Refiners Gushing Cash, But Will It Last?

The excess of shale gas in the North American market has depressed prices and frustrated investors looking for "easy" returns. Instead of patiently waiting for a saturated market to offload its glut, why not take advantage of it? Unlike energy exploration companies, refiners have taken advantage of low prices and the large spread in international oil benchmarks. The result? A historically low-margin industry is now flush with profits and cash. Can the tremendous rise of refiners continue in 2013?

Looks good from here
It doesn't matter how you look at the numbers or which numbers you look at: It's obvious that refiners are doing quite well. HollyFrontier (HFC) has grown the cash on its balance sheet 30% in the last year and 798% since the end of 2010. The newfound liquidity trickled down to shareholders through nine distributions totaling $2.75 per share in 2012. That equates to a gaudy 6% yield at current prices and nearly 10% from prices just one year ago. Tesoro (ANDV) finally reinstated its dividend after a 10-quarter hiatus. The company's shares soared 83% in 2012, but still enjoy a P/E ratio of just 10. Here's a look at two valuation metrics around the industry:

The numbers are great and valuations are still attractive, but with so many factors contributing to oil prices, margins could quickly change. What should investors really be watching in 2013?

Get cushy with Cushing?
By now, investors have probably heard of Cushing, Okla. -- the country's most important oil storage hub -- where prices for the West Texas Intermediate (WTI) are set. Major pipelines bring crude into Cushing from the country's largest oil fields and push crude out to refineries on the Gulf Coast. Some analysts have questioned whether or not the overcapacity of oil is due to temporary lags in infrastructure. The question is well-deserved, but even new outbound capacity might not help immediately.

Pipeline operators can spend years on a pipeline project only to have it snuffed out by a lack of interest from suppliers or stingy regulatory hurdles, which can vary by state. Luckily, that hasn't stopped Enbridge (ENB 1.09%) and Enterprise Products (EPD 0.21%) from getting the green light on major new pipelines. Seaway Crude, a JV between the two companies, has literally reversed the flow of one major pipeline between Houston and Cushing, which began taking away 150,000 barrels per day (bpd) last summer and will ultimately relieve about 400,000 bpd beginning this week. A larger pipeline due to be completed by Q1 2014 will take an additional 850,000 bpd to the Gulf Coast.

Will it be enough?
The latest crude oil stock numbers from the Energy Information Administration suggest that the oil monster at Cushing cannot be tamed by some measly new pipeline. On Jan. 4, crude oil stocks at Cushing (excluding the strategic petroleum reserve) hit 50 million barrels, despite the new capacity from Seaway.

Assuming no growth in domestic production and no changes in imports, the reversed Seaway pipeline would be able to reduce crude oil stocks to 20 million barrels (historical average) in just 75 days . I hope that sentence illustrates an important flaw.

No one-sided affair
The problem in assuming that new pipelines will destroy the profit engines of refiners is that it doesn't account for growth in production. Consider that between May and October of last year, domestic production of crude oil increased 8.2%, or 1.64%, each month. Production, which averaged 6.4 million bpd in 2012, is expected to increase to 7.9 million bpd in 2014 -- the same year Seaway plans to launch its 850,000 bpd pipeline. In fact, production is expected to increase 900,000 bpd in 2013 alone, making it the largest one-year increase in U.S. history.

Will new pipelines help relieve Cushing's glut? Little by little, yes, although it is plausible that new capacity will simply offset new production. Storing 30 million to 40 million bbl of oil at Cushing may be the new normal, which would keep downward pressure on WTI prices. Investors may want to consider that pipelines will actually help refiners in the short term by allowing them to continue to take advantage of favorable international prices at an even faster pace. If, of course, world benchmarks don't meet up again.

The real threat is abroad
In a recent interview with The New York Times, several chief officers gave their rosy outlooks for the refining industry. Phillips 66 chief economist Anthony Rouse opined, "Exports are where the growth is, since most people expect domestic demand to be flat or declining going forward." His company is attempting to grow export capacity by 40% in 2013. Meanwhile, Valero's chief executive and chairman, William R. Klesse, had this to say about the spread in benchmark prices:

"This is a huge competitive advantage. The (current) change in oil and gas production is the biggest thing in my career, and I've been through the Arab oil embargo, price controls, the Iraq-Iran war, the price break in 1986, and the Iraq and Afghanistan wars."

To me, one-sided concerns about pipeline capacity and hopeful pitches from executives get placed in the noise category. The signal that investors should be tuning to is the difference between the WTI and Brent crude benchmarks. After all, the spread is the driving force behind exports, which lead to increased profits, which lead to happy shareholders. If more pipelines do little to alleviate Cushing's hoard, investors should keep an eye on falling Brent prices abroad.

In 2012, the average spread between Brent (world) and WTI (U.S.) was $17.53 per barrel. The EIA projects that the spot average for a barrel of Brent will decrease $12.40 from 2012 to 2014, while the spot average for a barrel of WTI will decrease by only $3.12 in the same period. Should demand for Brent fall as expected, American refiners will see $9.28 (53%) of their advantage vanish for each barrel of crude they process in the next two years.