The Brent-WTI Spread Could Widen Further, and Here's How You Can Profit

The Brent-WTI spread per barrel has widened from $0.86 in September to almost $17 in November. And according to an analyst poll conducted by Bloomberg, the spread could widen even further. This presents a bullish case for U.S. refiners, including Phillips 66 (NYSE: PSX  ) , Western Refining (NYSE: WNR  ) , and CVR Refining (NYSE: CVRR  ) .

Here's how it affects refiners
The Brent-WTI spread is calculated by subtracting the spot prices of the Brent and WTI crude benchmarks. WTI crude represents oil produced in the U.S., while Brent crude represents international oil. Both the benchmarks are of similar quality, and their prices are determined by their respective supply and demand curves.

U.S. refiners that have access to the relatively inexpensive WTI crude procure and refine it. Then, they sell the refined products at the benchmark prices set by Brent crude. So, these U.S. refiners remain profitable as long as WTI crude trades at a significant discount against Brent. And if the Bloomberg poll suggests that spread will widen even further, then the above-mentioned refiners could see a boost to their profitability.

High growth = high risk?
The best way to lock-in explosive gains over the short term would be by investing in pure-play refiners like Western Refining and CVR Refining. These refiners don't have diversified operations, so their financial performance is entirely dependent on their refining operations.

Moreover, both Western Refining and CVR Refining process only WTI crude. Several refiners intentionally diversify their feedstock to spread their operational risks and reduce their reliance on WTI crude. However, the non-diversified feedstock of Western Refining and CVR Refining ensures that their financial performance is largely correlated to the Brent-WTI spread.

Period

 

Western Refining

CVR Refining

Phillips 66*

Q3FY13

Net Income

Margin/Barrel

$29.5 million

$14.22

$86 million

$11.89

$535 million

$6.14

Q2FY13

Net Income

Margin/Barrel

$126 million

$25.69

$339.2 million

$21.71

$958 million

$9.88

( * Total Income instead of refining income)

This correlation can be seen from the table above. Western Refining and CVR Refining were severely hit – in terms of net income – when the Brent-WTI spread plummeted during September. However, Phillips 66 wasn't as badly affected, due to its diversified business operations. But now that Brent-WTI spread is rising again, Western Refining and CVR Refining should (technically) benefit the most.

While this heavy reliance on WTI crude presents a tremendous upside potential for Western Refining and CVR Refining, it also presents some shortcomings. WTI prices have been volatile over the recent months, and the mentioned refiners are completely exposed to its wild fluctuations. This means that these refiners will be harshly hit, if the Brent-WTI spread narrows again. So, investors should understand the risks involved before investing.

Least affected peer
Phillips 66 is a well-diversified refiner that also owns chemical and midstream assets. And investors shouldn't expect it to perform in-line with pure-play refiners like Western Refining. This is because Phillips 66 generated about 50.2% of its Q2 net profits from refining operations, which significantly reduces its exposure to the refining industry.

Quarterly Earnings: 2013

Segment

Third Quarter

Second Quarter

Midstream

$148 million

$90 million

Chemicals

$262 million

$181 million

Refining

Refining Margin/barrel

$2 million

$6.14

$481 million

$9.88

Marketing and Specialties

$240 million

$332 million

Corporate and Other

($113 million)

($126 million)

Total Net Income

$535 million

$958 million

Diversified operations of Phillips 66 adding stability to its bottom line

Moreover, Phillips 66 processed about 66% advantaged crude during the previous quarter, while the rest was accounted for by Brent crude. According to the company, "advantaged crude oil includes heavy crude oil from Canada and Latin America, lighter Canadian grades, and West Texas Intermediate (WTI)." Its diversified feedstock indicates that Phillips 66 is not heavily reliant on WTI crude, which limits its gains from the widening Brent-WTI spread.

In addition, Phillips 66 plans to gradually switch its feedstock from WTI to Bakken crude – a North Dakotan oil benchmark. In order to do that, the refiner ordered 2,000 railcars earlier this year. However, its CEO recently stated that it might buy more railcars to further increase its Bakken crude shipments.

This move will further reduce its reliance on the WTI crude, and eventually, the financial performance of Phillips 66 will become correlated to the Brent-Bakken spread instead of the Brent-WTI spread. So, even though Phillips 66 could see modest short-term gains from the widening Brent-WTI spreads, investors should be prepared for its declining reliance on WTI crude over the longer run.

Final words
In my opinion, investors looking for quick gains over the shorter term can consider investing in both Western Refining and CVR Refining. Their financial performances are heavily reliant on the Brent-WTI spread. However, risk averse investors should consider investing in Phillips 66, as its diversified operations add stability to its overall business.

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