The question I have sounds like the end of a bad movie. “We have peace, but for how long” and the camera pans out to show the impending doom approaching. I wish I did not have to be so timely, since Valero (NYSE: VLO) just beat estimates. I like waiting at least a few days since I do not like to join all the cool kids in talking about what is fashionable. The circumstances that created the positive news for Valero is useful to look into for industry guidance, which will help analyze direct peers and other oil firms, and for great business practices and strategic decisions that can be used when analyzing other companies.
Valero Assualts the Estimates
Valero beat by so much it makes you wonder about estimates in general. Netflix and VMware are just the most recent extreme moves that are “surprises,” and those massive movements are becoming a regular occurrence. Instead of exuding infallible confidence, exude confidence with discussion about the “unknown” unknowns. Valero’s beat was not force majeure, or an act of god. It was great revenues, around $34B versus an estimate of around $31B, and margins that were 20% higher than expected.
All the numbers are great for investment purposes but boring over all. The why is much cooler. Valero was helped by North American oil from places like North Dakota and Canada. If you are not familiar with the boom going in North Dakota it is well worth reading about. The crude coming from the Midwest is cheaper than some other sources. Valero used this cheaper crude to push down costs. It also imported crude from Canada that requires some special equipment, but is also cheaper once the investment is made.
Valero has every intention of continuing to use the cheaper crude. It has the benefit of having refining operations close to that area. Rail and barges will help transport the oil in addition to existing pipelines. Ethanol margins were terrible and actually offset the fantastic margins that Valero posted. Think about that. Ethanol actually lowered overall margins, but margins were 20% higher than expected. The price of corn was cause of eroding margins. Revenue surprises will probably be harder, since estimates will take the new information into account. If Valero pulls back some it might be worth a buy into the next earnings.
What is in Store for the Peers?
Valero has national operations and refineries that are not in the Midwest or Gulf area are not able to get the benefit of cheap oil. That means Valero has a drag on it. Perhaps a smaller company with more local operations will be better. Having the refineries within shouting distance of the cheap crude would help margins. I bet local crude tastes better too, just like local vegetables if you are from a good growing area.
HollyFrontier (NYSE: HFC) has five refiners in the Midwest and Rockies only. The map of operations reveals that each refinery has access to crude already via pipelines, rail, and road if need be. That means that there does not need to be a lot of work done to ease the logistics. By truck is probably the least efficient way to move crude after mules.
The balance sheet looks healthy like Valero with over $2B in cash and a low debt-to-equity ratio of 0.2117. Net income for the trailing twelve months is $1.6B off around $19B in revenue ttm. Comparing Valero’s $2B net income ttm to its $134 revenue ttm would suggest that HFC has been enjoying larger margins, 11.5% net, for a while. HFC seems to have been doing better and a significant margin surprise might not occur.
It could be worth the shot to buy the stock into earnings. You could also try to find some cheap calls, but that is probably unlikely considering the focus on the sector now. Expectation of a rise probably demands a higher premium. Simply buying the stock would be the only realistic option. Valero was a “surprise” you are at best making an assumption of the same event based on being in the same industry. You should understand the underlying assumptions of the investment thesis. I will say that refiners are expected to continue their rise, so that suggests going long is a solid decision, but assumptions are never guaranteed to hold true.
At a market cap of $10B, HFC is one of the smaller companies. Marathon Petroleum (NYSE: MPC) is a $25B company. Net margins are at 5.75%, and if HFC is a guide there is some room for improvement there. Marathon is another company that has already been seeing benefits from the cheaper crude. If you peruse the internet some, yes peruse, you will see that both HFC and MPC have been cited as benefiting from the cheaper crude. MPC is up 98% in the last year, maybe more once this article appears. Further gains could be limited at least from a quick surprise source. These are companies benefiting from a positive macro environment that is likely to continue.
MPC’s operations are more easterly than HFC’s, but are still located to benefit from Canadian and Midwest crude. Marathon reported solid earnings as I write this last paragraph, but I am more interested in the long-term trajectory of the company, which is governed by the macro environment. MPC is a lot bigger than HFC, and for that reason I would go for HFC. Expansion is the key action being undertaken, and HFC has the lower revenues. I think that on a percentage basis HFC will see greater gains from expansion, also it has a PE of 6.5, which means there is no reason to wait for the price to subside after a Valero-fueled lift all boats event. Look for HFC to have a PE of 9 with increasing earnings.