True to Economics 101, the increasing supply has led to decreasing prices for WTI. Since the start of 2011, WTI has priced between 10% to 20% lower than Brent, spiking up to above 25% and currently at about a 15% discount.
HFC and WNR: Taking Advantage
This WTI price discount has benefited refiners that are geographically close to WTI production areas, or are connected directly via pipeline to WTI hubs like Cushing, Oklahoma. HollyFrontier and Western Refining are two such refiners. Four of HollyFrontier's five refineries fit this description (Cheyenne, El Dorado, Navajo and Tulsa), and Western Refining operates two refineries, in El Paso and Gallup, New Mexico, both in the region. Easy access to lower-cost WTI gives them a cost advantage against other refiners, and this can be seen in the margins. While firms like Valero ( VLO) and Tesoro ( TSO) continue to generate gross margins around 10%, HFC and WNR produced 18% and 17%, respectively, for 2011. In the refining business, where revenue levels are tremendous (HFC was over $15.5 billion last year), each point of margin leads to big gains in profits.
Can It Last?
HFC and WNR are in MFI because the market doesn't believe the current situation will last indefinitely. Steps are already being taken to free up the WTI backlog. The Seaway pipeline from Cushing to the Gulf Coast was recently reversed, sending flow out of Cushing to alleviate the bottleneck. Combined with planned new refining and pipeline projects, over time the WTI/Brent spread will most likely reduce back to more historically normal levels. But this could take some time to come to fruition.
Which is Better?
Let's take a quick look at the metrics:
Earnings Yield: HFC 29.3%, WNR 29.9%.
Free Cash Yield: HFC 19.1%, WNR 19.9%.
Dividend Yield: HFC 1.86%, WNR 0.78%.
Debt-to-Equity Ratio: HFC 0.25, WNR 1.02.
Interest Coverage Ratio: HFC 20.9, WNR 5.8.
Clearly, the numbers are in favor of HFC. It is in much better financial condition than WNR, pays a better dividend (with two special dividends in the past year), is larger and more diversified (particularly after the Frontier merger), and boasts a seasoned management team. If the refining story sounds intriguing, HFC looks to be the better pick of the two.
I'm not a big fan of either stock as a Magic Formula investment. Refining is just too unpredictable and historically difficult of a business. Neither stock looks particularly cheap against reasonable future expectations. These kinds of situations are difficult to handicap in MFI -- sometimes favorable conditions last long enough to generate ongoing great results, sometimes they do not. MagicDiligence is more interested in finding the sustainably great businesses the screen turns up. At the time of publication the author had no position in any stocks discussed in this article.