Must-know: An overview of Valero's 2Q14 earnings (Part 4 of 6)
Valero’s cost advantage
As reported in the earnings release, Valero (VLO) realized wider discounts relative to Brent crude oil over sour oil and North American light crude oils. The discount to West Texas Intermediate (or WTI) was $6.68 versus $9.17 in the same period last year, while the discount to light sweet oil was $3.41—lower than the previous year period when light sweet oil was trading at a premium to Brent.
The discount to WTI, in particular, narrowed this quarter compared to last quarter by $2.49. This was a result of inventory reduction at Cushing, Oklahoma—the delivery point for WTI crude. The Louisiana Light Sweet (or LLS) and the sour crude differential to Brent both widened this quarter relative to last year.
Why crude differentials matter to refiners
Crude differentials to Brent are important to domestic refiners because they determine their margins. Refiners buy domestic crude to produce refined products, like gasoline and diesel, which are then sold based on international Brent benchmarked prices.
So, the “cheaper” their input—domestic crude—and the “pricier” the value of their output—refined products—the better it is for refiners. In other words, the wider the differential between domestic crude and Brent, the better it is for refiners.
A shrinking WTI-Brent spread
Until recently, increased crude production, primarily from unconventional plays, combined with infrastructural handicaps due to limited pipeline capacity from Cushing to refineries situated on the Gulf Coast caused WTI crude to trade lower compared to Brent. This enabled refineries to earn higher refining margins.
However, due to expanding infrastructure, the spread between these two benchmarks has narrowed considerably, from ~$19 in November last year, to $7 last week.
The shrinking WTI-Brent isn’t a good sign for U.S. refiners such as Valero (VLO), Phillips 66 (PSX), Marathon Petroleum (MPC), and HollyFrontier Corp. (HFC) because it threatens to take away the advantage these companies currently enjoy. It’s important to note that most of these companies are components of the Energy Select Sector SPDR ETF (XLE).
The following part in the series analyzes how VLO has been doing in the market.
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