If Russia Situation Worsens, These Energy Stocks Could Surge

With the U.S. and its European allies now getting ready to impose additional sanctions on Russia if the country attempts to disrupt Ukraine's upcoming presidential election, the markets are eagerly watching how the situation will play out.

If the West ends up imposing sanctions on Russia's energy sector, which accounts for about half of its government revenues, it could be bad news for big oil companies, including BP , ExxonMobil , and Royal Dutch Shell , among others.

BP owns a 19.75% stake in Kremlin-controlled Rosneft and depends on Russia for nearly a third of its oil production and more than a third of its reserves. Meanwhile, Exxon is working with Rosneft to explore shale fields in Western Siberia, while Shell has an ownership interest in Sakhalin-2, a massive export-oriented oil and gas project offshore Russia, alongside state-controlled Gazprom.

But while deteriorating relations between Russia and the West would be generally bad for these and other large integrated oil companies with major ventures in Russia, they could actually be good news for some energy companies, namely U.S. refiners.

Drilling for oil in Russia. Photo Credit: Wikimedia Commons 

Why U.S. refiners would benefit
Understanding why U.S. refiners would benefit from deteriorating conditions between Russia and the West is relatively simple. Refiners' profits are driven by the price difference between U.S. crude oil prices, benchmarked to West Texas Intermediate (WTI) and Louisiana Light Sweet (LLS), and global crude oil prices, which are benchmarked to Brent. The greater this price difference -- known as the Brent-WTI or Brent-LLS spread -- the fatter their margins, all else being equal.

So, if the U.S. imposes sanctions aimed at hurting Russia's energy sector that causes a drop-off in Russian energy exports, Brent crude oil supplies would fall and prices would rise, assuming no change in global supply and demand otherwise. This would result in a wider Brent-WTI and Brent-LLS spread, boosting U.S. refiners' margins.

Of course, it's not as simple as that since WTI and LLS prices could rise or fall depending on production growth, seasonal factors, fewer supply bottlenecks due to new pipelines and other infrastructure, and other factors. But in general, escalating tensions between Russia and the West that could jeopardize Russian energy exports should result in a higher spread between Brent and WTI/LLS.

One refiner to consider buying
This would generally benefit all U.S. refiners with access to WTI, LLS, and other cheap domestic crude oil feedstocks. But some are better positioned than others. Valero is probably the best positioned, in my view, due to its significant refining footprint along the U.S. Gulf Coast that gives it preferential access to the cheap domestic crudes currently inundating the region.

Valero's sizable Gulf Coast refining capacity benefited it tremendously in the first quarter, as higher throughput volumes and stronger margins boosted its refining operating income 8% year over year to $1.3 billion, despite higher natural gas prices that increased the company's energy costs. Gulf Coast margins improved mainly due to wider discounts between Brent and LLS, as well as Brent and other light sweet crudes such as Mars and Maya.  

If Brent prices were to rise in coming quarters due to geopolitical risk, Valero's margins would improve further. But even if Brent prices don't budge, WTI and LLS prices are expected to fall over the next few quarters due to growing production from onshore shale plays and from the deepwater Gulf of Mexico, which would also boost Valero's refining margins, especially in the Gulf Coast and Midcontinent.

Beyond Valero's well-positioned refineries, the company also boasts a robust balance sheet with about $3.65 billion in cash and equivalents as of the end of the first quarter, which could be returned to shareholders through share repurchases or a dividend increase. It also looks relatively undervalued on an enterprise value-to-EBITDA basis, commanding a multiple of less than 6x, compared to peer Phillips66's  15.5x and an industry average of roughly 9x.  

Investor takeaway
While Valero would certainly benefit from higher Brent prices, it should continue to enjoy strong profitability in the near future given the likelihood that WTI and LLS prices will trend lower due to the massive oversupply of domestic light sweet crude. With a solid balance sheet and competitively positioned refineries along the U.S. Gulf Coast, I think Valero should continue to reward its shareholders for the foreseeable future.

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The article If Russia Situation Worsens, These Energy Stocks Could Surge originally appeared on Fool.com.

Arjun Sreekumar has no position in any stocks mentioned. 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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