DIESEL DOOMSDAY – Powering Through the Gas Crash

Freedom Financial Archive | Originally posted April 28, 2023

Dear Reader,

Welcome to our latest report on how diesel prices are crushing the energy sector.

Below, we will explore the dramatic impact the latest crisis is having on the energy sector and how diesel prices have been squeezed to historic highs.

Let me ask you a question…

How do you feel when you pull up to the pump at your local gas station?

You’re probably thinking, “How can gas be that expensive?”

Just imagine what the poor truck drivers are thinking.

“I deliver all these goods to the store, so people have toothpaste, deodorant, and food. And this is how they repay me!”

And if you take delivery of diesel to heat your home, your provider almost certainly adds a surcharge to your bill.

The price surge of both gas and diesel has been breathtaking and a near-term driver of inflation.

The questions are “When does the price fall?” and “Which price falls first?”

Gasoline is the fuel we see and feel in real-time.

After all, you must swipe your credit card or pay cash.

You feel this instantly, like the sharp pain that throttles you when you throw out your back.

Diesel is something that compounds across the supply chain and adds up to a big hit.

This is the over-spiced curry of pain.

You can’t feel it now, but boy, will you pay for it later!

For example, if you buy a t-shirt from Target, each leg of that journey consumes diesel.

Let me show you:

  1. Farmers in, say, India grow and harvest cotton. (Farm equipment and trucks run on diesel).
  2. The cotton is processed into a usable textile and either woven in India or sent to the next leg of its journey.
    • a. The next leg could be the processed cotton loaded on a ship (consuming diesel) to be delivered to the Under Armour facility in Vietnam.
  3. A truck driver picks up the container of cotton at the port and drives it to the factory.
  4. Another truck driver sends the finished shirt back to the port for passage to America.
  5. The container travels across the Pacific by boat to dock in Long Beach.
  6. There, yet another truck driver takes the shirt from the ship and drives it to the local distribution center.
  7. From the distribution point, you buy the t-shirt online and it goes into the UPS/ FedEx/ USPS process. Or it’s shipped to the local store.
  8. One of the logistics companies drops it at your doorstep or you drive to the store to pick up your new shirt.

Every leg of that journey requires distillate (diesel or marine gasoil).

And that distillate price gets added to the next business-to-business customer.

So, you aren’t paying for diesel once.

You pay for it seven or eight times.

This is why a diesel price shock is more, well, shocking than a gasoline one.

And we didn’t even talk about the increased labor costs, shipping rates, port fees, tariffs, and taxes we suffer in the global economy.

Yes, “suffer” is the correct verb to use when speaking of taxes!

We will all sit around and complain about our recent fill-up – I certainly do.

But really, it’s diesel that’s driving the pain.

The Backbone Of The Global Economy

In this chart, we can see the parabolic price progression of diesel.

The projection for the rest of 2023 is well above 2019 – 2021.

Remember, you, the consumer, aren’t paying for that just once.

Cracking Open Another Barrel

Refiners convert crude oil into various products that businesses and retail folk consume.

The “crack” is an industry term for breaking apart barrel of crude oil into its component products.

  • Gases like propane, heating fuel, and gasoline,
  • Light distillates, like jet fuel,
  • Intermediate or middle distillates, like diesel fuel, and
  • Heavy distillates, like grease.

Our friends over at Visual Capitalist created this infographic showing the breakdown:

The “crack spread” is the amount of money that a refiner can make for turning crude oil into its final product.

This margin drives earnings power for the local entity.

Each area has specific implications based on the type of crude bought, how the refiner is built, and if there is a local shortfall.

I Got Your Sanctions Right Here…

The Russian invasion of Ukraine worsened the shortages in the market because the U.S. and Europe imported a significant amount of oil and refined products.

Sanctions have reduced the normal flows to a trickle. This has pushed countries and companies to find alternatives.

India and China have been happy to buy the discounted crude (trading $40 below Brent).

They buy the Urals, ESPO, Sokol (all types of oil) and turn it into products that can be sold within their country or exported to Europe or the U.S.

This increases the miles per ton, because crude now must flow from Russia into Asia and back into Europe, rather than going from Russia to Europe directly.

India and China are buying crude well below market rates but sell their end products at market rates. This increases their margins.

The margins in Asia have been surging.

When we look at hydrocracking, it’s sitting just off a record level.

Whoa… Wait… What’s Hydrocracking?

What’s hydrocracking, you ask?

Hydrocracking is a process by which the hydrocarbon molecules of petroleum are broken into simpler molecules, such as gasoline or kerosene, by adding hydrogen under high pressure and in the presence of a catalyst. This process employs hydrogen gas to improve the hydrogen-carbon ratio in the cracked molecules and to arrive at a broader range of end products.

The major products you get from hydrocrackers are jet fuel and diesel.

That’s why hydrocracking is so important.

Because it yields the most middle distillate.

The global diesel shortage offers a terrific opportunity for investors around the world.

As the shortfalls are happening around the world, the healthy margin is creating a windfall for this report’s recommendation.

As we showed earlier, U.S. prices are elevated with a lot of staying power in this price point.

In the chart below, you can see how Singapore diesel commands a large premium over Dubai crude.

The same story applies to ICE gasoil over Brent. (BTW, Europeans refer to diesel as gasoil.)

The storage levels around the world are sitting at record lows.

Refiners are struggling to close the gap for several reasons that I will discuss shortly.

But it’s important to look at the data seasonally to understand the kind of opportunity these limitations present.

Middle distillate availability is either at record lows or approaching the lowest levels in over two decades.

Unfortunately – or fortunately, depending on your outlook – demand hasn’t fallen nearly as much as supply has dropped.

The market has faced supply chain issues that have forced companies to resort to more trucking and ways to get products to market.

Keep On Truckin’!

The trucking market has started to cool off as inventories bounce back and bottlenecks are better than before. But we are going to see the levels still are elevated against historic data.

The U.S. isn’t going to hit the highs of 2021, but trucking doesn’t have to, to keep diesel demand elevated.

There are still many households that rely on heating oil due to lack of alternatives.

Just to show you how our “betters” don’t think things through, get a load of this…

There have been law changes in the U.S., most notably the New York Tri-State area and New England (the largest consumers of heating oil) that only ultra-low sulfur diesel can be used in the systems.

Unwittingly – or dimwittedly – the government has pitted the heating needs for households against the truckers’ need for road diesel, leading to soaring demand and even higher prices.

Another issue is the creation of IMO 2020. The International Maritime Organization stipulates ships must burn very-low sulfur or ultra-low sulfur diesel unless they have a scrubber installed.

This rule now forces shipping to compete with road diesel and heating oil.

You may be thinking, “Why don’t refiners just make more diesel?”

If only it were that simple!

When a refiner makes one barrel of diesel it inherently makes two barrels of gasoline.

That’s just the chemistry. We can’t do anything about it.

Jumpin’ Jack Flash Burned His Gas, Gas, Gas

When we first started to create diesel (to replace whale oil), gasoline was a by-product that was dumped into oceans and rivers.

This resulted in the Ohio River burning several times.

Those Rockefellers were always troublemakers!

This by-product gave way to cheap feedstock for the internal combustion engine.

The organic chemistry of refining crude though hasn’t changed.

So, if a refiner wants to tackle the diesel problem, they also need to manage a plethora of other products, gasoline being the most important.

There are ways to reduce the gasoline output based on cracker configuration (changing the chemical composition through catalysts), running oil through other processes, or using a different mix of crudes.

There are over 100 different types of oil in the world.

About 54 of them commonly trade.

Each type of crude yields a different level of products, and some refiners aren’t equipped to handle the nuances of each grade.

Each crude type has important metrics:

  • Sweet versus sour: how much sulfur does it have?
  • API gravity: is it light (U.S. shale) or heavy (Canadian oil sands)?
  • TAN (total acid number): the acid quality of the crude.

There can be other problems such as heavy metals, water contact, and salt content.

But many of those thresholds are captured in the TAN.

The chart below helps to put into perspective the variety of options for a refiner.

A refiner’s complexity (the type of oil and product it can create) is measured by the Nelson Complexity Index.

The higher the NCI, the more “high-value conversion capacity is installed,” and the broader variety of oil that can be produced.

Typically, the crude types with the highest middle distillate components are on the heavier side of the spectrum: Egina (“Eg” on the chart) is a crude that has an API of 27.3, but also has a low sulfur content of 0.17.

Why is that important?

The more complex a refiner is, the more they can process sulfur. If they don’t have a coker (the unit that cooks the crude at the beginning of the process), they must rely on desulfurization units that can quickly be overwhelmed due to their limited nature.

So right now, refiners are trying to maximize the middle distillate cut.

If We Only Thought Ahead of the Next Election…

Over the last 7-10 years, the market has not been investing in finding or producing heavier crude grades.

All the while, Asia (mostly China) and the Middle East are bringing online new refiners, while the rest of the world is shutting down capacity.

The below chart shows a map of where new facilities are being built, while we face closures in the U.S., Europe, and other parts of Asia.

In the summer of 2019, there was an explosion at the Philadelphia refiner that annihilated the facility.

The owners had sold it multiple times… or at least tried to be because they always struggled to turn a profit.

When the explosion happened, I said: “This is going to change the distillate market permanently.”

The East Coast relied significantly on this facility to supply heating oil and gasoline for the Northeast corridor.

The world started to slow down in ’19, followed by COVID in ’20, so the first “real” year that would test the East Coast was ’21.

Distillate storage in PADD 1 (East Coast) started to drop like a rock, and the facilities in the region relied heavily on the import market, which just so happened to be… you guessed it… RUSSIA!

Even with the added flow, PADD 1 struggled to maintain storage.

Before the Russian sanctions, the trend was getting worse into the East Coast, which currently sits at a record low storage.

Now the situation is a bit different in PADD 3 (Gulf of Mexico) where most of the refiners in the U.S. operate. They have been trying to fill the void, but they face several important bottlenecks:

  1. Shortage of heavy barrels (the Keystone XL pipeline would have helped address this),
  2. Pipeline capacity to send refined product North (Colonial pipeline 1 & 2 only options), and
  3. Importing from one U.S. port to another requires a Jones Act vessel, severely limiting the ships that can carry the product north.

The Jones Act is a federal law that regulates maritime commerce in the United States. It requires that goods shipped between U.S. ports be transported on ships built, owned, and operated by United States citizens or permanent residents.

With no foreign ships allowed to help, the US is at a severe disadvantage.

Gulf of Mexico refiners have been exporting more product into the European markets while Asia (mostly India) and the Middle East increase their exports into the Atlantic Basin.

There’s money being made in the market, and China has just increased their export quota of refined products to 4.5 million tons.

This will help soften the blow, but it is also expensive to crack crude.

If you remember from earlier, hydro crackers are the most effective.

Hydrogen is created by converting natural gas into a core feedstock, and LNG prices have soared to record highs and are holding at records.

The high input costs, including crude, power, and natural gas will help keep crack spreads elevated for some time.

So how can we make money? What can we buy so that we don’t have to worry about imported products?

Our Recommendation

CVR Energy Inc. (NYSE: CVI) is a great company that plays in two important markets: refined products and fertilizer.

From Dun and Bradstreet:

CVR Energy refines and markets high value transportation fuels to retailers, railroads, and farm cooperatives and other refiners/marketers in Kansas, Oklahoma and Iowa. Located approximately 100 miles from Cushing, Oklahoma (a major crude oil trading and storage hub), the company’s two oil refineries in Coffeyville, Kansas and Wynnewood, Oklahoma represent close to a quarter of the region’s refining capacity. Through a limited partnership, the company also produces and distributes ammonia and ammonium nitrate to farmers in Illinois, Iowa, Kansas, Nebraska, and Texas.

The world is currently facing a double whammy of a diesel shortage and a fertilizer crisis… and this company makes both diesel and fertilizer.

Gasoline accounts for about 50% of sales, Distillates accounts for about 40%, and the remaining revenues came from Ammonia, UAN, Freight, Crude Oil, and other products.

The refining segment drives about 90% of sales with a little sweetener coming from the nitrogen fertilizer segment of 10%.

The company is earning millions in cash per day and given the current market backdrop, this isn’t going to change anytime soon.

We believe the company will earn over $2.25 billion in cash per quarter in 2022 and roughly $2.0 billion per quarter in 2023.

The current stock price doesn’t reflect the full value of the opportunity that represents over $10 of added stock price appreciation.

It’s important to appreciate that PADD 2 (Midwest), where the company runs, is also facing severe shortfalls in both distillate and gasoline. Gasoline can easily flow into PADD 1 (East Coast) from Europe with over 1 million barrels a day coming into the coast.

The beauty with the mid-west is that it’s landlocked without any big pipelines coming up from the Gulf of Mexico.

Sure, you can truck or train it to the region, but that is expensive!

CVR Energy is selling products in an area with record shortfalls.

So even if demand slows on the consumer level, they feed diesel and fertilizer to farmers throughout the breadbasket states.

The company is very insulated with a lot of drivers to support margins and protect revenue.

It’s important to note Carl Icahn has owned 70.8% of the company since 2012 and hasn’t sold a single share yet.

The company throws off a ton of cash and even at the current stock price yields 3.84% through a healthy dividend.

There have been rumors swirling that Ichan would just take the company private. But even if that never materializes, we’re positioned to capture a robust market and a healthy dividend.

In 2013, we had a big spike in crack spreads and shale crude that sent CVI to over $60. We now have crack spreads above 2013 levels and twelve million barrels a day produced in the U.S.

Fertilizer prices are still at near record prices but are still well above 2013 levels, the last time CVR Energy was above $60 a share. It is now at an excellent entry point to profit.

We are in a great position to capture the next surge higher in stock prices while clipping a nice coupon along the way!

The diesel gas shortage could pose many challenges if the refineries don’t increase capacity or if we don’t find ways to replenish supplies. If diesel gas prices continue to go up, consumers will feel this impact as the prices of everything will continue to increase.

Action to Take:

Buy CVI up to $35 per share.

Thank you for reading and for your investment in our research service.

Good Hunting,

Freedom Financial News