In The Energy Strategist, we haven’t been exposed to the refining sector in our model portfolios in many months. The last major play recommended in this group was Marathon Oil (NYSE: MRO), which we closed out for a big gain last fall. For those interested in understanding the refining business in more depth, check out my primer “The Energy Strategist Philosophy” in the March 29, 2005, issue of TES, which is available in the archives.

But many of the factors that supported earnings for the refiners throughout most of 2005 aren’t relevant at this time. It appears that a warm winter lowered demand for heating oil; US refiners saw a lull in demand that’s allowed them to refine copious quantities of gasoline and other refined products like jet fuel. The US is extremely well supplied with these refined products in the short term and demand is unlikely to pick up until the summer driving season gets underway. There’s more scope for a drop in refined products pricing.

Refiners make money on the spread between the cost of crude oil and that of gasoline and other refined products. As a result of the oversupply, refining margins are negative in the US.

I won’t belabor the point today–I will clarify my thoughts on the group in next week’s issue. I’m downgrading several of the refiners I track in How They Rate to sells, including Valero Energy (NYSE: VLO), Sunoco (NYSE: SUN), Marathon and Frontier Oil (NYSE: FTO).

I’m also recommending two ways to play falling refined products pricing. First, as I explained in the flash alert sent out earlier this week, airlines will benefit greatly from lower jet fuel pricing—I’m recommending Continental Airliness (NYSE: CAL) as a trade recommendation. Continental Airlines is a buy under 24.50 with a stop at 19.50.

And short Sunoco above 72 with a stop at 82.50. For those who prefer trading options to shorting stocks, I suggest the January 2007 80 put options (Symbol: VUN MP). If you decide to trade the options rather than the stock, remember to use a smaller-than-normal position size. I’ll track the Sunoco short as a holding within the Wildcatters Portfolio.

Note that my negative views on the refining industry are specific to that industry. The same fundamentals don’t apply to our other recommendations.