Nothing About Breasts

By Eric J. Fry

The oil-stock sector has become a financial slaughterhouse
– grisly, chilling and littered with the carcasses of
herding animals.

Even so, the long-term investor with a strong stomach might
want to consider sifting through the "renderings" of the
sector to find tidbits worth salting away. One possible
tidbit might be Valero Energy Corp. (NYSE: VLO).

But before we examine VLO’s considerable virtues, let’s
take a stroll down memory lane…

"Soaring growth. High returns on equity. Entrenched
competitive position. Low price-earnings ratio. Name that
company," James Grant quizzed his readers in a September
2004 edition of Grant’s Interest Rate Observer. "Lennar
Corp. is the answer, but no points will be deducted from
students who answered, instead, Pulte Homes, D.R. Horton,
Centex Corp. or Toll Brothers, leaders all in the
homebuilding field."

"Neither would we, the editors of the Rude Awakening,
deduct points from students who had guessed Valero Energy,"
we remarked in our column of October 8, 2004.

"Curiously, Lennar and Valero share quite a bit in common,"
we continued. "For starters, the name of each company is
six letters long…but that’s just the beginning. Both
companies operate primarily in the Southeastern portion of
the United States. The stocks of both companies have
doubled since the end of 2001. Yet both still sell for less
than 9 times 2004 earnings. What’s more, the stocks of both
companies have rewarded their shareholders in the face of
widespread skepticism…"

However, we proceeded to observe, one principal difference
between the two stocks and suggested that Valero might
offer the preferable opportunity for investors.

"The home-building sector has a certain peak-of-cycle scent
to it," we asserted, "while the oil refining sector is
still sporting the blossoms of investment springtime…

"The long-term story for the nation’s refining industry
seems as favorable as the short-term story. Supply is the
problem. Homebuilders love to talk about the ‘scarcity’ of
land and the formidable barriers to entry in their
industry. They have a point. But finding vacant land is
easier than finding oil UNDER vacant land; and building a
3,000 square foot ‘starter home’ with a cute backyard is
much easier than building a 500,000 barrel-per day refinery
in anyone’s backyard.

"Bull markets are not created equal," we concluded. "The
bull markets in housing stocks and refining stocks, though
they have sprinted side-by-side for some time, are unlikely
to finish the race together."

Since our story appeared last fall, Valero has chalked up a
shareholder-pleasing 75% gain, or triple Lennar’s 25% gain.
Six months later, investors could justifiably ask
themselves whether Lennar presents a better opportunity
then Valero. After all, Lenner still sells for less than 10
times last year’s earnings and less than 8 times 2005
estimated earnings, if Wall Street’s optimistic guesses
prove correct. Valero, by comparison, sells for about 11
times last year’s earnings and 10 times estimated earnings.

But this is where the story becomes very interesting. The
earnings estimates for Lennar seem to be best case, while
those for VLO seem to be worst case. Wall Street analysts
could only expect Lennar’s earnings to jump 25% this year
if they also believed that rising interest rates will not
impede the housing boom. We are dubious. Even so, we
wouldn’t bet against Lennar’s continuing prosperity, but
we’d rather bet WITH Valero’s.

VLO, which reports earnings on April 21st, seems very
likely NOT to "pull an IBM" by falling well short of
estimates. Indeed, VLO seems a solid candidate to "beat the
number," thanks mostly to the phenomenon illustrated by the
chart below: So-called "sour" crude oil sells for ever-
deeper discounts to light, sweet crude.

"Valero is the top U.S. processor of ‘sour’ crude oil,"
CBSMarketwatch explains. "Its ability to turn that cheap,
high-sulfur, heavy crude into gasoline and other top-end
petroleum products is what’s spelled success for the
company. While other refiners typically compete for pricier
‘light, sweet’ crude that requires less effort to turn into
gasoline, Valero tooled its refineries to run a higher
percentage of viscous, smelly, sour grades. The strategy
has paid off in spades."

A year ago, a barrel of sour crude from Saudi Arabia sold
at a $4.50 discount to benchmark West Texas Intermediate, a
light, sweet crude. That discount has since nearly tripled
to $13.20 a barrel. It should be little surprise than that
the company’s CEO, William Greehey, has been stating, in
very clear English, that his company will earn more than
Wall Street expects – not every quarter, perhaps, but over
the next couple of years.

"We have given all the reasons why 2005 will be better,"
Greehey explained in a February interview, "and probably
the most compelling one is that sour-crude discounts, which
last year started out good but really got great at the end
of the year, are starting out this year twice as good as
they were last year.

"Why is there such a disparity between your earnings
outlook and analysts’ estimates?" the interviewer wondered.

"Analysts don’t realize how much of the heavy crudes we’re
processing and the big discounts we have." Greehey replied.
"We keep telling them the estimates for the quarter are
low, for the year they’re low, and they’ve been wrong every
single year. A lot of them will take a look at the last
five years and what the average margins were and they’ll
say that’s how your stock should be priced on a mid-cycle
earnings range and give that a multiple of 10. If you look
backward and don’t look forward you get the wrong answer
because capacity is getting tighter and more and more
heavy, sour crude is being produced and upgrading capacity
can’t keep up with it.

"So how much more will you make in 2005 vs. 2004?" the
interviewer pried.

"The number in 2005 is going to be big because of how much
our operating earnings are going to increase as a result of
these outstanding discounts that we have on [sour] crude
oil," Greehey predicted. "That’s the big story for the
year. We’ve also said our volumes are going to go up by
about 100,000 barrels a day, and strategic projects will
add another $175 million to operating income."

In other words, Valero seems well positioned to meet or
exceed Wall Street’s current earnings estimates. Nothing is
assured, of course. Over the last 60 days, Wall Street has
been ramping up its estimates fairly aggressively for
Valero, which makes an earnings "surprise" all the more
difficult to achieve. So we wouldn’t buy the stock on that
expectation. Rather, the stock seems cheap on the basis of
the next several quarters, if not years.

Net-net, VLO might not gain another 75% over the next six
months, but neither is it likely to be led to the
slaughterhouse.

Did You Notice…?
By Eric J. Fry

Civil unrest has finally arrived in China…over ecological
issues. What could be a more compelling sign of economic
progress?

"Thousands of people rioted this week in a village in
southeastern China," the New York Times reports,
"overturning police cars and driving away officers who had
tried to stop elderly villagers protesting against
pollution from nearby factories."

For the most part, citizens of developing countries are too
preoccupied with securing the food they eat to complain
about the air they breathe…no matter how foul it might
be. But as the wheels of progress turn, ecological concerns
become increasingly important to the masses. [We predicted
this very trend in the February 24th edition of the Rude
Awakening. See:

Dirty Deeds in China

At first, the citizenry protests relatively essential
causes like polluted air or filthy water. Eventually
however, the populace takes up more refined ecological
causes like the loss of timber lands or the slaughtering of
whales. Before long, the plight of endangered insects
becomes a focus of national attention.

We here at the Rude Awakening wouldn’t have it any other
way, of course. Why shouldn’t prosperity co-exist with all
of God’s creatures?

"The riot described in Huaxi Village is seen as a symptom
of the widening social unrest in the Chinese countryside
that has become a serious concern for government leaders,"
the Times notes. "Last year, tens of thousands of
protesters in western Sichuan Province clashed with the
police in a protest over a long-disputed dam project.
Smaller rural protests are becoming commonplace and are
often violent."

Bravo China!

Welcome to the Developed World.

And the Markets…