Crude Oil Processing Spreads Are Not Bearish

by: Andrew Hecht

Crude oil has declined from the recent high.

Crack spreads are a real-time indicator of demand.

The gasoline crack spread has moved significantly higher.

The distillate crack spread has made higher lows and higher highs since April.

VLO profits from higher processing spreads.

The price of crude oil has corrected from the high at the end of April that took the price of nearby June NYMEX futures to a peak at $66.60 per barrel on April 23. Crude oil declined to a low at $60.04 on May 6, and on May 15 the price was at just over $62 on June futures. Technical support for the price of crude oil is at the May 6 low and at $55.31 which was the March 8 low for the energy commodity.

On May 13, the stock market plunged with the DJIA suffering an over 600-point loss on the session. All of the leading US stock indices fell between 2.38% and 3.41%. Copper declined to its lowest price since late January of this year, and soybeans fell to the lowest price in a decade on the back of new tariffs by the US and retaliatory measures by China as trade negotiations broke down last week. Other commodity prices were coaxing the oil market lower, but the situation in the Middle East screamed not so fast. This week, four oil tankers were sabotaged off the coast of the UAE near the Strait of Hormuz which means that geopolitical concerns are likely to continue to support the price of the energy commodity. At the same time, a drone attack on a Saudi oil pipeline is a sign of a new paradigm in the region. While the trade dispute between the US and China escalated, the potential for military conflict between the US and Iran in the Middle East has risen. This week's attacks had Iranian fingerprints all over them. China-Us trade and Iran are pulling the price of crude oil in opposite directions these days, which is likely to increase price volatility in the energy commodity.

Meanwhile, the trend in oil processing spreads has been bullish for gasoline since late January and for distillates since early April. While crude oil's price is likely to become highly volatile if the trade war escalates further, and Iran provokes the US and its allies in the Middle East, the firm processing spreads are good news for the shares of oil refiners in the US like Valero Energy Corporation (VLO). The shares of VLO slipped over recent sessions alongside the weakness in the stock market sending them back into the buy zone. Earnings for refining companies do not move higher or lower with the price of crude oil or products alone. Their profitability comes from the refining margin or differential between the oil that is the input, and the gasoline and distillates that are the output in the refining process. The current dip in the stock and oil market could provide another chance to buy VLO shares at bargain prices.

Crude oil has declined from the recent high

In Q4 2018, the price of crude oil fell from $76.90 in early October to a low at $42.36 in late December. The price then turned higher reaching its latest peak at $66.60 on April 23. Markets rarely move in a straight line, and the price of June NYMEX futures ran out of steam in late April.

Source: CQG

As the daily chart highlights, the price of crude oil traded to a low at just over $60 per barrel on May 6 and has been consolidating at just above there over the recent sessions. The news of attacks on oil tankers near the UAE on May 13 took the price to a high at $63.33, but the price turned lower and put in a bearish reversal on the session on higher than average volume and settled at just above the $61 per barrel level. The next two days, the price edged higher.

Price momentum and relative strength indicators are crossing higher in oversold territory on the daily chart, and open interest was stable at the 2.154 million contract level at the beginning of this week. The price of crude oil has come a long way from the low, and a correction should come as no surprise to market participants.

Crack spreads are a real-time indicator of demand

Crack or processing spreads represent the economics of refining a barrel of crude oil into oil products like gasoline and distillates such as diesel and jet fuels. I watch the price levels of crack spreads like a hawk for two reasons. First, they provide valuable fundamental clues about the price of crude oil. When crack spreads rise, it is a sign of increased demand by consumers because they purchase products rather than the raw crude oil. When they fall, it is a signal that demand for products, and crude oil by extension, is declining as the oil is the primary ingredient in the refining process.

The second reason is that aside from being a real-time indicator of demand, they also provide a constant window into the profitability of those companies that are in the business of processing oil into oil products. Higher crack spreads increase profits and volumes, and lower crack spread tends to cause a tighter earnings picture and lower demand often leads to less refining. Since refineries require significant capital investments, an increased volume that passes through the catalytic cracker creates economies of scale and lower per barrel costs. At the same time, higher cracks spreads can turbocharge profits.

The gasoline crack spread has moved significantly higher

Since the end of January, the gasoline crack spread has moved appreciably higher.

Source: CQG

As the daily chart shows, the crack spread that represents the economics of processing a barrel of crude oil into gasoline rose from $12.76 to $23.78 since January 31, 2019, and was trading at the $22.77 per barrel level on May 15, just $1.01 off the high and $10.01 above the lows over the period.

The gasoline crack moved higher because of seasonal factors as winter ended and the spring season arrived, but a look at the weekly chart displays strength in the gasoline refining spread.

Source: CQG

The weekly chart shows that the gasoline crack spread has traded in a range from $21.21 to $22.84 so far during the week of May 13. One year ago, the range in the spread was from $20.78 to $23.78. In 2017, the high in the spread was $19.15, and in 2016, the high in the spread during this week was at $21.13. Therefore, the margin for processing crude oil into gasoline is currently at the same level as last year and a higher level than the two previous years which both support the price of crude oil and the share prices of companies like VLO that receive their earnings from the processing spread.

The distillate crack spread has made higher lows and higher highs since April

The is some degree of seasonality in the heating oil crack spread, but not as much as in gasoline because heating oil serves as a proxy for other distillates like diesel and jet fuels which have year-round demand. The June heating oil crack spread turned higher in early April.

Source: CQG

The daily chart of June heating oil crack spreads shows the price reached a bottom at $21.43 on April 3 and rose to a high at $25.76 on May 15. At the peak on May 15, the refining spread is at its highest level since early March.

Source: CQG

The weekly chart illustrates that the heating oil crack traded in a range from $24.31 to $25.76 per barrel during the week of May 13, 2019. Last year, the high in the refining spread during the same week was $25.10, and in 2017 the peak was at $16.25 per barrel. In 2016, the high during this week was at the $14.91 level. Like in gasoline, distillate processing spreads are at the same level as last year, but higher than in 2017 and 2016 which is supportive of the price of both crude oil and Valero stocks.

VLO profits from higher processing spreads

VLO shares rose to the highest price in 2019 at $92.70 on April 25 after trading to a low at $68.81 in late December 2018, a recovery of 34.7% before pulling back to $78.79 per share on May 9.

Source: Barchart

As the chart shows, VLO traded to a high at $126.98 last June before turning lower. In 2017 the high was at $93.18, and in 2016 the shares peaked at $72.49 per share. VLO has been making higher highs over the past three years, and at $82.90 the shares offer value considering the price levels of the crude oil refining spreads. The shares trade at 12.59 times earnings with a 3.97% yield at its current level.

Crude oil is currently correcting towards the $60 per barrel level. At the same time, VLO is drifting back towards $80 per share. Any further selling over the coming days and weeks could provide market participants with an attractive buying opportunity in both oil and VLO shares as processing spreads for gasoline and distillate fuels is supportive for both.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author always has positions in commodities markets in futures, options, ETF/ETN products, and commodity equities. These long and short positions tend to change on an intraday basis.

The author is trading VLO from the long side of the market