Valero Energy Corp. (NYSE: VLO), the largest independent refiner in the U.S. market, is a well-known and avidly traded name. Despite being a member of the super hot energy sector, Valero has seen its stock price collapse from its 52-week high of $75.75 to Friday's close at $34.72 (a 54% decline). The 52-week low is $29.70, and the Wall Street analyst community remains very negative on the shares of the San Antonio-based company - even though it beat analysts admittedly reduced expectations for both revenue and earning.
The $64 million question (*) is this: Is it time to buy? During the past year, I have watched as many ventured into this stock for a trade - only to get clobbered. The key factor in determining Valero's profitability - and its stock price - is the refining profit margin, known as the "crack spread" in industry parlance. This is the difference between the cost of oil purchased by Valero and the price it can get for the distillates it obtains by refining the 3.1 million barrels of crude oil that it processes daily.
Recently, the overall industry crack spread has been narrowing. In fact, it has been for some time as governments around the world and gasoline companies actually try to hold down the pain motorists feel at the gas pumps.
The "perfect storm" that hit Valero this year had several catalysts:
- First, we watched as the price of crude oil soared exponentially, the result of rocketing global demand overseas and a lack of effort in both the United States and other countries to increase production.
- Second, demand for distillates in the United States waned as the U.S. economy slowed down and distillate prices soared trying to catch up with crude prices. This made it very difficult for the increases in the price of gasoline to be able to keep up with increases in the price of oil, compressing Valero's crack spreads from last year.
That was the bad news.
The good news is that crack spreads in the second quarter have increased from the first quarter of this year. Also, since Valero's refineries can process the cheaper "heavy sour" crude oil, the company has a sustainable competitive advantage over other refiners, giving its refineries staying power through rough times like these. For very-long-term holders, this is when you buy stocks such as this one; since the weaker rivals often disappear (the rivals either eventually get shut down, get sold off - or both), and the strong players emerge as the victors.
In the refinery sector, that strong player - and eventual victor - is Valero. But we are not there yet, and the lack of expansion in refining capacity in the U.S. market over the past decade has established a definite floor under crack spreads, meaning there's only so low they can go.
The U.S. government expects crack spreads to improve moving forward, but those spreads remain well below where they were in last year's second quarter. That's good because it means there's room for improvement - in both the margins and the share prices.
Another plus is that as oil prices have been dropping precipitously recently from the high of almost $150 per barrel, crack spreads have been increasing. And the drop in prices of natural gas, which is an input to Valero's refining process, has also declined, further adding to margins.
The bullish argument, then, is this: The drop in oil prices, and sequentially expanding margins (from quarter to quarter, as opposed to year over year), will combine with the low valuation in Valero's stock price (the current Price/Earnings Radio is 6.76, while the Forward P/E is 11.22) to boost the company's share price, which appears to have bottomed of late.
This bullish case could very well be accurate; unfortunately, it's still too difficult to call. And here's why:
- The U.S. economy isn't going into a recession. That means U.S. demand for petroleum products won't abate as much as analysts expected, and may actually soon begin to escalate anew (even if it's somewhat reduced because of energy-reduction initiatives).
- Emerging-market demand will continue to escalate as incomes rise and more consumers buy cars. The respite there also is likely to be a temporary manifestation: They have curbed gasoline demand subsidies because of the inflationary impact of high crude prices and food prices; as crude prices are abating, demand is likely to reaccelerate.
- Evidence about the resilience of emerging markets has been abundant of late. There was Cisco System Inc. (CSCO), which reported stronger-than-expected sales and profits last week, thanks largely to strong performance in Mexico, Russia and Asia - and especially China. There was the comment by Jeffrey R. Immelt, chief executive officer for industrial giant General Electric Co. (GE), who talked of the undiminished strength in the emerging markets - with a specific reference to the Asian infrastructure boom. And there's the launch of the $2,500 car - the Nano - in India by Tata Motors Ltd. (TTM), a domestic carmaker with global aspirations.
It's worth noting, too, that most of these markets outside the United States, which are currently slowing, have plenty of room to cut interest rates. And some will be able to do so, should the prices of commodities and other goods continue to decline.
Unfortunately for our evaluation of Valero, in addition to the ongoing gyrations in oil prices there's substantial uncertainty being created in Washington, largely because of the ongoing political battle that's focused on the lifting of the ban on drilling in offshore U.S. waters. The mere possibility of this ban being lifted has added much downside pressure to oil prices by motivating profit-taking by the speculators who had previously been betting that long-term prices were destined to head higher.
Hence, while Valero's beaten-down shares appear very appetizing right now, and while the shares seem well positioned for a near-term speculative trade, there's still too much uncertainty to call this an actual "Buy" for investors. Unless we see much-lower oil prices, which would rekindle gasoline demand in the U.S. market and expand Valero's margins, the upside, if any, in Valero's stock will remain very limited. So I cannot recommend to buy Valero here. However, since Valero's stock has come down dramatically, and the company still is profitable (they are still profitable, show mildly expanding sequential margins, and management is committed to support the stock with buybacks), neither do I see a compelling reason to call it "Sell" here. So I will stick with a tenuous "Hold" until we can at least start resolving the uncertainties surrounding oil prices and the U.S. economy.
Action to Take: HOLD Valero shares as we await a bit more certainty in both the oil sector and the U.S. economy.
[Editor's Note: Horacio Marquez was working as a vice president of the Merrill Lynch Emerging Markets Fixed Income Group in 1994 when he correctly predicted that both Argentina and Mexico were headed for currency crises - cementing his reputation as an expert on both the emerging markets and on the nuances of global finance. Now Marquez brings that expertise to you with his newly created "Shadow Stock Trader" service. To find out how to subscribe, please click here. "Buy, Sell or Hold" is a brand-new Money Morning feature that so far has covered such companies as . (CS), ABB Ltd (ADR: ABB), Cummins Inc. (CMI), and . . Next week, Marquez will write about Berkshire Hathaway Inc. (BRK.A, BRK.B), the investment vehicle run by famed investing guru Warren Buffett. ]
(*) It was once the "$64,000 question," but inflation has done its work all too well.
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