Trump policies could make refining stocks great again

Unencumbered by harsh regulations, and boosted by Trump's pro-growth economic policies, some of these companies could be compelling options for long-term investment. As well, despite being lifted by the recent rally, these stocks are still trading below their fair market value, offering attractive margins of safety.

 Tesoro (TSO) refines and markets petroleum products. The company operates seven refineries and retail fuel outlets in the Western and Midcontinental United States. It holds a 36% interest in Tesoro Logistics Partners, including the general partner interest.

"Combined with operational improvements including increasing distillate yields, integrating the acquired Carson refinery, and leveraging its marketing and retail operations, Tesoro should become one of the better-positioned refiners in the challenging California market," says a Morningstar report.

Tesoro's competitive position is expected to continue to improve over the next several years with greater access to cost-advantaged crude. Morningstar sector strategist Allen Good says Tesoro's refineries could "realize higher margins and improved returns through lower feedstock costs and improved yields while expending relatively little capital."

Morningstar projects the refiner will deliver more than US$615 million in annual improvement to its earnings before interest, taxes, depreciation and amortization (EBITDA) by 2017. Increased throughput of discount crude and the integration of Carson into the system could provide further help, says Good, who put the stock's value at US$124, which represents upside of nearly 50% from the current price.

Management's efforts to improve operating costs should offset any potential increase in natural gas prices, a key cost component, he adds. Moreover, improvement initiatives currently under way should result in earnings growth. "Tesoro will increase the flow of discount crude to the West Coast by 325,000 barrels per day over the next few years, resulting in lower-cost feedstock and improved yields," says Good. "Expansion of marketing channels should allow Tesoro to increase sales volumes and run its refineries at higher levels of capacity utilization."

 HollyFrontier (HFC) is an independent petroleum refiner that owns and runs five refineries with a total crude oil throughput capacity of 443,000 barrels per day. Also, it has a 39% ownership stake in Holly Energy Partners, which owns and operates petroleum product pipelines and terminals primarily in the Southwestern United States.

Despite weak third-quarter earnings data, its currently undervalued stock remains one of the more attractive names in the energy sector. The firm has benefited, more than any other refiner, from the recent wide price differential between West Texas Intermediate (WTI) and Brent crude, Good says in a Morningstar equity report. "With access to abundant supplies of WTI, HollyFrontier's refineries have enjoyed the additional margin that this spread offered," he notes.

While Good doesn't expect a return to the spread of a few years ago, he stresses HollyFrontier should continue to benefit from the price differentials that should "remain well above historical levels."

The firm's current projects, which include expansion of its Woods Cross refinery, "will nearly double the capacity of the refinery," says Good, who appraises the stock's fair value to be US$44, implying a forward enterprise multiple of 9.5 times.

The stock's attractiveness is further enhanced by a consistent and substantial return of cash to shareholders. Good says: "Flush with cash, HollyFrontier has substantially increased shareholder returns via repurchases and dividends, which have far outweighed similar efforts by peers."

 Marathon Petroleum (MPC) operates seven refineries in the mid-continent oil field and on the Gulf Coast of the U.S. It also owns and operates crude oil and refined product pipelines.

"Its existing refining asset base is well positioned to capitalize on the ever-changing domestic crude market," says a Morningstar report. The firm, the report notes, is also "investing to expand its midstream and retail businesses in an effort to diversify its earnings stream away from the more volatile refining business."

However, the refining segment still largely determines Marathon's near-term profitability, which Good regards "as a positive," considering the outlook for U.S. refining over the next five years and Marathon's competitive position.

Apart from organic growth, MPC has also used acquisitions to grow business and add value. The acquisition of the Texas City refinery from BP transforms Marathon into primarily a Gulf Coast refiner (62% of capacity in the region) while lowering its reliance on mid-continent refining, the main driver of its earnings over the past few years.

Good puts the stock's worth at US$56 and projects stronger margins and improved crude discounts in both regions where the firm operates, which leads to "greater profitability and leaves it better positioned to capitalize on [oil price] differentials compared with more geographically diversified peers."

 Valero Energy (VLO) is the largest independent oil refiner in the U.S. It operates 14 refineries in North America and the United Kingdom, and it owns a 69% interest in Valero Energy Partners LP.

"Valero is well positioned to thrive in almost any market environment, thanks to its high-quality refining assets and their location," says a Morningstar report. "Given its complex assets and concentration in the Gulf Coast, Valero retains the access and capability to process light or heavy crude, depending on which offers the greatest discount or optimal economics."

The refiner's investments in processing capacity, yield improvement and infrastructure can be quickly monetized through its master limited partnership (MLP), Valero Logistics Partners, says Good. The cash generated can be used to fund reinvestment or shareholder returns, he adds.

Historically, Valero has enjoyed feedstock advantage resulting from its access to heavily discounted waterborne crudes. As the most complex refiner in the U.S., Valero is able "to purchase cheaper, lower-quality crude as feedstock, increasing realized margins," says Good, whose US$68 fair value estimate provides the stock with a very slim margin of safety at its current market price.

In the coming years, U.S. refiners will continue to benefit from ongoing domestic light-crude discounts to international prices of several dollars a barrel, says Good, but cautions that "narrowing or reversal of those discounts would result in weaker than anticipated performance."

The firm has been deft and nimble in aligning itself to prevailing market conditions over the last few years by tactically "divesting underperforming assets and adding strategic assets cheaply to high-grade the overall portfolio, which should lead to higher returns," says Good.

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