The U.S. is constantly requiring more refined product, and the business of buying oil, refining it, and then selling for a profit seems simple. While the refining business can be lucrative, though, one of the sectors biggest worries is the Brent/WTI spread, a key indicator of profitability.
This is a worry that shareholders of HollyFrontier (NYSE:HFC) do not have.
Key part of business
The Brent/WTI spread is a key indicator for refiners. Why? Well, put as simply as possible, refiners acquire oil priced at the WTI benchmark and then sell it at the Brent benchmark.
The wider the spread, the wider a company's profit margins are. Because of this, refiners such as Phillips 66 (NYSE:PSX) and Marathon Petroleum (NYSE:MPC) have relied upon their now spun-off upstream divisions (ConocoPhillips and Marathon Oil) to support profits for much of the past few decades while the margins remained tight
HollyFrontier, on the other hand, was built around the fact that the Brent/WTI spread will be tight. Between 2001 and 2010 the spread averaged +$1, meaning that WTI traded at a $1 premium to Brent. In comparison, over the past three years the spread has been around -$15 on average where WTI has traded at a 15% discount to Brent.
Despite the fact that WTI has traded at a premium to Brent during the decade from 2001, HollyFrontier still managed to achieve an average return on capital invested of 22% during this period. On a per-barrel basis, HollyFrontier reported a net income per barrel of $2.7 on average during this 10-year period.
How has it done this? Well, HollyFrontier has utilized what is called an advantage crude slate, in other words, using a mix of crude oils from around the U.S., all of which trade at a discount to WTI. What's more, HollyFrontier's highly flexible refining system allows the company feedstock optionality -- the company can switch the oils it refines to produce better returns.
For the most part, HollyFrontier runs about 40% advantage crudes and around 50% WTI. The advantage crudes the company uses are Western Canadian Select, which currently trades at a discount of $20 to Brent, and West Texas Sour, which trades at a discount of around $10. As HollyFrontier's refineries are located around the country, the company can benefit from access to these advantage crude and achieve sector-leading results.
How much would prices have to move for HollyFrontier to come under pressure? Well, it would appear they would have to move a lot. Indeed, as mentioned above, WTI traded at a $1 premium to Brent during the period 2001 to 2010. According to Morningstar, during the period 2004 to 2010, HollyFrontier reported a net profit margin of approximately 5% on average. So, based on these numbers, it would appear that WTI could trade at a $2 or $3 premium to Brent before the company became unprofitable.
Management's prudence to construct a business designed for a poor operating environment has ensured that HollyFrontier is able to outperform its peers during the bad times and surge past them in the good.
During the five-year period from 2009 to 2013 where earnings per barrel of oil refined by the company moved from a low of -$0.50 (2009) to a high of $10.5 (2012), HollyFrontier reported an average refining margin per barrel of $4.76.
The company's closest peer, Marathon Petroleum, only reported an average refining margin of $3.7 per barrel during this period; that's a full 23% lower. The industry leader, Phillips 66, reported an average margin of $2.9 during this five-year stretch, and Valero, another industry leader, reported a $1.1 per barrel average margin. That was a full 75% lower than that reported by HollyFrontier.
This being said, when it comes down to return on capital employed during the past five years, HollyFrontier is on a par with Marathon Petroleum. Both outperformed the peer group average.
During the period 2009 to 2013, HollyFrontier reported a ROIC of 13%, Marathon Petroleum reported a similar figure, Phillips' ROIC came in at 11%, and Valero's was a lowly 4%.
The Brent/WTI spread is the biggest concern for the refining industry. However, HollyFrontier investors do not need to worry as much.
HollyFrontier was built around a tight Brent/WTI differential, and this prudence has ensured that the company stays profitable at times when the spread is tight. It also reports impressive profits when the spread widens again.
In conclusion, HollyFrontier is a sector leader when it comes to refining margins, and this is set to continue.