The refiners, particularly Valero (VLO), turned in quite a performance Wednesday. On the basis of a rumor -- Valero as the potential takeover target of the Indian firm Reliance Energy -- shares of Valero increased more than 16% on the session, dragging most of the other refining names upward with them. While this represents a fantastic explosive first act, I don't expect it to be much more than a one-act show.
We'll need to do a little reconnaissance on the industry to see it, but any ideas of refining as a fantastic new mergers-and-acquisitions opportunity are a bit far-fetched. With a little history behind us, we can see how difficult the refining business is and why its future is still very much in doubt.
Turning oil into refined products such as gasoline and heating oil is the most necessary part of the energy procurement process. After all, you can't use crude oil for much. It is only the processed products of crude that have real value. You'd think, then, that refining would be the most lucrative and desired part of the energy chain. It isn't.
That's because the prices that refiners can charge for finished products are financially traded, just as their input prices are. Think of them as Kellogg (K), making corn flakes: The price for corn that this company pays to process into cereal is openly priced, but so are the prices that Kellogg can charge for the finished product. That's not the best recipe for consistent and reliable profits.
Since the "electronicization" and "financialization" of oil completed in 2008, the price of refined products have barely kept pace with the input prices for crude, making the margins that refiners earn very slim indeed. Those difficulties have been reflected in the refining stocks themselves, as seen in the weekly chart of Valero below, which goes back to 2008.
Since 2008, most everyone with the opportunity has tried to shed their refining assets for precisely this reason: The margins are slim and at the whims of financial markets and totally unreliable. Companies from Chevron (CVX) to BP (BP) to Shell (RDS.A), and even Valero itself, have tried to lighten up on assets in the previous 12 months. Sunoco (SUN), once one of the greatest independent refiners out there, has now put up for sale their last two refineries. That makes the company little more than a real estate investment trust of gas stations and convenience stores. You could say they are now trying to sell Coca-Cola (KO) more aggressively than they are gas.
But recently the refiners, and their stocks, have seen some joy. The financial disconnect that began at the end of 2010 -- which had driven Brent oil prices to a large premium over U.S.-benchmarked West Texas Intermediate -- has inflated the margins that many refiners collect, even if only artificially.
However, everyone in the industry is aware that this ridiculous disconnect cannot continue forever. Whether the financial logjam gets cleared further (the spread has dropped almost $10 in the last trading week) or if the stockpiles in Cushing will finally be cleared by the building of the Enbridge Energy (EEP) "Wrangler" pipeline, it is a surety that the Brent-WTI spread will revert to historical norms no later than 2013.
With that, the refiners will be again stuck with skinny profit margins.
Add to that an infrastructure that is more than 45 years old, and regulation and oversight that is as strict as it is anywhere in the business, and you've got a tough company to run. It's not a company, moreover, that looks like such a tasty takeover target.
There must be some value to every company that's as clearly integral to the nation's energy chain as this is -- and this is definitely true with the refiners. Indeed, earlier this year Valero could have been bought for a bit more than $16 a share. Tesoro (TSO), for its part, could have been picked up for less than $8 a share in the depths of 2009. People need gasoline and heating oil, and enough new demand for refined products must inevitably expand margins again, possibly bringing back the "golden age" of refining that these companies experienced in the last decade. That domestic demand, however, is far from returning -- at least so far.
If you own these stocks short-term, my guess is these rumors will help pump them for another day or so, but cashing in on the good news would probably be a good idea. If you're looking for a long-haul play, the refiners may not be a bad one. Just be aware you'll be betting on a sector that has some serious headwinds in front of it.
Simply put, there's just better value in the energy patch today than what can be found in the refiners.