Stocks to Buy Before the Oil Bubble Bursts
by Mike Burnick
Recently, many investors have begun to speculate that the bull run in crude oil prices has reached bubble-like proportions. Some folks are saying that "speculators" have driven the price of crude to unsustainable levels and a painful correction is just around the corner.
There's one sub-sector of the energy industry that would actually benefit big time from such an oil correction: Refiners.
Since 2001, the price of a barrel of oil has risen more than 600% to a recent high of US$145. The price of unleaded gasoline however has jumped "only" 300% or so over the same time frame to a recent price of US$4 per gallon.
Stuck Between High Taxes and Refining Costs
That math just doesn't add up if you're in the refining business. Not surprisingly, the price of oil is the biggest factor that determines the price of gas. In fact, crude oil accounts for 75% of the total cost of gasoline. The other next two biggest factors (at about 10% each) are taxes, and refining expenses.
There's no way to avoid the taxes. One of the Presidential candidates proposed temporarily suspending Federal taxes on gas recently. But then someone pointed out that nobody would fix the potholes or widen the lanes on the interstate highway system if they stopped collecting gas taxes. That comment effectively silenced the idea.
So with taxes pretty much a "fixed cost" and crude prices escalating, the companies that refine oil into unleaded gasoline and diesel have been caught in a squeeze play. And it has decimated their profit margins.
In fact, profits at U.S. refinery operators plunged 98% in the first quarter because they were caught behind-the-curve on skyrocketing oil prices. Refiners have been raising prices to be sure. But they just haven't been able to hike prices for gasoline, heating oil, and jet fuel fast enough to keep up.
Keep an Eye on the Crack Spread
...to Know When Refiners are a BUY Again
As a result, refinery stocks in the S&P index have been clobbered. These stocks have sunk 40% even as oil prices set new record highs. But the key to refinery profits is what's called the crack spread.
The crack spread is the theoretical profit margin a refiner should earn from processing three barrels of crude into two barrels of refined gasoline and one of heating oil. That spread has plunged 38% over the past year. And it's taken industry profits down the drain along with it.
But crack spreads, like so many relative price relationships in financial markets, are constantly shifting from peak to valley and back again. Last year the crack spread for refiners was almost US$23, today it's just under US$14 — a big shift.
click to enlarge image
As you can imagine, this huge shift has come from crude oil's unusually strong advance. Falling crude prices however can actually be a boon to refiners. "You really want to own refiners when oil's going down, and not straight up," according to Cambridge Energy Research.
But now energy sector fortunes may be reversing. At least that's what smart-money investors, including industry insiders and hedge fund mangers, are saying.
In the last month alone, refining company executives have purchased US$2 million worth of their own shares, according to Bloomberg. That's more insider refiners buying than at any time since 2000. In fact before March of this year, insiders had been very consistent net-sellers of refining stocks — "dumping more shares than they bought every week since 2003.
"Anyone right now buying the refiners would have to be banking on a pullback in oil prices," according to one fund manager interviewed by Bloomberg.
A Lower-Risk Way to Make Money Off a Widening Crack
Buying the refinery sector right now just might be your best bet among the various energy sector plays, especially considering the "speculative" overbought state of crude oil futures at the moment.
Unfortunately, there's no ETF I know of that gives you a broad based bet on the refining sector, at least not yet. Several leading refiners including Valero Energy (VLO) and Tesoro Corp (TSO) are among the stocks with big recent insider buys, according to Bloomberg.
This should even make a good "pairs-trade" strategy for you. Typically a pairs-trade involves going long one stock or ETF — in this case a refiner. Meanwhile, you would sell-short another major, integrated oil firm like say, Exxon Mobil (XOM) at the same time.
But here's a pairs-trade twist that goes long-long — perfect for retirement accounts.
Buy the ProShares UltraShort Oil & Gas (DUG), which is designed to go up in price as the overall energy sector declines. At the same time, buy your favorite refiner, and earn potential gains as the razor thin crack spread widens again.
Disclosure: none
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This article has 15 comments:
I think the reasons are: (1) drop in oil and gas prices yesterday and today, (2) fear in the days last week that oil was a bubble and was going to fall.
I know of nothing specific other than the above.
Anybody else have any ideas?
Jack
Given your analysis that PWE will continue to enjoy a huge upside in profitability into 2009, even if oil does pull back to the 120's - Are you still confident that the trust unit price will move north of 40? I am specifically concerned about the context of the market being negative or strongly bearish. My only concern about the upside price for PWE is that it is possible (perhaps not entirely probable) that a strong financial report gets ignored by investors who are pulling money out of oil in general.
Funny- oil is way down today but the refiners are down nevertheless.
By the way, if you guys think the oils are down just take a look at the junior gold stocks, they were already at firesale prices and they have gotten a further clobbering the last couple of weeks.
HFAnalyst
seekingalpha.com/artic...
With this for Valero:
Valero Energy (VLO): “No, no, no. We have not liked the refiners for a year. That's one part of the business that's not been able to raise prices. I don't want to touch Valero." lol?
My opinion on the Canadian trusts is:
1. The oil bubble does exist and we should see less demand for oil, gasoline and other products ( like big cars and SUV's ).
2. In Canada, as oil and natural gas prices rose, drilling costs, etc rose and the cost increases reduce profits.
3. As oil prices drop, costs do not come down like they should because the executives like the high salaries and benefits they (and their employees ) get.
4. Recently, all of 12 Canadian Income Trusts that I track hit 52 week highs so I sold.
5. As of yesterday, July 8th, PWE, on my yahoo screen, was back to a $250.00 loss. If PWE goes to say $25.00/unit I might buy it back.
As you probably know,some firms were down 4 to 6%.
6. There is a lot going on in Congress about regulation of the COMMODITY SPECULATORS which many talking heads say do not exist. However those of you who read:
www.star-telegram.com/...
and
www.commerce.senate.go...
know about COMMODITY SPECULATION.
7. The tax law changes that Canadian Finance Minister Jim Flaherty pushed through will go into effect and PWE (and others) will probably post lower than normal EPS results (again in 2008) so as to avoid paying current shareholders (to the benefit of future shareholders)...And, The Province of Alberta always seems to want more taxes/royalties too.
9. Pwe has about one Billion dollars in goodwill which DECREASES Tangible Book Value.
These are some of the reasons for the drop in price. How low oil, gasoline and natural gas will go depends on the depth of the US/ world recession and, lately, some folks see a US depression.
So, if prices are too high and we go from 'A LITTLE SLOWDOWN" to a BIG SLOWDOWN then all bets are off.
I am hoping to see $60.00 a barrel soon. It will be good for the US/World economy. Just like unaffordable housing and real estate speculators (which include spec builders) pushed the US housing market into a recession...we will/are seeing the horrible results of high commodity prices.
ng
LONNIE K. STEVANS
Frank G. Zarb School of Business
DAVID N. SESSIONS
Hofstra University - Department of Accounting, Taxation and Legal Studies in Business
----------------------...
July 2, 2008
Abstract:
In this study, we examine the relationship between the U.S. real price of oil and factors that affect its movement over time: futures prices, the value of the dollar, exploration, demand, and supply. All of these variables are treated as jointly endogenous and a reduced form vector error correction model, testing for cointegration amongst the variables, is estimated. We find that for model specifications with short-term futures contracts, supply does indeed dominate price movements in the crude oil market. However, for specifications including longer-term contracts that are inherently more speculative, the real price of oil appears to be determined predominantly by the futures price. Moreover, there is empirical evidence of hoarding in the crude oil market: both oil stocks/inventories and futures prices are found to be positively cointegrated/correlate... with each other. From a policy perspective, the results of this analysis indicate that if regulators really wanted to limit speculation in the oil market, it should keep the shorter-term futures contracts and eliminate the more speculative six months futures contracts.
is there a price difference between the different crudes??????
Benson
So the foregoing conclusion is that you cannot tell where the stock will go, but have to agree that they have very valuable assets, different from other refiners, and that in the long run, asset prices tend to be reflected in stock prices. Why, because if say Petrobras decided tomorrow it would need to build 4 refineries, it would be cheaper and quicker for them to buy Valero at 30% premium. Therefore, when analysing Valero, you may want to set aside
EPS and look at Tangible assets.
Reg. speculators impact on spot prices via the futures market, it plays out like this. Buyer at refinery X sees ridiculous futures prices, so he doesn't buy contract for his production needs six months away. He figures they have to deliver the oil somewhere, so it will fall to reasonable price a few days before delivery. Six months later, with futures prices now 20% higher, it's cheaper to NOT deliver the oil and pay somebody to store it day-to-day and hold out for the higher futures price (instead of a "dropped" spot price). But now the buyer's facing a shutdown at the refinery, so he scrambles and pays the higher CURRENT futures price (which is 20% higher than it was six months ago). He's ticked, vowing not to let the speculators win. So he repeats this a few times. And the speculators win each time.
After a while, the buyer comes up with a new strategy. He buys the amount needed for production, plus an additional 3-6 months worth. HE will store it instead of the ruthless speculators.
So what do we have? Speculator prices STAY high even at the spot market, plus buyers are hoarding as much oil as possible, which hits the supply limits and further increases prices.
Easy test for Congress - eliminate speculators from the market for six months. If the price drops 30% or more, keep them out. It will drop at least that much.
For the uninformed, $4/gallon gas equates to $70/barrel of oil, not $140. If it stays at $140, gas will REALLY go up. I don't know about y'all, but I won't be driving oil-based vehicles if it goes to $8/galllon.
Texas Joe