The New Spread

Across the energy complex, first-quarter 2012 was marked by low conviction in equities, as evidenced by diminished trading volumes and fund redemptions. This phenomenon is largely true on a market-wide basis. Although U.S. stocks posted their best first quarter in more than two years, this was achieved on NYSE volume that was 15% lower than the year-ago period.

While the 13-F filing data showing institutional investment managers’ first-quarter 2012 capital allocations has not yet been submitted to the SEC, filings from previous quarters reveal a consistent trend. Money from all sectors is leaving the investment discretion of traditional equity managers, such as mutual funds, and rotating into sector-focused exchange-traded funds (ETFs), bond funds, private equity and hedge funds.

Fourth-quarter 2011 13-F data from the top 100 actively managed investors, as measured by their equity assets under management, indicated that these investors decreased their dollar value exposure to every single macro sector even as the quarter witnessed an 11% rise in the S&P 500.

During this period, energy saw one of the steepest capital outflows—nearly $50 billion from the top tier of institutional investors.

One oil and gas niche that has seen increased investor appetite, however, is the downstream, mirroring this subsector’s vast outperformance in the stock market. The S&P 500 Oil & Gas Refining & Marketing Index surged more than 23% in first-quarter 2011, doubling the next-best-faring sub-industry index, the Philadelphia Oil Service sector index, which increased 10% (and its counterpart, the S&P 500 Oil & Gas Equipment & Services index, only gained 2%).

Meanwhile, the S&P 500 E&P index rose 6%, despite the fact that Brent oil climbed more than $17 per barrel, or 14%, in the first quarter.

Upstream-focused equities have underperformed Brent since early 2011, and analysts estimate that these stocks are pricing about $100 per barrel crude oil, well below the current Brent price. By contrast, refiners have outperformed even as the planned reversal of the Seaway crude oil pipeline and weaker U.S. gasoline demand have compressed differentials.

According to Morgan Stanley, refining equities have outperformed the S&P 500 by an average of 29% in eight out of the last 10 years, in the months from December through May. This seasonal trade reflects tightening product balances during this period as refineries undergo turnarounds and maintenance ahead of the peak summer driving season, at the same time that demand is relatively high due to East Coast winter needs. Looking ahead to the second half of the year, the questions are, are refiner stocks overbought, reflecting a crowded and seasonal trade, and why are E&Ps undervalued and under-owned?

While the key metric driving oil and gas intrasector performance used to be growth, more recently, investment managers have eschewed E&Ps in large part because of their very success in producing domestic oil and natural gas, which has caused these commodities to trade at significant discounts to their global counterparts, thus diminishing their earnings capacity.

The other irony is that U.S. refiners, previously viewed as cyclical investments, are the chief beneficiaries of the structurally wider discounts on domestic production pricing. And while E&Ps are prohibited from exporting crude oil overseas, refiners have capitalized on a robust export market for finished petroleum products.

Even as the June reversal of the Seaway pipeline is expected to narrow the spreads of U.S. crudes to global benchmarks, wide discrepancies between oil priced north of Cushing, such as Bakken and Syncrude, and oil priced south of Cushing, such as Light Louisiana Sweet (LLS), are forecast to persist for years due to logistical constraints.

Pricing point

With the marginal North American barrel of crude oil destined for the Gulf Coast refining and export market, the Gulf Coast, rather than Cushing, Oklahoma, will become the relevant pricing point for North American crudes given the region’s ability to compete directly with global seaborne grades. In other words, the critical question for the domestic energy market no longer centers on the WTI-Brent spread, but on the spread between LLS and Brent.

Historically, LLS has traded at about a $2-per-barrel premium to Brent, encouraging the approximate 750,000 to 1 million barrels per day of foreign light-sweet crude oil imports to the Gulf. However, Gulf refineries are increasingly configured to handle heavy crude with limited flexibility to shift to light feedstock.

As Gulf-bound pipeline capacity expands, the Coast region could become flooded with light-sweet crude, both of foreign and domestic origin, thereby depressing LLS prices. Raymond James analysts estimate that it would take a $10-per-barrel LLS discount to Brent to cause Gulf refiners to invest in displacing their heavy capacity, but they forecast the differential will hover at only $5 by around 2015, even with assuming the cessation of foreign imports.

Another factor to consider in the Brent-LLS differential is the heightened possibility of an oil release from the Strategic Petroleum Reserve—especially as full Iranian sanctions take effect in July, coinciding with rising retail gasoline prices in the peak summer driving season and amid the Presidential race in the U.S.

Last June’s decision to tap the reserves due to supply concerns from Libyan outages saw the majority of SPR volumes released into the Gulf Coast, which caused WTI-LLS spreads to contract by more than $7 per barrel. According to Morgan Stanley, following the SPR release, the Midcontinent refiners underperformed both the S&P 500 and the broader energy sector by 4.1% and 3.3%, respectively, yet fully recovered after one week. If last year is any indicator, while an SPR release would likely result in the underperformance of LLS relative to Brent and WTI, the impact on the refining equities would be short-lived.

While it is unclear how much Gulf Coast refiners will be able to capitalize on cheaper LLS prices, it is clear that the higher multiples that the stock market has been awarding to the Midcontinent refiners over the past year, especially relative to their Gulf Coast peers, should moderate, especially as more oil moves south. Whether this will prompt a rotation of capital to the coastal refiners remains to be seen.

As for E&Ps, however, uncertainty in regional pricing trends in the U.S. crude oil and natural gas landscape will undoubtedly persist as headwinds.

—Tamar Essner is associate director of Thomson Reuters Energy Advisory Services and can be reached at 646-822-3646 or tamar.essner@thomsonreuters.com.