This is a particularly interesting issue if we consider the long-term future of refiners. I, for one, am a buyer of peak oil. It seems as though no one can verify the amount of oil the Saudis claim to have (maybe this is why their relief efforts have provided NO RELIEF in crude futures market), and the only new discoveries in recent years have come off shore in deep waters, which by definition are harder to come by because of their deep locations.
Petrobras seems to discover these types of oil fields all the time; there was the monumental oilfield back in november (which will cost them an estimated 240 billion dollars to retrieve), and one in the Campos Basin more recently. Despite these discoveries, crude has shrugged off this data, and continued its seemingly unstoppable ascent.
There have been many theses as to why Oil is going up, so lets briefly depict the most viable ones, without subjectivity….yet. These will be cookie-cutter, CNBC talking head explanations (or recaps for the least common denominator…ha!) Full Disclosure: I cannot stand Maria Bartiromo.
Back to the fundamentals…
- Supply & Demand issues: India and China have displayed booming economies, despite a stagnant US, and appear to be able to cover our decreased demand on their own.
- Weak Dollar: There isn’t much for the background on this one…the Federal Funds Target is still at 2%, primarily to bail out banks with bad paper. Many analysts speculate that Bernanke will raise rates by 25 bps at August’s FOMC meeting. Bottom Line: when the greenback decreases in value, a dollar denominated commodity will increase in value (because we need more dollars to buy the same quantity).
- SPECULATORS & Hedging Strategies: In order to hedge a depreciating dollar, investors (mutual funds, pension funds, hedge funds) have gone long oil because of the former two points.
Now that the framework is in place, we can finally delve into the probability of a sustainable pull back in oil.
Lets face it: the true driving factor of the oil run has been a booming economy in China, exacerbated by the fact that their Government has subsidized prices at the pump to the point which they have felt only an 18% increase year to date (compared to our outlandish 50%-60% change).
The only sign of a pullback occurred last Thursday, when China announced a decrease in their gasoline subsidy, resulting in an increase of 17%-18% for gasoline. This is an example of curbing demand. However what if there were an event which caused a natural decrease in demand…like a recession, or even a correction? This is an interesting prospect considering that the Beijing Olympics will end in August, and the potential mark of an end to their renaissance…could this be the chief reason driving Royal Bank of Scotland’s call for a global crash in 3 months?
Forgetting China for a moment, we can extrapolate a more certain outcome. I know we have never really had a strong dollar, only strong dollar policyat best. However Ben Bernanke was smart enough to figure out we had a Financial Crisis at hand, and that wasn’t so obvious to many. When we relieve ourselves of that wretched “core-inflation” statistic (or ex-food and energy), it is quite clear that average household income is being eaten alive. If Ben Bernanke is half the Fed Chairman he has been hyped up to be recently, he will increase rates rather aggressively in the coming months. This will result in a stronger dollar and should (key word) result in a noticeable pullback in oil…
If either of these outcomes seem remotely plausible, then you may be thinking of a way to play a fall in oil prices. One of the more obvious routes is by going long refiners. Two come to mind, primarily because they have been smoked YTD: Valero (-38% YTD) and Tesoro (-57% YTD).
Note: Tesoro is down by a greater amount for good reason. Their refineries are constructed to handle the more accessible “light sweet crude” which will be more scarce going forward. They have experienced far greater losses due to poor hedges. Valero has a competitive advantage, in that they have the capability to refine both the muck which Venezuela sends us, and the lower grade which Brazil will be sending the US for years to come.
Both companies have been victims to pinched margins. They buy crude (spot or future) and sell it for the fixed price at the pump. As the article says, they will continue to lose money until one input corrects; crude needs to drop, or gas prices need to rise. The fundamentals seem to point to one of these happening, at least for a little while.
Therfore on an intermediate basis, Valero should be a great trade (its around 42.80 as I write this). My price target is $52.oo, but would begin to scale out around $48.oo. I think it could go as high as $55.oo, but that may be a reach. If all goes to plan, this is a near 25% return on a 3-4 month time frame. Normally, I would talk about fundamentals/option strategies, but this post is already too long.
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