Time To Look at Valero?

I have not been much of a fan of the prospects for refiners. Now, I believe we may be on the verge of some opportunities ...

A little over one month ago, Brad Zigler (from HardAssetsInvestor.com) put together a very good article on Tracking Crack Spreads, which I strongly recommend for a clear explanation of that topic. In his explanation, he used the fairly standard "3-2-1" crack spread -- three barrels of crude oil to make two barrels of gasoline and one of heating oil. He further recommended using the product futures prices a month out from crude delivery in order to better simulate real-world conditions; for example, the crack spread for September crude would use the futures prices for October gasoline and heating oil. Of course, since oil contracts are measured in barrels while product contracts are measured in gallons, one has to multiply the prices of the latter by 42 in order to compare equivalent amounts.

I applied his methodology to the energy futures markets to see where traders were expecting crack spreads to go over the coming twelve months. As of 26 July, the crack spread, calculated as described above, for September crude (versus October distillates) was $28.23. The spread proceeds to increase throughout the fall and winter, reaching $48.64 in March, before beginning to decline. This is in line with normal seasonal patterns. Even next summer, however, traders do not expect the crack spread to reach this summer's lows -- for August, 2009, it is $42.54. Using the same futures pricing, refining margins improve from 23% to 39% in March, 2009, before easing to 34% in August. The profit spread on a cost of goods sold basis also improves, from 21% to 34%.

The stock price of Valero Energy Corp. (VLO) does not seem to reflect this same sentiment. After taking a fierce beating (though perhaps not by the standards of some financials!), the stock is down by more than 50% from its 52-week highs. Earnings estimates continue to be revised downwards, with the consensus EPS for this year down to $4.07, from $6.06 three months ago. For next year, estimates have dropped from $6.87 to $5.07. Despite a turn-around in the price of crude, Valero's stock is not much off its 52-week low of $29.70, closing Friday at $31.88.

If traders are correct, Valero now represents a good opportunity. The stock sells at a trailing P/E of 4.20 and a forward P/E (using 2009 earnings) of 6.29. Most of these predictions, however, were made before the recent action in crude prices and may not fully take into account the potential widening of the crack spread reflected in the futures markets. If this spread does widen, earnings have the potential to easily beat current expectations.

Additionally, Valero's management has wisely positioned it in the market and structured it for long-term success by developing the industry's most sophisticated refining system and enhancing its ability to process heavy and sour crudes. Valero's share buyback program, increased in February, should also contribute to appreciation in its stock price.

Earlier in the year, I was leery of investing in refiners given the volatility of the oil market and the continuing sky-rocketing price of crude. Now that oil appears to have topped, at least for a while, as a result of the demand destruction inflicted by its soaring price, the refiners appear to be a more reasonable, albeit still aggressive, play. Valero reports on 29 July and its share price may take another hit if earnings come in below expectations. If that occurs, it should provide a good opportunity for entry with a certain margin of safety.

Comments

[rover:]

The crack spreads have been calculated incorrectly. and are too high by a factor of three, making the "refining margins" also too high by the same factor. The calculation needs to be divided by three to put it on a "one barrel" basis. Therefore, the conclusions drawn by the author are fallacious and should be retracted with a full explanation.

2008 Jul 28 06:13 PM

[anachronist:]

Rover - Looks to me like the article focuses more on the changes in the crack spread, and those changes would still hold up if you divided everything by three. Also, when I do the calculations, I get the same percentages whether or not I divide the dollar amounts by three.

2008 Jul 28 11:48 PM

[Aidis Zunde:]

Rover, you are quite correct -- my crack spread numbers represent the spread on three barrels and so should be divided by three to provide the standard "one barrel" spread. (I should have caught that immediately, just by looking at the amount of the spread!) Therefore, for one barrel, this spread actually runs from $9.41 for September crude to $16.22 for March, before dropping somewhat to $14.18 for August, 2009. Similarly, the refining margin should rise from 7.6% for September to 13.0% for March, then ease back to 11.4% for August. Finally, the profit spread on the cost of goods sold should improve from 7.1% to 11.5%. Thank you for catching that.
However, most importantly, this recalculation does not impact the trend I have discussed.

2008 Jul 29 09:15 PM

[noam:]

Check out also Harvest Energy (HTE) which is a play on both production and refining. Currently sports an 18% dividend!!!

2008 Jul 31 06:43 PM