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Cracking The Refiners

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Refiners have been beaten up and declining since late February, but the downtrend has shown signs of a pause in recent weeks. The sector has been pressured by a meaningful drop in crack spreads (profit margins) in part linked to a narrowing of the Brent/WTI spread.  The supply/demand conditions in the oil market seemed to tighten as highlighted by a sharp drop in U.S. inventories and pick up in refinery activity.

The crack spread or margins are a key price driver:

Refiners have differing input costs depending on their ability to source and crack differing grades of crude oil. As the graphic displays, the stock price of refiners tends to follow the direction of crack spreads or their margins.  The 3:2:1 crack is overlaid against the average price of Valero (VLO - Free Report) , Western Refining , and Tesoro .  The 3:2:1 crack calculates the profits of converting three barrels of crude oil into two barrels of gasoline and one barrel of heating oil.

The graphic displays a generic view of margins using WTI crude oil for an input.  In reality, refiner profits are subject to the differing pricing of inputs.   There are light and heavy crude mixes and different prices among light and heavy crudes.    The Brent/WTI spread is an example of differing prices for light crude oil. These differentials can impact profitability.

Refiner processing slowing:

After surging to a peak of 16.237 million barrels a day (mbd) in the middle of July, refiner input eased to 15.611 mbd as of August 9th.  The Energy Information Agency is looking for refinery inputs to average 14.9 mbd in in Q3 and Q4 of 2013.  This reduction in usage may cut some of the tightness in the domestic oil market, and take some of the bid out of WTI. Refinery utilization declined 1.5% to 89.4% in the week of August 9th and fell below 90% for the first time since the week end June 14th.  

Tightness in the oil market expected to end:

U.S. crude oil inventories have fallen sharply, 37 mln barrels, between May 24and August 9.   Inventory levels have dropped from being well above the five year range to working within the five year range.  Seasonally, inventories are likely to drop through September, but then gradually build going into late spring.   A build in crude stocks may reduce concerns over tightness in the energy market and help bolster refiner margins.

The days supply of crude oil is 22.7 down from 23.4.  The days supply has been below a year ago for the past six weeks after a long period of exceeding a year ago.

In addition to inventory patterns, the WTI futures price curve shows a discount or backward structure.  September 2014 WTI futures were trading around $94.90 at writing and trading at over an $11 discount to September 2013 WTI futures.  The 3:2:1 crack on the CME is expected to rise from $14.53 to $22.73 between the September 2013 and September 2014 period.  In other words, crack margins are expected to improve.  

The outlook for strong North American crude oil production remains intact and infrastructure is being build to handle the transportation.

EPA biofuel blending wall less negative:

The cost of credits to comply with the renewable fuel mandate has been a negative for refiner profit growth.  The cost of a credit soared in the first part of 2013, but it looks like the EPA is willing to relax the mandate. The industry has been complaining and the cost is flowing into the price of a gallon of gasoline - hitting the consumer. 

The 2013 standard was revised down and the EPA is showing flexibility on 2014. There is an expectation that the mandate of biofuel will be a percentage of consumption.

The  price of credits remain elevated, but have recently declined from the peak.  The bleeding of profits linked to EPA regulations may be stopped, but the issue is a source of uncertainty and remains a headwind to profits (without the mandate and need to purchase credits, profits would be higher).  VLO recently said its cost to comply with the regulation would range between $600 to $800 mln in 2013.


The table displays the valuation picture for a select group of refiners.  The valuation in the sector is tight with forward PE ratios ranging between 8.5 and 9.2 with an average of 8.9. Based on this measure, WNR is most expensive and PSX and VLO are the cheapest.   Likewise, the price to tangible book value ranges between 1.4 and 3.8 with an average of 2.1.  WNR is also most richly priced by this metric, while VLO is the most inexpensive.

Price to cash flow is also present.  The range of values rests between 4.5 and 6.6 with an average of 5.7. VLO is cheapest, while TSO is most expensive.

The earnings picture is downbeat:

Earnings estimate revisions are trending lower for the sector. Every stock in the table is expected to see profits per share fall in 2013.  The picture is more mixed for 2014. TSO, VLO, and MPC are projected to post growth, while WNR, HFC, and PSX are expected see contraction.

All the stocks in the table are a Zacks Rank #3 (Hold) with the exception of VLO which is a Zacks Rank #5 (Strong Sell).   Earnings estimate revisions are unfavorable and analysts will want to see some type of expansion in crack margins before getting more bullish with their estimates.

As the graphic above showed, the price of refiners will be sensitive and driven by the change in crack margins with a widening needed to improve the outlook for higher stock prices.

Technical factors are mixed:

There are a few charts in the refinery sector which may be worth monitoring.  PSX has consolidated between about $55 and $70 in recent months.  Chartists may view this formation as a triangle pattern.  Usually this pattern signals a continuation of the trend upward, but a breakout will help set direction.

In contrast to PSX, TSO looks to be forming a large head and shoulders top.   A close below the neckline around $50 will provide confirmation of a trend change.  A rally over $58 would question and/or destroy the pattern and paint a more bullish picture.

VLO, HFC, and MPC have shown some variation of trading in or trying to break out of a broad downward sloping channel.  However, a small channel off the recent low is also present.

The chart of MPC is displayed, above, as a representative.  MPC looks vulnerable to a move toward the lower end of the major channel before trying another leg higher. It is on the cusp of breaking below the minor channel.


The refinery sector is in a funk. Earnings estimates are falling, valuations reflect cautions, and the EPA regulations are creating a headwind to profits.  However, if futures markets are correct in their pricing, crack margins may be able to improve into 2014.

It is interesting that VLO has the cheapest valuation based on the 12 month foward PE ratio and price to tangible book value, but is a Zacks Rank #5 (Strong Sell) due to its poor trend in earnings estimate revisions.  

Technically, more work in the sector needs to be done to prove prices are ready to work higher.  A breakout above the downward channels or above the triangle formation in PSX would suggest an improved outlook.

The technical condition of the sector is consistent with the Zacks Rank. Most of the sector is a Zacks Rank #3 (Hold) with the exception of VLO which is a Zacks Rank #5 (Strong Sell).

Those interested in an energy play may want to check out Murphy Oil (MUR - Free Report) .  It just announced a spin off its retail marketing business and is a Zacks Rank #2 (Buy).  It has stronger momentum in earnings estimates revisions. 

The bull story for pure refiners is trying to develop and the outlook for the refining sector looks “cracked” for the timing being.

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