Are Refiners Too Cheap to Ignore?

A little more than a year ago, independent refiners like  Valero (VLO) and  Tesoro  were flying high. Early in the summer of 2007, gross refining margins reached multidecade highs, soaring above $40 per barrel refined in some regions. Many forecasted a "golden age of refining" that would last for many years. In our view, many of the refining stocks were pricing in peak refining margins into perpetuity, valuations that weren't likely to hold up forever. During the last year, refining industry fundamentals have changed dramatically, and share prices have come down considerably. Valero is down about 75% during the last 12 months, Tesoro is down almost 85%,  Frontier Oil  is down more than 75%,  Sunoco  is down more than 65%, and  Western Refining  is down more than 80%. So is now the time to consider investing in refiners?

What Has Changed
In late 2006, my colleague Justin Perucki wrote about some refining trends he was watching. Many of these trends have finally started to play out and are contributing to the recent weakness in refining fundamentals and stock prices. First, both globally and in the United States, refining capacity has been growing for the last decade. Many of us have heard the argument: "A new refinery hasn't been built in the U.S. since the late 1970s." Unfortunately, that slogan is misleading. Although no new refineries have been built in the U.S. recently, refining capacity has been steadily creeping upward as existing refineries have been expanding output. Second, refineries in the U.S. have invested heavily in improving their complexity during the last few years. These moves have increased the refining industry's capacity to process lower-quality crudes and produce higher-margin products out of existing facilities. Thus the overall refining marketplace should become more competitive as complexity increases in aggregate.

During the last few years, stricter environmental standards in the U.S. helped constrain refining capacity as refiners experienced more frequent maintenance periods and longer turnarounds while also working on making necessary environmental upgrades. These stricter environmental standards (largely targeting lowering sulfur content) helped further insulate U.S. markets from foreign imports of refined products. Both of these factors helped support higher refining margins in the U.S. As new export-oriented refineries come on line, they will compete with domestic refiners and likely help suppress domestic gross refining margins.

Turning our eyes globally, we see a wave of new refineries cropping up during the next few years. Large, export-oriented refineries are being built in the Middle East, targeting Asian, European, and American markets. Saudi Arabia is building two very large refineries--at 500,000 barrels per day each. Soon to be the world's largest refining complex with total capacity of roughly 1.24 million barrels per day, India-based Reliance Industries plans to begin operating its new 580,000-barrel-a-day refinery sometime in November. Chinese refining capacity is also set to expand considerably during the next few years.

With both domestic and global refining capacity on the rise as well as the improving complexity of older domestic refineries, demand for refined products will need to keep pace if the industry hopes to support healthy profit margins in the future. Unfortunately, refined product demand has dropped considerably in the U.S. (more than a 7.5% decline year over year through mid-September, according to the Oil and Gas Journal), and other developed economies--Europe and Japan--have shown signs of weakness in recent months. Although the longer-term secular trend is likely up for emerging economies such as China and India--as automobiles become a primary mode of transportation for those large populations--the short-term trend is far less certain, given the present softening in global economic activity and the likely weakness to come in 2009.

Framing the Investment Opportunity
All of the pure-play refiners we mentioned above (Valero, Tesoro, Frontier, Sunoco, and Western) are trading well below our fair value estimates, so should investors consider this an opportunity to start buying these companies? The short answer is no, none of them are trading below our Consider Buying prices, so we think a greater margin of safety is required to make them compelling. However, for the first time in many years, we think 2008 has marked a return of value to some of these stocks, as a result of the large retreat in share prices.

Business fundamentals have eroded considerably for refiners, as have our fair value estimates for these companies. Therefore, we now think the market is pricing in reasonable--if not slightly bearish--profit forecasts for refiners. Should market sentiment continue to deteriorate for refiners' stocks, thus driving share prices lower, opportunities may crop up. Or, what would probably be even more attractive, fundamentals could begin to turn positive before the stocks react. We'll be monitoring the economic slowdown's impact on refined-product demand in the U.S. and emerging markets. Should demand destruction stabilize and demand improve, then the outlook for refining profits could brighten. Also, as in past episodes where the refining industry has built out too much capacity, we could start to see project delays and cancellations, which would help demand catch up more quickly.

If you want to take advantage of some of the value re-emerging in the refining business today, we'd consider some of the integrated oil companies; these companies are involved in refining, exploration and production, chemicals, and distribution (retail) in many cases. We presently have a number of these companies rated at 5 stars-- Exxon Mobil (XOM),  Chevron (CVX),  ConocoPhillips (COP), and  Marathon Oil (MRO).