Energy Stocks that Will Profit from Widening of the Crude Oil Crack Spread

By: Keith_Fitz-Gerald

Here at Money Morning over the past six months, we've talked a great deal about oil and gasoline prices. We've offered our predictions about how high those prices were going , and have detailed a number of investment opportunities - chosen as much for their margins of safety as for their profit potential.

This time we're going to detail three energy stocks with the potential for double-digit - or even triple-digit - profit gains. Admittedly, these are longer-shot, speculative plays. But we used a special energy indicator to help ferret out these energy plays.

This indicator is known as the “ crack spread .”

In case you've never heard the term before, the crack spread is the difference between the price of crude oil and the value of the petroleum products that refiners can make from it. The crack spread can widen or narrow over time, depending upon various combinations of supply and demand.

If the spread is positive, that means the price of the products that result from the refining process - gasoline, diesel fuel, aviation fuel, heating oil, kerosene and asphalt, to name a few - is greater than the cost of the crude oil needed to make them. But if the spread is negative, it suggests that the cost of crude is higher than the end-game value of its derivatives.

Right now, the crack spread is narrowing. In fact, it has been for some time as governments around the world and gasoline companies actually try to hold down the pain motorists feel at the pump.

Granted, governments and major oil players make for strange bedfellows. But they have a common interest right now: Both are trying to prevent “ demand destruction ,” the plunge in oil demand that would result if millions of motorists - fed up with high oil and gasoline prices - just stopped driving. Governments want to prevent an economic collapse, while the integrated oil companies simply want to avoid being branded as the “bad boys” of the soaring-oil-price era - making it much easier for the incoming presidential administration to slap the entire sector with an “excess-profits tax” (something that's already being discussed by Washington insiders).

But we can also see another scenario, one that's very different. Peering into our crystal ball, we can see a situation in which the crack spread begins to widen, and gasoline prices run away anyway - eventually reaching $7 or even $9 a gallon .

For motorists, the pain would be excruciating. For investors, however, there's a chance for double or even triple-digit profit gains.

Let me explain…

The Subsidy Gambit

It turns out that a number of Asian governments - most notably Taiwan, Malaysia and China, for instance - are actually reducing or eliminating fuel subsidies designed to shield their consumers from crude oil's relentless march . Ostensibly, this is designed to control demand, but history suggests this will merely give those with the money access to increasingly large supplies that they'll gobble up. In other words, we believe that demand may be growing fast enough to override the prices that governments around the world still believe to be inelastic .

Combine that possible new reality with the fact that a developing Asia accounts for as much as 70% of the increase in global oil consumption, this end of subsidies would probably hammer worldwide markets, including our own.

Given that Asia represents a mere 20% of current global usage, Asia's growth is critical to how the rest of the world uses and prices petroleum-related products - particularly gasoline. Incidentally, this stands in stark contrast to how Japan and much of Europe do things where high taxes on fuel and transportation are used to blunt demand.

The economic forces that will be unleashed when these subsidies are removed have the potential to make the Great Tunguska Blast that took place 100 years ago this month look like a wet firecracker.

Indonesia, for instance, spends nearly 20% of its budget to underwrite fuel costs and has telegraphed a 30% hike in fuel prices when those subsidies are removed. It's much the same story in China, India and the Philippines, where separate figures for fuel subsidies are hard to come by, but where it's safe to say that the net effect of these price controls have contributed to artificially low prices and artificially high levels of demand.

In China, where the government caps gasoline prices, for instance, motorists pay about half of what their U.S. counterparts pay. All in all, governments around the world will spend about $100 billion on oil subsidies this year - meaning about half the world's population is benefiting from “cut-rate” petroleum prices. This year, those folks will account for all of the growth in global oil demand, equal to an additional 1 million barrels of oil per day, says Deutsche Bank AG ( DB ).

Now, pressure is escalating globally for countries to end the subsidies the world economy can ill-afford. The International Monetary Fund (IMF), for instance, is “calling on governments to let consumers face market prices in order to kick-start conservation and reduce official spending,” says The Christian Science Monitor .

As I hinted earlier, this change has the potential to jam a lot of consumers personally. But it would allow world markets to function as, well, markets. And that, in turn, would afford investors one of the biggest turnaround opportunities available in the energy sector today. The reason: As the subsidy removals, pricing changes and demand shifts work their way through the global economy, the crack spread would widen again… and fast.

And the biggest beneficiaries could well be the oil refiners, which have seen their profits get zapped along with crack spreads in the past year.

The Best Way to Play the Shift From Subsidies

If there is a sector turnaround, the upside could be huge. And the three firms in line to benefit are Western Refining Inc., Valero Energy Corp. and Holly Corp. Let's take a closer look at each of the three:

• Western Refining Inc. ( WNR ) : The El Paso, Tex.-based Western is an independent crude-oil refiner that owns and operates four refineries, and that also owns and runs 155 retail service stations and convenience stores in the Southwest. Although Western's shares rose 77 cents each, or nearly 7.1%, to close at $11.66 yesterday (Thursday), the stock is down 82% from its 52-week high of $66.13. Independent researcher Soleil Securities Group Inc ., this week initiated coverage of Western with a “Sell” rating and a target price of $8 , contending that the company is highly leveraged and has seen its shares suffer in concert with its peers as part of a general sector downturn. That underscores the sentiment these companies face. But a return to its 52-week high would represent a 467% gain.

• Valero Energy Corp. ( VLO ) : The San Antonio, Tex.-based Valero Energy owns and operates a total of 17 refineries spread across the United States, Canada and Aruba, and its products run the petrochemical gamut. At yesterday's closing price of $44.42, Valero's shares are down 44% from their 52-week high of $78.68. A return to that 12-month peak would represent a gain of 77%.

• Holly Corp. ( HOC ): The Dallas, Tex.-based Holly is another independent petroleum refiner that focuses on such “light” products as gasoline, diesel fuel and jet fuel. It operates several refineries, about 900 miles of crude-oil pipelines, and a number of other operations. At yesterday's closing price of $40.44, Holly's shares are down 50% from their 52-week high of $80.55. If the shares were to bounce back to that 12-month peak from yesterday's close, investors would reap a return of 99%.

Clearly, these aren't “slam-dunk” stock picks. But volumes are going up and many of the sector players have been beaten down to bargain-basement levels not seen in years.

Besides, for a shot - even a long shot - at a 467% gain, investors can afford to be somewhat patient.

News and Related Story Links:

• The Christian Science Monitor: Subsidies: A Big Culprit in High Gas Prices .
• Money Morning News Analysis: Pain at the Pump: It's Time to Start Thinking About $7 a Gallon Gasoline .
• Wikipedia: The Crack Spread .
• Money Morning Investment Analysis: Two Ways to Profit as China and Japan Quietly Forge the Most Powerful Trading Alliance in the World .
• Wikipedia: Demand Destruction .
• Briefing . com: Short Stories (WNR).
• Wikipedia: Tunguska Event .
• Money Morning Special Investment Report:Money Morning Boosts Oil Target Price to $225 a Barrel, Thanks to Continued Scarcity, Burgeoning Demand in China

By Keith Fitz-Gerald
Investment Director

Money Morning/The Money Map Report

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