Why HollyFrontier's Bull Run Is Inevitable

HollyFrontier (NYSE: HFC  ) missed third-quarter earnings estimates by as much as $0.23, thanks to a narrower difference in the Brent premium to the West Texas Intermediate. Fellow refiners, Phillips 66 (NYSE: PSX  ) and Marathon Petroleum (NYSE: MPC  ) , too, bore the brunt as WTI stockpiles in Cushing fell in the last quarter making crude feedstock more expensive. What investors need to ascertain is whether this is just a short-term hiccup, or a permanent change in the dynamics of the domestic crude oil market going forward. Read on, and you will see that HollyFrontier is still fantastically placed to beat the market.

But before that, let's look at HollyFrontier's latest numbers.

The latest figures
HollyFrontier reported a net income of $82.3 million, or $0.41 per share -- an 86% drop from last year's third quarter. Refinery gross margins fell a sizable 65% to $10.6 per barrel from $30.6 per barrel last year. Additionally, the Renewable Fuel Standard, or RFS2, has remained a thorn in refiners' sides, with RIN prices increasing dramatically because of a perceived shortage in RINs.

Despite these constraints, revenue rose 2% from last year to $5.3 billion. Overall refinery utilization stood at 94%, a slight drop from 98% last year, thanks to planned maintenance and turnaround activities. In short, HollyFrontier's gloomy numbers aren't a result of a fundamental weakness in the business. On the contrary, with North American oil production poised to grow further, HollyFrontier's refineries are among the best positioned to take advantage. This could just be the lull before the bulls take over this stock. The current bearish sentiment could even be the right time for savvy investors to jump in.

What's going on?
The current price dynamics of crude oil in North America is a long-running saga that started in October 2010. Till then, both benchmarks -- the WTI and Brent -- were tracking each other without any significant difference. However, by early 2011, increasing shale oil production from the Permian Basin and the Bakken caused a bottleneck to develop at WTI's trading hub in Cushing, Okla. Crude oil stockpiles grew to unprecedented levels as takeaway capacity to refineries situated in the Gulf Coast proved inadequate. This caused the WTI to trade at a significant discount to the internationally traded Brent.

Source: Energy Information Administration.

The WTI's discount to Brent reached as high as $28 per barrel in September 2011. Refiners that had greater access to the cheaper WTI such as HollyFrontier, Marathon Petroleum and Western Refining (NYSE: WNR  ) witnessed soaring profits in the last couple of years.

Until February this year.

The fortunes overturn
Thanks to new takeaway capacity from Cushing to the Gulf Coast resulting from the reversal of the Seaway and the Longhorn pipelines, the oil glut at Cushing eventually started alleviating. These two pipelines increased the takeaway capacity to the Gulf Coast by 625,000 barrels per day. Additionally, crude oil by rail from North Dakota bypassed Cushing on its way to the Gulf Coast. In short, the differentials almost disappeared. The chart below tracks the spot prices of two benchmarks since April this year.

Source: Energy Information Administration.

The dashed circle -- indicating the third quarter -- reveals that the spread was at its narrowest during this period. It's no surprise, therefore, why refiners having access to the cheaper variant lost out. Additionally, we notice that the absolute price of WTI also rose substantially, crossing $100 per barrel. Refiners had no option but to buy crude feedstock at a higher price.

But something else seems to be cooking
We notice something peculiar in the preceding chart. Since October, not only has the spread widened, but the absolute price of the West Texas Intermediate has fallen. And why is this happening? Looking a little deeper, this isn't too surprising. The Gulf Coast is now seemingly oversupplied with crude oil from the inland and from the North. The following chart gives us an idea of the inventory levels that have been building up in the Gulf Coast region, or PADD 3.

Source: Energy Information Administration.

Since September, inventory levels having been building up in the Gulf Coast, indicating that refineries in this region are not suffering from a shortage of crude feedstock. In other words, demand for domestic crude has waned, and WTI prices are falling back. This should be music to the ears of refiners, especially those in the mid-continental region having access to both sweet and sour crude.

HollyFrontier's refineries are high on complexity, which means they can process sweet as well as sour crude with equal ease. To quote CEO Michael Jennings:

Looking forward, we see continued growth in North American crude oil production and are confident that our geographic proximity and ability to process both light and heavy crude streams will create attractive opportunities, even as transportation logistics and related crude differentials are rationalized.

Foolish bottom line
Long-term investors shouldn't be too bothered about the current sentiment markets have for this refiner. Crude by rail from North Dakota and Canada should only pick up henceforth, thus flooding the domestic market and pushing down crude oil prices. Also, looking at HollyFrontier's balance sheet and dividend payments, I think we have one of the most conservative management that knows its way around. It seems HollyFrontier's next bull run is just a matter of time.

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More advice from The Motley Fool
Dividend stocks can make you rich. It's as simple as that. While they don't garner the notability of high-flying growth stocks, they're also less likely to crash and burn. And over the long term, the compounding effect of the quarterly payouts, as well as their growth, adds up faster than most investors imagine. With this in mind, our analysts sat down to identify the absolute best of the best when it comes to rock-solid dividend stocks, drawing up a list in this free report of nine that fit the bill. To discover the identities of these companies before the rest of the market catches on, you can download this valuable free report by simply clicking here now.


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