Ignore Buffett: Refiners Are A Low-Quality Industry About To Plunge
Refining companies have been all the rage in 2015. After a brief lull, Buffett reignited passion for the sector buying a stake in Phillips 66. Ignore the hype, refiners are at the top of a cyclical boom. Aggressive investors should consider shorting the sector during this period of high volatility. So refiners are back in the news. They’ve been the toast of the town for much of 2015 as strong margins have driven rocketing share prices. Refining margins started plunging recently, and the stock market dumped; the one-two punch knocked the refining space down pretty hard. Predictably, lots of folks are running around calling it a big buy the dip opportunity. These calls are getting louder now that Warren Buffett has announced owning a large stake in Phillips 66 (NYSE: PSX ). He bought a stake worth roughly $4.5 billion, not chump change, even to a company as large as Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ). Buffett’s track record with energy is mixed. PetroChina (NYSE: PTR ) was a huge win for him, Chevron (NYSE: CVX ) and his dive into Energy Futures bonds were large mistakes that caused big losses for his company. His recent buy on Exxon (NYSE: XOM ) was extremely poorly timed, but he had the good sense to sell before it turned into another large loss. While I think buying refiners now is a terrible idea, I’ll give Buffett and his Phillips 66 a pass. Phillips is rapidly moving into other segments that are less vulnerable to the feast and famine dynamics of the refining industry. This is good because the refining industry stands like a shaky rig staring down a class four hurricane just miles away. Refiners have had a big boom since 2010, largely driven by expanding margins. Alas, these refining booms never last, this industry is a cyclical money pit that ends up having the same sort of returns that only fare well compared to, say, airlines or asteroid mining schemes. Just to be clear, this industry is about as far as you can get from anything suitable for buy and hold investors. It’s very much a trader’s paradise, buy when these companies are on the brink of bankruptcy, sell when people get euphoric again. Take the long-term 35-year chart for Tesoro (NYSE: TSO ), one of the more competent and (occasionally) beloved pure-play refiners. (click to enlarge) In 1980, yes, back when disco was still a respectable trend, Tesoro shares traded as high as $16. They then did nothing for the next 12 years, falling as low as $1.37 in 1992. Refining entered one of its periodic booms, sending shares up 8x to $10 in 1998 – still well short of where it was back in 1980. Then disaster hit on the next cyclical collapse, sending shares as low as 62 cents in 2002. That’s a miserable return on investment since 1980, a 96% capital loss over 22 years! And to be clear refining is a capital intensive industry, these guys only pay acceptable dividends (for short periods of time) during sector peaks, followed by long periods of abolishing the dividend all together while they’re in “avoid bankruptcy” mode. You’re not getting paid to wait owning these guys while their stocks go sideways decades at a time. After 2002, fortunes turned brighter with a big increase in gasoline demand as the SUV craze hit. As gasoline usage surged, refiners suddenly (finally) found themselves with excess demand for their industry, and margins soared. Tesoro shares would go on a monster run, clocking out a 100x return for anyone that bought near the low. Shares peaked in the 60s in 2007 and then started to dive. In 2008, as the economy started to sink and rising oil prices killed consumer demand for gasoline and other refined products, the refineries started another classic bust. Shares, which started the year at $45 in 2008 fell as low as $6 by that winter, a stunning 85% one-year collapse – a dive so steep, it put most of the banks to shame. Remember, if you paid $16 a share in 1980, at this point, you’re still sitting on a 60% loss, 28 years later – and Tesoro is a refining industry leader. Just think of how the lower-quality refiners did over that three decade span! In 2010, refiners started to recover, aided at first by some timely hurricane activity and then by the rise of US oil production. The glut of US oil produced by the domestic energy boom caused a massive oversupply of oil locally compared to the world market. This resulted in boom times for the US refineries, which suddenly got to enjoy cheap input fuels while the value of their refined products including gasoline, heating oil, and jet fuel remained robust. The recovering economy also helped on this count. Alas, the refining boom of 2010-2015 has died. They’re engraving its tombstone as we speak: “He had a great run, but in the end the oil bust and Chinese commodity collapse was too much for his aging heart to bear.” The refining boom was fueled up primarily by three factors. The glut of US oil, the improving US economy, and the lack of new refineries. All three of those factors are played out. As you know, oil prices have collapsed this past year. This is placing intense strain on US-based marginal oil producers. There’s a ton of data that disputes exactly where the break-even for a US shale project is, but it’s clearly north of $45 where we are today. There’s talk that US production isn’t falling yet, contrary to expectations, since capital-constrained players have to keep producing. Yeah, I acknowledge we may not see US domestic production fall straight off a cliff, but let’s be straight here, there’s no reason to expect US oil production to remain at these elevated levels. Capitalism stops unprofitable activity from continuing sooner than later. Lower prices will cause lower levels of production sooner or later, basic economics assures us of that. And US suppliers, as some of the higher marginal cost producers, will be among the first to shut up shop. When they do, the disparity of prices in between WTI and Brent crude, and particularly in discounted Midwestern crude that companies like Western Refining (NYSE: WNR ) have used to great advantage will fade. The refining boom was largely built on getting access to below normal market priced crude and letting all that extra margin soak through to the bottom line rather than going to consumers. That’s why you’ll not be seeing gas nearly as cheap as you expected at the pump with oil plunging. Another cause of higher margins has been that the US refining industry was capacity restrained. No new refineries had been built in 30 years, and many of the country’s refineries were shut in the 1980s when there was excessive capacity. The sudden appearance of the shale boom suddenly caused the nation’s refining stock to be insufficient to process all the country’s oil output. However, for the first time in ages, new refineries are being built in the US, which will add supply to the industry, putting pressure on margins. Additionally, there were an unusual number of strikes and explosions in refineries in early 2015 that put transitory upward pressure on margins. This boost is now dissipating. And finally, the economy had been improving in the US and neighboring regions that also consume US-refined petroleum products, namely Mexico and Canada. Canada now appears to be heading into a serious recession, and Mexico, while still growing economically, is sputtering. And the US economy is definitely decelerating, with the Fed threatening to tighten monetary policy as the domestic economy struggles and emerging markets are crashing. Sure enough, the crack spread has absolutely collapsed, falling from near 30 just a couple of weeks ago to the 15s today. It plunged during the market dive, and has continued diving this week, down 15% Monday, and another 5% Tuesday. To be clear, the crack spread is what butters the bread for refineries. The crack spread is the difference between their input crude and the output products such as gasoline, and fuel oil. Sure refiners can hedge, some have more exposure to other products like asphalt or specialty products, and whatnot. But that spread in general drives the industry. Notice how quickly refining stocks surged this spring when the spread shot upward. Now with it plunging again, refining stocks are likely to resemble falling anvils in coming weeks. Given the end of the conditions that caused the refining boom in the first place, there’s no reason for these stocks to have bids anywhere near these levels. Tesoro, for example, is trading at 9x cycle peak earnings levels. Analysts estimate earnings will drop by $4/share in 2016 to less than $8/share. That alone is eye-catching, you never want to see a company shed $4 in earnings power in a single year. Consider this : in 2009, Tesoro lost 87 cents a share, it lost a penny in 2010, made $4.02 in 2011, $6.20 in 2012, and then earnings plunged by more than 50% to $2.85 of EPS in 2013. Do you think that company’s current $10+ EPS earnings power is a permanent improvement, or a passing fad caused by a now-expired domestic oil boom? If EPS goes back to $2.85, like they earned in 2013, let alone making losses as they did in 2009-10, what would the stock be worth? The current $90 share price is a more than 30x multiple on earnings from just two years ago. Unless you think the domestic refining industry has entered a period of permanent bliss, despite all signs pointing to the contrary, paying 9x the unusually high current earnings is simply myopic. That refining stocks haven’t collapsed faster is a bit surprising. Perhaps they’re benefiting from the best house standing in a bad neighborhood effect. Previously, the “smart money” was flowing to the pipeline players such as Kinder Morgan (NYSE: KMI ) causing them to become substantially overvalued. I pointed this out this spring, Kinder shares are down sharply since then. Now that investors are scared out of pipelines, refiners are pretty much the last energy house that hasn’t collapsed. But their industry fundamentals have turned sharply negative, and profit margins have imploded in the past month. To sum up, here are long-term charts of two more pure-play refiners, Western and Valero (NYSE: VLO ). Western, a favorite of mine at $6 in 2008, but absurdly overvalued nowadays: (click to enlarge) And here’s Valero, the industry bellwether: (click to enlarge) Note how terrible these investments are over time – it truly is a miserable industry, like airlines for long-term holders. See where we were in 2007 when the SUV-driven refining craze ended? Yeah, that’s about where the refining industry is now. Take note of what happened next. Do your own diligence before following Buffett blindly into the refining sector. Disclosure: I am/we are short TSO, WNR. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.