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Valero Remains Evenly Poised

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We are maintaining our Neutral recommendation on Texas-based Valero Energy Corporation (VLO - Free Report) , the largest independent refiner and marketer of petroleum products in the U.S.

Among all the independent refiners, Valero offers the most diversified refinery base with a capacity of 3.0 million barrels per day in its 16 refineries located throughout the U.S., Canada and the Caribbean.

Valero has sped up its investment level to reap benefits from the current high trend of oil price and tepid gas price environment. Major capital investments, primarily hydrocracker units at Port Arthur and St. Charles scheduled for completion by the end of 2012, could be key drivers for future growth and are expected to drive a significant improvement in 2013 earnings. These projects position Valero to increase its diesel production and diversify its market exposure.

Valero’s new hydrogen plants at the Memphis and McKee refineries were commissioned early in 2012. Major plant turnarounds also occurred at Wilmington. The completion of other significant projects like the Montreal products pipeline and the Diamond Green Diesel joint venture, are expected to improve free cash flow in 2013 and in turn fund share buyback.

The completion of the ongoing projects would mark the end of a series of major expansion programs. This is likely to result in a drop in capital expenditure by around 35% in 2013 and generate free cash flow of $1.9 billion. The incremental cash flow will provide the company with additional financial flexibility and increased shareholder value.

Major growth drivers for the balance of 2012 are expected from reinvestments in existing plants, improved demand, acquisitions, higher sour crude oil discounts, ongoing cost-cutting efforts, and continued expansion of its retail and ethanol operations. Valero’s ability to process cheaper sour and heavy oil gives it an additional competitive advantage.

However, being the largest independent refiner in the country, Valero remains particularly exposed to the ongoing unfavorable macro backdrop. Particularly, in Europe, Valero remains exposed to the difficult economic environment and deceleration of the capacity rationalization process.

Further, refiners in the U.S. generally face uncertainty regarding future regulations pertaining to greenhouse gas emissions and the potential for higher requirement of biofuels.

Other threats include government regulations, weather conditions, crude oil and natural gas prices, as well as renewable fuel prices. These can result in increased costs, reduced growth and fines or other sanctions.

Valero, which faces competition from Marathon Petroleum Corporation (MPC - Free Report) , holds a Zacks #3 Rank (short-term Hold rating).

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