United States-based Valero Energy (VLO) is the largest independent marketer and refiner of petroleum products in the world. We are interested in Valero for three primary reasons: Valero is spinning off its retailing business, Valero is well positioned to benefit from increasing shale oil production, and Valero shares are cheap at the current price. In our opinion, Valero shares are trading at a significant discount to fair value which we place at about $52.00.
Valero operates three primary business segments which are Refining, Retailing, and Ethanol. Valero's Refining segment consists of 15 petroleum refineries located in Canada, the United Kingdom, and the United States. These refineries produce gasoline, jet fuel, diesel, lubricants, distillates, asphalt, petrochemicals and other refined products. Other services supplied by the Refining segment are transportation of petroleum products, distribution and supply of petroleum products, and the wholesale marketing of petroleum products. The Refining segment is the crown jewel of Valero's business which generated an operating income of $4.45 billion in 2012. Valero's throughput volume capacity is about 2.81 million barrels per day with 49% of the volume coming from acidic sweet crude, sour crude, and residuals. The remainder of throughput volume comes from sweet crude (35%) and blendstocks and other feedstocks (16%).
The Retail segment accounted for $348 million of Valero's operating income. Valero operates 1,032 retail locations in the United States and operates 848 retail locations in Canada. Three primary wholesale brands are marketed in the United States. These brands are the Beacon brand marketed in California and the Shamrock and Valero brands marketed throughout much of the rest of the United States. On the retail side, Valero markets the majority of its volume through branded channels with the rest being sold through dealers and distributors that operate as members of the Valero brand.
The Ethanol segment was a loser in 2012 with an operating loss of $47 million. This operating loss is in contrast to the operating income of $396 million generated in the previous year. Valero operates 10 ethanol plants located in the central plains region of the United States. These ethanol plants produce about 1.1 billion gallons of ethanol per year. Both internally produced ethanol and distillers' grains are sold through this segment.
One near term catalyst for Valero is that on April 4, 2013 Valero's board of directors approved the spin off of Valero's Retail segment. Valero plans to spin off its Retail segment on May 1, 2013. The spin off will be called CST Brands and the deal will spin off 80% of the shares of CST Brands to Valero shareholders. We believe that CST Brands will be valued at a higher earnings multiple than Valero and will create additional shareholder value on the order of about $500 million this year.
Also, we think that Valero is well positioned to profit from the shale oil boom with its refining operations in the Gulf Coast region of the United States. As shale oil production increases, larger volumes of light crude oil will flow through to the Gulf Coast where Valero has seven refineries. Three of these refineries are designed to refine light crude oil while the other four refineries refine heavy crude. We believe that larger volumes of light crude oil should lead to better light crude oil pricing for Valero's three light crude oil refineries. In our opinion, there will be a glut of light crude oil in the United States due to insufficient refinery capacity. This situation may persist until some heavy oil refineries are switched over to light oil refineries to deal with the supply/demand mismatch. With relatively low cost light crude oil inputs feeding its three light crude oil Gulf Coast refineries, Valero should be able to generate high refining margins and strong profits.
We believe that Valero is a good value at $40.72/share for the following reasons:
- Valero has an inexpensive forward earnings multiple of 7.5 times 2013 earnings.
- Valero has an attractive dividend yield of 2.00% and a history of consistent dividend increases with a 14.3% dividend increase this year.
- The average 12 month price target for Valero is $51.16/share
- S&P has a Strong Buy rating on the stock (5 out of 5 Stars) and a 12 month price target of $52.00/share.
One argument that can be made against our investment thesis is that increasing volumes of light crude oil delivered to the Gulf Coast region may cause local oil prices to go up instead of down. This may occur if the necessary infrastructure is put into place to ship domestic crude oil, from the Gulf Coast, to overseas markets where crude oil trades at a higher price than in the continental United States. If this happens, Valero would not get the benefit of lower input costs and would not enjoy the benefit of higher refining margins. Only time will tell how this light crude oil pricing issue will play out for Valero.
Disclaimer: Ulfberht Capital is not an investment advisor. This article is not a recommendation to buy or sell securities. Always consult your investment advisor before making any investment decision.