The ABC’s of the 3:2:1 Spread
There are a handful of MLPs that hold refining assets, but investors should really understand the refining business before attempting to take the plunge. The refining sector is cyclical, which may imply too much volatility for some investors looking for consistent, stable payouts from their master limited partnerships. But those who understand the nuances of the sector, are willing to accept somewhat higher risks and can correctly anticipate the cycles should be in line for rich rewards.
Refiners make money by converting crude oil into finished products such as gasoline, diesel and fuel oil. A refiner’s profit margin is the difference between the cost of crude oil purchased and the price of finished products sold. This is what’s known in the industry as “the crack spread.” “Crack” refers to the fact that oil is being cracked, or split up, into the various refined products, and “spread” reflects the price spread between the raw material (crude) and the processed fuels.
Although a barrel of oil is refined into many finished products like lubricants, waxes, coke, asphalt and liquefied petroleum gases, the crack spread typically refers only to the crude oil input and the gasoline and distillate output. The most widely utilized crack spread for US refineries is called the 3:2:1, which estimates the profitability of converting three barrels of oil into two barrels of gasoline and one barrel of distillate (diesel, jet fuel, and fuel oil).
The crack spread is a rough approximation of a refiners’ profitability. Because it depends on the differential between the price the refinery pays for oil and the price it receives for products, refiners are one segment of the oil and gas industry that can see profits increase as oil prices fall. But they also are at risk of seeing profits decline when oil prices are rising.
West Texas Intermediate (WTI) is a benchmark for crude oil prices in the US. Brent crude, which is of slightly lower quality than WTI, is the benchmark for most of the global oil trade. The price of Brent also strongly influences the price of finished products. Certain refiners can benefit (or suffer) from their location and logistics by buying crudes at WTI prices and selling finished products influenced by Brent prices. Thus, the differential in the price of Brent and WTI can influence the crack spread for these refiners.
Historically, the price difference between WTI and Brent has been small. Prior to 2010, WTI was usually slightly more expensive than Brent. But starting in 2010, the expansion in US oil production resulted in insufficient pipeline capacity for getting mid-continent oil to coastal markets. A glut of crude developed across the mid-continent, and as a result, the price of WTI became depressed relative to Brent. After years of having traded at a $1 to $3 discount to WTI, Brent suddenly began to trade at a premium to WTI. In 2011 this differential increased to more than $25/bbl, and it remained elevated in 2012.
The substantial increase in the Brent-WTI differential created profitable opportunities for refiners that could buy WTI-type crudes and sell the finished products into markets at prices where products were more reflective of Brent crude. As a result, refiners made strong advances in 2011 and 2012. But pipeline capacity started to catch up in 2013, and as the Brent-WTI differential shrank so did the share prices of most refiners.
Many analysts downgraded the refining sector in Q3 after the Brent-WTI differential had already collapsed. Simmons downgraded the sector to Neutral because of concerns about refining margins in Q3 and into 2014. JPMorgan, Cowen, and Credit Suisse also recently downgraded refiners, and other brokerages lowered their price targets.
Without a doubt, refiners are going to turn in disappointing year-over-year results for Q3. In Q3 2012, the Brent-WTI differential averaged $17.43/bbl. In Q3 of this year, the differential averaged $4.43/bbl. That is going to significantly drag down quarterly earnings of refiners relative to a year ago. Refinery MLPs are going to have a lot less cash relative to a year ago from which to make Q3 distributions.
But the Brent-WTI differential has increased significantly since Q3. Q4 performance will still almost certainly be below that of a year ago when the Brent-WTI differential averaged $22/bbl, but the differential is now back above $10/bbl and poised to head higher if WTI prices continue to weaken.
As a result, there may be some buying opportunities if the refining MLPs dip after announcing what will likely be disappointing Q3 results. In next week’s issue, I will profile the MLPs that own refineries, and discuss their prospects.
(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)
Portfolio Update
Coal Still Down, But Alliance Pays
The coal mining industry remains in the penalty box, but Aggressive Portfolio holding Alliance Holdings GP (Nasdaq: AHGP) continues to score thanks to its low costs and long-term supply contracts.
Alliance Resources Partners (Nasdaq: ARLP), the master limited partnership for which AHGP serves as the general partner, and from which it derives all its revenue, reported a 5 percent year-over-year revenue gain for the latest quarter Monday, while its earnings before items jumped 24 percent, boosted by a charge a year ago. And while ARLP raised its distribution 8.3 percent year-over-year, the new $3.23 annualized distribution rate set by AHGP’ works out to a 12.2 percent year-over-year raise as well as a 5.5 percent yield based on the current unit price.
CEO Joseph W. Craft III said market conditions for coal remain “difficult” as a result of intense competition, mild weather and “a stagnant economy in critical coal-burning regions,” though he continued to predict an improvement next year, when several new mines should bolster the coal miner’s profits. In the meantime, that 5.5 percent yield and the double-digit distribution growth rate are backed by a healthy distribution coverage ratio of 1.55 times, up from 1.45 times a year ago. Debt remains modest at 1.14 times trailing Ebitda.
AHGP remains the safest coal play, as evidenced by its outperformance relative to coal stocks in recent months, with plenty of leverage should prices and demand improve. Buy AHGP below $68.
Refiners make money by converting crude oil into finished products such as gasoline, diesel and fuel oil. A refiner’s profit margin is the difference between the cost of crude oil purchased and the price of finished products sold. This is what’s known in the industry as “the crack spread.” “Crack” refers to the fact that oil is being cracked, or split up, into the various refined products, and “spread” reflects the price spread between the raw material (crude) and the processed fuels.
Although a barrel of oil is refined into many finished products like lubricants, waxes, coke, asphalt and liquefied petroleum gases, the crack spread typically refers only to the crude oil input and the gasoline and distillate output. The most widely utilized crack spread for US refineries is called the 3:2:1, which estimates the profitability of converting three barrels of oil into two barrels of gasoline and one barrel of distillate (diesel, jet fuel, and fuel oil).
The crack spread is a rough approximation of a refiners’ profitability. Because it depends on the differential between the price the refinery pays for oil and the price it receives for products, refiners are one segment of the oil and gas industry that can see profits increase as oil prices fall. But they also are at risk of seeing profits decline when oil prices are rising.
West Texas Intermediate (WTI) is a benchmark for crude oil prices in the US. Brent crude, which is of slightly lower quality than WTI, is the benchmark for most of the global oil trade. The price of Brent also strongly influences the price of finished products. Certain refiners can benefit (or suffer) from their location and logistics by buying crudes at WTI prices and selling finished products influenced by Brent prices. Thus, the differential in the price of Brent and WTI can influence the crack spread for these refiners.
Historically, the price difference between WTI and Brent has been small. Prior to 2010, WTI was usually slightly more expensive than Brent. But starting in 2010, the expansion in US oil production resulted in insufficient pipeline capacity for getting mid-continent oil to coastal markets. A glut of crude developed across the mid-continent, and as a result, the price of WTI became depressed relative to Brent. After years of having traded at a $1 to $3 discount to WTI, Brent suddenly began to trade at a premium to WTI. In 2011 this differential increased to more than $25/bbl, and it remained elevated in 2012.
The substantial increase in the Brent-WTI differential created profitable opportunities for refiners that could buy WTI-type crudes and sell the finished products into markets at prices where products were more reflective of Brent crude. As a result, refiners made strong advances in 2011 and 2012. But pipeline capacity started to catch up in 2013, and as the Brent-WTI differential shrank so did the share prices of most refiners.
Many analysts downgraded the refining sector in Q3 after the Brent-WTI differential had already collapsed. Simmons downgraded the sector to Neutral because of concerns about refining margins in Q3 and into 2014. JPMorgan, Cowen, and Credit Suisse also recently downgraded refiners, and other brokerages lowered their price targets.
Without a doubt, refiners are going to turn in disappointing year-over-year results for Q3. In Q3 2012, the Brent-WTI differential averaged $17.43/bbl. In Q3 of this year, the differential averaged $4.43/bbl. That is going to significantly drag down quarterly earnings of refiners relative to a year ago. Refinery MLPs are going to have a lot less cash relative to a year ago from which to make Q3 distributions.
But the Brent-WTI differential has increased significantly since Q3. Q4 performance will still almost certainly be below that of a year ago when the Brent-WTI differential averaged $22/bbl, but the differential is now back above $10/bbl and poised to head higher if WTI prices continue to weaken.
As a result, there may be some buying opportunities if the refining MLPs dip after announcing what will likely be disappointing Q3 results. In next week’s issue, I will profile the MLPs that own refineries, and discuss their prospects.
(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)
Portfolio Update
Coal Still Down, But Alliance Pays
The coal mining industry remains in the penalty box, but Aggressive Portfolio holding Alliance Holdings GP (Nasdaq: AHGP) continues to score thanks to its low costs and long-term supply contracts.
Alliance Resources Partners (Nasdaq: ARLP), the master limited partnership for which AHGP serves as the general partner, and from which it derives all its revenue, reported a 5 percent year-over-year revenue gain for the latest quarter Monday, while its earnings before items jumped 24 percent, boosted by a charge a year ago. And while ARLP raised its distribution 8.3 percent year-over-year, the new $3.23 annualized distribution rate set by AHGP’ works out to a 12.2 percent year-over-year raise as well as a 5.5 percent yield based on the current unit price.
CEO Joseph W. Craft III said market conditions for coal remain “difficult” as a result of intense competition, mild weather and “a stagnant economy in critical coal-burning regions,” though he continued to predict an improvement next year, when several new mines should bolster the coal miner’s profits. In the meantime, that 5.5 percent yield and the double-digit distribution growth rate are backed by a healthy distribution coverage ratio of 1.55 times, up from 1.45 times a year ago. Debt remains modest at 1.14 times trailing Ebitda.
AHGP remains the safest coal play, as evidenced by its outperformance relative to coal stocks in recent months, with plenty of leverage should prices and demand improve. Buy AHGP below $68.
— Igor Greenwald
Stock Talk
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