
DOW 18,308.15 164.70 0.91%
S&P 500 2,168.27 17.14 0.80%
NASD 5,312.00 42.85 0.81%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

9/30/2016 4:02 PM
HFC $24.50 Up +0.89 +3.77%
HollyFrontier CAPS Rating: ****
MPC $40.59 Up +0.85 +2.14%
Marathon Petroleum CAPS Rating: ****
PSX $80.55 Up +1.27 +1.60%
Phillips 66 CAPS Rating: *****
VLO $53.00 Up +1.29 +2.49%
Valero Energy CAPS Rating: ****