The refining industry is undergoing a painful period right now. That makes it an attractive sector for both dividends and capital gains.
Refiners are big, stable businesses that aren't going away yet. They are at their lowest point in years, thanks to the unlikely combination of an oil glut and a pandemic. From a contrarian perspective, that means they are close to perfect.
"Refining margins are absolutely catastrophic," Patrick Pouyanne, the head of Total (TOT:NYSE), Europe's top oil refiner, told investors. That's the common sentiment among industry executives, analysts and traders.
The trouble in the refining industry began prior to 2020. Narrow margins made the business difficult. The low profit margins began to shake out the weak hands.
In 2019, there were seven U.S. refineries up for sale. That works out to about 5% of the total crude oil processing capacity in the U.S., according to Reuters.
On top of an already weak market, the pandemic clobbered gasoline and jet fuel demand.
In March 2020, the demand for fuel fell so far that it cost more to crack the oil into fuels than you could make back. In other words, it cost the refiners to. . .refine.
ExxonMobil's (XOM:NYSE) results illustrate just how difficult refining is. In the second quarter of 2020, the company booked $24.5 billion in revenue from its downstream refining segment. That was $29.5 billion less than it made in the same period in 2019. It also refined 11% less oil, which contributed to that decline.
Thankfully, the demand for diesel and gasoline rebounded from the low, but jet fuel has not.
That means the margins on the turning oil into fuels collapsed. In July 2020, according to Bloomberg, the price was half its seasonal average.
This didn't just hurt ExxonMobil. Another refining stalwart stumbled in 2020. Independent refiner Valero (VLO:NYSE) had only its second quarter of negative free cash flow since 2014.
It generated $893 million in free cash flow in the fourth quarter of 2019. That fell to –$484 million in the first quarter of 2020. That's a $1.4 billion swing from profit to loss.
However, that may change as 2020 closes and we turn to 2021. Refiners fortunes will hinge on the U.S. dollar. The chart below shows the Invesco DB US Dollar Index Bullish Fund (UUP:NYSE). The fund tracks the performance of the dollar against a basket of six major world currencies. As you can see in the chart below, the dollar is in a steady decline:
If it continues to depreciate, the way analysts expect, it could boost refiners' margins. Here's why.
First, it spurs demand. Oil trades in dollars. So, a weaker dollar means it will cost less in euros and yen. When fuel costs less we use more. In addition, a weak dollar tends to keep Americans at home. We vacation at home when Europe is "expensive."
That should bump up demand for fuel, both at home and abroad.
That's good news for companies like ExxonMobil and Valero. And that means it's a good time to look at investing in refiners.
While you could buy an exchange-traded fund (ETF) like the VanEck Vectors Oil Refiners ETF (CRAK:NYSE), I prefer to buy the individual companies because of their dividend yields.
You can buy Phillips 66 (PSX:NYSE) or Valero, which are both strong performers in the sector. They pay 6% and 7.5% dividend yields, respectively. That's a great return, with relatively low risk and the potential of a solid capital gain as the sector returns to normal.
—Matt Badiali
Matt Badiali is a geologist and independent financial analyst. He spent fifteen years researching and writing about great investments inside the natural resources sectors. He can be reached at www.mattbadiali.net.
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