Last month in Screening for Value Upstream, I introduced a new custom screening tool that allows us to quickly identify companies or MLPs that appear to be bargains. In that issue, I used the tool to highlight upstream MLPs that were trading at low multiples, and in fact that week one of those highlighted — Eagle Rock Energy Partners (NASDAQ: EROC) — announced that it would be acquired by Vanguard Natural Resources (NASDAQ: VNR).

Today I will use the screening tool on a sector that performed very well during the oil price plunge of the past year — the refiners (commonly known as the “downstream” segment). Refiners make money by converting crude oil into finished products such as gasoline, diesel and fuel oil. A refiner’s profit margin is mostly determined by the difference between the cost of crude oil purchased and the price of finished products sold. When crude oil prices fall, the fall in finished product prices often lags, which increases profit margins for refiners.    

In screening the refiners I will consider different metrics than in our screen of oil and gas producers. A pure refiner has no oil reserves, and hence no standardized measure or multiples derived from either. Because refining is a low margin, high volume business, it is less important to focus on the profit margin and more important to look at EBITDA, free cash flow, and return on assets.

The screen identified four downstream MLPs:

• EV = Enterprise Value as of May 22
• EBITDA = 2014 earnings before interest, tax, depreciation and amortization
• FCF = Free Cash Flow in 2014
• RoA = Return on Assets for the trailing twelve months
• CR = Current Ratio, current assets divided by current liabilities for the previous quarter
• 1 Yr Ret = 1 year total return (including dividends) as of May 22

Alon USA Partners (NYSE: ALDW) was spun off in 2012 by parent Alon USA Energy (NYSE: ALJ), which still owns an 81.6% stake. ALDW’s primary asset is a crude oil refinery in Big Spring, Texas, in the heart of the Permian Basin. Total throughput capacity of the refinery is approximately 70,000 bpd. The partnership also includes a wholesale fuels marketing business integrated with the Big Spring refinery, which markets gasoline and diesel to some 640 filling stations under the ALON brand.

Calumet Specialty Products Partners (Nasdaq: CLMT) isn’t a conventional refiner. It produces petroleum-based specialty products and fuels, operating 11 facilities in seven states with an aggregate production capacity of nearly 160,000 barrels per day. In addition to gasoline, diesel, jet fuel and asphalt, the partnership sells solvents, mineral oils, waxes and specialty lubricants.

CVR Energy (NYSE: CVI) spun off CVR Refining (NYSE: CVRR) in January 2013, and both entities remain majority-owned by Carl Icahn. CVR Refining’s primary assets are two refineries, in Kansas and Oklahoma, with a combined processing capacity of approximately 185,000 barrels per day (bpd). These refineries are strategically located near the major Cushing, Oklahoma shipment and storage hub, with easy access to discounted feedstock from the nearby Permian basin as well as the Bakken shale and Canadian oil sands.

Like ALDW, Northern Tier Energy (NYSE: NTI) isn’t a pure refining play. The partnership owns one refinery in St. Paul Park, Minnesota with a capacity to refine 89,500 bpd of crude oil. The refinery’s proximity to the Canadian border and to the Bakken in North Dakota gives it access to crude grades that are often priced below the WTI. Northern Tier Energy also operates 164 convenience stores and supports 79 franchised convenience stores, primarily in Minnesota and Wisconsin, under the SuperAmerica brand name. SuperAmerica filling stations are clustered around the refinery, which supplies their gasoline at prices that tend to give Northern Tier a margin premium over the regional crack spread. Western Refining (NYSE: WNR) controls NTI’s general partner and 38% of its limited partner units.

Northern Tier Energy also owns a 17% interest in the Minnesota Pipe Line Company, which owns and operates the Minnesota Pipeline. The 455,000 bpd crude oil pipeline system transports crude oil (primarily from Western Canada and North Dakota) from the Enbridge pipeline hub at Clearbrook, Minnesota to the refinery. The Minnesota Pipeline transports the majority of the crude oil processed in the refinery.

Of the four downstream MLPs, CLMT is also the only one committed to a steady payout. The other three pay variable distributions consisting of all available cash not needed for refinery upgrades or maintenance, and the amount paid per unit can vary greatly from quarter to quarter.

Alon USA Partners has performed best over the past year. In fact, its RoA was more than double that of the best C-corp refiners, yet it still trades at a modest EV/EBITDA multiple. Northern Tier Energy likewise has attractive financial metrics, including the highest RoA of the group, but its 2.8% total return over the past year lags far behind Alon USA Partners’ 38% return.

The Limits of Data

As I indicated in the opening paragraph, these screens are designed to identify companies or MLPs that appear to be bargains. Mass-produced valuation metrics don’t capture all the context important to every diligent investor, such as scale, location, strategy and the quality of management, to name but a few considerations that are hard to quantify.

Because the smaller refiners depend on one or two refineries. their output is subject to greater fluctuation as a result of scheduled and unplanned shutdowns, which can skew the valuation ratios. This concentration of business risk and the higher volatility may also explain the low valuations of some of the smaller operators.   

Conclusions

Nevertheless, refiners should continue to outperform the broader energy sector for the foreseeable future as they benefit from ample supplies of U.S. crude oil — due in part to a crude oil export ban. Since there is no export ban on finished products like gasoline, refiners with access to export markets should continue to see healthy margins regardless of whether oil prices are rising or falling (although falling prices are historically better for refiners). The single biggest risk for the group is that the crude export ban is repealed. The oil industry is pressing hard for an end to the ban, while several of the refiners have unsurprisingly voiced their opposition. I view this as unlikely in the next one to two years.

Investors should note that the downstream sector possesses far more risk and volatility than the midstream sector that is home to most MLPs. Further, three of the four MLPs discussed today are variable distribution MLPs. This can lead to unrealistically high yield projections when extrapolating the most recent quarterly distribution over four quarters.

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