Weak Earnings for Refiners Offer a Buying Opportunity

The famed Rothschild family accumulated a huge fortune through banking and finance. When asked about their secret to achieving such wealth, a descendent reportedly suggested to "buy when there's blood in the streets." While things weren't quite that bad for the refining industry, recent quarterly results were very bleak. Does their poor showing suggest a buying opportunity? Are the shares of refiners like Phillips 66 , Valero Energy , or Tesoro Corp. worth considering? Let's take a look.

A terrible quarter but taking steps to improve
There is no disputing that refiners have had a very tough time recently. Phillips 66 announced quarterly earnings that were down over 70% from a year earlier. The company's diversified business portfolio was the reason it showed any profit at all. It was midstream transportation, chemical, and marketing operations that made up the difference when Phillips' refining segment delivered a $2 million loss.

So it makes sense that the company is looking to grow its non-refining businesses. In Midstream, Phillips is developing a large natural gas liquids processing plant and plans to build a liquefied gas export terminal to take advantage of an abundant U.S. natural gas supply. A world-scale chemical's project, which includes three major producing facilities, is also planned. These plants are aimed at exploiting America's relatively low chemical production costs in a strong product-pricing environment.

Phillips is still highly dependent on the refining business, however. When things are going well, it dwarfs all the others in terms of profit. In last year's third quarter, a propitious time for refiners, the segment supplied virtually all of the company's $1.5 billion in net income. In the first nine months of 2012, over 83% of the $3.4 billion in profits came from refining.

Valero Energy is another refiner that reported disappointing quarterly results. Net income fell around 72% versus the prior year. The company could be considered an industry pure-play after spinning off its retail operations, called CST Brands, to shareholders. After distributing 80 percent of the business in May, Valero said they expect to eliminate any ownership by the end of 2014.

The refiner is currently concentrating on leveraging plentiful North American oil and gas supplies to improve results. Increasing access to less expensive U.S. and Canadian crude oil is a major goal. One successful project was the company's new receiving facility at its Quebec City refinery which will accept the cheaper oil by rail.

Tesoro Corporation, an independent refiner focused on the U.S. West Coast, also reported a noticeable drop in quarterly profits. Its adjusted income from continuing operations declined over 76% year over year. To boost returns, Tesoro is concentrating on increasing refining efficiency. Its goal is to up plant utilization while maintaining lower crude oil feedstock and operating costs.

Rationalizing the company's properties is one way to achieve those efficiencies. In June, Tesoro acquired a major refinery that could be easily integrated with other company properties. The $2.33 billion deal also included supply rights to approximately 835 fuel stations in the western U.S., a region where Tesoro already had great clout. Additionally, the company is getting rid of non-core assets. In September, it sold its entire interest in Tesoro Hawaii, which operated a smaller refinery, for $539 million.

Fundamentals indicate better times may be coming
It's fair to ask, if the refiners are working so hard to improve their businesses, why did they have such a lousy quarter? Refiner results are highly dependent on refining margins, known as the crack spread. These margins are greatly influenced by the discount between light sweet and sour crude oil, usually benchmarked by the price of West Texas Intermediate oil (WTI), and the international oil standard, typically determined by the price of North Sea Brent crude (Brent). Because U.S. refiners use mostly WTI-related oil but generally sell product on a Brent basis, the greater the discount usually means the greater the opportunity for profit. Unfortunately for the industry, the discount fell drastically in the latest quarter.

Tesoro reported that its recent period gross refining profit was generally $9.22 per barrel of oil processed, a noticeable slump from the $19.67 per barrel figure a year earlier. The good news is that the WTI to Brent discount seems to be widening again. It recently reached the widest point in almost seven months, thanks to rising U.S. crude inventories and production problems in Libya.

Higher discounts may also become more common. Increased domestic oil production, in conjunction with less dynamic international performance, will likely pressure WTI pricing and increase the chance for a higher Brent rate. Additional transport from Canadian crude oil sources, like the proposed Keystone pipeline and additional rail capacity, should also increase available U.S. oil supply, which will help to maintain wide spreads. To the potential benefit of refiner bottom-lines.

Final thoughts
Though the refining industry posted some terrible results recently, it looks fundamentally attractive. An increase in the WTI discount to Brent, a key determinant of refining profits, seems a realistic likelihood. In what could be a sign of the stock market's acceptance of the industry's potential, shares of Phillips 66, Valero, and Tesoro were surprisingly resilient in the face of dismal quarterly earnings. Thus, investors may want to view any noticeable weakness in refiner stocks as a possible opportunity to purchase shares at an attractive price.

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The article Weak Earnings for Refiners Offer a Buying Opportunity originally appeared on Fool.com.

Bob Chandler has a long position in Valero Energy and Tesoro Corp. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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