It should go without saying that the events in Houston and the surrounding area this week have been tragic in human terms. Many lives have been lost and many more devastated by the floods that resulted from Hurricane Harvey. It may seem trite and somewhat heartless to talk about the market implications of an event like that, but once we have donated to relief causes and said our prayers we can only return to our normal lives, and mine involves assessing how events shape markets.
In those terms, the reaction to the storm has been interesting. Given the Houston area’s prominent position in the oil industry, many were surprised by crude’s immediate reaction, a big drop in price. If you think it through, though, it made perfect sense. There were some closures amongst the rigs in the Gulf of Mexico, but those represented only a small fraction of U.S. crude production, which was in surplus before the closures. Oil prices have since recovered some as the extent of rig closures became known, but are still below the levels before the storm.
The biggest effect, however was not on crude production but on refiners. I was recently in the Houston area and it seemed that wherever I went I was always no more than a stone’s throw from a refinery. Little wonder then that by some estimates around twenty percent of America’s refining capacity has been lost this week.
That results in a short-term drop in demand for crude, hence the fall in price, and a shortage of refined products, most notably gasoline. Gas prices responded accordingly, and are continuing to climb as regional shortages bite. That has resulted in a big jump in the crack spread, the difference in price between crude oil and refined products, and that, somewhat obviously, gives refiners’ margins a big boost. For those operating in the Gulf area that is more than offset by production losses, but for those elsewhere it could lead to long term benefits.
Both gas and crude prices are somewhat regional, but still tend to move in unison, which means that refiners with operations outside of the affected area are seeing lower input costs (crude) and higher output prices (gasoline) while still running at normal production levels. As anybody who has ever driven a car will tell you, gas prices shoot up a lot more quickly than they fall, so even as the refineries in Texas and Louisiana come back on line it is likely that the crack spread will remain elevated for some time.
That is a big benefit to companies like CVR Refining (CVRR), whose operations are in the Mid-West.
(Click to enlarge)
In fact, in CVR’s case, it offers a potentially quite long-lasting solution to their biggest problem, margins. Even after the immediate pop this week, CVRR trades at very low price to earnings ratios (P/Es); the stock’s trailing and forward P/Es of 8.67 and 13.79 respectively are way below the stock market averages. There are many things that go into forward P/Es, but the main thing that has been holding CVR back are wafer thin margins. Even for a company with levered free cash flow of over $385 million, a profit margin of only one percent is not generally an encouraging sign and leaves no room for error.
With crack spreads at multi-year highs and still climbing, refiners that are not directly affected are an obvious play. CVR, given that those increasing spreads addresses the company’s main issue, stands to benefit more than most and looks like a solid investment at these levels.
