Dousing the Refiner’s Fire

During the epic rally that has defined Spring and Summer 2009, one of the few sectors that did not bank coin was that of the refiners. In fact, Valero (VLO), Western Refining (WNR), and Tesoro (TSO) all made 2009 lows in July and then again in September. All three have traded down between 50-70% of their 2008 highs. However, just as the broad market has begun to trend sideways, the refiners have caught fire, trading up 20% in about 2 weeks. The question is whether this is a mere over-sold rally, or the beginnings of a real industry recovery. Based on today’s EIA supply report and continued weakness in demand, the former appears more likely, at least through 2009. This post briefly analyzes the supply-demand picture as it relates to the refiners.

Taking a step back, why did the Refiner’s get their clocks cleaned to begin with? After all, oil made its bottom in December and has doubled since then, with oil, coal and other energy stocks doubling or tripling in the same period.

Well, the rise in Crude is actually part of the problem. The refining industry is pretty clear cut, in terms of input (costs) and output ($). A refiner inputs crude oil into a cracking column, distills the nightmarish mess of various hydrocarbons, and collects the useable fractions as output, namely heating oil and gasoline.

Thus, a rally in the price of crude oil would actually hurt a refiner’s profitability, assuming there was not a commensurate rally in the price of gasoline, which there hasn’t been. This summer market rally was built substantially on speculation that the recession would improve/end, not that this recovery has been occurring simultaneously. While the price of crude oil is not really a consumable and is thus more vulnerable to speculation, gasoline is a consumer good and price is determined largely by customer demand. That demand has not materialized to match the rally in crude.

Thus, the Crack Spread, which is a measure of refiner profitability calculated as the difference between input (crude) and output (gasoline) has fallen since the beginning of the year and is now steady under $10. The crack spread is shown below in Figure 1.

Figure 1: Gas-Oil Crack Spread

A Crack Spread below $10 is not going to fuel any sort of sustained rally in the refiners. Rally attempts in April, May, and July were all snuffed out by heavy selling as refiners lowered earnings estimates. The most recent rally the first two weeks of September has been the strongest in 2009, on the highest volume. Let’s look at the factors of supply and demand of gasoline to see if we should anticipate more followthrough, or simply another sell-off.

First, supplies of the input, crude oil, have been consistently above average for most of 2009. This is shown below in Figure 2.

Figure 2: Crude Oil Supplies

Due to the excess crude oil, gasoline supplies have also, unsurprisingly been above average their six-year averages for most of 2009. This can be seen below in Figure 3. Note the divergence between the six-year average and 2009 supplies over the past month.

Figure 3: Gasoline Stocks and differential between 2009 and average

High gasoline supplies indicate both low demand and high upstream crude oil supplies. The bottom portion of Figure 3 above shows the differential between average gasoline supplies and 2009 gasoline supplies. The spike in late August was likely partially responsible for the early September refiner swoon.

Refinery Operable Capacity (ROC) is a somewhat indirect way of estimating gasoline demand, from the producer’s view. The ROC is simply the percent of maximum capacity the sum total of US refiner’s is currently operating. A high Operable Capacity indicates that the industry believes the demand for product will grow, while a low Operable Capacity indicates that demand should remain low (or a hurricane has taken capacity offline…obviously not the case in 2009. Frickin El Nino.) and it would be wise to not flood the market with excess product.

Figure 4 below shows a graph of Refinery Operable Capacity for 2009.

Figure 4: Refiner Capacity and Differential between 2009 and average

ROC made a seasonal low in early April, as to be expected, as refiners traditionally increase output in preparation for the summer driving season. Output atypically fell from about 88% to 84% in July and early August, which was accompanied by a swandive in refiner equity prices. The most recent uptick in ROC in September is responsible for the increase in gasoline stocks mentioned above. Based on the surge in gasoline supplies seen in Figure 3, the demand was not there to accept the increased output associated with increased ROC.

Today’s EIA Crude Oil supply report indicated that Crude Oil supplies rose 2.8 million barrels, compared to a decline of 1.6 million barrels that is average for this time of year. ROC capacity declined to 85.6%, or nearly the seasonal average, for the first time this year (the rapid decline in the 6-year average is due to the prevalence of hurricanes, particularly in 2005 and 2008, during this period. The drop in ROC this week has nothing to do with hurricanes.)

Despite the dropoff, Gasoline supplies still increased by 5.4 million barrels, much higher than analyst estimates and much above the average 1.3 million barrel decline, further indicating that we are still in a high supply-low demand situation in the distillate market.

Following the storage report, TSO, WNR, and VLO declined between 2-5%.

Thus, despite the relative “cheapness” of some refiners, I would advise sitting on the sidelines right now. That being said, I believe there is limited downside to these stocks and would not advise taking short positions, or perhaps not even selling if you currently own them. The fundamentals just do not support a continued rally. I would not be surprised a significant pullback followed by some sideways action as a bottom tries to form.

Based on this rambling summary, here is what I want to look for before diving back into refiners.

High gasoline stocks mean either demand is low or crude oil supply is high. Likewise, high ROC means that refiners either anticipate a return of demand in the near-term, or are simply increasing capacity to cope with all the crude oil out there. I believe that all four of these conditions are influencing the current supply picture.

The only way to determine if demand is really increasing is to see both ROC increase/decline less than the seasonal average AND see gasoline supplies decline faster than the seasonal average. This indicates that despite increased output from refineries and more gasoline on the market, demand really is increasing. Obviously, this is not currently the situation.

As for individual stocks, WNR, VLO, and TSO are the best out there. I was in WNR from about 5.80 and got stopped out this morning at 7.70 for a nice 30% gain. Should the supply-demand picture show signs of turning around, I will look to get back in when the market pulls back. One-year charts of all three are shown below.

Of my other energy positions, I am up about 40% on my CHK position and 20% on my SWN position, and may look to sell portions on strength to lock in some profits. I’m trusting the Fly on my small FTK position and will wait till $3.00.

The tropics remain quiet and it is unlikely that anything will develop this week. TS Nora has formed in the very active Eastern Pacific, which, if it picks up the pace, has an outside chance of completing the alphabet this season. As inactive as the Atlantic has been in 2009, the E. Pacific has been as active. This is typical of El Nino.

Note:I will continue posting up to the end of my term next Wednesday, 9/30.

Note I: With the hurricane season heating up, Dr. Cane is now on Twitter as DrCane09 since this is often a faster way to provide updates as things quickly change. FOLLOW ME for regular updates regarding the Tropics, Trading, and misc other weather stuff.

Note II: The Hurricane Naming Contest is on the homestretch with the season finale coinciding with the end of the MLB season September 30. Current leaders are shown below.

Today’s storm is a hat-tip to TraderCaddy who was commenting on the lack of S. Florida storms this year…

Rankings 9/20/09

	Points	Points Back	Days to Elimination
1. DPeezy	16	–	–
2. Wabisabi	11	5.0	2
3. TraderCaddy	4	12.0	Playing For Pride
4. Yogi & Boo Boo	3	13.0	Playing For Pride
4. BuffaloUdders	3	13.0	Playing For Pride
6.  Jimmy Hill 7. Jim	2 1	14.0 15.0	Playing For Pride Playing For Pride

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