One Of These Oil Refiners Is Not Like The Others -- It's Cheaper, For One Thing

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Forget about playing the commodities markets, and about the companies that make money discovering and extracting raw materials, including oil and natural gas. As gasoline prices rise, the place to invest is in the shares of the refiners that generate profits by buying crude oil and then transforming it into gasoline, jet fuel and other crude byproducts. The difference between is the refining margin – and that has been climbing steadily, fueled in part by some oddities in the nature of regional crude oil markets and oil pipeline transportation networks.

For instance, HollyFrontier Corp. (HFC), formed by the recent merger of Holly Corp. and Frontier Oil Corp., operates several refineries in the Midwestern United States, plus Wyoming and Oklahoma. That’s a region in which exploration and production companies have been very active, drilling not only in the established Permian Basin but also extracting a lot of new oil from the Bakken Shield. But as supplies have climbed, prices have fallen, not only because demand hasn’t soared commensurately, but because the existing transportation infrastructure hasn’t expanded along with output. That has left a lot of crude oil “trapped” in the production region, and created a differential between the West Texas Intermediate (WTI) price that is determined by the supply/demand balance in Texas, and the global Brent price, which has been hovering around $21 per barrel.

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Brent WTI Spread Chart

That’s a recipe for hefty profit margin gains at HollyFrontier and other refining companies able to buy their feedstocks at the WTI price in order to resell the fuels they produce at prices pegged to Brent.

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HFC Gross Profit Margin TTM Chart

Of course, this is hardly secret. The refining companies and analysts that follow the energy industry have been monitoring this trend for a few years. The question today is whether this pattern seems to remain intact, and whether there is enough value left in these stocks to warrant jumping in or adding to positions at this point in the game. The stock price of Tesoro Corp. (TSO) has more than doubled over the last 12 months, while that of Valero Energy (VLO) has climbed 87%. But HollyFrontier has gained a relatively meager 68%, in spite of the fact that its rate of growth in net income has dwarfed that of Tesoro, for instance. Moreover, as the chart below shows, it’s easily the cheapest of the three stocks.

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HFC Forward PE Ratio Chart

There’s a reason for that. While HollyFrontier’s earnings soared 75% in the fourth quarter to $1.92 a share, analysts had been looking for a figure closer to $2.26 a share. The problem? The company’s refineries are older, and downtime and higher costs ate into some of the rising margins that HollyFrontier captured. Some of the company’s refineries had to take downtime – both scheduled and unscheduled – and more may be in the offing, some analysts fear. The result? HollyFrontier has lagged at least two of its peers, Valero and Tesoro.

This may create a buying opportunity for investors looking for a way to play the WTI/Brent spread and what is known as the “crack spread” (the difference between crude oil prices and the value of refined products) more generally. Argus Research recently boosted its price target on the stock to $68 a share from $48 previously. (The stock changes hands currently at about $56.) It has more than $1 billion of cash sitting on its balance sheet that it can use to overhaul any underperforming facilities, as well as fund its dividend. (HollyFrontier currently has an alluring enough dividend yield of 2.15% and plans to continue paying an extra 50 cents a share in the form of quarterly special dividends that some analysts have calculated place its real forward yield of closer to 6%.) The company’s operating cash flow has soared, and there is little indication that the supply/demand oddities that created this boomtime for refiners is about to change any time soon. Those positive fundamentals, the reasonable valuation and the industry backdrop combine to make this an appealing addition to a portfolio.

Suzanne McGee, a contributing editor at YCharts, spent nearly 14 years as a reporter at the Wall Street Journal, in Toronto, New York and London. She is also a columnist for The Fiscal Times, and author of "Chasing Goldman Sachs", named one of the best non-fiction books of 2010 by the Washington Post. She can be reached at editor@ycharts.com.


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