Have You Prepared Your Portfolio for a Narrowing Brent-WTI Spread?

The Brent-WTI spread has widened from $0.86 per barrel in September to a current $13.59 per barrel. This widening has expanded the profit margins of several U.S refiners, which process the WTI crude, and sell its refined products at benchmark prices set by the Brent crude.

Heading into 2014, however, Commerzbank estimates that rising crude production from North Africa and the Middle East could cause the Brent-WTI spread to narrow to around $6 per barrel. These estimates suggest that refining margins could shrink over the coming months, and thus risk-averse investors might want to stay away from pure-play refiners like Western Refining (WNR) and CVR Refining (CVRR).

Risks involved with pure-play refiners
Several U.S refiners diversify their feedstock by processing different crude benchmarks. This way, their financial performance doesn't become heavily correlated with the historically volatile Brent-WTI spread. However, Western Refining and CVR Refining process just WTI crude, which is why their profitability varies with the fluctuating Brent-WTI spread.

(All figures, except for refining margin/barrel, are in millions – Phillips 66 total net income shown as opposed to its refining net income)

As illustrated in the table above, Western Refining and CVR Refining have shown exceptional bottom-line growth when the Brent-WTI spread widened. Conversely, both the refiners recorded a deep plunge in their net income when the spread narrowed. This correlation suggests that the profitability of Western Refining and CVR Refining will take a hit assuming the Brent-WTI spread narrows to $6 per barrel.

Their lack of diversification makes matters worse. Western Refining and CVR Refining are involved in only refining operations, so they don't have other business segments to add stability to the bottom line. In addition, both companies operate with just two refineries each, and unforeseen downtime at even one of these refineries could spell trouble.

Keeping these factors in mind, Western Refining and CVR Refining appear to be quite risky investment options. Their lack of diversification works against them whenever the Brent-WTI spread narrows, which is why downstream-focused investors might want to consider investing in Phillips 66 (PSX 0.91%).

Benefits of diversified growth 
Unlike Western Refining and CVR Refining, Phillips 66 is a well-diversified company. The company owns midstream and downstream assets, and is also engaged in the production of industrial grade chemicals. Altogether, these business segments add stability and result in more balanced growth.

(All figures except for refining margin/barrel are in millions.)

The above table illustrates the benefits of its business diversification. When the Brent-WTI spread narrowed last September, Phillips 66 wasn't hit as hard as its peers.

In addition to business diversification, Phillips 66 has also diversified its refining feedstock. The company processed 66% advantaged crude in the previous quarter, which includes WTI, Bakken, and other Canadian crude benchmarks. This refining mix ensures that Phillips 66 isn't heavily reliant on the Brent-WTI spread, and the company enjoys modest but stable refining margins.

To further boost its refining margins, Phillips 66 is planning to increase its Bakken crude input – which was about $10 cheaper than WTI crude between August and October. The refiner is developing an offloading facility at its Bayway refinery, which will allow its refinery to directly receive up to 70,000 barrels of Bakken crude per day, respectively. The offloading facility is expected to commence operations in the second half of 2014, presenting a medium-term bullish case for Phillips 66.

Final words
Since the financial performance of Western Union and CVR Refining is heavily correlated to the Brent-WTI spread, risk-averse investors might want to avoid investing their funds in them. On the other hand, Phillips 66 offers diversified growth prospects, which can deliver balanced growth over the long-term.