For energy stock investors, the last six or seven months have been pretty lousy. Supplies of oil continue to rise, while demand has basically vanished. That hasn’t great news if you’re a firm that produces crude oil. As oil prices have plunged from their $100-plus per barrel peaks, both share prices and profits for many exploration and production firms have followed suit.
But it’s not all doom and gloom in the energy sector. Those firms that require crude oil as a feedstock are feasting on the cheaper prices. That’s translating into some big time profits at the refiners. For investors, it highlights the need for portfolio positions all the way up and down the energy value chain. (For more, see: What Determines Oil Prices?)
A Boost for Manufacturers
What a difference a few years makes. Rewinding back to 2013-ish, almost every integrated energy firm was looking to get rid of their downstream operations as they were a drag on profitability in the age of high oil prices. Well, it seems like the refiners may get the last laugh. The huge supply glut of crude oil is reversing the tide and that trend looks like it will continue for quite a while.
Energy production in the U.S. hit a record 9.4 million barrels per day during the first quarter of the year. This is in spite of a continued drilling slowdown and work stoppage in many marginally profitable shale regions. The nation is simply awash in crude. So much so, that the U.S. has seen its days of crude oil supply metric rise to 29.5 days’ worth versus 24.8 days this time last year. That amount of crude oil, plus continued rising supplies elsewhere in the world, has driven prices down by about 50% over the last seven months. While that drop means pain for shale operators like EOG Resources Inc. (EOG), it can be a boon for those that need oil to produce their wares. (For more, see: Oil and Gas Industry Primer.)
The Crack Spread
For the downstream industry, the key is what’s known as the crack spread. Basically, the crack spread is the difference between the cost of crude oil and the price of various refined products, including gasoline, heating oil and jet fuel. The lower the input cost of crude oil, the higher the crack spread. And for the refining sector, the margins have never been sweeter. At the beginning of June, the 3-2-1 crack spread — which looks at the difference between three barrels of raw crude oil and two barrels of gasoline and one barrel of heating oil made from it — sat at nearly $18 per barrel. While that’s not all-time highs, it still results in some pretty sweet profits for the refiners.
Adding to those refining profits have been other falling costs. First, natural gas also continued to see dwindling prices. The refiners have been able to lower their own energy costs by using the cheap fuel. Secondly, the Environmental Protection Agency’s (EPA) recent propels to cut renewable (i.e. ethanol) requirements should help margins even further as the downstream sector won’t be required to pay fees/fines for going over the so-called blenders wall. These two items plus rising refined productions export should help boost the downstream sectors potential over the longer term. (For more, see: The Difference Between Oil Services and Refiners.)
Making a Downstream Bet
Given the potential for higher profits in the downstream sector and lower average energy prices over the next year or so, investors may want to shift some of their energy capital to the refiners. Unfortunately, unlike many sub-sectors of the stock market, there is no broad downstream/refining exchange-traded fund (ETF). Some energy ETFs, like the Energy Select Sector SPDR ETF (XLE) or iShares US Energy (IYE), do have exposure. However, that’s only in the single digits. The PowerShares Dynamic E&P ETF (PXE) boosts that exposure to 33%. So far, that added exposure has made PXE a star performing in the energy sector.
However, this is one instance where investors may want to go with individual picks. And you can’t do wrong with leading refiner Valero Energy Corp. (VLO). VLO owns 15 refineries across the U.S. and has a total capacity of 2.9 million barrels per day. That size and scope makes Valero a great play on increasing margins. VLO has been able to use “just-in-time” sourcing to get the cheapest crude when it needs it to run its operations. As such, profits continue to rise at the downstream player. That’s helped boost free cash flows and its now healthy 2.7% dividend, as will tax savings and distributions from its Valero Energy Partners LP (VLP) master limited partnership subsidiary. (For more, see: Unearth Profits in Oil Exploration and Production.)
Speaking of distributions, investors looking for straight high-yield may want to check-out the trio of Northern Tier Energy LP (NTI), CVR Refining (CVRR) and Alon USA Partners, LP (ALDW). The trio are set up to pass through all of their cash flows from operations. As such, rising margins equals higher dividends. Currently, the trio yields 17.8%, 15.9% and 14.6%, respectively.
Finally, the smallest independent refiners could be worth your time. Firms like Western Refining Inc. (WNR) or PBF Energy Inc. (PBF), which are only a small handful of refiners that can act as a leveraged effect on better margins. While someone like VLO might be better play over the long term, PBF or WNR might give portfolios the biggest near-term boost. (For more, see: Oil Price Analysis: The Impact of Supply & Demand.)
The Bottom Line
The refiners are feasting on higher margins. And the sector could continue to see better profits down the road. For investors, the time to bet on the sector is now. (For more, see: Companies Affected Most by Low Oil Prices.)