Oil prices hit their lowest levels since 2003 this week on news that Iran will be adding another half a million barrels per day to an already highly oversupplied global oil market. While the oil glut has sent oil prices plummeting and hammered the share prices of many U.S. shale producers, falling crude prices and an overabundance of crude oil isn’t bad news for the entire oil industry.
Valero Energy Corporation (VLO) is one of many refiners that welcomes every barrel of oil that Iran produces. As you’ll see in the chart below, refiners have been laughing all the way to the bank in recent years as the broader energy sector suffered.
A Delightful Dynamic
For refiners, falling crude prices means falling input costs and higher margins, a recipe for higher profits and share prices.
In the past five years, top U.S. refiners Valero, Phillips 66 (PSX) and Marathon Petroleum Corp (MPC) have more than doubled the returns of the S&P 500, while the Energy SPDR (XLE) is down more than 25% during that same stretch:
The Iran news is yet another indicator that the global supply glut will likely take years to work through, and the beneficial market conditions for refiners will persist for now. This argument is the basis behind Credit Suisse analyst Edward Westlake’s December call that refiners will have another great year in 2016. Said Westlake:
“On balance, we think 2016 will be characterized by healthy earnings (driven by gasoline), with complex coastal refiners able to process cheaper medium crudes, with narrow mid-con crude differentials, and with diesel margins remaining challenged.”
In addition to Credit Suisse’s “Outperform” rating, just last week Morgan Stanley also gave VLO stock an “Outperform” rating, naming it as one of its top ideas for 2016. Analyst Evan Calio expects that refined product demand will exceed refining capacity again in 2016, which will push refiner earnings even higher. Calio sees high-complexity coast refiners well-positioned heading into 2016, and named VLO stock a top pick.
The VLO stock price has climbed more than 160% in the past five years, and investors might now be wondering how much more upside remains. Is it finally time to take profits on the winning trade?
Despite the big gains, Valero’s valuation metrics all remain very appealing. The stock’s P/E ratio of 7 is on the low side of its historical range. In addition its single-digit forward P/E of 8.5 is well below the S&P 500’s average of 15.7 and the overall Energy Sector’s average of 28.9.
Futhermore, several other traditional metrics also make VLO stock look attractive: Price/free cash flow (P/FCF) of 9.18 and price/book ratio of 1.53 both come in below those of peers Marathon and Phillips 66.
Yes, VLO has been on quite a run in recent years. One glance at the company’s surging EPS indicates just how strong the company’s performance has been. However, while Iran’s return to the global oil market is bad news for many oil producers, refiners are welcoming the news that cheap oil looks to be here to stay for the next couple of years. Until the global oil market once again finds its balance, refiners like Valero will have access to a cheap crude oil, high margins and high demand for their services — a perfect storm for investors.
As of this writing, Wayne Duggan did not hold a position in any of the aforementioned securities.
