Market Conditions Still Favorable for Independent Refiners
We think Marathon Petroleum and Valero are the most attractive.
Coming into this year, expectations around the effect of IMO 2020 regulation were high. Given the requirement for the reduction of sulfur in marine fuel to 0.5% from 3.5%, expectations were that shipowners initially would substitute some form of their lower-sulfur distillate fuel or mix for marine bunker oil as opposed to installing scrubbers and continuing to run the lower-quality fuel, driving an increase in distillate demand. Consensus held that the results on market prices would be higher distillate prices, lower high-sulfur fuel oil prices, and wider heavy sour crude differentials as simple refiners avoided those crude types to reduce output of residual fuel oil. So far, however, only one of those predicted outcomes has come to fruition, with HSFO prices falling.
The decline in HSFO prices suggests vessel owners are substituting distillate for bunker fuel oil, but the lack of reaction in ultra-low-sulfur diesel prices suggest global refiners are keeping the market adequately supplied with substitutes. Inventories in the United States and globally, measured by days of supply, remain near the bottom of their five-year range, low but adequate. While global inventory lags by several months, weekly U.S. data has actually shown a buildup in distillate inventories in the past several weeks, implying ample availability.
The absence of widening heavy crude differentials is probably a function of limited supply, particularly for U.S. refiners. Declining production from Venezuela and, to a lesser extent, Mexico--both key global producers of heavy crude--has reduced a key supply line for Gulf Coast refiners. Sanctions on Venezuela have compounded the issue by eliminating imports into the U.S. since May 2019. OPEC cuts have exacerbated the problem as producers typically reduce the production of lower-quality crudes to meet quotas. Although Canadian spreads have widened, that’s largely a function of the government relaxing production curtailments as opposed to reduced demand.
Market Still Expects Uplift
It remains early in 2020, and the effect of the International Maritime Organization regulations might not yet be fully reflected in the market. However, when questioned over the past year, refiner management teams typically indicated the effect would begin to be felt in the fourth quarter of 2019 as the market prepared for implementation. This is actually what happened with HSFO, so it would suggest that changes in demand for heavy crude and distillate have occurred as well, but have just not affected pricing.
Regardless, the market still appears to be anticipating an improvement in refining market conditions as a result of IMO 2020, as demonstrated in consensus earnings estimates for independent refiners. While earnings per share estimates for 2020 have moderated over the past 18 months, they still imply sharp gains in 2020 compared with 2019 in some cases, likely a result of anticipated IMO 2020 benefits. Valero (VLO), the only pure-play refiner we cover, is expected to benefit the most. Marathon Petroleum (MPC), now the largest independent U.S. refiner, stands to benefit as well. In contrast, HollyFrontier’s (HFC) improvement should be modest, as its earnings are tied more closely to gasoline and light domestic crude spreads. Phillips 66’s (PSX) relative growth from improved refining conditions is muted because of the company’s diversified portfolio.
Our estimates, which rely on future curves of refining margins for years one to three of our forecast, are largely below consensus, but still reflect year-over-year growth in most cases. In other words, incorporating the weak start to 2020, the absence of IMO 2020 benefits, and rising inventories, current market conditions still imply an improvement from 2019. However, futures are largely not reflecting any effect from IMO 2020, specifically they are not indicating a spike in distillate prices.
Furthermore, U.S. independent refiners should still be beneficiaries of what modest effect is occurring from IMO 2020. Their yields of HSFO remain relatively low compared with global peers, minimizing the effect of falling prices on earnings. Furthermore, higher-complexity refiners such as Valero, Marathon, and Phillips 66 can purchase HSFO as feedstock for their refineries, capitalizing on the lower prices. Also, even though distillate prices haven’t spiked, distillate margins remain strong, benefiting overall refining margins in the U.S.
As it has been for the past few years, gasoline remains a risk. Higher distillate margins continue to encourage high utilization levels, resulting in overproduction. So even though gasoline demand remains solid, margins are depressed as inventory levels remain high. The risk is then that demand will soften, sending inventories even higher and margins lower. However, IMO 2020 might play a beneficial role in the gasoline market as well. Refiners in North America that typically run vacuum gasoil feedstock through fluid catalytic cracking units to produce gasoline might be otherwise be encouraged to direct it toward creating low-sulfur marine fuel blends, which would reduce gasoline yields. In that case, it might act as a supply constraint that translates into lower inventories and improved margins.
Valero Looks Cheap, but We Prefer Marathon Petroleum
Those looking to play an improvement in refining conditions should look no further than narrow-moat Valero. The well-run pure-play refiner stands to benefit the most from improved refining market conditions, given its high-quality asset base, and the shares trade at a wide discount to our fair value estimate. Furthermore, management continues to exhibit capital discipline while maintaining a clear shareholder cash-return policy of 40%-50% of adjusted operating cash flow annually.
However, Marathon Petroleum trades at an even wider discount to our fair value estimate and is similarly well positioned to benefit from improved refining market conditions while undergoing restructuring at the behest of activist investors, which should act as a catalyst. Furthermore, changes are underway at the company that we do not think are fully reflected in the current share price.
The spin-off of the retail segment is set to take place early in the fourth quarter. Marathon’s retail business ranks as one of the better performers among publicly traded retail convenience store operators based on operational and financial metrics, such as EBITDA per store. As a result, it should garner a relatively high multiple when spun out of MPC.
The retail spin-off should unlock some value, given that the average multiple for publicly listed firms is 13.0 times, yet our valuation implies only 10.1 times. Issues surrounding MPLX (MPLX), Marathon’s master limited partnership, are probably the primary reason for the discount between the share price and our sum-of-the parts valuation. MLPs have fallen out of favor on concerns about governance, lack of interest, and flows. Investors in the space are also increasingly calling into question capital allocation and the balance between returning cash to shareholders and financing growth projects. Meanwhile, in some cases executive pay is not properly aligned with investor interests, with priority placed on distribution growth as opposed to returns on capital.
To address these issues, management teams have been eliminating the MLP structure through buyouts by the general partner or conversion to a C-Corporation. The C-Corporation results in better alignment of management and shareholder interests, more transparency around compensation, and a broader investor pool, as many funds and indexes are prohibited from owning MLPs.
An update on any strategic actions is expected in the first quarter, but we think Marathon will ultimately pursue the option of converting MPLX to a C-Corporation, either by spinning off the GP and then doing so through a buyout of MPLX, or just converting MPLX as it currently stands and retaining the GP. Marathon has already exchanged its GP incentive distribution rights for LP units, so it’s no longer acting as an overhang on the valuation.
MPLX is also likely to diversify low-growth assets so it can focus on the greater growth opportunity in the Permian and Marcellus. While we think MPLX has a set of quality assets, evidenced by our narrow moat rating, there is opportunity to trim the fat. The addition of Andeavor Logistics arguably diluted the portfolio as it was one the weakest refiner MLPs under our coverage. In pursuit of growth, Andeavor Logistics acquired midcontinent gas assets, which are now suffering due to a lack of activity because of low prices. The remainder of its assets are tied to storage and terminaling assets around Marathon’s California refineries. While offering steady earnings, growth is limited, and long term, they face the threat of declining refined product demand in the state. Divesting the midcontinent assets would improve the overall portfolio and leave it with ample growth opportunity in the Permian and Marcellus. The proceeds could also be used to repurchase shares.
Finally, the planned departure of longtime Marathon Petroleum CEO Gary Heminger in 2020 could spur further restructuring, and more action to unlock value might be expected. Former Andeavor CEO Greg Goff was previously understood to be the most likely replacement, but he is retiring as well, leaving the CEO role vacant. The board is currently searching for a replacement and will consider internal and external candidates. Regardless of the selection, we anticipate the new CEO’s arrival will spur further action, especially if Marathon continues to trade at a discount to our sum-of-the-parts fair value estimate.
Allen Good does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.