Valero's Sweet Spot

Seen as evil polluters by some not so long ago, oil refiners may now be viewed as necessary evils. So when William E. Greehey, CEO of the top independent refiner, Valero Energy (VLO ), hit Washington on Oct. 3 to lobby the Energy Secretary, suddenly he was also invited to meet with Vice-President Dick Cheney at his home.

Greehey's message, which he delivered separately to both the Vice-President and Energy Secretary Samuel Bodman, was twofold. First, Uncle Sam should extend tax incentives not just for construction of new refineries but also to expansions of existing refineries. Second, the government should issue the necessary permits faster. Greehey told me he's confident he got his points across. Whether his views will -- or should -- prevail is debatable, yet for investors in refining stocks, the fact that Valero wants to expand seems necessarily bullish. I say this despite the mega-returns in refiners' shares, which in 2005 have averaged 116%.

NO QUESTION, A ONCE-DEEP undervaluation of independent petroleum refiners -- a group of six independent refiners that returned an average of 107% in 2003 and 94% in 2004 -- has been righted. Yet the stocks still trade at middling to low multiples, and there's reason to expect further, if more modest, gains. To see why, imagine you're a refiner. You've been in a boom, making more money than ever, quarter after quarter, because long ago you invested in a scarce resource, the ability to turn oil into gasoline. Suddenly, to quell public dismay at the high price of your products, the White House issues a call (as President George W. Bush did Sept. 26): "We need more refining capacity. And I look forward to working with expedite the capacity of our refiners to expand and/or build new refineries." That might sound as if Washington wants to dull your gloriously profitable edge. To investors, it might ordinarily sound like a clanging sell signal.

Yet these are not ordinary times. Refiners remain eager to expand because the economics of oil refining -- a yawning gap between domestic supply and demand -- are so bullish that added capacity is unlikely to dent profit margins any time soon. It will take years for new or expanded refineries to boost supplies. Meantime, America keeps sucking in imports. At last report, the U.S. was importing record levels of gasoline -- 1.4 million barrels per day, or 56% more than a year ago. Yet demand is running so high that inventories kept falling.

Eventually, more supplies of crude oil interrupted by the hurricanes will reach refineries, refineries that were shut down by the hurricanes will start producing again, domestic supplies will rise, imports will fall, and prices will adjust. Valero's Greehey, however, sees his company's profit margins staying at least as wide as they are, if not getting wider. With a focus on the harder-to-refine sour types of crude oil, Valero's profits are being boosted by a glut in supplies of sour crude, which means its feedstock is relatively cheap. "We're going to have a great year this year," Greehey told me. "And next year is going to be even better...even if the economy slows down."

Naturally, not all refiners are identical investments. Sunoco, for example, isn't benefiting from the current low price of sour crude as it refines mostly higher-grade oil. It's also more diversified than most (less than half of sales are from refining; most of the balance is from retail sales of fuel and convenience-store items at its gas stations), and it pays the highest dividend yield, 1.1%. Some smaller players, including Holly and Giant Industries, are trading at noticeably higher multiples. All in all, though, count on the whole group to linger in Fat City. If I had to pick only one, given its scale, ambition, and lower valuation, it would be Valero.

By Robert Barker

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