How to Capitalize on the Bakken Oil Boom
Stocks in the refining industry never really attracted us in the past. They were usually highly leveraged, barely earning a return on capital, and there were no tailwinds for their earnings — consumption of gasoline in the U.S. has been on the decline for years (our cars are now more efficient, and we drive less). Refiners’ earnings power was a mystery to us, swinging from feast to famine on a dime.
But there have been significant structural changes over the past few years, and we’ve changed our mind. Using horizontal drilling and fracking, drillers have basically learned how to squeeze oil (and gas) out of rock. They found a lot of these oil-rich rocks in places where there was little easily obtainable oil and thus little existing refining capacity: in North Dakota. Oil production in the Bakken Shale region of North Dakota has soared from 400,000 barrels (bbl) per day in 2011 to 1 million bbl per day in 2013. North Dakota now produces more oil than does Alaska and is second only to mighty Texas, where oil production has tripled, to 2.1 million bbl per day. (Read more: “Energy Independence in the U.S.“)
Since crude oil is useless to us and our cars — it has to be refined, and it doesn’t magically teleport itself to refineries — it is important to understand our existing refining infrastructure, which has developed over a long period of time, based on production and consumption patterns. Historically, about a third of imports arrived from Canada and Mexico and 40 percent came from OPEC countries, though most U.S. suppliers were outside of the Persian Gulf (Venezuela, Nigeria, Algeria and Angola). Half of the U.S. imports came to the Gulf Coast region, which also accounted for half of the total U.S. refining capacity.
The East Coast has imported mainly refined petroleum from Canada, Russia and Europe, because of a lack of cheap refining capacity (and high-cost, unionized refineries). Midcontinent North America has the least amount of refining infrastructure, but that is where a big chunk of new oil is coming from.
There are some additional oil industry constraints. U.S. law prohibits export of unrefined oil. Therefore, this new oil cannot be shipped to the coasts and put in tankers and sent overseas; its flow needs to fit into our existing transportation and, even more important, refining infrastructure. That is why the importance of refineries has grown so much. Building a new refinery costs five times more than adding additional capacity to an existing one. We probably will not see a lot of new refineries built, however — nobody wants one in their backyard.
We were looking at how to capitalize on the Bakken oil boom. The benefits to railroads had already been priced into their stocks. Makers of railcars and barges looked interesting but were threatened in the long run by the pipelines that are coming online in 2014 and beyond. Refineries are the biggest beneficiaries. There were many to choose from, but we put our money where our mouth is and bought Northern Tier Energy (NTI). It’s the least known of the bunch and had the best risk-reward.
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Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email, click here or read his articles here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process (see PDF presentation here), as detailed in Vitaliy Katsenelson’s Active Value Investing (Wiley, 2007) book.