Refineries take raw crude oil and refine it into usable fuels and other refined petroleum products. That puts refining companies in the last link of the oil industry's three-part value chain that works together to transform raw production into usable end products:
- The upstream oil and gas segment produces hydrocarbons -- oil, natural gas, and natural gas liquids (NGLs) -- by drilling wells into underground reservoirs.
- The midstream segment then transports, stores, and processes these hydrocarbons.
- Finally, oil and gas flow into downstream facilities such as refineries and petrochemical plants, which transform them into usable products such as fuels and plastics.
Because refiners consume oil in their plants, refining companies tend to benefit when oil prices fall. That often makes a refining stock an excellent complimentary holding for investors who also have shares of an upstream oil producer in their portfolios. This investment pairing will help mute some of the effects of oil price volatility. It's one of the many factors that make refining stocks appealing to investors.
How is oil refined?
Oil refiners play an essential role in the oil industry. These industrial complexes process raw crude oil into a variety of higher-value refined petroleum products. These products include liquid fuels (gasoline, diesel, kerosene, jet fuel, heating oil, and fuel oil) and other products (asphalt, tar, paraffin wax, and lubricating oil).
Oil refineries process crude into these various products using a three-step process:
- The separation process pipes crude oil through hot furnaces that discharge the liquids and vapors into distillation units. The oil then separates into fractions according to their boiling points.
- The conversion process, also known as cracking, uses heat, pressure, and a catalyst to crack heavy hydrocarbon molecules into lighter ones.
- In the treatment process, a refinery will combine different hydrocarbon streams to create a finished refined product (i.e., gasoline, diesel, etc.). Those refined products then go into storage until they're transported to end users like gas stations.
Key refining industry terms
Investors who are new to the refining industry need to familiarize themselves with three key terms used in the sector:
- The crack spread is an oil industry term that refers to the difference in price between where a refinery buys raw crude oil and sells the petroleum products it makes from this oil. The spread is the profit margin made from "cracking" unrefined oil into higher-valued refined products.
- The Nelson Complexity Index (NCI) rates refineries on their ability to produce lighter, more refined and valuable products such as jet fuel and low-sulfur diesel. The scale goes from 1 to 20, with a higher number implying a more complex refinery. While high-NCI refineries cost more to build, operate, and maintain, they produce greater volumes of higher-valued refined products.
- The utilization rate is the percentage of a refinery's capacity that it used in a particular period. For example, if a refinery has 500,000 barrels per day (BPD) of throughput capacity but only processed an average of 450,000 barrels for the year, its utilization rate was 90%. The higher the utilization rate, the more efficient a refinery was during the period. Higher utilization enables a refinery to produce a larger quantity of refined products. That allows it both to make more money on the additional volumes and to spread its costs out over more barrels.
How oil refiners make money
Oil refineries typically buy raw crude oil from producers and have it shipped to their facilities via pipeline, truck, or rail. They process this oil into the following refined products:
- Jet fuel
Each 42-gallon barrel of crude oil typically produces about 45 gallons of petroleum products because of refinery processing gains. The largest finished product is gasoline, at 19 gallons from each barrel of oil. Refiners then sell these refined products to end users, including at their own branded gas stations.
Refineries make money by way of the crack spread; as noted earlier, it's the difference between how much they pay to buy raw crude oil and how much they make when selling the finished refined petroleum products. This spread fluctuates with the price of oil and with demand for refined products.
When oil prices are high, the crack spread tends to shrink until market prices for refined products increase to reflect the rise in crude prices. Meanwhile, if refined product consumption is low, refining margins tend to contract, which means refiners make less money. Oil refineries, on the other hand, can make a lot of money when the demand for refined products is high while oil prices are low. That market environment causes the spread between where they buy oil and sell the associated refined petroleum products to widen considerably.
Types of refining companies
Oil refining operations fall into two categories: Either they're integrated into large oil companies or they operate independently.
Many large oil companies own oil refineries so that they can process a portion of their production into higher-valued refined products. These entities, known as integrated oil companies, operate refineries for two reasons. First, it enables them to maximize their per-barrel earnings. They can make money not only on producing oil but also on the crack spread as they refine their crude into higher-valued petroleum products. The other benefit of this integration is that oil refining acts as a natural hedge against falling oil prices, since their refineries benefit from lower oil prices. That helps reduce their earnings volatility.
Independent oil refiners, meanwhile, focus mainly on operating refineries. Some independent refining companies will only operate refining complexes. Others, meanwhile, have some vertical integration but don't go all the way upstream. For example, many will own midstream assets like oil and refined products pipelines, as well as other downstream assets such as petrochemical plants, ethanol production facilities, lubricant manufacturing plants, and retail gas stations.
Integrated oil companies typically make most of their money producing oil, using their refining assets to maximize their per-barrel profit as well as to help mute some of the volatility of oil prices. Independent refining companies, on the other hand, tend to make the bulk of their profits by refining oil into higher-valued petroleum products. Given that difference, investors who are interested in making money from the refining industry should focus on independent refining companies.
One other thing that sets the refining industry apart from the upstream oil and gas production sector is that it's less capital intensive, which means that refiners don't need to invest as much money to maintain their operations. Many large independent refiners, for example, aim to reinvest 40% to 60% of their cash flow in capital projects, with only about 40% of that spending typically on maintenance activities and the rest on growth-focused initiatives. That enables them to return 40% to 60% of their free cash flow to investors via dividends and share repurchases. Oil companies, on the other hand, need to reinvest a larger portion of their cash flow into sustaining their production by drilling new wells, especially when oil prices are lower. That leaves them with less money not only for drilling new wells that grow production but also for shareholder-friendly activities like dividends and buybacks.
The top refining stocks
Many of the largest refining operations are buried deep inside integrated oil companies. However, several independent refining companies trade on public stock markets, which gives investors seeking direct exposure to the sector a few options. The five largest ones are on the following chart:
Top Five Refining Stocks
Marathon Petroleum (NYSE:MPC)
The largest U.S. refiner, with significant midstream and retail operations.
Valero Energy (NYSE:VLO)
The world's largest independent refiner and one of the top ethanol producers in the U.S.
Phillips 66 (NYSE:PSX)
A diversified downstream and midstream company.
PBF Energy (NYSE:PBF)
One of the largest independent refiners and suppliers of unbranded refined petroleum products.
A refining company and manufacturer of specialized lubricants.
Here's a closer look at these top refining stocks.
Marathon Petroleum: America's largest independent refining company
Marathon Petroleum used to be part of an integrated oil company. However, it gained its independence in 2011 when oil producer Marathon Oil spun it off as a separate entity. Marathon would go on to become the largest independent refiner in the U.S. by acquiring Andeavor in 2018. That transaction increased Marathon's refining system to 16 complexes, which had the capacity to refine 3 million barrels of oil per day as of the middle of 2019.
The company operates a coast-to-coast system, which provides it with several competitive advantages. Its nationwide footprint connects Marathon to not only all the country's key supply sources but each of its major demand hubs. Meanwhile, its integrated system enables the company to benefit from dislocations in the energy market. For example, it can process cheaper heavy Canadian oil as well as sell refined products in high-value markets like California.
Marathon not only operates a large-scale refining business but controls a large midstream master limited partnership (MLP), MPLX, and a significant marketing and retail arm that consists of the Marathon, Speedway, and ARCO brands. Marathon's investment in MPLX provides several advantages, including increasing its access to cheaper oil supplies by participating in new long-haul pipeline projects. Meanwhile, its marketing and retail operations enable Marathon to make even more money on the barrels it refines.
Marathon's large scale and diversification allow it to make more money refining oil than most peers. That gives it the funds to continue expanding its operations as well as to send cash to shareholders via a steadily growing dividend and meaningful share repurchase program.
Valero Energy: The top independent refining company in the world
While Marathon Petroleum is the largest independent refiner in the U.S., Valero Energy is the top one globally. As of the middle of 2019, the company operated 15 facilities in the U.S., Canada, and the U.K. that could process 3.1 million barrels of crude oil per day.
Valero has a strong refining presence along the U.S. Gulf Coast as well as in the mid-continent region. Those locations provide the company with two notable advantages. First, a significant portion of America's oil flows through those regions, coming either down from Canada and the Rockies or over from the Permian Basin of Texas. That keeps the company's facilities well supplied with low-cost North American crude. In addition to that, the company also benefits from its proximity to export terminals along the Gulf Coast, where it can ship its refined products to higher-priced global markets.
Valero also operates a large-scale ethanol business, which provides its refineries with low-cost supplies to blend into its gasoline. On top of that, the company operates a branded fuel marketing and retail business and midstream assets like pipelines and storage facilities. The retail operations help boost Valero's earnings per barrel, while the logistics assets improve its access to lower-cost oil as well as enhance its ability to transport refined products to higher-valued markets.
Valero's large-scale operations in key refining markets enable it to make more money per barrel than competitors in less attractive markets. That allows the company to generate significant free cash flow. It can use these funds to expand its operations as well as to reward shareholders through higher dividends and share repurchases.
Phillips 66: A diversified downstream company
Phillips 66 was also once part of an integrated oil company. However, U.S. oil giant ConocoPhillips spun off its downstream and midstream assets into Phillips 66 in 2012. That freed the independent company up to focus on making investments to expand those businesses.
Phillips 66 operated 13 refineries in the U.S. and Europe that had the capacity to process 2.2 million barrels of crude in mid-2019. Its U.S. refining operations go from coast to coast, though the majority of its capacity is in the Gulf Coast and Central Corridor.
Phillips 66's refineries stand out for two reasons. First, the company produces the highest percentage of higher-value distillates (i.e., diesel and jet fuel) among independent refiners. Second, thanks to its investments in both pipelines and refineries, the company processes more barrels of low-cost heavy Canadian oil than its peers. Those two factors help boost Phillips 66's refining margin.
The company, like most of its independent peers, owns midstream assets, including stakes in two MLPs (Phillips 66 Partners and DCP Midstream), as well as marketing and retail operations. However, what sets Phillips 66 apart from its independent refining peers is that it also has interests in the petrochemical industry. The company is a 50-50 joint venture partner with oil giant Chevron in CPChem, which is a leading petrochemicals producer. CPChem operates chemicals facilities along the U.S. Gulf Coast as well as in the Middle East. Not only does this business help diversify Phillip 66's revenue, but it provides the company with unique growth opportunities. Thanks to the U.S. shale boom, most of CPChem's expansions have been along the U.S. Gulf Coast.
Phillips 66's diversified downstream and midstream operations help reduce the volatility of the company's earnings and cash flow. That gives it a steadier stream of funds to invest in expansion projects as well as to return cash to shareholders through its dividend and stock buyback program.
PBF Energy: Focused on complex refining
PBF Energy operates several refineries across the U.S., though the bulk of its capacity is on the East and West Coasts. What sets it apart from its independent refining peers is a focus on operating the most sophisticated refineries as measured by the Nelson Complexity Index (NCI). As of the middle of 2019, PBF Energy had a peer-leading NCI of 12.8. For comparison's sake, its U.S. independent competitors had NCIs between 12.1 and 9.5 at that time.
PBF Energy's focus on the coasts as well as on operating the most complex refineries provides it with two notable advantages. First, its refineries are near the country's two largest population centers (New York and Los Angeles), which makes it a key supplier to these high-demand regions. Second, the company can turn each barrel of oil it refines into a larger volume of higher-valued refined products than its peers, which enables it to make more money.
Aside from its refineries, PBF Energy also operates logistics assets such as pipelines and storage terminals, which it owns mainly through its MLP, PBF Logistics. Most of the company's midstream infrastructure supports its refineries. That focus differentiates it from its independent refining peers, which have diversified their midstream investments to include things like long-haul oil and gas pipelines, natural gas infrastructure, and export terminals.
Another thing that makes PBF Energy a bit different from its large independent refining peers is that the company doesn't operate any branded retail stations. As such, it is the closest pure refining company among the largest independents.
PBF Energy stands apart for its focus. While the company has a coast-to-coast portfolio of oil refineries, it has concentrated on operating the most complex facilities near the country's two largest population centers. That focus enables the company to turn the oil it refines into greater volumes of higher-valued petroleum products that it sells into these two premium markets. However, its lack of diversification leaves it more exposed to the volatility of the refining market. If the crack spread shrinks, its profits will follow.
HollyFrontier: Concentrated in the middle
HollyFrontier operates several refining complexes in the Mid-Continent and Rockies regions. Like PBF Energy, HollyFrontier focuses on high-complexity refineries. As of mid-2019, the company's portfolio had an NCI of 12.1, which was second only to PBF Energy's.
One benefit of operating in the Mid-Continent and Rockies regions is their proximity to low-cost North American oil supplies. The company's Rockies refineries benefit from processing the cheaper oil that comes out of Western Canada, the Bakken Shale, and the Powder River Basin. Meanwhile, its Mid-Continent facilities receive crude from the STACK/SCOOP region and the Permian Basin. Add this to HollyFrontier's greater complexity, and the company can make lots of money as it refines low-cost crude into higher-valued refined products.
HollyFrontier also owns logistics assets, primarily through its MLP Holly Energy Partners, which mainly supports its refineries. This infrastructure helps supply its refineries with low-cost local oil while also transporting its refined products to key markets, such as Las Vegas and El Paso.
The company, like PBF Energy, doesn't own any branded retail outlets. However, HollyFrontier does operate a specialty lubricants business. These operations enable the company to make high-value branded lubricants and other specialty products, which it sells in more than 80 countries.
HollyFrontier, like PBF Energy, stands out for its focus. In this company's case, it operates a handful of highly complex refineries near low-cost oil supplies. That enables the company to earn high margins on each barrel. However, like PBF Energy, HollyFrontier's lack of diversification can hurt its profitability when refining margins are under pressure.
Refining stocks can help balance your portfolio
Oil refineries take raw crude oil and transform it into higher-value products, making money on the difference between the prices at which they buy oil and sell refined products. This process enables these companies to generate lots of cash, the bulk of which they use to either grow their operations or reward shareholders through dividends and buybacks.
These characteristics make refining stocks appealing options for investors. That's because they offer exposure to the oil market without the extreme downside that can come from lower oil prices, since refiners tend to benefit when crude declines. This factor should make refining stocks particularly appealing to investors who own shares of an oil-producing company. They might want to consider pairing that investment with a refining stock, since it should help mute some of the impacts of oil price volatility.
Aside from that, refining companies tend to be excellent dividend stocks. Not only do they tend to pay above-average dividends, but they also increase their payouts each year. That combination makes refining stocks ideal options for income-seeking investors to consider.