Generate Income With Undervalued Oil Stocks by Chad Shoop, The Sovereign Investor.
After just four days of March Madness, all the brackets have been busted — mine was busted after the first day. I had picked only one major upset, Harvard over UNC. (I am a Duke fan so I always want to see the Tar Heels head home early; clearly this doesn’t happen often.)
Harvard made it a great game, closer than any UNC fan would have imagined — but they don’t get any points for making it close. UNC ended up winning by just two points. Odd makers in Vegas actually were expecting UNC to topple Harvard by nearly 10 points.
Unfortunately, March Madness brackets don’t use the spread to even out the odds. If it did, I would still have been in good shape after day one.
But upsets aren’t just limited to basketball. The oil sector, too, has seen its share of busts…
Much like having a busted March Madness bracket, practically every invested portfolio took a hit as oil and oil stocks tumbled from their highs last summer, leaving you wondering when to jump back in, or add exposure, to this underdog sector.
Even though everything related to oil sold off, there is one group in the oil sector that has differentiated itself — oil refiners.
That’s because instead of it being an even match, there is a spread in the market that is stacking the odds in the refiners’ favor … and now is the time to jump in.
The Crack Spread
It’s known as the crack spread — the difference between the price of crude oil and the refined oil product (like gasoline). This is basically what sets the tone for oil refiners’ profit margins as they sell the refined oil for a higher price than the crude.
Clearly there are other inputs and factors that shape companies’ profit margins, but this lays the groundwork.
As the price of oil fell, oil refiners fell right alongside them because the crack spread tightened. But that has started to change dramatically in March.
While crude oil has slipped to new 52-week lows, prices at the pump haven’t followed suit. In fact, the national average for a gallon of gasoline today sits around $2.40, compared to an average of just $2.03 earlier this year. That’s 18% above what we paid at the pump when oil was even more expensive than it is today. Sure, it’s not consoling for consumer wallets, but it is a significant tailwind for oil refiners.
With the price of gasoline still well off its highs from last year, consumer demand remains strong and oil refinery companies are running at max capacity — churning out as much oil as their factories allow. And the beauty of it is that they are doing so as the crack spread is improving — which will equate to fatter profits in the quarters ahead.
Oil refiners also have a history of returning this improved profit margin right back to the coffers of shareholders in the form of dividends, largely because they are set up by a parent company for that exact reason – to generate a consistent stream of income.
Even though the fundamentals for oil refiners to generate fatter profit margins are already on the move, there are still several undervalued oil stocks in the sector. Lucky for you, I have found one that is yielding north of 14% and trades at just six times its 2016 expected earnings: CVR Refining.
Buying With the Spread
CVR Refining is a Texas-based oil refinery … and it is your underdog to bet alongside this spread.
The company is a master limited partnership (MLP). That means that it’s not taxed on its profits because these are all paid out as dividends. In turn, these dividends are taxed as income on you, but in return, you can expect a consistent string of income.
Aside from a 14% dividend yield, the best part is that even though this spread has improved and investors have begun to discuss its benefits, the stock is still trading well below its 52-week highs.
Assuming the stock will reach new highs in the coming year due to the improved profit margin and a shift in investor sentiment, we could see more than 30% to the upside by the stock simply returning to a reasonable valuation. Not to mention the 14%-plus gain from the dividend as well as any added boost we get from a turnaround in oil stock sentiment.
All told, I expect CVR Refining to generate a return north of 45% over the next 12 months — and that’s based on conservative valuations.
If the equity fetches a price-to-earnings multiple of just 14, the average amongst its peers, the shares and dividend combination would generate 165% gain in less than 12 months.
Not a bad return for using the spread to stack the odds back in your favor in these undervalued oil stocks.
Editor, Pure Income