- HFC has markedly underperformed the market since it peaked early this year.
- As a result, the stock has become a bargain.
- Thanks to a series of tailwinds, I expect the stock to rally at least 10% in the next few months.
HollyFrontier (HFC) has markedly underperformed the market since it peaked early this year. To be sure, during this period, the stock has lost 17% whereas its peer, Valero (VLO), has lost just 5% and S&P has declined just 4%. Therefore, the big question is whether HollyFrontier has become a bargain or there is more pain ahead for its shareholders.
First of all, the crude oil that HollyFrontier processes in its five refineries is priced based on WTI, which is cheaper than Brent. Even better, this crude enjoys a discount compared to WTI. Therefore, the input cost of this refiner is lower than that of its international competitors, who pay for their crude oil based on Brent. Moreover, the company has managed to increase the capacity of its refineries by 15% in the last three years. As a result, it has significantly grown its production volumes during this period. In addition, it has markedly reduced its operating expenses, from $6.16 per barrel in 2014 to $5.40 last year. This is a critical parameter, as it determines how competitive each refiner is during a downturn of the sector.
Apart from refining, HollyFrontier also has a midstream segment, which involves pipelines, storage tanks and terminals of crude oil and products. The revenues of this segment are 100% fee-based and are thus resilient even when the price of oil is low. More than 80% of these revenues come from long-term contracts, with strict commitments from the side of the customers. Therefore, as the midstream segment offers a reliable and predictable stream of revenues, it is not surprising that it has achieved 52 consecutive quarterly distribution hikes. On the other hand, although the diversification provided by this segment is certainly a positive element, it is unfortunately limited, as this segment comprises only 18% of the total value of the company.
The other segment that enhances the diversification of the company is its lubricant business. This segment has consistently generated EBITDA margins between 10% and 15% and hence it has served to reduce the overall exposure of the company to the cycles of the refining margins. Nevertheless, as the lubricants comprise only 16% of the total value of the company, the refining segment is by far the most important determinant of the overall results.
Just like the other domestic refiners, HollyFrontier has been negatively affected by the increasing cost of biofuel credits. However, the RIN cost of the company decreased by $27 M in Q4 thanks to the exemption of its Wood Cross refinery. Moreover, the US government is now trying to limit the cost of biofuel credits for the domestic refiners. Of course there were similar attempts in the past, which had caused great expectations but failed to materialize in the end. Nevertheless, as the refiners have not given up on their efforts to convince the government for a change in its policy, it is not unlikely that these costs will be reduced at some point in the future. When that happens, HollyFrontier will enjoy a strong tailwind. It is also remarkable that the refiners are considered the great winners from the recent tax reform. Therefore, the political factors currently seem to be supportive for the domestic refiners.
It is also worth noting that HollyFrontier is about to benefit from the typical seasonality of the refining margins. More precisely, gasoline demand greatly increases during the summer and thus boosts the refining margins. Moreover, whenever a hurricane hits the Texas Gulf, it shuts down other refineries but not the refineries of HollyFrontier, which are located inland. As a result, HollyFrontier greatly benefits from the spike in the refining margins in such instances. This is exactly what happened last year, which was characterized by fierce hurricanes.
While all the above factors bode well for HollyFrontier, investors should never underestimate the risk of rising oil prices. More precisely, when the price of oil increases, it has a negative effect on the supply/demand balance of the oil market and hence it tends to exert downward pressure on the refining margins. After three years of suppressed oil prices, OPEC and Russia now strongly support them with their drastic production cuts. As a result, the price of oil currently stands near a 3-year high and is likely to remain supported for the foreseeable future. On the one hand, if it remains around its current level, it is not likely to be a concern for the refiners. On the other hand, if the oil price keeps climbing, it is likely to result in lower refining margins. Therefore, the refining margins do not seem to have meaningful upside while they have significant downside risk.
Fortunately, this risk seems to have already been priced into the stock of HollyFrontier, at least in part. To be sure, the stock is currently trading at a forward P/E=11.8, which is much lower than the P/E ratio of the broad market. Consequently, if the price of oil experiences a rally, HollyFrontier will be negatively affected, but that effect will probably be limited.
To sum up, HollyFrontier is likely to enjoy a combination of tailwinds later this year. The tax reform, a potential change in the cost of biofuel credits and the favorable seasonality in the summer all bode well for the stock while its valuation is quite attractive. Therefore, I expect the stock to rally at least 10%, up to $47, in the next few months.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in HFC over 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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