While the US stock market has been lacking volatility this year, our energy sector has been up and down riding the waves of geopolitical risk and the changing value of the US dollar. The refining subsector is stretched thin and as a result, we’ve become bearish on several names as growth slows down and cracking margins reach all-time highs.
Two names we’re inclined to short are HollyFrontier Corp. (HFC) and Tesoro Corp. (TSO). We’ve outlined our bearish case for HollyFrontier in the past. As we reach peak levels for crack spreads, which are bullish for refiners when they are high, we believe the time is right to begin shorting refiners as the cycle shifts and cracking profits come down.
With Brent crude oil at $115 a barrel and the Brent-WTI spread at $18, the market is setting up to agree with our bearish case. The US refining index is +65% year-to-date vs. the S&P 500, which is only up +13; the benchmark cracking margin is +91% year-to-date. We have found that the relative performance of the refiners correlates well with cracking margins (a proxy for the profit margin from “cracking” a barrel of oil into refined products).
Hedgeye energy analyst Kevin Kaiser has outlined his concerns into several comprehensive bullet points below:
• Refining is a structurally-challenged industry that is plagued by excess capacity, no pricing power, intense regulation, and a secular decline in gasoline demand due to many factors: increased fuel-efficiency, ethanol in the gasoline blend, a deleveraging consumer, weak employment, social media, and more. (US gasoline demand is down 4% Y/Y.)
• Over the long-term, revenue growth is limited (a new US refinery has not come online since the 1970s), margins are low, and maintenance capex is high due to increased environmental regulations.
• Cracking margins are highly volatile and cyclical, as are the share prices of the refiners.
• Many investors and analysts have pointed to the high dividend yields and special dividends (HFC in particular) from the refiners as reasons to buy the stocks. In our view, it is a reason to sell the stocks. For one, it is an admission that investment opportunities are limited or that the return on invested capital will be poor. Second, free cash flow (and thus the dividends paid out) is highest when margins are near peak – this is the time to sell the stocks.
• Sentiment is bullish relative to historical levels (more sell-side “buys” and lower short interest).
• The insiders at these companies are selling large amounts of stock: in particular WNR, HFC, VLO, DK, and ALJ.