13 mayo 2007

Implications of Valero's Refinery Sale on Capacity Valuation

Valero (NYSE: VLO) sold off one of their refineries yesterday to a Canadian buyer for $1.9+ billion, with the amount Valero receives being dedicated to buying back stock. Now, some background:

Valero originally purchased the refinery as part of the Premcor deal in 2005 - doing a bit of math, they paid an average of $10,120 for each barrel per day of refining capacity. The deal made yesterday was for $11,515 bpd in capacity, a 13.7% increase. I see that as a bit misleading though, because the Lima refinery sold yesterday can't process the same amount of heavy, sour crude grades as the other refineries, so in a way that 13% increase in $/bpd capacity understates the true value appreciation that refining capacity (especially the kind that can handle inferior grades) has seen.

This sale leads me to draw a few inferences: refining capacity is going to stay tight and petroleum byproducts are going to get a premium. While I’m undecided on peak oil, I’ve long agreed with the Saudi’s argument that high gas prices are due to a lack of refining capacity, not a lack of oil production. The trouble with oil production is that much of the new finds are the hard-to-process grades; this should keep the differential between light, sweet crude and heavy, sour crude wide enough to allow Valero to keep generating huge amounts of cash… cash that is being used for buybacks. Following the quarterly earnings announcement, Valero upped its buyback program by $4 billion to a total of $6 billion; one week later the company dedicates an additional $2 billion to that buyback. What does that imply? Valero executives think VLO is still cheap, even after the recent run. At the rate the company is buying back shares, it will only add to the upward pressure in VLO.

Further, the new buyer (Husky) is purchasing the facility to handle the fabled Canadian tar sands; and significant amounts of money will need to be spent to upgrade the facility to be able to handle those. It will be interesting to see the outlays Husky needs to make to add substantial heavy, sour crude process capacity - and that will also allow us to see what the market rate for a heavy, sour crude refinery is.

Here, I am specifically thinking about Frontier Oil (NYSE: FTO) and Tesoro (NYSE: TSO), both of which have heavy, sour crude refining abilities. Frontier is the pure-play here on non-ideal grades, and it shows from the premium valuation: FTO has an enterprise value/barrel per day refinery capacity (EV/BPD) of $22,160. Tesoro’s refining facilities are more mixed in terms of grades, and that company trades at a EV/BPD of $14,730. That amount ignores the non-refining assets the company has, namely the retail side of the business. As for Valero? After stripping out the sale of the Lima refinery and adding back the cash to be received, Valero trades for $14,245 EV/BPD - and like Tesoro, Valero also has retail sales channel.

Between the huge buybacks, seemingly low price-to refining capacity, and current record highs in the crack spread, I think VLO sees $80.