I have frequently heard that oil inventories aren’t very important because refining capacity is the gating factor for most products. According to a recent MSNBC article:

There hasn’t been a new refinery built in the U.S. since 1976, the result of extremely tight environmental restrictions, not-in-my-back-yard community opposition, and the high cost of new construction. Used refineries currently sell for about 30 to 50 percent of the cost of building a new one, so it’s cheaper to buy an old refinery and upgrade it. Or squeeze a little more gasoline out of the refineries you already own.

Expansion of refining capacity is also made more difficult because oil refineries are a lot more complicated to build and operate than your average widget factory. For starters the raw material — crude oil — has many different properties, from thickness to sulfur content, so not all refineries can blend just any barrel of crude.

You would think that in this type of environment the refineries would be able to charge whatever they like. But recent PPI data suggests otherwise.

After a prolonged period of significant price gains, the year/year change in refinery pricing power dipped into negative territory early in the year and has been relatively flat since. Are the glory days over or is this a temporary lull? For help answering this question I turned to the recent conference calls from three of the larger companies that get most of their business from refining and marketing: Sunoco (SUN), Valero (VLO) and Holly (HOC).

First, speaking to refining margins, as we did last quarter, if you look at slides 6 to 9, we have included some detail of the realized refining margin versus our reported market benchmark for each of our geographic refining regions. Rather than walk through each slide in too much detail, let me make a few summary comments.

In the Northeast, our realized gross margin for the quarter was $12.32 a barrel, which was up about $0.75 a barrel from last year’s very strong second quarter, and was also about $0.73 a barrel better than our standard 6321 benchmark. On the input side, realized crude costs in the second quarter were $1.66 a barrel higher than our Dated Brent plus $1.25 a barrel benchmark. So still reflective of a very expensive market for light sweet crude in the Atlantic basin, but improved from the first quarter of this year….

If I can turn now to the MidContinent region, where industry downtime had a more significant market impact, our realized gross margin in the second quarter was $22.14 a barrel, up over $7 a barrel from the second quarter of last year but about $6 a barrel lower than our standard WTI based 321 benchmark. Again, on the crude side, actual crude costs were $2.17 a barrel above the WTI plus $0.75 a barrel marker, as WTI continued to be a weak relative benchmark.

Additionally, the price of Canadian syncrude, which accounts for about half of our crude slate at Toledo, traded at an increased premium to WTI during the quarter, due largely to upgrade or maintenance and other downtime among Canadian producers.

On the product side in the MidContinent, our realization was almost $4 a barrel below the benchmark. This correlation, also seen in last year’s second quarter, is fairly typical of periods when gasoline crack spreads are very strong. This is primarily because the 321 marker we use implicitly assumes that two-thirds of our MidContinent refinery production is gasoline when it actually averages more like about a half.

So let me say in summary, putting all those numbers and relationships aside, clearly second quarter refining margins were very strong by any historical measure.

(Excerpt from full SUN conference call transcript)

Paul Sankey - Deutsche Bank

Hi everyone. I think we’ve just about hit all my questions, actually, but one that’s outstanding is the way the curves have shifted. Is there any meaningful impact for you from the moves that we’ve seen to backwardation in crude markets? As a follow up, any observations you could make about the fact that crude inventories, ostensibly, are quite high in the U.S., but we’ve seen obviously very high prices. At the same time, gasoline inventory is not super loose by any means, but a cratering of the price there - any observations you can make on those would be great.

Unidentified Company Representative

Well, I’ll speak to gasoline. Gasoline pries are very low. They’re very low on a historical basis. So the decline that we’ve seen in the margins there isn’t necessarily fundamentally driven. We’re entering the season where we will start blending butanes back in, and so we know that will have an effect on the inventories. Nonetheless, we go into that period with inventories at very attractive levels relative to previous years.

On the crude, the change in the market structure just means that we’re not paid to carry it right, so what we’ll do, what we always do, is we aggressively manage the inventory to the market structure, as we’ve done on the product side.

Paul Sankey - Deutsche Bank

Right, so I’d expect to see inventories continuing to fall, but maybe the price, nevertheless, staying high.

(Excerpt from full VLO conference call transcript)

Historically high industry-wide margins, our location advantage product prices, and record production levels at our facilities fueled the best quarter in Holly’s history.

The pure gasoline and diesel prices in our markets, due to the tight supply/demand balance in our Rocky Mountain and Southwest markets, combined with lower raw material costs to create historical quarterly average gas and diesel cracks at both plants.

Higher runs at lower cost black wax crudes at Woods Cross and a widening of the discounts for sour crudes run at Navajo, compared to compressed WTI prices versus similar worldwide crudes, helped drive down our raw material costs.

Our folks ran both plants at 99%-plus utilization rate, realizing the full benefit of the 2006 midyear expansion of the Artesia refinery and enabling a virtual full capture of the great margin environment experienced during the second quarter….

Although, as in other markets, our margins have reduced substantially in July and August from the lofty levels experienced during the second quarter, we remain extremely bullish on the refining industry fundamentals.

(Excerpt from full HOC conference call transcript)

Now I’m no energy expert, but it sounds to me like there is very little wrong with refining industry fundamentals. If anyone out there can enlighten me, please do so.

With the end of the first quarter approaching, it is time to adjust the names in my Watch Lists. I will price all the new lists as of the close on Friday, June 29.

Today I present my planned updates to the Small Cap Watch List. There was a fairly high level of turnover to the list. 12 of the 24 names from the previous run made it to the current list, which was also 24 names. Performance-wise, the list created in March has returned an unweighted average return of 2.6% through June 28, with 80% of the stocks in positive territory. All of the money-losers from the previous list fell out of consideration.
So without further ado, the names on the chopping block from the previous list are: PW Eagle (PWEI), Insteel Industries (IIIN), Allied Defense (ADG - Annual Report), Hartmarx (HMX), Parlux (PARL), Hansen Natural (HANS), FirstFed Financial (FED), Young Innovations (YDNT), ITT Educational (ESI), Rent-a-Center (RCII), Valassis (VCI), and Travelzoo (TZOO). The castaways include four of the five money losers from the previous portfolio (HMX, PARL, YDNT and TZOO) as well as the biggest gainer (ESI).
The new list is:

I will continue to track both lists on StockPickr.

Small Cap Watch List (Track at Marketocracy) member VAALCO Energy, Inc. (EGY), announced that for the first quarter of 2007 earnings were $4.6 million or $0.08 per diluted share. Analysts had been expecting the company to earn $0.12. According to the company:

We have begun exploration activities in earnest on our exploration blocks in Gabon (Etame — offshore, Mutamba — onshore) and offshore in Angola. During the quarter, we shot 400 square kilometers of new proprietary 3-D seismic data on the Etame Block to delineate several prospects and leads in anticipation of a 2008 drilling campaign. In Angola, we acquired a license to 1,000 square kilometers of 3-D seismic in the fairway of Block 5. Processing and interpretation of the seismic is underway. The $5.1 million expensed to acquire these data is an investment in our future efforts to build reserves through the drill bit.

Perhaps. The $5.1 million spent is roughly the pre-tax equivalent of the $0.04 they were short.  So if estimates were expecting zero investment in such activities (which seems unlikely) the adjusted results would be on target.

Compared to last year, the company got less ($57.03 vs. $60.93) for each barrel of oil sold, but spent more ($8.35 vs. $6.38) to get it. Further, depletion costs per barrel nearly tripled to $9.13. These are clearly not favorable trends.

Superior Energy Services (SPN) issued the following statement in an 8K filing:

On April 11, 2007, the Board of Directors of Superior Energy Services, Inc., upon recommendation of its Nominating and Corporate Governance Committee, approved increases in the cash and equity compensation payable to non-management directors. The Nominating and Corporate Governance Committee received input from an independent compensation consultant in order to ensure that non-management director compensation reflected current competitive market conditions.Effective May 1, 2007, the amount of the annual retainer for non-management directors will be increased from $30,000 to $40,000 per year. In addition, the dollar amount of restricted stock units awarded to non-management directors following the 2007 annual meeting of stockholders will be increased to $140,000 from $100,000 awarded in 2006.

That sounded awfully generous to us, but looking through the recent proxies for other small- and mid- size oil and oil services companies on our watch lists it looks pretty much in line, if not at the low end.

If there are any such companies in need of a new director, we hereby offer our services.

With the end of the first quarter approaching, it is time to adjust the names in our Watch Lists. We will price all the new lists as of the close on Friday, March 30. Today we present our planned updates to the Small Cap Watch List (Track at Marketocracy).

Frankly, we were surprised at the amount of turnover in our screens. Only 9 of the original 29 names made the cut for the new list (which comes in at only 24 names.) Still, given the level of outperformance we saw in the first quarter (actually just two months) and the fact that much of those gains were achieved early, perhaps the turnover is warranted.

So without further ado, the names on the chopping block from the previous list are:

Silgan Holdings (SLGN - Annual Report); Steel Dynamics (STLD - Annual Report); NVR (NVR - Annual report); Middleby (MIDD); Vector Group (VCG); Sanderson Farms (SAFM); Downey Financial (DSL); Waddell & Reed (WDR); Wilshire Bancorp (WIBC); Harrington West (HWFG); Gamco Investors (GBL); Apria Healthcare (AHG); Papa John’s (PZZA); Cato Corporation (CTR); Meredith Corporation (MDP); CSG Systems (CSGS); Energy East (EAS); Dynamics Research (DRCO); Ingram Micro (IM); and Dade Behring (DADE).

The new watch list will be:

Yes, we know it has only been two days since the Watch Lists were priced, but they were a nice two days. In fact, despite our complaints that some stocks were going up dramatically between the time we announced the watch list and the time we priced it, several names had nice earnings reports Wednesday night and got an immediate boost to their at-the-close official pricing.

The small cap watch list was up 1.31%, significantly better than the 0.50% and 0.58% posted by the Russell 2000 and S&P small cap indices over the two day period. The performance was driven by particularly strong results from Silgan (SLGN - Annual Report), Landstar (LSTR - Annual Report), Rent-a-Center (RCII) and NVR (NVR - Annual report). The worst performers were Vaalco Energy (EGY) and Apria Healthcare (AHG).

The mid-cap watch list turned in 1.58%, compared with just 0.46% for the S&P mid-cap. Due to significant overlap, the same names accounted for the gain. However, Vaalco is not in the mid-cap watch list so the second-worst performance came from Equifax (EFX).

The 0.49% return for the large cap watch list was also sufficient to beat the S&P 500’s 0.28%. Positive stocks were fairly evenly dispersed, but the performance was held back by poor returns from Freeport McMoRan (FCX - Annual Report), TJ Maxx (TJX) and Ricoh (RICOY.OB).

We’ll also continue to track the original all-cap watch list against the S&P 500 and our own portfolio. Embarrassingly, the only negative performance this week was our own portfolio.

We asked, but no one answered. So we are taking our own counsel and breaking our Watch List into three portfolios: Small Cap, Mid Cap and Large Cap. Each will be tracked against the relevant S&P index going forward from their collective inception date of January 31 (priced at the close of market trading that day.)

For your viewing pleasure, the Small Cap Watch List (Track at Marketocracy) (to be measured against the S&P 600) follows.

In addition, we will provide a “quick and dirty” analysis of each name, with a goal of one such analysis per day. As the name implies, the quick and dirty analysis will be incomplete. We are hoping you will join in the debate and fill the gaps in our analysis.