Valero Energy Corporation Proves Itself a Top-Notch Refiner

Valero Energy  had a stellar first quarter, pushing its total operating income up from $1.1 billion to $1.3 billion. These numbers are a testament to the value of organic investment by executives who understand industry trends. At current valuations Valero's dividend yield is not very high, but over the long term its ability to grow earnings will boost its dividend.

Valero's growth 
Excluding earnings from spun-off retail operations, Valero's Q1 2013 operating income was really $1 billion, thus painting an even more encouraging picture of the first quarter of 2014. 

From Q1 2013 to Q1 2014, Valero's refining segment operating income grew from $1.2 billion to about $1.3 billion. This is impressive considering that many markets' gasoline and distillate margins fell along with the West Texas Intermediate-Brent spread, though larger Gulf Coast discounts helped out. These numbers show how Valero's position on the Gulf Coast gives it great access to the lucrative international market.

Valero's organic investments are starting to pay off. Its Quebec City refinery helped the refinery segment, as discounted North American crudes went from none of its feedstock in Q1 2013 to 45% in Q1 2014. Valero's big investments in hydrocrackers are performing as planned. Its recently constructed hydrocrackers at Saint Charles and Port Arthur operated at full combined operational capacity of 120,000 barrels per day (mbpd) in Q1 2014, helping to produce more high-value products. 

Its ethanol segment provided the majority of the recent earnings improvement. Its operating income improved from $14 million in Q1 2013 to $243 million Q1 2014. Ethanol's operating income improved due to higher per-barrel margins and increased production. There are some long-term concerns about the viability of the U.S. ethanol industry given the 10% blend wall and structurally depressed domestic gasoline demand; but ethanol remains a critical tool for Valero to shield itself from volatility in the secondary market. 

The competition
Marathon Petroleum's  Q1 2014 operating income fell to $361 million from approximately $1.2 billion a year earlier. The fall in operating income was mainly due to its refinery segment's operating income falling to $362 million from $1.1 billion.

Marathon had a hard quarter for a number of reasons. Higher crack spreads did help, but it is hard to grow income when oil spreads are falling by significant amounts. The upside is that some of its issues are related to temporary turnarounds and the weather. Altogether weather difficulties and turnarounds decreased Marathon's throughput by 100,000 barrels (mbpd) more than what was expected, pushing its refinery capacity utilization down to 85%.   

ExxonMobil is a huge upstream producer with a small downstream segment, but its downstream segment is still important. In Q1 2014 its downstream earnings fell to $813 million from $1.5 billion a year earlier. 

Year over year ExxonMobil's refinery throughput only decreased slightly from 4,576 mbpd to 4,509 mbpd, and its total petroleum product sales actually increased. This means that the majority of its fall upstream income comes from falling margins.

ExxonMobil's executives are focused on its larger upstream assets, so it is understandable that they don't give much attention to downstream growth projects. Valero has a distinct advantage, as its executives are able to focus on income-boosting organic investments. Meanwhile, ExxonMobil's downstream operations are more of a sideshow.

HollyFrontier's numbers are in line with the industry's. Year over year its first quarter 2014 operating income fell from $549 million to $271 million. HollyFrontier's refinery utilization did improve from 86% a year earlier to 94%, but its per-barrel net operating margin fell from $16.64 to $8.46. Such trends are hard to avoid, as the midstream industry is slowly starting to unlock unconventional production.

The upside is that even as WTI-Brent falls, HollyFrontier is still able to churn out profits, though at a slower rate. From 2001 to 2010, WTI traded at an average $1 premium to Brent, and HollyFrontier was still able to produce an average $2.69 in net income per barrel. All things considered it is unlikely that WTI would permanently return to such a disadvantageous spread, as crude product demand in export markets continues to supersede demand growth in the U.S.

Investor takeaway
Valero is putting big bucks into organic investments, and this is translating into improved earnings now and in the future. Marathon's big fall in operating income is understandable, as temporary issues only exasperated industrywide challenges. HollyFrontier's fall in income is somewhat concerning, but in the long run its small refineries will benefit from being close to producing areas.

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