A previous WrapUp on October 10th looked at a potential rebound for refinery stocks based upon historical price relationships between crude oil prices and refinery margins, 3-2-1 crack spread. Typically a bottom in refinery stocks is seen when the ratio of crude oil prices to the crack spread rises to several standard deviations above the long term average (10+ years), with tops in refinery stocks seen when the ratio falls below the average.
In October the ratio peaked at a multiple of 18.64, nearly six standard deviations below the average multiple over the past ten years of 5.5, which indicated that refining margins were severely depressed relative to crude oil prices.
Figure 1
Source: Bloomberg/DOE
Refining margins typically track closely with crude oil, with the multiple of the two primarily oscillating within two standard deviations of the average (between the two solid red lines). However, as can be seen in the figure above over the last two years there have been dramatic price swings primarily the result of elevated crude oil prices from supply disruptions and geopolitics as refiners are not able to pass on as much of the cost inflation (crude oil) to the consumer by way of higher gasoline prices, thus refinery margins become depressed relative to crude oil.
This presents attractive entry points into positions in refinery stocks as reversion to the long term average is likely. As seen in the figure below, refining margins undershot crude oil in October of 2006 and set the stage for a rebound in refinery margins that later overshot crude oil prices in late May of this year. Again, refining margins have undershot the price of crude oil causing the crude oil to crack spread multiple to rise nearly six standard deviations above the average, with a reversion to the mean underway.
Figure 2
Source: Bloomberg/DOE
Refining margins bottomed at .75 a barrel on October 19th and have risen to .71 a barrel currently, an increase of 125% and likely have further to go as the crude to crack spread multiple is still one and a half standard deviations above its long term average.
A likely catalyst to rising refining margins and profitability in the near term is cold weather that will increase distillate demand and refined product prices. Distillate demand is currently well above last years levels which have depressed U.S. distillate inventories to lower end of their 5-year range.
Figure 3
Source: EIA
Figure 4
Source: EIA
Gasoline inventories are also on the low side this time of year relative to the 5-year average and also near the lows seen over the past 17 years. Low inventories favor higher prices and currently low levels may be setting the stage for an increase in both distillate and gasoline prices over the next six months.
Figure 5
Source: EIA
Figure 6
Source: Moody's Economy.com/EIA
One possible development that may depress refining stocks over the coming six months is weaker U.S. demand for gasoline as the economy slows. Currently demand is tracking levels seen last year and it was the above average demand (gold line above dashed blue line in Figure 7) seen in the first half of this year that led to plummeting gasoline inventories (Figure 5) and a huge spike in refining margins (Figure 2) that were up 320% in May since the first of the year.
Figure 7
Source: EIA
However, gasoline inventories are depressed relative to their 5-year average (Figure 5) and this sets the stage for a possible rise in refining margins and gasoline prices as a number of bullish developments may surface. Falling domestic gasoline production, falling imports, flat to rising demand, or above normal refinery repairs and maintenance all have the potential to lead to an increase in refinery profitability. Last year it was the above average gasoline demand, above normal refinery outages and below average imports (Figure 8) that led to a drop in gasoline inventories and a rise in prices.
Figure 8
Source: EIA
It is widely known that no refinery has been built domestically in roughly 30 years, with the number of domestic refineries falling from 325 in 1980 to few than 150 today. The age of currently operating refineries presents a problem as more maintenance and capital investment will be required to keep them running. This has the potential to lead to longer outages and greater maintenance work that will led to lower refinery utilization and gasoline production. Lower refinery utilization is a greater problem today than in the past as refinery capacity is below levels seen in 1980 making us more dependent on imports of gasoline.
Figure 9
Source: Moody's Economy.com/EIA
Figure 10
Source: Moody's Economy.com/EIA
The above mentioned developments have bullish implications for refinery stocks and despite some refinery stocks up more than 40% year-to-date, refiners still remain a value play as their price multiples remain below average levels. An index composite of seven refiners is shown below using Ford Equity Research's Custom Graphs. The figure below shows the index plotted in the top clip against their 5-year price-to-earnings (PE) band, with price-to-earnings to growth ratio (PEG) shown lower clip. The index of the seven refiners shows the group is near the 5-year PE low and the PEG ratio of 1.22 is currently one standard deviation below its 5-year average of 1.55, indicating the group remains an attractive investment.
Figure 11
Source: Ford Equity Research
Today's Market
Stocks fell in early morning trading as news came out of weaker-than-expected retail sales as well falling home prices. The International Council of Shopping Centers (ICSC) said its index of chain store sales rose 2.8% last week, a smaller gain than the ICSC expected. Home prices posted their largest monthly drop since early 1991 in October, falling 6.7% according to Standard & Poor's/Case-Shiller home price index
"No matter how you look at these data, it is obvious that the current state of the single-family housing market remains grim," said Robert Shiller, who helped create the index, in a statement.
The markets staged a rally in early afternoon trading on news of Davis Selected Advisors new stake of 5.1% in bond insurer MBIA (MBI). The news helped lift other mortgage finance companies and the overall market. The Dow Jones Industrial Average rose 2.36 points to close at 13551.69 (+0.02%), the S&P 500 gained 1.21 points to close at 1497.66 (+0.08%), and the NASDAQ rose 10.91 points to close at 2724.41 (+0.40%).
Treasuries fell with the yield on the 10-year note rising 6.9 basis points to close at 4.281%. The dollar index was down, falling 0.42 points to close at 77.18. Advancing issues represented 48 and 53% for the NYSE and NASDAQ respectively, reflecting a mixed market.
