Yesterday, refining giant Valero Energy (NYSE: VLO) touched my recommended stop order at $41.50, selling us out of the stock for a loss.

Fortunately, Valero is one of the only stocks in The Energy Strategist model portfolios that’s been trading lower in recent weeks. In particular, many of our favored natural gas-leveraged names, such as Nabors Industries (NYSE: NBR), have been performing extremely well.

At first glance, it may be puzzling that Valero is trading lower in an environment in which oil hits fresh highs almost every day; crude this morning has surged an additional $2.50 to trade north of $142 per barrel. Many investors assume that refiners such as Valero should follow the rest of the energy sector.

But there’s absolutely nothing unusual about Valero’s action in the current environment. Refiners don’t make money from rising oil or natural gas prices. In fact, these companies are often actually hurt by rising crude.

I explained the refining industry at great length in the March 21, 2007, issue, Looking Refined. To review, independent refiners such as Valero buy crude oil on the open markets as feedstock for their refineries; these companies have no way to produce oil internally, so they must buy the oil from producers.

These companies then convert that crude oil into a host of refined products, the most common of which include gasoline, jet fuel, heating oil and diesel. Refiners then sell these refined products to earn revenue.

When oil prices rise, refiners’ costs rise because they have to pay a higher price for their crude oil feedstock. If the price of the gasoline and jet fuel these refiners produce doesn’t also rise, profit margins get squeezed. And that’s exactly what’s happened so far in 2008.

This may be hard for many consumers to imagine, with retail gasoline prices well more than $4 per gallon across most of the US. But crude oil futures are up roughly 51 percent so far in 2008, while gasoline futures are up less than 40 percent. Although heating oil futures–a good proxy for diesel–are up roughly in line with oil, your typical US refiner processes far more gasoline than heating oil. Therefore, rising oil prices are offsetting any benefit from rising gasoline and diesel prices. Refiners’ profit margins, known as crack spreads, are unusually depressed this year.

So far this year, Valero is actually one of the better-performing refiners, outperforming companies such as Tesoro Corp and Alon USA, because it’s able to refine heavy, sour grades of crude oil that haven’t seen as dramatic price gains as New York Mercantile Exchange (NYMEX) crude oil futures (light, sweet crude). Valero also has been selling off its underperforming refineries and buying back stock; these are shareholder-friendly moves.

I’ve recommended holding on to Valero for two reasons: as a hedge against an oil price fall and on a valuation basis. As to the first point, I remain convinced that the refiners will bottom as soon as crude oil sees a significant correction. A pullback to less than $120 per barrel in crude would trigger a big run-up.

As to the second point, we all know that refiners are facing a tough environment this year; however, Valero and others are already trading at bargain-basement levels. Currently, Valero trades at 1.2 times book value and 0.22 times sales. The last time Valero traded at these levels was back in 2003 and into early 2004.

But in that period, refining crack spreads were even weaker than they’ve been so far in 2008. In 2003, the 3-2-1 NYMEX crack spread hit a high of around $12.59 per barrel, compared to the current quote of $13.67 and this year’s highs of more than $20 per barrel.

Bottom line: Valero is trading at a valuation that prices in a great deal of bad news, and I don’t believe the stock is getting full credit for its profitability-enhancement moves. That said, negative sentiment on the group will likely persist as long as oil prices remain as elevated as they are today.

I see the refiners today as very much like the natural gas and coal stocks in the summer of 2007. The group was depressed and weak but ready to surge at the first whiff of good news. This will be the first group I look to re-enter on any sign of oil-price weakness.

I’ll also watch Valero and other refiners carefully as they report earnings in late July and early August. With expectations so low, there’s a good chance they may actually be able to beat their estimates; this could also be the catalyst for a turn in the group. For now, stand aside from Valero Energy and other refiners.

In closing, it’s also worth commenting on oil prices once again. As I explained at length in the June 4, 2008, issue, Crude Realities, I don’t believe oil is in a bubble or is being driven by pure speculation. I definitely wouldn’t try to call a top in this market.

However, whenever I see a market move as sharply higher as oil has over the past few weeks, I become worried. I see the potential for a signification correction in oil prices at some point over the next three to six months. This correction could be fed by any number of catalysts, including a strengthening dollar, further signs of US demand destruction, a slowdown in China’s demand growth or a partial normalization of developed-world inventories. This correction will be counter-trend in nature–a pullback within the context of a multiyear oil bull market.

The market continues to focus too much attention on demand; the serial oil top-callers usually talk about demand destruction and China. The real story is supply, not demand, this year. In other words, as I pointed out in the most recent issue of The Energy Letter, Tight Oil Markets, any decline in US consumption has been offset by far-weaker-than-expected supply growth. Even Saudi Arabia has only 1.45 million barrels per day of spare capacity.

I recommend that all subscribers re-read the June 12, 2008, flash alert, Unsteady as She Goes, for a rundown of ways to hedge our exposure to the volatility that a pullback in oil would likely bring. I also recommend focusing on stocks levered to natural gas, a commodity I believe has stronger near-term fundamental support and is less vulnerable to any oil-led pullback.