Profiting From Rising Fuel Prices

Automobiles, Investing Strategies, Oil

Most of you are surely aware of the headlines blaring that retail gasoline prices in the United States rose again and hit another all-time record, surpassing one set in March.

On May 10, the average cost of a retail gallon of gasoline hit $4.374, according to the American Automobile Association, surpassing the former record of $4.331. Since March 30, crude futures have lost about 7%, but gasoline futures are up 9.4%. In fact, they hit a record on May 6 of $3.7590 per gallon before selling off a bit over the next few days.

Why Prices Are Rising

Refinery closures due to both scheduled maintenance and unplanned upsets (Russian invasion of Ukraine) have boosted fuel prices.

The world has lost one million barrels of refining capacity and 1.5 million barrels of oil supply since the pandemic.  This is an estimate given by Mike Jennings, CEO of HF Sinclair (DINO) in an earnings call on May 9.

“That’s 2.5% of world consumption…it’s a big number,” said Jennings.

He isn’t kidding. Worsening shortfalls of diesel, gasoline and jet fuel across the country point to a refining system stretched to its limits by both the robust post-pandemic recovery in fuel demand and the aforementioned loss of Russian supplies.

At this time of year, refiners normally prioritize gasoline output ahead of the summer driving season. However, this year is different. Refineries have had to increase distillate output to meet jet fuel and diesel demand in Europe and the United States, as sanctions on Russia curtailed its fuel exports.

Despite refiners’ efforts, diesel inventories in the U.S. are at their lowest levels since 2006 and prices at the pump are nearly $5.50 a gallon, a record high, according to the Energy Information Administration.

Plummeting diesel supplies are at the epicenter of the problem and why fuel prices are rising. Diesel fuels our country’s construction, heavy industry and food production industries as well our rail and trucking systems across the country.

Karim Fawaz, a director at S&P Commodities Insight, told the Financial Times there was little sign of fuel markets loosening, especially as increased travel buoys demand over the summer months.

He said, “You’re running at historically low inventories, with basically very limited spare refining capacity and you’re staring down potentially Europe phasing out another tranche of Russian diesel imports. It’s difficult to see how the system bounces back in the short term.”

The problem here in the U.S. is a direct result of the fact that there is little excess capacity in the system to lift fuel output and restock inventories. This is thanks to a wave of refinery closures during the pandemic, when demand collapsed and refining companies suffered heavy financial losses.

Refiners in Paradise

Conditions for the companies that refine crude oil are nearly ideal now and will stay that way for the foreseeable future. That means the ongoing surge in their profits will continue.

In a sign of the extreme tightness in fuel markets, the Gulf Coast 3:2:1 crack spread — essentially the amount a refiner gets for the fuel it sells above the price of crude it buys to make it and a sign of refiners’ profit margins — hit all-time highs of more $60 a barrel over the past week. The indicative 3-2-1 margin is based on the assumption a refinery produces two barrels of gasoline and one barrel of diesel from refining three barrels of crude.

Martijn Rats, an analyst at Morgan Stanley, wrote this in a recent note to clients: “The system is now behaving as though [refining] capacity has effectively run out. This is not easy to solve quickly, especially if demand recovers further. Margins have not just risen, but surged to unprecedented levels.”

These ideal conditions will likely last into 2023. That’s when more refining capacity is scheduled to come online in Asia and the Middle East.

Refining Investment

Refiners’ stock prices have surged on the prospects of many months of blockbuster profits. The S&P Refining & Marketing index is up nearly 50% this year, even as the broader market has fallen.

Mark Lashier, president of Phillips 66 (PSX), told investors in an earnings call on April 29 “We’re probably as constructive on refining as we’ve been in a long time.”

Many of these refining companies pay a decent dividend as well. For example, Phillips 66 has been slow and steady on increasing its dividend payout every year – from $2.18 annually in 2015 to $3.62 in 2021. The stock currently yields 4.15%, with an indicated payout of $3.68 this year.

Phillips 66 is a downstream energy company with assets in four segments: Refining, Marketing,

Chemicals, and Midstream. Its refining and marketing operations include 14 refineries with net crude

capacity of 2.2 million barrels per day. Its chemicals operations are conducted through a 50% interest in

Chevron Phillips Chemical Company, which has more than 33 billion pounds of net annual processing capacity. Its midstream operations are conducted through a 50% interest in DCP Midstream (DCP), and through the company’s controlling stake in Phillips 66 Partners.

The current state of the refining market was clearly visible in its latest earnings report. Phillips 66 reported a first quarter 2022 adjusted net profit of $595 million or $1.32 per share, up from an adjusted net loss of $509 million or $1.16 per share a year ago. The swing to an operating profit reflected strong performances in three of its four business segments, with particular strength in chemicals and refining. First-quarter revenue spiked 68% to $36.722 billion.

I like its diversified portfolio of businesses because its makes the company’s cash flow less volatile than that of most pure-play refiners.

That’s a big reason why PSX has a long history of returning excess cash to shareholders through buybacks and rising dividends. In April, the company repaid $1.45 billion in debt. As a result, it plans to resume stock repurchases that it had suspended in 2020.

With one of the highest distillate yields among its peers, Phillips 66 is well positioned for the long term since the growth outlook for distillates is better than for gasoline.

And with its policy is to invest about 60% of operating cash flow over time and return the rest to shareholders, this will likely translate to double-digit dividend growth for the next several years.

PSX is a buy on the recent weakness in energy stocks, anywhere in the $85 to $90 range.

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