Although he has been maintaining a cautious stance on the refining group, energy sector expert Elliott Gue is now boosting the rating on Valero Energy (NYSE: VLO).
In his The Energy Strategist, the advisor explains, "Valero is now attractive for three reasons: superior geographic exposure, refinery complexity and a new focus on profitability."
"Our caution on the refining group was due to expectations that crack spreads would be weak through the spring, a period during which spreads tend to widen. Overall, this call was correct: Refiners have underperformed the energy patch since mid-March.
"And longer term, I have some concerns about new refining capacity expansions due to come online over the next few years. As this supply comes online, it could put downside pressure on margins.
"But over the next six to nine months, the refiners look like a compelling play. Gasoline inventories are now back in line with seasonal norms; it's likely gasoline prices will now rally further relative to crude oil. In fact, we're already seeing an obvious spike in crack spreads.
"Valero remains an outstanding play on a recovery in refining margins. Unlike most energy stocks, the company has been weak this year, and in an improving margin environment, I'd expect to see the stock play catch-up with the rest of the energy patch.
"As noted, from a company-specific standpoint, Valero is attractive for three reasons: superior geographic exposure, refinery complexity and a new focus on profitability.
"To the first point, Valero has refineries located all over the US; because refining margins can vary greatly between regions, this ensures the company has exposure to the most-profitable markets.
"Second, Valero has some of the most complex refineries in the US. I explained complexity at some length in the March 21, 2007, issue, Looking Refined.
"To summarize, not all crude oils are alike. Some grades known as sour oils have a high sulphur content and others, known as heavy oil, are more difficult to refine. Lower-quality grades of crude can trade at a huge discount to West Texas Intermediate (WTI), the benchmark crude in the US used as the basis for the New York Mercantile Exchange futures contract.
"Therefore, refiners with complex facilities can purchase heavy, sour oils at a considerable discount to WTI prices. This allows those refiners to earn higher profit margins. And the spread between WTI and sour crude oil is unusually high right now. This plays right into the hands of Valero.
"Finally, Valero is executing its plans to sell off smaller, less-profitable operations and focus on investing in its most-profitable facilities. Management has been using the cash to buyback stock and increase dividend payout.
"These are both shareholder-friendly moves. I'm now recommending Valero Energy as a buy under 60. If crack spreads continue to rise, as I expect, the stock could easily rally to the $70 region over the next few months."
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