Refining is a tough business. Environmental regulations and high capital costs have resulted in no new refineries being built in the US since 1976.
It's also a highly cyclical business, with margins often tied to not only the price of oil, but the differences, or spread, between two different oil benchmarks. One such benchmark is the WTI/Brent spread. WTI, or West Texas Intermediate, is how most of America's 11 million barrels/day (bpd) of production is priced. Brent is the global standard and the basis for the cost of refined oil products.
One way to think about the WTI/Brent spread is this: Refiners buy at the lower WTI price and sell products at the higher Brent based price, resulting in higher margins.
From 2011 through 2013 a glut of oil in Cushing, Oklahoma, where WTI is priced, resulted in record high spreads and refiner margins.
Two factors have now all but eliminated the WTI/Brent spread, and this represents a problem for refiners such as Valero Energy (NYSE: VLO ) , Calumet Specialty Products Partners (NASDAQ: CLMT ) , and Phillips 66 (NYSE: PSX ) .
First, new pipelines to Cushing, Oklahoma have eliminated the oil glut and caused WTI prices to rise.
The Energy Information Administration estimated that this infrastructure build out would result in the WTI/Brent spread averaging $9/barrel to $11/barrel through 2015.
However, recently the commerce department has begun issuing export licences for companies to start exporting a form of minimally refined, ultra-light crude called condensate.
The prolific Eagle Ford shale produces 27% condensates, and some analysts believe exports could reach 1.7 million bpd/day by 2018.
Thus condensate exports could result in a permanent reduction in the WTI/Brent spread to levels far below what refiners have come to expect. Does that mean that investors in Valero Energy, Calumet Specialty Products Partners, and Phillips 66 should head for the hills? The answer is no, and the reasons why are diversification and specialization.
Specialization saves the day
|MLP||Yield||10 Year Projected Annual Earnings Growth||10 Year Projected Dividend/Distribution Growth||10 Year Projected Annual Total Returns|
|Calumet Specialty Products Partners||8.80%||18.30%||12.17%||23.10%|
Valero Energy is the largest independent refiner in the country, and its refineries are heavily concentrated on the Gulf Coast. In the short term Valero's oil prices are likely to be kept low due to regional oversupply, sparing Valero the worst of margin compression. Past 2016, Valero's CEO Bill Klesse expects pipelines such as the Keystone XL to deliver Canadian crude to the Gulf Coast, resulting in cheaper feedstocks and a maintenance of margins.
Wall Street likely overreacted to the change in oil export rules (Valero Energy dropped 8.3% the day of the announcement), and Valero now trades at attractive valuations that make it a solid dividend growth stock.
Meanwhile, Calumet Specialty Products Partners and Phillips 66 are diversifying away from their dependency on refined commodity goods.
Calumet Specialty Product Partners operates 14 refineries with 160,000 bpd capacity. A third of sales come from 6,000 specialty petroleum products such as industrial lubricants and waxes, yet this makes up 79% of gross profits.
I believe Calumet Specialty Product Partners to be the best refiner in America for three key reasons: its growth prospects, diverse product line, and history of distribution growth.
Credit Suisse estimates that Calumet can double EBITDA (earnings before interest, taxes, depreciation, and amortization) based on several large projects currently under construction, including a joint venture building the first new US refinery in 38 years, in North Dakota's Bakken formation.
Calumet's growth plan is based on a long track record of successful accretive acquisitions, and cost-effective organic growth. Most recently Calumet Specialty Products Partners announced a $25 million joint venture to build a 1,600 bpd gas-to-liquids plants (to make specialty petroleum products) in Lake Charles, Louisiana.
Calumet also just secured a $150 million increase in its credit revolver and at a lower interest rate.
With its liquidity at $714 million at the end of Q1, Calumet has plenty of capital to grow its business and secure and grow its distribution. Credit Suisse predicts the distribution coverage ratio reaching 1.34 by the end of 2014 and 1.6 by the end of 2015.
Phillips 66 is my second favorite refiner because of two major diversification growth efforts. First, it is investing $6 billion between 2013 and 2016 into its midstream operations -- which consist of a 50% general partner stake in DCM Midstream and 100% general partner stake in Phillips 66 Partners.
Phillips 66 is also investing $3 billion through 2016 into liquefied petroleum gas exports, whose production is expected to increase by 79% through 2020.
Phillips 66 estimates that its Sweeny fractionator and Freeport LPG export terminal will generate $210 million in profits (5.6% 2013 earnings) its first year.
Though the collapse of the WTI/Brent spread and condensate exports certainly aren't good for refiners' long-term margins, these factors won't doom them either. Valero Energy, Calumet Specialty Products Partners, and Phillips 66 remain excellent long-term income investments due to their diversification and specialization efforts. These will preserve or even raise margins and allow for market-beating total returns over the next decade.
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