My Number One Pick to Prepare for a Bounce in Crude

I have, for a few weeks now, been saying that I expected crude to move lower based on questions about demand, particularly from the US and China, the world's two largest oil consumers. That has been the case, and despite a bounce after breaking below $70, there could still be a little more room to the downside on that trade. However, oil will turn at some point, so I have been taking some of my profit from the short trades and looking around for oil related stocks to buy.

However, because I am still not convinced that a real recovery in crude prices is imminent, I have been looking at downstream companies rather than anything in the E&P space. As you may know, falling prices can actually be an advantage for refiners and marketers of oil products as they increase the "crack spread", the difference between what they pay for crude and what they get for the refined products they sell. Despite that, when crude is in a bearish trend based on demand questions, downstream stocks will still fall, but the crack spread advantage means that they will often be the first to bounce should sentiment begin to turn.

There are reasons to believe that could happen quite soon.

In trying to gain the middle ground in US politics, Kamala Harris has taken a much more fossil fuel friendly stance on energy policy recently. I am not one to trust any politician to do what they say they will do, but the Democratic candidate's public renunciation of the anti-oil rhetoric will at least lessen the fear of an all out war on oil should she win the election, and Donald Trump has made a pro fossil fuel stance a keystone of his campaigning. So, the overall, long-term outlook for US demand is not as bad as it was even a few weeks ago. And, in the short term, it looks increasingly likely that the Fed will shift to easier policy and lower interest rates before long, which will reduce fears of a recession and make the turnaround in oil a little more likely.

As for China, the most recent data have been somewhat encouraging, which has been part of the reason for oil finding a bottom, albeit maybe a temporary one, just below that $70 level.

As I said, I am not fully convinced that we have seen the absolute low of this move, but a drop below $65 now looks quite unlikely, so picking up some discounted downstream stocks at these levels seems like a logical thing to do. The one that most catches my eye in terms of both value and safety is the Dallas, TX-based HF Sinclair (DINO).

DINO is down over 20% over the last 6 months, and more than 30% from its April high but, as I write, is trading close to the August low of around $44. That makes for a decent entry point for a stock where the value is obvious to anyone that looks.

For starters, trailing and forward P/Es of around 7 and 8 suggest value, but there are other valuation measures that are even more compelling. The current price represents a price/book ratio of 0.86 and a price/sales of 0.27. Those are the kind of numbers you usually see when a company has cash flow or liquidity issues, but neither of those things apply to Sinclair.

They have positive free cash flow of nearly $1.7 billion and a current ratio over 2, indicating that not only are they secure, but also that maintaining the dividend that represents a 4.5% forward yield should be relatively easy for them. Those facts made DINO one of the picks for Forbes' "Safest Dividend" model portfolio, which is a bonus, but the main motivation for me getting involved is capital appreciation.

Given the balance sheet strength and good cash flow, it won't take too much of a sentiment shift around oil for DINO to bounce, and if a bounce starts, there are enough new shorts out there to result in a bit of a squeeze. The number of shares held short jumped from 8.19 million at the end of July to 9.47 million at the end of last month, with the short ratio (the number of days of average trade volume needed to cover those shorts) edging up towards 5. That makes it likely that a move up to say. $50 would quickly become a move up above $55, which would be my initial target for some profit-taking and a re-evaluation of the position.

No trade, even one that has been good to you, lasts forever, and that is particularly true when it comes to commodities. They have a well-known self-correcting tendency built into simple supply and demand theory. At some point before too long that self-correction will happen in crude, so taking some profit on shorts and investing in a potential bounce, albeit in something that can still perform should oil resume its downward trend for a while, looks like a smart move right now. That is what I will be doing over the next few days, and DINO will be my starting point for that transition.