Are Oil Refiners a Dangerous Investment Right Now?

Compared to the international benchmark -- Brent crude oil -- cheap U.S. oil was a boon for refiners for many quarters. As their input costs remained low, their refined products, such as gasoline and diesel, realized international prices. This resulted in much wider profit margins than international peers, and as profitability surged, so did the stock prices of high-quality refiners like Phillips 66 and Marathon Petroleum .

Unfortunately, as the saying goes, all good things must end. That's exactly what happened when domestic oil prices began climbing. As crude touches $110 per barrel, the strong margins refiners have enjoyed for so long are narrowing, and it's having a decidedly negative effect on their results. In that light, how wary should investors be of refiners' prospects going forward?

Pain across the board
Phillips 66 more than doubled in share price after being spun-off from energy giant ConocoPhillips back in June 2012, then declined to its current level of $57 per share.

Sluggish underlying performance effectively put a halt to the stock's upward momentum.  The company's second-quarter adjusted earnings fell by one-third, and the clear culprit was the company's refining segment. Second-quarter refining earnings dropped by nearly half, especially significant since refining represents the company's biggest segment.

Importantly, Phillips 66 showed weakness not just in refining but in the company's other segments, meaning there was nowhere for Phillips 66 to hide during the quarter. Adjusted earnings from the chemicals segment dropped by a quarter year-over-year, largely due to unplanned power outages and downtime, which resulted in lower production and sales volumes for ethylene and polyethylene. For investors, these issues are unlikely to occur each quarter, so the chemical segments results should see a boost in subsequent quarters if these issues are properly addressed. 

At the same time, Marathon Petroleum has endured an equally rough ride as Phillips 66. For its part, Marathon Petroleum skyrocketed from $63 per share all the way to $90 per share in just a couple of months before giving back a considerable portion of those gains. Presently, shares exchange hands for $73 per share.

Its own second-quarter adjusted earnings clocked in at $1.95 per diluted share, compared with $2.53 in per-share diluted EPS the same period one year ago. That represents a 23% drop year-over-year.

Management fully acknowledged narrowing margins as the primary culprit for its lackluster performance. Marathon Petroleum realized a gross margin of $11.13 per barrel in the second quarter of 2012, which fell to $6.18 per barrel in the current quarter.

A refuge for skittish investors
Those who aren't willing to wait for the dust to settle within the refining space could consider ConocoPhillips. The former parent company of Phillips 66 is now immune to poor refining results, and its heftier dividend yield and more stable performance may be attractive to risk-averse investors.

ConocoPhillips yields in excess of 4.2% at recent prices and reported strong first-quarter operating results. The company realized 3% growth in adjusted earnings per share through the first three months of the year. Moreover, it directs investors to the progress being made on several of its growth priorities, including two significant oil discoveries in the Gulf of Mexico.

Don't let poor short-term results scare you away
For investors who simply don't want to take the risk of refiners' results deteriorating further but still want exposure to the oil space, they could opt for a stock like ConocoPhillips.

At the same time, since oil prices can be volatile and it's extremely difficult to anticipate future price direction, it's likely the poor refining environment is a short-term issue. Phillips 66 and Marathon Petroleum are high-quality businesses and are likely to remain resilient.

As an added dose of confidence, both Phillips 66 and Marathon Petroleum increased their dividends earlier this year by 25% and 20%, respectively. Their strong commitment to returning cash to shareholders serves as a meaningful margin of safety. Management teams of these refiners are clearly bullish on the long-term prospects for their companies, and investors should be as well.

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