To The Moon

Summary

• HF Sinclair has strong business performance thanks to high refining margins amid the tightening of the global market of oil products caused by the Ukrainian crisis.
• The stock is trading at only 5.3 times its expected earnings this year.
• However, earnings per share are expected to decrease in the upcoming years, and the boom in clean energy projects poses a risk for refiners.

AEKKARAT DOUNGMANEERATTANA

In early October, I rated HF Sinclair (NYSE:DINO) as a "hold", as its strong business performance and its exceptionally low price-to-earnings ratio of 5.4 back then were offset by the risks related to the high cyclicality of the refining industry and the secular boom of green energy projects. A few weeks after my article, the company posted markedly strong third-quarter results, with earnings per share of $4.06, which exceeded the analysts' consensus by $0.36. Despite its solid business performance, HF Sinclair has underperformed the broad market by a wide margin since my article (+2% vs. +10% of the S&P 500). Such a divergence between the business performance and the stock price may lead some investors to think that the stock has become undervalued. However, I maintain my hold rating for HF Sinclair due to some risk factors.

Business overview

All the domestic refiners and most international refiners have been thriving since the onset of the Ukrainian crisis early last year. The sanctions imposed by the U.S. and the European Union on Russia have greatly tightened the global markets of crude oil and refined products. However, Russia has found ways to circumvent the sanctions on crude oil by significantly increasing its crude oil sales to China, India and a few other Asian countries. On the contrary, Russia has not managed to circumvent the sanctions on its exports of refined products. As a result, the global market of refined products has become much tighter than the global oil market and hence refiners enjoy exceptionally high refining margins thanks to the Ukrainian crisis.

The positive effect of the sanctions of western countries on Russia is reflected in the results of HF Sinclair. The company grew its earnings per share nearly 10-fold, from $1.52 in 2021 to an all-time high of $14.73 in 2022. As this level of earnings per share is more than double the previous all-time high of $6.44, which was recorded in 2018, it is easy to understand how strong the tailwind from the Ukrainian crisis is for HF Sinclair.

While refining margins have somewhat moderated off their blowout levels last year, they remain much higher than historical average levels. In the third quarter, HF Sinclair processed 7% lower crude oil volumes than those in the prior year's quarter due to scheduled maintenance and its realized refining margins contracted by 16%. As a result, earnings per share decreased 11%, from $4.58 to $4.06, but exceeded the analysts' estimates by $0.36.

An 11% decrease in the earnings per share vs. a record base is certainly benign. HF Sinclair still enjoyed the third most profitable quarter in its history. It is also worth noting that the refiner has beaten the analysts' estimates by a wide margin in 9 of the last 10 quarters. This is a confirmation that the crisis in Ukraine still provides a strong tailwind for HF Sinclair.

According to a report of McKinsey, the benchmark refining margins for Gulf Coast are likely to remain above average until 2025. They are expected to continue hovering around $19 per barrel, which is much higher than the historical average of $7 per barrel, which was recorded during 2015-2019.

Analysts seem to agree that HF Sinclair will not achieve record earnings anytime soon but it will keep thriving in the upcoming years. More precisely, analysts expect the earnings per share of the company to decrease by 35% next year and by another 7% in 2025, from $10.09 this year to $6.12 in 2025.

It is also important to note that HF Sinclair has an exemplary management. In contrast to many companies, which tend to curtail their investments in order to maintain generous dividends, HF Sinclair suspended its dividend for one year and issued some shares in order to perform two high-return acquisitions during the coronavirus crisis.

The company acquired the Puget Refinery from Shell (SHEL) for $350 million in 2021 and Sinclair Oil in 2022, thus acquiring two refineries, a renewable diesel business and a branded marketing business. As refining margins surged to unprecedented levels shortly after these two acquisitions, HF Sinclair has enjoyed extraordinary returns from these investments. An exemplary management is paramount in every sector, especially in the highly cyclical refining industry, in which a counter-cyclical approach is critical for the survival and the long-term prosperity of a company.

Risk factors

While a high-quality management is paramount, investors should always remember that refiners are highly sensitive to the path of refining margins, which are beyond the control of refiners. During periods of wide margins, some companies tend to expand their refining capacity and thus they increase the total supply of oil products. Whenever the demand for oil products incurs a shock, e.g. during a recession, refining margins plunge. This helps explain the dramatic cyclicality of refining margins.

Due to the sky-high refining margins that have prevailed during the last two years, the global refining capacity is expected to grow by 2.9 million barrels per day until 2025, from 102.7 to 105.6 million barrels per day. A 2.8% increase in the global refining capacity may seem benign but it represents a risk factor for refiners.

To be sure, we are going through an unprecedented boom of green energy projects. Almost all the countries around the globe are doing their best to transition from fossil fuels to renewable energy sources in order to avoid another energy crisis, such as the one experienced last year due to the war in Ukraine. The global investment in clean energy projects is expected to surpass the investment in fossil fuels by an unprecedented margin this year ($1.7 trillion vs. $1.0 trillion). This trend certainly poses a risk for refiners, particularly given the aforementioned expected increase in the global refining capacity.

On the one hand, no-one can predict when the boom in clean energy projects will severely hit refining margins. As the global energy crisis proved last year, it may take several years for the world to shift from fossil fuels to renewable energy sources. On the other hand, investors should be aware of this threat facing refiners.

Valuation

HF Sinclair is currently trading at only 5.3 times its expected earnings this year. However, as its earnings are extraordinary this year, it is prudent to focus on its expected earnings in 2024-2025. The stock is currently trading at 8.0 times its expected earnings in 2024 and 8.7 times its expected earnings in 2025. The future price-to-earnings ratio of 8.7 is lower than the 10-year average price-to-earnings ratio of 10.3 of the stock. Therefore, the stock appears somewhat undervalued right now, at least on the surface.

On the other hand, given the high cyclicality of the refining industry and the aforementioned secular risk, it is prudent to purchase HF Sinclair only when it trades at an exceptionally cheap valuation level. For instance, the stock would receive a "buy" rating if it declined towards the technical support of $40, which is 25% lower than the current stock price. At that level, the stock would trade at only 6.5 times its expected earnings in 2025. However, investors will probably have to wait for the next downturn of the refining industry in order to purchase HF Sinclair at such a price.

Final thoughts

HF Sinclair is characterized by a high-quality management and has been thriving over the last two years, primarily thanks to the Ukrainian crisis, which has greatly tightened the global market of refined products. However, refining is a highly cyclical business that faces the risk related to the unprecedented boom in clean energy projects. Therefore, I find it prudent to maintain my "hold" rating for HF Sinclair around its current stock price.