HollyFrontier Corporation (HFC) enjoys the unique advantage of having all of its refineries located in close proximity to crude oil producing regions. The upside is that it results in cheaper feedstock costs for the Dallas-based refiner, since crude oil prices nearer to the wellhead almost always trade at a significant discount to the WTI crude price benchmark. The largest independent mid-continent refiner, as a result, generates relatively higher profit margins with minimal capital investment -- a massive advantage in the current low oil price environment.
However, HollyFrontier's future growth story lies in its operational turnaround, as well as balance sheet management that the company is targeting.
A background on HollyFrontier
Apart from owning and operating five refineries in the mid-continent region, HollyFrontier also owns and operates NK Asphalt Partners (that operates asphalt terminals in Arizona, New Mexico, and Oklahoma) in addition to a 50% stake in Sabine Biofuels in Texas.
More importantly, HollyFrontier owns a 39% interest in its own master limited partnership, Holly Energy Partners (HEP 0.35%) that includes its 2% general partner interest. Through the MLP, the refiner owns logistical assets that include pipelines, storage terminals, and truck-loading racks. These assets are what make it easier for the five refineries to access cost-advantaged crude oil right from the well-head.
While total refining capacity of 443,000 barrels per day, or bpd, is relatively low compared to other U.S. independent refiners, HollyFrontier's impressive systemwide Nelson-complexity index of 12.2 rivals the best in North American refining. In simpler terms, it means HollyFrontier's refineries are capable of processing a wide range of crude oil types, from light-sweet variants to bituminous, heavy-tar types from Canada.
This flexibility again plays a critical role in keeping HollyFrontier's higher crack spreads, or gross margins per barrel, stable. For example, if for some reason a regional variant of light sweet crude becomes more expensive, then there's the option to run heavy crudes and produce high-value products such as wax, specialty lubricants, etc., over and above commodity engine oils.
So, where does growth come in?
During the Analyst Day held earlier this month, management stressed that a systematic turnaround in refining operations is expected to increase annual EBITDA by a solid $245 million. Key to the plans are increasing refinery reliability and cutting down on controllable operating costs.
Over the last four years -- since the merger of Holly and Frontier in July 2011 -- the company had been putting in place an industry best practices manual that management looks very keen to implement. Historically, HollyFrontier has always been dogged with reliability issues that have created quite a drag on its share price in recent years (see share price chart above). To put it briefly, management is aiming to achieve first quartile operational reliability in the refining industry.
In addition, HollyFrontier is aiming to shave off 15% in fixed operating expenses from 2014 levels. Management thinks this should bring down overall operating expenses to $5.50 per throughput barrel.
Optimizing input and product slates
HollyFrontier's high Nelson-complexity refineries gives management the flexibility to buy higher value inputs and, in the process, capture higher margins for the products. To put it in management's own words, it's about "putting the right molecule in the right refinery or market at the right time."
On the supply side, the refiner is looking to optimize its Permian crude supply through its MLP-owned gathering systems. This is so important because the refiner wants direct access to Permian crude rather than accept a crude feedstock from the WTI-hub in Cushing, Oklahoma, which could be a mixture of various grades.
On the product side, HollyFrontier intends to increase its reach to a wider market within the mid-continent region. Also, management feels there's greater demand for higher margin products apart from the typical engine oils such as specialty process oils, industrial and marine oils, aromatics, and waxes.
Capital investments and balance sheet management to drive growth
Capital investments include expansion of the Wood Cross refinery in Utah by 50% to 45,000 bpd. However, that's just half the story. The 12.5-Nelson complexity refinery is being redesigned to become more flexible. The additional 15,000 bpd capacity can be used to process both sweet as well as waxy crudes alike. That gives management massive leverage regarding the type of feedstock to be processed at any given point, depending on market conditions.
Currently, HollyFrontier's balance sheet is almost free of debt. With a paltry $32 million of outstanding debt and $626 million in cash balance at the end of the second quarter, the refiner has enough room to increase its financial leverage. By taking on debt, HollyFrontier can continue its excellent practice of returning cash to shareholders either in the form of share buybacks or through special dividends -- apart from increasing its regular dividend.
Since the merger in 2011, the company has returned a whopping $3.2 billion in cash to shareholders. Already, the board has given approval for a $1 billion share buyback last May that must be executed within 12 months.
Foolish bottom line
All in all, management feels there's a 91% upside to HollyFrontier's current share price within the next three years. The aggressive approach to redefine the company's balance sheet gives investors all the confidence that's needed. Here is a management that has always been prudent in capital management by attaining the best industry returns on investments.