RD's Picks

Valero is the largest refiner in the US and unlike an integrated oil company; their primary business is refining and marketing gasoline, distillate fuels and other products refined from crude oil.

Some investors might think that with gasoline prices skyrocketing, refiners should be making money hand over fist. But they have to contend with the crude oil prices, and those prices have been rising even faster.

This chart shows why VLO and other refiner stocks haven't been performing well. I compared weekly US gasoline price records from the US Dept. of Energy with the United States Oil (USO) ETF as a proxy for crude prices. Both prices are indexed to 100 as of 12 Apr '06. Nothing special about that date, it's just how far back the USO price goes.

The problem with refiner earnings is clear. For the first half of 2007, gasoline prices rose faster than crude oil prices expanding the crack spread, or margin between crude and refined products. From about June of last year, crude has been rising quite a bit faster than gasoline narrowing the crack spread and putting a crimp on refiner profits.

VLO looks cheap with a PE of 7.8 on estimated 2009 earnings, price-to-sales ratio of .24 and 1.4 times book value. They pay a dividend which yields 1.2% based on today's closing price. However, it's likely analysts don't have the full impact of $130 crude oil in their earnings models. VLO does have some advantage over its competitors since they have a significant capability to handle less expensive sour crude as an input.

I believe market conditions going forward will continue to squeeze US refiners. Even though US gasoline demand is down slightly, growing consumption in China, India and other growing economies is keeping world demand high. That leaves Valero and their competitors facing a US market where it is difficult to raise gasoline prices fast enough to keep up with rising crude prices.

I did hear an interview with an analyst who thought some of the refiners could be buyout targets because the market caps were below the cost of building the plant and equipment. Sorry, don't recall the name of the source.

VLO is less than 10% off its 52-week low and I don't think it has much downside. But I also don't see an economic environment supporting wider crack spreads any time soon. And with higher prices starting to impact consumption, revenue may taper off going forward.

In summary, I thought refiners were dead money when Tesoro was the question of the week last month. Nothing's happened to change my mind.

References:
a) Valero Investor Relations Industry Fundamentals Page
b) Energy Information Administration Retail Price Data

Comments: View Comments |  Thursday May 29, 2008