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Profitability versus Production Growth

By Elliott H. Gue on Mar. 11, 2013

As we explained in the March 3, 2013, installment Energy Investing Weekly, Profiting from California’s New Oil Rush, the most populous US state imports more than 1 million barrels of crude oil per day, half of which arrives from international markets via tankers.

A lack of incoming pipeline capacity prevents the state’s downstream operators from refining volumes of discounted inland varietals of crude oil. Instead, refiners must rely on expensive waterborne crude oil, resulting in lower profit margins. A state-mandated fuel blend also saddles refiners with higher costs, while insufficient refining capacity in the state leads to sudden spikes in gasoline and diesel prices whenever unplanned outages occur.

While these challenges have consumers gnashing their teeth and refiners such as Valero Energy Corp (NYSE: VLO) contemplating an exit from California, the state’s oil producers currently benefit from higher price realizations than their peers that deliver their volumes to inland hubs such as Cushing, Okla.

Surging output from prolific unconventional fields such as the Bakken Shale has overwhelmed takeaway capacity, resulting in a localized glut of oil and depressed prices. But oil volumes produced in California compete with waterborne imports that track the price of Brent crude oil, an international benchmark that reflects global supply and demand conditions. Accordingly, exploration and production operations in the state sell their output at a roughly $20 premium to West Texas Intermediate (WTI) crude oil.

These favorable price differentials make oil-producing acreage in California particularly valuable. In the previous issue of Energy & Income Advisor, we highlighted Focus List holding Linn Energy LLC’s (NSDQ: LINE) acquisition of Berry Petroleum (NYSE: BRY), an exploration and production company with significant operations in the state.

The latest addition to our Focus List–an integrated oil and gas company whose stock trades at an attractive valuation–also offers exposure to California’s elevated oil prices and has shifted its strategy to return more capital to shareholders.

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