Do Squeezed Margins Spell Trouble for These Refiners?

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

To say that the publicly-traded oil refinery stocks had been on a tear in recent months would be an understatement. For instance, Phillips 66 (NYSE: PSX) traded for $30 per share shortly after being spun-off from ConocoPhillips back in June 2012, then soared to $70 per share one year later.

The economics of the refining industry were extremely favorable for these stocks as oil prices stayed low, and consequently, their spreads remained high. Unfortunately, nothing lasts forever, and the period of abnormal returns for refiners may have passed now that spreads are tightening due to rising oil prices.

As a result, how should investors view these refiners going forward?

Profits no longer gushing

Phillips 66 wasn’t the only refiner benefiting from the extremely favorable operating environment for refiners.

Marathon Petroleum Corporation (NYSE: MPC) traded for $63 per share at the beginning of 2013, then proceeded to skyrocket all the way to $90 per share in just a couple months.

And, let’s not forget industry stalwart Valero Energy (NYSE: VLO), which racked up greater-than 40% gains from the start of the year through March.

More recently, however, these stocks have fallen considerably from the highs seen not too long ago. Earnings reports are starting to roll in from the refiners, which have largely confirmed that their huge margins are quickly shrinking.

Valero kicked off earnings season for these three, and the numbers weren’t pretty. The company’s second quarter operating income declined 43%, which the company attributed to lower refining throughput margins.

On a positive note, Valero increased its dividend by nearly 13%, and now provides a solid 2.5% yield at recent prices.

Phillips 66 actually showed resilience in its own second-quarter results. Adjusted earnings fell by a third, but this was not a surprise. As you’d expect, the main culprit was the company’s Refining segment. Second-quarter Refining earnings dropped by nearly half, and it didn't help that refining operations represent the company’s biggest segment.

At the same time, the company demonstrated its own thorough commitment to its shareholders by generating $968 million in operating cash flow and returning $738 million of it to shareholders in the form of dividends and share repurchases.

As a result, Phillips 66 shares declined only modestly after releasing earnings.

Marathon Petroleum, meanwhile, saw its shares rise 2.5% after announcing earnings, and in a familiar pattern, showed some strength in the midst of a tough operating environment.

Second-quarter adjusted earnings clocked in at $1.95 per diluted share, compared with $2.53 in per-share diluted EPS the same period one year ago. That represents a 23% drop, due largely to rising costs and expenses. The company’s adjusted EPS topped Wall Street expectations, which explains why shares rose after the earnings release.

Even better, Marathon Petroleum gave investors a 20% dividend increase. The new payout of $1.68 per share represents a solid 2.25% yield at recent prices. Rapid dividend growth is becoming a pattern for Marathon Petroleum: the company has increased its dividend three times in the past 24 months. In all, Marathon Petroleum has more than doubled its payout since it became an independent public company.

The Foolish takeaway

You may not have previously considered oil refiners, but they too represent an important piece in the American energy puzzle. For several quarters, refiners like Phillips 66, Valero, and Marathon Petroleum reported outsized profits due to fat margins.

At the same time, the conditions that were once so favorable to the refiners have now, for the most part, disappeared. Should oil prices continue their recent surge, refinery margins will continue to be squeezed, and it isn’t unreasonable to think their stock prices would follow suit.

That being said, even though further downside is a real possibility for the industry due to such difficult operating conditions, these companies remain steadfast in their commitment to returning cash to shareholders. In addition, margins tend to fluctuate, so I’m tempted to believe the drop in profitability is not a long-term threat. Therefore, it seems the recent price drop in shares of refiners represents an attractive buying opportunity for patient investors willing to weather the storm.

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Robert Ciura has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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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