Monday, May 13, 2013

Should you trust the refiners going forward?

I have done a Discounted Cash Flow (DCF) analysis on one of the larger oil refiners in the US HollyFrontier (HFC). They have benefited the past year and half due to the wide Brent/WTI spread and Crack spread. The Brent/WTI spread is the difference in price between WTI crude oil, the US benchmark and Brent crude oil, the European/global benchmark. What we have seen recently is weakening demand for Brent and steady demand for WTI. With more technology, we are able to draw more supply out of Cushing, OK and push the price of WTI up, despite the EIA showing our current WTI supply near 20 year highs. It seems as though the US is trudging along, and Europe continues to remain weak.

The crack spread is the difference between the price of crude oil and its petroleum products; basically it is what an oil refiner's profit margin will be after breaking apart the oil. The most widely used crack spread is the 3:2:1 (3 barrels of oil, 2 barrels of gasoline, 1 barrel of heating oil).

Within the past two months, we have seen the Brent/WTI spread go from $20.00 to currently $7.88, as well as the crack spread go from $44.00 to $24.78.

Looking longer term at the Brent/WTI spread, it has kept between 0-$10 while the crack spread remains elevated, but looks to break lower.

Below is the DCF model I have worked out:

Even though I have a price 25% above today's current market price, I believe that the days of the wide Brent/WTI and Crack spread are just about over, and their profit margins going forward will substantially be hurt. The refiners have run up over 100% in a one year period due to these spreads widening, but I believe their current market price has not put in the fact that the spreads have fallen this far this fast. HFC is down 17% since the beginning of March, it's all time high; at the same time, the Brent/WTI spread was also at its widest point ever. I would advise not to get stuck in this trap, and not buy the stock, or if you own, take profits.

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