The amount of crude oil now sloshing around in tankers and other storage facilities is staggering. With an Iran deal potentially coming to fruition and domestic production continuing at a rapid pace, oil supply will be plentiful for the foreseeable future.
Because of this oversupply, we expect West Texas Intermediate (WTI) Crude to trade in a range of $40 to $65 for the next 12 months, a far cry from $108 just over a year ago. In fact, in the near-term, the risk is to the downside of this range.
U.S. Energy Production
United States energy production is here to stay, as the U.S. is now the largest oil producer in the world. Over the past 6 years, U.S. oil production increased from roughly 5.5 million barrels a day to 9.6 million today.
This increased competition from the U.S. led to the Organization of the Petroleum Exporting Countries (OPEC) flooding the market with oil, in an effort to curtail U.S. oil production. Much to the surprise of OPEC, U.S. oil production proved resilient. Each day shale producers become more and more efficient, and correspondingly, their breakeven point (originally thought to be around $65-$80) is now considerably lower.
Due to these efficiencies and heavy start-up investments already out of the way, frackers are driving their breakeven point to around $50-$60. According to the U.S. Energy Information Administration’s (EIA) July 2015 report, “production is expected to generally continue falling through early 2016 before growth resumes.” The EIA anticipates any drop in U.S. production to have minimal effect, as output is expected to remain above 9 million barrels a day.
Refiners
Year-to-date through July 16th, the overall energy sector was down 6%, and down more than 25% over the past year. However, refiners are benefiting from low oil costs. Refiners are able to profit from low input costs and sell their refined goods at prices that do not fall as quickly as crude. Specifically, the difference between the monthly average spot price of gas or diesel and the average price of crude oil purchased composes the profit of a refiner. This spread widens as crude prices move down.
U.S. refineries are particularly attractive in comparison to their international counterparts because of their ability to refine West Texas Intermediate (WTI) Crude versus the global benchmark, Brent Crude. WTI is plentiful in the U.S. and extremely light and sweet, which allows it to be easily converted to gasoline. The drilling boom in the U.S. permits refiners to purchase WTI several dollars cheaper than Brent. Given the low input costs and increasing production in the U.S., we expect this trend to continue.
Our Picks: Valero Energy and Marathon Petroleum
Analysts expect most U.S. oil to end up in the Gulf Coast because of location (Texas) or transportation efficiencies by rail or pipeline. Valero (VLO) is the largest Gulf Coast refiner, as depicted in the chart below, and will be the primary benefactor of the increase in U.S. oil production. We expect the glut of oil in the Gulf and the WTI/Brent spread to lead to continued high margins.
Aside from the growth in U.S. oil production and increased margins, a few other characteristics make Valero an appealing investment. Currently Valero trades at a forward multiple of around 10 times earnings, making it one of the cheapest stocks among its refining peers and the S&P 500. Secondly, Valero continues to demonstrate a commitment to returning cash to shareholders with a 45% dividend hike in the first quarter of 2015 and a $2.5 billion stock buyback program approved on July 13th.
While we like Valero as the “value play” among the refiners, other well managed operators will stand to benefit from this favorable trend in refining margins. Marathon Petroleum (MPC), a Findlay, Ohio-based refiner with retail locations primarily in the Midwest and Southeast under its Marathon and Speedway brands, has seen its shares rally throughout the downturn in energy prices.
A recent strategic acquisition of MarkWest Energy Partners expands the company into the natural gas processing business, significantly extending its distribution pipeline and demonstrating that management will use its balance sheet strength. MPC shares jumped 8% on July 13th, the day the news was made public, signifying the market’s endorsement of the deal. MarkWest is but one of many acquisition opportunities that have resulted from smaller energy peers exposed to low commodity prices. We expect additional M&A activity to be a wild card for this sector.
Summary
Look to buy Valero and Marathon Petroleum on share price weakness. The refiners tend to sell off when oil prices rally, so a savvy trader will be presented good opportunities. Both of these companies have been in favor, but with oil in a new trading range of $40 to $65 for the foreseeable future, and with risk to the downside of this range, we expect shareholders to enjoy additional gains.
David Kudla is CEO and Chief Investment Strategist of Mainstay Capital Management, a fee-only, independent, Registered Investment Advisor. More information about his firm can be found at www.mainstaycapital.com. Follow him on twitter @David_Kudla.
Disclosure: Clients and employees of Mainstay Capital Management may hold the securities mentioned in this article in their investment portfolios. The securities mentioned may not be suitable for some investors, based on their tolerance for risk or their investment time horizon.
