Are Oil Refiners Finally out of the Woods?

Earlier this year, as the price of West Texas Intermediate oil rose above $100 per barrel, oil refiners saw business conditions deteriorate. Since their underlying profits are based in large part on the margins they're able to generate, higher oil prices put a dent in refining profitability. This caused investors a great deal of worry for most of the year.

Thankfully, the trend is starting to reverse, and oil refiners are seeing operations improve once again. Crude is falling once again, particularly when compared to the international benchmark, which should please both consumers and refiners alike, and if the pattern continues, it means better days ahead once again for well-run refining stocks.

Crude's pain is refiners' gain
Oil prices have begun a noticeable trend downward, and recent data points may lead to further declines. The U.S. Energy Information Administration reported that crude oil supplies increased for the sixth straight week. In all, supplies rose by more than 4 million barrels, much higher than the 3.5 million barrel increase expected by analysts. Looking back further, crude oil supplies climbed by 28.2 million barrels over the past six weeks, according to the EIA.

This caused crude oil for December delivery to fall to $97 on the New York Mercantile Exchange. This has been a direct benefit to refiners including Valero Energy Corp  (NYSE: VLO  ) , whose management reiterated the view that brighter days are on the horizon. Valero's underlying results have struggled so far this year, indicated by the fact that operating income per barrel is down 28% through the first nine months of 2013. That being said, CEO Bill Klesse stated that distillate margins are strong to begin the fourth quarter, and that U.S. and Canadian crude oil discounts are favorable as well, which is setting the table for a strong end to the year.

Improving margins will be critical for Phillips 66, which has been hit particularly hard by the narrowing discount between West Texas Intermediate and Brent crude. Phillips 66's refining unit actually posted a loss in its most recent quarter, and the segment is the company's biggest by far. That being said, Phillips 66 is actually performing quite well in all of its other core operating segments. Of the company's four main segments (Midstream, Chemicals, Refining, and Marketing and Specialties), Refining is the only one to have posted lower earnings through the first nine months of the year.

One refiner that may be spared some pain is Tesoro Corp  (NYSE: TSO  ) , due to its advantageous location within the United States. Expectations are for Tesoro to report $0.50 per share, down hugely from $2.05 in EPS in the same quarter last year. Estimates may be on the low side, considering Tesoro operates primarily in the Western U.S., where it's able to secure a more favorable refining margin due to its crude cost advantages. As the company outlined in a recent presentation, it's realizing more favorable pricing for its Bakken crude as compared to the Canadian Light Sweet equivalent.

The final takeaway
There's little refiners can do to change the fact that when spreads narrow, profits get crimped. Oil prices are market-driven, and as a result, management teams can only position their companies to succeed when underlying business conditions hopefully improve once again.

While there's no denying the falling profits for these refiners, Valero, Phillips 66, and Tesoro are well-run companies that will once again succeed when the pricing environment for refiners improves. That's already starting to happen, thanks to West Texas crude dropping significantly over the past few weeks, and if the trend continues, should lead to strong fourth quarter and 2014 results. As a result, it appears the reduced share prices for Valero, Phillips 66, and Tesoro represent solid buying opportunities rather than value traps.

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