Introduction

Everyone has heard the adage that the oil industry is cyclical, for reasons that are pretty straightforward. High prices spur investment in new production. New production comes online and eventually outstrips demand. This often causes oil and gas prices to crash. Low prices cause investments to dry up, and eventually, supply begins to lag demand once more. Prices recover, and the cycle repeats.

Oil and gas companies do well in the up cycle, and poorly in the down cycle. These are “upstream” companies, where the “stream” is the oil and gas that comes out of the ground and ultimately flows to the consumer.

The downstream sector refines oil and natural gas into finished products and distributes that to finished customers. Downstream usually trades out of phase with upstream. When oil prices are rising, refiners tend to see margins erode. On the other hand, when oil prices are falling, consumers are much less likely to drive out of their way to save a few dollars on gasoline. For the refiner, that means margins grow as oil prices decline. Hence, they tend to do well when the upstream companies are doing poorly.

Characteristics Of A Good Refiner

The profitability of a refiner is largely influenced by four factors. The first is the direction of crude prices. Falling crude oil prices are typically ideal because finished product prices tend to lag. Flat oil prices are usually OK for refiners, but margins may tend to erode over time. Rising oil prices will usually result in eroding margins.  

The second factor is the location of the refineries with respect to access to different crudes and the location of markets for finished products. A light, sweet crude oil refinery processing Bakken crude oil in North Dakota makes great sense from a supply standpoint but will be challenged in disposing of substantial quantities of finished products.

The third is the type of refinery. A light, sweet refinery with little or no access to discounted crudes will be in a far worse position than a Gulf Coast refinery that can process a wide slate of crudes.

The fourth factor has become an issue for refiners in the past dozen years. Ethanol usage in the US fuel supply has been mandated since the Renewable Fuel Standard (RFS) was first implemented in 2005. Refiners are forced to add ethanol to the gasoline they produce, in amounts defined in the RFS but enforced by the U.S. EPA.

Refiners have complained about the cost of complying with the RFS. Valero (NYSE: VLO), for instance, has said RIN compliance cost $750 million in 2016, with similar expense forecast for 2017. For reference, Valero reported 2016 adjusted net income attributable to stockholders of $1.7 billion, so RIN compliance consumed just over 30% of Valero’s profit by that measure.

Carl Icahn has long been a vocal critic of the current arrangement. He is the majority owner of the refiner CVR Energy (NYSE: CVI). He is also advising President Trump on the issue, which means there could be a change in store that would benefit the nation’s refiners.

Breaking Down The Options

There are an even dozen publicly traded U.S. refining companies listed in the subscription-only S&P Global Market Intelligence database. I will list them below for completeness, along with some important financial metrics for each. However, note that there are substantial differences in these refiners – for example, in their business models and corporate structures – that an apples-to-apples comparison across the entire slate is inappropriate. With that in mind, here they are, in order of descending enterprise value (EV):

• EV – Enterprise value in billions of U.S. dollars, as of July 20th
• FCF – Levered free cash flow, in millions for the trailing 12 months (TTM)
• EBITDA – Earnings before interest, tax, depreciation and amortization, in millions for TTM
• Debt – Net debt at the end of the most recent fiscal quarter
• Yield – Annualized yield based on the most recent dividend
• 1 Yr Ret – Total shareholder return, including dividends, over the past 12 months

There are some caveats to this list. Some of these are Master Limited Partnerships, some are holding companies, some are primarily specialty chemical producers, and some are in the process of, or recently completed a merger. Also, Tesoro (NYSE: TSO) will be changing its name to Andeavor on August 1^st.

Here are my comments on the four largest refiners on the list.

Phillips 66 (NYSE: PSX) is the most valuable of the refiners. Its EV/EBITDA ratio is elevated relative to the rest of the group, but this is because Phillips 66 has significant chemical manufacturing operations, which provide higher margins than commodity fuels. But its debt is also higher than its peers, and as a result, I have avoided recommending this one. Indeed, it has lagged most of its peers over the past year, although Warren Buffett is a fan of the company. Buffett’s Berkshire Hathaway owns 16% of the company – a stake valued at $6 billion. The attraction to Buffett is likely due to synergies between Phillips 66 refineries and Buffett’s BNSF railroad, which can transport discounted crude to the refineries from the mid-continent region.

Marathon Petroleum Corporation (NYSE: MPC) is a component of both The Energy Strategist portfolio and the Personal Finance Growth Portfolio. Over the past year, it was the 3^rd best performer among all refiners and the top performer among the major refiners with a total shareholder return (TSR) of 50.4%. MPC is the nation’s third-largest refiner and the largest refiner in the Midwest. MPC’s Gulf coast refineries can access the lucrative export markets in Latin America, while its in-house filling stations help limit the rising cost of ethanol blending quotas. Marathon releases earnings on July 27 and analysts are projecting strong year-over-year earnings growth.

Valero processes more crude oil globally than any other independent petroleum refiner. Over the past year, Valero produced more cash flow and EBITDA than any of its competitors. Nevertheless, when compared to its peer group of refiners, Valero has less relative debt, a higher yield, and a lower EV/EBITDA ratio. The dividend has grown for six straight years, and the current yield of 4.1% only reflects a payout ratio of 62%.

Valero’s discount may be a result of concerns about the company’s dependence on Venezuelan crude oil. I briefly addressed the situation with Venezuela at the end of last week in Impact Of Potential Oil Sanctions On Venezuela. But according to data from the Energy Information Administration (EIA), only 6.5% of the crude Valero processed in 2016 was from Venezuela. So this is more a perception issue than a serious risk to Valero’s business.

Valero also produces a significant amount of the ethanol it needs, lessening the impact of ethanol policies on its bottom line. Valero is trading near a 52-week high, but still a good value relative to its peers. Nevertheless, investors may drive down Valero’s share price this week if sanctions on Venezuela seem imminent. As a result, although I believe it is a value at the current price, I am going to wait one or two weeks before making a recommendation on Valero. 

It’s hard to make a bullish case for Tesoro, given the financial metrics for Valero. Tesoro is inferior to Valero by just about every performance metric, and yet is more expensive according to EV/EBITDA, and has higher relative debt. From a fundamental standpoint, Tesoro is not in the same class as Valero or Marathon.

Conclusions

The energy sector has been battered since mid-2014, but refiners have performed well in this environment. Margins eroded somewhat as oil prices bounced back from last year’s lows, but the refining segment should continue to do well as oil prices face headwinds.