Thursday, October 16, 2008

Refiners: ALJ and VLO

I do not profess to know much about the refining business.  I do know now that middle Tennessee is dependent on the refineries located around Houston, with deliveries made through the Colonial pipeline starting in Houston, moving to Atlanta with a spur line coming into Nashville. I only know that now, after many decades of living here, because Nashville ran out of gas for a week after hurricane Ike came ashore and disrupted the large number of refineries located in its path.   Now, we all know how gasoline is delivered to Middle Tennessee.  There will be another run whenever a hurricane approaches Houston again.   Valero had three refineries shut down due to that Hurricane but I do not believe Ike impacted Alon. I can be fairly brief about this subject due to my limited knowledge.

While I am certainly no expert on the crack spread, the profit margin representing the difference between the input cost for oil and the output revenue for the distillate products "cracked" from oil like gasoline and heating oil, I did notice the refiners took off in price when the crack spread widened and contracted when the profit margin contracted.  It seems that it was very hard for the refiners to make money when oil continued to rise  from the middle of last year until it reached its peak price near $150 barrel, since the input costs were rising faster for the refiners than the price that they could charge for the end products of the refining process.  This is a relatively simple analysis and probably does not capture anywhere near all the variables.  But I overlaid a chart of OIL, the ETF for crude, with the stock prices of the refiners.  In September 2007, OIL was trading at around 42 and it then started going up and up until peaking at around 87 in July 2008.  Using the split adjusted price for Valero, it was near its high in September 2007 at around 71 and was cut in half by July 2008.   Earnings for the 3 months ending June 2008 were 1.37 compared to 3.57 for the prior year. Since then, oil has fallen more in price and Valero skidded even further to where I bought it today at below 17, down another 50% since September 25th.  Part of that fall is due to general market conditions and a concern about demand for the end products of the cracking process.   The costs of the oil input, a main driver of the price decline from September 2007 to July 2008 in my view, has certainly changed in the refiners' favor. 

Demand for gasoline, however, has slipped almost 6% from a year ago. Gasoline inventories are still below a year ago. I would view the decline in demand to be due in large part to the price prevalent until recently and only secondarily to the slowing economy. I would anticipate demand to pick up even with an economic slowdown as prices fall to $3 or  below for regular gasoline. If this occurs, with the price of the input falling, the crack spread should return back to favor the refiners' profit margins. The bear case is summarized in a recent Morningstar report found at yahoo finance, and a different bearish point was made in this note. Part of the bear argument is that new refining capacity is coming on line during the next several years.

I also found these articles useful in understanding the refining business. Time For Crack Spreads? - Features and Interviews - Hard Assets Investor

Since Valero uses about 65% of sour crude or acidic crude which costs less than sweet crude, their profitability is also impacted by spread between sweet crude and sour crude prices, which remained favorable for Valero during the quarter ending June 2008. Valero did sale it Krotz refinery in Louisiana to Alon (ALJ) on 7/1/08  prior to the time that refinery had to be shutdown for the hurricane which came ashore in Louisiana. 

I also bought Alon (ALJ) back today, a much smaller company than Valero. It owns two small refineries in California, with 70 and 54 thousand barrels per day capacities respectively, the Krotz refinery in Louisiana just purchased from Valero and the Big Springs Refinery with a 70000 barrels per day capacity. 

Alon also  owns and leases about 300 7-Eleven convenience stores in the southwest mostly in Texas,  and it operates some asphalt plants.  I believe the two California refineries can process sour crude but I would expect that there is a demand issue for gasoline in that market now, though that is just a suspicion. I did check their SEC filing and found that the crack spreads had fallen significantly this year compared to the same periods in 2007, which is what I would expect to see due to the relentless rise in crude's price during that time period. I made a quick 50%+ profit in Alon  this summer buying at a higher price than I did today and selling when it shot past 12, missing the last two or so points before it started to slide from over 15 on 9/15 to less than 7 today. During the heyday for refiners, between July 2006 and July 2007, before the spike in crude prices, it was trading in the mid 40 range. My price today is less than its book value. ALJ: Key Statistics 

While I do not expect a return to the refiners' glory days, one key factor causing their decline, the relentless rise in oil prices, is no longer applicable. I would be pleased with a return to 10 to 12 for Alon, and this is a trade, not a long term holding.

One final note is that Alon is mostly owned by an Israeli company called Alon, something like 80% of the common stock.  It is similar in that respect to a company based in Brentwood, Tennessee called Delek (DK), also majority owned by a different Israeli company. Delek owns only 1 refinery, in Tyler Texas, and  it owns the Mapco chain of convenience stores. I thought that Alon was more attractive than Delek today but both have suffered greatly over the past year.  I may add Delek too on further weakness.

Based on this article, the crack spread has turned up since August. Oil Spreads Widen AND Narrow - Brad's Desktop - Hard Assets Investor

I also reviewed the following articles prior to making the small investment today. Fitch: Hurricane Ike May Not Be Enough to Save Weak Driving Season | ReutersCrack spread - Wikipedia, the free encyclopedia Seeking Alpha MarketWatchMarketWatch The last article is about the dividend which stands at about 3.5% based on my cost. 

I also reviewed several research reports focusing on Valero which was the new investment for me. The Value Line was negative over the short term but positive long term. Book value is almost $36 per share and my purchase today was at more than a 50% discount to book. VLO: Key Statistics 

Earnings estimates are for $4 this year and $4.24 next year. VLO: Analyst Estimates But this company is not Proctor & Gamble so estimates can be widely off the mark both up and down. If this estimate holds true, I would have bought a around 4 times earnings.  Market cap is around 9 billion but revenues may top 132 billion this year-a very low price to sales. The expected PEG ratio using analyst estimates is around 2 over the next five years. 

So, even for a small position that will have no significant impact on me, even if they fail or succeed beyond my wildest expectations, I still followed the same process of conducting several hours of research before tapping that button. 

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