Investment Manager’s Letter April 2008
Western Refining Inc is an independent crude oil refiner and marketer of refined products. It also operates service stations and convenience stores. The Western Refining owns and operates four refineries with a total crude oil capacity of approximately 234,000 barrels per day (bpd). In addition to a 124,000 bpd refinery in El Paso, Texas, and as the result of the May 31, 2007 acquisition of Giant Industries, Western Refining owns and operates a 70,000 bpd refinery on the East Coast of the United States near Yorktown, Virginia, and two refineries in the Four Corners region of Northern New Mexico with a combined throughput capacity of 40,000 bpd. Western Refining operates in three business segments: the refining group, the wholesale group and the retail group. The Western Refining’s refining group operates the four refineries and related refined products terminals and asphalt terminals. At its refineries, it refines crude oil and other feedstocks into finished products, such as gasoline, diesel fuel, jet fuel, and asphalt. The Western Refining’s refineries market finished products to a diverse customer base, including wholesale distributors and retail chains. Its retail group operates service stations and convenience stores and sells gasoline, diesel fuel, and merchandise. Its wholesale group distributes gasoline, diesel fuel and lubricant products.
As of February 22, 2008 Western Refining owned and operated 155 retail service stations and convenience stores in Arizona, Colorado and New Mexico, a fleet of crude oil and finished product truck transports, and a wholesale petroleum products distributor, Western Refining Wholesale, Inc., which operates in Arizona, California, Colorado, Nevada, New Mexico, Texas, and Utah. CEO David Foster came to El Paso in 1993 to manage an existing refinery that was then in bankruptcy. In 2000 Foster and his managers bought the refinery from the creditors. Three years later the same group bought another contiguous refinery. Both of these facilities dated to before World War II but had been modernized extensively by 2000. In January 2006 they took the operation public at $17.00 per share, and paid off all of the Western Refining’s debt. Then in May of last year came the acquisition of Giant with three more refineries and the retail locations in Arizona, Colorado and New Mexico.
This is a management team that definitely eats its own cooking. CEO Foster owns 42% of the Western Refining and together the Management and the Directors own over 62% of the outstanding stock. In addition, Management’s annual bonuses are paid in restricted stock, so that up to two thirds of their annual compensation every year comes in the form of stock. I think that we can expect this management to act like the owners they are.
Petroleum refining is a competitive business with much of Western Refining’s competition coming from bigger companies, and from large international oil companies that produce some or all of the crude that they refine. It is a cyclical business whose profitability tends to run separately from the Price of crude oil. There are certainly questions about Western Refining’s near term prospects with the price of crude oil at historic highs and the prospect that high gas prices that may cause customers to drive less this summer. Western Refining’s margins decreased in the third quarter of 2007 because of merger related administrative costs. In the fourth quarter the Western Refining lost $26 million. The loss was caused by low margins (the price Gasoline did not keep up with the increase in the price of crude oil), maintenance problem at the Yorktown refinery, and pipeline problems in El Paso. Mr. Market, ever vigilant, passed judgment by discounting the price of the Western Refining’s stock from the mid sixties to the low teens. Whether his judgment is rational and reasonable, or mostly emotional is the question that we are trying to answer here. There has been a general decline in price of all the refiners. Valero Energy is down to $51 from a high of $78, Alon is at $16 down from $47, and Frontier from a high of $49 is now at $27. (See chart below).
In millions except share data
|Cost of Products||$6,376||$3653||$3,002||$1,990||$831|
|Earnings Per Share||$3.55||$3.13|
Jim Grant in his January 21, letter had this to say about the current price to the stock.
“Just to judge by the collapse in the share price, you’d never suppose that Western Refining (WNR) has boosted its refining capacity by 70% since the completion of a contentious merger with Giant Industries last year. In fact, you’d probably guess that the merger was stillborn, crack spreads (i.e., refining margins) had turned negative, fuel cells had wholly displaced gasoline and America’s towns and cities were clamoring for the privilege of building a new refinery. Not at all. In fact, crack spreads hover above their five-year averages, gasoline remains America’s preeminent automotive fuel and, at least in the matter of refinery construction, NIMBY is still America’s mind-set.”
In fact, U. S. Refining capacity has remained flat for the last 30 years. The countries 149 refineries currently handle 17.4 million barrels a day. In 1978 there were twice as many refineries that were capable of refining about the same amount of crude. As a result of the failure to add capacity today we import $3.4 million barrels of refined products (gasoline, diesel and jet fuel).
On April 7 the Wall street Journal ran a story reporting that Royal Dutch Shell PLC and Saudi Aramco are in the process of spending $7 billion to expand their refinery at Port Arthur Texas, from 275,000 barrels a day capacity to 600,000 barrels a day. The cost of this project on a barrel per day basis ($7 billion divided by 325,000) is $21,500 per barrel. In comparison Western Refining paid $11,000 per barrel for Giant Industry’s capacity, and Mr. Market thinks they are both crazy.
It is interesting that the Market has decided that the refining capacity is worth so much less than what Shell and Aramco are willing to spend to build new capacity. It is not likely that Western Refining’s older facilities would ever be able to operate as efficiently as the facilities that Shell will build, but still the discount (82%) does not seem particularly rational. By this measure of value, buying Western Refining is buying dollars for $.18.
During the fourth Quarter of 2007, 92% of Western Refining’s operating income came from the refineries, So Western Refining is still mostly in the business of refining crude oil. Because of this, the Western Refining’s profitability (or lack thereof) is almost totally dependent upon the “Crack Spread” (the difference between what it costs the Western Refining to buy crude oil and the price at which it can sell its refined products). For refiners in general, profits tend to be seasonal with the Second and third quarters strong because the crack spreads tend to be higher during the summer driving season. In the short term the stocks of refiners are primarily a speculation on crack spreads, and in that sense things should be getting better over the next couple of quarters. The first quarter is now over and we know that spreads in the first quarter were considerably better that they were in the fourth quarter. The Crack spreads in the first quarter were back to about where they were in the third quarter of 2007. A level that, barring any nasty surprises we have not heard about yet, should generate a nice profit for Western Refining. Margins like the third quarter of 2007 should give the Western Refining $.60 to $.70 per share earnings in the first quarter. Progress on any of their operational issues would allow better results. Because the operating profit for a refiner is not dependent upon the price of crude oil, it is possible for refining margins to decline as oil prices are increasing (which is what happened in the third and fourth quarter of 2007). At the same time falling crude oil prices can make for happy refiners.
The table below is a list of the operating income of Western Refining and three of their competitors. The biggest and oldest of these is Valero Energy Corp. Although Valero is quite a bit larger than Western Refining their operations are similar, and prior to Western Refining’s merger with Giant industries their operating margins were about the same. This was particularly true in 2005, 2006, and first two quarters of 2007. The operating profit at Frontier oil are considerably higher than the other refiners in this table because their two refineries (in Cheyenne Wyoming and El Dorado Kansas) are able to process a higher percentage of heavy crude.
|Company||Market Capitalization 4/5/2008 (millions)||Capacity (Barrels Per Day)||Market Value (Per Barrel per day)|
Frontier processes about 33% of total production as heavy crude. This compares to Western Refining’s refineries which currently refines about 10% heavy crude at El Paso. Yorktown should be able to refine 50% heavy crude but maintenance problems have kept Yorktown in the red since the merger.Both companies refine considerable quantities of West Texas Intermediate crude. While The West Texas Crude generally runs $4 to $5 per barrel cheaper than light sweet crude the difference between Heavy and light crude has been running from $15 to $20 per barrel.We can see from the Table that refining margins were strong during 1990’s when Crude prices were declining, but weak from 1997 to 1999, and 2002 and 2003. In the short term it is likely that refining margins will remain weak as Crude prices increases, but with a long term perspective it is interesting that these margins (even with the hurricane spike in 2004 and 2005 still are not back where they were in the early Nineteen Nineties. Refining margins fell in the fourth quarter of 2007 because the price of crude oil was increasing while gasoline prices failed to keep pace (probably because seasonal weakness). Valero’s operating margin in the fourth quarter was 3.08% about one fourth of the rate in the second quarter, but also less than half its rate in the fourth quarter of 2006. For Western Refining their fourth quarter resulted in a loss, but refining margins were not the only problem, there were also maintenance problems at Yorktown; and Pipeline problems at El Paso.
Below is a list of potential factors that will affect Western Refining’s profit level for the next year or two.
As a percentage of Revenue
|Western Refining||Valero Energy||Frontier Oil||Alon USA Energy|
|AVE 5 YEARS||6.25%||8.87%||5.66%|
|AVE 5 YEARS||2.47%||4.97%|
|AVE 10 YEARS||4.36%||6.92%|
|AVE 9 YEARS||9.94%|
|AVE 19 YEARS||7.15%|
Refining margins do not recover this summer (crude oil prices continue to increase and the price of gasoline diesel, and jet fuel fail to follow.
Maintenance expenses at Western Refining refineries come in above estimates.
A Hurricane Hits Yorktown Virginia. The Yorktown refinery is on the Virginia Coast and is vulnerable to damage from any hurricane that strikes this area.
Western Refining fails to realize cost Synergy’s it expects from merger.
Western Refining’s merger and the debt that resulted from the purchase of Giant Industries together with current conditions in the debt market have cut the Western Refining’s margin for error. A prolonged period low refining margins or a series of serious maintenance problems at its refineries could cause financial problems.
Refining margins recover to levels seen in the last three years.
The Four Corners refineries are able to acquire enough crude to approach operational capacity (Versus present operation at 69% of capacity). Before the merger in 2005 Giant industries purchased a pipeline that runs from West Texas 424 miles to Northwestern New Mexico that had been idle for seven years, the company has refurbished the pipeline and in late 2007 put it back on line. Prior to 2007 the only supply available to the Four Corners refineries was from local producers that were able command a high price for their crude Even with this local production there was not enough crude available to run these refineries at full capacity.
The Yorktown refinery returns to profitable operation. Yorktown operated at a loss in the second half of 2007 in spite of its ability to process heavy crude with up to 54% of its capacity, and so should be Western Refining’s most profitable refinery. These production Problems appear to be related to crude oil purchased by Giant that is causing maintenance problems. Purchases of this crude have been terminated.
A Hurricane hits the western Gulf Coast. Western Refining has no refineries exposed to the Gulf Coast. Hurricanes in 2004 and 2005 damaged refineries along the Gulf coast and the resulting temporary reduction of refining capacity. This caused a spike in refining margins.
Western Refining is able to successfully raise its overall capacity for heavy crude from 12% before the merger and 25% after the merger to their projected goal of 45% by the summer of 2009.
Merger synergies are successfully realized. Western Refining projects $25 to $30 million reduction in administrative costs as a result of the merger.
All things considered it appears a good deal of the potential bad news has been discounted by current price. While short term prospects for the industry are indeed cloudy, the known risks are mostly in the price of Western Refining’s stock. Any good news will be a surprise, and with short interest high any good news could causes a sharp rally in the stock.
Short interest in the stock has been increasing rapidly since December 31. In December there were 1,698,800 shares held short, By March 14 short interest had jumped to 4,566,100 shares, and by March 31 the figure was 5,764,800 shares, this is about 21% of the Western Refining’s 27 million share float. It appears that the shorts smell blood and are piling on big time. This is a factor that will tend to prolong the present down trend, but is at the same time is piling up ammunition for an eventual rally. At the end of March the Western Refining was even appearing on lists of stock with naked short positions.