As refiners approach earnings season, Wall Street is abuzz with anticipation.

The sector is thriving, with the price of petroleum products consistently outpacing even the soaring price of crude; margins are fat. Companies that process heavier and cheaper oil, whose prices have held relatively low during the rally in light crude, are winning big-time.

Companies such as Valero ( VLO) and acquisition target Premcor ( PCO) are expected to post record earnings this quarter, as they continue to benefit from high retail prices and wide refining margins.

"It's been an unbelievable performance," says Fadel Gheit, oil analyst at Oppenheimer & Co. "Margins and prices are going to remain very high." (Oppenheimer has no investment-banking relationship with the companies in this story.)

With no significant additions to refining capacity on the horizon either in the U.S. or globally, the uptrend is likely to continue.

Valero recently said in an update to investors that it expects record-breaking second-quarter earnings of $3 a share, compared with the $2.28 a share it earned in the second quarter of 2004. It chalked up the performance to "exceptionally strong distillate margins and wide sour crude discounts." Shares are up 83% this year to $82.82, about 10 times the 2005 earnings consensus.

"The real demand is for crude products, not for crude, and refiners today are in the driver's seat," Gheit says. He says the refining industry has made more money in the first quarter of this year than it has over the last three years put together. "Refiners went from dust to gold in three years."

Thanks to its refining capabilities, Valero benefits from buying heavy oil at cheap prices and turns it into lighter, "sweeter" products such as diesel. Called differentials, the spread between the two types of crude has increased to four times its historic norm. From a $3 average spread between heavy and sweet crude, the gap has widened to $11 recently and was as high as $18 in 2004.

The reason is simple. Big oil producers, such as Saudi Arabia, are currently producing more heavy crude than light and sweet oil, because that's what is left as oil fields deplete. This allows refiners with heavy crude processing abilities to enjoy the discounts.

Also lending support to refiners' earnings is an extraordinarily strong demand for distillates, which has pushed retail prices of gasoline and diesel to record highs.

With hefty distillates and gasoline demand, record high retail prices and plenty of cheap crude, Valero looks posed for a bright future. And once the merger with Premcor is completed, it will become the largest refiner in the U.S.

"Valero has yet to reach its replacement value, which means it is still valued less than what it's really worth," says John Selser, portfolio manager for the Maple Leaf Partners hedge fund, which is long the stock. "The company is reaping the rewards of years of investment in highly complex refineries that can process heavy crude."

As for Premcor, the same market conditions have worked well for the company, as illustrated by Wall Street's expectation for a 65% jump in second-quarter earnings to $2.66 a share. Full-year estimates are pegged at $6.64 a share, up from last year's $5.75 a share, according to Thomson Financial. At $76.08, the stock fetches 11 times this year's estimate and 10 times next year's.

Premcor CEO Jefferson Allen said that "conditions in the second quarter to date have been robust, with refining margins even stronger than during the first quarter, and crude oil price differentials only slightly weaker."

Jay Saunders, analyst at Deutsche Bank, however, thinks that shares of Premcor are trading near a takeover price, and doesn't see much upside for the company.

Another refiner exposed to crude differentials is Frontier Oil ( FTO). The Houston firm is expected to post record second-quarter earnings of $1.07 a share, up from 80 cents a share the same time last year. Earnings estimates for the full year are twice as high as in 2004, at $2.36 a share. At $28.58, the stock sports a 13 earnings multiple.

Still, Frontier Oil isn't the subject of much analyst enthusiasm. Deutsche Bank's Saunders recently downgraded Frontier to hold from buy, saying the shares are overvalued. Saunders said in a note that Frontier trades as if it were a takeover candidate -- but that no buyer is in sight. Maple Leaf Partner's Selser said that given its size -- 150,000 barrels a day -- "I don't think they are an attractive buy." (Deutsche Bank owns shares of the company and has an investment-banking relationship with it.)

On the other side of the phenomenal refining story are companies such as Tesoro ( TSO) and Sunoco ( SUN), which continue to profit from rising gasoline and distillates prices, or crack spreads, but aren't geared for heavy crude processing.

Sunoco made a conscious decision not to invest in heavy crude processing, betting that -- sooner or later -- heavy oil prices are going to increase and differentials will shrink back. The Philadelphia-based company, which operates five refineries in the U.S. with 890,000 barrels per day of crude oil processing capacity, is expected to post second-quarter earnings of $3.12 a share, essentially flat compared with last year's results.

Crack spread margins in the East Coast, Sunoco's territory, averaged $8.20 in the second quarter, down form about $13 in last year's second quarter, but up from the first quarter of 2005.

As for Tesoro, its shares surged 53% since the beginning of the year, though Wall Street is predicting lower second-quarter earnings of $2.44 a share, down form $3.11 in the year-ago period.

"Tesoro had record second-quarter earnings in 2004 due to exceptionally high refining margins in California," Gheit says. "It would be very hard to repeat that success."

Still, if Tesoro meets expectations for this quarter, it will earn half of what it made in all of 2004. To Sauders, Tesoro shares look relatively cheap at 10 times earnings.

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