Shrinking Brent-WTI Spread: Why You Should Avoid These Midwest Refiners

From The Motley Fool
By Sarfaraz A. Khan

The Brent crude-West Texas Intermediate (WTI) spread has fallen to its lowest levels in more than two and a half years to $4.31 by the end of first week of June. This after touching this year’s peak of $23.19 in the first quarter, which shows a decline of more than 80%. The spread represents the difference between Europe’s Brent crude and the WTI crude, which trades at the New York Mercantile Exchange. This collapse of the difference between two of the world’s leading-traded crude grades will create problems for some refiners, such as HollyFrontier (NYSE: HFC), Marathon Petroleum (NYSE: MPC) and Valero Energy (NYSE: VLO).

The drop in the gap, shown in the picture above, is coming on the back of

the improvements in rail links and pipeline networks – and is inline with the prediction Goldman Sachs made more than a year ago. The two (Brent and WTI) have traditionally traded within a few dollars of one another, but the uptake in the U.S production in 2011 caused a significant drop in WTI as compared to Brent. But now, the narrowing gap is bringing more stability and is considerably less lucrative to traders -- who rely on the spread’s volatility to generate profits -- than it was three years ago.

Margin threat

This would create even more problems for some of the Midwest refiners mentioned earlier who have been enjoying a premium – which was nearly $20 throughout most of the 2012 – which gave a boost to their margins. The refiners purchased the cheaper WTI and sold them as refined products at higher prices linked to Brent. But with the drop in the spread, this advantage would go away as quickly as it came. For instance, HollyFrontier’s quarterly profit margin has risen considerably since 2010 when it averaged 1.2% to 6.2% in 2011 and finally 8.6% in 2012. This is shown in the picture below.

However, in the coming quarters, with the drop in Brent-WTI spread and evaporating premium advantage, HollyFrontier will find it increasingly difficult to maintain its profitability.

Same holds true for Marathon Petroleum and Valero Energy. Then there is the traditionally weaker second half to follow, which would put more pressure on the shares. The shares of the three companies have struggled in the last three months, dropping by more than 16% in this period.

	HollyFrontier	Marathon Petroleum	Valero Energy
Stock 3 Months	-16.67%	-16.23%	-19.37%
P/E	4.48	6.64	5.95
P/E Full Yr Est	6.84	7.14	6.70
Yield	3.00%	2.00%	2.40%
Operating Margin (past 12 Months)	15.17%	6.72%	4.22%
ROA	18.39%	11.92%	8.17%
ROE	29.19%	32.62%	18.39%

Long-term bullish

Of the three firms, Valero Energy is the least profitable and generates the lowest return on assets and equity, but it reported improvements in its refining margins and a drop in refining operating costs in the previous quarter. The company reported a $700 million increase in its quarterly operating income mainly due to higher refining throughput margins in all of its regions except the West Coast. The business is currently considering a spin-off of its retail arm while it is aiming to increase its exports, which would have a positive impact on its margins in the coming years. Valero is the world’s largest independent refiner that is planning to return cash to its shareholders through dividend hike and share buyback and is recommended for long-term investors.

Marathon Petroleum earns nearly all of its income – more than 95% of its operating profit -- through the refining and marketing of oil. Like Valero, Marathon Petroleum also reported an increase in its income due to higher refining margins. The company is also looking toward exporting refined products to drive its margin higher in the long term.

Investors should also note that although HollyFrontier gives a yield of 3%, this is only on paper. In reality, it has been a high dividend-paying stock, which gives a yield of ~8%. This is because in each quarter, it has rewarded shareholders by regularly giving a “special dividend.” On May 16, the company approved a $0.30 per share quarterly cash dividend and a $0.50 per share special dividend. The special dividend comes at the board of director’s discretion and since this is never certain, it is not represented in the conventional yield calculation. In fact, the company appears to be a value investment that pays out an attractive yield.

Of the three, HollyFrontier is the most profitable while both HollyFrontier and Marathon Petroleum generate return on equity of nearly 30%. In the last 12 months, the three companies have generated positive leveraged free cash flows of more than $1.4 billion.

Should you invest?

A simple answer to this question is: not now.

I believe that while the three firms are profitable with strong fundamentals along with the increase in U.S. production, there are reasons to remain long-term bullish on these stocks; but now is not the time to invest. This year, their shares will remain under pressure and there is going to be more volatility.

There seems to be no consensus among analysts regarding the future of the Brent-WTI spread, which will have a direct result on the profit margins of the three refiners. While some, such as Capital Economics, suggest that the spread will “disappear” by the end of the current year, others believe that it will improve from the present level and eventually settle somewhere between $6 and $8. However, one thing is for sure, the days of a Brent-WTI gap of $20 are certainly over.

HollyFrontier, Marathon Petroleum and Valero Energy– as well as others such as Calumet Specialty Products – have received downgrades recently from analysts at Bank of America/Merrill Lynch and JPMorgan Chase and I believe that others will follow. The second-quarter results are due in a few weeks and I wouldn't be surprised if earnings misses are reported. The traditionally weaker second half coupled with the shrinking spread could even lead to a downward revision in the outlook for the rest of the year, which would drive the stocks even lower. Therefore, I believe that at the moment, investors should avoid HollyFrontier, Marathon Petroleum and Valero Energy. 

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Privacy/Legal Information

Sarfaraz Khan has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. 

Additional Disclosure: I, Sarfaraz A. Khan, have no position in any stocks mentioned and no plans to initiate one within the next 72 hours of this publication. I have written this article myself and this reflects my own personal opinion. I have no business relationship with any company whose stock is mentioned in this article.