Anyone who gets involved in trading soon encounters the division between two camps - technical analysis and fundamental analysis. The most orthodox technicians insist that fundamentals are useless as it is all reflected in the charts. The fundamental analysts point to the long term success of value investors as evidence of its validity. Recently, the macro focus has emerged and seems very relevant in today's global investing climate where all markets are linked.
My stance towards these camps is neutral. I think all have merit and we can pick and choose their strategies that work for our time frame, approach and risk tolerance. Further, it seems clear that our job as traders is to craft a strategy that is rewarded by market conditions. As investors given a long enough time period, we can pursue more out of favor strategies and wait for market conditions to change.
However, I find that the best trades are the ones in which support can be drawn from all camps. This is one reason why I have focused on precious metals, discussed in this article. Another opportunity with similar characteristics are the refining stocks. I will examine the refiners from each perspective:
Just as the main driver of profitability for a copper mine would be copper prices, the main driver of profitability for refiners is the crack spread. The crack spread is basically the profits a refiner can extract from crude oil when it breaks down crude into gasoline and petroleum products such as kerosene, diesel, heating oil, aviation fuel, etc.
The two biggest potential catalysts for refiners to continue moving higher are the weather and the troubles in the Middle East. The refiners alongside the Gulf are vulnerable to damages from hurricanes. Given the already tight supply due to refiner shutdowns over the past decade, any drop in supply leads to rocketing crack spreads. Therefore, any severe weather could have positive effects on refining stocks.
Another potential catalyst is increasing political tensions in the Middle East. Brent Crude has enjoyed a premium to West Texas crude due to the uncertainty surrounding Iran-Israel, Libya and Egypt. The outcomes of these situations are quite unpredictable. However, the refiners do benefit as they profit from the premiums since they can sell refined products all over the world.
Another secondary benefit to being long refiners is their generally positive correlation with gasoline prices. Thus, they serve as a hedge against inflation via gasoline prices which are again nearing recent highs.
Link for Crack Spread Prices
|Price||Market Cap||P/E||PEG||Dividend Yield (%)||$/Share||Gross Margin (%)||ROE (%)||Short Float (%)|
Delek US Holdings, Inc. (NYSE:DK)
|Western Refining Inc. (NYSE:WNR)||26.50||2.41B||19.3||4.8||1.21||3.81||12.1||21.7||23.9|
|HollyFrontier Corporation (NYSE:HFC)||40.00||8.14B||5.64||1.66||1.50||8.05||18.9||47.1||2.4|
|Alon USA Energy Inc. (NYSE:ALJ)||13.47||761.7M||37.4||2.07||1.19||1.02||10.0||8.36||5.1|
|CVR Energy Inc. (NYSE:CVI)||34.65||3.01B||10.0||-||-||7.98||13.3||15.6||3.4|
|Hess Corporation (NYSE:HES)||54.78||18.7B||14.8||2.71||0.73||1.20||24.8||6.52||1.6|
|Tesoro Corporation (NYSE:TSO)||40.34||5.64B||8.68||0.53||1.19||9.46||10.7||17.32||6.34|
|Valero Corporation (NYSE:VLO)||32.78||18.1B||11.3||2.07||2.14||2.35||7.81||10.1||2.38|
In terms of fundamentals, there is a great deal of diversity within the sector. I think the near term movements will be dictated by macro events and the crack spread, however longer term the more fundamentally strong stocks will outperform and serve as safer stores of capital during pullbacks.
A more conservative approach would be choosing a stock with greater cash/share and lower P/E with a larger cushion or "margin of safety." However, in the short term the best gains would be expected from the stocks that are more leveraged and with more shares short.
These three stocks are good representations of the charts in the sector. Most of them have broken out to 52 week highs or are within 1-2% of their 52 week highs. Further, they have crafted a strong pattern of higher lows. Currently, the refiners after breaking to highs over the summer have moved sideways with an upwards bias for the past few weeks.
A bullish interpretation of this sideways movement is that shares are being transferred from weak hands to strong hands as all weakness is being bought and the market corrects its overbought state over time and not price. Its normal to expect a pullback after a strong move due to longs taking profits and shorts looking for a reversion to the mean trade. Therefore, its a sign of strong demand that instead of pulling back the shares remain rangebound.
Of course, not every stock that moves sideways for a period of time ends up breaking out. Often, it simply rolls over and selling can be intense due to the longs who bought during the rangebound period looking to cut losses. However, given the potential catalysts, I think its possible we break up.
Another advantage to this trade is that a stop loss can be put at the lower end of the range. Any close below the lower end of the range would invalidate this setup. A different approach with even less risk is to wait for a break above the range on strong volume and then taking a position with a stop close to the breakout point. If the stock falls back into the range, then the breakout is negated and the position is exited.
My interest in the refiners stems from the overlap of these factors. However, the news flow will certainly have a huge impact on the trade especially given the volatile nature of the Middle East and unpredictability of weather. Therefore, I think particular attention needs to be paid to stop losses. Keeping losses small is the key to preserving capital and being able to take advantage of future opportunities. In my opinion, the best feature of this trade is the relatively tight stop loss in case it does not work.
In a future article, I will discuss the individual names in more detail.