July 2010 Is the Time to Buy Refineries
By Chris Mayer
July 7, 2010

Thomas O’Malley, a 68-year-old investor, has made billions for himself and his backers as an investor in oil refineries — those twinkling jungle gyms of pipes and tanks and columns that turn crude oil into useful products like gasoline.

This is O’Malley’s playground. He has probably bought and sold more refineries than any man alive. He knows them like an old chef knows the inside of his kitchen.

O’Malley got rich by following a reliable formula. He bought refineries when they were cheap — castoffs, unloved by Big Oil — trading for less than the cost to build them. Later, he sold them for billions.

For example, in the aftermath of the 1987 crash, he picked up a 26% stake in Tosco, then a tiny refinery. O’Malley eventually turned Tosco into the largest independent refiner in America. He sold it to Phillips Petroleum — now ConocoPhillips (NYSE: COP) — for $7 billion.

Two weeks after he closed that deal in 2002, he took over Premcor, becoming its top executive. He did it all over again, using Premcor as a vehicle to buy refineries on the cheap. Four years later, he sold Premcor to Valero (NYSE: VLO) for $6.9 billion.

His is the Midas touch in the refinery space. And he’s mostly laid low since 2007. But now he is back again, buying a Delaware refinery he once owned and sold to Valero. The deal is worth $220 million and is the first purchase of a new $2 billion fund created to buy U.S. refineries. O’Malley says he’ll look at any U.S. refinery on the market.

In other words, it looks like O’Malley is going for the hat trick — trying to get rich three times in the same game.

It’s a contrarian bet, as most people think ill of the refining industry. It’s plagued by costly regulations, weak profit margins and lower demand for motor fuel. But you don’t get to buy stuff below replacement value when times are rosy. As David Foley, an investor with O’Malley put it, “Last time we did it, we made six times our money.”
Based on his track record, I would not ignore O’Malley’s play here. Clearly, he thinks the industry has hit bottom. And there are good reasons to think so, as we’ll see.

One reason comes from Barry Bannister, an analyst at Stifel Nicolaus. He shows how peaking oil prices on a year-over-year basis are usually a catalyst for better refining margins. (See chart below. “WTI” is “West Texas intermediate,” a common benchmark for crude oil.)

Higher refining margins means more profits for refiners. Higher profits usually mean higher stock prices follow. Valero, the bellwether refinery stock, is down about 75% from its all-time high in 2008, which reflects the collapse of refining margins. So an uptick in refining margins will likely work wonders for Valero’s stock price, like rains greening a desert.

Expect other refiners to gain in kind…

[Ed. Note: Naturally, there are a slew of small-cap refining plays that you can get into right now. Among them are Tesoro Corp. (NYSE: TSO), Holly Corp. (NYSE: HOC), and Frontier Oil (NYSE: FTO) — all of which own independent refining operations. Buyer beware, though, the current oil climate has left these refiners burning cash lately. This is a speculative investment…]

Sincerely,
Chris Mayer