DINO - Expect More Profits From Valero

2023-04-12 05:22:01 ET

Summary

• Valero is a $50.3 billion market cap oil refiner paying a 3.0% dividend with an investor-friendly stock buyback program.
• Both oil and refined products exports are higher, creating a push-pull effect on margins.
• Valero is well positioned on renewable diesel and ethanol in addition to basic oil refining. But in contrast to last year, refiners will not benefit from SPR releases.

Valero Energy Corporation ( VLO ) is one of the two largest US independent oil refiners .

The company's asset-heavy infrastructure presents barriers to entry for competitors, and it produces needed energy-dense transport fuels against a backdrop of limited supply - as was particularly seen in the 4Q22 demand for diesel.

In general, investors may also recall that demand is not for oil qua oil but for hydrocarbon products like gasoline, jet, and diesel vital to trade and transport.

Refiners are expected to report strong 1Q23 results. The sector is coming into the 2Q and 3Q travel seasons.

In addition to its baseline gasoline, diesel, and jet production, Valero is a key ethanol provider. Its joint venture with Darling Ingredients ( DAR ) is the second-largest renewable diesel manufacturer in the world. The company will profit as that market grows. And it is entering the sustainable aviation fuel sector.

While few companies, including Valero itself, are likely to repeat its achievement of nearly quadrupling yearly EBITDA , Valero is well-positioned for demand in the big, traditional fuel markets and growth in new fuels.

I own shares of Valero and recommend energy investors interested in capital appreciation consider buying it. The company will release 1Q23 results on April 27, 2023.

Oil Supply and Prices

US oil production in the week ending March 31, 2023, was 12.2 million barrels per day ((BPD)), not far off the February 2020 high of 13.1 million BPD.

Of course, Valero sources its oil from around the world, and US producers are not always marginal oil suppliers (and oil price-setters). Indeed, because of Valero's equipment configurations, it can make even better margins from heavy sour crude, like that from Canada or Venezuela.

The April 11, 2023, closing NYMEX oil price was $81.53/barrel for West Texas Intermediate ((WTI)) crude oil for May delivery. The NYMEX closing gasoline (reformulated blendstock for oxygenate blending or RBOB) price was $2.87/gallon ($120/barrel), also for May delivery.

High, moderate, or low oil prices translate to high, moderate, or low gasoline prices since oil is the largest cost in making gasoline.

The current low level of the SPR could result in a perceived crude shortage--the stocks will have to be replaced -- and cause the oil price to increase.

Oil Refining Margin Illustration

Refining margins differ by crude type (light/heavy and sweet/sour), operating costs, and product slate (usually how much gasoline and distillate). Distillate is further divided into major fuels of diesel/heating oil and jet fuel.

A reference metric for gasoline is shown below, with the futures price of a high-quality (light, sweet) crude-Brent, in blue on the left axis - compared to the difference between the price of the higher-valued gasoline "stand-in" ((RBOB)) and the futures price of Brent. This is the crack spread shown in light brown on the right axis.

Because many countries are no longer buying Russian distillate exports, the distillate crack spread was especially high in 1Q23.

2022 Results

For 2022, Valero reported net income of $11.5 billion , or $29.04/share, compared to 2021 net income of $920 million, or $2.27/share. It reduced debt by $2.7 billion.

Operating income for 2022 was $15.7 billion compared to operating income of $2.13 billion for 2021. The company divides into three segments: refining, renewable diesel, and ethanol. In 2022, operating income was:

• $15.8 billion for refining vs. $1.9 billion in 2021
• $774 million for renewable diesel vs. $709 million in 2021,
• $10 million for ethanol vs. $473 million in 2021.
• Corporate and intersegment eliminations resulted in a -$997 million subtraction to operating income.

According to the company's 4Q22 report, it "continues to target a long-term total payout ratio between 40 and 50 percent of adjusted net cash provided by operating activities."

EV Fueling Competition

In 2021, electric vehicles are estimated to have displaced a very small 0.54% of US gasoline use. Moreover, the cost of sourcing minerals like lithium, cobalt, and copper from China and Africa for EVs has increased.

Refining Competitors

Valero is an independent oil refiner and marketer headquartered in San Antonio, Texas. It is one of the world's largest refiners, along with Marathon Petroleum Corporation ( MPC ).

Other competitors range from large Exxon Mobil ( XOM ) on the US Gulf Coast to smaller Delek ( DK ) in inland markets.

Barriers to the US oil refining industry remain high due to siting issues; the large, fixed cost of capital assets; policies from the federal level and some large states -- like California -- that are anti-hydrocarbon; and a regulated, consumer-facing gasoline, jet fuel, and diesel business that is competitive and much-scrutinized.

Renewable Diesel Competitors

The primary market for renewable diesel is California due to its incentives, although the push to EVs there introduces long-term market uncertainty, as does any temporary regulatory advantage. Valero's Diamond Green Diesel comprised 46% ( 1.2 billion gallons/year) of 2022 RD capacity. The next-largest RD producer was HF Sinclair ( DINO ) at 334 million gallons/year from three different plants for a market share of 13%.

Overall, in 2022, RD capacity of 2.6 billion gallons/year outstripped biodiesel capacity of 2.3 billion gallons/year.

Governance and Regulatory

At April 1, 2023, Institutional Shareholder Services ranked Valero's overall governance as an 8, with sub-scores of audit (2), board (6), shareholder rights (7), and compensation (10). In this measurement, a score of 1 represents lower governance risk and a score of 10 represents higher governance risk.

As of August 2022-so several months ago-Valero's ESG ratings from Sustainalytics were "medium" with a total risk score of 30 (64th percentile). Component parts are environmental risk 18.2, social 7.2, and governance 4.7. Controversy level was 2 (moderate) on a scale of 0-5, with 5 as the worst.

Approximately 3.9% of the floated stock is shorted and insiders own only 0.55% of the company's stock.

Valero's beta is 1.64, well above market average volatility, especially for a company of its size. However, feedstock and product prices (margins) have varied considerably during the last few years.

California, followed by other states, plans to eliminate sales of gasoline-powered vehicles by 2035, electric vehicles are more expensive than their internal combustion counterparts. In 2021, California was the second-largest gasoline-consuming state, with a 9% share of total US gasoline consumption at 33.3 million gallons/day or 0.79 million barrels per day. (Texas was the largest gasoline-consuming state at 38.6 million gallons per day or 0.92 million barrels per day.) Be aware that the cost of electricity (for fueling) is expected to rise in California due to large, expensive grid upgrades needed to accommodate renewables and maintain reliability.

On December 30, 2022, much of Valero's stock was held by institutions, some of which represent index fund investments that match the overall market. The four largest institutional holders were Vanguard (11.3%), BlackRock (9.9%), State Street (7.5%), and FMR/Fidelity (4.1%).

BlackRock and State Street are signatories to the Net Zero Asset Managers Initiative, a group that, as of December 31, 2022, manages $59 trillion in assets (down from $66 trillion in November 2022 after Vanguard bowed out) worldwide and which--despite less energy supply due to reduced Russian exports to Europe--limits hydrocarbon investment via its commitment to achieve net zero alignment by 2050 or sooner.

Countering this, the US state of Texas has developed a list of companies and funds prohibited from doing business with the state, its state pension funds, and local governments. Other than BlackRock, most companies on the list are European. However, the list of funds (350) is lengthier, and includes, for example, funds managed by US companies Goldman Sachs and JP Morgan.

Financial and Stock Highlights

Valero's April 11, 2023, closing price was $136.71/share for a market capitalization of $50.3 billion. The 52-week price range is $96.71-$150.39 per share, so the closing price is 91% of the high. It is 84% of the one-year target of $163.69/share.

Trailing twelve months' ((TTM)) earnings per share ((EPS)) was, again, a mind-boggling $29.04 for a modest trailing price/earnings ratio of 4.7. Analysts' average projected 2023 and 2024 EPS are $24.13 and $16.15, respectively, for still-attractive forward price/earnings ratios of 5.7-8.5.

TTM return on assets was attractive at 16.6% as was the return on equity of 52.5%.

On December 31, 2022, the company had $35.5 billion in liabilities of which $10.5 billion is long-term debt and finance lease obligations and $17.5 billion is current liabilities, and $61.0 billion in assets. This gives Valero a liability-to-asset ratio of 58%.

Trailing twelve months' operating cash flow was $12.6 billion and levered free cash flow was $8.95 billion. Valero's dividend is $4.08/share for a yield of 3.0%. Its stock buyback program provides underlying price support.

The company's mean analyst rating is 2.4, or "buy" leaning toward "hold" from 21 analysts.

The enterprise value/EBITDA ratio ($56.6 billion/$18.3 billion) is a very bargain-level 3.1, far below the preferred maximum of 10.0.

Recommendations for Valero

Despite a quadrupling of its EBITDA in the last year, Valero still has 20% upside to its one-year target price. More specifically, concern about the immediate displacement of 135 billion gallons of US gasoline use per year by massive amounts of electricity (e.g. internal combustion engines by electric vehicles) seems overwrought, if not completely hyperbolic.

Of course, electric vehicles are growing in popularity and are regulatorily incentivized by both the federal government and states like California, a factor not to be ignored. Doubling down, the California government also expects to eliminate consumption of all hydrocarbon fuels in the state; Valero has two California refineries. Further, California could also change its regulatory preference for renewable diesel, rendering that part of Valero's business less valuable. Moreover, the company has a refinery in Wales and the UK (and Europe) also plans to eliminate gasoline use.

Its primary risk is higher oil costs and/or lower product prices. Also, a big part of its liabilities, about half, are current liabilities, so exposure remains considerable.

The company pays a 3.0% dividend, has an investor-friendly stock buyback program, doubled operating cash flow in 2022 over 2021 to $12.6 billion, nearly quadrupled EBITDA over the same period, has a very attractive forward price-earnings ratio range of 5.7-8.5, and after profitable quarters from diesel is moving into high-gasoline-volume, high-value summer travel season.

The company's operations experience plays out in its dominant position not just in meat-and-potatoes gasoline, diesel, and jet, but also the growth areas of ethanol, renewable diesel, and soon, sustainable aviation fuel.

I recommend Valero to energy investors, particularly those seeking capital appreciation.

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