Oil Bubble: Buy Refiners Like TSO and VLO
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The price of crude oil has recently been on a strange trend. In 2008, WTI crude oil hit a record high of about $145 per barrel before dropping to around $30 per barrel at the end of 2008 before once again rising above $100 per barrel in 2010 (EIA). As of this writing, WTI crude oil currently sits at $105.27 per barrel and Brent crude oil sits at $118.20 per barrel. This large fluctuation in price is mainly due to speculation in the futures market and only partially due to changes in short term fundamentals. As proof, Saudi Oil Minister Ali al-Naimi stated in a conference last year that crude oil prices of $70 to $80 per barrel is fair for producers and consumers (Bloomberg). Therefore, oil production cost (the breakeven price) has to be below $70 per barrel and is obviously not the main contributing factor to the price fluctuation.
Also, the Energy Information Administration (EIA) recently released on April 27 a report, which showed that during January and February the world’s spare crude oil production capacity was an average of 2.5 million BPD. Furthermore, crude oil inventories in the USA in April rose to 375.9 million barrels with stockpiles at Cushing, Oklahoma reaching a record high of 43 million barrels (Bloomberg). Thus, supply and demand is not the issue. Hence, the most logical conclusion is crude oil is experiencing a pricing bubble. Since bubbles eventually burst, investors should take this opportunity to invest in undervalued stocks that will benefit greatly from lower crude oil prices. In other words, invest in refining companies.
While independent refiners are part of the oil industry, they do not benefit from high crude oil prices. Crude oil is a raw material to refining companies. Hence, the lower the cost of crude oil, the better for refiners. Two refiners that are currently trading below book value are Tesoro Corp (NYSE: TSO) and Valero Energy Corp (NYSE: VLO). Valero is the largest independent refining company in the USA and Tesoro is the largest refining company in the West Coast. Furthermore, both of these companies have a history of profitability under more normal crude oil prices.
Valero and Tesoro
Valero owns 15 refineries with a capacity of more than 2.9 million BPD. Currently, Valero has a book value of about $29 per share and a stock price of $24.21 per share. Thus, Valero is trading at a discount of 16.5% to its book value and investors are basically paying zero for Valero’s earnings power. Historically, from 2002 to 2011, Valero has been profitable every year except in 2008 and 2009, during which the economy crashed and oil went to a historic high. Furthermore, in its most recent quarter, excluding an asset impairment loss of $605 million, Valero made a profit of $173 million. Conservatively, from a discounted cash flow analysis Valero is worth at least $40 per share.
Tesoro operates 7 refineries with a total capacity of 665,000 BPD. Currently, Tesoro has a book value of about $26 per share and a share price of $22.90. Therefore, Tesoro is trading at a 12% discount to its book value. From 2002 to 2011, Tesoro has been profitable every year except 2002, 2009, and 2010. In its most recent quarter Q1 of fiscal year 2012, Tesoro generated a profit of $56 million. Furthermore, Tesoro is sitting on $710 million of cash. From a conservative discounted cash flow analysis, Tesoro is worth about $42 per share. Hence, Tesoro is trading at a 45% discount to its intrinsic value.
Conclusions
Whenever a company trades under book value, investors should take notice. Buying below book value gives investors a strong cushion because investors are able to acquire the company’s earnings power for free. Two refiners that are currently below book value are Tesoro and Valero. Tesoro, Valero, and the refining industry as a whole have suffered from high crude oil prices and a slow economy. Investors should take this opportunity to invest in refiners. First, refiners produce products that are essential to the modern world. Second, the price of crude oil should return to more normal levels because current prices are not supported by fundamentals. The market has provided investors the opportunity to buy two fantastic companies at a great price.
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