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Last June, I published “Valero: US Gasoline Prices Will Soar This Decade As More Refineries Shutter,” which explained my bullish outlook for Valero (NYSE:VLO). I believed VLO would rise in value at that time due to a prolonged increase in “crack spreads,” or the difference between gasoline and oil prices. My long-term view is that the spread between refined oil products (gasoline) and crude oil will remain high due to a general shortage of refinery capacity compared to demand in the US. That gap stems from decades of underinvestment in both capital and labor.
Since then, VLO has delivered a total return of 50%, significantly outpacing the S&P 500. Oil has fallen slightly, while gasoline has hardly nudged higher. That said, the crack spread between the two has increased, causing another rise to Valero’s core profit driver. See below:
Looking forward, we’ll need to consider if the recent rebound in crack spreads will last, likely pushing VLO’s OI per share back to the $10-$12 range. The crack spread rise is a significant driver of VLO’s recent rally as its income outlook improves again. That said, higher income is only bullish for equity investors if the stock trades at a reasonable valuation. In my view, VLO is not nearly as discounted as it was when I covered it last.
The Refinery Golden Era Will Grow and End
Refinery capacity remains down dramatically from 2020 levels primarily due to labor shortages exacerbated in 2020. Today, demand for oil products is high, as illustrated by the “products supplied” data. However, capacity utilization is also down to 86.8%, trending negatively, indicating a continued decrease in US gasoline supplies. See below:
As there is an insufficient pool of refineries and skilled energy-sector workers, existing refineries benefit from a lack of competition. Even a 1% gap between gasoline supply and demand is likely enough to cause a considerable rise in profits for refineries like Valero because the energy market demand curve is very steep. Most consumers of gasoline and other energy products cannot dramatically reduce their demand if prices rise, meaning refineries benefit from potential oligopoly pricing power from immense barriers to entry.
These barriers include increased regulations on energy, divestment of the fossil fuel energy sector, high capital costs (both physical and monetary), and a lack of a skilled labor pool for refinery capacity expansion. In my view, the latter point is under-discussed but very important as we look toward an aging energy sector workforce that is not being replaced by younger generations. There is some logic to this, as pursuing a career in an industry that may not exist in twenty years is likely unwise and should scale down within ten. Further, it is not a great business decision to pursue new refinery construction that will not turn a profit for a decade or more, by which time US gas demand should be falling.
I will not argue, as some may believe, that the US will never transition away from gasoline. EV sales are still rising quickly, while legacy vehicle sales are slowing. Electric vehicles are becoming more comparably priced to conventional cars. The transition may take longer than expected, but new technologies like Solid State Batteries could also accelerate EV demand as range and cost issues are supplanted. Thus, I only expect Valero to earn a decent profit over the next decade or two, with significant risk surrounding substantial improvements in EV technology. After that, refineries may only be used for chemicals, meaning a >90% reduction in overall sales.
So, for Valero to be a “buy” today, we must expect positive discounted cash flows from today to that time that is appropriate to its valuation. In my view, Valero and its peers will benefit significantly from the natural shortage of refinery capacity that has occurred as a result of the sour long-term demand outlook. That said, because its EPS should decline over the long term, VLO’s valuation must be relatively low to be reasonable today.
RBOB Crack Spread Rebounds Again
VLO saw slight gains during the latter half of 2023, with tremendous acceleration in 2024, rising by 26%. Most of those gains have occurred over the past month, with VLO increasing by 16% MoM. The most recent spike is likely driven by the significant increase in the RBOB crack spread. At the same time, diesel spreads have slipped while heating oil remains decent. See below:
The core cause for the rise in the RBOB crack spreads (the most important for VLO) is a sharp decline in US refinery capacity utilization, driven by reduced plant operations across the US. Maintenance and weather are major causes; however, these short-term pressures mirror the long-term issues in refineries that seem to be causing permanent difficulties for refiners looking to maintain utilization. As we saw during 2020, these short-term pressures expose and (often) exacerbate long-term structural issues, leading to lower supply.
Gasoline storage levels are plummeting, lifting the retail gasoline price. See below:
Over the coming month, I expect we should see the retail gasoline price rise closer to $4 as gas storage continues to dwindle due to lower supplies. This change is largely priced into the futures curve, as seen in the crack spread jump.
Of course, this temporary situation is driven by short-term factors in refineries. Thus, I do not expect crack spreads to remain at the high $30+ level. Still, with each refinery utilization decline, we’re seeing the RBOB crack spread gravitate closer to that $30-$40 range. In the new era, it seems unlikely we will see the spread back below $20 for a prolonged period, as there is no reason to believe the general refinery shortage should permanently end soon.
Given that, I expect VLO’s annual EPS to be closer to $20 in 2024 and likely remain near or even above that level for the next five years, given no sharp decline in US gasoline demand. Analysts expect VLO’s EPS will be closer to $15-$16, but that does not account for the recent crack spread increase. Further, I disagree with the analyst’s consensus that VLO’s EPS will stabilize at an annual $8, given its profit margins should remain chronically elevated due to the long-term issues in refineries until EV technology and adoption are sufficiently high.
The Bottom Line
Based on my estimates, VLO is trading at a forward “P/E” closer to 8X, potentially as low as 5-6X if we assume a prolonged crack spread increase, but it may also be around 10-12X if the spread quickly returns lower. An 8X “P/E” may seem very low to investors in less cyclical or faster-growing sectors. However, 8X is not necessarily low if we consider its EPS should decline to, or even below, zero by 2040.
Yes, that is a long horizon, but there is also a risk that it will shorten. Ideally, Valero will have some role in an EV future, as it markets itself with a great deal of ESG-oriented value, but the overwhelming majority of its assets today are older fossil fuel capital items that will depreciate. Thus, should VLO have a clean-energy future, it will need to reinvest a great deal of income into it that may be better spent and returned to shareholders through dividends.
Overall, I believe VLO is fairly valued today. I would not invest in it expecting significant positive returns or bet against it. I think VLO may continue to rise in the coming weeks and months as speculative fervor appears to be building around the refinery sector, as seen in many equity segments today. However, even if that makes me seem wrong, I am never one to chase the crowd in speculative rallies unsupported by fundamentals. At its current price, VLO appears to be supported by fundamentals, but I would have a bearish outlook if it were trading for just 10% more than it is now.
