Crack spreads measure the cost of refining a barrel of crude oil into oil products, which are gasoline and distillates. Crack spreads offer clues about the demand for crude oil. Direct consumers fill their cars with gasoline and heat homes with heating oil, a distillate fuel. Indirect consumers fly on planes, purchase goods that come to market in vehicles powered by diesel or fly on planes that require jet fuel or other modes of transportation that need distillates. The demand for oil products translates to the need for crude oil, which is the main ingredient in the cracking process.
Crack spreads are also a real-time indicator for the earnings of companies that refine crude oil into products. These businesses have no direct exposure to the price of crude oil or products as they purchase the input at market prices and sell their output at the current rate. However, companies like Valero Energy Corporation (NYSE:VLO) make or lose money based on the crack spread or the differential between the price of oil and the products. When crack spreads rise, profits increase. When then decline, profits fall or turn into losses.
Even as the stock market rose to new record highs in January and February 2020, energy-related companies did not participate in the rally. When the price of oil spiked to a high of $65.65 per barrel on January 8, oil-related shares continued to lag both the stock market and the price of the energy commodity. Meanwhile, as the price of oil and stocks turned sharply lower, energy companies have declined to the lowest level in years. The current risk-off environment has sent the price of Valero shares to the lowest price since June 2017, which could be an opportunity.
Risk-off puts the oil market on an elevator to the downside
After rising to a high of $65.65 per barrel on January 8, when the tensions between the US and Iran reached a boiling point, the price moved lower to $49.31 in early February as the situation in the Middle East calmed. Nearby crude oil futures on the NYMEX division of the CME recovered to $54.50 per barrel on February 20, when they ran out of steam on the upside.
Source: CQG
As the weekly chart highlights, the price of crude oil took an elevator to the downside during the final week of February 2020, reaching a low of $43.32 per barrel on March 3, 34% below the January 8 peak. Risk-off in markets across all asset classes caused a severe correction in the stock and crude oil markets. The price of nearby April NYMEX crude oil futures was trading at $47 per barrel on March 3, after a bounce from the low.
Crack spread move lower as products underperform
Gasoline and distillate prices moved lower with the price of crude oil during the risk-off action in markets.
Source: CQG
The daily chart of April gasoline futures shows the move from $1.9862 per gallon on January 8 to a low of $1.4411 on the first trading day of March, a decline of 27.4%.
Source: CQG
At the same time, heating oil futures, a proxy for all distillates, plunged from $2.1043 in early January to $1.4383 per gallon in late February or 31.6%. Nearby April gasoline and heating oil futures settled at $1.4828 and $1.4773 per gallon, respectively, on Friday, February 28, and both bounced higher with the price of crude oil on Monday, March 2.
Meanwhile, the processing or crack spreads have declined since early January.
Source: CQG
The weekly chart of the gasoline crack spread fell from $24.75 to $17.13 at the end of last week. However, the winter season is a time of the year when demand for gasoline falls to a low. In late February 2019, the gasoline processing spread traded in a range from $16.01 to $17.23 per barrel. This year, the crack spread is around the same level as at this time in 2019.
Coronavirus has weighed on the global economy leading to the risk-off conditions in markets across all asset classes. The spread of the virus threatens travel and demand for products all over the world. Therefore, the distillate crack spread has displayed significant weakness.
Source: CQG
The weekly chart shows that decline from over $24 per barrel at the end of 2019 to the $17.20 level at the end of last week. During the final week of February in 2019, the distillate crack spread traded in a range from $27.27 to $28.62 per barrel, significantly above the current level.
OPEC and central banks should announce emergency measures
As risk-off conditions continue to weigh on markets across all asset classes, we could see both the international oil cartel and central banks act to stabilize markets.
OPEC oil ministers had said that the sweet spot for Brent crude oil futures is between $60 and $70 per barrel.
Source: Barchart
At below $50 per barrel on the nearby Brent crude oil futures contract at the end of last week, the price of the energy commodity was around $10 below the bottom end of the cartel's desired range. Brent is the benchmark price for crude oil from Europe, Africa, and the Middle East.
OPEC cut production at its late 2019 meeting as the cartel increased its reduction from 1.2 to 1.7 million barrels per day. Saudi Arabia threw in another 400,000 barrels for good measure bringing the total cut to around 2.1 million barrels. Given the decline in the price of crude oil on the back of the spread of Coronavirus, the Saudis have been pushing OPEC and Russia to cut output further when they meet over the coming days to evaluate the current production policy. At the current price level, the odds of an additional reduction to balance the market's fundamentals are high.
At the same time, on Friday, February 28, the Chairman of the US Federal Reserve issues a brief statement that the central bank was ready to act to address the risk-off condition in markets. Central banks around the world have treated crisis conditions with liquidity in the form of short-term interest rate reductions and programs of quantitative easing that push rates lower further out along the yield curve. With stocks falling off the side of a cliff last week, and inflation well below the Fed and other central bank's 2% target rate, the path of least resistance of rates is lower. An interest rate cut would not be bearish for stocks or the price of crude oil, but the jury is out as to whether they will rally in the face of the rising potential of a pandemic.
Valero shares tank
Valero is a refiner of crude oil into oil products. Historically, VLO shares have been most sensitive to the gasoline market. However, risk-off conditions have created an almost perfect bearish storm for the price of the stock.
Source: Barchart
The chart of VLO shares shows that the low in May 2017 was at $60.69 per share. VLO shares dropped from a high of $101.99 in early November 2019 to a low of $62.41 last week, a decline of 38.8%. VLO closed at $66.25 on February 28.
VLO had a market cap of around $27 billion at the February 28 low. VLO trades an average of over three million shares each day and pays shareholders a 5.92% dividend. VLO is consistently profitable.
Source: Yahoo Finance
VLO's EPS has beat consensus estimates over the past four consecutive quarters. Most recently, the company beat the forecasts by 51 cents per share with an EPS of $2.13. An average of 17 analysts on Yahoo Finance has an average price target of $107.00 per share for VLO, with a range of $90 to $122. The shares fell to over $30 below the bottom end of the range last week, which means that VLO was trading at a bargain-basement price.
We have been here before
Risk-off conditions in markets across all asset classes are nothing new. In 2008, the global financial crisis led to a significant rise in the stock market. In late 2015 and early 2016, stocks fell sharply on the slowdown in China's economy. In Q4 2018, the stock market declined on the back of rising interest rates in the US and the escalating trade war between the US and China. All of those events where fear and uncertainty weighed on markets led to significant buying opportunities.
Coronavirus and the US Presidential election are currently creating risk-off conditions. We are likely to see a bumpy road in markets over the coming weeks and perhaps months. However, if history is a guide, the current price action is creating another opportunity to buy profitable companies at bargain prices. VLO is exposed to the refining margin for crude oil, not the price of the energy commodity or its products. I view the current price level at under $70 per barrel as a compelling sale. Moreover, the increase in volatility has lifted the price of put options on VLO shares. Selling puts on VLO intending to purchase the shares if the price remains below the strike price at expiration could turn out to be another golden opportunity in the coming months.
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