DK is US based owner of 2 inland refineries in West Texas and Arkansas, with combined capacity of 140 Kbpd and 9.0-9.4 Nelson complexity. DK’s refineries have recently experienced a period of unsustainable high profitability which resulted in substantial stock outperformance on the back of both high product crack spreads and historically wide discount on WTI oil caused by the lack of takeaway pipeline capacity out of Cushing. The stock is trading at 6x peak earnings, which is expensive for a refiner, and as conditions in mid-cont normalize, I expect both DK’s profitability and multiple to revert to normal levels. In the normal environment DK should earn just about ~$0.50/sh and get 4-5x of that, implying a low single digit valuation. This drastic dislocation will become apparent to the market participants as catalysts outlined below materialize

 

 

DK is extremely levered to WTI/LLS spreads. WTI/LLS spread is set to narrow as Cushing, OK inventory pressure is lifted: WTI has been trading at a high discount ($10-$20) to waterborne crudes for the second summer in the row as result of increased domestic production from unconventional sources and the lack of takeaway capacity. The amount of takeaway capacity which is currently ramping up or under construction is sufficient to alleviate crude inventories build up in Cushing:

 

Project	Owner	Description	Completion	Full Ramp-Up	Capacity (kbpd)
Seaway reversal (incl. capacity upgrade)	Enterprise/Enbridge	Cushing, OK and USGC (Freeport, TX)	Q2 2012	Q1 2013	400
Seaway twin line (formely "Wrangle")	Enterprise/Enbridge	Cushing, OK and USGC (Freeport, TX)	Q1 2014	Q3 2014	450
Keystone XL lower leg	Transcanada	Cushing, OK to USGC (Nederland, TX)	Q3 2013	Q2 2014	830
EOG rail project	EOG/NuStar	Bakken, Eagle Ford and Wolfcamp to USGC (St. James, LA)	Q1 2012	Q1 2013	70
Hess rail project	Hess	Bakken to USGC (St. James, LA)	Q1 2012	Q4 2012	55
				Total:	1,805

 

 

By mid 2014, the incremental takeaway capacity will reach 1.8 mb/d, which will be sufficient to bring the inventory back to the mid-90mmb level and compress the differential to the marginal pipeline tariff ($4-$6 on Seaway). In fact, we can expect lower spreads by the end of 2012 as the last barrels that Seway dumped into Cushing before it was reversed are being worked through.

 

The impact on DK's profitability would be rather drastic. Unusually wide WTI/LLS spread has resulted in unusually wide product crack spreads. In the last 2 quarters, US GOM 3-2-1 WTI crack spread was averaging $20-$25, while LLS cracks were averaging ~$10, allowing DK to earn .76/sh in the quarter. If WTI was trading "normally" with $4 discount to LLS, other things (slates, utilization, etc.) equal, the company would have earned .11/sh as WTI crack spreads would approximate $8.

 

The company is massively overearning and its profitability, and valuation, is poised to revert to a lower level.

 

 

Capacity by crude slate (kbpd)
El Dorado	80
WTI/Inland	25
LLS Oil	45
Other/Maya	10
Tyler	60
WTI/Inland	50
LLS Oil	10
Other/Maya	0
Crack Spread Calculation
LLS	105.0
WTI (USCRWTIC)	101.0
Differential (LLS - WTI)	4.0
Conventional Gasoline (MOIGC87P)	2.6
Heating Oil (NO2IGCPR)	2.5
Implied 3-2-1 Crack Spread US GOM	7.7
El Dorado
Utilizarion %	95%
Utilizarion kbpd	76.0
Refining Margin $/bpd	$7.8
Direct Cost $/bpd	($4.0)
Refining EBITDA	$19.85
Tyler
Utilizarion	87%
Utilization kbd	52.2
Refining Margin $/bpd	$7.7
Direct Cost $/bpd	(5.0)
Refining EBITDA	12.9
Total Refining EBITDA	32.8
Marketing	8.0
Retail	6.0
Corporate & Other	(1.0)
Depreciation	(19.0)
EBIT	26.8
Interest Expense	(12.5)
Pre-Tax	14.3
Tax at 34%	(4.9)
Net Income	9.4
SHO	85.5
EPS	$0.11

 

LLS/WTI spread narrows as the year progresses, resulting in lower profitability for DK