Bakken Update: Riding The Refiners

Includes: ANDV, MPC, PBF, PSX, VLO
by: Michael Filloon

The refiners have had a nice run since the start of 2013. In 2012, this sector outperformed. This run continued in January as the market is still bullish. Valero (NYSE:VLO) blew out fourth-quarter numbers, backing the bulls in January. I have been on the refiners since July, and will go over some reasons why to take some profits or possibly stay in this trade.

Stock prices continue to head higher in the refining space. This has increased valuations. These are at its highest in years, and could retract if GDP numbers are lowered in the United States and abroad. The WTI/Brent differentials have been the highest in years. If this pulls back, it will significantly affect margins. I do not believe either of these will occur, but keep an eye on these numbers going forward.

There are ample reasons to be bullish the refiners. The first is margins. The wide WTI/Brent differential continues. It could take years to tighten and I believe WTI will continue to lag Brent pricing. The refiners could continue to grow on volumes. Although markets have improved, demand for refined products should increase in the upcoming years. U.S. refiners have an advantage selling these products overseas due to cheap feedstocks. I believe we will continue to see refinery closings overseas and on the U.S. east coast. This will decrease global production of refined products. Light sweet crude is being railed to refineries on the east and west coast. This will lower the overall cost of feedstocks to refiners like Tesoro (TSO) in California and PBF Energy (NYSE:PBF) in Delaware. The most important variable is Canadian crude. Gulf Coast refiners are able to refine heavy crude. The differential between heavy and light/sweet is excellent for refiners. Look for companies like Valero to benefit from logistical improvements.

Valero's quarter wasn't a story on volumes, as its Aruba refinery was shut down in the first quarter of 2012. It's a story on margins. Fourth quarter throughput margin was $12.27/barrel. This was a year over year improvement from $5.46/barrel. Its hydrocracker projects in Port Arthur and St. Charles helped to take advantage of low natural gas prices and good diesel fuel margins. It is also separating its retail business from its refining. This should unlock value. Valero's ethanol business has not done well due to higher corn costs. In the fourth quarter, it purchased 4.2 million shares and 10.6 million shares for the full year.

Valero's strategy for 2013 is an example of great management. First and foremost is logistics. Valero will spend to get increased access to domestic crude. It is also investing in refinery modifications that increase its ability to export products to premium markets. Lastly it is to expand its hydrocracker operations at Port Arthur, St. Charles, and Meraux.

The rails are the key variable to owning the U.S. refiners. Valero plans to rail crude into St. Charles, Quebec, Memphis and its two west coast refineries. It continues to buy railcars. Pipeline projects have been slow, and there is no reason to believe this will change in the short term.

Phillips 66 (NYSE:PSX) recently announced a five year contract with Global Partners to transport 90 million barrels of Bakken crude to its Bayway refinery. In December, Phillips had a record month for exports. For the year, it purchased $350 million in company stock and paid down $1 billion in debt. In February, it plans to take delivery of its first group of 2,000 railcars. This brings its total to 9,000. Phillips plans to rail more Bakken crude to the east and west coasts. This crude is destined for its Bayway and Ferndale refineries. Phillips is also focusing on getting heavy Canadian crude to California. It purchased two Jones act vessels to take Eagle Ford volumes from corporate around to Haynes. It travels through the loop system and around to Bayway. Phillips sees better flexibility and cost advantage to rail. Refining realized margin was $13.67/bbl. The table below breaks down margins by area.

Phillips 66 Q4 Of 2012 Crack Spreads

Area Crack Spread
Atlantic Basin/Europe $9.73
Gulf Coast $9.08
Central Corridor $24.80
Western Pacific $12.01

During the fourth quarter, it ran 67% U.S. advantaged crude versus 57% in the fourth quarter of 2012. South Texas crude has a $5 to $8 differential. Heavy to light oil differentials will be more important in 2013. Phillips is bearish on California. It is a high cost area, with lower growth prospects going forward.

Phillips saw earnings improvements across all refining regions. This was attributed to both higher market crack spreads and improved feedstock advantage. Its best area was the Gulf Coast followed by the Central Corridor. Improvements in Canadian crude supply to several refineries also contributed. Its advantaged crude slate was 52% in 2011, and 62% in 2012. More importantly, it was 70% in December. The table below shows how its crude slate has changed.

2011-2012 Phillips 66 Crude Slate

Crude 2011 2012
Brent 48% 38%
Shale 2% 7%
Other Heavy 27% 27%
Canadian Heavy 7% 10%
WTI Based 16% 18%

Per barrel metrics have improved. Income increased to $4.12/bbl in the fourth quarter versus $.59/bbl a year ago. For the year, income per barrel improved to $4.28 versus $1.95 in 2011. Margins have improved internationally, along with demand. Phillips had a 47% increase in income exporting in 2012 year over year. This is impressive as demand is still lackluster in Europe and Japan. Phillips has seen a 400 basis point improvement in refining. Phillips is able to take advantage of low NGL pricing as a net buyer. This enables it to capitalize in the chemicals space. Phillips believes weakness will persist for 4 to 5 years, or until export facilities are built. Export capacity will be important going forward. Phillips currently can export 285,000 barrels per day, with an increase to 370,000 by year end.

Marathon Petroleum (NYSE:MPC) didn't have as good a quarter as Phillips or Valero, but beat analyst expectations. In 2012, it bought back $1.35 billion in stock. Marathon plans to buy another $2.65 billion through 2014. Its Detroit heavy oil upgrade project was completed in November. This increased heavy oil processing capacity by 20,000 barrels per calendar day. Marathon also signed an agreement to purchase BP's (NYSE:BP) Texas City refinery. This is a world class refinery with a complexity of 15.3.

Marathon's better Q4 of 2012 results were due to better gross margins. The blended LLS 6321 crack spread improved by $2.73/bbl. when compared to Q4 of 2011. Chicago and Gulf Coast crack spreads were also higher over the same time frame. The most important differential driving earnings is the sweet-sour. It was $13.41/bbl. for the Q4 of 2012 versus $.97/bbl. in Q4 of 2011. The LLS WTI differential was $21.29/bbl. compared to $16.77 in the fourth quarter of 2011.

In 2013, Marathon will continue to improve diesel and gasoline yields at its Garyville refinery. This will be completed in 2015. It is also increasing Garyville's export capacity. Marathon is positioning itself to be the predominant player in the Utica shale. It is purchasing new barges, and working its truck to barge crude system project. This will connect Utica production to Marathon's Wellsville terminal and Canton refinery. Marathon has no plans to make a large investment in the rails. It believes using pipelines will create much lower transportation costs. Marathon believes there will be no material foreign light sweet crude in the Gulf for 2013.

Although the refining stocks are up significantly over a short period of time, there may be more room for growth. Refiners are getting more access to low cost U.S. and Canadian crudes. Some companies can still increase usage replacing foreign oil. Refineries with less access will be unable to compete with its higher cost products. Since 2008, 39 refineries have announced capacity closures. Another 4 are planning closures through 2014. The majority are located in Japan and Europe, but refineries on the U.S. east coast have also contributed. 15 refineries are currently for sale or under review. This is why we will continue to see refineries shut down in PADD 1 and Europe. To a lesser extent, the west coast or PADD 5 will also struggle. PADD 2, 4 and 3 have the advantage in that order. As refineries are closed, the advantaged areas will be able to sell more products domestically and abroad. High complexity refineries like Valero's in the Gulf Coast, will continue to increase heavy Canadian crude capacity. The Keystone XL will add 700,000 barrels per day of Canadian crude to the Gulf Coast. This should free up additional light crude for other lower complexity refineries. Brent will continue to set global prices for waterbourne crude and feedstocks. LLS will start selling at a discount to Brent, as operators like EOG Resources (NYSE:EOG) continue to rail Bakken crude to Louisiana. Bakken differentials will stabilize some, but remain cheap enough to rail across the United States.

In summary, the refiners look to be fairly valued. Barring another recession, we should continue to see increased demand at home and abroad. Refineries that use Brent as a feedstock will continue to decrease production and/or close opening up new markets. U.S. oil production will continue to increase. Although this is not a huge amount when compared to world production, it should be enough to feed the majority of U.S. refiners. Look for these names to continue to outperform barring a tightening of differentials or a downgrade of global GDP.

Disclosure: I am long PBF. 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.

Additional disclosure: This is not a buy recommendation. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, are not guaranteed for accuracy or completeness, do not reflect actual investment results, do not take in consideration commissions, margin interest and other costs, and are not guarantees of future results. All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market, or financial product does not guarantee future results or returns. For more articles like this check out my website at Michael Filloon is a Director at Fracwater Solutions L.L.C. We engage in industrial water solutions for oil and gas companies in North Dakota. This includes constructing water depots, pipelines, and disposal wells. We also provide contracting services for al types of construction at well sites. Other services include soil remediation. Please contact me via email if you are interested in working with us.