Apart from the recent uptrend in the WTI Crude prices, there are other undercurrents in the Oil sector that are creating renewed opportunities for investors. While companies like Schlumberger Limited (SLB) are poised to benefit from rising prices, there is one company that seems to benefit from a "real estate aspect".
Take a look at Valero Energy Corporation (VLO).
Valero is a major U.S. based refiner with sixteen refineries spread across the United States, Canada, United Kingdom, and Aruba, producing many things related to oil. The company owns hundreds of retail stores (6800 and counting) spread across these same regions, and also operates ten ethanol plants, three of which were acquired in 2010.
Before venturing into why Valero will benefit in the next few years, let us take a fifty-thousand foot view of the changing Oil canvas in the United States.
The Cushing Problem
Lately a huge amount of oil has been gushing from the oil shale reserves, but a lot of that oil ends up in Oklahoma's small city named Cushing, which is a major hub in oil supply connecting the Gulf Coast suppliers with northern consumers.
The problem is that we don't have much pipeline capacity connecting the gulf coast to the mid-continent of the United States, and this has made the Cushing oil hub a bottleneck for the North American energy industry.
Solution in the works
The solution to the Cushing problem is not out completely yet, but is in the works. There are two big pipeline projects underway.
- Transcanada's Gulf Coast Pipeline project is expected to finish it's pipeline project in mid to late 2013, which will connect Cushing to the Gulf Coast refiners in the Texas.
Note that this project is the third phase of the controversial KeyStone project.
- Enbridge is expected to finish it's Flanagan South Pipeline project by 2014, connecting Cushing to pipelines in southwest Chicago.
Enbridge also partly owns Seaway, the company that reversed the 500 mile Seaway pipeline flow between Cushing and Houston, Texas, in May 2012. Because of that project, all the Gulf Coast refiners started getting cheap crude oil, and in good speed too.
Since Valero is the largest oil refiner in the Texas Gulf Coast region, the company will benefit a lot once the bottleneck at Cushing is removed, or even reduced.
The pipeline capacity is bound to expand in the next couple of years, largely thanks to these TransCanada and Enbridge projects. Taking a high level view of this development, Valero will have a location advantage over its competitors, as it will get cheaper crude oil in good speed, and this low input cost will help them derive higher margins.
Also, on July 6 2012, Valero's investor presentation provided the following positive points for the company:
- Valero comprises 24% of U.S. gasoline and distillate exports (Slide 7). This appears to be the biggest share in the pie.
- New projects such as St. Charles and Port Arthur projects are expected to contribute to annual EBITDA (Slide 17).
- Expect a significant decline in capital spending after 2012 (Slide 21).
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Last but not the least, Valero has good fundamentals. Take a look at the following key statistics:
- Dividend Yield: 2.54%
- Return on Equity: 10%
- Although inconsistent, Valero's earning growth has a positive trend.
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It appears that William Dillard was right even for the Oil refiners, when he said the famous words, "Location, location, location". Valero, a big refiner with good fundamentals and a healthy dividend, is poised to benefit from the recent developments in the United States's oil industry.
Risks to Valero's outperformance in the next couple of years are:
- Any obstacles or delays in the pipeline projects discussed above could make Valero less attractive until the issues are resolved, providing trading opportunities to traders and causing nervous moments for long term investors.
- Volatility in oil prices and commodities.
- Reduced operating margins in the Refining Segment that provides more than 80% of income to Valero.
- Valero could face trouble servicing its debt in dire circumstances, because neither the company's operating profits nor current assets alone are great enough to satisfy interest obligations. The Debt/Total Capital Ratio is 32.2%.