Prudential report on Refiners
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EQUITY RESEARCH
JANUARY 3, 2001
REFINERS - REDUCING RATINGS BASED ON VALUATION BUT REMAIN
OVERWEIGHTED
Independent Refiners Opinion
Michael Mayer • 650.320.1620 • michael_mayer@prusec.com Current: Accumulate
Andrew F. Rosenfeld • 650.320.1632 • andrew_rosenfeld@prusec.com Prior: Strong Buy
Risk: Low
HIGHLIGHTS
· Group outperformed 45 percentage points in 2000 (refiners up 35%, S&P 500 down 10%).
· Refining fundamentals remain very attractive, margins currently near all time highs.
· Expect margins and earnings to remain above normal in 2001, our EPS estimates are 5% above
consensus.
· Stocks now near our target prices, but still have 25% upside potential.
DISCUSSION
U.S. refining margins averaged $6.30/bbl in 2000, their highest average ever, and ended the year at
$9.20/bbl an all time high. The refiners tracked this surge in margins and rose 35% on average in 2000,
while the S&P 500 declined 10%. The sector is now discounting $4.70/bbl and the stocks are near our
target prices, which are based on normalizing $4.55/bbl, but still have 25% upside potential.
The fundamentals of the U.S. refining industry remain very attractive. A combination of very good
economic growth, reduced investment in new capacity, low product inventories, industry consolidation,
and more stringent product specifications led to a very strong increase in refining margins in 2000 to an
average of $6.30/bbl. This was the highest annual margin on record. We believe the fact that this
remarkable margin improvement was achieved against a backdrop of very high oil prices is further
evidence that the underlying economics of the business have improved substantially. Industry earnings
have followed margins, and we forecast them to more than triple in 2000 versus 1999.
We are forecasting a 15% drop in refining margins in 2001 to a still excellent $5.35/bbl, which is
18% higher than our normalized estimate of $4.55/bbl. However, we expect industry earnings to be
essentially flat versus 2000, with higher marketing margins and the full-year benefit of 2000 acquisitions
more than offsetting lower refining margins. There are no changes to our margin or earnings outlook.
While we expect margins to trend down, they should remain well above normal for the next 12 months
for the following reasons:
The expected downward trend in oil prices to an average $25/bbl this year compared with $30.25/bbl in
2000 should reduce feedstock costs. With product inventories lean, we think market conditions will most
likely allow refiners to reduce product selling prices at a slower rate than the drop in oil prices and thus
enjoy some margin expansion.
Heating oil inventories remain very low, virtually assuring excellent margins this winter. Refiners are
expected to produce more heating oil over the next few months at the expense of gasoline production.
This raises the probability that gasoline inventories will be low going into this year’s summer driving
season.
Significant refinery maintenance was deferred in 2000 as refiners struggled to manufacture sufficient
gasoline and heating oil in order to build inventories in 2000. We believe this increases the probability
of unscheduled downtime and supply disruptions in 2001.
Investment Conclusion: Reducing Ratings Based on Valuation But Remain Overweighted
While we forecast refining margins to trend down, they should remain well above normal for the next 12
months. This should lead to excellent earnings and very high free cash flow, resulting in substantial debt
reduction across the industry, as well as meaningful share buybacks.
The market has taken notice of these excellent margins, with refiners outperforming by 24 percentage
points over the past month (refiners up 17%, S&P 500 down 7%) and 45 percentage points in calendar
year 2000. The group is now near our target prices, based on normalized margins. The stocks could
trade through our target prices and approach our upside potential (up 25%) if the market became willing
to discount the high end of the margin range. Please see our reported dated September 18, 2000,
initiating coverage of the Refiners for a detailed discussion of our valuation model.
We are revising our company ratings based on recent price performance:
Sunoco is being downgraded to Accumulate from Strong Buy. It is now 4% below our target price of
$34 and has 24% upside potential.
Tosco is being downgraded to Hold from Accumulate. It is now 11% above our target price of $31 and
has 15% upside potential.
UDS is being downgraded to Hold from Accumulate. It is now 5% above our target price of $30 and has
26% upside potential.
Valero is being downgraded to Accumulate from Strong Buy. It is now 2% below our target price of
$37 and has 34% upside potential.
Recent Target Price Upside Potential
Refiners Rating Price $/sh %Chg $/sh %Chg
Sunoco (SUN)* Strg Buy to Accum $33 $34 4% $40 24%
Tosco (TOS) Accum to Hold 34 31 -11% 40 15%
UDS (UDS) Accum to Hold 31 30 -5% 39 26%
Valero (VLO) Strg Buy to Accum 36 37 2% 48 34%
*Sunoco does not include the effect from the discontinued lubricants operation
or the recent Aristech acquisition.
Source: Prudential Securities estimates.
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