HollyFrontier's Positioned to Succeed

HollyFrontier is the largest independent refiner that has all of its facilities located in the midcontinent, Rockies, or Southwest regions. As a result, it has benefited from the difference in price between West Texas Intermediate and other high-quality waterborne crude such as Brent. With access to abundant supplies of WTI, HollyFrontier’s refineries have enjoyed the additional margin that this spread offered. While the spread is likely to remain narrow in the near term, we expect it to widen over the next five years. Ultimately, we think the transportation costs to move light crude from the midcontinent to the Gulf Coast result in a long-term WTI differential to Brent of $5 per barrel, well above historical levels (before 2010).

HollyFrontier also has a crude advantage thanks to the complexity of its refineries and their proximity to cost-advantaged feedstock. HollyFrontier has a systemwide complexity rating of 12.1, which allows it to process heavy crude and produce comparable yields of refined product cheaper than refineries that use only the easier-to-refine, but more expensive, light crude.

Given its location, HollyFrontier should have ample supply of heavy crude to process thanks to Canada’s increasing oil sands production. In addition, the company’s smallest refinery benefits from its advantageous location in Utah, where it has access to a local cost-advantaged crude source. The refinery can process black wax crude, which trades at an average discount of about 20% to WTI benchmark prices. To extend this advantage, HollyFrontier recently completed a project to increase the refinery’s throughput of the discount feedstock. As part of the project, total capacity increased to 45,000 barrels a day from 31,000 b/d and black wax throughput capacity increased to 24,000 b/d from 10,000 b/d.

Lower Feedstock Cost Is an Advantage Perhaps more than any other refiner, HollyFrontier has benefited from a wide WTI differential, thanks to the position of its refining assets. All of HollyFrontier's five refineries are in the midcontinent, ensuring 457,000 b/d of capacity to process either discount light or heavy crude while enjoying a discount, given their proximity to the source of production. Given the feedstock cost advantage, we think HollyFrontier earns a narrow economic moat.

While we do not expect a return to the differentials of a few years ago, HollyFrontier should continue to benefit, as we project the differentials to remain well above historical levels.

These projections include projects HollyFrontier has underway to extend its advantage. The company has expanded its Woods Cross refinery by 14,000 b/d and has plans to integrate its recent petrochemical acquisition into its refining system. HollyFrontier does not export product to foreign markets, but it should benefit from continued Gulf Coast exports, which will prevent supply from moving inland.

The continued discount of midcontinent light and heavy crude should continue to benefit HollyFrontier, but with its peers gaining increasing access to discount feedstock as well, it will be difficult to improve its relative position. Expansion and upgrading of its refineries should deliver strong returns on capital, but they do relatively little to alter the competitive advantage, just extend it. While the narrowing of the WTI differential should result in lower margins than the past years, our forecast for it to remain well above historical levels and wider than other differentials ensures HollyFrontier maintains its advantage. A narrowing of the WTI differential beyond our estimates or below their regional differentials could result in a negative moat trend.

Economy, Oil Prices Hold Risk HollyFrontier holds the same industrywide risks as its competition. Primary among these are a potential economic slowdown or quickly rising oil prices that would destroy demand and in turn crush margins. Additionally, its strong performance recently is attributable to wide crude differentials. Significant narrowing or elimination of these differentials would negatively affect performance. Its relatively small refineries represent a concentrated revenue base that puts HollyFrontier at risk in the case that, for whatever reason, one facility experiences an extended shutdown. Legislation designed to reduce carbon dioxide emissions could dramatically increase costs for refiners.

Although debt increased after the acquisition of Suncor’s petrochemical business, HollyFrontier still remains one of the most financially sound independent refiners. We expect free cash flow should allow for deleveraging in the coming years.

Spending should fall over the next few years with the completion of expansion projects. We anticipate operating cash flow should be more than sufficient to cover spending, given current market conditions.

Robust market conditions have resulted in excess cash flow that management has sought to return to shareholders through special dividends. During the past few years, HollyFrontier paid a quarterly special dividend of $0.50 per share. However, since the market never fully credited the company for the higher payout, management decided to redirect capital toward share repurchases. The company still sports a yield above 5%.

Stewardship Is Exemplary Though the old management team has moved on, we retain our confidence in HollyFrontier's leadership. We have thought highly of the executive team for its ability to shrewdly expand the company. The most notable example was the acquisition of two Tulsa facilities at rock-bottom prices. By combining the two facilities, Holly was able to avoid $100 million of regulatory capital that made the facilities uneconomical to their previous owners while creating value for Holly shareholders. We think this disciplined, opportunistic capital-allocation strategy remains in place with the new leadership.

In the past, when robust operating conditions resulted in excess cash flow, management substantially increased shareholder returns via repurchases and dividends, which have far outweighed similar efforts by peers. While HollyFrontier has increased cash distributions, it has not done so to the detriment of the underlying business. HollyFrontier continues to invest in improving its competitive position, most notably in the Woods Cross expansion. We anticipate management will continue to look for similar opportunities to expand the company and deploy capital effectively, most likely in projects to capitalize on discount feedstock or to improve yields. Some of these projects will also be dropped down to Holly Energy Partners HEP to increase its growth rate and make it more competitive with peers’ master limited partnerships.

Refinery acquisitions are possible within HollyFrontier’s current geographic footprint, but we think they are unlikely. If opportunities for acquisitions or increased investment arise, HollyFrontier should not have trouble taking advantage despite the dividends and repurchases, given its strong balance sheet.

Considering management’s acquisition and capital-allocation record and delivery of cash returns to shareholders relative to peers, we think the team earns an Exemplary stewardship rating.