Last spring, I pointed investors to the long-suffering refining industry's bounce off the bottom. And bounce it did. From moderating losses in the first quarter of 2010, to the return of profitability in Q2 and Q3, independent refiners have rumbled back from the dead, in turn pushing up stalled stock prices by 30%-50%.
Now, that's all well and good, but switching from the rearview mirror to the road ahead, the question is, can the industry maintain cruising speed in coming quarters, or is the course littered with obstacles?
Market fundamentals -- fundamentally sound
Hostage to a handful of sometimes-unrelated forces, strong refining results depend upon more than a simple pop in economic activity or corporate profits. Yet right now, pretty much everything is trending in the right direction.
Below, I've summarized the key factors.
- U.S. gasoline and distillate (diesel and fuel oil) consumption ticked up 0.7% and 3.7%, respectively, in 2010. Continued (but lower) growth is forecast for the next two years.
- Meanwhile, crude oil differentials have widened substantially, as OPEC and Latin America have brought to market greater quantities of heavier, sourer product.
- These two trends have helped bolster crack spreads, which have generally moved higher in 2010 and 2011 in three of the five PADD districts.
- U.S. refining capacity has come down in the past year, which improves supply/demand fundamentals going forward.
- A rebounding export market, headlined by robust demand in Mexico and Brazil and supply issues in Venezuela and France, has helped reduce domestic inventories of finished product, contributing to a favorable backdrop for refining margins. Such global strength could well continue.
- U.S. and global distillate demand has rebounded strongly, and is expected to maintain an upward trajectory (think greater zipping and zooming about of planes, trains, ships, and trucks).
Broadly speaking, refiners' stock prices have benefitted from two additional developments.
The first is company-specific events, of which there've been several. Sunoco (NYSE: SUN), for instance, announced the sale of its Toledo refinery and a strategic shift toward its competitively advantaged logistics and retail business. Western Refining (NYSE: WNR) amended and extended its revolving credit facility, reducing interest payments and expanding its liquidity. Meanwhile, Tesoro (NYSE: TSO) and Frontier Oil (NYSE: FTO) have benefitted from their geographic positioning, with the former enjoying higher-than-average margins and the latter soaking up cheaper heavier-grade crude.
Second, the rising tide of investor enthusiasm that first broke the levies of gloom last August has lifted all boats, dinged hulls of refiners included. Beginning with the whiff of what became QE2, investors have found ample invitation to take on risk, from positive forecasts out of economic bellwethers such as FedEx (NYSE: FDX), to the passing of what's been perceived by some as a pro-growth tax package. Add in recent upward revisions to 2011 U.S. GDP by Ben Bernanke and Goldman Sachs, and it's easy to see that investors could continue to fill up on refiners' shares well into the new year.
Your best bets (assuming you want to bet)
My first pick for risk-seeking investors is Frontier Oil, a company I originally highlighted in early 2009, or some $5 per share ago. As a refresher, geographic niche markets have historically advantaged Frontier, resulting in product pricing premiums and favorable crude differentials. Today, the company is benefitting from its proximity to the well-known Bakken and the emerging Niobrara fields, a factor that brings down crude oil transportation costs and often contributes to better crude differentials.
Also, relative to peers, Frontier sports the lowest overhead and highest net income per barrel of crude capacity. Not a bad mix.
Then there's Valero (NYSE: VLO), a company that I haven't been high on in the past but which my Foolish colleague Chuck Saletta tapped as the best stock for 2011. He could be right. For one, the company has the highest conversion factor in the industry, which is a fancy way of saying that it can process more lower-grade crude as a percentage of total capacity than anybody out there. In fact, almost two-thirds of Valero's inputs are discounted versus benchmark WTI -- well above the 46% figure for Frontier. In times such as the present, when the discount on these feedstocks is widening, that can be a powerful boon to the bottom line.
Finally, Valero's Gulf Coast operations position it to benefit from ongoing export opportunities. If global demand rises, the impact to overall results could be substantial.
Slow down, Speed Racer
Try on this fun fact: Global shipper and logistics company UPS (NYSE: UPS) plans to raise the fuel efficiency of its U.S. automotive fleet by 20%. Good for air quality, bad for refiners. And it's simply one data point in a larger trend.
In fact, overall gasoline demand in the U.S. could plummet by a like amount during the next decade, owing to higher fuel efficiency standards and regulations that will triple the amount of biofuels blended into gasoline. Also, consider that there are only roughly 110,000 natural gas vehicles in the U.S. versus 12 million or so worldwide. If the U.S. ever gets religion on this low-cost fuel, gasoline demand could drop even more.
Furthermore, while facility upgrades and new technologies certainly hold promise in bringing down costs for refiners, such gains could well be offset by tighter environmental regulations.
It all adds up to a bummer of a long-term view on U.S. refining profitability. Sure, some companies may eventually score modest gains by converting existing operations into hubs or biofuels processing facilities, but such changes are likely to be slow and painful. The CEO of refiner Alon USA, for one, thinks the U.S. refinery count needs to come down from 148 to 125.
Ultimately, while 2011 is, at this early stage, poised to be a good year for refiners, it's no place to camp out for the long haul.
And when it comes to stock valuations, what kind of multiple the market decides to hand these volatile names is anybody's guess.
