The Economics of the Upstream Petroleum Industry
The economics of the petroleum extraction is overwhelmingly colored by the economic factors of depletion and commoditization. Due to the fact that production depletes limited natural resources, the upstream industry must constantly explore for and develop additional resources. Given that the capital investments required to replace depleted resources are usually quite significant in relation to operating costs, resource replacement is a primary driver of costs. Commoditization describes the lack of differentiation in upstream business models and their end products. As a direct result of commoditization, the value propositions of upstream businesses are strongly levered to external market conditions (i.e., namely prices). Taken together, high replacement costs and supplier susceptibility to external market conditions have resulted in endemically cyclical petroleum supplies and prices.
Valero Energy Corporation’s (VLO) conservative valuation reflects a history of and expectations for cyclical margin pressures, secular regulatory pressures, and a management regime which does not create excess long-term shareholder value.
Management has singled out asset drop-downs to company sponsored MLP, Valero Energy Partners (VLP), as the most promising avenue for unlocking shareholder value.
Although the value gap between VLO and VLP is real, unless management radically accelerates VLP’s financing trajectory, the drop-down strategy will not significantly drive excess returns for VLO shareholders.
Disproportionate focus on arbitraging market value dislocations could detract from more enduring drivers of long-term value such as distressed asset acquisitions and continuous rationalization of core refining and logistics assets.
VLO’s core refining assets are among the best positioned and most complex in the world. If competently utilized, these assets are worth significantly more than the company’s market capitalization.
In the world of investing and corporate finance, the Efficient Market Hypothesis (EMH) casts a long shadow. EMH states that a sufficiently liquid market reflects the “correct” price at all times. Since efficient markets factor in all known and relevant information at all times, it is therefore practically futile to attempt to predict the future direction of market prices. In other words, a blindfolded monkey throwing darts at the Wall Street Journal has about the same chance as beating the market averages as any professional investor. At one extreme, the founder of Vanguard Investments Jack Bogle revolutionized the mutual fund industry around cheap indexing, which he posited as the solution to efficient markets. At the other, Warren Buffet’s seminal essay, The Super-Investors of Graham and Doddes-ville, defends the notion that right-headed investors can carve out a significant edge [1. The Super-Investors of Graham and Doddes-ville]. In the middle, you have the greater majority of investors who will likely cede that both extremes contain some amount of the truth. Even 2013 Nobel Laureate Eugene Fama, of the University of Chicago Booth School of Business, who is credited with developing EMH, has stated that “[asset prices] are typically right and wrong about half the time” [2. The Super-Brainy Quote]. Being able to determine when they are right and when they are wrong is the holy grail to traders and investors alike. In order to investigate how correctly assets prices reflect all known information, we must develop an intuition and methodology for estimating the fair value of an asset. As we will discuss, just because a methodology is descriptive does not mean it is predictive (i.e., correlation does not imply causation). Continue reading →
After recently having completed testing on a general method of discounted cash flow (DCF) analysis for estimating a broad basket of stocks’ intrinsic values, I became more concerned with “quality”. While DCFs remain the foundation of any sound business valuation, I discovered they are highly sensitive to the assumptions and data used. Slightly changing a minute detail can drastically influence the result causing an attractive investment to all of sudden seem not so attractive and vice versa. While relative valuation methods were a natural alternative (Wall Street’s preferred choice, in fact) to circumvent the sensitivity issues, I was inclined to believe that an ability to define robust ‘quality factors’ would complement the ideological purity of the discounted cash flow approach much better. The purpose of this discussion is to demonstrate that a good company can indeed also be a good investment. Continue reading →