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Option1307 (30.24)

Why Refiners are a Buy, Still!

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April 18, 2010 – Comments (4) | RELATED TICKERS: VLO , SUN , WNR

I know I know I’m sure many of you Fools think I’m completely a fool (lower case) for liking such a dismal sector. I mean let’s not kid ourselves; you basically could have picked any sector, other than refiners, and made a tremendous return this last year. In fact, while the overall market is up some ~70% from the March 2009 lows, the fabulous refining sector has gained, well let’s just say it’s about flat. Not very impressive at all, in fact you could easily say this has been one of the worst sectors the past year! Ugh!

With this being said, I’ve been bullish for the last 6-12 months on the refining sector as a whole. What in the hell Option, how could you have been so dumb? Valid question Fools, valid question indeed, but allow me to explain and I think you will begin to see the light at the end of the tunnel.

Refiners are very interesting companies and somewhat difficult to understand and follow b/c they present a few unique characteristics. I’ll do my best to provide some basics. First off, you need to understand that refiners are essentially cyclic in nature. This tends to present a challenge to many investors simply b/c you can’t go around buying refiners using the same standard criteria you might normally use, e.g. increasing revenue/EPS/etc. You need to be willing to scoop them up when times are rough and be ready to sell when life is grand and their profits are rocketing to the moon.

I’m going to use Valero (VLO) as an example, but basically it is representative of the sector. So, how are things for refiners right now, what stage of the cycle are we currently experiencing? I’ll give you a hint, but let’s just say that they’ve been beaten pretty badly by a giant superman-like ugly stick, their charts are horrid, plain and simple. What about actual numbers, how are those holding up your thinking? You don’t even want to know how bad things look on paper, well maybe you do. It’s like driving by a bad car crash, you’re scared to look but intrigued nonetheless, right? Check out this train wreck:

Revenue:

2007: 95M

2008: 118M

2009: 68M

EPS:

2007: 7.72

2008: -2.16

2009: -0.65

Yikes! Ya, pretty much Sh*t hit the fan in late 2007 for refiners and it was all over from there. Those are some absolutely ridiculously bad year/year declines for both revenue and EPS. However, as I mentioned above, refiners are cyclic and it is only a matter of time before they return to the cash producing machines that they truly are.

So what happened, why did they sector get destroyed the last few yrs? Well, essentially their profits got significantly squeezed and they did not anticipate the downturn in demand very well either. Refiners use something called “crack spreads” in order to discuss their profit per barrel of oil they process and ultimately sell in various forms. You can simply Google the term and learn more about the several ways to calculate it, it’s not that difficult, don’t be scurred! Or if you’re way lazy, have a look over here b/c another Fool graciously did the work for you. So lazy!

The important thing to know is that crack spreads were hanging out at a nice comfortable ~25 or 30 in summer of 2007, all was good and paradise was seemingly endless, and then suddenly they fell off a cliff and began a death spiral to the low single digits which they reached in late 2008 and again early 2009. Ouch, that is an impressive fall! (Sort of reminds me of GS’s reputation, ohhhhhh no he didn’t!) The stock prices of refiners obviously followed suit as revenue and profits declined dramatically because of drastically shrinking crack spreads.

However, remember boys and girls that whole thing about being cyclic? Ya, it means that one day refiners will come back and throw up huge numbers like they did before their profits went down the drain. Here is their EPS from the most recent glory days, a nice indication of what is to come:

2004: 3.27

2005: 6.10

2006: 8.64

Hot damn those are nice looking!

How do we know that refiners will eventually return? Well we don’t for sure, but let’s think about this a quick second. As much as we’d all love to go out and plant a few trees and save the environment one oil spill at a time, the reality is that oil is here to stay for the foreseeable future. Gasoline, heating oil, and just about every plastic product is not going away anytime soon. Secondly, and more importantly, cracks spreads have actually been improving recently and look to have turned the corner finally as they are at 10 month highs.

Let’s do some quick mental math here for a little perspective. VLO is currently trading at 19 dollars and change. Est. 2010 and 2011 EPS are ~$0.90 and ~$2.00 respectively. That puts VLO currently at around 9.5 forward P/E 2011 earnings. Not too shabby! I’m willing to bet by 2012 refiners will be pumping out the cash and things will only continue to get sweeter. I don’t trust est. that far out, but for the sake of completion, imagine 2012 EPS of ~$4-6 (very very realistic). That puts VLO at a forward P/E in the low single digits. Me likey!

There is still a ton of bearishness on the sector in general, and to be fair, 2010 is likely to be another tough year for refiners.  (VLO has said in their most recent conference call that they expect to return to profitability in 2010.) However, remembering that this sector is cyclical in nature, this tells me that now is the time for picking up some refining shares. What is that famous saying, “you should be buying when others are selling and selling when others are buying” or whatever, you know what I mean. That cliché phrase applies to refiners right now more than ever.

In the short term, week or so, I could see refiners going down a few more percent, especially after Friday’s smack down, and I will possibly scoop up some more shares. However, trying to time stocks is not always the best idea. Especially when you have so much to gain in a few short years, what is a few percent here or there amongst friends?

So before you get all crazy and start buying up all the crap out there, cough financials cough, do yourself a favor and look into refiners. Better yet, get off your couch and go place a buy order, do it!

(Btw, I own VLO, SUN, and WNR in real life and may add if I so feel inclined to at a later date.)

4 Comments – Post Your Own

#1) On April 18, 2010 at 9:27 PM, megalong (< 20) wrote:

I just closed my WNR calls at a nice profit.  Because of their higher debt load I think of them as a speculative/trading stock while the others (VLO, SUN, FTO, TSO, etc.) are closer to investment grade.  I might buy shares of TSO sometime.

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#2) On April 18, 2010 at 9:49 PM, Option1307 (30.24) wrote:

I pretty much agree with you here, WNR does have a significant amount of debt and this obviously does pose a risk going forward. With that being said, as long as the refining sector turns around sometime in the next year or so, they will be alright and in no danger of defaulting/etc. on their debt. But yes, this is definitely the most speculative of the bunch.

But what's investing without a little bit of risk!

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#3) On April 18, 2010 at 10:01 PM, TMFUltraLong (99.95) wrote:

Why Refiners Are A Buy, Still

Because I said so... do we really need a better answer?

UltraLong

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#4) On April 18, 2010 at 10:16 PM, Option1307 (30.24) wrote:

Ha ha ha, no I guess not!

 

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