In last week’s Energy Letter, I provided an overview of the refiners. My advice was to avoid the sector for now, but today I want to take a deeper dive and look at some individual refiners utilizing the proprietary screening tool I have developed.

Please refer to The Energy Letter for a broader overview. To review, refinery profits are the difference between the cost of the purchased crude oil and the realized value of the refined fuels made from that crude. That margin is known as the “crack spread.”

Although a barrel of oil is refined into a number of distinct finished products, the crack spread typically assumes an input of crude oil input and the output of gasoline and distillates. The most widely used crack spread for U.S. refineries is called the 3:2:1, which signifies 3 barrels of oil converted into 2 barrels of gasoline and 1 barrel of distillates (diesel, jet fuel and fuel oil.)

Note that in the weekly commodity table above, I provide a calculated 3:2:1 crack spread which is based on an input of West Texas Intermediate and an output of the price of gasoline and heating oil at New York Harbor. While there will be some regional differences in the crack spread, the trend across the country will be similar. Current crack spreads are about half of what they were a year ago, and this is reflected in the diminished profits reported by the refiners. More on that below.

Investors should generally look to rotate into refining stocks when oil prices are falling, because that’s when refiners’ margins swell. And you want to rotate out when oil prices are rising.

The significant risk of rising oil prices is what prompted us to purge the refiners from the portfolios last September. But given the large decline the sector has seen, some bargain hunters are naturally wondering if this might be the time to jump in.

An observant reader might note that oil prices are currently a bit lower than they were a year ago. All things being equal, that ought to mean improved refining crack spreads. But all other things aren’t equal; there are other factors that affect refiners’ margins.

One critical consideration is the elevated current level of gasoline inventories. While U.S. consumption of gasoline is at a record, the refiners have produced gas well in excess of that record demand. This is analogous to the crude glut that caused the price of oil to crash despite record demand. So, despite slightly lower oil prices than a year ago and record consumer demand, gasoline inventories in the U.S. reached a record high in February:

Of course inventories have come down since then because summer is the peak driving season. But there are two things to keep in mind.

First, as inventories started to come down — which would normally be bullish for refiners — oil prices rose sharply. Recall that for a number of days in February WTI crude traded below $30 per barrel. As inventories were declining, the price of oil was headed to $50/bbl — bad news for refiners.

Second, we have to put things into historical perspective. Inventories always fall during the early part of the year and through the summer. That’s because spring is a busy maintenance season at  refineries, limiting their output. That’s followed by summer driving season. Taking those factors into account, here is what the current inventory picture looks like with respect to recent history:

So even though gasoline inventories have come down since February they’re more out of whack from recent seasonal patterns than in February. Further, gasoline inventories have climbed over the past month. Fears of a persistent and growing glut have depressed gasoline prices relative to the cost of oil, and that has crushed refiners’ margins.

But can’t refiners export excess gasoline? Yes, but the situation globally isn’t any better. The Wall Street Journal reported last week that global gasoline inventories, which were the same at the beginning of 2016 as a year earlier, are now nearly 12% higher than a year ago. Year-over-year levels worldwide have climbed in every month this year, and it is going to take some time to work off this excess.

Some of you may feel that this situation will resolve itself sooner rather than later, in which case today’s refiners present a good long-term value proposition. Only time will tell, but I won’t be surprised to see most stocks in the sector setting new 52-week lows in the months ahead.

In any case, let’s take a look at how the refining stocks stack up right now. I screened the major refiners in the U.S., excluding those that are MLPs and those that own refining assets through MLP stakes. That excluded from the list Alon USA Energy (NYSE: ALJ), Alon USA Partners (NYSE:ALDW), CVR Refining (NYSE: CVRR), CVR Energy (NYSE: CVI) and Calumet Specialty Products Partners (NASDAQ: CLMT).

That left the following, ranked in descending order by enterprise value (EV):

• EV – Enterprise value in billions of U.S. dollars, as of July 28
• EBITDA – Earnings before interest, tax, depreciation and amortization, in billions for the trailing twelve months (TTM)
• FCF – Levered free cash flow, in millions
• FQ – Fiscal quarter (MPC and VLO reflect Q1; all others are Q2)
• Debt – Net debt at the end of the most recent fiscal quarter
• Yld = Annualized yield based on the past year’s distributions
• YTD Ret – Total shareholder return, including dividends, thus far in 2016   

Note that EBITDA and FCF for the past year are positive for the group, in contrast to many oil producers. Because of the nature of the refining business — buying oil and selling finished products — we’re unlikely to see a rash of bankruptcies like those that have plagued the oil industry. Refiners tend to take on less debt than oil and gas producers, so they are better equipped to survive extended downturns.

Phillips 66 (NYSE: PSX) experienced a significant cash drain, but that’s a function of some major capital expenditures. On the other hand, its stock has held up better than the rest of the group, and as a result of major declines among its peers, PSX has become relatively overvalued on an EV/EBITDA basis.

Valero (NYSE: VLO) is still the star of the group with respect to most metrics, but that hasn’t stopped it from losing 25% YTD. Valero reported earnings this week, and beat expectations. Q2 earnings came in at $1.79 per share, far below last year’s $2.67 per share, but still comfortably in the black. In its earnings release Valero indicated that its biofuel blending obligations had cost it $173 million during the quarter. Note in the commodity table above that the profit margins for ethanol producers are improving, and as I noted in the previous issue this is detrimental to a refiner’s bottom line.

As other refiners report earnings, they will likely show the same pattern: profitable in Q2, but much less so than a year ago. Further, free cash flow deteriorated in the most recent quarter for all the refiners. Given that this is peak demand season for gasoline and given the current state of gasoline inventories, that trend can’t be expected to reverse soon.   

Conclusions

The situation with refiners is analogous to what has happened over the past couple of years to oil and natural gas producers. In both cases, there was record demand for the product, but also record production that outpaced demand. We have to always keep in mind that there are two sides to the supply/demand equation, and not count too strongly on record demand propping up prices. First in the natural gas market, and then with oil, high production resulted in growing product inventories. In each case, this eventually crashed the price. We are now seeing that with the refiners.

The bottom line is that it’s hard to find a compelling argument to invest in any refiner right now. We don’t recommend any. If you still feel like the downside risk is bearable, the safest bet in the group is probably Valero. But I would bet that you will be able to buy it cheaper over the next few months.

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