What Next for Oil Refiners? Investors Should Exercise Caution

by: James Shell

The frequent followers of the oil refiners have been delighted over the price appreciation in these stocks since early December, which has averaged 35%, highlighted by a near-doubling in the stock of Western Refining (NYSE:WNR).

So the big question at this point is: What next? With the current valuations, should investors anticipate further improvement, or take a little money off the table?

We all know, based on our previous work, that the refiners earnings are driven primarily by the crack spread. Here's a little table:

60/40 Avg Crack Spread
Period $/bbl
2007 14.03
2008 11.17
1H2008 13.00
2009 8.54
2010 10.04
4Q2010 10.50
Last 30 days 13.00

In addition to whatever overall market momentum we saw, the improvement in crack spreads over the past 30 days is significant, particularly since it occurred during December counterseasonally, and so it makes sense that investors should be a little more excited about this group. Here's a little summary of what happened:

Stock Price EPS
1-Nov 15-Jan 2011 Est FPE
WNR 6.78 11.25 0.76 59.2
MRO 33.92 42.8 4.45 9.6
TSO 14.17 18.89 1.50 12.6
FTO 14.60 18.57 1.24 15.0
VLO 19.14 24.85 2.11 11.8
SU 35.68 38.67 2.50 15.5
CLMT 21.11 24.13 1.38 17.5
HOC 32.25 43.23 2.94 14.7

The EPS estimate is the median analyst estimate per Yahoo Finance, and the forward PE is the current price divided by the forward estimate. The average, excluding the overachiever WNR, is over 14.

Let's assume, optimistically that the crack spread in 2011 will be comparable to those that we saw in 2007 (we can have a conversation about the likelihood of this if you want...)

Here's a table of the January stock prices, 2007 actual earnings, and PE ratios as of January 2007 for this group:

Price Jan 07 2007 EPS FPE 2007 High
WNR 25.46 3.53 7.2 62
MRO 43.58 5.69 7.7 66
TSO 32.84 4.06 8.1 64
FTO 26.73 4.62 5.8 49
VLO 49.36 7.72 6.4 76
SU 36.33 6.02 6.0 54
CLMT 40.71 6.38 6.4 54
HOC 50.22 5.98 8.4 79

Average PE in this group was a bit over 7, anyone who went long on any of these stocks at that point had a chance for significant appreciation, particularly if they were smart enough to predict the future and take money off the table in July when most of these stocks reached their all time record.

2007 EPS 2007 High PE @2007 High
WNR 3.53 62 17.6
MRO 5.69 66 11.6
TSO 4.06 64 15.8
FTO 4.62 49 10.6
VLO 7.72 76 9.8
SU 6.02 54 9.0
CLMT 6.38 54 8.5
HOC 5.98 79 13.2

Here are the PE's of these stocks at their 2007 peaks. The average is 12.

So, what are we to make of all of this?

First of all, you have to ask the question: With the current demand situation for finished products like it is (not up to 2007 levels), and the current situation with the crude oil pricing like it is (counterseasonally overheated), what's the likelihood that there will be a repeat of 2007 in this business?

Based on the prevailing PE's at the time, most of these stocks are a little pricey now, compared to what they were in the beginning of 2007. These stocks are a little overheated unless, and it's a big unless, you anticipate continued high crack spreads. Based on their earnings estimates, the PE's are already higher than they were at the peak in 2007.

Keep in mind that the owners of some of these stocks are in them for other reasons. CLMT for their 8% dividend, MRO because it behaves more like one of the integrated oil companies and is conservative and safer, SU because they want to participate in oil sands. And investors of WNR are anticipating that the management reorganization will work and return this company to what it was....

And also keep in mind, that there could still be some upside in this group, depending on what the overall market is doing, and continued high refining margins.

But, the world is chaotic, perils are everywhere, and unless you think a repeat of 2007 is on the way, a little caution is in order.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.