Profits ahead for refiners, thanks to differentials

Share prices for US refiners have soared over the past year because they've leveraged a $20 per barrel differential between Bakken oil and Brent crude. This year refiners' profit potential looks solid, but the differential could narrow.

Courtesy of Valero Energy Corp.
Refiners in the US with access to discounted crudes, especially those along the rail route from the Bakken to the Washington coast or into northern Oklahoma, should continue to see big profits as long as the Bakken-Brent differential holds up.

Over the past year, oil refiners have been one of the biggest stories in the energy business. After a few years of lackluster performance, the share price for refiners surged -- in some cases by triple digits -- over the past 12-15 months.

It is important to understand why this happened, so readers can be in a position to profit if these conditions persist.

The slide above was presented by Valero (NYSE: VLO) at the UBS Global Oil and Gas Conference last month, and it highlights some very important points. First it gives transportation costs for oil via pipeline and rail from the oilfields in West Texas, the Bakken, and Alberta into various regions of the country. In 2012 the Bakken-Brent differential spent much of the year bouncing around $20/bbl. Because finished products tend to trade at prices influenced by the price of Brent crude, it should come as no surprise that refiners were chalking up record profits. However, someone had to transport that crude. So the railroads and pipeline companies also fared extremely well over the past year. Warren Buffett owns a railroad that services the Bakken, and a piece of Phillips 66 (NYSE: PSX) which has several refineries in the West and Midwest that have benefited from low-priced Bakken crude.

With a $20 differential, one would expect from the graphic that refiners based along the rail route from the Bakken to the Washington coast or into Northern Oklahoma would fare very well. The railroads serving those routes should also do very well. And in fact many of the refiners whose shares soared into triple digits do have refineries along those routes.

Thus, refiners in the US who continue to have access to discounted crudes should continue to see big profits as long as the Bakken-Brent differential holds up. (Bakken crude generally trades at a $2-$5/bbl discount to WTI).

The main risk for refiners who enjoyed such a big year in 2012 is that new pipeline project and expanded rail shipments will ultimately cause that differential to disappear. One of the predictions that I made for 2013 was that the Bakken-WTI differential would shrink this year, and that has thus far proven to be the case.

The run for refiners isn't quite over. 2013 will be another solid year, but will be unlikely to repeat the outstanding performance of 2012. Just keep your eye on the differentials, and be aware of the refiners, rail companies, and pipeline companies who are positioned to benefit when the differential is high.

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