This article originally appeared in the January issue of Financial Advisor magazine.
A lot of disgruntled motorists have damned Big Oil for its ability to lighten wallets no matter what the price of oil. Especially galling was the recent summertime rise in pump prices as the per-barrel cost of crude was falling. While drivers’ blood boiled, investors were puzzled by the seeming disintegration of oil and gas companies. Why does Big Oil now want to dump (or at least distance its shareholders from) refining operations?
Bigger used to be better in the oil patch, but there’s been a tectonic shift in thinking. Small is better now. Marathon Oil Corporation (NYSE: MRO) recently spun off its downstream properties into a separate company. ConocoPhillips (NYSE: COP) and Sunoco, Inc. (NYSE: SUN) have followed suit and disclosed plans to carve themselves into upstream and downstream entities.
Integrated oil companies say a refining business spin-off focuses them on their individual mandates, freeing the parents to invest more in higher-margin exploration operations.
Big Oil is also selling refining operations piecemeal to outfits such as Valero Energy Corporation (NYSE: VLO) and Calumet Specialty Products Partners (Nasdaq: CLMT). Valero, for example, greatly enlarged its footprint when it picked up Murphy Oil Corporation’s (NYSE: MUR) Gulf Coast refineries, together with inventory, for $625 million. Though expensive, the buy was a relative bargain compared to Valero’s cost to upgrade its existing equipment. Calumet’s capacity jumped by 50% overnight when it acquired Murphy’s Wisconsin operations in a deal financed by a $200 million private placement.
It’s the bottom line that’s driven all the spin-offs and sales. Refining’s always been a—ahem—volatile business, but it’s been especially so since the 2008 economic nosedive. Profit margins have been squeezed by swings in the price of crude feedstocks and rampant demand destruction in finished distillates.
Sunoco’s refining business got so bad, in fact, that the company vowed to idle its cracking operations if it couldn’t offload them. Like Murphy Oil, Sunoco’s East Coast refineries, relying on import grades of crude, was undercut by cheap domestic oil, the lighter and sweeter feedstock favored by refiners taking deliveries at the Cushing, Okla., terminus.
Regional refiners such as HollyFrontier (NYSE: HFC) have been the beneficiaries of the widening spread between domestic and European crude oil prices. Domestic oil, benchmarked by West Texas Intermediate (WTI) recently traded at a $26 per barrel discount to North Sea Brent, a European standard. WTI, because of its lower viscosity and sulfur content, is favored for gasoline production and ordinarily trades at a premium to Brent. But a decline in global crude supply, together with a downturn in domestic gasoline demand, has turned the spread upside down this year to the benefit of Midwestern/Gulf Coast refineries supplied by lighter, sweeter grades of crude.
To understand how this happens, you have to know of something called the “crack spread.” The crack spread depicts the potential profit that an oil refiner can obtain by “cracking” crude oil into its major tradeable distillates, namely gasoline and heating oil. It doesn’t represent the profit margin earned by all refiners, or any one refiner, in fact, but it is important as an indicator of refiners’ intentions. Together with other indicators, such as crude oil inventories and refinery utilization rates, shifts in crack spreads or refining margins can give investors a better sense of where some companies, and the oil market in general, are headed in the near term.
To get at the margin, you first have to rationalize crude oil and distillate prices. Crude oil is priced in dollars per barrels, but gasoline and heating oil prices are denominated in gallons. You’ve also got to find prices for crude and the distillates. The most transparent marketplace is a futures bourse where trades are made publicly.
Recently, you could have seen the nearby futures contract for New York Mercantile Exchange (NYMEX) crude trade at $86.38 per barrel while unleaded gasoline and heating oil, destined for delivery a month later, changed hands, respectively, at $2.7091 and $3.0102 per gallon. In this instance, November crude simulates the refinery input while December contracts stand in for the gasoline and heating oil outputs. The delivery gap simulates real world conditions; using distillate prices a month out from the crude delivery mimics a storage, refining and marketing cycle.
A crude oil futures contract calls for delivery of 1,000 barrels. So, too, do the distillate contracts, albeit indirectly. Heating oil and gasoline contracts specify delivery of 42,000 gallons, but with a barrel holding 42 U.S. gallons, it’s really 1,000 barrels. Just multiply the distillate prices by 42 to get the barrel prices. Your gasoline, then, fetches $113.78 a barrel and a barrel of heating fuel, $126.43.
A classic refining model yields two barrels of gasoline and one barrel of heating oil for every three barrels of crude input. Thus, a “3-2-1” crack spread would be found through simple arithmetic as shown in Figure 1.
Because the prices of spread components vary, the value of the crack ebbs and flows, sometimes dramatically. In November 2008, for example, the NYMEX spread collapsed to just $3.23 per barrel, a decline brought about by a massive unwinding of derivative positions. Then the price of WTI crude was halved in just four months.
The great variability of input and output prices necessarily makes historic comparisons difficult. That’s why industry insiders often quote refining margins rather than outright spread values. It’s easy to see why. A crack spread of $15 a barrel is impressive when crude costs $30, less so when the input price is $60.
Measuring Refining Profits
If $31.62 represents the current gross profit on a barrel of oil that costs $86.38, the gross refining margin can be said to be 36.6% ($31.62/$86.38). Over the past 12 months, the margin has averaged 25%, while it averaged 12.6% a year earlier. Refining profits are now much richer than they were in the recent past. Or the not-so-distant past. Since 2005, the mean margin’s been 18%.
Therein is a clue to the oil companies’ intentions. If you’re going to sell an asset, it’s best to do so when it’s most valuable. Margin improvement boosts the value of refineries much like high rents make an apartment building more attractive and costly. It also implies a fear of lower future values.
Refining’s relatively low utilization rate denotes overcapacity. It’s really the unusual WTI discount to Brent that’s been propping up domestic refining margins. When that diminishes, so too will the refiners’ margins. Big Oil seems to think the maximum value of its refining operations can now be extracted by spinning them off before the next downturn.
While the denizens of the Oil Patch keep an eye on refining margins, stock analysts tend to gauge profits from a cost-of-goods-sold (COGS) perspective. From their viewpoint, our refiner’s current potential profit is actually $94.85 on every $353.99 of product sales, or 26.8%. It’s useful to know how both profits are calculated because one running significantly ahead of the other often signals a windfall.
As you can see in Figure 2, there’s a certain seasonality to refining profits. Switchovers in refinery configurations—stepping up gasoline production for the summer, then resetting to produce more heating oil for winter—accounts for much of the seasonal variance, while the underutilization of U.S. refining capacity also acts as a lever.
Traditionally, crack spreads tend to be wider in the spring because most refiners perform annual maintenance during late winter. Refiners tend to operate nearer capacity in the fall to assure heating oil supplies for the coming winter months. That’s when spreads will typically be weakest.
Of course, refiners can tweak their outputs to adapt to changing market conditions. When margins are soft, refiners can raise overall profitability either by slowing operations and keeping capacity utilization relatively low or by closing down less-efficient units entirely. The resulting price spikes for refined products then push crack spreads higher.
You’ll also note from Figure 2 that the difference between the gross refining margin and the COGS also increases in the spring. This, as we’ll see, is a buying signal, but we’ll circle back to that shortly.
Margin Shrinkage Requires Tactical Approach
Slumping gasoline use has made refining a low-margin business, despite this year’s unseasonal extension in the crack spread. The prolonged run of the 2011 crack spread season is an anomaly wrought by tight Brent supplies and a relative glut of WTI crude. WTI’s discount to the European benchmark narrowed sharply in late October as costs for domestic oil flipped into backwardation, a phenomenon featuring higher prices for front-month deliveries. Without the narrowing in the WTI-Brent discount, the refining margin/COGS differential would likely have closed by the end of July. The crack spread, in fact, peaked in August, more than $5 a barrel higher than its July month-end level.
The domestic appetite for petroleum may never rebound to levels seen earlier in the decade, even if a strong economic recovery takes hold. Excess refining capacity is likely to keep crack spreads and margins thin by historical standards.
That’s not to say there won’t be profit opportunities for petroleum investors. A more tactical approach, however, may be necessary to snag gains from the refining sector.
Futures users have long been able to trade the vagaries in the crack spread. Selling crude oil futures and buying contracts on gasoline and heating oil, for instance, captures profits as the crack spreads (and therefore, refining margins) widen.
Securities investors, unfortunately, have been locked out from snagging these seasonal profits, even after the introduction of exchange-traded funds tracking petroleum futures. There is, however, a margin-timing trade based simply on the outright purchase of small-cap oil refiners, companies whose bottom lines are exquisitely sensitive to changes in the WTI crack spread.
Spread Trading Without Futures
Take HollyFrontier as an example. There’s a distinct correlation between the refining margin-COGS spread and HFC’s stock price. Specifically, investors have been making bank on HFC whenever the WTI refining margin sustains a surge ahead of the COGS.
Since October 2005, there have been four periods when the spread exceeded 5 percentage points for more than two weeks. During these periods, HFC shares averaged a start-to-peak gain of 35.2% (see Figure 3).
As we can see, there are still seasonal profits—albeit greatly attenuated—available to investors after the 2008 meltdown. Simply holding the refiner’s shares from start to finish—that is, as long as the gross margin ran ahead of the COGS by 5 points or more—netted an average 49.3% gain in 2006 and 2007. After the Great Deleveraging, the average gain has shrunk to 3.6%.
Whether refining spreads will return to a more normal pattern remains to be seen. What we know now is that there’s still money to be made in refiner stocks, just less of it than before. A lot less. That’s why Big Oil is distancing itself from refining.
Still, in times like these, it’s better to have some profits rather than none.