What The Street Might Be Missing On Refiners; Why The Brent/WTI Spread Might Continue To Contract

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Includes: CVI, DK, HFC, MPC, TSO, VLO, WNR
by: Non-Correlating Stock Ideas

Introduction: Recently the stocks of refining companies have drawn some attention as this has been a strong momentum group that has suddenly pulled back about 15-20% from recent peaks. Most of the focus has been on the announcement from the EPA concerning new regulations around sulphur content in gasoline. There's also been focus on the overall decline in the price of oil and thereby gasoline prices, and how it will affect refining margins. But the primary issue I think that the street assumes won't be an intermediate to long-term risk is the continued contraction in the WTI/Brent crude spread. The global oil market is the largest and arguably the best example that economic theory has of a perfectly competitive marketplace. This is why historically there hasn't been a spread between crude prices in Cushing Oklahoma (WTI) and Brent crude blend (Brent) in the North Sea.

Background: Over the last couple of years, however, a significant spread has appeared due mostly to the increase in U.S. domestic production of oil from shale fields, and a pipeline system that was not designed to move oil production from internal sources towards the gulf coast. Most refineries are located on the coasts as traditionally the majority of their stocks were coming from foreign sources. This created a rise in crude inventories at Cushing, which pushed the local price down relative to the global market. Refineries that can access this cheaper cost crude stock can benefit as their end product prices are still set by the global market. Assuming capitalism still works, then eventually this spread will contract returning to a normal balance with global pricing. The initial economic response was to shift the direction of flow for the Seaway pipeline in 2012 from crude flowing to Cushing to transporting crude away from Cushing toward the refineries in the Gulf of Mexico. Next, the owners of the Seaway announced an expansion plan to increase the total rate of flow through the Seaway system, and then more announcements for new pipelines followed. The big picture is that the spread will return to normal. It is only a question of how long it will take to get there.

Economic Thesis: If you read some of the transcripts from the companies at the Refining Conference last month, then you'll find that everyone is pretty much pushing the same view that the spread should hang in there for the next couple of years before returning to normal. As expected, the analysts have pretty much fallen right in line with the management views. So what does an investor do? One thing is to dig in deep and try to learn about every possible variable that could affect the equation. In this case, you can make estimates for the growth in domestic oil production from key geographic regions. You can make estimates for when pipeline reversals and expansions occur, and you can make estimates for total economic growth and market demands for refined products overall. This would give you a basis for forming a detailed opinion as to when the market would return to balance and the spread would return to normal. The problem is that there are a ton of estimates you have to make in such a situation, and the danger is that you get lost deep in the trees and miss the forest. That's why I like to turn to technical signals for assistance in determining the timing of something like this. We know the spread is going to contract, but we need help in determining when.

Catalyst: The technical indicator I use for help in these matters is Point & Figure. What we are looking for is a sign that we can expect the spread between Brent and WTI to contract, and I think we have a setup right now that looks remarkably similar to the period in Q4 2011 when these stocks sold off by about 30-40% from their peaks. If something similar happens now, then these refining stocks may only be half way through their respective contractions.

Click to enlarge

As you can see, the pattern is eerily similar to that seen in Q4 2011. The key trigger for the stocks seemed to be when the second leg of the "M" pattern broke below the previous low in the spread. That's when you saw the refining stocks really make a move lower. We just had that happen a few days ago, and once again the stocks took it hard. Last time the spread had further to contract after a brief move back up to the breakdown point. It wouldn't surprise me to see another attempt to get the spread moving back out, but if it doesn't get past that breakdown point again then expect further contraction. Last time it was just the announcement of the Seaway reversal that caused the spread to contract without any fundamental changes in the logistics of crude. This time there have been some changes, and while all of the announced reversals and expansions have not been completed yet; I think there is more risk today that the spread just continues to contract from here on out until balance is restored in the future. Once markets sniff out the inevitability of something, they have a funny way of getting there well before the full fundamental force has taken place.

Valuation: Another reason to be wary of the refiners is that valuations may not seem as cheap as they first appear. This is a business that is the epitome of a cyclical stock. Using earnings or cash flow based valuation metrics is going to get you into a lot of trouble, because these stocks will always seem cheap at the top and expensive at the bottoms. What I like to use for refiners as a valuation metric is Enterprise Value to refining Capacity. Here are four refining stocks and the multiple range of EV/Capacity that they have traded in over the last six years.

CVI

2007

2008

2009

2010

2011

2012

Stock High

26.25

30.94

13.89

15.35

29.61

49.63

Stock Low

19.00

2.15

3.13

6.71

16.62

19.19

Shares

86.14

86.24

86.33

86.41

87.77

87.39

Net Debt

470.33

486.95

454.37

343.70

465.57

1.12

Capacity

123,500

115,000

115,000

115,000

115,000

185,000

ev/cap high

22.1

27.4

14.4

14.5

26.6

23.5

ev/cap low

17.1

5.8

6.3

8.0

16.7

9.1

HFC

2006

2007

2008

2009

2010

2011

2012

Stock High

27.98

40.28

28.41

16.77

20.69

38.90

47.39

Stock Low

13.96

22.50

5.42

8.36

11.66

19.92

28.05

Shares

111.91

108.83

100.21

100.49

106.53

159.29

206.18

Net Debt

(250.29)

(270.68)

150.47

506.28

580.12

(575.80)

(1,052)

Capacity

109,000

111,000

116,000

131,000

131,000

187,000

443,000

ev/cap high

26.4

37.0

25.8

16.7

21.3

30.1

19.7

ev/cap low

12.0

19.6

6.0

10.3

13.9

13.9

10.7

DK

2006

2007

2008

2009

2010

2011

2012

Stock High

22.85

30.77

20.47

12.41

8.44

17.50

27.58

Stock Low

12.08

14.82

3.51

5.27

6.06

6.83

10.99

Shares

47.92

52.85

54.40

54.48

54.26

57.03

59.61

Net Debt

185.00

250.90

270.70

183.70

246.70

200.70

(239.50)

Capacity

60,000

85,950

85,950

85,950

87,680

140,000

140,000

ev/cap high

21.3

21.8

16.1

10.0

8.0

8.6

10.0

ev/cap low

12.7

12.0

5.4

5.5

6.6

4.2

3.0

WNR

2006

2007

2008

2009

2010

2011

2012

Stock High

29.44

66.13

25.77

16.30

10.78

21.44

31.04

Stock Low

14.33

23.60

4.50

4.45

4.01

10.23

13.98

Shares

65.78

67.60

67.72

79.16

88.20

109.79

111.82

Net Debt

(263.17)

1,293.94

1,261.18

1,042.11

1,010.09

633.17

46

Capacity

124,000

234,000

238,000

238,000

221,000

151,000

153,000

ev/cap high

13.5

24.6

12.6

9.8

8.9

19.8

23.0

ev/cap low

5.5

12.3

6.6

5.9

6.2

11.6

10.5

Click to enlarge

Source: company reports and SEC filings.

As you can see, this group has seen a general rise in the upper band of the valuations, and as you can see below the current multiple is much closer to the high ends of the band than the lower ends. Suggesting that there is greater risk from multiple compression than expansion at this point.

4/4/2013

VLO

TSO

CVI

HFC

MPC

DK

WNR

Capacity bpd

2,640,000

665,000

185,000

443,000

1,699,000

140,000

153,000

Last Price

41.44

52.98

50.70

48.25

82.62

37.28

32.43

ev / capacity

10.7

11.2

24.0

20.1

16.2

14.2

24.0

Click to enlarge

Source: company reports and SEC filings.

Strategy: All refining companies are not the same. In this case, the stocks most at risk are the ones that have benefited the most from the widening of the Brent/WTI spread due to the proximity of their plants to the cheaper sources of crude stock. Below is a chart showing EBITDA margins for a number of refiners from Q1 2010 till the end of last year on a quarterly basis. Where possible I used company-provided adjusted EBITDA numbers, and refining-segment only numbers for companies that separated their business segments appropriately.

Ebitda Margins:

Q1 '10

Q2 '10

Q3 '10

Q4 '10

Q1 '11

Q2 '11

Q3 '11

Q4 '11

Q1 '12

Q2 '12

Q3 '12

Q4 '12

VLO

1.9%

6.1%

4.5%

3.3%

2.3%

5.4%

7.0%

1.6%

0.4%

5.0%

4.9%

5.7%

TSO

(2.2%)

4.9%

4.5%

3.0%

4.9%

6.5%

8.6%

(0.7%)

3.0%

9.4%

7.0%

5.2%

CVI

(0.5%)

4.9%

6.3%

4.6%

8.3%

15.1%

18.1%

4.9%

7.6%

17.1%

19.0%

10.9%

HFC

0.3%

7.2%

6.2%

3.1%

7.8%

11.8%

17.3%

8.3%

9.6%

17.9%

19.9%

14.2%

MPC

5.7%

4.3%

3.3%

5.8%

7.4%

9.6%

0.4%

5.8%

7.6%

10.1%

7.1%

DK

0.1%

3.2%

1.0%

1.3%

4.4%

6.5%

7.6%

1.4%

4.8%

6.5%

8.3%

6.2%

WNR

1.4%

5.0%

4.5%

3.4%

6.1%

9.1%

12.4%

6.4%

7.8%

14.8%

9.7%

13.3%

Click to enlarge

Source: company reports and SEC filings.

Notice the very sharp contraction of the EBITDA margins in Q 2011. That is the definition of a cyclical business. Here is a chart that overlays all of these companies' margins together:

Click to enlarge

Source: company reports and SEC filings.

It becomes quite clear that there was a significant change in the business starting in 2011, and while historically the group tended to have similar margin levels; significant separation started to occur then best represented by the difference between Holly Frontier (HFC) and industry heavyweight Valero Energy (VLO). The former saw its margin explode to just under 20% in Q3 2012 versus the latter's near 5% mark. The next chart stacks the rate of change in the margins from the first point, which easily displays which companies have benefited the most from the unusual spread in Brent/WTI from whatever their starting point.

Click to enlarge

Source: company reports and SEC filings.

Conclusion: The chart above shows in descending order the companies with the most to lose on a continuation of the contraction in the spread. Each company has its own set of specific fundamental opportunities and risks as an investment, and I encourage anyone to learn about each stock's individual characteristics before making any investment decisions. However, as long as the spread doesn't break back above that middle point in the "M" on that Point & Figure chart I showed above, then I expect these stocks to continue to decline despite the Street's expectation of the spread holding steady for the next couple of years.

Disclosure: I am short DK, HFC, MPC, WNR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.