From Shale Boom to Refinery Revolution: Massive Investment Potential

Note: Following on from last week’s Inside Investor report with Dan Dicker where he mentioned CVR Refining (up over 10% since last Friday.) We decided to spend some time looking into the refining sector for additional investment opportunities.

If 2012 was a great year for refiners and anyone who invested in them, 2013 is shaping up to be more profitable than even the most astute analysts predicted. In September 2012, combined crude oil and condensate production in the Eagle Ford play topped 700,000 barrels per day; by 2016 we could be looking at as much as 1.6 million barrels per day. All this crude has to go somewhere.

But let’s not bury the lead. Follow this trail … Valero Energy Corp (NYSE:VLO) sends crude oil extracted in the Eagle Ford Texas shale play to its refineries in Quebec City.

This is very significant on two levels. It means that:

•    production is growing to the point that it is starting to replace refiners’ more expensive overseas imports
•    if Valero is refining Eagle Ford crude in Quebec City, this means it got special approval from the US federal government to EXPORT US crude

The Year of the Refiner

What is happening, in effect, is that the shale boom is ramping up production to the extent that refiners are drowning in supplies of light sweet crude to the point that they no longer have to import as much from West Africa, Mexico and Venezuela, for instance. Profits are soaring.

This is how the market can dictate major, controversial decisions such as whether the US federal government should allow unlimited exports of the country’s oil and gas. Right now, companies must seek special approval from the US Department of Commerce on a case-by-case basis. The debate has the oil and gas industry lined up in a lobbying standoff with manufacturers (like Dow Chemical), who would think that unlimited exports would lead to a rise in prices on the domestic market and curtail new manufacturing projects.

But the market itself may sideline the debate entirely. If production continues to increase at its current pace, what Valero has managed with Eagle Ford crude may become the norm.

Let’s look at Valero first because it is the clear market darling.

Valero has 15 refineries with a total capacity of 2.8 million barrels/day. Nearly 70% of that capacity is near the US Gulf Coast, with smaller capacities in Tennessee and Quebec. 

Exporting light sweet crude from Eagle Ford to its Quebec City refinery will save it around $2/barrel as it has traditionally imported this type of crude from West Africa. The company has had a series of successes over the past year, and is now becoming a market darling. Fourth quarter 2012 earnings reached a seven-year high. Overall, Valero’s 4th quarter numbers are very impressive. (Analysts’ predictions on Valero were way off—no one thought they would make the switch from light sweet crude imports so quickly):

•    $1.01 billion profit--up from $45 million in 2011!
•    Shares up 8.5% to $42.10
•    Cash on hand is $1.7 billion (up 68% from 2011)
•    Dividends have risen 14% and analysts predict more earnings for investors soon
•    Refinery operating expenses were down 4.9%
•    Average per/barrel earnings for the 4th quarter: $12 (double the figure for 2011)
•    $1 billion slated in spending for 2013 on logistics
•    Plans in place to increase its refining capacity in Canada

Beyond Valero

While Valero—the world’s largest independent refiner—is the obvious investment, let’s look at some other refiners who will follow in its footsteps (and some who already have) to make the switch from light sweet crude imports probably by the middle of this year.

Marathon Petroleum Corp. (MPC):

Marathon has also profited on higher refining margins. It has also come up ahead of analysts’ forecasts, and shareholders are being promised higher dividend yields. The company has halted overseas imports of light sweet crude. Marathon plans to move first on buying oil and condensate from the Utica Shale in Ohio, and will be expanding its refinery infrastructure in both Ohio and Kentucky.

Here are the 4th quarter 2012 numbers:

•    Profit - $755 million ($2.24/share), compared to $75 million loss for 2011
•    Adjusted earnings - $2.26/share
•    Sales revenue - $20.68 billion (up 6.5%)
•    Cash in hand - $4.9 billion (up 44%)
•    $2 billion stock-repurchase program approved

Phillips 66 (PSX):

It was only in April last year that Phillips 66 was looking to pipelines to balance the volatility of its refining business, but the year ended with numbers that exceeded analyst expectations and this company, too, has profited on higher refining margins nicely. Phillips 66 spun off from ConocoPhillips (COP) in early 2012 to become the largest US independent refiner. By the third quarter, its profits were already on the rise with a 52% gain at the end of that quarter. However, with Phillips 66, its gains from the refining margin were overshadowed by a $565 million investment write-down and weaker revenues. Fourth quarter 2012 results were disappointing, but this is still a transition. The company’s refining business earnings soared to $1.1 billion, but superstorm Sandy took its toll on Phillips 66 and its East Coast operations suffered $56 million in losses directly related to Sandy, while refining utilization rates declined. Still, we expect a strong year as the company continues to gain from the refining margin:

•    Earnings down 65%
•    Shares up 1.8% at $60.95 (after it doubled its stock buyback authorization and boosted annual dividend 25%)
•    Profit - $708 million ($1.11/share), down from $2.01 billion ($3.17/share)

Tesoro:

Tesoro operates seven refineries in the western US with a total capacity of around 675,000 bpd. We don’t’ have the company’s 2012 4th quarter results yet, but will be eyeing them closely when they are released on 6 February. So far, the company has shown positive trading, with shares up around 4.84% to a high of $48.05 with a trading volume of 5.93 million shares. We’ll look at Tesoro more closely in a subsequent newsletter.

Conclusion

Refiners are rewarding investors after years of volatile earnings. This year should be the best yet, and refiners are in a solid position to outperform. They are beating analyst’s predictions almost across the board and this means cash for shareholders.