It is a well-known observation in the refining business that when oil prices rise, gasoline prices rise very quickly. When oil prices fall, gasoline prices don’t follow nearly as quickly. This phenomenon is commonly referred to as “rockets and feathers.” Several studies have confirmed this effect. But why does it happen? A Wall Street Journal article reporting on this effect a few years ago posited an interesting theory:
“The theory of the day to explain sluggish declines at gas pumps points squarely at consumer behavior, as the folks at Knowledge Problem pointed out recently. When prices are rising, everybody drives all over town to shave a cent off each gallon. Once oil and gas prices start to fall, people get thrilled by $3.88 gas, and fill up at the corner station. Since there’s less comparison shopping, gas stations don’t have to change prices as often.”
For refiners, the net effect is that more often than not, when oil prices are falling refiners earn higher margins. This signals an occasional short-term profit opportunity for savvy investors who recognize when conditions are right, since this makes refiners a good short-term bet in a time of softening oil prices.
This was part of the logic behind our Oct. 17 advice in The Energy Letter to buy refining companies with significant California operations. Since that October 17th letter, refiners have been one of the only bright spots in the oil and gas sector. Valero Energy has gained 9.3% and Tesoro Corp. has gained 9.6%, for example, while ExxonMobil (NYSE: XOM) has lost 4.6% and Chesapeake Energy has fallen 16.4%.
Pure refiners stand to benefit the most from softening oil prices. Integrated oil companies will show mixed results – better downstream performance but lower upstream performance. Pure oil producers will typically see the lowest performance if oil prices are softening.
The refining sector appears set for further gains, but conservative investors may consider locking in some profits after the quick run-up. In any case, if oil prices begin to gain strength, that would probably signal a sell, unless certain exceptions occur. One of these would be if U.S. gasoline inventories are at low levels. In that case, margins can remain strong even as oil prices rise, which was the case in 2005.
The refining sector is not one that I typically recommend as a long-term holding in a portfolio. Refinery earnings are inconsistent, but during the right time of the cycle refining companies can be very profitable. However, over the next few years refineries that have access to disadvantaged feedstocks from the mid-continent region should consistently outperform those will less access to those crude oil supplies.
Investing in refiners is certainly not for everyone, but for those investors who like to take advantage of short-term trends, refiners offer opportunities for significant gains provided you know the right indicators for getting in and out of the companies.
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