Valero Still the One
In the previous issue, I used our new stock screening tool to look at integrated oil companies, as well as mid-sized oil and gas producers. Today I use it on a sector that performed very well during the oil price plunge of the past year — the refiners. Any time a market sector has had a significant run-up, it’s natural to ask whether it’s too late to join the party. Let’s begin to answer that question with a stock screen.
We will consider here different metrics than in our screen of oil and gas producers. A pure refiner has no oil reserves, and hence no standardized measure or multiples derived from either. Because refining is a low margin, high volume business, it is less important to focus on profit margin and more important to look at EBITDA, free cash flow, and return on assets.
The Downstream Corporations
My initial screen identified 21 companies in the Oil & Gas Refining & Marketing category. However, four of those were master limited partnerships (MLPs) and several were incorrectly categorized. After weeding the list, I was left with 10 corporate refiners. Let’s look at them first, and then we will examine the MLPs.
All dollar measures are in billions unless otherwise noted. In alphabetical order:
EV = Enterprise Value as of May 22
EBITDA = 2014 earnings before interest, tax, depreciation and amortization
FCF = Free Cash Flow in 2014
RoA = Return on Assets for the trailing twelve months
CR = Current Ratio, current assets divided by current liabilities for the previous quarter
1 Yr Ret = 1 year total return (including dividends) as of May 22
The four largest corporations have all had double-digit returns over the past year, with the exception of Phillips 66 (NYSE: PSX), which had huge gains in 2012 and 2013. Phillips 66’s free cash flow was negative last year (which is not necessarily a problem) and its EV/EBITDA is one of the highest in the group. Thus, it appears expensive relative to its peers.
At the other end of the value spectrum is Valero (NYSE: VLO). Despite having the highest FCF and the fourth-highest RoA, Valero trades at the lowest EV/EBITDA. In fact, I would argue that Valero is easily among the top four companies on the list (and some would argue that it is #1), yet its EV/EBITDA is 38% below the group average.
Valero’s only relative shortcomings are a debt level slighter above the group average (i.e., Valero’s current ratio is lower than the group average) and a dividend yield below the group average (despite the recent payout hike of 45%). I expect Valero to outperform the refining sector, enough so to make the Growth Portfolio holding our top-ranked Best Buy.
Two other refiners with a low EV/EBITDA despite having the two best RoAs on the list are Western Refining (NYSE: WNR), an Aggressive Portfolio recommendation and our #3 Best Buy, and Growth pick Marathon Petroleum (NYSE: MPC), our #6 Best Buy.
Tesoro, on the other hand, looked much more appealing when we first added it to the Growth Portfolio nearly two years ago. After the 69% return over the past year it no longer offers quite the value of a Valero or Marathon for growth-oriented investors. The stock has returned 20% year-to-date, and we’re locking in some of that by halving our standard position here.
The Downstream MLPs
For investors seeking the tax advantages of an MLP (keeping in mind that the income from downstream MLPs will be very unpredictable), there are four downstream options:
Note that Alon USA Partners (NYSE: ALDW) handily outperformed its parent company Alon USA Energy (NYSE: ALJ) over the last year. In fact, its RoA was more than double that of the best C-corp competitors, yet it still trades at a modest EV/EBITDA. While the parent company is a Buy in our Aggressive Portfolio (albeit slightly above the limit price at the moment), these metrics make a strong case for Alon USA Partners as well, and we are adding ALDW to the Aggressive Portfolio with a buy limit of $21. (For more on Alon USA Partners, see “Israeli Two-Step in the Permian” elsewhere in this issue.
Northern Tier Energy (NYSE: NTI) also presents a compelling valuation, but Alon USA Partners would be my top choice among the downstream MLPs based on the valuation metrics. The only real downside for Alon is that it’s the most leveraged partnership of the group, but that level of leverage isn’t a big concern.
We did add CVR Refining (NYSE: CVRR) to the Aggressive Portfolio on Jan. 8 because we felt it was unjustifiably discounted. In fact, it has returned 20% since, so a chunk of that discount is now gone.
The Limits of Data
Of course, mass-produced valuation metrics don’t capture a lot of context important to every diligent investor, such as scale, location, strategy and the quality of management, to name but a few considerations that are hard to quantify.
Because the smaller refiners depend on one or two refineries. their output is subject to greater fluctuation as a result of scheduled and unplanned shutdowns, which can skew the valuation ratios. This concentration of business risk and the higher volatility may also explain the low valuations of some of the smaller operators.
Big-Picture Risks
Refiners should continue to outperform the broader energy sector for the foreseeable future as they benefit from ample supplies of U.S. crude oil — due in part to a crude oil export ban. Since there is no export ban on finished products like gasoline, refiners with access to export markets should continue to see healthy margins regardless of whether oil prices are rising or falling (although falling prices are historically better for refiners).
The single biggest risk for the group is that the crude export ban is repealed. The oil industry is pressing hard for an end to the ban, while several of the refiners have unsurprisingly voiced their opposition.
Considering the difficulty the Obama Administration has had in approving the Keystone XL pipeline — which in my view should have been a no-brainer — I see very little chance that they will open the door to crude oil exports. Thus, while I think overturning the ban would hit the refiners hard, I see little chance of it happening over the next two years. Nevertheless, we will continue to closely monitor this situation, and if pending legislation seems likely to pass, we will react accordingly.
There are a couple of smaller risks. One is the uncertainty around the ethanol mandates under the Renewable Fuel Standard. Refiners are “obligated parties,” which means they must show compliance by either blending ethanol into their fuel or by buying credits from someone else. At times the EPA has issued rules changes that sharply drove up the cost of compliance, and took a bite out of refiners’ margins. There are other pending environmental rules changes with the potential to hurt refiners, but none as significant as our ethanol policy.
Finally, should oil prices rise sharply, demand for oil products will slow. This would in turn slow the growth rate for refiners, but would likely be a short-term phenomenon as consumers once again adjusted to the higher prices.
Conclusions
For investors who worry that they are too late to benefit from what has been in recent years a golden age for refining, fear not. This week’s screen shows a lot of value among the refiners, validating our inclusion of three refining stocks among our Best Buys.
The refiners have certainly been one of the brightest spots over the past year as the energy sector slumped. But because I don’t expect a return to $100/bbl oil soon, I expect demand for oil products to remain strong. With the crude oil export ban in place, U.S. refiners will continue to benefit by turning discounted crude into value-added fuels, increasingly for export. Thus, the outlook for this sector remains strong.
(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)
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