Investment Opportunities In Downstream Oil

Includes: ANDV, HFC, PSX, VLO, WNR
by: Bennington Investment Ideas

Many investors are enchanted with oil and gas stocks given the economy's continued dependence on oil. However, the oil and gas industry is often split into two segments: upstream and downstream. The upstream business is focused on the exploration for and production of oil and natural gas. Upstream businesses are characterized by large capital expenditures required to identify and develop assets. The downstream business is focused on refining crude oil into useful products for consumers, as well as the retail distribution of those products.

Individuals are most familiar with gas station brands ranging from the integrated companies like Exxon Mobil (NYSE:XOM) and Chevron Corporation (NYSE:CVX) to the pure downstream plays like Valero Corporation (NYSE:VLO) and Phillips 66 (NYSE:PSX), which was formerly part of ConocoPhillips (NYSE:COP). Other pure downstream plays include Tesoro Corporation (TSO), HollyFrontier Corporation (NYSE:HFC), and Western Refining, Inc. (NYSE:WNR). This article will focus on the pure downstream plays listed in the table below:

Downstream Oil Stocks

Ticker Name Recent Price ($) Market Capitalization ($B) Enterprise Value ($B) Current Dividend Yield (%)
PSX Phillips 66 43.92 27.5 32.4 1.8%
VLO Valero Corporation 29.01 16.0 21.8 2.4%
TSO Tesoro Corporation 38.29 5.4 5.7 1.3%
HFC HollyFrontier Corporation 37.37 7.6 7.2 1.6%
WNR Western Refining, Inc. 24.34 2.2 2.4 1.3%
Source: Yahoo Finance

The first observation is that these companies have limited leverage when looking at EV to MC ratios. They also pay reasonable dividends. However, the yields are somewhat below the market average, with the exception of VLO. Also, while these companies are not small caps, they're are not giants, either. Most of the larger companies in refining are not pure plays, but integrated companies.

Downstream Oil Is A Capital Intensive Business

The downstream business is challenging and often subject to low returns. Similar to the airline industry, refining is a very capital intensive business, but with low marginal operating costs. Refineries range in size and complexity. They have different capacities to process lighter or heavier fractions of crude oil. Crude oil is not a single homogeneous commodity, but rather a varying cocktail of different hydrocarbons ranging from very light fractions (Liquefied Petroleum Gases (LPGs) like butane and propane) to medium fractions (distillates like diesel and jet fuel) to heavier fractions (Number 6 heating oil) to the heaviest fractions (asphalt and bitumen). The refining process has numerous steps and processes to separate the fractions, as well as impurities like sulfur. Refineries are optimized for certain types of crude oil and sometimes, even more specifically, for a given set of wells in a given field. And within those constraints, the crude oil can still vary.

Valuation Varies A Little Across The Sector

The following table looks at a variety of valuation metrics for these five downstream plays:

Valuation Metrics

Ticker Price to Book EV/EBITDA Trailing P/E 2013 Forward P/E
PSX 1.5 8.4 5.7 7.7
VLO 1.0 4.1 9.8 6.0
TSO 1.3 3.8 8.2 6.9
HFC 1.4 3.8 5.3 6.9
WNR 2.2 4.8 12.1 5.9
Source: Yahoo Finance, Author Calculations. EBITDA is 2011 for all, except PSX.

These five players show a range of Price to Book values and EV to EBITDA multiples, with a slight premium paid for the larger, presumably more stable firms. The forward P/E ratios are in a relatively tight band from about 6 to a high of 8. The trailing P/Es show a little more variation. WNR shows the highest historical multiples (P/E and P/B) with the lowest forward P/E, suggesting that its recent performance is more disappointing. This might result in a discount on the future performance.

Fundamental Performance

The following table looks at some fundamental performance metrics, including Return on Assets and profit margins.


Ticker 2011 Net Margin 2011 ROA 2011 ROE
VLO 1.7% 5.2% 13.3%
TSO 1.8% 5.9% 15.9%
HFC 6.6% 10.7% 19.5%
WNR 1.5% 5.1% 17.7%
Source: Yahoo Finance for base data and Author Calculations.

These metrics show the clear strength of HFC, making it an interesting opportunity. One can also see the importance of leverage, with VLO, TSO and WNR having very similar ROAs but different ROEs.


Overall, I am skeptical about refining stocks as investments. They operate in a challenging business that often struggles to return investors' cost of capital. For a dividend investor, I would not suggest any of these companies given their low yields -- even VLO's yield, which is above the market average.

Among these companies, I think the most interesting opportunity is HFC, given its higher metrics and still relatively low valuation multiples (EV to EBITDA and P/B). However, additional research and analysis would be important prior to any investment decision. In particular, it would be worthwhile to dig more deeply into the specific refineries owned by HFC to see their performance, capacities, and locations.

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.

Disclaimer: This article is for informational and educational purposes only and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.