Sunoco and Valero Energy pre-announced better-than-expected earnings for the second quarter today. As U.S. refinery capacity has reached its limit, tight gasoline supplies have forced prices up. The result has been a big upswing in margins and free cash flow for refiners.

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By Brian Lund (TMF Tardior)
June 4, 2001

It was a crude-licious day for oil refining companies. Sunoco (NYSE: SUN) announced that second-quarter operating earnings will be 7% to 38% above what analysts expected. San Antonio's Valero Energy (NYSE: VLO), meanwhile, said its expected earnings for the second quarter would exceed $4 per share and come in 10% to 20% better than expected. That's $4 per share for the quarter. That's good.

Both companies said refining margins have been exceptionally strong in recent months. And why not? As the supply of refined gasoline has shrunk over the past two years, the spread between the spot prices of crude oil and gasoline has widened. According to the U.S. Energy Information Administration, the average spread was $0.08 per gallon in the summer of 1999 and $0.15 in the summer of 2000. In April 2001, the spread more than doubled to the atypical high of $0.34.

What's going on here? The problem is that refining capacity in the U.S. is reaching its limit. For almost 20 years, we had excess capacity in this country. As a result, no new refineries were built. Imports can make up for some of the shortfall -- we import over 500,000 barrels per day on average -- but certain regions of the country will inevitably have periodic shortfalls when refining capacity is low.

The wide spread has meant good times for the refining industry, and companies have done their best to take advantage of it. Valero, a Fortune 500 company, recently announced that it would acquire Ultramar Diamond Shamrock (NYSE: UDS). The combined company will have over $32 billion in annual revenue and total throughput capacity of over 2 million barrels per day, making it the second-largest U.S. oil refiner in terms of capacity, behind Exxon Mobil (NYSE: XOM). Valero also announced today that it has leased, with the option to buy, a refinery, pipelines and terminals from El Paso Energy (NYSE: EPG). Valero plans to transform the facility into America's fifth-largest refinery.

There is reason to hope the supply crunch will scale back in the near future. Refineries generally begin maintenance in February or March, and finish in April. With prices soaring, demand should fall as refineries run at maximum capacity and imports continue to pour into the nation. Already we have seen gas supplies rise in the past few weeks.

But the gravy train isn't over for Sunoco and Valero. Both are predicting record second-halves of the fiscal year. Sunoco anticipates $400 million in free cash flow for 2001. Valero achieved that last year and had over $200 million in Q1 2001 alone. It currently trades at just a little over three times its trailing 12-month free cash flow. With what looks like a huge second-quarter and half ahead of it, Valero offers intriguing prospects to investors.

Brian Lund generally begins maintenance in February or March, and finishes in April. His stock holdings can be viewed online, as can The Motley Fool's disclosure policy.

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