US refiners can profit from natural gas woes in Europe. Here are the stocks to buy.

U.S. oil refiners are making big money again, but investors aren’t quite piling into stocks. They should be, a top energy analyst tells me. The profit boom could last until the end of the decade, helped by a price problem that won’t be easy to fix: the giant premium Europe has to pay for natural gas.

Two key things to know about natural gas is that it plays a bigger role in the production of gasoline and other fuels than many investors realize, and it’s a colossal pain to carry around.

Any moonshiner will tell you that pot stills require a lot of heat to turn fermented mash – botched beer, essentially – into high-alcohol vapor that can then be cooled down to liquid. In refineries, botched beer is crude oil and stills are massive towers. Moonlight ranges from combustible gases to thick bitumen, with many bestsellers in the middle: gasoline, jet fuel and diesel, to name a few. The heat can partly come from the combustion of the combustible gases produced, but it is supplemented by external purchases of natural gas.

Natural gas is also useful for sludge washing. For example, thick fuels can be used to power ships, but a 2020 maritime rule reduced the amount of sulfur the fuel can contain. Treating fuel with hydrogen can banish sulphur, and industrial gas suppliers like


Linde

(symbol: LIN) and


Air products and chemicals

(APD) will gladly sell the hydrogen. But large users can also create their own by chemically “cracking” methane from natural gas into hydrogen and carbon dioxide.

Refineries increased their consumption of natural gas as they did more cooking to increase production of light fuels and more washing to get the most out of heavy fuels.

Meanwhile, over the past year, the price of US natural gas has doubled, recently hitting $5.50 per million metric British thermal units, or MMBtu. But a key Dutch benchmark soared more than fivefold, to around $36.

I convert. Dutch natural gas is usually quoted in euros per kilowatt hour. There is an orgy of competing measures in the global gas trade, because until recently it wasn’t really a global trade. Transporting the gas requires building pipelines or terminals that can liquefy it for shipping, and either can take years.

Perhaps you have ever seen a vertical pipe with an open flame near an oil well. This is called flaring. Wells often produce both oil and gas, and drillers who cannot afford to bring the latter to market sometimes simply burn it, rather than release it as harmful methane.

Side note: A recently published study from Stanford University examines wells and pipelines in the Permian Basin of New Mexico and finds that methane leaks equal 9.4% of production. If that’s even close to accurate, the industry is about to be in the wrong corner, as the Environmental Protection Agency had estimated 1.4% leakage. The EPA claims that methane is 25 times more potent than carbon dioxide as a greenhouse gas.

The Stanford number is therefore high enough to make natural gas more harmful than coal, even though it burns cleaner. Expect a war on leaks.

Back to business. Russia had supplied more than a quarter of European oil before the tap was turned off. This loss is manageable because oil is easy to ship, so while prices are up everywhere, Texas crude at $112 a barrel isn’t far off Brent at $118. Natural gas is another story. Russia supplied 40% of European demand, and there is no easy replacement.

At the current $30 per MMBtu differential between the U.S. and Europe, U.S. refiners have a $9 per barrel cost advantage, according to Doug Leggate, who manages U.S. oil and gas hedging at Bank of America Global Research. . Under normal conditions, their long-term cash margin is only $5 a barrel.

Prices won’t always stay so skewed, of course. The United States and Europe should rush to new maritime terminals. But these could nevertheless take several years to build. Leggate assumes that the natural gas price differential will fall to around $5 per MMBtu by the end of the decade. But even that would add $1.50 a barrel to U.S. cash profits, leaving them 30% higher than usual.

Some European refiners could close loss-making plants, leading the continent to reduce shipments of refined products to the United States, which would tighten the market here. Already, demand is outpacing supply, as during the pandemic, when roads emptied, refiners had to offer gasoline at a loss, and some reduced capacity to save money.

The end result for refiners is just that – bigger bottom line numbers.


Valero Energy

(VLO) is expected to earn $7.67 a share on Wall Street this year, down from a loss two years ago, and a profit of $7.37 in its last year of plenty, 2018. The shares, at $97 recently is up from pandemic lows, but is below its high of over $120 reached in 2018. Leggate’s earnings estimates are well above consensus numbers, and it says U.S. refiners are entering a new “golden age” that could propel stock prices much higher. His price target for Valero, his top pick in the group, is $135, suggesting a nearly 40% upside. He expects similar good things from the actions of


Marathon Oil

(MPC),


Phillips 66

(PSX), and


HF Sinclair

(DINO).

High profits do not necessarily mean high pump prices. I asked Denton Cinquegrana, the senior oil analyst at the Petroleum Price Information Service, or OPIS, a corporate cousin of Barronswhat’s in store.

He says the national gasoline average, recently below $4.30 a gallon, could flirt with $5 as summer driving peaks, then fall below $4 by the end of the year, as supply increases.

“Don’t curse the guy you buy gas from,” he says. “There are chances [he’s] do not make a murder and do not defraud yourself.

Write to Jack Hough at jack.hough@barrons.com. Follow him on Twitter and subscribe to his Barron’s Streetwise podcast.

Mary I. Bruner