Besides boring old pipelines, the refiners are the sub-sector of the S&P Energy Composite that I believe is most neglected. While pure-play refiners only make up roughly 3.5% of the entire composite, if you include other companies’ refining operations the number is closer to approximately 20% of the composites revenues depending on the quarter.
It seems like the broader market has also ignored the refiners as they have not participated in the Energy rally that started on March 3rd, 2009. The major integrated companies were left out, but this rally included a 20% move by the Energy Spider (XLE), a 25% move by the Oil Services ETF (OIH), and moves of between 20% and 50% for many of the exploration and production companies. Without any media coverage, the refining companies have also made great strides in the last month, albeit from much lower prices, as during 2008 the refiners underperformed the other energy stocks greatly. The real question is what can investors expect from the pure-play refiners going forward?
What Are the Key Drivers for the Refiners?
Most investors are instructed by their financial advisors to avoid the refiners because the business model is tough to understand on a macro economic level. I generally agree with this advice, and I don’t like the buy and hold strategy when it comes to the refiners. I do, however, believe that if timed correctly the refiners could lead to some quick profits for experienced investors. The base of everything that has to do with the refiners what is called the “crack spread” in the industry.
The crack spread refers to the profit margin of the refiners with certain types of inputs and outputs. For example, one of the most famous crack spreads is the WTI 321 spread, WTI standing for West Texas Intermediate, a form of light, sweet, high quality and easy to refine crude oil. 321 stands for refining or “cracking” three barrels of crude oil into 2 barrels of gasoline and one barrel of distillate (generally heating oil). As you can imagine, the crack spread has a very close correlation to the margins and in turn the bottom line of these refiners.
The Crack Spread Versus the Refiners
Over the last half year I’ve been watching my favorite indicator for the refiners, and recently it has been very accurate. I like to look at the crack spread divided by a refining company’s equity price. Using this metric, you can track relatively how undervalued the refining equity is compared to its potential margin expectations. Obviously the correlation for this type of analysis is not one to one, but the point is to get a rough estimate very quickly in order to understand what the market is pricing in for the future.
Since the beginning of November, I decided to use my ratio on Valero (VLO) as it is one of the more stable and largest refiners in the United States. It also has more exposure to heavier types of crude oil and with the current glut of West Texas Intermediate, I decided that it would have more potentially for optimism in the short term. Over this time period the ratio has fluctuated between 0.199 and 1.5016 (where the lower the ratio means Valero is more overvalued and the higher the ratio means Valero is more undervalued).
The low for the ratio occurred around early early December, and the high occurred around the end of December. If you would have bought into Valero at the high of the ratio and then sold a month later when the ratio crossed its average of 0.955, you would have made around 25% on Valero’s move from $20 to $25. Obviously the average is arbitrary based on the time period that you chose to use, but manipulating the time period for different length I found averages between 0.85 and 1.1. 20/20 vision is hindsight, but if you would have traded on this metric with discipline then you could have made a handsome profit.
The refiners have bounced off of their significant lows, in some cases over 25%, and buying in now wouldn’t be extremely prudent. In Valero’s case, the ratio is sitting right below the average level and it seems to be valued correctly for the short term. I think it is possible that we see a drop of 10-15% in most of these names over the course of the next few weeks. If this drop occurs and the crack spread stays healthy, I would take a very careful look at the individual refining names, because the chance for a quick rebound in the equity prices would be very high.
As I stated before, this type of trade would be something I would only recommend to investors with higher risk tolerances who have the ability to monitor the markets on an intra-day basis. Names that I think could be acceptable for this type of trading would be Valero, Sunoco (SUN), Hess (HES), Tesoro (TSO), and Western Refining (WNR). Some of those names I wouldn’t like to be in long term, but they can still work for this type of trading strategy. As an investor, you will never be right every time, but playing the odds over the long run will make you a winner.
- Charles W. Petredis
Disclosure: The author’s family is long XLE. The fund the author manages is interested in going long VLO.