Valero Stays Committed to Dividend But Needs 2021 Demand Recovery
Valero reported earnings on October 22, recording its second straight quarterly loss as the refining industry continues to be upended by the pandemic.
Valero's refineries process crude oil into gasoline, diesel, jet fuel, and other products. With fewer people flying and driving during the virus outbreak, fuel demand remains around 15% below pre-crisis levels.
Meanwhile, Valero's feedstock costs have lost some of their advantage. Many of Valero's assets are located around the U.S. Gulf Coast where domestic energy production grew faster than takeaway capacity for most of the past decade.
Given its close proximity to this abundant source of landlocked supply, Valero could buy oil at a discount compared to benchmark crude oils such as WTI and Brent.
But the downturn in commodity prices has caused U.S. shale producers to pull back on drilling, causing domestic oil production to fall and oil spreads to narrow.
As a result of these pressures, Valero's refining margin per barrel of throughput fell to $4.10 in the third quarter, down from $10 in the prior-year period and below even the lows of 2007-09 financial crisis.
Source: Simply Safe Dividends, Valero Filings
Despite this extremely challenging backdrop and expectations for operating losses to continue in the short term, Valero is sticking with its dividend.
"We basically feel we're a long way from rethinking the dividend. At the end of September, you all saw we had a little over $4 billion in cash and about $5.7 billion of liquidity available under our committed facilities. We saw positive signs in the third quarter, demand improved, export volumes picked up. So we think things are headed in the right direction. It's just a question of how fast. Of course, the vaccine would really accelerate things along.
"But looking bigger picture, this pandemic is an isolated event, and we're very reluctant to revise our long-term capital allocation framework that served us well for so many years. With our cash and liquidity position and the way things appear to be headed right now, this time we just don't think adjusting the dividend is a step we're going to need to take."
– CFO Jason Fraser, 10/22/20 Q3 Earnings Call
Chairman and CEO Joe Gorder also stated that Valero is prepared to honor its dividend "even if the current low-margin environment persists for longer than currently anticipated."
Valero's dividend costs $400 million per quarter, so it's not a major drag on the company's nearly $10 billion of liquidity.
The firm's $4 billion of cash is above management's $2 billion target level as well, providing some cushion without needing to borrow more money.
Keeping the dividend also does not pose an immediate threat to Valero's investment grade credit status.
The company's BBB rating has a negative outlook from the ratings agencies due to a sluggish demand recovery but still sits two notches above junk.
"The view in April was that this would be a 1- to 2-quarter event with pretty full earnings recovery in the fourth quarter. That's what we were looking at. I think that was [the rating agencies'] view, too. But that was before the summer infection spikes hit and things clearly going to take more than getting back to absolute normal in the fourth quarter.
"And we really think that view – that there's going to be delayed recovery along with our new debt, which will – that will all lead to a longer period with elevated credit ratios. That's really what the negative outlook reflects. They look out the next 12 months, and are you going to have higher ratios than what they like in your regular baseline, and the answer is yes. And that is true. But it doesn't affect their view of us as an investment-grade credit longer term."
– CFO Jason Fraser
If necessary, management said they even see room to take on more debt without jeopardizing the company's investment grade rating.
That said, Valero can't wait forever for fuel demand and margins to recover.
Last quarter, Valero's adjusted operating cash flow loss, capital expenditures, and dividend burned through around $1 billion of cash.
If that run rate continued, Valero would fall below its minimum cash balance target by mid-2021 if it didn't borrow more, which would further stress its credit metrics.
The bottom line is that Valero appears to have the desire and financial capacity to continue supporting its dividend for at least the next few quarters.
However, if a recovery in fuel demand gets pushed out beyond the second half of 2021, then Valero may be forced to reevaluate its capital allocation framework.
We are maintaining the company's Borderline Safe Dividend Safety Score, but an investment in Valero is not for the faint of heart.
The stock could keep its dividend intact and appreciate significantly if a recovery comes in the near future.
After all, shares trade for just 7x Valero's average adjusted EPS over the last 10 years, down from a 20x multiple less than a year ago.
But excess capacity pressures and travel demand headwinds could weigh on the industry for longer than expected if consumer behaviors have changed more permanently than management suspects.
Valero, with its low-cost production and investment grade balance sheet, could be an interesting recovery idea for folks who have a high risk tolerance and remain optimistic about the long-term future of gasoline produced from fossil fuels.
However, most conservative income investors are best avoiding the volatile refining industry. We will continue monitoring Valero and provide updates as needed.
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