Refiners May Not be Fine
By: Steve Smith
Refiners have been the bright light in the energy patch thanks to low oil delivering high margins. But the best days might be over and shares are looking pricey as trickle down of expanded margins and higher sales volume might be drying up.
Like real estate, in which everything is local, the prospects of the energy sector are also highly dependent on where along the stream you operate. Currently with the price of crude and gas near decade lows it pays to be downstream; that is coveted area the refiners have occupied for the past 10 months.
Even as, or more accurately because, the price of oil has tumbled some 40% to sit solidly below $60 per barrel for the past six months the shares of refiners such as Tesoro (TSO), Valero (VLO) and Holly Frontier (HFC) have gained over 18% each for the year to date in 2015.
This stand is stark contrast to the drubbing that most other energy related stocks have suffered; from the majors such as ExxonMobile (XOM) and Chevron (CVX) down some 20% each, to those that supply equipment such as rigs like Transocean (RIG) to the 50% plus wipeouts in independent and gas heavy firms such as Chesapeake (CHK) and Cheniere (LNG). Sorry Carl.
But the pain of low oil and gas has hurt most everyone else has been a boon to refiners, which not only has enjoyed expanded margins but also increased sales at their company owned gas stations. This has truly been a case in which owning the last mile as benefited from trickle down economics.
Crack is out of Whack
The main driver of refiners share price higher has expanded profit margins. This to the result a widening between spread between the price of crude and the price of gasoline affectionately known as the “crack spread.” Refiners, especially those focused in the United States, have been able to buy crude at ever lower prices while selling the refined or finished products such as gasoline, diesel, jet fuel and even lubricants, at relatively higher prices.
Simply put, the sale price of the refined products has not declined as steeply as the input cost of crude. As anyone that has filled car’s tank knows, the price at the pump go up a lot quicker than they go down. When oil collapse below $40 a barrel the crack spread which had expanded to north of $20 during the summer.
But as oil has stabilized in the $50 the crack spread has narrowed causing margins to noticeably contract in recent weeks.
As of the end of September the crack spread was at $8 and appeared headed towards a more normalized $4-$6 level.
I think this spells the end of the bull run for refiners such as Valero (VLO) as most of the upside has been realized. My view is the risk is to the downside as Asny increase in the price of crude will have a large negative impact on profitability and share price.
Valero No Go Higher No More
Valero (VLO) is a refining and marketing company in the United States, Canada, the United Kingdom, and Ireland. It operates through two segments refining, wholesale marketing, product supply and distribution, and transportation operations. The company markets its refined products through bulk and rack marketing network; and through approximately 7,400 outlets including the Valero, Shamrock, Texaco, and other names.
The company is expected to earn $8.43 per share in fiscal 2015, a 25% increase over the prior year. But forecasts call for earnings to decline by 19% back to $6.78 per share in 2016. Even at reduced profit level shares are still trading with 9.4x multiple which is about 15% higher than its 10 year average p/e. We’ll get a peek at the earnings trend when the company reports Q3 results on October 28.
The shares broke down with the overall market in late August and are now heading back into resistance at the $64 level.
This offers a good risk/reward entry point. Even the broader market stabilizes and rallies shares of Valero and other refiners could diverge and head lower.
The thesis being that allayed concerns over a global slowdown would be a main catalyst for a broad market rally. If it is deemed the global economy is starting to recover that would drive up oil prices from these low levels. That in turn would hurt the refiners and investors would begin rotating out of those shares.
The recovery in crude prices could take a while and the implied volatility level Valero options, currently, 39%, is near a 52-week high. For this reason I want to use a long dated put spread. Specifically;
-Buy March16 $62.50 Put
-Sell March16 $52.50 Put
For a $3.50 net Debit
These options expire on March 18, 2016 giving the bearish thesis plenty of time to play out. Of course, profits can be taken prior to expiration as shares decline below the $52 level.
Here is what the risk graph of the position looks like: