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As oil falls, Valero should rise

With crude prices falling, the stock of the No. 1 independent refiner should benefit. Also: more on why speculators aren't to blame.

By Jon Birger, senior writer
Last Updated: August 6, 2008: 12:19 PM EDT

Valero's profit margins on refining should increase as gas prices fall.

NEW YORK (Fortune) -- Looking for a way to profit from falling oil prices?

Here's an easy one: buy Valero.

The nation's largest independent oil refiner, Valero (VLO, Fortune 500) has been stung this year by the rapid run-up in crude prices. In the oil biz, retail prices tend to be stickier than wholesale ones, which is a breezy way of saying the cost of Valero's raw material (i.e. crude oil) has been rising faster than what it can charge for its end product (gasoline).

As a result, Valero's second quarter profit fell 67%, to $734 million, or $1.37 a share, from $2.25 billion, or $3.89 per share, during the second quarter of 2007. Of course, what crimped Valero's earnings on the way up should help on the way down.

Since July 11, the price of crude oil has fallen 19% - from $147 to $119 a barrel. Meanwhile, retail gasoline prices are down only 6%, from a high of $4.11 a gallon to the current national average of $3.87, according to the motorist club AAA. (The decline in oil prices isn't exactly shocking - fuel prices often rise in late spring and early summer as refiners stock up for the summer driving season, only to fall in late summer and early fall.)

The bottom line is that the profit margin for Valero and for all oil refiners has widened significantly, yet Valero's stock price doesn't reflect that. Since July 2007, Valero's stock has cratered from $77 to $32 a share. (Disclosure: my track record with Valero is mixed. I recommended it at $9 in October 2001 in a Money magazine piece. Unfortunately, I also recommended it last fall at $69, before the oil boom took a bite out of refining margins.)

Valero now trades at a mere 7 times projected 2008 earnings. Analysts expect 2009 earnings to be up 21%, given the almost inevitable normalization in refining margins. Yes, gasoline demand could continue to slump a bit, but falling prices should slow, if not reverse, that trend. And longer term, it's not like a bunch of new refining capacity is going to come online and crimp Valero's margins. There hasn't been a refinery built in the United States since 1976.

Throw in Valero's 1.8% dividend yield, and you've got an attractive stock in an otherwise unattractive market.

Don't blame speculators

I've gotten quite a few, shall we say, skeptical responses from readers who doubt my argument that futures-market speculators have nothing to do with the price of oil.

A lot of my correspondents remain convinced that Wall Street is profiting from their pain.

Josh Glass, from Boyne City, Mich., sums up the argument this way: "Are the recently added speculators making money? Of course they are, or they wouldn't be there. It is completely wrong to allow investors who otherwise have no legitimate interest in commodities to enter the market. Any money they make gets passed down to the bottom rung, the consumer. Harvard University, with its much-touted $38 billion endowment fund, has no business jumping into oil futures just to make a quick million bucks that I pay for."

The problem with that argument: it's just not true that speculators are cleaning up. In fact, Merrill Lynch analyst Mary Ann Bartels writes in a recent report that they're not making any money at all. Over the past year, she found, the average commodity futures fund lost 5.85%.

One big reason: plenty of hedge fund managers didn't believe the run-up in oil prices could be sustained, and they were placing bets on prices going down.

Bartels' report echoes many of the findings found in a task force report from the Commodities Futures Trading Commission, issued in late July. When the task force examined non-public trading data for so-called swap dealers (traders such as investment banks) that handle transactions for institutional investors, they found no evidence that their activity was pushing prices up.

Rather, the CFTC found that the dealers "have held roughly balanced long and short positions in the crude oil markets over the last year and actually held a net short position over the first five months of 2008."  To top of page

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