As a result, WTI-Brent spreads have narrowed to $0.20 per barrel from $23 per barrel in February. So naturally, domestic oil (WTI) producers are enjoying fat margins with higher volumes. But the narrowing WTI-Brent spread has also stressed the profitability of U.S refineries. These refiners buy low-cost WTI, and sell the refined products at global benchmark prices set by Brent crude. So U.S refineries stay profitable as long there is a significant pricing differential between WTI and Brent crude.
However, Morgan Stanley estimates that the WTI-Brent spread can widen up to $12 per barrel by the end of 2013. Analysts at the firm believe that the demand for WTI crude is saturated, and its oversupply (caused by excessive pipeline capacity) should lead to a 10% to 15% crash in WTI crude prices. Even Goldman Sachs estimates that the spread could widen beyond $10. So if these estimates hold ground, it is highly probable that U.S refineries could start rallying again.
So here are a few refining companies that appear to offer the most upside.
Profiting from the spin-off
When it comes to the refining sector, it’s hard to miss Valero Energy Corporation (NYSE:VLO). It operates with 16 refineries across the U.S, Canada and the U.K, with a combined refining capacity of 2.8 million barrels per day. The oil and gas behemoth recently spun off its CST Brands (retail division), after which it generates almost all of its income from refining activities.
While this spin-off will shrink its revenue, it will also allow Valero Energy Corporation (NYSE:VLO) to perform inline with the improving WTI/Brent spread. And since Valero Energy Corporation (NYSE:VLO)’s refining capacity in North America accounts for more than 85% of its total processing capacity, it appears to be one of the prime beneficiaries from the widening spread. This favorable geographical mix coupled with value that’s unlocking from its spin-off suggest that Valero Energy Corporation (NYSE:VLO) has more upside potential with less downside risks.
Most undervalued refiner
Another major U.S refiner is Tesoro Corporation (NYSE:TSO). It operates with seven refineries in the U.S, which altogether have throughput capacity of 845,000 barrels per day. Besides that, Tesoro Corporation (NYSE:TSO) also owns 2,200 retail gas stations, which diversifies its business operations. But since the company generates 92% of its revenue from refining operations, its financial performance is basically dependent on the movement in the WTI-Brent spread.
Tesoro Corporation (NYSE:TSO) recently acquired BP’s Carson refinery in California, which increased its total refining capacity by nearly 30%. Thanks to this major positive, most investment research firms including Barclays, Oppenheimer, UBS and Deutsche Bank now have an outperform rating on the refiner. And with a forward P/E of just 8.2x, Credit Suisse believes that Tesoro Corporation (NYSE:TSO) is one of the most undervalued petroleum companies with respect to its growth prospects. Since analysts estimate its FY 2014 EPS to grow by 30%, investors looking to invest in the petroleum industry should definitely consider Tesoro Corporation (NYSE:TSO).
A diversified value play
Phillips 66 (NYSE:PSX) is also one of the largest refiners in the U.S, with its 15 refineries aggregating to total capacity of 2.2 million barrels per day. It also owns interests in a pipeline network of over 15,000 miles spread across the U.S. Since pipelines operate on a fee-based structure, the rising demand for domestic crude logistics translates into higher revenue. This secondary income has spearheaded Phillips’ impressive financial growth over the last year.
As a result of its spectacular growth, shares of Philips 66 have appreciated by nearly 72% since it went public last year. Yet its shares appear to be undervalued with a forward P/E of 8.3x. And just like its peers, Phillips 66 (NYSE:PSX) also has its share of positive triggers.
Last month, the company announced that its Sand Hills and Southern Hills pipelines are open for service. They have a collective network of 1,500 miles, and will increment its existing pipeline coverage by around 10%. Phillips 66 (NYSE:PSX) already has one of the most strategically mapped pipeline networks in the U.S, and the new additions will connect the hydrocarbon-rich Permian basin and Eagle Ford to the Gulf Coast. This extends its lead over its peers, and analysts now estimate that shares of Phillips 66 (NYSE:PSX) can very well double in value over the coming years
Final words
In my opinion, all of the above-mentioned companies are worth a buy rating. Where Valero Energy Corporation (NYSE:VLO) offers value that’s unlocking, Tesoro Corporation (NYSE:TSO) and Phillips 66 (NYSE:PSX) offer stellar growth potential. But since this thesis holds ground if the WTI-Brent spread widens, investors should keep a close eye on the spread. As of today, the spread stands at $2.47 per barrel, which seems to have started widening.
The article Are You Prepared for a Refinery Turnaround? originally appeared on Fool.com and is written by Piyush Arora.
Piyush Arora has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Piyush is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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