Tread Carefully With Refining Stocks

Few sectors can deliver short-term return numbers like refining stocks do when they have the wind at their backs. A near-perfect environment in the third quarter has led the refiners to post incredible earnings results, driving their stock prices to outstanding returns in recent weeks.

The year-over-year profit results point to an industry with everything going its way: Valero Energy (NYSE:VLO) reported growth of 297%, while Tesoro Corp. (NYSE:TSO) profits rose 516%. Marathon Petroleum (NYSE:MPC) — which was spun out of Marathon Oil — said its earnings quadrupled, while Alon USA Energy (NYSE:ALJ) moved from a net loss of $15.6 million to a gain of $28.6 million. Western Refining�s (NYSE:WNR) net income jumped from $6.9 million to $84.9 million.

These results haven�t been lost on investors. From the Oct. 3 market low through Nov. 8 (27 trading sessions), some refining stocks have produced gains that are nothing short of parabolic:

The reason for these gaudy results is straightforward: soaring profit margins. The past year has been characterized by an enormous spread between the prices of Brent North Sea crude and West Texas Intermediate Oil. At its peak, this gap rose to an unheard-of level of $27.90 because of a glut of WTI supply in storage.

Why is this important for refiners? Very simply, many U.S. refiners are able to buy cheaper WTI oil and sell their finished products at prices tied to Brent crude. In other words, it�s a license to print money. The result has been explosive gains in profit margins and a surge of investor cash into the refiners once the markets returned to �risk-on� mode in October.

This type of positive news flow has made for an outstanding autumn if you already own shares in the refiners. If not, it might pay to wait at this point rather than trying to catch up. Consider that the crack spread, which measures the difference between the cost of crude oil and the price at which refiners can sell their finished product, averaged record levels in the third quarter, but it has since come down quite a bit. Similarly, the gap between Brent and WTI has narrowed in recent weeks, indicating that the fourth quarter might not be as dramatically positive as the quarter just passed.

Consider, too, that demand for gasoline continues to fall. According to the U.S. Energy Information Administration, consumption had lagged 2010 for eight consecutive weeks through Oct. 21, while the national average of gasoline prices had fallen from a peak of $3.91 in May to $3.45 in October.

Add it up, and the takeaways are:

It�s Too Late to Play Chase

The third quarter looks like a classic case where the fundamentals can�t get any better … and therefore probably won�t, at least in the immediate future. With the stocks having come so far, and the earnings reporting season for the outstanding third quarter now mostly in the rear-view mirror, the sector is likely due for a pause. As a result, a measure of patience is warranted for those who are looking to go long.

Still, Don�t Think About Shorting This Group

Click to Enlarge Even if refiners are set for a breather, shorting this sector is an exceptionally dangerous proposition. Anyone who has ever tried to short these stocks knows they can rally long past the point where it seems they can�t possibly go higher. The Valero chart from 2004 to early 2006 is a major red flag for anyone looking to pick up some �style points� by going short into the teeth of this rally:

Click to Enlarge Further, the TSO chart is very strong technically, and it is likely that a breakout for this industry bellwether will be taken as a bullish sign for the entire sector. Keep an eye on this in the days and weeks ahead:

Be Ready to Add on Weakness

Longer-term, it appears that there will continue to be a glut of oil supply at the Cushing, Okla., storage facilities, meaning the gap between Brent and WTI can continue indefinitely. According to Forbes, a recent research note from Nomura Securities said current futures show the gap remaining in place through 2016. This suggests that refining stocks will continue to have a long-term source of support — making the sector a good candidate for a �buy the dip� trade if weakness in the broader market provides a more attractive entry point.

As of this writing, Daniel Putnam did not own a position in any of the aforementioned stocks.