Valero Is Investing to Grow and Diversify Its Earnings; Increasing Fair Value Estimate
Valero Is Investing to Grow and Diversify Its Earnings; Increasing Fair Value Estimate
Business Strategy and Outlook| by Allen GoodUpdated Apr 12, 2022
Valero remains well positioned for almost any market environment thanks to its high-quality refining assets and their location, which affords it greater feedstock flexibility. Historically, Valero has held an advantage thanks to its system of 14 refineries that is more complex than competitors', allowing it to process lower-quality feedstock into a high-value product. With the emergence of domestic light crude discounts it pivoted to processing greater amounts of high-quality discounted domestic crude by substituting domestic for imported crude, constructing additional light crude processing capacity and investing in transportation infrastructure.
Through its complex assets and concentration in the Gulf Coast, Valero retains the access and capability to process light or heavy crude, depending on which offers the greatest discount or optimal economics. As a result, it can do well in a variety of market conditions and continually capitalize on the crude differentials that provide U.S. refiners with a cost advantage.
Through its large Gulf Coast footprint, Valero is able to export surplus product, a critical advantage as it supports high utilization levels and potentially captures higher margins. We expect exports to grow over time as the foreign market call on U.S. product grows and domestic demand wanes.
Although U.S. refiners face growing threats to their competitive position and profitability in narrowing light and heavy spreads, declining domestic demand and growing global refining capacity, we expect Valero to adapt.
To improve its competitive position, Valero is investing in refining optimization and margin improvement projects. It is also a first mover into renewable diesel through its Diamond Green joint venture, which aims to carve out a competitive advantaged by processing lower carbon feedstock. Current gross capacity stands at 700 million gallons per year and eventually to 1.2 billion gallons per year by 2023 based on currently approved projects.
With growth in the renewable diesel business combined with the refining projects, Valero aims to increase annual EBITDA by up to $1.7 billion a year without the need for improved market conditions.
Economic Moat| by Allen GoodUpdated Apr 12, 2022
We think Valero earns a narrow moat rating. It owns one of the higher-quality collections of refining assets among independent refiners. It is the most complex refiner in the U.S., with a weighted average complexity of 11.6. This complexity, combined with access to discounted heavy waterborne crude, has historically allowed Valero to realize a cost advantage by processing cheaper, lower-quality crude as feedstock, increasing realized margins. We expect this advantage to persist.
Meanwhile, Valero has invested in logistics assets and processing capacity to capture discounts associated with domestic light crude production. It currently has the flexibility to run more than 1.6 million barrels a day of domestic light crude through its system. By completely backing out more expensive foreign light crude imports to its refineries and replacing them with discount domestic light crude, Valero's crude slate is almost entirely cost-advantaged.
Valero also exports the greatest amount of refined product among its peers. It currently has capacity to export about 700 mb/d and could increase that amount in the future if demand warrants. It exported about 310 mb/d of product in 2021. Given our projections for the maintainability of the export markets, this should remain a competitive advantage for Valero, as it enables the firm to capture higher margins and maintain high utilization levels.
Valero has invested in projects to capitalize further on low gas prices. Its two new hydrocrackers will use hydrogen, sourced from natural gas, to increase volume of high-value product. As a result, we see low natural gas prices as a greater relative benefit for Valero.
We have incorporated environmental, social, and governance risk into our moat evaluation, but no risk is material or probable enough in the next 10 years to influence our narrow moat rating. A carbon tax is likely to be implemented and will likely affect demand, but not in the near term. Meanwhile, Valero is planning to reduce its carbon intensity through improved efficiencies, emissions offsets from ethanol production, and renewable fuels blending.
Also, to address potential petroleum product demand destruction, reduce carbon intensity and reinvest in growth, Valero has moved into renewables via its 50% ownership of Diamond Green Diesel. It currently has production capacity of 700 million gallons per year and after completing a 400 mmg/y expansion in 2021. A further expansion project is on the books to expand renewable diesel production capacity by a further 470 mmg/y, to be completed in 2023. Given DGD’s use of low-carbon feedstock with higher associated LCFS credits, lack of a blend wall and global blending mandates, renewable diesel offers Valero an opportunity to grow volumes and earnings and capitalize on existing competitive advantages. The company estimates returns for the segment could exceed refining returns on capital, supporting our narrow moat rating.
Unlike other independent refiners, Valero does not own a listed master limited partnership to house its midstream assets after it bought out Valero Energy Partners in late 2018. Though now combined with its refining segment, Valero still owns 3,100 miles of pipelines, 130 million barrels of storage capacity, over 5,250 railcars, and over 50 docks plus truck rack and terminal assets. It continues to invest in midstream assets to increase feedstock and product flexibility. Previously held within Valero Energy Partners, these assets garner a narrow moat rating.
Fair Value and Profit Drivers| by Allen GoodUpdated Apr 12, 2022
We are increasing our fair value estimate to $93 from $81 per share after updating our model with the most recent near-term refining margins and latest financial results. Our fair value estimate corresponds to a forward enterprise value/EBITDA multiple of 4.1 times our 2022 EBITDA forecast of $7.7 billion.
Our fair value estimate reflects our updated refining margin deck, into which we incorporate our long-term outlook for crude differentials. Our long-term outlook for the West Texas Intermediate/Brent differential is $5, and that for the Light Louisiana Sweet/Brent differential is $2. We assume long-term Gulf Coast refining margins of $14 and adjust capture rates to reflect asset quality and investment.
Over the long term, we expect Valero to improve its margin capture rates across the portfolio as investments in improving yield and increased throughput of low-cost feedstock are completed in the coming years. We project per-barrel operating costs to hold relatively steady as natural gas prices remain low and cost-cutting measures take hold. Given the amount of operating leverage in a refiner, our valuation is highly dependent on our refining margin assumptions. A significant improvement or deterioration in crack spreads could result in significant upside or downside to our valuation.
In the next five years, the renewable diesel segment should contribute a greater share of earnings and cash flow. Based on current expansion plans, the segment contributes about 15% of our fair value estimate.
Risk and Uncertainty| by Allen GoodUpdated Apr 12, 2022
We assign Valero a very high uncertainty rating based on the fundamentals of the refining business.
Success in refining is primarily a function of the difference in the amount the refiner pays for oil and the amount at which it sells the refined product. As such, the short- and long-term risks depend on movements in the prices of crude oil and gasoline. The primary risks stem from supply interruptions or increased demand that drive up oil prices, along with demand destruction or economic slowdowns that depress gas prices. In the coming years, we expect U.S. refiners to benefit from ongoing domestic light crude discounts to international prices of several dollars a barrel. A narrowing or reversal of those discounts would result in weaker-than-anticipated performance. Any extended turnaround or shutdown because of an accident or weather will also damage financial performance. In the long term, electric vehicle adoption, autonomous vehicles, and ride-sharing present challenges to demand for Valero's primary products.
We have incorporated environmental, social, and governance risks into our uncertainty rating, but they are not material or probable enough to alter the scenario analysis-derived very high rating. Valero’s primary ESG risk is the implementation of a carbon tax on the emissions associated with its operations and products. A carbon tax would likely increase the final price of refined products as emission costs would likely be born by consumers. While we expect a carbon tax to eventually be implemented, the negative impact on product demand would likely take time. Meanwhile, Valero is investing in efforts to reduce its operated emissions which should lower its costs over time.
Valero also holds the risk of a oil or product spills or emissions from its refineries. While this is likely to occur, we expect the amounts to be small and any financial penalties to be manageable.
Capital Allocation| by Allen GoodUpdated Apr 12, 2022
Based on our capital allocation framework, which evaluates the soundness of the balance sheet, investment strategy, and appropriateness of shareholder distributions, Valero earns an Exemplary rating.
Although Valero’s business has a high amount of operating leverage as well as revenue cyclicality, management operates with relatively low levels of debt that retains flexibility in times of market weakness. This is evident in its ability to raise debt during 2020 and still keep net debt/capital under 35% while net debt/EBITDA should remain below 2.0 on average during the next three years. Near-term maturities are also relatively low. All of this amounts to a sound balance sheet in our framework.
Valero also scores an exceptional rating for its investment strategy as it's sufficient to maintain its competitive position while exploiting growth opportunities. Past investments have been measured and focused on improving its already strong competitive advantage by focusing on increasing discount crude processing, improving yields, and lowering costs. In the refining segment, these areas will remain the focus along with reducing secondary costs through greater investment in transportation assets. Meanwhile, growth investment will flow into renewable diesel projects, which hold attractive returns and a strong growth outlook.
Finally, we see Valero’s shareholder distribution policy as appropriate, given the volatility of the refining business. Its commitment to return 40%-50% of operating cash flow provides a clear target to shareholders while retaining flexibility. Dividend growth is steady but measured with excess cash in time of robust market conditions returned through shareholders. Although excess cash is typically available when market conditions are favorable and stock prices likely high, historically, repurchases have occurred below or near our fair value estimate at the time, meaning they have not been value-destructive. About 70% of total share repurchases over the last 10 years occurred at a price/fair value of 1.0 or less.