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  • Part 1: Introduction To the Independent Refiners 0 comments
    Apr 29, 2010 7:53 PM | about stocks: VLO, HFC, WNR, ALJ, FTO, SUN, TSO, DK
     Welcome to the Chain Bridge Investing: Independent Oil Refiners series. Through a series of posts during the next several weeks, we will continue to expand upon the various factors an investor should consider when evaluating any of the companies in this industry.  Contrary to our company focused research, which is another new feature of Chain Bridge Investing, the Independent Oil Refiners series will focus on industry forces more than company-specific factors.

    Researching Due to Depressed Prices and Historical Fundamental Levels

    After noting multiple occurrences of several independent oil refiners in our value/contrarian screen results, Chain Bridge Investing (“CB” or “we”) began researching the oil refinery industry as the first step in assessing the investment potential of these companies.  While we consider industry knowledge imperative for any potential investment, we believe it to be especially necessary – for reasons discussed below – for the independent refiners.  At present, this industry consists of the following publicly-traded companies:

    • Valero Energy Corp. (“VLO”)
    • Holly Corporation     (“HOC”)
    • Western Refining Inc. (“WNR”)
    • Alon USA Energy, Inc. (“ALJ”)
    • Frontier Oil Corporation (“FTO”)
    • Sunoco Inc. (“SUN”)
    • Tesoro Corporation (“TSO”)
    • Delek US Holdings (“DK”)


    A glance at these companies’ stock price histories (as shown in the chart below) reveals that, in general, their prices began to peak mid-to-late 2007 before declining in 2008.  Unlike the general stock market and many other industries, the prices of the oil refiners continue to remain depressed.  At the current prices, the companies generally appear cheap when compared to their historical operating results (not including fiscal year 2009) and book values, which explains their appearance in our screen results.  As a result, during our research and interviews, we were not surprised to discover that many other value and contrarian investors are also delving deeper into these companies.


    For the remainder of this post, we will briefly introduce the reader to the various topics he/she should consider when evaluating the refinery industry and its companies.  This industry study is not meant to be comprehensive, but instead a starting point.  We believe that the investor should study the following factors to gain a handle on this industry before making investment decisions:  (1) the refined products spread; (2) the light-heavy crude differential; (3) the operations and operating decisions of the refinery, such as capacity utilization; and (4) regional economics.  Below, we briefly introduce the first three topics, which will be discussed further in future posts.  The second post in this series will deal with in more detail the operations of a refinery, which are heavily dependent on all four topics mentioned above.   Regarding regional economics, that is a topic better tackled from a company-specific view, but we may decide to delve into it if we believe there are good investment opportunities in this industry.

    Refiners Use Crude Oil to Produce Refined Products

    First, in general, an oil refinery is an industrial processing plant that takes crude oil and subjects it to various equipment and processes that yield refined, usable petroleum products (these processes and equipment will be further explained in the next post) such as gasoline and diesel.  Alone, crude oil has very few uses and is generally worthless.  Thus, without the ability to turn crude into refined products there would be little need for the production of crude oil.  As some may already know, not all crude oil is created equal and there are many grades - approximately 160.  The two main factors affecting the quality of crude are its gravity, or density, and its sulfur content.  The gravity of crude oil is measured using the American Petroleum Institute's ("API") gravity degrees.  Nevertheless, one will find that the companies report their own definitions of light, medium and heavy crudes within a range of these API gravity markers.  Light crude tends to be defined as having an API gravity greater than 31 degrees, while heavy crude tends to be defined as having an API gravity of less than 22 degrees. The heavier the crude and the higher the sulfur content, the more difficult the crude is to refine and will yield fewer high priced products like gasoline and diesel using basic refinery equipment.  Consequently, to increase the profitability of heavier crude oil the refinery has to invest in additional equipment and processes, which amount to more capital spending (this topic will be covered more below and in a future post).

    The Spread Between Refined Products and Crude is Critical to Refiners' Operations

    The independent refiners’ operating results are primarily dependent on the difference, or spread, between the market price of refined products, which are the finished products resulting from crude oil such as gasoline, and the market price of feedstock, which primarily consists of crude oil but includes a small portion of other materials that affect the quality of the refined products.  Many independent refiners report this spread on a per barrel basis as the refinery gross margin.  This refinery gross margin, or the refined products spread, is the most important factor, when evaluating an independent refiner.  As one will see throughout this series, refiners can manipulate many variables to affect profitability, but even optimal refinery configurations and management actions cannot always offset the effects of the refinery gross margin on a company’s profitability.  One industry insider explained that despite his company’s best efforts during fiscal year 2009, the company reported a loss due to a narrowing of the refinery gross margin.  Remember the refinery gross margin does not include a refiners’ operating and overhead costs.

    For the purpose of briefly examining the refinery gross margin, we will assume that the only grade of crude oil being used is West Texas Intermediate (“WTI”).  WTI is light crude with an API gravity of approximately 39.6 degrees and .24% sulfur.  Furthermore, WTI is a benchmark crude grade that is commonly used for oil pricing.  To optimize profit a refiner should turn a barrel of WTI into the most profitable blend of refined products possible.  Many refineries have a team of analysts and engineers that use linear programming to determine the most profitable slate of products that a refinery can produce based on refinery constraints, configuration, and product prices.

    While the market price of a refined product depends on many factors, one of the primary factors is the level of demand for the refined product relative to supply in the targeted market.  For instance, gasoline and diesel, which represent nearly 41% and 25% - respectively - of North American refined products, tend to command higher prices when vehicle miles traveled increases faster than the refiners can adjust supply.  In the U.S., with transportation representing approximately 70% of overall petroleum demand, demand for gas and diesel should remain strong as long as substitutes continue to represent a small portion of the market. Yet, the continued emergence of hybrids, electric cars, and bio-fuels may reduce demand for gas and diesel in the U.S. faster than expected, thus sending refined product prices down.  Ideally, the price of crude would drop as well, but the crude market is global and increased crude demand in Asia and Latin America may support a higher price of crude.  As a result, the refinery gross margin would decrease, thus demand for end products merits careful observation.

    Further affecting the market’s spread between refined products and crude are the collective impact of operating decisions implemented at individual refineries across the market.  As many know, refineries can operate at different capacity levels, whether they are forced to due to a natural disaster or choose to due to market events.  These changes in operating levels can affect the supply and the inventory levels of refined products, as well as affect the demand and the inventory levels of crude oil.  Moreover, refinery operating decisions can play a role in industry expansion or rationalization.  Such refinery operating changes should be analyzed since they can have significant effects on refiners’ profitability levels as well as the refinery gross margin and the light-heavy crude differential.  An interesting dilemma currently affecting the industry is that in the U.S. there is excess refinery capacity, while in globally there is a shortage of refinery capacity.  In a future post we will consider this dilemma as well as the actions and consequences of the refiners operations on the industry and profitability.

    Moreover, one should be cautious when comparing the refinery gross margin across various companies since the reported spread is affected by: (1) the companies’ choices of inventory accounting methods; (2) the companies’ choices of crude slates, which is the combination of grades of oil a refinery chooses to use; and (3) the companies’ choices of product slates, which is the combination of refined products a refinery chooses to produce.

    Below are a few charts that show the historical market price spread between a barrel of a refined product and a barrel of WTI crude oil.  While the gasoline spread peaked earlier than those of the diesel spreads, one can see that the performance of these spreads generally reflects the performance of the independent refiners’ stock prices over similar time periods.  Based on these charts, the market seems to base the value of the independent refiners on the width of these spreads.  If these spreads are the primarily drivers behind the companies’ stock prices, then it makes sense that these spreads are the priority of any refinery industry analysis.

    Data from Argus and CBOT.  ANS = Alaska North Slope Crude.


    Nevertheless, the refined products spread is very difficult to predict and is primarily beyond the control of individual refiners.  As a result, the refiners’ profitability tends to be primarily a result of the market equilibrium for refined products and the market equilibrium for crude oil, thus making them a commodity business and leaving many refiners with few competitive advantages.  Company-specific investors and investors unfamiliar with the petroleum markets may want to avoid investments in the independent refiners.

    In a future post we will delve deeper into the factors behind the refined products spread.  Such a post will likely focus on whether the current spread will eventually widen, and if so when that may occur.  While prices and spreads in commodity markets tend to be volatile over time, there may be structural changes occurring that could keep the spread depressed for longer than history indicates.  A potential structural change that could occur would be the diminishing demand for gasoline, which would require evaluating: (1) the acceptance rates of current substitutes; (2) the future growth of vehicle miles traveled; (3) the commitment of China to an electric car economy; and (4) possible government disincentives on gasoline dependence.  This evaluation would be in addition to various supply considerations such as the historical trend of increasing European exports of gasoline to the U.S and increased environmental regulation on refineries.  We worry as some others in the industry, that such an analysis may yield no conclusive answer for the future direction of the refined products spread.

    The Light-Heavy Crude Differential can Increase Profits During Certain Market Conditions

    The light-heavy crude differential, which is the spread between the prices of light and heavy crude oils, can increase profits for refiners when (1) the differential is wide enough and (2) when the refiner possesses the correct equipment to run heavier grades of crude.  In the above discussion of the refinery gross margin we assumed that the grade of crude was WTI.  With nearly 160 different grades of crude, refiners have a choice in what crude grade they use.  Nevertheless, the selection of crude must be compatible with the equipment at the refinery.  Historically, a refiner has been able to increase the spread between the refined products and crude by using a heavier grade of crude.  Normally a heavier grade of crude such as Maya from Mexico, which has an API gravity of 22 degrees, will trade at a discount to WTI, thus increasing the potential refinery gross margin.  Yet, the margin only increases if the discount is large enough to cover the costs of the additional equipment the refinery will need to upgrade the product yields of the heavier crude.

    Lighter crude oil tends to yield a higher percentage of light fuels such as gasoline and diesel with less complex refinery processes and equipment.  On the other hand, heavy crude going through the same refinery processes as a lighter crude will produce less gasoline and diesel and much more residual fuel, which is much less profitable.  As a result of this less profitable product slate, the heavier crude trades at a discount to the lighter crude.

    If a simple refinery upgrades its equipment by adding a coker and a cracker, then it becomes more complex and better able to produce high quantities of lighter fuels that rival those of a lighter crude.  In general, the U.S. has the most complex refineries, which means that the U.S. can handle more heavy crude than most other nations.  However, if the light-heavy crude differential narrows, then it becomes unprofitable to run as much heavy crude.  The refiner may choose to reduce the operations of its coker or temporarily shut it down, while it decides to run a lighter grade of crude.

    Nevertheless, very complex refineries cannot switch to light crude and run at full capacity.  Due to the equipment needed to operate with heavy crude, a very complex refinery will be able to run lighter crude but not at full capacity nor with the product yields previously experienced on heavy crude.  The refinery will be able to get by, but will not be operating at optimal levels.

    At present, many refiners like VLO had to reduce their heavy crude operations due to the narrowing of the light-heavy differential.  The companies would lose money if they continued to operate at the full capacity with the current differential.  The current narrowing of the light-heavy differential results from: (1) a decrease of heavy crude supply by Saudi Arabia, which cuts the more expensive to produce heavy crude when cutting production quotas; (2) decreases in supply of heavy crude from both Mexico and Venezuela; and (3) an increase in refinery demand for heavy crude.  The chart below shows the narrowing of the light-heavy crude differential.

    Source: EIA

    While the light-heavy differential is not as important as the spread between refined products and crude, it can make a significant difference in the profitability of a refiner.  In fact, when the differential is large it is a significant bonus to a complex refiner’s profitability.  Yet, when the spread narrows it can create additional costs for the refiner.  It is similar to the effects of leverage.  Does the investor want this leverage and also the potential insurance it offers if the world’s produced crude continues to become heavier?

    When we write about the light-heavy differential in a future post we will focus on whether the differential will continue to remain narrow, and will consider the following: (1) heavy crude represents a larger portion of the world’s reserves than light crude, but is also more expensive to produce; (2) Canada is aiming to significantly increase their production of heavy crude by 2015; (3) a pipeline from Canada to the Gulf Coast will make heavy crude more available to the Gulf Coast refiners; (4) an examination of the complexity of the future refining capacity; and (5) the effect on complex refinery equipment spending from the current narrow spread.



    This concludes the first part of our series.  As stated above, the next post in this series will deal more with the daily operations of a refinery.  We chose not to focus on the operations in this post because we wanted to briefly cover the factors that we feel investors need to consider while researching their investments in this industry.  Much of the profitability of these companies depends on the refined products spread and the light-heavy crude differential.

    More focused discussions to follow.


    CB is not an investment adviser and individuals should not view any of its work as investment advice.  Please consult your financial adviser before making any investment decisions and do your own due diligence.
    Also, please read the full disclaimer at

    Disclosure: No Positions
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