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Last night on my and subscription sites I laid out the case argued by Morgan Stanley for believing that distillate prices are heading higher in the face of a tight supplies for these refinery products. One of the refiners Morgan Stanley picked as a major recipient of that trend was Valero Energy (VLO.) The stock popped 4.1% today to $119.71 on Morgan Stanley’s call. I’m adding it to my Jubak Picks Portfolio as of tomorrow. I certainly would have preferred to catch the shares before their recent extreme strength but I think the stock has further to run as we move into the summer driving season in the United States and as international tensions widen the spread between international crude (Brent) and West Texas Intermediate. This is a relatively short-term call with a target price of $128 a share by October 2018. The shares pay a dividend yield of 2.76%.

In the first quarter Valero reported a 93,000 barrels a day year over year increase in refinery volume to 2.9 million barrels a day. Operating income from refining climbed to $762 million in the quarter, up $122 million on an adjusted basis from the first quarter of 2017. The key to higher operating income was stronger margins on distillate, exactly the trend that Morgan Stanley pointed to in its recommendation of the shares.

Besides the increased profit that Valero is likely to show from rising prices in any distillate supply squeeze, the company benefits when the spread between international Brent crude and West Texas Intermediate prices widen. (The companies big Gulf Coast refineries are ideally placed to take advantage of rising exports of refined products from the United States as a result of that spread in crude prices. The company exported about 13% of its refinery production in 2017 and I think that’s headed up under current conditions.) In late April the Brent/West Texas Intermediate spread was about $6.60 a barrel. Today the spread is $7.94 a barrel. I don’t anticipate it going a whole lot higher but I don’t see it narrowing significantly either in the short term. Which should result in higher margins for Valero.

The company has adopted a policy of returning 40% to 50% of adjusted net operating cash to shareholders through dividends and share buybacks. In the first quarter of 2018, the company saw a payout ratio of 57% in dividends and repurchased $320 million in shares. The policy will provide support to the share prices as operating cash increases in the next few quarters.

The company has told Wall Street that it plans a budget of $2.7 billion in capital spending for 2018. One project is the Sunrise Pipeline that would increase oil flows from the Permian Basin and thus relieve some of the bottlenecks from oil shale protection in that geology. Of course, those increased flows of relatively inexpensive Permian oil to Valero’s refineries figure into that capital spending budget.