Stock Quotes in this Article: ALJ, CVI, DK, TSO, VLO, WNR

WINDERMERE, Fla. (Stockpickr) -- One sector that’s setting up for some big earnings beats and for the potential of extremely higher stock prices is the refining complex.

Clearly, the refining stocks are sitting in the sweet spot and are poised to benefit off of skyrocketing oil prices. But that’s not the only real reason to love this sector. The refining stocks are also positioned to see major profit margin gains due to the record spread in crude oil futures contracts.

The premium spread between North Sea Brent crude oil and West Texas Intermediate, or WTI, crude widened for the sixth day Thursday as Brent crude continues to trade near record levels. Brent crude for May delivery is now being quoted at about $123.89 a barrel on London’s ICE Futures Europe exchange, a $16.22-a-barrel premium over WTI futures for May, which are changing hands at about $107.67 a barrel on the New York Mercantile Exchange.

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    Market players need to understand that the longer this spread stays at a massive premium, the higher the probability is for the refining sector to capture huge profits in the coming quarters. As Daniel Dicker explained in a recent column, think of the WTI price as representing the refiners’ input costs and the Brent price as representing the price charged at the pump.

    The reason the spread is so out of whack is because Brent crude oil is mainly produced in troubled regions of the world such as the Middle East and North Africa. Due to all of the current unrest in these regions, the commodities market is slapping a giant “fear premium” on Brent crude oil. The more unrest we get out of the Middle East and the higher that “fear premium” is going to go.

    The other major catalyst for higher refining stock prices is the exploding crack spread. The crack spread is a term used in the oil industry and futures trading for the differential between the price of crude oil and petroleum products extracted form it. In other terms, this is the profit margin that a company which specializes in refining oil can make by “cracking” crude oil down into gasoline for sale to consumers.

    Guess where that crack spread is trading at right now? U.S. gasoline crack spread against crude oil hit $29.20 a barrel on Wednesday, the widest level in almost four years. It’s pulled back today to $27.83 after hitting that high, but the path of least resistance for the crack spread is higher.

    Now that you know about the fundamental trends that are driving the refining sector, let’s take a look at some refining stocks that have big upside.

    Western Refining

    One of my top ideas for playing the refining sector is Western Refining (WNR), an independent crude oil refiner and marketer of refined products that also operates service stations and convenience stores. So far in 2011 this stock has racked up gains of over 65%, but don’t let that keep you away. The technical and fundamental setup is signaling that Western can trade significantly higher from current levels.

    This company has a current market cap of $1.58 billion and an enterprise value of $2.52 billion. One of the best qualities about Western is how dirt cheap the stock is right now, trading at a forward price-to-earnings only 9.19. This company has a great chance at crushing numbers when they report first-quarter earnings. If that happens, we’re going to see the market realize that this stock is too cheap, and it will begin its spike higher.

    I would be a buyer of this stock right now since shares have recently pulled back from its highs at around $19.50 a share. I would use a stop just under the 50-day moving average of $16.46 in case market forces decide to take this lower. Remember, you can always get back in if the stock pulls back more. I would add aggressively add to any long positions once WNR breaks out above some past overhead resistance at $18.28 and $19.50 a share.

    Related: Top-Rated Oil & Gas Stocks

    One of the main reasons I love WNR here is because the stock is heavily shorted. Heavily shorted stocks that are uptrending relentlessly tend to crush the bears. This is especially true when momentum traders meet fundamental/value investors and money pours into the name. It’s only a matter of time before this happens with WNR because once earnings show strong upward trends the value players will have to show their clients they own this.
    The current short interest as a percentage of the float for WNR is a whopping 26.7% as of March 31. Those shores have even been increasing their bets from the last reporting period by 29.6%, or 3.2 million shares. This stock also has a low tradable float at only 66 million shares. The potential here for a massive short covering rally is big.

    Delek U.S. Holdings

    One of the great things about the refining sector is that there are some under-$20 names that extremely attractive. One of those is Delek U.S. Holdings (DK), a diversified energy business focused on petroleum refining, wholesale sales of refined products and retail marketing. The company’s business consists of three operating segments: refining, marketing and retail. So far in 2011 this stock has returned over 90%.

    Delek has a current market cap of $763.58 million and an enterprise value of $970.02 million. The stock trades at a forward price-to-earnings of 19.76. This company is due to report earnings on May 5. I would be looking to get into this name well ahead of those earnings.

    The way I would trade DK is to be a buyer once the stock breaks out above some past overhead resistance at around $14.37 a share. A move above that level, especially on volume that’s well above the three-month average activity of 246,000 shares, should set up this name to re-test $20 a share. This stock once traded as high as $30 a share, so there’s no reason we can’t eventually head back that level if the uptrend continues. I would use a mental stop just below $12 in case the trend changes.

    This is another heavily shorted refining stock. The current short interest as a percentage of the float for DK stands at around 10.2%. The bears have also been increasing their bets in this small-cap refiner. Short-sellers have added around 336,000 new short positions, or a whopping 47.8% increase from the last reporting period.

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    If this stock ends up breaking out, then the shorts are going to wish they weren’t betting against this name. It’s rarely a good idea to short a stock where the path of least resistance is higher. We know that path is higher right now in DK because the stock is so close to brand new 52-week highs.

    Alon USA Energy

    Another great under-$20 play on the coming refining sector boom is Alon USA Energy (ALJ), an independent refiner and marketer of petroleum products operating primarily in the South Central, Southwestern and Western regions of the U.S. This stock has been one of the hottest plays in the refining sector so far this year, with shares up over 130%. Again, don’t let those gains keep you out of this name because I think the trend is our friend here on the refining sector.

    This company has a current market cap of $755.74 million and an enterprise value of $1.57 billion. The stock trades at a forward price-to-earnings of 40.47, which is rich. However, the company is projected to grow at over 107% this year, so that’s not as expensive as it might seem. That really won’t look expensive if earnings accelerate as I am anticipating they will for the entire refining sector.

    Related: Stocks That Could Move Big on Earnings

    This company is set to report earnings on May 6, so I would suggest getting into the stock soon because so you don’t miss out on any potential ramp-up in price. I would look to buy this stock soon and anticipate a breakout over $15.58 a share. You could use a mental stop below $12 a share, but remember any trading plan you implement should fit your own risk criteria. This stock once traded as high as $45 a share, but my target falls close to $30 which is the next significant overhead resistance area.

    Once again, ALJ is another heavily shorted refining stock. Apparently, the bears are betting against just about all of the stocks in this sector. I don’t know if that’s because they think that crude spreads are a one-time phenomenon or because they think crude is in for a big fall. Either way, I don’t buy into either argument; the path of least resistance on crude oil is higher.

    The current short interest as a percentage of the float for ALJ stands at around 12.4%. Once again, the bears have been increasing those bets from the last reporting period by a whopping 30.7% or around 289,000 shares. All I can say is that if ALJ breaks out, we have a great chance of seeing massive short covering.

    CVR Energy

    Another refiner that could be setting up for big upside is CVR Energy (CVI), which, together with its subsidiaries, refines and markets transportation fuels in the U.S. The company also produces and markets nitrogen fertilizer products. So far in 2011 this stock is off to a great start, with shares up over 40%.

    This company has a current market cap of $1.94 billion and an enterprise value of $2.10 billion. The stock is extremely cheap, trading at a forward price-to-earnings of just 10.70.

    CVR Energy is such an interesting stock because market players can win not just off the refining boom but also off the ag boom, with the company’s fertilizer division. Talk about being in the right sectors at the right time. Its 2010 operating income for the fertilizer business was $20.4 million on net sales of $180.5 million. This shows that CVR isn’t just some small-time player in the ag space, and it shows there’s plenty of room for future growth.

    Related: 8 Ag Chem Stocks With Upside

    One of the best things about CVR is how strong the stock is acting technically. Shares have been making higher highs and higher lows for the past 6 months. Clearly, this stock is in a very strong uptrend, and it just recently found some support at its 50-day moving average of $20.49. If you’re bullish on the refining sector, then you can buy this stock now with a mental stop below the 50-day. I would add aggressively if it breaks out above its 52-week high at $24.38. I would add even more if it trades above its all-time just over $30 a share.

    CVR isn’t as heavily shorted as some of the other refiners, but it’s worth noting that around 4.1% of the float is currently sold short. Even though the total short interest isn’t very high, the bears have been increasing their bets dramatically from the last reporting period. As of March 31, the short-sellers upped their total potions by an unreal 120.9%, or by around 1.7 million shares.

    Valero, Tesoro

    Two best-of-breed refining stocks with great trading liquidity (as measured by daily volume) are Valero Energy (VLO) and Tesoro (TSO). These are two of the bigger players and highest profit generators in the space. Tesoro has a market cap of around $3.7 billion, and Valero is even bigger, with a market cap of $15.7 billion. Both of these majors are also trading at extremely attractive valuations. Tesoro’s forward price-to-earnings is just 10.09, and Valero Energy’s forward price-to-earnings is a ridiculously cheap 7.84.

    The current short interest as a percentage of the float for TSO is 9.2%, and for Valero it’s only around 2%. Both stocks are trading only a few points off their 52-week highs and have been pulling back the past few trading sessions, so this might be the time to get long. I will issue a bit of caution on Valero, though, because the stock is now trading below its 50-day moving average of $28.35. I wouldn’t buy it until it has at least traded back above that key technical level.

    To see more refining stocks that could be set to skyrocket, check out the 6 Refining Stocks With Big Upside portfolio on Stockpickr.

    -- Written by Roberto Pedone in Winderemere, Fla.

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    At the time of publication, author had no positions in stocks mentioned.

    Roberto Pedone, based out of Windermere, Fla., is an independent trader who focuses on stocks, options, futures, commodities and currencies. He is also an outside contributor to Beconequity.com and maintains the website Maddmoney.net, which he sold to Blue Wave Advisors in 2008. Roberto studied International Business at The Milwaukee School of Engineering, and he spent a year overseas studying business in Lubeck, Germany.