The revolution in shale oil is changing the composition of crude oil available to U.S. refiners, including Valero (VLO). Over the past several decades, crude imports and domestic production have become increasingly heavy as marginal supply has come from heavier oil projects in places such as Canada, Venezuela, Mexico, Colombia and even traditional light suppliers such as Saudi Arabia. In the U.S., the transition from onshore to offshore for oil production over the past several decades has seen an increase in medium weight oils such as the deep water MARS blend. In response, certain refiners have reconfigured their plants to run heavier crude slates or have focused acquisitions on refineries that are designed to handle those same heavy crudes with Valero especially leading the charge in this area.
In Valero's own words "we are still basically a heavy complex coking refiner," meaning a large portion of the company's refining technology is in delayed coking equipment. Coking works by slowing "cooking" the heavier parts of the crude oil after other processes such as distilling and catalyst cracking have already taken place. The lighter hydrocarbons in the crude are slowing vaporized and collected while only a solid coke is left behind. The process is relatively time intensive and results in low quality residuals which is the ultimate reason heavier crudes trade at a discount to lighter crudes, other factors being equal. For example, in the above linked transcript Valero claims that running the coker demands at least a 7-8% discount for heavy oils.
The basic reasoning behind Valero's historical strategy was that crude availability would come increasingly from heavier weight oils; however, the recent boom in shale oil has called this assumption into question. Crude production from the Bakken, Eagle Ford and Permian is of light oil and even some condensates that are useful as blending components. This has created a challenge for Valero because it has pressured light / heavy differentials. The company has the capacity to make some adjustment at its refineries to run lighter grades of crude, but the amount that can be switched without major capital programs is limited. The company states that it has switched about 200,000 barrels a day (bp/d) already and another 200,000 bp/d can be switched with limited capital expenditure. For reference, Valero produced 2.6 million bp/d in the first quarter of 2012.
Given the amount of focus and capital expenditure devoted to producing shale oil plays in the U.S. by E&Ps, it is unclear if the gradual amount of change Valero will be able to produce from small dollar investments will be enough to keep its refineries competitive. With petroleum product consumption in the U.S. down close to 15% from its peak in 2005 and product refined down over 5% (with the difference accounted for by exports) and the trend continuing, refiners are under constant competitive pressure to be the low cost producer. Valero has witnessed this competitive pressure first hand as it has been forced to mothball its Aruba refinery and sell at a significant loss its Delaware City refinery as they have become uncompetitive for various reasons.
The major issue to think through is whether the shale oil boom will produce enough incremental light barrels to force Valero to respond by making major capital investments in its refineries. This would continue what has been viewed as abnormally high levels of capital expenditure in recent years, but may in fact be a more normal level of expenditure.
Turing to valuation, some investors believe that in light of the company's low price-to-earnings multiple that the company's stock is cheap. However, due to high capital expenditures free cash generation has been quite low; in 2009 through 2011 cumulative capital expenditures have been 40% higher than depreciation, the continuation of a long-standing trend. What we are likely seeing here is a depreciation rate that does not really represent the true economic reinvestment needs of the business, partly because that rate is not accounting for the need to change the refinery to deal with changing 1) feedstocks and 2) end product demand, such as gasoline versus diesel. While we are seeing this in increased light crude availability now, we saw it in increased heavy crude availability previously.
The impact of an increased depreciation rate implies lower earnings and a higher price to earnings multiple; for example, on trailing twelve month earnings, the ratio would increase about 2.5x if depreciation was adjusted higher 40%. A more fulsome valuation exercise would look at discounted future free cash flows but this simplistic analysis should give some directional guidance at least in terms of the valuation impact.