Oil Refiners: Cheap for a Reason

With gasoline and diesel fuel prices where they are, it figures you'd have gigantic moves in the shares of independent oil refiners. Consider some of these price moves over the past year: Frontier Oil (symbol FTO) 28%. Valero Energy (VLO) 40%. Tesoro (TSO) 63%. Alon USA Energy (ALJ) 64%. Western Refining (WNR) 76%.

Now, here's the punch line: All of these numbers represent losses, not gains. While pipelines, oil producers and energy-service companies enrich stockholders, refiners are doing just the opposite.

Believe it or not, the business of buying crude oil and "cracking" it into gasoline, diesel, jet fuel and heating oil is losing money. It really is hard to believe, considering that everything this industry sells fetches 50% more than it did a year ago.

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But just like bakers who are staggering from the rising cost of flour or ice cream makers who are paying through the snout for milk and cream, refiners are squeezed by the rising cost of crude, whose price is rising much faster than the price of gasoline.

From the start of 2004 through the end of 2007, the gap between the cost of crude and the price of refined products was wide. During that period, the gap -- called a "crack spread" in the trade -- peaked at $28 a barrel in May 2007 for the spread between Brent crude and unleaded gasoline. In some locations, the spread reached $40. The normal historical spread is about $20. Shares of Tesoro soared nearly nine-fold from the start of 2004 through October 2007.

But starting in the spring of 2007 the crack spread started to narrow. It disappeared altogether this past winter, before recovering in March. Valero says its spread averaged $8.50 in the first quarter of 2008, a weak showing.

Refiners bear heavy maintenance costs and big debt loads and spend the billions to buy or build capacity, so slim spreads mean that little money sinks to the bottom line. If you're a stockholder in a refinery (as opposed to a company that both produces oil and refines and sells it, such as ExxonMobil or BP), it doesn't matter whether a gallon of gas retails for $1.50 or $4.00. What's critical is the cost of goods sold (crude oil and additives) in comparison with the market price of the refined products and the conditions that determine whether and when the spread widens or narrows.

Crack spreads are so small now because of the unprecedented speed with which crude prices have leapt. This has prompted some refiners to rush to buy oil on the spot market to get supplies under control before prices go even higher. That helps contribute to -- you guessed it -- still-higher crude prices.

Rage if you want at the owner of your local gas station, but if crack spreads were at last year's levels, you'd be paying more than $4 a gallon in most of the U.S. and more than $5 in California.

Tesoro chief executive Bruce Smith told an investors' conference in February that in Hawaii, Tesoro had been paying $15 a barrel above the posted price for West Texas Intermediate crude. Tesoro couldn't pass its higher costs along, even though gas costs 30 cents a gallon more in Hawaii than the national average. The result is declining profits for refiners and sinking share prices.

To cite just one example, Tesoro, which closed May 9 at $21.90, is 62% below its October high. The question now is whether the stock and others in the group are cheap enough to buy.

The answer: Not until crude oil prices ratchet down. Refiners' gross margins will be slim and company earnings nonexistent until their biggest expense, crude oil, starts falling. Then you'll see earnings bump up as crack spreads widen before prices of finished products retreat. At that point, the stocks should jump.

As is always the case, specific company developments affect why one stock does better or worse than another. On May 7, Valero sold a refinery in Louisiana to Alon for what works out to $4,000 a barrel of capacity. In 2007, Western Refining paid about $15,000 a barrel to acquire Giant Industries and its three refineries in Virginia and New Mexico (plus a few gas stations and oil terminals). That steep price, just as crack spreads started to weaken, explains why Western's shares have been the worst of this sorry bunch.

Don't expect the oil giants to buy out the independent refiners. A few years ago, when gasoline prices first crossed $2 a gallon, executives from Big Oil said flatly that it made no sense for them to build refineries because returns wouldn't be sufficient. And that was when crack spreads were wide.

Refining stocks should rebound from their 52-week lows in coming months because summer gasoline blends required in some states are more profitable than fuel sold the rest of the year. But the real possibility that Americans will cut back on driving is a potential negative.

Tesoro and some of the other refiners have planned to address profit weakness by retrofitting facilities so that they can process cheaper grades of "sour" crude, which can cost $20 a barrel less than the light sweet crude that's most easily refined into motor fuels. But these ventures require enormous capital expenditures and a lot of time, so they don't promise any quick fixes for shareholders.

When the cycle turns, you'll have plenty of time to get in and make good money. But for now, stick to the other parts of the oil and gas industry.