Prudential Report on Refining Industry 4-3-03
HIGHLIGHTS
· Raising our 2003 refining margin forecast to $7.25/bbl from $4.65/bbl to reflect what we believe are
excellent industry fundamentals. This raises our average 2003 EPS estimates by 38%.
· Refining margins should remain well above normal this year due to improved demand, low inventories,
the lingering effects of the Venezuelan work stoppage, and anticipation of lower absolute crude and
product prices, which should keep refined product inventories near the bottom of the five year range for
the next several months.
· Introducing our 2004 refining margin forecast of $4.65/bbl and associated EPS estimates, reflecting our
view that refined product inventories will begin to be rebuilt towards the end of 2003.
· Raising target price for Tesoro to $14, reflecting improving balance sheet and reduced liquidity issues.
· Stocks appear fairly valued but expect prices to approach our upside potential prices, which are
discounted at a $6.00/bbl refining margin. Our top choices are the Buy rated stocks: Ashland, Tesoro,
and Valero.
DISCUSSION
Raising our 2003 Refining Margin Forecast To $7.25/bbl, Reflecting What We Believe Is An
Excellent Operating Environment. Our U.S. refining margin has averaged $7.84/bbl year-to-date
versus $4.27/bbl in the same period last year, marking a new seasonal high. Our new 2003 refining
margin estimate of $7.25/bbl is 56% higher than both last year and our normalized estimate of $4.65/bbl.
We believe that improving demand and a declining price curve (for both crude and refined products)
should keep refined product inventories near the bottom of their five-year range and be the catalysts for
higher refining margins and better downstream earnings in 2003.
While we expect refining margins to trend lower in the second half of 2003, they should remain well
above our normalized values this year due to the following reasons:
We believe that refined product demand will exceed supply this year; our preliminary estimates indicate
refinery capacity creep will be about 0.6% (the prior five-year average is 2.1%), which is well below our
forecast for U.S. demand growth of 1.7%. We expect higher operating rates and product imports will be
required to meet our forecast. However, our 2003 refined product demand growth forecast is below the
current 2003 Energy Information Administration (EIA) forecast of 2.5% growth, as we believe that the
relationship between GDP growth and refined product demand growth will be lower than the implied EIA
relationship.
Refined product inventories are now at a new seasonal low for their five-year range. While we expect
inventories to rebuild slightly now that the heavy first quarter maintenance schedule is complete, we
forecast them to remain in the bottom quarter of the five-year range.
In addition, if there are any major unplanned refinery outages, refining margins could increase rapidly due
to the current low inventory levels.
The expected downturn in oil prices to an average of $27.50/bbl this year, compared to the first quarter
average of $33.75/bbl, should reduce feedstock costs. With product inventories lean, we think market
conditions will most likely allow refiners to reduce product prices at a slower rate than the expected drop
in oil prices. In addition, a declining price curve (backwardation) provides no incentive for the refiners to
build and hold inventory.
However, the Venezuelan work stoppage has essentially ended and we now expect the Venezuelan
refineries to return to normal operation and begin exporting refined products.
California refining margins should remain strong due to reduced gasoline production, gasoline blending
problems, and gasoline logistical issues as a result of the ongoing conversion to the CARB III
specifications, which substitutes the gasoline additive ethanol for MTBE.
Introducing Our 2004 Refining Margin Forecast And Associated EPS Estimates.
We are also introducing our 2004 refining margin forecast of $4.65/bbl, which is the same as our
normalized refining margin estimate. This forecast rests on the following three assumptions: (1) refined
product demand will continue to improve; (2) refined product inventories will increase bringing them
towards the middle of their five-year range; and (3) normal weather patterns will prevail. Our normalized
refining margin and EPS forecasts remain unchanged.
Refining and Marketing Margin Estimates
2002 1Q:03E 2003E 2004E NormalizedE
Refining margins, $/bbl
Actual New Old New New
U.S. Average $4.64 $7.84 $4.65 $7.25 $4.65 $4.65
East Coast 3.25 7.76 4.00 6.40 4.00 4.00
Mid-Continent 5.87 8.71 5.30 8.50 5.30 5.30
Gulf Coast Cracking 2.78 6.37 2.55 5.25 2.55 2.55
Gulf Coast Coking 4.62 7.41 4.60 7.55 4.60 4.60
West Coast 7.28 9.83 8.00 9.50 8.00 8.00
Marketing margins,
$/gallon $0.093 $0.090 $0.094 NC $0.095 $0.095
Source: Reuters, EIA, and Prudential Securities estimates.
Our New 2003 EPS Estimates Are On Average 14% Above Consensus.
Our new EPS estimates are shown below. The posit ive effect of raising our refining margin assumptions
is partly offset by higher operating costs, primarily natural gas, and lower throughput during January and
February 2003. Our new 2003 estimates are about 14% above the current consensus estimates.
EPS Estimates
FY-2002 CY-1Q:03E 2003E 2004E NormalizedE
Adjusted EPS Actual New Old New New Old/New
Ashland* $1.83 ($0.55) $3.70 $4.00 $4.15 $4.50
Frontier 0.04 0.25 1.10 2.15 1.40 1.40
Premcor (0.22) 0.75 0.90 3.15 1.70 1.75
Sunoco (0.33) 0.95 2.55 4.20 3.25 3.90
Tesoro (1.83) 0.10 1.20 2.00 1.50 1.50/1.60
Valero 0.83 1.40 4.60 5.75 4.60 4.65
First Call Consensus EPS
Ashland* NA ($0.37) NA $2.98 $4.35 NA
Frontier NA 0.23 NA 2.11 2.12 NA
Premcor NA 0.81 NA 2.79 2.99 NA
Sunoco NA 0.94 NA 3.77 4.36 NA
Tesoro NA 0.03 NA 1.21 1.69 NA
Valero NA 1.27 NA 5.21 5.49 NA
*Ashland Fiscal Year ends September 30.
Source: Company reports, First Call, and Prudential Securities
estimates.
Raising Tesoro Target Price Due To Improving Fundamentals And Expectations Of An Improving
Balance Sheet. We are raising our Tesoro target price to $14 from $8, to reflect the company’s ability to
reduce debt with its increased cash flow, provided primarily by higher refining margins and increased
liquidity. At the time we initiated coverage on December 4, 2002, we believed Tesoro should be valued
at an approximate 55% discount to the rest of the refiners, reflecting a highly leveraged balance sheet and
limited financial flexibility.
Based on improving refining fundamentals and the company’s renewed efforts toward debt restructuring,
including a Moody’s Investor Services press release after the market close on April 2, 2003, we believe
the worst is behind Tesoro. The Moody’s Investor Services press release suggests Tesoro is in the
process of obtaining a new revolving credit facility for $650 million replacing the current $250 million
facility, enabling it to free up cash currently being used for working capital. In addition, we expect
Tesoro will refinance its term-A and B loans, which have an approximate outstanding balance of $840
million.
Our new target price of $14 is based on a 22% discount to the rest of the refiners and normalized cash
flow multiple, reflecting our view that Tesoro will remain the most leveraged refiner in the group.
Investment Conclusion: Fundamentals Appear Strong, Maintaining Group Rating of Market
Outperform Based on our view that we are in the early stages of a global refining margin recovery, we
rate the Refiners Market Outperform. We believe exc ellent fundamentals augur well for refining margins
to remain above normal this year. The fact that the current margin environment exists against a backdrop
of very high crude oil prices is further evidence that the underlying economics of the business have
improved substantially. Elevated refining margins should lead to excellent earnings and high free cash
flows, resulting in debt reduction across the industry as well as remove some of the uncertainty
surrounding refiners will fund the capital expenditure programs for low sulfur gasoline, low sulfur diesel,
and new source review legislation.
The refiners have outperformed by 12 percentage points (refiners up 13%, S&P 500 up 1%) since the
beginning of the year. The refiners are discounting $4.60/bbl, compared with the $3-$6/bbl range implicit
in our valuation model and the $4.65/bbl level reflected in our target prices. Our target prices are on
average 1% above current levels. Our top picks are Ashland, Tesoro, and Valero. Given our operating
outlook, we think the refiners could trade through our target prices and towards our upside potential
prices (which are discounted at a $6.00/bbl refining margins) if the market becomes willing to discount
today’s high margins.
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Above is nothing to do with E&P companies, but I figured I'd post it here anyway. I'm investing a lot in some refining stocks these days, since I believe that crude prices are gonna continue to soften going into the summer, whereas gasoline prices will stay high because demand will go up due to the summer driving season and a decent economy. My two favorites are Giant Industries (GI) and Tesoro Petroleum (TSO). |
