Be Patient With E&P Companies

 | Jun 30, 2014 | 11:00 AM EDT
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The ostensible end of the domestic crude import ban ended last week, as we saw catastrophic stock retreats from all the major dedicated refiners. What we didn't see is an equally enthusiastic price response for the mid-cap exploration-and-production (E&P) companies working in the Eagle Ford and Permian basins. Both of these trends strike me as worth heeding: I would not own any refinery stock right now and I remain cautious on the newly advantaged (E&P) players.

Many analysts are pushing back on my point of view on the new Commerce Department ruling on Condensates, giving "refined product" status and, therefore, export ability to these grades of crude oil -- specifically to Pioneer Natural Resources (PXD) and Enterprise Product Partners (EPD). While they believe that it is a small ruling that will only marginally affect exports, I believe it marks the end of the export ban.

While infrastructure to distill sweet crude barrels into condensate is rare today, this ruling will create a fast-growing cottage industry to install the relatively cheap distillation units all over West Texas and in North Dakota. It is in this processing and transport opportunity that Enterprise was included in the PXD ruling. Every player in the Bakken, EFS and Permian will scream for precisely the same dispensation that Pioneer got, and Commerce will be hard pressed not to give it. In the end, it will not be the barrels that are exported that will matter to these E&P companies anyway – It will be the option that export gives them, which will insure a basis price that is much, much closer to global benchmarks -- in many cases, more than $20 a barrel higher.

The refineries will definitely lose their margin advantage that cheap crude has given them for much of the past four years. The mid-continental refiners with strong access to glutted crude sources such as Western (WNR), Holly Frontier (HFC) and Tesoro (TSO) will feel the margin cut first, while Gulf Coast refiners like Phillips 66 (PSX) and Valero (VLO) won't be long behind. This is a margin collapse that will get worse as the progress of condensate distillation gains steam. I wouldn't own a refinery stock right now at any price.

But why shouldn't the E&Ps have seen a greater rebound last week on this good news for them? The reason is that while refinery stocks are more apt to react to future threats, E&P companies are very much required to "show me the money" today in order to woo new investors. The potential production for Pioneer and EOG Resources (EOG) and Cimarex (XEC) are already well priced into their shares, while this price premium is still months away.

I am virtually alone in believing that the WTI/Brent spread will be permanently smashed by this Commerce Department ruling and margins between Midland WTI (Permian crude), Bakken blends and Louisiana Light Sweet (Gulf Coast refinery benchmarks) are destined to collapse forever. That makes it inevitable that those E&P companies I mentioned will see another significant leg up -- but not until the first quarter of 2015 at the earliest, as the condensate decision is more widely felt.

Bottom line: If you are long E&P companies, be patient. Another leg up is on its way. And, if you're long refiners, get out -- it's going to get worse for them.

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