Wall Street has long considered crude-oil refining to be the red-haired stepchild of the oil and gas industry. Refining historically has offered modest returns while being capital intensive, politically sensitive and environmentally risky. Over the past several years, integrated majors have reduced their downstream segments as their companies' share performances have lagged those of upstream producers. Within the past three months alone, BP announced plans to sell half of its U.S. refining capacity—some $3.7 billion in assets; ConocoPhillips targeted $1 billion of downstream asset sales; and Chevron sold its $2-billion U.K. refinery.

In the last two months of 2010, however, shares of the five biggest U.S.-based independent refiners (excluding Sunoco, which is undergoing a restructuring), Valero Energy Corp., Tesoro Corp., Holly Corp., Frontier Oil Corp. and Western Refining Inc., soared 38% on average. These stocks have continued their momentum into 2011; as of March 25 they are up by an average 48%, making the refiners one of the best-performing subsectors in the entire market.

In fourth-quarter 2010, Thomson Reuters recorded $17.4 billion in new institutional capital allocated to these five independent refiners, with low-turnover investments outweighing high-turnover investments by a margin of 53%. At the same time, equity research analysts upgraded their outlook on the companies' shares, improving their Thomson Reuters I/B/E/S ratings by 11% to an average 2.34, with 1 being a Buy and 5 representing a Sell rating.

There are two primary reasons for the refiners' strong equity performance and improving Wall Street sentiment. First, with about half of domestic refining margins derived from gasoline, the upcoming summer driving season is potentially a major catalyst.

The second factor is the widening differential between international oil benchmarks and domestic grades. In particular, West Texas Intermediate, the Nymex staple priced at Cushing, hit a record $20 discount to Brent, the ICE equivalent traded in London, in mid-February.

Historically, WTI trades at an approximate $2-per-barrel premium to Brent, as it is physically lighter and sweeter. But the two grades approached parity during 2008, and the spread has been widening ever since. Still, the movement to the record $20-intraday differential was sharp—from approximately $3 on January 3 to more than $12 in early February, on unrest in Egypt, and to $16 by mid-month, on supply disruptions from Libya. Landlocked WTI was relatively insulated from events in the Middle East and North Africa, while offshore Brent was more directly affected.

While the geopolitical factors bolstering Brent prices are transient, there are also structural factors underlying the decoupling in oil benchmarks. On the one hand, there is downward pressure on WTI prices from burgeoning inventory levels at Cushing. Supplies at the price hub have surged on the development of nearby resources (particularly the Bakken shale and Permian Basin) and from rising Canadian imports from the Keystone pipeline extension.

Furthermore, the steep contango in the WTI curve, whereby the spot rate is trading lower than future prices, has encouraged speculators to buy crude oil at current prices, pay for storage and subsequently sell at a locked-in future price, promoting inventory accumulation.

On the other hand, there is upward support for Brent prices not only from temporary disruptions in supply from North Africa, but also from permanent declines in production from the North Sea, the source for Brent oil.

The capital markets have bet that North American refiners will reap higher margins as their input costs lag the market prices they receive for finished products. According to Bank of America/ Merrill Lynch, each $1 move in the differential equates to a 15% advance in U.S. refiners' earnings.

In other words, the surge in shares of refiners stems from favorable crude oil input costs rather than from strengthening fundamentals, such as growth in demand for gasoline or heating oil. However, most Wall Street analysts do not believe that today's $17-plus WTI-to-Brent differential is sustainable, though they do not expect a reversion to a WTI premium, either. Consensus forecasts from both sell-side analysts and corporate management teams call for a discount of $6 to $12 through 2016, as infrastructure projects to address Cushing's storage issues take years to build and production from the Rocky Mountain and Midcontinent shale plays continues to build supplies.

Yet, as for fundamentals, the outlook on refining is decidedly bearish due to the oversupply of refined products. Furthermore, if the run-up in crude prices persists and buoys gasoline prices, we could see an adverse impact on the U.S. and global economy, resulting in demand destruction for refiners' products.

The critical question over the coming months will be whether U.S. refiners can parlay the discount in domestic oil prices into a bottom-line advantage, when in fact less than half of the country's refining capacity has access to WTI—most U.S. refining capacity is actually linked to global benchmarks. It is mainly the Midcontinent-based refiners that can physically source WTI crude with the potential to profit from the spread.

But even if the disparity between Brent and WTI clears, and the latter closely tracks global oil-price movements, it is doubtful that WTI can reclaim its prior status as the primary global oil benchmark.

Many traders believe that we are headed toward implementation of a basket oil price, comprised of Brent and other international grades. This would be a dramatic shift for the capital markets, with important implications for how investors assess the value of energy stocks.

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