Hurricane Fuels Refinery ETFs More Than Oil

August 31, 2017

The energy sector can't catch a break. Still reeling from the worst oil price collapse of the modern era, the industry just got hit by another hammer in the form of Hurricane Harvey. This week, the monster storm wreaked havoc on Texas, while shuttering countless oil wells, natural gas wells and refineries in the state and surrounding areas.

On a personal level, hurricanes like Harvey are nothing but horrific, with the incalculable damage they inflict on people and property. But when it comes to energy stocks, these storms are sometimes a boon. In 2005, when Hurricanes Katrina and Rita swept through the Gulf of Mexico before making landfall in the U.S., energy prices surged to record highs, pushing energy stocks up along with them.

This time, there's been no such lift for the beleaguered energy sector. Oil prices hit a one-month low around $46 on Tuesday, and the Energy Select Sector SPDR Fund (XLE) traded close to its lowest level of the year, down 15.8% year-to-date.

 

YTD Return For XLE, WTI Crude Oil

 

Energy is by far the worst-performing stock market sector of 2017 and, along with telecom, is only one of two sectors in the red for the year.

Demand Destruction

On the surface, it may be puzzling that energy prices and ETFs have fallen despite significant disruptions to supply. According to a Barclays report published on Tuesday, more than 500,000 barrels per day of oil production and 1.5 billion cubic feet of natural gas production is offline due to the storm.

However, traders may be shrugging off these disruptions because the negative hit to demand from the hurricane may more than offset the supply losses.

"At this point, the market appears to have determined that oil demand impacts may outweigh the supply-side impacts," said the authors of the report. Flooding, destruction and high fuel prices cut oil demand by almost 1 mb/d in the aftermath of the 2005 hurricanes, roughly twice as much as the usual seasonal downturn from August to September, they pointed out.

 

Meanwhile, the situation could be even worse for natural gas, which was last trading just below $3/mmbtu and showed little reaction to Harvey.

About 295,000 electricity customers are without power, mostly in Texas, which dampens demand for the power-generating fuel. Moreover, the storm is also disrupting liquefied natural gas exports and exports to Mexico, leaving supply stranded in the U.S.

"Shifting geographic fundamentals mean severe storms will be increasingly bearish for natural gas prices," the Barclays report warned, while noting that the importance of natural gas production in the Gulf of Mexico is down substantially over the past decade, accounting for 4% of the nation's supply, down from 15%.

Refiners Buck Trend

With energy prices flat to lower in the wake of the hurricane, it's no wonder energy stocks continue to struggle.

Within the broader sector, almost every subgroup is hurting. From oil producers to natural gas producers to energy service companies to MLPs, they're all down―with one exception: oil refiners.

At the same time that the broader energy sector has dripped lower day by day, oil refiners have silently moved higher. The VanEck Vectors Oil Refiners ETF (CRAK), which holds stocks of firms that generate more than 50% of their revenue from oil refining, spiked to a fresh record high just this week.

The chart for CRAK, which is up 22.4% year-to-date, is essentially the mirror image of the chart for the aforementioned XLE.

 

YTD Returns For CRAK, XLE

 

 

Crack Spreads Surge

Unlike most other energy stocks that are largely driven by oil and natural gas prices, refiners are more concerned about the spread between crude oil and refined product prices, also known as the "crack spread."

The crack spread "measures the difference between the purchase price of crude oil and the selling price of finished products, such as gasoline and distillate fuel, that a refinery produces from the crude oil," according to the Energy Information Administration. "Crack spreads are an indicator of the short-term profit margin of oil refineries because they compare the cost of the crude oil inputs to the wholesale, or spot, prices of the outputs."

If there's one area of the energy industry where Harvey has had the greatest impact, it's refining margins. Analysts at Raymond James and Wells Fargo estimate that 2 million to 3 million barrels per day of refining capacity―equal to 15% of the nation's capacity―are offline due to the storm, tightening supplies of gasoline, diesel and other refined products.

The 3-2-1 crack spread, which roughly measures the profit margin of a refinery that processes three barrels of crude into two barrels of gasoline and one barrel of diesel, surged 37% since last week, as product prices soared while crude prices faltered.

With many refineries likely to be offline for some time due to extensive flooding, crack spreads and refining stocks may remain well-supported, said analysts.

Periods Of Disruption

"Overall, each refining company will tend to benefit (at least from a margins, earnings, and stock price perspective) from periods of disruption like this, even if they have assets affected," analysts at Raymond James wrote on Monday.

Wells Fargo analysts agree. "Crack spreads are likely to remain elevated and refining equities are likely to respond positively," they wrote on Sunday, while adding that refining stocks have outperformed the broader stock market by 6% to 19% in the 10-20 days following a major hurricane landfall.

On the other hand, Barclays analysts cautioned that refined product cracks are likely to sag in the months ahead, depending on how quickly refineries return.

"The post-hurricane trend is clear: the strength in cracks may be short-lived, with the 3-2-1 crack halving in subsequent weeks despite the hurricanes’ impact on refined product supply," they said.

Contact Sumit Roy at [email protected]

 

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