Narrowing Brent/WTI Spread Could Mean Short Oil And Long Rail

Includes: GBX, VLO
by: Robert Loftus

Prior to the Great Recession in the U.S., Brent and WTI crude futures tended to hold very close to one another. As oil production increased in North America, the WTI price began to fall. At the same time that oil production was increasing in the U.S., the demand curve for gasoline assumed a gentle downward slope. Oil production in the U.S. is now higher than it's been in over 20 years. In order to keep their plants active, American refiners -beginning around early 2010- sought to take advantage of the discount on WTI crude, and have actively sought export markets for finished gasoline and diesel fuel. As the spread between WTI and Brent has narrowed, the financial incentive for selling finished gasoline and diesel fuel to foreign markets has been reduced. Looking back at past Weekly Oil Inventory highlight reports, we can see that exports of finished gasoline and diesel from U.S. refineries has fallen dramatically in the last six months. Part of the reason that the Brent price has fallen, is a reduction in the amount of North Sea crude imported to East Coast (PADD District 1) refineries over the course of the last two years.

The decline in demand for gasoline is structural in nature. Many late '90s and early '20-oughts era SUVs are now being retired from America's roadways. Although the Ford F-Series and Chevy Silverado pickup trucks still dominate auto sales (they have for years now), the top-selling passenger cars sold in the U.S. are all compact and mid-sized sedans that are capable of better than 30 miles per gallon on the highway. Hybrid vehicles are also becoming more popular, and so long as retail sales figures indicate strong new car sales, it's likely that gasoline consumption in the U.S. will continue to decline.

As the spread between WTI and Brent crude narrows, so does the cost advantage enjoyed by U.S. refiners. The EIA Weekly Oil Inventory for the week of June 12, 2013, indicated that crude oil and finished gasoline stocks in the U.S. are above the upper limit of the average range for this time of year. This creates a situation for oil and gasoline refiners where in order to maintain the sales volume needed to satisfy their shareholders' earnings expectations, they will have to become more aggressive about getting crude from the Dakotas and Wyoming to East Coast refineries, and in getting finished gasoline to East Coast consumers. Petroleum rail car ladings are already up significantly over last year, and shippers are concerned over a shortage of rail cars. Given recent events in the U.S. with chemical plant explosions and F5 hurricanes, the prospect of continuously expanding the Cushing, Oklahoma, storage facility so companies can hold products away from the market until prices rise to the level they'd like isn't politically or practically viable. Also, oil refiners are in the business of refining oil and selling petroleum products, not refining oil and storing petroleum products.

This combination of factors means that oil refiners could be in for a bit of a profits-pinch in the second half of 2013. Given that the East Coast states are highly developed, include many protected Parkland Areas and National Monuments, and the fact that even if it were politically possible, construction of new oil pipelines to East Coast refineries couldn't be finished fast enough to respond to current market conditions, it's likely that railroads will see additional growth in petroleum shipping, and that increase will be inversely related to the size of the Brent/WTI spread: as the spread grows - rail traffic declines, as the spread shrinks - rail traffic grows. This growth in rail traffic is likely to impact all rail-related firms operating in the NorthEastern United States, but the primary beneficiaries may be rail car companies. Railroads will be moving more traffic, but the cost of adding rolling stock will weigh on their earnings per share.

Long Opportunities

At the time this article was written The Greenbriar Companies (NYSE:GBX) was trading at $24.80. That's just off a 52-week high of $25.24 and well above the 52-week low of $13.25. Given its long-term growth prospects this stock would be a strong buy if it were a bit farther off its 52-week high. Right now it looks a little range-bound but it could be an excellent pick if you grab it on a dip or right before Q2 of 2013 earnings reports are released.

American Railcar Industries (NASDAQ:ARII) was a bit further off its 52-week high, trading in the $33 range versus $47.10. This company actually saw sales growth of 7%YOY, but saw its stock price fall after the release of its Q1 earnings report due to a missed estimate - perhaps a victim of its own over-confidence. This company appears to be an excellent candidate for a portfolio of long-term holds.

Short Opportunities

FreightCar America Inc. (NASDAQ:RAIL) Is only slightly above a 52-week low, closing at $17.42 per share on June 13, coming off a low of $17.07 and well below a 52-week high of $25.15. Nonetheless this company is under the Short Opportunities heading because it failed to adapt to the marketplace. FreightCar America is a manufacturer of open rail-cars of the type used for hauling granular solids like coal and gravel. A review of the company website does not indicate any plans to begin producing petroleum, petroleum distillate, LPG or CNG type railcars.

Sunoco Logistics Partners (NYSE:SXL) is likely -along with other gasoline and diesel fuel refiners and retailers with heavy exposure in the Northeastern States - to get caught in a profits squeeze as the Brent/WTI spread continues to shrink. At the time of this article shares had closed at $63.37, off a 52-week high of $68.44, and well above a 52-week low of $32.52. There is significant downside potential for this stock.

Hess (NYSE:HES) This stock is facing the same challenges as SXL, and is also in the upper half of its 52-week high-low range: $66.84 at close versus $74.48 over $39.67.

Valero Energy Corporation (NYSE:VLO) Another operator with heavy retail exposure in the Northeastern States. $38.66 at close versus $48.97 over $21.54.

Disclosure: I 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.

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