Indicator Points to Higher Gas Prices - and 3 Potential Power Plays

At Money Morning over the past six months, we’ve talked a great deal about oil and gasoline prices. We’ve offered our predictions about how high those prices were going, and have detailed a number of investment opportunities - chosen as much for their margins of safety as for their profit potential.

This time we’re going to detail three energy stocks with the potential for double-digit - or even triple-digit - profit gains. Admittedly, these are longer-shot, speculative plays. But we used a special energy indicator to help ferret out these energy plays.

This indicator is known as the “crack spread.”

In case you’ve never heard the term before, the crack spread is the difference between the price of crude oil and the value of the petroleum products that refiners can make from it. The crack spread can widen or narrow over time, depending upon various combinations of supply and demand.

If the spread is positive, that means the price of the products that result from the refining process - gasoline, diesel fuel, aviation fuel, heating oil, kerosene and asphalt, to name a few - is greater than the cost of the crude oil needed to make them. But if the spread is negative, it suggests that the cost of crude is higher than the end-game value of its derivatives.

Right now, the crack spread is narrowing. In fact, it has been for some time as governments around the world and gasoline companies actually try to hold down the pain motorists feel at the pump.

Granted, governments and major oil players make for strange bedfellows. But they have a common interest right now: Both are trying to prevent “demand destruction,” the plunge in oil demand that would result if millions of motorists - fed up with high oil and gasoline prices - just stopped driving. Governments want to prevent an economic collapse, while the integrated oil companies simply want to avoid being branded as the “bad boys” of the soaring-oil-price era - making it much easier for the incoming presidential administration to slap the entire sector with an “excess-profits tax” (something that’s already being discussed by Washington insiders).

But we can also see another scenario, one that’s very different. Peering into our crystal ball, we can see a situation in which the crack spread begins to widen, and gasoline prices run away anyway - eventually reaching $7 or even $9 a gallon.

For motorists, the pain would be excruciating. For investors, however, there’s a chance for double or even triple-digit profit gains.

Let me explain…

The Subsidy Gambit

It turns out that a number of Asian governments - most notably Taiwan, Malaysia and China, for instance - are actually reducing or eliminating fuel subsidies designed to shield their consumers from crude oil’s relentless march. Ostensibly, this is designed to control demand, but history suggests this will merely give those with the money access to increasingly large supplies that they’ll gobble up. In other words, we believe that demand may be growing fast enough to override the prices that governments around the world still believe to be inelastic.

Combine that possible new reality with the fact that a developing Asia accounts for as much as 70% of the increase in global oil consumption, this end of subsidies would probably hammer worldwide markets, including our own.

Given that Asia represents a mere 20% of current global usage, Asia’s growth is critical to how the rest of the world uses and prices petroleum-related products - particularly gasoline. Incidentally, this stands in stark contrast to how Japan and much of Europe do things where high taxes on fuel and transportation are used to blunt demand.

The economic forces that will be unleashed when these subsidies are removed have the potential to make the Great Tunguska Blast that took place 100 years ago this month look like a wet firecracker.

Indonesia, for instance, spends nearly 20% of its budget to underwrite fuel costs and has telegraphed a 30% hike in fuel prices when those subsidies are removed. It’s much the same story in China, India and the Philippines, where separate figures for fuel subsidies are hard to come by, but where it’s safe to say that the net effect of these price controls have contributed to artificially low prices and artificially high levels of demand.

In China, where the government caps gasoline prices, for instance, motorists pay about half of what their U.S. counterparts pay. All in all, governments around the world will spend about $100 billion on oil subsidies this year - meaning about half the world’s population is benefiting from “cut-rate” petroleum prices. This year, those folks will account for all of the growth in global oil demand, equal to an additional 1 million barrels of oil per day, says Deutsche Bank AG (DB).

Now, pressure is escalating globally for countries to end the subsidies the world economy can ill-afford. The International Monetary Fund [IMF], for instance, is “calling on governments to let consumers face market prices in order to kick-start conservation and reduce official spending,” says The Christian Science Monitor.

As I hinted earlier, this change has the potential to jam a lot of consumers personally. But it would allow world markets to function as, well, markets. And that, in turn, would afford investors one of the biggest turnaround opportunities available in the energy sector today. The reason: As the subsidy removals, pricing changes and demand shifts work their way through the global economy, the crack spread would widen again… and fast.

And the biggest beneficiaries could well be the oil refiners, which have seen their profits get zapped along with crack spreads in the past year.

The Best Way to Play the Shift From Subsidies

If there is a sector turnaround, the upside could be huge. And the three firms in line to benefit are Western Refining Inc., Valero Energy Corp. and Holly Corp. Let’s take a closer look at each of the three:

• Western Refining Inc. (WNR): The El Paso, Tex.-based Western is an independent crude-oil refiner that owns and operates four refineries, and that also owns and runs 155 retail service stations and convenience stores in the Southwest. Although Western’s shares rose 77 cents each, or nearly 7.1%, to close at $11.66 yesterday (Thursday), the stock is down 82% from its 52-week high of $66.13. Independent researcher Soleil Securities Group Inc., this week initiated coverage of Western with a “Sell” rating and a target price of $8, contending that the company is highly leveraged and has seen its shares suffer in concert with its peers as part of a general sector downturn. That underscores the sentiment these companies face. But a return to its 52-week high would represent a 467% gain.

• Valero Energy Corp. (VLO): The San Antonio, Tex.-based Valero Energy owns and operates a total of 17 refineries spread across the United States, Canada and Aruba, and its products run the petrochemical gamut. At yesterday’s closing price of $44.42, Valero’s shares are down 44% from their 52-week high of $78.68. A return to that 12-month peak would represent a gain of 77%.

• Holly Corp. (HOC): The Dallas, Tex.-based Holly is another independent petroleum refiner that focuses on such “light” products as gasoline, diesel fuel and jet fuel. It operates several refineries, about 900 miles of crude-oil pipelines, and a number of other operations. At yesterday’s closing price of $40.44, Holly’s shares are down 50% from their 52-week high of $80.55. If the shares were to bounce back to that 12-month peak from yesterday’s close, investors would reap a return of 99%.

Clearly, these aren’t “slam-dunk” stock picks. But volumes are going up and many of the sector players have been beaten down to bargain-basement levels not seen in years.

Besides, for a shot - even a long shot - at a 467% gain, investors can afford to be somewhat patient.

Comments

[bds231]

As an American driver, I care about Asian gas prices only in as much as they help determine the global supply and demand equilibrium. If Asian prices go up, be it through deregulation or any other means, the amount of gas consumed in Asia will go down (all other things being equal), and therefore the amount of gas consumed globally will go down. Which means, if the Asian and US markets are linked, the price of gas in the US should go down, putting MORE pressure on crack spreads.

Since the 3 stocks mentioned are US/North American companies, wouldn't this scenario put more pressure on them, not less? It seems to me that in order for these companies to succeed, either the price of oil must break or US/North American governments must cut gas taxes so that more of the cost of gas goes into the refiners' coffers than the governments'. This is the opposite of cutting subsidies, as the author proposes.

Am I missing something?

[AlexS]

bds231, I think the idea is that a sudden price increase for gasoline in Asia will indeed break the crude oil price dramatically. Since there will be essentially no change, however, in the demand for fuel in the U.S., this will enable marketers to maintain prices somewhat and for refiners in turn to raise margins. Interesting idea.

[John Galt]

A quick drop in crude seems a given, and it may even shock some people when you consider the downside effect of the ETF's selling "at any price" when the CNBC ETF herd rotates to the next thing. But even if we assume a return to the crack spreads of last summer, lower volumes mean lower overall profits. An assumption that stock prices will return to previous highs may be naive, unless crack spreads exceed last year by enough to offset the lower volume.

[ChBobII]

Don't forget Frontier Energy (FTO), also a refiner. All have their issues but if the crack spread widens they will go up smartly. Most days they react inversely to the change in crude prices so you will be hoping for crude to go down so that the refiners can keep their prices up & increase their crack spread. Sorry folks but gasoline pump prices will not immediately follow any crude price drops.

[FourBrane]

This article's premise that lower demand worldwide will mean increasing margins flies in the face of economic fact. Markets experiencing decreasing demand always see downward pressure on margins. Oil is not exempt from economic law and it would take four or five years of reduced oil prices to lull the consumers back into buying Hummers and other guzzlers. Meanwhile, deepwater drilling, oil sands extraction, biofuels, etc. come at HUGE cost increases, so where would that leave supply?
When crack spreads widen it won't be because of falling demand; it will be solely due to internal industry pressure--you just can't keep producing for peanuts and maintain your equipment properly. So, at some point next year, expect to see spreads widen modestly on their own.

[inthewings]

AlexS, thanks for connecting the US dots. When reading the article my brain was focused on foreign refiners. It seems to me that, altho US refiners could indeed benefit from the sudden crack spread when developing countries end their gasoline subsidies, refiners in those countries could benefit even more so with a "doubling" of petrol prices. Specifically, I would look for refiners in those countries.

As for buying US refiners right now and waiting for the turnaround while my principal shrinks, that's what I feel I have BEEN doing these last few months with other O&G investments! LOL

[paulk8756]

All that's fine, but what you fail to mention is that at equilibrium, natural gas is selling at the equivalent of about $75 per barrel of oil right now. If oil hits $150 this summer (...about a 10% additional upward move), nat gas could well DOUBLE in price from here.

Boone Pickens has it exactly right. The best and most immediate substitute for gasoline is to use nat gas as a transportation fuel instead of as a utility feedstock. But this would require the Congress to OK additional nuclear reactors (...that will also be required for plug-in cars), which they aren't about to do anyway.

[CLH]

Keith---Your post is interesting but I'm not sure the reasons make any sense. However, I have been nippling at the refineries.

[paulk8756]

P.S. I keep thinking the public will wise up to this self-imposed energy boycott contrived by the Greens and their minions in Washington. But
it now appears it's going to take $8-10 a gallon gasoline for that to take place, if then. (Yeah, that's right, $250 oil and $30+ nat gas are not out of the realm of possibility... Wow!)

[User 210330]

Even though I am an investor in one of the refiners mentioned, I will try to be objective in my comments about this crack spread problem. Other investments in the stock market have been gratifying while there has been a sizeable loss in the refiner. However, if these companies are forced to operate at a loss or on a slim margin for an extended period of time, we could find ourselves with a refining capacity much less than is in the best interest for the nation.

Due to restrictive regulations and/or huge investments involved, there has been no new refineries built in the U. S. for an extended period of time. So, there has to be some relief in the market for this to change. The nation's capitalists are always eager to finance ventures that have profit potential but they will not fund something that is "dead in the water." Indeed, it would be a catastrophe if half of the refining capacity in this country ceased operations due to losses or slim margins. The consuming public would pay a dear price if that occurred.

[Shaggieman]

If Oil comes down it will definitely help the refiners. The order I would buy though is VLO, FTO, HOC, TSO, ALJ, SUN, DK, WNR.

The reason I put WNR last is the high leverage this company is at due to the purchase of GI. WNR is up against loan covenants that could trigger mainly around the 20th of every month when the previous months crude oil payment is due. Violiating the covenants would place the ownership of the company under the debt holders (BAC) and make the shares near worthless.

So very high risk.

On the plus side the management owns over 50% of the shares and they've said "we're not going to violiate the coventants". However, the funds have mostly bailed and currently NO SIGN of re-entry.

[haydete]

In the Subsidy Gambit, if those that have the money to buy more after the subsidy is removed, why aren't they buying more now while prices are cheaper? What am I missing (along with the rest of the points of this article? )

[paultaut]

Roughly 12 million Chinese enter the middle class every year, they will not differentiate between what was and what may have been. They will only see what is now and act accordingly.

Additionally, their culture is geared to accepting whatever is tossed at them without objection. Food/oil prices are up, they will endure. All of the noise regarding inflation is currently being generated by their government which has another 200+ million farmers to relocate or say another 15 years of construction, increased energy usage, etc. over and above keeping those already transplanted happy.

Refining margins have been screwed into the ground because of ethanol's prices. The overall cost of gasoline has been kept down because 10% or more of each gallon is under their cost to produce. With the midwest under water, corn/ethanol prices are moving dramatically higher. Ethanol's move to parity or above gasoline production cost will drive refining margins up.

All refiners will benefit but my favorite is ALJ which has 3 sour and 1 heavy refinery. Plus asphalt facilities as well.

[galewhitaker]

Higher energy prices are the best thing that has happened to our country in years. In our democracy their is no one doing any long term planning. Apparently the only way systemic changes come about is when there is an emergency. Hopefully these higher gasoline prices are going to force Americans to use energy more wisely so that it will last a little longer. Maybe if folks are forced to walk more it will reduce the number of Americans with heart disease. That number currently stands at 24.1 million. A little walking will also be good for the 189,000,000 Americans who over weight.

[bearfund]

galewhitaker, very true, and there are long-wave demographic shifts already under way in that direction. It's unfortunate that so many Americans live in places where there aren't even sidewalks and nothing within an hour's walking distance anyway because it's just assumed that everyone has a car and uses it as his exclusive mode of transportation regardless of destination or distance. But then we'd be talking about the misallocation of resources represented by suburban and exurban expansion, probably the single biggest mistake the US has ever made and the one that stands the best chance of making these refiners pay off in the medium term. But as reurbanization takes off in the next several decades, US refiners will eventually be crushed by falling demand, especially for gasoline and jet fuel. It will take centuries to depopulate and repurpose all that land, a process that will never really be completed. Still, I'd be looking abroad if I were going to invest in refiners for the long term; that's where the growth will be.

[jdlech]

For those who seem to misunderstand, gas is not oil. When Asian gas prices reduce consumption, Asia will buy less oil. That means more oil supply for the rest of the world. QED, lower oil prices. The American demand for gas will be largely unaffected by the price of oil. QED, wider crack spreads.

Now, gasoline is just one product made from oil. These refineries are producing hundreds of different chemicals that are used in everything from the food you eat to the plastic containers in which they come. Already, the refiners should be swithing over to producing millions of gallons of heating oil for the winter instead of gasoline and diesel fuel. It's important to consider the crack spread on ALL of these chemicals.