Description

Thesis

North American crude supply is increasing at a rapid rate.  What once became a benefit for landlocked Central US refiners is now repeating itself now in the US Gulf Coast.  The alternative routes are thin, and the resulting crude spreads are large.   We think the market has reached a point of saturation in the Gulf Coast and will result in structural discounts that will be enjoyed by Gulf Coast refiners, like VLO.

Recent History on Crude Spreads

Crude spreads develop as regions become oversupplied, which show up in inventories.  In 2011, crude inventories in Cushing, OK started reaching levels that tested out the maximum capacity of the system.  This led to massive crude spreads relative to the Gulf Coast (well above the cost of trucking crude oil).  As the new pipelines came online in April 2013 to send crude down to the Gulf Coast, the inventories dropped sharply, leading to narrower crude spreads.  Overall PADD 3 (South Central US) inventories this summer were normal, which is why LLS (Gulf Coast oil marker) traded at a premium to Brent and WTI (Cushing oil marker in Oklahoma) almost reached parity.  Inventories rebuilt counter-seasonally starting in October (evident in the EIA Inventory data...inventories were 10% higher in Oct-Dec 2013 vs the previous 6 years), however Cushing was not the majority of that build, which indicates the Gulf Coast was building inventories quickly.  Eventually the saturated Gulf Coast started backing crude back into Cushing again (which is when Cushing inventories started increasing again). 

Crude Oversupply

The crude market has grown nearly 1MMBbl/d in North America over the past few years.  As the refining system has absorbed this crude, we are starting to add more domestic light oil supply than the Mid-Continent and Gulf Coast refiners can handle.  On the Gulf Coast specifically, we have seen the market go from a light oil import market to a saturated market in the last 4 months.  Crude supply is increasing 200-300KBbl/d per quarter, yet the Gulf Coast has no more capacity to handle these crudes unless they become more advantaged than the cheaper sour and heavier crudes they currently process.  Therefore, the price for light oils has to be incentivized to move to the West and East Coasts through barge/boat/rail.  Ship movements are limited due to the Jones act and refining configuration changes take time and money (while the sour and heavier crudes are trying to compete as well).  Tanker and barge capacity is limited, so rail will have to be incentivized out of the region, which the Bakken will set the discount for the Gulf Coast relative to the East Coast (it costs $14-17/bbl to rail transport into the more marginal East Coast refineries while pipe to the Gulf is $9/bbl, leaving a good $5-8/bbl Brent-LLS spread).  We can see that Middle East prices into the Gulf Coast are competitive with the local discounts, while they continue to price in to Europe and Asia with the Brent world marker.

Crack Spreads

The impact on crack spreads (proxy for refining margins) is significant.  During November and December 2013, the LLS crack spreads look pretty close to summer levels (summer is usually the highest margins due to summer driving demand), yet, in Europe (Brent), those spreads are at the seasonal low, but entered those lows earlier than usual (September).  The Gulf Coast refineries are processing cheap domestic crudes and undercutting international refineries in key refined product import regions (Latin America and Africa).

If we recut the crack spread data to separate the amount US refiners are earning from discounted crude spreads versus refining margins, the statistics are shocking (wish we could paste in charts).  Refiners in US are earning the same amount as they would in the summer, but they are earning basically nothing on the refining margin, all the earnings is based on the LLS crude differential.  As a whole, zero refining crack spreads cannot be sustainable worldwide, otherwise refineries who don’t earn a crude spread margin will have to shut down very soon (over the last 5 year history it is unusual to have zero refining margins for a sustainable period of time). 

Earnings Possibilities

Tying all this together, we can currently assume crude production will continue to grow and the Gulf Coast will not have enough capacity to handle the crude quite soon (clearly evident again now), but even after the 2Q14 when maintenance turnarounds (which increase available crude supply) are done and incremental production hits the gulf coast (along with additional pipelines).  Running the numbers, even with a poor refining market (Bear case is a shut down the rest of the refining world scenario), the low case I can see with a $5 Brent-LLS spread is $5 of EPS for VLO (which is near the current 2014 consensus of $5.53).  Otherwise, estimates are well above $7 (assuming a 2013 type worldwide refining margin market and $5/bbl Brent-LLS spreads) with a good shot of hitting $10 ($10/bbl Brent-LLS spreads with a 2013 type worldwide refining margin market) like how a few analysts predict (the 4Q13 pre-announcement is a pre-cursor to how this plays out).  A big change to everyone's model is the impact Brent-LLS is having on the heavier and sour grades (both are pricing down with LLS instead of pricing off world markers).  With a 5x EV/EBITDA multiple, the stock will most likely trade around $70 with a bullish upside case of $91 depending on what they do with the cash. 

Note, $10 Brent-LLS spread is no magic number, could it be much larger?  Yes, this is what we saw with Brent-WTI ($20-30 spreads don’t anchor down to any transportation method, including trucking).  Remember, crude spreads can’t come in too much with a bear case refining scenario, otherwise available US crude will begin to build again.

Crude Exports

There is a lot of talk on crude exports.  The US currently does not allow crude exports aside from select movements to Canada.  It is not inconceivable (especially with all the rhetoric) to see this overturned, but the two questions are 1) timing, 2) what differential would the US level off at?  I argue that timing is challenging during the Obama administration (let alone this election year for Congress) unless we have massive differentials ($20-30/bbl).  Oil companies earning $90 oil while the world is at $100 is not going to gain a lot of sympathy with the Democratic controlled Senate.  But more importantly, if exports are allowed, where will they go?  Trade flows will have to increase and the most likely home will be Asia, which is at least a $5/bbl ride from here using relatively depressed tanker rates (Latin America, Africa and the Middle East export crude, while Europe imports a lot from the Middle East into the Mediterranean/North Africa and more importantly Russia/CIS), which should support the Brent-LLS spread for the US.  Optically any talk of reversing this is not good for refiners, but these stocks aren't priced for monster differentials either.

Catalyst