Three months ago, I wrote this article warning that the Brent / WTI spread was collapsing, and the effect on a specific group of mid-continent refiners would be negative. Since then the stocks are down about (15%) to (25%). The downside risk to the stocks, however, is not over. The oil spread has continued to contract to about $5 currently from $10 back then. Second quarter reports are about to begin, and the valuations of the stocks still do not reflect a normalized operating environment for these refiners. That leaves the risk of more downside for the stocks of (35%) or more.
For a detailed explanation of why these refiners' returns are tied to the Brent / WTI oil spread, please refer to my previous article. Since then the spread has continued to narrow. The peak for the spread was in the high 20's in the fall of 2011. In April of this year it was about $10, and that has now contracted to just $5. You can see a chart of this spread here. This coming second quarter report could be a negative catalyst for these stocks. Not just because the second quarter is at risk of missing analyst consensus estimates, but the outlook for the next two quarters are likely to be revised materially lower from the current street numbers.
Below is a chart that contains a number of refiners that benefit from the spread, and a couple that don't receive nearly as much of an effect. It shows each company's EBITDA margin dating back to the second quarter of 2010 up to the last report. At the bottom is the spread at the end of each quarter. There is seasonality in the refining business. The second and third quarters are usually the peak margin period during summer driving months. So the absolute margin is not going to correlate completely with the oil spread. It's also the average spread over the entire quarterly period that matters. Not just the period end figure that I have listed on the chart.
source: company reports and SEC filings.
Valero (VLO) and Tesoro (TSO) are examples of more diversified refiners that don't get as much of a benefit from the oil spread. An investor in refining companies at this point needs to decide what a logical EBITDA margin should be expected for the other companies on this list considering the contraction in the oil spread. For example, Western Refining (WNR) in 2010 was generating an EBITDA margin of 4.5% in the third quarter when the spread was about $3. That spread nearly tripled to 12.4% by 2011's third quarter, and was 9.7% in the same period of 2012. So what should we expect for WNR for 2013's third quarter? Assuming the oil spread stops contracting and averages about $5, then it looks like something between 3.5% and 6% for an EBITDA margin should be anticipated based off of the Q3 '10 - Q1 '11 historical performance. Last quarter WNR reported an 11.1% margin. So it appears there is risk of it getting halved or more in the near future. Delek (DK), HollyFrontier (HFC), CVR Energy (CVI) and Marathon Petroleum (MPC), all show similar downside risk to their margins in varying degrees. So have Wall Street analysts adjusted their numbers yet for these margin risks?
The simple answer is no. The bullish argument on the street expected the spread to stop contracting at the $10 point. The thought process was that the cost of transporting crude by rail averaged about that $8 figure which would act as a buffer zone to future contraction. The assumption was also that the pipelines that were due to come on-line to alleviate the bottle neck of crude inventory in Cushing OK, wouldn't start having an impact until further into 2014. However, the market doesn't care as it has continued to contract the spread anyway. Why? That's what markets do. Once the market sees the trend it tends to discount the future conclusion sooner than the actual supply demand inputs would suggest. This is also the mistake the Federal Reserve is making with the markets regarding the tapering comments. It doesn't look like many analysts have adjusted their numbers yet. The street usually waits for an event to issue reports and change their numbers. There are always a few analysts to get out in front, but the herd tends to wait for company reports. The picture so far suggests a lot of adjusting needs to be done. The second quarter reports that start soon are likely to be the catalyst for the necessary revisions.
|EPS||Q1 '13||Q2 '13e||Q3 '13e||Q4 '13e||FY '13e|
|HFC||$ 1.63||$ 1.62||$ 1.66||$ 1.08||$ 5.99|
|CVI||$ 1.81||$ 1.68||$ 1.27||$ 0.61||$ 5.37|
|WNR||$ 0.94||$ 1.35||$ 1.12||$ 0.70||$ 4.11|
|MPC||$ 2.17||$ 2.73||$ 2.96||$ 1.94||$ 9.80|
|DK||$ 1.28||$ 1.28||$ 1.20||$ 0.52||$ 4.28|
source: yahoo finance.
So where can these stocks decline too? In my previous article, I outlined how I like to use a non-traditional valuation metric of Enterprise Value to Total Capacity (EV/Ton). I believe this gives a good encapsulation of the cyclical nature of the business, and avoids the earnings or cash flow pitfalls associated with such metrics as Price to Earnings (P/E) for such a company. If you think these companies are cheap, then you must answer to yourself why the stocks always peak with low P/E multiples, and bottom with high P/E multiples. Once you answer that question, then you'll understand why P/E is the wrong metric to use for valuing these kinds of companies. What I have done on the chart below is take the average high and low EV/Ton of capacity from 2008-2010 for HFC, WNR and DK. I then applied those average ranges to the current enterprise value of the companies to get implied high and low end valuation ranges. This assumes that the market is going to discount back to the normal compressed oil spread before the 2011-2012 time frame. This analysis admittedly does not include the many company changes that have occurred since then. For example, some of these companies have added more capacity. The market may decide to value the new capacity higher than what it used to give the company without it. Also, there has been significant improvement in the leverage employed on these companies' balance sheets. Thanks mostly to this unusual period of expanded oil spreads. So this is just a framework to show you how much potential downside still exists. The market also may not take them all the way down to these valuations since there's still a $5 spread. However, as I mentioned the risk in markets is that they discount before the end gets there if it believes that conclusion is inevitable. The result is that there may be (35%) to as much as (70%) more downside left in these stocks.
|08-'10 High End||21.3||10.4||11.4|
|08-'10 Low End||10.1||6.2||5.8|
|Impld High End||$ 50.81||$ 13.87||$ 30.58|
|% from cur price||25.6%||(48.8%)||9.8%|
|Impld Low End||$ 26.71||$ 8.08||$ 17.27|
|% from cur price||(34.0%)||(70.2%)||(38.0%)|
source: company reports and SEC filings.
To conclude, the Brent / WTI oil spread has continued to contract all the way down to just $5. The likelihood of material EBITDA margin compression for the refining companies that benefit is very high, and the magnitude of that compression could be as much as (50%) or greater. The street analysts have not lowered their numbers yet to account for the contraction in margin, and the catalyst for doing so is likely to occur after this second quarter earnings report. Despite the stocks declining (15%) to (25%) from when I last wrote about this subject, there is still significant downside risk in the stocks based upon their traditional valuation ranges on an EV/Ton basis. Even if you believe that the second quarter numbers are going to be close to street estimates for a given company, I suspect that the forward look is going to be low enough to drag these stocks down further. Therefore, don't hold on to these stocks thinking that enough damage has already been done. There is plenty more downside left for these refiners that have benefited so well from the unusual Brent / WTI oil spread over the last couple of years.