Delek Vs. PBF Energy: A New Pair Trade From Morgan Stanley

Oil prices held up well in 2017, brightening the outlook for energy companies. Against this backdrop, Morgan Stanley recommends a pair trade in the U.S. refining sector.

A pair trade is a market neutral strategy, which helps to make profits irrespective of how the market moves by taking opposing positions in a pair of highly correlated instruments.

The Analyst

Morgan Stanley analyst Benny Wong upgraded shares of Delek US Holdings, Inc. DK from Equal-weight to Overweight but downgraded shares of PBF Energy Inc PBF from Equal-weight to Underweight.

Morgan Stanley's price target for Delek shares was raised from $34 to $44. The firm lifted the price target for PBF Energy from $30 to $37.

The Thesis

Valuations of U.S. refining stocks largely reflect a "constructive" 2018 macroeconomic backdrop, Wong said in a Thursday note. (See the analyst's track record here.) 

The analyst estimates strong global demand growth of 1.2 million barrels of oil per day, or MMbpd, exceeding the supply growth of 0.9 MMbpd.

Global product inventories are expected to continue to normalize throughout 2018, Wong said. 

In the U.S., demand growth is expected to accelerate from 0.8 percent in 2017 to 2.4 percent in 2018, the analyst said. 

"As such, we expect an above mid-cycle crack environment in 2018 with our Morgan Stanley base crack indicator at $14.90/bbl, relatively flat year-over-year even though 2017 was heightened by the effects of Hurricane Harvey," Wong said. 

U.S. refining equities have outperformed the S&P 500 by 40 percent and the broader energy group by 31 percent since mid-August 2017, according to Morgan Stanley. 

See also: Pains At The Pump, Gains For Oil Investors: The 2018 Gas Outlook

Refining valuations are "not overly rich" and do not fully incorporate IMO 2020, although they do reflect the constructive macro environment and impact of the U.S. tax cut, Wong said. 

Non-refining segments offer better value in Morgan Stanley's view, and Wong said the firm prefers diversified names, with upside to cash returns for shareholders.

Morgan Stanley's upgrade of Delek comes on the basis of the comapny's valuation, locational advantage, meaningful MLP exposure and positioning for higher cash returns to shareholders, Wong said. 

PBF Energy stock, after outperforming peers by 30 percent since mid-August, trades at 5 times the 2018 refining EBITDA and above the 3.5 times at which it historically traded, the analyst said.

The downgrade, Wong said, is geared to reduce exposure to refining, with over 85 percent of PBF Energy's EBITDA being driven by refining. The company has higher earnings achievability risk given its concentrated asset base, and PBF Energy's logistics/MLP business has a lower growth outlook than peers, the analyst said. 

The Price Action

Shares of Delek and PBF Energy are up about 51 percent and 45 percent, respectively over the past year.

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