A Little History
CVR Refining (NYSE:CVRR) is a master limited partnership that has had a controversial history given its majority ownership by Carl Icahn. Along with the rest of the oil industry in general, and the refining industry in particular, CVRR had huge problems from the end of 2015 through the early part of last year. Crack spreads (the difference between the price of crude oil input and the price of products sold which are mostly gasoline and diesel) collapsed to the point where they were losing a lot of money. The climb back of both crude and product prices returned the refinery business to profitability in 2017 and has accelerated in the last 12 months.
There are an endless number of crack spreads out there. The ones most often referred to are the NYMEX 3-2-1 and the Gulf Coast 3-2-1. The first part of the names refers to the physical location of the oil. The markets are very different in different parts of the country and it is important to know which markets your company is in. The numbers refer to the conversion ratio. The first number is barrels of crude oil. The second number is the number of barrels of gasoline produced and the third number is the diesel produced. 3-2-1 means that 3 barrels of oil is refined into 2 barrels of gasoline and 1 barrel of diesel. That is the most common ratio for refineries in the US.
CVR Refining produces quite a bit more diesel than most American refineries, almost as much as it does gasoline. And CVRR has refineries located in Kansas and Oklahoma which are part of what is called PADD II or the Mid-Continent market. So the crack spread that is most applicable to CVRR is the Mid-Con 2-1-1.
The Mid-Con 2-1-1 collapsed in the 4th quarter of 2015 to $13.90 from $21.53 the previous quarter. It bottomed out the next quarter at $10.44 and gradually clawed its way up until Hurricane Harvey hit last August, which drove the Mid-Con 2-1-1 up to $20.57 for that quarter. In the last quarter reported by CVRR (2Q18), the crack spread was $19.18 per barrel.
Projections For Q3
In the second quarter of 2018, CVRR reported net income of $118 million. MLPs use EBITDA (earnings before interest, taxes, depreciation, and amortization) and DCF (distributable cash flow) to better describe their business and show what distributions (dividends for MLPs) are possible. In 2Q, adjusted EBITDA was $147MM and DCF was $97MM.
So, what has changed from the second quarter to the third? First of all, the 2-1-1 crack spread has increased from $19.18 to $19.88 per barrel. They process about 220,000 barrels per day, so this change will add a little over $16MM to all of the above numbers.
In the second quarter, there was a power failure (from their external utility) which caused a shutdown of one of their refineries for a couple of weeks. In the conference call, management stated that this shutdown cost them about $16MM in net earnings for the quarter, so we can add this amount in as well.
In the second quarter, RIN (renewable identification numbers - the ethanol mandate) cost CVRR $50MM in expenses. RINs cost an average of $.306 each in Q2. Their cost dropped to an average of $.207 in Q3. This reduces costs for the quarter by a little over $16MM (I know, this number keeps popping up, but I am rounding off). Just to clarify a little, oil refineries are required to blend a certain amount of ethanol (from corn) into their products as part of the "clean air/carbon neutral/conserve oil" mandate from the Federal Government. Refineries (like CVRR) that do not have access to ethanol must buy "RINs" to make up the difference. It has been claimed that the RIN market was being manipulated, forcing the price over $1 several times in the last few years. So, the decline in price here is a really big deal for CVRR.
Next, in their Q2 SEC filing, CVRR made projections for the 3rd quarter of certain items. One of those items was their "Direct Operating Expenses." They projected $85MM for the quarter vs. $94MM for Q2. This adds another $9MM to net income. I am assuming that they did not include any RIN's expense reduction in this number since they were only 3 weeks into the quarter when they made this projection and could not know that RIN prices would fall the way they did.
Finally, CVRR processed about 6,600 barrels per day of heavy sour crude. This is Western Canadian Select (WCS), which sells at a significant discount to West Texas Intermediate (WTI). That discount in the second quarter was about $18 per barrel, and in the third quarter, that discount had expanded to close to $30 per barrel (it is $50 now). That $12 difference should net them over $7MM for the quarter.
So, taking all of these changes into consideration, we get incremental net income of $64MM. This gives net income for the quarter of $182MM or $1.23 per share. To put earnings into perspective, Wall Street is expecting $.94 per share for the 3rd quarter. Adjusted EBITDA goes to $211MM and DCF goes to $161MM or $1.09 per share, which should be the amount of the distribution for the quarter. That is an increase of 65% from the distribution in the second quarter of $.66.
Implications For Stock Price
Oil refiners and MLPs usually trade on a multiple of their adjusted EBITDA rather than earnings and is based on their enterprise value rather than just the stock price, in order to take into account the net debt of the company. CVRR has cash, equivalents, and working capital that are just about equal to its debt, so net debt here is about zero. The normal EV/EBITDA ratio for refineries is about 6.5 times. The trailing 12-month EBITDA for CVRR is $488MM and at 6.5X, the fair value of the stock should be about $21.43 which is about what it has averaged since the last earnings report. It is $18 a share as I write this in the wake of a major market sell-off, but this is clearly just a matter of short-term market issues.
Now, if adjusted EBITDA does go to $211MM for the 3rd quarter, trailing 12-month EBITDA goes to $560MM and 6.5 times that is $3,640MM. With just under 148MM shares outstanding, this gives a fair value of $24.59. This is a 36% increase to the current price and represents a great opportunity.
The natural question is "can they keep up these numbers?" The answer is both yes, and it is getting better. 4th quarter crack spread is up to $21.82 average or $2 higher than Q3. RIN prices are down another 25%. And as noted above, the Western Canadian discount is vastly higher. So they can not only keep it up but things continue to get better. And just to put this into perspective, 4th quarter of last year yielded an EBITDA of only $76MM. If cracks, RINs, and WCS all stay where they are now, we are looking at an increase in EBITDA in the 4th quarter of $46MM higher than Q3. That would be $257MM for the quarter and a trailing 12-month EBITDA of $741MM. That would give a fair value of the stock at $32.50. The future is very rosy for CVRR.
Disclosure: I am/we are long CVRR.
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.