CHICAGO--(BUSINESS WIRE)--Fitch Ratings expects to rate Valero Energy Corporation's (NYSE: VLO) pending issuance of senior unsecured notes 'BBB'. Net proceeds from the issuance will be used for general corporate purposes, including the redemption of $750 million 6.125% 2017 notes and $200 million 7.2% 2017 notes.
Fitch currently rates Valero as follows:
--Issuer Default Rating (IDR) 'BBB';
--Unsecured credit facility 'BBB';
--Senior unsecured debt including industrial revenue bonds (IRBs) 'BBB'.
RATINGS RATIONALE
Valero's ratings reflect the company's size, diversification, and asset quality; advantaged cost position including access to discounted North American crudes and inexpensive power and shale gas; low mandatory capex requirements and strong free cash flow (FCF); good liquidity; and track record of defending the rating through dividend cuts and equity issuance.
These strengths are balanced by the historical volatility of the refining sector, which is prone to boom and bust periods; currently high refined product inventories in the U.S.; the removal of the crude export ban; unfavorable U.S. regulations that will cap domestic refined product demand; and exposure to volatile Renewable Identification Numbers (RINs) compliance costs. Distributions to shareholders have also been rising but Fitch expects these will not be debt-funded.
KEY RATING DRIVERS
SIZE, DIVERSIFICATION, AND ASSET QUALITY
Valero is the world's largest independent refiner with 15 refineries and approximately 3 million barrels per day (bpd) of throughput capacity. Outside of North America, the company owns the Pembroke refinery in Wales, UK, and the Montreal refinery in Quebec. Valero also retains significant leverage to heavy sour crude processing economics through its deep conversion refineries in the Gulf. Valero is one of North America's largest renewable fuel producers (11 ethanol plants totalling 1.4 billion gallons per year [gpy] of capacity, plus biodiesel production), and holds the 2% General Partner (GP) interest and a majority of Limited Partner units in Valero Energy Partners, its affiliated logistics MLP.
DISCOUNTS NARROW BUT ASSET QUALITY HOLDS UP
Key crude oil spreads have narrowed sharply due to the collapse in oil prices and repeal of the crude export ban. Brent-WTI is currently trading close to parity, versus levels as high as $20 in 2011-2012, removing a source of windfall profits for the industry.
While Valero has substantial flexibility to access these crudes (it can take up to 50% light sweet crude slate following recent investments in rail and topping capacity), it is less reliant on crude spreads for cash generation than other refiners. A key strength of VLO's diversified refining portfolio is its deep conversion coking capacity on the Gulf coast which is now in the money. VLO's coking units are economic when the discount between light sweet and heavy sour crudes increases. In the first half 2016, Maya's discount to Brent averaged 23%, implying strong coking economics. Increased availability of medium and heavy sour crudes in the Gulf may cause this to persist.
CAPEX AND FINANCIAL FLEXIBILITY
Valero's financial flexibility remains strong over our forecast period. Capex for 2016 is approximately $2.6 billion but the company's run-rate 'must-spend' capex (regulatory, environmental plus turnarounds) is in the $1.5 billion-$1.6 billion range. Discretionary spending is split between logistics and asset optimization (hydrocracker expansion, crude topping units, alkylation units).
RECENT FINANCIAL PERFORMANCE
Valero's recent financial performance has been solid. Latest 12 months (LTM) EBITDA at June 30, 2016, was approximately $6.9 billion, versus $8.3 billion in 2015. Fitch expects EBITDA is likely to weaken further from 2015 highs as the lingering impact of the warm El Nino winter pressure margins, particularly for distillates. Despite this, Valero's outlook is reasonably good and Fitch expects the company will be significantly FCF positive in 2016.
At June 30, 2016 (prior to the proposed issuance), VLO's consolidated debt stood at approximately $7.5 billion. This figure includes $314.1 million of VLP debt that is consolidated on VLO's balance sheet but is non-recourse to VLO and has no cross defaults with parent debt. VLO's consolidated debt/EBITDA was 1.1x, EBITDA/interest coverage was 16.2x, and funds from operations (FFO)/interest coverage was 13x. The company's LTM FCF was approximately $1.8 billion, comprising cash flow from operations of approximately $4.8 billion minus capex of $2.0 billion and dividends of $1.0 billion. These results included an unfavorable working capital swing of -$367 million linked to volatility in crude oil and other input prices.
It is important to note that VLO's consolidated metrics include VLP's results - including its debt - because of Valero's ownership of the controlling GP stake. However, when determining Valero's credit quality, Fitch expects to look primarily at VLO deconsolidated (standalone) metrics. Under our base case assumptions, VLO's deconsolidated leverage is expected to remain below 2x over the forecast period, consistent with an investment-grade rating for a refiner of this size and scale.
HIGHER SHAREHOLDER DISTRIBUTIONS
VLO has ramped up its shareholder-friendly activity over the last few years. The company currently targets 75% of its adjusted net income for shareholder distributions (dividends + buybacks). Dividends were a modest portion of net income at year-end (YE) 2015 (21%), with buybacks making up the remainder (approximately $2.8 billion). We expect the company will reduce buybacks significantly in the current year in line with lower crack spreads. It is also worth noting that in past downturns, Valero has cut its dividend to protect financial flexibility (including a 75% cut in 2009 and the issuance of stock). We expect the dividend policy could be revisited if a serious downturn were to take place.
VLP PROVIDES FUNDING OPTION
Fitch expects Valero's spun-off logistics MLP, Valero Energy Partners, LP (VLP), to provide a meaningful source of future liquidity to parent VLO through asset drop-downs, as well as a fast-growing stream of distributions up to its parent.
At June 30, 2016, Valero held 66.1% of VLP's common units as well as the 2% GP stake in VLP (which includes IDRs). A significant portion of VLO's discretionary capex of the past few years was spent on logistics investments that can potentially be dropped into an MLP structure. VLO currently has $1 billion in rateable EBITDA that may be dropped down to VLP at a tax-advantaged multiple, including pipelines, racks, terminals & storage, railcar, marine, and wholesale fuel marketing. Given recent transaction multiples of 8x-13x for logistics drop-downs, this could entail several billion in possible proceeds for the parent. However, as stated earlier, this is likely to be spread out over multiple years given VLP's small size and limited current capacity to absorb large transactions. At the end of August, Valero dropped down its Meraux and Three Rivers Terminal Services Businesses to VLP for total consideration of approximately $325 million.
KEY ASSUMPTIONS
Fitch's key assumptions within our rating case for the issuer include:
--WTI oil prices of $45/bbl in 2017, $55/bbl in 2018, and $65 in 2019;
--Crack spreads that revert to inflation-adjusted historical averages over the forecast period;
--2016 capex of $2.6 billion, stepping down to approximately $2.2 billion in 2018;
--VLO dividend growth of 10% starting in 2017;
--50/50 debt-equity funding of drop-downs and expansion projects at VLP.
RATING SENSITIVITIES
Positive: Future developments that may lead to positive rating actions include:
--Greater earnings diversification/evidence of lower cash flow volatility; and sustained debt/EBITDA leverage at or below approximately 1x on a deconsolidated basis.
Negative: Future developments that may lead to negative rating action include:
--A change in philosophy on use of the balance sheet, which could include debt-funded acquisitions or share buybacks;
--Sustained debt/EBITDA leverage above approximately 2.3x on a deconsolidated basis.
LIQUIDITY
Valero's liquidity was robust at the end of the second quarter of 2016 (2Q16), and included cash on hand of approximately $4.9 billion, three committed credit revolvers: a $3 billion unsecured revolver due November 2020 (approximately $2.9 billion available); a $750 million VLP revolver due December 2020 ($436 million available); a C$50 million revolver due November 2016 ($40 million available); a $1.3 billion A/R securitization facility due July 2017 ($1.1 billion available); as well as separate letter of credit (LoC) facilities. Excluding the VLP and LoC facilities, Valero's core liquidity at June 30, 2016 totalled approximately $9 billion.
Valero's near-term maturities are manageable. Pending maturities include $950 million due 2017, and nothing due 2018. Covenant restrictions on Valero's debt are light. There are no major financial covenants on existing unsecured debt, but Valero's main revolver had a consolidated net debt/capitalization ratio requirement of 60%. Other covenants include restrictions on secured debt (maximum of 15% of consolidated net tangible assets), limitations on mergers, a change in control clause, and a material adverse effect (MAE) clause. The change in control clause is triggered by ownership or more than 25% of voting power of the company. The revolver also allows for issuance of LoCs of up to $2 billion. None of VLO's debt or financing agreements contain rating triggers.
OTHER LIABILITIES
Valero's other obligations were modest. At YE 2015, its asset retirement obligation was $64 million versus $71 million in 2014. Long-term environmental liabilities declined to $231 million at YE 2015 versus $269 million the year prior. The deficit on the funded status of Valero's Pension Benefit Obligation (FV Pension Assets - PBO) decreased to $418 million in 2015 from $472 million at YE 2014. The main drivers included actuarial gains, and higher contributions from Valero. This shortfall is not material as a percentage of underlying cash flows. Valero's hedging program is limited and aimed at hedging physical commodity transactions (e.g. delays between crude loading and refined product sales, ethanol corn purchases), although it also has a small trading operation. In addition, Valero uses derivatives to manage FX risk. There are no investment-grade ratings triggers in any of its agreements.
Summary of Financial Statement Adjustments
Deconsolidated Leverage Forecast: In calculating forecasted deconsolidated debt/EBITDA, Fitch deducts VLP debt from total consolidated debt. To estimate deconsolidated VLO EBITDA, Fitch deducts VLP EBITDA and adds distributions from VLP to VLO.
Date of Relevant Rating Committee: July 18, 2016
Additional information is available on www.fitchratings.com.
Applicable Criteria
Corporate Rating Methodology - Including Short-Term Ratings and Parent and Subsidiary Linkage (pub. 17 Aug 2015)
https://www.fitchratings.com/site/re/869362
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