Over the past 60 days, the refining sector has experienced significant gains. However, due to concerns about valuation and risks associated with peaking margins, analyst groups like Bank of America have downgraded the industry as a whole. This raises the question of whether these companies are still a good investment at current prices.
While Bank of America’s viewpoints seem reasonable, it’s important to note that not all refiners are the same. In fact, when comparing the three largest refiners in the US (Marathon, Valero, and Phillips 66), you’ll find distinct differences in their business structures.
In this article, we will focus on two refiners, Phillips 66 (NYSE:PSX) and Valero (NYSE:VLO). Only one of these companies has the potential for long-term growth and warrants your investment, while the other is at greater risk of facing the challenges feared by Bank of America.
The Refiner’s Advantage
Since the pandemic, the refining industry has undergone significant changes. Refinery capacity has decreased to 2014 levels due to closures and underinvestment, leading to a shift in supply and demand and higher rates for refiners. As a result, refiners have posted outstanding financial results over the past 12-18 months.
Additionally, with the growing focus on renewable diesel and its environmental and economic benefits, major players in the industry are investing in renewable diesel projects to capture high margins offered by renewable credits. Some notable renewable diesel projects include Valero’s DGD 3 at Port Arthur, PSX’s Rodeo Renewed project, PBF’s St. Bernards facility, and Marathon’s Martinez Renewable Fuels facility.
Although the market may take some time to fully respond to these changes, the Energy Information Administration projects that crack spreads will remain elevated in 2023 before settling back to slightly higher levels by 2024.
So, does all of this indicate the demise or regression of the refinery sector? Let’s dive into Valero and Phillips 66 to find out.
Valero Energy: A Risky Investment
Valero, with a market cap of $46 billion, operates 15 refineries and has a renewable fuels segment consisting of two renewable diesel facilities and 12 ethanol plants. While Valero’s renewable initiatives show promise, their economic value is still uncertain.
Valero’s Q2 10-K report reveals that the renewable diesel and ethanol groups account for 12% of its operating income, indicating a contribution to the company’s bottom line. However, the profitability of the renewable fuels segment heavily relies on government incentives such as RIN credits, LCFS credits, and BTC credits. These incentives are subject to supply and demand fluctuations, and their value could decrease as more renewable projects come online.
Considering these factors and the gradual adoption of electric vehicles, which could reduce demand for conventional transportation fuels, Valero may face downward pressure in the medium term. While it currently has diversified revenue streams, the impact of declining crack spreads on its refining business may overshadow the potential gains from its renewable initiatives.
Phillips 66: A More Promising Investment
With a refining capacity of just under 2 billion BPD and around 2,500 gas stations, Phillips 66 has a diversified business model. Refining accounts for only about 50% of its income, with the remainder coming from its midstream segment, marketing, and chemical businesses.
What sets Phillips 66 apart is its strong presence in the midstream sector. It recently increased its ownership stake in DCP Midstream, which operates a vast network of pipelines used to transport crude oil, refined products, and natural gas to export terminals. This provides Phillips 66 with stable and diverse sources of revenue throughout the value chain, making it less reliant on refining margins.
Furthermore, Phillips 66 is on track to complete the Rodeo Renewed project, which will convert its existing refinery into a renewable diesel unit. This project has the potential for high-margin production, and Phillips 66 aims to generate an annual EBITDA of $700 million from it.
While the risks associated with declining crack spreads and government incentives also apply to Phillips 66, its diversified business model and focus on midstream operations make it a more stable and promising long-term investment compared to Valero.
Balance Sheet Comparison
Another important aspect to consider is the overall financial health of each company. Phillips 66 carries more debt obligations in the coming years that may impact its cash flow. In contrast, Valero has a stronger balance sheet with sufficient cash on hand to meet its debt obligations.
Overall, while both companies face risks related to declining crack spreads and renewable fuel incentives, Phillips 66’s diversified revenue streams and midstream presence make it a more desirable long-term investment. With anticipated growth in LNG and NGL exports, as well as the upcoming Rodeo Renewed project, Phillips 66 has the potential to outperform Valero in the long run. However, investors should closely monitor these risks and changes in market dynamics.
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