Retail Gasoline: The Forgotten Investment Opportunity

Introduction

2014 has been a busy year for energy investors, with lots of ups and downs. With a long list of unexpected geopolitical twists, there was never a dull moment: the deepfreeze in the U.S. causing natural gas prices to spike, Russia's annexation of Crimea and the possibility of natural gas supply disruptions to Europe, the rise of ISIS and the splintering of Iraq, and more.

At the beginning of the year, no one would have predicted these events.

But the most surprising development in 2014 by far was the crash in oil prices.

This column often highlights major energy opportunities with new technologies, exciting offshore plays, and below-the-radar shale basins that nobody is talking about. But in an oil market that is looking increasingly likely to stay low for a while, companies are going to be much more conservative moving forward, at least in the short term. That limits the potential for homeruns.

But it also opens up new opportunities.

Upstream? Not Now

And that means staying away from small and mid-sized companies in upstream oil and gas. The largest oil companies can withstand an extended period of low prices due to their size, breadth, and diversity. Companies like ExxonMobil (NYSE:XOM) have integrated their operations so that they also earn when prices drop, due to their large refining assets. ExxonMobil's share price, while bobbing up and down over the course of 2014, has barely budged from where it was in January, despite the momentous decline in oil prices.

Smaller companies don't have that luxury. Stay away from the pure-plays on upstream oil and gas moving into 2015. For example, the huge winners in the Bakken over the last five years have been the smaller companies that have bet the farm on oil output from North Dakota. Continental Resources (NYSE: CLR), Oasis Petroleum (NYSE: OAS), Triangle Petroleum (NYSE: TPLM), and Whiting Petroleum (NYSE: WLL) are just a few of the Bakken stars that are now seeing their stock prices crumbling. Continental's CEO Harold Hamm has seen billions of dollars of his personal fortune go up in smoke as much of the value has vanished off his company's balance sheet.

These companies are starting to run into financing trouble, with banks beginning to raise concerns about the ability to see their loans repaid. This is enough to avoid small and mid-sized companies that have used debt to drill, betting their entire futures on high prices.

To be sure, investors may have a huge opening to jump in now with many stocks at multiyear lows. But, it is far from clear that the oil rout is over. With the upstream sector a no-go zone for now, what is an investor to do?

Midstream

The midstream sector, which involves moving oil and gas products around, is not entirely insulated from oil prices, but it does offer growth while still being largely removed from the swings of the day-to-day oil market. The U.S. may see some of the weaker producers shaken out of the market, but on the whole, the country is still expected to see production gains for natural gas, natural gas liquids, and crude oil. That means there will be a need to move product around.

Phillips 66 (NYSE: PSX), mostly known for its refining, is betting heavily on a small but fast growing midstream portfolio. In fact, while the rest of the energy sector is slashing capital expenditures, Phillips 66 is stepping up investment on pipelines to carry crude. It increased its 2015 spending on its midstream business by 43% to $4.6 billion. The markets didn't take too kindly to this move given the slump in oil prices, and Phillips' share price has dropped by about 16% over the last several months.

But the markets are missing the point. Only a small slice of the company's earnings are affected by crude oil prices. Moreover, U.S. energy production is expected to stay elevated for years to come, making midstream an enormous growth sector. And by the time Phillips brings its new pipelines and rail hubs online, oil prices will likely be off of their multi-year lows. As an added bonus, Phillips 66 has also promised double digit increases in dividends over the next several years.

Downstream - Retail

One of the least sexy energy sectors for investors is at the retail level. After all, gasoline stations have never been cash cows - margins on gasoline sales are so low that owners often make more of their revenues from snacks and drinks rather than gasoline. Far from a breakthrough opportunity or a hot new market, retail gasoline has often been overlooked.

However, with few safe investments out there, retail gasoline offers a hedge against falling oil prices. And even more than that, the margins for retail gasoline owners are growing quickly as oil prices drop.

When oil prices fall, you can track the decline in share prices for upstream exploration companies along with the price of crude. But there is an inverse relationship between oil prices and the fortunes of companies like CST Brands (NYSE: CST), a fuel retailer, which has seen its value take off since the summer, just as crude prices began to fall off a cliff.

That is because gasoline prices often fall slower than the price of crude oil, opening up a wider margin for their owners.

CST owns and operates 1,900 gasoline stations across the United States. The company will earn 27 cents per gallon of gasoline in the last quarter of 2014, according to Gabelli & Co., which is nearly double the 15-cent per gallon margin it received at the same time last year.

Another retailer, Murphy USA (NYSE: MUSA), has also benefited from the oil price environment. Its share price is up more than 50 percent since the beginning of 2014, and nearly a third since just October, when the oil price decline picked up pace. It expects to take in 13 cents per gallon this year, lower than CST, but still up about 25% from a year earlier.

For a more integrated play on the downstream sector, check out Marathon Petroleum Corp. (NYSE: MPC), the downstream arm of Marathon Oil (NYSE: MRO). Marathon Petroleum operates seven large refineries, with the capacity to refine 1.7 million barrels per day, enough to make it the fourth largest refiner in the country. It also has over 5,400 retail stations, and sells asphalt and other petroleum products using oil and gas as a feedstock. Its share price has seesawed in 2014, but Deutsche Bank recently upgraded the company to "buy" with a $114 price target, way above the $87 per share it was trading towards the end of December.

If nothing else, it is important for investors to have contingencies in place when energy companies falter under the weight of falling oil prices. Take a look at the chart below, which compares four companies mentioned in this article. The two retail gasoline companies, CST Brands and Murphy USA, have performed very well since the decline in oil prices really took off in October. In contrast, Continental Resources and Whiting Petroleum, big Bakken producers, began to nosedive at the same point in time.

Investors should certainly swing for the fences with their portfolios by going long in cutting edge technologies, or frontier exploration companies. But, it is also good to load up the portfolio with some safe, unsexy, mom-and-pop retail gasoline companies as well in order to play both sides of the oil price coin.

Downstream -Refining

Likewise, while retail gasoline stations benefit from low oil prices, downstream companies in refining can see their margins balloon. Refining companies, in which crude oil is a cost, not a source of revenue, love to see oil prices fall. More to the point, U.S. refiners like Phillips 66 (NYSE: PSX) gain mostly from the spread between WTI and Brent, a quirk resulting from the crude oil export ban in the United States. Until the U.S. Congress lifts the export ban, Phillips 66 will continue to inordinately profit off of what essentially is an arbitrage opportunity. Other companies that fall into this category are Valero (NYSE: VLO) and Tesoro (NYSE: TSO).

Conclusion

The energy sector is going through a very tough but interesting period. Upstream companies have been demolished in the last two to three months, and investors who haven't prudently hedged were most likely burned. Here is a chance to straighten out the portfolio, by filling up on some good ol' fashioned retail gasoline companies. We know it is not the most exciting gamble in the world, but it offers the best opportunity in a depressed oil price environment.