Valero Energy (NYSE:VLO) is arguably one of the greatest beneficiaries of the U.S. oil production resurgence. The domestic supply glut has suppressed oil prices in the U.S., with the West Texas Intermediate benchmark (WTI) being significantly lower than Brent in the years since the oil boom. Naturally, U.S. refiners have benefited immensely from the wide spread because they use cheap WTI as feedstock while their competitors use more expensive Brent.
Cheaper feedstock has given U.S. refiners such as Valero an opportunity to not only price more competitively relative to their global competitors, but to also enjoy great margins at the same time. In the fourth quarter of 2013, Valero reported a net income of $1.3 billion, up 28% from $1 billion a year earlier. While the earnings were driven by an array of factors, including liquidating the remaining interests in CST Brands, cheap feedstock played a central role in driving the margins.
The discount that Valero gets on domestic crude has allowed it to earn great profits and pad its coffers. In the fourth quarter, for instance, it paid out $120 million in dividends, with the annual yield for shareholders coming in at around 2.10%. Although this is relatively low, Valero combines its dividend payouts with an aggressive share repurchase program. In the quarter under review, it paid $339 million to purchase approximately 8.3 million shares of its common stock, bringing the total 2013 stock purchases to 22.4 million shares at a cost of $928 million. The repurchase program has progressively reduced Valero's shares outstanding, allowing it to post higher EPS and contributing to continued share price appreciation. In addition, continued profitability and consistent dividends have also increased demand for the stock, leading to higher share prices. In the trailing twelve months, Valero's shares have gained about 117%.
However, Valero's rally may soon hit a wall: It can no longer rely on low crude prices as a growth driver.
Low crude price environment coming to an end
Earlier in the week, WTI crude oil futures for March topped $100 per barrel. And as of Thursday, the Brent/WTI spread was at the lowest level since October 9, with WTI ending the trading day at $100.35/bbl and Brent settling at $108.73/bbl.
As the Brent/WTI spread goes lower, the competitive advantages that U.S. refiners such as Valero enjoy relative to their global peers continue to diminish. Moreover, indications point toward a prolonged period of higher crude prices. This essentially means that refiners such as Valero will have to go back to the drawing board and look for new growth drivers.
One reason for the uptick in crude prices was OPEC's upward revision in oil demand for 2014. It expects global demand to increase by 50,000 barrels per day to 1.09 million barrels per day. The key informant behind this upward revision was the strong growth in North America and Europe. Seeing that economic conditions are brightening in Europe and North America, high global demand is likely to be sustained, pointing toward a longer period of high crude prices.
Oil producers will also do all within their power to make sure that prices don't drop to previous lows. This seems like the only viable play at the time to reverse slowing upstream volumes. Low prices have made it uneconomical for producers to pursue reserves. Chevron (NYSE:CVX), for instance, saw its 2013 production slip by 3.5%. It is likely that upstream and midstream companies will ration supply to sustain current high prices and increase both the incentive to produce and transport -- it's the only card left. As is, the series of divestments that big oil companies are undertaking are just enough to pay dividends and follow through on share repurchase programs. Prices need to go high enough to allow oil majors to notably increase production.
Another likely contributor to higher prices in the long run is the debate on the U.S crude oil export ban, which was passed 40 years ago. As it turns out, there are some gray areas in the ban that opponents of the ban can use to further their arguments. Some 1 million barrels of the 8 million barrels of oil produced in the U.S. every day are condensates, petroleum byproducts with a lucrative export market, according to the Wall Street Journal. The export rule bans condensates that come directly out of the ground in liquid form. However, the law doesn't cover condensates that are recovered from natural gas at processing plants. Furthermore, there is a compelling economic case to commence the export of condensates that are not covered by the export ban; they trade at a discount to the benchmark WTI and global oil futures. As such, condensates will not affect domestic prices if exported.
If those seeking to bring down the export law managed to export these condensates (highly likely) then be certain that the eventual amendment of the export law will follow -- maybe not this year, but in the foreseeable future. Again, this points toward higher prices in the long run.
Valero has had a good run, and I'd certainly love to be the guy who got in at $30 a share. However, its long-term outlook is uncertain in view of the likely continued increase in crude prices. Valero needs new growth drivers in order to present a strong 'buy' case as it did a year ago when crude prices were lower.