Valero: Hooked on Crack Spreads

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We've all heard about the terribly addictive qualities of crack cocaine. Valero (NYSE: VLO), however, is hooked on the crack spread. And the industry benchmarks are called 3-2-1 crack. Let's break down the jargon.

Refineries turn crude oil into products like gasoline, low-sulfur diesel, and heating oil by "cracking" large chains of hydrocarbons into smaller ones. They make money by selling these products for more than what they pay for the crude. That price differential is the spread.

3-2-1 crack is an approximation of the profit margin that a refiner earns by turning crude oil into end-use products. Take the price of two barrels of gasoline and one barrel of heating oil, divide by three, subtract this average from the price of a barrel of crude, and there's your crack spread.

Companies like Valero, Tesoro (NYSE: TSO), and Frontier Oil (NYSE: FTO) are all hooked on the crack spread. And due to an unusually tight gasoline market for this time of year, the spread is strong. On April 28, the spread hit $24.68, the highest level since the post-Katrina recovery 18 months ago.

This is the key to understanding Valero's record first-quarter results, reported last Thursday. Operating margins improved almost 30% (from 6.4% to 9.0%), more than offsetting slightly reduced output. The cash is simply pouring in, and the company rewarded shareholders with both a 50% hike in the dividend back in January and a recently announced massive increase in the size of its share repurchase plan.

These high spread levels can't last indefinitely -- so be careful with this refiner group. It's inevitably going to come down hard, which makes it hard to justify adding a member of this group to one's portfolio at this point in the cycle. If you just need to be in oil, a safer play would be to look at an integrated company. Firms like Petro-Canada (NYSE: PCZ) and Income Investor pick Total (NYSE: TOT) benefit from strong refining margins, but also have a more diversified asset base, which cushions the downside.

For related Foolishness:

• Valero's Refined Quarter: Fool by Numbers
• Valero: Sludge in the Pipeline
• This Just In: Upgrades and Downgrades

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Fool contributor Toby Shute doesn't own shares in any company mentioned. The Motley Fool has a disclosure policy.