Derivative trades: they are an exciting way to take advantage of a recent trend that you happened to notice. The word ‘derivative’ may bring back bad memories from your high school calculus days, but in the universe of investing, derivatives are actually much easier to identify. Tried and true relationships between asset prices have a way of repeating correlation over and over again as time goes on.
Take currencies for example. During the days of the Quantitative Easing “carry trade,” the Euro-Dollar was tightly correlated to a risk-on environment for equities and commodities, whereas the Yen-Dollar was correlated to a risk-off environment. Equity traders could take cues from these currency pairs to quickly assess the state of global equities and bonds in an instant, and made a lot of money trading in a very binary environment.
The Brent-WTI Spread Derivative Trade
A derivative trade that is playing out over the month of October 2013 is the move that refinery stocks have had in response to a trend change in the Brent-WTI crude spread. Refinery stocks like Valero (VLO), Tesoro (TSO) and Holly Frontier (HFC) have been rallying ever since Brent-WTI crude spreads began widening. Refiner stock performance is usually pegged to this spread because refiners purchase their inputs (WTI crude) at WTI prices, and sell their outputs (refined crude) at Brent prices. From a business economics standpoint, it’s a simple matter of a company’s input prices and output prices, which when subtracted from one another give us an understanding of their operating margins. Here is a graphical depiction that demonstrates the concept.
To further demonstrate how refining stock performance is directly correlated and a derivative of the movement in the Brent-WTI spread, here is a year to date chart plotting the performance of the Brent-WTI spread compared to the performance of Holly Frontier.
You can see that the March price peak in Brent-WTI foreshadowed a peak in HFC shares later that month, and the price trough in Brent-WTI initiated a move higher in HFC shares in early October.
The Brent-WTI spread recently dropped to as low as zero in late September, and it is now trading around 10. The peak for the spread in 2011 was at 28, so it’s reasonable to believe that the spread will continue to rise from here, albeit at a more modest pace absent a geopolitical event that causes the spread to widen rapidly.
The Second Derivative Trade
So, we may have missed the first derivative trade in refiners, but there’s a second derivative trade that the fast money has not caught up with yet — going long refinery MLPs.
Energy MLPs own energy infrastructure in the U.S., including pipelines, natural gas, gasoline, oil, storage, terminals, and processing plants. They are integral to run the energy infrastructure to the U.S., therefore providing a very basic, stable business, which have consistently performed for investors. Throughout the recent period of time in which government bonds have yielded historically low rates, individuals with investments in MLPs have enjoyed robust dividend yields – just look at Kinder Morgan Partners (KMP).
Recently, we’ve seen a trend of refining companies spinning off infrastructure components of their companies into MLP IPOs because the MLP structure serves as an excellent tax shelter. Conoco Phillips (COP) spun off their infrastructure operations into Phillips 66 (PSX) in May of 2012. In the near future, Valero is planning on spinning off an MLP to be called Valero Partners.
One refinery MLP that has piqued my interest is Holly Energy Partners (HEP). A spinoff from Holly Frontier in 2004, Holly Energy Partners’ assets include approximately 810 miles of refined product pipelines from New Mexico to Texas, 510 miles of refined product from Texas to Oklahoma, 400 miles of product from Utah to Las Vegas, and potential projects from Cushing, Oklahoma to Tulsa and Denver. All of these pipelines are crucial to North American oil production and transport.
Recently, North American oil production surpassed Russia and Saudi Arabia as the #1 oil and natural gas producer. Pipeline operators like HEP are a major player in the growth of U.S. production. Expect for HEP’s operations to continue to increase, and for the demand for more pipelines to be produced to build out capacity. These circumstances are very bullish long term.
Holly Energy Partners Offers Solid Risk/Reward
Despite the bullish macro picture offered by the oil industry, shares of HEP have actually underperformed the market this year. One need not look any further than HEP’s earnings performance history to see why it has been such a laggard. The company missed earnings per share estimates the last six quarters, making February 2012 the last time the company beat the estimate.
Despite that poor performance, the company actually has been managed pretty well. It sports a 31% return on equity, gross margins of 68%, and last quarter’s earnings miss was mostly due to deferred revenues, and a damaged pipeline that ran out of operation. EPS growth this year has been -6%, but next year it is expected to grow by 14%. From a fundamental perspective, things are pointing up for HEP.
An overlay of the shares of Holly Frontier, parent refining company, shown as a blue line on the chart, give us some historical evidence that HEP is a derivative trade off its big brother company. Each time that HFC has rallied, it has occurred prior to HEP, and each time that it has declined, it has occurred prior to HEP. As you recall from the first chart in this article, HFC shares have rallied since late September, on the heels of the rise in the Brent-WTI spread. HFC is leading out once again, and using history as our guide, HEP shares should follow HFC higher.
We recommend buying HEP at current prices with a minimum price target of $36 per share. There is near term support at $30 per share and we recommend setting stops below that level. Partnerships tend to be big dividend payers, which is true of HEP. As yields rose this year, dividends fell out of favor temporarily. However, we expect that trend to reverse as the Fed continues to pursue an easy monetary policy. You should consider the current 6% yield on the stock as part of your risk assessment.
InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.