Who Wins as Oil Soars?

Pure-play refiners like Valero appeal to some, but not all.
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Energy investors may still be able to spot a gusher or two.

Thanks to record oil prices, which peaked at $41.85 on Monday, some investors have already hit paydirt with supermajors like

ChevronTexaco

(CVX) - Get Report

and

ExxonMobil

(XOM) - Get Report

, which are near their 52-week highs. But the real winners with more room to gush could be the pure-play refinery companies.

Already, refineries are running at full throttle to churn out gasoline in response to low supply and high demand. As a result, several big refiners recently posted their best quarters ever. And

Valero

(VLO) - Get Report

, which ranks as the largest independent refiner in the nation, promised even better days to come.

"As we look at the balance of 2004, it's obvious that this is going to be another record year of earnings for us," Valero Chief Executive Bill Greehey said on April 28, when the company released its first-quarter results. "It is also just as obvious that 2004 earnings estimates for Valero continue to be significantly too low."

Greehey went on to forecast second-quarter earnings of more than $3 a share that, at the time, exceeded analyst estimates by at least a dollar. And he insisted one day later -- when raising Valero's dividend -- that the company continues to enjoy "the best refining fundamentals we have ever seen."

The stock, which slipped 6 cents to $65.73 on Monday, set a fresh peak after Valero's quarterly update. But analysts merely shrugged. Indeed, Prudential Equity's Andrew Rosenfeld -- who downgraded the refinery sector to underweight before its glowing reports -- actually reiterated his bearish stance earlier this month.

Rosenfeld said he's convinced that gasoline inventories, which drive refinery margins, won't get any smaller. He therefore sees potential for inventories to grow, and profit margins to shrink, in the sector.

But Valero fans foresee positive surprises.

"Valero is actually on track to make more than $5 per share in the second quarter," calculates Harry Chernoff, an analyst for Pathfinder Capital Advisors. Together with his partners, Chernoff owns a stake in Valero.

"Whether the crude and product spreads stay at these levels is obviously not certain, but the difference between the Valero run-rate (of earnings) and the First Call consensus shows an astronomical level of disbelief in the current pricing environment and a near-collapse in very short order. We disagree."

Deep faith

Chernoff bases his faith in Valero on both industry-wide and company-specific elements.

Gasoline demand is high, and inventories are low. Also, due in part to environmental restrictions, Chernoff says, the United States hasn't built a new refinery in nearly three decades. Instead, he says, existing refineries have simply expanded their capacity to meet growing consumer demands. But the refineries are now reaching their expansion limits at a time when they are already running at nearly 100% capacity. And foreign refiners can't necessarily help out.

Chernoff notes that some reliable suppliers in Venezuela, for example, have been cut off because of political reasons. Meanwhile, he says, suppliers from other countries have failed to meet new environmental restrictions that "shut out hundreds of thousands of barrels per day of imports." The same restrictions, he adds, proved too expensive for small domestic refiners that wound up shutting down.

Looking ahead, as new diesel and tougher gasoline standards take effect in 2006, Chernoff expects other domestic refiners -- generating at least 300,000 barrels of fuel per day -- to fall out of compliance as well. And the remaining refiners will see their own capacity drop "by a very considerable amount" when they begin operating their newly compliant, but less productive, equipment.

In the meantime, he notes, foreign fuel demands -- particularly in eastern Asia -- continue to pressure supplies.

"Unless China has a crash landing, the growth rate in demand will only decline from extremely high to very high," Chernoff says. "The tight capacity market that the refiners have been saying would eventually arrive has arrived."

Chernoff believes that Valero is best positioned to capitalize on the situation. Indeed, he says that Valero -- unlike some other refiners -- will benefit even if more oil is released by the Organization of the Petroleum Exporting Companies.

Chernoff says that Valero is one of the few domestic refiners that is well-equipped to convert heavy, sour crude -- like that pumped by OPEC -- into acceptable U.S. products. Already, he says, Valero enjoys "very large and little noticed profits" from the wide spreads it collects for processing the heavy oil.

"All the spare OPEC capacity is medium sour or heavy sour," he continued. So "if world oil prices go down because OPEC pumps more, Valero's profits go up."

Still, Chernoff recognizes that many investors worry about energy prices -- and stocks -- falling instead.

"A lot of people think the prices are unsustainable because Venezuela will be back online, price increases will lead to demand declines, refiners will ramp up to make the necessary fuels, OPEC will open the spigots, hedge funds will dump their long positions, etc.," he said. "My partners and I recognize that these events are likely to happen but that spreads are not going to return to historical levels. And until the refiners' rolling average margins are much higher than the historic margins, the market is going to stay very tight for a very long time."

Better bet

Massachusetts investment strategist Peter Cohan questions whether Valero is, in fact, the best bet among refiners.

To be sure, Cohan says Valero is a "nice money maker" that's trading at a relatively inexpensive price-to-earnings ratio of just 12.2. Moreover, he notes, the company is growing both revenue and profits at a much faster clip than the overall industry.

But he says the big refiner is more heavily leveraged than most. And Valero generates smaller margins and returns than its peer group, Cohan adds.

"There has definitely got to be a better-run refiner out there," said Cohan. "If I were investing in this industry, I would be looking for that one," said Cohan, who nevertheless can't specify what that better option might be.

Last month, bond analyst Jon Cartwright steered investors away from refinery names entirely. He said the same companies he liked two years ago, including

Tesoro

(TSO)

and Valero, now look too expensive. And he expects gasoline prices -- which drive refinery stocks -- to actually drop going forward.

"If prices remain high, summer formulation standards will be suspended, refineries will operate above boiler-plate capacity and OPEC's (cheating) members will find some extra oil," wrote Cartwright, director of institutional research at BOSC. "Don't be fooled by the headlines. It is time to take profits."

Cartwright recommends other energy companies -- specifically

ConocoPhillips

(COP) - Get Report

,

Marathon Oil

(MRO) - Get Report

and

Union Oil of California

(UCL)

that benefit from high energy prices instead.

Jake Dollarhide, chief executive of Longbow Asset Management in the big oil town of Tulsa, is looking outside the refinery sector as well. He has chosen three familiar industry giants -- ExxonMobil,

Baker Hughes

(BHI)

and

Southern

(SO) - Get Report

-- for exposure to the energy sector.

Dollarhide considers ExxonMobil his top pick. But he likes Baker Hughes as well, because energy services firms generate more business when energy prices climb. And he views Southern as one of the healthiest utilities despite its reliance on expensive natural gas and the recently flat performance of its stock.

Still, Dollarhide acknowledges that even his favorite energy stock could take a hit if oil prices fall.

"There will be a camp that will sell ExxonMobil," he explained. "But in my opinion, it will be a core holding no matter what. We have made a commitment to have energy as part of our portfolio, and as I scan the industry, I see no company that's better than this one."

ExxonMobil's stock, which slid 22 cents to $43.05 on Friday, has climbed 22% over the past year.