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Is Valero a Better Buy than Exxon Mobil?

by: Hard Assets Investor July 16, 2008 | about stocks: COP / CVX / DBO / TSO / USO / VLO / XOM    
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By Brad Zigler

Cocktail party conversation can take some strange turns at times. Over the Independence Day holiday weekend, I found myself in the unusual position of defending a fellow partygoer's purchase of Valero Energy Corp. (NYSE: VLO) shares to others.

Not that I recommended Valero shares, mind you. I was merely attempting to illustrate how such a transaction could be rationalized in response to the question originally put to the buyer: "Why buy an oil stock when you could buy the oil itself?"

A good question, that.

Of course, the simple answer is this: Some folks can only buy the stock; they can't buy the oil itself. These investors could be limited by charter or disposition to equity investments. For them, oil futures are anathema. There are, of course, exchange-traded funds that track oil futures. Those, like the United States Oil Fund (AMEX: USO) and the PowerShares DB Oil Fund (AMEX: DBO) are stock-like securities with a commodity backbone.

Even if one were permitted to use the equity backdoor to the commodity market, an investor may still not wish to cross the threshold. Commodities, over time, can only be expected to earn the inflation return. Folks invest in stocks to derive returns in excess of inflation. Put another way, companies that issue stocks can improve efficiencies and grow their earnings. Commodities can't. That's enough to keep some investors out of direct involvement with the commodities market.

If stocks are the only way for an investor to play the oil game, there's a further choice to be made: What kind of oil company to buy? After all, there are companies that specialize and those that generalize. The really big companies are integrated and control the entire value chain from exploration to distribution. Among these are Exxon Mobil Corp. (NYSE: XOM), Chevron Corp. (NYSE: CVX) and ConocoPhillips (NYSE: COP). Specialists include refiners, exploration and development companies, and oil services outfits.

The stocks of integrated oil companies are essentially defensive issues. Their share prices are relatively stable (emphasis here on "relatively") and they pay decent dividends. The average dividend yield for the big three companies is 2.2%. Not inflation-busting, but still offering a decent risk premium to three-month Treasury bills. It's the capital gains potential of integrated oil stocks that beats inflation. Since May 2006, for example, Exxon Mobil's stock has risen at an average compound rate of 15.6% per annum. Granted, most of that gain was realized last year, but we'll get to that momentarily.

Investors, as consumers, are most keenly aware of refiners such as Valero or Tesoro Corp. (NYSE: TSO). These firms don't own their own oil reserves, so they make their money by purchasing crude from others and refining it into gasoline and other distillates. Not surprisingly, the earnings of refiners are much more volatile. In times of cheap oil and relatively expensive products, refiners' earnings can grow disproportionately fast since they're operationally streamlined.

These are obviously not such times. Refining margins have been universally pressured because distillate prices, most particularly those for gasoline, can't be raised to keep pace with increases in the cost of crude.

Over the past 12 months, crude's risen 91% and unleaded gasoline has ticked up 54%. In that time, the "crack spread" - the profit potential earned from distilling crude into heating oil and gasoline - has shrunk 35%.

 

Refining Margins Shrink & Stagnate

Chart: Refining Margins Shrink & Stagnate

So, why would I defend the purchase of Valero, a refiner whose fortunes are clearly at the mercy of the crack spread?

Because Valero's problem is narrowly defined and very fixable if one has the right tools.

Over the past year, crude oil's cost trajectory torpedoed Valero's stock price, but the resulting margin squeeze also stymied Exxon Mobil shares. Analysts are now building in expectations of moderating oil prices for the coming year into their outlooks. These estimates differentially affect the companies' growth prospects. Earnings growth for Exxon Mobil is estimated to decline from 32.3% this year to 7.2% in 2009. Valero's, meanwhile, is expected to swing from -43.3% to 24.4%.

The opportunity for Valero holders, if expectations are thought to be reliable, is significantly better than that for Exxon buyers. But there's that pesky problem with current margin volatility.

That's where a tool, namely an exchange-traded oil fund, comes in. Suppose we compare the outright purchase of 100 Exxon Mobil shares versus an oil-protected version of Valero: 50 shares of the company's stock bought for cash, together with a margin position in 100 United States Oil Fund shares.

If we'd put our position on a year ago, we would have significantly increased our profit potential with a negligible increase in risk. The hedged Valero stock would have produced a 63% gain, fully 60 percentage points better than the return generated by Exxon Mobil, even after accounting for a year's worth of margin account interest.

Better still, the hedged Valero position needed only 75% of the capital requirement of the Exxon Mobil stake.

Make more and pay less for roughly the same risk. What's not to like?

 

Tale of the Tape (02-Jul-08 to 08-Jul-08)

 

Annualized

Return

Annualized

Volatility

Reward-to-

Risk Ratio

Capital

Commitment

 

 

 

 

 

Exxon Mobil (XOM)

2.5%

26.7%

0.09

$8,482

Unhedged Valero (VLO)

-49.9%

39.5%

-1.26

$7,427

Hedged Valero (VLO+USO)

63.2%

35.9%

1.76

$6,390

United States Oil Fund (USO)

112.7%

30.9%

3.67

$5,353


Hedged Valero position combines a cash account purchase of 50 VLO shares with a margin account purchase of 100 USO shares, meeting the 50% equity requirement with cash. The return depicted reflects the resulting margin loan carried at 1.25% below prime; all other positions depicted reflect cash account purchases of 100 shares.

 

Hindsight, of course, is 20/20. There's no guarantee that the next 12 months will look like the past. Still, this notion does make for some interesting chatter while the canapés are served. Try it at your next party.

 

Daily Performance Chart

Chart: Daily Performance

 

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This article has 13 comments:

  •  
    Jul 16 08:56 AM
    I just don't see the future in the refiners. The volume of refined oil is going to decline as the consumer reduces his use of it. This is happening now and will accelerate over the next years as people shift to smaller cars and then, eventually, to elecric hybrids or pure electrics. Volume going down is death for this business.
    Reply
  •  
    Jul 16 09:30 AM
    Agree on the margin/volume concerns, but at 7x EPS, one is presumably being compensated for this risk, with potential upside from higher margins if crude oil falls.
    Reply
  •  
    Jul 16 10:15 AM
    Out on US I-95 my mental tracking of the traffic and its speed tells me that there aren't many folk changing their driving habits. A few truckers have followed me at 60 mph (I am one who is trying to cut back a bit) but most are wheeling along at 70 or more. Some near 80 mph. (est.)
    Something tells me that $4.00 gas is being accommodated in our economy with very little pain - or adjustment. If that's the case, any dips in the price of oil will be filled by the increasing demand of new drivers rather soon.
    Finally, some engineer could calculate this: How fast would hybrid or new fuel cars have to be produced - and sold - to make a significant enough dent in demand to truly force prices to abate to oil at $100.00/bbl. Methinks there's not enough auto production capacity to do this quickly and secondly methinks there's not enough demand around for $2.00 gas. Too much money in circulation!
    My bet is on $5.00 gas before $3.00 gas. Any takers?
    Reply
  •  
    Jul 16 11:21 AM
    truckers on i95 never go less than 85 mph, time is money.
    > jack
    Reply
  •  
    Jul 16 12:09 PM
    As American consumers cut back in response to the climbing prices of most commodities, the slack is being absorbed by rising demand in foreign markets. We are witnessing a reallocation of natural resources away from our shores toward more dynamic economies. This rebalancing is overdue since we have long ago become wasteful and complacent with respect to our bounty.

    It is unfortunate that this shift in resources is flowing to countries who appear to be emulating our inefficient ways. We need more public transport, they are headlong into building individual transport. In some sense, every new car on China's streets makes it harder for us to keep ours rolling as usual. This is not necessarily a bad thing since having too many cars on the road is just as bad as not having enough.

    If we act now, this country will adjust to these new conditions without undo hardship. The upside of wastefulness is that we can enjoy efficiency gains and still meet our needs. Precious time has been wasted by a failure of leadership unmatched in living memory. This failure is not only political, but includes our board rooms and CEO offices as well.

    Reply
  •  
    Jul 16 12:22 PM
    I certainly agree with the premise of the article, and also many of Steve's comments above. This might be a smart time to take a contrarian view to all that seems obvious for the short-term. In the longer-term the safer monetary havens like gold and silver will most likely outperform VLO and XOM combined. Just my opinion.
    Reply
  •  
    Jul 16 12:45 PM
    Hybrid, total electric, natural gas or hydrogen? What would you do?
    I recently bought a new car, if any of the alternative fuels were available today I would not immediately sell my new car to buy one that was powered by the alternatives. Most people could not cast their present vehicle aside that easily. This is going to be a slow painful process. It's going to take longer than anticipated.

    The biggest problem with our oil supply is the unwillingness of congress to lift the freeze on exploration of our own, known, oil reserves.

    I don't believe the claim that there aren't sufficient experienced oil field hands available to drill for the oil available in this country.
    Reply
  •  
    Jul 16 02:33 PM
    Clearly one of the issues is that the global warming religion crowd in this country also combines their fervor with a "punish America" fervor.
    Rationality or reason is not tolerated.

    The reality is that petroleum and other fossil-based fuels are plentiful in this country if we have the will to use them.Unlike ethanol, these fossil fuels represent organic energy already created millions of years ago, requiring no fertilizer inputs, no irrigation water, and no competitive use of our food producing land.

    Today's cars need to work on better mileage, which is certainly achievable.The emission standards today have resulted in actually very clean emissions from the tailpipes of modern vehicles.

    But for the environmental fanatics,oil is bad, no matter what the facts. Sure, lets grow corn,dump the phosphate fertilizers on the land, kill the undersea life in the Gulf, etc. to get the massively subsidized ethanol.

    Electric cars- a great idea. When will we hear Al Gore and his flock demanding the construction of the nuclear reactors we need to create the electricity for these cars? Never.

    And of course it is ok for China to pollute the skies for some time in the future, after all it is "their turn".For a country that has overpopulated itself to the point of requiring a "one child per family" rule,private auto transport should not even be in the cards. They should focus on public transportation.

    Sorry, that is politically incorrect judgementalism, I know. We certainly can't have that.
    Reply
  •  
    Jul 16 05:45 PM
    dsrt--You are certainly right. Global warming is a religion with no science behind it.
    Reply
  •  
    Jul 16 07:54 PM
    Expect new taxes on short selling hedging, option buying, etc. People who do this will be blamed for the crisis, labelled "bad guys" and forced to cough up any gains.
    Reply
  •  
    Jul 17 01:52 AM
    "As American consumers cut back in response to the climbing prices of most commodities, the slack is being absorbed by rising demand in foreign markets."

    You really think $140/bbl oil isn't causing pain overseas? Imagine te impact in a country with half to a tenth our GDP. At least we can buy oil with our own borrowed currency.
    Reply
  •  
    Jul 21 11:32 AM
    Do NOT worry about the truckers and the speed at which they go. Either the HOS rules are forcing minimal driving hours (fast speed, beam me up Scotty) or the trucking company is strugling financially (mandate to drivers is drive slow and maximize fuel efficiency). Will probably see two groups and nobody in between.
    Reply
  •  
    Jul 25 04:12 PM
    The US still imports refined products so there is no overcapacity in this area. The refiners are trading at below replacement value and are a great long term buy. Right now they are suffering because of being at the wrong end of the stick (weak economy/high oil). Worldwide the demand for refined products is increasing so the long-term fundamentals are great for this industry.
    Reply
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