VLO - Get Report) as my specific best. Going into 2010, there were indications that the refining space had been oversold and that the group's fundamentals were about to improve. Refiners are a relatively easy sector to at least understand. They take a raw product, crude oil, and manufacture a finished product -- mostly gasoline and heating oil. In contrast to most other manufacturers, however, the price that they can charge for their finished product is not up to them. Both gasoline and heating oil are market priced, as is the crude oil that they use. One analogy I've used to describe this is if Kellogg ( K - Get Report) were forced to buy corn on open markets but limited in the price it could charge for corn flakes. Its profit margins would be entirely out of their control. >> Who Owns Tesoro?: Atticus Capital So it has been with the refiners. The measurement of refinery margins is known as a "crack" spread, the price differential between crude oil and refined products. Those margins have been miserable for the last two years. In response, refiners have been forced to make draconian changes in their business models, cutting staff, pushing back maintenance scheduling and in some cases, closing refineries entirely. I saw this trend in late 2009 and posited that these cutbacks were going to result in fundamental shortages of refined products in the spring of 2010 that would not only drive margins higher and help the stocks, but also enflame the buying frenzy into crude oil, pushing a barrel of oil up to and perhaps past $100.
So far, some of this has come true. Refinery utilization numbers, a measure of how hard the refiners are working and how much product they're pumping, has been at historic lows for this time of year. This, however, has caused only a frustratingly moderate increase in crack spreads and a moderate increase in share prices, although my top stock Valero is up more than 22% for the year. That's nothing, though. I was looking for a double on these this year. Tesoro has lagged Valero and the other refiners horribly. It has put off maintenance runs which some blame for the fatal fire at its Anacortes refinery that killed five. It also received that downgrade from Deutsche, which caused a 6% decline in the stock on Monday and leaving it unchanged for the year. There are no more refineries being built in the U.S., however, and Tesoro's Western portfolio of refining assets are irreplaceable. I see this as an opportunity to buy their stock very cheaply. Even if you don't believe in the refinery story going forward, as I do, Valero and Tesoro have had very good historical correlation -- almost 85%, compared with other refiners like Marathon ( MRO - Get Report) or Sunoco ( SUN - Get Report). A hedge fund play would just buy Tesoro here while selling Valero, looking to take advantage of the dislocated spread. I prefer to just buy the stock. I've rolled out of my Valero position and "traded" it for exposure in Tesoro. I still am a believer that the shortages in gasoline are coming, right at the middle of the summer when the market will be most vulnerable as the recovery in the domestic economy really hits its stride. Even pushing out the margins a little should have an overwhelmingly positive effect on the stock, which is trading about $13.50, but don't drool at this too much. It traded as high as $65 in late 2007. Can it get back there ever again? That would require a real "crack squeeze," where margins get really wide for a long time. It's happened before, not so long ago. And some of the symptoms of a squeeze are definitely in place. I think that possibility makes having one of the refiners in your portfolio a must, and Tesoro is the one on sale this week.