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Refineries are really tough to value. Earnings swing wildly, making things like P/E almost meaningless. Book value can be all over the map, depending on what price people are willing to pay to add capacity.

Yet, I think Valero is worth a look right now.

Current market cap is: $13.1 B
Total debt: $7.65 B
Total cash: $2.83 B
Enterprise Value: $17.98 B

Value of refining assets:
In one of my most painful lessons as an investor, I was working for Tesoro when the stock bottomed around $1.70 per share back in 2002. Risk was that they would go bankrupt. I kept thinking that all they'd have to do is sell their refineries and they'd be able to pay off all the debt and have $4/5 per share left over. It was a screaming value.

I thought, "why not take a risk with a small position?" I didn't. The stock turned into a 70-bagger before the recession hit. Ouch.

Today, Valero is not nearly the same screaming deal, but the risks are also much lower.

Valero has 16 refineries. 13 in the U.S., 1 in Canada, 1 in Europe, 1 in Aruba. Total throughput is about 3 million barrels per day (bpd). They also own several ethanol plants, along with terminals and convenience stores.

That said, refining will clearly be the driver of the business.

The company value is currently about $6,000 per bpd capacity.

To put this in perspective, it costs about $18,000 per bpd to expand capacity and $27,000 to build new. However, recent sales of refineries on both sides of the Atlantic have been at lower prices than the above.

Valero, in fact, sold their Paulsboro and Delaware City refineries for about $3,000 per bpd during the recession (Delaware City sold for even less because it was already closed).

Profile of current capacity
That said, all capacity is not created equally. Refining needs scale to be profitable and flexibility in feedstock. The current profile of
Valero's refineries is relatively complex with about 2/3 of their capacity capable of handling mid-to-heavy sour crudes. This is the crude that is at a significant discount to the quote you see on the news every night.
Valero is also spread over a wide geographic range, with some access to oil from the Cushing terminal (for which pipeline capacity is inadequate causing this oil to be significantly discounted to global rates).

Valero now only has 2 relatively small refineries--Ardmore, OK and Three Rivers, TX. Ardmore is perfectly placed to benefit from the Cushing discount and is probably making over $1/day in profit. Until new pipelines are constructed, this market anomoly will remain--i.e. likely for years.

Valero has the scale, geographic diversity, and crude stock diversity so that it can be seen as essentially a proxy of the refining industry.

Drivers that will make the stock go up will be falling crude prices, constrained refining supply, and economic recovery which spurs additional demand.

Falling Crude Prices
* Actually more probable than most people think. There is a ton of new capacity coming on line in the U.S., Canada, Brazil, offshore Africa, and maybe Iraq. Geopolitical tensions and risks aside, the high prices of the past decade have created a big incentive to drill.

* Constrained refining supply. More refineries are going out of business. The 500,000 bpd refinery on St. Croix just announced they are closing. That's the largest refinery in the Western Hemisphere. Several other smaller players have closed as well. No new refineries are being built, although a few projects have recently come on line or are coming on line to increase supply. Call it a draw.

* Economic recovery. Upside is certainly possible.

Worth keeping an eye on and consider buying if there is another dip. Even in the depths of the recession, Valero didn't stay below $20/share very long.

Also need to do some due dilligence on management/corporate governance.

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hi sf

As an industry insider, can you dissect what happened in 2007 in refining that made it so perfect for profits?

The heavy crude refiners did especially well and it had a lot to do with the spread between heavy sour and light sweet.

Was their extraordinary profit due to just low prices on heavy sour or was there something else at work? maybe gas prices vs oil prices were more favorable? There have been times of high gas prices since then that have not translated into these 2007 record profits. If you could just outline what made that period so special from an insider's POV?
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It was both substantial heavy crude discounts and extremely high refining margins. Valero posts pricing information here:

If you look up 2007, in the column "LLS less Maya", you see numbers in the "15" range for 2007. Then if you look in the column "Conv 87 Gasoline less LLS" you see a value around 22. Thus for converting a heavy crude oil barrel into gasoline, they whould make "15" for the crude discount, plus "22" for the refining margin less their costs per barrel. I do not remember what those were at the time but I recall it was calculable from their 10-k filing.

If you look at these two metrics, 2011 was a pretty good year. Of course at the moment, refining margins are pretty bad (which they seem to always ben in Dec/Jan).

If you see these numbers move up, and not the corresponding run-up in price, its time to load up. At the moment---kind of indeterminate.

long VLO
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Sorry, 2007 refining margin was around 11, not 22.

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As an industry insider, can you dissect what happened in 2007 in refining that made it so perfect for profits?

The period of 2003--2007 was a sweet spot for the refining industry which no one saw coming, but will likely repeat again somewhere down the road.

Normally, refineries make a small profit on the differential between crude oil and refined products called the "crack spread." Normally, the crack spread goes up when crude prices fall and goes down when crude prices rise.

In 2003--2007, this relationship changed. Not only did crude prices rise substantially, but the crack spread also hit record highs. Back in the 90's, refiners would operate on single-digit crack spreads. In California, because of their special gasoline formulation, crack spreads were higher--typically about $7/bbl. In the rest of the country, the crack spread would often be $3/bbl. (Note: perhaps because crude was only $20/bbl the gross profit % was similar to today, but I'd rather earn $20/bbl than $7/bbl, even if the gross profit % is lower.)

The reason for this decoupling was simple supply and demand. Back then, you'd hear every week about how no new refineries had been built in the U.S. since 1979. Bush proposed using closed military bases as potential sites. People blamed big oil for price fixing. Leftists proposed windfall profit taxes. No one remembered that refineries had been going out of business for decades and had very low margins.

Meanwhile, the must-have cars were the Hummer H2, Lincoln Navigator, Cadilac Escalade, or perhaps a pick-up truck with a Hemi (whatever that is), or for those with more refined taste a BMW. Average fuel economy made no improvement from 1987 to 2005, miles driven increased, and the number of cars on the road increased. Refining capacity did not increase.

It all came home to roost in that period from 2003 to 2007.

Now, here is the speculative part of why I believe it will happen again. There has definitely been demand destruction from the recession. U.S. petroleum consumption peaked in 2005 at 20.8 million bpd. Since then it has fallen to 19.18 million bpd representing a total drop in demand of 8%.

Since the recession, 1.2 million bpd of refining capacity has closed (this includes the recent closure of the Hess refinery in the Virgin Islands and Sunoco, Marcus Hook, PA closure.) So, there was a 1.6 mbpd drop in demand and a 1.2 mbpd drop in supply.

However, consumption in 2011 grew for the first time in the past 6 years at a rate of 2.1%. If the economic recovery continues, another 2% increase in demand will put the supply/demand balance as tight as it was in 2005 (1.2 million bpd lower supply and 1.2 million bpd lower demand).

However, it is highly unlikely that anyone will make a significant investment in new capacity due to fuel efficiency and ethanol mandates which are cooked into the equation through 2020. (The only exception is there is a proposal to build a refinery in South Dakota to handle oil from Bakken. It will be 7-10 years before anything is built, so we can ignore it for now.)

Therefore, what I forsee is periods of inflated profits during economic recovery, followed by closures and heavy losses during recessions. Perhaps undulating in this cycle for a very long time. One could argue that the refining industry has always been that way. I just think it will be more extreme (like everything else) for the next decade or more.

As a counterpoint, here is a seeking alpha article saying refiners are a value trap:
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thanks for the explanation

Three things are important? Crack spread, gas price and demand
About low priced crude---when you say crude hit record highs in the 2003-2007, that high price must have given TSO and VLO an edge because they took advantage of lower-priced Mayan. VLO and TSO hit some very high prices back then

Gas prices were record high in 2008 and they almost got there again in early 2011. TSO responded partially, VLO not so much. But they never got near 2008 levels--why? Was Mayan not as favorable compared to, say, Brent as it was in 2008? The crack spreads then were less wide than 2008 for these heavy refiners --did the difference between heavy sour and light sweet close?

Finally, demand appears to be the most important variable. Or maybe not. It seems to take all three being in perfect alignment, but even when gas prices rise a little and crude falls (as it did in 2009) refiners just don't do as well unless high demand is underlying it all.

Any idea why Holly continued to do so well while everyone else lagged?

thanks a bunch for all this
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Gas prices were record high in 2008 and they almost got there again in early 2011. TSO responded partially, VLO not so much. But they never got near 2008 levels--why?

I suspect the difference is that 2003--2007 was a period of economic growth, so investors believed tightness of supply would persist. Very few considered how quickly demand could be destroyed by a recession.

Now, prospects look bleak, so investors do not see a persistently tight supply situation.

My personal belief is that when the economic recovery picks up steam, refined product supply will become tight very fast and the refiners will outperform the market. I suspect this will happen this year, perhaps only based on foolish optimism.

Then, when people start wondering why there haven't been any new refineries built, it will be time to head for the exits.
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