A truly scary movie can make you jump, even if you've seen it before.
Fools may recall one of the scariest horror shows of 2008, starring the screaming refiner Calumet Specialty Products (Nasdaq: CLMT). Like the ill-fated character who descends into the basement while the audience screams not to, Calumet dragged investors into a dungeon of pain.
After a brief hiatus, the thriller is playing again, and Fools are reminded that it's safer to leave than to explore the dark unknown. The entire refining industry enjoyed a reversal of fortunes in the first quarter that restored profitability for a moment. As second-quarter results from majors such as Valero (NYSE: VLO) and ConocoPhillips (NYSE: COP) have shown, however, conditions have turned decidedly spookier. Western Refining (NYSE: WNR) recently announced a $7.8 million adjusted loss, as revenue was brutally chopped in half.
Calumet managed to beat expectations with adjusted earnings of $0.70 per share, despite missing on revenue by $50 million. Shares plunged after the release, supporting the refreshing notion that investors might look beyond the expectations game while digesting results. What startled the Calumet faithful?
For starters, Calumet's results corroborated the debilitating margin weakness observed last week by Valero, exacerbated by the anticipated impacts of a 2008 LIFO inventory liquidation. Unlike the fuel-focused refiners, however, Calumet suffered a significant disruption to demand for products like lubricating oils and solvents, which dampened specialty sales volumes by nearly 15%.
Even scarier, Calumet replayed a memorable scene wherein earnings were once again ravaged by derivative losses. Total derivative losses were enormous, and the accounting of them downright fuzzy. The company reported a $9.9 million net derivatives loss on the income statement, already representing more than half of gross profit, but recorded another $24.6 million mark-to-market writedown of derivative hedging instruments within the reconciliation of cash flows. As I suggested in the case of Yamana Gold (NYSE: AUY), betting on the derivatives casino often feels scarier than the risks it's meant to protect us from.
The crude conclusion
Refining is presently an impaired industry. When a leader like Valero is projecting a third-quarter loss, and oil prices face the specter of inflation-fed price increases that may well be unmatched by fuel demand, I consider the sector unsound. Some may see that assessment as a buy signal, but I follow the fundamentals. I believe that opportunities further upstream, like natural gas movers Energy Transfer Partners (NYSE: ETP) and Kinder Morgan (NYSE: KMP), offer a nearly comparable dividend yield to Calumet, with a far more refined outlook.
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