Thanks to the rapid development of pipeline infrastructure, refineries now have better access to West Texas Intermediate (WTI) crude-oil feed. This, in turn, has caused a spike in WTI crude demand. The oil is also relatively easier to refine, which altogether has sent prices soaring. Over the last year, WTI spot prices have risen by nearly 16%, while Brent crude prices have remained flat.
As a result, WTI-Brent spreads have narrowed to $0.20 per barrel from $23 per barrel in February. So naturally, domestic oil (WTI) producers are enjoying fat margins with higher volumes. But the narrowing WTI-Brent spread has also stressed the profitability of U.S refineries. These refiners buy low-cost WTI, and sell the refined products at global benchmark prices set by Brent crude. So U.S refineries stay profitable as long there is a significant pricing differential between WTI and Brent crude.
However, Morgan Stanley estimates that the WTI-Brent spread can widen up to $12 per barrel by the end of 2013. Analysts at the firm believe that the demand for WTI crude is saturated, and its oversupply (caused by excessive pipeline capacity) should lead to a 10% to 15% crash in WTI crude prices. Even Goldman Sachs estimates that the spread could widen beyond $10. So if these estimates hold ground, it is highly probable that U.S refineries could start rallying again.
So here are a few refining companies that appear to offer the most upside.
Profiting from the spin-off
When it comes to the refining sector, it's hard to miss Valero Energy Corporation (NYSE:VLO). It operates with 16 refineries across the U.S, Canada and the U.K, with a combined refining capacity of 2.8 million barrels per day. The oil and gas behemoth recently spun off its CST Brands (retail division), after which it generates almost all of its income from refining activities.
While this spin-off will shrink its revenue, it will also allow Valero Energy Corporation (NYSE:VLO) to perform inline with the improving WTI/Brent spread. And since Valero Energy Corporation (NYSE:VLO)’s refining capacity in North America accounts for more than 85% of its total processing capacity, it appears to be one of the prime beneficiaries from the widening spread. This favorable geographical mix coupled with value that's unlocking from its spin-off suggest that Valero Energy Corporation (NYSE:VLO) has more upside potential with less downside risks.
Most undervalued refiner
Another major U.S refiner is Tesoro Corporation (NYSE:TSO). It operates with seven refineries in the U.S, which altogether have throughput capacity of 845,000 barrels per day. Besides that, Tesoro Corporation (NYSE:TSO) also owns 2,200 retail gas stations, which diversifies its business operations. But since the company generates 92% of its revenue from refining operations, its financial performance is basically dependent on the movement in the WTI-Brent spread.
Tesoro Corporation (NYSE:TSO) recently acquired BP’s Carson refinery in California, which increased its total refining capacity by nearly 30%. Thanks to this major positive, most investment research firms including Barclays, Oppenheimer, UBS and Deutsche Bank now have an outperform rating on the refiner. And with a forward P/E of just 8.2x, Credit Suisse believes that Tesoro Corporation (NYSE:TSO) is one of the most undervalued petroleum companies with respect to its growth prospects. Since analysts estimate its FY 2014 EPS to grow by 30%, investors looking to invest in the petroleum industry should definitely consider Tesoro Corporation (NYSE:TSO).