Avoid the Margin-Squeezed Refiners

Higher oil prices aren�t just hurting consumers, they�re also crimping profits for refiners operating in what’s known as the “downstream” sector of the energy market. Entering one of the worst refining environments in years, this group has recently begun to disappoint. With overall higher crude prices still on the horizon, analysts predict more disappointment for the sector for years to come.

Major integrated oil company Chevron (NYSE:CVX) was the latest firm to warn of lower profits due to shrinking margins in its refining operations. Its most recent interim update, issued last week, Chevron reported that it expects earnings for fourth-quarter 2011 to be significantly below third-quarter 2011 results. While its “upstream” — exploration and production (E&P) — earnings were comparable to the previous quarters, earnings for its downstream segment will barely break even.

The culprit: substantially falling Gulf Coast refining margins due to the price rises in the U.S. benchmark West Texas Intermediate (WTI) crude.

Firms operating in the downstream sector make money based on the difference between their crude oil costs versus what they can charge for refined products. For most refiners, oil inputs are priced in WTI oil. However, global gasoline pump prices are based on the price of the European standard, Brent crude.

WTI prices spent much of 2011 far below Brent prices due to the supply glut in Cushing, Okla., the primary oil storage facility in the U.S. Rapidly expanding oil production in North Dakota’s Bakken shale is to blame for that. However, Enbridge�s (NYSE:ENB) recent decision to reverse the direction of the Seaway pipeline has sent WTI crude prices upwards, narrowing the spread between the two oil measures. The WTI-Brent difference shank to only $8 a barrel at the end of the fourth quarter, down from around $26.

Since then, a variety of downstream firms have reported or warned about weaker profit numbers. West Coast refiner Tesoro (NYSE:TSO), recentlysaid it will lose between 55 cents and 80 cents a share in the fourth quarter. Similarly, analysts expect both Valero (NYSE:VLO) and Marathon Petroleum (NYSE:MRO) to report dismal fourth-quarter earnings numbers.

Skip The Sector

While some analysts cite pure refining stocks, such as HollyFrontier (NYSE:HFC) as bargains now, I�m not so sure. In the end, refining is a very tough and margin-intensive sector to operate in. With a variety of plans to export crude from Cushing now in the works, the spread between WTI and Brent will ultimately narrow even more. (And both will continue their rise upwards.)

This is why many of the major integrated oil firms have begun to spin off or sell their refining operations. In July, ConocoPhillips (NYSE:COP) was the latest to announce plans to spin off its downstream business, and Sunoco (NYSE:SUN) has been closing or selling off various refineries to focus on more profitable assets.

With refiners needing nearly perfect conditions to produce a real profit, the majority of market strategists predict that 2012 will be a tough year for the sector. Recently, Moody�s cut its outlook on the global refining and marketing sector to negative from stable.

So, investors may be wise to skip the sector completely or focus on the major integrated energy firms like Chevron. With this blip in earnings, it�ll interesting to see whether Chevron follows Conoco�s or Marathon�s lead and spins off its refining businesses.

Either way, long-term global demand for crude oil should help push up Chevron�s E&P earnings. Ultimately, strong revenues from its upstream business should help cushion weakness from the refining business, until any spin-off/asset sales are planned. For investors, that cushion can be quite valuable. Chevron shares have already recovered from their dip.

Still, with the WTI-Brent spread continuing to narrow, the refiners should see stifled gains throughout the year. That should be warning enough for investors.

Aaron Levitt doesn’t own any of the stocks mentioned here.