Refiners Have Something Left in the Tank
Take advantage of near-term volatility to capitalize on long-term opportunity.
Refiners have been the lone bright spot in the energy sector during the past year, handily outperforming every other subsector. While oil prices have deteriorated, refining margins have improved, thanks to strength in gasoline margins due to key refinery outages and strong demand. We maintain a favorable view of the refiners, but do not think the shares are screaming buys. However, buying opportunities could present themselves, with seasonally weaker demand and the return of previously offline refineries likely to weigh on margins and share prices. Beyond the seasonal lull, we expect gasoline demand growth to continue, thanks to sustained low prices, while a potentially above-average maintenance season could keep product inventories in check. Differentials may also come under pressure as U.S. production declines, but we expect any narrowing will be temporary, as transportation costs should create discounts when production growth resumes. Favorable market conditions, earnings growth from refining and nonrefining projects, and sustainable yields combine to make refiners buys on the dips.
Gasoline Margins Likely to Remain a Tailwind
The combination of strong demand and refinery outages has boosted gasoline margins about 50% this year, offsetting narrower differentials and lifting overall benchmark margins. Once thought to have peaked, gasoline demand is approaching 2007's record highs, as lower prices and a strengthening economy are driving an increase in vehicle miles traveled (also approaching 2007 peak levels) and contributing to record vehicle sales (led by trucks and SUVs). Meanwhile, refinery outages, particularly in California, have kept inventories balanced despite high utilization rates.
With the close of the summer driving season, we expect gasoline margins to weaken, as they typically do. However, we anticipate continued demand growth outside of normal seasonality, thanks to the stimulant effect of low prices. Future curves for 2016-17 currently indicate that Brent prices will fall below the year-to-date average price, suggesting that gasoline prices could fall further. Gasoline prices may actually revisit and hold at levels last seen during the oil price crash of 2008-09, but this would be driven by global oil oversupply, not cratering demand. The stability of low prices, as opposed to the quick recovery in 2008-09, may also have a greater impact on behavior (for example, consumers might purchase more SUVs) that leads to longer-term demand increases. In addition, this increase in U.S. consumption alone won't come close to balancing global crude markets (and increasing prices) anytime soon, given the magnitude of current oversupply. This disconnect between global crude supply and domestic product demand creates an ideal situation for refiners.
Furthermore, gasoline inventory levels are likely to remain supportive of margins. Despite refiners running at record levels and a 20% increase in gasoline imports in the year to date, inventories remain within their five-year-average levels. Distillate inventories also remain within average ranges, despite softening demand.
In the coming months, inventory levels are at risk of increasing and further weighing on already seasonally weak margins, given that key refinery outages are ending. However, an above-average amount of maintenance and turnaround activity is likely to occur through the first half of 2016, preventing a large buildup in inventories. Refiners have been running all out to capitalize on the recent margin strength, in part by delaying maintenance. Labor strikes during the past 18 months have also resulted in the deferral of maintenance. Both factors suggest a high level of maintenance and lower utilization in the near term.
Crude Differentials May Narrow in the Near Term, but Won't Disappear
While differentials have narrowed since first emerging (outside of short-lived spikes), we continue to see transportation costs as providing a floor over time. In fact, future curves indicate relative stability in key differentials, with the West Texas Intermediate/Brent differential at about $5 a barrel through 2017. However, there are two potential threats to this projected stability: falling U.S. production and approval of U.S. crude exports.
We think the decline in U.S. production is the greatest threat to differentials, given its near certainty, but the timing and magnitude of the decline are the key issues. Our forecast indicates that U.S. domestic production will decline during the next two years, but not to the point that foreign light sources of crude will be needed to meet midcontinent refining demand (approximately 2.2 million barrels a day), which would probably cause WTI to revert to a premium to Brent. We anticipate, however, that spreads could come under pressure during the next two years, as crude production declines to more closely match refinery demand. As result, during the same period, we project declining flows to the Gulf Coast and a drawdown in inventories resulting in an increased probability of narrowing during times of high utilization, such as summer. We do not expect any narrowing to be permanent, however, as U.S. production resumes growth in the long term.
Exports are similarly unlikely to result in a permanent narrowing of spreads. While an outright repeal of the export ban has been gaining steam in Washington, it remains far from certain. Even if the ban is repealed, crude differentials will probably only tighten, not completely evaporate, as the discounting of U.S. prices will continue in order to cover transportation costs to export terminals. As a result, any excess production after meeting domestic demand, of which there will likely be little in the near term, will flow to the Gulf Coast at transportation costs of $3-$5/bbl, then potentially discount further to cover overseas shipments.
Our view is that the near-term market dynamics of robust refinery demand, falling U.S. crude production, and excess international supply are likely to increase the volatility and unpredictability of differentials. However, U.S. refiners' recent investment in logistics assets, their highly complex assets, and their ability to flex crude types (domestic/import, light/heavy, and so on) leave them in a strong position to compete in that type of environment. Over the long term, we view U.S. oil production as cost-competitive with other global supply sources, and we therefore expect it to resume growing in the next couple of years. At that point, transportation costs will support differentials, regardless of export approval.
Refining Earnings Can Improve Even If Market Conditions Don't
To their credit, management teams have not undertaken large, capital-intensive expansions or chased expensive acquisitions with the surplus cash flow generated during the past several years. Instead, investment has been limited to capitalizing on the greater availability of discount crude and natural gas or improving yields. These projects typically require much less capital (processing capacity is much cheaper for light crude than heavy crude), have short payback periods, and generate attractive returns. Thanks to the completion of many of these projects, as well as improved operating performance, refiners can generate earnings growth in a flat-margin environment (or at least help offset the impact of deteriorating margins).
Tesoro (TSO) holds the most potential, thanks to its ongoing improvement and integration programs in California. HollyFrontier (HFC) is investing in a variety of improvement projects, most notably its Woods Cross expansion. Marathon Petroleum's (MPC) increase stems primarily from increasing condensate processing (condensate splitters), distillate production, and exports. Western Refining (WNR) is investing in logistics projects that will increase throughput of cost-advantaged light crude.
Refining Earnings Hold Less Influence Over Time
The other route that refiners have taken to increase earnings is through diversification. Investment in midstream assets (which were later put into a master limited partnership) has been the most visible, but some refiners have been equally aggressive in other areas, such as retail/marketing operations and chemical production. Aside from providing earnings, these nonrefining operations often achieve higher midcycle returns with less volatility than refining. The relative stability of these operations also provides steady cash flow to support shareholder returns, which has been a more important element of their investment appeal. Nearly every refiner, but most notably Phillips 66 (PSX), Marathon, and Tesoro, will be less dependent on refining earnings (especially compared with 2015, a banner year for refining) by 2019, meaning that refining margins (and crude differentials) will diminish as a driver of value.
MLP Acquisitions Offer Way to Accelerate Growth
Refiners initially created MLPs to unlock the value of their midstream assets whose earnings and cash flows were commingled with those from refining operations and valued at a discount as a result. The decision has largely paid off, with MLPs earning high valuations (based on forward multiples) and providing refiners with up-front cash flow through monetization via the dropdown process. At the same time, refiners retain an ever-increasing portion of future cash flow from these assets by retaining all of the general partner interest.
While each refiner started with a large queue of midstream assets available to expand the MLP (HollyFrontier being the exception, given HEP's age), some chose to grow more aggressively through acquisition. The transactions increase GP incentive distributions more quickly, thus increasing the refiner's value without cannibalizing C-corporation earnings. The acquisitions also give the MLPs size and scale to increase organic investment and growth.
The market responded favorably to Tesoro's and Marathon's acquisitions, but we don't think the other refiners will necessarily pursue similar deals. Phillips 66 and HollyFrontier have the more valuable currency of MLP equity, but their management teams sound more circumspect regarding potential deals. Both remain the most likely to acquire another MLP, however. Valero (VLO) could pursue a deal eventually, but its MLP remains relatively new, has yet to receive a credit rating, and has ample dropdown EBITDA pending. Western is more likely to increase WNRL through dropdowns of logistics assets currently under construction or those held at Northern Tier, in which it owns a 38.7% interest. It's also evaluating potentially placing its refining assets in an MLP structure.
Shareholder Returns Are a Focus for Management Teams
With investment restricted, refiners have generated meaningful free cash flow, which they have returned to shareholders through a mix of dividends and share repurchases. While dividend growth has been impressive, yields have remained relatively low. Part of the reason is share price appreciation, but it's also because management teams are aware that the good times rarely last, and a downcycle is practically inevitable. As such, they aim to keep dividend payouts manageable for when a downturn occurs to avoid the dividend cuts of the last downcycle. This policy has also resulted in sizable share repurchases during the past few years. Based on our forecast, we expect the payouts to continue with ongoing repurchase authorizations and annual dividend growth as refiners look to appeal more to long-term investors.
Current Valuations Leave Us Waiting for a Pullback
We think the outlook for refiners is positive, given that market conditions remain favorable and company-specific aspects supportive. Valuations are less compelling, however, as most refiner stocks do not approach an adequate margin of safety, in our opinion. Additionally, asset-based metrics indicate that refiners are trading in line with midcycle levels.
We think better buying opportunities may present themselves, however. Apart from further market volatility, especially in energy, seasonal margin weakness or narrowing of differentials may pressure share prices. We highlight Marathon and Tesoro as currently the most compelling of the group, based on their discount to our fair value estimate and outlook.
We like Marathon's high-quality asset base, which is concentrated in the midcontinent and Gulf Coast, its integrated model, and its nonrefining earnings growth potential. Its acquisition of Hess' retail operations offers earnings upside through integration and location enhancement. The acquisition of MarkWest Energy (by MPLX) creates a larger MLP platform to take on more growth. Concerns about whether the deal will close (we think it will) is probably pressuring Marathon's share price, making the shares more attractive.
Tesoro offers the greatest potential to generate earnings growth through further improvement projects and integration of its California operations. It also holds the greatest opportunity for improved feedstock costs with the completion of its Port Vancouver rail-to-marine facility, which we think will ultimately go forward. California margins are weakening with the anticipated return of Exxon's Torrance refinery, which could pressure Tesoro's share price, creating an opportunity for long-term-oriented investors.
Allen Good does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.