Nothing Could Be Finer, Than Buying A Refiner
Nothing Could Be Finer, Than Buying A Refiner
Over the past year we have seen just about every extreme situation imaginable from the crude oil market. We have seen extreme highs that were absolutely unjustified considering an abundance of inventory and weakening demand in July 2008, and we also saw a considerable sell-off that took crude oil down to $33 a barrel in March 2009, which seemed overly-done given just how much of the crude market is controlled by twelve foreign countries and given their pricing power.
The crude oil market seems to be settling into a new trading range here which I highly anticipated earlier in the year would be $57-$72 a barrel. The interesting thing here is that regardless of the price of crude, there are companies out there in the oil and gas sector that are only somewhat dependant on its price and by this I mean specifically the refiners.
Refiners are handcuffed by demand so in that respect their elasticity to respond to changing market demand with regards to their profit margins are slim to none. If crude demand is down, the amount of finished product will be down, and vice versa. But refiners do have one common denominator in this mix and that is the crack spread.
The crack spread is merely the overall profit per barrel the refiner can expect to make when they crack the raw crude oil down into its sellable components like gasoline and heating oil. There are numerous formulas that are used to calculate crack spreads, but I’ve learned the two most common are the 3-2-1 spread and the 2-1-1 spread. What this means simply is that 3 barrels of crude will break down into 2 barrels of gasoline and 1 barrel of heating oil, or as the second spread shows, 2 barrels will break down into 1 of gasoline and 1 of heating oil. The great thing about the calculations of crack spreads is that you can often find future contracts that calculate them for you, otherwise you can also use simple arithmetic and calculate them for yourself.
For a 3-2-1 crack spread, the following formula will work:
The assumption is made that everything needs to be in gallons. That means a 1000 barrel delivery of crude contains 42,000 gallons, so the current price of gasoline and heating oil will need to be multiplied by 42.
[(2 X (current gasoline future price X 42)) + (1 X current heating oil future price X 42)] – (3 X current crude oil price) = (answer) divided by 3
This would give you a rough look at the profit in dollars per barrel of crude.
Something sneaky however lies within these figures. If you take this profit per barrel and divide it into the current price of crude oil, you get a rough picture of the gross refiners margins. But adding in the actual basis costs of those goods will give you a much clearer picture of their health; So taking this one step further and taking your gross answer (the answer prior to a division of 3 in the formula above) and dividing it into the 3 X current crude oil price number will yield a true potential profit percentage.
Likewise, the 2-1-1 crack spread can be calculated as follows:
[(1 X (current gasoline future price X 42)) + (1 X current heating oil future price X 42)] – (2 X current crude oil price) = (answer) divided by 2
Luckily its simple arithmetic and this gives you an analyst’s view of just how they gauge the health of the refining sector. But now that I’ve thrown just two of the common crack spreads analyst’s use, how do you determine which one to “run with?” Typically, its best to let the 2-1-1 spread dictate the health of the refining sector but you’ll get numerous opinions on this. In an economy that requires more gasoline production and an increase in petrol demand, the 3-2-1 crack spread will be a better determiner of overall refining health, but based on our current economic situation and for the foreseeable future, I see the 2-1-1 spread being the better indicator.
So we know that refiners clearly have only limited control over their output since petroleum product demand ebbs and flows based on the strength of the overall economy and to some extent the price of the underlying commodity. Refiners do however have a vested interest to produce as much finished product as possible during times when crack spreads return to highly profitable states. I had to dig around through every trench imaginable but I did find a nearly 20 year long chart which shows these crack spreads from 1990 through late 2008.
One thing that is particularly notable from the above chart is just how uncommon it is for crack spreads to dip heavily into negative territory and that any dip down into negative territory is simply unsustainable. Refiners are, for lack of a better word, cash machines. They tend to make a profit on their finished products in practically any environment, whether crude oil as a commodity is up or down, or whether or not revenues are way up or way down.
Take a look at the most recent results from refiners. Most refiners saw revenues dip somewhere in the range of 40-55% yet still turned out a substantially better than expected quarterly profit. Demand is down significantly for crude oil, but crack spreads have improved dramatically since this last chart was produced and have returned to an above normal number in relation to the 19-year average.
Now I know what you must be thinking, crack spreads tend to peak in May and back off during the rest of the year. This has to do with the extreme ramp-up in anticipation of the summer driving season, and the fact that refiners tend to do most of their structural maintenance in the Winter. So yes, crack spreads are more than likely peaking now, but that leaves yet another quarter of surprising profits from most of these refiners despite the doom and gloom forecasts we’ve been getting from analysts. If you look at the above chart again, you’ll notice that crack spreads have historically resumed an uptrend very quickly after the end of a recession. Now I am in no way, form, or shape calling us anywhere near the end of a recession, but our days in negative territory for crack spreads are gone for now and I think refiners represent an excellent value at these levels.
There are a lot of refiners however, and despite improving crack spreads, some represent better values than others. There are four in particular that have caught my attention and look ripe for the picking.
Valero Energy (NYSE: VLO)
Valero has been putting out one stinker of a news story after another and yet the underlying profit potential here is huge. Valero recently priced a secondary offering which I’m actually glad they got out of the way now and didn’t do this a year from now when I fully expect the refiners to be in rally mode. Secondary offerings are rally-killers, flat out! Valero is also dealing with two of their refineries being down longer than expected for maintenance but despite this reported better than expected profits during Q1. Valero is currently trading at just 0.55 times book value, 0.08 times sales and a mere 5.72 times 2010s profit projections. This is historically way too inexpensive for a refining juggernaut like Valero and given the long-term technical trend in this stock, now looks like the time to take a hefty position for 1-5 years out.
Sunoco (NYSE: SUN)
You’re going to notice a trend here with the four companies I’m mentioning because they have had a recent history of obliterating analyst expectations. Sunoco has reported profits which have trounced analyst expectations by anywhere from 25% to as much as 90% over the past four quarters. Sunoco as well is trading below book value (not nearly as much as Valero though) and just 0.06 times sales. Unlike Valero, Sunoco isn’t seeing their revenues dip as badly, just 24% in 2009, yet the trend remains the same that their forward price to earnings ratio is just 6.03! Historically this is low for Sunoco and like Valero above, it makes for a solid 1-5 year hold.
Holly Corp. (NYSE: HOC)
Holly is the “expensive” refiner of the group at 1.62 times book value and 0.18 times sales, but historically speaking and taking the last two years as that reference, Holly has had some of the best margins in the business and its translated into some of the smallest revenue shrinkage during this economic maelstrom. Holly is only expected to see revenues decrease by 18% this year while they have stood behind a forecast of over 40% revenue growth in 2010. Despite this amazing growth, Holly still sits at a relatively tame 6.65 times forward earnings and has a much more manageable debt pile than most other refiners. One thing I will mention about Holly, the trend here has severely deteriorated over the last few weeks to the point that I feel it wouldn’t be prudent to take a position just yet. I would suspect that you could nab Holly a good 15-20% lower than current prices if you were patient and waited another 2-6 weeks. Then again I’m not looking to time these to the “T”, but rather present movers in the refining sector that should outperform both the S&P and their competitors.
Western Refining (NYSE: WNR)
Western Refining is last, but definitely not least on my list of outperformers. Despite an expected growth in revenue in 2009 and 2010 from WNR, the stock has seen a 50% haircut in just a matter of weeks. At just 0.56 times book value, 0.09 times sales and 5.81 times forward earnings this company looks like a gold mine, if not for that massive pile of debt on their balance sheet. Western Refining is the one of four on this list that definitely represents the most potential risk with 1.28 billion dollars in debt, but given a rich history of profits, I’m not quite as worried, although I admit that is an awfully large amount of debt to be carrying relative to the cash they currently have. Still, their margins have been good (not great) despite the economic downturn and I think they could easily outperform over the next 1-3 years.