U.S. refiners have taken a beating recently due to an announcement late last month that the U.S. will allow exports of minimally refined condensate, a form of ultralight crude oil. If condensate export volumes are sufficiently large, they will put upward pressure on domestic crude benchmark prices like West Texas Intermediate (WTI) and downward pressure on the price of Brent, the global crude benchmark, thereby reducing refiners' margins.
Judging by the markets' reaction to the ruling, investors seem to believe that it's a pretty big deal. Since it was announced in late June, shares of Valero, the nation's largest independent refiner, have slumped 15%, while shares of Marathon Petroleum are down about 13%. With both companies trading at seemingly cheap valuations, is now the right time to buy?
The bull case
I think it could be. Here's why. To my mind, the condensate export ruling doesn't appear to signal a major strategic change in U.S. policy toward crude oil exports and may instead merely be a clarification of existing statute. And even if it does signal a major change, additional hurdles including infrastructure limitations and high processing and export costs suggest export volumes will be low.
If this is the case, then I think Valero and Marathon Petroleum are two of the most attractive refining stocks right now. Firstly, they're cheap. Valero trades at just eight times forward earnings and commands an EV/EBITDA multiple of just over five times, while Marathon Petroleum's forward P/E is also eight times and its EV/EBITDA multiple is just north of six times -- big discounts to peers, including Western Refining, HollyFrontier, and even Tesoro, which trade at 13 times, 11 times, and nine times forward earnings, respectively.
Gulf Coast advantage
Second, their concentration along the Gulf Coast should prove to be a major advantage in coming quarters. This is mainly because North American crude oil production continues to grow rapidly with much of it being directed toward the Gulf Coast. As a result, the previous glut in Cushing, Oklahoma, the nation's main oil storage hub, has shifted toward the Gulf Coast.
Meanwhile, geopolitical risks in Russia, Iraq, and other key oil-producing regions suggest the risk to Brent is skewed to the upside. This means that Gulf Coast differentials relative to Brent are likely to remain high in the near-term. If true, Valero and Marathon stand out as two of the biggest beneficiaries.
Valero has roughly 55% of its total refining throughput capacity located along the Gulf Coast, while Marathon's Gulf Coast refineries now account for a whopping 62% of its total refining capacity thanks to its acquisition of BP's Texas City refinery in February of last year. In addition to their location advantage, Marathon and Valero have plenty else going for them.
Marathon benefits from a number of accretive acquisitions that will diversify its earnings away from the historically volatile refining business and toward more stable midstream and retail operations. For instance, its recent purchase of Hess' retail business effectively doubled its retail store count and gave it a leading position in the lucrative East Coast retail gasoline market.
The company is also investing heavily to improve its refined product export capacity. By 2018, it expects to boost its export capacity to 475,000 barrels per day (b/d), up from 320,000 b/d last year. Combined with its peer-leading return of capital -- highlighted by the repurchase of more than $3 billion worth of shares over the past two years -- I think Marathon deserves to command a higher multiple.
Meanwhile, Valero benefits from its unparalleled size and scale and its robust balance sheet, which boasted more than $3.6 billion in cash and equivalents and long-term debt of less than $6 billion as of the end of the first quarter. With that cash pile likely to grow even more this year, the company could easily pursue a share buyback program or significantly boost its dividend.
Like Marathon, Valero is also investing heavily to boost its light crude oil processing capacity. The company plans to add crude topping units at its 160,000-b/d Houston refinery and its 325,000-b/d Corpus Christi refinery, which will boost their light crude processing capacity by 90,000 b/d and 70,000 b/d, respectively, by year-end 2015. This should provide a further uplift to margins.
Though Valero and Marathon's outlooks hinge on the volume of condensate exports, their concentrated refining footprints along the Gulf Coast should prove to be a major competitive advantage over peers in coming quarters. Combined with their cheap valuations and other advantages, they may be two of the best picks in the refining sector right now.