The U.S. government's decision to allow the export of condensates sent shares of some refiners down nearly 10% last Wednesday. Condensates are ultra-light oil with an API gravity over 45 and account for as much as 12% of daily crude production. This type of light oil is most prevalent in Texas production, especially the Eagle Ford area, and in shale production up the East Coast.
While the decision changes the refinery picture at the margins and opens the door to lift the export ban on unrefined oil, the drop in refinery shares has created an opportunity in two companies. The export approval will affect some refiners in a limited capacity, but even that will likely not be for almost a year.
Several factors point to limited effects and a potential upside
First, the export of condensates actually delays a refinery bottleneck in light crude. The revolution in U.S. oil production has caused an oversupply condition, especially in the Southern and Gulf regions. Refiners have only recently started building out their capacity to refine light crude and we are potentially facing a bottleneck where oversupply would cause production to slow. Condensate passes through a stabilization process at the field so effectively the approval means that the product could bypass the refinery. Exporting the condensate while keeping overall production growth stable could mean a steady flow of higher-margin oil to the refineries.
The export of condensates is also not as large a step as you might think. Condensate products run through a splitter were already approved to be exported. The boom in energy production has sent inventories to a record high of 399.4 million barrels in April and production is the highest since 1986. The American Petroleum Institute reports that U.S. refineries set an all-time record last month in gasoline production at an average capacity utilization of nearly 90%. Even if producers are able to export almost all of their condensate production, I doubt that refineries will miss it.
Several midstream companies, including Kinder Morgan Energy Partners (NYSE: KMP ) and Magellan Midstream Partners (NYSE: MMP ) already had plans to build out new splitters. These new projects already had long-term contracts in place, up to ten years, so the export approval will likely not affect revenues. Projects for new splitters at other companies might be delayed or canceled on the news.
Lastly, it will take time for infrastructure to be built to export the condensate and The Wall Street Journal doesn't expect exports to begin until August at the earliest. Earnings for refiners were already coming under pressure due to the spike in WTI prices, especially against the price of overseas Brent crude. The fear over the export ruling is that higher exports of products will increase demand for domestic crude and push WTI prices higher.
Though I do not see the condensate approval as affecting the market as much as some fear, the refineries on the East Coast and Gulf Coast would have the most to lose. Shares of Valero Energy Corporation (NYSE: VLO ) underperformed the group with an 8.4% slide before rebounding more than 2% on the following day.
HollyFrontier Corporation (NYSE: HFC ) operates several refineries mid-continent and in the southwest, along with asphalt operations in Arizona and New Mexico. Its 443,000 barrels per day of crude processing capacity should be relatively safe from the effect of the export announcement yet the shares still lost 6% on the approval. Shares trade for 0.45 times revenue and pay a 2.6% dividend yield. The valuation is slightly above the 0.30 multiple for the industry, but the company's operating margin of 6.2% is well above the industry average.
Alon USA Energy (NYSE: ALJ ) also conducts most its refinery operations outside the danger-zone for condensate exports. Refineries in California and Texas should be relatively safe though the company's 83,100 bpd of capacity (34% of total capacity) at its Louisiana plant could come under pressure. Alon also operates asphalt products and owns 298 convenience store retail locations in Texas and New Mexico. The diversified operations should help to moderate any risk to higher condensate exports and higher WTI prices. Shares dropped 6.2% on the export approval and now trade for 0.19 times revenue with a 1.6% dividend yield. The company's operating margin of 2.1% is slightly below the industry average, but shares are closely held by insiders and institutional owners. I think this could support the price over a rough 2014 until WTI prices come down and revenue picks up again.
Ultimately, ever higher domestic production should bring down the price of WTI crude and support prices for refiners. Insurgent attacks in Iraq have driven up both WTI and Brent lately but have not affected supply out of the country, a good sign for future prices. A full reversal of the crude export ban could send prices spiking and is just not on the political calendar. Condensates were approved because Washington knows that it will likely have little effect on prices but would allow them to quiet those calling for more exports. Take advantage of the fear in the refinery space to add strong names to your portfolio.
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