This Sector's Pullback Has Exposed The Market's Deepest Value

By
A A A

For the past few years, there's been an anomaly in the global oil industry.

Brent crude oil, which comes from the Middle East, Africa and Europe, has been far more expensive than West Texas Intermediate (WTI) crude, which is drilled right here in the U.S. Both Brent and WTI are known as light,sweet crude , which means they are easily processed into gasoline, diesel and other distillates.

So why had Brent been trading for up to $20 more per barrel than WTI? Blame it on geography.

Although the U.S. has tapped into a mother lode of oil in the past few years, much of the produced oil had nowhere to go. Storage hubs were filled to capacity as a lack of pipelines kept all of the oil from flowing to U.S. Gulf Coast, the West Coast and the East Coast, where manyoil refineries are located.

All that has changed. The opening of many new pipelines in recentquarters has enabled the oil to start flowing more quickly, and as refiners boost demand for WTI crude and seek less Brent crude oil, we're seeing the price for these two types of crude oil converge.

Trouble is, gasoline and diesel are globally fungible, so refiners haven't been able to hike wholesale gas and diesel prices as quickly as their own costs are rising. As a result, refiners'profit margins have fallen sharply in recent months, taking their share prices with them.

The pullback means that the major oil refiners are now among the cheapeststocks in themarket .

Before we go any further, you'llnote that three of these stocks sport especially highdividend yields.

  • Northern Tier Energy ( NTI )
  • Alon USA Partners ( ALDW )
  • Calumet Spec. Products (Nasdaq: CLMT)

They are structured as masterlimited partnerships (MLPs), so they pay out almost all of theircash flow in the form of dividends. (The rest reserve much of their cash flow forcapital spending and growth initiatives.) 

You'll also note that the super-high yields for these MLPs are too good to be true. The decline in refining margins means the dividend needs to be reduced, but these should still be solid yields, even after the dividend cuts take place. For example,analysts at Citigroup expect Alon USA Partners' dividend falling from $2.74 per unit in 2013 to just 88 cents per unit, before rebounding to $1.74 per unit in 2015.

Yet the fact that most of these refiners now trade for less than 10 times projected 2014 profits should draw your attention. More importantly, the pullback in margins, as painful as it is, doesn't signal that profits have peaked. 

Instead, look at these refiners in the context of the energy boom that is now underway. As the U.S. produces ever-higher amounts of crude oil over the next five years, these refinerswill be able to generate much higher volumes of refined products, eventually displacing much of the imported gasoline, diesel and other distillates now coming to the U.S. from elsewhere. 

Also, as oil production keeps rising, it should eventually push prices down, opening up the spreads these refiners had been profiting from. The Energy Information Administration (EIA) sees U.S. oil production rising 30% between now and the middle of 2015, though the rising output should alter refining dynamics well before then. Goldman Sachs anticipates "the effective elimination of light crude oil imports to the Gulf Coast, which we expect to occur around year-end 2013." Analysts at Merrill Lynch add that "growth in regional production in the Eagle Ford and Permian basins will likely 'back out' light sweet crude imports within ayear ."

Yet for investors, it's fair to wonder if it's best to wait until the current cycle of falling profit margins andprofit forecasts has played out. "We find that at key inflections, investors often look through short-termEPS revisions," noted Goldman Sachs analysts. In other words, by the time you wait forearnings estimates revisions to trend upward, you will have missed out on some of the nextrally in this group. 

Goldman Sachs recommends HollyFrontier ( HFC ) , Marathon Petroleum (NYSE: MPOC) ,  Western Refining ( WNR ) , Alon USA Partners (Nasdaq: ALDW) and Northern Tier Energy ( NTI ) . The first two stocks carry more than 50%upside to Goldman's price targets. 

Merrill Lynch rates Valero ( VLO ) and Tesoro Energy (TSO) as a "buy," as those companies have the best organic growth prospects in the industry, thanks to planned capacity additions. They also think Valero will soon spin off a portion of its business in the form of an MLP. Such moves have historically given instant boosts to share prices. 

Risks to Consider: Any global crises that lead to a spike in oil prices wouldput further pressure on refiners' profit margins. Also, a sharp economic slowdown in the U.S. would hamper demand for refined products like gasoline and diesel. 

Action to Take --> The recent share price pullbacks are a reflection of 2013 industry dynamics. But as long as you focus on the long-term dynamics impacting refiners, you'll find the current low earningsmultiples to be quite appealing.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.


This article appears in: Investing , Investing Ideas , Stocks

Referenced Stocks: ALDW , HFC , NTI , VLO , WNR

StreetAuthority

StreetAuthority

More from StreetAuthority:

Related Videos

Stocks

Referenced

100%
100%
100%
86%
67%

Most Active by Volume

55,414,702
  • $15.38 ▼ 0.39%
38,503,210
  • $66.34 ▲ 2.26%
36,466,704
  • $8.36 ▼ 9.52%
35,253,294
  • $26.55 ▲ 1.34%
32,752,347
  • $6.55 ▲ 1.87%
31,778,001
  • $95.22 ▲ 0.19%
28,396,556
  • $51.49 ▼ 0.62%
23,800,987
  • $42.09 ▲ 0.97%
As of 7/11/2014, 04:03 PM