There's no denyingValero Energy , America's largest independent refiner, has handily beaten the total returns of the S&P 500 in the last five years. The secret? Spinning off less profitable businesses, investing in the efficiency of the most profitable, and even founding a master limited partnership have all helped. Being in the right place (American refining) at the right time (shale energy boom) has helped, too.
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While a price-to-earnings ratio of just 8.3 makes the company relatively cheap compared to its peer group, nothing guarantees Valero Energy stock will keep rising from current levels. In fact, there are several tangible reasons the stock could fall.
Headwinds facing ethanol market
Valero Energy may be the largest independent refiner, but it's also one of the largest ethanol producers in the country with 1.3 billion gallons of annual capacity. That helped tremendously last year, as low corn prices and healthy ethanol selling prices provided a major boost to manufacturers. Consider that the company earned a record annual operating income of $786 million in 2014 compared to just $491 million in 2013. Ethanol manufacturers simply couldn't lose.
Unfortunately, the ride is over.
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Corn prices have risen, ethanol inventories have accumulated, and ethanol prices have fallen significantly compared to the highs witnessed in 2014. Valero Energy was actually hit by the reversing trend in the fourth quarter of last year. Operating income was $158 million, compared to $269 million for the fourth quarter in 2013. And the company still managed to pull off a record year! If that doesn't demonstrate that 2014 was a fluke and that headwinds are piling up, then perhaps nothing will.
Cheap and abundant natural gas in North America is set to reshuffle global supply chains and trade routes for petrochemicals. Major manufacturers and refiners are investing up to $124 billion in infrastructure capable of converting cheap components in natural gas to valuable chemicals typically derived from petroleum feedstocks. The economics heavily favor using certain gas components, such as ethane, instead of more expensive petroleum feedstocks, such as naphtha. What does that mean for Valero Energy?
Well, petrochemicals accounted for $3.8 billion in revenue in 2014. That may have represented just 3% of total revenue; which is heavily dependent on gasoline, diesel, and jet fuels; but petrochemicals have among the highest profit margins in the company's product portfolio. In other words, an outsized amount of profits could be pressured as new natural gas-to-petrochemicals infrastructure comes online in the next several years. Valero could shift to more valuable products or those that remain out of reach of ethane, but that would require additional investments. It doesn't represent a catastrophic risk by any means, although it is an area investors will want to keep an eye on.
Oil prices are bound to rise again
Refiners such as Valero Energy are benefiting from low price crude today, but oil prices are bound to rise again. When? Investors cannot say for sure, although we've been here before. The oversupply in global markets will eventually vanish, which will allow oil prices to continue their trek higher.
That could be bad news for Valero Energy. As I pointed out in the counterarticle to this one, the important thing isn't the price of crude oil, but the price difference between crude oil and the products (fuels, petrochemicals, asphalts, and the like) coming out at the other end. Prices of the latter typically follow the price of crude oil very closely, but refiners can sometimes manage to sell into disadvantaged markets struggling with higher-priced oil to create valuable revenue streams.
Unfortunately, that doesn't always happen. While the Brent Crude to West Texas Intermediate, or WTI, spread is high now (meaning the scenario above is more likely), the closer the two benchmarks get the less favorable market conditions become for refiners. Consider what happened to Valero Energy stock the last time oil prices rose higher and the Brent-WTI spread was close to zero.
It seems likely that North American crude will continue to keep its edge (a positive Brent-WTI spread) in global markets, but cheap crude coming out of the North Sea could weigh on the trend.
What does it mean for investors?
While I think Valero Energy is poised for long-term growth and has the potential to continue creating market-beating returns for shareholders, there are always threats and risks to every investment opportunity. Remember: Mr. Market or Wall Street analysts could punish the stock for various reasons, whether based on sound reasoning or knee-jerk reactions. I wouldn't get too caught up in the day-to-day movements of Valero Energy stock or commodities in general, but I would certainly acknowledge the "what ifs" before creating or adding to a position.
The article 3 Reasons Valero Energy Corporation Stock Could Fall originally appeared on Fool.com.
Maxx Chatsko has no position in any stocks mentioned. Check out hispersonal portfolio,CAPS page,previous writingfor The Motley Fool, and follow him on Twitter to keep up with developments in the synthetic biology field.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.
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