Refining Stocks Make Sweet Crude Profits
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By George S. Mack of The Energy Report
Focus on earnings achievability.
It's not often that a guy gets around his industry to the extent that recent The Energy Report interviewee Evan Calio has. He's an honors grad attorney who served as special counsel for the U.S. Securities and Exchange Commission's (SEC) Division of Corporation Finance focusing on the energy group. He then went to JP Morgan where he managed energy risk and proprietary positions, and today he is an executive director in equity research at Morgan Stanley where he follows integrated oil and refining companies as an analyst. Whew!
When we spoke by telephone I wanted to know what interesting trends Calio had on his mind. I was immediately flooded with the big picture of oil production. "The biggest story right now is the widening West Texas Intermediate (WTI) discount to water-borne, global crudes like Brent," he says.
But why is WTI discounted? It's "Largely as a result of unconventional oil production growth in the U.S." He is of course looking at the bottleneck in the Midwest of the United States where oil production is growing faster than the producers can get it out. This is a huge assist to the storage and transportation infrastructure industries and of course for the refiners whose pipelines are full. In fact, it is going to become a bigger story. Calio's forecast is for U.S. oil liquids production to grow 2 million barrels per day (MMB/d) over the next five years. If you throw in Canadian production flowing into U.S. refining capacity, that would add nearly 700,000 barrels per day (700K Mb/d). "That is a pretty material amount of production growth on a relative basis and could result in increasing U.S. oil independence," he says. "Not since the late 1960s have we seen that type of relative oil production growth."
The question is what does this do to the upstream [exploration and production (E&P)] where oil and gas are found and produced. "Essentially, it's providing them with incremental growth profiles versus what they've had historically," he says. But, "I think some of that is offset by lower gas production driven by lower prices. A combination of fear of current oil prices, possibly lower natural gas prices and higher costs have acted as a headwind to that [E&P] sector so far this year." It makes sense then that the refining sector is outperforming, but Calio also believes the upstream will also benefit at some point this year.
One upstream play that has worked quite well for Calio is his big call on Cobalt Energy Group (NYSE: CIE), a 100% exploration stock with a market cap of nearly $9 billion. Although the stock has been weak over the past three months, it's still a double from six months ago. When initial data were released in late December on a discovery in Angola, Calio went all in. He's still bullish on the play.
He likes Sunoco Inc. (NYSE: SUN), which is in the midst of a makeover from a refining company to a general partner holding company similar to a Kinder Morgan Energy Partners L.P. (NYSE: KMP) type of play. A new chief executive officer came in to divest refining assets, and by year end the company will be a true midstream entity paying distributions to shareholders, although it will still own its marketing businesses.
He is also recommending integrated oil company Hess Corp (NYSE: HES), which will trade with the underlying commodity price, that being Brent crude. He calls it a "GARPy (growth at a reasonable price)" story. "The company has significantly underperformed majors over the last 12 months," he says. "A lot of things really went wrong, but we think all those things will improve going forward." Calio is looking for a growth rate approaching 10% next year. "When things get better," he says, "we think it makes sense to buy."
I'm always interested in smaller stocks where there are possibilities for bigger returns, and to that end Calio follows E&P company Bonanza Creek Energy Inc. (NYSE: BCEI) which has a recent market cap of only $766 million. "We really like it," he says. "It came into the market at a cheap price and made a lot of operational momentum through the core on the Niobrara shale formation." He says success depends on how this play develops.
Asked for a downstream pick, "In refining, I like HollyFrontier Corp. (NYSE: HFC)," he says. "Its earnings achievability for the full year is the best among all the refiners. It's essentially paying a special dividend on a quarterly basis that we believe is sustainable, based on projected cash flow for the next five years." Calio calls HollyFrontier a pure play on the price per barrel differential between Western Canadian Select (WCS) and WTI.
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