Oil refiners are going through a dark phase, one that has not only taken a toll on their profit margins, but that threatens to extend this harrowing narrative for the foreseeable future -- a high crude oil price environment.
A typical day in an oil refinery would entail buying feedstock -- crude oil used as input -- and processing the said feedstock into a finished product such as diesel for sale. Ideally, any business would want to keep its cost of raw materials and production low in order to rake in sizable profits after selling the finished products. However for oil refiners, this ideal is increasingly becoming elusive. Painfully high crude prices have put great pressure on refiners' margins.
A good case in point is BP plc (NYSE:BP). Poor earnings in 2013 were largely driven by the ailing downstream segment. In the fourth quarter, profits in BP's downstream unit slipped from $1.4 billion in the year-ago period to just $70 million, plausibly explaining the 22% slip in the oil major's full year profits, which came in at $13.4 billion. Royal Dutch Shell plc (NYSE:RDS.A) also serves up another good example. In part because of weakness in its refining segment, the oil major has been compelled to initiate a spate of asset sales that will, at completion, bring in around $30 billion needed to restore balance in the overall business.
Oil refiners with heavier exposure in the U.S. have also suffered, but not as much as their foreign counterparts. West Texas Intermediate (WTI), which determines U.S. domestic crude prices, has continually been lower than Brent, which determines international crude prices. Naturally, this discount has translated into a competitive advantage for U.S. refiners. However, this competitive advantage is coming to an end as witnessed by recent gains in WTI. Apart from the cold weather that increased demand for domestic crude, the WTI/ Brent spread is narrowing because of a number of strong factors, including the fact that the potential revision of the 40-year energy policy that bans crude exports has become a debatable topic, as well as the fact that oil producers, who need high crude prices to offset high production costs, deliver a profit and reward shareholders, are pushing hard for even higher prices.
Essentially, the crumbling of oil refiners is a matter of when and not if. Just to be clear, this is not a blanket statement. There are some refiners like Valero that have unique businesses that can survive even in the absence of the advantage of a high WTI/Brent spread.
Gap in market will be filled by solar energy
As higher prices eliminate refiners whose businesses survived solely on low prices -- and there are such companies -- a gap will automatically be created in the market for refined crude products. However, this time around, don't expect the gap to be filled by imported products. Instead, expect a higher uptake of solar energy.
This is for two reasons.
First, solar uptake has increased in the U.S. on lower costs of installation. According to the Solar Energy Industries Association, U.S. solar capacity jumped 35% in the third quarter of 2013. This was in part driven by the fact the cost of installed solar equipment has dropped more than 50% since the beginning of 2010, according to the Solar Foundation.
Second, and perhaps more weighty, is the fact that environmentalists have a significantly strong lobbying position in Washington. This has come out repeatedly in the past, with a more recent case being the warning that they gave President Obama with regard to the decision that he will make on the Keystone XL oil pipeline. If President Obama goes through with the project, environmentalists warn of significant political ramifications. This plausibly explains why the president has dragged his heels on giving a definitive stance on Keystone XL.
With a strong lobbying position, a scenario where environmentalists push for the U.S. to broaden its energy mix and allocate more dollars to solar energy is very conceivable, especially when a slip in oil refiners provides a ready gap in the market. Not to mention, many companies that are not necessarily energy companies have started exploring green solutions with an unmistakable thirst. For instance, the world's largest solar plant in Nevada is partly owned by tech bigwig Google.
The Impending fall of U.S. oil refiners could thrust solar stocks into prominence. How should you make your picks?
A good place to start would be SolarCity (NASDAQ:SCTY.DL). Despite trading intimately close to its 52-week high, it is arguably still trading at a discount in view of how its market position and business model meshes perfectly into the changing solar industry landscape.
In addition to other business clients such as Wal-Mart, one of SolarCity's key customers includes major government organizations such as the U.S. military. In view of how pressure from environmental groups is likely to push the government to widen the energy mix and 'give' a higher proportion of the market to solar energy going forward, SolarCity is likely to see higher orders for large-scale projects in the future. Because the government is a business client, these orders will eventually trickle down to the residential market, allowing SolarCity to significantly increase its footprint. There is still more room for growth in this revolutionary solar stock.