UBS Sees Challenges to Oil Refiners From Ethanol and Middle East, but Near-Term Looks Bright

Investment bank UBS AG started coverage of U.S. oil refiners, saying they face a favorable short-term outlook but could see their robust profit margins squeezed in the long run by competition from overseas refiners.

UBS analyst Mohan Mandrekar said in a note to clients Monday that margins at independent refiners, which make gasoline and other products from crude oil but do not have oil drilling operations, should remain healthy through 2009, amid growing gasoline demand and new environmental regulations that keep supplies down.

With tight environmental regulations on fuels, refiners will struggle to ramp up production, Mandrekar said. U.S. production has been at below-average levels all year due to refinery breakdowns and delayed maintenance.

Domestic refiners should also benefit, the report said, from delays in competition from overseas refiners in the Middle East and Asia, who are not expected to provide new capacity until around 2011.

Though corn-based ethanol production is rising and should top out at 10 percent of U.S. gasoline demand, Mandrekar said the push for ethanol consumption should not have a "meaningful impact" on gasoline demand because the country lacks a widespread distribution network for ethanol, and because ethanol contains about two-thirds as much energy per gallon than gasoline.

Mandrekar was most bullish about Valero Energy Corp., which he rated "Buy" with a 12-month price target of $95 per share, citing a $6 billion share buyback program and increased efficiencies. Mandrekar also expects Valero to sell at least one refinery.

The UBS analyst was bearish on Western Refining Inc., which got a "Reduce" rating and a price target of $55. Mandrekar said Western, the fourth-largest U.S. independent refinery, is "vulnerable to a decline in refining margins" and is overvalued by investors.

Mandrekar gave Frontier Oil Corp. a "Neutral" rating and set a price target of $51. Also receiving "Neutral" ratings were Holly Corp. ($80 price target), Sunoco Corp. ($80 price target) and Tesoro Corp. ($62 price target).