It's not only energy companies that profit from rising U.S. oil production. An often-overlooked energy sector that is also quietly raking in record profits is oil and gas refining.
Only a handful of pure-play refineries are left in the United States. Many have either merged into bigger players or were forced out of business in the 1980s by increased regulation and obsolete equipment. The few that remain are enjoying a boom, thanks to rising domestic oil production and widening crack spreads.
Converting crude oil into fuel is a complex process that requires expensive equipment, but determining refinery profits is simple. Profits are determined by the crack spread, which is the difference between the selling price of gasoline and other refined products and the cost the refiner pays for crude oil.
At present, refineries that obtain crude oil from the midsection of the U.S. or from Canada pay much less for crude supplies than refineries on the East or West coasts. However, selling prices for gasoline are fairly uniform across the United States, which means well-located refineries earn larger crack spreads and profits.
In the April edition of High-Yield Investing, my colleague Carla Pasternak looked at two high-quality refineries that are expected to post near-record profits this year. Carla also took note of several recent refinery IPOs that may still be flying under the radar. Let's look at two recent high-yield refinery offerings.
Alon USA Partners (ALDW)
Alon went public in November as a spin-off from Alon USA Energy (ALJ).
The company's main asset is a refinery that is capable of processing 70,000 barrels of crude oil a day. Located in the West Texas city of Big Spring, this refinery was essentially rebuilt from the ground up after a fire in 2008, making it among the most modern in the industry.
Another big advantage for this refinery is its ability to run sour crude, which is more difficult to process (but cheaper to purchase) because of its greater levels of impurities. Roughly 80% of Alon's production comes from sour crude.
Alon's refinery is near the Permian Basin, which provides a second crude pricing advantage. According to the Energy Information Administration, daily production in the Permian Basin is forecast to rise from 1 million barrels in 2011 to 1.55 million barrels by 2014 and 2 million barrels in 2015. A lack of pipeline infrastructure limits the movement of Permian crude out of the area, allowing Alon to purchase crude supplies at a discounted price.
In addition, Alon also benefits from a captive distribution system for its gasoline, which is marketed at 650 retail sites under the Alon brand.
Alon nearly doubled earnings to $93.5 million or $1.50 a share, in the first quarter of 2013 from $48.1 million a year earlier. Cash flow improved 66% to $116 million.
Strong profit growth was mainly due to widening crack spreads: Alon's refinery operating margins have soared 89% to $28.76 per barrel compared with a year ago. Profits improved despite the fact that throughput that was 14% lower than last year due to scheduled maintenance and downtime during the quarter. Alon expects daily throughput to rise 21% to 72,000 barrels between March and June.
Alon announced a first-quarter distribution in April of $1.48 per unit. At an annualized rate of $5.92, Alon shares would yield a phenomenal 25%. Although this high payout rate is likely unsustainable, Alon shares have risen 27% since the IPO, indicating that investors anticipate more big quarterly distributions.
CVR Refining (CVRR)
CVR Refining debuted in January as a spin-off from CVR Energy (CVI). The former parent company retains a more than 80% stake. This company owns two refineries in Kansas and Oklahoma with a combined processing capacity of 185,000 barrels per day. CVR also owns and operates 350 miles of pipeline, 125 crude oil transports and 6 million barrels of crude oil storage.
Due to the locations of its refineries, CVR Refining can take advantage of low-cost crude supplied from the mid-continent and Bakken regions, as well as Canada. In addition, CVR Refining enjoys favorable supply and demand dynamics in its key markets of Kansas, Oklahoma, Missouri, Nebraska and Iowa. In the past five years, demand in that region has exceeded production by an average of 17%.
As a result of increased throughput and refining margins, CVR's cash flow more than doubled in the first quarter, to $310 million from $143 million a year earlier. Earnings vaulted to $275 million from a loss of $37.4 million last year. Throughput was 32% higher at 204,590 barrels per day, and refining margins were 42% higher at $26.44 per barrel.
CVR will pay an initial distribution of $1.58 per share this month. At the time of its IPO, the company expected distributions totaling $4.72 this year, but management has since raised its guidance and now expects to pay between $5.50 and $6.50. Even at the lower end of the range, the revised payout implies a rich 17% yield. These shares have gained 29% since the company went public in mid-January.
Risks to Consider: The Environmental Protection Agency has proposed clear air standards that would force refineries to buy expensive equipment to reduce the sulfur content of gasoline by more than 60%. However, CVR Refining says its current equipment can handle the change, and Alon estimates the upgrades will cost less than $10 million.
Action to Take --> Both of these refinery limited partnerships are great high-yield plays on rising domestic oil production and widening crack spreads. At a price-to-earnings ratio (P/E) of only 6, CVR Refining looks like a better bargain than Alon, which trades with a P/E of 18.
With that said, investors should be aware that distributions are likely to vary from quarter to quarter, depending on feedstock and refined product prices. However, while cheap crude oil is available, both of these partnerships should continue to offer generous distributions.
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