The story since summer 2014 has been one of diving oil prices putting the energy sector through the ringer, and sparking a great deal of volatility across the markets.
Energy stocks broadly have suffered a great deal of collateral damage.
There has been at least one profitable area in this sector: U.S. refineries. However, it’s time to start thinking about whether they can sustain profits going forward.
The problem? It’s not a fear of rising oil prices … but a rise in oil supply.
The U.S. and other world powers just agreed on a preliminary nuclear agreement with Iran, and while an actual deal is far from finalized, the fallout from this policy could allow more oil to hit the market.
Could this hurt refineries? Possibly. But there’s at least one refinery that’s secure enough to even make it through this difficult of a situation.
Let’s look at how oil prices affect refineries, what you should watch out for concerning an Iran nuclear deal, and a stock that’s capable of weathering some volatility.
How Refineries Make Their Money
Oil refining involves taking crude oil and turning it into products the whole world uses.
The Department of Energy says that roughly 70% of each barrel of crude oil goes into making gas and diesel fuel. Additional products include ingredients to make plastics, lubricants and construction materials.
Lower oil prices theoretically should produce better margins for refineries … but that would only be true if the cost of finished products remained the same. Yes, nearly three-quarters of a barrel of crude goes into making gas and diesel … but usually, when the price of oil drops, so do gas prices. So margins wouldn’t change.
That’s where the Brent-WTI spread comes into play.
All oil is not created equal. Where you drill determines the type you collect and how easy it is to refine. The two major benchmarks for world oil prices are West Texas Intermediate (WTI) and Brent crude oil.
WTI crude is our domestic benchmark as it’s found here in the American Midwest. Brent is more of a global benchmark as it services Europe and is a part of the OPEC market basket, which is used globally. The price per barrel for each benchmark — which is the basis for its spread — is dependent upon your typical supply-and-demand relationship.
Over the past four years, Brent has been more expensive than its WTI counterpart due to the explosion of Bakken shale in Canada and North Dakota. These new sources caused a supply gut domestically, lowering prices.
But this bigger spread caused a boom for U.S. refineries.
Refineries were able to buy cheaper WTI oil, refine it, then sell it on markets based on the price of more expensive Brent crude (gas and diesel fuel are more related to the price of Brent crude). Thus, they were winning the margins game.
After the price of oil plummeted last summer, the Brent-WTI spread diminished to near parity earlier this year. However, over the past few months, the spread has come back with a vengeance as a result of civil unrest in Libya and fighting in Yemen driving up the price of Brent. All seemed great for U.S. refineries.
Then came the real possibility of an Iran nuclear deal, and with it the real possibility of Iranian oil hitting the market.
How an Iran Nuclear Deal Could Hit the Spread
Recent news that Iran had reached a preliminary nuclear deal with the U.S. and other global powers sent crude prices lower. If Iran stays in line with the stipulations of the agreement — specifically not attempting to build a nuclear weapon — current sanctions maybe lifted.
The reason crude declined was that if those sanctions are lifted, Iran could increase its oil production … and over time, the extra supply could bring down Brent prices. In turn, that would translate into a narrower spread.
While we shouldn’t expect any final agreement until June, here’s what investors should watch for:
- Timing and short-term implications: In a MarketWatch article published last month, John Macaluso — research analyst at Tyche Capital Advisors — said the “most immediate impact of a deal would be the release of at least 30 million barrels of Iranian floating storage on a fleet of supertankers hitting a crowded, oversupplied market once Western sanctions are lifted.” When and if this happens, expect the price of oil to plummet immediately.
- Iran’s infrastructure over the long-term: It’s possible Iran could add an additional 800,000 barrels a day onto the market. However, many analysts feel see this as unlikely due to a failing and ignored oil infrastructure due to the current sanctions. But you have to believe Iran will do everything in their power to produce as much as they can as quickly as possible. It’s a game of wait-and-see.
A Play in the Refinery Space
There is a way to play refineries, but you have to expect some volatility here and follow the developments of the Iran nuclear deal — along with some other world developments. Anything can (and has) happened.
If you look long-term, there is strength at the very top of the industry in Valero Energy Corporation (NYSE:VLO).
VLO is more than just about playing the spread as it is the leading and biggest independent oil refiner in the world with its 2.9 million barrel daily capacity — that’s more than 700,000 a day more than its nearest competitor Phillips 66 (NYSE:PSX).
The company’s size coupled with its efficiency in costs and its geographical advantages make Valero stock a long-term play, where its business can withstand the current volatility of oil prices.
As of this writing, Jason Jenkins did not hold a position in any of the aforementioned securities.
