VLO - Checking In On The Health Of Valero And Its Markets

2023-07-09 00:05:40 ET

Summary

• Valero reported a strong first quarter in 2023 with net income attributable to stockholders at $3.1 billion, operating at 93% capacity utilization rate, and reducing debt by $199 million.
• Despite concerns over a recession in the general diesel market due to a slowdown in manufacturing and freight transport, Valero has seen a 16% year-over-year increase in gasoline sales and a 25% increase in diesel volumes.
• Valero expects capital investments for 2023 to be approximately $2 billion, with about $1.5 billion allocated to sustaining the business and the balance to growth.
• Evaluating the June quarter results seems prudent before buying.

The determining question for Valero ( VLO ) and other refineries resides in the stability of the historically high crack spreads. Valero's low production cost position kicks the results into a higher gear even during a period of recessionary economics. The big question for all of us remains, how stable are the historical high cracks spreads? With the major performance influence from crack spreads and their continuing lower, our position remains a hold until results for the 2nd quarter are issued. Without perfect crystal balls available, we simply are left with digging deeper into fundamentals both of today's markets and into the future. This company, at some level, beats to a different drummer than competitors. Its health should stand better. Jump in the car with us and head to the doc for the checkup.

1st Quarter

For the 1st quarter , Valero reported relatively strong results summarized below:

• Generated a net cash of $3.2 billion from $4.1 billion in operating income.
• Operated at extremely low operating expense of $4.80 per barrel.
• Operated at 93% capacity despite planned maintenance.
• Purchased $200 million debt.
• Achieved a net debt capitalization ratio of 18%.
• Earned income of $3.1 billion or $8.30 per share up from $2.20 year over year.
• Paid interest expense of approximately $150 million on $9 billion in debt.
• Holds $5.5 billion cash.

Looking at guidance for the 2nd quarter, management stated:

• Fundamentals remain supported "by low global light product inventories, tight product supply and demand balances . . ."
• For 2023, capital expenses were guided at $2 billion of which $1.5 is sustaining.
• Utilization between 90-93% slightly lower. (Management refused to add detail, but it was clear that the lower rate was due to maintenance outages.)

The 1st quarter was phenomenal with crack spreads remaining historically high. Of note, from our own data collection, the Gulf Coast 2-1-1 average crack spreads were, beginning with the oldest: $50, $40, $40 and $36. The 2nd quarter of 2023 will be $30 down 20% quarter over quarter . Again, the stock pricing remains at risk until cracks bottom.

General Diesel Market Place

At the docs, we began an analysis of the markets with a closer look at a key marker, diesel. Analysts recently word labeled the general diesel market, recession, a few used steep recession. The driver resides with the economic growth structure. From Reuters,

"Historically, GDP has grown in tandem with manufacturing activity and diesel consumption as more goods orders increase the need for freight transport, the main driver of diesel demand. . . Historically, GDP has grown in tandem with manufacturing activity and diesel consumption as more goods orders increase the need for freight transport, the main driver of diesel demand."

Another article outlined several other important factors including:

• Expected 1st quarter diesel demand lower by 4% .
• Exxon's ( XOM ) capacity expansion is likely negated by Lyondell's refinery closure in the Houston area.
• Expect West Coast region diesel supply to further tighten with expectations for refineries converting to renewable products.

Other sources signal signs of slowing. The purchasing managers index (PMI) now trends significantly below 50, contraction, the last value being 46.9. This reflects a major contraction in manufacturing, thus lower diesel demand in transportation. JB Hunt signaled transportation recession at its last report backing off beliefs for a stronger 2nd half. But, "It's just a question of when and what position will we be in when our customers start ringing our phone again in ways that they have in the past," JB Hunt CEO stated." The EIA predicts softness continuing through 2024 with manufacturing growth stunted. Past reviews of longer-term PMI charts suggest otherwise, that prolonged periods under 50 aren't strongly supported historically.

In summary , "Milne said the market has seen a gradual rebuilding of diesel stocks. This is mainly because of reduced diesel demand thanks to a global slowdown in manufacturing and fewer freight movements."

Even with diesel weak, the gasoline market remains strong to some degree, offsetting the market structure a level of firm heartbeat. The weak demand has pushed the price of diesel lower now trending less than gasoline. The weakness at 4% matters .

Valero's Market Place

When asked about Valero marketplace, management responded with different answers than it appears the analysts were expecting. Manav Gupta, of UBS asked about strengths in product sales in general and about diesel. Gary Simmons, Valero's EVP & Chief Commercial Officer, answered,

"Yes, sure. So, so far, our 7-day average in our wholesale system, our gasoline sales are up 16% year-over-year. Our diesel volumes are up 25% year-over-year. So our wholesale team continues to do a great job."

Continuing with diesel weakness, "weakness, we're just not seeing it." The strength referred in his comment includes internal U.S. transportation and across Europe and South America.

Concerning other markets, management offered insight. When referring to VGO exports, the company's concern with response toward Russia sanctions haven't yet materialized. With respect to sour crude issues, the likelihood for the Lyondell refinery shutdown and OPEC production back on the market leaves the balance bullish.

Clearly Valero hasn't yet experienced softness in any of its critical markets. Its low cost production position probably drives this fact, thus far.

Dividend

With every dividend paying company, investors must follow the cash flows for signs of changes. Obviously, under the current business conditions, the company is under paying in extreme fashion with the dollar per share per quarter on 370 million shares. From the report, "Net cash provided by operating activities was $3.2 billion in the first quarter of 2023." Dividends equaled one tenth of the cash generation . The 2nd quarter cash from operations will be down perhaps lower by 20% or more with crack spreads having fallen significantly.

Valero used $1.5 billion in cash to repurchase 11 million shares, a rate of 50 million a year. Like other refineries, which used significant levels of cash to repurchase shares, the company can't forever continue to repurchase at these levels. For example, at this rate, the company will only have 270 million shares left in the near future. At what point does this become counterproductive, forcing major changes in actual dividends? Double or tripling the payout at some time frame might be in order. It isn't far away.

Looking Ahead Including Risks and Valuation

Beginning with valuation, refineries pricing tends to at least loosely follow crude pricing and more crisply follow crack spreads. Analysts are torn on predicting crude pricing. There is a lot of noise. One theory, by Osama Rizvi, a known authority in the oil market, claims that the world's recessionary posture in Europe and possibly approaching the U.S. signals weak demand. Other valuable resources such as Goldman Sachs and the IEA suggest otherwise, that demand remains exceptionally strong . A more recent study fills in a gap with a warning, inventory reduction, sometimes massive, always coexists with rising interest rates. The number of long-contracts being extinguished with this phenomena leaves markets exposed to risky volatility. The dampening from capacitance disappeared. The lack of long-contracts now approaches dangerous levels according to these analysts. In our view, the later scenario is playing out rather than the former. Demand has remained strong. Investors can expect higher prices going forward suggesting higher stock prices with a loosely positive relationship discussed in a former article.

When considering major risks or positive drivers, softness in crack spreads obviously pose the biggest risk or potential at the doc's office. But what is the risk really? Marathon ( MPC ), at its last conference, stated, "At the same time, supply remains tight, supported by nearly 4 million barrels per day of global refining capacity that has come offline in the last couple of years." Management of Marathon also noted its U.S. location advantage especially with Europe for exporting. In our view, the June quarter results coupled with the trending in cracks spreads for the balance of the summer offer investors a more certain view of the future. The June quarter numbers seem to be very important for Valero and other refineries such as Marathon.

A second issue resides with diesel consumption. The EIA claims that the weakness continues through next year. Their belief seems to reside with higher interest rates restraint on manufacturing being the reason. In our view, PMIs can't remain at their basement levels forever. Although JB Hunt's management isn't confident of a return to normal during the 2nd half of the year, they also understand that a turn at some time frame occurs. The diesel weakness drives the low crack spreads strangely even the slight weakness. Once diesel inventories turn downward, crack spreads will jump with the tight supply in place. We aren't so sure that the EIA has it correct. In fact, it seems far-fetched. We could be wrong. We noted above the lack of historical support for pre-longed periods.

Waiting for the next report seems most prudent to observe the full effect of what might be the bottom in crack spread averages. Although in our prior article the hold resulted from unsustainably high crack spread, our hold now results from fully understanding the economic impacts from the lower, but likely stable spreads . We also believe that the future payouts will drastically increase, if or when cracks have bottomed. The patient passed the physical, it's simply a matter of the receiving final score.

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