Gasoline Freefall - Valero Yet Again

By Dr. Duru written for One-Twenty

September 10-11, 2006

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Everytime I pass the gas station these days, it seems the price has dropped another penny or two. Literally. I have noted two occassions in the past two weeks where the gas price in the evening was lower than the price I saw in the morning. Over the span of 5 weeks or so, gasoline in my area has cratered at least 20%. I am sure you have seen it too. Amazing, isn't it? We had almost gotten used to rising gas prices..and now, folks are trying to delay filling up the tank as long as possible to take advantage of tomorrow's lower prices! At least the Fed will be happy that our inflation expectations on oil have finally become "moderated."

This steep and rapid decline in gas prices seems odd, strange, eerie even. After all, there has been no big news that has had immediate impact on supply or demand. Sure, the devastating hurricances that we braced for never arrived, a big basin of oil was discovered in the Gulf of Mexiso that will take years to get flowing, and the Iran nuclear deadline came and went with no major action taken by the West against Iran. However, we did get signs that oil/gasoline likely could not sustain those inflated prices without a big correction. In May/June, we heard from the oil minister of Saudi Arabia himself as he declared that the world has plenty of oil. Oil bears have been saying the same thing and continue to insist we will see $50 oil again (they are probably now looking forward to $40 oil!). So, general market sentiment just needed to catch up to sink oil (and gasoline) prices straight down. If you recall, gasoline prices peaked at similar levels just about a year ago. It seems the $3.00/gallon level remains a magic wall beyond which gasoline refuses to budge in the near-term. And now, here we are. I have no idea when prices will stabilize - sentiment changes often carry substantial inertia. But I do believe that it will take an outright recession to keep oil and gas prices down at these levels for long.

If oil prices do stay down, and we do not get a recession, we must then ask ourselves will the decline in energy prices be enough to help stave off the inflation threat that still looms in the economy? Will cheaper oil save the consumer, or at least those at the lower-end of the payscale who are struggling with large debt burdens and the dissipation of opportunities to "make money" by equity drawdowns on homes? It seems that the answer must be yes to prevent the current slowdown from becoming a recession in the first place. So far, retail stocks have not benefited much from lower oil prices. Airline stocks have not responded much although they were soaring right along energy prices earlier this year - some, like AMR, have actually gone down in the recent period. It is also hard to see silver, gold, and other commodities and commodity-related stocks maintaining current levels if oil continues downward given the inter-connected trades that seem to go on with these things (I recently wrote about silver's amazing comeback since the most recent trough in June. Silver has neatly corrected a bit (of course!) since I wrote that piece).

Speaking of know what else has gone down about 20% since gas prices peaked? You guessed it, my favorite oil refiner, Valero (VLO). I have visited the chart of this stock twice this year. Both times, I came up with bearish conclusions that I chose to paint in the best light possible. Now, the stock has finally fulfilled its bearish tidings with a 22% decline since its most recent peak in early August. I post the chart below and encourage you to visit earlier missives if you want some longer-term views:

Valero (VLO)

At a P/E of 6.6, VLO is now at bargain basement levels. But careful! The market is telling us that it expects nothing but bad news from VLO for the time being. What is cheap can always get cheaper. VLO has had an amazing multi-year run that, I believe, is unprecedented in the history of the stock and probably not normal for gas refiners period. Gas refining has typically been a hard industry featuring very low margins. The U.S. is still not planning to build any new refineries, so the restricted capacity story is still in play. Lower gas prices may ignite demand all over again. Folks may get back to buying gas guzzling RVs and SUVs. Who knows. But for now, the market is betting on lowered demand from a slower economy, perhaps one that goes into recession. Time will very soon tell.

In the meantime, be careful out there!

DrDuru, 2006