2023-05-15 12:29:17 ET
Summary
- PBF Energy is going for a low multiple and is returning capital to shareholders.
- The crack spread breakeven for PBF Energy is low.
- The current regulatory environment makes for a decreasing supply of refining capacity.
- Writing calls against long stock can take advantage of high implied volatility.
Overview
PBF Energy (PBF) is an American oil refiner with six facilities. Over the last year or so, crack spreads have widened, causing a windfall in profitability for refiners. PBF Energy has used the opportunity to pay down debt and return capital to shareholders. In my opinion, this has caused a lot of opportunities in this space as valuations are already low, and my belief is that crack spreads will continue to stay higher due to regulatory constraints. Combing this with returning capital to shareholders makes for a compounder. For those not familiar, a compounder stock is one that will over long periods of time compounds at a high ROIC and does so in all economic environments. A common example everyone is familiar with is Berkshire Hathaway (BRK.A) (BRK.B) which has historically made higher returns than most equity benchmarks with lower drawdowns and with lower risks taken.
I see PBF Energy as a compounder stock as the earnings yield is high and with management looking to return a majority of cash flow to stockholders via buybacks and dividends, it can compound on itself. Along with that, the industry has a moat which will widen margins and raise profitability over time. On top of this, I would use call writing to enhance yield and compound at a higher return.
Crack Spread Breakeven
An interesting way to stress test a refinery is to do a crack spread breakeven analysis. The point of looking at crack spread breakeven is that it measures what level the crack spread would have to be for the company to make a profit, and what level it would have to be for the company to generate a large enough profit to justify the valuation.
First, we'd have to start with what the crack spread is. To get this, we'd take RBOB futures multiplied by 42 (conversion from gallons to barrels) and subtract WTI futures. For this analysis, I'm using the front-month contract for both, but it could be argued that using the back month would be better as it has less volatility.
Below is the monthly chart for the RBOB-WTI crack spread:
The blue line indicates zero on the crack spread. As can be seen, it is extremely rare for the crack spread to go negative. Even if it does, it quickly reverts due to the lack of viability of a negative crack spread.
This means the company will almost always have a positive gross profit.
To get breakeven profitability from here, we can look at the margin between the gross profit and operating income. This margin can then be multiplied by the crack spread to get the breakeven operating income.
Below is the income statement:
The spread between the TTM gross profit of 5585.4 mm and the TTM operating income of 4582.4 mm is ?18%. The average crack spread over the last year has roughly been $30. 18% of $30 is $5.4. This makes for an operating income breakeven of $5.4.
To visualize this on the same chart, I've put another blue line where this would be on the crack spread:
As can be seen, the crack spread is almost always above the operating income breakeven. The only time there was a significant dip was in 2020 and 2008-2009. These significant dips are usually followed by unusually large rises in profitability afterward. I believe this goes to show that the downstream business model can be great from the perspective of the risk of permanent loss of capital; all of this though is dependent on continued demand for the end product. I will touch upon why I believe there is a declining supply of refined end products (which benefits this company) later in the article.
There are many caveats to this sort of break-even analysis. The first of which is that not all of the refinery input is WTI and not all of the refinery output is gasoline. The company also has outputs of heating oil, petrochemical feedstocks, diesel etc. With that said, the correlation between the different inputs and outputs is very high, so if one spread is a certain way, it is likely the others are too.
The other caveat with this kind of breakeven analysis is that there are backwards-looking factors which might be different in the future. These would include depreciation & amortization, general & administrative expenses; along with this, there are other expenses which aren't taken into account in operating income such as interest expenses and taxes. Also, this breakeven analysis was done for the whole company, but it would be prudent to perform separate breakeven analyses on each facility.
Current Regulatory Environment Provides A Moat
My belief is that the current political and regulatory environment creates a barrier to entry into the industry. First off, when it comes to the political side of things, there is clearly a move by most policymakers to transition to green energy quickly. The issue is of course that it will take a long-time, if ever, for an energy transition to take place as there is no viable alternative that can quickly be implemented. This move by policymakers to regulate the fossil fuel industry is causing companies all across the oil and gas supply chain to invest less in CAPEX, which in turn causes a shortage of refining capacity. To add to this, there is a large regulatory hurdle to creating new refineries.
Since the mid-1970s, there hasn't been a single significant refinery built. Below is what the Institute For Energy Research had to say in regard to regulation:
Policies hurting the refinery industry include Biden’s Corporate Average Fuel Economy ((CAFE)) standards for fuel efficiency in vehicles, the Renewable Fuel Standard (RFS) created in 2005 requiring a certain amount of biofuels such as ethanol to replace petroleum-based fuels, and electric vehicle tax subsidies , to name a few.
This environment has made it so that over time older refineries are getting shut down or converted to refine other products, new refineries aren't being built along, and CAPEX isn't being invested into existing facilities. Many top executives including but not limited to the Chevron CEO have said he never expects another refinery to be built in the U.S. This environment makes it so that over time the crack spread will widen and help existing refiners due to this regulatory moat.
Paying Down Debt and Returning Capital To Shareholders
Over the last year, PBF Energy has had a great year and has used the extra cash flow to pay down debt. Total liabilities in March 2022 were 10.4222 billion, while a year later in March 2023 total liabilities were 7.8708 billion.
Now the company seems to be focusing on returning capital to shareholders. The company, a month back, declared a dividend of $0.20 per quarter, per share . Along with this, the company has already done $500 million of stock buybacks and just earlier this month raised the authorized amount for stock buybacks to $1 billion.
Quoting from PR Newswire , PBF Chairman and CEO Tom Nimbley said:
The first quarter of 2023 continued to build on the momentum generated in 2022. PBF remains focused on operations and the continued improvement to our financial health. During the first quarter, we conducted extensive turnaround work across 75% of our regions. While executing this work, our operations supported further gross debt reductions of $525 million, payment of our dividend and ongoing execution of our increased share repurchase program, which will continue through 2025.
Based on what Tom Nimbley said, this means that current stock buybacks are just the beginning. A company with stable forward-looking earnings with stock buybacks + dividends = long-term compounder.
Trade Structure
The trade structure that I like for this stock is a covered call and short put as part of a wheel strategy.
The current implied volatility for options on this stock is very high. This could be taken advantage of by implementing a buy-write strategy, and if the stock is taken away due to an assignment, then a put could be shorted. This process can be repeated in the wheel strategy. While doing this, dividends can be reinvested through a DRIP.
The Bottom Line
PBF Energy is a long-term compounder due to its high return of capital to shareholders while its stock is at a low valuation. Along with this, the regulatory environment provides it with a moat that will hold the crack spread up. Writing calls against long stock allows investors to collect high premiums on the options.
For further details see:
PBF Energy: Long-Term Compounder At A Low Multiple