3 ways to win from the oil glut

By Jim Jubak

There's an oil glut.

Don't expect to see it in the prices you pay at the pump, however. Unfortunately, the glut is in the kind of heavy sour crude oil that is tough to refine into gasoline. The supply of crude that is easiest to refine into gasoline remains tight enough to keep the price of filling up truly painful.

But the glut in heavy sour crude should change where you look for profits among oil stocks. The relatively few oil companies focused on refining heavy crude are making record profits on each barrel that they process.

Here's the crux of the problem for gasoline consumers and oil companies: There's just not enough light sweet crude to meet demand. And, while there's plenty of heavy sour crude, a barrel of heavy sour crude yields about a third less gasoline than does a barrel of sweet light crude. That's if you can refine it to begin with: Many refineries, especially in Asia, can't handle heavy sour crude at all. (A heavy crude is thicker than light crude. A sour crude contains a higher percentage of sulfur.)

The result is a scarcity of light sweet crude and a glut in heavy sour crude that has led to increases in the price of easily refined light sweet crude and big drops in the price of heavy sour crude.

How big a glut? A big, big one, judging by the price of light sweet and heavy sour crude. At the end of June, Nigerian Bonny Light, one of most sought-after grades of light sweet crude, was selling on the spot market for $71.65 a barrel, while Saudi Arabian Heavy sold for $58.70 a barrel, according to the U.S. Energy Information Administration. That's a spread of almost $13 a barrel, way above the $5 a barrel historical average for the spread between light sweet and heavy sour grades.

So big a glut that Saudi Arabia, a big producer of heavy sour crude, cut back production in May and that month produced slightly less oil than permitted by OPEC (Organization of Petroleum Exporting Countries) quotas. Iran, which has steadfastly refused to discount its heavy sour crude, has begun storing some excess production in tankers. The current total in tanker storage off Iran is believed to be around 20 million barrels.

Slow change

This glut of heavy sour crude and the unusually wide spread isn't likely to go away anytime soon. Almost all of world's very limited spare production capacity in the Middle East consists of reserves of heavy sour crude. A majority of the new oil that is being discovered is heavy sour crude. To meet its growing demand for oil in a world where most newly discovered oil is sour, the Asia Pacific region will have to add 1 million barrels a day of refinery capacity by 2015 and shift its current refinery mix from 55% sour to 68% sour, the International Energy Agency estimates.

No way in the world will the region be able to add that much refining capacity and shift refining technology on schedule, the International Energy Agency says. Building a new refinery or upgrading an old one to handle heavy sour crude takes a long time at the best of times. But because of the global energy boom, every oil company from Irkutsk in Siberia to the Orinoco Basin in Venezuela wants to explore, drill or build, and there simply aren't enough engineers, pipes, valves or control gear to go around. That has sent construction costs skyrocketing to the point where even companies that can line up the construction crews and materials that they need are canceling projects. On Monday, U.S. oil refiner Tesoro (TSO, news, msgs) cancelled its planned upgrade of its Anacortes, Wash., refinery to handle heavy sour crude. Costs on the project, originally set at $250 million, had soared to $375 million.

Refineries that can turn heavy sour crude into gasoline aren't evenly distributed around the world. Europe and the United States have more than their share. About 60% of the crude refined in 2005 by Valero Energy (VLO, news, msgs), for example, was heavy sour crude.

Here are my three picks -- in a regular week, I'd call them my CNBC-TV picks, but I'm not doing CNBC this week. But, as per the parameters of my series of CNBC picks, each has a six-month time horizon, and I'd call each a moderate risk -- for a world in which the ability to refine sour crude can produce some very sweet profits.

• Valero Energy. Valero swallowed Premcor, another specialist in refining heavy sour crude, in 2005 to become the leading heavy sour-oil pure play. Now the largest refiner in North America, with a daily throughput capacity of 3.3 million barrels, the company's ability to refine cheaper sour grades of crude give it a major competitive advantage that went straight to the bottom line in the first quarter of 2006. First-quarter operating income soared by 67% to $1.5 billion from $900 million in the first quarter of 2005 on higher margins for gasoline and other distillates (and the acquisition of Premcor in September 2005.) When the company announced first-quarter earnings on April 26, Valero's CEO reported that margins had started off strong in the second quarter, as well and looked likely to continue through the summer. Wall Street took those remarks to heart and has projected an 81% increase in earnings for the second quarter. (Valero reports on Aug. 1.) But Wall Street believes that the second quarter will mark the end of these strong margins. Earnings will grow just 5% in the third quarter and actually decline by 10% in 2007. With the light sweet crude in short supply and heavy sour crude a glut on the market, I think Wall Street is just plain wrong on that.

• Frontier Oil (FTO, news, msgs) is a fraction of the size of Valero Energy -- throughput of 162,000 barrels a day for Frontier versus 3.3 million for Valero -- but it is even more focused on heavy sour crude. Both of the company's refineries -- in Kansas and Wyoming -- can process heavy sour crude. In 2005, according to Friedman Billings Ramsey, about 70% of the oil Frontier refined was heavy sour crude. (Compared to 60% at Valero.) Wall Street is predicting an even more abrupt drop in earnings for Frontier Oil than for Valero: After increasing by 72% for the second quarter, Wall Street sees earnings at Frontier Oil dropping by 17% in the third quarter and 15% in 2007. With production of heavy sour crude ramping up in Canada, the company seems to me to be very well positioned (Frontier Oil also owns a 38% interest in a crude oil pipeline in Wyoming) for the next decade -- as well as the next six months. The company is due to report second-quarter earnings per share on Aug. 7.

• Holly (HOC, news, msgs) is just a little smaller than Frontier Oil -- a market capitalization of $3 billion, versus the $4 billion market cap of Frontier -- and has just slightly less exposure to heavy sour crude with slightly more than 60% of the output of its two refineries coming from heavy sour crude. With refineries in New Mexico and Utah, Holly -- like Frontier -- is in place to capture a significant share of the increase in heavy sour crude production due from Canada over the next decade. (The company sold its Great Falls, Mont., refinery in March, reducing its throughput capacity to 100,000 barrels a day.) In the first quarter of 2006, refinery gross margins at Holly rose to $11.96 per produced barrel, a huge 59% jump from the $7.51 refinery gross margin in the first quarter of 2005. As with Valero and Frontier, however, Wall Street expects this earnings-growth gravy train to stop with a 45% increase in the second quarter of 2006. After that, Wall Street projects earnings growth will drop to 11% in the third quarter and turn negative at 4% in 2007. The company is due to report second-quarter earnings on Aug. 7.

Editor's Note: A new Jubak's Journal is posted every Tuesday and Friday. Please note that Jim's CNBC picks, like those in this column, are short-term recommendations with a 6-month time horizon. For picks with a longer time horizon see the 12-to-18 month Jubak's Picks portfolio or his truly long-term 50 Best or Future 50 portfolios. You'll find links to all three at the left near the top of this column.

E-mail Jim Jubak at jjmail@microsoft.com.

At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column. He doesn't own short positions in any stock mentioned in this column.