If You Must Bet On Refiners... Then Look For Safety And Yield

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Includes: PSX, VLO, WNR
by: And Value for All

Summary

US refiners are facing headwinds: fears of oversupply, high stock levels have depressed the crack spread. Crude oil price outlook is also bullish.

Based on the unfavorable outlook, no company in the industry seems a clear bargain, but some analysts are counting on seasonal trend as a possible bullish catalyst.

When comparing major US refiners, most fundamentals appear similar across the players in the industry, possibly indicating none has a clear advantage over the others.

In such a situation, shareholders’ interest may be best served investing in players with a moat or high yields.

Among the various issues, my recommendations in the industry are Valero, Phillips 66 and Western Refining.

A close-up on US refiners

Till the end of 2015, US refiners have been benefiting from a combination of friendly legislation banning direct export of US crude oil and global prices downturn. Maximizing the advantages of the cheap US feedstock, refiners had been able to rack up record profits during the last fiscal years: market valuation soared as a consequence. However, as the export ban on US crude oil was lifted by US congress in December last year, the market started to reverse quickly. As the bull scenario run out of fuel, enthusiast investors who jumped too late on the bandwagon have been left holding the bag. The following chart details the 2016 stock performance for the major US refiners:

Click to enlarge(Source: Google Finance)

The new bearish proposition is based on the idea that legislation allowing crude oil to be exported directly from the U.S. has put refiners in the midst of an internationally competitive environment in which the feedstock is more expensive and the cracking margins are thinner. Moreover, the mild winter has contributed to a weaker-than-usual demand for Q12016, resulting in a large build-up in fuels inventories and disappointing Q1 earning sessions.

So far for the facts. Now, the most bearish analysts have started to add some gloomy projections that as future gasoline demand keeps diminishing (also due to technology trends such as electric cars hitting the market) the glut is going to continue indefinitely, maintaining crack spread ultra-thin and eating out refiners' profits.

It is no wonder that together with the price, the whole industry P/E and P/B ratio, as well as other common valuation metrics, are down to very attractive low levels. As an aficionado of low P/E investing myself, I also heard the call of starting a long position at a supposed bargain valuation. However, the apparent bargain may deceive investors. As P/E ratio compares an always up-to-date number (price) with an historical one (earnings), the low P/E only indicates that the market has already weighed in the new industry conditions in the price, while earnings are still accounting 2015 record highs.

Despite the unfavorable scenario, a few analysts also here on SA have restarted some bullish coverage on refiners. The long cases are mainly based on the compelling fundamentals of the companies and the summer driving season trend, which will increase gasoline demand and help reducing the stock oversupply acting as a catalyst. While some recovery has been seen in the crack spread over Q2, the latest news about refiners' prospects for the upcoming quarter are far from reassuring.

Most US refiners have similar strengths when it comes to financial health and profitability, though of course each player has peculiar advantages. For example, Valero's (NYSE: VLO) has refineries with higher Nelson complexity index, which are able to process lower quality crude as feedstock than competitors, Western Refining (NYSE: WNR) has a competitive positioning and easily access to discount midcontinent crude through its proximity to the Permian Basin, and so on. Sheer size might also be a factor in the end, but it is hard to predict winners at this point.

Yet, the recent market developments may be about to trigger an M&A wave to consolidate the industry. It is only a little more than just speculation at this point, but indeed some activities have been noticed in the market (mostly already progressing deals which have been accelerated). ExxonMobil (NYSE:XOM) has just completed the sale of its Torrance refinery to PBF Energy (NYSE: PBF), Chevron has announced to be contemplating refinery divestments and Western Refining has recently executed the acquisition of Northern Tier (NYSE:NTI). Big movements are yet to be seen, but I wouldn't exclude anything at this point.

Given the broad range of unclear developments currently associated with the industry, it is reasonable for defensive investors to stay on the sidelines and look elsewhere for safety. However, for those who do not fear the short-medium term risks associated with investing in a cyclical industry experiencing a downturn, I use the rest of this article to suggest two possible strategies.

1. The guru strategy (risks diversification strategy)

While the other traditional refiners have taken a much worse stock price hit over the past months, Phillip 66 (NYSE: PSX) seems to have held through the tempest in a much better way. The stock is down slightly more than 10% from beginning of 2016, but the positive gap when compared to peers is evident. This price resistance is especially surprising when considering that quarterly earnings of PSX have taken roughly the same hit as competitors' ones.

Then, where is the moat for this Berkshire Hathaway stock? Probably, the reason behind the better stock performance is not to be found in Phillips 66 financials, as they do not show any particular strength over the competitors. The company has worked well and increased its gross margin during fiscal 2015, but by contrast operating margin remained low. Operating cash flow is also no better than the one of Marathon Petroleum Corp (NYSE: MPC) or Valero.

What set aside Phillips 66 from the competition might be its current strategic choices. PSX has been repositioning away from the pure refining business, operating the business through four segments: Midstream, Chemicals, Refining, and Marketing and Specialties (M&S). Noteworthily the company brands itself as a "diversified energy manufacturing and logistics company with a portfolio of integrated businesses" and as the Phillips 66 Fact book details, "our Midstream segment is at the core of our growth plans. The segment consists of natural gas liquids (NGLs) and transportation businesses, Phillips 66 Partners, and our 50 percent interest in DCP Midstream. Growth in our Chemicals segment is an important part of our strategy to create shareholder value. CPChem, our 50-50 joint venture with Chevron, is one of the world's leading petrochemical companies". The presentation indeed sheds a lot of light on how the company is making a lot of efforts in repositioning itself and emphasizing growth in different areas than refining. If the management keeps executing the strategy, Phillips 66's profitability might soon be far less dependent on crude prices and cracking margins than competitors. Or, what set aside Phillips 66 from the competition might be being a Berkshire Hathaway stock.

The market has appreciated the company's efforts and has granted a moderate indifference of the stock price in the midst of the adverse market mood. For those who believe in the growth prospect of the company, buying now at a slight discount compared to beginning of the year might indeed be a good time to start a long position. In addition to all these, a dividend yield of 3.35%, well covered by company financial means, nicely rewards investors and should be only revised upwards going forward.

2. The dividend strategy

Statistics indicate that, in the long run, the stock market has averaged a return of 11% for investors (or 7% when netted from inflation). This figure however accounts for total returns achieved through both growth (8%) and dividend payouts (3%). Dividends are therefore an important source of income for shareholders but, unlike bonds, payoff associated with them can be far from stable. As refiners in recent years have worked hard to reward shareholders, I suggest taking a comparative look at the dividend situation

TICKER Div. Yield Payout Ratio 3Y Increase Current Ratio D/E
WNR 7.40% 43.5% 78.30% 2.38 131.1%
HFC 5.70% 45.7% 29.70% 1.68 19.8%
VLO 4.95% 33.3% 37.80% 2.13 35.7%
MPC 3.50% 35.0% 23.90% 1.49 90.1%
PSX 3.35% 37.8% 69.20% 1.63 38.5%
TSO 2.70% 16.8% 89.90% 1.70 78.0%
Click to enlarge

(Source: Author's work)

I specifically added the current ratio and Debt/Equity (at market value) as a proxy of refiners' financial condition, to understand whether dividend distributions might be at risk during a downturn in profits. Reviewing the data, I identify two possible plays for investors:

A pure buy and hold strategy on Western Refining, focusing on the fat dividend that will flow in investors' pockets. High yield seekers should be willing to ignore further possible negative price movements associated with the stock in the short term and possibly add more if the company proves its ability to sustain the distribution throughout the downturn. It is hard to imagine further increases in dividends in the short term, but the payout indicates at least current levels should remain sufficiently covered. The company has a history of returning even more to shareholders through special distributions, as long as conditions permit. The high leverage associated with WNR will raise some eyebrows and it is definitely a primary source of concern, but at least in the short term the company seems stable. WNR is indeed a long shot, a small player in the industry that ultimately may reserve some positive surprises. Having a moat in its privileged position which grants access to cheap feedstock and good operating margins, the company is dragged down by investors' concerns related to its debt and the small scale of its operations. Moreover, what I personally like about WNR is that management has recently bought heavily into the stock at the current prices. Although it is true that no management has a crystal ball, heavy insider buying is definitely something to be bullish on.

The second possible play is Valero. Valero already relies on a larger percentage of foreign oil for its feedstock to make gasoline and other petroleum products. Many of Valero's refineries have been built to process international crude oil rather than the lighter oil that comes from U.S. shale. It is arguably a player capable of sustaining the recent developments and move forwards in the cycle. Among the three major refiners (Valero, Phillips 66 and Marathon Petroleum Corp), Valero sports the cheapest valuation while arguably being the one in best financial shape (highest current ratio and lowest D/E ratio). Valero has a first class dividend yield close to 5% and the ability to continue distributions during downturns because of its healthy balance sheet. When looking at the long term chart for the company, investors can immediately realize that it is what already happened in the past: the company has kept dividends payments since 1989.

Click to enlarge

(Source: Google Finance)

Conclusion

The economic outlook for US refiners remains difficult in the near future, latest quarter's results have been very disappointing and stock prices have been badly hit as a consequence. Further downside is highly possible, although a few analysts have resumed to be somewhat bullish because of the picking gasoline demand during summer driving season. I argue that short term contingencies should be rather ignored as they are not enough to reverse the negative macro trends in which the industry is currently navigating.

Investors should be extra cautious before assuming long positions, nevertheless, a few interesting plays can be currently found within the industry and the adds may be included in larger portfolio strategies. As one company may be more or less suitable than the others according to different investor's strategy, I avoid direct recommendation of a single issue but argue that the most promising issues within the industry at the moment may be, for the reasons explained above, Phillips 66, Valero and Western Refining.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.