The hottest sector in the market is energy, up almost 14% YTD, well ahead of the 5% move in the S&P 500 and more than double the 6% move in the second best sector (technology). The sources of strength are broad, but one of the groups fueling the rally is refiners.
There are three refiners in the S&P 500, and they are up an average of 19.5% despite one being a dog. Smaller refiners are doing even better. Here are the 9 refiners in the Russell 3000 (click to enlarge):
Wow! The smaller stocks are doing even better, leading to a 42% YTD return on average. With the recent announcement that Holly (HOC) is buying Frontier (FTO), one might think that M&A is driving it, but that's not the answer. It's all in the "crack spread":
The above-look is a snapshot of the past year, courtesy of Bloomberg. For a longer-term view, you can visit their website, which also defines the calculation. Generally, the range has been 10-20, but it has fallen as low as 2 near the end of 2008 and reached 30 around Memorial Day in 2007. The crack spread, which is nearing its five-year highs (and the clearly above the 20 peak that has been more typical) and has gone up four-fold since Labor Day, is essentially the profit margin the refiner can earn by converting oil into heating oil and gasoline. The higher the number, the higher the profit. If you live in the Northeast or drive a car, you have probably noticed that heating oil and gasoline have been rising a lot faster than oil these days.
Back to our list, a few questions come to mind:
- Is this sustainable?
- What's wrong with Sunoco (SUN)
- Is there another way to play?
I don't follow any of these companies closely. Sadly, for me, I am doomed in my quarterly stock-picking contest by the success of Alon (ALJ), which was the pick of one of the participants for Q1. I have observed how poorly this group has fared over the past few years (only HOC is up and the rest are down hard), as the low valuations (relative to asset values) have intrigued me. Besides significant financial leverage, the low margins of the industry left me as just a curious observer. I was aware that there was very little new supply coming on (only a new plant from Marathon Oil (MRO)), but the crack spread wasn't there. Now, after a very cold winter, it is.
I am no expert, but this seems like a huge momentum run to me rather than the beginning of a trend. A couple of issues could hurt the profitability in my view, including consolidation of gas stations and likely improving fuel economy in coming years that will sap demand. Finally, it looks to me like the group has been heavily shorted. Perhaps some of the explosive growth these past two months has been due to short-covering.
The sun isn't shining on SUN - is this an opportunity? Again, I haven't followed the company closely, but this is what I have learned. First, as reflected in the table, the earnings estimates have been coming down sharply, in contrast to the rosier outlooks from the peers. Second, the stock actually did better than average in 2010, so the lag is probably corrective. Third, the company has faced operational issues. Fourth, while it is spinning it out, it has significant coking. Finally, it appears to have higher-than-typical retail and logistics exposure. So, while SUN may jump out initially as a potential opportunity, it doesn't appear to be.
Now, the most important observation I can share is one I have previously addressed when I discussed my bullish view on Big Oil. The biggest refiners aren't even on this list, but part of the Big Oil companies like ExxonMobil (XOM), Chevron (CVX), ConocoPhillips (COP) and Marathon (MRO). It seems to me that the huge move in the refiners is only partially reflected in the stock prices of big oil. What a safer way to play improving conditions for the refining industry, if that is indeed the case. CVX, which is my largest position in the Conservative Growth/Balanced Model Portfolio, has been optimizing its portfolio rather effectively recently and is rumored to be selling a UK refiner to Valero (VLO).
Another way to play better times for the refiners is service companies. I need to spend more time identifying these names, but two companies I know that are benefiting are Clean Harbors (CLH), which is on my watchlist (and a great company), and Matrix Service (MTRX), which a couple of my clients own. These companies provide "turnarounds", which is a maintenance service that refineries have been deferring until recently.
So, as I look at the spike in refiner stock prices, I see it as a bounce that isn't likely sustainable. Short-covering most likely played a role as the crack spread broke out of normal ranges after a spike in heating oil. Fundamentals for the industry seem helped by the lack of new supply and some consolidation, but there are some challenges ahead on the demand side. Rather than jumping into these stocks, I would suggest looking at big-cap integrated companies with large embedded refinery operations or service companies that might be the beneficiary of improved profitability in the industry.
Disclosure: CVX is in the Conservative Growth/Balanced Model Portfolio at Invest By Model
