Dear Reader,
You may have heard of the tight supplies of diesel across many areas of the U.S. It’s all over the news. And it’s likely to remain in the headlines for months.
The Biden administration promises action to fight high prices for gas and diesel. However, this administration has only made politically expedient, short-term-oriented moves like draining the Strategic Petroleum Reserve.
The cold, hard reality that green energy advocates need to accept is that the billion-plus fleet of internal combustion engines around the world will need diesel and gasoline for decades into the future.
Pandering to a political base of radical environmentalists will only result in the loss of political power, whether it’s in the U.S. or Europe.
Until we see more political support to maintain U.S. oil, gas, and refining production capacity – and years of catch-up investments are made – we will keep bumping up against constraints.
Demand for refined products is still strong despite soaring prices. Gasoline and diesel prices might seem high, but that’s only because it’s natural to make a mental anchor to super-low prices in 2020 and early 2021.
Gasoline and diesel are not very high compared to the value they create for all sectors of the economy.
Why U.S. Refinery Earnings Are Set to Skyrocket
Access to lower-cost natural gas is why U.S. refineries will enjoy a huge competitive advantage versus competing refineries in Europe and Asia.
Natural gas prices in Europe have cooled off in recent weeks as demand has slowed. However, prices will surge again once meager storage levels get drawn down this winter.
Another surge in gas prices will remind investors that it will be exceedingly difficult to profitably refine crude in Europe for years into the future. The continent may see more refinery shutdowns in the years ahead. If so, it will rely more on imported products from geographies that have been investing in refineries, including the Middle East. Mothballed European refineries act to tighten refined product supply, which boosts profits at U.S. refiners.
Planned sanctions and “self-sanctions” on Russian- refined products have worsened refined product supplies – especially distillates (heating oil and diesel). Of course, Russia gets around sanctions by exporting to third parties.
But the net effect is an increase in miles traveled for the global refined product tanker fleet. That means there will be more refined products on the water and fewer products sitting in onshore tanks. Tighter onshore supplies keep prices high.
Without enough reliable energy supply, all other links in the economic value chain will malfunction. It’s fair to say that all other sectors of the economy are contingent on the smooth functioning of the energy system.
Underinvested also describes the state of the refinery industry. According to the U.S. Energy Information Administration (EIA), U.S. refining capacity fell for the second straight year in 2021. It started 2022 at 17.9 million barrels per day, down from 19 million barrels pre-COVID.
So even if demand for gasoline and diesel demand falls in a recession, tighter refining capacity will cushion the downside risk in refining margins.
Data collected by the International Energy Agency (IEA) on global refining capacity paints a similar picture. In its flagship oil market report, the IEA in October reduced its worldwide refinery production estimate for 2023 by 720,000 barrels per day. Demand reduction, OPEC+ production cuts, and lower contributions from sanctioned Russian refineries are all factors pushing refinery runs lower.
Refining has been underinvesting for several years, so it’s a suitable time to own refiners.
The mid-2000s was a golden age for U.S. refiners. Profits were high and consistent, and refining stocks left the S&P 500 in the dust.
Europe is structurally short of diesel. Also, the global economy demands refined products that can only be produced by complex refineries. Earnings at refiners have been phenomenal and will likely remain high for years.
Pipeline companies safely deliver trillions of cubic feet of natural gas to power plants, industrial facilities, businesses, and homes.
Billions more gallons of liquid fuels are delivered to refineries, terminals, and refueling stations. Pipelines keep the economy supplied with energy.
Many different types of companies own oil and gas pipelines.
- Oil and gas producers own pipelines to transport production from wells to refineries and market centers.
- Utilities use pipelines to transport natural gas to their power plants and distribute that gas to consumers.
- Meanwhile, many midstream companies focus entirely on owning and operating pipelines and other energy-related infrastructure.
- They typically are paid a fixed fee to let other energy companies use the capacity of their pipeline systems.
Pipeline companies generate steady cash flow, backed by long-term contracts.
- They earn fees as oil and gas flow through their systems.
- That gives them the funds to pay high dividends and invest in expanding their operations.
- Because of that, pipeline stocks tend to be great options for investors looking to generate some passive income.
One unique aspect of the pipeline sector is that some companies have chosen to structure as master limited partnerships (MLPs) for tax purposes.
- MLPs tend to distribute a substantial portion of their cash flows to investors, making them more appealing to income investors.
Pipeline companies are attractive long-term investments in both periods of economic growth and uncertainty.
- If higher interest rates are a result of accelerating economic growth or increased inflation, pipeline companies are well positioned to benefit through greater volumes transported or higher tariffs.
- Though the income-producing facet of pipeline companies is its headline benefit, years of being undervalued has left these companies in position for large capital gains, as well
Before we get to our plays…
It’s Worth the Effort to Understand A Few Basic Investing Terms…
If you’re taking a longer view, you want to think like a long-term owner of a share in a real business. And to do that, it helps to understand the basic investing terms below.
I don’t want to go into detail in this report, but these definitions are important if you’re a new investor who plans to buy and hold a stock, and you plan to treat your stock investments as shares of ownership in a bona fide business.
Otherwise, you might be under the impression, as many new investors are, that stock prices fluctuate on the crowd’s opinion of what companies will dominate the future – that investing is like voting in a popularity contest. It’s not, really. Sure, the crowd’s sentiment toward a company matters greatly in the short term. But sentiment doesn’t pay dividends; earnings and cash flow pay dividends.
Ultimately, every investor expects some type of return on their investment. Otherwise, they wouldn’t be involved. Riding a stock higher based only on a company’s temporary popularity might feel great. But it can feel even worse riding that same stock back down if there is no fundamental support from rising earnings, cash flows or dividends to justify the rise in a stock price.
The best free financial education resource I’ve found online is the Investopedia website. I’ll include links to Investopedia pages defining and explaining in detail each term:
- Market capitalization, or market cap:
The number of shares outstanding of a listed stock times the stock price. This is the market’s way of assigning value to an entire company by applying the price at which the last, marginal share was traded to every share that exists. There’s nothing concrete about market cap because an investment bank with a $20 billion market cap in 2007 could have a market cap close to zero by the end of 2008. But it becomes more concrete when either a corporate buyer or a private equity buyer of a company starts thinking about buying it. If a company has a $1 billion market cap, and an acquirer expects its free cash flow to be $100 million this year, and grow free cash flow by 5% per year, then the acquirer would see excellent value, and perhaps be willing to offer $1.5 billion (about $5 per person in the US) to buy it (a 50% “premium” over the market price). It would be offering 15 times free cash flow (or if you take the reciprocal of a 15 multiple to calculate a yield, you get a 6.7% – and rising – free cash flow yield for the business). If you own the acquired stock at a $1 billion market cap because you recognize the value first, then you stand to make a 50% overnight gain. - Enterprise value (or “EV” in the financial world):
Market cap, plus total debt, minus net cash. This is the number the acquirer in the example above would use to calculate the net cost of an acquisition. It considers the debt that must be assumed in an acquisition, minus the cash that is already on the acquired company’s balance sheet. If EV is less than market cap, a company has a net cash position. If, as in most cases, EV is greater than market cap, a company has a net debt position. Unless you’re looking at a financial stock, like a bank or an insurance company, generally EV is not too much bigger than market cap. Here’s a tip to avoid non-financial stocks that are at elevated risk of going to zero: if EV is five, ten-, or fifteen-times market cap, then the market is expecting a high probability of bankruptcy. The key statistics page of Yahoo Finance is an excellent free source of information on EV, and many related metrics. Here’s the key statistics page for iPhone maker Apple Inc. No company on earth can buy Apple at a $2.2 trillion (about $6,800 per person in the US) valuation, so AAPL shareholders’ only method of getting value from holding it here is to project a steadily rising dividend per share for decades in the future. Maybe that’ll happen, maybe it won’t. But the higher the price one pays for Apple compared to this year’s dividend, the more risk one is taking that AAPL’s price will in the short term be driven by sentiment, or index fund flows, than it is by solid cash returns. - Return on Invested Capital, or “ROIC”:
Net Operating Profit After Tax (“NOPAT”) divided by Invested Capital. Investopedia’s article does a superb job explaining these terms. Broadly speaking, NOPAT is the profit a business generates that can be used to out to shareholders, or to reinvest into growing its business. And Invested Capital is the physical plant, human capital and working capital (inventory, receivables and more) that is necessary to generate the yearly profit. A perfect business is one that reliably produces much more cash from its operations than is needed to sustain its operations.
To continue the ROIC theme, let’s contrast a monopoly software provider with a second-rate auto manufacturer.
The software company must only invest enough incremental cash in new software products to keep customers happy and renewing.
To do that, it must keep its staff of software engineers loyal and motivated. If so, the software company can grow rapidly with minimal incremental investments, produce remarkably high profit margins, and return a million times more cash to its shareholders than was ever invested into the company since its inception. Software’s marginal cost of delivery to a new customer is practically zero, so incremental margins are near 100%.
Conversely, a second-rate auto manufacturer must retool its factories every few years, pay scores of auto designers and engineers, manage incredibly complex supply chains, and risk investing in auto models that flop in the market – all while earning erratic, low profit margins. Most of the cash earned each year must be plowed back into risky new products to have a chance to beat the competition.
The result is an auto manufacturing business that, over a full economic cycle, consumes much more cash than it produces.
(By the way, this auto manufacturing model has such a low ROIC that the biggest players got into the auto lending business long ago. Auto lending results in more value capture, rather than letting the value of interest income on loans be captured by banks and credit unions).
If cash consumption continues for too long, bankruptcy becomes inevitable. For a free-market system to be sustained in the long run, we need a market with a critical mass of companies producing positive profits and positive ROICs.
Companies need to produce more value with the raw materials that they process than the cost of those raw materials. If not, that company’s operations are making society poorer. Of course, there are exceptions to this principle.
Many startups and rapidly growing companies produce losses or negative ROICs as they try to achieve scale. But if they still consistently lose money and have negative ROICs once they reach scale, they are not worth much. And maybe they are worth zero.
Those are the basic definitions I wanted to clarify upfront, before you read this report. From the figures above (market cap, EV, and ROIC), you get an idea of what you’re paying for a stock, compared to the value you’ll get in the future. Market cap and EV are snapshots at any given time of what the market is saying companies are worth. And ROIC includes the track record of each company’s past record in value creation. One must also estimate roughly what type of ROIC can be generated in the future, and how sustainable it might be.
Value can come in the form of a small cash dividend today, or a much larger dividend in ten years (as a “growth investor” tries to predict). Or value can come from owning a stock that has a high net debt position, but also has the cash flow strength to pay down its debt in a few years. In this case, enterprise value effectively shifts from creditors to shareholders. Each dollar of debt reduction, in theory, adds a dollar to shareholder value.
Or perhaps you make the mistake of buying a stock that goes to zero in bankruptcy before paying any dividends, and simply tells stories and issues more shares to new investors on the way to zero. This happens more often than you might expect at small, deteriorating companies. You rarely hear about this on bullish-biased business television.
Again, if you’re just starting out, or even if you’re an experienced trader, and have not invested at least a few hours or days to familiarize yourself with the basic investing jargon, I highly recommend investing some time. It can pay dividends over your investing career.
Also, education will broaden your interest in the fascinating stock market, which is loaded with great opportunities and hard-to-see pitfalls. More education and experience will help you recognize opportunities and avoid pitfalls.
I’ve been researching stocks professionally for over twenty years, and still approach it as a youthful finance and economics student. When you’re always learning, and the environment is constantly adapting around certain core principles, this venture doesn’t get boring.
If you approach stock investing as though you’re owning a share of genuine business, and not trading flickering tickers on a screen, you’ll stick with it when times are tough. And in tough bear markets, it feels best to quit and sell, usually at the worst possible time.
In today’s market environment, most investors are frustrated. Investor sentiment surveys are bleak. However, fund flows and portfolio positioning still show plenty of hope that we’re going back to the good old days of easy, high returns in index funds.
Mark-to-market losses have hammered investors on both stocks and bonds in 2022. The Fed has jacked up interest rates to try to fight inflation. Some have sold stocks and boosted portfolio allocations to cash, but many have not. Many investors are hoping for a “Fed pivot” and a return to the way things were prior to Covid. But that’s not happening. We’re in a post-Covid world with debt levels sky-high and inflation a persistent challenge. This environment calls for flexibility, diversification, and defensiveness – especially if you are in or near retirement.
As recently as November 2021, most investors were looking in the rearview mirror and saw nothing but twelve years of rising prices for the major indices. But as any driver knows, you don’t want to drive looking through the rearview mirror.
The path forward in stocks is unknowable with certainty. But experience and valuation tell me the three plays below offer more reward than risk in the current energy environment.
Three Oil & Gas Plays to Make Right Now
The stocks we feature below are quite distinct from one another. But all are great plays to make in the energy sector right now.
They include:
- a domestic refining company;
- a world-class pipeline company; and
- an international petrochemical and polymer manufacturing company;
CVR Energy Inc. (NYSE: CVI)
It’s extremely profitable to be refining crude oil on the U.S. East Coast right now.
That’s the region with the most U.S. refinery closures in recent years.
Shutdown decisions were driven by the age of these refineries, the capital investments needed to keep them in compliance with environmental regulations, and the low profit margins they’ve delivered in recent years.
This wasn’t just a U.S. phenomenon. A refinery in the Canadian province of Newfoundland shut down in 2020 soon after the COVID crash in oil product demand. Before its shutdown, that Canadian refinery was supplying a lot of diesel to the New England region.
Guess who stepped in? The Russians. After the War in Ukraine broke out, the Biden administration put a quick end to imports of Russian diesel to the East Coast.
If Russian diesel exports to Europe and the U.S. are going to be cut off (and that’s almost certain to happen in the months ahead), then where will these markets source the diesel they need to heat homes, run generators, and truck food to grocery stores?
They’ll just have to bid for it on the open market. That’s great news for the few healthy refineries operating on the East Coast. They have a shipping cost advantage.
Now the U.S. East Coast is an extremely profitable place to be refining oil into diesel and other valuable products.
That’s why we recommend CVR Energy Inc. (NYSE: CVI).
CVR energy is a great company that plays in two important markets: refined products and fertilizer.
CVI 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 of 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 diesel shortage AND a fertilizer crisis… and this company makes both.
Gasoline accounts for about 50% of sales, distillates account 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 throwing off millions in cash per day and given the current market backdrop, it isn’t going anywhere.
We believe the company will throw off over $2.5B in cash per quarter in 2022 and over $2.25B per quarter in 2023.
The current stock price doesn’t reflect the full value of the opportunity which represents over $10 of additional stock price appreciation.
CVR Energy is selling product into 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 also shouldn’t be ignored that Carl Icahn owns 70.8% of the company starting in 2012 and hasn’t sold a single share the whole way through.
The company throws off a ton of cash. Even at the current stock price, it yields 3.84% through a healthy dividend.
There have been rumors swirling that Icahn would just take the company private. But even if that never materializes, we’re able to capture a robust market and a healthy dividend.
If we remember 2013 – when CVI went to over $60 – we had a big spike in crack spreads and a lot of shale crude.
We now have crack spreads above 2013 levels and 12 million barrels a day being produced in the U.S. Prices are still at near-record levels but are still well above 2013 levels. That was the last time CVR Energy was above $60 a share.
We are in a great position to capture the next surge higher in stock price while clipping a nice coupon along the way!
CVR Energy Inc. (NYSE: CVI) is a buy
Enterprise Products Partners LP (NYSE: EPD)
Pipeline companies can be great passive-income producers.
Generating passive income is a terrific way to add stability and wealth to your portfolio.
Many investors hold dividend stocks for this purpose.
And pipeline stocks are one of the best ways to generate high dividend yields and steady growth.
Even during times of inflation, pipelines companies outperformed bond returns in 13 of 16 periods of rising rates since 2001 by an average margin of 11.7% and 10.7%, respectively.
What about investing in a world of higher interest rates?
While most companies with high debt suffer in a high-rate environment, midstream and pipeline companies generally utilize 70 to 100% fixed-rate debt, making their cash flow growth and longer-term performance less sensitive to higher rates.
In short, we believe the direct impact of rising rates on pipeline companies is minimal and, in our view, will not significantly hinder growth.
That’s why we are recommending Enterprise Products Partners LP (NYSE: EPD).
EPD’s business model is both large and diversified, giving it more avenues for growth, and reducing downside risk if a particular geography and/or energy commodity were to experience outsized headwinds.
EPD profits from virtually every category across the midstream value chain and has generated some of the most consistently strong results and returns on invested capital in the entire sector.
The company has arguably the strongest balance sheet in the entire midstream sector with an industry-leading BBB+ (stable outlook) credit rating, a meager 3.1x leverage ratio (which is below the low end of its target leverage ratio range of 3.25x-3.75x), a whopping $3.3 billion (about $10 per person in the US) in consolidated liquidity, and weighted average term to maturity on its debt of 20 years.
EPD is also poised to generate sufficient free cash flow after distributions and growth capital expenditures moving forward to fully retire near-term maturities when combined with its current liquidity.
As a result, there is little to no concern about EPD’s financial strength and ability to respond opportunistically to market dislocations.
As the CEO said on the Q3 earnings call, “Thinking back on my career, first with Dow and here at Enterprise, I can’t count the number of downturns I’ve been through. At Dow, the downturns were always painful, but here at Enterprise they always bring opportunity. In the current environment, while the uncertainties are real, the certainty that Enterprise will always deliver is real too.”
EPD is about to hit a quarter century of consecutive distribution growth and boasts a phenomenal distribution coverage ratio of 1.8x.
With a price target of $30.44, most analysts think EPD has a 21.8% upside.
It’s also a leading dividend payer. It pays a dividend yield of 7.62%, putting its dividend yield in the top 25% of dividend-paying stocks. It’s increased its dividend for 24 consecutive years.
Earnings for Enterprise Products Partners are expected to grow by 2.02% in the coming year, from $2.48 to $2.53 per share.
The P/E ratio of Enterprise Products Partners is 10.78. That means it’s trading at a less expensive P/E ratio than the market average P/E ratio of about 122.79. This could indicate the stock’s a steal.
EPD’s track record is also vastly superior, and its management, balance sheet, and asset portfolio are also considered the best in the industry.
In our view, EPD is the ultimate retiree income stock as it combines an attractive current yield with very consistent distribution growth along with a low-risk profile.
You can sleep well knowing that your distribution next year will be higher than this year’s and that this security can go a long way toward meeting your retirement goals.
In fact, you can probably own an outsized position in it given its low-risk profile and excellent management, with 1/3 ownership of the partnership by insiders.
Enterprise Products Partner LP (NYSE: EPD) is a buy
Westlake Corporation (NYSE: WLK)
The world is close to a global recession, something that rarely happens.
Even when some economies enter recession, other major economies may be performing better and are able to help pull the slowing economies out of their rut.
In a global recession, there is no economy or economic group that can perform this locomotive role for the rest of the world.
That’s why the industrial sector in the U.S. has weakened over the past few months.
Inflation has been persistent. Central banks have tightened their policies and promise more rate hikes in the future.
In such conditions, capital expenditures and long-term infrastructure projects grind to a sudden halt. Projects are canceled, market participants go bankrupt, and large corporations slash budgets.
None of this is to suggest financial distress or bankruptcy for the stock we are about to recommend. It does suggest a sharp decline in revenues and earnings, and a correlative crash in the stock price.
That’s why we are recommending buying put options on this stock.
Westlake Corporation (NYSE: WLK) manufactures and supplies petrochemicals, polymers, and building products worldwide.
The company offers its products to a range of customers, including chemical processors, plastics fabricators, small construction contractors, municipalities, and supply warehouses for use in various consumer and industrial markets, including residential construction, flexible and rigid packaging, automotive products, healthcare products, water treatment, and coatings, as well as other durable and non-durable goods.
With recession fears and rising interest rates, a slowing economy makes the outlook for this company dismal.
8.91% of the float of Westlake has been sold short. Short interest in Westlake has recently increased by 3.51%, showing that investor sentiment is decreasing.
What’s more, earnings for Westlake are expected to decrease by -40.44% in the coming year, from $20.13 to $11.99 per share.
Westlake has a PEG Ratio of 2.64. PEG Ratios above 1 indicate that a company could be overvalued.
As far as dividends, Westlake pays an annual dividend of $1.43 per share and has a dividend yield of 1.4%. Not a great yield.
So, you can see why I think this firm’s shares are ripe for a downswing.
That’s why selling this stock short makes sense.
I don’t think it’s unreasonable to imagine gains in the 300%-400% range when they take the plunge — which could literally happen any day, by my calculations.
Action to Take: “Buy to Open” the WLK
That concludes our report on our top three oil & gas plays to invest in right now.
Stay tuned for more trade opportunities as conditions call for.
Thank you for reading, and for your investment in our research service.
Kind regards,
Freedom Financial News
