Value in the Oil Frontier
Phil is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Every couple of months I run my value screener to look for new value opportunities. More often than not I eliminate the companies on the list after I do deeper analysis. Lately my screen has been picking up a new company. The company is HollyFrontier Corporation (NYSE: HFC), which hasn’t shown up before because it didn’t exist until 11 months ago.
Nearly one year ago, on July 1st, 2011, the Holly Oil Corporation and the Frontier Oil Corporation completed their merger to become the HollyFrontier Corporation, one of the largest independent petroleum refiners in the USA. As the anniversary of their unification approaches let’s take a look at how this new, bigger company is doing.
HollyFrontier Corporation, headquartered in Dallas, Texas, has refining operations in five states throughout the mid-continent, southwestern and Rocky Mountain regions. The company produces gasoline, diesel, jet fuel, asphalt, heavy products and specialty lubricants.
HollyFrontier also owns a 75% interest in the 400-mile UNEV pipeline joint venture, and holds 42% interest, including a 2% general partnership interest, in Holly Energy Partners, L.P. (NYSE: HEP), a master limited partnership that operates petroleum logistics assets.
Unlike most of its competitors clustered around the Gulf coast, HollyFrontier seems to be well situated to serve the western and northern parts of the continent with access to inland crude supply from Canada, and the domestic Bakken, Permian, Niobrara and Mississippian sources. In addition, HollyFrontier recently entered into a 10-year agreement with Newfield Exploration to receive supply from the Uinta Basin in Utah.
The Spread Factor
Refining profit margins tend to vary significantly based on the purchasing price of crude oil (feedstock), and the selling price of refined products. The price differential of crude oil and the petroleum products extracted from it is referred to as the Crack Spread. The spread has been in a range between $13 and $40 for the past year, averaging around $30.
Domestic refiners' profitability also depends on the price differential between domestic and imported crude oil. The selling price of refined products is typically determined based on imported Brent crude prices. But domestic crude is priced based on the West Texas Intermediate (WTI) benchmark, which averages about $15 per barrel cheaper than Brent. The difference in price between Brent and WTI is called the Brent-WTI spread.
Many US refiners, like BP plc (NYSE: BP), Chevron (NYSE: CVX), Exxon Mobil (NYSE: XOM), Marathon Petroleum (NYSE: MPC) and Valero Energy (NYSE: VLO), are dotted around the Gulf Coast, where feedstock is priced at Brent crude import prices. HollyFrontier gets its feedstock from inland sources at a discount to WTI, so it benefits from wider Brent-WTI spreads. In the past quarter HollyFrontier paid on average $3.95 per barrel below WTI. In the Rockies region, feedstock on average was $10.55 below WTI crude, and in mid-continent it was priced $2.22 below WTI.
Although a wider Brent-WTI spread helps profitability, HollyFrontier is not dependent on it. From 2001-2010 WTI traded at a premium to Brent, and Holly (pre-merger) was still able to maintain industry leading returns. But wide Brent-WTI spreads affect many coastal refiners’ behavior, which tend to export more of their refined products for higher sale prices when the spread is high. This bodes well for HollyFrontier, already sporting the highest earnings per barrel among US refiners.
For the March quarter HollyFrontier reported operating income of $420 million and net income of $242 million, $1.16/diluted share, from production levels of 433,000 barrels per day (BPD). Operating expenses were $242 million, and cash flows from operations totaled $254 million for the quarter. The company paid $126 million in dividends to shareholders and repurchased $62.5 million in common stock during the quarter. Cash and equivalents stood at $1.9 billion, versus consolidated net debt of $1.3 billion, including $688 million HollyFrontier debt and $624 million HEP debt.
The quarter looks quite good, slightly better than Q4. However, in contrast to the 3rd quarter, their first as a newly merged company, when HollyFrontier reported net income of $523 million, $2.48/share, this quarter seems a bit pale by comparison. Q3 stands out as a record quarter mostly due to large crack spreads and elevated Brent-WTI spreads, which many of us felt at the pumps during the past 6-9 months. With gas prices coming back down, HollyFrontier’s margins are returning to more realistic levels, near $6 per barrel net, the best in the industry.
Paying the Shareholders
One of the things that stands out about HollyFrontier, besides their industry leading margins, is their generous dividend. In May the board of directors approved a 50% increase in the quarterly cash dividend to $0.15/share, their third increase in less than a year, pushing the yield to 2.03%. In addition, the company has also paid a special quarterly cash dividend of $0.50/share since August, 2011.
Since the completion of the merger in July, 2011, the HollyFrontier board has authorized special and regular quarterly dividends totaling approximately $510 million, or $2.44 per share, representing a combined total yield of over 8% on an annual basis. In addition, the company has repurchased more than $100 million of its common stock since completing the merger, effectively returning more than $600 million in capital to the shareholders.
Without adding new refineries, HollyFrontier estimates it can grow production from 440,000 barrels per day to 690,000 by 2016, a 56% increase.
In addition, the board of directors approved a $350 million share repurchase program in January, of which $287.5 million has yet to be exercised.
HollyFrontier's investment in the UNEV Pipeline from Salt Lake City to Las Vegas, which just started up in January 2012, along with the new Uinta Basin crude supply, will help HollyFrontier capitalize on the seasonal gas premiums in Las Vegas, and should give HollyFrontier greater access to the growing high margin Rocky Mountains market. The expansion of the Woods Cross facility from 31,000 to 45,000 BPD, expected to complete in 2014, will further boost returns from the premium West Coast and Rocky Mountains markets.
Acquisition speculation has been in the media as of late. CVR Energy (NYSE: CVI), acquired through hostile takeover by Carl Icahn earlier this year, has been mentioned repeatedly as a good candidate for HollyFrontier to acquire. CVR’s refineries in Coffeyville, Kansas, and Wynnewood, Oklahoma can produce about 185,000 barrels a day combined. With $1.9 billion in cash, and historically low borrowing rates, HollyFrontier likely could pay for CVR without much stress, adding over 40% to their existing capacity.
Threats and Concerns
Spreads are the biggest threat to refiners, particularly the crack spread. HollyFrontier has been very successful in keeping operating costs down and acquiring feedstock below WTI benchmarks. All refiners have also benefited from strong crack spreads. If either or both spreads begin to narrow significantly, profitability for HollyFrontier and all other refiners will be impacted. Such was the case in 2009 when crude prices dropped to near $40/barrel, resulting in a net loss on every barrel processed.
Fear of a deep recession in Europe, the slow-down in Chinese production and the easing of tensions in the Middle-East over Iran’s nuclear program are all driving crude oil prices down from highs of $115/barrel a year ago to $80/barrel last month. On the one hand, lower petroleum prices heading into the summer are good for consumers, but if the slide in crude oil continues it will ultimately drag down all the oil stocks with it, including the refiners.
Another potential threat is the regulatory climate. The EPA's Tier-2 standards, enacted in 2004, forced refiners to cut sulfur levels from an average of 300 parts per million (ppm) to an average of 30 ppm at significant cost to the refiners. New Tier-3 rules proposed by the EPA require sulfur content in gasoline to drop further from 30 ppm to 10 ppm. According to a report from Baker and O'Brien conducted for the American Petroleum Institute (API), the Tier-3 rules would add approximately six to nine cents per gallon in manufacturing costs. Some of these costs will likely be passed on to consumers, but perhaps not entirely, potentially impacting the refiners.
Shares are currently trading at just 4.8 times trailing earnings, making HollyFrontier the cheapest domestic crude oil refining stock on the market based on earnings. Based on cash and free cash flow, HollyFrontier is again one of the cheapest refiners in the business with a price to cash (P/C) ratio of 3.4, and price to free cash flow (P/FCF) ratio below 9.
HollyFrontier’s 5-year track record (including pre-merger stats) of growing earnings by 25% and growing sales by 31% is unmatched among refiners. Their return on equity (ROE) of nearly 40% is also tops in the industry.
Based on these statistics alone, HollyFrontier appears to be cheap, so cheap in fact that insiders have recently been buying shares on the open market. However, what makes HollyFrontier really stand out among its peers is the regular and special dividends yielding over 8% in the past year. With significant cash reserves and manageable debt they should have no problem maintaining those dividends for the next five years, and the repurchasing program already approved will further boost shareholder value.
Based on my analysis, I find HollyFrontier is indeed the best value in the oil refining sector and one of the best values on the market currently. As my disclosure period expires, I will be looking to add HFC to my portfolio.
Invest wisely, my friends.
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