Refining and marketing companies are buyers of crude who use the commodity as an input from which they derive refined petroleum products (including heating oil, gasoline, residual oil, etc.) and a plethora of non-energy materials (like asphalt, road salt, clay, and gypsum).
Since the start of 2017, the companies have experienced a strong margin environment with product prices remaining robust. In fact, gasoline – the prime transportation fuel in the United States – is currently trading at its highest in four years.
Quite naturally, elevated product prices push up the realizations that these downstream operators receive via their refining and marketing segments. Domestic refiners have also benefited from the record oil production in the United States and Canada, which have led to crude being priced at a discount in these places.
With fuel demand remaining stronger-than-average even after the end of the summer driving season amid a healthy crack spread (difference between the price of oil and refined products), the sector components are primed for upward pressure on both revenues and earnings. Independent refiners, who produce low-sulfur products, are also expected to gain from the impending marine fuel regulations to curb pollution.
Industry Outperforms S&P 500 & Sector by a Wide Margin
Looking at shareholder returns over the past year, it is quiteapparent that investors have been pretty confident about the industry’s prospects. With robust product demand and the subsequent surge in profitability for downstream entities, the space enjoyed consistent markups and certainty surrounding their cash flow generation abilities.
The Oil And Gas - Refining & Marketing, part of the broader Zacks Oil and Energy Sector, has materially outperformed both the S&P 500 and its own sector over the past year. While the stocks in this industry have collectively gained a healthy 34.5%, the Zacks S&P 500 Composite and the Zacks Oil and Energy Sector have rallied 16% and 11%, respectively.
One-Year Price Performance
The Premium Not to Be Feared
Since oil and gas companies are debt-laden, it makes sense to value them based on the EV/EBITDA (Enterprise Value/ Earnings before Interest Tax Depreciation and Amortization) ratio. This is because the valuation metric takes into account not just equity but also the level of debt. For capital-intensive companies, EV/EBITDA is a better valuation metric because it is not influenced by changing capital structures and ignores the effect of noncash expenses.
Following the massive industry outperformance over the past year, the valuation picture appears a little lofty, in comparison to the market at large. The industry currently has a trailing 12-month EV/EBITDA ratio of 13.25, at a premium to the S&P 500’s EV/EBITDA ratio 11.99. However, the group’s valuation leaves decent room for upside when compared with its highest level of 16.74 and median level of 13.56X over the 12-month period.
Enterprise Value/EBITDA Ratio (TTM)
As the industry’s valuation multiple is closely corelated with crude prices, comparing the group’s EV/EBITDA ratio with that of its border sector may make better sense to many investors.
The parameter shows that the group’s EV/EBITDA ratio — at 13.25 — is significantly above that of its broader sector’s 6.11. While the hefty premium might scare some investors, one should note that this asset class has commanded a premium valuation since 2017 on bright fundamentals.
Enterprise Value/EBITDA Ratio (TTM)
Bullish Prospects Based on Robust Earnings Outlook
Of late, the refining and marketing companies have rewarded investors with consensus-beating financial performances as they took advantage of strong fuel demand and an oversupply of shale. The favorable margin picture helped sustain the firms’ revenues and free cash flows.
But what really matters to investors is whether this group has the potential to perform better than the broader market in the quarters ahead. Despite the high-flying performance of the downstream operators over a year, one could still consider the current price levels as good entry points as there are convincing reasons to predict continued growth in the near term.
One reliable measure that can help investors understand the industry’s prospects for a solid price performance is the earnings outlook for its member companies. Empirical research shows that a company’s earnings outlook significantly influences its stock performance.
While one can get a good understanding of a company's earnings outlook by comparing the consensus earnings expectation for the current financial year with the previous year’s reported number, an effective measure could be the magnitude and direction of the recent change in earnings estimates.
The Price & Consensus chart for the industry shows the market's evolving bottom-up earnings expectations for it and the industry's aggregate stock market performance. The red line in the chart represents the Zacks measure of consensus earnings expectations for 2019, while the light blue line represents the same for 2018.
Price and Consensus: Zacks Oil and Gas – Refining & Marketing Industry
This becomes even clearer by focusing on the aggregate bottom-up EPS revisions trend. The chart below shows the evolution of aggregate consensus expectations for 2018.
Please note that the $4.91 EPS estimate for the industry for 2018 is not the actual bottom-up dollar estimate for every company within the Zacks Oil and Gas – Refining & Marketing industry but rather an illustrative aggregate number created by our proprietary analytics model. The key factor to keep in mind is not the industry’s earnings per share for 2018 but how this estimate has evolved recently.
Current Fiscal Year EPS Estimate Revisions
As you can see here, the $4.91 EPS estimate for 2018 is up from $4.78 at the end of April and $4.16 at this time last year. Agreed, the current estimate has stuttered recently and has actually declined from its peak of $4.99 attained in the end of May. Still, the sell-side analysts covering the companies in the Zacks Oil and Gas – Refining & Marketing industry have been fairly consistent with their estimates since the start of 2018.
Zacks Industry Rank Confirms Bullish Sentiment
The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, paints a pessimistic picture for the near term.
The Zacks Oil and Gas – Refining & Marketing Industry currently carries a Zacks Industry Rank #111, placing it at the top 43% of more than 250 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.
On top of that, our proprietary Heat Map shows that the industry’s rank has been in the top 50% for the past eight weeks.
Long-Term Growth Prospects Look Solid
The long-term (3-5 years) EPS growth estimate for the Zacks Oil and Gas – Refining & Marketing industry look appealing when compared with the broader Zacks S&P 500 composite. The group’s mean estimate of long-term EPS growth rate is currently pegged at 9.9%. This compares to 9.8% for the Zacks S&P 500 composite.
Mean Estimate of Long-Term EPS Growth Rate
In fact, the basis of this long-terms EPS growth could be the recovery in top line and net income that the downstream operators have been showing since the beginning of 2017. It’s quite clear that the substantially increasing fuel demand and attractive realizations have been fueling the sector components’ cash flows.
Revenues: Zacks Oil and Gas – Refining & Marketing industry
Net Income: Zacks Oil and Gas – Refining & Marketing industry
Overall, the income from converting crude into gasoline and diesel – also known as refining margin or crack spread – have been going up during the last few quarters. Moreover, the margin strength is expected to continue over the near-to-medium term given the positive market conditions.
In particular, shortage in the Permian takeaway capacity in the face of exponential production growth has led to widening differential, forcing producers to sell their crude at a sharp discount. The downstream companies’ whose refining capacity are leveraged to lower Permian pricing are poised for significant bottom-line growth.
Expectations for elevated margins for some time into the future provides investors with an excellent chance to accumulate some quality refining and marketing names – more so the ones with strong earnings outlook.
4 Refining & Marketing Stocks to Bet on
Galp Energia, SGPS, S.A. (GLPEY) is an integrated oil company with extensive refining and marketing operations.The shares of this Lisbon, Portugal-based downstream player has gained 13.3% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 3.4% upward over the last 60 days. Galp Energia carries a Zacks Rank #2 (Buy).
You can see the complete list of today’s Zacks #1 Rank stocks here.
Price and Consensus: GLPEY
Delek US Holdings, Inc. (DK) is a Permian-focused independent refiner, transporter and marketer of petroleum products.The shares of this Brentwood, TN-based downstream player has gained 60.2% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 1% upward over the last 60 days. Delek US Holdings carries a Zacks Rank #3 (Hold).
Price and Consensus: DK
HollyFrontier Corporation (HFC) is one of the largest independent refiners and marketers of petroleum products in the United States.The stock of this Dallas, TX-based downstream player has gained 96.5% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 3.2% upward over the last 60 days. HollyFrontier carries a Zacks Rank of 3.
Price and Consensus: HFC
Phillips 66 (PSX) s a diversified energy manufacturing and logistics company with chemicals, midstream, marketing and specialties, and refining businesses.The stock of this Houston, TX-based downstream player has gained 23.4% over the past year. The Zacks Consensus Estimate for the current-year EPS has been revised 3.7% upward over the last 60 days. Phillips 66 carries a Zacks Rank of 3.
Price and Consensus: PSX
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