Refining stocks’ performance was mixed in the fourth quarter. While Marathon Petroleum (MPC) and HollyFrontier (HFC) fell, Valero Energy (VLO) and Phillips 66 (PSX) rose. Now, as we step into 2020, refining dynamics are changing rapidly.
The IMO (International Maritime Organisation) 2020 ruling has brought a massive change in refined products’ demand-supply dynamics. Shippers are now required to use low-sulfur fuels.
Also, a weaker refining environment hurt the sector’s stocks last year. Wall Street analysts estimate refiners’ earnings fell. However, in 2020, they expect the refining environment to strengthen and refining companies’ profits to soar. Let’s review refining companies’ earnings outlook amid these changing conditions.
Refining stocks’ earnings outlook
In 2019, analysts estimate Valero’s EPS fell the most among refiners, by 32% to $5. However, this year, they expect the company’s EPS to rise the most, by 96% to $9.90. In 2019 and 2020 combined, analysts forecast Valero’s EPS to rise by 34%, again the most among peers.
Valero’s forward PE multiple is 9.5x, a bit higher than the peer average of 9.4x. The stock also has the highest dividend yield among peers, of 3.8%.
Meanwhile, analysts forecast Marathon Petroleum’s EPS falling by 28% to $4.40 in 2019, and then rising by 67% to $7.40 in 2020. Over both years together, they forecast its EPS rising by 21%, the second-most among peers. MPC stock’s forward PE multiple is below average, at 7.9x. The stock has the second-best dividend yield in its peer group, of 3.6%.
Last year, analysts estimate Phillips 66’s and HollyFrontier’s EPS fell by 24% and 22%, respectively, to $8.90 and $5. This year, they expect these companies’ EPS to rise by 20% and 2%, respectively, to $10.70 and $5.20. In both years together, analysts expect Phillips 66’s EPS to fall by 9% and HollyFrontier’s to fall by 20%.
Furthermore, Phillips 66 and HollyFrontier have a high valuation, with forward PE multiples of 10.6x and 9.7x, respectively. These refining stocks have relatively low dividend yields. Phillips stock’s yield stands at 3.2%, while HollyFrontier’s is 2.8%.
Which refining stocks are best placed?
Over 2019 and 2020, analysts expect Valero Energy’s earnings to grow the most, followed by Marathon Petroleum, Phillips 66, and HollyFrontier. VLO and MPC have the highest dividend yields, and their valuation is lower than PSX’s and HFC’s. Therefore, Valero and Marathon Petroleum seem well placed for 2020.
Why the better forecast for 2020?
Analysts expect refiners’ earnings to surge in 2020 due to strengthening refining conditions. IMO 2020 is set to play a central role in these changing conditions, with shippers now requiring low-sulfur fuels. They can either buy low-sulfur fuels from refiners or buy high-sulfur fuel and convert it using a scrubber.
In Valero’s third-quarter earnings call, senior vice president of supply, international operations, and systems optimization Gary Simmons said, “We certainly anticipated, you’d see scrubbers come online, but it appears there’s a lot of technical issues around the scrubbers that maybe they don’t come on as fast as what we thought.”
Refining dynamics to change
As a small portion of the world’s fleet has onboard scrubbers, many shippers will need low-sulfur fuels. Therefore, demand for low-sulfur fuel could rise exponentially this year. Refiners will try to keep up with the higher demand. They might also reduce the supply of other refined products, such as gasoline, which could widen refining cracks and margins and boost earnings.
Simmons also said, “moving forward you look and gasoline sitting just a little above the 5-year average range, diesels at the lower end of the five-year average range on apparent days of supply, both gasoline and diesel below the five-year average range. So, the fundamentals look very good for both gasoline and distillate.”
To produce low-sulfur fuels, refiners can use sour or sweet crude oil. To use sour oil, refiners need to have costly advanced refining units that take time to set up. Refiners that already have such units in place could use sour oil to produce low-sulfur fuels.
Others will use sweet crude oil to produce low-sulfur fuels. As more refiners opt for sweet crude, the demand for sweet crude oil could rise exponentially. As a result, sweet oil prices could increase, widening the spread between sweet and sour crude oil prices. A wider sweet-sour oil spread is beneficial to refiners who use sour oil, as using sour oil to produce high-value refined products is cheaper.
Valero seems best placed
Valero Energy is well placed to handle IMO 2020 and the widening cracks and spreads. The company’s conversion capacity of 30% (of crude distillation) is at the higher end of the peer range of 14%–30%. The conversion capacity includes gasoil hydrocracking, fluid coking, delayed coking, and residual hydrocracking units.
Plus, the company has several growth projects on the go. Valero expects its expansion and modernization projects to add $1.2 billion–$1.5 billion in incremental EBITDA by 2022. The company’s debt position also provides it with financial strength and flexibility. To learn more, read Valero Energy Stock: Are Analysts Buying Its Growth Story?
Marathon Petroleum looks good
Marathon Petroleum also seems well positioned to face IMO 2020. The company’s hydrotreating and resid upgrade capacities are the best among peers. Hydrotreating capacities include diesel, kerosene and jet, and other distillate desulfurization, and resid upgrade capacities include resid hydrocracking, coking, resid deasphalting, and asphalt.
Additionally, Marathon Petroleum’s refining, midstream, and retail capacities have grown massively since the integration of Andeavor’s assets. In the third quarter, activist investor Elliott Management recommended breaking up MPC. It cited management’s lack of oversight, internal conflicts, and MPC’s ineffective integrated business model as reasons for it to break up. It also believed the break-up would unlock hidden value in the company. To learn more, read Marathon Petroleum: Shaw Backed Elliott, Stock Rose 8%.
Perhaps heeding Elliott’s advice, MPC decided to spin off its retail arm, Speedway, in the fourth quarter. Plus, the company is evaluating alternatives for its midstream segment. So, sooner or later, MPC’s potential value could be unlocked, and investors could benefit.