Are Refiners Losing Power?


By Sam Stovall Given the continued strength in crude oil prices, it's not surprising that shares of the companies that refine, market, and transport petroleum products have soundly beaten the overall market. Indeed, the S&P 1500 Oil & Gas Refining, Marketing & Transportation Index rose 31.5% year-to-date through Sept. 3, vs. a 0.2% decline for the S&P 1500. In the past 13 weeks, this subindustry index gained 4.8%, compared with the broader market's 0.8% drop. That performance has landed the group on S&P's industry momentum list.

Looking at the relative-strength chart below (which compares the rolling 12-month price performance for this subindustry index with the S&P 1500), the refiners appear to have begun their uptrend last summer. But now that the relative-strength line has moved above its "normal band" (as defined by one

standard deviation above and below its average relative price performance since 1990), is much of the move over?

Could be. Tina Vital, S&P's Integrated Oil & Gas analyst, believes much of this group's share-price run has already occurred. Her investment outlook for the refining, marketing, and transportation (RM&T) segment is neutral. The reason? While U.S. retail margins have widened over the past few weeks, S&P believes U.S. refining margins peaked in 2004's second quarter, though they should remain near current levels through 2005. But stable refining margins, in S&P's view, may be offset in part by higher turnaround and environmental costs at U.S. refineries due to the phase-in of more stringent gasoline specifications.

WIDER SPREAD. Vital notes that with Labor Day marking the end of the summer driving season, U.S. gasoline prices should continue to decline as demand subsides. The supply picture has improved as high gasoline prices and wide refining margins in 2004's first half encouraged U.S. gasoline inventories to build to the upper end of their five-year range. S&P expects U.S. regular-grade gasoline prices to drop below $1.80 per gallon this fall, down from $1.87 currently. However, with crude oil prices just below record highs, reflecting fears of supply disruptions and increased demand, S&P sees pump prices remaining above historical levels.

U.S refiners' margins can be influenced by the different grades of crude oil they're equipped to process. This is an increasingly important factor as the price spread between light and heavy crude oil has widened, leading to greater relative discounts on the less-expensive sour (high sulfur content) crude oil. Vital expects the spread will remain strong through next year.

Why is the price differential widening? Vital cites increased demand for sweet (low sulfur) crude as North American and European refiners comply with low-sulfur gasoline regulations and increased production of lower quality, heavy crudes from OPEC and other producers.

HEFTY "RISK PREMIUM." Oil market conditions will obviously play a major part in determining the direction of refined-product prices. Vital notes that with world economic growth expected to boost oil demand 3.3% in 2004 and 2.4% in 2005, vs. about 2.2% in 2003, OPEC raised its 23.5 million barrels-per-day (bpd) production quota by 2 million bpd from July 1 and 500,000 bpd more from Aug. 1. The move was in line with earlier calls by key cartel members to align targets with production.

While the physical oil market appears well supplied, says Vital, with very little spare OPEC capacity left, fears of disruptions have recently boosted prices for the benchmark West Texas Intermediate (WTI) grade of crude oil to above $49 per barrel -- which she believes includes a "risk premium" of over $10 reflecting factors such as Iraq instability, the continuing woes of Russian producer Yukos, and other factors.

Separately, crude oil inventories reported by the Organization for Economic Cooperation & Development recently increased to within a normal five-year range. However, the OECD "days of forward demand cover," a measure of how many days of future demand are covered by current inventory levels, remained low -- near 53 days -- in July, 2004. That level historically would imply oil prices of near $30.

FAVORING REFINERS. Using data from Global Insight, an independent economic forecasting firm, S&P estimates that WTI oil prices will drop toward $43 per barrel by yearend and average near $39 in 2005, reflecting reduced demand growth and increased supply from Saudi Arabia, West Africa, and Russia.

So what should investors take away from all this? In S&P's view, with world fuel demand on the rise amid limited refining capacity, refiners' fundamentals look favorable. However, the investment outlook remains neutral. Vital believes those refiners with low-cost positions hold a strategic advantage in this competitive, commodity-based segment. S&P's top-ranked names in the group are refiners with the ability to process lower-quality, heavy-crude feedstocks, such as Premcor (PCO) and Valero (VLO), both of which are ranked 4 STARS (accumulate).

Industry Momentum List Update

For regular readers of the Sector Watch column, here is this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) and their proxies (the highest STARS-ranked companies in the subindustry index; tie goes to the largest market value) as of September 3, 2004:

Industry

Company

Ticker

STARS

Price

Commodity Chemicals

Lyondell Chemical

LYO

3

$20

Consumer Electronics

Harman International

HAR

5

$99

Diversified Metals & Mining

Peabody Energy

BTU

4

$55

Fertilizers & Agricultural Chemicals

Scott's Co.

SMG

4

$64

Internet Retail

EBay

EBAY

5

$89

Internet Software & Services

Yahoo!

YHOO

3

$28

Multi-Sector Holdings

Leucadia National

LUK

NR

$54

Oil & Gas Exploration & Production

Apache

APA

5

$46

Oil & Gas Refining & Marketing & Transportation

Premcor

PCO

4

$33

Steel

Nucor

NUE

3

$80

Tires & Rubber

Cooper Tire

CTB

3

$23

Wireless Telecommunication Services

Nextel Partners

NXTP

5

$15

Required Disclosures

Standard & Poor's Stock Appreciation Ranking System (STARS)

5-STARS (Buy): Total return is expected to outperform the total return of the S&P 500 Index by a wide margin, with shares rising in price on an absolute basis.

4-STARS (Accumulate): Total return is expected to outperform the total return of the S&P 500 Index, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate that of the total return of the S&P 500 Index, with shares generally rising in price on an absolute basis.

2-STARS (Avoid): Total return is expected to underperform the total return of the S&P 500 Index, and share price is not anticipated to show a gain.

1-STARS (Sell): Total return is expected to underperform the total return of the S&P 500 Index by a wide margin, with shares falling in price on an absolute basis.

As of June 30, 2004, SPIAS and their research analysts have recommended 35.9% of issuers with buy ratings, 52.7% with hold ratings and 11.4% with sell ratings.

All of the views expressed in this research report accurately reflect the research analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request to Standard & Poor's.

Other Disclosures

This research report was prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"). The research and analytical services performed by SPIAS are conducted separately from any other analytical activity of Standard & Poor's. No research analyst that prepares a research report on a subject company has a financial interest in or is associated with that subject company. SPIAS is affiliated with other entities, which may receive compensation for performing services for companies covered by Standard & Poor's Equity Research Services.

Disclaimers

This material is based upon information that Standard & Poor's considers to be reliable, but neither SPIAS nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale so any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Stovall is chief investment strategist for Standard & Poor's


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