A Fresh Opportunity in Refining Stocks

The one party that continues to roll on in the midst of a very quiet energy sector remains refining.  But you must be particularly careful where you go here, as many of these issues are now incredibly overextended and are finally facing some fundamental headwinds. 

During 2012, the energy sector has been an awful place to be, but the refiners were a strong island in an otherwise stormy sea.  Some of the best performers in the S+P 500 outside of financial stocks have been the refiners, particularly those in the midcontinent, taking advantage of an unusually wide WTI/Brent spread -- stocks like Tesoro (TSO), Western Refining (WNR) and CVR Energy (CVI).

Fundamentally, there shouldn't be any reason to get out of these high flying stocks.  The oil market deals in two financial benchmarks to determine global prices for crude, Brent oil from the North Sea and West Texas Intermediate, priced in Cushing Oklahoma.  The North Sea has continued to see a declining production profile, causing an almost endless loop of supply tightness, while the Cushing surplus seems to be unsolvable, even with the added drain coming from the newly opened Seaway pipeline.  These two fundamental pressures on these two individual benchmarks should assure spreads stay inordinately wide and refiners in the mid-con would continue to enjoy large profit margins for many more quarters to come.

And yet, we've been in a very strong downtrend in the WTI/Brent spread, which I noted in columns a few weeks ago, dropping from over $23 to now hover around $16.50.  Sometimes, all the analysis in the world doesn't matter;  what matters is what the market is doing and how you react to it.  So, with refinery stocks, we want to be very selective in where we go, trying hard not to replicate an APPLE-like top-down mistake and own a stock about to drop off the table -- even if they'll do it without solid fundamental reasons. 

One place where there seems to me fresh opportunity is in the CVI spinoff, CVR refining (CVRR).  Carl Icahn is a big investor without a preferred price, owning $100M of shares.  And with the one-time dividend for CVI announced by the board of $5.50 a share, the parent company estimated 2013 distributions of 19% (!) for the MLP spinoff.  They look more likely to make that number considering they also announced that they were 40% hedged into the Brent/WTI spread at an average of $26(!) -- making their margins, at least for 2013 and much of 2014 -- guaranteed. 

Special dividends are great, but in the case of CVI, I'd finally consider this the top of the market indicator and begin to roll out of refining shares after it goes ex-dividend on February 8th, particularly if the Brent/WTI spread finds its way at or under the critical $15 premium.  While that premium would still represent a tremendous margin for the mid-con refiners, it would also represent a breakdown in the spread and a likely top for this high-flying sector. 

As you can see if you follow Apple, parties have a way of ending badly, too.