What: Shares of Valero Energy (NYSE:VLO), one the largest petroleum refining and marketing companies in North America, galloped higher by $0.91 per share, or 1.5%, to close at $60.18 on Thursday after research firm Deutsche Bank issued a rating upgrade and also boosted its price target for the company.
So what: According to analysts at Deutsche Bank -- which lifted their rating on the company to "buy" from "hold," and raised their price target (or the share price at which Deutsche Bank believes Valero Energy is fairly valued) to $70 from $60 -- Valero Energy has three catalysts at its sails that could push its shares higher.
First, U.S. product demand has been high, which shouldn't come as a genuine surprise since the price of crude oil has been running near a five-year low. As prices have fallen, motorists have been willing to consume more gasoline, thus improving refinery demand.
Secondly, "inventory-driven West Texas Intermediate differentials" are also expected to add some pep into Valero's bottom line. As the price between WTI crude and Brent crude widens, Valero's refining operations on the U.S.'s Gulf Coast could begin to see (or are probably already seeing) a surge in demand for refined products.
Lastly, Deutsche Bank described Valero's Gulf Coast operations as being "awash in crude optionality." In plainer English, Deutsche Bank was merely highlighting the company's refining flexibility in a region which is expected to see high activity as WTI and Brent prices split further apart.
Now what: The question that investors need to be asking here following this upgrade and 17% price target hike from Deutsche Bank is whether or not Valero has what it takes to hit $70 per share.
On one hand there are plenty of catalysts that should push Valero higher, at least in the near-term. Low gasoline prices are likely to increase spring and summer driving capacity and should keep refiners busy well into the third or even fourth quarter. Even if production from drillers falls Valero should benefit from considerably improved crack spreads, meaning it could make even more money despite a drop in revenue.
The other side of the coin is that the refining industry is very cyclical and there's a pretty good chance that these low crude prices aren't going to last for years (at least in my opinion). A rapidly rising oil price tends to sap refiners' margins and could send Valero heading lower as quickly as it has moved higher in 2015.
On paper Valero still appears attractive at 10 times forward earnings and sporting a dividend yield of 2.7%. However, I believe Deutsche Bank's target price is about where I, too, would cap off Valero's intermediate (one-to-three year) potential. Unless we see a considerable widening of WTI-Brent spreads it's probably going be tough for Valero to expand much past $70 per share. So while I do agree Valero could be worth $70, it's beginning to lose its attractiveness as an undervalued investment in my eyes.
Sean Williams has no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.
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