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Why Refiners Deserve a Long Second Look


Spending $23 to fill up a station wagon, as I did the other day, is no one's idea of a good time. Unless you're an oil refiner. Companies that do the dirty work of turning crude into fuel are enjoying their best days in many years. Profits are surging. So are the stocks. Some, such as Holly (HOC) and Frontier (FTO), are up better than 85% this year. Ultramar Diamond Shamrock (UDS), which is set to merge with Valero Energy (VLO), has more than doubled in the past year.

So this must be the time to sell these stocks, right? Oil refiners' profit margins may soon top out, yet few in the industry see margins plunging to old lows. That bullish scenario--margins dropping back a bit, yet still remaining high--is hardly being credited on Wall Street. In a twist on the custom of companies tamping down Wall Street's earnings estimates, some refiners say analysts' forecasts are just too pessimistic.

Take Tesoro Petroleum (TSO). The Street expects the San Antonio company to earn $1.95 a share this year. Tesoro already earned 52 cents a share in the seasonally slow first quarter. It sees profit for the year of at least $2.40. In 2002, the Street thinks Tesoro will suffer a slide in earnings, to $1.41. Tesoro is eyeing $3. For Houston-based Frontier Oil, the analysts' consensus forecast of 2001 profit is $1.96 a share. "We will substantially beat that," Frontier CEO Jim Biggs told me. "The estimates are going to end up being way low."

Not every refiner is so openly bullish. Sunoco, which after the Valero-Ultramar merger will be the No. 2 independent, thinks the inherent volatility of commodity prices turns profit forecasts into so much guesswork. Yet not even Sunoco envisions refining margins swinging back down to 1999 levels. In the first quarter that year, Sunoco's main refining operation grossed just $2.04 per barrel. This year, the first quarter brought a margin of $7.80 per barrel, profitability that is persisting so far this spring.

The good times for refiners are flowing directly from one fact: As with electricity in California, the U.S. uses more gasoline than it can make. The nation's refineries have been running flat out, and although imports are climbing, inventories remain low. That's why the average price for a gallon of regular gas in early May topped $1.70, up from $1.46 a year ago. Since no one is planning to build refineries--1976 saw the last brand-new one--there's little slack in the production chain. It figures to be tightened further by new environmental rules that render some older refineries obsolete.

BIG DEALS. Some veteran investors, such as Vanguard Energy Fund's Ernst von Metzsch, think that if inventories build for the summer driving season and prices ease a bit, stocks of refiners may sell off their highs. Yet that would spell opportunity to von Metzsch, who already owns Ashland (AHX), Sunoco (SUN), and USX-Marathon, each with major refining stakes. They all look cheap to him given the high asset values implied in Phillips Petroleum's (P) $7 billion bid for Tosco and Valero's $6 billion Ultramar merger.

If Valero completes its deal, it will run neck-and-neck with Exxon Mobil (XOM) as the leading U.S. oil refiner, including 488,000 barrels a day in California. CEO Bill Greehey says Wall Street is out to lunch on the profit potential. "The analysts really are not keeping up with what's happening," he said. The Street sees Valero, assuming the deal goes through, earning $7.08 a share in 2002. Greehey told me Valero will earn at least $7.85. And he expects the companies this year to pump out $1 billion in "free" cash flow--that is, $1 billion after another $1 billion in capital spending.

Does this mean oil-refining stocks have nowhere to go but up? No, but look at it from this angle: Many people, myself included, would be sorry if Internet auctioneer eBay disappeared tomorrow. But if Valero's California refineries went poof, a persistent wailing would be audible from Left Coast to Right. The market values eBay at $17 billion. Valero and Ultramar's market values add up to $7 billion. Next time you pump gas, see if you don't think that's out of whack. By Robert Barker


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