Back to Main

How Oil's "Crack Spread" Can Lead to a 37% Gain

By: Melvin Pasternak
Posted: 2/24/2011 1:00:00 PM
Referenced Stocks: CVX;VLO;WTI;XOM

My colleague Nathan Slaughter knows just about everything there is to know about the energy industry.

He's been warning investors that just because the price of oil is touching $100 a barrel doesn't mean you should necessarily buy stocks like ExxonMobil (NYSE: XOM ) or Chevron (NYSE: CVX ) .

There's good reason for that. As he puts it: "It's the relationship between oil and gasoline -- called the 'crack spread' -- that determines profitability of an integrated oil company. So don't assume that $3-a-gallon gasoline automatically means a cash windfall for major oil companies." [ Go here to find out what Nathan likes instead.]

But I've found a company that depends on the "crack spread" for its profits.

Formed in 1980, this Texas-based Fortune 500 company is the largest independent oil refiner in the United States. It operates 14 refineries across North America and the Caribbean.

The company is one of the largest U.S. gas retailers, operating nearly 6,000 stations across North America, under brands such as Ultramar, Beacon and Diamond Shamrock.

It is also a top ethanol producer, operating 10 ethanol plants around the U.S. Corn Belt.

The name of this super-sized Texas giant?

It's oil refiner Valero (NYSE: VLO ) -- whose stock is trending near a two-year high -- thanks to an increasing "crack spread."

What's the crack spread? To elaborate on how Nathan described it, it's basically the difference between the amount a refiner pays for crude oil and the cost to refine this oil. The greater the price differential, or spread, the more the refiner makes. The term comes from "cracking" large chains of hydrocarbons into smaller, finished molecules used for products like gas and diesel.

Crack spreads have increased nearly four-fold since September 2010. And in February of this year, they touched $25.43 U.S./barrel -- their level highest since 2007.

Pushing up the crack spread is the hefty supply of thebenchmark crude oil West Texas Intermediate ( WTI ). There is excess supply of this U.S. feedstock because there is not enough pipeline capacity to move the crude to the big Gulf of Mexico refineries.

Excess supply has meant Valero has had to pay less for the crude -- a perfect formula for the refiner's profits.

As a result, Valero's stock has been soaring.

Between 2009 and most of 2010, Valero was trapped between long-term historical support (labelled on the chart below) near $14.85; and old resistance, which has become new, major support (marked on chart), near $22.81.
 

Treading near $14.85 support in August 2010, the stock bounced off this level to form an intermediate-term uptrend line (marked on chart). In late December 2009, the stock broke old resistance, now major support, at $22.81, bullishly completing an ascending triangle .

Now on an accelerated uptrend, Valero has been almost unstoppable. On Feb. 16,shares jumped to their highest level since 2008 after RBCCapital markets upgraded the stock.

Encountering resistance around $30.42, the stock pulled back slightly this week, along with overall market weakness. However, the stock remains on an accelerated uptrend and appears to be forming a second ascending triangle pattern with resistance just above $30.

If Valero can break minor $30.42 resistance, the measuring principle for a triangle -- calculated by adding the height of the triangle to breakout levels -- projects a price target of $41.77 ($30.42 - $19.07 = $11.35; $11.35 + $30.42 = $41.77), a price not seen since 2008.

Fundamentally, the stock shows strong growth potential.

In the fourth-quarter of 2010, revenue increased 24% to $22.2 billion, from $17.9 billion in the year-ago quarter. Increased crack spreads, combined with growing retail and ethanol sales drove up revenue. From the year-ago quarter, retail sales increased $61 million, while ethanol sales jumped by $70 million.

For the full 2011 year, analysts project revenue will increase 9.9% to $90.4 billion, from $82.2 billion. By 2012, revenue is projected to rise another 8.7% to $98.3 billion.

Although fourth-quarterearnings were negatively affected by the sale of the company's interest in the Cameron Highway Oil Pipeline, Valero still managed to slim its earnings loss to $0.77 a share from a $2.51 per-share loss in the fourth quarter of 2009. Excluding the sale, earnings would have been $0.32 a share.

For the full 2011 year, earnings are expected to rise 61% to $2.61 from $1.61 a year ago. By 2012, they are projected to edge up a further 17% to $3.04.

Valero also has an attractive price-to-sales ( P/S ) ratio near 0.2 and  offers a forward annual dividend yield of about 0.70%.

Action to Take -->
With strong technical signs and growing fundamentals, driven by a wide crack spread, I believe Valero offers a good trading opportunity and is a strong buy if it can penetrate $30.42 resistance. If you were to use my $41.77 target as calculated by the measuring principle and the $30.42 resistance as an entry point, you could see a 37%profit from this trade.


-- Dr. Melvin Pasternak

P.S. -- Nathan Slaughter has been doing some intense research into natural resource plays. The supply/demand imbalance for nearly every basic good around the world is leading to soaring prices for gold... wheat... copper... even uranium. So on March 8 at 1:00 p.m. EST (with opportunities for later viewing), Nathan will conduct a special free web presentation to discuss his findings. In it, he'll discuss three commodity markets that have reached a critical supply/demand imbalance that could create big profits for investors. For more information and to sign up for the free presentation, follow this link.

Disclosure: Neither Melvin Pasternak nor StreetAuthority, LLC hold positions in any securities mentioned in this article.