Valero Energy Call Spread Idea

You would think that with oil prices skyrocketing, the people who turn barrels of crude oil into usable products like gasoline for our cars and heating oil for our homes would be absolutely minting money.  Well, unfortunately, when the refineries' input commodity (crude oil) price skyrockets, the margins for the finished products (outputs) actually get compressed.  This margin is often referred to as the "Crack Spread" and it's something that is highly cyclical and thus, the refinery stocks that live and die by the spread are also highly volatile.  One such name that we've followed for quite some time is Valero Energy (VLO).  Today's pick is a call spread on VLO.

Valero Energy (VLO) operates as a crude oil refining and marketing company in the United States and internationally. Its refining activities include refining operations, wholesale marketing, product supply and distribution, and transportation operations primarily in the Gulf coast, mid-continent, west coast, and northeast regions.

The company produces conventional gasoline, distillates, jet fuel, asphalt, petrochemicals, lubricants, and other refined products, as well as reformulated gasoline mixture, gasoline meeting the specifications of the California Air Resources Board (CARB), CARB diesel fuel, low-sulfur and ultra-low-sulfur diesel fuel, and oxygenates. As of 31 December 2007, Valero Energy owned and operated 17 refineries in the United States, Canada, and Aruba with a combined throughput capacity of approximately 3.1 million barrels per day.

The company's retailing activities include the sale of transportation fuels at retail stores and unattended self-service cardlock sites; sale of convenience store merchandise in retail stores; and sale of home heating oil to residential customers in the United States and Canada. As of the above date, it operated approximately 5,800 retail and wholesale branded outlets under various brand names, including Valero, Diamond Shamrock, Shamrock, Ultramar, and Beacon.

The company was founded in 1955. It was formerly known as Valero Refining and Marketing Company and changed its name to Valero Energy Corporation in 1997. Valero Energy Corporation is based in San Antonio, Texas. 

click to enlarge image 

The chart above shows VLO for the last six months. The stock has been compressed as the profit margin of each barrel of oil they refine has been similarly impacted negatively by the irsing price of crude oil.    The Relative Strength Index [RSI] and Moving Average Convergence / Divergence [MACD] stochastic lines are both rounding out at low levels, indicating a bounce, at least on a  technical basis could be coming.      

VLO's Fundamental Data

• Current Price:  $40.86
• Shares Outstanding:  528.5 million
• Market Cap: $21.6 billion
• Forward Price / Earnings (avg. Est): 6.8x
• PE/G Ratio (5 Year Expected):  5..7x
• Price / Book:  1.2x

Valero's revenues have been surging lately.  As you can imagine, just selling the same amount of energy product while the price soars nearly 100% will give you a revenue boost of 100%.  But VLO has been unfortunately not making as much of a profit per barrel of oil as they did in 2007.  The 2008 annual earnings estimates for VLO are averaging about $5.23 per share right now for the full year ending in December 2008, versus a 2007 full year figure of $8.17 per share. Try to get your head around the fact that VLO's revenues have surged over 42% in that time, and you'll fully understand the seriousness of the compression of the crack spread.  VLO's operating environment in higher oil price conditions is just plain brutal.  2009's earnings estimates are currently posted at $6.03 per share, though revenues are expected to grow another 10%.

Given VLO's current valuation and earnings expectations, we think the market has basically denied them any potential benefit of either a respite from rising oil prices (which could happen) or a cessation in the compression of the crack spread.  The second potential factor would immediately follow the first.  We think the present value of VLO, given its earnings and revenues outlook under what is today arguably a "worst case" scenario has much downside risk to it.  Quite the opposite - we see the price today representing a great value and a free call option to the upside.

Valero's balance sheet has a nice-sized cash cushion of over $1.4 billion.  The debt they carry though, amounts to over $6 billion.  Still, with the annual revenue run rate of over $130 billion, they have an EBITDA number on a trailing twelve month basis of over $6.64 billion.  If they wanted to, they could probably pay off the company's debt within one year - that's powerful.  Certainly within two years, but then that's probably not the best use of funds for the Company.  Share buybacks have happened here in significant size in years past, and we would expect that to continue.  VLO pays a $0.60 dividend, and that could easily see an increase, as the payout ratio is currently at only 6.0%. 

Investment Recommendation

Our recommendation this week is to buy VLO stock at its present price of $40..86.  We would also buy a September call spread in the $42.50 / $52.50 strike prices.  We would look to acquire the VLO Sept $42.50 call for $3.00, and write the Sept $52.50 puts for $0.70, for a net cost of $2.30 to this spread.  We would look to sell this put spread at a level of $8.00 or higher between now and the future expiration, giving us a return of just over triple the money.

We've heard from a few of our readers who just want straight option buy recommendations, rather than spreads.  For investors who do not wish to write the higher strike call, a direct purchase of the September $42.50 call for $3.00 would be an alternative.  We would look to sell that call at a level of $9.00 or higher.

Please note: Options trades all involve a high degree of risk and the potential to lose some or all of your investment. These recommendations are general in nature, and you should consult your own financial professional who is familiar with your situation as to the appropriateness of these trade ideas.

Disclosure: Analyst has no position in VLO stock or VLO options.

Comments

[richjoy]

Good (and appreciated) advice...
This is the kind of gem I expect for having to suffer 100 less-than-useful postings on Seeking Alpha.

[Daniel Jones]

Thanks for that compliment. I'm chuckling out loud - sorry you had to sift through the others to find me. I'd refer you back to my website for a subscription if you really wanted a regular good read.

[bushwachergary]

While you're descibing a call spread, your write-up uses the term "put"

[CaptainWrongwayPeachfuzz]

You said: "We think the present value of VLO, given its earnings and revenues outlook under what is today arguably a "worst case" scenario has much downside risk to it. Quite the opposite - we see the price today representing a great value and a free call option to the upside."

Did you mean "little downside"???

[jjason]

Frankly, I would much rather see options trading made illegal.

I do not see the benefit in trading options because it does not produce anything.

In other words...ranchers produce beef, farmers produce corn, wheat etc. What do options produce?

For the same reason, I would do away with all toll roads and toll bridges and tunnels in the US.

The gains in productivity would be good for our economy.

[swimjames]

agree about toll bridges, you sound like my dad!

[Allan Harris]

I read about your VLO trade here: philsbackupsite.wordpr.../

Attached to that post is my Comment that I was buying VLO puts at the same time you were doing your call spread. As of today, July 10, 2008, my VLO August 37.5 puts are up over 200%. How is your spread doing?

[CoverIsBetter]

Forgive me for stating this obvious, but this trade idea has gone horribly wrong to date.