3 &#58 2 &#58 1 … Get Cracking

Refining is a highly cyclical business, and not a sector I would recommend for the buy-and-hold investor. But traders who get their timing right can enjoy superb results, as has been the case for refining bulls over the past year.

refining stocks chart

Refiners make money by converting crude oil into finished products such as gasoline, diesel and fuel oil. A refiner’s profit margin is the difference between the cost of crude oil purchased and the price of finished products sold. This is what’s known in the industry as “the crack spread.” “Crack” refers to the fact that oil is being cracked, or split up, into the various refined products, and “spread” reflects the price spread between the raw material (crude) and the processed fuels.

refining products breakdown

Although a barrel of oil is refined into many finished products, the crack spread typically refers only to the crude oil input and the gasoline and distillate output. The most widely utilized crack spread for US refineries is called the 3:2:1, which estimates the profitability of converting three barrels of oil into two barrels of gasoline and one barrel of distillate (diesel, jet fuel, and fuel oil).

The crack spread is a rough approximation. Reality is more complex. For example, three barrels of light, sweet crude oil run through a typical US refinery will actually produce less than 1.5 barrels of gasoline, perhaps one barrel of distillates and, depending on the refinery configuration, the remainder could be lubricants, waxes, coke, asphalt and liquefied petroleum gases. (European refineries are configured differently to accommodate Europe’s higher demand for distillates.)

The price of crude oil is obviously a critical factor in the calculation of the crack spread, and it varies with the properties of the crude and the cost of transporting it to a refinery. Thus, crack spreads can span a wide range, and the profitability of a refiner will be strongly influenced by the selection of available crudes.

This is why East Coast refineries were shutting down last year to avoid losses even as Midwestern competitors were reporting record profits. The refineries in the Midwest had access to cheaper crude than those on the East Coast.

Light, sweet crudes with access to waterborne transportation are highly sought after, and are therefore generally more expensive. Examples include the Brent and the Louisiana Light Sweet. Crude extracted from remote fields must be transported to refineries at a higher cost and will therefore trade at a discount. As US oil production has ramped up over the past few years, West Texas Intermediate (WTI) began to trade a discount to the waterborne crudes like Brent.

Brent-WTI spread chart

Crudes from the Bakken area face even higher transport costs than the WTI and typically trade at a $2/bbl discount (although that differential has ranged from a $25-per-barrel discount to WTI in early 2012 to a $5-per-barrel premium in September 2012). The heavy crudes from western Canada are even more disadvantaged than those from the Bakken, and typically trade at a $20-$30/bbl discount to WTI.

Bakken-WTI spread chart

Geography is not the only factor that influences the price of crude oil. Crude can be light or heavy, sweet or sour, and it can be contaminated with various metals such as vanadium. Light, sweet crudes require the least processing, and historically more refineries were configured to process light, sweet crudes. These crudes have traditionally commanded the highest prices.

Heavy crudes require additional processing, in which the heavier hydrocarbons are cracked into smaller molecules. Sour crudes — those with a higher sulphur content — require hydrotreaters to remove the sulfur. More processing may be needed to remove the metals from crude oil. The more processing is required, the more complex — and costly — the refinery.

At present, the perfect refinery from an investor’s point of view would have the following characteristics:

  • Access to discounted crudes

  • The complexity to process heavy, sour crudes

  • Access to waterborne transport for finished products

For example, our ideal refinery would be sufficiently complex to process and advantageously located to secure the deeply discounted heavy Canadian crudes, but with a finished product pipeline to port facilities.

While no company can ever fully match this ideal, some are better positioned than others. Further, geographical diversification is important, because today’s conditions may change. If WTI were to trades at a premium to Brent in the future, for example, the definition of the ideal refinery would change.

In this week’s issue of The Energy Strategist, we will take a look at which refiners are poised to build upon this past year’s amazing run.

Portfolio Update

Geospace Technologies (Nasdaq: GEOS)
The supplier of seismic surveying equipment has traded weakly and erratically for the last two months, and we’re removing it from the Growth Portfolio.

Quarterly sales reported in May were up 36 percent year-over-year, but nevertheless fell well short of aggressive Wall Street estimates. Management blamed the “lumpy” nature of orders in its business and expressed confidence in long-term demand. But after reversing course and rallying in dramatic fashion after the conference call, the stock has since given up all those gains and then some.

The catalyst for Monday’s heavy losses was apparently a negative report from Off Wall Street, a boutique Cambridge, Mass., short-side research firm. According to StreetInsider.com, Off Wall Street warned of increased competition, pricing pressure and market saturation, adding insult to injury with a $53 price target.

Boutique sell-side research is a motley cottage industry of highly variable quality and credibility, but Off Wall Street has a pretty solid reputation. The owner, Mark Roberts, is a former Fidelity Investments analyst, and his firm turned bearish on Enron five months before the energy giant crumbled.

We’re not abandoning Geospace because Off Wall Street is calling it a Sell. We’re doing it because the stock has not performed well and is attracting more controversy. These are not desirable characteristics in any portfolio holding, much less a Best Buy. And the fact that it was designated as such, only added to portfolio in February and is down considerably since doesn’t factor in the decision to sell, frankly.

The only criterion that matters in that regard is the stock’s likely performance in the future relative to the available alternatives. And when the facts change on this score a smart investor will change with them, appearances be damned. If Geospace can’t hold its 200-day moving average with crude at $95 and the market near all-time highs, if it trades this ugly in response to a short call, we’d rather watch the next few developments from the safety of the sidelines. There are a lot of healthier stocks out there right now. Sell Geospace Technologies.

Petroleum Geo-Services (Oslo: PGS, OTC: PGSVY)
It just hasn’t been a good day for seismic stocks. Marine seismic data trawler and supplier PGS tumbled on both sides of the Atlantic after a presentation unveiled at an industry conference in London struck a noticeably more cautious tone than previous pronouncements.

Specifically, while as recently as two months ago the company was touting “pricing and margin uplifts from the 2012 season, on Monday the company found “current bid level lagging,” especially in the Gulf of Mexico and off the coast of Brazil. Further, it suggested that its customers’ cash flow is “under pressure” and might affect year-end seismic spending, indicating the lull might last awhile.

That was certainly the implication of a cautious note last on the industry last week by the Norwegian broker ABG Sundal Collier, which warned that producers will be cutting seismic spending in anticipation of softer oil prices.

Like Geospace, PGS boasts attractive valuation metrics, bolstered in its case by ample and cheaply valued cash flow. But, as with PGS, its stock is setting off alarms. We find it prudent to cash in our gains and step aside. Sell Petroleum Geo-Services.

— Igor Greenwald

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