In my last post(Crude Oil Bubble Trouble), I pointed out that many investors are beginning to speculate the bull-run in energy – particularly crude oil – has reached bubble-like proportions. Some folks are saying that “speculators” have driven the price of crude to unsustainable levels, and that a painful correction is just around the corner.
There’s one sub-sector of the energy industry that would actually benefit big-time from such a crude-price correction: Refiners.
Since 2001, the price of a barrel of oil has risen more than 600% to a recent high of $145. The price of unleaded gasoline however has jumped “only” 300% or so over the same time frame, to a recent price of $4 per gallon.
Share Prices and Profits Plunging for Refiners
That math just doesn’t add-up if you’re in the refining business. The biggest factor in the price of gas is (not surprisingly) the price of crude oil, which accounts for 75% of the total cost for gasoline. The other next two biggest factors (at about 10% apiece) are taxes, and refining expenses.
There’s no way to avoid the taxes. One of the Presidential candidates proposed temporarily suspending Federal taxes on gas recently; until someone pointed out that nobody would be fixing the potholes or widening lanes on the interstate highway system if no gas taxes were collected!
So with taxes pretty much a “fixed cost,” and crude prices escalating, the companies that refine oil into unleaded gasoline and diesel have been caught in a squeeze play that has decimated their profit margins.
In fact, profits at U.S. refinery operators plunged 98% in the first quarter as they were caught behind-the-curve on skyrocketing oil prices. Refiners have been raising prices to be sure. But they just haven’t been able to hike prices for gasoline, heating oil, and jet fuel fast enough to keep up.
To Know When Refiners are a BUY Again... Keep an Eye on the Crack
As a result, refinery stocks in the S&P index have been clobbered for a 40% decline, even as oil prices set new record highs. But the key to refinery profits is the crack-spread. And no, this doesn’t have anything to do with illegal drugs.
The crack spread is the theoretical profit margin a refiner should earn from processing three barrels of crude into two barrels of refined gasoline and one of heating oil. That spread has plunged 38% over the past year, taking industry profits down-the-drain along with it.
But crack spreads, like so many relative price relationships in financial markets are constantly shifting from peak to valley and back again. Last year the crack spread for refiners was almost $23, today it’s just under $14 – a big shift.
That’s mainly due to crude oil’s unusually strong advance. Falling crude prices however can actually be a boon to refiners. “You really want to own refiners when oil's going down, and not straight up,” according to Cambridge Energy Research.
But now energy-sector fortunes may be reversing. At least that’s what smart-money investors, including industry insiders and hedge fund mangers, are saying.
In the last month alone, refining company executives have purchased $2 million worth of their own shares, according to Bloomberg. That’s more insider buying at refiners that at any time since 2000. In fact before March of this year, insiders had been very consistent net-sellers of refining stocks – “dumping more shares than they bough every week since 2003.”
“Anyone right now buying the refiners would have to be banking on a pullback in oil prices,” according to one fund manager interviewed by Bloomberg.
A Lower Risk Way to Make Money Off A Widening Crack Spread
Buying the refinery sector now just might be your best-bet among the various energy sector investment plays, especially considering the “speculative” over-bought state of crude oil futures at the moment.
Unfortunately, there’s no ETF available that gives you a broad based bet on the refining sector, at least not yet. However, several leading refiners including: Valero Energy (VLO) and Tesoro Corp. (TSO) are among those stocks with big insider-buys recently, according to Bloomberg.
This should even make a good “pairs trade” strategy for you. Typically a pairs-trade involves going long one stock or ETF – in this case a refiner. Meanwhile, you would sell-short another – in this case a major integrated oil firm like say, Exxon Mobil (XOM) – at the same time.
But here’s a pairs-trade twist that goes long-long… perfect for retirement accounts.
Buy the ProShares UltraShort Oil & Gas (DUG), which is designed to go up in price as the overall energy sector declines. At the same time, buy your favorite refiner, and earn potential gains as the razor thin crack-spread widens again.
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