Refining Margins Look Set for Seasonal Expansion: Good Time to Buy Tesoro, Valero

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Includes: FTO, HES, HFC, INT, SUN, TSO, UGA, VLO, XLE
by: Todd Campbell

If you’ve been waiting for the right time to get back into refiners, this is it. Refining margins typically expand between Q1 and Q2 and that's great news for our two favorite refiners: Tesoro Corp (NYSE:TSO) and Valero Energy (NYSE:VLO).

How compelling is the trend for seasonal strength? The BP Refining Marker Margin has finished Q2 higher than Q1 in 18 of the past 21 years. And, it has moved higher in each of the past 7 years. On average, the RMM has improved by $2.18 per barrel in Q2 from Q1 and the only 3 years it moved lower were the 1991, 1994 and 2003 recession years.

Why do refiners like Tesoro and Valero earn big profits in Q2? Because daily commutes and summer vacations account for the lion's share of the 72% of refinery demand generated by the transportation industry. In the past two years, gasoline demand rose 11.9% and 9.6% from the 4th week of January to the summertime peak. Q1 is the weakest quarter for demand, so refiners like Tesoro and Valero use the time to reduce production for maintenance. As Q2 inventory building is leveraged against tight supply, prices swell.

Will better fuel economy reduce demand? Despite the average new car and light truck seeing a jump from 25.8 mpg to 29.2 mpg from 2006 to 2010, vehicle miles and freight mileage trends are rising. Given improving job growth and consumer sentiment, summer miles will be strong in 2011.

Fuel consumption is also up thanks to rebounding freight traffic. Heavy-duty vehicles account for 12% of all petroleum demand and 2011 consumption is expected to rise to 2.5 MMbbl/d, up from 2.1 MMbbl/d in 2010. As of November, the BTS Freight Transportation index was 5.4% higher than the summer of 2009. Jet fuel trends are solid too. In the 12 months ending November, revenue passenger miles had grown 2.8%.

Tesoro and Valero aren’t just going to benefit next quarter, they’re already benefiting from an improved market. So far in 2011, strength in West Coast margins, which are 16.3% higher year-over-year, are helping lift the Refining Marker Margin up 12.9%. And, since Q4 the RMM is 2.51% higher, despite weaker Mid West margins, on a 21.7% jump in margins at Gulf Coast refiners.

And, how’s the supply situation shaping up? In the most recent week, operable utilization at refiners was 84.5%, down from 88% at year-end. This is up from 78.5% in the comparable week in 2010 but well below the 86.24% average utilization since 2000. In 2010, 137 refineries operated, down from 141 in 2009, as 11 sat idled versus 9 the prior year. So, we remain well below our average level of production over the past decade, heading into the seasonal period of maintenance shutdowns, bullish for upward marching prices at Tesoro and Valero’s 7 and 14 refineries, respectively.

The tight capacity has helped move diesel prices up in each of the past 9 weeks and regular gas prices have gone up in 8 of the past 9 weeks. At $3.44 a gallon, diesel is $0.66 higher than this time last year. Retail gas prices, at $3.11 a gallon, are $0.44 higher. In the past few weeks Rocky Mountain prices saw the biggest price jump and West Coast prices remain highest at $3.29. The following table shows the percentage change in gasoline prices by region over the past year.

Regular Gasoline Prices

Year-over-Year % Change

U.S.

14.97%

East Coast (PADD 1)

14.73%

Midwest (PADD 2)

17.64%

Gulf Coast (PADD 3)

14.57%

Rocky Mountain (PADD 4)

11.29%

West Coast (PADD 5)

12.01%

Click to enlarge

So, higher prices offer bigger profits in what is historically the weakest season for refiners. And, lower average production and rising summer consumption will boost profits further in Q2, making this a fine time to buy Tesoro and Valero.

Disclosure: I am long TSO.