Description

A Macro Driven Investment 

There is a large component/factor/element of macro in this investment.  The macro event is the world returns to a pre covid world in 2021-2022.  The return to normal is facilitated by a covid vaccine.  I expect VLO to trade to $65-$75 by 2022, trading at 6x normalized multiple.  VLO should pay a dividend of $3.92 a year. I also expect a refining cycle in 2022-2025 time frame driven by reduced capital spending and capacity closures.  

Returning to a pre covid world will result in and require energy utilization to return back to historical levels.  For all the talk about electric vehicles, they form an insignificant percentage of existing transportation base.  There is simply no return to pre covid gdp and employment levels without hydrocarbons being cracked/refined and petroleum products consumed. 

Contrarian Energy Play 

Energy prices have been in structural decline driven by global economies becoming energy efficient and greater supply of oil from US shale.   I don’t see this trend reversing in the foreseeable future.  I expect US petroleum demand to become similar to US electricity demand in the 2000-2020 timeframe.  Stable in absolute terms but deciding as percentage of GDP for the next few decades.

Low Relatively Stable Oil

I have an expectation of low and stable oil prices driven by Saudi aggressively producing (they see the long term trend) and US shale being the marginal supplier.  Oil prices in the $40-$60 similar to what the futures look like.  China, Elon Musk and US shale have pretty much broken OPEC and oil prices. 

I also don’t see the US consumer switching to more energy efficient ICE vehicles long term. US consumers will either seek electric vehicles or bigger SUVs and trucks fully taking advantage of cheaper gasoline and diesel prices.   SUV and trucks are 72 percent of light vehicles sales and headed to 80 percent.

Shrinking US refining sector 

The US refining sector will shrink over the next 20 years.  We have already seen that starting to happen.  Numerous refineries have been permanently shutdown in last 12 months and have accelerated further in the age of covid. 

As marginal US oil plays shrink and go away so do sub scale refineries dependent on that feedstock.  At the same time state level environmental regulations is shrinking refining on the west coast.  

The ideal long term survival refineries are large complex refineries with access to domestic, Canadian and imported oil.  Valero asset portfolio is exactly those kinds of refineries.  

Capital Market Forced Discipline 

Refineries trade at 15-20 percent of replacement cost.  Buying refineries generally involved massive capex and environmental outlays as refineries are typical rundown before they are sold.  

I expect a lot more marginal refineries to shutdown than to find buyers in this environment.  Only interesting M&A geographic region is PADD IV with Canadian WCS pipelines access and strong local market demand.  Majority of the refineries on the market to be sold will actually never be sold but will be shut down.   They are for sale because they are uneconomic.  Economic refineries that were for sale by the majors because they were sub scale for majors have been pulled off the market as the majors refocus capital allocation across upstream and downstream projects (for example, XOM Billings Montana refinery).

I don’t think we see a lot of divestitures from majors going forward. With majors trading at 10 percent dividend yields  and a focus on cash flow generation.  I expect majors to hold on to refineries and downstream assets that generate cash before plowing that capital in upstream projects that are projected to generate cash many years in the future and have significant commodity price risk.  Otherwise I see majors as permanently shutting down inefficiently refineries. Current cash flows matter when majors are financing dividends thru credit market capital raises. 

Three significant refinery closures have been announced in recent weeks: the 161,000-barrel-per-day refinery operated by Marathon Petroleum in Martinez, California, which sits in the Bay Area; the 27,000-barrel-per-day Marathon refinery in Gallup, New Mexico; and the 140,000-barrel-per-day San Francisco refinery complex of Phillips 66, which consists of two refineries connected by a 200-mile pipeline.  Philadelphia 365,000 barrel refinery has also been scrapped.  

Since refining assets trade at 15-20 percent of replacement value and the equity markets are focused on dividends and return to shareholders.  Growth cap ex hurdles have become exceptionally high in refining.  Capital investment will not be recovered in anything other than cash flows generated from that capital.   Valero has a 25 percent irr hurdle for capital investment.   I expect massive curtailments in growth capex. 

I expect refining to be in a world of shrinking brownfield expansion, no new greenfield refineries and mothballing to second and third tier refining assets. Add in demand recovery to pre covid levels, work thru of inventory/stockpiles in system, low and relatively stable feedstock prices and sector capital discipline, 2022-2025 looks like it is setting up for a nice refining cycle.  

VLO, XOM and other dividend paying energy companies in 2020 are using the debt markets to finance their dividend.  If one is borrowing to pay a dividend then no one is running out building new capacity till the debt raised to finance the 2020 dividend is paid off.  We are entering a phase of shrinking growth capex.   The shut down of marginal refineries and curtailed growth capex at core refineries will result in a tight refining market for most of this decade. 

VLO

Clean structure

VLO has a clean capital structure with $10 bill debt and $18-20 bil. of equity market cap.   Historically, VLO has been 1-1.5x levered.  In March, VLO debt got decimated along with nearly all other corporate credit but it has recovered nearly all it loses. VLO corporate credit spread is  300-400 bps for long dated debt and it has access to capital markets. 

In 2020 VLO will be cash flow negative and will fund its dividend thru borrowing in the debt markets.  2021 onwards the credit and financial markets will require VLO to delever back to 1-1.5 level.  The capital that historically has gone to buybacks will go towards paying down debt.

Paying a dividend to VLO is a core business tenant, same as for XOM.  I think a variable dividend policy would be a better approach, but I don’t see VLO adopting it near term. They will use debt to fund dividends in the 2020 framework.   The debt market is much more liquid and accommodative that it was in March 2020.  VLO recently raised short term debt at sub 3 percent

VLO does not have a captive mlp with any financial engineering having off balance sheet leverage (HFC and HEP for example).  VLO wisely took in its mlp structure in 2018. 

Cash flow 

2020 is simply ugly.  VLO will be $2-$3 billion free cash flow negative.  Net Debt will go up to $10 bil.  A dividend will be paid via debt issuance.

2021 is a transition year with recovery but with a headwind from jet fuel demand.  

VLO goes from $6.2 bil in ebitda in 2019, to $2 bil in 2020, $4 bil. in 2021 to $6-$7.5 bil. in 2022.  The bridge in ebitda back to 2019 levels requires jet fuel demand to come back and that will take till 2022 or 2023.  

My 2022 valuation

$6.5 bil ebitda ($7.5 estimate at MS, GS $6.5) 

6x normalize multiple 

$39 bil. Tev

$10 bil. Net debt

$29 bil. Equity 

410 mil. Shares

$70 target price  

$6-$8 in annual dividends 

I expect 50 percent total return over 18-24 months.  

A check on 2022 ebitda numbers can be inferred/guesstimated from futures in oil and refined products markets.  I use these only as a reference cause energy prices are volatile and VLO footprint is too big to hedge in the financial markets.  

Excellent asset 

Large complex gulf and mid con refineries 

Valero is one of the world's largest independent refiners, with 15 refineries and approximately 3.2 million barrels per day (bpd) of throughput capacity. 

Refinery complexity is above average with a Nelson complexity rating of 11.5 across the portfolio, and 12.4 for the Gulf Coast region. 

Outside the U.S., the company owns the Pembroke refinery in the U.K. and the Montreal refinery in Quebec.

Biodiesel ethanol and green asset portfolio 

Valero has a strong position in renewables, which includes a large ethanol position (14 dry mill plants in the Midwest with capacity of 1.73 billon gpy). 

Valero is also the largest renewable diesel producer in the US and the second largest producer in the world through its DGD joint venture (275 million gpy of joint capacity, expanding to 675 million gpy by late 2021). 

Renewables have several attractive long-term features, including diversification from conventional fuels, the ability to hedge environmental compliance costs (RINs), and, in the case of renewable diesel, a robust return profile. 

While renewable diesel has regulatory risk given its dependence on state and federal government program credits, the momentum behind renewables in the U.S. is generally strong, particularly on the state level (California) and in a Biden administration. 

Return of capital

Going forward I don’t know if the half capital for dividend and half capital for share buyback works.  I think this whole sector would be better off with a variable dividend model and leverage below 1x.  

Valuation versus Sell Side 

To invest in VLO one needs to look at 2022 performance metrics and valuations.  2020 is a mess with covid and forced public policy driven  economy shutdowns.  2021 is a transition.  2022 is the first clean year where multiples should return to normal - 6x.

The sell side and the market is focused on 3-6 months out.  This investment requires one to look 18 months out.  My expectation is after a covid vaccine there will be a pull forward into 2021 what the market expectation is for 2022.   

Once the market sees the pull forward in demand/macro, the crack spreads and utilization will move as will the stock prices.

Return to Normal World 

We cannot go back to the pre covid world without global energy use not returning to pre covid levels.  I expect a pent up demand from mid-2021 into 2023 as the world catches up (travel, vacations, highway miles) on everything covid has denied.  

Capital Allocation 

I have an issue with using debt to pay a dividend.  But VLO management believes the divided is a core element of its social contract with its shareholders.  I would prefer a variable dividend model like CVR has but that won’t be happening anytime soon.  Maybe in the future VLO moves away from a dividend and buyback return of capital model to a special dividend approach instead of a buyback.  The cyclical nature of refining has the company normally buying back stock when the stock is pretty rich.  That to me makes little sense.  But going forward the first use of cash will be to delever.  I don’t think the equity and credit markets are going to give VLO or any other refining company a free bye in using debt to pay 2020 dividend.  The leverage added will need to be reduced on a gross basis.  I expect stock buy backs and growth capex to take a back seat to debt reduction.  

Risk 

Covid 2.0

Another covid shutdown would devastate refining.  I don’t see Trump shutting the economy down and so the risk is a Biden administration in 2021 shuts down the economy again to control Covid. I think by January 2021 the focus will be on a vaccine and failure of a vaccine will be a bigger risk than a shutdown.  

Political 

Trump administration has not been friendly to energy and refining equity shareholders even as they profess to be pro energy. There has not been any clarity on RIN for refining sector.

Biden and the Democrats with the new green deal may sound risky.   The end of day anyone who wants to reduce unemployment and get the economy back to pre covid levels is going to need to have refining return to pre covid levels.  Refined petroleum products is simply critical to the functioning of a modern economy. With its ethanol and biodiesel facilities, VLO is well situated to arbitrage any regulatory regime. 

Elon is right 

Elon and Tesla change the world a lot faster than anyone expects.  Electric vehicles come to dominate automobiles within next 5 years.  Global energy demand declines significantly as world transitions to green energy.  

I don’t think this is realistic or likely.  China and India have core long term public policy goals based on hydrocarbon use.  Everything electric in China is just a mechanism to insure cheaper hydrocarbons.  Looks like everything in India is to free ride based on China having effective  policies for cheaper global hydrocarbon prices.

Global Capacity 

This is is a risk VLO, if Europe and US refining shutdowns are exceeded by new global supply there is a risk that refined product margins on distillate exports will get compressed. 

Catalyst

Return to Precovid World

2022 Earnings and Cash Flow