Buy These Three Refiners for a Recovery in the Brent-WTI Spread

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

West Texas Intermediate (WTI) crude has been on a roll recently, the benchmark is pushing highs of around $106 to $107 per barrel, but this trend could soon be over. Indeed, while the WTI oil benchmark is pushing to new highs, supply is only increasing and stockpiles continue to hover around multi-decade highs (although they have fallen back off highs seen earlier this year).

In addition, oil production from non-OPEC countries will grow at the fastest pace in 20 years during 2014, further adding to the supply glut. Furthermore, it appears that this short-term bounce is not supported by the market as WTI contracts for future delivery are in steep backwardation. For example, the WTI contract for delivery in December 2021 is trading at $79.61.

The spread is closing

Unless you have been living under a rock, you will know that the rapidly rising price of WTI is squeezing the Brent-WTI spread, a key metric for refinery profitability. The spread has contracted to as little as $1.32 in recent days, down from $23.18 in February. This closing spread has piled the pressure on refiners and investors have sold off the stocks, fearing lower profits and a deteriorating outlook.

However, this outlook could be about to change as the spread is currently predicted to change tack and widen again. Indeed, according to CME Globex futures, the spread is already set to widen to $5 by December.

This presents an opportunity

The best way to play this widening spread would be through refiners as profitability will rise as the spread widens again. There is also potential for an increase in bullish sentiment among investors in the sector.

For risk-off investors

Phillips 66 (NYSE: PSX) is a large, global refiner and a good company at a great price.

Phillips 66 is the largest refiner on the market, with operations around the world and a collection of assets that are not just linked to refining. However, despite the company's size, global exposure and diversification, it is still trading at a discount to the majority of its peers.

In particular, Phillip 66 trades at a lowly P/E of 8.6 while the 10-largest companies by market capitalization in its sector trade at an average historic P/E of 11.5. Furthermore, the company currently trades at a PEG ratio of 0.8, indicating that it could offer growth at a reasonable price.

Moreover, as testament to the company's long-term sustainability, Warren Buffett's Berkshire Hathaway is a holder of Phillips 66 shares, and the conglomerate has formed a strong relationship between Philips and Berkshire's Burlington Northern Sante Fe unit.

Philip's has recently indicated that it is going to pull-out of Europe as refining margins fall on the continent, which should boost the company's overall profitability going forward.

For value investors

As a value play, HollyFrontier (NYSE: HFC) looks perfect. The company conforms to all of Benjamin Graham's investment criteria and currently trades at nearly half of its indicative Graham value of $71.37.

HollyFrontier has been sold off after it missed EPS estimates for Q1 this year. The company reported EPS of $1.63 compared to estimates of $1.76, which was entirely down to the company's lower utilization rate of 90% for the quarter, compared to estimates of 95%. In contrast, most of the company's peers beat estimates.

Still, HollyFrontier looks like a good play on the recovering Brent-WTI spread, with risk minimized due to its strong financial position. Indeed, the company's current assets cover current liabilities nearly three times and current assets cover total debt twice. Moreover, the company has paid a dividend for more than 20 years and earnings have grown 616% during the last 10 years; bear in mind for the majority of this period, WTI was trading at a premium to Brent, solidifying the view that HollyFrontier will continue to be profitable even if the spread collapses further.

I have written further about HollyFrontier's value investment potential here.

A high yield

Northern Tier Energy (NYSE: NTI) only owns one refinery but also operates a retail division, with 166 convenience stores and 67 franchised convenience stores, primarily in Minnesota and Wisconsin, under the SuperAmerica brand name. Northern Tier also hold 17% of the Minnesota Pipe Line Company, a 455,000 bpd crude-oil pipeline system bringing oil down from Western Canada and North Dakota.

Northern Tier's refinery is located within easy access of its part-owned Minnesota Pipe Line, and for this reason, the company is able to achieve wide profit margins on low-cost crude from Canada and North Dakota. For example, Northern Tier has a gross profit margin of 18.6%, 2.2% above that of mammoth peer Phillips 66.

Additionally, the company generates a 17.5% return on assets, once again above the 9.8% ROA achieved by Philips and above the sector average of 15.5%. These impressive ratios translate into shareholder returns far above that of the company's peers. The firm has a historic dividend yield of 19% and I believe this is set to continue as more cheap crude flows through the US.

The company is bolstered by its relatively defensive retail division, which should cushion any failure at the refinery.

Foolish summary

So overall, the rapidly contracting Brent-WTI spread has spooked some investors but this contraction is expected to reverse over the next few months as supply exceeds demand and WTI is pushed lower. 

The three refiners above each present a different play on the recovering spread and an opportunity for every type of investor. Although, if I had to pick one, HollyFrontier offers the best value for money. 

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Fool contributor Rupert Hargreaves owns shares of HollyFrontier and NORTHERN TIER ENERGY LLC. 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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