Image Source: BP.com.

This article was updated on June 23, 2015 from its original publish date of January 18, 2015.

There is nothing sexy at all about oil refining, yet in a strange way it's fascinating when you stand back and think about it. It takes a product that by itself -- crude oil -- serves no purpose and transforms it into thousands of different products that we use on an everyday basis.

Like many other parts of the energy business, though, companies in the oil refining space have little name recognition, because the only real association the everyday person has with oil and gas companies is the name of the local gas station.

It's a shame, though, because oil refining stocks can be a very interesting way to play the energy sector. 

There are, of course, the basic financials you need to know when it comes to refining stocks, but there are also some more specific things you should know that will help you identify the best ones for your portfolio. To help you get started in this industry, here is a basic primer on the things you need to know.

What are we talking about?
Oil refining is like the kitchen of the energy business. It takes the raw materials, and through heat, pressure, and some mixing, it creates a multitude of finished products. The way refiners make their money is to sell all of these products for more than the raw-material costs. The most common products you and I know are gasoline and diesel, but other common products include asphalt and bitumen for paving and construction, organic chemicals for the manufacture of plastics and synthetic fibers, or even waxes and lubricants.  

Product breakdown from a barrel of crude. Image source: Department of Energy.

Of all these products, the most valuable ones are gasoline and diesel. So refineries are traditionally geared to get as much of these two products from a barrel of oil as possible. According to the Department of Energy, gasoline and diesel represent more than 70% of the finished products per barrel of crude oil. 

In fact, a common way to measure profitability in the business is known as the crack spread, which is the price of selected finished products minus the total barrels of crude it will take to create those products. These spreads can vary depending on the output of the refinery and the price of the particular crude used, but certain parts of the U.S. use particular benchmark crack spread calculations:

RegionCrack Spread BenchmarkWhich Translates To:
U.S. Gulf Coast  3-2-1 3 barrels of crude (Light Louisiana Sweet price)-2 barrels of gasoline-1 barrel of ultra-low-sulfur diesel
Midwest 2-1-1 2 barrels of crude (West Texas Intermediate price)-1 barrel of gasoline-1 barrel of ultra-low-sulfur diesel
U.S. East Coast  6-3-2-1 6 barrels of crude (Brent price)-3 barrels of gasoline-2 barrels of fuel oil (for home heating)-1 barrel of residual oil
U.S. West Coast 5-3-2 5 barrels of crude (Alaskan North Slope price)-3 barrels of gasoline-2 barrels of ultra-low-sulfur diesel

Source: Howard Weil weekly refining indicator report.

This isn't to say that each refinery located in these general locations follows these benchmarks to the letter, but they are a pretty good indicator of profitability in the business. 

Who are the players?
The face of oil and gas refining has changed quite a bit over the past several years. Since 1985, the U.S. has brought on only 13% more refining capacity. Over that time, though, more than 44% of the nation's refineries have been closed down. So the 150 or so refineries still refining crude today are considerably bigger on average than they were 30 years ago, and there has been a consolidation of the companies that own those refineries.

Just like every other part of the oil and gas industry, some of the largest oil-refining operations are part of the integrated oil and gas companies. However, they have their own drivers as companies, so we're going to focus on the independent refining and marketing companies here in the United States. There are a dozen public companies in the U.S. that are considered refining and marketing specialists:

CompanyRefining Capacity (in Thousand Barrels of Oil Per Day)
Valero (NYSE:VLO) 2,900
Phillips 66 (NYSE:PSX) 2,200
Marathon Petroleum (NYSE:MPC) 1,699
Tesoro (NYSE:ANDV)

849

PBF Energy (NYSE:PBF) 729*
HollyFrontier (NYSE:HFC) 443
CVR Refining LP (NYSE:CVRR) 185
Calumet Specialty Products Partners LP (NASDAQ:CLMT) 180
Western Refining (NYSE:WNR) 151
Alon USA Energy (NYSE:ALJ) 147
Delek US Holdings (NYSE:DK) 143
Northern Tier Energy LP (UNKNOWN:NTI.DL)

96

*Note, all figures related to PBF Energy  in this table and the following ones are pro forma pending the acquisition of Chalmette Refining's 189,000 barrel per day facility.

Source: Company presentations.

All of those companies are mostly geared toward the production and sale of transportation fuels (gasoline and diesel) with the exception of one: Calumet Specialty Products. This company focuses much more of its efforts on the manufacturing of specialty products such as mineral oils, waxes, solvents, and asphalt. So for the rest of the discussion we will focus mainly on the companies that work more closely with transportation fuels, which may not apply to this one specialist. 

A rough sketch of crude distillation, the basic step in petroleum refining. Image Source: University of Chicago.

The 4 "C"s for researching refining stocks
Since refiners act in between two commodities, much of their fate is beholden to the prices of crude oil and refined products. Sometimes the refining space can be great, like when the price of crude drops and the price for products holds steady or drops slower, and other times it can really stink, like when crude prices rise as gas prices stay put. Such is the life of a company in a commodities business. 

That being said, there are certain things a refiner can do to minimize these impacts and in some ways distinguish themselves from others in the space. So here is a set of things you should look into when buying a refining company for the long term.

Complexity
The fundamental step of refining is simple. Crude is heated to the boiling point and then is passed into a distillation tower, where the various crude molecules cool at certain temperatures and are therefore separated. The only thing with this simple method is that it produces a bunch of different products that aren't gasoline or diesel.

Many companies have developed more complex chemical and physical processes to convert some of those other products into something of greater use. These processes can vary from chemically breaking up larger molecules, such as those found in asphalt, into several smaller molecules of gasoline. 

The addition of these advanced methods of refining petroleum is known as adding complexity to the refinery. Generally speaking, the more complex a refinery, the more capable that refinery is at converting crude into high-value products. It also means that it can handle crude oil that's more difficult to work with, such as what we call heavy crudes -- ones that have a lower natural percentage of small molecules for gasoline. These heavier crudes are much less expensive than lighter crudes -- those with a higher light molecule content -- and can boost a refiner's profit margins.

Refinery complexity is measured using what's known as the Nelson Complexity Index, which assigns a number to the complexity of a certain physical or chemical process, and then the refinery is assigned a score based on how much crude can be run by those complex processes in relation to the facility's overall processing capacity -- the higher the number, the better. In 2010, the global average Nelson Complexity Score was 5.7. Here are the average Nelson Complexity Scores for each U.S. refining company.

CompanyNelson Complexity Index
Valero  11.1
Phillips 66  11.4
Marathon Petroleum  11.6
Tesoro 9.5
PBF Energy 11.7*
HollyFrontier  12.1
CVR Refining LP 11.5
Western Refining  8.2
Alon USA Energy 9.4
Delek US Holdings 9.2
Northern Tier Energy LP 

11.5

Source: Company investor presentations, industry publications.

Just about every refinery in the country rates much higher in terms of value added compared with the global average. That means the U.S. is most adept at taking those cheaper, harder-to-work-with crudes and creating more value-added products. 

Crude access
Unlike oil production that shifts around based on where oil can be found, refineries have to stay where they are. This can make sourcing crude challenging if production that's used to supply a certain region starts to dry up and a new source is needed. So one thing to look for is where a company's refiners are located and how it can source crude oil. Is it sitting in a region that has lots of production? Is it located on a major pipeline route? These sorts of things will help a company secure sources at potentially less than market price and help boost profitability. 

To give an example, let's look at HollyFrontier. Here are a couple of maps for its refineries.



Source: HollyFrontier investor presentations.

Most of HollyFrontier's refineries just happen to sit on locations where oil production in the U.S. is starting to take off, and the majority of its refining capacity is relatively close to either major pipelines or oil-trading hubs such as Cushing, Oklahoma. Having access to local production as well as strong pipeline and rail access, the company has, on average, been able to access crude for $3 to $5 less per barrel than benchmark prices. 

Typically, a company will show its feedstock costs in relation to some benchmark in an investor presentation, which can give you an idea of its crude access capabilities. 

Cost efficiency
Given that refiners have little pricing control for refined products and need to find small inefficiencies in the market to keep feedstock costs down, another thing the refiners can do to improve business outcomes is to run cost-efficient operations. This is something that can be measured with two metrics: capacity utilization and operational cost per barrel. 

Refinery utilization is the amount of crude a refinery runs in a quarter divided by the nameplate capacity of the facility. Obviously, higher utilization rates are better. This is important because there are lots of fixed costs associated with refining, meaning the company has to pay them regardless the amount of crude processed. Increasing utilization is one of the most effective ways to reduce per-barrel costs. 

Operational cost per barrel simply shows how cheaply a company can run its operations. This is very important, because it's independent of the crack spread. If the crack spread for a refiner is less than its operational cost per barrel, then in all likelihood the business is losing money. Not every company breaks out operational costs -- some think that giving that information away is like giving away corporate secrets -- so you have to estimate them using overall costs divided by total crude processed. But here's a list of the utilization rates and operational costs per barrel for companies that gave them over the past nine months of operations.

CompanyRefinery UtilizationOperational Costs Per Barrel of Produced Product
Valero  92% $8.75
Phillips 66  84% $6.64
Marathon Petroleum  97% $6.47
Tesoro 82% $6.51
PBF Energy 86% $7.43
HollyFrontier  94% $7.47
CVR Refining LP 117% $6.18
Western Refining  110% $6.59
Alon USA Energy 93% $5.77
Delek US Holdings 64% $7.02
Northern Tier Energy LP 

96%

$5.81

Source: Company quarterly reports. Includes depreciation and amortization expenses.

Cash conversion
As you would expect, refining isn't an industry full of growth stocks. With total oil demand in the U.S. remaining relatively flat over the past several years, the companies in this space aren't expected to have huge net income growth. Instead, investors buy them for their ability to generate cash and grow the value of their investments by buying back shares to increase EPS and to pay decent-sized dividends.  

What this means is the stock performance of these companies will be largely predicated on their ability to make a return. So when you're looking at these companies, be sure to focus on metrics that evaluate their ability to generate cash and returns, such as levered free cash flow margin, and return on capital. 

CompanyAverage Levered Free Cash Flow Margin (Q1 2010-Q4 2014)Average Return on Capital (Q1 2010-Q4 2014)
Valero  1.2% 10.2%
Phillips 66  0.57% 6.6%
Marathon Petroleum  2.17% 15%
Tesoro 1.68% 10%
PBF Energy (4.83%) 12.6%
HollyFrontier  3.30% 14%
CVR Refining LP 3.69% 21.1%
Western Refining  3.36% 18.8%
Alon USA Energy 1.38% 6.1%
Delek US Holdings 1.23% 13.4%
Northern Tier Energy LP  2.38% 24.9%

Source: S&P Capital IQ.

Refining in the days of Standard Oil. Source: Western Reserve Historical Society via Wikimedia Commons.

What a Fool believes
Refining isn't quite the same business as it was when John Rockefeller built the Standard Oil Empire. Back then, when oil and gasoline were much harder to move, Rockefeller was able to use ownership of refineries to control the cost of feedstocks and the refined products afterwards. Today, these refiners don't have that sort of price control, but that doesn't mean these companies can't be strong investments over the long term, thanks to their decent dividend payments and a propensity to buy back shares when times are good.

The cold, hard truth is that these companies' share prices will fly up and down with the relationship between the price of oil and gasoline. However, there are few things each of these companies can do to get the most out of their assets in both good times and bad. These rough guidelines should help you identify which ones are built to maximize the value of each barrel of oil and which ones will continue to return value to shareholders over the long term.

Other subjects in the Energy Investing 101 series:

Tyler Crowe has no position in any stocks mentioned. You can follow him at Fool.com or on Twitter @TylerCroweFool.

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