Valero, Tesoro: Margin of Security in Refinery Assets

Includes: TSO, VLO
by: Tom Armistead

Shares of refiners Valero Energy (NYSE:VLO) and Tesoro Corp (NYSE:TSO) have tanked badly over the past few months, falling 60% and 77% respectively from their 52 week highs.

Crack spreads were squeezed as oil prices skyrocketed and consumers dug in their heels on gas prices. They are valued at 1 X tangible book and well less than market value of their complex refineries. At recent prices of 32.57 and 18.08 respectively they are trading at a little less than 6 X 5 year Average EPS, or 1 X Tangible Book Value. GAAP Book Value understates their assets: if consideration is given to the replacement cost or market value of their complex refineries, both are trading at well less than fair value.

Refining over the past five years has been extraordinarily profitable, but for many years before that excess capacity made it a miserable low margin business, with correspondingly sluggish stock prices.

Based on recent developments, some observers suspect that refining will go back to the way it was: however, I am more optimistic, and have begun to build positions in both.

The replacement cost and market value of the refineries provide margin of security for these investments. Looking at VLO's European Investor Presentation (6/23-24/08, available on their website) page 20 provides a graphic, demonstrating that at June's price of $44 per share, the implied value of their refineries was substantially less than new build cost, replacement cost, or market valued derived from recent industry transactions.

Similarly, TSO's Presentation at Bernstein's Strategic Decisions Conference (5/29/08) on page 30 asserts that the most recent industry transaction implies a value for their refineries of $43 per share. Again, the information is available on their website.

The primary plus here is that the US is not building new refineries, due to NIMBY considerations. With that fact in mind, existing refineries are extremely valuable - when properly located, large, and of sufficient complexity to produce the best mix of gasoline, distillates and other products from a variety of feedstocks, to include heavy and/or sour oils. My thinking is, geopolitical considerations make it very important to have such refining capacity here in the US, so in the event tensions reduce the availability of light sweet crudes, we can keep the economy functioning by using a wide variety of less desirable grades. Also, it is important to produce more gasoline and distillates compared to “bottom of the barrel” products.

My thesis is that due to the increasing complexity of the refining business, crack spreads may decrease from historical highs, but will not go back to historical lows. All crude oil is not created equal, heavy/sour grades cost less, and the ability to extract the proper amounts of gasoline, diesel or heating fuel, and other products from a variety of feedstocks will be economically important. The business is not as simple as it used to be.

Of course, it's a cyclical business, and the intermittent presence of speculative money in the futures market is not going to reduce price fluctuations, to put in mildly. Also, right now the market has been kind to negative momentum players, so anything that goes down has the potential to just keep going. Recently the price of Refiners has been moving contrary to the price of E&P companies, and both are driven by the price of oil. High oil favors E&P, low oil favors Refiners, or so the market believes.

In any event, I think that the long term trend in oil is up, for the usual reasons: finite supply, increasing demand from China and India, and geopolitical tensions. VLO and TSO both provide a valuable service and should be able to participate in the trend. I have taken starter positions in both, with the intention of adding to them on the dips. There is margin of security in the value of the physical assets, and patience will be rewarded.

Disclosure: Author holds long positions in VLO and TSO