by Ivan Martchev | March 15, 2012 6:00 am
Since rebounding off the panicked “Europe” low in early October, crude oil is up 35% while the most-followed benchmark U.S. Dollar Index is up 1.7%. Often, crude oil rallies have been associated with dollar selloffs, giving credibility to the idea that a falling dollar tends to boost the price of crude oil.
This is true, but there is quite a bit more to it. A falling dollar driven by easy Fed policies and a rising trade deficit boost the price of crude oil as it is traded internationally in U.S. dollars, which in return tends to suppress the dollar via increasing the trade deficit due to more expensive crude imports.
And so the feedback loop repeats …
But there is another (more) important driver of the price of crude. Emerging markets tend to have faster GDP growth that is more energy-intensive, as their economies industrialize and consumers spend newly created wealth. Most emerging markets also have strong population growth. As the oil use per capita grows much faster from tiny bases than the level of consumption in the developed world, is it any wonder that there is upward pressure on the price of oil?
Still, those are long-term strategic considerations. From a short-term tactical perspective, we have geopolitics and seasonality driving the price.
There always are issues in the Middle East, and Iran has been in the news (again!), resulting in a perfect storm right in the middle of driving season. It is entirely possible to see a rather large spike this summer, with or without a dollar selloff, with driving season kicking in. (Most people refer to the dollar exchange rate using the U.S. Dollar Index, which is 57% overweight euros — a clearly problematic currency. A better gauge is the Trade-Weighted Broad Dollar Index, thanks to the broader composition, including BRIC and other currencies.)
Click to Enlarge The layman’s definition of a refining crack spread is the level of profitability per barrel of oil. This profitability is seasonal, and you can’t do anything about that.
Despite the clear seasonality (see the accompanying chart), the crack spreads sometimes are a lot higher than their typical averages. Right now this indicator of refining margins is at the second-highest level in the past five years (last year was the highest for the period; before that was 2007).
There is a recent trend of big oil companies trying to spin off refineries because of highly volatile refining profitability. Spinning off refineries raises the operating margins of the remaining business and “unlocks” shareholder value. Such was the case with Marathon Oil (NYSE:MRO) and Marathon Petroleum (NYSE:MPC) in 2011, and such is the case with ConocoPhillips (NYSE:COP) this year. Before the spinoff, MRO shares were notable outperformers in the sector last year, which is one reason why COP shares have been outperforming since early February.
The spinoff is only one part of management’s strategy to sustainably increase profitability per barrel of oil — by $7 in 2011 — which ultimately will benefit shareholders. There have been many asset sales, as well as debt retirement and stock buyback programs, in addition to the dividend of 3.4% with a mere 29% payout ratio. If the profitability per barrel of oil produced keeps rising — clearly management’s intention supported by a long history of success — the shares sooner or later will reflect the profit surge.
With such an industry-wide surge in refining margins, it is no wonder that we see refining stocks showing improving trends of EPS and sales estimates.
With such refining margins, it will be interesting to see what happens with the sector during the strongest period for refining margins, over the summer. But keep in mind that pure refining stocks are more volatile than integrated ones as 1) they typically are smaller companies by market cap and 2) no amount of hedging can completely smooth out the swings in refining margins as the futures markets anticipate the swings, resulting in more volatile seasonal EPS swings for refiners — great for trading.
Crack spreads bottomed out in early December 2011, while many refiners bottomed out beforehand in October and November. They might again top out before refining margins begin to decline (four to six months from now, based on historical patterns).
One company that benefits from this seasonal swing in refining margins as well as the increasing spread between WTI crude (U.S. benchmark) and Brent (the European benchmark) is Chevron (NYSE:CVX), as the majority of its revenues come from abroad. The WTI/Brent spread is partly a geopolitical issue and partly a pure organizational issue when it comes to supplying the regional markets with various governments and pipelines involved.
But the Chevron refineries that were losing money in the fourth quarter are now minting money, and the WTI/Brent spread — currently standing at $19.43 and still increasing — was one of the reasons for the big outperformance of Chevron’s stock over the Select Sector Energy SPDR (NYSE:XLE) in 2011. 2012 is shaping up similarly for CVX.
Ivan Martchev is an independent research consultant associated with institutional money manager Navellier & Associates. The opinions expressed are his own. Navellier & Associates holds positions in Chevron, ConocoPhillips and Marathon Oil for its clients. This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the above mentioned securities.
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