Frontier Oil Poised to Benefit from Strong Diesel Demand

Frontier Oil (FTO) recently reported a 38% drop in net income for first quarter '08 as a result of weaker refining margins and lower output (126k bpd). The company posted earnings of $0.44 per share, compared with $0.68 a year prior. Read their conference call transcript for information regarding their capital expenditures and projects.

However, FTO is poised to deliver stronger second and third quarters due to increasing output (144k bpd Q2) and more favorable gasoline and diesel crack spreads. The company is able to process cheaper heavy and intermediate crudes, which provides better margins than the refining of more expensive light crude oils.

Frontier expects a strong agribusiness demand for diesel fuels, and is shifting production to maximize profits from a stronger diesel spread. The Energy Information Administration is predicting retail diesel prices to average $3.94 per gallon, up from $2.88 in 2007; rising diesel prices are the product of strong global demand, particularly in Europe, China and India.

It boils down to this: FTO stands to benefit from two strong stories; first, the global growth boom in emerging markets such as India or China; secondly, with high commodity prices farmers will working to increase their harvests, further increasing the demand for the diesel that powers their equipment and machinery.

FTO trades at 6x trailing and 8.5x forward earnings, and has averaged a 35% return on equity over the past 5 years. The stock has been beaten down this year but so far has set a floor around $24.60-$24.75, having tested it twice. Having declined about 35% year-to-date, Frontier presents a cheaper way to play the global boom, as opposed to richer valuations of the agri-stocks.

Disclosure: none