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Opportunity in Refiners?


Hawks
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With the crude oil decline, are refiners like TSO VLO an opportunity in the making?  or does their lower input costs get offset by declining fuel prices at the other end?  Is anyone into these stocks and has some expertise and experience with the refining business?

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I'm not an expert, and I just started looking. Some of the things i noticed are:

 

- Many of these refiners seem to be dependent on larger spreads between the various oil benchmark prices (WTI, etc)

the spread has been narrowing recently, so it also partly depends on where the refiners can get their input supply, especially the refining companies that are more focused on a particular geographical area. This can vary depending on the diversity of "connections" into the refinery. (railcar vs pipeline vs marine transport)

 

- Refiners also vary in the kind of products (not just gas and diesel) that they produce and the amount. Some of the pricing of these products are less tied to the swings in the oil price.

 

- Some of them also put on hedges, and vary in the amount that they hedge. I think someone like PBF (a recent Klarman/Baupost addition) might have more hedges on than others.

 

Would love for someone with more experience and knowledge to chime in.

 

 

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Their profitability depends on:

A- The type of oil that the refinery processes.  Some refineries are optimal for light oil (e.g. from shale reserves), others for heavy oil (e.g. from oil sands from Canada).

B- The supply and demand for refinery capacity.

C- The location of the refinery / the local supply and demand in that particular area.  American refineries are often located far away from oil production.

 

The supply of refinery capacity doesn't look like it will be increasing.  New refineries haven't been built in a long time.  The permitting is difficult.  Seaborne oil is a different story.

 

If you think that technology and cheap capital is driving down the cost of light oil from shale, then it could be the case that *certain types* of refineries will do well in the future.  If light oil from shale pushes out oil sands, then refineries that are optimal for heavy oil may not do so well.

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Except for the past few years, refineries are horrible businesses.  I invite you to look at the longer-than-four year history.

 

 

Without a sustained cost advantage, which it clearly seems like doesn't exist (though it did for a couple of years when WTI was $10-$20 less than Brent), it's a purely commodity business, but actually seems worse than most commodity businesses. 

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Except for the past few years, refineries are horrible businesses.  I invite you to look at the longer-than-four year history.

 

 

Without a sustained cost advantage, which it clearly seems like doesn't exist (though it did for a couple of years when WTI was $10-$20 less than Brent), it's a purely commodity business, but actually seems worse than most commodity businesses. 

 

I think that is a bit of an oversimplification.  In looking at the economics of refining, you need to ask yourself whether we are in an extended cyclical upswing, or whether there has been a structural change in refining.  I would argue that we are in the middle of a cyclical upswing, which will ultimately be ended when the midstream folks finish building out a pipeline network that provides east coast and west coast refiners with access to inland crude.  At that point, we will probably see more of a convergence in Brent-WTI, as well as a narrowijg in the spreads currently enjoyed by the inland and gulf coast PADDs relative to the east coast and west coast PADDs.

 

At that point, profitable refining will simply depend on what the crack spreads are, and the ability of the refiner to produce higher margin specialty products such as base oils, lubricants, solvents, etc.  profitability of the larger refiners will also to some degree depend on their midstream assets and logistics assets.  Both Tesoro and PSX have decent midstream and logistics assets, while PBF has been building out logistics assets on the east coast (primarily rail terminals). 

 

I personally don't think there is much opportunity in the larger refiners.  I think the current share prices are reflective of my expectation to future performance.  However you might consider looking at some of the niche companies in the business that produce specialty chemicals.

 

I have a fairly large position in Calumet Refining (CLMT).  They are a refiner in the sense that they own about half a dozen small refineries.  However, the primary purpose of their refineries is to supply their specialty chemical operations with base oils and other important feedstocks.  Thus about 80% of their EBITDA is based on the production and distribution of specialty chemicals.  I also find them to be attractive because they have been rolling up small mom-and-pop specialty chemical companies and distributors.  Their share price has been whacked along with the sell-off in crude...I suspect we have been seeing a capitulation if retail yield seekers.  Anyways, CLMT seems to be priced as a specialty chemical producer, based on current EBITDA and a substantial amount of debt.  However, the debt is the result of a fairly large organic growth program that should yield an incremental 200million EBITDA per year, with the first project coming online now, two more projects coming online in mid 2015, and the final project coming online in q12016.

 

 

 

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Good article in today's WSJ about someone who has very successful in the refinery business:

 

http://www.wsj.com/articles/boss-talk-pbf-energy-keeps-focus-on-growth-1418766312?mod=wsj_boss_talk

 

Looking briefly, it appears refinery businesses operate on razor thin margins.

 

8.5% owned by Baupost, (bought at higher prices?), representing about a 3% position for them on latest 13-F.

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Except for the past few years, refineries are horrible businesses.  I invite you to look at the longer-than-four year history.

 

Without a sustained cost advantage, which it clearly seems like doesn't exist (though it did for a couple of years when WTI was $10-$20 less than Brent), it's a purely commodity business, but actually seems worse than most commodity businesses.

+1

Agreed, it is probably easier to list the positives than all the negatives of the industry. One that comes to mind is limited capacity expansion.

 

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One that comes to mind is limited capacity expansion.

 

Isn't that a good thing for the refiners?

 

That's not entirely accurate.  Capacity expansion can occur via two mechanisms: (1) Brownfield expansions (i.e. the expansion and improvement of BP's Whiting Refinery a few years back, primarily via addition of massive coking units; the expansion of CLMT's Montana Refinery by way of new distillation towers and a new mild-hydrocracking unit); and (2) Greenfield expansions (i.e. new MDU/CLMT refinery in the Bakken which is first new refinery in the United States in 30 years). 

 

Capacity is growing in the United States, primarily because of the opportunity to export refined products to Europe and Asia.  In addition to the new MDU/CLMT refinery in the Bakken, another topping refinery is far along in the planning stages for the Bakken, and a third MDU/CLMT topping refinery is being considered for the Bakken.  These are relatively small 20k/day refineries.  On top of this, folks like KMI and EPD have also been planning new "refineries" where they will minimally process crude distillates for export. 

 

If you are going to play the refinery business, I see two ways to do it profitably:

1.  Figure out where there are going to be structural changes in feedstock that have not been priced into the shares (i.e. PFB on the east coast transitioning from expensive seaborne Brent to cheaper inland crude).

2.  Look for the niche players that are using their refinery business as a means to provide cheap feedstock to their higher margin specialty chemical business.  CLMT is one; there are a few others if you look closely.   

3.  Play ALDW.  They are a variable distribution refinery, essentially paying out all of their cash flow.  If you are willing to track the spread between WTI and their feedstock on a daily basis, you can pretty closely estimate their payout for the upcoming quarter given they have one refinery with access to a limited slate of feedstocks.  This should be pretty obvious to all market participants, but for the most part, the share price generally reflects the previous quarter distribution rather than expectations for the upcoming quarter.  Pretty easy to arbitrage this for some capital appreciation and the dividend if you are willing to spend some time tracking this information. 

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One that comes to mind is limited capacity expansion.

 

Isn't that a good thing for the refiners?

 

Sorry I was not clear. Yes, this is a good thing.

I wanted to list all the negatives but then thought it was much easier to list the one positive that came to mind.

;)

 

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If you are going to play the refinery business, I see two ways to do it profitably:

...

2.  Look for the niche players that are using their refinery business as a means to provide cheap feedstock to their higher margin specialty chemical business.  CLMT is one; there are a few others if you look closely.   

I sent you a PM but I am curious about this as well. I presume the thesis is that higher margin specialty chemicals won't experience the price-drop that feedstock has? Thanks for the idea.

 

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If you are going to play the refinery business, I see two ways to do it profitably:

...

2.  Look for the niche players that are using their refinery business as a means to provide cheap feedstock to their higher margin specialty chemical business.  CLMT is one; there are a few others if you look closely.   

I sent you a PM but I am curious about this as well. I presume the thesis is that higher margin specialty chemicals won't experience the price-drop that feedstock has? Thanks for the idea.

 

Specialty chemicals will be subject to the same margin compression and margin expansion as fuel when the price of crude changes.  The important difference are the margins.  CLMT's fuel segment had gross margins of ~$3/bbl in Q32014 (July, Aug, and Sept).  During this time, WTI declined from ~$102/bbl to ~$92/bbl.  CLMT's specialty chemicals segment had gross margins of ~$43/bbl, which comprised ~80% of CLMT's EBITDA for the quarter. 

 

Generally speaking, I expect the margins for specialty chemicals to fluctuate as crude pricing fluctuates.  This doesn't impact my thesis.  My long-term thesis for CLMT could be summed up by a couple of key points:

1.  Specialty chemical business (production and distribution) is pretty segmented in the United States.  There is a lot of room for consolidation.  CLMT has been quite active doing this, and appears to have been pretty successful in integrating new production lines as well as new distribution teams. 

2.  Specialty chemicals tend to be pretty sticky, and the demand tends to be pretty inelastic.  There are a lot of examples that come to mind...   

3.  CLMT sells about 90% into domestic market, and 10% into foreign market.  Recent acquisition gives them toehold in foreign distribution.  Once the price of crude stabilizes, I expect them to start pushing more into foreign markets.  Given that I expect the Brent-WTI differential to persist for quite some time, CLMT will have a pricing advantage even when selling into foreign markets.

4.  CLMT established an agreement with Wal-Mart, and now Wal-Mart is carrying their Royal Purple line of lubricating oil.  This provides a pretty substantial step-up in retail distribution for CLMT. 

5.  Controlling family owns about 26% of the limited partner units, plus the general partner interest.  This gives me a little bit of confidence that they are not going to dilute their limited partner units willy-nilly.  This belief has been confirmed by their limited use of an ATM program. 

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