HollyFrontier: Upside Supported By Both Fundamentals And Technicals

Summary

• We really like the operating environment for HollyFrontier and believe that synergies with Red Giant Oil are underappreciated, as is the company's intention to pursue further acquisition opportunities.
• Technical support and strong fundamentals suggest a run up is likely into late fall and into 2019.
• Shares are undervalued and below $70, we plan to initiate a position for a trade, while longer-term investments should enjoy limited downside.
• On a forward basis, our earnings projections suggest a $95 share price target if traded at recent historical ratios.
• Investor risks include unforeseen negative catalysts moving the energy market below our conservative outlook for 2019, or meaningful capacity add-ons at existing or base chemical new plants.
• This idea was first discussed with members of my private investing community, BAD BEAT Investing. To get an exclusive 'first look' at my best ideas, start your free trial today >>

HollyFrontier Corporation (HFC) is on our radar this week, declining nearly 8% in recent sessions. We believe the chart suggests there is underlying technical support, and the medium-term fundamentals suggest a renewed runup is likely in shares from present levels. We're keen to scale into the name under $70. We believe the stock is still reeling from the company having some unexpected downtime in Q2, which resulted in a miss versus expectations on the earnings front. However, based on our modest projections in oil and gas pricing, limited capacity increases in coming years, and synergies from acquisitions, our expectations for performance going forward suggest the stock offers investors a compelling risk-reward ratio. Let us discuss.

Investing thesis

We believe HollyFrontier shares are undervalued. We think the stock could trade well over $100 by 2019, provided the macroeconomic outlook remains similar to the present situation and our near-term expectations for energy to trade in a range bound fashion hold.

There are several key reasons we believe investors should consider this name. The first is that we project the price of oil to be relatively stable into 2019. The second is that the spreads between what the company pays for its input, raw oil, and the costs for what it sells its products for, is projected to remain wide (if not widen). Third, the company's refiner downtimes are temporary, and while turnaround is costly, they are a long-term benefit to help boost capacity which is extremely limited for base III oils with so few companies in the space. Coupled with rising demand for base III oils in several industries, the demand/capacity picture is attractive. We will add that a possible rollback of fuel standards, and also RIN credits which are required and costly biofuel additives, could reduce expenditures longer-term. Fourth, the recent purchase of Red Giant Oil, with management telegraphing it is working on future synergistic deals, is underappreciated. Fifth, the company is quite liquid, with modest debt, allowing it to easily fund the appropriate opportunity to inorganically grow. Finally, on several rudimentary valuation metrics, the stock has upside based on our moderately bullish expectations for future earnings, but also suggests upside remains even if we are off significantly.

To be clear, this investment should not be considered if you are bearish on energy but is one to consider if you have a neutral to range bound view on underlying benchmark pricing. In this report, we discuss the company's growing presence, its performance, as well as our expectations going forward and why we believe investors should consider this stock.

Fundamental discussion

First, let us understand the company's presence and operations. The name has a large presence in much of the energy rich areas of the United States:

Source: HollyFrontier September presentation

The company is primarily a base oil and lubricant company. It has been quietly in growth mode for several quarters, though the stock has taken a breather in recent weeks, and we believe there is an opportunity here, as the company is making acquisitions to expand its footprint, setting up for long-term success in its operating sector.

Among the most notable of investments that HollyFrontier has made is its most recent decision to acquire the Red Giant Oil company. Red Giant Oil is a lubricants company and is one of the largest suppliers of engine oil for locomotives in North America. This will expand the company's footprint in Idaho, Utah and Wyoming, along with bringing in a blending and packaging facility in Texas. This is highlighted in the asset map above.

Red Giant Oil is expected to generate approximately $7.5 million in annual forecast EBITDA for HollyFrontier. We think that number is too conservative on management's part and believe that it can approach $10 million additional EBITDA in coming years depending on oil pricing and margins but also in factoring in growth in demand as well as limited capacity for additional production in the Americas for specialty lubricants.

As the next few quarters advance, we expect immediate synergies from this acquisition, and suspect, based on EBITDA contributions, it could add $0.06 in earnings. Future acquisitions cannot be ruled out and as you can see there is room for expansion into some of the oil rich areas of the United States. We view a path of inorganic acquisition, and in particular, the synergies expected from Red Giant Oil as bullish. But the market gave us a bit of a sale in shares recently following Q2 performance.

Recent performance

Let us talk about performance. The stock is still reeling from its Q2 that was reported earlier this summer.

What we want to first say is that the growth is evident and was much better than expected in the most recent performance period. HollyFrontier reported Q2 revenue of $4.5 billion; a result that grew from the Q2 2017 results by 29% and handily surpassed the analyst consensus by $400 million.

The revenue number was driven by better than expected refined fuels prices and strong margins. Now, one of the reasons the bears pounced was that there were some unexpected higher expenditures stemming from downtime in certain refineries that led to some pressure on EBITDAs in each segment. Let's talk more about this. It is a temporary issue, though with future planned outages (which are discussed later), the market could be hesitant to bid shares back up in the near term. We view this breather share price action as attractive for entry in our estimation.

Obviously, downtime is temporary. We believe investors may have sold shares off harder than justified given the fact that although the downtime was known, the degree to which the downtime weighed versus expectations was high. As such, it stands to reason that 2018 results may not be as high as previously expected. Still, despite downtime, and despite the high expenditures incurred as a result, the growth path remains intact for 2019 and beyond. This is where we are looking. From a market perspective, we believe that, given the anticipated growth and our read on the underlying commodities trends, the market is mispricing HollyFrontier.

Growth is strong in nearly all segments, and EBITDA is expanding thanks to strong margins, driven by costs and pricing. We expect volume strength and mild fluctuations in pricing going forward into 2019, and as such, we project continued expansion in EBITDA in coming quarters. Volumes were an issue in Q2, however. The refining and marketing segment reported adjusted EBITDA of $384.8 million compared to $192.8 million last year. This increase was primarily driven by lower laid-in crude costs which resulted in a refinery gross margin that expanded big time, all the way to $16.57 per produced barrel, a 46% increase compared to $11.36 last year.

While EBIDTA growth was impressive, we mentioned volumes were an issue. Crude oil charges averaged 463,480 barrels per day for the current quarter compared to 467,090 barrels per day last year in Q2 2017. This is where the unexpected downtime at the Woods Cross refinery weighed, and we believe the bears punished the stock in part because of these issues. Woods Cross ran at reduced rates for most of Q2 as a result of an outage beginning in March 2018. It has likely since returned to the full run rate, and we believe the market is not fully appreciating this return to full capacity. We believe this is the case because in August, in the Q2 earnings release, the company stated:

"We expect to increase production during August and return to full run rate by early September."

This was reiterated on the conference call:

"The repairs on the crude unit are mechanically complete, and we anticipate ramping production through August and reaching full run rates by September. "

Should the company confirm a return to full capacity, the market may give the stock a small boost, though this is of course speculation on our part. In any event, the downtime did hit the charge rate. Here is a look at the charges historically coming into 2017:

Source: September presentation

Here is what we think is important and investors must take into account. While the Street punished the stock for downtime and the hit to what could have been even greater volume growth in the quarter, charge volume has been growing reliably. Despite the downturn in Q2, charge volume will grow for 2018 and in the years beyond. Of course, pricing materially impacts performance, so keep an eye on it, even though we expect no major catalysts higher or lower.

When we turn to the lubricants and specialty products segment, we see that this segment reported EBITDA of $39.4 million, driven by consistent Rack Forward sales volumes and margins. Rack Forward EBITDA was $51.9 million for the quarter. We believe that based on the current outlook for pricing (factoring in some base oil market weakness this year) and the operational efficiencies we are seeing, Rack Forward EBITDA will exceed $200 million for 2018. Keep in mind The Red Giant oil acquisition will contribute here (and already is). We believe the market underappreciates the additional synergies, even if this will only impact earnings by a few pennies. Perhaps more relevant to the story is that we also believe that price differentials remain wide across the Permian while the input crude oil used to make the end market products continue to trade at discounts. More on this in a minute.

Then, there is the subsidiary Holly Energy Partners. Here, they reported EBITDA of $81.9 million for the second quarter compared to $75.1 million in the second quarter of 2017. This growth was driven by recent acquisitions of the SLC and Frontier Pipelines as well as volume growth in their Permian crude gathering system. We do not want to get into detail about the arrangement of the structure of the Holly Energy Partners, but it is set up as follows:

We do recommend you read up on the recent 10-K filing to get a better feel for the arrangement, but for the purposes of the present column, keep in mind HollyFrontier has a 57% stake in the partnership, and that the segment's sales are nearly all fee-based revenues with long-term contracts in place:

Source: Annual Report

Holly Energy Partners' revenues are predominately fee based, and so they are one segment that is not levered to commodities and the pricing fluctuations. In other words, if energy prices sink, or spreads collapse, HollyFrontier as a whole will be impacted, but this segment will hold up well. This is because most of the big refining customers are long-term committed. Above, you can see a figure which shows the partners' growth in distributions along with crude price movements.

As we move forward, it is our view that this segment will perform well, regardless of whether energy pricing is strong or weak. The next contract renewal is not until 2019, so there is no cause for any concern of declining revenues in the near term. We also want to point out that operationally, the company has implemented a number of cost savings initiatives, so this is helping margins and should pricing turn lower, this will preserve EBITDA potential. Keep that in mind.

Costs savings initiatives help long term, underappreciated near term

Is it possible that the market does not have faith in the cost savings initiatives and their benefit as we move forward? Possibly. Let us take a look at these initiatives in a bit more detail. One area of significant expenditure has been in the renewables that refiners are required to put into their blends. The regulations from the government require refiners to add annually increasing amounts of “renewable fuels” to their petroleum products or purchase credits, known as RINs, in lieu of such blending. HollyFrontier incurred RIN costs of $288.4 million in 2017. The company has attempted to reduce costs associated with these requirements by reinstating past year RINs, and this saved $57 million in 2017. The company is working to acquire small refinery exemptions (such as the one granted for Woods Cross in Q4 2017) to help save on such costs. Another example of these cost reductions include Q1 2018's EPA allowance for Holly Frontier to generate new 2018 RINs to replace the RINs previously submitted to meet the Cheyenne Refinery’s requirements. This reduced the cost of products sold by $33.8 million.

The company is also controlling its turnaround executions. For those reading that are unfamiliar, a turnaround is essentially planned downtime to conduct maintenance, repairs, or upgrades. Perhaps casting some doubt is the company still having planned turnaround in Q3 and Q4 2018, the impacts to which are "going to affect the numbers" according to Richard Voliva, CFO, in response to analyst questions. However, the company is making concerted efforts to reduce offline time and increase efficiency of maintenance during downtime. These turnarounds are vital for improving charge volume and long-term margins by reducing costs, but they come at significant short-term expense and high risk (like prolonged production delays or unforeseen costs etc.). Long term, we are pleased to see the company building in turnaround projects and focusing on execution. Recent successes include work at Navajo and planned work at El Dorado. Given the work to improve El Dorado beginning this month, and lasting about 6 weeks, in Q3 2018, the company will run between 420,000 and 430,000 barrels per day of crude oil. These turnarounds are costly in the short term, but are done for long-term benefit:

Source: 10-Q

Total spend will approximate $450-$530 million between capital and turnaround expenditures. It is important to note that turnaround expenditures in 2018 will be higher than in the last few years but are vital to long-term costs savings and efficiency of the company's refineries. One hidden positive? The Trump Administration and current Congress are unlikely to impose new compliance regulations on the company on top of what is already in place. Another possibility is continued deregulation. This is something to watch, because a significant portion of capital spending is associated with compliance-related capital improvements, driving up expenses. Trump's recent proposal to freeze fuel standards is a possible benefit. This is because Tier 3 federal fuel regulations require expensive limits on sulfur and other contents in blended oil products. A rollback or freeze here would be a positive.

Cash position

In assessing the company's cash position, we continue to see energy as range bound and see no significant reason why there would be any cash burn, aside from further decisions to seek acquisitions. In Q2 2018, net cash provided by operations totaled $394.4 million. The cash position is decent but investors would be advised to keep an eye on debt levels.

At the end of Q2, the company had $979.9 million in cash and equivalents, a $198.4 million increase from the start of Q2. The company is also shareholder friendly. In the quarter, the company paid $58.6 million in dividends and spent $28.6 million in stock repurchases, and we can expect these levels of expenditures to continue. But what about debt? Now, understanding a bit of the Holly Partner arrangement helps here, but the company has $2.38 billion in debt. However, exclusive of the Holly Partners debt, which is 'nonrecourse to HollyFrontier', debt was $992.2 million at the end of the quarter.

So, there is $1 billion of standalone debt outstanding, and it is worth noting that the company has zero drawings on its $1.35 billion credit facility. This puts liquidity at about $2.3 billion, and debt-to-capital is a merely 15%, which we view as quite modest.

Overall, we consider this 1:1 cash to debt ratio quite favorable especially in a cash flow positive environment, and given the cash position increases, we believe the debt will easily be paid down. We have no reason to expect otherwise.

Demand versus capacity projections

As we look to the start of a new decade, our longer-term oriented followers will be pleased with projections for the demand for base oil production versus production capacity:

Source: September presentation

These projections are key, and our review of current performance and industry trends leads us to believe the demand curve is accurate. While production capacity can get a little sticky to project with precision given that we do not know the state of producers years ahead, the key takeaway here is that we expect no meaningful increases in the ability to produce more base oil.

The projected demand for higher performance lubricants and specialty products, coupled with the limited production capacity into the next decade, is bullish in our estimation. While pricing will fluctuate quarter to quarter on energy exchanges, the fact is that there will be increasing demand for higher performance finished lubricants and specialty products moving forward, while capacity is flat to down. As HollyFrontier is the largest producer in North America, we view this as bullish and believe investors still have the opportunity to capture alpha from this divergence.

More on Refinery Capacity

Limited refinery capacity expansion in the future is important to look at. In its August Short-Term Energy Outlook, the EIA forecasts that U.S. refinery runs will average 16.9 million barrels per day and 17.0 million barrels per day in 2018 and 2019, respectively. If achieved, both would be new record highs, surpassing the 2017 annual average of 16.6 million barrels per day. However, this is for all oils. For base III oils, HollyFrontier is one of the only producers. The Petro-Canada Lubricants plant is the largest producer of base oils in Canada with 15,600 barrels per day of lubricant production capacity, and until 2017, it was the only North American producer of Group III base oils. It remains unclear at this time whether other companies will step into the realm of producing these oils, which could impact the capacity versus demand charts.

Our research suggests that demand will grow in the auto industry, but at this time, few companies have expressed interest moving in this direction. The only one we have identified has having produced base III oils are Calumet (CLMT). At the 13th ICIS Pan American Base Oil conference, base II oil producer Motiva announced it will produce Group III base oils commercially at its Port Arthur, Louisiana base oil facility. With the limited number of players in the space, HollyFrontier enjoys an advantage.

We also note the limited capacity of not just refining, but piping, has benefited spreads here in Q3. On the recent call (linked above):

"In the heavy market, second quarter differentials at Hardisty averaged over $19.25 a barrel. Recently, however, we have seen this differential widen to more than $25 per barrel as pipeline capacity limitations continue."

This bodes well for Q3, which so far, the stock has been struggling in.

Outlook and valuation

Forecasts for HollyFrontier's earnings overall in FY 2018 and FY 2019 have risen over time as oil prices and spreads have been favorable. That said, some analysts have come down slightly in recent weeks on their estimates given some of the downtime at Woods Cross and the associated increase in expenditures to get this back up and running, and presumably, from planned turnarounds remaining in 2018.

We want to be very clear. This is temporary, and we view the market as correcting some of the pricing of the stock higher once we receive full confirmation the refinery is back to full run rate (we would opine that based on the timeline, we are there now for Woods Cross). Further, as we look ahead with our expectation for a stable energy market, we have reason to be positive. We are also more bullish than consensus by about 10%, given our expectations for energy prices, expenditure controls, and crack spreads. Further, certain valuation measures are favorable.

While some of the short-term forecasts have been reduced recently, we reiterated that the consensus estimates have also steadily increased over the course of 2018 to date. Management gave several indications in the earnings report and subsequent earnings call that the refiner's operating outlook remains strong for the rest of 2018. We have no reason to suspect otherwise.

Many key valuation metrics are favorable. Take a look relative to its own 5-year averages and the sector:

Source: Data from Morningstar, graphics BAD BEAT investing

We are most impressed with a 10 times forward earnings ratio and an EV to EBITDA ratio of 6.6. This suggests the name is highly undervalued and takes the name back to levels seen before the oil price drop in 2014 and 2015. In addition, as cash flows have remained strong we believe the price-to-cash flow metric is attractive.

From the most basic of expectations, if the share price rose to its average forward earnings multiple of 13.2 (we think this is more than reasonable), that would yield a share price around $95. Can it get there?

Any rise in energy prices will likely move the stock higher, as we have shown a moderate correlation with oil prices. Longer term, crude is still in an uptrend, and although we are neutral to mildly bullish on crude, the chart suggests continued upside pressure.

Source: MacroTrends

Of course, while the stock's performance has been correlated with oil price movements, this is a refiner. This means we need to focus not just on the price of oil, which is important, but the spread between oil and the final product prices. This is the crack spread, a gauge of the profit refiners can make from taking actual crude oil and turning into marketable gasoline/oil based products. On the surface, the correlation with oil matters, but the overall profitability is driven largely by operational reliability, which we believe is strong, and favorable crack spreads.

Recall the map of the company's footprint above. This is relevant to the crack spread. The company has a location advantage. It is one of the only downstream companies physically located near the drilling sites. This means that it is not vulnerable to high transportation costs. This is one reason we see the company having strong spreads into the future. Another reason is the way the products are priced. We know from the company's operations that HollyFrontier consumes input oil at WTI crude oil prices, but it actually sells the end products in relation to the more expensive Brent crude oil prices. Brent just hit over $80, which suggests that the spread is nearly $10 which is quite high, above our expectations currently.

Here is what we think is important about the spreads. The spreads the company enjoys tend to be higher than the difference in the WTI and Brent benchmarks. HollyFrontier is often able to purchase WTI at a discount relative to its peers. The reason that the company can purchase WTI at a discount to its peers is its location. HollyFrontier is among the only downstream companies that is actually located near the drilling sites. This has led to the ability to purchase the upstream surplus of WTI at a sizable discount. This had led to strength regionally in the crack spread, though it is also dependent on the mix:

Source: HollyFrontier Index, 9/18

The mix is regionally dependent, but the spreads are impressive. The data show spreads have been improving, and we think the market is not taking this fully into account, or is factoring in a tightened spread. We believe this is in error, at least with recent trends. Take a look at the last 6 quarters of spreads, delineated by region:

Source: Data HFC index data, historical quarterly data, graphics by BAD BEAT Investing

As you can see here, spreads can fluctuate wildly, and as such this is why looking to simply oil prices is not necessarily sufficient. Of course, when we look at a longer period of data, we do see that spreads have increased overtime, just like oil prices have moved higher:

Source: Data HFC index data, historical quarterly data, graphics by BAD BEAT Investing

As you can see in the graphic above, while quarter-to-quarter crack spreads vary, based on a number of different factors, over time they have moved higher since early 2016. So have oil prices. So, while performance is certainly dependent on the spread prices, we can see why oil price movements have a material impact on the stock as well. One reason we also believe the market is underpricing the stock is because we see crack spreads as widening into 2019.

One way to generally predict whether we can expect a stronger or weaker spread is to look at differences between WTI and Brent. An investigation into forecasts of general pricing suggests the pricing spread could widen in 2019. Take a look at projections of pricing from May and most recently in the summer:

Source: EIA projections, May 2018

Source: EIA projections June 2018, graphics by BAD BEAT Investing

Where pricing will actually go is anyone's guess, and we are targeting around $70 oil, which is just above the EIA outlook of $68. For interested investors who like to stress test estimates, you can look at a great interactive data browser on varying energy related prices and forecasts here. But the key here is not necessarily the actual price of oil, but to recognize the ongoing widening of the spread between WTI and Brent. Keep in mind what we detailed earlier about HollyFrontier being able to acquire discounted WTI:

Source: September Short-term energy outlook

Looking at the benchmarks in graphical form can be helpful. Actual margins are wider than what we see for the underlying benchmarks given a variety of factors, but these projections are favorable when considering the spread between benchmarks:

*Based on actual pricing and projected pricing

**Projected pricing

Source: Data from September Short-term Energy Outlook, Graphics by BAD BEAT Investing

With this outlook for the trend in energy and pricing, we believe that our outlook is moderately bullish but appropriate. Our forward expectations are in the middle of the analyst pack. Based on $70 oil, synergies from Red Giant Oil (excluding any future acquisitions), comparable expenditures in 2019 relative to 2018, efficiencies from 2018 turnarounds, and share repurchases, we anticipate 2019 earnings per share to approximate $7.75, in a range of $7.30-$8.15. This is higher than consensus ($6.98) as we believe our colleagues who are on the more conservative side may be using $60 oil expectations for a narrowing spread. In the interest of transparency, here are the current expectations for 2019, with estimates ranging from a very bearish $4.31 to a very bullish $9.50:

Source: Yahoo Finance Analyst summaries (linked above at opening of the outlook and valuation section)

Using $7.75 as our estimate, and the target entry price of just under $70, you will be able to purchase shares at 9 times 2019 earnings. If we get a broader selloff that does not impact our expectation for oil (e.g. a $10-15 decline per barrel for the year), and shares declined to $61.25 on a major selloff, our final tranche recommendation would imply you are buying a significant discount of 7.9 times 2019 earnings.

What if we are wrong. And that oil does fall and spreads narrow? Let us assume earnings came in 20% below our expectations. This would peg earnings per share at $6.20, well below consensus. This would mean at $70 per share, you would still be able to purchases shares at 11.3 times forward earnings. Rather discounted in our estimation.

If 2019 earnings come in here at our expectation of $7.75, and the trailing-twelve-month present multiple holds (currently 17, on $4.26 in earnings,) that would put shares at $131. That seems a bit stretched. The historical trading multiple is about 13. So, that would put shares at $100.

What if we are more conservative in our earnings target, but hold the 13 times multiple? Well, at $7.30 in earnings, this puts us at the low end of our range for 2019 and yields a $95 price. If we are drastically off, and 2019 earnings per share are 20% lower than our moderately bullish outlook, a 13 times multiple from $6.20 in earnings would still yield a share price of $80.60, which is still almost 15% upside from present levels.

Using the low end of our expected range, which factors in continued strength in the spreads and limited volatility in oil pricing, we see 35% upside from our recommended first buy level.

We would be remiss if we did not mention the just announced expanded buyback program which could reduce the float by as much as 8%. This suggests our earnings per share estimates could even be too conservative in a strong energy environment. The new $1 billion share repurchase program represents 8.2% of the current market capitalization. This replaced the former program which still had about $40 million on it. Those investing can rest assured management is returning excess free cash flow to shareholders. A dividend hike can also not be ruled out, particularly as cash flows are improving.

Finally, we want to point out that future acquisitions for inorganic growth are likely. While we are not pricing in the unexpected into our forecasts, we got a good read on the Q2 call after management was asked about future acquisitions by Neil Mehta from Goldman, who cited the potential "rich pipeline of opportunities". Management responded that it is targeting possible opportunities:

"...in the $0.5 billion range. Small deal takes almost as much time and effort as a bigger deal, but at the end of day it all comes down to how attractive we feel the opportunity is. We're seeing a lot of deals. So, we're keeping a little more dry powder in reserve in expectation that some of these deals that we're seeing and working on will come to fruition, but again there is no guarantees that they will. And if they do again, we'll use the cash on the deal "

This is something that needs to be considered in conjunction with the cash position section we documented above. There is opportunity to leverage some of the cash on hand of $1 billion in addition to the untapped credit facility. If the right opportunity comes up, we believe HollyFrontier will pounce, given that is its keeping "dry powder" on hand. This to us telegraphs that the company is definitely looking to acquire further synergistic opportunities. Investors should keep this in mind.

With that understanding, what do the charts tell us?

Technical setup and recommended play

Here is a look at the one year chart. As you can see, the stock is still in an uptrend:

Source: BAD BEAT Investing

This is still a strong one-year chart, but as you will notice, the stock has stalled since the summer began. Our chartist has looked at this chart a bit. Here is what he sees on a three-month basis:

Source: BAD BEAT Investing

So, for this play, we are recommending it one of two ways. You can either play it off the $70 level, which just below is our first tranche purchase (again one could buy today if they wanted to start a pyramid buy, but we are more conservative), and take a gain at $75, with a stop loss around $66.

This would be for those traders who follow our work. But this play appeals to the longer-term investor in our estimation. We recommend a medium-term position in the stock and would recommend building a position if it comes down. Our levels would be $69.80, $64.35, and $61.25, based on the chart. If we only get the first level and it goes up, well, then we have a high-quality problem. If it comes down and you're building a position, well, good, because we see upside.

Risk and investor takeaway

Primary risks to the thesis here include an energy market that rolls over leading to our expectations (which are conservative) for $70 oil to be incorrect. Based on the revenue contributions of each segment, a $10 decline in average oil could impact the top-line as much as an estimated 7-12%, depending on spreads, and in turn lead to earnings that likely are in the $6 range. One strength is the partnership exposure which is not at risk revenues wise, but the market will likely punish shares heavily in a declining oil environment. Note that $6 in earnings and the historical trading ratio (13x) would imply shares are still undervalued.

While the demand and capacity trends are favorable for base oils, and global energy demand versus supply continues to be favorable, we see little reason to expect a sizable decline in oil prices short of an economic recession. Another risk to consider is that there could be compression between the WTI and Brent curve, which would be bearish given the costs that the company has on the input side of the equation versus the price it sells products for. One item to consider in the capacity outlook is that the pricing across a lot of chemicals and oil businesses have improved, which could lead to more new builds or capacity additions at existing plants which would make the trends less favorable. Companies entering the mix could be a competitive pressure that removes the company's current advantages as they related to base III oils.

Another issue to keep in mind is that energy pricing, while highly correlated to HollyFrontier's product pricing, is not perfect. HollyFrontier's actual pricing and margins may differ from the benchmark prices for many different reasons. In processing and producing its products refineries runs a wide variety of crude oils across its refining system and crude slate pricing may vary quarter to quarter. This can also impact the yields of each input. The final product yield differs quarter-to-quarter as a result of changes in crude quality, crude slate issues, operational downtime, and labor related issues. In addition, there is variance in transportation and storage costs to consider.

All of these impact the final refining margins and crack spreads. That said, we do believe the correlation between share prices movements and underlying energy benchmarks is strong enough to opine that a meaningful move higher or lower in the benchmark pricing will have an impact on share prices. Keep in mind that we want you to be aware specifically that higher pricing of benchmarks may not necessarily equate to gains in product selling prices or margins.

Take home

With these risks in mind, we believe that as long as energy doesn't roll over, or the spreads don't collapse, this play looks promising in the medium term. A short-term trade can be made here as well, but it is best played by scaling in, and if the market provides a few sessions of weakness overall, favorable entry points can be had. Based on our expectations, we see a reasonable price target of $95 here, implying 35% upside from the first buy level recommendation, with limited downside.

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. I have no business relationship with any company whose stock is mentioned in this article.

Disclosure: I am/we are long HFC. 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.