Reconsidering the Refiners

 | Jan 24, 2013 | 5:00 PM EST  | Comments
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Stock quotes in this article:

cvi

,

cvrr

One party that continues to roll in the midst of a very quiet energy sector is refining. But be careful: many of these stocks are incredibly overextended and finally facing fundamental headwinds.

The energy sector was an awful place to be in 2012, but refiners were an island in an otherwise stormy sea. Outside of financial stocks, some of the best performers on the S&P 500 were refiners, particularly those in the midcontinent, taking advantage of an unusually wide Brent crude/West Texas Intermediate spread -- stocks like Tesoro (TSO), Western Refining (WNR) and CVR Energy (CVI).

Fundamentally, there's no reason to get out of these high-flying stocks. The oil market has two financial benchmarks to determine global prices for crude: Brent oil from the North Sea and West Texas Intermediate, priced in Cushing, Okla. The North Sea production profile is in decline, causing an almost endless loop of supply tightness, while the Cushing surplus seems to be unsolvable, even with the added drain from the newly opened Seaway Pipeline. These fundamental pressures on the two individual benchmarks should ensure that spreads stay inordinately wide and refiners in the midcontinent continue to enjoy large profit margins for many quarters to come.

Yet there's a very strong downtrend in the Brent/WTI spread, which I noted a few weeks ago, dropping it to around $16.50 from more than $23. Sometimes, all the analysis in the world doesn't matter; what does matter is what the market is doing and how you react to it. So, with refining stocks, we want to be very selective, trying hard not to replicate an Apple (AAPL)-like, top-down mistake and buy a stock that's about to drop off the table -- even if it happens without solid fundamental reasons.

One place where there's fresh opportunity is the CVI spinoff of CVR Refining (CVRR). Carl Icahn is a big investor without a preferred price, owning $100 million worth of shares. And with CVI's one-time dividend of $5.50 a share, the parent company estimates 2013 distributions of 19% for the master limited partnership spinoff. It is more likely to make that number considering it also announced it was 40% hedged into the Brent/WTI spread at an average of $26 -- making margins, at least for 2013 and much of 2014, guaranteed.

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

Those who follow Apple know that parties have a way of ending badly, too.

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