Valero (VLO) and the other refiners, Marathon Petroleum (MPC) and Phillips 66 (PSX) have a positive outlook this year as the Brent – WTI crude oil spread and the 3:2:1 crack spread have widened. The Brent – WTI price differential was $10.04 as of the close on June 12, 2018. This increased from a mid-single digit spread from the beginning of the year. The 3:2:1 crack spread (difference between the price of oil and refined products) increased to $23.43, up from $15 a year ago and from below $15 earlier this year.
The widened spreads for Brent – WTI and 3:2:1 will keep profit margins strong for the refiners as input costs are lower and output prices are higher. The higher Brent – WTI spread are likely to increase exports from the U.S. refiners since refined products are benchmarked in Brent prices. Increased exports will lead to revenue growth, while wider profit margins will help increase earnings growth. With valuations still low, the stock prices are likely to continue higher in this environment.
The demand for refined products that the refiners sell is likely to remain strong as global economic growth continues. Global GDP is expected to grow 3.9% in 2018 and repeat that growth rate in 2019. This will keep the demand strong for refined products such as gasoline, heating oil, diesel, and jet fuel as businesses and consumers will be increasingly using these products.
Since the refiners have cyclical businesses, their valuations tend to remain below the valuation of the S&P 500. Since the spreads between Brent and WTI crude and the 3:2:1 crack spread fluctuate, the refiners’ margins and profitability also fluctuates. Regardless, the refiners are still trading attractively below the S&P 500, which has a forward PE of 17.62.
What makes the refiners’ valuations attractive right now is the improving refining margins, which will lead to above average earnings growth for 2018 and 2019. Earnings estimates have increased for all three companies for 2019 as a result of the improved refining margin environment. This is what the forward PE ratios are based on. The strong earnings growth combined with attractive valuations will drive the refiners’ stocks to outperform over the next year.
The stocks of the refiners have room for PE expansion in my opinion. This can happen even if the valuations remain below the levels of the S&P 500. For example, the forward PEs of these refiners are between 12 and 13 right now. I think these can rise to about 15 as a result of the positive refining margin conditions.
The risk to my thesis is that conditions could change to narrow the Brent/WTI and 3:2:1 spreads. This would narrow the refining margins for these companies and have a negative effect on profitability. If the refining margins were reduced significantly, the stock prices of the refiners would likely drop or lag the market’s performance.
Valero announced in May that they will acquire Pure Biofuels del Peru. Pure Biofuels is the 3rd largest fuels importer in Peru. Pure Biofuels has 1 million of total products storage capacity with the ability to expand. This acquisition will help Valero expand internationally.
This is a strategic location for Valero to supply other countries on the Pacific coast of Latin America and also in Mexico. This is a region that has a strong potential for growth. The acquisition shows that Valero will increase its global footprint going forward. This will help set the company up for long-term future growth.
Source: Valero Investor Presentation
Valero is planning on spending about $1.5 billion annually in CapEx through 2021. The company has been achieving an ROIC of about 15% (trailing twelve months). So, Valero will be getting a good return on their investments.
Valero is also one of North America’s largest ethanol producers with 11 plants producing over 1.45 billion gallons per year. The market for ethanol is expected to remain strong. The strong market is being driven by increased travel and an attractive market for ethanol exports. Valero increased their market share of ethanol exports to over 30% in Q1 2018.
Overall, the attractive environment for refiners will make it likely for Valero to achieve the expected 12% revenue growth and 47% earnings growth for 2018. This strong above average growth should drive the stock to outperform the S&P 500.
Marathon Petroleum is another attractive refining company. Marathon announced in April that they will acquire Andeavor (ANDV) (formerly known as Tesoro) for about $152 per share. The acquisition (when completed) will make Marathon the largest U.S. refiner by capacity.
Andeavor is worth about $34 billion in annual revenue, $2.5 billion of EBITDA, and $1.52 billion in net income (based on figures for the past 12 months). To put that into perspective, Andeavor’s TTM revenue of $34 billion is 49% of Marathon’s TTM revenue of $69.86 billion. The deal is expected to close in the 2nd half of 2018. Therefore, Marathon will benefit for a portion of 2018 from the acquisition if the deal closes as expected.
The attractive refining margins and boost from the Andeavor acquisition, will help drive Marathon’s earnings to grow at an above average rate. This will help drive the stock to outperform.
Phillips 66 just announced that they are investing $1.5 billion to expand their Sweeny Hub in Texas. The expansion includes the construction of two 150,000 barrels per day natural gas liquids [NGL] fractionators. The expansion also includes additional NGL storage capacity and pipeline infrastructure. Operations are expected to begin in late 2020.
Phillips 66 achieves a strong ROIC of over 16% [TTM]. So, I expect the company to get a good return for this $1.5 billion investment.
The expansion will take the current Sweeny Hub NGL fractionation capacity of 100,000 barrels per day up to a total of 400,000 barrels per day. It will also take total storage capacity from 9 million barrels to 15 million barrels. The increased production capacity will provide a long-term boost to the company’s Permian Basin NGL operations. That will help the company grow revenue and earnings over the long-term.
All three companies have strong expected earnings growth according to consensus estimates. I think the positive conditions such as wider Brent – WTI and 3:2:1 spreads will help keep refining margins strong. This will help the refiners meet/exceed analysts’ estimates. With the valuations attractively below the broader market, I expect the stocks of all three companies to outperform the S&P 500 as long as the spreads remain attractive.
Keep in mind that if the spreads between Brent and WTI crude narrow and if the 3:2:1 crack spread narrows, earnings estimates could be lowered and the stocks could underperform. So, the spreads will be something for investors to keep an eye on going forward for those who like to trade in and out of the refiners.
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