Where Is the Value in the Oil Sector? (original) (raw)

The best way to play this is via refining sector companies with the best earnings leverage.

As everyone seemed focused on what OPEC would or would not do at the Vienna JMMC meeting last week, it seems OPEC has become a bit like the Fed: too scared to see oil prices fall so prefer cutting (or rather leaving) production out of the market to give it some support. Be that as it may, it does give a sense of a floor price for Brent around 50−50-50−55/bbl. Of course, demand is always the harder part of the picture to predict and OPEC has learned their lesson well over last year and this year during two market corrections. What most people tend to forget is that oil is driven by its products gasoline and distillate depending on the season we are in. Oil is just the input that goes into process a barrel of these products. Now we are in the peak of the summer driving season where gasoline demand is key and gasoline inventories matter.

Officially gasoline driving season starts from June onwards till the Labor Day in September. As reported by the DOE, gasoline inventories have been drawing down for the past four consecutive weeks. From starting the year above the 5-year average at 250 million barrels, they have now come down to the 5-year average of 230 million barrels; trend has been improving. Gasoline demand has been averaging around 9.6 million barrels per day (mbpd), top end of the 5-year range. As we get into the heart of summer driving season, refiners keep buying oil to process it into gasoline, thereby raising their utilization rates to capture the higher refining margins.

Currently gasoline crack 321 generic refining margins are trading around $22/bbl. A big fire at a Philadelphia refinery, operated privately by Philadelphia Energy Solutions, occurred towards the end of June that caused roughly 335,000 barrels per day of crude oil processed out of the market. This is a quarter of the refining capacity in PADD1 region along the East Coast. PBF Energy (PBF) operates two refineries in the region with a combined capacity of 370,000 barrels per day. As the East Coast market tightens, PBF is a direct beneficiary of these increased crack spreads. Valero Energy (VLO) is one the largest independent U.S. refiners having exposure to the Gulf Coast and East Coast refining trends.

The crack spreads in the Gulf Coast increased from 12.9/bbl.inJuneto12.9/bbl. in June to 12.9/bbl.inJuneto15.6/bbl. towards end of June. If these positive trends continue, then Valero will deem to have very good Q319 numbers. Valero has been one of the more stable refining companies as its dividend growth this quarter has been 12.5% year over year. Currently its dividend yield is about 4.5%. It has maintained that it will adhere to strict capital discipline and will not increase its debt to purchase more shares (which is a lot I can say for most U.S. companies in S&P 500!). There has also been a pick-up in Short Interest in names like Valero and Marathon Petroleum (MPC) and Delek US Holdings (DK) as the companies may report a softer Q219 given refining margin trends during that time.

Fed Chairman Powell released his testimony statements to the Congress and surprised the market with a more dovish tone than expected, especially as they just held their June FOMC meeting whereby the word patient was removed but still suggested some monitoring of data was needed to make a call for rates being cut or not. What is even more surprising is that over the last two weeks, the "uncertain" outlook regarding trade risks had settled down as a trade truce was declared between presidents Trump and Xi in Osaka. In addition, non-farm payrolls reported last Friday were extremely positive, beating expectations. So, one wonders, what happened in last two weeks that caused "many Fed officials to see a stronger case for somewhat easier monetary policy", especially as the S&P 500 market touched an all-time high today of 3000.

Trump's pressure directed to Powell may have affected his view on cutting rates in July to offset the increase in December. For now, that should please the market. Low and behold the dollar fell and markets rejoiced as they once again got the fix they desperately needed. This should boost commodities short term that have been beaten up recently on growth slowdown fears.

Oil has gotten a boost from OPEC production cuts, together with tight gasoline markets and higher demand from refiners to process more product. Throw in a dovish Fed and you have a supportive buy case for oil. The best way to play this is via the refining sector with the best earnings leverage to this environment. Names like Valero and PBF Energy seem attractive buys here.

At the time of publication, Maleeha Bengali was Long VLO, PBF.