Psx Pic

Source: Phillips 66.

Refining margins usually increase when oil prices fall, meaning refiners such as Phillips 66 (NYSE:PSX)Marathon Petroleum (NYSE:MPC), or Valero Energy Corp. (NYSE:VLO) can make excellent hedges in an energy portfolio.

The same holds true with my favorite high-yield refiner, Calumet Specialty Products Partners (NASDAQ:CLMT). Calumet just reported great results that exemplify three reasons this specialty refiner deserves to be on every income investor's radar. Find out what steps the MLP is taking to secure both its growth and its generous 10.5% payout in this age of extreme energy-price uncertainty.  

Business is booming thanks to cheap crude

MetricYTD 2015YTD 2014YoY Change
Gross profit $562.7 million $406.4 million 30%
Adjusted EBITDA $295.3 million $229.5 million 29%
Distributable cash flow (DCF) $216.8 million $106.9 million 103%
Distribution coverage ratio (DCR) 1.41 0.75 88%

Source: Calumet Q3 10-Q.

Cheaper oil prices have been a boon to Calumet's margins, especially its payout funding DCF. The MLP's fuel products division saw the biggest boost in profitability, with this quarter's gross margin per barrel soaring 170%, including hedges and excluding a one-time impairment. 

Refiner Yield Q3 Gross Margin/Barrel Q3 EBITDA Margin
Calumet Specialty Products Partners 10.5% $10.30 0.4%
Phillips 66 2.4% $13.96 10.2%
Marathon Petroleum Corp. 2.3% $17.27 10.9%
Valero Energy Corp. 2.8% $14.38 11.6%

Calumet's Q3 EBITDA margin was 5.5% adjusted for one-time impairment charges. Sources: Investor presentations, Q3 10-Qs.

As you can see Calumet Specialty Products Partners isn't nearly as profitable as other refiners such as Phillips 66, Marathon, or Valero. However, the primary reason to own Calumet is for the very attractive yield and potential for further distribution growth which could fuel even better long-term total returns. 

According to Bill Hatch, Calumet's outgoing interim-CEO, with the completion by year's end of the MLP's multi-year major organic growth initiatives next year's capital expenditure budget will decline substantially. This should greatly increase the refiner's free cash flows which will be put toward a combination of moderate distribution growth, continued niche acquisitions into high-margin specialty products, and optimizing existing assets to boost profitability.

Of course a high and potentially growing distribution isn't much good if it isn't sustainable and I'll admit that given how volatile refining margins can be long-term payout security has often been a major concern for Calumet investors. To address the risk of recovering oil prices crimping margins and DCF management has established a two year portfolio of hedges to lock in crack spreads of $17-$18 per barrel for its fuel segment. Additional hedges guarantee a fixed gross profit margin on its gas, diesel, and jet fuel production in 2016.

Coverage ratio set to soar in 2016
For several years now, Calumet has been working on some major organic growth projects designed to secure its distribution in the face of volatile refining margins that have brought its payout to the brink of being cut in years past. 

Clmt Coverage Ratio Over Time
Source: Calumet third-quarter earnings presentation.

By the end of 2015, Calumet Specialty Products Partners will have completed its final three major projects, and by March its expanded refining base will be up to full capacity, resulting in approximately $100 million in annual adjusted EBITDA growth.

What should really excite Calumet investors is that in this low-oil-price, high-refining-margin environment, Calumet is converting 73% of adjusted EBITDA into DCF.

Should low oil prices persist through 2016, that means Calumet could see a $73 million DCF boost that would increase its 2016 coverage ratio to 1.57, compared with the 1.1 achieved over the past four quarters.

Given that Calumet's long-term distribution coverage goal is 1.2 to 1.5, if refining market conditions remain favorable, Calumet would not only have a rock-solid distribution in 2016, but it could also potentially afford to grow it. 

There's an additional benefit that comes from a high coverage ratio. The excess DCF generated can be used to pay down debt or invest in expanding its business, either through further organic growth projects or through acquisitions. Toward that end, Calumet's latest quarter brought one final piece of wonderful news. 

An improving balance sheet means stronger future growth prospects
Refining is a capital-intensive industry, and to expand access to sufficient liquidity is a must. Thus, a strong balance sheet is required to comply with debt covenants and be able to borrow at reasonable interest rates. 

Thanks to low oil prices and Calumet's bringing organic growth projects online, the past five quarters have seen its leverage ratios improve dramatically. 

Clmt Q
Note: Fixed charged ratio = adjusted EBITDA/interest cost. Yellow ratio excludes special one-time charges. Source: Calumet earnings presentation.

With ample liquidity of $317 million as of Oct. 1, Calumet Specialty Products Partners has more than enough resources to complete its three major refinery expansions, which should grow its annual adjusted EBITDA by 27% next year. That should further bring down its leverage ratios and improve the MLP's credit quality, potentially making financing future expansions and acquisitions easier and more profitable. 

Bottom line: 
Calumet's greatly improved results this year were largely a result of highly favorable market conditions due to low oil prices. However, thanks to the DCF boosting effects of the completion of its organic growth this year, as well as the protection provided by its new hedges, I believe the MLP is much better positioned to survive the next refining industry downturn with its payout intact.  

In the mean time, with a business model that acts as a natural hedge to cheap oil prices, I think this high-yield refiner could be just the thing to boost the income of your diversified energy portfolio in 2016.

Adam Galas has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.