One Thing You Must Know Before Investing in Oil or Steel

Marie is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

At first glance oil and steel don’t have much in common. Yes, they’re both commodities, but the similarities end there, right? Wrong. There is one major characteristic that the two share: refining operations are the key to both the oil and steel industries.

High-strength refining

When it comes to steel, refining is the process of taking already-made steel and customizing it to meet specific demands of customers. Often, refining deals with an advanced heating and cooling process that makes steel stronger while also making it 30% to 40% lighter. Many car companies such as General Motors desire this refined steel for two reasons: they can build stronger, lighter cars, and the high-strength steel helps them meet federal regulations and safety standards.

According to US Steel (NYSE: X) CEO John Surma, refining is the future of the steel business. In fact, US Steel recently expanded a factory in Leipsic, Ohio that is focused on making high-strength steel for auto-makers, who are just a few hours north in Detroit. The factory is small (it only employs 312 workers), but its profits are high.

US Steel isn’t making the high-strength steel simply because there is increasing demand for it. The company is focusing on refining mainly because margins are extremely high. Today, a ton of traditional steel sells for about $630, but a ton of high-strength steel sells for around $890, or 41% more. Focusing on refining also allows US Steel to get away from big commodity players and compete in the smaller refining market.

I think Surma’s strategy is brilliant. In today’s often volatile market, focusing on smaller, more profitable segments is a smart move. Moreover, the auto industry continues to be one of the most reliable industries in the world, and US Steel can rely on increasing demand from auto-makers for years to come. The amount of high-strength steel in cars doubled since 2008, while the amount of traditional steel used went down 4% over the same period. Auto-makers are shifting fast: GM’s new Silverado is 67% high-strength steel.

US Steel isn’t the only steel company increasing focus on refining. Steel manufacturer ArcelorMittel announced that it would shut down two blast furnaces in France, but would spend $230 million tooling the same site to make high-strength steel for European automotive companies. The steel industry is changing, and successful steel companies are evolving along with the industry.

From oil to profits

In the oil industry, refining has a different meaning. When oil companies talk about refining, they are referring to the process of turning crude oil into the gasoline, diesel, and heating oils that power our lives. Most oil giants have large refining segments to complement their drilling and extracting businesses. In today’s market, oil firms reap huge profits from their refining businesses.

For example, in the fourth quarter of 2012, Chevron (NYSE: CVX) posted a 41% increase in quarterly net income to $7.2 billion – up from $5.1 billion the year before. The greater part of the increase came from Chevron’s refining business; the refining segment made a profit of $925 million, up from a loss of $61 million in the same quarter a year ago. You read that correctly, Chevron’s refining segment accounted for 49% of the increase in profits.

Compare that to ConocoPhillips (NYSE: COP), an oil giant whose stock continues to be sluggish while Chevron's goes north. Chevron outperformed ConocoPhillips by over 33% over the past five years, and the gap widened last year.

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Why did the gap widen? Refining operations. In April of 2012, ConocoPhillips spun-off its refining segment, which is now Phillips 66. Since then, Phillips 66 has taken off while ConocoPhillips remains flat-lined.

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For the first quarter of 2012, Phillips 66 posted a profit of $1.4 billion, up 120% from $636 million a year ago. That’s $1.4 billion in profits that could have been on ConocoPhillips’ books. Instead, ConocoPhillips profits fell 28% in the first quarter to $2.1 billion from $2.9 billion the year before. As Chevron and Phillips 66 reap the benefits of refining, ConocoPhillips is missing out.

Bottom line

Whether you invest in an oil company or a steel business, be sure to take a look at each firm’s refining segment. Successful companies will have thriving refining businesses, while firms lagging behind will be missing out on big profits.

Go for the profits. Refine your portfolio.

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This article was written by Randy Holcombe and edited by Marie Palumbo and Chris Marasco. Chris Marasco is Head Editor of ADifferentAngle. None has a position in any stocks mentioned. The Motley Fool owns shares of Apache. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own! 

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