Widen your energy stock horizon if refining margins roll over, Todd Gordon advises

My editors are probably not thrilled with me this week.

I turned this in late, and the reason is I started my research looking for confirmation of a bullish view on the oil refiners and came back with something quite different. That happens because, as active portfolio managers, we have to listen to what the market is telling us, and we need the emotional intelligence to admit the market is smarter than we are.

When she talks, we best listen. There's a lot of noise right now about interest rates, inflation, the Middle East and energy prices. I think there's more to the story than headlines are telling you. We just wrapped up our 3-day client appreciation event here in Saratoga Springs, N.Y.

Clients of Inside Edge Capital flew in from all over the country to spend time at my house, hear presentations on the economy and financial planning, sit in on a 45-minute Q & A with Chad Brown — one of the best horse trainers in the country, play some golf and spend a day at the Saratoga horse track.

You can watch the presentation here https://insideedgecapital.com/our-insight/inside-edge-capital-2026-client-appreciation-event/ I bring it up because of what people actually wanted to talk about. We're in the middle of an AI revolution and the most questions I got were about the Middle East, inflation, interest rates and our energy allocation.

So let's talk about those four. Watch this yield spread On August 4, I wrote that the Fed probably won't hike until it sees more than a 47-basis point spread between the 2-year yield and fed fund futures. That spread is now 64 basis points, which puts us above the level where the fed started tightening in December 2015.

But December 2015 was the tightest of the six interest rate liftoffs we've seen in the last three decades. We've cleared the lowest bar in the sample, not a typical one, so I'm staying a little cautious on calling for an actual hike. The futures market is less patient than I am.

For the September 16 meeting it's pricing a 31.8% chance of no move, down from 34.6% the day before, and a 68.2% chance of a hike. By the October 28 meeting, the aggregated odds of a 25 basis point hike are 97%. Despite the re-escalating tensions in the Middle East, the tons of reporting on oil driving inflation and the futures market leaning towards a hike, I think there's more going on underneath.

Another chart I showed in Saratoga was this three panel look at the 10-year nominal yield, expected inflation and the real 10-year yield. The real yield is just the top panel minus the middle one: 4.73% - 2.31% gets you 2.42% This concept is a little abstract but it matters. Say you're a fixed income investor looking at the 4.73% on the 10-year Treasury and it looks attractive.

The market expects inflation to run 2.31% a year over that stretch, which dilutes what you actually keep. Your after-inflation return is 2.42%, quite a bit different than the headline nominal yield of 4.73% Expected inflation trend Here's the takeaway look at the middle panel. West Texas Intermediate crude oil is pushing back above $90 and expected inflation (in orange) is moving down, not up.

If the bond market thought $90 oil was going to become a lasting inflation problem, that orange line would be rising, but it isn't. Combine that with nominal yields climbing on top and you're likely to find buyers stepper stepping into Treasurys at these real yields, which takes some pressure off the Fed to hike.

What's interesting from a sector standpoint is that energy stocks via the XLE are up 46.6% for the past year, with second-best technology trailing badly at 27.9%. Even more interesting is what's happening underneath that number, because energy is not one trade. It's several, and each one is levered to something quite different.

Exploration and production is upstream. Find it, drill it, sell the barrel, which creates the most impact from the underlying commodity price. They're the largest group in the broader energy universe at 32 names, and 8 of them are inside the XLE sector ETF.

Refining and marketing is downstream. These companies buy crude and convert it to gasoline, diesel and jet fuel. Their earnings come from the crack spread, not the crude price, which is why refiners ( MPC , VLO , PSX , PBF ) often do well exactly when E & Ps struggle.

Storage and transportation is the midstream — pipelines, terminal storage, LNG liquefaction and export tankers. These are mostly fee-based and driven by volume rather than price, similar to a toll road as opposed to a commodity bet. These names pay fat yields and include many master limited partnerships (MLPs).

Crack spread key A quick word on the crack spread, since it's about to do a lot of work here. A refiner doesn't really sell oil — it buys oil and sells gasoline, diesel and jet fuel. The crack spread is what's left over: the price of those finished products minus the cost of the crude it took to make them.

It's called a 3-2-1 crack because the standard math assumes three barrels of crude yield two barrels of gasoline and one of distillate. The graphic above shows one group that just doesn't didn't win, it lapped the field. Refining and marketing returned 108.7%.

The other four came in between 33% and 42%. Three refiners, MPC, PSX and VLO, are 15.8% of the fund's weight and delivered 17.2 percentage points of XLE's 48.5% total return. That's better than a third of the sector's entire year out of three stocks.

So what's the dynamic at work? Renewed hostilities around the Strait of Hormuz, plus sustained Ukrainian drone strikes on Russia and refining infrastructure, have squeezed global refined product supply. Russian crude processing outputs have fallen reportedly to the lowest levels in two decades from that damage.

There's also refining constraints in the U.S., where seven major U.S. refinery closures and conversions since 2019 have removed about 1.2 million barrels of oil processed per day. When the spread widens, the companies that own the refineries reap large rewards. To show it, I've overlaid the VanEck Oil Refiners ETF ( CRAK ) over the actual crack spread.

It's pretty clear where the outperformance came from. But drill into a year-to-date view and the spread may be flashing the same warning it flashed in the spring. Notice how the actual 3-2-1 crack made its high in July and put in a lower high in August, while the CRAK ETF pushed to a higher high.

The stocks are climbing while the thing that pays them is rolling over. We saw a version of this earlier in the year: the crack stalled out into April at roughly the same level it hit in February, while CRAK kept rising, and CRAK gave back ground into June. This time it's cleaner, because the crack isn't just flat, it's lower.

Pullback suggested This is not the time to add to our already overweight refining and marketing positions. It may be better to wait for the pullback the spread is suggesting. Or maybe we look at a different corner of energy all together — exploration & production, which is tied to the commodity price itself, especially with no apparent end in sight to the geopolitical tensions and crude potentially testing $100/bbl.

One name on my radar in that group is ConocoPhillips ( COP ). Unlike PSX, VLO, and MPC, which are very extended after a 108% year, COP is breaking out through $135 and just printed $136.19. Notice the lower panel — one-, two- and three earnings projections are all turning up, following the price higher.

I'm not ignorant to the persistent threat of inflation, or to the possibility that the Fed hikes rates if crude rips higher from here. What I am saying is that persistently wide crack spreads would keep inflation expectations elevated on their own, through refining margins, even if the price of crude drops. So let's watch that lower high divergence.

If the spread starts to come down, that helps inflation expectations along with it. And if crack spreads keep moving higher instead, the businesses that buy refined fuel rather than sell it take the damage. Airlines face higher jet fuel costs out of the constrained refining market.

Trucking and freight will face higher diesel prices hurting their margins, usually with a lag before those fuel surcharges catch up. Consumer-facing businesses that spend on fuel logistics like retailers, food distributors and delivery services, will face the same margin pressure. In closing look at what a rising crack has done to the transportation and airline ETFs — same chart but opposite directions.

Should the crack spread roll over, the industries that have been squeezed by fat refining margins are the ones that should get a boost. Too early to tell just yet what the ideal move is.

For now, I'm looking to add COP to the portfolio, but be on guard for a reversal in the refining and marketing names should the crack spread divergence play out and move lower. -Todd Gordon, Founder of Inside Edge Capital, LLC We offer active portfolio management and financial planning for retail investors, as well as regular market updates like the idea presented above.

Visit us at https://www.insideedgecapital.com/cnbc DISCLOSURES: Gordon owns VLO, PSX, MPLX personally and for clients of his wealth management company Inside Edge Capital, LLC.

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