E This Specialty Oil Play Is Unique And Is Poised To Move Higher

We believe HollyFrontier Corporation (HFC) shares are undervalued, and have been buying in a pyramid style fashion on the way down, while also owning some protective puts which have given profit. We think the stock could trade well over $100 by 2020, provided the macroeconomic outlook remains similar to the present situation and our near-term expectations for energy to trade in a range bound fashion hold.

There are several key reasons we believe investors need to consider this name. The first is that we project the price of oil to start to stabilize into 2019. While our initial expectations for the price of crude have been revised lower given the recent glut, what matters is the crack spreads. The spreads between what the company pays for its input, raw oil, and the costs for what is sells its products for, is projected to remain wide (if not widen).

 

Source: HollyFrontier

We also believe it is key to point out that the company's refiner down times it had experienced were temporary, and while turnaround is costly, they are a long-term benefit to help boost capacity which is extremely limited for base III oils with so few companies in the space. Coupled with rising demand for base III oils in several industries, the demand/capacity picture is attractive. We will add that a possible rollback of fuel standards, and further RIN credits (required costly) biofuel additives could reduce expenditures longer-term.

The recent purchases of Red Giant Oil and Sonneborn, are underappreciated. There is a great dividend, now approaching 2.5%, and the company is pretty liquid, with modest debt, allowing it to easily fund the appropriate opportunity to inorganically grow. Finally, on several rudimentary valuation metrics, the stock has upside based on our moderately bullish expectations for future earnings, but also suggests upside remains even if we are off significantly.

If you do not recall our first overview of the name, this is a specialty oil company that has a large presence in much of the energy rich areas of the United States:

 

Source: HollyFrontier September presentation

So what does it do? Holly is a base oil and lubricant company, primarily. It has been quietly in growth mode for several quarters, though the stock has taken a breather in recent months with oil, and we believe there is opportunity here as the company is making acquisitions to expand its footprint, setting up for long-term success in its operating sector.

What is up with Lubricants and Specialty Products?

The lubrication and specialty oils market is a really interesting niche market in the oil industry. It is pretty small and it is involved in the utilization of different processes and expertise than commodity petroleum products. While not world-scale, lubes and specialty products are high-margin, yet not an easy field to enter. The operational decision to group the lubes operation of the Tulsa refinery with the Mississauga operation can be expected to improve efficiency. The company made several recent acquisitions to REALLY boost its dominance in this space. What are we talking about here?

Great acquisitions

The first recent purchase of note was of Red Giant Oil. This is a lubricants company and is one of the largest suppliers of engine oil for locomotives in North America. This will expand the company's footprint in Idaho, Utah and Wyoming, along with bringing in a blending and packaging facility in Texas. Red Giant Oil is expected to generate approximately $7.5 million in annual forecasted EBITDA for HollyFrontier. We think that number is too conservative on management's part and believe that it can approach $10 million additional EBITDA in coming years depending on oil pricing and margins, but also is factoring in growth in demand as well as limited capacity for additional production in the Americas for specialty lubricants.

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Disclosure: Quad 7 Capital is long HFC in the BAD BEAT investing portfolio

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