Valero is approaching bargain territory – valero energy corporation (nyse_vlo) _ seeking alpha

Valero Energy (NYSE: VLO) is trading at a remarkably cheap valuation, with a forward P/E ratio of 9. Given that the company reported record earnings last year, the low valuation may seem particularly surprising to many investors. On the other hand, as the refining business is highly cyclical, some investors may wonder whether the cheap valuation implies that the US refining margins topped last summer and are about to experience a new downtrend. In this article, I will analyze why investors can make a nice profit of about 10% within the next 3-6 months.

First of all, there are some reasonable worries for the US refiners due to the recent lift of the ban on US oil exports. Due to the lifting of the ban, the premium of Brent over WTI has greatly decreased, and hence, US refiners have lost a great competitive advantage over other global refiners. While the exports of crude oil from US have been almost negligible so far, they may increase in the near future. Even if they do not increase significantly anytime soon, the spread between Brent and WTI is likely to remain narrow, as the lift of the export ban will not allow the spread to trade around the high levels ($10-30) seen in the last 5 years. This factor is likely to be partly responsible for the suppressed valuation of Valero.

On the other hand, Valero enjoys a great competitive advantage from the uniquely cheap US natural gas. As its refineries consume 896,000 mmBtu/day, the company greatly benefits from the markedly low price of US natural gas, which currently trades around $2. Given the much higher price of European natural gas, Valero saves about $750 million in pre-tax annual costs compared to its European counterparts. Moreover, as the inventories of natural gas are expected to remain around their seasonal all-time high levels for the foreseeable future, this competitive advantage of the company is likely to remain in place.

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While the above points are important for both the short term and the long term, the most important factor for my thesis on a short-term profit is the seasonality of the refining margins. More specifically, the US refining margins pronouncedly decreased from last year’s Q2 and Q3 to Q4-2015 and Q1-2016. This decrease is probably the most important factor behind the 14% decrease of Valero stock off its peak and its current cheap valuation. However, as we are headed into the gasoline summer season, the refining margins are likely to rally, just like they have done in all the recent years. This is also the thesis of a recent report of Wells Fargo and another report of Bank of America, both of which state that the seasonality will greatly benefit the US refiners, including Valero. Therefore, the stock is likely to receive a meaningful boost from seasonality in the next 3-6 months.

It is also worth noting that Valero has some defensive characteristics, which will be highly appreciated by those investors who are afraid of an imminent broad market correction or even a bear market. More specifically, if the market heads south, the price of oil will follow, and hence, the refining margins are likely to appreciate. This trend has been prominent throughout the entire oil bear market in the last 2 years. Therefore, if the market incurs a correction, Valero is likely to benefit from the resultant elevated refining margins.

To conclude, the major reason for the cheap valuation of Valero is most likely the environment of relatively low refining margins during the last two quarters. However, as experience has shown, the refining margins are likely to receive a great boost, thanks to the upcoming summer gasoline season. Therefore, Valero, which is now trading at a forward P/E of only 9, is likely to enjoy a seasonal rally in the next few months. I recommend purchasing the stock after any pullback to around $60 and take an approximate 10% profit within the next 3-6 months. While Valero is very well managed, I do not recommend holding it for the long term, due to the great cyclicality of the refining business. While the company has a great management, it cannot influence by any means the cycle of the refining margins, which is the major determinant of its earnings.