Valero Spins Crude Into Gold

This is the fourth in a series of articles regarding the outlook for investments in the oil industry in 2006 and beyond.

As a little kid, I remember being enthralled by the story of Rumpelstiltskin and his ability to spin straw into gold. So I suppose that it's no surprise that I'm equally enchanted by the prospects of his modern-day equivalents in the oil industry: independent oil refiners such as Valero Energy (NYSE: VLO  ) , Sunoco Products (NYSE: SUN  ) , Frontier Oil (NYSE: FTO  ) , and Tesoro (NYSE: TSO  ) .

These companies have been delivering gold into investors' pockets over the two years ended March 22, 2006. Their shares advanced an average 300%, well ahead of the more-than-decent 80% gain posted by the AMEX Oil Index over the same period, and quite a bit better than the 19% increase recorded by the S&P 500.

Has the refiners' magic spinning wheel lost its golden touch? Don't bet your firstborn on it. Despite the Energy Department's recent report that crude stocks remain at a five-year seasonal high of 338.6 million barrels, crude oil is expected to average $64 per barrel in 2006 (16% ahead of 2005). The benchmark Gulf Coast refining margin -- the difference between what refiners pay for crude oil, and the market price for which the refined product sells -- averaged $10.10 per barrel in the fourth quarter of 2005, up 129% from $4.40 per barrel in the year-ago period.

This all-important margin should increase further in 2006 due to a number of issues: increased demand for refined products, driven by continued economic growth; the government-mandated switchover to low-sulfur diesel fuel; and the refiners' planned phase-out of gasoline additive MTBE because of liability concerns.

Increased demand for refined products
According to the Energy Information Agency, regular gasoline is expected to average $2.42 per gallon in the U.S. in 2006, up roughly 7% from 2005. On-highway diesel (versus the high-octane off-road variety) is expected to increase 3.3% to an average $2.49 per gallon, though this forecast may prove low because of issues arising from the low-sulfur regulation mentioned below.

Low-sulfur diesel
The diesel fuel market will face increased tightness in June 2006 as the Environmental Protection Agency's low-sulfur regulations become mandatory. These regulations require that the sulfur content in highway-class diesel fuel be reduced some 97%, from 500 ppm (parts per million) to 15 ppm, with full compliance by 2010. In fact, 80% of all highway diesel fuel must have the 15 ppm limit by of June of this year -- a fact that will drive increased refinery shutdowns (as they retool to meet these new specifications) and thus limit diesel supply (good news for refining margins). Since Canadian drivers will be facing similar restrictions this year, North America's supply/demand imbalance for low-sulfur diesel should be considerable.

The MTBE phase-out
Methyl tertiary-butyl ether (MTBE) is a gasoline additive used by refiners since 1992 to meet the standards incorporated into the Congressional Clean Air Act Amendments of 1990. MTBE is an oxygenate which, when combined with gasoline, allows for cleaner combustion in engines and lowers air pollution. Unfortunately, it now turns out that this possibly carcinogenic substance has been leaking into drinking water supplies in several states. Due to the obvious legal ramifications, refiners have started to phase out the use of MTBE. Valero estimates that the removal could take as much as 145,000 barrels a day off the market, roughly the equivalent gas production of two large U.S. refineries.

While these factors will prove beneficial to independent and major refiners alike, I think Valero enjoys the biggest advantage in the current market.

Valero victorious?
The company is the largest independent U.S. refiner, operating 18 refineries in the U.S., Canada, and Aruba with a throughput capacity of roughly 3.3 million barrels per day. The term "super-independent" isn't a misnomer, since the next-largest independent refiner, Sunoco, has a refining capacity of merely 940,000 barrels per day. Frontier and Tesoro together have a throughput capacity of roughly 725,000.

While Valero's scale and geographic diversity are certainly a plus, the "sexiest" part of the company's story is its ability to process large amounts of heavy/sour crude. Most refineries are configured to refine so-called "sweet crude," oil that has less than 0.5% sulfur content. Global demand for sweet crude continues to grow, but most of the new supply being brought to the market, primarily by Saudi Arabia, is the heavy/sour variety.

Heavy/sour oil contains high levels of sulfur, metals, and other impurities that make it more difficult to process into refined products. These inherent impurities in heavy/sour crude cause it to sell for a significant discount to the price of light sweet crude. According to Bloomberg, the spread between the price of a barrel of West Texas Intermediate crude (sweet) and Maya crude (heavy) is now approximately $18/barrel, significantly ahead of the five-year average of $9.57.

Since 55% of Valero's throughput volume of roughly 3 million barrels per day in 2005 was of the heavy/sour variety, it allowed Valero to post refining margins of $11/barrel for the year and $11.91 for the fourth quarter, both ahead of the industry average. There's little reason to believe that this trend won't continue. Morgan Stanley estimates that for every $1 change in the heavy-sweet spread, Valero stands to earn an additional $1.16 per share.

The strong fundamentals of Valero's business enabled it to post record earnings of $6.10 per share in 2005 (up from $3.27 in 2004), pay down debt (net debt to total capitalization stood at 24.8%, versus 30.7% at the end of 2004), and repurchase roughly $570 million worth of stock.

Those trends should continue on all fronts in 2006; the company has already said that it expects another year of record results. Analysts' consensus estimates call for earnings of $7.54/share and around $3 billion in free cash flow. That would enable Valero to expand its share buyback program, repay additional debt, grow its dividend, and possibly finance an acquisition such as the U.K.'s Pembroke refinery.

Foolish bottom line
With shares trading at around eight times fiscal 2006 earnings, the likelihood of a further increase in the spread differential between sweet/sour crude, and the potential for government imposed regulations to create further bottlenecks in gasoline production, I believe that investors seeking to pile up some gold in their portfolio should consider giving Valero a spin.

Further Foolishness that's anything but crude:

Fool contributor Will Frankenhoff is enjoying his time writing for The Fool more than playing golf or reading the latest science- fiction novel. He welcomes your feedback. He does not own shares in any of the companies mentioned above. The Motley Fool is investors writing for investors.


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