A Refiner With a Big Edge

04/24/2008 12:00 am EST

Focus: STOCKS

Michael Murphy

Former Editor, New World Investor

Michael Murphy, editor of New World Radar Report, says Holly’s advanced technology enables it to get more from a barrel of oil than its competitors can.

With the summer driving season coming up, the price of oil is likely to hold near current record levels, and gasoline will go up from its record $3.50 a gallon. The oil refiners' stocks tanked beginning last summer, and a little recent rally based on hopes that higher gasoline prices are restoring profit margins seems to be reversing. 

There hasn't been a new refinery built in the US in 29 years, and there won't be another one for at least ten more years. But with our gasoline consumption up almost 50% over the same period, refiners are in the key spot to capture a lot of the value added between a barrel of oil and a tank of gas.

The key to these stocks is the “crack spread,” or the difference between the selling price of all the products that come out of a barrel of oil and the cost of that barrel. But when the price of oil is shooting up, product prices tend to lag and the crack spread and refining margins get squeezed.

The New York Mercantile Exchange crack spread is [around] the $12 area. I expect the summer driving season to drive it to $20 or more. The rally in the [refining] stocks should approach 50% just from this move in the crack spread.

Holly Corp.’s (NYSE: HOC) first advantage is that it can process "heavy" or "sour" crude oil, which sells for $10 to $30 a barrel less than sweet crude. Its advanced technology [can] handle these harder-to-process oils, including bitumen from Canadian tar sands.

Second, Holly recently upgraded its refineries by investing in hydrocrackers that can convert 90% of a barrel of oil to gasoline or diesel, while their competitors can convert only 50% to 70%. Heavy crude sells at an average 20% discount to light sweet crude, yet Holly can get more barrels of gasoline out of a barrel of heavy crude than their competitors can out of light sweet crude!

Holly has made money for each of the last 32 years, and hit $5.98 in earnings per share last year. I expect it to [earn] around $4.00 a share this year and $6.00 in 2009. The stock is selling for only seven times trailing earnings, and [less than 11x] this year's depressed estimate.

The independent refining industry will take advantage of the summer driving season to pick up some extra pricing per gallon, and sentiment towards this sector should change quickly. Right now, three brokerage firms are bullish, four are neutral, and one is bearish. The last two analyst actions in mid-March were downgrades. There's plenty of negative sentiment to fuel a sharp move up.

I want you to buy HOC under $48 for a $70 target, possibly as early as Labor Day. (The stock closed below $43 Wednesday—Editor.)

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