The fortunes of US refiners have been on a roller coaster ride over the past year and a half. This is nothing new for the refining industry, which has ridden a cycle of boom and bust for decades. The current cycle was largely influenced by the differential between the price of Brent crude and West Texas Intermediate (WTI), which exceeded $25/bbl at times in 2012.

Historically Brent crude was discounted relative to WTI, but for the past 2 1/2 years Brent has mostly traded at premium of more than $10/barrel. This historic flip-flop was a result of expanding US oil production, which swelled crude inventories in Cushing, Oklahoma to record levels.

This differential is important for refiners, because they can buy discounted crude from the Bakken, Eagle Ford, or Permian Basin at prices influenced by the price of WTI and then sell finished products that are generally priced on the basis of Brent crude.

 

Many refiners are effectively in a position to pocket most of the differential between Brent and WTI, and so when the spread grows wide refiners’ profits grow large. Thus, it should come as no surprise that refiners like Valero Energy (NYSE: VLO), Tesoro (NYSE: TSO), and Marathon Petroleum (NYSE: MPC) saw profits surge in 2011 and 2012. As a result of these favorable conditions, the share prices for refiners had a huge run-up from early 2012 to early 2013, when many of them notched triple-digit gains.

However, in 2013 refiners have been hit with a rash of negative news that’s hurt performance. The first bit of bad news was covered in a March issue of the The Energy Letter in which I discussed the issue of the looming ethanol blend wall, which is leading to soaring costs for refiners as they attempt to comply with federal ethanol mandates.

Next came a proposal from the US Environmental Protection Agency (EPA) to lower the limit on sulfur in gasoline from 30 parts per million (ppm) to 10 ppm. The cost of complying with the new regulations has been estimated in the range of $10 billion for adding new hydrotreater capacity to the refineries. EPA estimated that annual operating costs for US refiners would increase by $3.4 billion by 2030.

Those two pieces of news stalled the momentum that refiners had carried over from 2012. But one more piece of bad news is one I have warned about since last year: the Brent-WTI differential is reverting to the historical norm.

I expected the differential to shrink this year because several projects will relieve the bottleneck in Cushing. In May 2012, Seaway Crude Pipeline Company — a joint venture between Enterprise Products Partners LP (NYSE: EPD) and Enbridge (NYSE: ENB) — reversed the flow direction of the Seaway Pipeline. This allowed the transport of 150,000 barrels per day (bpd) of crude oil from Cushing to Gulf Coast refineries near Houston. But that wasn’t enough to slow the growth of inventories in Cushing, as it represented a small fraction of the increasing oil production flowing into the hub.

In January 2013 the capacity of the Seaway Pipeline was increased by 250,000 bpd to a total capacity of 400,000 bpd. Seaway is also executing a project designed to parallel the existing right-of-way from Cushing to the Gulf Coast. This project is scheduled to be completed by the first quarter of 2014, and will more than double Seaway’s capacity to 850,000 bpd.

Later this year the southern leg of the Keystone pipeline is scheduled to come onstream. This Keystone-Cushing extension will have an initial capacity to transport 700,000 barrels of oil per day from Cushing to Gulf Coast refineries (not to be confused with the Keystone XL project which is still awaiting approval by the Obama Administration). These Seaway and Keystone projects have a combined capacity of more than 1.5 million bpd, which mounts to some 70 percent of the increase in US oil production capacity over the past four years.

Cushing inventories have yet to be significantly eroded, although they have come down somewhat from their highs. Anticipation of further inventory declines may be one reason the Brent-WTI differential is shrinking. This has helped WTI maintain strength as the price of Brent crude weakened on signs that the global market may be amply supplied.

Whatever the reason, a declining differential will hurt refiners that have benefited so much from unusual circumstances over the past two years. But the differential is not the whole story. The profitability of a refinery can be predicted on the basis of the difference between the crude oil it purchases and the finished products sold and is expressed in terms of the “crack spread.” The price of Brent is really a proxy for the price of finished products.

The problem for refiners is that the price of those finished products is weakening. Many news stories leading up to the July 4 holiday were about falling gasoline prices. Gasoline prices typically peak some time after Memorial Day, and once they start to decline it is bad news for refiners if the price of crude is holding steady or rising.

This is exactly the case this year, which is why second- and third-quarter profits will be noticeably down from 2011 and 2012.

A lower differential has bearish implications for on other segments of the energy sector as well. On the other hand, some segments actually benefit from a shrinking differential — and these include some of our portfolio companies. We’ll address the changing risk/reward ratio for several of these companies in this week’s issue of The Energy Strategist.

Portfolio Update
ARII Railroaded

In the small hours of Saturday morning, 73 train cars transporting Bakken crude along the Montreal, Maine & Atlantic Railway somehow got loose from a parked locomotive and sped downhill into the center of the small Quebec town of Lac-Megantic. There they derailed and exploded in a monstrous fireball, leaving 5 people dead, some 40 more missing and the town center in ruins.

Canadian Prime Minister Stephen Harper called the accident, which remains under investigation, “an unbelievable disaster.”

The catastrophe will only stoke the controversy surrounding the proposed Keystone XL pipeline, since proponents claim pipelines are safer than crude transport by rail. And there are fears, voiced today by a Stifel analyst, that oil by rail will become ensnared in a regulatory crackdown, ultimately resulting in costly new safety requirements and lost tank car orders.

All this sounds like a leap while the cause of the accident remains unknown. (The engineer who left the train at the end of his shift has reportedly said he set all the necessary brakes.)

I find it doubtful that a single admittedly horrific accident will end the railing of oil increasingly vital to the energy industries in the US and Canada. Pipelines can’t match the flexibility rails offer, the main reason I expect rail transport of oil to expand whether or not the Keystone XL is approved. Energy producers and consumers remain reluctant to make long-term pipeline commitments while the depletion curve of the shale deposits now being exploited remains a matter of guesswork.

As for ARII’s share price, bottoms are a process, not a moment. So while the stock is down not quite 3 percent on the day, so far the June low near $30 has not even been tested. If and when it is, the stock’s 3.1 percent dividend yield, healthy balance sheet and ample cash flow should provide decent protection. ARII remains a Hold.