Published June 8th, 2018 by Aristofanis Papadatos
Oil refiners have enjoyed an impressive rally in the last 12 months thanks to a series of tailwinds. As a result, they have significantly outperformed the market in this time period.
During this period, the S&P 500 climbed 12% whereas the big oil refiners have generated the following returns:
- Valero (VLO up 99%
- Phillips 66 (PSX) up 55%
- HollyFrontier (HFC) up 237%
- Marathon Petroleum (MPC) up 55%
There are three major reasons behind the impressive rally of the domestic refiners…
First, U.S. oil production has reached a record level this year and is expected by EIA to climb to new all-time highs next year. This supply glut has resulted in a wide discount of WTI to Brent, which greatly boosts margins for the domestic refiners.
Second, after having paid hefty amounts on biofuel blending costs for years, domestic refiners are likely to see these costs meaningfully fall thanks to an expected change in EPA regulation. While the magnitude of the relief and its timing are still unknown, the benefit is expected to be significant.
Finally, refiners will greatly benefit from the new international marine standard, which will come in effect in early 2020. According to the new standard, all vessels will be forced to start burning low-sulfur diesel instead of heavy fuel oil. As a result, the demand for diesel will greatly increase and will thus provide a boost to refining volume.
Given the impressive rally of the refiners, investors should be extra careful in their choices, as a great portion of the future growth has already been priced in. With oil prices continuing to rise, this holds true for much of the energy sector.
In addition, the price of oil has enjoyed an impressive rally since last summer and is now trading near a 3.5-year high. A high oil price adversely affects the demand for oil products and thus it usually hurts refining margins. Thanks to the domestic crude supply glut, this effect has not been visible yet. Nevertheless, it is a risk factor to consider for the future, particularly if the crude supply glut eases via increased exports.
In this article, we will compare the expected 5-year returns of the four major refiners by summing their EPS growth, their dividends and their expected P/E expansion or contraction. Expected total return data comes from our 200+ stock (and growing) Sure Analysis Research Database.
Large U.S. Oil Refiner Analysis: Phillips 66
Phillips 66 was spun off from ConocoPhillips in 2012. Phillips 66 operates in four segments:
It is a diversified company with each of its segments behaving differently under various oil prices. When the price of oil began to collapse in 2014, the refining segment became by far the most profitable segment for Phillips 66 as low oil prices improved the demand for oil products and boosted refining margins.
Despite the rally of the oil price since last summer, oil is still much cheaper than it was four years ago…
As a result, the refining segment of Phillips 66 still earned as much as the other three segments combined last year.
On the other hand, higher oil prices favor the results of the midstream segment and the chemicals segment. That’s why these two segments almost doubled their earnings in Q1.
Phillips 66 is the only refiner that has meaningful diversification. Those who believe that the price of oil will continue to rise should prefer Phillips 66 from the other refiners, as its midstream segment will thrive in such a scenario thanks to the increase oil volumes produced and transferred at higher oil prices. The increase in the earnings of its midstream segment will offset to a great extent the pressure that higher oil prices will exert on refining margins.
It is also important to note that Phillips 66 is now in the positive phase of its investment cycle. As growth projects in the oil industry tend to take many years to start bearing fruit, there is a great lag between capital expenses and their resultant cash flows.
Fortunately for the current shareholders of Phillips 66, the company is currently at a point where it has reduced its capital expenses but is reaping the benefits from its huge investments in 2014 and 2015, when it invested a total of $9.6 B. This year, the company intends to invest only $2.3 B, from which about half will be directed to growth and the other half to maintenance.
Source: Investor Presentation
It is also critical to note the importance of the quality of the management. Warren Buffett has repeatedly stated that the primary reason for his high stake in the company is the quality of the management, which is disciplined and thus invests only in high-return projects.
The management of Phillips 66 has also proved markedly shareholder-friendly. While the company has more than doubled its dividend in the last four years, it has also reduced its share count by 4% per year on average in the last five years.
Given this reduction pace of the share count and the discipline of the management to invest only in high-return projects, it is reasonable to expect at least 6.0% average annual EPS growth over the next five years.
On the other hand, thanks to its impressive rally, the stock is now trading at a P/E of 16.6, which is higher than its historical average P/E of 14.1. Therefore, if the stock reverts to its average valuation level in the next five years, it will incur a 3.2% annualized P/E contraction.
Overall, the stock is likely to offer a 5.5% average annual return over the next five years thanks to 6.0% EPS growth and its 2.7% dividend, which will be partly offset by a 3.2% annualized P/E contraction.
Large U.S. Oil Refiner Analysis: Marathon Petroleum
Marathon Petroleum is in the process of acquiring Andeavor (ANDV) for about $23 B. The deal does not have any meaningful hurdles ahead and is thus expected to close in the second half of this year. As the deal price was 24% higher than the prevailing price of Andeavor, which was already an all-time high, the market initially punished Marathon with a 15% plunge. However, the market now seems to have appreciated the prospects of the merger and hence the stock has retrieved its losses.
As soon as the deal closes, the combined entity will be the largest U.S. refiner, with a total capacity of 3.0 M barrels per day. Moreover, this acquisition will greatly expand the reach of Marathon, as Andeavor operates in the Midwest and the West whereas Marathon operates in the East.
Source: Investor Presentation
Marathon expects to achieve more than $1 B in cost synergies thanks to this deal. Therefore, there is huge potential for cost savings. The new company will make over $10 B of purchases per year. As a result, even a 1% discount thanks to scale will result in $100 M savings. Moreover, Marathon already has a proven record of synergies, as it has achieved more than $200 M of synergies with its Hess Retail takeover.
Furthermore, Marathon will greatly benefit from the inland location of some of the refineries of Andeavor. Thanks to the oil supply glut, these refineries buy their crude oil at a discount to WTI so they enjoy high margins.
Thanks to the expected synergies from the merger, Marathon has the highest EPS growth potential in its peer group. Given these synergies and the above tailwinds for refiners, the new entity is likely to grow its EPS from $4.80 this year to at least $7.50 in 2023.
On the other hand, Marathon is now trading at a P/E of 16.7, which is much higher than its historical average of 10.6. As all the catalysts will play out in the next five years, it is reasonable to expect the P/E ratio of the stock to drop at least down to 12.0 in this period. As a result, the stock will incur a 6.4% annualized P/E contraction.
Overall, the stock is likely to offer a 5.2% average annual return over the next five years thanks to 9.3% EPS growth and its 2.3% dividend, which will be partly offset by a 6.4% annualized P/E contraction.
Large U.S. Oil Refiner Analysis: Valero
Valero is currently the largest petroleum refiner in the U.S. It owns 15 refineries in the U.S., Canada and the U.K. and has a total capacity of about 3.1 M barrels/day. It also has a midstream segment, namely Valero Energy Partners LP (VLP), but its contribution to total earnings is less than 10% so Valero should be viewed as an almost pure refining company.
While Valero is currently the largest domestic refiner, Marathon will have almost the same capacity when its takeover of Andeavor materializes. Moreover, as some of the refineries of Valero are located abroad, Marathon will soon surpass Valero in domestic refining capacity.
Valero has a competitive advantage over its peers, namely the high complexity of its refineries. As it has the highest Nelson Complexity Index in its group, it can benefit the most from the gyrations of the prices of oil and refined products by optimizing its blend of feedstock and products.
Source: Investor Presentation
Its high complexity also renders it the most resilient during downturns, as the least complex refineries are hurt the most during such periods due to their lack of flexibility.
Just like the management of Phillips 66, the management of Valero is remarkably shareholder-friendly. It has more than tripled the dividend in the last four years while it has also reduced the share count by 5% per year on average in the last five years. While the repurchases will continue for the foreseeable future, they will be less efficient due to the strong rally of the stock. Nevertheless, given all the above catalysts for refiners and a meaningful decrease in its share count, Valero is likely to grow its EPS by about 6.0% per year over the next five years.
On the other hand, the stock is now trading at a P/E of 16.9, which is much higher than its 10-year average P/E of 10.0. As the above catalysts play out, it is reasonable to expect the stock to revert towards its average valuation level in the next five years. If its P/E ratio drops to 12.0, the stock will incur a 6.6% annualized P/E contraction. Therefore, Valero is likely to offer a 2.0% average annual return over the next five years thanks to 6.0% EPS growth and its 2.6% dividend, which will be partly offset by a 6.6% annualized P/E contraction.
Large U.S. Oil Refiner Analysis: HollyFrontier
HollyFrontier was formed with the merger of two independent U.S. refiners, Holly Corporation and Frontier Oil, in 2011. The company operates in three segments:
- Holly Energy Partners (HEP), a midstream entity
Nevertheless, HollyFrontier should be viewed largely as a refiner. The refining segment generated 78% of the total operating income in Q1 and is likely to raise this proportion even further in the upcoming quarters.
HollyFrontier has vastly outperformed its peers in the last 12 months, as it has more than tripled during this period. While the discount of WTI to Brent has favored all the U.S. refiners, HollyFrontier has benefited even more from the crude oil supply glut, as it buys its crude oil at a discount to WTI thanks to the proximity of its refineries to the domestic oil production.
HollyFrontier has also benefited from reduced RIN costs lately thanks to the exemption of its Cheyenne refinery. Moreover, the company has increased the capacity of its refineries by 15% in the last three years. Furthermore, it has markedly reduced its operating expenses, from $6.16 per barrel in 2014 to $5.40 last year.
Source: Investor Presentation
All these factors have helped the company post impressive results lately. In Q1, the company earned adjusted $0.77 per share vs. a loss of $0.19 in Q1 2017. The great improvement resulted from a 70% increase in its refining margins, from $7.54 to $12.83 per barrel, and a 12% increase in the volume processed by its refineries. Moreover, the company intends to increase its processed volume by almost 10% in Q2.
Given the above mentioned catalysts for refiners and the advantaged location of the refineries of HollyFrontier, it is reasonable to expect it to grow its EPS by about 7.5% per year over the next five years. On the other hand, thanks to its breathless rally, the stock is now trading at a P/E of 15.6, which is much higher than its historical average P/E of 10.4. Therefore, if the stock reverts to its average valuation level in the next five years, it will incur a 7.8% annualized P/E contraction.
Overall, HollyFrontier is likely to offer a 1.3% average annual return over the next five years thanks to 7.5% EPS growth and its 1.6% dividend, which will be partly offset by a 7.8% annualized P/E contraction. In other words, too much future growth has already been priced in the stock.
Thanks to the strong tailwinds they enjoy, the U.S. refiners are likely to significantly grow their EPS in the next five years. However, they have rallied so impressively that they have already discounted a great portion of their future growth. Therefore, investors should be particularly careful before making their choices in this group.
In the comparison of the four major refiners, the dividend yield did not differentiate them significantly. The outlier was HollyFrontier, which offered by far the lowest yield (1.6%) while the other three companies had negligible differences. Moreover, HollyFrontier has vastly outperformed its peers, as it has more than tripled in the last 12 months. Consequently, its valuation is the richest compared to its historical norm and hence it is the stock with the greatest expected P/E contraction and hence the lowest expected 5-year return.
On the contrary, Phillips 66 seems to have the most reasonable valuation right now compared to its historical average. As a result, its expected P/E contraction is the lowest in its group and hence the stock is likely to offer the highest 5-year return. Investors should also note that it is the only refiner that is highly diversified and can keep thriving even in a downturn of the refining margins.
In fact, if the price of oil continues to rise in the upcoming years, it will probably exert pressure on refining margins due to its pressure on the demand for oil products. In such a scenario, the midstream segment of Phillips 66 will offset most of the damage of the refining segment. Therefore, in such a scenario, Phillips 66 is likely to outperform its peers by a wide margin.
Phillips 66 is likely to offer the highest 5-year return in its group while it is also the most diversified and thus most resilient in the event of a downturn in the refining sector.