The WTI-Brent Spread
The spread between West Texas Intermediate (WTI) and Brent crude reflects the dislocations in the crude oil markets. Before 2011, the difference between the two benchmarks has rarely deviated by more than a few dollars. However, for the past two and a half years, Brent has typically traded at a significant premium to WTI. This is despite WTI being considered to be of superior quality to Brent crude because of its lower density and low sulfur content. WTI is therefore easier to refine; and hence it has typically traded at a slight premium over Brent in the past. However, technological breakthroughs in horizontal drilling and hydraulic fracturing (commonly referred to as "fracking") led to a surge in oil production in the US. With the logistical constraints of moving significant quantities of crude over long distances, this had caused a supply glut in Cushing, Oklahoma, the delivery point for WTI contracts.
As new pipelines came online in early 2013, as well as the expanding use of road and rail to move oil from Cushing to the gulf refineries, and as the refineries displace Brent or Brent-like crude imports with domestic light sweet crudes; the WTI-Brent spread narrowed sharply. Since February 2013, WTI's discount to Brent narrowed from around $23 to briefly trade at parity in July.
The narrowing of the WTI spread reflects the shrinkage of the dislocations in the crude markets. U.S. refiners typically purchase crude at lower cost sources, and sell refined products at prices which appear to remain linked to the more expensive Brent crude. The effect of this has been significantly reduced refinery margins, which had caused substantial falls in the quarterly profits at many U.S. oil refiners.
Recent political turmoil in Egypt, and concerns over further supply disruptions in the Middle East and North Africa have once again led to the divergence of the prices of WTI and Brent crude. As of yesterday, Brent traded at more than a $6 premium to WTI. With U.S. oil and gas production increasing, there would be further pressure on the logistical constraints of moving crude to the refineries. As such, we should continue to expect volatility in the spread on the price of crudes amongst different regions in the next few years. Although the WTI-Brent margin may not widen back to the above $20 levels, it remains likely that the WTI-Brent spread will continue to persist at the mid-to-high single digits.
Rising cost of RINs impacting earnings
Another factor affecting recent earnings has been the rapidly rising cost of Renewable Identification Numbers (RINs). Under the 2007 Renewable Fuels Standard, U.S. refiners are required to blend an increasing quantity of biofuels into fuels such as gasoline and diesel. For refiners who fail to blend their mandated amount of biofuel, they are obliged to purchase RINs, which act as ethanol credits, for the shortfall of the amount they are mandated to blend into their fuels. With declining gasoline consumption, partly as a result of increasing efficiency in vehicles, the proportion of biofuel in fuels would have to exceed the so-called 'blend-wall', which is 10%. Car manufacturers rarely recommend the use of gasoline which has a content of ethanol which exceeds 10%, as fuel containing more ethanol could damage its engines.
Refiners which have limited ethanol blending operations, such as with operations in the Mid-West and the Northeast, have been most vulnerable to the rise in the market price of RINs. One such example of a refiner affected would be PBF Energy (NYSE:PBF), which now expects to spend over $200 million on RIN purchases, which is $140 million more than originally budgeted. PBF has said it is planning to increase blending of renewable fuels and export more of its refined products to reduce its RINs' exposure. Many refiners, who are also reliant on purchasing RINs from the open market, are also seeking to do the same. Valero Energy (NYSE:VLO), HollyFrontier (NYSE:HFC), and Alon USA (NYSE:ALJ) are some of the other refiners with significant RINs' exposures to satisfy their blending targets.
On the other hand, BP (NYSE:BP) has benefited from the sale of its Carson, California refinery to Tesoro Corporation (NYSE:TSO), and its Texas City plant to Marathon Petroleum earlier this year. Combined with its retention of RINs generated from its U.S. terminal ethanol blending operations, and those generated at its Brazilian ethanol operations, BP has been on a net-long position of RINs. With the price of RINs have been trading at, BP has managed to benefit from selling its surplus RINs to the open market.
Earlier in August, the Environmental Protection Agency announced that refiners have been given an extension of four months to meet their 2013 targets; which would help ease the rush to purchase RINs in order to meet their obligations. It also implied that they would lower the targets for 2014. This should ease some of the panic buying, as people had anticipated the potential of hitting the "blend wall" in 2014, which sparked excessive buying and hoarding of RINs in fear of the price rising further. Although, with rising ethanol targets and declining domestic gasoline consumption, it appears to be only a matter of time before we hit the so called "blend wall".
The outlook on U.S. oil refiners
With the likely easing of the price of RINs, the persistence of the dislocations in the crude oil market, and the increasing exports of refined products to Latin America, Africa and Asia; the outlook for U.S. refiners remains strong. With the expansion of U.S. shale oil production, refineries based in the U.S. can exploit the discrepancies of the price of crude oil in North America to those in the rest of the world. Despite declining domestic gasoline consumption and recent hits to profitability; the long term fundamentals are in the domestic refiners' favor. Refineries in the U.S. are seeing the most crude processed since 2005.
Although a return to the wide refinery margins experienced earlier this year, and those achieved between 2005 and 2007 are unlikely to return for any prolonged period of time; refinery margins should widen in the short to near-term, given current developments. Furthermore, capital expenditure on upgrading and maintaining U.S. refineries are expected to decline, as much investment has already been carried out to adapt towards changing market fundamentals. Combined with increasing refinery output, which partially offsets the declining margins, free cash flow is likely to remain strong for the near term. This would allow more capital to be returned to shareholders through increased dividends and stock buybacks.
Many integrated oil supermajors have significant refinery assets in the U.S., and they have also seen their downstream profitability compressed. They may also benefit from diversification through their upstream operations and their reduced exposure to RINs. ExxonMobil (NYSE:XOM) claims to blend a high proportion of its fuels which minimizes its RINs purchases: whereas Chevron (NYSE:CVX), which owns five refineries in the U.S., said it was a net seller of RINs. However, specialized refinery stocks offer a "purer" play on the U.S. refinery market. Furthermore, many large integrated oil companies including ExxonMobil, Chevron and Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) have seen continued weakness in oil production, which has been putting pressure on its upstream earnings.
One refiner which should attract attention would be Marathon Petroleum (NYSE:MPC), the fourth largest domestic refiner. It reported net income for the second quarter fell 27% to $593 million, despite revenues rising 27 % to $25.7 billion. The gross margin at its Refining & Marketing segment fell to $6.18 from $11.13 per barrel in the second quarter of 2013. On a brighter note, the refined product sales volume rose from 1.57 million barrels per day (bpd) to 2.13 million bpd; as a result of higher refinery utilization, as well as the acquisition of the Galveston Bay refinery. Strong revenues, bold acquisitions and increased volumes show that Marathon Petroleum is positioning itself to take advantage of strong demand and a return to wider margins. Currently it trades at a modest forward P/E ratio of 9.3 on forecasted 2013 earnings.