Time to Rethink Your Investment Strategy for U.S. Oil Refiners

West Texas Intermediate crude has traded above $100 a barrel (largely considered the benchmark for high prices) for more than a week now. Strained crude supplies as well as demand driven by prolonged cold weather have primarily driven the rally.

While oil explorers and producers have warmed up to higher crude prices -- it is an opportunity to earn a higher margin on produced crude -- U.S. refiners have not taken this new development in similar vein. Before, the significant differential between international Brent and domestic WTI allowed U.S. refiners to pay less for feedstock compared with other refiners around the world, presenting an opportunity to enjoy higher margins as well as to price more competitively. However with the recent rally in WTI, the WTI/Brent spread has narrowed, erasing the discount that U.S. refiners previously enjoyed.

Momentary break
On the bright side, U.S. refiners may soon catch a break, albeit momentary. On February 20, the U.S. Department of Energy (DOE) reported its weekly report on crude inventory data for the week ended February 14. Although crude reserves increased modestly, data for gasoline and distillates, which are refined crude products, painted a gloomy picture for overall crude oil prices going forward.

Gasoline inventories increased by 0.31 million barrels, beating analysts' projections of a 0.62 million barrel drop. Distillate inventories slipped by 0.34 million barrels, representing a modest decline in comparison to analysts' expectation of a 2.13 million barrel drop.

Higher than expected inventory levels for refined crude products suggest that domestic demand for crude is waning for the time being. Ideally, lower demand should translate into lower domestic crude prices, momentarily restoring the competitive advantage that U.S. refiners enjoy over their overseas competitors. This outlook is a plausible explanation for the recent awakened interest in structured notes tied to Valero Energy Corporation (NYSE: VLO  ) . Structured notes are hybrid securities created by banks through packaging debt and derivatives in order to adjust the risk/reward profile. Investors have bought $59.6 million of securities tied to Valero in four offerings so far in February, the biggest monthly sales period since January 2010.

Look at the bigger picture
Although the general consensus points toward a return to normalcy in domestic crude prices in the near-term, the long-term picture is not nearly as rosy for U.S. refiners.

Why?

Domestic crude prices will rise in the long term. Currently, crude volumes being produced domestically don't match the infrastructure needed for transportation and storage. One estimate from the U.S. Energy Information Administration indicates that around 35% of Bakken Natural gas production was flared, or burnt at the well, in the past year, underscoring the deficiency in infrastructure.

The shortfall in midstream infrastructure is expected to drive robust growth for the U.S. midstream sector. Moody's expects capital spending in North American midstream infrastructure to increase by 20%-30% in 2014. Deloitte, on the other hand, says that increasing midstream infrastructure needs could require more than $200 billion in additional investment by 2035.

As expected, midstream companies have been compelled to tap into external sources of capital over the years, in the process presenting relatively attractive yields needed to compete more effectively for limited capital. Enterprise Product Partners (NYSE: EPD  ) , for instance, has a yield of 4.30%. The only downside to this approach is that midstream players will have to rake in sufficient profits in the long run -- enough to not only offset high payouts to providers of capital, but also fuel reasonable growth. Naturally, this need for higher-than-usual profits will be factored into the price of crude oil, leading to progressive upward shifts in domestic prices.

Final thoughts
A higher domestic crude price regime is definitely in the cards, though in the long term. Worse still, domestic crude prices could rise against the backdrop of a decline in Brent prices. China, a major market for crude, is witnessing slowed economic growth, recently posting 7.7% growth in 2013 compared with double-digit growth several years ago. This slowdown in economic growth is expected to have a downward effect on demand for crude oil going forward, suppressing global prices. Similarly, OPEC may also seek higher production output going forward in order to compete with rising production in the U.S. This will create a supply gut, suppressing Brent prices.

Essentially, a scenario where WTI converges with Brent is not entirely off the mark. If the WTI/Brent spread becomes negligible, U.S. refiners will lose their competitive edge relative to their global peers.

Long-term investors need to rethink their strategies and pick refiners that have unique business models that can prevail even in the absence of the discount that the entire U.S. oil refining sector has long enjoyed on crude inputs.

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