Why Valero Energy Corporation Will Outperform Its Peers in the Long Run

America's oil production resurgence literally thrust Valero Energy (NYSE: VLO  ) to the fore. The independent oil refiner has risen more than 200% over the past five years. In addition, Valero repurchased four million of its shares and increased its quarterly dividend by 11% to $0.25 per share in January 2014. Although the yield, which comes in at 1.90% at the current share price, is relatively low, the overall stock makes for a strong proposition if you consider the fact that Valero blends the unique set of qualities of a growth stock and an income stock.

Valero's strong profile explains the huge investor interest over the past several years, as signaled by the extended rally. However, despite the compelling case, long-term investors are viewing U.S. oil refiners in a different light and wondering whether performers such as Valero will plateau in view of the impending challenges in the oil refining business landscape.

Industrywide challenge in the offing
The domestic supply glut caused by increased oil production has greatly suppressed the U.S. West Texas Intermediate crude oil price benchmark relative to the international Brent benchmark. The difference between WTI and Brent allows U.S. refiners such as Valero to gain a competitive advantage by using cheaper feedstock—WTI—relative to their international counterparts, who use feedstock priced using the Brent benchmark.

However, now, the consensus seems to be that this unique advantage will fade away in the mid-term, making it hard for some U.S. refiners to shield themselves from bigger international competitors. This outlook is informed by the fact that the argument for lifting the U.S. crude oil export ban is gaining notable steam, and that more liquefied natural gas export terminals are being approved, strengthening the likelihood that U.S. crude will ultimately be exported. If this happens (which is likely), Brent and WTI will converge, eliminating the price advantages that U.S. refiners previously enjoyed.

From this perspective, the doubts over refiners' long-term outlook are warranted. Valero however has what it takes to outperform the broader industry and give investors great long-term returns even in the face of the imminent industrywide hurdle.

Circumventing impending convergence between WTI and Brent
First, Valero's refinery footprint is strategically spread across key coastal locations. Compared with other independent refiners, Valero has the largest Gulf Coast footprint. This places it strategically close to Louisiana and Texas. With its refineries close to key areas in the U.S. shale narrative such as the Eagle Ford, Valero spends far less on transports costs per unit of crude bought from the oil-rich Eagle Ford area when compared with other inland refiners. This inherent cost advantage will allow Valero to offset the increased costs of feedstock should the WTI and Brent benchmarks converge in the midterm, enabling it to maintain growth within its targeted range.

More notably, Valero is increasing investments in two key areas that will allow it to greatly reduce costs in the mid term and long term, offsetting any increments in the costs of feedstock caused by opening up U.S. crude to foreign markets, and allowing it to maintain forecasted growth in a challenging sector landscape.

Overall, Valero spent around $1.25 billion in expenditures labeled as growth investments in 2013. This figure, however, is estimated to reach $1.52 billion in 2014, according to company reports. In 2013, 46% of the growth investment was allocated to logistics while 7% was allocated to the processing of light crude, with the remainder going to hydrocracking, natural gas, petrochemicals and 'others.' However, in 2015 it is estimated that 45% will go to logistics and 27% will go to processing light crude.

The increased spending in processing of light crude will allow Valero to add specialized equipment that allows it to process crude into components that require further processing to get final products like fuel, but that have been sufficiently refined to be legally exported. By reducing the steps involved before exportation, Valero will be able to reduce its refinery costs, allowing it to protect its margins even in the face of increased price of feedstock.

Similarly, the largest portion of growth investment spending will go to logistics in 2014, as was the case in 2013. This basically allows Valero to use its own rail and pipelines instead of exclusively transporting through midstream players. This will be advantageous when sourcing crude from key inland sources such as the Bakken area as it will allow Valero to cut out the middleman and save on costs, further enabling it to offset any incremental costs that will be induced by WTI converging with Brent in the mid or long term. 

Valero has had a good run over the past five years. Going forward, the strengthened argument for allowing U.S. crude exports as well as the exportation of natural gas to Europe and other markets could eliminate a key competitive advantage that U.S. refiners enjoy relative to their international counterparts—lower priced feedstock. Valero is however uniquely positioned to overcome this hurdle relative to the broader market. Its long-term investment case is convincing.

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3/30/2015 10:05 AM
VLO $63.06 Up +1.19 +1.92%
Valero Energy Corp CAPS Rating: ****