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The return difference between Valero (NYSE:VLO) and Western Refining (NYSE:WNR) has widened recently to more than 850 basis points from one month ago compared to three months ago. Part of the latter's outperformance stems from its de-risking practices: everything from hedging to reducing leverages and shifting geographical focus. Currently, the Street is more bullish on Valero, but both receive around a "buy" rating compared to Sunoco (NYSE:SUN), which is rated a "hold." All in all, I share this sentiment.

From a multiples perspective, the most preferred refiner, Valero, is the cheapest of the three. It trades at a respective 5.2x and 5.3x past and forward earnings, in addition to offering the highest dividend yield at 3%. Whereas Sunoco does not offer any dividend distribution, Western does at a yield of 1.1%.

Even still, Western is making the most progress in de-risking. On the third quarter earnings call, Western's CFO, Gary Dalke, noted favorable results:

"Operationally, we had a very good quarter with El Paso and Gallup running near capacity. Overall total throughput averaged to approximately 150,000 barrels per day during the quarter. Also, during the third quarter we authorized construction of new facilities to receive additional quantities of Bone Springs and Avalon crudes which are logistically a yield advantage for the El Paso refinery. We will continue to evaluate opportunities, which will allow us to process additional barrels of local Permian crude.

Another key component of our strategy in this margin environment is our crack spread hedging activity. During the quarter, distillate and gasoline Gulf Coast forward cracks remained well above historical levels. We felt it was needed to add to our crack spread hedge positions during the quarter allowing us to lock-in the strong margins on a portion of our future refining production."

Note specifically the "hedge positions" in gasoline and diesel, which have protected margins. The company has also dramatically raised cash and will likely be aiming to further reduce Term Loan. Western recently sold Yorktown for $180M and the New Mexico pipeline for $40M, which will be closed in the fourth quarter. Not only does this reduce leverage and attract investors to a safer security, but also shifts the company to its flagship Southwest projects. This region has the benefit of being more stable than many other regions. In addition, unlike most of its competitors, Western has solid profitability at all phases of the production cycle. With that said, the Brent-WTI oil spread has gone up.

Consensus estimates for Westerns EPS are that it will turn positive in 2011 at $3.33 and then start to decline 13.2% and 17% in the following years. While the accelerating loss following 2011 does give pause, when you consider probable PE ratios, the company appears to have tremendous upside. Assuming the multiple declines to 7.5x and a conservative 2012 EPS of $2.79, the stock has 40.6% upside.

Valero similarly is well positioned to be a big winner. It has solid connections to major export areas, top production power, and remains committed to returning free cash flow to shareholders. It too is improving the balance sheet. While nine of the 11 revisions to EPS estimates may have gone down for a net change of -5.6%, the stock still merits its "buy" rating.

Consensus estimates for Valero's EPS are that it will grow by 173.5% to $4.43 in 2011, decline by 12% in 2012, and then grow by 6.2% in 2013. Assuming a multiple of 7.5x and a conservative 2012 EPS of $3.84, the rough intrinsic value of the stock is $28.80, implying 41.4% upside. Even if the multiple were to hold steady and 2012 EPS turns out to be 3.6% below consensus, the stock would barely drop. Accordingly, Valero has favorable risk/reward.

Source: Over 40% Upside For Valero, Western Refining