Refiners to shell out record amounts of money to comply with U.S. fuel standards

Refiners to shell out record amounts of money to comply with U.S. fuel standards

Over the past two years, the price of oil in the U.S. has fallen from over $100 per barrel to as low as $27 per barrel as recently as February. Oil has recovered since then to $48 per barrel, but it still sits at less than half the 2014 peak level. The oil crash has claimed many victims along the way, across the entire industry—from the integrated super majors, to small exploration and production firms, to pipeline operators.

Now, the pain is spreading even further, to the one area of the oil and gas industry that had so far been spared. Refiners, which were actually benefiting from the volatility in oil prices because it reduced their feedstock costs, are now suffering alongside their peers. That is because, not only are crack spreads weakening, but the refining industry will have to spend record amounts of money this year to comply with fuel standards.

Investors that had thus far flocked to the major refining stocks for shelter from the storms, need to know that there is an underappreciated risk that could upend the high-flying refiners.

Phrase of the day: Renewable Identification Numbers

The phrase “Renewable Identification Numbers” may not be familiar to investors, but this seemingly innocuous term could have drastic implications for the oil refining industry. Refiners are required to meet a standard of 10 percent biofuel. This is done by blending biofuels like ethanol into gasoline. For companies that are not able to meet the 10 percent hurdle rate, there is a way out, which is to buy credits from other companies with biofuel concentrations above and beyond the necessary threshold. These credits are called Renewable Identification Numbers, or RINs.

This practice has worked fairly well over the past several years, but recently, the cost of RINs has soared. In the second quarter of this year, the price of renewable energy credits was approximately $0.78 each, roughly 25 percent higher than at the same point last year. The price increase has mostly been attributed to more aggressive ethanol requirements by U.S. regulators. The impact has been significant, to say the least. Over the first half of 2016, collectively the 10 refiners purchasing RINs have spent $1.1 billion on these credits, according to regulatory filings submitted to the SEC. This would put the group easily on track to exceed the previous record, which was $1.3 billion in 2013.

The heightened level of spending to meet the new regulatory standards could throw cold water on one of the hottest investment themes in the oil and gas industry during the oil crash, which was to buy refining stocks to hide from the damage. Indeed, refiners have significantly outperformed their sector peers, because of their relative safety during periods of falling commodity prices. For example, over the trailing five-year period, shares of refining giant Phillips 66 (NYSE: PSX) have increased 113 percent. And, that return figure does not include the company’s dividend payments to shareholders over that period. By comparison, the broader energy sector, as measured by the Energy Select Sector SPDR ETF (NYSEARCA: XLE), has gained just 1 percent in the same time frame.

This is why the refiners have attracted the attention of risk-averse investors. Even some high-profile investors have plowed into refining stocks for their industry outperformance, including none other than Warren Buffett, Chairman of Berkshire Hathaway (BRK.B). As of June 29, Berkshire Hathaway owned more than 78.7 million shares of Phillips 66 stock. The investment stake is worth $6.25 billion, and represents 15 percent of the company’s shares. Buffett has expressed his fondness for the company and its business model, and it is easy to see why. Phillips 66 grew its profits by 11 percent last year, a notable achievement in an extremely difficult economic climate and for the energy sector more broadly. Not surprisingly, the biggest reason for the company’s strong performance was Phillips 66’s refining business, which saw profits soar 60 percent for the fiscal year.

But moving forward, investors may want to rethink whether the refining industry is as attractive of an investment opportunity as its past returns suggest. There are a number of large refiners, including Phillips 66 and others, that could see a significant decline in profit over the remainder of the year, because of the higher levels of spending required to meet regulatory standards.

Companies to watch

Among the refiners that have a lot to lose this year from elevated regulatory spending is Valero Corp. (NYSE: VLO). The RIN issue is such a problem for refiners that it is compelling investors and management teams to speak out publicly. Valero specifically stated on last quarter’s earnings call with analysts that RIN spending was a key factor for why the company’s refining operating profits came in $1.2 billion lower last quarter than in the same quarter last year.

The outcry has not stopped there. CVR Energy (NYSE: CVI) CEO John Lipinski mentioned on last quarter’s conference call that since 2013, CVR Refining has spent nearly $500 million on RINs. Furthermore, he expects the company will spend $200-$235 million this year alone. Separately, noted activist investor Carl Icahn, who personally owns 82 percent of CVR Energy shares, recently wrote a letter to the Environmental Protection Agency calling for changes to the renewable fuel credit market. The EPA considers RIN credits to be a currency of sorts, which accomplishes the twin goals of limiting harmful carbon emissions and limiting the reliance on foreign oil. In the letter, Icahn argued, "The RIN market is the quintessential example of a 'rigged' market where large gas station chains, big oil companies and large speculators are assured to make windfall profits at the expense of small and midsized independent refineries which have been designated the 'obligated parties' to deliver RINs."

Marathon Petroleum (NYSE: MPC). Marathon is another refiner to watch because the positive momentum it had displayed heading into 2016 is already beginning to reverse, and higher regulatory spending would only serve as an additional headwind going forward. For example, Marathon’s operating profit in the core refining business declined 39 percent last quarter after excluding a one-time gain. Marathon is one of the refiners reporting elevated levels of spending on RINs this year, which means full-year earnings are likely to decline.

Bob Ciura is an independent equity analyst. Since 2012, his work has focused on fundamental investment analysis of publicly-traded companies in the energy, technology, and consumer goods industries. Bob has a Bachelor's degree in Finance and an MBA in Finance.  

Originally published on August 25, 2016