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Benefiting from the Oil Correction

by: Calvin Oh July 21, 2008 | about stocks: HOC / SUN / TSO / VLO    

Calvin Oh

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We advised caution in the oil markets on July 2nd, 2008. We are seeing the correction now. For targets I have $80-$100 as the low. The correction should continue through the end of this year.

When we originally wrote this article, my partner Sergey got a lot of negative commentary on some boards, which made us pretty confident about our analysis. The majority of the public is always wrong near the peaks and valleys. The public sentiment is probably one of the best trading indicators around.

Original Warning Advising Caution: Oil - it’s time for caution



As a hedge against falling oil prices there are several things you can do. One of the easiest is to purchase the ETFS Short Crude Oil from ETF Securities, which trades on the LSE under the symbol SOIL. The closing price for SOIL on 7/18/2008 was $US 35.65. This should provide a direct benefit from falling oil prices. I do not see oil prices falling below $80 however. I forecast a low between $80-$100. These numbers will be refined as the weeks pass, but for now, this is the 'area' in which I see strong support.

My current favorite way to play this downturn in oil is to purchase the oil refinieries. They have been pummeled for a good year because their refining margins have been shrinking due to the rise in oil costs. As oil prices begin to fall now, the refining margins, or "crack-spread" as it is known, should begin to show improvements. And improved margins should impact the earnings of the oil refineries directly.

NYMEX Crack Spreads


The chart above is of the NYMEX crack spreads. These are tradeable instruments that allow refiners to hedge risk. By the way, the above chart is from an article by Brad Zigler who does an excellent job of explaining how crack spreads, oil and refiners are all intertwined. I highly recommend it.
Tracking Crack Spreads - Seeking Alpha

Since there isn’t an oil refiners ETF, the only way to play this is to buy the oil refiners directly. In order to mitigate company specific risk, (since we are making a trade based on the anticipation of lower oil prices increasing refinery profit margins), we are going to buy the top 4 public oil refiners.

They are Holly Corp, Sunoco, Tesoro and Valero. We are not going to do an individual analysis of each company, since as explained, this is a proxy on falling oil prices. The closing prices for the companies as of 7/18/2008 are below:

HOLLY CP (NYSE: HOC)
Last Trade:28.59
Market Cap:1.43B
P/E (ttm):5.68
EPS (ttm):5.04
Div & Yield:0.60 (2.00%)


VALERO ENERGY CP (NYSE: VLO)
Last Trade:33.11
Market Cap:17.50B
P/E (ttm):4.36
EPS (ttm):7.60
Div & Yield:0.60 (1.80%)


SUNOCO INC (NYSE: SUN)
Last Trade:36.70
Market Cap:4.29B
P/E (ttm):6.64
EPS (ttm):5.53
Div & Yield:1.20 (3.30%)


TESORO CORP (NYSE: TSO)
Last Trade:16.69
Market Cap:2.30B
P/E (ttm):6.30
EPS (ttm):2.65
Div & Yield:0.40 (2.20%)


Summary:

 I believe that an extended correction in oil will take it ultimately to $80-$100. Where will it ultimately bottom? I don’t know. The point is that oil is going down significantly from here for an extended period, most likely into the end of this year. This correction in oil comes in tandem, I believe, with what may be a rally in the dollar from the 70 mark. I opined on this possibility here: The Always Precarious Dollar

In order to benefit from the decline in oil, positions should be established in the ETFS Short Oil which trades on the LSE under the symbol SOIL.

Secondly, declining oil prices should directly benefit oil refineries. As such we will be adding positions, in equal parts to the four refiners Holly Corp. (HOC), Tesoro (TSO), Valero (VLO) and Sunoco (SUN).

All of these conjectures are moot if an X-factor such as war with Iran or some other serious unrest breaks out. If such an X-factor comes into play then you should immediately close out any of these positions since oil will rocket higher once again and you should overweight positions in ETFS Leverage Precious Metals as discussed previously:

(BUY) ETFS Leveraged Precious Metals

Calvin’s Picks 7/19/2008:
Buy ETF Securities Short Crude Oil initiated @ 35.65
Buy ¼ part Holly Corp initiated @ 28.59
Buy ¼ part Tesoro initiated @ 16.69
Buy ¼ part Valero initiated @ 33.11
Buy ¼ part Sunoco initiated @ 36.70

Disclosure: Author is long HOC, TSO, VLO, SUN, LSE: SOIL

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This article has 6 comments:

  •  
    Jul 21 08:33 AM
    Good call on oil topping out recently. Calvin's view is that there is a extended correction in oil to usd80-100 by year end. This view is different from Goldman Sachs which says while oil may bottom out at usd100, year end target is usd150. Let's observe which way oil actually goes in the months ahead.
    Reply
  •  
    Jul 21 08:50 AM
    Why not buy DUG for shorting oil?
    Reply
  •  
    Jul 21 09:55 AM
    I agree with the target at either side of $100; given marginal production costs at the most expensive conventionar fields of $70-80, that leaves a significant geopolitical risk premium in the price. I have analysed the Peak Oil hysteria in depth in my finance blog, and absent a major hurricane, the path looks a one way bet after last week's technical carnage.
    Reply
  •  
    Jul 21 10:46 AM
    DTO is a better pure short crude play.
    Reply
  •  
    Jul 23 01:32 AM
    What about WNR?

    finance.yahoo.com/q?s=...
    Reply
  •  
    Jul 23 09:56 AM
    i think you confused the positions. reverse crack spread is a bet on a narrowing margin, so that would be buying crude futures and selling gas/heating oil, and vice versa for a long spread position
    Reply
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