Valero Energy Corporation (VLO) is an independent petroleum refining and ethanol producing company doing business in the United States, Canada, the United Kingdom, and Ireland. It operates through two segments, (1) Refining and (2) Ethanol. In the refining segment, the company turns crude oil into gasoline and distillates and markets those products at the wholesale and retail level. As of December 31, 2016, the company owned 15 petroleum refineries with a combined throughput capacity of approximately 3.1 million barrels per day. It markets its refined products through the wholesale rack and bulk markets; and through approximately 7,400 outlets under the Valero, Diamond Shamrock, Shamrock, Ultramar, Beacon, and Texaco brand names. It also operated convenience stores at many of these gas stations and truck stops. In its other segment, the company produces and sells ethanol, distiller grains, and corn oil primarily to refiners and gasoline blenders, as well as to animal feed customers. It owns and operates 11 ethanol plants with a combined ethanol production capacity of approximately 1.4 billion gallons per year. In addition, it operates a 50-megawatt wind farm. In the last 4 quarters, the company made $2.1 billion ($4.53 per share) on $82 billion of revenue.
The refining business has been operating in the sweet spot economically for quite some time now. Global refining capacity is in balance and with US oil production and there is a growing demand for refining capacity. This has helped maintain refining margins. An easy way to keep an eye on the potential profitability of an oil refinery is to monitor the crack spread. The crack spread measures the difference in price between crude oil prices and the price of gasoline and distilled products like kerosene and jet fuel. The chart below shows the near futures price of gasoline and the crack spread. It shows that crack spread has been fairly steady even as the price of gasoline moves around substantially. It is currently around $0.40 per gallon of gas which means it is about $16.80 per barrel of oil.
The crack spread for distilled products is about $0.30 per gallon ($12.60 per barrel) at the moment and is more volatility. It is somewhat depressed from levels seen the last few years, so it has some room to rise which would help profitability.
VLOs share price has been in a trading range the past 3.5 years and it looks like it is about to break out of that range to the upside. RSI is neutral but trending higher and momentum is slowly turning higher. If the stock does indeed breakout of the trading range, standard technical analysis projections suggest the price could move the width of the trading range or about $30.
Valuation is supportive of the bullish case. The shares are priced at a PE of 14 based on trailing earnings and 11 based on analyst’s expectations of next year’s earnings. The company will be reporting earnings on or about July 27, and we think they will hit expectations and may exceed them as the industry enters the summer driving season. In addition, EV/EBITDA is at 8 indicating the company is currently trading a modest multiple of cash flow. With this free cash flow, the company regularly repurchases shares typically repurchases shares. In 2016 the company repurchased 7.2% of its shares and in 2015, the company’s share count shrunk by 5.7%.
In the final analysis, we think VLO is a good company in a steady to growing industry with a share price that is probably too low and we think the share price is poised for a repricing. Continuous repurchases certainly support the share price and as the share count continues to shrink, the P/E will rise. If you own the stock we suggest you keep it. If you are a stock only investor and the addition of VLO would improve the diversification of your portfolio, we suggest you buy it. If you would like to take a bullish position with limited risk, we suggest you consider buying a put spread risk reversal. This is a synthetic call that one can modify to minimize the cash paid up front or maximize a credit. With the stock trading at $64.75, we recommend the following structure.
To initiate this trade, the investor will collect a nominal $13 upfront per put-spread risk-reversal. The breakeven level is $64.87, which is very close to the current price. We chose to sell a slightly in the money put to generate premium and to give more leverage to an upside move. The efficient market hypothesis suggests there is a 46% chance of success on this trade. The most one can lose on the trade is $737, which is more risk than we typically like to take, but it is the price we have to pay for the upside leverage. We would suffer that loss if the share price fell to $57.50 or below. We think there is a very low probability event, but it could happen if the price of oil falls further and energy investors throw the baby out with the bathwater. Since the position is long a call, it has infinite upside potential.
As a final note on trading tactics, we think the stock is poised to break out of the trading range, so we are prepared to buy here. For those looking for technical confirmation that the move in probably underway, you can wait for the breakout to occur. And remember, always use limit orders.
