Refiners had a stellar 2012, easily outperforming the overall market, as most of the sector posted better than 50% gains on the year. Historically, refiners have been cyclical plays, so, ordinarily, investors would be justified to be wary about continuing to play the group after such an outstanding year. However, the industry has changed over the years and it is propelled by longer-term secular trends.
The first tailwind for the industry is the continued large annual increases in domestic oil production providing refiners with a cheaper and more reliable product input than imports. In addition, no major refinery has been built since the 1970s, making existing refinery assets more valuable. Given the environmental stance of the current administration, it is a safe bet that no new refineries will be built in the near future. The industry seems to have gotten smarter recently about how it deploys capital expenditures, and stocks in the sector are still cheap valuation-wise, even after 2012's large run up.
Five reasons why North America's largest refiner, Valero (VLO), still offers compelling value at $35 a share:
- The company is well positioned to take advantage of increasing oil production from major shale regions (e.g., Bakken) and the Canadian oil sands, which flow through the Mid-Continent to the Gulf Coast. More than 70% of Valero's refinery capacity lies within the Mid-Continent (15%) and Gulf Coast (58%). The company is configured well to process lower-cost heavy and sour crude. It also could benefit long term if Venezuela gets different political leadership, as it has refineries that can process the country's sour-crude production.
- Even after gaining more than 60% in 2012, VLO is still priced at a little over 7x forward earnings, sells for just over 13% of book value and is well under replacement value.
- Valero has easily beaten earnings estimates each of the last three quarters, and consensus earnings estimates for both 2012 and 2013 have risen over the past two months.
- The fiscal-cliff deal virtually ensured nothing will be done about ethanol subsidies, which is a positive as Valero gets just under 10% of revenue from ethanol production. It also has two hydrocracker projects in progress that will increase distillate yields to 39% from 33%.
- The company plans to spin off its retail operations (6800 gas stations), which should be a positive for the stock. Valero also pays a dividend of 2%. Given the company's low payout ratio (approximately 15% on this year's earnings) and rising cash flow, I would look for this to increase substantially over the next few years.