3 Reasons This Refiner Is Primed for a Correction

Jordo is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Refinery companies are usually slow movers because their businesses are considered to be low-margin and accident-prone. However, their businesses are doing better because of cheaper natural gas and domestic crude oil.

Valero’s (NYSE: VLO) stock price reflects a change in how refining companies are now viewed. Over the last 52 weeks, its stock price has jumped 59%. For a refining company, such a large rally is unusual, and I think that Valero’s stock price has gotten ahead of itself. Perhaps now is the time to get out of this stock. There are three reasons that I think that Valero’s stock is primed for a correction. 

1. Valero is overvalued.

Valero’s price to earnings ratio of 16.9 is extremely high for an oil refiner, especially when compared to other, more efficient independent refiners. 

<table> <tbody> <tr> <td><strong>Company </strong></td> <td><strong>PE Ratio</strong></td> </tr> <tr> <td>Marathon Petroleum (MPC)</td> <td>8.48</td> </tr> <tr> <td>HollyFrontier (HFC)</td> <td>6.24</td> </tr> <tr> <td>Tesoro (TSO)</td> <td>7.52</td> </tr> <tr> <td>Industry Average</td> <td>12.6</td> </tr> </tbody> </table>

2. Valero's earnings and free cash flow do not support its high multiples.

Valero’s third quarter net income was $674 million, and its earnings per share came to $1.22. That was an 81% decrease in net income and 74% earnings per share when compared to the third quarter of 2011 when its net income was $1.2 billion and its earnings were $2.12 per share. As a result of the decrease in net income and the purchase of two refineries Pembroke and Meraux, Valero’s cash flow has suffered. Valero’s trailing-12-month free cash flow currently stands at -$289 million.

The Pembroke refinery is located in the United Kingdom, and it was purchased from Chevron for $730 million. The Meraux refinery is located in Meraux, Louisiana, and it was purchased from the Murphy Oil for $585 million. 

3. Valero’s stock price could be primed for correction because of its low margins.

Valero has a serious operational problem. Most of Valero’s refineries are located in the Gulf Coast. That means that their feedstock is mostly limited to Light Louisiana Crude (LLC) which cost about $18 a barrel more than the West Texas Intermediate crude oil that competitors Marathon Petroleum (NYSE: MPC) and HollyFrontier (NYSE: HFC) use. 

Valero's Gulf Coast refineries “process more than 1.5 million barrels per day (bpd), or about 55% of the refiner's total throughput capacity.” At a rate of 1.5 million barrels times $19.75 (1.5 x $19.75 = $29.63 million), the premium that Valero is forced to pay totals about $30 million per day or about $2.66 billion per quarter. This is a major problem for Valero, and it is not likely to go away. As a result of the high price of LLC Valero’s refining, margins fell to $10.63 or 7% on a quarterly over year quarterly basis. When compared to other independent refiners, Valero’s margins are not competitive. Valero’s operating margin is 2.62, and its profit margin is 0.81. That is paltry when compared to its competitors.

<table> <tbody> <tr> <td><strong>Company</strong></td> <td><strong>Operating Margin</strong></td> <td><strong>Profit Margin</strong></td> </tr> <tr> <td>Marathon Petroleum (MPC)</td> <td>5.01</td> <td>3.39</td> </tr> <tr> <td>HollyFrontier (HFC)</td> <td>13.11</td> <td>7.83</td> </tr> <tr> <td>Tesoro (TSO)</td> <td>3.6</td> <td>1.85</td> </tr> <tr> <td>Western Refinery (WNR)</td> <td>8.58</td> <td>1.4</td> </tr> </tbody> </table>

Profits are flowing at refineries that are located near newly drilled Midwest and Southwest shale oil fields and to Gulf of Mexico ports. As a result of new drilling technologies, the new Bakken shale oil fields in North Dakota and the now lucrative Eagle Ford shale oil fields in South Texas are producing so much oil that there is a glut of oil for refineries that are located in the Midwest and Southwest.  The glut has driven down prices for the refiners that have access to it. The refineries of Marathon Petroleum, HollyFrontier and Western Refining will now have an operational advantage over Valero because they have access to the cheaper WTI oil. The oil that these companies access flows through Cushing, Oklahoma, which is the delivery point and storage hub for WTI. Unfortunately for Valero, the current pipeline systems are not able to transport enough oil from Cushing to run their Southeast U.S. refineries. This is a problem that could take years to correct. 

One bright spot for Valero is its Three Rivers refinery, which is located about 70 miles south of San Antonio and just a few miles from the Eagle Ford oil fields. The Three Rivers refinery will benefit from the lower WTI oil prices, and from low natural gas prices. Valero executives are excited about the prospects from the Three Rivers refinery and have spent $50 million to improve the plant's efficiency. 


Valero has enjoyed a good run up. However, history has shown that after such a run up a stock can become overvalued and vulnerable to a correction. I believe that Valero is such a stock. The stock is priced at a premium to its competitors, and the company’s performance (operating margin and profit margin) is beneath that of its competitors. I like the stocks in the refining business, but I think that Valero’s stock is primed to take a hit.

jordobivona has no position in any stocks mentioned. The Motley Fool owns shares of Western Refining. 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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