Companies in the oil refining business had a tough go of it in 2016, but one company that got hit harder than most others was CVR Refining (NYSE:CVRR). Not surprisingly, CVR Refining's parent company, CVR Energy (NYSE:CVI), also saw its stock plummet in 2016.
Like many other refiners, this past year's stock decline isn't as much a fault of the company itself but rather the environment in which it operates. Perhaps that suggests 2017 will vastly improve the outlook for this independent refiner. Let's take a look at the year that was and whether better times are around the corner.
Revenge of the refining margins
One thing to keep in mind about this past year's stock performance was that refiners were going from one of the best years in recent memory -- 2015 -- to one of the worst -- 2016 -- in terms of refining margins. Typically, the price changes in refined products will lag behind the price change in crude oil, so as oil prices started to rise in January 2016, refined product prices were still on the decline. This led CVR Refining and several other refiners to post absolutely abysmal results in the first two quarters.
If that wasn't enough of an issue, the costs to comply with the U.S. EPA's renewable fuels standards rose significantly last year. Independent refiners such as CVR that don't have ethanol-producing or ethanol-blending facilities are required to buy credits that are generated with each barrel of ethanol. The trouble is that those credits can also be bought by people and institutions that may not consume or have need for those credits. As a result, the market for Renewable Identification Numbers -- those ethanol credits, also known as RINs -- can be susceptible to speculation. This was on full display in 2016, as CVR's costs for RINs were the company's highest operating expense -- more than double its labor costs.
Despite this very challenging market, CVR Refining continued to do well with the things it could control. Its per-barrel operating costs remain some of the lowest in the business, and some new logistics assets are allowing it to source crude oil at a decent discount to benchmark prices. From an operations standpoint, you couldn't really ask for more from a small-fish refiner.
What really upset investors wasn't the operations -- it was the fact that the market was so challenging for the company that it stopped paying a distribution to shareholders. CVR Refining is set up as a variable rate master limited partnership that pays out all available cash at the end of each quarter after meeting debt targets and setting aside maintenance and turnaround capital. Since cash coming in the door was so tight, and management anticipates some major turnaround work in 2017, it elected to conserve cash for a couple of quarters.
This is concerning for CVR Energy because its dividend is deeply dependent on CVR Refining's ability to throw off cash to shareholders. CVR Energy owns 66% of all shares outstanding in CVR Refining, and its other investment -- nitrogen fertilizer producer CVR Partners (NYSE:UAN) -- produces a much smaller portion of cash. It's also worth noting that CVR Partners is in its own funk because of low fertilizer prices. So when CVR Refining suspended its payout, CVR Energy was forced to pay out its own dividend from cash on hand. As you can imagine, Wall Street has not been a fan of these things happening.
Ready to rocket in 2017?
As much as investors hope that this coming year will be better than the prior one, much of it will come down to market conditions for CVR Refining. If we continue to see weak margins for refining and elevated RIN costs, then we may not see another cash distribution from CVR Refining. It's also worth noting that the company expects to perform some large turnaround activity on one of its refineries this year, which will seriously crimp its already tepid cash generation. That is a double issue for CVR Energy because it can only pay a dividend for so long without cash coming in the door from its subsidiaries.
One idea that Wall Street seems to be enamored with lately is that CVR Energy's largest shareholder -- Carl Icahn -- has been nominated to a special position in the Trump administration to act as an advisor on business regulation. For years, Icahn has railed on the Renewable Fuel Standard. If he were to get his way in this special advisory role, these regulations would get scaled back significantly or even repealed.
The chances of that happening in 2017 seem pretty slim, though. Anyone considering these two stocks would probably be better off ignoring this for at least this year. Also, this is a hypothetical situation that may or may not happen. So for conservative investors, it's probably better to not even consider this when making an investment.
That being said, CVR Refining has proven over time that it is a good operator of its facilities and does have some competitive advantages, despite the challenge of being an independent refiner with significant RIN exposure risk. Likewise, CVR Energy is intrinsically tied to the success of CVR Refining. With shares of CVR Refining trading at 1.3 times tangible book value and CVR Energy trading at 2.3 times tangible book, both are at decent discounts to their five-year trading averages. Refining margins always wax and wane with time; like any other commodity, it's just a matter of when. It may not happen this year, but an investment today in a low-margin environment might pay off rather well when the market for refined petroleum products improves.