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Valero Energy Corp. (NYSE:VLO) is one of the many refineries in this country that refine oil to make gasoline, heating oil, and other petroleum products. Even though Valero is the nation's leader in this sector competition in the industry is fierce. From the integrated oil side of the business Valero's refining business competes directly with the likes of Marathon Petroleum (NYSE:MPC), Phillips 66 (NYSE:PSX), Tesoro Corp (NYSE:TSO), and Murphy Oil (NYSE:MUR). Due to Valero's size the company also competes with some of the bigger names out there too, Exxon Mobil (NYSE:XOM), BP plc (NYSE:BP), ConocoPhillips (NYSE:COP), Chevron (NYSE:CVX), Total (NYSE:TOT), and Royal Dutch Shell (NYSE:RDS.A).

From a fundamental standpoint Valero is a financially sound company. Valero currently trades for $44.25 per share and has a P/E of 11.79, and generates fairly consistent EPS growth with good free cash flow. Valero currently has $1.73 billion in cash on hand and has a book value of $32.66 per share. The firm offers a modest dividend of $0.80 per share which at current market price yields 1.80%, but most investors buying this stock are not looking for income, but instead growth through share price appreciation. The stock is up roughly 10.10% year to date compared to the S&P 500's 8.40% increase. Valero's market beating performance is mainly attributed to the company announcing a better than expected quarter back in January.

Valero The Oil Play

Valero like most refiners makes money on the spread between what it has to pay for light sweet crude oil and what it can sell its refined bi-products (mainly gasoline and heating oil) for in the open market. This spread is more commonly known by traders as the "Crack Spread: and it is the margin that Valero makes. This margin due to the nature of it being so dependent on market commodities is extremely volatile. In years prior Valero's margins have been particularly tight especially due to higher than average price crude oil that was selling for $90 - $110 per barrel. Granted gasoline and heating oil prices have also run up in conjunction with the price of crude oil, but those price increases are very rarely equal in value to completely offset each other.

In Valero's most recent quarter the company posted earnings that were considerably above the street's consensus. Valero posted an EPS of $1.88 compared to the Street's estimate of $1.18. That surprise represented a 59.3% beat.

The International Energy Agency in November forecasted that U.S. oil output could top production from Saudi Arabia and Russia by 2020. Since that announcement Valero over the past year has been quickly replacing all of its expensive foreign crude oil shipments with cheaper domestic oil. This move has resulted in significant increases in margins for the company because Valero is now able to buy its oil in the U.S. for far less than the $95 per barrel market price of oil. Valero was then still able to sell its byproducts for much more at the going market price. To better illustrate the significance of this input cost change. Valero in Q4 of 2011 reported a net income of $45 million. One year later in Q4 of 2012, the firm's net income jumped up to $1.01 billion. That represented a 2,144% increase in net income year over year, mainly the result of those increased margins.

Other refiners are also starting to jump on this bandwagon but not to the same level and degree that Valero already has. This can be clearly seen in the earnings surprises that have been reported in the past year. The below chart compares and trends Valero against some of its main refining competitors on overall earnings surprise/disappointment.

Company

June 2012 Surprise

September 2012 Surprise

December 2012 Surprise

VLO

4.90%

8.60%

59.30%

MPC

0.80%

2.50%

7.60%

PSX

25.30%

26.40%

22.60%

TSO

24.80%

-12.00%

-2.20%

Valero's Agricultural Play

What makes Valero the most unique compared to its above mentioned competitors is that Valero also is a major competitor in the ethanol space. Back in 2009 Valero bought seven ethanol plants from VeraSun Energy for $477 million. At the time VeraSun was in the middle of a chapter 11 bankruptcy filing, so Valero was able to get the plants for pennies on the dollar. After these plants were added to Valero's current holdings Valero became the country's third largest producer of Ethanol with ten plants under its ownership. This large holding allows Valero to be a major competitor in the ethanol space and compete against other large ethanol companies like Archer Daniels Midland (NYSE:ADM), Green Plains (NASDAQ:GPRE), and Pacific Ethanol (NASDAQ:PEIX).

The move to buy these plants had two main intentions. One, Valero wanted to gain some penetration into the (at the time) ever growing ethanol market. Two, cost savings could be achieved by Valero in the input of ethanol into gasoline, since gasoline it is currently mandated to contain at least 10% ethanol. After realizing why the company did this it might seem like a brilliant move to buy these ethanol plants for pennies on the dollar, but it is also important to remember that the ethanol market is far from black and white, and can be even more volatile than the oil market. The number of external factors that affect the price movement of ethanol vary greatly and are usually out of anyone or any one company's control. Current factors that could play an adverse effect on the future price of ethanol include.

· Government subsidy cuts to this area could dramatically hurt the overall profitability of running the plants - Most plants are not able to independently sustain themselves without government help

· Dramatic fluctuations in the prices of corn/soybeans - Last year's drought pushed prices up causing increased pressure on input costs for ethanol producers

· Transportation costs make moving ethanol difficult. Moving ethanol through a transitional pipeline causes the ethanol to begin to breakdown the pipeline due to its corrosive properties, because of this ethanol can only be transported in compatible materials that won't corrode - usually via semi resulting in increased transportation costs

· Public acceptance outside of the Midwest is quite low - ethanol is sold to the public as a green fuel but after factoring in all of the external input costs associated and refining costs it is far from green

Even amongst all of this negativity on the space if the conditions are right and government legislation remains constant money can still be made in this space. Especially for the likes of Valero which have a dual purpose for the plants.

The Next Phase of Valero

If there is one thing Valero has it is a diversified portfolio. Even as the ethanol industry is starting to bottom out the company has been able to capitalize on the newfound oil reserves here in the U.S. Back in August it was reported the Kinder Morgan Energy Partners (NYSE:KMP) would be partnering with Valero on building a 136 mile, 16 inch pipeline that would be in full service by mid-2013. Valero also announced last year, similar to the likes of Marathon Oil (NYSE:MRO) and ConocoPhillips that it planned to spin off its retail business. This spinoff is reported to generate almost $3.5 billion for the company later this year, helping to create even greater value for shareholders and make Valero an even stronger company.

As Valero continues to take advantage of low domestic crude oil prices and high market prices of heating oil and gasoline the future for Valero's refining business seems bright indeed. Unfortunately, depending on how the growing season goes this year and what new legislation comes out of Washington Valero could continue to face downward pressure in its ethanol business. Even with this hanging over the company I still feel that Valero provides shareholders with significant value, especially given its current earnings growth. Given this I would consider any significant weakness seen due to its ethanol business as a buying opportunity in Valero, the agricultural oil company.

Source: Valero, The Agricultural Oil Play