Oil Prices lead to Refinery Gains

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With gas prices rising at the pump an average of $0.50 in the last month, a lot of people are talking about oil prices. While natural gas prices have been in a slump, crude oil prices have been steadily rising. 

<img src="/media/images/user_16267/screen-shot-2013-02-26-at-122631-pm_large.png" />

There has been an increase in global demand of oil as India and China become more industrialized. Oil prices at the time of this writing are at $93.11 per barrel. Oil production and consumption is increasing, too. And all crude oil must go through the refining process, making oil refineries solid investment vehicles.

In an increasingly promising environment for refineries, refiners Valero Energy (NYSE: VLO), Marathon Petroleum (NYSE: MPC) and HollyFrontier (NYSE: HFC) may merit a closer look.

<table> <tbody> <tr> <td> <p><strong>Company</strong></p> </td> <td> <p><strong>Share Price</strong></p> </td> <td> <p><strong>EPS</strong></p> </td> <td> <p><strong>P/E</strong></p> </td> <td> <p><strong>12-month Return</strong></p> </td> </tr> <tr> <td> <p><strong>Valero Energy</strong></p> </td> <td> <p>$45.99</p> </td> <td> <p>$3.75</p> </td> <td> <p>12.26</p> </td> <td> <p>87.48%</p> </td> </tr> <tr> <td> <p><strong>Marathon Petroleum</strong></p> </td> <td> <p>$82.74</p> </td> <td> <p>$9.89</p> </td> <td> <p>8.36</p> </td> <td> <p>94.18%</p> </td> </tr> <tr> <td> <p><strong>HollyFrontier</strong></p> </td> <td> <p>$55.69</p> </td> <td> <p>$8.38</p> </td> <td> <p>6.64</p> </td> <td> <p>68.04%</p> </td> </tr> </tbody> </table>

Each of these companies has had an excellent 12-month stock price gain, but they also have strong earnings with low price-to-earnings multiples. This is a conservative industry, and investors price each of these companies accordingly. The industry average P/E for oil and gas refining and marketing is 15, making these three companies' earnings relatively inexpensive for investors.

Their history of performance has led each of these companies’ shares to be primarily held by institutional investors: 

<table> <tbody> <tr> <td> <p><strong>Company</strong></p> </td> <td> <p><strong>% Held by Institutions</strong></p> </td> </tr> <tr> <td> <p><strong>Valero Energy</strong></p> </td> <td> <p>85.5%</p> </td> </tr> <tr> <td> <p><strong>Marathon Petroleum</strong></p> </td> <td> <p>84.4%</p> </td> </tr> <tr> <td> <p><strong>HollyFrontier</strong></p> </td> <td> <p>91.8%</p> </td> </tr> </tbody> </table>

In short, these are three strong companies that attract the “smart” money. But what are they really worth?


<img src="/media/images/user_16267/screen-shot-2013-02-28-at-100250-am_large.png" />

Each of these companies has undergone a drastic increase in earnings over the last three years. But in the next two years, earnings aren’t expected to sustain their previous momentum.

The average growth rate for earnings over the last three years is 169%. Compare this to the average expected growth rate for these companies for the next two years: 2%. Clearly, their momentum is slowing. With slower or declining earnings, investors should expect share prices to fall for Marathon Petroleum and HollyFrontier. Since Valero has an expected earnings increase, it may still see some more gains.

Using a discount rate of 10%, which is standard for the oil and gas industry, and a future growth rate of 2%, the potential share prices are as follows:

<table> <tbody> <tr> <td> <p>VLO</p> </td> <td> <p> $46.88</p> </td> </tr> <tr> <td> <p>MPC</p> </td> <td> <p> $123.63</p> </td> </tr> <tr> <td> <p>HFC</p> </td> <td> <p> $104.75</p> </td> </tr> </tbody> </table>

This can be misleading, because earnings aren’t expected to grow at exactly 2% each year for each company. 2% is simple the average across the next two years for all three companies.

When capitalizing future earnings by the 10% discount rate, you get the following per-share valuation:

<table> <tbody> <tr> <td> <p>VLO</p> </td> <td> <p> $50.87</p> </td> </tr> <tr> <td> <p>MPC</p> </td> <td> <p> $100.17</p> </td> </tr> <tr> <td> <p>HFC</p> </td> <td> <p> $69.83</p> </td> </tr> </tbody> </table>

A third method of valuation is taking the future earnings and using the current price-to-earnings multiple:

<table> <tbody> <tr> <td> <p>VLO</p> </td> <td> <p> $62.36</p> </td> </tr> <tr> <td> <p>MPC</p> </td> <td> <p> $83.74</p> </td> </tr> <tr> <td> <p>HFC</p> </td> <td> <p> $46.37</p> </td> </tr> </tbody> </table>

When looking at each of these valuation methods together, the average expected share price is:

<table> <tbody> <tr> <td> </td> <td> <p><strong>Average Share Price</strong></p> </td> </tr> <tr> <td> <p>VLO</p> </td> <td> <p> $53.37</p> </td> </tr> <tr> <td> <p>MPC</p> </td> <td> <p> $102.51</p> </td> </tr> <tr> <td> <p>HFC</p> </td> <td> <p> $73.65</p> </td> </tr> </tbody> </table>

While looking at growth rates, P/E multiples and discount rates can be effective, surprises along the way can change everything. This industry is expected to grow at 7.4% next year and 13.5% the following year. If these growth rates were used instead of 2%, the valuations would be over $300 per share.

There may be short-term gains to be had for these companies as earnings grow in the next year, but they aren’t expected to maintain this momentum much longer. Watch for future earnings, and if they begin declining, reevaluate your position.

higginsaustin has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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