Taking Advantage of the Oil Refining Slump

Thomas O’Malley, a 68-year-old investor, has made billions for himself and his backers as an investor in oil refineries — those twinkling jungle gyms of pipes and tanks and columns that turn crude oil into useful products like gasoline.

This is O’Malley’s playground. He has probably bought and sold more refineries than any man alive. He knows them like an old chef knows the inside of his kitchen.

O’Malley got rich by following a reliable formula. He bought refineries when they were cheap — castoffs, unloved by Big Oil — trading for less than the cost to build them. Later, he sold them for billions.

For example, in the aftermath of the 1987 crash, he picked up a 26% stake in Tosco, then a tiny refinery. O’Malley eventually turned Tosco into the largest independent refiner in America. He sold it to Phillips Petroleum (now ConocoPhillips) for $7 billion.

Two weeks after he closed that deal in 2002, he took over Premcor, becoming its top executive. He did it all over again, using Premcor as a vehicle to buy refineries on the cheap. Four years later, he sold Premcor to Valero for $6.9 billion.

His is the Midas touch in the refinery space. And he’s mostly laid low since 2007. But now he is back again, buying a Delaware refinery he once owned and sold to Valero. The deal is worth $220 million and is the first purchase of a new $2 billion fund created to buy U.S. refineries. O’Malley says he’ll look at any U.S. refinery on the market.

In other words, it looks like O’Malley is going for the hat trick — trying to get rich three times in the same game.

It’s a contrarian bet, as most people think ill of the refining industry. It’s plagued by costly regulations, weak profit margins and lower demand for motor fuel. But you don’t get to buy stuff below replacement value when times are rosy. As David Foley, an investor with O’Malley put it, “Last time we did it, we made six times our money.”

Based on his track record, I would not ignore O’Malley’s play here. Clearly, he thinks the industry has hit bottom. And there are good reasons to think so, as we’ll see.

One reason comes from Barry Bannister, an analyst at Stifel Nicolaus. He shows how peaking oil prices on a year-over-year basis are usually a catalyst for better refining margins. (See chart below. “WTI” is “West Texas intermediate,” a common benchmark for crude oil.)

Higher refining margins means more profits for refiners. Higher profits usually mean higher stock prices follow. Valero, the bellwether refinery stock, is down about 75% from its all-time high in 2008, which reflects the collapse of refining margins. So an uptick in refining margins will likely work wonders for Valero’s stock price, like rains greening a desert.

Besides owning a refinery, another way to play the revival is by owning stock in a company which builds and upgrades them, an E&C, or engineering and construction, company. There is one such stock in the Capital & Crisis portfolio. It has more exposure to the downstream, or refining sector, than other E&Cs. Yet it has a better balance sheet and is more consistently profitable than the refinery stocks. It also has greening potential, as it is also about three quarters off its 2008 high.

It also has its own favorable cyclical winds working, as Bannister shows. Bannister does the best work on the E&Cs in the business that I know of. What I enjoy is his study of past cycles. In one of his historical studies, he found a reliable pattern in our stock’s book-to-bill ratio.

Book-to-bill means how much work a company books (or sells) over how much it bills (or completes). A book-to-bill ratio over 1 means the business is expanding. If it is under 1, it is shrinking.

Bannister found that the book-to-bill ratio for our company experiences major peaks followed by about two-year sharp declines, followed by about two-year sharp recoveries. Such a dating puts the bottom somewhere in mid-2010 — right about now — as a backlog shows signs of picking up. Bannister believes the bottom is in. Such dating also puts the next peak off in 2012, plenty of time to make hay now.

Another way to see this is in the E&C firms as a family. Take a look at the chart below. Note where we are today, lingering in the basement. But if history follows — and this history goes way back — then we are looking at a move to the penthouse ahead.

Bannister forecasts a total backlog of $5.75 billion in 2011. Backlog correlates well with the stock. (More work on the backlog implies higher future earnings.) A $5.75 billion backlog would equate to a solid 40% gain.

If O’Malley, the refining investing whiz, is right, as I think he will be, refinery margins will rebound. That will warm the hearts of refinery owners everywhere, but it will also put a smile on the face of this stock’s owners too.

Chris Mayer
Whiskey & Gunpowder

July 14, 2010

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