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For holders of the VanEck Vectors Oil Refiners ETF (CRAK), it’s unfortunately been a lackluster year. Since the oil market topped around October of last year, CRAK has fallen by 17% and underperformed the S&P 500 by 16%.
In this article, I will dig into the fundamentals of the refining sector and show what has driven this underperformance. Also, I will make the case that the immediate fundamentals have shifted, and it is now time to buy CRAK.
When examining the refining sector, an excellent starting place is to take a look at refining utilization across the entire country on a seasonal basis, as seen in the following chart.
This year, refining runs started at some of the highest levels seen for the beginning of the year. Not only was utilization high, but the tendency for refining capacity to creep upwards most years means that outright crude runs were some of the strongest we’ve ever seen in January.
A refinery makes a whole gamut of products, but the largest outputs are gasoline (at around 47% out of output) and distillate (at around 29%) of output.
This basically means that if you understand these two markets (gasoline and distillate), you can get a pretty good idea of what’s driving the refining sector and fueling the economic decisions of the refineries.
Gasoline
The gasoline markets have been quite volatile this year. At the beginning of the year, refineries massively overproduced gasoline and created a very large supply glut, driving inventories to the highest levels seen in at least 5 years for the first quarter of the year.
This increase in gasoline stocks has resulted in a substantial oversupply in inventories in one of the key regions for the refining sector, PADD III.
Given PADD III’s relevance as the location with over half of the refining capacity in the country, these stocks have directly impacted the economics seen for most domestic refiners.
Even though we saw strong stock builds at the beginning of the year, it’s important to note that gasoline stocks have strongly fallen since mid-February. With a year that started with one of the largest year-to-date builds in stocks, we have now reversed to one of the largest year-to-date draws in stocks seen in at least a decade.
In other words, there is a very significant switch at work in the gasoline markets: they are potentially changing from oversupply to tightness, which is excellent for economics.
Distillate
The distillate markets have been the bright spot of the refining sector for several quarters. As you can see in the following chart, not only have distillate stocks been weak versus the 5-year average, they seem to be on course for further weakness throughout the year.
It is important to note that these distillate draws are coming despite strong product supplied and net production.
Indeed, refineries have been so eager to fill the demand for distillate that they have been leaning heavily into distillate yield with current yields near the top of its 5-year range for most of the year.
Economics
The basic situation for each commodity is this:
- Gasoline (Becoming bullish) – Gasoline has been oversupplied, but that supply is drawing very quickly.
- Distillate (Bullish) – Distillate has been bullish for at least a year, and this trend doesn’t seem to be stopping.
When we are talking about the CRAK ETF, however, we need to look at the actual economics of each of these markets to get an idea as per earnings that refineries are either making immediately or will be making in the near future. The clearest barometer we have for this analysis is the crack spread. The crack spread is the difference between product prices and crude prices and serves as an excellent indicator of general direction and magnitude of refinery earnings.
Simply said, the gasoline crack has been on a tear. The U.S. Gulf Coast represents the location with the most refining capacity, and we have witnessed the gas crack switch from underperforming all year to massive strength in the last month as inventory draws have accelerated.
The NYMEX gas crack shows a smoother trend, with RBOB prices rallying versus crude prices in all but 1 of the last 10 weeks.
When examined in a standard charting format, the strength of these rallies can be put into additional perspective.
Across the entire country, we are seeing gasoline cracks rally to nearly the highest levels seen since Hurricane Harvey in 2017 in one of the fastest switches ever seen. This is strongly bullish for the refining sector in that refineries across the country are now earning significant margins for their largest product. The CRAK ETF hasn’t reflected this fact, which, I believe, represents an excellent buying opportunity.
Distillate cracks have rather consistently told the same story, and that story is one of strength. When examined from the same trend basis as our previous chart, it can be seen that distillate has remained strong and continued to trend upwards in most quarters of the past two years.
I believe that now is an excellent time to buy CRAK. There are a few reasons for this.
First, there is a decoupling in price between the CRAK ETF and the fact that refining economics have now switched to be strongly bullish. The economic situation which has setup in refining over the last month is one of the best we’ve seen in several years.
Next, there is a favorable risk/reward situation in that prices for the ETF (and its underlying refiners) are already depressed. The economic situation strongly shows that refiners have had a few excellent weeks, and these weeks are bound to continue based simply on product inventories and supply situations. In other words, the upside here is much better than the downside.
And yet, CRAK ETF’s price has not budged. In fact, it’s done the opposite in that it’s seen a brief dip in performance over the last few weeks. This is an attractive buying opportunity. When you couple this with the fact that we’re headed into summer driving season, we are likely to see these economics persist at least through the end of summer. In other words, I think the next 4 months are going to be great for CRAK.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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