Reduce Risk By Investing Downstream

The latest crash in oil prices probably has many investors hanging their heads, lamenting the deteriorating quality of many energy investments. After all, with oil prices less than half of what they were just one year ago, and even down a quarter since June, how can anyone have the confidence to put their money anywhere in the sector?

But there are always opportunities.

Exploration companies are struggling under the weight of their own growing debt, and some could go belly up in the coming months. The oil majors are not in such extreme danger, but the ballooning costs of megaprojects has them dealing with their own set of problems. Medium size drillers do offer a good rebound option, as they are sure to ride out the storm and could emerge with an upside to their share prices. However picking out the right companies can be difficult.

Amid all the uncertainty, it is probably safer to stick to one segment of the energy industry that is actually profiting from low oil prices.

Go Downstream

It may seem obvious, but the refining sector is sitting pretty, even more so now that crude prices have failed to rebound in any significant way, despite optimistic predictions to the contrary.

For refining companies, crude oil is a cost, not the final product that brings in revenue. Thus, low prices are a godsend. But the situation is even better than simply refiners enjoying low oil prices.

Refiners sell gasoline to drivers, jet fuel to airlines, and an array of other refined products for an endless list of industrial purposes. Typically, low crude oil prices correlate with a depressed economy, which erases part of their customer base. For example, after the global financial meltdown in 2008, sure, refiners had cheap crude to work with, but they also had a depressed marketplace in which to sell their products.

That is not what we have now. Currently, oil prices are at their lowest levels in years, but the economy is doing relatively well (at least outside of Canada, Brazil, and Southern Europe). Unemployment is low once again in the U.S., and industrial activity is humming along. Not since the 1990s have oil prices been low during a period of strong activity.

That means refiners are enjoying their best few quarters in years. Take Valero (NYSE: VLO), the world's largest independent refiner. The company has 15 large refineries and processes 2.9 million barrels per day of a broad portfolio of refined products. Many of these are located along the Gulf Coast, such as the company's Corpus Christi facility, which has a throughput of 325,000 barrels per day.

Valero has done well, and the $32 billion company even increased its dividend over the past year, boosting it from 28 to 40 cents per share on a quarterly basis. The company pulled in $1.4 billion in the second quarter, or $2.66 per share.

The company also controls Valero Energy Partners LP (NYSE: VLP), a master-limited partnership that focuses on the midstream sector, with a series of pipelines that have a fee-based model. In other words, the company takes in revenue simply by moving product around, and depends less on oil price fluctuations.

Phillips 66 (NYSE: PSX) is another midstream/downstream pick. It has 2.2 million barrels per day in refining capacity, with facilities located along the Gulf Coast, but also on the East and West Coasts, and in between. Phillips has managed to boost its quarterly dividend from 20 cents per share in 2012 to the current 56 cents. Its share price has not skyrocketed this year in the same way that Valero's has, so there is plenty of room to move up. Phillips also has quite a few assets in the midstream sector, which, like Valero, earn from a fixed-fee model.

One more to look at is Alon USA (NYSE: ALJ), a smaller independent Texas-based refiner. Alon has just 217,000 barrels per day in capacity, an order of magnitude smaller than the other picks on this list, Valero and Phillips. The company's assets are concentrated in the south and southwest - in Texas, Louisiana, New Mexico, Arizona, and California. Alon could provide investors with a bit more exposure - its share price has just about doubled since the start of 2015.

Outlook

One of the challenges that refiners have had in recent years were the bottlenecks that the company ran into because of a shortage of pipeline capacity. To a certain degree, the gushing crude upstream in places like West Texas and North Dakota had trouble finding sufficient pipeline capacity to get to refineries. But a variety of pipelines have been completed in the past few years (and especially in Texas over the past year) that have unlocked ever more volumes of crude for refining. The lack of pipelines is no longer the problem it once was.

As mentioned before, the two ingredients for success for this sector are low oil prices and strong demand.

On the first point, oil prices are flirting with multiyear lows once again, and the prospect of a rebound looks much worse than it did in March when oil prices last reached such low levels. Earlier this spring Goldman Sachs predicted oil would fall to $45 per barrel later this year, which generated a lot of eye rolls. But that price has been reached much quicker than expected. The investment bank predicts that oil prices will remain near these low levels for years to come. That means that there is still quite a bit of time left for the golden age that refiners now find themselves in.

Second, demand looks strong both domestically and around the world. Cheap oil has more drivers hitting the roads.

The U.S. has become the world's largest exporter of refined products, and with demand growing around the world, that position will only continue to grow. Consumers are burning through ever more supplies of refined products, so growth prospects look good.

The IEA predicted last year that North America is becoming a "titan of unprecedented proportions" in terms of refined product exports.

Drawbacks

There are a few reasons for caution, however. One is simply the danger of too much success. Refining companies have benefitted from the oil bust as low prices fattened margins. Share prices of some of the industry's best companies have exploded over the past year. Valero's share price is up over 30 percent since the beginning of the year.

That raises the possibility that there is less of an entry point for investors at this stage, so proceed with caution. However, Valero, for example, still trades at an extremely undervalued 7.40 P/E ratio, so it still has room to grow. There are good reasons to think that the best days are yet to come.

Another challenge facing the sector is one of policy. Refining companies are profiting off of a quirk in the U.S. legal system. Oil companies are prohibited from exporting oil from U.S. shores, blessing refiners with an abundant supply of cheap oil. Not only that, but WTI trades at a discount to Brent, precisely because of the ban, enlarging margins for refiners. This is a huge boon to the industry.

However, there is a concerted effort in Washington DC to scrap the ban on exports, a movement that is picking up steam. If the export ban is lifted, that would be highly negative for the downstream sector. For now, it is still in place, and refiners are lobbying to keep it that way.

One other challenge comes from the prospect of falling U.S. oil production. If output drops significantly, oil prices could rise a bit. Moreover, the discount between WTI and Brent could narrow, eroding the advantage that refiners have been enjoying.

Conclusion

There are few low-risk investments in the energy sector, especially now that it is undergoing a wave of turmoil not seen in years. However, midstream and downstream players offer a lot less risk than trying to pick upstream producers who might enjoy a rebound.

Refiners have seen their share prices surge over the past year as they pocket revenues from widening margins. That margin may eventually shrink, but in the near term, refiners are a solid bet.