Oil Refiners and Margins: Why Location Makes All the Difference

 |  Includes: CVI, FTO, HFC, SUN, VLO
by: Richard Bloch
On Tuesday I wrote about CNBC Fast Money contributor Joe Terranova’s view of some of the oil refining stocks, pointing out a few to avoid because their refining margins are so low. In Joe’s words:

Domestically here in the U.S., it’s about the refiner trade. Valero (NYSE:VLO), Sunoco (NYSE:SUN) -- you want to avoid them. They're paying higher prices for oil because they're getting the oil from the gulf.

You want to go mid-continent, to look at a name like Frontier (NYSE:FTO), CVR Energy (NYSE:CVI), and Holly Corp. (HOC). They're paying cheaper, getting WTI at 96 bucks.

How big a difference does it make? What’s the profitability of refining “cheap” West Texas Intermediate (WTI) crude vs. the more expensive Brent oil?
A few charts below show my attempt at measuring this, but first here’s a look at the divergence between WTI and Brent.
Location, location, location
WTI should command a premium over Brent, as it usually does, but now most of the world’s market is based on Brent pricing. Want WTI crude? Go to Cushing, Oklahoma. That’s where it’s cheap.
In fact, there’s a similar oil called Louisiana Light. This chart I published on Tuesday shows how expensive it’s been compared to WTI:

Why so expensive? Because you don’t have to go to Oklahoma to get it. It’s in Louisiana, ready to get on a boat. That’s pretty much what it has going for it: Location.
The crack spread: Measuring the refiner’s margin
What does this mean for refiners? Consider the cost of the oil against products distilled from it, such as gasoline and heating oil. One convenient way to view this is by taking a look at what’s known as the “3:2:1 crack spread.” This assumes that three barrels of crude oil yields two barrels of gasoline (84 gallons) and one barrel (42 gallons) of heating oil.
In many ways, this is a theoretical analysis. There are so many different grades of crudes, each with its own specification – not to mention various varieties of gasoline and heating oil – that no one formula is exactly correct. But it is a benchmark worth watching.
This chart shows the 3:2:1 crack spread over the past two years, essentially showing the profitability of refining WTI oil:

But what if you’re not a “mid-continent” refiner? What’s the profit margin for refining Brent oil or one that’s priced like it? The yield is probably a bit lower for Brent, but if the same 3:2:1 ratio is any guideline, you’re not making as much as you used to, as this chart shows:
And compared in percentage terms, the difference in margins is striking.

Looking at charts like these explain why Terranova suggested avoiding stocks like Sunoco and Valero. They’re facing tighter margins, while the “mid-continent” companies he mentioned -- CVR Energy, Holly Corp. and Frontier -- are not.
Here’s a look how at these stocks have performed year to date:

This would have been an interesting long/short paired trade, but the short part wouldn't have added much to the return. And trade might be over anyway. It seems unfathomable that the WTI/Brent spread will continue to widen, but I've certainly been fooled before. I mean, how far does the spread have to widen before it makes economic sense to ask everyone with a car near Cushing to drive a few gallons of crude oil down to New Orleans? (All expenses paid, of course.)
Until we get there, expect more of the same.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.