I want to show a cautionary tale using the Zacks Rank. The industry I chose today, Oil Refiners, is currently ranked #15 out of 265 industries in the Zacks Rank system that includes 4400 stocks. That sounds like the perfect earnings estimate industry landscape to find a buy.
On top of that, there are 23 companies in the Oil Refining industry, which is a large set of companies for an industry to have. The last few weeks have shown a huge 53 positive earnings estimate revisions, and only 18 negative revisions. That means there is a broad, optimistic consensus on the EPS outlooks for Oil Refining companies. Annual forward-looking EPS outlooks improved broadly.
We all know what that landscape is: Energy, and more specifically: Oil prices.
That’s the cautionary element in this tale.
The Zacks Rank doesn’t care about the durability of an earnings estimate revision. It offers a 1- to 3-month call. In oil markets, the key underlying fundamental earnings driver -- oil prices -- acts with extremely volatility. Anyone living through the last 12 months can fully appreciate that.
Here are 6 key points to consider when evaluating a strong Zacks Rank company in the CURRENT oil industry.
6 Key Points on Oil Companies
The U.S. Dept. of Energy projects retail gasoline prices for summer 2015 to be more than $1 per gallon lower than last summer. This decline reflects a large drop in Brent crude oil prices.
Point #1: U.S. retail gasoline prices are more closely tied to prices for globally traded North Sea Brent than domestic crude oil prices.
The Brent crude oil spot price is forecast to average $58 per barrel, which equals $1.39/gallon at the pump this summer. This is down from last summer’s average of $106 per barrel, which equals $2.52/gallon. That projected $1.13/gallon decline in Brent price this summer accounts for the entire decline in retail gas.
Point #2: Falling oil prices mean most ‘upstream’ energy companies and their investors can expect lower profits in coming months.
However, in addition to the price of Brent crude oil, U.S retail gasoline prices are generally determined by three broad ‘downstream’ elements:
(1) Refining costs and profit margins (wholesale margin)
(2) Retail and distribution costs and profit margins, and
(3) Taxes.
Elements two and three compose the retail segment of the supply chain. These costs tend to be relatively stable. Element one refining cost and profit is more volatile
Point #3: Like crude oil prices, refining costs and profit margins can be volatile.
Refining profit margins have a seasonal component. They are typically higher during spring and summer -- when gasoline demand is higher -- and lower during fall and winter. This summer, average refining margins are projected about the same as last summer. More gasoline supply from greater refinery runs should balance with higher projected gasoline consumption this summer.
Given it is a regular event, all upside to spring and summer refining margins are likely priced into refining stocks.
Point #4: Recently, big, integrated oil companies have found this recently unloved part of their business -- oil refining -- provides a cushion.
Take BP (LONDON:BP) PLC (BP - Analyst Report). The British oil company told The Wall Street Journal it loses about $275 million in annual pretax operating profit when the Brent oil price drops $1, since the company’s so-called ‘upstream’ division earns less for the oil it produces.
But BP’s refining operations -- which have done so poorly in recent years investors have pressured some companies to leave the business -- now provide some insulation. The ‘downstream’ operations, which refine oil into gasoline and other products, become more profitable when the oil they use is cheaper.
Prices of refined products such as gasoline typically don’t fall as quickly as those for crude. For each dollar-per-barrel of improved profit margin for refined products, BP generates $500 million in extra pretax operating profit annually.
Point #5: Companies only get short-term support in ‘downstream’ earnings when oil prices fall.
Why? Enhanced earnings only last as long as the hedge.
Refineries have to buy oil. In pretty much every industry, increased input costs lead to lower profits. Refineries do pass on most of the costs to end-users, but not all, and not immediately. Many times, refinery outputs -- gasoline, diesel, etc. -- are sold in advance as futures. This is a hedge (or protective bet) against drops in fuel prices.
Point #6: If an oil refiner bets that fuel prices will drop, then having them rise will cause a loss or reduction in refiner profits.
The basic point is that ‘upstream’ producers of oil and gas, aka the drillers, the E&P companies, and the oil services providers will win if oil prices rise from here. If they are range-bound, there is no play for either ‘upstream’ or ‘downstream’ companies. If oil prices rise, the refiners are definitely not the play. The recent spate of earnings estimate revisions can and will come down if oil prices rise.
That is a good place to conclude this cautionary tale. If this still sounds like the right place for finding a top Zacks Rank pick, then consider these two companies.
Marathon Petroleum
Marathon Petroleum Corp (NYSE:MPC). is a leading independent refiner, transporter and marketer of petroleum products. It holds a Zacks #1 Rank in mid-April.
The company, in its current form, came into existence following the 2011 spin-off of Houston, TX-based Marathon Oil Corporation (NYSE:MRO)’s refining/sales business into a separate, independent and publicly traded entity. Marathon Petroleum operates in three segments: Refining and Marketing, Speedway (Retail) and Pipeline Transportation.
- Refining and Marketing: The unit’s operations include seven refineries having a combined crude processing capacity of 1.7 million barrels per day, concentrated primarily in the Midwest, Gulf Coast and Southeast regions of the country. This segment over 89% of the company’s 2014 earnings.
- Speedway (Retail): Marathon Petroleum has a profitable retail footprint in Enon, OH. Known as Speedway LLC, the unit is the second largest chain of company-owned and -operated gasoline and convenience stations in the U.S. Speedway consists of approximately 2,740 stores in 22 states.
- Pipeline Transportation: This segment -- which is one of the biggest petroleum pipeline networks in the U.S. -- owns, operates, leases or has an ownership interest in about 8,300 miles of pipeline, consisting of 52 systems spread over 15 states and federal waters.
- Marathon Petroleum surpassed expectations in Q4-2014, beating the Zacks Consensus Estimate for both earnings and revenues.
Caution! Being primarily a refiner and marketer of petroleum products, Marathon Petroleum is expected to benefit from a weak crude pricing environment.
Lower input costs and higher product sale realizations would likely to drive earnings for the firm.
Also, the company’s impressive asset quality and extensive midstream/retail network, in addition to the increased assets from the acquisition of Hess’ retail business, lend support to the company’s growth story. As such investment in the company appears lucrative amid expectations of increased earnings and cash flows.
Marathon keeps Findlay, OH as its headquarters.
Phillips 66 (NYSE:PSX)
Phillips 66 holds a Zacks #1 Rank in mid-April. It is a ‘downstream’ energy company. The company operates in three segments: Refining and Marketing, Midstream and Chemicals.
- The Refining and Marketing segment purchases, refines, markets and transports crude oil and petroleum products primarily in the United States, Europe and Asia. This segment also includes power generation operations.
- The Midstream segment gathers, processes, transports and markets natural gas and transports, fractionates and markets natural gas liquids primarily in the United States.
- The Chemicals segment manufactures and markets petrochemicals and plastics.
Phillips 66 Partners L.P keeps Houston, Texas as its headquarters.