E-mail this article Printer-Friendly

Taking stock in energy — but not in the oil patch

It’s the opinion of this U.S. advisory that more investors should be looking at refined oil, not just crude oil, for their portfolios.

Right off the bat, the most recent issue of Personal Finance takes a distinct position on energy stocks.

In his opening remarks, Mr. Neil George, the editor, makes the point bluntly: “If you’re looking for us to write that the price of oil has nowhere to go but to the moon and that you just have to load up on Exxon Mobil, you’re reading the wrong newsletter.”

Convinced that we have not, in fact, picked up the wrong newsletter, we proceed to the accompanying story on energy stocks, penned by Mr. George and his associate, Mr. Elliott Gue.

The first sentence drives the point home: “The petrol market is a lot more than the price of crude oil.” The authors point out that a successful portfolio of petrol stocks must be built on the companies that “generate lots of cash, whether crude is trading in the 80s, the 40s or somewhere in between.”

Cracking the code

Understanding how to invest in energy, say the authors, is “all about cracking the code of how the industry actually makes money, rather than simply going along with the hordes and hoping we get it right by buying into any Super Oil or some wildcatter.”

They point out that this advisory has done well in its portfolios by investing in Canadian trusts and U.S. partnerships that know how to pump petrol out of the ground. But that’s just the beginning of a good petrol portfolio.

“The next step involves what happens after crude flows from the wellhead downstream to consumers. And that means looking at the refiners and transporters of petrol products.”

They begin with the refiners and processors who buy crude oil and turn it into gasoline, diesel, heating oil and other refined products. These industries make their money on the spread between crude oil prices and the prices of refined products, not just the price of crude or gasoline alone.

If the prices of refined products rise above the price of crude, refiners obviously see their margins expand. And they can still profit when crude oil prices go down.

“This is why we continue to like the downstream industries,” say the authors, “yet another core means to profit from petrol — whether the market is in a mania, or subdued.”

It all comes down to profit margins, and in the refining industry these are known as the crack spread. The term comes from refineries that “crack” a barrel of crude to make refined products. This spread is calculated by comparing the cost of crude oil with the price of refined products futures like gasoline and heating oil.

This in turn becomes a general measure of the profitability of the refining industry.

Set up for profits

Valuable as the crack spread is, it’s still just an estimate. Some refineries are far more profitable than the futures spread would suggest, some lose money even when the spread is favourable. “Selectivity is absolutely crucial,” add the authors.

In short, the best companies do better in almost any situation, the lesser lights can foul things up even when conditions are ideal.

Personal Finance has included a graph entitled “Opportunity Cracks” which shows that the market is set up for great profits for refiners, but “we still have to do more to find the best in the business.”

They find three.

Heavy oil, sweet oil and the oil sands

The authors didn’t have to work overtime to find their first pick. Valero Energy (NYSE-VLO) is the largest refiner in the United States. It can put through more than 3 million barrels per day, and it has increased its capacity sixfold in the past decade.

But it’s more than just big. It’s also flexible; the company can handle heavy oils from Venezuela or Canada as well as sweet crude from Saudi Arabia. It’s also flexible in the variety of its locations, which matters. In areas that are chronically short of refining capacity, like the southwestern and western United States, the crack spreads are better, and Valero can take advantage of them.

“Trading at less than half of its trailing revenues,” say the authors, “Valero is a cheap refiner and rates a buy under 85.” At the close of trading Tuesday (since yesterday was the Fourth of July), it stood at $74.47.

Frontier Oil (NYSE-FTO) has some of the highest margins of any refiner in the U.S. There’s a simple reason for that: it has access to the cheapest crude oil in North America, which it draws into its refineries in Wyoming and Kansas.

And Frontier is benefiting from the Canadian oil sands. Because there is still limited pipeline capacity from the oil sands toward the east and west coasts, much of the oil flows directly into the oversupplied middle of the United States.

That means competition between crude oil suppliers is coming to a head, and many local crude oil producers are lowering their prices. That’s good news for Frontier, which can turn around and sell its refined products at full prices into underserved markets like Denver and Salt Lake City.

Frontier is a buy under 80, according to the authors. Tuesday it closed at just $46.18.

The third company on the list is Calumet Specialty Products LP. As a publicly-traded partnership (akin to an income trust) it would make Canadian investors subject to the 15 per cent withholding tax dictated by the Canada-U.S. tax treaty. Still, let’s take a look at its workings.

Calumet is something of a specialist. With three refineries in Louisiana (54,000 barrels per day total capacity), its primary source of revenue is specialty lubricants and oil-based chemicals. Only a third of its production is in gasoline or diesel fuel.

The margins in this area of the business tend to be even higher than for fuel refiners; as spreads are running in its favour, Calumet builds up cash for distributions. To maintain these distributions, the company makes extensive use of the futures and options markets to hedge its costs and sale prices.

It yields 4.9 per cent and, say the authors, has the scope to increase its distributions to 10 to 15 per cent annually. They have it as a buy under 57. It closed at $49.00.

Let’s put it this way. From the time the stuff comes out the ground until the time it finds its way into your gas tank or your furnace, lots of people make money every step of the way. Why shouldn’t you?