Relevant to HTE (which owns a refinery)
Goldman Sachs Oct 8
With $80 oil, 300 OSX, refiners have major upside potential
1. Refiners the biggest opportunity in energy sector. We believe investors should take advantage of investor obsession with traditional refining margin seasonality to add to positions over the next 4-6 weeks.
We see the refiners as overwhelmingly having the most favorable risk/reward among energy sub-sectors and reiterate our Attractive coverage view. Our favorite US refiners are Buy-rated Valero Energy and Sunoco, though we expect all four of our covered companies including Neutral-rated Frontier Oil and Tesoro to perform well.
2. $80 oil and 300 OSX are not consistent with depressed refining valuations. In our view, oil at $80/bbl and the OSX at 300 are not consistent with depressed refining sector share prices. Given our bullish commodity view for 4Q 2007 and 2008, we think the gap will close via a sharp rally in the refiners.
While trading is likely to remain choppy over the next 4-6 weeks during the remainder of the “shoulder months”, we do not believe the refiners will fall through mid-August lows in the absence of a meaningful sell-off in the S&P 500.
In terms of upside, we believe an $80/bbl oil price—which is our base-case forecast for 2008—is consistent with $14/bbl Gulf Coast 3:2:1 refining margins and 42% upside for refining equities on average to our 12-month target prices (based on asset value, P/E and cash flow valuation analyses; key risk is sustained lower commodity prices).
3. VLO “convergence trade” points to trading upside. We find that Valero Energy’s shares (adjusted for the level of the S&P 500) are strongly correlated with moves in the 2-year WTI strip and 1-year Gulf Coast 3:2:1 strip. At the moment, Valero’s share price looks very undervalued based on the current WTI 2-year strip and 1-year Gulf Coast 3:2:1 strip. Given the “convergence trade” nature of the analysis, the question for investors is whether the strip prices fall or Valero’s share price (relative to S&P 500) rises.
The current 2-year WTI strip is $76.50/bbl and the 1-year Gulf Coast 3:2:1 strip is $12.25/bbl, both of which are below our respective 2008 forecasts of $80/bbl and $14/bbl, respectively. As such, we believe Valero’s share price will rally at a minimum to levels consistent with the current commodity strip prices. However, with both crude oil and refining margins expected to rally further over the next year, we believe additional absolute upside exists in Valero shares.
