Record Throughput And Policy Uncertainty Will Pressure Long Term Refining Margins

Catalysts

About Valero Energy

Valero Energy operates refineries and produces renewable diesel and ethanol, selling transportation fuels and related products.

What are the underlying business or industry changes driving this perspective?

• Record refining throughput at 3.1 million barrels per day and 98% utilization, if treated as a new normal, could leave limited headroom to grow volumes further and expose revenue to any pullback in utilization or demand.
• Heavy reliance on favorable sour crude discounts and current quality differentials, as highlighted by the focus on Venezuelan and Canadian heavy barrels, could pressure refining margins and earnings if differentials revert or freight and geopolitical factors shift.
• The plan to cease refining operations at the Benicia refinery, along with incremental depreciation and lower sustaining capital tied to that asset, may reduce West Coast operating flexibility and constrain long term revenue from that region.
• Ongoing policy uncertainty around renewable diesel and 45Z production tax credits, including RVOs, tariffs and small refinery exemptions, could undermine the economics of the Renewable Diesel segment and weigh on segment operating income and cash flow.
• Growth projects are largely shorter cycle optimizations within existing assets. If refining product demand or crude slate advantages soften, these projects may deliver lower incremental returns, limiting upside to net margins and future earnings capacity.

Assumptions

How have these above catalysts been quantified?

• This narrative explores a more pessimistic perspective on Valero Energy compared to the consensus, based on a Fair Value that aligns with the bearish cohort of analysts.
• The bearish analysts are assuming Valero Energy's revenue will decrease by 2.7% annually over the next 3 years.
• The bearish analysts assume that profit margins will increase from 2.0% today to 2.5% in 3 years time.
• The bearish analysts expect earnings to reach $2.7 billion (and earnings per share of $10.99) by about April 2029, up from $2.3 billion today. However, there is some disagreement amongst the analysts with the more bullish ones expecting earnings as high as $6.9 billion.
• In order for the above numbers to justify the price target of the more bearish analyst cohort, the company would need to trade at a PE ratio of 19.9x on those 2029 earnings, down from 31.6x today. This future PE is greater than the current PE for the US Oil and Gas industry at 16.3x.
• The bearish analysts expect the number of shares outstanding to decline by 4.53% per year for the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 6.98%, as per the Simply Wall St company report.

Risks

What could happen that would invalidate this narrative?

• Sustained strong refining fundamentals, including continued tight global product balances and healthy export demand from regions like Latin America and Europe, could keep utilization and crack spreads supportive for longer than bearish assumptions imply. This would help revenue and segment operating income.
• Valero’s long running focus on high mechanical availability, cost discipline and shorter cycle optimization projects across refining and ethanol may keep unit costs in check and throughput robust. This would support net margins and earnings even if headline refining margins soften.
• Management’s commitment to a through cycle payout ratio of 40% to 50% of adjusted operating cash flow, combined with an 18% net debt to capital ratio and a long history of reducing share count, could underpin per share earnings and cash flow more than a simple revenue decline scenario assumes.
• Growth and policy developments in renewables, including full capture of 45Z production tax credits in renewable diesel and potential credits in ethanol, together with the ability to run waste oils and produce sustainable aviation fuel, could provide a more resilient long term earnings contribution from these segments than currently baked into a bearish view.
• Secular demand for low carbon fuels and octane, reflected in growing ethanol exports, capacity creep in ethanol plants and potential wider adoption of E15, may support ethanol volumes and pricing. This would help diversify the business mix and support consolidated revenue and earnings.

Valuation

How have all the factors above been brought together to estimate a fair value?

• The assumed bearish price target for Valero Energy is $170.0, which represents up to two standard deviations below the consensus price target of $220.76. This valuation is based on what can be assumed as the expectations of Valero Energy's future earnings growth, profit margins and other risk factors from analysts on the more bearish end of the spectrum.
• However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $290.0, and the most bearish reporting a price target of just $170.0.
• In order for you to agree with the more bearish analyst cohort, you'd need to believe that by 2029, revenues will be $106.7 billion, earnings will come to $2.7 billion, and it would be trading on a PE ratio of 19.9x, assuming you use a discount rate of 7.0%.
• Given the current share price of $247.08, the analyst price target of $170.0 is 45.3% lower. Despite analysts expecting the underlying business to improve, they seem to believe the market's expectations are too high.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.