March 14, 2015
Major Market Disconnect
Sets Up 69% Trade
By Jared Levy
There's a huge disconnect in the market right now... and it has created an even bigger opportunity.
So far in 2015, oil prices have plunged 16%. Yet, during that same time period, fuel prices have jumped 6%. History shows we can make a 69% gain in the coming months thanks to this anomaly if you know where to invest.
Let me explain...
There's a huge supply of oil in the market. The most recent EIA Petroleum Status Report showed an inventory build of 10.3 million barrels of oil, more than double analysts' expectations for an increase of 4 million.
As you can see from the chart below, inventories (blue) have not just been growing... they've been consistently exceeding expectations (orange line) for most of 2015.
Generally, oil producers slow production if they see a glut of supply, but that hasn't been the case here. With nowhere for the crude to go, storage prices are at a premium, and one of the only ways to move that oil out of storage is for oil prices to fall.
Well-respected analysts at both JP Morgan (NYSE: JPM) and Goldman Sachs (NYSE: GS) believe oil is likely to stay below $50 for at least the first half of 2015... potentially lower if the market can't find a way to drain the current surplus.
So with oil inventory at all-time highs and crude prices just a few dollars above six-year lows, you'd expect fuel prices to be dropping as well right? Wrong!
According to EIA data, the average price of fuel (all grades and formulations) has been steadily climbing since mid-January despite the surplus of oil, and is now at $2.49.
To further demonstrate this disconnect, I want to show you another chart. The below chart shows the crack spread, which is industry jargon for the difference in price between crude oil and petroleum products extracted from it.
When the crack spread rises, it means the petroleum extracts, such as fuel, are rising faster than the price of crude oil. Year to date, the spread has jumped from $3.50 to $19.90 -- a 469% increase. The current spread is also twice as wide as the 20-year average of $8.73.
While a large spread does not help most oil producers, it's great for oil refiners -- the companies that turn crude oil into distillates like gasoline. When input costs (oil) are low, but fuel prices are rising, these refineries can capture bigger margins.
And there's one best-in-breed refiner that is not only cheap from a fundamental standpoint, but also exceptional at squeezing dollars out of low-grade crude: Valero (NYSE: VLO).
Out of all U.S. refiners, I like it best because of its large size, unique technological edge and low valuation compared to the sector.
Valero operates 15 refineries, with a capacity of 2.9 million barrels per day -- 15.7% of U.S. daily oil consumption reported in 2014. In addition to wholesaling its petroleum products to other distributors, Valero also operates its own fuel stations in nearly every state. This allows unique price controls for its final product.
The company operates two unique and proprietary devices called hydrocrackers, which are uncommon in the industry. Hydrocracking units transform cheaper, lower-grade feedstock (oil) into high-quality distillates (gasoline) at more efficient rates than the traditional equipment used throughout most of the industry.
Valero's two hydrocrackers, located at its Port Arthur refinery and St. Charles plant, give it an added advantage over competitors when it comes to margin and the creation of products such as jet fuel, kerosene and diesel. VLO has been increasing output of these hydrocrackers over the past two years and is continuing to push for further expansion.
Despite the company's size and technological advantages, Valero's price-to-earnings (P/E) ratio is just 8.85, making it 51% cheaper than its peer average. The rest of the metrics also favor VLO comparatively.
But the real opportunity lies in the fact that Valero is now buying oil 50% cheaper than last year, but has only had to reduce its selling price by 35%. Incredibly, shares are actually lower than where they were last year, despite the cheaper costs, increased consumption and improved margin.
When Valero hit a high of $59.69 in May 2014, oil was trading at $100 per barrel and a gallon of gasoline cost $3.76. Today, crude is trading for $50 and gas is at $2.45 -- a much better profit ratio and overall environment for refiners -- but VLO shares are only trading for $57.
I expect VLO's earnings per share (EPS) to hit $6.50 in 2015. Using a forward P/E of 10 (a realistic multiple looking at five years of forward P/E history) puts VLO at a fair value of $65. That's only 11% above current prices. But using my profit amplifying strategy, we could make 69% in only three months.
Specifically, I recommend buying (to open) VLO Jun 55 Calls for $5.90 or less.
This call option has a delta of 65, which means it will move roughly $0.65 for every dollar that VLO, but it costs a fraction of the price of the stock.
The trade breaks even at $60.90 ($55 strike price plus $5.90 options premium), which is 4% above current prices.
If VLO hits my $65 price target, the call options will be worth at least $10 ($65 stock target minus $55 strike price). That means we can make 70% from an 11% increase in share price.
Note from the editor: These are exactly the type of lower-risk/high-reward trades Jared publishes each week in his new Profit Amplifier newsletter. And using options, Jared can amplify gains from stocks that move up or down. And considering the bull market that started in 2009 has lasted longer and gone up further than most in market history, I think it's critical that investors at least learn more about how options can help them minimize risk and even make money in a market crash.
That's why we've made Profit Amplifier available at a 50% discount for the next few days. We want to make his newsletter accessible for every investor that's interested. So if you want to learn more about Jared's service, I urge you to click here before Tuesday, March 17. | |
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