Buying Refiners on the Dip

 | Apr 04, 2013 | 12:00 PM EDT
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On March 18, I posted in Columnist Conversation that I was lightening up on the refinery stocks. I had a great run over the previous 12 months, but thought it was prudent to sell half of my holdings. I did this as the sector had staged a huge run over the past year, the sentiment on the sector was overwhelming positive and I thought the new mandates on refiners had the potential to require significant new investment from the sector which would cut margins.

That call turned out to be prescient, as most of these stocks have lost 10% or more since then. The fall has been driven on concerns about new EPA mandates, which caused analysts to revise earnings estimates lower on some of the major refinery stocks like Tesoro (TSO) and Valero (VLO). In addition, crack spreads have weakened a bit recently as well.

I am not ready to pull the trigger yet on increasing my exposure into the sector, but I am putting together a plan to do so if the sector sheds another 5% to 10%. Some of the secular tailwinds for the domestic refinery sector remain firmly in place. We have not built a major new refinery in the U.S. since 1976, and given the current administration's environmental leanings of the, I don't see that changing over the next few years.

In addition, oil production in this country continues to boom, providing refiners with a cheap feedstock. Finally, there is always a chance that the new EPA mandates will be relaxed or phased in over a longer time frame due to political pressure. (If you were a politician running in 2014, would you want to have gas prices go up another $0.05 to $0.10 a gallon?)

Given this outlook, here are two of my core positions in the sector that I plan to add to should we see a slightly bigger pull back in the sector.

Calumet Specialty Products Partners (CLMT) produces and sells specialty hydrocarbon products from a couple of refineries in North America. CLMT yields 7% and the limited partnership entity has more than doubled its distribution payouts since it came public in 2006. The company just broke ground with partner MDU Resources (MDU) on the first diesel refinery built in 37 years. This facility will produce fuel that powers fracking rigs and other equipment used in the development of the Bakken shale.

The stock has come down substantially from a recent intraday high above $40 a share; it now sells for less than $35. Part of this decline was due to Calumet issuing 5 million new units (in part to build the new refinery). This issuance is a regular activity for limited partnerships (LPs) and master limited partnerships (MLPs) in this space. CLMT is selling at just over 8x this year's expected earnings. I have held the stock since it was trading at $24 a share and I will add to the position if we get down to the $32-$33 range.

Valero is North America's largest refiner. After trading at $48 a share a few weeks ago, the stock now sells at just over $40 a share. The shares have been hit as the company has stated it will need to spend several hundred million dollars to upgrade its plants to meet new EPA standards. It also has decided to upgrade its two California refineries instead of selling them.

I believe this is a good long-term move as it will expand Valero's capacity to take in crude oil via rail as production continues to expand. However, it will increase its capital expenditures in the short term. The stock sells for approximately 7x 2014's projected earnings and VLO yields close to 2% (1.8%). I plan to add to my existing position if the stock can move down to the $37-$38 range.

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