When the largest refinery on the East Coast, a facility
snugged up to the Schuylkill River in South Philadelphia, sold in
July, it immediately became a symbol of the rapidly changing
The sale ended Sunoco's tenure as a refiner, which had lasted
more than a century.
The facility is being reorganized by aCarlyle Group (
)-led partnership to take advantage of low-priced gas flowing out
of the Marcellus Shale fields. Its rail terminal, designed for
high-speed offloading, aims to gulp increasing shipments of cheap
oil from the Bakken Shale in the Midwest.
The aggressive repositioning is only one snapshot of a
thin-margin industry which, after decades of baby-step progress,
finds itself suddenly restructuring at a gallop.
Refiners across the industry have seen recent profits either
crumple or soar. In addition to Sunoco's final bow,BP (
) downsized its U.S. refining operations. It sold two of the
largest U.S. refineries at bargain rates while investing $4
billion to upgrade its Whiting, Ind., unit.
The central theme driving nearly all of that change, says John
Felmy, chief economist with the American Petroleum Institute, is
"the relative cost of (refiners') crude inputs vs. their
In a nutshell, the rise of shale oil production has meant that
Midwest refiners pay less for crude, giving them a profit
advantage relative to their counterparts on the East and West
As a result, midcontinent refiners have posted some of the
industry's strongest stock-price moves this year.
Western Refining (
) is up 89%,CVR Energy (
) up 112% andHollyFrontier (
) advanced 82% year-to-date through Friday. Those moves are
helping to hold refiners in the top 20 rankings among the 197
industry groups tracked by IBD.
The questions now: Will the group's earnings hold up? Will the
price differential between coastal and interior crudes remain?
And how will refiners adapt?
The Bakken Shale is a geological region spread beneath North
Dakota, Montana and Saskatchewan. The name rose into common use
as oil producers began applying high-pressure fracturing and
horizontal-drilling techniques first used to open up natural gas
deposits across the South and Northeast.
These techniques lifted North Dakota's oil production from
less than 100,000 barrels per day in 2005 to 729,000 barrels per
day in September.
Chris Micsak, senior energy analyst with energy researcher
Bentek, estimates that daily production will reach 748,000
barrels in November, with an additional 81,000 barrels coming
from the Bakken's Montana side. And the numbers just keep
growing, says Bob Levin, a managing director of commodities
research for CME Group.
"If you tend to be conservative in the way you express
yourself, you consistently underestimate the production levels
and flows. They are surprisingly high and growing," Levin
The effects of that homespun oil boom are rippling around the
Historically, West Texas Intermediate (WTI) crude, priced at
the pipeline hub in Cushing, Okla., trended about $2 above Brent
crude, produced in the U.K.'s North Sea. The price spread was
good for domestic oil producers, but costly for refiners.
The spread fluctuated, but WTI always, eventually returned to
its premium. That began changing in 2010, when U.S. shale oil
production ramped up. New oil supply flowed from the Bakken and
joined incoming tar sands crude imports traveling south from
Pipelines out of the Midwest were limited, geared to
traditional volumes. In fairly short order, the tank farms at the
Cushing storage hub were overwhelmed with supply. WTI prices
trended lower and have traded recently around $86 a barrel. Brent
has hovered near $109.
That difference imposes a significant price disadvantage upon
coastal refiners, helping to explain moves like the closing of
the South Philadelphia refinery.
The South Rises
But Gulf Coast refiners, which account for nearly half of all
U.S. refining capacity, are gradually being exempted from the
The Seaway pipeline, a joint venture owned byEnterprise
Product Partners (EPD) andEnbridge (ENB), reversed its original
course and began moving crude from Cushing to Freeport, Texas,
just south of Houston.
It made its first deliveries in June and is expected to ramp
capacity to 400,000 barrels early in 2013. A parallel line,
slated for completion in 2014, aims to raise the flow to 850,000
TransCanada 's (TRP) Keystone XL line, a political football
farther north, is already approved running south from Cushing to
Nederland, Texas, near Port Arthur.
In addition, production from other shale plays has also ramped
up. Production in the Eagle Ford fields in South Texas has
increased, with much of that supply flowing toward Gulf
Combined, the new supplies will place downward pressure on the
Light Louisiana Sweet benchmark used as a gauge for Gulf Coast
Eventually, it could also affect Brent prices. Energy
Information Administration data show foreign imports into the
Gulf have dropped by half since 2010.
The MLP Factor
Independent refiners are gathering an increasing share of U.S.
production capacity, even though large integrated plays likeExxon
Mobil (XOM) andChevron (CVX) still own the country's largest
But the sale of BP's refinery in Carson, Calif., toTesoro
(TSO), as well as the sale of a Texas facility toMarathon Oil
(MRO), boosted independent market share.
In addition, Marathon had already divided much of its refining
and pipeline assets into the independentMarathon Petroleum (MPC)
in 2010. In May,ConocoPhillips (COP) spun offPhillips 66 (PSX) as
its stand-alone refining play.
The sector is also rapidly restructuring as it rolls pipeline
assets into master limited partnerships. MLPs make competitive
investment vehicles because they pay out whatever cash flow is
not directly used in company operations. In addition, pipelines
tend to be noncyclical, making the MLP stock prices theoretically
The primary owners of the assets used to create the MLP
generally incorporate a managing partnership. This governs
pipeline activities and typically receives a large share of the
Refineries are occasionally shifted into MLP settings:
Northern Tier (NTI) andNuStar (NS) are refining MLPs.
The refining sector saw a flurry of downgrades in
mid-September, led by analysts at Citi and Credit Suisse. The
analysts reasoned the industry had worked through the benefit of
a rash of shutdowns, and that the Bakken's rising rail shipments
were eating into the spread between domestic and imported
But Credit Suisse analyst Edwin Westlake reversed course in
late October, based on the potential for MLP-related valuation
improvements. In an Oct. 26 report, Westlake upgraded Phillips
66,Delek U.S. Holdings (DK) and Marathon Petroleum -- all
refiners with a midcontinent focus -- to outperform from market
weight, and raised their price targets.
Two weeks earlier, Goldman Sachs' lead energy analyst Arjun
Murti had upgraded his view on the refining sector to attractive,
raising Western Refining to buy from hold and reiterating buy
ratings on HollyFrontier, Marathon Petroleum and Northern
Murti put the general trading range for Brent crude between
$100 and $110 per barrel through 2015. He widened his projected
spread between Brent and WTI prices to $7 from $5 per barrel.
In addition, Murti noted that rising rail shipments from the
Bakken to the East and West coasts could drive U.S. domestic
prices even further below the international benchmark, pointing
to "long-term crude oil discounts of $7-$12 (per barrel)."