Back to Part I
Part I provided an overview of the factors that affect energy commodities, what is changing and one good, long-term investment idea. This installment is intended to provide a brief explanation on how some of the changes in supply now and expected in the future are affecting the prices of energy resources and provide an overview of a leading company in one of the industries of the sector.
Change is upon the energy sector
The biggest factors that have prompted change in energy are fracking (fracturing) shale and environmental and climate change concerns. The later have lead to massive investments in renewable energy sources such as wind and solar as well as innovations and conservation efforts. Hybrid and electric vehicles are just two such innovative creations that are entering the main stream. The next two decades should be interesting in terms of even more innovations either coming to market or gaining acceptance by consumers.
A decade ago shale was in its early stages producing oil and natural gas in the U.S. Back then total oil production from shale was just over 1 million bpd (barrels per day) and is currently at about 5.4 million bpd. According to BoAML (Bank of America Merrill Lynch) analyst, Francisco Blanch, shale oil production could increase by as much as 700,000 bpd annually through 2022, or a total increase of 3.5 million bpd over five years (see chart below). But that assessment is based upon an average price of WTI (West Texas Intermediate) crude oil of $60/barrel. I do not expect that such a high price is either attainable or sustainable.
As a result of the combination of low oil prices and rising production from shale, investments in exploration and production from conventional sources has fallen off a cliff in the last two years. According to the Oil and Gas Journal:
“Conventional oil discoveries declined to 2.4 billion bbl. in 2016 from an average of 9 billion bbl./year over the past 15 years. Meanwhile, the volume of conventional resources sanctioned for development last year fell to 4.7 billion bbl., 30% lower than the previous year as the number of projects that received a final investment decision dropped to the lowest level since the 1940s.
“Also, the number of conventional resources sanctioned for development last year reached their lowest level in more than 70 years, according to the International Energy Agency.”
What this could mean in the not-so-distant future is that the world may become more dependent upon shale oil production to meet rising demand. Since there is a natural reduction in production from all wells over time, depletion of existing conventional wells combined with the relatively low amount of production coming on line each year (from conventional sources) is likely to result in the eventual decline in global production of oil from conventional sources.
Of course, that will only happen if investment in exploration for conventional oil continues at historically low levels. If such were to be the case, then I would expect future potential shortfalls in supply to result in higher prices for crude again, at least until more supply can be brought on line to meet demand. This has nothing to do with “peak oil” but, rather, it is a new possibility that comes from the addition of shale oil production to the mix.
Then again, if the price of crude were to fall further (a possibility if OPEC decides to reclaim market share from shale producers by raising production) investment in exploration could also fall further. That, in turn, could cause reductions in shale production again and end the glut in oil supply leading to higher prices.
The whole point of this section on shale is to emphasize that, even though oil production and pricing has always been cyclical throughout history, the potential for greater volatility and shorter cycles from peak to trough is rising. With shale the time it takes to bring new wells into production is dramatically shortened compared to conventional E&P (exploration and production), from several years to a matter of months. This is why it no longer makes business sense to invest billions into a new conventional well in deep water, even though the life of the well will be much longer. The risks and cost are just too high relative to the alternatives offered in shale today.
There is a lot of talk about how shale is going to end badly by running out of the least expensive fields and having to develop higher cost fields. There is also a legitimate concern about the fracking concentration leading to an overlap of cracks. That would reduce the pressure and make recovering reserves more expensive. Frackers cannot just drill anywhere anymore. They need to be cognizant of what has been done nearby in the past to maintain the integrity of each well.
Costs continue to come down as the time it takes to drill and complete a shale well declines, but as more rigs are put back into service the day rates will also increase adding back some of the cost that has been saved. A gradual, planned increase is far preferable to another boom-like expansion as costs can be controlled better and the probability of another substantial price decline can be reduced. But with so many players in the game it is difficult to conceive a smooth ramp up of production. So far it has been relatively controlled, but greed is the overriding factor. That often leads to undesired consequences.
Change is going to be a theme that I come back to time and again in this series. I will delve deeper into the changes coming in other areas in future articles.
An area of relative stability within a sea of volatility
There are few industries within the energy sector that do not ride the waves of volatility in extreme fashion. Integrated oil, as I mentioned in Part I, can provide somewhat less volatility that other areas such as E&P. In the downstream portion of energy, including refining and marketing, there is still volatility but it too can be less extreme than the broader energy sector. The key, once again, is to identify the best company or companies within the industry that have a sustainable business model and management focused on keeping costs and the balance sheet under control.
One such company is Valero Energy (VLO). I realize that is does not operate in the shale fields, but its margins can be impacted by what goes on there. Its marketing business is relatively stable and dependable in terms of volume. Its refining operations are always going to be subject to short-term gyrations in prices of inputs and outputs. VLO is one of the lowest cost refiners and has built refineries capable of adjusting to the markets, otherwise called high complexity refining capacity. This term simply means that as the prices of varying grades of crude and the refined products change VLO can adjust its inputs and outputs to optimize its crack spread.
The crack spread is basically the difference between the price three barrels of crude and the price of three barrels of product (mixture of products varies by region and seasonally), then divide by three to determine the spread per barrel. It varies significantly by region, even within the U.S., due primarily to the differentials in state requirements, sources and grades of crude and product pricing. A refiner such as VLO can blend more than one grade of crude oil, along with biofuels such as ethanol, to meet the requirements of state regulations (which can vary depending upon the time of year; think California) and demand for multiple product outputs (which is also seasonal) to take advantage, to the fullest extent possible, of differences in input costs and advantageous pricing of products. The capability of such flexibility allows VLO to maintain better control over costs in producing the products demanded by the markets it serves.
Crack spreads are generally higher when there is greater disparity in prices of the various grades of crude oil. When the prices converge too closely, refiners with complexity capacity lose some of the advantages that come from being able to blend inputs. So, watching the differences in Brent versus WTI, for instance will help determine the direction of the crack spreads of those refiners that are located geographically to use either input source. Of course, that is an over-simplification since there are multiple grades of crude and some are only available to refiners in specific geographic locations.
WTI is considered light, sweet crude. On the other end of the scale there is crude from oil sands which is very heavy. Also a factor is the amount of sulfur content which varies by source. The chart below provides some idea of the geographic dispersion of sulfur content and grades of oil (light to heavy). As you can see, crude from the Middle East is mostly heavier with higher sulfur content than crude produced in the U.S.
Source: U.S. Energy Information Agency (eia.gov)
The other major variant in the crack spread is the demand for products (such as gasoline, diesel, heating oil, jet fuel, lubricants, etc.). When demand for products is rising briskly, as often happens during the driving season in the U.S. summertime when the economy is humming and jobs plentiful, it can lead to higher crack spreads. The ideal situation for VLO is when the difference in various crude grade prices is wide and demand for product is rising rapidly. Conversely, when demand is weak and crude grade prices are narrowing is the most difficult. Currently, demand for products is good, but crude prices of the various grades appear to be converging. This would mean it may not be the best nor the worst time to invest in VLO.
The all-important crack spread
The crack spread for Gulf Coast refining using a 3:2:1 crack spread mix (three barrels of WTI versus two barrels of gasoline and one barrel of heating oil) rose by 0.5 percent in the latest week according to eia.gov. You can use that link to follow the crack spread on the Gulf Coast where VLO has a significant presence along with prices for refined products if you want to try identifying trends.
When the crack spread is high, VLO is more profitable. But strategically, such an environment may provide the worst time to initiate an investment. The crack spread is cyclical and even VLO has only so much control over its own crack spread. When the spread narrows, margins for all refiners are depressed and the result is usually lower stock prices. The best time to invest in a refiner is when the crack spread is low but beginning to rise. Profits will be relatively low at this point in the cycle and financial improvements will lag the changes in the crack spread. Following the trends in the crack spread is probably the best way to identify a good entry point for initiating or adding shares of a refiner like VLO.
Other aspects to consider
Other aspects to consider about VLO is its dividend yield (4.15 percent), management’s commitment to a rising dividend and growth prospects in terms of revenues. The compound annual rate of dividend increases has been 34 percent over the past five years and over 16 percent in the last year. I do not expect those rates of increase to continue as it is faster than the rate of EPS (earnings per share) growth I expect going forward and the payout ratio, while sustainable, should not be raised further. EPS have grown at a compound annual rate of 6 percent over the last five years but are down by 38 percent in the last year. The crack spread has been narrowing. In the four years prior to last year EPS had grown at an annual compound rate of 21 percent. That speaks to the volatility that underlies this industry. But that does not make it a stock or company to forget. It merely means one must pay attention to the details and where we are in the cycle before initiating a position. If one invests in VLO at the right time (near the bottom of the cycle) it could be a rewarding investment, especially now that the dividends have been raised nearer to the industry average.
What Friedrich tells us about Valero
Of course, one must always scour the financial reports (balance sheet and cash flows) or, at the very least, look at the pertinent ratios to determine the ability of a company to service debt, pay dividends and meet capital expenditure requirements. I use Friedrich for checking the ratios and pay particular attention to the consistency over time. Here is the data file for VLO from Friedrich below.
It may not be all green the way I would prefer but there are some things that I do like. First is that the FROIC (Free cash flow Return On Invested Capital) is maintained (since 2013) at a decent level. This is not your typical growth stock so high single-digits to low double-digits is fine. Second, at the current price of $67.52, VLO may not be below the bargain price but it is getting very close. Third, the CapFlow rate (or percentage of cash flow used for capital investments) is relatively low for a company in a very capital-intensive business. Fourth, the Price to Bernhard ratio (Price to free cash flow) is well below 15. This means that the company is not overpriced. I also like that the Sherlock Debt Divisor is not much above the share price. That means that debt is not excessive relative to working capital.
The two things that would normally raise a red flag for me are the Friedrich Cash Machine level and the revenue growth. The Friedrich Cash Machine measures the amount of free cash flow generated by each dollar of revenue. Normally, I like this to be much higher but this is a low-margin business where small improvements add up to significant gains in the bottom line due to the huge volumes being processed and sold. I also like more consistency in this ratio but, as pointed out above in the article, this is a very cyclical business. The revenue growth also fluctuates because of the cyclicality of the business. VLO does a better job than most peers in managing the volatility to remain profitable and keep the long-term trend in earnings sloped upward. Both revenue and earnings will dip, sometime meaningfully, when the crack spread narrows but the dips are always temporary.
Future Growth Prospects
In terms of future growth potential, VLO is systematically expanding refining operations into Mexico and Latin America as well as adding capacity in its logistics unit. The company projects an annual increase in EBITDA of $1.2 – $1.4 billion by 2021. That equates to about a 50 percent increase from current levels to the bottom line. Combine that with a likely improvement in the crack spread over the same period that could add another 40 percent to the bottom line and the potential for the stock price to appreciate suddenly looks enticing. It does not hurt to be collecting a dividend yield in excess of four percent and growth, either.
In addition to our Friedrich algorithm, I rely on a tool that I found to be very useful in verifying our work. The Forensic Accounting Stock Tracker (FAST Model) helps identify companies that may be resorting to more financial tricks to make analyst estimates. The model helps pinpoint where management might be aggressive with revenue recognition, cash flows, the balance sheet, and also takes into account valuation and other metrics. Here is an example of the FAST Models results for VLO:
Not many companies achieve such a high rating from forensic stocks. This points to one of those hard to quantify qualities that I like about Valero: management is not cooking the books. Stated another way, what you see is what you get.
The Venezuela issue
Some may be concerned that Valero has historically been one of the largest importers of oil from Venezuela. It does so because it has maintained a stable relationship with the regime enabling it to get a good price for its crude inputs used to blend with U.S. oil. If the regime proceeds with controversial reforms to gain a tighter grip on power it is possible that the U.S. government will inflict sanctions that could outlaw imports. If that happens, there is a plethora of alternative sources from which to purchase crude in this world. I do not foresee this becoming a sustained problem for VLO. It may cause a short-term blip that provides investors with an even better potential entry point. But it would not create a lasting negative impact on VLO operations. Once again, temporary problems for quality companies merely create great opportunities for astute investors.
The stock may have bottomed or it may fall a bit further, but the dividend will ease the pain for those with a long-term holding view for the stock. I would prefer to enter this one at about $62 per share if possible. That would provide a yield of 4.5 percent. This is not a company likely to go out of business nor is it likely to lose money or even cut the dividend; all admirable qualities. On the flip side, it is also not going to make us rich quickly.
The downside potential is probably in the vicinity of $50 should the crack spread narrow dramatically or should a recession occur which would temporarily reduce demand. The important word in that last sentence is “temporarily.” When the economy and the cycle improve there is significant upside potential to go along with that sweet dividend.
If you have any questions, please feel free to ask them in the comment section below and don’t forget to hit the “Follow” button next to my name at the top of this article. I hope that readers will stick with the series as I do my utmost to peel the onion that is the future of energy. There is a lot more detail underlying the preview you just read.
For those who would like to learn more about my investment philosophy, please consider reading “How I Created My Own Portfolio Over a Lifetime.”
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: DISCLAIMER: This analysis is not advice to buy or sell this or any stock; it is just pointing out an objective observation of unique patterns that developed from our research. Factual material is obtained from sources believed to be reliable, but the poster is not responsible for any errors or omissions, or for the results of actions taken based on information contained herein. Nothing herein should be construed as an offer to buy or sell securities or to give individual investment advice.