Refiners Vs. Big Oil: 3 Stocks To Buy Today

|
 |  Includes: CVX, MPC, MRO, OXY, VLO, XOM
by: Cris Frangold

Just last year, oil companies were downsizing their refinement facilities. Today, big names like Warren Buffett and Carl Ichan are investing in fuel refiners, attracted by the promise of larger refinery spreads based on lower oil prices. Shifting balances of power between refiners and oil producers make it clear neither set of companies always dominates the other. Investors should seek the best values from both sets of companies.

Refiners Currently on Top

There is an important distinction to be made here. Independent oil refineries such as Valero Energy (NYSE:VLO) are cashing in on oil production. Big oil companies like Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX), however, are struggling as they face concerns about defraying costs incurred by the smaller than hoped for profits from crude and natural gas. While the U.S. is leading the market in fuel production, it is the small refineries that are taking the lead, not the crude producers. Valero Energy outperformed Exxon 10 times over. Valero not only beat Exxon with its gains averaging 43%, but topped the charts by besting Standard & Poor's 500 Index in energy.

U.S. based companies are expected to reap the profits of having the most innovative and efficient refining technology for processing cheap crude oil. Implementing the new technology of cracking shale rock to produce gas, production costs of oil have been cut by the shale wells in the Midwest reaching all the way down to the U.S.-Mexican border, especially in the Gulf region. This new method of harvesting U.S. natural resources has allowed oil production companies to purchase crude materials at a much lower price than their global competitors, giving U.S. companies a leg up in exporting oil. These positive developments for U.S. oil production have now benefited this U.S. industry for three years, causing profits that have been compared to the earnings in the mid-2000's. Because the demand at home for oil is waning, the U.S. exported more fuels in 2011 than it imported, a development the oil market has not seen since 1949, and the amount of oil exportation is predicted to continue increasing. Analysts predict a surge in profits for U.S. refiners as worldwide demand for a limited commodity product increases.

There are geographical differences, too. Broad U.S. success starkly contrasts with companies in Europe and even Euro-exposed companies on the U.S.'s eastern seaboard who are scrambling to make ends meet as they deal with the financial crisis.

Valuation vs. Operational Risk

Since firms which produce crude oil and the refiners that crack it into valuable products are constantly renegotiating their transactions, investors should not try to pick one industry over the other. Instead, investors should accept that sometimes refiners will do better, and sometimes resource-laden oil and gas companies will do better. With this in mind, investors ought to find the best values in each industry.

Since the struggle between refiners and producers whip-saws, companies with lower profit margins will suffer first when large swings in commodity prices move against them. For this reason, we can compare profit margins as a measure of safety. The complementary measure of cheapness is the price-to-sales ratio, which was also compiled for each group of firms.

Consider these refiners:

Ticker

Company

P/E

P/S

Profit Margin

Projected Profit Margin

 

Valero Energy

10

0.12

1.19%

1.20%

(NYSE:MPC)

Marathon Petroleum

7.03

0.21

3.06%

1.97%

(NYSE:MUR)

Murphy Oil

13.24

0.38

2.86%

3.43%

(NYSE:HES)

Hess

13.43

0.46

3.35%

4.12%

(NYSE:MRO)

Marathon Oil

11.2

1.28

11.43%

11.16%

Click to enlarge

There is a clear relationship between profit margin and the price-to-sales ratio. As the ratio goes down (cheaper stock) the profit margins go down (riskier stock). This relationship was modeled using a linear regression which quantified this trend. An increase of 1 in the price-to-earnings ratio corresponds to a 8.5% increase in profit margin. This relationship was projected on the firm's price-to-sales ratio, generating an industry-averaged profit margin for each stock. When compared to this trend value, it is clear that Marathon Petroleum is undervalued since its profit margin is considerably above trend.

This analysis was repeated for oil and gas producing companies:

Ticker

Company

P/E

P/S

Profit Margin

Projected Profit Margin

 

Exxon Mobil

9.29

0.82

9.60%

9.61%

 

Chevron

8.45

0.9

10.79%

10.13%

(NYSE:COP)

ConocoPhillips

11.06

1.07

10.55%

11.25%

(NYSE:OXY)

Occidental Petroleum

11.78

3.06

24.38%

24.33%

Click to enlarge

These stocks do not deviate as much from a straight line. Chevron's profit margins are a bit higher than trend, which suggests that this firm is either currently underpriced or reflects the future costs of the fire at its Richmond, CA refineries. With this news in mind, investors should consider Exxon and Occidental Petroleum as firms with profit margins which are in-line with the trend.

Conclusion

Investors should consider buying shares of Marathon Petroleum, Exxon, and Occidental Petroleum. A mix of oil refiners and oil producers will protect investors as dynamics between industry players change over time.

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