Refining Some Profits

By Aaron Levitt | February 28, 2011 AAA

As oil prices continue to rise, many companies within the energy sector have also seen similar gains. Funds like the Vanguard Energy ETF (NYSE:VDE) have been quite successful in capturing the recent upside in energy equities. However, while the oil service sector and exploration and production (E&P) firms have shined in the spotlight, the refiners haven't been so lucky. Despite the fact that refining margins are at their highest level since 2007, many integrated oil companies have been trimming their refinery holdings to help reduce the volatility of their earnings. This record glut of refinery capacity for sale has created one of the few values left in the energy sector and recent M&A deals highlight what's to come.

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Record Asset Sales
Oil and gas producers have put up refineries for sale corresponding to nearly 2.5 million barrels of daily refining capacity for sale globally. Approximately enough capacity to process the entire crude output of Nigeria or Norway. As major oil producers have been selling refineries in order to cut debt and redistribute capital into exploration and new developments in higher growth regions, refinery assets are available for 80% less than they fetched in 2006. Sunoco (NYSE:SUN) sold a Toledo plant to privately held PBF Energy for $400 million or about 23% of the plant's historic value, and more recently, Holly (NYSE:HOC) offered to buy-out Frontier Oil (NYSE:FTO) at a discount, although refiners have been historically acquired at a 17% premium.

These fire sale prices have attracted energy producers domestically and abroad as refining margins have tripled since November. Foreign oil giant's Petroleo Brasileiro (NYSE:PBR) and Russia's Lukoil OAO have been eying U.S. refinery operations as a way to increase their access to the world's largest gasoline market. All of these refinery sales and deals come just as demand for gasoline and diesel is increasing. Improving job growth, consumer sentiment, and freight traffic will continue to boost margins and, according to Chief Executive and President of Valero Energy Corp. Bill Klesse, world diesel demand is estimated to grow to nearly 27 million barrels a day by 2012 . The 80% plus discounts refineries are currently fetching, put them in the "dirt cheap" category relative to future profitability and global demand. (The inability to forecast future events can turn the markets upside down. Find out how to stay right-side up, check out Investing During Uncertainty.)

Finding the Bargains
So far there has been just over $93.7 billion in energy and power M&A activity in 2011. That's already 40% more activity than during all of 2010. The refiners represent an opportunity for investors to add one of the few values left in the energy sector ahead of rising profits and additional merger activity. Here are a few picks.

Last month, Marathon Oil (NYSE:MRO) announced plans to spin off its six refineries and its Speedway convenience-store chain. This will create the fifth-largest American-based refiner. According to analysts, the spin-off will have a cheaper valuation than any other U.S. refiner that also doesn't have E&P operations. Investors can get ahead of the cheap prospect now by buying shares pre-spin-off.

Just like its namesake, Tesoro Corporation (NYSE:TSO) may be one of the treasures in the refining sector. Since 2007, the company has been the subject of more than a dozen takeover rumors. However, the company has continued to get metrically cheaper and currently has the cheapest valuation among U.S. refiners based on projected EBITDA. Its seven western refineries could be a prize in any M&A transaction. Similarly, smaller refiners Western Refining (NYSE:WNR) and Alon USA (NYSE:ALJ) could be targets as well.

Finally, on the acquisition end, Valero (NYSE:VLO) has been on the hunt for refinery capacity in Europe. Valero CEO Bill Klesse has been quoted as saying a European deal would add "a lot of shareholder value," and "There's quality stuff for sale in Europe." This is has lead to speculation that Valero will buy Chevron's (NYSE:CVX) Pembroke U.K. refinery. Either way, Valero still represents one of the largest and better-suited refiners to participate on the buying end of any deals.

Bottom Line
Despite the recent rise in oil prices, the refiners seemed to have missed the boat. The recent glut of asset sales in the space, come at just at the moment when margins and demand are rising. Trading at 80% discounts to historical values, refineries are one of the few value plays in the energy sector. The previous picks represent some of the best ways retail investors can take advantage of the discounts and add the subsector to portfolio.

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