This column was originally published on RealMoney on March 12 at 2:03 p.m. EDT. It's being republished as a bonus for TheStreet.com readers. For more information about subscribing to RealMoney, please click here.
Because the high price of gasoline has been making the news so often over the past few weeks, an oil trader's perspective could be quite valuable. To get that, you'll need a short education in the role of the refiner.
Simply put, you'll have to know how the system works, how the commercial players are gaming the market, how the public is getting gamed and how you can at least try to make some money off the whole deal, as opposed to being a victim of it.
Fortunately, Dano's here to the rescue.
The Basics of the Business
First, realize that crude oil has absolutely no value on the retail market. It can't be burned for fuel, and it has no other commercial use. Only after crude oil is refined into retail products does a barrel of crude have any value at all.
Most modern refineries are set up to release gasoline and heating oil as their two main products. The process of converting crude oil into these products is known as "cracking." The general convention is that three barrels of crude oil will "crack" into two units of gasoline and one unit of heating oil. Remember, this is only a convention. Refineries are all a little different in the absolute ratios they produce, and when crude is refined, it also gives off many other petroleum by-products.
Using this convention, however, is convenient for refiners that are looking to hedge their forward price risk. They can buy 3 units of crude oil (CL) and sell 2 units of unleaded gasoline (HU) and 1 unit of heating oil (HO). Cracks were quoted in this 3:2:1 ratio for a long time, but the convention has been practically abandoned these days. Now, everyone quotes cracks using one unit of crude to one unit of a product, whether gasoline or heating oil.
Refiners have no control over the price of either their input crude or their output product. A higher margin (crack) means better profit, of course, but refiners have a more consistent goal that they can better control: They want to try to have buyers ready for every bit of product they refine.
In other words, they want supply to mirror demand perfectly. Storage costs money and cuts into profits very quickly. In a nutshell, then, you know the reason for the "refining shortage" that Washington has been bleating about for the past three years. Consumers may want an oversupply of gas and oil, but to put it simply, nobody wants to be in the refining business when cracks are cheap.
I remember once, early in my trading career, when cracks went negative. Refiners were losing money on every barrel they refined. It taught me that anything can happen in trading, but it also taught the refiners a lesson they never forgot: Don't build fresh refineries unless you're sure the product can be entirely accounted for beforehand. That policy keeps product-refining capacity on the absolute edge of demand.
A Look at the Charts
For example, during the 1990s, cracks traded mostly between $5 and $10.
A Look at Cracks
Recently, though, the increase in demand for refined products both in the U.S. and overseas, combined with a reticence in the industry to build fresh assets, has resulted in a far wilder chart:
More Dramatic Action
Be sure to look at the scales on the right. Cracks that traded in the $2-to-$10 range in the 1990s have seen levels between $15 and $30 seven times in the past three years alone.
In the most recent "squeeze" on gasoline, a few mostly innocent factors combined to create the spike. Refineries that normally shut down for maintenance in late winter to be ready for the peak summer driving season were down longer than expected. In addition, a number of refinery fires shut down some remaining capacity at the
California refinery, the
McKee unit in Texas, the
Manticoke unit and the
Poof, you've got an $8 crack move in three weeks.
Can we benefit from all this information? Let's try.
First, don't call your futures broker and get long crack spreads. They are violent and can separate the best oil traders from their heads in a matter of days. This latest move was difficult to call from fundamental factors alone, although some hedge funds try to game it by spending countless hours keeping track of refining capacity, maintenance schedules, outages, demand numbers, the works. Tough game.
Instead, let's look at two pure refinery stocks: Tesoro and Valero. Their five-year charts, shown below, reinforce a very important point: Refining has been a flat-stock-price, no-growth, supremely
business until very recently.
But now and going forward, both stocks look like a value player's dream come true. They have forward price-to-earnings ratios in the single digits and offer tremendous return on capital to investors. Plus, that tiny dividend continues to increase, which will keep you warm at night, to boot.
Most analysts don't like the fact that these companies aren't growing very fast, but in this case, we can make an argument for that being a good thing. This is not a "build it and they will come" business model. Instead, these companies are more interested in keeping margins as high as they can and squeezing every dime out of the capacity they have. Plus, if they can catch a nice gas or heating oil crack squeeze once or twice a year, they can really increase their margins and profits.
In any case, it seems clear to me that Valero and Tesoro have figured this out to good effect in the past three years, and their stock prices have reflected this. Have they outpaced their growth yet? I don't think so. The demand for refining looks only to be increasing, and the wild swings of crack prices don't look to be diminishing any time soon.
Valero and Tesoro are not the only ones that have realized that refining might be the "lock bet" of the energy world going forward. One company, which is one of the largest retail traders of oil and oil products, has spent some money in the past few years acquiring a lot of expensive refining assets.
So who is it?
Nope. That would be
At the time of publication, Dicker had no positions in the stocks mentioned, but positions can change at any time.
Dan Dicker has been a floor trader at the New York Mercantile Exchange with more than 20 years' experience. He is a licensed commodities trade adviser. Dan's recognized energy market expertise includes active trading in crude oil, natural gas, unleaded gasoline and heating oil futures contracts; fundamental analysis including supply and demand statistics (DOE, EIA), CFTC trade reportage, volume and open interest; technical analysis including trend analysis, stochastics, Bollinger Bands, Elliot Wave theory, bar and tick charting and Japanese candlesticks; and trading expertise in outright, intermarket and intramarket spreads and cracks. Dan also designed and supervised the introduction of the new Nymex PJM electricity futures contract, launched in April 2003, which cleared more than 600,000 contracts last year alone. Its launch has been the basis of Nymex's resurgence in the clearing of power market contracts over the last three years. Dan Dicker has appeared as an energy analyst since 2002 with all the major financial news networks. He has lent his expertise in hundreds of live radio and television broadcasts as an analyst of the oil markets on CNBC, Bloomberg US and UK and CNNfn. Dan is the author of many energy articles published in Nymex and other trade journals. Dan obtained a bachelor of arts degrees from the State University of New York at Stony Brook in 1982.