A Golden Age for U.S. Oil Refiners

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So the argument we're basically making is this isn't the golden age of refining as we knew and loved it in 2003 when we made that call. That was a kind of a 3-year, 4-year period of elevated refining margins, but it ultimately was killed by the financial collapse in 2009. This time around, we think this could be more enduring, and it's largely because of natural gas.

Hello and welcome to the Barron's StreetWise Podcast. I'm Jack Howe, and the voice you just heard is Doug Leggate. He runs US oil and gas coverage at BofA Global Research, and he says natural gas could hold the key to sending shares of U.S. companies that turn oil into gasoline much higher. We'll learn all about that in a moment, and we'll hear from Denton Cinquegrana, the Chief Oil Analyst at the Oil Price Information Service, or OPIS, about why gasoline prices could head higher this summer and who is and is not to blame. Listening in is our audio producer Jackson. Hi Jackson.

Hi Jack.

So much to cover this episode. I plan to mention fractional distillation and crack spreads, maybe even flaring. Are you fired up?

I'm pretty stoked. I did not know they'd be flaring.

Well, imagine your luck. Now we talked about oil just a couple of months ago. The focus of that episode was drilling, why U.S. shale producers have been reluctant to ramp up output despite a run-up in the price of crude. This episode will look more closely at oil refining and pump prices for gasoline. Gasoline peaked at a national average of $4.33 a gallon on March 11th, according to AAA. Since then, it's come down by around a dime. One concern about the high prices we're seeing now for commodities like gasoline, natural gas, and grains is that they could force consumers to cut back on spending elsewhere and even trigger a recession. A spike in commodity prices in 1990 did just that, and the rise then was smaller than now as a percentage of consumer spending. But Goldman Sachs thinks we can avoid that fate this time around. It points out that there's a big difference between 1990 and now— wages. Back then, wages weren't growing quickly enough to keep up with commodities. Now they are, and then some. So Goldman expects the U.S. economy to grow by 1.9% this year. It's hardly a rip-roaring expansion, but it's much better than a recession for workers and investors. Okay, on to oil refining. You already know that crude oil can be turned into no end of refined products, including, from lightest to heaviest, propane, gasoline, naphtha, which can be used to make plastics, jet fuel and kerosene, which are pretty much the same, diesel fuel and home heating oil, which are also nearly the same except that home heating oil is red because the IRS requires it to be dyed to show that it's exempt from road tax. Unlike diesel fuel for trucks.

No one ever sees home heating oil. So how do I know you're telling the truth?

It's going to take either trust or a siphon. One of them is messier than the other. Where was I? Okay. Heavier than diesel are industrial fuels, lubricating oils, and bitumen, which is a binder used in paving and roofing. Now, there's a process used to separate crude oil into these things., and it's similar to how booze is made. Maybe you've seen an old TV show called M*A*S*H where two of the military doctors, Hawkeye Pierce and Trapper John McIntyre, made gin in their tent using a still. Swill gin? Sir, I have sipped, lapped, and taken gin intravenously, but I have never swilled. Still is short for distillery, and fractional distillation is the process of separating a mixture into its component parts. If you make a slurry from grapes or grains and then you add yeast to turn some of the sugar into alcohol, you haven't distilled anything. You've made wine or beer using fermentation. But if you then put your wine into a still and heat it to give off a vapor, and elsewhere in the still you cool the vapor to condense it back into a liquid, and you end up with a beverage with a much higher concentration of alcohol, you've distilled. You've made brandy. If you distill your homemade beer or other starchy mixture into fairly pure alcohol that you can dilute with water, you've made vodka. If you mix in botanicals, especially juniper berries, and distill it again, you're making gin. And if you distill beer and then age it in a barrel until the color darkens from contact with the wood, You've made whiskey.

Is this still an investing podcast?

An oil refinery is basically a giant still. You heat crude oil to create vapor and then separate the vapor elsewhere into liquids of various weights. There's more processing involved, especially for the heaviest liquids, but that's enough from me on moonshine and refineries. Let's hear from an expert on refining. Although I bet he could make a mean whiskey if he wanted to. Hey, Doug, how are you?

Good to hear from you.

What's going on? That's Doug Leggate. He's the head of US oil and gas coverage at BofA Global Research, part of Bank of America. Regular listeners might recall that we just heard from Doug a couple of months ago, so it's soon for me to bother him again. But there's a lot going on with oil now, and it's Doug's fault, really, for publishing a report on the refining industry that grabbed my attention. The industry is on the cusp of a golden era of profitability, he says, and it has a lot to do with natural gas. Now, natural gas is made up of methane and so-called natural gas liquids, including ethane, propane, and butane, and it comes from some of the same wells that produce oil. Gas is more difficult to transport than oil, which is why Some drillers flare it. They literally burn it. That's why you sometimes see long vertical pipes with open flames at oil wells. Flaring is wasteful and not great for the environment, but it's less destructive than releasing methane into the air, which, by the way, the industry also seems to do a lot of. A new study from Stanford University estimates that methane leaks from pipelines and wells in New Mexico's Permian Basin are equal to 9.4% of total production. That is much higher than the Environmental Protection Agency's estimate of 1.4%. It's a high enough number to suggest that gas takes a heavier environmental toll than coal, even though it burns cleaner. If the study has good news, it's that a small number of companies seem to be doing a lot of the leaking, so maybe the problem is addressable. Anyhow, just know that natural gas is a pain in the neck to transport, which will come up later. Doug says natural gas plays two key roles in refining crude oil. The first is simple: to generate heat.

You know, a refinery column, the distillation tower, is just a big boiler, basically, and you need heat for that. Now, generally speaking, you can start up the refinery. Once it gets up and running, you're going to have its own fuel sources. So basically, the light ends that boil off the top of the refinery are fuel gases. So you— to some extent, the refinery is always going to be a little bit self-sufficient in that regard. So natural gas's initial role there is a makeup gas for the incremental energy that the refinery can't produce on its own.

So refiners purchase natural gas to supplement the fuel gases they produce in order to make the heat their distillation towers need. Now, the other use for natural gas is just a little more complicated.

As you process the heavier crudes off the bottom of the distillation tower, you get all this heavy stuff, this molasses-type stuff. And that needs to be broken down. And the way— those are long-chain hydrocarbons, as they call them. They break those down with hydrogen. Well, where do you get the hydrogen from? Well, you've got two options. You can either buy it from someone like Air Products or Linde or something like that. Or you can produce it yourself by a steam methane cracker. So basically you're taking natural gas methane and you're breaking it down and you're basically producing CO2 on the one hand and hydrogen on the other hand.

Does that make sense? To turn the sludgy stuff into something more useful, you have to treat it with hydrogen. And one cost-effective way to get hydrogen is to separate it from natural gas, because natural gas, like oil, is a hydrocarbon, which means two things it has a lot of are hydrogen and carbon. The demand for this type of processing has soared lately because sludgy fuel used to be used in ships, but now there's a new rule that slashes the amount of sulfur allowed in shipping fuel, so it needs more processing with hydrogen, which means refiners need more natural gas.

And rule of thumb, somewhere between 0.2 And 0.3 thousand cubic feet per barrel is the consumption of the aggregate refinery. It doesn't matter where that refinery is located, whether it's in the US or whether it's in Europe or Asia, it needs natural gas to a certain extent.

Okay. Now hold that thought. Gasoline prices are high at the moment, but that on its own doesn't tell you whether it's a lucrative time for refiners. Oil prices are up too. Turning expensive oil into expensive gasoline isn't necessarily more attractive than turning cheap oil into cheap gasoline. There are a few price differentials or spreads that matter. The most important of these is called the crack spread, and it's the difference between the price of refined products and the price of crude oil. The gasoline crack spread collapsed to close to zero during the pandemic when roads emptied. That means that refiners were losing money after paying costs beyond the price of oil. Some of them reduced capacity to save money, and now demand has bounced back and supplies are tight, so crack spreads are exceptionally wide. There are other factors that can give U.S. refiners an edge in the world market. Some U.S. refiners have upgraded to sophisticated equipment that can process heavy sour crude oil, which tends to be cheaper than light sweet crude. Also, sometimes American crude oil is cheaper than comparable oil sold in Europe. It's only a little cheaper now. Doug's point is that there's another price spread that we should start to talk about when discussing the profitability of refiners. U.S. natural gas recently sold for $5.50 per MMBTU, or million British thermal units. It's a measure of heating potential. An equivalent amount of one key benchmark gas in Europe recently sold for around $36, a premium of more than $30 over the US. Natural gas prices in the US have more than doubled over the past year, but those in Europe have multiplied more than 5 times. Why? Europe gets 40% of its natural gas from Russia, and that supply, of course, has been disrupted. So have supplies of oil, but it's much easier for Europe to find new oil than new gas because, as I said earlier, gas is a pain to transport. You have to build pipelines, and if you want to export it overseas, you have to build terminals that can convert it to liquid for shipping, and that can take years. The bottom line is that the price differential on natural gas could be slow to change. Right now, it gives U.S. refiners an incredible $9 per barrel cost advantage. Their typical long-run cash margin is only about $5 per barrel. And even if we assume that European natural gas by the end of the decade is only $5 more expensive than American gas, that would still give American refiners an advantage of $1.50 a barrel. Which is like raising their typical cash margin by 30%. Here's Doug.

If this gas, this critical source of operating cost for a refinery regardless of where it's located, has moved to a structural premium in Europe, well, it's a global market for refined products. If refinery margin is going to have to move to cover that, which is a windfall for U.S. refiners, it basically resets the mid-cycle earnings power and free cash flow of U.S. refiners.

The U.S., you would think, would stand to export more refined products to Europe given its cost advantage. And that's possible, but Europe also exports some refined products to the U.S. now. If its refineries can't cover their costs, some might have to close. And if that happens, Europe would have to cut its exports of refined products to the U.S., which would leave the U.S. market tighter which would also benefit U.S. refiners. Now, as a result of all of this, earnings for U.S. refiners have jumped, but the shares trade cheaply relative to those earnings, probably because investors think this will be just another short-lived boom. But if Doug is right and U.S. refiners enjoy a long new golden age, their shares could trade higher. Doug has buy ratings on several of them, His favorite is Valero, ticker VLO, which he thinks will hit $135 a share within a year, or about 40% above its recent price. I think of price targets like that as being more of a qualitative than quantitative signal because near-term investor behavior is difficult to predict with any precision. But basically, Doug sees Valero as being significantly underpriced, and the same is true of Marathon Petroleum, MPC, Phillips 66, that's PSX, and HF Sinclair, that's DINO. We'll see. One last thing. I asked Doug, why were gasoline prices so slow to come down once oil prices started falling? Were refiners just being greedy? He says it's more complicated than that. Imagine you're Valero and you have the infrastructure to process heavy Russian crude. But you're watching the war in Ukraine and you make a sudden decision to stop buying from Russia. You cancel a VLCC. That's a type of ship. It stands for very large crude carrier. Very large as in 2 million barrels. Then you call a trader like Trafigura. Here's Doug.

So they go to Trafigura and say, okay, we've just given up 2 million barrels on a VLCC from Russia. We need to get 2 million barrels PDQ. Where are we going to get it from? So Trafigura says, well, we've got a cargo going from West Africa to Brazil. We'll sell that to you, but it's going to cost you $20 more. So there's a scramble for supply to backfill the decision you made to not take Russia crude. And you get a spike in oil prices. The critical thing, however, is that's transitory, we think. Because on a 4 to 6 week view, those contracts are going to be reset. So now you're buying your crude from West Africa. You're not having to scramble to pay the massive premiums. So our belief is that this spike in oil prices is a little bit of a transitory situation that's probably going to settle down on a 4 to 6 week kind of view, which is what we're actually starting to see now, oil back in the low hundreds.

Thank you, Doug. Let's turn our attention to what's next for gasoline prices at the pump. That's coming up after this quick break.

Data is everywhere, but is it ready for consumption? Morningstar developed the language of global investment data so you have the right ingredients to help you shine. Morningstar, where data speaks.

Welcome back, Jackson. I know there was a whirlwind of technical details earlier, but this part will be more straightforward.

Does that mean no more MM-Bootus?

You've got it. To learn more about how gasoline prices respond to changes in oil prices, I reached out to someone who studies prices for a living.

Denton Cicogrona, I'm the chief oil analyst at OPIS. Which is now a Dow Jones company in what, 2.5, 3 weeks? It's been an awesome ride so far.

Welcome to the family, by the way. As Denton says, his employer, OPIS, which stands for Oil Price Information Service, was recently bought by my employer, Dow Jones, the publisher of Barron's and The Wall Street Journal and MarketWatch. I asked Denton, why does it seem like gasoline prices are slower to fall than they are to rise?

Now granted, yes, we are seeing the whole rocket and feather theory come to life, but a lot of it has to do with timing. So, Jack, say you and I own competing gas stations across the street. I may be terrible at timing my purchases, or at least this time around I was. So I paid $3.50 a gallon delivered, etc. I got to make sure, you know, I still have my margin, all that. But you paid $3.25, you paid $0.25, you have that much more margin. Unless I move my price, you know, you're gonna like, well, I'll stick right here where my competitor is, or maybe be a penny or two lower because I could absorb that. So now I'm going to start moving my price down.

For gasoline prices to fall quickly where you live, it helps to have high-volume stations.

Unless you have a low-price leader, places like Wawas and Kwik Checks, they're going to be the ones who move first. And because they turn over their tanks so often, They may, instead of getting a delivery once every 3, 3.5, 4 days, they're getting them once a day, sometimes even twice a day during high demand periods. So they'll be turning those tanks over and obviously taking advantage of some of the lower prices where maybe the mom-and-pop station that doesn't necessarily turn over as quick is still stuck with that gasoline that costs them $3.50, $3.60, $3.75 on the wholesale level.

By the way, New Jersey, where Denton lives, has had a ban for 73 years on letting drivers pump their own gas. There's an effort underway to lift that ban, but just this past week, the state Senate president said he opposes it, so it might be dead. He says that self-serve gas wouldn't save drivers money and that polls show that drivers don't want it. His opponents say that voters want a choice. Denton points out that gas is more expensive in neighboring New York and Pennsylvania, even though both have self-serve. The price difference, he says, comes down to taxes. Okay, back to national prices. Denton says if you think gasoline is high, take a look at diesel, and we'll all feel the effects of high diesel prices whether we drive diesel vehicles or not.

Diesel prices are just astronomical right now, over $5 a gallon on average. And when you think about it, whether it's buying eggs in the grocery store, whether it's ordering a pair of Air Jordans off of Nike, you know, all that stuff gets to you via diesel. And if diesel prices are higher, you're going to see trucking companies issue fuel surcharges that are ultimately going to be passed along to the consumers.

One reason diesel has gotten so high is that it never really fell off like gasoline and jet fuel during the pandemic because while we weren't driving or flying, we were still ordering plenty of goods from Amazon that were delivered by trucks. I asked Denton where he thinks prices are headed. For gasoline, the national average was recently just under $4.30 and Denton says he wouldn't be surprised if it has a brush with $5 a gallon this summer, in part because prices tend to rise in summer as people drive more. But he also thinks prices could settle back down below $4 by the end of the year if more production comes online and if things don't get worse geopolitically, and if there aren't any hurricanes that knock out refinery capacity. But again, Denton says that if prices do rise this summer, we shouldn't blame the owners of our local gas stations.

Don't curse out the guy you're buying gas from. He's barely making a penny on it. When the price of oil was dropping, sure, he recovered some of that margin. But chances are the guy on the— that you're buying the gas from on the corner is not making a killing and not gouging you.

Thank you, Doug and Denton, and thank all of you for listening. Jackson Cantrella is our producer. If you need kilowatt hours converted into Mmbutos, he's your guy. Subscribe to the podcast. If you listen on Apple, write us a review. And to complete this spiritual journey, you can follow me on Twitter. That's @JackHough.

H-O-U-G-H.

It's cheaper than ayahuasca.

See you next week.

Data is everywhere. When orchestrated properly, it sings. At Morningstar, we analyze and enrich data, making it actionable and powerful for you. Morningstar, where data speaks.