For the refining stocks, the last few years have been absolutely great. As we continued to frack and unearth more and more crude oil, prices continued to drop. While that glut stank for energy producers, it was a boon to those firms that use crude oil as one of their main ingredients. The halcyon days for the refiners were here at last.
That is, until the global economy started to show signs of cracking, and gasoline, diesel and jet fuel demand fell by the wayside. Margins plunged and refiners like Valero (VLO ) saw their share prices tank as well.
However, in that price drop, there’s plenty of value to be had in VLO and its rival refiners, especially considering summer driving season and higher crack spreads are just around the corner.
An Oversupply Problem
For Valero, and the entire sector, the problem stems from 2015’s banner year. With margins so high throughout most of the year, the refiners opened up the spigot to get as much juice out of their facilities as possible. However, as with most commodities, when prices rise and production increases, we tend to get gluts when things go bad.
As China, Europe and many other nations began to slow their growth, gasoline demand collapsed. Without excess demand, the supply of refined gasoline continued to build up. Prices for winter-grade gasoline plunged as the refiners tried to get rid of the huge stockpiles. Further, the mild winter in North America didn’t help. Again, prices for the fuel sank hard as refiners worked hard to reduce the glut.
In all of this oversupply, crack spreads continued to narrow. In fact, the decline in refiners’ margins were the steepest in over eight years.
That huge decline manifested itself in VLO’s fourth-quarter earnings. Valero managed to see a 74% drop in profits. While it did have some issues with its ethanol businesses, the bulk of that drop was due to lower profit margins. And after being rewarded in 2015 with higher margins, investors haven’t been too pleased with Valero. Shares of VLO have sunk by more than 8% since the start of the year.
Crack Spreads Aren’t Cracking Anymore
For Valero, the dour situation may be getting a tad bit better.
That’s because crack spread losses have already begun to alleviate themselves. Today, that number sits north of $19 per barrel, up from just $8 or so, a few months ago.
Also alleviating itself is the glut of gasoline. After spending much of the first quarter at record highs, gasoline inventories are now declining and following a more typical pattern. Warmer weather has pushed up the summer driving season by a few weeks, while early and more intense plant maintenance has taken much of the supply out of the market. Analysts at Morgan Stanley estimate that strong demand in the U.S. should absorb any new capacity that comes online during the year.
Second, oil spreads between WTI and Brent have improved in recent weeks. When Congress lifted the 40-year-old crude export ban back in December, the spread between the crude oil metrics narrowed immensely. However, that has backed off as traders realized that some of the benefits of exporting just aren’t there. The growing spread difference works in VLO’s favor as most refined products are tied to Brent-benchmarked crude. However, VLO is able to buy and use lower-priced WTI. Any widening of spreads provides an extra boost to VLO’s bottom line.
Buying VLO
With the two key metrics affecting Valero’s profitability starting to improve, investors, specifically dividend investors, may want to consider the stock. During the halcyon days of 2015, Valero returned much of its excess cash back into investors’ pockets, and it continues to do so. The latest bump in its dividend was a 20% increase back in January.
As crack spreads and margins finally resume their upwards trend, cash flows at Valero should once again accelerate. While it most likely won’t repeat the best days of 2015 this year, there’s no reason why they shouldn’t increase throughout the rest of 2016.
For investors looking at VLO, the time to buy could be now. The year-to-date drop in shares has pushed Valero down to trade at a P/E of less than 9. That’s dirt cheap for any stock, but especially for one that should show signs of improving metrics. Add in the firm’s 3.70% and constantly growing dividend yield and you have a recipe for long-term outperformance.
The bottom line is that Valero could be one of the biggest dividend values in the energy sector right now. Investors shouldn’t pass it up.
