by Travis Johnson, Stock Gumshoe | October 14, 2011 10:33 am
This article originally was restricted to the Stock Gumshoe Irregulars when published in October, but was opened up to public readership on December 2, 2011. The article was not revised, but author disclosure remains the same (I don’t own any of the stocks mentioned).
We’re right at mid-month today, which would ordinarily be the time when I’m finishing up the “Idea of the Month” article for the Irregulars (that’s you) and sending it out. But this month, we’re pushing back the schedule a bit — because I’m heading out to the Value Investing Congress early next week and I’d like to share my favorite idea from that conference with you as my “idea of the month” for October.
So look for that next Friday, and I’m also hoping to post some special notes on Monday and Tuesday while I’m at the conference — you’ll probably see the Wall Street Journal headlines from whatever Bill Ackman and David Einhorn say in their presentations (as with Einhorn’s takedown of St. Joe last year, the speakers at this event often move stocks significantly), but I hope to provide some of the quieter details if a few other interesting ideas are presented (and they almost always are). Stay tuned.
Today, then, we’ll look at a teaser for the meat of our Friday File — this time, it’s one that many of you have been asking about, from the Money Map folks about a “glitch” in the price of oil. This comes in as a “special report” teaser that they’re using to try to get subscribers to Money Map Report, so it’s not for Kent Moors’ Energy Advantage newsletter (which Money Map also publishes), though it sounds like an idea that may have come from him. Here’s how the ad gets our motors running:
“There’s a multi-billion-dollar deal going down in the U.S. oil markets.
“It involves a glitch in the price of oil… a glitch so big, you could drive a semi rig through it.
“Secretary of State Hillary Clinton recently said ‘We are leaving no stone unturned,’ when it comes to ‘fixing’ this glitch. Yet, as you’ll see, fixing this glitch is a pipe dream.
“And for once, we’re looking at a big oil situation that doesn’t benefit ExxonMobil, BP or ConocoPhillips.
“They can’t do a thing about this glitch either, as much as they’d like to.”
Huh? What does the Secretary of State have to do with an “oil glitch?” We’ll get into that — but then they get into the hinting about the stock that will benefit from whatever this glitch might be:
“Thanks to this market anomaly, one small, independent refinery in New Mexico stands to rake in enormous profits, estimated at $6.7 billion over the next 24 to 36 months alone. That’s a lot of money for a small company with a market cap just over 1.5 billion dollars.
“Yet the small New Mexico refinery is not the only one sitting in the catbird seat…
“For investors, this is the chance – finally – the chance for the little guy to come out on the long side of a big oil deal.”
If there’s a company that’s going to make $6.7 billion in profits over three years but trades at just a $1.5 billion market cap, I WANT IN. If that were annualized and we’re assuming the earnings are split evenly among those years, that’s a forward PE ratio of 0.67. You don’t see PE ratios with a decimal in front of them, not even for fraudulent Chinese shell companies who make up their earnings (you need your invented earnings to sound feasible, after all).
Don’t get too excited, though — that’s a ridiculous number, so there must be some kind of catch. We’ll get into it in a minute.
So what’s the story with this refinery, and why on earth would a capital-intensive, highly-regulated, historically tough business like refining be so profitable?
“Thanks to this unusual price glitch, this tiny refinery can buy oil at perhaps the lowest price in the world.
“And according to our research, this refinery stands to rake in billions in profits… regardless of whether oil prices rise or fall… regardless of mild or severe winters… regardless of politics, OPEC, and just about anything else.
“JPMorgan Chase recently said ‘it will take a couple of years before we finally get [this glitch] cleared.’ International investment consultancy Société Générale added that ‘this trend is likely to continue.'”
The big issue? The spread between WTI crude and Brent crude — that is, the price spread between the historical benchmark US oil price, West Texas Intermediate, set for delivery at the pipeline crossroads of Cushing, Oklahoma; and the more global, European-set price of Brent crude, historically based on production from the North Sea but now the most frequently used standard benchmark for seaborne oil that’s traded internationally.
And while those two standard benchmarks (there are a couple others, too) have typically traded at pretty close prices to each other — which makes sense, given their similar makeup and the global nature of the oil markets — they have diverged and created a “market anomaly” this year.
As the ad puts it…
“Brent crude is going for up to 25% MORE than WTI.
“That’s a wildly different price for virtually identical raw materials.
“How is it possible that the price for the same commodity could get so out of whack?
“‘Trapped Assets’ Provide Huge Opportunity
“Quite simply, there’s a GIGANTIC crude glut in certain areas of the interior United States.
“It’s a flood so huge, that if a barrel of Brent costs $100 on the shores of Galveston, you’ll pay only about $75 for a barrel of WTI in parts of land-locked New Mexico.
“Economists call this unusual condition ‘Trapped Assets’…
“But you can just call it “a life-changing opportunity.”
“You see, it doesn’t matter whether a refinery paid a full $100 for Brent, or just $75 for WTI…
“It still charges the same price for the gasoline, diesel, and heating oil it produces from that crude!”
Or, in a little quote from the Wall Street Journal that makes this “glitch” a bit clearer:
“WTI’s discount has been a boon to the refiners that can get the crude, because the price of gasoline and other fuels that refiners sell has kept pace with more expensive Brent crude.”
So that’s our glitch: some refiners can buy crude oil much cheaper than others, and they can sell refined gasoline at the same price, which should mean that they’re reaping much fatter profit margins.
And, you guessed it, the Money Map Report folks are teasing us that they’ve got the refiner picked that you should buy — if you’ll just pitch in with your subscription bucks to get their “NUCA Oil Jackpot” special recommendation.
So which one is it? Here are some more clues from him — and a second “glitch” that he says will ramp up their profits even more:
“For the small refiner I’ve been telling you about, this price glitch has already led to record profits.
“Last quarter, net income grew a mind-boggling 595% over the previous year…
“… there’s a hidden ‘wild card’ in this glitch. Few, if any, know it exists. Yet it’s a game changer that stands to ramp up profits even more….
“In fact, our research estimates that it’s worth hundreds of millions in additional profits every single year to this company – and big money for investors.
“So what is this ‘wild card,’ this ‘game changer?’ …
“… it’s the ‘ease’ of transportation that gives this company additional billions.
“You see, this refinery sits near the bordering corners of New Mexico, Utah, Colorado and Arizona (we call it the ‘NUCA Junction’).
“And it’s the ONLY active refinery within 350 miles.
“Better yet, it processes only cheap WTI crude straight from the NUCA Junction area itself.”
And yes, in case those four states don’t sound familiar this “NUCA Junction area” is known to pretty much everyone else in the world as the “Four Corners” — the actual border hosts a monument, a tiny spot otherwise in the middle of nowhere, and is the only place in the country where you can stand in four states at the same time. Much of the region (southwestern corner of Colorado, northwestern corner of New Mexico, northeastern corner of Arizona and southeastern corner of Utah) is referred to as the Four Corners area, and it’s a rural area that mostly belongs to a few Native American reservations. I don’t think I’ve ever heard of anyone else call it the “NUCA Junction” or touted Four Corners for its economic significance in any way … but it does sound mysterious and exciting, right?
So we’re told that this company will reap billions because it buys local crude (WTI) at the Cushing price and can sell it, with low transportation costs, directly into the closest cities (Albuquerque, Tucson, Phoenix), giving it a big advantage over refiners who are hundreds of miles away and/or have to rely on imported crude priced off of Brent — like industry leader Valero, for example, which has a major refinery 475 miles away.
And what’s the State Department doing in this? The reference to Clinton is because one of the ways that the industry is trying to close the “WTI/Brent Spread” is by better connecting the Canadian tar sands exports to the Gulf refineries by building the massive Keystone XL pipeline.
The teaser ad says that Keystone XL “doesn’t have a snowball’s chance … at least not in our lifetimes,” and that’s part of the reason why they think this competitive advantage for the teased company will persist — personally I have no idea, the pipeline has ignited a firestorm (the ad includes an excerpt from the NY Times editorial against the pipeline from August, which you can see here), and it does come under the State Dept’s purview because it’s an international line (Canada to the US), so that’s where Clinton will come in, with criticism no doubt coming from both sides — the administration has announced that a decision will come by the end of this year.
So what stock are they talking about? Well, in it goes to the Thinkolator, crack those clues, and we get our nicely refined answer out the other side: Western Refining (WNR)
This is one of a relatively small number of “pure play” refinery stocks — most of them are bigger, like giant Valero (VLO) or “still pretty big” Tesoro (TSO) and HollyFrontier (HFC), and pretty much of all of them look cheap right now. WNR may not really be a “small cap,” with a market cap of about $1.5 billion, but it is small for the sector (even if we don’t note that most refining is actually done by the big oil majors, who are certainly not “pure plays” on this part of the midstream business).
And though refining has been a business that rides some really bumpy rails, the stocks do indeed almost all look inexpensive at the moment, with forward PE ratios down between four and six for the most part. WNR, despite the fact that the stock has performed substantially better than most of the refiners this year, is right in that mix with a forward PE of about 5.
WNR’s outperformance this year has largely been because of their margin advantage that has allowed them to recover from a big debt load that they took on for an acquisition a couple years ago near the top of the market — they’ve also been trying to shed or convert assets (turning one of their refineries into a storage terminal, for example), so now they’re basically down to two refineries, both in the Southwest, and they do enjoy a margin advantage thanks to their ability to buy nearby WTI crude and refine it at low cost for markets (particularly Albuquerque and Phoenix) that are somewhat captive to their pipelines and, in the case of Phoenix, their blends. That “captivity” is not guaranteed to persist, but with the cost and difficulty of building new pipelines and revamping refineries to adjust blends it might linger longer than investors expect.
Being relatively small and having just two refineries means they’re not at all diversified for different inputs or outputs, or to mitigate potential problems at one of their refineries, so that’s probably a risk worth considering. But they do seem to be the class of the bunch in terms of profit margins, with those margins likely to remain comparatively good as long as pipeline capacity doesn’t further expose the market in their region to more crude input or other refined product suppliers.
It’s still pretty hard to get to $6.7 billion in three year earnings unless they somehow dramatically ramp up capacity, though — they’ll have sales approaching $10 billion next year, and this last quarter was the first time they had operating margins up over 5% since 2009. They did post a $100 million profit in this last quarter, but it seems more than optimistic to predict that their earnings are going to grow by 500% between now and 2014ish. Current run rate of record earnings in the latest quarter gives them $400 million in profit if you annualize it (that’s fancy analyst-speak for “multiply by four”), which is almost twice what they’ve ever earned in a year before, and getting that to $2 billion+ in profit over the next year or two to reach the “enormous profits, estimated at $6.7 billion over the next 24 to 36 months alone” teaser would mean massive 400%+ earnings growth over just a couple years. I guess it’s possible, but that’s a very bold prediction even if you do appreciate the nice niche advantages they’re enjoying right now.
They still do have quite a bit of debt, but it’s an asset intensive business and that debt doesn’t seem to be a current problem — they have been through some restructuring and are considering what to do with their (currently offline) Virginia refinery in Yorktown, so it’s possible that selling that facility or spinning it off into a MLP will further help Western’s balance sheet (I haven’t checked to see if they’ve made a decision on this yet).
They halted their dividend when things turned South in 2008, but that’s probably not a key part of an investing decision here — some of the refiners pay decent yields of 1-2%, but if you want substantial dividend income from a refining-connected company you’d probably really have to move into a midstream MLP that also owns pipelines and storage, or a big integrated oil company.
And yes, they did post 595% earnings growth year over year (actually 597%), though that was one of those atypical “back from the dead” earnings jumps, not necessarily an indication of more of the same to come. Analysts are projecting $3.47 in earnings for 2011 and $3.25 for 2012, so that’s a forward PE of just over 5 at the current $17 share price. Analysts have a really hard time predicting refinery numbers, it should be noted, since they depend not only on corporate performance but on market factors that have proven to be very volatile, like oil and gas prices, so demand for oil and gas and predictions of possible pipeline-driven competition in their regional markets mean that the average estimate of $3+ for earnings includes guesses of both $1.38 and $5.14 for next year.
If you’d like another look at WNR, one of the analysts at the Motley Fool (Which owns WNR in its corporate portfolio) did a pretty good piece on them over the summer here.
So that’s the latest from the Money Mappers — I like the relatively focused operations of WNR that allow them to enjoy this margin boost currently (and possibly for several years if the WTI/Brent spread remains high), and there’s also the possibility that a larger player could bid for Western Refining or that their restructuring will provide more of a boost than expected. On the other hand, if you’re looking for exposure to the “crack spread” in general (that’s the difference between crude oil and refined product prices, which determines the profitability of refining in broad terms) then you’d probably sleep better with a bigger and more diversified player like Valero or even the larger regional player HollyFrontier (born of the merger of, you guessed it, Holly and Frontier).
I don’t personally own any refining stocks and probably won’t buy any in the near future, but it’s often worth digging in when there’s a company with a margin advantage in an often-unloved industry. If you’ve got an opinion or any insight into refining generally, or Western Refining specifically, we’d love to hear it with a comment below. Thanks!
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