2 Great Ways to Invest in Oil Dividend Stocks While Hedging Against Falling Crude Prices

Oil prices keep falling, and oil stocks keep dropping. Here are two undervalued oil dividend stocks that could actually profit from falling crude prices.

Adam Galas
Adam Galas
Feb 7, 2015 at 9:00AM
Energy, Materials, and Utilities

Oil prices have crashed to six-year lows, and almost all oil stocks have been beaten down along with them, including refiners HollyFrontier (NYSE:HFC) and MLP Northern Tier Energy (UNKNOWN:NTI.DL)

WTI Crude Oil Spot Price Chart
WTI Crude Oil Spot Price data by YCharts.

Oil prices collapses aren't all bad. In fact falling oil prices can actually benefit oil refiners. So I'd like to focus on why HollyFrontier and Northern Tier Energy may be two excellent ways for long-term income investors to profit from oil's recent crash while still hedging against the potential for cheaper oil in the future. 

Cheaper oil can help refining margins

WTI Crude Oil Spot Price Chart
WTI Crude Oil Spot Price data by YCharts.

As this chart shows, lower oil prices need not mean lower margins for refiners. Refiner's main input cost is oil so falling oil prices can boost margins and refiners can benefit from growing EBITDA. This has been the case with both HollyFrontier and Norther Tier Energy, which reported 64% and 138% increases in EBITDA, respectively, in their most recent quarterly earnings reports.

Great income opportunities
However, my bullishness on HollyFrontier and Norther Tier Energy isn't based purely on margin improvement and earnings growth from lower oil prices. I also like both of these refiners as long-term income opportunities.

Company or Partnership Yield 18-Year Historic Dividend Growth Rate Projected 5-Year Dividend Growth Rate
HollyFrontier 8.9% 30.8% 17.1%
Northern Tier Energy 18.8% NA 0%
S&P 500 1.97% 5.1% 5.1%

Sources: Fastgraphs, Yahoo! Finance.

HollyFrontier has a long track record of strong and consistent dividend growth that is expected to continue for years to come. In addition Holly Frontier has a history of paying special dividends. In fact since November of 2011 each quarter's regular dividend has been greatly exceeded by a special $0.5 per share special dividend that makes the true yield 8.9% on today's price and means that HollyFrontier is a hidden high income stock. Nothern Tier Energy, meanwhile, is a variable distribution MLP, meaning it pays out nearly all of its distributable cash flow to unit holders each quarter. This means payouts will be highly variable. However, that volatility can be useful to long-term investors, because in quarters where the payout drops, so might the unit price, which allows for dollar-cost averaging that can reduce your cost basis.

Refiners with competitive advantages
There are many refining stocks and MLPs to choose from, so what makes these two special and worthy of your consideration? 

For Northern Tier Energy, the answer lies in its location. The MLP's refinery is located in St. Paul, Minnesota, and is supplied by oil from North Dakota's Bakken shale and Canadian oil sands projects.  This access to Canadian West Select, or WCS, oil helps Northern Tier boost its margins, since that grade of oil sells for significantly less than the American standard, West Texas Intermediate, or WTI. In fact, in December, WCS was selling for $16 per barrel less than WTI. This cheaper oil allows Northern Tier's to operate the third most profitable independent refinery in the country. 

Meanwhile, HollyFrontier thanks to the locations of its refineries is able to purchase oil at a discount to WTI of between $3 and $5 per barrel over the last year. This helps it to achieve strong margins and profits per barrel. In addition the company has a good history of acquiring new refineries at very lost cost per barrel. This allows for accretive acquisitions that help the company to drive its impressive dividend growth record, both in the past and likely in the future. That fact is helped by the company's strict discipline of only going after acquisition targets that represent returns of at least twice its cost of capital.

Finally, while thus far representing a small portion of the company's cash flow I Holly's MLP, HollyFrontier Partners (NYSE:HEP), of which it owns 37% of the limited partner units as well as a 2% general partner stake and the incentive distribution rights. Holly Frontier Partners owns complete or partial stakes in 2980 miles of oil and refined product pipelines across the Midwest and southwest U.S. and is expected to grow its distribution by 11.6% per year through 2019. In the future I expect this MLPs cash flows to its parent company to represent a larger, and more lucrative cash flow stream that should help HollyFrontier maintain its excellent dividend growth record with less sensitivity to commodity prices thanks to the long-term fixed-fee nature of the MLP's contracts.

Bottom line: The market's miss-pricing of these stocks can be your gain
In my opinion, Wall Street is punishing HollyFrontier and Norther Tier Energy in a way that is unjustified by their actual business models. Given their competitive advantages and the potential for greater sales growth and margins due to cheaper oil, at today's prices, I think all long-term investors should consider whether these companies deserve a spot in their diversified income portfolios.