The Long Case for Valero Energy

| About: Valero Energy (VLO)

Given the run-up in energy related names, combined with a rising interest rate environment and significant increases in energy capex (capital expenditures), I would only want to purchase Valero Energy (NYSE:VLO) on weakness. That said, at 7x forward earnings and 6x cash flow, VLO may offer investors a significant opportunity.

After its recent acquisition of Premcor, Valero has become one of the largest refiners-marketers of energy in the U.S. Given it's large footprint and the investment it has made in its system, VLO may find itself in the "perfect storm" of some powerful industry dynamics that will allow it to sustain if not grow its cash flow for years to come. Currently most Wall St. analysts are basing 2007 & 2008 numbers on "normalized" energy prices (i.e. $35-$40 per barrel), however if oil prices were to stay at the level that current future contracts indicate ($60), these estimates will move dramatically upward, particulary for Valero.

Valero has a unique competitive advantage in the "complexity" of its refinery system. Refineries are classified by something known as the Nelson Complexity index, where VLO scores the highest in the industry. Put simply, the higher a refinery's complexity, the more capable it is of processing a broader range of crude. Essentially, these refineries have installed more "cokers" and "crackers" and other equipment that enables them to transform the heaviest and sourest crudes into value-added petroleum products. Interestingly, when the majority of U.S. refineries were built, most of our raw material came from Texas, when the Light Sweet Blend of West Texas Intermediary was fairly easily refined. Fast forward to 2006, much of the U.S. oil supply comes not from Texas, but from places like the Middle East, Africa, and South America, where reserves are predominantly of the heavy-sour type. The world is awash in heavy sour, the bottleneck lies in the shortage of refineries that can process it. The tight supply of Light-Sweet and the abundance of Heavy-Sour increases the value of complex refiners, such as VLO.

The "crack spread" or the difference between a refiners inputs and its finished goods, has historically been around $5.00. Recently this number has approached $15.00, driving higher margins and cash flow for Valero. Over the last 12 months this company generated almost $6.5B in EBITDA (earnings before interest tax and depreciation), not bad for a $30B company.

If you think that the growing global demand for energy products and increasingly uncertain supply trends are here to stay, excess capacity will remain tight, and prices will remain strong. Perhaps, given it's position in the industry, Valero may be the perfect way to ride out this perfect storm.