As Oil Slides, Will Contrarians Turn to Refiners?

There aren't many energy stocks sitting nearly 60% below their highs, but as the crude oil bull market has continued in 2008, refiners have gotten crushed. The explanation for why refiners fare poorly in the face of rapidly rising crude prices is pretty simple. Refiners buy crude oil, refine it, and resell it to users of gasoline and other refined products like jet fuel. If the price of your core cost component is soaring and end demand for your finished product is falling because of high prices curbing demand, profit margins will contract pretty aggressively.

As a result, shares of refiners such as Valero Energy (VLO) have been pummeled. After earning about $8 per share in both 2006 and 2007, profits for VLO are expected to fall 50% this year, to around $4 per share.

But what happens when crude oil stops going up so fast? Already we have seen per barrel prices top out in the 140's and trade down below the 120's and gasoline prices nationwide are below $4 per gallon again. Frankly, the backdrop for refiners really can't get much worse that is has been so far this year. As a result, VLO shares have fallen from a high of 78 last year all the way down to the 30's.

There appears to be some value here if investors are willing to be patient and wait out a turn in refining industry fundamentals. Let's value VLO stock two different ways and see what we come up with.

1) P/E Ratio Valuation

Let's assume normalized EPS of $6 per share, up from the current run rate because conditions stand a good chance of improving, but 25% below the levels of 2006 and 2007. Use a 10 P/E and we get $60 per VLO share.

2) Asset Liquidation Valuation

Valero has sold 2 refineries since last year for about $3 billion. Those two refineries produced a total of 250,000 barrels per day. Valero now owns 16 refineries producing 3 million barrels per day. Let's assume they sold all of their refineries for the same price. That would net them $36 billion, or $66 per share.

As a result of the tremendous value that appears to be embedded in the stock, VLO is being added to the Peridot Blog Model Portfolio today. Refining margins stand a good chance of improving over time, as long as crude oil prices behave better, which would likely positively affect VLO's earnings per share, earnings multiple, and in turn, the share price.

Disclosure: Long shares of VLO at the time of writing

Comments

[cjct:]

Demand destruction for gasoline and other refined products will ensure that margins remain tight for VLO, TSO and others. I would rather just go short energy than try to play it going long refiners.

2008 Aug 08 11:02 PM

[IA.countryBoy:]

I'm betting on a "relief bounce" in gasoline consumption. You can hardly give away your SUV and big pickup and now that prices are not so high people will go back to more comfortable consumption until hit by another kick in the pants. I never bet against Americans' self indulgence.

2008 Aug 09 09:26 AM

[Timothy Stolz:]

One would think that you could short oil and play the long position on oil refiners at the same time. This past week, Sunoco Inc (SUN) went up by 14.07%, Holly Corp (HOC) by 12.32%, Valero Energy (VLO) by 11.94%, Frontier Oil (FTO) by 12.93% and Alon USA (ALJ) by 5.00% while crude oil went down by -5.70%.
My hunch is that we can rely on the American consumer to soon return to some of their previous wasteful driving habits and keep the demand for refined crude oil products high. That would bode well for this group of stocks, easing the conservation effect that demand destruction was beginning to provide, unfortunate as that may be.
We are likely to see crude oil level off and hold somewhere around $110 a barrel and that support level could hold into early fall, providing the refiners ample time to stockpile crude oil inventories and/or future contracts to meet their needs for some time to come. That would further stabilize this industry past the near future.
I'm going with Chad on this call....that contrarians will turn to oil refiners and I believe that they began to do so about a week ago.

2008 Aug 09 09:35 AM

[rhj123:]

I agree with Timothy. We Americans do use large SUVs and pickups, for good reasons. But folks back in NY, out in LA, in Chicago, etc., don't do heavy work with their pickups, so they are easily led into thinking there is no need in having those vehicles. The rest of the country does things like towing trailers, work or pleasure, and getting materials to jobs. And even using them off the highway, of all things! So, now with oil prices dropping, we country folks will continue using heavy SUVs and pickups. And most of the city folks will quietly return to using them, too. Excellent time to invest in refineries....

2008 Aug 09 01:54 PM

[safariman:]

Demand destruction for gasoline? It doesn't seem so earth shaking. Looks like it is down about 2% YoY based on latest EIA Report.

The big surprise, US petroleum import levels have been nearly flat the past four years. This suggests that higher prices are pulling more reserves than would be the case if prices were lower right here at home. So the market does work. And people still love their mobility.

Refining margins on the 3-2-1 crack spread have continued weak, probably because of recession fears. Valero, etc. will look better WHEN the refining margin increases.

2008 Aug 09 04:10 PM

[pockyclips ...:]

Country boy hits the nail on the head. Any pullback will be short-lived. Which is why simply drilling for more just won't work.

Pay attention to Russia-Georgia conflict. Hasn't been shone on our self-censored TV, but some tension between Bush and Putin @ the Olympics was evident. One picture shows Putin pointing his finger within inches of W's face. A sudden, 1.25 million barrel production shortfall could easily spike oil $20/barrel, and put us right back in $135 land.

2008 Aug 09 05:51 PM

[scfranklin94:]

Unfornately for my wallet, I have to agree with Pocky. Crude may drift down to $100, but Americans have no short-term memory; when they see gasoline down around $3.00, they'll start increasing gasoline demand again. Any gain in the refiner's stocks will be short-lived; I would buy the stock now and sell long-dated calls. Wait for the prices to drift up and then sell the stock and purchase puts.

2008 Aug 10 03:01 AM

[fxtrader07:]

all that talk about 'demand destruction' hm, what about #supply destruction' in gasoline and distilled products when a lot of non-sour refiners are actually losing big bucks now? How long can Tesoro and others produce while losing money on their products?
On the other hand, people will get used to $4/gallon gas pretty soon The very structure of the us economy and its transportation system allows only for so much 'demand destruction'. While the idiots like rumsfeld and cheney loved to brag about 'old europe' they never realized that europe has actually learnt a great deal from the oil crises of the 70s. Many countries there have a public transportation system the usa could only dream about to get. because opver there $9-$10/gallon is the rule, not the exception. And THAT is a level for demand destruction. not $4 or $5

2008 Aug 11 08:52 AM

[Alan Brochs...:]

Chad - VLO looks cheap, but your exercise above omits one factor - the debt. If you value your assets, you need to subtract your debt. Still cheap though!

2008 Aug 15 08:48 AM