This article was written by Invesco PowerShares Senior Equity Product Strategist Nick Kalivas.

Petroleum refiners got a boost last week with the US Environmental Protection Agency’s (EPA’s) proposal to lower its mandate for the use of renewable fuels. Renewable fuel standards were established in 2005 with the aim of reducing petroleum imports, cutting greenhouse gas emissions and encouraging the development of renewable energy resources.1 While ethanol production has given a boost to rural Midwestern economies, consumer demand for ethanol blends has flagged, and the nature of US energy production has changed over the past decade. This has raised questions about how much biofuel can actually be consumed.

Not surprisingly, the EPA’s announcement was met with vociferous opposition by the nation’s ethanol producers and cheered by refiners, whose profit margins have been squeezed by the renewable fuel requirements.

Refiners could benefit from mandate reduction

With last week’s announcement, the cost of complying with renewable fuel standards is expected to ease. That could provide support to oil refining shares, which are already benefitting from a decline in oil prices. During the five months ended May 31, 2015, the S&P 500 Oil & Gas Refining & Marketing (Sub-Industry) Index has rallied 16.04%, while the S&P 500 Exploration & Production (Sub-Industry) Index has lost 1.62%.1

Refiners’ share prices have been rising because issuers’ margins, known as crack spreads, are also elevated. A crack spread is the difference between the cost of crude oil and the price charged for refined products, such as gasoline and distillate fuel. The 3:2:1 crack spread for West Texas Intermediate Crude oil was $17.96 on June 1, and has been at the top end of the range since December 2013.2

Widening refining margins are favorable for refiner stock performance. The chart above shows that refiners (as measured by the S&P 500 Oil & Gas Refining & Marketing Index) have outperformed the energy sector as a whole (S&P 500 Energy Index) over the past 10 years when crack spreads are wide or widening, while falling crack spreads have been a drag on the relative performance of refining shares. That’s because cheaper fuel prices help to stimulate product demand, while ample supplies of oil help lower the cost of production.

Oil market looks well supplied

But just how long will these elevated oil supplies last? Over the near term, conditions look favorable:

  • US crude oil production averaged 9.4 million barrels per day in the first quarter, while the weekly US days of supply of crude oil is now 29.5 days, compared with 24.8 days a year ago.3
  • As of Mar. 31, Russian production of oil and natural gas condensate rose 1.6% on a year-over-year basis, reaching a post-Soviet high of 10.71 million barrels per day.4
  • Saudi Arabia pumped 10.25 million barrels per day of crude in May, matching its highest level of output since May 1989.5

US fracking technology has the capacity to boost production further, and could help keep a cap on oil prices over the long term, in my view.

Factor-driven exposure to refiners

Given this outlook, investors in the energy sector may want to consider the PowerShares DWA Energy Momentum Portfolio (PXI) and PowerShares Dynamic Energy Exploration & Production Portfolio (PXE). As shown in the chart below, both of these factor-driven smart beta portfolios have offered significantly higher oil refining and marketing exposure than their peers.

ETFs: factor-driven smart beta portfolios oil refining and marketing exposure

This higher exposure to oil refining and marketing firms has helped boost the relative performance of PXI and PXE over the past three and five years.

Standardized Performance as of May 29, 2015

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