Are Refining Stocks Headed for Tough Times?

Are tough times ahead for refiners? Recent share price advances for industry participants like Tesoro Corporation (NYSE: TSO  ) , Valero Energy (NYSE: VLO  ) , and Marathon Petroleum (NYSE: MPC  ) seems to suggest things are just fine. Investors may want to be cautious, however. There is evidence that refiners could find profits harder to come by over the longer-term.

A troubling indicator
Refiners could be facing a major earnings headwind. So says a typically good indicator of refining profitability: the spread, or difference, in price between two major oil classes.

Brent crude (Brent), an international benchmark oil and proxy for refined product pricing, usually trades at a higher price than West Texas Intermediate (WTI), an input cost surrogate that is typically produced in North America. The bigger the WTI discount to Brent, often the more profitable domestic refiners will be. 

Recent WTI discounts have narrowed noticeably, with the spread being around $6 per barrel in mid-April, down from $7 per barrel in March and well below the $14 a barrel difference six months ago. The closing disparity between Brent and WTI doesn't augur well for refiners. It should curb sector profitability at some point.

A refiner at risk
While all oil refiners are exposed to shrinking spreads, Tesoro Corporation might be most at risk. Already hurting from a narrowing differential, refining income fell over 60% year over year in the latest quarter. The company could see even lower profits as the WTI discount is further narrowed.

In the most recent quarter, ended December 31, Tesoro saw its refining gross profit drop a steep 37% from the prior year. Hurt by a decline in North American crude oil discounts to around $9 per barrel, a nearly 36% plunge from the price spread achieved in 2012. A further deterioration in the differential would be troubling since over 80% of company profits come from refining.

Tesoro does have a substantial retail business, generating 11% of income from over 2,200 fuel station locations, but significant profit growth from the division is not expected. Sluggish demand and weak profit margins resulted in stagnant earnings last year and make future gains offsetting potential refining shortfalls unlikely.

An ethanol backstop
Valero Energy Corporation looks less at risk from a narrowing WTI discount, at least in the short term. The company reported a relatively strong performance last quarter with operating income equal to the prior year. However refining earnings did fall about 14% as a sharp drop in the Brent-WTI spread overwhelmed an over 5% increase in refining volumes.

Fortunately, the slump in refining  was made up by the company's ethanol business. Valero, a major producer, operates 10 ethanol production plants with 1.2 billion gallons of total annual capacity. The division delivered $269 million in operating income last quarter, up from only $12 million provided a year earlier. The increase was driven by lower input cost and steady product demand.

Ethanol profits may help support Valero for awhile. Severe winter weather created ethanol shortages in many high-demand areas, which forced a spike in pricing over the last few months. The U.S. Energy Information Administration reported that East Coast ethanol stocks were at their lowest level on record in March, down around 28% from a year ago, which caused New York Harbor spot ethanol prices to shoot up over 60%, according to financial reporting by Bloomberg.

While Valero should benefit from record high ethanol pricing in the near-term, it is not clear how long the bonanza may last. Supplies have already started to rebound. Early April production helped inventory levels grow 1.4%. Dropping the year-over year ethanol supply deficit to 9.2%, a gap that will likely be closed if production remains robust.

Given ethanol support, Valero may not see seriously deteriorating results over the next quarter or two. But the refiner may face a double whammy longer term. If shrinking benchmark crude differentials do crimp refining margins at the same time ethanol profitability normalizes, future year-over-year earnings comparisons could prove very disappointing.

Counting on diversification
A diversified business model may help Marathon Petroleum Company better endure damaging shrinking benchmark oil price spreads. Besides being a major U.S. refiner, Marathon operates the nation's fourth-largest convenience store chain, Speedway LLC, and owns or operates approximately 8,300 miles of pipeline.

Though diversification does provide some protection, Marathon is not immune to refiner troubles. Companywide operating income declined about 15% year-over-year in the last quarter -- almost solely due to a refining profit drop of $169 million, as narrowing crude differentials overshadowed some pricing strength and better sales volumes.

Given the trend toward reduced benchmark oil spreads, it's not surprising the company is looking to grow beyond refining. Marathon invested in some major North American pipeline projects and Speedway's retail footprint expansion last year. While these more stable sources of income should help buffer possible further declines in refining profitability, it is not clear how adequate the shelter will utlimately be.

Bottom line
While refiners will likely benefit from the recent harsh winter near-term, a waning WTI price discount to Brent crude suggests the longer term for companies like Tesoro, Valero Energy, and Marathon Petroleum might not be as rewarding. Though refiner shares appear carefree at the moment, investors may want to temper their enthusiasm for the sector. If the Brent-WTI price spread is as indicative as it's been in the past, refiners could be headed for some difficult times.

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