U.S. refiners have had a great run over the past few years. Valero (NYSE:VLO), the nation's largest independent refiner, is up more than 250% over the past five years, while shares of HollyFrontier (NYSE:HFC) have surged more than 400% over the same period. And Phillips 66 (NYSE:PSX) is up nearly 120% since it made its debut on the NYSE in April 2012.
The main factor driving refiners' strong performance has been a wide gap between the price of domestic crude oil benchmarks like West Texas Intermediate, or WTI, and the global crude benchmark, Brent. This price difference, known as the Brent-WTI spread, is the chief determinant of U.S. refiners' margins.
But some argue that a new federal ruling announced late last month could end refining stocks' multi-year run, since it could potentially lead to a compression of the Brent-WTI spread. Since the announcement, shares of Valero and HollyFrontier are down by about 13%, while Phillips 66 has slumped 7%. Is this simply a hasty knee-jerk reaction, or is refining stocks' run really over for good?
Hard to tell
Based on the information provided so far, the short answer is that we can't really be sure at this point because key questions remain. Most importantly, what kind of condensate export volumes can we expect, and how exactly do federal regulators define processed condensates?
As I understand it, the ruling qualifies condensate that has been stabilized by passing it through a distillation tower to qualify as a processed petroleum product that is eligible for export. That, by itself, does not appear to signal a sea change to the 40-year-old crude export ban, since stabilized condensate is chemically closer to a refined product than to unrefined crude oil.
What could, however, be a game changer is if the ruling turns out to be part of a broad strategic change in the Obama administration's policy toward oil exports. To be sure, there's a good case for exporting condensate -- we have way too much of it. Domestic production of condensates has surged by about 70% over the past three years to more than 1 million barrels per day, according to RBN Energy LLC.
But because most Gulf Coast refineries can't process condensate, it is trading at a massive discount to other crude oil benchmarks. By exporting it, we can help eliminate this price gap and allow domestic oil producers to get a higher price for their condensate production, thereby giving them incentive to boost production. Still, even if the ruling does mark a broad shift in U.S. policy, additional hurdles remain.
For instance, infrastructure limitations and the additional costs of processing and export, which could be at least $4-$5 per barrel, may deter some companies from exporting condensate, according to analysts at Morgan Stanley. Further, Eagle Ford condensate's low distillate yield and high paraffin content may make it undesirable for many global refiners, limiting its export potential, Morgan Stanley added.
Outlook for refiners
As you can see, the outlook for refiners hinges largely on whether the recent condensate export ruling is simply a minor technical tweak of existing statute or whether it signals a broad shift in the Obama Administration's policy toward oil exports. If it is the former, then I think refiners are still a good place to be, especially Valero and Phillips 66.
Valero's heavy concentration along the U.S. Gulf Coast should continue to boost the company's overall refining margins, as it has done in recent quarters. That's because the region is expected to remain oversupplied with crude oil for quite some time, driving down Valero's feedstock costs. The company is also investing heavily in new topping units at two of its Gulf Coast refineries that should further increase its ability to process cheap Eagle Ford crudes.
Phillips 66 also benefits from its leading position along the Gulf Coast and from its favorable crude slate, which consisted of 91% cost-advantaged crudes as of the first quarter. But the company's biggest advantage over other refiners is its midstream and chemicals segments, whose stronger and more stable margins help offset volatility in refining margins. As these business segments account for a greater share of the company's earnings and cash flow over the next few years, they should allow it to comfortably grow its dividend.