Description

Valero is the largest independent refiner in the US with 3.15 mil. barrels a day of throughput.   With oil at $145 and US demand for gasoline declining it is a miserable macro environment for refiners.  VLO has traded down from $70 at the start of 2008 to $37.  At current prices VLO represents a good long value investment with a potential to double in 24-36 months.

 

US Refining Environment

In 2008, US refiners have borne the brunt of a close to 40% increase in the price of crude as refining margins (crack spread) have decreased as a result of reduce gasoline demand and working capital needs which have increased significantly.   All independent refining stocks have traded down 50-85% in the last 9 months.  The crack spread for the remainder of 2008 looks ugly too.   The street has significantly lowered EPS estimates for the independent refining sector.

 

Given this macro head wind why own VLO?

VLO underlying refining assets are very cheap on a replacement cost basis. 

 

Equity Market Cap                         $19.6 bil.

Debt                                                $6.5 bil.

Less: Net Cash                         -$1.4 bil.

EV                                                $24.7 bil.

 

Less: Working Capital            -$1 bil.

Less: Inventory                        -$7.1 bil.

Less: Retail Assets                        -$1.0 bil.

 

Refining Assets :                        $15.6 bil.

 

Implied Value per:

Barrel of daily throughput capacity                        $4,952

(3.15 million barrels per day)

 

Barrel of complexity adjusted capacity            $502

(using Nelson complexity of 11.3)

State owned Kuwait National Petroleum is build Al-Zour - a 615,000 barrels per day refinery at a cost of close to $15 bil.  or $25,000 per barrel of daily throughput capacity.  This is a large refinery being currently built in the Middle East by a state owned entity with minimal environmental and NIMBY issues. 

VLO refining assets trade for less than 35% of replacement value and under 30% of new build.  This is for assets located in the US where the last refinery was built 30 years ago and its is very unlikely that state and local regulators, environmental groups and other community organizations will allow a new refinery to be built.   

My investment thesis is that in the long run – beyond the typical analyst quarterly eps model, the replacement cost of building a new greenfield (very unlikely in the US) or brownfield expansion will determine long run normalized crack spread/margin.  Refining assets are long-lived assets but the market views and trades them with the 3 months crack spread. 

 

Distillate/Diesel

Refining is become a global commodity.  The US currently imports gasoline and exports distillates – diesel.  Distillate margins are very strong reflecting global demand for diesel and gasoline margins are weak reflecting weak US gasoline demand.  Globally refiners are changing the configurations of their refineries to produce more diesel.  In the long run I expect US import of gasoline to decline and US export of distillate to also decline.  Importing crude from the Middle East to refining and export diesel to Europe is not a long run sustainable strategy.  However, long run US diesel consumption will increase as US consumers move towards diesel cars and trucks to obtain better fuel economy.  VLO corporate strategy is focused on diesel and by 2011 VLO expects to increase diesel yield to 36%.

 

Complex Refining and Asset Divestitures

VLO original business model was to acquire and roll up refineries.  The new business model is to divest assets acquired cheaply (example Aruba refinery) or small less complex refineries (Kotz, Memphis, Lima)  and focus on group of core large highly complex refineries located on the coast. 

VLO wants to be able to refining discounted feedstocks that are primarily imported – maya and sour crude.  These are varieties of crude that trade at a discount to sweet crude that are the reference for most financial contracts – WTI and Brent.  The main reason for the discount is that unlike sweet crude, sour crude is difficult to refine.  A refiner with complex refining assets is able to capture the spread between sour crude and sweet crude.  VLO expects to be 75% discounted feedstock by 2011 up from 65% today.  

In sell side research environment focused on looking at crack spreads for margin analysis across independent refiners, VLO’s ability to refine sour and maya could provide for some positive earning surprises.  As crack spreads have collapsed for sweet crude – maya and sour spreads have held up relatively well compared to last year, which was a record year for crack spreads.  

By focusing on large complex coastal refineries VLO can arbitrage global markets for the cheapest feedstock – sour crude and rely primarily on imported crude that trades at a significant discount (up to $20 per barrel in the current high crude environment) to wti.  VLO cap ex is focused on building a portfolio of highly complex refineries that are competitive globally in a heavy/sour crude dominated crude market. 

VLO is selling its smaller less complex refineries and using the proceeds to buy back stock.  It sold Lima, Ohio and Krotz Springs, Louisiana refiners for a higher price per barrel that that market was valuing its assets.  I expect asset sales to be the short term catalyst that will provides cash to repurchase stock and show that asset sale transactions value refining assets substantially more than the markets with its 3 month focus on crack spreads does the equity of refiners.

VLO has Aruba, Memphis and Ardmore, Oklahoma up for sale.  Petrobra is rumored to buy Aruba  and Deltek is rumored to buy Memphis.  I expect the asset sale to show the under valuation of VLO equity and its individual assets are sold for substantially more than the market values VLO. 

 

Share Repurchase

I expect VLO management to actively buy back shares using free cash flow, asset sale proceeds and short-term borrowings.  VLO has a $3.8 bil. buyback authorization in place and this management/ceo likes to buy back shares  and return capital to shareholders.  Last year they spent over $5 bil. buying back shares at much higher prices than where the stock is today.  When I asked the management why they were buying back shares they said that the shares then were trading at a discount to replacement value and cash flows/irr from new expansion and any refining assets they could buy.  Today the shares are much lower and replacement values have actually gone up.  VLO strategy is to sell second tier assets at a premium to where the equity values its portfolio and use assets proceeds to buy back shares – basically buy their premium assets at a discount.

 

Between 4Q 2005 and 1Q 2008, VLO has reduce share count  by over 110 mil. shares.  The share count today is around 540 mil. shares and with a $3.8 bil. buyback and $37 price, the company would buy back over 100 mil. shares with asset sale proceeds and free cash flow.  I don’t expect the share count to decline by 100 mil. as I don’t expect the share price to remain around $37 long term.  But I like the fact that this company wants to return capital to shareholders and will sell assets and reposition its portfolio in a changing global energy environment.  

 

Valuation

 

LTM EBITDA was $7.1 bil. – going forward in 2008 I expect this to decline.  Given the volatility in crack spreads and VLO reliance on sour crudes it is near impossible to forecast quarterly ebitda and eps numbers.  I expect VLO to be cash flow positive in 2008 and its 1Q2008 earnings miss was due to operational issues.  Relative to other independent refiners VLO trades at a discount on all valuation metrics – this makes no sense to me as it has a better asset portfolio and more portfolio diversification that any other independent refiner.  I do not recommend shorting other independent refiners against VLO as the sector has gotten beaten down this year and other refiners might be more leveraged to the crack spread on the upside. 

 

Risk Factors

 

Oil Spike

The independent refiners and the crack spread has been decimated by the volatility and price of crude oil.  If oil spikes to $200 or higher due to a hurricane or war in the Middle East then VLO and other independent refiners will be impacted short term.  This stock is volatile and the short-term impact could be very volatile.

Long term the independent refiners margin should be independent of the price of oil.  Long-term margins are determined by supply and demand for refining capacity.  Supply of refining capacity is a function of return on capital – given VLO and other independent refiners trading at under 30% of replacement value I don’t see new entry in the US via brown field expansion by independent refiners.  As refined products become more global – US exporting diesel to Europe I would expect international refiners to look at US assets.  Example, Israeli firms Alon and Deltek in the US refining.  The consumer demand for oil is a derived demand.  There are only 4 natural buyers of crude in the world – 4 power plants in Japan than burn crude (very inefficiently) to generate power.  Every other consumer of crude needs to refine the crude into refined products that are consumed.  Long-term crude prices cannot go to $300 and every refiner liquidating and shutting down operations.  The US is a net importer of refined product and refined products are becoming a global commodity.

VLO long-term business model is to refine heavy and sour crude via complex refining.  The world’s oil supply is becoming more heavy and sour crude as the easy to refine/sell light crudes have been consumed.   Oil sands will generate heavy and sour crude that will need complex refining.  VLO is developing a portfolio of refineries to make significant cash flows in a high oil price and difficult to refine heavy/sour dominated crude world.  But Mr. Market is focused on the 3-month crack spread and every talking heavy on CNBC says sell refiners as they are short oil trade.

 

Operational Issues

Refining is a complex petrochemical process and refiners have a tendency to have regularly operational and safety issues in the ordinary course of their business activities.  VLO runs a tight ship but there can and most likely will be operational issues.  VLO portfolio of 14 refiners (assuming divestitures) provides portfolio and risk  diversification.

 

Insider Selling

The CFO has been selling shares (non option related) and has cut his holding by 1/3.

 

Catalysts

 

Replacement Cost Discount for Assets , Asset Portfolio of Complex Coastal Refineries, Free Cash Flow Generation based on ability to use discounted feedstocks, Asset Sales, Share buybacks

Catalyst

Replacement Cost Discount for Assets , Asset Portfolio of Complex Coastal Refineries, Free Cash Flow Generation based on ability to use discounted feedstocks, Asset Sales, Share buybacks