Refining stocks have had an incredible run since last fall. Western Refining (WNR) has led the way, quadrupling off its all-time low of $4.01 last September to hit a high of $17.09 this week. The rest of the sector has seen large gains as well, with most refiners roughly doubling off their recent lows. The upswing has gained momentum in 2011 with moves picking up strength. For example, Delek US Holdings (DK) has moved from under $7 to almost $11 in just the past month. With most of the refining sector selling at prices not seen since 2008, investor sentiment is clearly running high. In the past weeks, it has, in fact, been nearly impossible to find a bear in the refining space.
As someone who stocked up on shares of Valero (VLO), Tesoro (TSO), and Western Refining in the doldrums of 2009, and then watched the sector's struggles deepen in 2010, the recent surge has come as a welcome relief. However, I've been forced to ask myself whether the recent rally can continue on much further without a significant correction.
There's been plenty to be excited about in the refining space in the past few months. For starters, the 3:2:1 crack spread (a popular measure of the difference between the price of finished refined oil products compared with the input cost of crude oil), from which refiners generate their profit margins, has soared from a low of $6 a barrel in September of 2010 to $23.40 a barrel today according to Bloomberg.
For the past couple years, the crack spread has generally traded in a range centered between $8-12 a barrel which has been insufficient for many refiners to generate much in the way of profits. For refiners with higher costs or substantial debtload such as Western or Alon (ALJ), it has appeared that mere survival was at stake. With the crack spread at $6 a barrel and Western stock at $4 last September, few analysts expected the company to be able to successfully service its debt much longer.
However, refiners are highly levered to the crack spread, so even brief spikes in the crack spread can cause refiners to reap large profits. In the fall of 2008, following the infrastructure damage caused by Hurricane Ike, the crack spread soared as gasoline briefly fetched $5 a gallon in some parts of the southern U.S. The refiners turned in hugely profitable quarters, for example, Western earned $1.61 a share for the hurricane-impacted quarter. Western traded at $8 a share at that time, so $1.61 profit per share in a single quarter was an enormous profit. However, the crack spread quickly declined after the hurricane, profits evaporated, and refining sector deflated.
Presently, the crack spread has been rising for a variety of reasons, and this rise appears to be more durable than past moves. Impacts from the recession finally may be fading (though asphalt demand remains moribund), there have been quite a few refinery outages reducing excess inventory, and a bitter cold snap has boosted margins. Some refiners, in particular Western, Delek, and Frontier (FTO), have also benefited from receiving a large portion of their crude oil input from domestic sources which have offered more attractive pricing than foreign sources recently.
Barron's has recently suggested that refiners' earnings should rise significantly in 2011 as it appears a period of sustainable lasting higher margins has arrived. Analysts have been raising their expectations and price targets for refiners recently and sentiment is quite bullish. The next round of earnings reports should produce solid quarters for just about all players in the sector. Clearly things are going well for refiners.
However, when things can't get much better, they typically get worse. As this is the case, it is wise to be taking profits on your refining positions or to refrain from making new investments in the sector until there is a significant pullback. The crack spread is quite vulnerable to contraction when the recent cold weather moderates. The spread would also contract if the relatively low rate of industry-wide refinery utilization rises in the coming weeks. You can bet that refiners will be bringing as much of their capacity online as they can to take advantage of the current profit margins.
Also, many refiners face substantial debt-loads, and it wouldn't be shocking to see substantial dilution in the coming weeks or months as refining companies have the opportunity to raise capital with their share prices at the highest levels they've been at in years. For Western in particular, the company couldn't be faulted should it choose to raise cash. Western greatly overpaid for the Yorktown refinery in which it has since suspended operations, and faces more than a billion dollars of outstanding debt. The company has two shuttered refineries, Bloomfield and Yorktown, that don't appear to have potential buyers at reasonable prices, and as such, a substantial chunk of Western's assets are illiquid. It'd make a lot of sense to raise cash now while the market is willing to accept a large share dilution to guarantee the company's long-term survival. I wouldn't be surprised to see much of the rest of the debt-laden refining space also dilute.
I think the long-term bullish story on refining stocks is still correct. The crack spread has been unnaturally low for the past eight or so quarters, but it appears this period has ended as refiners have finally regained some of their pricing power. While I doubt there will be a return to the peaks of the 2007 refining boom, in the long run refining stocks should continue trending higher.
However, in the short-term, it appears that refiners may have run too far without having yet earned the profits to justify their recent outsized gains. With the crack spread vulnerable to contraction and a substantial risk of dilution across the industry, a decent pullback in the refining space can be expected. If you have large profits on refining positions, be protective and reduce your exposure if you are overweight the sector. If you are looking to establish a new position, you'd be wise to wait for a pullback.
Disclosure: I am long WNR, TSO.