Valero (VLO) Offers a High Yield, But is the Dividend Safe?

As Warren Buffett continues adding to his stake in oil refiner Phillips 66 (PSX), many investors are wondering if Valero (VLO), another refiner, is an equally attractive dividend stock.

 

Valero offers a high yield of 4.4%, trades at less than 10x trailing earnings, and has more than doubled the S&P 500’s return over the last five years.

 

Dividend growth has been outstanding as well. Valero’s quarterly dividend payment has increased from 5 cents per share in 2010 to 60 cents most recently.

 

Offering a strong combination of yield and income growth, many conservative dividend investorsare wondering if Valero is a good fit for their portfolios or if the company’s best days are behind it.

 

After all, Valero slashed its quarterly dividend by 67% in 2010. If business conditions are about to deteriorate in a meaningful way, some investors wonder if history will repeat itself.

 

Let’s start with a review of the company before digging deeper into the safety and growth prospects of Valero’s dividend.

 

Business Overview

Valero incorporated in 1981 and is the world’s largest stand-alone refiner with 15 petroleum refineries across the United States, Canada, and the United Kingdom.

 

The company’s refineries process crude oil into many different products. Valero buys crude oil from other companies and processes it into conventional and premium gasolines, diesel, jet fuel, asphalt, petrochemicals, lubricants, and other refined products (e.g. petroleum coke, propane, lubes).

 

Valero sells its branded and unbranded refined products on a wholesale basis through a bulk marketing network and roughly 7,500 outlets that carry its brand names.

 

In addition to its refineries, Valero owns 11 ethanol plants that sell ethanol on a wholesale basis. Valero’s ethanol is primarily used in renewable fuels.

 

Valero is also the majority owner of Valero Energy Partners (VLP), a fee-based master limited partnership that operates liquids-focused pipelines and logistics assets. Valero owns the entire 2% general partner interest, all incentive distribution rights, and 67% of outstanding LP interests.

 

Valero used to have a company-owned retail network of gas stations and convenience stores but spun off this business in 2013.

 

Segments

Refining (97% of 2015 operating income; 88% of 2014 operating income): Valero’s petroleum refineries have total throughput capacity of 3.0 million barrels per day. Over 70% of the company’s refining capacity is located in the U.S. Gulf Coast and Mid-Continent.

 

Ethanol (3% of 2015 operating income; 12% of 2014 operating income): Valero’s ethanol plants process corn to produce ethanol and distillers grains. Ethanol is sold primarily to refiners and gasoline blenders. The price of ethanol generally follows the crude oil and gasoline prices, which is why this segment’s contribution to total operating income collapsed in 2015.

 

Business Analysis: Valero

Refining is extremely capital intensive. Valero spends $1.5 billion annually just to maintain its existing facilities.

 

A single refinery can be the size of several football fields and cost several billion dollars.

 

Building new refineries is especially challenging due to permitting issues and stringent environmental regulations.

 

Refineries also require access to transportation systems, pipelines to move their products, and feedstock supply agreements.

 

For these reasons, there are few new entrants to the market. Until 2012, the U.S. hadn’t seen a new refinery built in 30 years.

 

Not surprisingly, a handful of large players control the majority of total refining capacity.

 

Despite the industry’s high barriers to entry, operating margins are volatile and typically sit in the low- to mid-single digit range.

 

Margins are slim because refiners sell commodities on a global basis, have little to no pricing power, and have capital-intensive operations.

 

The best companies in commodity markets are those with the lowest costs and strongest balance sheets, which makes Valero a potentially attractive investment candidate.

 

Valero is the largest independent refinery in the world and can process some of the most complex crudes compared to its competitors.

 

Many different types of crude oils can be processed – light sweet, heavy sour, etc. – and each type has its own benefits, disadvantages, and price points depending on market conditions.

 

Valero can process over 80 different types of crude oils, giving the company input flexibility to capitalize on a range of different market conditions to maximize profit.

 

The chart below highlights the feedstock flexibility enjoyed by Valero:

 

Valero VLO Dividend Safe

Source: Valero Investor Presentation

 

While approximately 59% of Valero’s crude oil feedstock requirements are purchased under contracts (the rest are purchased on the spot market), its input flexibility prevents it from being overly dependent on any single supplier.

 

Beyond scale and flexibility, Valero’s operations also benefit from their geographical positioning. Over half of Valero’s refining capacity is positioned in the U.S. Gulf Coast.

 

These advantaged locations enjoy access to low-cost energy sources and provide Valero with easy access to export markets around the world.

 

Valero’s MLP subsidiary (Valero Energy Partners) also helps the company’s operational efficiency because its assets are integrated with Valero’s refineries.

 

The MLP provides access to low-cost logistics and transportation systems to source and move Valero’s oil feedstock and end products.

 

As seen below, Valero is the lowest cost operator in the industry on a per barrel basis:

 

Valero VLO Dividend Safe

Source: Valero Investor Presentation

 

While selling prices fluctuate heavily, petroleum refiners benefit from the predictable demand for refined products.

 

Downstream demand for Valero’s products essentially follows GDP growth, and investors do not need to worry about the company’s end products ever going obsolete (gasoline will remain an essential need despite increased energy efficiency over the coming years).

 

However, even when demand trends are steady, Valero’s quartery profits can swing wildly.

 

Key Risks: Refining Margins are Volatile!

Valero’s ethanol and refining segments have different risks. The ethanol business is sensitive to the price of oil, which drives the prices Valero can charge.

 

Additionally, renewable fuel standards impact demand for ethanol and are a controversial issue. With ethanol contributing less than 5% of Valero’s total operating income last year, I won’t dwell long on this topic.

 

Investors seeking more information about the risks of ethanol should review the risks I outlined inmy thesis on Archer Daniels Midland (ADM), which has more meaningful exposure to ethanol.

 

The refining business is what will really make or break Valero’s profits going forward. A common evaluation of refiners’ profitability is the crack spread, which measure the difference between the purchase price of crude oil and the selling price of finished products (e.g. gasoline).

 

U.S. refiners have enjoyed an unprecedented boom in profitability over the last five years thanks to the surge in domestic production of crude oil and natural gas. Daily oil production nearly doubledfrom 2010 through 2015.

 

As a result, domestic oil prices (West Texas Intermediate – WTI) began to trade at a major discount to Brent crude oil prices, which serve as a benchmark for refined products sold internationally.

 

Since U.S. refiners source their crude oil needs domestically, they benefit from a wide Brent-WTI spread.

 

As seen below, the Brent-WTI spot price spread remained near zero from 1992 through 2009. Once U.S. oil production took off, a flood of domestic capacity kept WTI prices

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