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Oil Prices And Refiner Margins

Adam Johnson of Bloomberg TV often spotlights stocks he feels are undervalued. On Wednesday, he noted on Twitter that, as oil prices drop, margins for oil refiners could potentially expand:

Falling oil lowers refiners' costs (widens margins)... and the stocks are cheap: $HFC P/E 4.5x, MPC 5.1x, $WNR 5.2x, $VLO 5.8x, $TSO 6.4x $$

- Adam Johnson (@AJInsight) May 23, 2012

Johnson is right, all things equal: i.e., assuming prices for refiners' products (primarily gasoline and diesel) remain steady. But if economic weakness is what's putting downward pressure on oil prices, it may have the same effect on gasoline and diesel prices, in which case lower oil prices may not prove much of a boon to refiners' margins.

For investors long refining stocks and considering hedging them, the table below shows the costs, as of Wednesday's close, of hedging the five refiners Adam Johnson mentioned in his tweet against greater-than-21% declines over the next several months, using optimal puts. Unfortunately, these stocks aren't cheap to hedge now.

Comparisons

For comparison purposes, I've added the Market Vectors Oil Services ETF (NYSEARCA:OIH) and the SPDR S&P 500 ETF (NYSEARCA:SPY) to the table. First, a reminder about what optimal puts are, and a note about decline thresholds; then, a screen capture showing the optimal put option contract to buy to hedge the comparison ETF, SPY.

About Optimal Puts

Optimal puts are the ones that will give you the level of protection you want at the lowest possible cost. Portfolio Armor uses an algorithm developed by a finance Ph.D. to sort through and analyze all of the available puts for your position, scanning for the optimal ones.

Decline Thresholds

In this context, "threshold" refers to the maximum decline you are willing to risk in the value of your position in a security. You can enter any percentage you like for a decline threshold when scanning for optimal puts (the higher the percentage though, the greater the chance you will find optimal puts for your position).

Often, I use 20% thresholds when hedging equities, but one of these stocks was too expensive to hedge using a 20% threshold (i.e., the cost of hedging it against a greater-than-20% drop was itself greater than 20%, so Portfolio Armor indicated that no optimal contracts were found for it). There were optimal contracts available for all of these names using a decline threshold of 21%, so that's the threshold I've used below.

The Optimal Puts for SPY

Below is a screen capture showing the optimal put option contract to buy to hedge 100 shares of SPY against a greater-than-21% drop between now and December 21st. A note about this optimal put and its cost: to be conservative, the app calculated the cost based on the ask price of the optimal put. In practice, an investor can often purchase puts for a lower price, i.e., some price between the bid and the ask (the same is true of the other names in the table below).

Hedging Costs as of Wednesday's Close

The hedging costs below are as of Wednesday's close, and are presented as percentages of position values.

Symbol

Name

Hedging Cost

(NYSE:HFC)HollyFrontier Corporation12.1%***
(NYSE:MPC)Marathon Petroleum Corp.4.94%*
(NYSE:WNR)Western Refining, Inc.16.1%*
(NYSE:VLO)Valero Energy Corporation9.64%***
(NYSE:TSO)Tesoro Corporation8.75%**
Market Vectors Oil Services4.85%*
SPDR S&P 5002.58%***

*Based on optimal puts expiring in October

**Based on optimal puts expiring in November

***Based on optimal puts expiring in December

Source: As Oil Prices Drop, A Look At Hedging Refiners