>CRACK SPREADS AND REFINER STOCKS (BCA)

CRACK SPREADS AND REFINER STOCKS: HOW TO PLAY THE CYCLICAL RECOVERY

COMMODITY & ENERGY STRATEGY

Distillate crack spreads should widen, although part of this is captured in the futures curve contango. Good news for refiner stocks.

The current state of affairs in the refinery sector is a mirror-image of the “excellent” industry conditions and euphoric investor expectations that prevailed in 2006 and 2007. Inventories of distillate fuels are at an all-time high, while consumption is plummeting. Distillate cracks are down $25 from their record high 16 months ago and projections of refineries’ earnings are gloomy (Chart 1, top panel). Valero shutdowns and layoffs add to the negativity.

This pessimism about the refining outlook is overdone and a contrarian strategy is warranted. Structural shortages of distillate products, caused by rapid shifts in government fuel content regulations, will resurface at a time when economic prospects are improving. Obvious beneficiaries are distillate refining margins and refining stocks.

Our research shows that distillate crack spreads will soon widen as global economic growth strengthens. Some of this may be priced into the distillate forward price curve. As a result, we anticipate onlytactical opportunities (i.e. not “buy and hold”) from the long side.

One asset that has not anticipated a cyclical rebound in crack spreads is refining stocks. Refinery stocks are at the low end of their long-term range in absolute terms as well as relative to the broad market (Chart 1, bottom panel). The reason is that market participants believe that global refining capacity is in oversupply and therefore refining margins will stay low for the foreseeable future. Furthermore, some analysts are proclaiming the end of the distillate era, suggesting that massive investments in diesel capacity will not bring positive returns.

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