Time to Tap the Brakes on Independent Refiners

After being bullish on refiners for the past 18 months, we have turned cautious following a hurricane-related runup in the shares. While storms knocked refineries off line long enough to put a dent in swollen product inventories, boosting margins in the process, we do not see the improvements as sustainable.

On the basis of our analysis of past hurricane activity, these more favorable conditions will prove ephemeral. With stock prices higher, we see much less opportunity in the space and would wait for a pullback. We see warning signs emerging that current strong domestic product demand growth might soon stagnate, increasing the importance of exports for U.S. refiners. And while U.S. refining holds some competitive advantages that will keep exports growing, some companies are better positioned than others.

That said, a shift in capital allocation over the past several years has left many refiners much less reliant on more volatile refining earnings and cash flow than in the past, meaning that dividends are safe even in a downturn.

Hurricane Benefits Unlikely to Persist Prior to the recent hurricane activity, high inventory levels of gasoline and distillate were creating an uncertain outlook for U.S. refiners. The hurricanes that struck in late August appeared to provide a solution by severely hampering refinery utilization for a short time, but long enough to allow inventories to fall back to within their five-year-average ranges. Margins increased (and differentials widened) as a result, and they remain elevated, benefiting refiners as utilization levels recover. However, our analysis suggests these improvements in inventory levels and gains in margins will prove short-lived.

Slicing the data for comparable Category 4 and stronger hurricanes where product inventories were also above five-year averages, we find that the hurricane effect on inventories typically wanes relatively quickly, with distillate and gasoline inventories returning to pre-storm levels within 11 and 6 weeks on average, respectively. Harvey appears so far to be no different, with gasoline inventories recovering towards pre-Harvey levels. Meanwhile, diesel inventories have fallen further, suggesting a longer recovery, but in line with previous events. This also suggests margins are not sustainable at the current level and will probably come under pressure toward the end of 2017 and into 2018, based on our analysis of previous hurricanes. Apart from Hurricane Dennis, whose impact was amplified by the devastation of hurricanes Katrina and Rita that followed, distillate margins typically retrace to pre-landfall levels within 13-18 weeks. Gasoline margins showed a quicker retracement to previous levels of just 3-8 weeks, excluding Dennis.

Warning Signs Emerging on Product Demand With inventories set to rise again, by our estimates, we turn our attention to how and why inventories were so high in the first place. The answer is a mixed bag for refiners but points to trouble ahead, in our opinion. On one hand, high inventories were a function not of weak demand, but of oversupply. This is good for refiners, as the high inventories resulted from above-average utilization and record-high throughput thanks to a relatively favorable margin and differential environment. Furthermore, gasoline demand is robust, with weekly demand figures setting new records, resulting in inventory adjusted for demand (days of supply) sitting at reasonable levels. And although distillate demand remains well below record levels set in 2007, inventory levels adjusted for demand are below average.

On the other hand, the recently strong demand growth is likely to slow or stagnate, in our view. Gasoline gains have largely resulted from the drop in prices, leaving future demand growth likely to be challenged as the bottom in prices has most likely been realized. Meanwhile, distillate demand growth continues but remains well below record highs, as increased economic activity has not translated into greater consumption. With refiners likely to return to high utilization and throughput, inventories could swell again, even on a demand-adjusted basis, threatening margins.

Gasoline Demand Growth Likely to Ebb A host of issues are working against future gasoline demand growth in the United States, including demographics, urbanization, and electric vehicle adoption. However, those are more likely to play out over a longer period. In the near term, we see two key elements that have driven the recent growth in gasoline demand growth but are running out of steam: prices are unlikely to decrease further, if not increase, and unemployment levels are unlikely to improve much more.

Since 2007, gasoline demand has demonstrated much more price elasticity, first declining in the wake of the oil price spike in 2008 and then again in 2011-12, when oil prices returned to the $100/barrel level. Conversely, demand spiked in the past two years, setting new records on a sharp drop in prices in late 2014. However, we think we’ve seen a bottom in oil prices already and, as a result, a bottom in gasoline prices. While our oil price forecast is $51/bbl in 2018, implying a move lower from current levels, we see prices eventually averaging $60/bbl. In any case, $51/bbl oil implies higher gasoline prices than we saw in 2015-16. We think at the least this will translate into higher gasoline prices and act as a headwind to further growth, if not lead to an outright decline.

Although lower prices have likely been the primary variable, we think steadily improving employment levels have also contributed to a recovery in gasoline demand. Typically, higher levels of employment would mean more commuting--that is, more miles driven. While we’re not forecasting future employment levels, it stands to reason that with unemployment currently at 4.4%, further improvement compared with the past several years is likely to be limited, given that the lowest point on record is 3.8%. Furthermore, while employment levels have continued to grow, recent additions appear in part to be related to stabilization of the workforce participation rate, meaning that further gains without an improvement in the unemployment rate would require an actual reversal and move back toward historical levels.

One potential mitigating factor is the increase in sales of light-truck sales the past few years, spurred in part by the drop in gasoline prices. Much less fuel-efficient than passenger cars, sales of which have fallen, light trucks could ultimately support gasoline demand in the face of rising prices. While overall fuel efficiency had been rising, it appears that the previous boom in truck sales (2003-05) probably contributed to the stagnation in the overall improvement in light-duty fuel efficiency in the following years. A similar outcome could occur in the coming years, thanks to the latest bump in light-truck sales.

Economy Is Booming, but Where's the Distillate Growth? Distillate demand growth typically tracks economic growth, yet it has proved elusive since 2011, despite steady economic expansion with volumes essentially flat at 3.9 million barrels per day, well below the record levels reached in 2007 (4.2 mmbbl/d). Two factors appear to be at play. First, demand for residential heating oil has collapsed 25% since 2007, with more homes using natural gas, removing a key historical demand plank. Second, while economic and shipping activity has steadily increased since the last recession, on-highway distillate consumption--the greatest source of demand--remains below 2007 levels. This disconnect may speak to greater reliance on regional distribution networks, which has probably resulted in shorter routes and smaller loads. This explanation would also help explain the dichotomy between the Federal Reserve's indexes (freight transportation services and truck tonnage) and the American Trucking Associations Truck Load Index since the recession. While the former has surpassed its high of 2008, the latter has grown but remains below its peak, suggesting less reliance on long-haul truckloads, which would typically drive distillate demand. Heavy-duty truck mileage per vehicle and truck ton miles are also below previous peaks. These factors, combined with modest fuel efficiency improvements, mean a greater amount of shipping and distribution activity is occurring with less distillate than previously. Speaking more broadly, the economy appears less reliant on distillate than it has been in the past. As such, even if calls for continued strong economic growth prove correct, it might not necessarily translate into the same magnitude of distillate demand growth.

Importance of Exports Increases With Domestic Demand at Risk With the outlook for future domestic demand growth increasingly at risk, U.S. refiners will become more reliant on the export market. In fact, distillate has already laid the groundwork and provides a potential path forward for gasoline. Distillate exports have allowed increases in production despite no increase in domestic demand and now account for 25% of production. Gasoline exports remain a relatively small portion of production at 7%, but they are growing and will probably need to continue doing so for refiners to maintain high utilization levels.

When we look at the reasons for the recent growth in exports, we see potential for future growth. First, recent export growth has largely come from increasing volumes to Latin America, where a decline in refining capacity in the face of growing demand has been exacerbated by falling utilization. As a result, Latin American countries have had to increasingly turn to imports to meet growing demand. Thanks to the advantage of low-cost, high-quality assets and proximity, U.S. refiners capitalized on the situation to increase gasoline and distillate exports to over 500 mmbbl (1.4 mmbbl/d) in 2016 from 250 mmbbl (700 mbbl/d) in 2010. We expect Latin American markets to remain a growth opportunity for U.S. refiners, providing a natural home for excess refined product. Even if utilization levels recover, Latin America is set to realize demand growth of 500 mbd through 2022, compared with capacity additions of less than 100 mbd, owing to delays and cancellations of major projects, keeping the structural supply deficit in place. On that note, refiners such as

Outside Latin America, global refining capacity additions are set to total 6.8 mmbbl/d by 2022, but 30%, or 2.3 mmbbl/d, of that is in China. Based on history, some of that capacity will be deferred or canceled outright. The bigger threat to U.S. refiners is the planned 2.1 mmbbl/d of capacity to be added by 2022 in the Middle East, given that U.S. refiners are likely to directly compete with Middle Eastern refiners for European market share. We maintain, however, that U.S. refiners hold important competitive advantages that keep export growth viable even in the face of growing capacity. With their complexity, low-cost feedstock access, and operating cost advantage thanks to natural gas, we expect U.S. refiners to continue expanding their export position.

U.S. refiners will also potentially benefit from changes in marine fuel standards by the International Maritime Organization that lower the sulfur emissions cap for marine bunkers to 0.5% from 3.5%. While marine fuel is a relatively small portion of global oil demand at 4%, it still equates to an incremental 3 mmbbl/d of low-sulfur diesel demand in 2020. U.S. refiners’ high complexity means they produce little residual fuel that is currently used for marine bunkers, limiting their exposure to the change. Meanwhile, the incremental demand could either tighten global supplies, boosting margins, or create additional export opportunities.

Amongst U.S. independent refiners, those on the Gulf Coast are best positioned, given their high complexity and access to export markets. In our coverage universe, Valero,

Exports also keep margins connected to the international markets, without which U.S. margins would be set on U.S. supply demand fundamentals only. While this has historically not been an issue, it has become important with the advent of light crude differentials, primarily the West Texas Intermediate/Brent spread, which advantages U.S. refiners. Without the link to international markets and the marginal price set by Brent prices, inland light crude discounts would result in lower product prices, not extra margin. While not an issue for Gulf Coast refiners, it is a risk for inland refiners as they become largely self-sufficient. Previously reliant on Gulf Coast refiners to meet demand, PADD 2 (midcontinent) refiners are now meeting all of their own gasoline production and nearly all of their distillate. Once this full self-sufficiency occurs, inland refiners might find that more low-cost U.S. light crude results in lower gasoline and distillate prices, not wider margins as it has in the past. It also raises the risk that increases in production will not be possible without access to additional markets, which will be difficult without infrastructure.

With Hurricane Bump, Valuations Look Full Even with only modest gains from their master limited partnerships, refining shares have performed well over the past year, outpacing the market. Additionally, shares have run in the wake of the recent hurricane activity and concurrent expansion in product margins and light crude differentials. As such, we see shares as more fully valued today than we did a year ago. This is also reflected in our asset valuations (enterprise value/complexity), which have improved over the past 18 months, with shares now trading at or above our estimates of historical midcycle value.

While there was initial optimism in the wake of the presidential election that the Trump administration would abandon renewable fuel blending targets or move the point of obligation further downstream away from refiners, those hopes have faded, and prices for renewable identification numbers have risen in response. Although it was recently reported that the Environmental Protection Agency would allow exports to count toward the standard, which would reduce pressure on RIN prices, reports now suggest the president has directed the EPA to halt any planned changes to the renewable fuel program. Consequently, RIN prices have continued their upward climb.

Strong Record of Shareholder Returns to Continue Since emerging from the recession in 2009, refiners have prioritized shareholder returns through dividends and repurchases. In addition to strong refining conditions over that time, refiners have generated cash through asset drop-downs to MLPs that have gone on to support those returns. Shareholder returns have slowed in recent years, with repurchases falling and dividend growth moderating as the refining environment has become more challenging and cash proceeds from drop-downs have tapered off. However, we still expect the group to continue its strong record.

While we expect refining conditions to remain favorable enough to generate strong cash flow, our confidence in continued dividend growth and additional share repurchases lies with the structural changes in refiners that have occurred since the last cycle. These changes include the diversification of earnings away from refining and toward businesses with more stable earnings, such as midstream and retail. Perhaps the greatest benefit of earnings diversification is the stabilization of cash flow that can ultimately support future shareholder returns. Historically, dividends have proved difficult for refiners to maintain in downcycles. During the 2009 downturn, Valero cut its dividend while Andeavor eliminated it outright. Only HollyFrontier, which had relatively little debt, maintained its dividend through the downturn. We think this risk has been greatly diminished with the diversification of earnings into retail and midstream, making independent refiners more palatable to dividend-oriented investors who would otherwise avoid the space. By our estimates, in 2020, all refiners but Valero and HollyFrontier will be able to cover their dividend with free cash flow from nonrefining segments.

Valero has gained attention for communicating a clear shareholder-return policy with guidance for a 40%-50% payout ratio of adjusted operating flow (previously 75% of net income) , setting it apart from peers. While others are less forthcoming, our analysis suggests many have similar capability. When applying a 45% payout ratio to operating cash flow in 2018 and 2019 (combined), we see that Valero would pay out about 75% of its free cash flow. If other refiners were to adopt the same policy, they would end up paying out a similar portion of free cash flow. Including proceeds from drop-downs, many others such as Marathon could easily pay out 40%-50% of operating cash flow.

Alternatively, when we look at what companies are likely to do based on our dividend increase forecast and current repurchase authorizations, we see that Valero’s stated policy leads to the highest yield and greatest implied payout of free cash flow. However, other refiners’ lower payout levels suggest they could actually increase payouts to match Valero if they so desired. In other words, their lack of a clear payout policy is not necessarily indicative of their ability to generate free cash flow. In Marathon’s case, management has signaled that it will be using proceeds from its accelerated drop-down schedule to repurchase shares, giving Marathon a yield nearly equivalent to Valero’s with upside.

Retail Operations Support Refiner Moats, but Hold Room for Improvement Of the independent refiners we cover, Marathon (Speedway) and Andeavor both have large retail segments. In our view, retail operations increase refiners' value and provide steady cash flow and earnings to support shareholder returns. We also think they can be considered moat-enhancing.

On the basis of historical returns on invested capital, Casey’s General Stores and Couche-Tard stand out among independently run retail businesses for level of returns and consistency. When we compare the key operating metrics of Marathon’s Speedway retail segment and Andeavor’s (combined Tesoro and Western) retail segment with these two companies, we find they do well on volumes but lag on margins, indicating room for improvement.

We evaluate convenience retail outlets on their two revenue and earnings streams: merchandise (grocery and food) and fuel. On merchandise, we look at sales revenue per store and gross margin. Speedway and Andeavor do well on driving volume through their stores, as indicated by their above-average revenue per store, but fail to match the margins of others, especially Casey’s, which has a large prepared-food operation. Fuel is a similar story, where both drive relatively high volumes but deliver below-average margins. The two are likely linked, with food offerings probably attracting fuel customers who are willing to overlook higher fuel prices. That said, the higher-than-average merchandise volumes for Speedway and fuel volumes for Andeavor result in increased EBITDA per store for Speedway and Andeavor, while they also deliver strong EBIT margins, indicating strong operating performance and cost control. Overall, we see good stories for both, as they are currently operating at average levels but have room for improvement and potential for future earnings growth outside store count expansion.

While historical ROIC performance of some independent retail operators might suggest narrow economic moats, we find they actually hold few sustainable competitive advantages and suffer from a lack of switching costs. Despite these challenges, Couche-Tard and Casey’s would seem to qualify, given the level of returns and consistency. Casey’s, for example, benefits from a reduced cost structure thanks to its use of technology, proximity to distribution centers, and fresh food offerings that set it apart.

The moat argument for retail as part of a refining operation would be slightly different, however, as it would be part of an integrated business and offer cost benefits. As Marathon recently noted in its analysis of whether to keep or spin off its Speedway retail segment, it realizes upward of $390 million per year of synergies through integration with refining. Andeavor probably realizes similar benefits, given its retail segment’s size after the acquisition of Western Refining. Importantly, a retail segment provides opportunities to blend biofuel and create RINs, defraying a cost incurred by the refining operation. In the current environment of high RIN prices, an integrated refining retail business would be at a cost advantage.

Market Placing an Increasingly High Value on Retail Operations The market appears to value retail earnings more than refining earnings. At issue for Marathon in its review of Speedway was whether the market accurately recognizes this value. The issue has become more relevant as several recent M&A transactions have highlighted the potential value of strong-performing retail operations.

For our part, we value the cash flows from retail operations for both Andeavor and Marathon, and as such, we recognize their value independently from the refining and other operations and in line with market valuations. Given that Marathon is trading close to our fair value estimate, we find ourselves in agreement with management that the market is recognizing this value and there is no need for a spin-off.