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Refining Our Outlook

By Elliott H. Gue on Apr. 9, 2016

When crude-oil prices began to weaken in summer 2014, portfolio managers piled into refining stocks to fulfill their mandated exposure to the energy sector without taking on excessive downside risk. The rationale behind this move: A decline in crude-oil prices reduces refiners’ input costs, bolstering their profit margins.

This trade worked for a time, with the Bloomberg North American Refining & Marketing Index delivering a total return of more than 40 percent from June 30, 2014, to its peak in December 2015.

Over the same period, the Bloomberg North American Independent E&P Index, which tracks oil and gas producers, gave up about 66 percent of its value, while the Philadelphia Oil Service Sector Index and the Alerian MLP Index tumbled by about 40 percent.

(Click graph to enlarge.)Energy TRAs

We cashed out of our position in Valero Energy Corp (NYSE: VLO) in March 2015 for a total return of 60 percent on a stock that we highlighted as one of the names that would benefit from the selloff in oil prices. In the same Alert, we also exited our position in Alon USA Partners LP (NYSE: ALDW), a smaller refiner that’s organized as a master limited partnership (MLP) and pays a variable distribution. (See Taking Profits.)

These sales reflected the growing risk that Saudi Arabia’s efforts to retain market share and squeeze out high-cost production would narrow the price spread between West Texas Intermediate (WTI) crude oil and international benchmarks that reflect global supply and demand conditions.

When the US shale revolution was in full swing, surging production of light, sweet crude oil from America’s prolific unconventional plays flooded the local market with inexpensive, domestically produced volumes that fetched a significant discount to Brent crude oil and other international benchmarks.

This unprecedented discount, which peaked at more than $25 per barrel in fall 2011, stemmed from the long-standing US ban on crude-oil exports (lifted last year) and insufficient takeaway capacity to move these volumes from emerging production centers to the refinery complex on the Gulf Coast.

In this environment, US refiners generally enjoyed a significant upsurge in profitability by running flat out, processing this discounted crude oil and selling the gasoline, diesel and other products in international markets where competitors faced significantly higher feedstock costs.

This competitive advantage didn’t evaporate as quickly as we’d expected, and further downside in the price of crude oil—a refiner’s primary input cost—drove further upside in the industry’s gross margins.

(Click graph to enlarge.)Refiner Margins

In hindsight, we should have held our positions in Valero Energy and Alon USA Partners for a while longer and eked out some additional upside. But in these uncertain times, turning a paper gain into a real profit is never a bad idea, especially in an industry that’s notoriously cyclical.

However, the headwinds that we warned about a year ago have started to manifest themselves.

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