I Thought Oil Was the Trade (I Was Wrong)

The Saudis made their final decision on oil supply for next month.

After recent attacks on their “East-West Pipeline” it seems they had a choice to make, between supplying enough crude and fuel for themselves versus serving their international customers.

First to be hit is Europe, as there will be zero oil supply to the EU next month, and I suspect the U.S. may soon follow if nothing is resolved in October.

Today I would like to introduce a different possibility, one that has the midterm elections in Trump’s crosshairs as the ultimate incentive to end the war and normalize oil supply flows once again.

Let’s forget about oil for now, as there is another gauge that is screaming where all the trouble is going to come from (and in some areas, already is.)

Diesel.

Just last week, Costco (COST) began rationing motor oil to customers, as this necessary item saw little elasticity effects on rising prices.

At the end of the day, you need oil changes no matter how expensive they get…

Other names like Valvoline (VVV) are now well into a bear market as diesel feeds directly into their distillate input costs.

The same can be said for Southwest Airlines (LUV) and RXO Inc. (RXO) in the transportation industry.

Because if energy markets normalize into the midterms, some of these businesses could become enormous coiled springs.

But,

If this timing goes horribly wrong, there is also a way for you to cash in on a continuation of this crisis.

The market, as you will soon find out, has already voted which way it wants to trade.

Let’s get into it.

I thought Oil was the trade (I was wrong.)

This is far from being a perfect relationship, but if sentiment holds as it has in the past, it means diesel prices are now trading as if Brent Crude prices were above $180/barrel.

We’re obviously not there, which creates a twofold assumption from energy traders:

I am leaning more toward the first option, and I’ll tell you why in a few simple points:

When you place all those chips on the table, I would say the odds favor a normalization of diesel and everything that comes downstream from it.

Especially if you know Venezuela has the most sour/heaviest crude in the world, which is perfect for diesel production.

However,

To see diesel normalize, we first need to see WTI and Brent do the same.

For now, it seems that we will close the week with WTI futures below $100, which is an encouraging sign.

Just like in 2022 and every other energy run before it, diesel cost wedges are spiking ahead of both gasoline and WTI.

Which directly points to a supply shock, not demand shocks per say.

However,

Because there are still enough crude, gasoline, and distillate (diesel) inventories in the United States, we need to zoom in on where the scarcity is specifically being priced in through this rising wedge in diesel costs.

Well,

Refineries are running at ~97% utilization on average, so this is more about how quickly we can turn crude to diesel rather than there being an outright supply crisis (yet.)

That is exactly where the biggest leverage is for a return to normal in diesel prices, as a resumed oil supply flow will likely be seen through a falling diesel wedge first.

For now though, there are still lots of things pointing to a sustained high oil price.

Such as:

In other words, most external markets are behaving as if there won’t be a quick resolution to all this.

Which is fine, money is rarely made in consensus.

So let’s assume that we are right, and the November midterms do bring an end to the war and thus a lower WTI price:

When you make a mental model for what happens IF the situation goes back to normal, keep this chart in mind.

Most of the relief will be seen in gasoline directly, but there’s also very little upside in playing first-order effects.

I want you looking in the second-order and onward, which is distillate fuels (diesel, heating oil, others.)

Then,

All the way on the other extreme, we have lubricants and base oils, of which I am most interested in motor oil as it is now being rationed and related companies being punished from it.

This also means distillate-exposed industries see the first wave of relief, while lubricants are last in line.

Starting with the distillate-exposed industries, here are some timeline expectations as to when that sigh of relief is actually delivered:

Tankers, parcels, trucking, and freight.

These are part of the most exposed industries (first relief wave) and also the ones able to recover their margin line the quickest.

In the case of trucking, it only takes one week to see gains from lower distillate fuel prices!

I think this is where we’d want to start building an upside watchlist in case fuel prices do come down toward midterms season.

On the other end we have airlines.

10-16 weeks on average to see a proper recovery.

Except one name, which has a refinery of its own within the United States, removing most of the fuel input cost effects from distillates (I’ll reveal that as part of the fuel crisis portfolio next week for Premium members.)

At the same time,

If I’m wrong and prices do push higher through midterms, then at least you know to avoid all the names on this pass-through list with the exception of construction.

That’s where ROAD comes in as the perfect upside hedge to rising distillate prices.

CVR Energy (CVI), PBF Energy (PBF) have a clear reason to be the current outliers.

Markets are willing to pay a massive premium for CVI because of how much EPS growth is now expected (over 150%) next year.

If you believe prices (diesel) are going higher through midterms, then you want to bet along with the market in a long CVI or PBF position.

I’ve placed VVV on that plot as well because of its above-average forward P/E and EPS growth expectations as well, which could be the market’s way of saying:

“Things are bad right now, but hey, here’s a tail opportunity for you”

In fact, when you spread VVV versus another refinery like VLO, you will see that there’s a negatively correlated trade in events when the diesel wedge cost spikes (2022, today.)

You get the idea, higher diesel wedges = buy more refineries and sell more trucking/freight

But,

That’s been the trade since the Iran war broke out, and I now think we should explore what happens if the opposite is true.

Refineries will be the losers in this case, and I think the market is beginning to build that expectation into prices right now.

Otherwise,

Why would P/E ratios be trending lower for the names who are supposed to win during a spiking diesel cost wedge?

Because most of that gain is already priced in.

In fact, the market is now voting in favor of diesel buyers in the airlines, lubricants, and trucking industries.

While also pricing worse expectations for diesel sellers (like refineries.)

If this is not a clear message of lower diesel prices in the foreseeable future… I don’t know what is.

Even better, we now have a clear catalyst found in the U.S. midterms and the 10-year Treasury closing below 5% consistently as another signal.

You know where to look now.

Premium members will know what I end up trading in the Telegram community.

Apart from the above valuation spreads and how the market is starting to treat this tail risk trade,

I’ve noticed an interesting setup in the options market for Valero (VLO) specifically:

Traders have already put on a bear spread here it seems.

On a ~4:1 ratio, the current VLO options setup looks like this:

A one-directional trade designed to pay off if diesel cost wedges normalize between now and the midterms in November.

As I said above, a very strong setup with a clear catalyst beginning to draw in big bets from market participants.

Now $414.85.

That’s not how I would necessarily play it though.

I am designing a stronger long/short equity trade around the winners and losers of this normalization tail risk trade.

Coming soon to the Telegram and Premium newsletter.

Meanwhile, here is the latest from Goldman Sachs on how stocks could absorb and digest the recent rate hike (and potential further hikes to come.)

A great way to think about what could be ahead for the equity markets:

Until next time,

OFFSIDE RESEARCH

Against the Tape, Ahead of the Curve.