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Valero Top Of The Oil Barrel

Posted: Sep 05, 2008 14:51 PM by Ryan Barnes

Tickers in this Article: VLO, TSO, SUN, XOM, CVX

Valero Energy (NYSE:VLO) and other oil refiners dodged a bullet this week as Hurricane Gustav largely spared the U.S. hub of refining capacity north and west of the Gulf of Mexico. As that storm dissipates, however, the pressure of a terrible summer for the refiners has many investors feeling exhausted and uncertain about the future.

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Summer Squeeze on Margins, Profits
As crude oil prices pushed on to all-time highs throughout the early summer (peaking at just over $140/barrel), the prices for many refined products like gasoline, petrochemicals and jet fuels failed to keep pace. The crack spread for gasoline shrank to its lowest levels in many years, causing Valero to report a 67% drop in net income for the second quarter despite growing revenues by more than 50%.

More drastic shortfalls were seen at other independent refiners: Sunoco (NYSE:SUN) reported that profits fell more than 80% in the second quarter, while Tesoro (NYSE:TSO) saw net income collapse to just $4 million from over $400 million a year ago.

Such is the nature of the independent refiners: When the price of crude oil gets volatile, upstream margins follow suit. The integrated oil corporations like Chevron (NYSE:CVX) and Exxon Mobil (NYSE:XOM) do much of their own refining, but because they are vertically integrated they get extra juice on the exploration/production side when crude oil rises on the open market.

Is Oil's Bull Market Over?
Crude spot prices, which hover around $107 per barrel, have quickly fallen about 20% from their peak. Several factors have played into this, such as concerns over weaker global economic growth, the rise of the U.S. dollar against major currencies and the demand downfall at gas pumps in the U.S. and abroad. (Learn more in What Determines Oil Prices? and Become An Oil And Gas Futures Detective.)

Many speculators who ventured into the futures market have been shaken out, which might help ease the overall volatility in crude for the remainder of the year.

Strong secular trends are still in place. The developing world needs oil and its derivatives to grow, especially in the beginning phases of infrastructure and manufacturing. Weakness in the U.S. economy is bound to affect the global whole, but I see the global economy maturing out of this pattern as developing nations make rapid gains in wealth and gross domestic product.

Valuation Ruminations
The recent pullback in the price of oil is a welcome break for the refiners, and all of them have seen a small reversal of their stocks' downward summer march. Based on trailing earnings, the group looks fantastic. Exxon's trailing 12-month P/E is around 9.5, and Chevron's sits at 8.5, but so many variables have changed since then.

Accurate valuations of the major players involve some subjectivity: Do we use run-rate earnings based on today, averages seen over the volatile past year or do we extrapolate based on prospects for the future? A case can be made for utilizing all three, but given all the uncertainties in the industry, investors should first seek out the best operator.

Valero Stands Apart
I like the unique advantages offered by Valero. It actually separates itself in a market dominated by commodities. The company has some of the most technologically advanced refineries, is spread out across the map (which reduces geographical concentration risk), and is able to process a cheaper form of crude (known as sour crude or "heavy sour"). While all the refiners have some of this capability, Valero can use it for greater than 50% of its inputs across the company’s 3-million-barrels-per-day (bpd) capacity. Valero has also been able to increase its production of diesel and other distillates, which have carried much higher margins than gasoline of late.

Perhaps most importantly, Valero has tremendous value in the refineries themselves. The company sold a refinery last year for $1.9 billion that processed 165,000 bpd. If that same value were applied to the rest of Valero's refineries, one could easily reach an asset value that exceeds the current enterprise value of the stock (roughly $25 billion). Even applying 50% of that sale’s value would justify the full price of the stock at current levels. In a shaky market asset valuations will fluctuate, but over the long term these assets provide a floor for the stock and give any future earnings growth a little extra power to drive shares higher.

Parting Thoughts
Investors should tread cautiously and volatility haters won't enjoy being in this industry. But if crude oil remains at lower levels, the refiners should begin to see some incremental margin improvement. Among the focused refiners, I think Valero's valuable assets and the ability to process high volumes of cheaper inputs will have it outperforming its rivals.

By Ryan Barnes

Ryan Barnes has over 10 years experience in portfolio management and investment research, covering equities, fixed income and derivative products. Barnes has worked with Merrill Lynch, Charles Schwab, Morgan Stanley and many others as an institutional trader, and maintained AIMR compliant performance for a diverse set of high-net-worth investors.

Barnes is currently working as a writer and financial modeling consultant specializing in capital appreciation and hedging strategies, and is the editor of EpiphanyInvesting, a website devoted to finding long-term success in the stock market.

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