So far, 2016 hasn’t exactly been a bang-up year for the refiners. Gone are the amazing margins as crack spreads have narrowed and refined-products inventories have built-up to glut like levels. The slowdown in the global economy hasn’t helped either, causing refiners to limit gasoline exports. As a result, profits and share prices have dwindled over the past eight months or so.
But the refiners are facing an old enemy that’s rearing its ugly head once again. And that would be ethanol.
Costs to blend the fuel are rising to record levels and that’s putting some major pressure on some of the major refiners.
Enough pressure to potentially bankrupt some of the smaller players. The question now is whether these issues represent a chance to buy the sector or if the refiners are once again back to being “dead money.”
The Refiners and Their Ethanol Issues
Just a year ago, the refiners were in their halcyon days. Crude oil was plentiful and cheap, gasoline and other refined products demand was steady. The refiners were able to feast on the low feedstock cost and produce profits not seen in pretty much ever. All was right in the world.
Then the bottom dropped out.
Since then, the sector has spent much of its time cutting costs, reducing throughput and dealing with higher crude oil/lower crack spread margins. The good news is the efforts have started to pay off and the drop in crude oil prices have helped crack spreads return to being decent — albeit nowhere near as juicy as a few quarters ago.
But the refiners aren’t necessarily out of the woods just yet. The downstream sector’s old foe, ethanol, is back with a vengeance.
Under the Energy Policy Act of 2005, refiners of gasoline and diesel fuel are required to add a certain amount of ethanol or other renewable fuels to each gallon they produce. If they can’t do it, they are required to buy credits called Renewable Identification Numbers to make up the difference. The RINs are created when the ethanol is made and once it’s blended, the RIN can be sold to anyone. And that includes a hedge fund or other commodity investor that isn’t a refiner.
And there lies the problem. The prices for RINs have skyrocketed in recent months and are approaching record levels per credit. That’s causing all sorts of “extra costs” many refiners are now having to deal with.
Mega-refiner Valero Energy Corporation (NYSE:VLO) estimates that it’ll spend more than $850 million on RINs this year alone. All in all, the top ten refiners in the U.S. have already spent $1.1 billion on RINs during the first half of the year.
That’s already near the $1.3 billion spent for all of 2013.
So It’s Time to Dump The Refiners, Right?
The answer is not exactly. For those smaller independent refiners like HollyFrontier Corp (NYSE:HFC), CVR Energy, Inc. (NYSE:CVI) and Alon USA Energy, Inc. (NYSE:ALJ), the sustainable higher RINs costs are going to kill them. Carl Icahn — who owns the bulk of CVI stock — predicts continued high RINs cost will bankrupt many of the smaller individual refiners in the nation.
But for those downstream players that have marketing arms — i.e. gas stations — boom time could be coming again.
Ethanol is very corrosive, so adding it to gasoline takes place at terminals near service station hubs. That way it doesn’t have to be shipped very far.
As a result, many refiners who also own service stations do their own blending. What happens is that the refiner hands the service terminal/blender a check for the RINs. It’s like you writing yourself a check and depositing it into another bank account you own. It’s still your money.
These refiners will be able to navigate the current RIN situation with relative ease. More importantly, the improving crack spreads and dwindling inventories of fuel will have them getting back to real profitability.
Meanwhile, the overall sector drop has many of them paying better than average dividends yields. For investors, these refiners offer some of the biggest bargains in the sector.
Two Refiners to Buy
First up would be Marathon Petroleum Corp (NYSE:MPC). Back in 2014 — the year after the last RIN price spike — MPC made one of its smartest buys ever by securing a retail network of gasoline stations from Hess Corp. (NYSE:HES).
That buy not only expanded its own service station footprint, but gave it plenty of blending/terminaling assets for the production of RINs.
Incidentally, it’s tucked many of these terminals into its MLP — MPLX LP (NYSE:MPLX) — for additional tax savings. Meanwhile, crack spreads at the firm improved last quarter and have continued to improve further.
All of this will help MPC continue to pay its steady and rising dividend. Considering that Marathon can be had for price-earnings ratio of 11, investors are getting one heck of a bargain at current prices.
Like MPC, refiner Tesoro Corporation (NYSE:TSO) could be a big buy in the face of rising RINs and better crack spreads. TSO also holds a host of blending terminals and retail outlets — 2,400 of them — that generate credits. In fact, TSO was able to generate enough credits that it saw “no material impact” from the more than doubling in their price during the first quarter of the year. Even better is that TSO stock can be purchased for less than eight times earnings.
The Bottom Line: Don’t let the high costs of ethanol fool you out of the downstream sector. Things are only getting better for the refiners that can offset the high cost of blending ethanol.
Both TSO and MPC make prime picks for those investors looking for bargains and big dividends in the downstream sector.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.
