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TheStreet Open House

Cracking Open Two Magic Formula Oil Refiners

Stocks in this article: HFC WNR VLO TSO

NEW YORK ( MagicDiligence.com) -- Oil refining has not historically been considered a business with particularly attractive returns on capital, but recent conditions in the oil markets have led to highly desirable conditions for two refiners in particular, HollyFrontier (HFC - Get Report) and Western Refining (WNR - Get Report).

As a result, and of investors not sold on the longevity of those favorable conditions, both stocks are currently a part of the Magic Formula® Investing (MFI) "universe."

Let's take a look at the business, why the going is good at present, whether it can last, and which of these two players is the more attractive choice for investors intrigued by the story.

Oil Refining: The Quick and Dirty

Refining is a relatively simple business to understand. Crude oil pumped out of the ground by exploration and production firms (E&Ps) is then transported to refineries, usually via a network of pipelines and storage terminals. There, crude is heated to separate, or "crack," it into the industrial end products sold by the refiners: gasoline, diesel, jet fuel, asphalt, motor oil, lubricants and so forth.

The profits earned by the refiners are the difference between the prices they can obtain crude at and the prices they can sell their end products for. In the industry this is sometimes referred to as the "crack spread."

Given the volatility of crude oil prices and less volatile nature of end-product selling prices, refining can be quite an up and down business, with dramatic peaks and valleys in profitability. In general, though, this is a historically low-margin business. Even the most well-run refiners only earn operating margins of 2% to 3% over the long run, and returns on capital struggle to exceed 10%.

The Flavors of Crude

There are actually over 160 different types of crude oil, but the two that are traded on commodity markets are West Texas Intermediate, or WTI, and Brent. WTI is produced mainly in North America, while Brent is imported. Historically, these two types of crude have been priced fairly close to each other.

However, this has changed dramatically over the past year and a half. Huge production increases in North America, due mainly to shale fracking, have brought a tremendous amount of WTI crude into the system, more than the existing refining, pipeline and storage terminal system can efficiently process.

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