Thursday, April 28, 2005

Valero leverages the “Perfect Storm” in sour crude refining; will it be wiped out?

Valero Energy announced plans Monday to acquire Premcor as part of a deal that would create the largest refiner of crude oil in North America. With Premcor, Valero will gain four more refineries for combined output of 3.3 million barrels per day or 19.6% of total U.S. refining capacity, giving it top U.S. market share for refined products.
Unique in the industry, Valero has focused since the early 1980’s on one simple strategy: refining sour oil, which has high sulfur content and sells at a lower price compared to sweet crude. Investing in sour crude processing capacity has reaped greater rewards for Valero as sweet crude oil prices have risen in the last two years to more than $55 per barrel. Currently, sour crude oil sells at a discount of as much as $20 per barrel for some grades. Gasoline and diesel prices are based on the higher priced sweet crude prices.
Because many of its competitors do not have the technology to refine heavy and sour grades of oil, Valero has a distinct competitive advantage – it pays less for crude oil than many other refiners do. It buys cheaper grades of oil and refines them into high quality derivatives like gasoline.
The current market environment for Valero’s business is ideal: the number of refineries in the U.S. has declined from 325 in 1981 to 149 at present, leading to low inventories which keeps margins high. At the same time, U.S. refiners have seen rising demand spurring historic gains in fuel prices, while the discount of sour crude versus sweet is near historic highs, maximizing Valero’s margins.
In an interview Monday, CEO William Greehey explained, “There’s $350 million, at least, of synergies that are involved. Their assets fit well with our system. This is a tremendous deal for Valero shareholders and Premcor shareholders.” He believes that the trend of high discounts from sweet to sour crude will continue: demand is exceeding refining capacity growth and capacity is getting tighter, thus world reserves of heavier sour crude – Valero’s specialty -- will be used to meet increasing demand. Some analysts suggest that spreads will likely trend narrower. Greehey’s response: “As demand picks up, discounts will widen. We’re not concerned.”
Analysts have several reasons to be positive. Margins are high because of high and increasing demand with little reason to expect that to change. In addition, competitors should have trouble building equivalent technology within the next two years.
Ann Kohler, analyst for IRG, said, “We believe the fundamentals for the refining sector remain outstanding, particularly for those companies, like Valero, with sophisticated refining hardware capable of processing less expensive sour and heavier grades of crude.” Merrill Lynch analyst Andrew Fairbanks, despite having downgraded the stock recently, noted that the deal “fits well with the company’s refining margin outlook and strategy to grow its capacity in an environment where demand is expected to exceed capacity increases.”
Fairbanks continues: “Synergies of $350 million are targeted and backed up with identifiable projects. Reduced administrative costs and refinery yield improvements make up the bulk of the increase, which is sensitive to refining margins.”
Still, there is at least one influential group of bears on the deal: the credit agencies. S&P cut Valero to one level above junk and placed it on negative credit watch, reflecting “concerns that refining margins could weaken considerably.”
In fact, the firm plans to pay off the debt linked to the acquisition within two years, not leaving much room for error. For this reason, UBS analyst Stewart Morel downgraded Valero from “buy” to “hold.”
Moody’s noted that Valero paid a higher price than other recent refinery acquisitions. Jay Saunders at Deutsche Bank commented, “Valero is paying up for Premcor…and the rest of the refiners win with a high benchmark valuation for refineries.” Ultimately, Valero is paying over twice what comparable deals have gone for: $9 million per daily barrel compared with recent deals of $4 million.
Saunders at Deutsche summarizes his view: “We see strategic enhancement for Valero, with size and quality into strong margins, but significant risk on the price and timing, as Valero could be buying within a year away from the top of the market.” Light-heavy spreads are at all-time highs.
From a competitive standpoint, Morningstar says, “We think adding sour crude capacity will be at the top of many refiners’ project lists. Although doing so is capital intensive, there are few barriers to adding sour crude capacity. When competition intensifies, Valero’s wide margins will disappear.”
So the questions remain. Will the competition expand competitive sour refining capacity? Will margins narrow between sour and sweet crude? Will demand growth slow? These legitimate concerns posed by analysts have been used as criticisms of the deal. To us, $350 million in synergies seems low compared to spending $8 billion on Premcor at twice the value of comparable deals. Valero has extremely cyclical performance; profits will decline rapidly when and if discounts on sour crude shrink and refined product prices decline. We question the advantages of scale as a competitive advantage in a commodity business. Finally, the history of Valero is one of cautious, slow acquisitions of sour refineries for bargain basement prices. This was great when margins were small in this industry which they did for the past 20 years. To suddenly pay such an extreme value for Premcor strikes us as pure empire building, not strategic enhancement of competitive advantage or shareholder value.
Authors: Patrick Brickley, Lindsay Lowe, James Smith


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