Are Refining Stocks a Buy Now?

• The refining business depends on the economy
• Valero (VLO) and Marathon (MPC) make a comeback
• Lots of room for higher prices-Sector rotation can be a powerful force
• Earnings depend on crack spreads- An economic indicator
• Vaccines, US energy policy, and seasonality scream buy on weakness

Sector rotation in the stock market describes a phenomenon where share prices of companies in similar businesses tend to perform alike. Since 2018, the energy sector of the stock market has lagged the rest of the market. With the leading indices trading at or near all-time highs, energy-related companies have not participated in the bull market.

As stocks moved higher over the past years, energy shares lagged the upside move. When corrections occurred, the energy sector often led the way on the downside. Energy has not been the place to be since 2018. Moreover, the Energy Sector SPDR (XLE) hit its all-time peak over six years ago in mid-2014 when it traded to $101.52. At the March lows, the product that holds shares in the leading US energy companies fell to a low of $22.88, less than one-quarter the price at the 2014 peak.

The high-flying stock market has made technology shares, and many other sectors move to record and lofty levels. Justifying the current share prices will require a continuation of record earnings. The bottom line is that locating value in the stock market is challenging these days.

In a 2008 letter to Berkshire Hathaway’s shareholders, Warren Buffett wrote, “Long ago, Ben Graham taught me that ‘Price is what you pay; value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is markets down.” In the stock market, technology stock prices are sky-high, which is problematic for value. In energy, the leading companies qualify as “quality merchandise” that is marked down.

Since November 9, the energy stocks have been making a comeback, but they have a long way to go to catch up with the stock market. Oil refining companies have suffered with the rest of the energy sector. Shares of Valero Energy Corporation (VLO) and Marathon Petroleum Corporation (MPC) have rallied since November 6. However, there is plenty of room on the upside as both companies continue to offer compelling value.

The refining business depends on the economy

Refining crude oil into products is highly dependent on economic conditions. When the economy is booming, refineries work overtime to produce gasoline, heating oil, jet and diesel fuels, and other oil products that power our lives.

In March, at the height of the risk-off period when energy demand evaporated, gasoline fell to its lowest price since 2006 when it traded to 37.6 cents per gallon wholesale. Heating oil futures, a proxy for distillates like jet and diesel fuels, reached 58 cents per gallon, the lowest price since 2002. People were not driving to work, traveling on planes, or doing many things that require oil-based fuels.

Source: CQG

The chart shows that the refining margin for processing crude oil into gasoline fell to a low of negative $3.65 per barrel in March 2020, which was a losing proposition for refiners.  

Source: CQG

The distillate refining margin fell to a low of $7.20 per barrel in May 2020 and a lower low of $6.44 in September. The low levels in the refining margins weighed on profits at refineries and sent shares prices reeling.

Valero (VLO) and Marathon (MPC) make a comeback

On November 18, 2019, Valero (VLO) shares were trading around the $100 level.

Source: Barchart

The chart illustrates that VLO fell to a low of $31 on March 18, 2020. After a recovery to over $77 in June, the shares slipped to a low of $35.44 on October 29.

Successful vaccine trials at Pfizer and Moderna caused optimism that an end of the pandemic is near in early November, lifting VLO to a high of $56 per share level on November 18. VLO closed last week at $50.82.   

Source: Barchart

On November 18, 2019, MPC shares were at $64.50. The stock fell to a low of $15.26 on March 19, 2020. After a recovery to $44.12 in early June, MPC declined to a higher low of $26.77 on October 29. At the end of October, coronavirus cases were rising in Europe and the United States, which weighed on the refinery stocks. However, the prospects for a highly effective vaccine lifted MPC back to over $41 per share on November 18. The stock closed at $38.26 on November 20.

Lots of room for higher prices-Sector rotation can be a powerful force

The stock market continues to put in new all-time highs, but energy stocks have not participated in the bull market. The all-time high in MPC shares was in 2018 at $88.45. That same year, VLO reached its peak at $126.98 per share.

If COVID-19 begins to fade into our memories in 2021, we will likely see a substantial return of demand for oil products. In a stock market where finding value is challenging, MPC and VLO stand out as two companies that stand to benefit from sector rotation. Investors and traders will look to shift portfolios to the companies that will benefit most in the post-coronavirus era.

While the trend towards a greener planet runs contrary to the production and consumption of hydrocarbons, most cars, trucks, planes, and other modes of transport continue to require oil products. The potential for a refinery earnings boom that lifts stocks is high if the vaccine is successful and creates herd immunity to the virus over the coming months. Sector rotation in the stock market at all-time highs could be a powerful force for companies like MPC and VLO.

Source: Yahoo Finance

The chart shows that MPC has consistently beat earnings estimates over the past four quarters. A survey of fifteen analysts on Yahoo Finance project a price target of $43.80 per share, which is slightly above the price on November 18. Meanwhile, most analysts rate MPC shares as a buy or an overweight in their portfolios.

Source: Yahoo Finance

VLO earnings have also consistently beat consensus estimates over the past four straight quarters. A survey of eighteen analysts on Yahoo Finance has an average price target of $58.56 for the shares, with many rating the company an overweight in portfolios.

Meanwhile, at $50.82 per share, VLO continues to pay shareholders a $3.92 dividend, which equates to 7.7%. MPC’s yield was 6% at $38.26 as the dividend is at $2.32 per share.

Earnings depend on crack spreads- An economic indicator

The companies that refine crude oil into gasoline and distillate products do not take the price risk of the input, the petroleum, or the output; it is the refining margin or crack spread that determines profits or losses. VLO and MPC purchase crude oil at market prices and sell their products at the going rate.

The companies take the risk of the crack or refining spreads, which are a real-time indicator of their profits or losses. Earlier this year, when crack spreads fell to multi-year lows, the companies posted quarterly losses. A rise in crack spreads in 2021 would support a return to profitability.  

Source: CQG

The daily chart of January heating oil crack spreads shows a steady recovery from $7.69 per barrel in late September to the $11.79 level on November 20. In November 2019, the heating oil processing spread traded to a low of $22.11 per barrel, almost double the current level.

Gasoline is a more seasonal product as the demand tends to drop during the winter months when drivers put less mileage on the automobiles.   

Source: CQG

Meanwhile, December gasoline cracks have recovered from a low of $4.35 in late July to $6.88 on November 20, an encouraging sign for the refining business. In November 2019, the gasoline crack spread reached a low of $10.52. Pent up demand in the aftermath of the global pandemic would likely lift crack spreads, making profits for VLO and MPC rise.

Vaccines, US energy policy, and seasonality scream buy on weakness

The price action in the crude oil market on November 6, the day of Pfizer’s announcement, was a sign that we could see a substantial rally in the aftermath of the coronavirus nightmare. The January 5 runoff election in Georgia will determine the future of US energy policy. If Republicans capture one of the two Senate seats up for grabs, they will maintain a majority in the Senate, preventing the Biden administration from making substantial changes in energy policy.

A victory by Democrats that flips the Senate majority would usher in a new green era, but oil and oil products continue to power the US and world. The perception of a decline in US energy production could boost prices over the coming years until alternative energy sources replace fossil fuels, which could take more than a decade.

Meanwhile, we are at a time of the year where seasonality tends to weigh on crude oil and oil product prices. The pandemic is only exacerbating the decline in demand as people are not traveling.

Refining companies like VLO and MPC offer tremendous value, even after the recent price recoveries. The potential for capital growth is compelling, and the companies both pay shareholders attractive dividends, which is a bonus while waiting for the shares to continue to recover. My initial targets on VLO and MPC are $77.11 and $44.12, the early June highs. However, we could see much higher levels for refining companies in 2021.

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XLE shares were trading at $40.03 per share on Tuesday afternoon, up $1.69 (+4.41%). Year-to-date, XLE has declined -29.83%, versus a 14.41% rise in the benchmark S&P 500 index during the same period.

Andy spent nearly 35 years on Wall Street and is a sought-after commodity and futures trader, an options expert and analyst. In addition to working with StockNews, he is a top ranked author on Seeking Alpha. Learn more about Andy’s background, along with links to his most recent articles.

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