The Secret Energy Trade Investors Are Ignoring

Includes: VLO, WNR
by: StreetAuthority

By Michael Vodicka

Energy has been one of the worst-performing sectors in the S&P 500 during the past year.

While the broader market is up an impressive 13%, the energy sector has gained just 2.5%. That performance looks even worse when compared with the market's most bullish sectors, with healthcare up 29% and so-called consumer defensive stocks (which include makers and retailers of food and household and personal goods) up 23%.

But overall weakness in energy stocks is masking a lone group of standouts from the lackluster sector: refineries.

In fact, this group of stocks hasn't just been strong relative to its energy peers -- it has been one of the best-performing industries in the entire market in the past year. Take a look at the chart of two leading companies.

This growth is being driven by a phenomenon known as the crack spread.

The crack spread is the profit a refiner can expect to realize from converting a barrel of oil into gasoline. This spread has been extremely profitable in the past year because of a profound divergence in the price of Brent crude from Norway and West Texas Intermediate crude.

Historically, the spread for a barrel of crude oil between Brent and West Texas Intermediate has been only $1 to $3.

But in the past few years, increasing domestic crude production and falling demand in the slow-growing economy has lifted that spread to record levels, with Brent at $110 a barrel and West Texas Intermediate crude trading at just $97.

And with gasoline prices at the pump tied to Brent, it has become incredibly profitable for domestic refiners to use West Texas Intermediate crude as feedstock to produce gasoline. As it stands, that trend is showing little sign of slowing. These are the kind of natural resource investment opportunities you'll find in Nathan Slaughter's Scarcity and Real Wealth.

That's because the United States is continuing to ramp up crude production amid a slow-growth economy, with daily production projected to top 8 million barrels a day by the end of 2014, a 16% increase from 2012. And with limited pipeline and infrastructure to feed that West Texas Intermediate crude to the rest of the world, the domestic supply will remain swollen for years to come. That's means there is still plenty of time to cash in on refiners.

Here is a list of six leading refiners with their market caps and forward P/E (price-to-earnings) ratios.

From the group, I have chosen to highlight Western Refining (NYSE:WNR) because of its proprietary access to pipelines and Valero Energy (NYSE:VLO) for its dominant market position.

Western Refining

This is the smallest company on the list, with a market cap of just over $3 billion.

In addition to refining, Western also has wholesale and retail operations to provide some mix of revenuestreams. One of the company's biggest weapons is its proprietary access to pipelines, enabling it to control the supply of West Texas Intermediate crude being shipped to its competitors. Western has also begun cutting costs to improve margins, closing old refineries and consolidating others. The company recently raised its dividend by 50%, to 12 cents a share, and now carries a dividend yield of 1.4%.

But in spite of all that good news, Western's forward P/E (price-to-earnings) ratio of 7 times is a discount to its peer average of 9 times.

Valero Energy

Valero is one of the largest refiners in North America, with 14 refineries across the United States, Canada and the Caribbean capable of producing 2.8 million barrels per day. That has put Valero in the perfect position to cash in on the crack spread, with shares surging more than 64% in the past year.

To further streamline the company's business, Valero recently announced its intent to spin off its retail unit, CST Brands. The spinoff is expected to close in the second quarter of 2013 and further unlock the core value of Valero's powerful refining operations. With a forward P/E ratio of 8, Valero trades at a discount to its peer average of 9 and the S&P 500's 14.

Risks to Consider: Better domestic infrastructure for the distribution and consumption of refined energy products would strengthen West Texas Intermediate crude prices and tighten the spread with Brent. A stronger domestic economy would also fuel more demand for West Texas Intermediate crude, also tightening the spread with Brent.

The crack spread is enabling refiners to log record profits. That dynamic is in position to continue due to regional production factors. That means it's still a great time to buy refiners. My two favorite stocks from the group are Western Refining because of its proprietary access to pipelines and Valero Energy because of its dominant market position.

Original Post

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.