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Tickers in this Article: VLO
With much of the country under snow, ice and cold for the past few weeks, the energy focus has shifted to oil and natural gas.

As the March winds abate and the snow caps begin to melt there is an opportunity available to investors in the refining stocks.

As was the case in the previous year, Street analysts have called for falling oil prices and narrowing refining spreads.

Those estimates have kept the valuation on the refining stocks low as supplies of gasoline are being drawn down and the driving season is approaching.

The supply story remains intact for consumers.

The refiners are running at breakneck capacity and our country has not seen the sights of a new refining plant in over 20 years due to the regulatory nightmare and costs.

Now as we have struggle for oil supplies there is an additional issue. The U.S. has few refineries with the capacity to process heavy sour crude instead of the Saudi Light crude. This short capacity leads to very wide spread margins for those with the ability to refine heavy sour crude.

One of the leading refiners with the capacity to refine the heavy sour crude is Valero Energy (VLO). With the recent acquisition of Premcor, VLO now stands as the largest refiner in North America, with a refining capacity of 3.3 million barrels per day. Additionally, the company owns approximately 4,700 retail outlets primarily west of the Mississippi and in Canada.

The mix of sweet/sour spread is important to VLO. The acquisition of Premcor gave them higher capacity to process sweet crude but it also lowers their spread margins.

Sweet crude runs are approximately 33% higher than VLO's historical levels, driven by the acquisition of Premcor and the implementation of the EPA's Tier II clean air gasoline regulations. This will shift downward as VLO is working to expand its sour crude processing capacity to more than 80% by the end of this decade. In the short run, capital expenditure will be heavy -- $3.5 billion alone in 2007 -- but VLO will enjoy higher margins in the long run.

The sweet/sour spread has been running around $6.40 in recent quarters with heavy crude running at about a $13 discount. Capital related costs may rise as VLO has experienced some unexpected downtimes due to fires and outages as well as recovery in the Gulf from the hurricanes.

Costs are rising as qualified labor market is tight. For VLO, costs in the Gulf are 20-30% higher than at their other operations. Higher steel costs may limit VLO's ability to expand capacity as well.

Despite the higher costs, VLO has a strong wind at their backs. The new CEO is now moving to a focus of organic growth and returning cash to shareholders. They are now upgrading its operational performance and divested poor performing assets. They have hired an investment banker to explore the possibilities with its Lima, Ohio refinery. Estimates are that VLO can receive about $1 billion through a sale.

The valuations of VLO are quite compelling at this point. Street estimates are for VLO to earn $7.09 in 2007 and $6.66 in 2008. VLO earned $8.30 in 2006. A positive earnings surprise is quite possible as the Street has been using $45-50 as the price for oil in their estimates. Currently, oil is trading at over $60/bbl.

The bear argument is that refining is cyclical and the spreads may collapse. Unless you are in the camp that a recession is imminent or that a miracle substitute for gasoline will be found, it is an unlikely scenario that the spreads will collapse.

The major risk to VLO's earnings is a political one. If demand increases and supplies dwindle, $3.00 gasoline is possible this summer. The political risk that a Democratic Congress will impose a windfall profits tax is real. Not necessarily economically sound but a real threat nonetheless.

VLO generates an enormous amount of cash flow. With management's new focus of returning cash, VLO is seeing a dividend increase to $0.48 annually and they have announced a new $2 billion share buyback authorization.

There are other refiners that may draw attention to investors but do not have the same compelling valuation metrics, such as Frontier Oil (FTO) and Sunoco (SUN).


One company that may be of some interest for those investors with a higher-risk profile is Tesoro (TSO).

TSO is a small-mid cap refiner that is well-positioned with its refiners all placed in the West Coast market. TSO recently announced it is buying Shell's Wilmington refinery and 250 Shell retail outlets in Los Angeles for $1.63 billion. This acquisition of 100,000 barrel/day of refining capacity will lift TSO's output by 18%. The acquisition will raise debt levels to around 50%, however management expects to have that level down to 40% by year end.

On a valuation basis, TSO is selling at 0.31x on P/S basis and around 6x P/CF basis. More interesting is that TSO is selling around 3.72x EV/EBITDA, which is well below the group's average of 6.2x. This may make TSO a very attractive candidate for acquisition or to go private.

Is now the time for investors to stock up on refiners before the stocks become as hot as the desert heat in the summer?

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