Hey trader,
Gas is over $4 a gallon right now with oil at $75.
Go back to 2007. Oil was in a similar neighborhood and gas was nowhere close to that…
Same commodity, same country, wildly different price at the pump…
So today I want to walk through what actually changed, because the answer explains the best trade in energy this year and the reason it’s about to get dangerous.
Ask yourself what kind of system this is
We can’t build refineries in this country.
EPA policy has made it effectively impossible, and we’ve had major closures on top of that over the last four years. So whatever refining capacity we have today is all we’re going to have.
Now think about what that describes. A handful of players control the supply of something everybody needs, and nobody new is allowed to enter.
There’s a word for that. We had a ratings agency version of it going into the financial crisis, where a few firms controlled the whole market. What we have in refining right now is a government-mandated cartel.
Have you ever thought about it that way?
It gets worse at the state level. California has real production capacity and imports Brent crude instead, which is the most expensive oil in the world. Then it mandates multiple different blends, which pushes capacity utilization down further and prices up.
Out West we have almost no refiners at all, so prices are quick to go up and slow to come down. We’ve been pushing $4.50 and $5 in the last week on $80 oil.
That’s not a market outcome. That’s a policy outcome.
Why that made refiners the best trade of the year
A refiner doesn’t sell oil. It buys oil.
Valero and Phillips 66 are oil buyers who make a product out of it, so their entire profit is the gap between what crude costs them and what gasoline sells for. The industry calls that gap the crack spread.
Cap the supply of refining and that gap gets enormous. Which is exactly what happened, and it’s why those stocks have been the strongest thing in the sector all year.
And why I think it’s the next shoe to drop
The spread is contracting.
It’s coming down from a record, so this isn’t a collapse. But the trend right now is down, and refiners get squeezed in both directions.
If oil rises and gas doesn’t rise fast enough, margins compress. If oil falls and gas falls faster, margins compress. The second one is what we’re watching happen.
Look at Valero. Phenomenal earnings beat last week. The stock gapped down, then rallied, then held, and today it’s printing a bearish belt hold into the lows.
That’s a stock sitting at its highs with the mechanism underneath it moving the wrong way.
What the flow is telling me
I went hunting for it today and the direct names were quiet. Nothing compelling in Valero, Phillips 66 or Marathon on the console.
The trade showed up one level out. Yesterday somebody bought 5,000 puts in XLE for the August 14th expiration at the 56.50 strike, and there was bearish activity in XOP as well.
That landed a full day before the pressure showed up on the tape.
Where I’d look
Straight refining is the purest version and the most exposed to the spread.
Or an integrated name like Exxon or Chevron, which produces, refines and distributes, so it carries exposure across the whole chain. On Exxon I’d want to see a break through, then a retest, maybe a two-thirds retrace back toward 165.
What I’m not doing is shorting oil. Oil could surge tomorrow on any headline out of the Middle East and that’s a coin flip.
The spread isn’t a coin flip. It’s a mechanical relationship between two prices, and the mechanism is already moving.
Brandon Chapman, CMT
Creator of Ghost Prints
