Refining Margins Set to Rise Through Q2

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 |  Includes: HFC, INT, PDCE, TSO, VLO, WNR
by: Todd Campbell

The sun rises in the east and sets in the west and refiner margins rise in the spring ahead of summer driving season.

It's that time of year again - when we dust off our chart books and search for upcoming seasonal plays likely to provide profits to your portfolio.

Refiners offer investors an under-owned basket with lots of upside potential. Why? Margins were abysmal in 2009 as the global economy slid to a standstill. Capacity investments in '06 and '07 increased supply just as industrial production rolled over and consumers, hung over from $4 per gallon gas and 15 MPG SUVs, curtailed spending. Job loss reduced average miles driven and tougher, more expensive, regulations weighed on profits.

As a result, refiners became as unloved a basket as any, the excess having been rung out of each stock. Holly (HOC) fell from a peak of $80 to $11. Tesoro (NYSE:TSO) fell from the mid $60's to below $7. Western Refining (NYSE:WNR) dropped from over $60 to less than $5. The story goes on and on.

I've always been a fan of buying "smart". This doesn't mean low. No one knows where the bottom will be and certainly many buyers of TSO at $30 probably felt the stock was cheap. Instead, I like to look for "smart" buys - good opportunity at the right time. It doesn't hurt that HOC is trading at about 10x rising 2010 estimates, but the real story isn't where the Street estimates are currently. but where they're likely to be in 6 months. The Street is famous for over-estimating earnings at the top of the cycle and under-estimating at the bottom. Refiners should prove no differently.

The following chart, available on BP's website, shows the global margin for refiners and the improving trend:



February kicks off the refiner maintanence season and with it, significant capacity comes off-line. Currently, refining capacity utilization is running below 78% - well below the 83.5% in '09, 85% in '08, 87.1% in '07, 87% in '06, 91.6% in '05 and 87.6% in 04 (the first full year following the bear market low in 2003). We expect lower production to help support pricing through spring.

Miles driven has a significant impact on gas demand, as does average vehicle mileage. Corporate managers, similar to Street analysts, always ramp production too much near the high and cut it too much near the low. While average miles per gallon for vehicles is rising, miles driven is set to start to climb again - helping prop up demand. The turn up in temporary services hiring historically proceeds permanent hiring - which boosts commuter traffic and gas demand. We believe capacity cuts will offset risks from a more fuel-efficient fleet of vehicles, allowing rising mileage to translate into price support.

The mandated summer grade switchover coincides with annual increases in per gallon pricing. The supply of summer grade will need to be built up through Q2, providing price support along the way.

Car production forecasts are rising here in the U.S. while global auto sales in emerging nations like China are growing incredibly fast. Last year, 46% more autos were sold in China than in 2008. The global demand for vehicles is rising and expanding emerging markets will drive transportation related diesel demand.

Overall, we see the group as under-owned with significant earnings upside on margin recovery tied to capacity shutdowns and the summer grade switchover.

Disclosure: Currently hold long positions in HOC, PETD, TSO, VLO