Refining Stocks: Bet On Brent/WTI Spread Or Not?

 |  Includes: BNO, CRUD, HFC, MPC, OIL, PSX, USO, VLO
by: YCharts

By Dee Gill

Oil and gas refiner HollyFrontier (HFC) gained some fans on Wall Street recently, including a couple of competing fund managers with great track records for finding value. But a well-respected energy analyst has just slapped a rare sell rating on the shares, saying they’ve become overvalued in the rise of refining sector popularity generally.

So should we love this stock or steer clear?

HFC Chart

HFC data by YCharts

HollyFrontier was mentioned as fund picks in a couple of Barron’s interviews recently. Goldman Sach’s (GS) senior investment strategist Abbey Joseph Cohen named HollyFrontier as her energy favorite for 2014. Timothy Pettee, chief investment strategist for SunAmerica Asset Management, also liked it. A recurring special dividend brings its unofficial yield up to about 6.7% now, making the company very interesting to income seekers. YCharts pro's HollyFrontier rating is excellent for both fundamentals and value.

On the flip side, Raymond James (NYSE:RJF) downgraded the shares to hold last week. Citigroup’s (C) Faisel Khan moved from hold to sell on the shares a couple of weeks earlier. Both houses were put off by HollyFrontier’s share price valuations, which are sitting at the high end of its historical range. Their forward PE ratio and price to free cash flow ratio haven’t been this high since early 2011, when Holly and Frontier Oil merged.

HFC PE Ratio (NYSE:<a href='' title='Tata Motors Limited'>TTM</a>) Chart

HFC PE Ratio (TTM) data by YCharts

Ultimately, however, the smartest call on HollyFrontier will be determined by the direction of a line on a different chart: the Brent/WTI Spread. It’s the difference between the price of West Texas Intermediate, or domestically sourced crude, and the price of Brent Crude, which comes from the North Sea. And the spread reflects imperfect transport of WTI from the middle of the U.S., making it expensive to move around and dampening demand for the stuff. That, of course, gives buyers in the part of the country a lower-cost feedstock.

Brent WTI Spread Chart

Brent WTI Spread data by YCharts

HollyFrontier fortunes are unusually dependent on the spread because all of its refineries sit in the middle of America. Unlike more diversified competitors, HollyFrontier buys all of its crude at WTI prices and then sells refined goods at Brent-based prices. When the spread is wide, as it was for most of 2012, HollyFrontier’s profit margins expand. Those margins narrow along with the Brent/WTI spread.

HFC Gross Profit Margin (<a href='' title='Tata Motors Limited'>TTM</a>) Chart

HFC Gross Profit Margin (TTM) data by YCharts

JPMorgan Chase (NYSE:JPM), whose analysts have buy recommendations on HollyFrontier, are forecasting a roughly $10 differential for the next couple of years. (Goldman Sachs’ forecast is similar, and the U.S. Energy Information Administration forecasts an approximate $9 spread for 2014.)

Several factors could disrupt those forecasts and lead their fund managers and analysts to take a dimmer view of HollyFrontier shares. A big demand for domestic oil, perhaps caused by lots of blizzards or an economic resurgence, could reduce inventories and lift WTI prices closer to Brent. More transportation options from competitors, like TransCanada’s Keystone XL Pipeline, would tighten the spread. Although infrastructure projects are expensive and slow, several are underway in HollyFrontier’s territory.

HollyFrontier’s geography makes it a bigger bet on the spread than most of the major players in refining. A huge gap would make HollyFrontier’s shareholders rich just as a reversal of WTI prices to more ordinary just-below-Brent levels likely would tank the shares from here. Investors looking for more of a safety cushion should check out some of the other companies in the refining sector, which is generally a favored one this year. Valero Energy (VLO), Phillips 66 (PSX) and Marathon Petroleum (MPC) each source crude both overseas and domestically.

VLO Chart
VLO data by YCharts

Disclosure: None