Valero Energy

Adjusted earnings soared to $3.7 billion from $714 million the year before, easily topping expectations, with global supply disruptions driving very strong refining results. Valero returned 59% of adjusted operating cash flow to shareholders as net debt/capital fell to 11%.

Why it matters: Shares are now up 91% year to date as ongoing refining disruptions in the Middle East and Russia are constraining global supply and driving margins toward record levels. As US refiners are largely protected from these disruptions, they are free to capitalize on the strong margin environment.

The bottom line: Our $190 fair value estimate and narrow-moat Rating are unchanged, leaving shares materially overvalued. We don't have an argument with the near-term outlook for continued strong margins, likely persisting into next year, or the quality of Valero's refining assets and management. However, we see share pricing is materially higher than midcycle margins for the duration of our forecast, which we view as unrealistic. To arrive at today's share price, we would have to increase our midcycle margin assumptions by about 45%. That is still about 40% lower than benchmark margins are expected to be for full-year 2026, demonstrating the strength of the current market.

Bulls say: Valero management articulated the bulls' view well on the call: midcycle refining margins will be structurally higher because product crack spreads are now being set by less efficient Northwest European hydroskimming margins rather than historical cracking margins. This is further reinforced by rising carbon credit costs, inflationary pressures on capital and operating expenses, and limited global refining capacity additions. Additionally, the case is bolstered by a bullish outlook for heavy sour crude discounts and persistently low global product inventories relative to resilient transportation fuel demand. In this situation, Valero will be a major beneficiary as one of the highest-quality US refiners.

The refining segment's adjusted operating income increased to $4.4 billion from $1.3 billion the year before as realized margins improved to $23.62/bbl from $12.35/bbl a year ago and $14.90/bbl in the first quarter. Operating costs fell to $4.70/bbl from $4.91/bbl last year. Ethanol and renewable diesel segments also posted material increases in earnings, contributing to the year-over-year improvement.

We are increasing our fair value estimate to $238 per share from $190 after updating our near-term margin forecast to reflect the latest market crack spreads, which reflect the impact of the war in Iran and between Ukraine and Russia. Our fair value estimate corresponds to a forward enterprise value/EBITDA multiple of 1.7 times our 2026 EBITDA forecast of $21.4 billion. Our valuation remains anchored to a return to midcycle conditions from currently elevated levels by the end of our forecast, leaving our fair value well below current share prices.

Our fair value estimate reflects our updated refining margin deck, which incorporates our long-term outlook for crude differentials. Our long-term outlook for the West Texas Intermediate/Brent differential is $5, and for the Light Louisiana Sweet/Brent differential is $2. We assume long-term Gulf Coast refining margins of $15 and adjust capture rates to reflect asset quality and investment.

Over the long term, we expect Valero to improve its margin capture rates across the portfolio as investments to improve yield and increase throughput of low-cost feedstock are completed in the coming years. We project per-barrel operating costs to hold relatively steady as natural gas prices remain relatively low over time.

Given the level of operating leverage in a refiner, our valuation depends heavily on our assumptions about refining margins. A significant improvement or deterioration in crack spreads—for example, due to more global refinery outages or a recession—could create substantial upside or downside in our valuation. Currently, futures curves imply record-level margins will persist through 2027 and remain high into 2028. We incorporate these higher margins into our forecast, but our fair value remains anchored on a return to midcycle levels by 2029 and beyond. Stronger-than-expected margins would likely lift shares, while demand destruction from high prices or a resumption of disruptions in the Middle East or Russia could weigh on refining margins and, in turn, Valero's shares.

In the next five years, the renewable diesel segment should contribute a greater share of earnings and cash flow. Based on current investment plans, it contributes about 10% of our fair value estimate.

Valero earns a narrow moat rating as it operates one of the higher-quality collections of refining assets among independent refiners. It is the most complex refiner in the US, with a weighted average complexity of 11.8. This complexity, combined with access to discounted heavy waterborne crude, has historically allowed Valero to realize a cost advantage by processing cheaper, lower-quality crude as feedstock, increasing realized margins. We expect this advantage to persist.

Meanwhile, Valero has invested in logistics assets and processing capacity to capture discounts associated with domestic light crude production. It can currently run more than 1.6 million barrels a day of domestic light crude through its system. By fully backing out more expensive foreign light crude imports and replacing them with discounted domestic light crude, Valero's crude slate is almost entirely cost-advantaged.

Valero also exports the most refined products among its peers. It currently has the capacity to export about 700 thousand barrels a day and could increase that amount if demand warrants it. It exported about 350 mb/d of product in 2024. Given our projections for the maintainability of export markets, this should remain a competitive advantage for Valero, enabling the firm to capture higher margins and maintain high utilization levels.

Valero has invested in projects to capitalize further on low gas prices. It invested in two hydrocrackers that use hydrogen, sourced from natural gas, to increase high-value product volume. As a result, we see low natural gas prices as a greater relative benefit for Valero.

We have incorporated environmental, social, and governance risk into our moat evaluation, but no risk is material or probable enough in the next 10 years to influence our narrow moat rating. A carbon tax might be implemented, which would likely affect demand, but not in the near term. Meanwhile, Valero is planning to reduce its carbon intensity through improved efficiencies, emissions offsets from ethanol production, and renewable fuels blending.

To address potential petroleum product demand destruction, reduce carbon intensity, and reinvest in growth, Valero has moved into renewables via its 50% ownership of Diamond Green Diesel. It currently has production capacity of 1.2 billion gallons per year after completing a 470 mmg/y expansion in late 2022. Given DGD’s use of low-carbon feedstock with higher associated credits, lack of a blend wall, and global blending mandates, renewable diesel offers Valero an opportunity to grow volumes and earnings and capitalize on existing competitive advantages. It also plans to start producing sustainable aviation fuel, a nonpetroleum alternative fuel billed as critical to decarbonizing air travel. The company estimates segment returns could exceed refining returns on capital, supporting our narrow moat rating.

Unlike other independent refiners, Valero does not own a listed master limited partnership to house its midstream assets after it bought out Valero Energy Partners in early 2019. Though now combined with its refining segment, Valero still owns 3,100 miles of pipelines, 130 million barrels of storage capacity, over 5,250 railcars, and over 50 docks, plus truck rack and terminal assets. It continues to invest in midstream assets to increase flexibility in feedstock and products. Previously held within Valero Energy Partners, these assets garner a narrow moat rating.

Valero enjoys a cost advantage thanks to its proximity to cost-advantaged light crude oil, ability to process discount heavy sour crude, and low operating cost from lower domestic natural gas prices.

Valero is investing in renewable diesel and sustainable aviation fuel, which should increase volumes and provide attractive returns, given global blending mandates and favorable renewable fuel credit treatment.

Management has committed to maintaining the dividend through the cycle while returning cash to shareholders with a specific target of 40%-50% of operating cash flow.

Growing EV adoption will destroy gasoline demand and leave Valero's refineries uneconomic, given the high portion of gasoline production.

The market continues to expect strong earnings recovery to above midcycle levels, which could prove overly optimistic in the event of economic weakness, resulting in a lower share price.

International refining capacity is growing, which will increase supply in the export market. This means US refiners may not be able to export as much refined product as necessary to balance the US market and support margins.