It is a well-known observation in the refining business that when oil prices rise, gasoline prices rise very quickly. When oil prices fall, gasoline prices don’t follow nearly as quickly. This phenomenon is commonly referred to as “rockets and feathers.” Several studies have confirmed this effect. But why does it happen? A Wall Street Journal article reporting on this effect a few years ago posited an interesting theory:

“The theory of the day to explain sluggish declines at gas pumps points squarely at consumer behavior, as the folks at Knowledge Problem pointed out recently. When prices are rising, everybody drives all over town to shave a cent off each gallon. Once oil and gas prices start to fall, people get thrilled by $3.88 gas, and fill up at the corner station. Since there’s less comparison shopping, gas stations don’t have to change prices as often.”

For refiners, the net effect is that more often than not, when oil prices are falling refiners earn higher margins. This signals an occasional short-term profit opportunity for savvy investors who recognize when conditions are right, since this makes refiners a good short-term bet in a time of softening oil prices.

This was part of the logic behind our Oct. 17 advice in The Energy Letter to buy refining companies with significant California operations.  And it was the main reason we reaffirmed Valero Energy (NYSE: VLO) as a Buy in the Energy Watch List in the October 17 issue of The Energy Strategist. In that same issue, we changed our rating of Tesoro Corp. (NYSE: TSO) to Buy in the Energy Watch List.

Since that October 17th letter, refiners have been one of the only bright spots in the oil and gas sector. Valero has gained 9.3% and Tesoro has gained 9.6%. Over the same time period, for example, ExxonMobil (NYSE: XOM) shares have lost 4.6% and Chesapeake Energy has fallen 16.4%. Pure refiners stand to benefit the most from softening oil prices. Integrated oil companies will show mixed results – better downstream performance but lower upstream performance. Pure oil producers will typically see the lowest performance if oil prices are softening.

The refining sector appears set for further gains, but conservative investors may consider locking in some profits after the quick run-up. In any case, if oil prices begin to gain strength, that would probably signal a sell, unless certain exceptions occur. One of these would be if U.S. gasoline inventories are at low levels. In that case, margins can remain strong even as oil prices rise, which was the case in 2005.

The refining sector is not one that I typically recommend as a long-term holding in a portfolio. Refinery earnings are inconsistent, but during the right time of the cycle refining companies can be very profitable. However, over the next few years refineries that have access to disadvantaged feedstocks from the mid-continent region should consistently outperform those will less access to those crude oil supplies.

Investing in refiners is certainly not for everyone, but for those investors who like to take advantage of short-term trends, refiners offer opportunities for significant gains provided you know the right indicators for getting in and out of the companies.

Tesoro has two refineries that benefit from purchasing disadvantage feedstocks. One of these refineries is in North Dakota and one in Utah, and they cumulatively account for about 17 percent of their refining capacity. As previously discussed, Tesoro’s California exposure should benefit them this quarter.

Valero also has refineries position to benefit from discounted WTI crude (about 15 percent of their refining capacity), and like Tesoro they have operations in California. But they also have significant ethanol operations, and this may provide a drag on their earnings in the near term.

Western Refining (NYSE: WNR) may be the company best positioned to benefit from purchasing lower priced mid-continent crude oil and selling the finished products into more attractive markets than the Gulf Coast. Western Refining operates two refineries – one in El Paso, Texas and one in Gallup, N.M. The company refines disadvantaged mid-continent crude oil and sells the finished products into markets in attractive markets like Northern Mexico, El Paso, New Mexico and Arizona.

However, there are two caveats associated with Western Refining. The first is that the stock has already doubled over the past year. Its shares currently trade at a premium over both Valero and Tesoro. The other downside is that the good times won’t last forever. Once significant pipeline capacity exists to relieve the bottleneck of mid-continent crude, oil prices there will rise and the WTI discount to Brent crude will likely vanish. This will put Western Refining at a significant disadvantage relative to their current margins. However, the current situation is likely to persist for several more years, so aggressive investors should look to buy Western on dips as a play on this trend.

Around the Portfolios

Occidental Petroleum (NYSE: OXY) shares continued to slip this week after Deutsche Bank downgraded its rating on the stock from Buy to Hold. We think Occidental is oversold and remains an excellent long-term play on rising oil prices in the coming years. Buy Occidental Petroleum below 100.