R&M and biofuels trading update--SUN now our favorite R&M; raising refining margin and EPS estimates; introducing ethanol price forecasts - Goldman Sachs - June 12, 2006
We are raising our 2006-2007 refining margin forecasts, introducing ethanol price estimates, and now consider Sunoco (IL/A) our top R&M pick. Our 2006/2007 R&M sector EPS estimates are now 19%/54% above consensus. While we see more upside in SUN on the basis of valuation, we think Valero and Tesoro (both IL/A) can also perform well. We continue to see small-cap R&Ms like Frontier (U/A) as over-valued versus peers and now recommend as part of our "relative value" portfolio a long position in SUN over FTO at a beta- neutral hedge ratio of $1 long SUN versus $0.50 short FTO. With finished gasoline output down 2.2% YTD, we expect refining and blending stock margins to remain at levels high enough to ration demand and stimulate imports. We differentiate demand rationing in a period of robust economic growth from voluntary demand reduction, with the former bullish for refined product prices.
GASOLINE SUPPLY DECLINES FUELING REFINING AND BLENDING MARGIN STRENGTH
Finished gasoline production has declined 2.2% over the first five months of 2006 compared with the same period last year. We attribute the weak output to the following: (1) the effective replacement of MTBE with ethanol has reduced conventional gasoline output owing to the greater challenge of meeting Reid Vapor Pressure (RVP) requirements with ethanol than MTBE; (2) greater maintenance activity in 2006 owing to the big changes in environmental regulations that need to be met; and (3) ongoing disruptions due to normal "unplanned" downtime plus the lingering effects of hurricanes Katrina and Rita.
The weakness in finished gasoline production relative to desired gasoline demand growth in light of strong economic activity we think places upward pressure on the need for blending components like ethanol as well as imports of finished gasoline and blending components from outside the United States. The large ramp-up in ethanol demand coupled with the logistical challenges of delivering ethanol produced primarily in the mid-western areas of the United States to the coasts where gasoline demand is highest has contributed to strong ethanol prices in 2006.
The tight supply situation has sparked a sharp rise in retail gasoline prices, which we think is necessary to ration demand. We believe analysts/investors that focus solely on apparently lackluster headline gasoline demand growth miss the bigger bullish picture. That is, demand cannot grow in excess of available supply, with available supply about flat this year including imports. Flattish supply will need to force a flattening in demand via a rise in prices. Given strong US economic growth, we think there is a desire for gasoline demand that is in excess of available supply, hence the sharp retail price rise that is needed to ration demand.
RAISING OUR 2006/2007 REFINING MARGIN FORECASTS
In light of the bullish supply and demand fundamentals for gasoline, we are raising our estimates for refining margins as highlighted in Exhibit 1. We now forecast that the benchmark Gulf Coast 3:2:1 refining margin will average $12/bbl in both 2006 and 2007 up from our previous forecast of approximately $10/bbl for both years. We note that our updated forecasts remain well short of current spot margins that are in excess of $15/bbl. However, we continue to expect seasonality in gasoline cracks, with a heightened volatility during the seasonally strong spring and summer period due to very tight supply/demand balances.
INTRODUCING INITIAL ETHANOL PRICE FORECASTS
Exhibit 1 also highlights our initial forecast for ethanol prices--what has now become the key gasoline blending component--as well as detailing the build-up of our ethanol price forecast based on our forecasts for West Texas Intermediate (WTI) spot oil, gasoline cracks, and the spread between ethanol and gasoline. In an environment where octane is in tight supply, we believe our ethanol price forecast relative to our underlying WTI spot oil and conventional gasoline crack assumptions could prove conservative. With that said, with ethanol a relatively new fuel to analyze for most Wall Street analysts/investors, we think a somewhat conservative bias is a good starting point.
The spread between ethanol and conventional gasoline has been volatile over time and we expect to be volatile in the future. However, we think over longer periods of time that ethanol will be able to at least maintain the $0.51 per gallon federal ethanol tax credit premium over conventional gasoline. This key assumption reflects our view that octane will continue to trade at a greater premium in the years ahead than it did in the 1990s owing in part due to the Renewable Fuels Standard (RFS) minimum required ethanol usage requirement (see Exhibit 2). While we expect substantial investments to be made in ethanol capacity in the years ahead, we see similarly sharp increases in ethanol demand based on both the RFS plus our expectation for limited conventional gasoline production growth until the end of this decade or early next decade. In other words, we see ethanol as both a blending fuel and a substitute fuel for traditional conventional gasoline.
SUNOCO NOW OUR FAVORITE R&M EQUITY AND RECOMMENDED AS PART OF A PAIRS TRADE OVER FRONTIER; TRADING RALLY ALSO EXPECTED IN VALERO AND TESORO
Exhibit 3 highlights our updated EPS estimates for our R&M coverage universe. Our 2006 and 2007 EPS estimates are 19% and 54% above the corresponding First Call consensus forecasts for our R&M coverage universe.
We now consider Sunoco to be our favorite IL/A-rated R&M equity. The stock is down 15% in 2006 and is in the fourth quartile of energy sector relative stock price performance. By comparison, Frontier Oil is up 40% in 2006, Valero has risen 15%, and Tesoro has gained 5%. We attribute Sunoco's lagging performance this year to relatively weaker 1Q 2006 earnings results owing to refinery downtime and weakness in certain non-refining businesses plus some give-back in performance following a previous period of strong outperformance. However, with better earnings performance expected in 2Q 2006, Sunoco's now slightly discounted EV/DACF valuation versus a more typical slight premium we think points to greater upside in its shares versus other R&Ms (see Exhibit 4). We note that Sunoco has a large stable of non-refining businesses in comparison to the other R&M companies we cover, somewhat reducing its earnings and share price volatility versus peers. In addition, we feel Sunoco is the most committed of the R&Ms to returning excess cash to investors via dividends and stock buyback. The combination of somewhat lower volatility and strong shareholder focus we think contributes to it typically trading at a premium valuation.
Relative to traditional peak values that reflect a $7/bbl equivalent benchmark Gulf Coast 3:2:1 refining margin, we see 44% upside for Sunoco to a $94 value, 15% upside for Valero Energy to a $68 value, and 16% upside for Tesoro to a $74 value. All three stocks we think can perform well over the next few quarters driven by strong refining margins and the need for the Street to raise EPS forecasts.
We continue to believe small-cap R&Ms like Frontier are over-valued relative to larger peers, though underlying earnings fundamentals are similarly bullish for small-cap R&Ms as is the case for large-caps. We see 19% downside for Frontier to a $42 traditional peak value calculated in a manner similar to other R&Ms. We think the likely source of our less favorable view of Frontier versus the Street is in our view of the duration of wide light-heavy spreads currently reflected in Frontier earnings (see our May 8, 2006 note, "Frontier Oil: Large valuation premium over R&M peers unsustainable; maintain U/A" Message 22432668 ). It is not so much that we think Canadian light-heavy spreads--which we see as a proxy for Frontier's overall advantaged crude slate--will be narrower than what the Street expects, but rather that we do not think a similar long duration of margin strength is built into the large-cap R&Ms. In other words, investors appear to be assuming the period of strong margins and light-heavy spreads is longer lasting for small-cap R&Ms than large-caps, an illogical assumption in our view.
We are adding a long position in Sunoco versus a short position in Frontier to our "relative value" portfolio at a beta-neutral hedge ratio of $1 long SUN for every $0.50 short FTO. We note that given the broad market and R&M sector pull-back, it is possible that should the sector bounce back that Frontier could outperform on the initial bounce, providing further support for using the beta-neutral hedge ratio. However, given our favorable outlook for Sunoco as well as our view that Frontier' valuation is very expensive versus Sunoco, we are comfortable putting on the trade today, fully cognizant of bounce back risk.
As per our practice, the recommended Sunoco versus Frontier trade will take effect using June 13 closing stock prices since this note has been published before the open on June 13. Since inception on April 5 (and therefore using April 6 closing stock prices), our relative value portfolio has returned +2.1%. By way of comparison, the S&P 500 has returned -3.8%, the energy stocks in the S&P 500 -7.0%, and the utility index +3.8% over the same time period. Not surprisingly, our "relative value" portfolio has tended to lag long only benchmarks during periods of upside volatility, while performing better during periods of downside volatility. Other ongoing recommended trades within the "relative value" portfolio include long Nexen over Petro-Canada as well as our ConocoPhillips structured trade (see our April 3, 2006 report, "Conoco preferred over R&Ms for refining exposure" Message 22322575 ).
Our ConocoPhillips structured trade is intended to highlight Conoco's inexpensive implied R&M valuation by shorting a basket of E&Ps at a $0.45 weighting and Valero at a $0.15 weighting relative to a $1 long position in Conoco. Note, we have a favorable fundamental view of many E&Ps as well as Valero. As such, some investors may prefer to simply be long Conoco, which we also recommend.
R&Ms AS A SECTOR CONTINUE TO SHOW LESS UPSIDE THAN DO E&Ps OR DOMESTIC INTEGRATEDS, BUT A TRADING RALLY SEEMS IN ORDER
While we have a bullish fundamental outlook for refining margins and R&M equities, on a relative basis we continue to see even greater upside in the E&P and domestic integrated oil sub-sectors. However, we think a trading rally in R&Ms could be in order given the strong upward bias to consensus 2006 and 2007 EPS revisions and in the case of Sunoco as making up for its lagging performance this year. The one short-term trading issue that could weigh against R&Ms is the slew of ethanol-related initial public offerings (IPOs) expected over the next several weeks and months. While not exactly a direct competitor to the R&Ms, we believe especially small-cap portfolio managers may choose to lighten up on small-cap R&M equities to the extent there is a desire to hold any of the new ethanol equities. The potential for this to occur further fuels our unfavorable view of Frontier's relative valuation.
Given the ongoing broader equity market weakness and "de-risking" trade sparked by concerns over potentially slowing economic growth, we think a pairs trading strategy is more appropriate for investors that are uncertain as to the future trend in economic growth. Investors confident in future economic growth we think would likely prefer a long only strategy to the R&Ms and for that matter the broader energy sector, while investors believing we are headed toward recession would likely want to avoid the sector altogether. Our own view is that the combination of supply, demand, spare capacity, and geopolitical turmoil point to a continued bullish outlook for the energy sector; hence our Attractive coverage view.
UPDATED ESTIMATES
We have updated our 2Q, 3Q, 4Q 2006, and full-year 2006-2010 EPS estimates for Frontier, Sunoco, Tesoro, and Valero based on updated refining margin and light-heavy crude differential assumptions, and minor other adjustments.
For Frontier, our updated EPS estimates now stand at $1.50 ($1.37 before), $1.87 ($1.64 before), $1.27 ($1.16 before), $5.64 ($5.19 before), $6.25 ($5.60 before), $1.60 ($1.07 before), $1.87 ($1.14 before), and $2.18 ($1.22 before) for 2Q-4Q 2006 and full-year 2006-2010, respectively.
For Sunoco, our updated EPS estimates now stand at $2.75 ($2.14 before), $3.70 ($2.50 before), $2.19 ($1.78 before), $9.21 ($7.00 before), $11.65 ($8.50 before), $4.45 ($4.35 before), $4.86 ($4.70 before), and $5.44 ($5.15 before) for 2Q-4Q 2006 and full-year 2006-2010, respectively.
For Tesoro, our updated EPS estimates now stand at $4.10 ($1.95 before), $4.10 ($3.26 before), $1.05 ($2.76 before), $9.91 ($8.60 before), $11.20 ($11.15 before), $3.35 ($3.30 before), $3.52 ($3.45 before), and $3.67 ($3.60 before) for 2Q-4Q 2006 and full-year 2006-2010, respectively.
For Valero, our updated EPS estimates now stand at $3.20 ($2.15 before), $3.30 ($2.47 before), $2.26 ($2.13 before), $10.07 ($8.05 before), $11.50 ($8.60 before), $3.75 ($3.35 before), $3.95 ($3.50 before), and $4.22 ($3.65 before) for 2Q-4Q 2006 and full-year 2006-2010, respectively.
Our estimates for 2008, 2009, and 2010 reflect our current "mid-cycle commodity price/margin assumptions (i.e., $5.00 per barrel Gulf Coast-WTI 3:2:1 refining margin and commensurate other regional refining margins) and are not intended as spot estimates.
Each of the analysts named below hereby certifies that, with respect to each subject company and its securities for which the analyst is responsible in this report, (1) all of the views expressed in this report accurately reflect his or her personal views about the subject companies and securities, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report: Arjun Murti, Luis Ahn. |
