Year-End Forecast Questions Clarified

A friend of mine asked for some further clarification in my recent year-end forecast entry about the nature of the EMC-long/VMW-short trade and to describe "cracking spreads". The following is the clarification.

EMC/VMW Long-Short Trade

VMWare is a company that EMC bought a while back. It is the market leader in server virtualization. EMC sold 14% of the company in an IPO about 2 months ago and retained 86%. The reason for the IPO was that VMWare is growing very rapidly and the value of VMWare was not being fully reflected into EMC’s share price.

VMWare’s IPO price was about $30/share. VMWare closed today at $122, a gain of over 400%. In the same period since the IPO EMC is only up about 20%. In fact, VMWare’s current market cap is about the same as EMC’s. This means that you can buy a share of EMC, get all of EMC’s businesses, and essentially get VMWare for free.

So what professional traders are doing is buying EMC and selling short VMWare. That trade should work. EMC should move up to take into account the value of its 86% ownership in VMWare. There is no question that VMWare is overextended on any valuation basis and is being pushed up by momentum traders. Shorting VMWare should be a sure thing, but it keeps going higher, crushing the shorts. Meanwhile EMC continues to lag behind.

Refiner Cracking Spreads

One of the key components in a refinery is the hydrocracker. The hydrocracker is what separates the raw crude into the different components that can then be further refined into finished goods (gasoline, heating oil, etc.) The cracker is usually the most significant constraint on throughput in a refinery.

The “crack spread” or “cracking spread” is the difference between the cost of the inputs (a barrel of oil) and the price of selling the outputs (gasoline). Right now oil prices are at an all time high, but gas prices have not moved up the same amount. That squeezes the refiner’s margins. When the spread widens the refiners basically print money as it all falls straight to the bottom line.

This is why the refiners went on a tear late winter and early spring this year. The crack spreads were at an all time high. Since then the crack spread have continued to narrow. Right now is what is called “shoulder season” for the refiners. The high demand for gas from the summer driving season has passed while the winter demand for heating oil has not picked up yet.

All of this is why Exxon Mobile got killed today, down about $3.50. They reported disappointing earnings before the bell largely due to margin pressures on their refining business. It seems a bit counterintuitive, but high oil prices can actually hurt the big, integrated oil companies (those companies that both produce oil, refine it, and sell it through retail outlets).

Disclosure: at the time of this post the author was long EMC and short XOM, USO.