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OPEC Won’t Restrict US Refiners (Or Their Dividends)

November 14, 2018

The Organization of Petroleum Exporting Countries (OPEC) just had one of their regular meetings, where they reported that for the four quarters of 2018, they saw drawdowns from reserves and storage from a deficit in their production against the sales from their member producers. Saudi Arabia is arguing for a cut to official OPEC production limits, meaning there would be less crude to go around and prices would go up. This is perhaps a threat to the lucrative US refinery market and for the dividend payments of many of the leading companies in that space.

However, they have released a report claiming that 2019 will find member countries stockpiling crude again, with softer demand against their attempt to bump up production earlier this year. But it’s not by a huge margin from its more bullish report just two months ago. They see global demand at 31.5 million barrels per day (BPD), which is only 500,000 BPD less than the prior report and 1.4 million BPD below current OPEC production.

Interestingly, the OPEC report is claiming that non-OPEC production will increase, ignoring that major production estimates have been revised down from 2018’s numbers for Canada, Brazil, Mexico and others. OPEC is still fearing the US as the world’s largest oil producer.

Daily demand is expected to drop by 70,000 BPD, with emerging markets expected to have lower economic growth.

But given the major political battles between Saudi Arabia, Iran and other OPEC members, this call for a cutback in production may be more about internal Middle East politics than good business. Saudis continue to have proxy battles with Iran, and reducing income from a proposed cutback would harm some of their frenemies’ current accounts.

In addition, Saudi Arabia would like to cut the legs off of US producers with lower prices. That didn’t work for them over the last few years, and given overall supply and demand conditions for petroleum, it won’t work going forward.

With US West Texas Intermediate (WTI) and regional crude prices at discounts due to pipeline and other infrastructure limitations, it has only made the case to get more pipe and other assets online quickly into 2019. So, the US, as by some estimates the largest oil producer in the world, is set to supply refiners with more crude oil regardless of OPEC.

You can see this in the level of imports from OPEC to the US, which continues to fall over the last five years. With US production on the rise, overall imports have fallen by 54.71% between October of 2012 and October of this year.

US Imports from OPEC
Source: US Census Bureau & Bloomberg

This means that refiners have been relying less on OPEC and its higher-priced crude oil, and more on US production, which they can buy at a discount, with WTI sitting now at a discount of 14.98% to global Brent crude.

The key for refiners’ profitability and the ability to pay better dividends comes from the margin between the cost of a barrel of crude oil and the price of refined products including gasoline, diesel, jet fuel and other distillates. This is what is known as the crack spread.

The current broad measure of the crack spread is the spread between the US WTI price at the Cushing, Oklahoma hub against prices from US Gulf Coast refiners. And this spread, while down from recent highs this past June, is still nicely up from lows in March by 45.88%.


US WTI / Gulf Coast Crack Spread
Source: Bloomberg

But this spread doesn’t reflect even better discounted prices for crude coming from fields in the Permian Basin, the Bakken Shale and even deeper from Western Canadian fields.

The clogged pipeline networks mean that refiners are able to contract for crude at discounts from the glut of production that’s finding ways to them. And then there’s the addition of train- and truck-delivered crude which is also making its way to refiners.

One of my favorite refiners for dividends and growth is Marathon Petroleum (MPC). This company recently completed its acquisition of Andeavor to become a major national refinery. It is now pulling crude from around the US and Canada for its refinery operations.

Marathon’s operating margins are quite good, at 6.10%, 2.63 times better than in the first calendar quarter (before the merger).

This is driving an impressive return on the expensive capital of its refinery and other assets at, 14.50%. For shareholders, the return on their equity is running at 27.40%.

Revenue is climbing over the trailing twelve months by 20.00%, and this is piping in profits to fund dividends, which are up this past year by 20.27% to a current payout of 46 cents, giving shareholders a yield of 2.86%. Projections for the next dividend set to be declared in January are for a further increase in the distribution to 50 cents.

Yet, despite the great underlying fundamentals, Marathon’s stock has been deeply discounted. The stock is valued at a discount of 64% of its trailing sales. And the stock’s price-to-book value has gone from 2.62 times in late September to a bargain buy at only 1.91 times today. And remember, new refineries are very hard to get permits to build, so its assets are truly valuable and hard to replicate.

Marathon has less to fear from OPEC and more to capitalize from US producers, making it a good dividend paying stock for income and growth over time.