(Oil refiners story, updated with latest data on crude stockpiles, gasoline consumption, OPEC position, and to clarify that Dahlman Rose ratings)



) -- Oil refiner stocks have been among the biggest gainers in 2011, and given the gains, a volatile trade in this energy sector niche remains likely.

Some of the biggest U.S. refiners sold off early this week, led by

Holly Corporation

( HOC),

Frontier Oil

( FTO),

Tesoro Energy



Western Refining



Western Refining led the decline among refiners, down 13% in the first two days of the week, though the refiner halted its losing ways on Wednesday. Trading volume in shares of Western Refining was twice its average volume, at over eight million shares traded on Tuesday, as profit-taking in the big gaining refinery stocks represented at least a portion of the selling action.

Frontier, Holly and Tesoro were all down by more than 4% on Tuesday, but reversed course in Wednesday trading, as the spread between the West Texas Intermediate and Brent crude again widened, one day after the spread had narrowed to less than $10. The lack of resolution to the Libyan civil war continues to dominate oil trading. New OPEC commentary on Wednesday that it saw no immediate need to add to crude oil supply, a reversal from commentary on Tuesday, lifted Brent crude, while a larger than estimated stockpile of U.S. crude in Cushing, Oklahoma sent the WTI oil price lower.

It would be easy to make the case that the 40% gain in Western Refining shares year-to-date is reason alone for a pullback, according to analysts in the sector, and that would go for many of the refiner stocks, up in a range between 20% and 40% this year. Yet the damage in the past few days among refining stocks, and the slight rebound on Wednesday, haven't been meted out equally, and all refining stocks are not created equally either.

Whereas the rising oil prices are good for the energy sector, the oil prices trend is not inherently good for refiners, with the spread between crude oil prices and the prices on refined petroleum products the key metric for these companies. Yet just as a broad decline in energy can't explain the refiner trade, the crack spread -- as the spread between crude oil and refined petroleum products is known -- is also too simple a way to look at the refiner stocks.

"These are not hot stocks anymore, so maybe expectations need to be adjusted. From that standpoint it's more challenging, but there is nothing I see that will cripple this group," said Dahlman Rose analyst Sam Margolin.

In any event, given the 2011 rally in refiner stocks and the recent pressure on some of the refining companies, led by Western Refining, here are a few key themes and issues to focus on in monitoring the refiner stock group.

TRIGGER #1: The Momentum Trade

Investors making a long-term bullish bet on the health of the refining market are likely to see some volatile trading days ahead that mirror the declines on Monday. It's not just that the stocks have rallied so extensively year-to-date and been buoyed by the crack spread and individual market events like

Marathon Oil's

(MRO) - Get Report

plan to spin-off its refinery business as a separate company. The composition of traders in the sector is a significant factor.

Just a year ago, refiners were in the doghouse, and that led to value investors piling into the space. Value investors haven't left the refining space in droves, according to Dahlman Rose analyst Sam Margolin, but some value investors may have begun to book profits. More importantly, the trade pendulum has swung away from the value investors and to the momentum traders who are quick to pull the trigger on profit taking opportunities.

Most analysts seem to be in agreement on this point:

"Part of it is that these stocks moved up way too far, way too fast. You get a very different kind of investor in refining stocks, thus it tends to be more volatile group, reflecting differences in the investor population. The shorter-term, more momentum driven investors are enjoying this opportunity to profit," said Mark Gilman, analyst at the Benchmark Company.

"The value guys went in a long time ago, when these stocks were really low, and now it's the momentum guys," said Argus Research analyst Phil Weiss. "This is a volatile part of the oil sector and has had a really strong upward run so it's easy to make the argument to take profits," the analyst said.

"I'm not sure if all the value players are out or planning to exit, because I don't think the story has fully played out, but certainly the momentum payers are looking to exit here as the crack spread stops moving up," Dahlman Rose's Margolin said.

TRIGGER #2: Are the Best Margins Behind the Refiners?

Benchmark Company's Mark Gilman downgraded the entire refiner group to an underweight two weeks ago, and not just because the group moved up so quickly, but because the analyst believes that the group is frothy based on margins that are "unsustainably high."

Gilman seems to be the exception to the rule on Wall Street right now, though, with most other analysts positive on at least some refining stocks, if not the group as a whole. There are analysts as bullish on all the refiners and Gilman is bearish, like Dahlman's Margolin, who has a buy on all 7 refining companies under his coverage.

Even as he doesn't rate any stock in the group a sell (Dahlman Rose has four buys and three holds in its refiner coverage), Margolin, like other energy analysts, says it's best for investors to focus on the refiners, company by company, and the mix of their crude supply as an indication of where the bull bets should remain in place.

TRIGGER #3: Focus on Refiners with More WTI Exposure

If saying that rising crude oil prices are bad for refiners is too pat, focusing on the advantage for refiners that benefit from the spread between WTI and Brent crude is a crucial way to view refiner stocks. The spread has finally come in under $10, but Sam Margolin of Dahlman Rose says there is a sustainable $6 to $8 in the spread between WTI and Brent crude that isn't linked to day-to-day headlines from the Middle East and Northern Africa.

The wide spread between North Sea Brent crude and West TexasIntermediate crude has been as much as $17 recently, but historically, the spread is usually within a dollar or two. On Tuesday, the spread continued to narrow as Brent crude decline by almost four times as much as WTI light sweet crude, with OPEC commentary that it might add more light sweet crude production coveted by European refiners hit hard by the Libyan oil production shutdowns.

>>OPEC Comments Cools Oil Prices

This trend reversed on Wednesday though, and the U.S. refiners that stand to benefit from the spread, like Holly and Frontier, were climbing even as the energy sector declined. The Department of Energy data released on Wednesday indicated that crude stockpiles in Cushing, Okla., the delivery point for Nymex-traded futures, rose to a record high of 40.3 million barrels last week. Brent crude was up 2% on Wednesday while WTI crude declined in the early afternoon.

From late November to March the crack spread soared, and it wasn't until recent weeks that some chinks in the crack spread armor appeared. In the first week of March the crack spread has declined steeply. "As crack spreads come down to more normalized levels it's inevitable we get more trading, and some selling off, but most companies are still well positioned with strong balance sheets, especially the ones with a concentration in WTI," said Dahlman Rose's Margolin.

"In general, rising oil prices are bad for refiners," said Argus Research analyst Phil Weiss. "It's hard for them to pass on costs that quickly. They can't raise prices that fast and crude prices are moving up so much."

The Argus Research analyst says one refining stock which he rates at underperform,


(SUN) - Get Report

, can be traded based on its lack of exposure to cheaper WTI crude oil prices. It's not the only reason that the Argus Research analyst rates Sunoco at underperform, but Sunoco's exposure to international crude supply pushes up prices and cuts into refining margins relative to U.S. based refiners that are focused on WTI supply.

Dahlman's Margolin isn't bearish on Sunoco, but concedes that two factors make a refining stock most susceptible to a short-term correction: not being able to take advantage of the spread between WTI and Brent crude, or rallying to an extent greater that peers. In the former case, Sunoco's lack of exposure to WTI could be a negative trading trigger, even though the Margolin makes the case that Sunoco has several other units that remain profitable regardless of the spread between WTI and Brent and for this reason, the stock is range bound. In the latter case, Western Refining is susceptible solely based on its rally, and that seemed to be in evidence this week.

"If you are Holy and you have access to Cushing

Cushing, Oklahoma WTI trading hub, that's a good place to be," says Argus Research's Weiss. Sunoco does not have access to Cushing.

Dahlman's Margolin agreed that Holly and Frontier, who have plans to merge, are reads on the divergence between WTI and Brent crude.

TRIGGER #4: Light Versus Heavy Crude

With all the focus on the premium in Brent crude versus WTI, analysts say some investors might be missing a spread that's as crucial: light sweet crude versus heavy crude. As the WTI-Brent crude premium narrows, there's room left for refiners to exploit the divergence in the pricing between lighter and heavier crude and the potential margin erosion stemming from reliance on harder to refine heavy crude.

"You can make the case that the light-heavy crude dynamic is more sustainable than the WTI-Brent divergence," Dahlman Rose's Margolin said. "It's being overlooked now and the discount between lower quality heavier crude and light sweet crude will widen with record levels of consumption."

In addition, any incremental barrels of oil coming from the OPEC heavier crude supply as a result of extended production disruptions in Northern Africa or the Middle East can increase this divergence from refiners based on their mix. "For a company like Valero, with significant complexity in their system, it's just as important as the WTI-Brent spread and they can maximize the heavier crude input," Margolin said. Valero is notable for its capabilities for refining what is known as sour crude, like heavy crude another alternative to light sweet, and defined by having a higher sulfur content than light sweet crude.

Weiss at Argus Research noted that Sunoco, on the other hand, is more limited in terms of its reliance on light sweet crude as the WTI-Brent gap narrows.

Taking Sunoco as an example, with Libyan barrels lost, there are fewer light, sweet barrels on the market. Most light, sweet crude comes to the East Coast from North Africa (e.g., Nigeria). If Europe is short light, sweet crude, it's more likely to get it from North Africa. North Africa is going to require a higher price to send it to the U.S. due to increased shipping costs. Even if this doesn't happen, with less light, sweet crude on the market, prices should rise and differentials between high and low quality crudes should widen.

Operating under the assumption that most supply that is brought on to replace what's lost from Libya is lower quality (likely sour), "This environment is bad for Sunoco, as it can't easily benefit from the market changes and is more likely to be hurt by them," Argus Weiss said.

Weiss noted in his recent research report on Sunoco, "all of Sunoco's Northeast crudes are priced off of Brent, leaving the company's Northeast refining assets in a particularly vulnerable position, as it will pay relatively more for feedstock than those peers that can acquire cheaper crudes."

The Argus Research analyst added that Valero's refineries have a higher complexity, meaning they can process lower quality crudes (heavy, sour), and as more lower quality crude comes on the market, differentials are likely to widen (greater supply to a fixed market in terms of capacity results in lower prices).

TRIGGER #5: Gasoline Consumption and Demand Pressure

Rising crude oil prices haven't just lifted the energy stock sector but also led to the inevitable fears that gasoline consumption and global oil demand will slow.

"The issue has moved to the forefront and if you believe that the rising gasoline prices at the pump are where we see demand destruction, that's a negative for everyone. Refiners are the most volatile part of the oil group -- and you can always make the argument that you want to take the profits in the refiners when you can get them, and with gas at these levels, it's time to take profits," Argus Research's Weiss noted.

Dahlman Rose analyst Margolin concedes that a material slowdown in demand remains a risk, but isn't overly concerned right now, arguing that the geopolitical risks make it just as likely that crude oil prices and gasoline prices move back down and the U.S. economy and oil product consumption stays on track.

On Tuesday, the Department of Energy's Energy Information Administration revised its 2011 estimate for oil prices higher, to $102 for WTI crude, up from $92, and said there is a 25% chance of $4 gasoline for the U.S. summer driving season. The EIA also said that these estimates include a big margin of error given the impact of events in the Middle East.

On Wednesday, the Department of Energy reported that consumer demand remained strong for gasoline, heating oil and diesel in the most recent week, with stockpiles decreasing even amid the higher oil prices, and decreasing more than analysts had expected. It was a short-term read that the surge in oil prices has not yet led to a consumption pullback, even as the fears of demand destruction remain embedded in the day-to-day action in equities and the oil trade.

-- Written by Eric Rosenbaum from New York.


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