Oil refining stocks have been totally out of favor. Are there any out there worth buying on the cheap?
The oil refining industry, like all of the energy sector, is heavily out of favor. Year to date, the seven stocks in my Cabot Turnaround Letter universe of traditional energy refiners are down an average of 61%. Many are approaching five- and 10-year lows. The market’s disappointment in the push-out of the recovery’s timing by perhaps a year has led to a recent sharp sell-off that has pulled oil refining stocks down to near their March lows.
That said, we think the group has some interesting contrarian appeal as the economy works through the pandemic.
What to Like about Oil Refining Stocks
At the most basic level, oil refining is straightforward: processing crude oil (which is essentially unusable in that form) into usable products, primarily gasoline, distillate and jet fuel. Profits are a function of the volume of barrels refined and the spread between the input (crude oil) price and the output price (determined by the mix of refined products). Volume is driven by customer demand, which currently is well below historical averages, particularly for jet fuel.
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And refining spreads are exceptionally low. The benchmark 3-2-1 crack spread, which refers to the process by which heavy hydrocarbon molecules are “cracked” into their lighter components, is around $6.85/barrel, compared to a historical range of $10-$25 per barrel. Pragmatically, refiner profitability is much more complex, based on regional crude prices, the ability to refine different grades of crude and produce a range of end products, and access to other geographic markets.
Over the past 10-20 years, the industry structure has changed. Most refining capacity used to be owned by major integrated oil companies, but today it is increasingly owned by independent refining companies. Along with favorable industry conditions, this shift has brought more efficiency to the industry and a way for investors to directly participate. Several companies sponsor publicly-traded pipeline partnerships – which may be interesting stocks in their own right.
When the pandemic eventually passes, demand for gasoline, jet fuel, diesel (used heavily by the trucking industry) and other refined products should recover, boosting both refining volumes and margins. Most of the oil refining stocks have remarkable upside, and offer high dividend yields, as investor sentiment is dour at best.
Potential investors should be aware of several risks. A prolonged downturn could lead to dividend cuts and debt service problems, post-election tax rates and regulations may increase, and input costs may rise if fracking is deterred. Also, a rapid conversion to electric vehicles could permanently weaken gasoline and diesel demand. We believe these risks are overstated and increasingly offset by the stocks’ sharp sell-off.
In the latest issue of my Cabot Turnaround Letter, I highlight four oil refining stocks that look both very interesting from an upside-potential perspective yet also have a good likelihood of enduring until the recovery. Our valuations are based on consensus estimates, yet these averages obscure the wide range of underlying estimates, given the high degree of uncertainty.
To learn the names of these four potential turnaround stocks in the oil refining industry, and what other contrarian stocks I’m currently recommending, click here.
Editor’s Note: This post was an excerpt from this week’s issue of Cabot Turnaround Letter.
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