The current drop in crude oil prices is putting a little more cash in the pockets of consumers at the expense of the big integrated oil and refining companies. The reason is fairly simple: there is more oil being produced than being consumed — and that’s true globally, not just within the US. In the US, however, the prospects for refiners are currently determined by the price spreads between WTI and other varieties of crude oil, most especially Brent crude.
By that yardstick, the latest outlook for North American refining companies published by Fitch Ratings is right on the mark:
Ongoing weakness in U.S. and European product demand and downward revisions in emerging market growth are likely to soften the outlook for North American refiners and prolong the lopsidedness of the current sector recovery, which depends significantly on crude oil spreads (Brent-WTI and shale-based crudes) as a source of profits rather than traditional drivers of refining profitability such as coking economics.
The Fitch report concludes:
[D]espite the challenges of slowing growth, industry [free cash flow] still looks reasonable going forward, due to the combination of adequate cash flow and limited mandatory capex.
Although Fitch does not specify the refiners, the group would include pure refiners like Valero Energy Corp. (NYSE: VLO), Marathon Petroleum Corp. (NYSE: MPC), Phillips 66 (NYSE: PSX), Tesoro Corp. (NYSE: TSO), Western Refining Inc. (NYSE: WNR), and HollyFrontier Corp. (NYSE: HFC). Major oil companies like Exxon Mobil Corp. (NYSE: XOM), Chevron Corp. (NYSE: CVX), ConocoPhillips (NYSE: COP), and BP plc (NYSE: BP) would also be included.
By “mandatory capex” Fitch means “growing regulatory burden in the form of higher renewables mandate, higher vehicle fuel efficiency standards, and looming greenhouse gas regulation.” These regulatory demands will become an issue for refiners at some time in the future, but not immediately.
The result, according to Fitch, is that free cash flows for refiners will be “reasonable” and the companies will be able to use the cash as they choose rather than being forced to invest in mandated improvements to operations.
The report also notes that crude spreads “are likely to persist, but should weaken as more logistical solutions (pipeline, trucking, and rail) come online to move shut-in crude to end markets.” One example is the recently completed reversal of the Seaway crude pipeline which now transports crude from the Cushing, Oklahoma, hub to the Gulf Coast of Texas. Valero, Exxon, Phillips 66, and BP should see some benefit from the Seaway pipeline because they have large operations along the Gulf Coast.
A quick look at potential upside to the refiners’ stocks indicates potential upside from 26% for Western to 50% for Marathon. Both Marathon and Western depend on US feedstock, which currently sells for about $14/barrel less than Gulf Coast crude, whether imported or domestic. The lower upside for Western is due to its lower capacity and its smaller market, plus the fact that shares are up nearly 15% in the past year.
Only Western, of all the pure refiners, shows share price growth in the past 12 months. For the year to date, Western’s share price is up nearly 39% and HollyFrontier’s shares are up more than 26% (HollyFrontier’s potential upside is 28%). Marathon, with a gain of about 6%, also shows a share price rise since January. All three are on the right side of the crude spreads, and that’s the only place for a refiner to be right now.