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A Blast From the Past

By Robert Rapier on May 11, 2016

The primary benefit of subscribing to The Energy Strategist is timely advice for stocks in the energy sector. For much of 2015, while most of the energy sector was melting down, subscribers profited from our many Buy recommendations on refiners. But we soured on them by September.

Below I will include an extensive excerpt from the issue in which we foretold the refiners’ recent woes. (See last week’s Wall Street Journal article Oil Price Upheaval Finally Hits Refiners or my Forbes article Why Refiners Are Getting Crushed for the latest on the sector.)

In a nutshell, we prefer refiners when oil prices are falling or are expected to remain depressed. We want to avoid this sector when oil prices are rising. I learned the reasons for this firsthand when I was an engineer at the ConocoPhillips (NYSE: COP) refinery in Billings, Montana, which is now owned by Phillips 66 (NYSE: PSX).

I worked in the refinery’s economics group, and became very familiar with the factors that impact refiners’ profits. One of the most important involves changes in the price of oil. There is a phenomenon in the refining business called “rockets and feathers.” It means that when oil prices rise, gasoline prices go up like a rocket. But when oil prices fall, gasoline prices drift down like a feather.

Several studies have confirmed this effect, which is driven by consumer behavior. When gasoline prices are climbing consumers will drive out of their way to save a nickel on a gallon of gasoline. Competition is more intense, but every filling station has a financial incentive to keep up with increases in the price of crude and wholesale gasoline. But when prices are falling consumers do less comparison shopping. As a result, refiners and retailers are much slower to reduce prices as oil prices fall.

While there are other important variables, a general rule of thumb is that falling oil prices earn refiners higher margins, while rising crude costs hurt them. 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.

But then rising prices can crush margins and profits. Our expectation last September was that there was a significant risk that oil prices would rise in coming months, and this was one factor that led us to take profits in the sector. Here is an excerpt from the Sept. 14 issue of The Energy Strategist (“Selling High on Refiners”):

Valero has returned 67% for the Growth Portfolio in less than two years, and our recommendations of Marathon and Tesoro in 2013 have also proven rewarding. Alon USA Energy (NYSE: ALJ) is up 34% since we recommended it as part of the Aggressive Portfolio in March.

But the trends responsible for this outperformance are under growing strain as oil producers retrench, automakers continue to improve their vehicles’ fuel efficiency and new overseas refineries compete aggressively for market share.

Refiner share prices owe a lot to the events of the past year. And yet as shale drillers have proven over that span, investing in energy stocks based on the fundamentals that soon may not apply can be very, very costly.

Refiners stocks won’t necessarily suffer an implosion of shale proportions: that’s the worst-case scenario and hardly the most likely. But it’s difficult now to see where the additional upside will come from, given the likelihood of more expensive crude and an increasingly competitive refining market that’s unlikely to sustain its recent growth rate.

As a result, we’re recommending the sale of Alon USA Energy (NYSE: ALJ), CVR Refining (NYSE: CVRR), Western Refining (NYSE: WNR), Delek Holdings (NYSE: DK), HollyFrontier (NYSE: HFC), Marathon Petroleum (NYSE: MPC) and Tesoro (NYSE: TSO).

We’re also advising selling half of your position in Valero (VLO). This is the only refiner we’re keeping in the portfolio, because Valero’s scale and balance sheet should cushion its decline when the downturn comes. [Note: We removed the remainder of VLO from the portfolios a month later.]

That’s still one more refining stock than was included in The Energy Strategist portfolios three years ago, and the decision to exit a group that’s done so much for performance has been very difficult, made more so by our bullishness on the refining stocks earlier this year.

But we can only take what the market gives us, and if one keeps demanding what is not forthcoming eventually the market will take its revenge.

We’re paid to analyze the energy sector with an eye not just on the present day but on how the future will diverge from expectations, because that’s what moves share prices.

And our sense is that expectations for the sector are increasingly based on favorable but unfortunately unsustainable recent trends. We expect to revisit many of the recommendations we’re exiting today at significantly lower prices down the road.

So how has this group performed since that sell recommendation eight months ago? Badly:

160511TELrefiners

Performance of select refiners since Sept. 14, 2015. Chart from Yahoo Finance.

You can argue that we were a little early on the call, because the group didn’t begin collapsing until December. But market timing is hard. We make our recommendations based on our views of the fundamentals, which ultimately win out. The group we recommended to sell on that September day now has seen its best performer (Tesoro) drop 15.6% since, while most others are down 40%-plus.  

What’s an energy investor to do now? Join us at The Energy Strategist to find out, or you can wait 6 to 12 months and I can revisit today’s advice then as I have done today.

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)



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