Get Crackin' with Tesoro and Valero

Company descriptions by Bloomberg:

Tesoro Corporation* refines and markets petroleum products, and provides transporting services. The Company operates refineries, as well as a network of retail and refueling stations in the western United States. Tesoro also markets gasoline and diesel fuel to independent marketers and commercial end users.

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Valero Energy Corporation* is an independent petroleum refining and marketing company that owns and operates refineries in the United States, Canada, and Aruba. The Company produces conventional gasolines, distillates, jet fuel, asphalt, petrochemicals, lubricants, and other refined products as well as diesel fuel, low-sulfur and ultra-low-sulfur diesel fuel, and oxygenates.

These two companies' fortunes are tied to the crack spread- basically the profit margin between their crude oil costs and the combined prices they get from the array of refined products that they produce. Crack spreads can be quite volatile as are the earnings these companies generate. Ironically, the best time to own these highly-cyclical shares is generally when profits are near their lows and investors shun them.

Earnings hit high levels in 2001 for both TSO and VLO at $1.05/sh. and $2.21/sh.
EPS peaked again at all-time highs for each company in 2006 at $5.73 and $8.30 respectively. Here are the shareholder numbers for those who sold when things looked great and bought back when times were tough:

Both stocks hit their 2008 low on the same November 20, 2008 market day of infamy when about 95% of all stocks got clobbered by panic selling. Each of these issues made their 52-week highs exactly one year ago on June 26, 2008 [@$20.89 and $43.30 respectively].

Zacks is looking for 2009 – 2010 EPS of $1.17 and $1.75 for Tesoro and $1.43 and $3.01 for Valero. While earnings predictability is low for this industry, it appears likely that things should be getting better over the next year or two.

Value Line sees year end 2009 book values of $24.45 and $29.65 for TSO and VLO while assigning them financial strength ratings of B+ and A. The dividend yields of 3.14% and 3.64% are the highest in more than 16 years for their shareholders (excepting buyers at last fall’s lows).

Patient investors should do very well by picking up shares in these companies and putting them away for a few years. Tesoro and Valero showed their ‘boom period’ earnings power in their numbers from 2005-2006-2007.

Recovery potential seems quite substantial from today’s quotes.

Less patient investors might want to consider playing with these issues by buying shares while simultaneously selling options to lock in nice returns even if the shares ‘hang around’ for the next seven or eight months.

If Tesoro shares remain above $12 (as they are today) on Feb. 19, 2010:

• The $12 calls will be exercised.

• You will sell your shares for $12,000.

• The $12 puts will expire worthless.

• You will likely have collected $200 in dividends.

• You will have no further option obligations.

• You will hold no shares and $12,200 cash.

That best-case scenario would result in a total net profit of:

$4,400 / $7,800 = 56.4%

That would be achieved (in just eight months) on shares that:

• Went up.

• Stayed unchanged.

• Declined by up to $0.75 or (-5.8%) from trade inception.

What’s the risk?

If TSO shares are < $12 on Feb. 19, 2010:

• The $12 calls will expire worthless.

• The $12 puts will be exercised.

• You will be forced to buy another 1000 shares.

• You’ll need to lay out an additional $12,000 cash.

• You will likely have collected $200 in dividends.

• You will have no further option obligations.

• You will hold 2000 TSO shares and $200 cash.

What’s the break-even on the whole trade?

On the first 1000 shares it’s their $12.75 purchase price less the $2.75/share call premium = $10.00 /share.

On the ‘put’ shares it’s the $12 strike price less the $2.20/share put premium = $9.80 /share.

Your average cost would be $9.90 /share (ignoring dividends) or $9.80 /share including the $200 in yield.

Tesoro shares could drop by as much as $2.95 /share or (-23%) without causing a loss on this trade.

Valero closed at $16.48 today.

Here’s a nice seven month play for those who are options savvy:

If Valero shares rise to $17.50/share (up 6.2%) by Jan. 15, 2010:

• The $17.50 calls will be exercised.

• You will sell you shares for $17,500.

• The $15 puts will expire worthless.

• You will likely have collected $300 in dividends.

• You will have no further option obligations.

• You will hold no shares and $17,800 cash.

That best-case scenario would result in a total net profit of:

$5,120 / $12,680 = 40.3%

That would be achieved (in just seven months) on shares that only needed to rise by 6.2% from the trade’s inception price.

What would the return be if the shares remained unchanged (at $16.48/share) through expiration date on January 15, 2010?

• The $17.50 calls would expire worthless.

• The $15.00 puts would expire worthless.

• You will likely have collected $300 in dividends.

• You will have no further option obligations.

• You will hold 1000 VLO shares and $300 cash.

The liquidation value of your holdings would be $16,848.

The ‘static return’ would be a net profit of:

$4,168 / $12,680 = 32.8%

That would be achieved (in just seven months) on shares that did not go up from the trade’s inception price.

What’s the break-even on the whole trade?

On the first 1000 shares it’s their $16.48 purchase price less the $1.95/share call premium = $14.53 /share.

On the ‘put’ shares it’s the $15 strike price less the $1.85/share put premium = $13.15 /share.

Your average cost would be $13.84 /share (ignoring dividends) or $13.54 /share including the $300 in yield.

Valero shares could drop by as much as $2.94 /share or (-17.8%) without causing a loss on this trade.

Disclosure: Author is long TSO and VLO shares and short TSO and VLO options.

Comments

[TradingHelp...:]

I need a very strong coffee before I quite get to grips with this one, but I can see you know your stuff and will follow you accordingly.
Pass me that scientific calculator please.

Jun 28 06:19 AM

[Old Trader:]

Without getting into the nuts and bolts of the options aspect of the article, if the energy bill just passed in the house makes it through the Senate without substantial revision, I'd be looking at foreign refiners, given that the domestic refiners will be laboring under a cost disadvantage, leading to increased imports of distillates.

Jun 28 05:02 PM

[claudio.lan...:]

I have been reading Paul for a bit now and this one also loses me a little. If the best time to buy is when the stocks are at there lows and right now are at the 52 week high. It seems the trade starts against the idea of buying at the low..Also why spends the dollars to buy both companies instead of the one with the possibility of the highest return? Please clarify

Jun 28 10:10 PM

[Paul Price:]

Check the charts. Both stocks are very much near multi-year low points. They are down from $66 and $78 in 2007.

Jun 28 10:32 PM

[U Dontknow ...:]

BUSINESS JUNE 29, 2009 Valero Harnesses Wind Energy to Fuel Its Oil-Refining Process

By ANA CAMPOY

SUNRAY, Texas -- In this windswept corner of the high plains, a big oil refiner is embracing new green technology in order to make more money producing old-fashioned fossil fuels.

Valero's $115 million Texas wind farm, above, will pay for itself in about 10 years at current electricity prices.
Valero Energy Corp., which has the capacity to process more crude than any other U.S. refiner, recently installed 33 windmills to supply a refinery here with green electricity to produce gasoline and diesel.

The marriage is one of convenience, Valero executives say. "We didn't build the wind farm so we could get into the wind-energy business," notes Tom Shetina, the refinery's manager, who expresses awe at the windmills' size. "We built the wind farm so we could support the refinery and run it more economically."

The company hopes to lock in fluctuating electricity prices by developing its own source of power, rather than relying on the grid, and to cut the $1.4-million-a-month electricity bill at the seven-decade-old refinery. The $115 million wind farm, which will be ready to operate at full capacity in August, will pay for itself in about 10 years at current electricity prices, company officials said.

Valero, which is based in San Antonio, does have some environmental motives. It hopes to produce its petroleum-based fuels more cleanly, something it could be forced to do if Congress enacts legislation to curb greenhouse gases.

While the wind farm will make the refinery greener, it won't reduce the greenhouse gas emissions spewed by cars and trucks as they burn the fuels that Valero makes.

Transportation generates 33% of U.S. carbon emissions, with gasoline accounting for the bulk of them, government data show. Transforming crude oil into fuels accounts for less than 5% of U.S. emissions, according to industry trade groups.

Valero is experimenting with alternative fuels -- it bought several ethanol plants earlier this year -- but it and other refiners are betting that Americans will continue to fill their tanks mostly with gasoline and diesel for years to come.

And faced with increasing competition from refineries located in lower-cost areas overseas, it wants to make those fuels more cheaply.

According to Ken Starcher, director of the Alternative Energy Institute at West Texas A&M University, the cost of electricity from a typical wind farm in the area averages 4.5 cents per kilowatt hour during the project's lifetime, including the initial investment and maintenance. That's about 1.5 cents less than the current utility-company rate, he says.

After the Sunray wind farm is completed in August -- and when the wind is blowing -- Valero expects to generate 50 megawatts of electricity an hour, the full load required to run the refinery next door. That should cover the refinery's needs 40% to 45% of the time, it says, an estimate that experts say is reasonable for the area if the wind farm is well managed.

Valero says it will also receive tax credits from the project and could potentially sell the renewable-energy certificates from its wind power, which will displace electricity that is mostly generated by burning Wyoming coal.

The refinery, which was built here in the 1930s to take advantage of nearby oil wells, happens to be in one of the most desirable wind-power-producing regions in the U.S. Located some 40 miles north of Amarillo, the refinery has few neighbors aside from cattle and prairie dogs, which don't seem to mind the towering white windmills.

For the refinery's workers, the new wind farm, with its sleek towers and swooshing sound, is a lesson in contrasts between the old and new energy. It will take only about three local people to operate, compared with the 450 to 1,500 workers required to keep the refinery's noisy labyrinth of tanks and pipelines running in good shape.

Jun 29 05:49 AM

[tunaman4u2:]

Paul also recommended SUN a little bit back...
Do you have a best of the 3 between VLO, SUN & TSO for those small investors that can't spread thin between 3 refiners?
VLO also had a monster dilution just a short while back.

Jun 29 02:56 PM