Cracking the Heavies

Take two guys at a cocktail party. One develops high-rise condo towers; the other owns the septic tank cleaning business at the local RV park.

Who would you guess makes more money with less risk?

I’d take the septic tank guy. I bet the profit for cleaning septic tanks – a job no one wants to do - is far higher than selling beachfront property.

This phenomenon is at work in the oil refining industry. For the company that discovered this unpopular niche, profits are huge. Even better, the niche is protected from new competitors by regulation.

Here’s how it works: Broadly speaking, crude oil is graded on two counts: its sulfur content and its density. Light, low-sulfur crude oil is much cheaper to process, requires a less complex refinery. There’s less waste and you get more gasoline from each barrel. It’s also about $6 a barrel more expensive.

The best oil in the marketplace – called light, sweet crude – is Malaysian Tapis, West Texas Intermediate and Brent crude from the North Sea. The heaviest, sour crude, comes from the Gulf of Mexico, Saudi Arabia and Venezuela.

Oil is used to make many products, from diesel fuel and gasoline to plastics and grease. But the energy products are most profitable. So the traditional oil refiner simply purchased the best crude oil available, extracted the diesel and gas, and then sold the leftovers.

Scientists call these leftovers “long-chain hydrocarbons.” Petroleum jelly, paraffin, bitumen and asphalt are all examples long-chain hydrocarbons.

Here’s where it gets interesting. It’s possible to extract diesel and gasoline from long-chain hydrocarbons... but you need a special refinery to do it. They call this a “hydrocracker.” It’s a dirty business. It’s also expensive.

The Valero Energy Corporation (VLO) is the leader in this dirty business. Refining heavy, sour crude oil – and cracking these long-chain hydrocarbons - is Valero’s niche. Heavy crude makes up 85% of their capacity.

When Valero chose this unpopular niche in the early 1980s, heavy crude refining was not a popular business. Now, Valero is America’s largest independent refiner of crude oil.

There are five major trends that have helped Valero grow faster than its competition.

1) America’s shift towards Venezuelan and Mexican crude oil in favor of oil from the Middle East. Mexican and Venezuelan oil is heavy.

2) Heavy crude is cheaper than light crude.

3) The crack spread is the difference in price between the refined product Valero sells to gas stations and the crude oil Valero buys in the oil markets. It’s Valero’s profit margin.

The crack spread is widening as demand for gas has increased every year, yet supply of refined product has not. There hasn’t been a new oil refinery constructed in America since 1983. This was Valero’s refinery in Corpus Christi, Texas. And half the refineries open in 1982 are now closed.

4) Building a new refinery is a regulatory nightmare. There are layers and layers of environmental, technical and safety hurdles to jump over. Refineries look awful and they smell even worse. People hate them. Valero’s unique business model is protected from competition.

5) Valero’s strategy produces higher quality gasoline. 60% of Valero’s output is clean-burning premium fuel, compared to the 45% industry average.

So now you know about Valero’s business, let’s talk about Valero’s stock price.

VLO is up 50% in the last year and nearly 300% since late 2004. The best thing is, Valero is still cheap with a p/e ratio around 10. Why? Wall Street doesn’t believe high oil and gas prices will last. That’s my feeling anyway.

I like Valero as an investment and a play on higher oil prices. And I like the contrarian moral of the story. But there’s one more thing...

Valero is the superpower of the heavy oil refiners and a $40 billion company. Its story is well known. But there are many other small-cap heavy oil refiners out there. These stocks have the real potential, but because they are small, investors haven’t found them yet.

My colleague Matt Badiali is a geologist and energy speculator. He recently found just such a “baby hydrocracker.”

It’s already up 40% since June, but he thinks the price could run much further. I can’t give you the name out of deference to his paying subscribers, but he wrote up the full story in his oil and gas newsletter, The S&A Oil Report.

Good investing,

Tom Dyson