It is not every day we see a $10 billion company like Valero Energy (NYSE:VLO) shed 20% of its value. When it happens, it is certainly action worth investigating.

The sudden decline comes thanks to the company’s executives estimating a fifty-cent per share Q2 loss, versus $0.59 per share earlier estimates and $0.74 per share consensus projections. The jaw-dropping news sent shares of competing refiners into the dumpster as well.

Frontier Oil (NYSE:FTO) is down over 15%. CVR Energy (NYSE:CVI) is down over 17%. And Suncor (NYSE:SU) is down by 8%.

The more a company’s profits rely on refining revenues, the deeper the decline.

The day’s action has created opportunities for options investors.

Sure, things are bad at Valero, at least in the short run. But its competitors do not face such a bleak outlook.

The market makes mistakes

Valero claims its Q2 loss will be due, in part, to its temporary shutdown at its Delaware City facility as well as unfavorable margins, especially in the diesel market. There is no doubt volatile crude prices over the last six months have made managing the business extremely difficult. Margins have been anything but predictable.

Refiners must walk a thin line to reach maximum profitability. Much of their fate relies in the hands of energy traders. Creating and sustaining maximum margins takes incredible financial diligence and hedging. Get one calculation wrong and, well, just look at Valero.

But as I said, Valero’s problems are not systemic. The industry as a whole should not have dropped by such large levels today.

For options investors, it spells an opportunity to buy short-term calls. Front-month calls carry the most reward, but are the most risky.

CVR Energy’s June 7.50 calls are worth looking at. And Suncor’s June 33.00 calls are worth your time.

The best profits will come if the markets make a significant rebound off of today’s depressing action. Even if the next several weeks offer moderately bullish action, the profit potential is eye-opening.

Big, industry-wide moves like we saw today are what options investors depend on for triple-digit gains. The market does not make such big mistakes often, but when it does the profits can be spectacular.

Source: Take Advantage from the Refining Industry Fallout

Spreading Your Bet Without Losing Any Profits

Instead of outright betting on oil’s price, let’s use the spread between oil and gas. After all, some of the largest companies in the world do this. All the large oil companies (ExxonMobil -NYSE:XOM-, BP, Shell -NYSE:RDS.A-, etc.) do it by owning refineries.

Now, to be fair, most of their profits don’t come from the refinery process. But big money is still out there for the taking. Just take a look at industry leader Valero (NYSE:VLO). Last year, while it may not have been a normal environment for a energy related business, Valero brought in $119 billion in revenue.

Unfortunately, most of the money disappeared because, as a refiner, the company had to purchase the oil to process. Oil hit $147 last year, which certainly put a dent in Valero’s bottom line.

So, the question if oil is rising again, will gas and heating oil follow? And if so, by how much?

Inviting the Mathematicians to the Oil Field

The most important figure in the refinery business is something called the crack spread. Using a West Texas Intermediate (WTI) crude refining model, the ratio is three barrels of crude (cost), two barrels of gasoline (gain), and one barrel of heating oil. That’s written like this: 3-2-1. If you are using OPEC grades, which produce less gasoline, the ratio is 2-1-1.

Until you see where it’s been and where it’s going, all this info is useless. Here’s a frame of reference:

Cracking the Crack Spread

As you can see, it’s been all over the board the last few years. It even went negative at one point last year, which means the refinery loses money on every single barrel of crude it processes.

We expect, over time, that this spread will stay above $7, probably even north of $10 or $12. This is not an exact science. Not only are we guestimating, we’re using a number that is only relevant to refinery investors, not refineries.

You see, every refiner has pays a different price for its oil, and has contracts set months ahead of time for the sale of its gas and heating oil… not to mention the other products that come out of this system (coke, propane, butane, slurry, sulfur, etc.).

So every refinery has its own crack spread number. And that can vary far less than what the above example would have you believe. For instance, do you think that a refiner will take a contract to sell its products at a lower price than its contract to purchase the crude? Absolutely not. So, other than extreme cases, its unique spread will never be negative.

We found a refiner that is doing just fine, and even has a leg up on competition through a unique business pairing.

Unlikely Paring Presents a Lucrative Penny Stock Opportunity

We’re talking about CVR Energy Inc (NYSE: CVI). CVR is a domestic refiner with operations in Coffeyville, Kansas — about 100 miles from Cushing, Oklahoma, which is a major crude oil trading hub.

Its refinery business brought in $4.8 billion last year. That’s quite a bit of business for a penny stock. And that’s not even the most interesting part about this play.

The company has a second segment that accompanies this petroleum business perfectly: nitrogen fertilizer manufacturing. You might not think of these two operations as brother and sister, but I assure you they are.

There are two ways to make nitrogen fertilizer: by using coke or natural gas. Natural gas is the obvious one everyone chooses because it is convenient and easy to transport.

CVR is the exception to this rule. It uses coke from its refinery, which is located right next door to the fertilizer plant. This cuts out one of the major costs of running a fertilizer business, and coke is just a by product of its refinery business.

Both segments have been a bit volatile over the last 12 months. With oil and gas prices spiking mid-summer last year, it caused the company to become much more flexible.

CVR’s refinery business, for example, moved from a complexity of 10.3 to 12.1 last year. A refinery’s complexity is a number that describes its flexibility to maximize yields (getting the most out of every barrel of crude and staying economical). This is a fantastic complexity ratio. It beats Valero’s average, which is the lowest cost refinery business in the country.

When you combine the next-to-no cost of CVR’s fertilizer business with the efficiency of its refinery business, you get one of the most attractive companies in either industry. And right now, it’s a steal for just a little over $8 per share.

You can’t ask for a better way to play America’s two favorite vices: gas and food.

Sincerely,
Jim Nelson

Source: The Perfect Refinery Penny Play