Do Refining Stocks Have Anything Left in the Tank?
Refiners posted strong gains in 2010, but additional upside may be limited.
Refining stocks are on course to post strong gains for 2010 after suffering declines the previous two years. Much of the share price appreciation took place in the last few months as the recovery in margins showed resilience. After reaching their lows in the fourth quarter of 2009, refining margins remained anemic in the first quarter of this year. However, they soon recovered in the second quarter buoyed by seasonal factors such as low capacity utilization and rising demand that typically result in stronger crack spreads. At the time we believed that the second quarter would mark a high point for the year and that refiners may find the rest of the year more trying. Instead, several key factors that proved beneficial to margins in the second quarter continued through the end of the year. Other trends later emerged that supported higher margins. These outside factors helped lead to the recent run in refining shares. Now many of the refiners in our coverage universe trade above our fair value estimates, leading us to wonder if further gains are possible. Below we examine several of these underlying trends and attempt to determine whether they will persist.
Improved Inventory Levels
In our last look at the refining environment, we highlighted the positive effect that first-quarter reductions in refining capacity had on inventory levels. At the time, refiners successfully reduced capacity utilization levels to allow for excess inventory levels to be consumed, resulting in improved margins. During the second quarter and throughout most of the third, refiners steadily raised utilization rates in anticipation of the summer driving season. However, thanks to maintenance, utilization levels began to fall again as the summer wound down. As a result, inventories did not continue to build and remained manageable. In the past two months, gasoline stocks have remained within their historical average range. Also, distillate stocks are at the top of their average range after spending the first nine months of the year well above. While product stocks moving into their respective historical average ranges are positive, the trend may not continue. In recent weeks refiners have been increasing production to take advantage of higher oil prices, which will create a greater tax deduction due to LIFO accounting. As a result, percent utilization capacity has increased, while inventory levels--particularly for gasoline--are starting to build. After the year's end, refiners could very well curtail some production to keep inventory levels in check, but those types of responses typically lag. Consequently, we could see inventory levels move back over their historical average ranges if not met with higher demand levels.
Allen Good does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.