Why This Refining Stock Could See Further Gains: Valero Energy Corporation (VLO), HollyFrontier Corp (HFC), Western Refining, Inc. (WNR)

The U.S. Gulf Coast is about to be inundated with oil. But not foreign oil, as was often the case in the past. I’m talking about light, sweet crude oil produced right here in America. The reason?

A number of pipeline projects — some already in service and others expected to come on line this year — will provide a substantial boost to takeaway capacity from the Eagle Ford and the Permian Basin, both major oil plays located in Texas. When the crude oil deluge hits the Gulf Coast, analysts expect the regional benchmark price — Louisiana Light Sweet, or LLS — to fall substantially.

Valero Energy Corporation (NYSE:VLO)At the same time, the expansion of the Seaway pipeline and the start-up of the Keystone XL Gulf Coast extension project are expected to lead to a narrower spread between the main domestic oil benchmark — West Texas Intermediate, or WTI) — and the global crude oil benchmark, Brent.

These are both major changes with some major implications for different refiners. Let’s first look at the broad impacts on mid-continent and Gulf Coast refiners and then examine one refining stock that appears best positioned to capitalize on these trends.

Impact on mid-continent refiners
Over the past couple of years, mid-continent refiners with access to cheap WTI have enjoyed remarkable profits and soaring stock prices. As a whole, their net operating margins averaged $18.59 last year, significantly higher than margins in 2011.

For instance, HollyFrontier Corp (NYSE:HFC), which operates five refining facilities in the mid-continent, southwestern, and Rocky Mountain regions, benefited tremendously from its access to crude oil flowing from North Dakota’s Bakken shale and Texas’ Permian Basin. In the fourth quarter, the company’s overall refining margins jumped to $24 a barrel, up from $15.32 a barrel in the year-earlier  period.

This favorable refining environment, along with an increase in production, contributed to the company’s record 2012 earnings. In the fourth quarter, HollyFrontier Corp (NYSE:HFC) posted a profit of $391.6 million, or $1.92 a share, representing a whopping 75% increase over the year-earlier period.

Similarly, Western Refining, Inc. (NYSE:WNR), a company that struggled for years with heavy debt and poor refining margins, has also reaped the rewards stemming from its highly advantageous geographic position. The company’s 128,000-barrel-per-day refinery in El Paso, Texas, has capitalized on cheap crude flowing from the nearby Permian Basin, which has boosted overall margins and allowed the company to reduce its debt load and even raise its dividend.

Going forward, however, if the spread between Western Refining, Inc. (NYSE:WNR) and Brent narrows significantly, it would lead to weaker refining margins for these companies. But for reasons I discussed in a separate article, I think there’s a good chance that this is unlikely and that the WTI-Brent spread will remain wide throughout the year.

Impact on Gulf Coast refiners
On the other hand, I’m more convinced that LLS prices will fall, which would be good news for Gulf Coast refiners. Analysts at Tudor Pickering, an integrated energy investment and merchant bank, summed it up well in a note released earlier this year:

“The early stages of the U.S. crude supply renaissance benefited a minority of U.S. refining capacity in the middle portion of the U.S. … However, midstream bottleneck alleviation is quickly bringing this crude to the coasts, particularly the Gulf Coast, where 9 million b/d of capacity awaits.”