How You Should Play a Refining Relief Rally

by Daniel Putnam | November 18, 2011 9:42 am

Refining stocks have been pulverized in the past week, as the near-perfect environment that lifted the sector in October[1] has done a 180-degree turn. Could this mean an opportunity is in the works?

First, let’s look at what has gone wrong for the refiners. Three key elements of the story have changed in recent days:

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The crack spread — which measures the difference between the cost of crude oil and the price at which refiners can sell their finished product — has plunged from the record levels of the third quarter.

The five-year chart shows how rare it is for the crack spread to fall this far, this fast. It finished Thursday down 57% from its Oct. 14 close.

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Second, the spread between Brent North Sea crude oil and West Texas Intermediate crude has collapsed from its record level of just a few weeks ago. This spread allowed certain refiners to buy cheap WTI and sell finished products at prices that are tied to Brent, leading to rising profit margins and outstanding third-quarter profits.

Now, the evaporation of the price difference has quickly clouded the earnings outlook. The gap stood at 9.33 at Thursday’s close, down from 27.88 on Oct. 14. As with the crack spread chart, the size of the recent move is far above average compared with the past five years.

Third, on Wednesday, refiners were hit hard by the following news item from Bloomberg BusinessWeek: “Enbridge Inc. said today it agreed to buy ConocoPhillips’s 50 percent stake in the Seaway pipeline system for $1.15 billion. Enbridge and Enterprise Products Partners LP then announced they plan to change the pipeline’s direction to make it flow from the crude storage hub at Cushing, Oklahoma, to the U.S. Gulf Coast…The change may help alleviate a bottleneck at Cushing that has kept WTI crude prices from going higher.”

Together, these developments have hammered the entire refining sector. Below are the moves in select refining stocks in the six sessions since Nov. 8:

In such destruction lies a potential trading opportunity. Sentiment has turned so fast that any reversal in either the crack spread or Brent-WTI relationship — which should be on the way soon given the magnitude of the recent moves — could set up a relief rally in these stocks.

Of the names on the list above, three stand out as being the most technically oversold: Holly Frontier (NYSE:HFC[2]), CVR Energy (NYSE:CVI[3]) and Western Refining (NYSE:WNR[4]). All three closed Thursday below their lower Bollinger bands and with very low readings on momentum indicators such as stochastics and RSIs. Further, Tesoro (NYSE:TSO[5]) and Valero Energy (NYSE:VLO[6]) both finished the day at their 50% Fibonacci retracements, while Marathon Petroleum’s (NYSE:MPC[7]) decline had stalled at its .618 retracement level.

For those thinking of taking a swing from the long side, HollyFrontier looks like the best bet. The company is in a strong financial position, as evidenced by Wednesday’s announcement of a special 50-cent dividend and an increase to its regular dividend to 10 cents from 8.75 previously. The stock — which closed Thursday at $23.93, well below the consensus price target of $43 — has a forward P/E of 4.2 and, notably, a short interest of 6.5% of shares outstanding as of Oct. 31. Finally, HFC’s metrics stack up well compared to its industry peers:

While it’s always difficult to fight the tape with the refining stocks, this is a rare chance to buy a fundamentally sound stock that’s off more than 25% in a week without negative company-specific news. Still, keep in mind that the wind is no longer at the refiners’ backs, so don’t hesitate to take profits quickly if this trade works.

As of this writing, Daniel Putnam was long HFC.

  1. lifted the sector in October:
  2. HFC:
  3. CVI:
  4. WNR:
  5. TSO:
  6. VLO:
  7. MPC:

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