August 5, 2011
Valero Energy Corp. (VLO)
Written By Gregory Spear
“Valero Energy Corp. (VLO) is the largest refiner in North America, with 14 refineries pumping out 2.6 million barrels per day. It is also the world’s largest independent refiner. But why invest in a domestic-based refiner when U.S. petroleum demand is waning? Good question. Here is a hint. Crack spreads (a measure of the profit margin in the refining industry) are at record levels even though refinery utilization rates in the U.S. are near seven-year lows for the month of June. This is a paradox worth pondering.
“According to Valero, demand from emerging markets is responsible for the unusually profitable conditions. (Valero is expected to more than double net income in 2011 over 2010.) While U.S. petroleum demand is down 10% from its 2004 peak, global demand is near record levels. Oil prices are high, but consumers appear to be getting used to them, so sellers are not cutting into the crack spread in order to keep the retail prices down. If this is a new plateau, it is entirely possible that refiners like VLO will no longer be beholden to the consumption habits of North American drivers, a potential paradigm shift in the industry.
“Interestingly, Valero already has a 28% market share in gasoline and distillate exports. Meanwhile, global refinery capacity is growing quite slowly. In fact, over 2 million bpd of capacity has been shut down since 2008. Global spare refining capacity actually contracted in 2010 for the first time since 2005. If this is the start of a multi-year trend, then VLO will have a cycle of windfall profits similar to what it enjoyed during 2002-2005. The key to VLO’s long-term success has been its emphasis on refining so-called ‘sour’ or heavy crude, denser and more acid than the ‘light-sweet’ variety. As most of the world’s oil supply consists of heavy crude, the commodity sells at a handsome discount from spot, which can be as much as $18/bbl. This differential will only get wider as light-sweet gets harder to find. OPEC is already producing more sour, as is Latin America. Currently, 80% of Valero’s capacity is dedicated to processing discounted (sour) feedstocks.
“On the technical side, the company is one of the most experienced and flexible in the industry. There are more than 100 varieties of crude oil and last year VLO ran 86 of them. VLO’s conversion ratio (i.e. efficiency) is greater than any other major refinery operation in the U.S., including Exxon Mobil (XOM) and Chevron (CVX). High margins, high efficiency means high profits. The company’s refining network is geographically diversified, with only seven refineries in the Gulf coast area, which makes Valero less vulnerable to hurricane outages and allows it to optimize profits according to regional margin trends. Its refinery in Aruba gives VLO excellent access to the market in South America. Valero recently announced the acquisition of Chevron’s Pembroke refinery in the U.K. for $730 million. Pembroke is one of the largest and most complex facilities in Western Europe with a crude capacity of 220,000 bpd. It is designed to process the oil from the North Sea. The accretive deal includes more than 1000 Texaco-branded outlets, an aviation fuel operation, an interest in four major pipelines and 11 storage terminals. Pembroke gives Valero the strategic opportunity to serve growing demand in Africa. Management expects to close the purchase of this bolt-on acquisition in the fall. Valero also owns significant petroleum pipeline and terminal operators, with over 9,000 miles of pipelines and 89 terminals and storage facilities throughout the U.S., Canada, Mexico, the Netherlands and the United Kingdom. The company is also a leading ethanol producer with 10 plants in the Midwest producing one billion gal/yr. Management acquired these plants at bargain prices two years ago and they have already earned back 60% of their cost. …
“Valero is a growth-oriented company with a focus on shareholder value. Management has six expansion projects underway, not counting the Chevron acquisition. Even though VLO executives own less than 1% of the outstanding shares, management is compensated based on earnings per share, shareholder return and return on investment. This aligns their interest with shareholders. … As crack spreads began to contract in 2005, VLO initiated its own austerity program, reducing the number of administrative employees by almost 20% since then. Its cash operating expenses have fallen commensurately to $3.69/bbl, the lowest among independent refiners. The company paid off $500 million in debt last quarter and ended with $4 billion in cash and a $4 billion credit facility, putting its debt-to-capitalization ratio at just 20%. This is very low for a refiner in the midst of a major growth cycle. Shares of VLO are trading 66% below its 2007 peak and have been in a downtrend since April. This week the trend changed. We think this is a very opportune time to pick up shares for the long-term.”
Gregory Spear, The Spear Report, 7/22/11