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A refined approach to investing in the price of energy

As the economy slows, investors may be better off counting on the price of refining oil rather than the price of crude, says a leading expert.

Whatever the stock markets do, whatever the economy does, the energy problem is not going to go away. For all of the sincere resolutions to cut down on consumption, the world’s thirst for energy is getting larger, not smaller.

This raises a question for investors: with the price of crude oil bumping up against and occasionally exceeding $100 a barrel, isn’t the most obvious course of action to buy up the shares of oil companies?

Not necessarily. If the U.S. economy continues to lose momentum, the price of most commodities will begin to slide as corporations and consumers cut back. That includes the price of crude oil.

According to a leading U.S. expert on energy stocks, the secret to prosperity in the months ahead may be to bet on the price of gasoline, not the price of crude oil.

Writing in Louis Rukeyser’s Wall Street, Mr. Elliott Gue suggests that investors look not to the companies that go get the oil, but the companies that refine it. He has one strong buy in mind.

This advisory also has its own take on what investors should be looking for in the near future, and we’ll look at that a little later on.

No one consumes crude oil

“Oil-refining companies don’t make money by selling crude oil or, for that matter, natural gas,” states Mr. Gue. “In fact, refiners are often hurt by rising crude oil prices.”

That’s why Valero Energy (NYSE-VLO) is an attractive buy today, he adds. It is the largest independent refiner in the U.S., putting through some 3.1 barrels a day. It has 16 refineries in the U.S., Canada and Aruba. (Ultramar is the Canadian outlet for Valero, and its Jean-Gaulin refinery in Levis, Quebec is one of Canada’s largest.)

The fact is, we don’t actually use crude oil.

“No one consumes crude oil directly,” says Mr. Gue. “You don’t fill the gas tank with oil, nor do you run trains or airplanes using crude. What we actually consume is a refined product made from crude — such as gasoline, heating oil, jet fuel and diesel.”

Fair enough, the refineries are the middlemen. What does this mean for investors?

Making money on the spread

The price of crude oil is not the only thing investors should be looking at. The refineries buy crude oil as their feedstock and produce gasoline and other products with it. “Therefore, refiners make money from the spread between crude oil prices of refined products, not the price of crude or gasoline alone,” explains Mr. Gue.

If the price of gasoline is rising faster than the price of crude, the refiners see their profit margins expand. So refiners can actually make money while crude oil prices are falling. If gasoline prices remain steady or rise while crude slips, the refineries do well.

There’s a way to measure this: it’s called a “crack spread” (“cracking” is another term for refining). This is the difference between the cost of crude oil futures and the price of refined products futures, primarily those of the two biggest products, gasoline and heating oil futures.

Even this doesn’t tell the whole story. Not all crude oil is created equal.

West Texas vs. Maya

Different grades of crude oil trade at vastly different prices. West Texas intermediate crude, for instance, trades at around $90 a barrel. But the tough-to-crack, high-sulphur Mexican benchmark known as Maya trades at closer to $76 per barrel.

These lower grades can work to the refiner’s advantage, says Mr. Gue. The price of the gasoline or heating oil they produce remains the same, so the lower cost of the crude simply expands the refiner’s profit margins.

This stands Valero in good stead. With its advanced refineries, it can handle all kinds of crude oil types. That means it can go out and buy the most economical crude available.

There’s one more wild card in the mix: geography. Refining margins can actually differ from one region to another. California, for instance, is chronically short of refining capacity. So margins on the west coast — where Valero has two major refineries — tend to be higher than in the east.

Since no new refineries have been built in the United States since 1976 (that’s right, thirty years without building a single refinery in the country that is the world’s biggest consumer of energy), this imbalance is not about to change.

Driving season

The best time for the refineries is now. As Mr. Gue puts it: “Refining margins tend to expand between January and May as refiners gear up for the summer driving season; typically refining stocks see seasonal outperformance during this time period.

“With crude prices now coming off their highs, it looks like the seasonal expansion in crack spreads is underway.”

Valero has expanded capacity more than sixfold in the pat decade, via acquisition and the expansion of its existing plants. It is also working to enhance profitability. Almost a year ago, it sold off a small refinery in Ohio to Husky Energy (TSX-HSE) for $1.9 billion. It intends to sell off the lesser performers among its facilities.

The cash it received from Husky has gone into upgrades in its largest refineries and a $4 billion share buyback program stretching over the past two years.

“At less than seven times 2008 earnings estimates, Valero is trading at a historically cheap valuation and a discount to its peer group,” says this expert. “It’s attractive under $65.” It opened this morning at $59.83, about $5 higher than when this article was published last week. So perhaps those spreads are taking hold.

Remember, for this equation to work, the bottom doesn’t have to fall out of the price of crude oil, it just has to move down while the price of gasoline does not.

Speaking of the bottom falling out, what’s going to happen with the U.S. economy?

Stagflation and the disco era

As we sift through the many advisories that come our way, the tide of opinion amounts to a divide between those who think things are going to be horrible for a long time, and those who think things aren’t quite as bad as they look. Nobody’s happy, but some people are less unhappy than others.

Louis Rukeyser’s Wall Street falls into the latter camp. Mr. Nicolas Lanyi, who has assumed the mantle of editorship from the late Mr. Rukeyser, takes a traditional bad news-good news.

Mr. Lanyi is not one of those who think that Mr. Ben Bernanke, the chairman of the U.S. Federal Reserve Board was utterly irresponsible with his emergency cut of 75 per cent in the federal funds rate. Overseas markets were plummeting, the S&P 500 had suffered one of the quickest corrections in history and a full crisis was underway.

But there’s a limit to how much good these rescue missions can accomplish. “The bad news isn’t over, folks,” says Mr. Lanyi. “Bernanke’s knight-in-shining-armour routine, dramatic as it was, actually underscores the reality that the U.S. may very well be not only on the verge of a recession, but already in one.”

Economic statistics are mixed, but employment figures are softening up and investors keep on selling because “they see storms on the economic horizon.”

Then there’s inflation. Or worse. “The specter of stagflation — recession combined with high inflation — looms over the U.S. economy for the first time since the disco era.” That’s the later 1970s for those too young to remember, or those who didn’t care to listen in the first place.

Most economists still doubt that we’ll see stagflation, says the editor. “But with commodity prices soaring while the economy is tanking — and the Fed obviously more inclined to stave off recession than clamp down on inflation — it’s a real possibility.”

The good news

But there is good news, says Mr. Lanyi. It has to do with the value of stocks.

The price-to-earnings ratio of the average S&P 500 stock is now 14.5 times analysts’ expected 2008 earnings. It is a rule of thumb than a P/E ratio of 20 means it is fully valued, so there is plenty of wiggle room beneath the ceiling.

In fact, says the editor, stocks are reaching records for cheapness, since “the overall market is historically inexpensive.”

As an example, he cites two of America’s best companies: Intel Corp. (NASDQ-INTC) and Cisco Systems (NASDQ-CSCO). These high-tech giants have been trading at less than 15 times next year’s earnings.

“Good investors look for bargains,” concludes Mr. Lanyi, “and we see plenty today. Now, a recession could well mean a bear market, perhaps lasting months or even years. But high-quality companies will thrive and survive, and investors with fortitude to buy them now will come out ahead — eventually.”

So good stocks are available at bargain prices because the economy and the markets are in serious trouble. Oil refining stocks look like a good buy because the price of gasoline is way, way up. We sure are asked to take a lot of bad with our good these days.