In December, I predicted that tax overhaul would help fuel a rally in energy stocks. I highlighted the refining sector: “Expect the overall energy sector, but especially the refining sector, to emerge as a significant winner from the tax reforms.” Here’s why I was correct. I also explain what it means going forward.

Refiners convert crude oil and natural gas into finished products and distribute that to finished customers. Refiners usually trade out of phase with oil companies. When oil prices are rising, refiners tend to see margins erode. But when they fall, gasoline prices tend to lag, which leads to fatter margins. As a result, refiners soared during the downturn in oil prices that began in mid-2014. 

Oil prices have rallied in 2018, but so have refiners. Take a look at some of the key financial measures of the top U.S. refiners: 

• EV – Enterprise value at the close on May 24, 2018
• EBITDA – TTM earnings before interest, tax, depreciation, and amortization
• TTM – Trailing twelve months
• FCF – Free cash flow
• Debt – Net debt at the end of the previous fiscal quarter
• Yld – Percent distribution based on the past four quarters of distributions
• YTD Ret – Total shareholder return (including dividends) this year through May 24, 2018

My December prediction came true. There can’t be many sectors that have outperformed the refining group in 2018. Every refiner in the group has generated positive free cash flow over the past year. By comparison, only one major U.S. oil company (excluding integrated companies), ConocoPhillips (NYSE: COP), made more than a billion dollars in FCF over the past year.

Characteristics of a Good Refiner

What is driving these outsized returns? 

A huge factor is the return of the WTI-Brent spread. Historically, West Texas Intermediate (WTI) crude traded at a slight premium to the international Brent crude oil benchmark. But a surge of U.S. shale oil, insufficient transportation logistics, and a crude oil export ban all conspired to push the price of WTI well below that of Brent.

U.S. refiners benefited greatly from this arrangement, because they could buy discounted WTI and sell finished products on the international markets, where Brent crude has a greater influence on the price. Finished product exports soared, and are now above five million barrels per day (BPD). 

The crude oil export ban was repealed in 2015, but finished product exports have continued to rise. A key reason for that is insufficient pipeline capacity to get crude oil to the export market. This has been especially problematic in the Permian Basin, where crude oil recently traded at a $15/bbl discount to WTI in Cushing, Oklahoma (which is trading at a $8/bbl discount to Brent crude).

Consequently, refiners can make huge profits on finished products they manage to export out of the region. That’s especially true for those in and around the Permian Basin, such as Delek (NYSE: DK), Andeavor (NYSE: ANDV), and Holly Frontier (NYSE: HFC).

One final item that is improving profits for refiners involves the ethanol mandates that are enforced by the U.S. EPA. Each year, refiners have to pay billions to comply with the Renewable Fuel Standard (RFS) that has been in place since 2005. But EPA Administrator Scott Pruitt has long opposed these mandates, and his office has been granting waivers to many refiners that have requested them. That saves these refiners money, but it has also lowered the price of the credits refiners must pay to comply with the mandate.  

The upshot: refiners have become cash-generating machines. That’s one reason that Warren Buffett’s Berkshire Hathaway (NYSE: BRK.B) owns 10% of Phillips 66 (NYSE: PSX). It is the 7th largest holding in the Berkshire portfolio and the only energy company in the portfolio. Buffett recently lightened his stake in the company from 16% to just under 10%, which he said would reduce regulatory pressure for Berkshire.

But PSX shares have rallied by 35% since Berkshire lightened its stake. The regulatory burden may have been worth the trouble after all. 

But nobody’s perfect. Not even Warren Buffett. 

As I’ve just explained, refiners are reaping big profits. But we’ve pinpointed other exciting investment opportunities. If you’re looking for other reliable methods of wealth-generation, check out this free presentation.