Valero Braces for Unprecedented Drop in Fuel Demand
The coronavirus pandemic has sapped demand for gasoline and jet fuel as more people worldwide are told to stay home and avoid non-essential travel.
It's hard to say how long these restrictions will remain in place, but they have created a cloud of uncertainty over refineries, which primarily process crude oil into conventional and premium gasolines, diesel, jet fuel, and other products.
Source: Valero Investor Presentation
On March 17, Reuters reported that "margins for producing transportation fuels turned negative in Europe and Asia, and briefly did the same in the United States."
Simply put, this rapid demand destruction is unprecedented and even worse than what America experienced following September 11th.
As a result, fuel prices have fallen even faster than the plunge in oil prices, which would otherwise increase Valero's refining margins. It's unclear how long this environment will persist, and how severely it will impact Valero's profits.
As you can see below, the business has historically generated around $5 billion of operating cash flow (OCF) most years, and its dividend has increased significantly over the last decade.
Management plans to return 40% to 50% of OCF to shareholders, and the dividend consumed around 30% of OCF in 2018 and 2019.
Source: Simply Safe Dividends
During the financial crisis, Valero's OCF fell from $5.3 billion in 2007 to $1.8 billion in 2009, a 65% decline. Back then, oil prices and interest rates were higher, the refining industry was more fragmented, Valero's capital needs were higher, and its production was less efficient.
It's very difficult to say where Valero's OCF could end up this year given the unprecedented plunge in demand. If OCF is cut in half to about $2.7 billion this year, then Valero's dividend would consume nearly 60% of cash flow.
The company would also be about $1.4 billion short of covering both its $1.6 billion dividend and planned $2.5 billion of capital expenditures (of which $1.5 billion is sustaining capex).
The good news is that refiners plan for volatile cycles; it's the nature of their business.
As a result, Valero maintains relatively low leverage and earns a BBB credit rating from Standard & Poor's. The company's liquidity is also sound with $2.4 billion of cash and $5.3 billion of available borrowing capacity through its credit revolvers.
Source: Simply Safe Dividends
We estimate that the company could borrow $1.7 billion to reach a 30% net debt-to-capital ratio, which represents the high end of management's 20% to 30% target range.
This could possibly cover the firm's free cash flow deficit for perhaps a year, especially if growth capex is reduced and Valero's operations hold up better than they did in 2009.
The bad news is that Valero's balance sheet and liquidity position were in similar shape in early 2010, but management still decided to cut the dividend to preserve cash as weak fuel demand weighed on the company.
Here's what management said in October 2009:
"With respect to our balance sheet at the end of September, total debt was $7.4 billion. We ended the quarter with the cash balance of $1.6 billion. We had $4.5 billion of additional liquidity available both similar to last quarter. At the end of the quarter, our debt to cap ratio net of cash was 26.5% which is far below the credit facility covenant that requires a ratio below 60%.
As you can see, we continue to have a comfortable cash balance and plenty of liquidity. However, I think you all would agree that given the loss we incurred this quarter and the expectation of another loss in the fourth quarter, we may need to evaluate our dividend to pay out level. As stated in our last dividend release if industry's conditions do not improve measurably the dividend level will have to be reevaluated."
Management seems more committed to the dividend this time around as they try to prove that this Valero is a better cash generator and more resilient than the Valero of 10 years ago (and thus worth a higher valuation).
At a recent investor conference on March 2, CEO Joe Gorder made the following remark:
"The dividend yield that we're looking at here is extraordinarily high, I would say. If you had told me we'd be at a 5.5% dividend yield early in the year, I probably wouldn't have believed it. But with what we've had happen over the last week, it has created an incredible opportunity for an investor who's looking for yield because this dividend is very sustainable."
Admittedly, a lot has changed since then with demand cratering unlike ever before. Based on what we know today, a dividend cut in the near term would be surprising, especially given how long Valero took to reduce its dividend during the financial crisis (well after it was generating quarterly losses).
Given the firm's balance sheet and stronger commitment to the dividend, it would likely take bleaker operating conditions than 2009 to consider adjusting the dividend now rather than wait to see if better times are ahead after next quarter.
However, the bottom line is that the coronavirus pandemic has created sudden and significant demand uncertainty that is severely depressing the short-term profitability of refiners.
Since this shock could result in Valero needing to borrow money to fund its dividend, we are downgrading the company's Dividend Safety Score from a low Safe rating to Borderline Safe.
Valero reports earnings on April 23 and will have a better assessment of the coronavirus related demand impact at that time.
