- In this article, I start by breaking down the favorable business environment for Valero Energy, thanks to a sky-high crack spread as a result of supply/demand issues.
- Valero is maintaining $2.2 billion in CapEx, paving the way for high free cash flow used to accelerate shareholder distributions and debt reduction.
- Investors have aggressively upgraded earnings expectations as we head towards 2Q22 earnings.
- VLO stock is attractively valued, even without incorporating the current surge in profitability.
The world needs reliable, affordable, and sustainable energy.
Introduction
For most of my readers, it shouldn't be a surprise that I like Valero Energy ( VLO ). For example, in May, I wrote an article titled "Valero: My Favorite Energy Dividend Stock". Valero was and still is, the perfect fit for my portfolio as it combines a more than decent yield, with high (expected and historic) dividend growth, a dominant position in the North American and global energy supply chain, and the fact that it's an incredibly well-run business that has become my 7th-largest position this year thanks to its stellar performance.
As we're slowly approaching the 2Q22 earnings release on July 28, I want to use this opportunity to (among other things):
- Share my thoughts on Valero's performance.
- Dive into the industry fundamentals (in light of earnings).
- Discuss its dividend characteristics.
Especially in light of President Biden's comments, it's important to get a better understanding of the industry and the fundamentals that drive this very volatile dividend stock.
FINVIZ
So, let's get to it!
The Mighty Crack Spread
Although Valero has lost a quarter of its market cap since early June, the stock is up roughly 45% year to date. This beats the S&P 500 by a mile, as the world's largest equity index is down 17% during this period while I am writing this.
Valero has a number of (related) things going in its favor:
- Economic growth has rebounded over the past two years as the pandemic has now more or less faded.
- Refinery capacity is a huge problem, boosting margins.
- The European energy crisis favors refineries capable of exporting petroleum products.
The crack spread, I have to admit that it sounds incredibly funny, is basically a tool to track refining margins. The 3-2-1 crack spread shows what we can expect in terms of refinery profitability. In this case, 3-2-1- stands for the cost of 3 crude oil future contracts, 2 gasoline futures contracts, and 1 ULSD diesel futures contract. If refined product prices rise faster than the price of oil, refineries make more money when buying a barrel of oil. After all, Valero does not produce oil, it buys feedstock for its operations consisting of "traditional" refining, renewable diesel, and ethanol.
With exposure in the United States, Canada, the United Kingdom, Ireland, and Latin America, Valero owns 15 petroleum refineries located in the US, Canada, and the United Kingdom. In its facilities, it has the capacity to produce 3.2 million barrels per day.
Valero also co-owns Diamond Green Diesel Holdings, which produces renewable diesel on the Gulf Coast with an annual capacity of 700 million barrels.
The company also owns 12 ethanol plants with a combined capacity of 1.6 billion gallons per year. These operations require 553 million bushels of corn per year and produce 4.2 million tons of dried distillers grains as by-products.
With that said, and to return to the crack spread, we're in a very unusual situation right now. Crack spreads have gone through the roof. Not just in the US, but also in ARA (Amsterdam, Rotterdam, Antwerp), and Singapore to use three benchmark spreads.
Prior to 2022, spreads were roughly $10 per barrel of oil, which varied depending on weather, economic growth, and related circumstances. The pandemic caused a steep decline in profitability.
EIA
Using RBOB Gasoline Crack Spread futures trading on NYMEX, we see that the surge in spreads has guided Valero higher this year.
Note that Valero (like its peers) does not move in lockstep with the crack spread on a long-term basis. The spread is often "rangebound" while refinery companies invest in their businesses, boost output volumes, and buy back shares. All of this increases the long-term value and results in a lower long-term correlation. The correlation is high during economic downturns and upswings as margins have a large impact in these situations. And as I already said, volumes are key as revenue is basically output multiplied by price.
TradingView (Black = VLO, Orange = Crack Spread)
The latest data shows an average crack spread of $39.
Why is the crack spread so high? It's one of the issues the Biden Administration has raised as it believes that oil companies are price gouging.
The problem isn't price gouging - and I'm not saying that to defend energy companies. As the EIA reports , it's a result of the pandemic, which forced the closure of refineries and overall lower investments in new supply:
The International Energy Agency estimates that global refining capacity decreased by 730,000 barrels per day (b/d) in 2021—the first decline in global refining capacity in 30 years. In the United States, refining capacity has decreased by about 1.1 million b/d since the start of 2020, contributing 184,000 b/d to the global decline in 2021. Global demand for refined products dropped substantially in 2020 as a result of the COVID-19 pandemic. Less petroleum demand and the associated lower petroleum product prices encouraged refinery closures, reducing global refining capacity, particularly in the United States, Europe, and Japan.
In 2020 and large parts of 2021, this wasn't a huge issue. It became a problem when the demand came back. Supply wasn't able to catch up, causing inventories to plummet to multi-year lows.
EIA
This was made worse by Russia's invasion of Ukraine and the sanctions that followed. According to the EIA:
Associated sanctions on Russia— with well over 5 million b/d in crude oil processing capacity— disrupted exports of Russia’s refined products into the global market, and will likely continue to do so as import bans in the European Union and United Kingdom come into full force.
With these numbers in mind, the IEA (don't confuse this with the American EIA), estimates that *net* refinery capacity is set to expand by 1.0 million barrels per day in 2022 and 1.6 million barrels per day. China and the Middle East are expected to add 4.0 million *gross* barrels per day during this period.
In other words, the difference between net and gross is roughly 1.4 million barrels per day over the next 2 years, which indicates that supply is set to remain tight in western countries.
The only expansion in western countries is in Beaumont, which is owned by Exxon Mobil ( XOM ).
EIA
In other words, unless foreign nations start to dump refined products in the US, the United Kingdom, or Europe, Valero continues to be in a good spot to benefit from long-term high margins - even though I expect the crack spread to get close to $10-$20 again when the war in Ukraine ends.
Also, a steep recession could hurt energy demand enough to weaken both margins and volumes.
Now, before you ask why American producers do not simply build new refineries, that's because no CEO wants to take on these very expensive projects. Especially not in an environment where politicians, major shareholders, and other groups push for a trend toward sustainability.
With that in mind, it helps tremendously that Valero is a cheap producer. It is consistently refining cheaper than its peers when excluding turnaround and depreciation and amortization expenses.
Based on this context, let's look at the company's valuation and the value it brings to the table.
Buying Attractive Quality Yield (At A Great Price)
Supportive favorable macro-economic developments are one thing. Generating value for shareholders is another thing. That's hard. Doing it consistently is even harder.
Since 1985, Valero has returned 13.5% per year with a standard deviation of 42%. This beats the S&P 500, although not on a volatility-adjusted basis (Sharpe/Sortino ratio).
This outperformance has everything to do with the company's ability to generate value. Not only does it have efficient operations, but it has also lowered sustaining CapEx as a percentage of depreciation and amortization from more than 100% in 2012 to 47% in 2021.
This year, the company is expected to do $2.0 billion in CapEx ($2.2 billion according to analysts). Only 40% of this will be focused on growth projects. Half of growth CapEx will go towards renewables.
$2.2 billion is basically what the company is spending on CapEx in an average year. What this means is that higher net income results in higher free cash flow. While 2022 is expected to be a total blowout year with more than $8.0 billion in free cash flow (19% of its $41.3 billion market cap), we're looking at longer-term FCF close to $4.3 billion. If the company is able to sustain that, it would imply a longer-term FCF yield of more than 10%.
An implied 10% FCF yield supports everything investors can possibly wish for. It supports the company's current 3.6% dividend yield, buybacks, and debt reduction. Net debt soared to more than $11.3 billion in 2020 as a result of imploding demand, high CapEx, and dividends (the company did NOT cut its dividend). Now, the company is set to lower net debt to less than $4.0 billion in 2023, that's less than 0.5x EBITDA.
In other words, when people ask me when I expect (aggressive) dividend growth to return, I think it will happen in 2023.
Historic dividend growth has been impressive. Between 2012 and 2022E, the average annual dividend growth has been 19.7%. Moreover, buybacks have been aggressive in the years prior to the pandemic. Since 2012, the company bought back 27% of the common shares outstanding.
To go back to my dividend comments, the company restarted share buybacks in 1Q22. VLO returned $545 million to shareholders. $144 million of this was returned via buybacks.
This resulted in a payout ratio of 44%. Note that the company aims to return between 40% to 50% of net income. In other words, we're now at a point where higher shareholder distributions make sense - especially because net debt is dropping rather quickly.
It also helps that VLO is trading at an attractive valuation. The company has a $47.5 billion enterprise value based on its $41.3 billion market cap, $4.0 billion in net debt, $600 million in pension-related liabilities, and $1.6 billion in minority interest (related to Diamond Green Diesel).
This is roughly 4.8x next year's EBITDA estimate of $9.9 billion. If EBITDA is able to remain elevated in the years ahead (without incorporating an extreme scenario), I believe the company can do $9.0 billion in annual EBITDA.
This would imply that investors are paying 5.3x (average) EBITDA.
In other words, I believe the company's fair value is at least 60% above its current price. That's a lot, but I believe it's warranted.
The problem is getting there.
Economic expectations like the Philadelphia Fed manufacturing index below are pointing at a manufacturing recession. This would hurt demand, causing margins to narrow (crack spread).
Philadelphia Federal Reserve
The good news is that a lot has been priced in. I would say that a manufacturing recession has become the base case (which helps the risk/reward). However, if indicators continue to drop beyond August, I think Valero has 10-20% more downside.
Investors need to take that into account - as well as its above-average volatility, which is very important to be aware of before starting a position in VLO.
Some Comments On Valero Energy's Upcoming Earnings
Valero will announce earnings on July 28, before the market opens. The company is expected to do $9.39 in earnings per share. That's one of the highest estimates ever.
This consensus estimate is based on 6 estimates. Five estimates/analysts have upgraded their estimates in the past 4 weeks. The company received zero downgrades.
While the company has a history of beating earnings, it is hard to tell what to expect. What matters to me is the company comments on:
- Expected refining supply in the United States and abroad.
- The crack spread and related pricing issues.
- Demand and economic growth.
- Shareholder returns (maybe comments on dividend growth?).
- Among other things.
Takeaway
In this article, I explained why I am a firm believer in Valero's mid- and long-term success. The company benefits from a very tight market for refined products in western countries, which is causing the crack spread to hover well above the historic average.
Based on roughly $2.2 billion in annual CapEx, the company is seeing a rapid increase in (expected) free cash flow. Management is reducing net debt, paving the way for future (aggressive) dividend hikes and much higher buybacks.
As we're getting close to earnings, I believe that the company offers good value for investors. Its valuation has come down due to the recent (demand-fear-driven) decline in its stock price and higher analyst estimates.
The dividend yield is close to 4.0% again.
Hence, I am a firm believer that VLO can continue what it has done in the past 40+ years: delivering outperforming capital gains for investors.
(Dis)agree? Let me know in the comments!
For further details see:
Valero Energy: The Mighty Crack Spread And Outperforming Shareholder Returns