) -- Are crack spreads cracking?

On Monday and Tuesday all the action in the oil refiner stock sector was about the flooding down south, but by Wednesday, more fundamental fears about the historically high crack spreads that have buffered the refiner outlook bubbled to the surface.

"The scale of the floods is no joke, but aside from a few specific flood cases, the volatility in refiner stocks is commodity-driven now, and there is violence in the swings," said Dahlman Rose analyst Sam Margolin.

The biggest loss among big refiner losses during the recent energy rout went to

Alon USA Energy


, down more than 13%, and it is tied to Alon refining operation proximity to floodwaters. On Wednesday afternoon, Louisiana Governor Bobby Jindal said that Alon's Krotz Springs refinery will be shut if the Morganza spillway is opened to relieve flood pressure. At a press conference Jindal said opening the spillway is a "necessary step," which Louisiana official expect may happen by Saturday. Alon shares were down another 3% on Thursday, taking this week's loss to 18%.

On the other hand, the flooding issue could provide a short-term opportunity to European-based refiners or refiners in the U.S. Northeast far from flood waters. Still, analysts were more concerned about what happens after the flood waters recede, and whether the crack spreads could, in effect, crack as demand weakens and refined petroleum product demand slumps, leaving the entire refiner stock sector vulnerable after its massive 2011 rally.

The crack spread is the difference in what a refiner has to pay for crude oil and the profit it can make from refining the crude into petroleum products including gasoline. This year, some refiners have also been supported by the historically wide spread between Brent crude and WTI crude, with the lower priced WTI light, sweet crude serving as another reason for mid-continent-based U.S. refiners to rally.

The crack spread, which had started Wednesday at a historically high level of $32, plummeted through the afternoon and ended trading at $29.86. On Thursday, the crack spread was down another 7% and below $28.

The action in the crack spread is itself volatile. On April 25 the crack spread was at $25 and then soared to $32 this week. In-the-year-to-date period, though, it's been straight up in the crack spread with a move from $12 to the $30-range.

The last time the crack spread had been above $30 was in May 2007. Dahlman Rose's Margolin noted that there is a limited history for crack spreads above $30 (in fact only the May 2007 event).

"Once the crack spreads started to contract from there, they didn't stop until $10 and that's what everyone is worrying about now," Margolin said, though he added that he remains cautiously optimistic about the refining sector, with 4 stocks rated at a buy and three stocks rated at a hold. The analyst noted that the WTI discount to Brent crude is creating a floor under the Nymex crack spread so he doesn't believe it is going to $10, but it could go back to the $15 to $20 range. "That would be a better, safer trip from here to there, but it won't be a fun ride for these stocks," Margolin said. He added that if the economic recovery remains on track and the WTI/Brent differential above $12, that could put a $20 floor value on the crack spread.

Certain Midwestern-based refiners like Holly and Frontier and Western have benefitted from the spread between Brent crude and WTI, which was between $13 and $14 on Thursday. However, not all refiners see the WTI discount boost, and even for U.S. refiners, it's one million barrels of WTI light sweet crude being refined daily, versus 16 million barrels of Brent. From this perspective, the Nymex crack spread can overstate the benefit the U.S. refiners are seeing from the WTI discount.

Western Refining







( HOC) and

Frontier Oil

( FTO) were all down roughly 2% on Wednesday, even as the energy sector losses stopped after Wednesday's heavy selling.

Dahlman Rose's Margolin noted that the investment case doesn't change if Holly shares are $55 versus $60. Holly shares were trading at $56.87 on Thursday afternoon.

Peter Beutel, president at energy specialist firm Cameron Hanover, said after gasoline futures fell by 7% on Wednesday that he became concerned about a longer-term impact to refiners, beyond the flooding. "To see gas drop that much more than crude in one day, that takes down the crack spread right there," Beutel said. On Thursday, gasoline futures were trading down by 1.9% in the afternoon, while crude oil rebounded and was up slightly in the afternoon.

"We're not talking about all the refiners when WTI is the issue, and I'm wondering about substantially seeing the end of the move up in crack spreads. They can come back in very easily to $7 or $8," Cameron Hanover's Beutel said. "Historically, you always see this widening against the crude spread and the crack spread almost always tightens from May through October. The chance of seeing $7 to $8 crack spreads wasn't there two weeks ago and now it's on my radar," Beutel added.

While there was focus this week on the rise in gasoline stockpiles, the Cameron Hanover executive said he is much more interested in total demand for all refined petroleum products. The four-week average went from being up 1.4% to down 0.45% in the latest date. "That is infinitely more interesting and scary. You usually don't see a move more than 30 or 40 basis points a week and the four week average was still up 3.3% two weeks ago," Beutel noted.

Refiner analysts stressed that the refiner stocks are volatile and margins move around a lot, and that crack spreads don't need to be above $30 for the refiners to be fundamentally healthy. "Refiners tend to bounce around day to day and longer-term, as long as they don't see a major negative demand response from the consumer, it should be OK," said Morningstar analyst Allen Good. Good also pointed to the WTI versus Brent opportunity. "You certainly want higher margins but you're still capturing the spread at $13 and making margins strong, though that won't be the case for everyone."

Marathon Oil

(MRO) - Get Report

has seen its shares rally this year by 37%, not just as part of the energy sector bump, but after it announced plans to spin off its refinery operations as a separate company. Analysts don't expect the sudden uncertainty in the commodity market to slow the spin-off, though. As the refiners have declined this week, Marathon shares have remained steady, and more generally, energy analysts say that the spinoff plans have put a floor under Marathon shares during a volatile time for energy stocks.

Market conditions will be harder now for any story that is commodity related and the energy universe as a whole, however, the Marathon IPO is a unique story on the refining side, with good exposure to Canadian heavy crude that trades at an even greater discount to Brent than WTI crude. "There's still some substance to that story," Dahlman Rose's Margolin said.

The Cameron Hanover executive Beutel didn't want to be the voice of doom, but said he can't avoid an eerie feeling after the recent volatile action and even given the still relatively healthy outlook for refiners. "I don't trust it right here. It could be a world of hurt and surprise to the downside from here," Beutel said.

-- Written by Eric Rosenbaum from New York.


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