"Sweet Profits" for Refiner

08/12/2005 12:00 am EST

Focus:

Charles Norton

Editor-in-Chief, Supernova Stocks

"The oil tide has lifted a lot of boats," says Charles Norton, editor of Supernova Stocks. "Of the ten best-performing industry groups in the market right now, four of them are oil-related. Here, he looks at one favorite, Valero Energy, a play on the refining sector.

"As a growing US economy spurs shipping and travel, demand for gasoline is at record levels. Meanwhile, in recent years there has been little increase in refining capacity needed to produce gasoline, with the last US refinery built nearly 30 years ago. Regulatory obstacles and not-in-my-backyard protests have helped to keep refining supply tight. As a result, companies that convert crude oil to gasoline have been reaping a windfall. Perhaps none are benefiting more than Texas-based Valero Energy (VLO NYSE).

"As rising fuel prices help increase margins, Valero is uniquely positioned to handle high-sulfur oil, so-called sour crude, which costs less because it is more difficult to process and fewer refineries can do so. Around 70% of the oil that Valero refines is low-grade crude, which can be purchased at a hefty discount to higher-quality, sweet crude oil. For example, high-sulfur Maya crude from Mexico sells for around $15 a barrel less on average than the benchmark light, sweet grade, West Texas Intermediate. And that discount is likely to increase, as increasing anti-pollution regulations are more easily met with lower-sulfur crude that’s simpler to refine.

"Yet, even though the lower grade oil can be purchased on the cheap, the fuel produced from Valero’s refineries meets the same stringent environmental standardsand is sold for the same price as gas fashioned from higher-quality oil. With 15 refineries throughout the US, Canada, and the Caribbean, the company currently stands as America’s third largest refiner. But not for long. In April, Valero announced that it would buy Premcor for $8 billion. The combined firm will be the country’s largest refiner ahead of both ExxonMobil and ConocoPhillips.

"As the integration of the two firms unfolds, the supply-demand imbalance continues to favor refiners, and sour crude discounts persist, the company’s sales and earnings are likely to expand. But Valero’s fundamentals are already first-class: Sales in the recently reported second quarter were 31% better than last year, while earnings jumped 34%. Margins are lush, of course, as the company buys cheaper crude but sells its refined products at an ever-increasing price. Return on equity stands at a robust 27%. In short, Valero is converting opportunities into profits. Plus, the expansion of its production capacity and recent acquisition of Premcor will make Valero’s advantage in this area that much more sweet."

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