The refining industry bolted out of the gate this year with returns ranging from 40% to 150% from the start of the year to the July highs. Part of the reason that the refining stocks did so well was due to the expansion in refining margins.
Figure 1
Source: Stockcharts.com
In September of last year the Nymex WTI Cushing crude oil 3-2-1 crack spread was roughly .63 a barrel, with crude oil (WTIC) at .25 a barrel, putting the crude oil to crack spread multiple at 14.31. Looking at the relationship between the relative prices of the two shows an average multiple of 5.37 and extreme deviations between the two can be used to determine refining margins tops and bottoms. For example, the multiple reached more than three standard deviations from the mean in February and October of last year, indicating refining margins were depressed relative to crude oil. Conversely, extreme lows in the multiple indicate that refining margins should come down relative to crude oil prices, with tops seen in August of 2006 and July 2007.
Figure 2
Source: Bloomberg
With the refining stocks entering 2007 with the crude to crack spread multiple 4.4 standard deviations above the mean, the stage was set for refining margins to expand as well as the stocks. This is exactly what happened with the crack spread bottoming at .42 a barrel in early January and running up to .84 a barrel in May, up 302% in five months. Refining shares in that time had moved up 20% to 80%, and continued higher along with the markets even as refining margins were coming down.
Figure 3
Source: Bloomberg
The run up in refining margins pushed the crude to crack spread multiple to its lowest levels in more than six years, marking a peak in refining margins relative to crude. The run up in refining margins overshot to the upside in May with the subsequent correction undershooting to the downside currently. The multiple is again more than three standard deviations above the mean (Figure 2), levels that have marked previous bottoms in refining margins relative to crude, marking an attractive entry point in the refining stocks.
Figure 4
Source: Bloomberg
Lending further support for a rebound in refining stocks is the fundamental pictures of supply and demand. Gasoline production is declining precipitously and is below last year's levels as refinery utilization rates have fallen from a high of 92% in August to 87.5% currently.
Figure 5
Source: Energy Information Agency (EIA)
Figure 6
Source: Moody's Economy.com
The falloff in demand with the end of the summer driving season is stabilizing while at the same time additional supply coming from imports is falling. With falling production, falling refinery utilization rates, falling imports, and stabilizing demand, it's no wonder that U.S. gasoline stockpiles are well below the average for this time of the year.
Figure 7
Source: Energy Information Agency (EIA)
Figure 8
Source: Energy Information Agency (EIA)
Figure 9
Source: Energy Information Agency (EIA)
With the above mentioned fundamentals for the refining industry, refining margins are likely to rebound as are the stocks. Despite refining stocks posting year-to-date (YTD) returns ranging from the low 20% range to the low 60% range, they still offer great value as an equally-weighted index of seven refiners shows the index is closer to a 3-year price-to-earnings (PE) low than a high, with the 3-year PE low of 7. The 3-year PE high of 14 was seen back in late 2005 with the destruction brought on by hurricanes Katrina and Rita, with the index consolidating in 2006.
The index broke out this year with a sharp correction back towards the 3-year PE low, and an expansion of the current multiple back to the 3-year high would be 46% gain in the index, while a correction back to the 3-year PE lows would be a loss of 13%. Thus, on a PE multiple basis the risk-to-reward potential appears to be skewed on the positive side with the refining stocks likely to advance strongly from current levels.
Key Market News
British oil company BP announced that a fire at Prudhoe Bay oil field in Alaska caused the company to cut 30,000 barrels of daily production over an estimated period of two weeks.
Alcoa, the first member of the Dow average to report results, reported that their sales had declined by 3.2%.
Chevron intimated that third-quarter net income was 'significantly below' last quarter's record period.
Boeing has announced the delay of their 787 Dreamliner deliveries from May 2008 to the end of 2008.
And, the Commerce Department announced that sales at wholesalers climbed 0.4 percent.
