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TSO > SEC Filings for TSO > Form 10-Q on 1-Nov-2012All Recent SEC Filings

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Form 10-Q for TESORO CORP /NEW/


1-Nov-2012

Quarterly Report


ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Those statements in this section that are not historical in nature should be deemed forward-looking statements that are inherently uncertain. See "Important Information Regarding Forward-Looking Statements" on page 53 for a discussion of the factors that could cause actual results to differ materially from those projected in these statements. This section should be read in conjunction with Management's Discussion and Analysis of Financial Condition and Results of Operations in our Annual Report on Form 10-K for the year ended December 31, 2011.

BUSINESS STRATEGY AND OVERVIEW

Strategy and Goals

Our vision is to be the premier low-cost supplier of transportation fuels in the refining and marketing business within our markets, providing value for our customers, while delivering industry leading returns for our shareholders and conducting ourselves responsibly in the communities in which we operate. To achieve these goals we are pursuing the following strategic priorities:

• improve operational efficiency and effectiveness by focusing on safety and reliability, system improvements and cost leadership;

• drive commercial excellence by strengthening our supply and trading activities to provide additional value to the business;

• strengthen our financial position by exercising capital discipline and focusing on improving our liquidity; and

• capture value-driven growth through a focus on our logistics assets, growing our marketing business and other strategic opportunities accretive to shareholder value.

Our goals were focused on these strategic priorities and we accomplished the following in the first nine months of 2012:

                                                      Operational                        Value
                                                     Efficiency &  Commercial Financial  Driven
                                                     Effectiveness Excellence Discipline Growth
Decreased manufacturing costs per barrel by
approximately 5% compared to the first nine months         l
of 2011
Leveraged our logistics operations to strategically
source lower cost crude oil and place refined                          l
products
Completed the expansion of our North Dakota
refinery, planned turnaround activity at our
Martinez, Hawaii and Alaska refineries and made            l                               l
significant progress on our large capital refinery
projects
Purchased shares of common stock to offset the
dilutive effects of new stock-based compensation                                  l
awards granted in 2012
Strengthened refining and marketing integration with
the acquisition of 49 retail stations and the                                              l
successful transition of 174 leased retail stations
Completed sales of the Martinez crude oil marine
terminal and the Long Beach marine terminal and Los                                        l
Angeles short-haul pipelines to TLLP
Established a $500 million share repurchase program
and initiated a quarterly cash dividend to return                                 l
excess cash to shareholders
Redeemed the remaining outstanding 6.250% Senior
Notes due 2012, 6.625% Senior Notes due 2015 and
6.500% Senior Notes due 2017, and completed the                                   l
issuance of $925 million aggregate principal amount
of the 4.250% Senior Notes due 2017 and 5.375%
Senior Notes due 2022
Entered into an agreement to purchase BP's
integrated Southern California Refining and                l           l          l        l
Marketing business


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Tesoro Logistics LP

At September 30, 2012, we held an approximate 53% interest in Tesoro Logistics LP ("TLLP"), including a 2% interest in the general partner. TLLP was formed to own, operate, develop and acquire logistics assets to gather crude oil and distribute, transport and store crude oil and refined products. Tesoro Logistics GP, LLC ("TLGP"), a 100% consolidated subsidiary, serves as the general partner of TLLP. As of September 30, 2012, TLLP's assets consist of a crude oil gathering system in the Bakken Shale/Williston Basin area of North Dakota and Montana, eight refined products terminals in the midwestern and western United States, two marine terminals, storage tanks and short-haul pipelines in California, a crude oil and refined products storage facility and five related short-haul pipelines in Utah.

Effective April 1, 2012, Tesoro entered into a transaction (the "Martinez Marine Terminal Sale") to sell to TLLP the Martinez crude oil marine terminal assets (collectively, the "Martinez Crude Oil Marine Terminal") and associated pipelines for $75 million, comprised of $67.5 million in cash financed with borrowings under the senior secured revolving credit agreement ("TLLP Revolving Credit Facility") and the issuance of equity with a fair value of $7.5 million. The Martinez Crude Oil Marine Terminal consists of a single-berth dock, five crude oil storage tanks with a combined storage capacity of 425,000 barrels, two firewater tanks with 48,000 barrels of shell capacity and related pipelines that receive crude oil from third-party marine vessels for delivery to our Martinez refinery and a third-party terminal. Total throughput capacity for the Martinez Crude Oil Marine Terminal is estimated to be approximately 145 thousand barrels per day ("Mbpd").

Effective September 14, 2012, Tesoro entered into a transaction (the "Long Beach Assets Sale") to sell to TLLP the Long Beach marine terminal assets and related short-haul pipelines, including the Los Angeles ("LA") short-haul pipelines (collectively, the "Long Beach Assets"), in exchange for total consideration from TLLP of $210 million, comprised of $189 million in cash financed with borrowings under TLLP's private placement debt offering and the issuance of TLLP equity with a fair value of $21 million. These assets, located near our Wilmington refinery, consist of a two-vessel berth dock leased from the City of Long Beach, six storage tanks with a combined capacity of 235,000 barrels and six related pipelines with 70 Mbpd throughput capacity connecting our Wilmington refinery to the marine terminal and other third-party facilities.

Effective September 14, 2012, TLLP completed a private offering of $350 million aggregate principal amount of 5.875% Senior Notes due 2020 ("TLLP 2020 Notes"). The proceeds of this offering were used to fund the acquisition of TLLP's Long Beach Assets and to repay the outstanding balance on the TLLP Revolving Credit Facility, with the remaining amounts to be used for general partnership purposes.

On October 5, 2012, TLLP closed an offering ("TLLP Equity Issuance") of 4,255,000 common units at a public offering price of $41.80 per unit, which included a 555,000 unit over-allotment option that was exercised by the underwriters. Net proceeds to TLLP from the sale of the units were approximately $171 million. Subsequent to the TLLP Equity Issuance, we owned an approximate 47% interest in TLLP, including an approximate 2% general partner interest.

Unit Train Unloading Facility

We intend to offer the Anacortes, Washington unit train unloading facility to TLLP in the fourth quarter of 2012. We expect to deliver an average of approximately 40 Mbpd in the fourth quarter of 2012 and up to 50 Mbpd by mid-2013 of Bakken crude oil through this facility to our Washington refinery. The construction of the facility was substantially completed in the third quarter of 2012.

Completion of North Dakota Refinery Expansion

We completed a project to expand the crude oil throughput capacity at our Mandan, North Dakota refinery from 58 to 68 Mbpd. The expansion allows the refinery to process additional crude oil from the nearby Bakken Shale/Williston Basin area delivered via the TLLP High Plains System (the "High Plains System").

Labor Negotiations

In June 2012, we completed the negotiation of the collective bargaining agreements covering approximately 1,300 full-time represented employees at the six of our seven refineries covered by collective bargaining agreements. The agreements for approximately 1,060 of the employees will expire in the first quarter of 2015. The agreements covering the remaining employees will expire in the second quarter of 2015. We believe that the contracts ratified at these refineries are fair, competitive and consistent with other national agreements accepted by the United Steelworkers union.


Table of Contents

Hawaii Operations

In January 2012, we announced that we intend to sell our Hawaii operations as part of our strategy to focus on the Mid-Continent and West Coast markets. These assets include our 94 Mbpd Kapolei refinery, 31 retail stations and the associated logistical assets.

Acquisition of BP's Southern California Refining and Marketing Business

On August 8, 2012, we entered into a purchase and sale agreement with BP West Coast Products, LLC and certain other sellers to purchase BP's integrated Southern California refining and marketing business ("BP Acquisition"). The assets to be acquired include BP's 266 Mbpd Carson refinery located adjacent to our Wilmington refinery, three marine terminals, four land storage terminals, over one hundred miles of pipelines, four product marketing terminals and approximately 800 dealer-operated retail stations in Southern California, Nevada and Arizona. In addition, the assets include the ARCO® brand and associated registered trademarks, as well as a master franchisee license for the ampm® convenience store brand. Additionally, we will acquire the sellers' 51% ownership in the 400 megawatt gas fueled Watson cogeneration facility; and also a 350,000 metric ton per year anode coke calcining operation, both located near the Carson refinery. We expect to realize significant operational synergies through the integrated crude oil supply, enhanced optimization of intermediate feedstocks and product distribution costs, improvements in light product yield and reductions in manufacturing costs and stationary source air emissions.

The purchase price is $1.175 billion, plus the value of inventories at the time of closing. The purchase and sale agreement required an advance payment of $90 million to secure the acquisition. Upon the closing of the BP Acquisition, the sellers have agreed, subject to certain limitations, to retain certain obligations, responsibilities, liabilities, costs and expenses arising out of the pre-closing operations of the assets. We have agreed to assume certain obligations, responsibilities, liabilities, costs and expenses arising out of or incurred in connection with decrees, orders and settlements the sellers entered into with governmental and non-governmental entities prior to closing. We expect that upon closing the BP Acquisition, we will record certain assumed environmental liabilities. We do not expect such liabilities will have a material impact on our liquidity. The BP Acquisition, which is subject to customary closing conditions and will require approval from the Federal Trade Commission and the California Attorney General, is expected to close before mid-2013. The purchase and sale agreement provides for us to pay a break-up fee of up to $140 million in the event that we terminate the agreement (except for termination for specified reasons).

We intend to offer TLLP the integrated logistics system to be acquired in the BP Acquisition in multiple transactions during the first twelve months following the closing of the BP Acquisition. The integrated logistics system includes three marine terminals, four land storage terminals, over 100 miles of pipelines (including connected access to the Los Angeles International Airport) and four product marketing terminals.


Table of Contents

Industry Overview

Our profitability is heavily influenced by the cost of crude oil and the aggregate value of the products we make from that crude oil and is affected by changes in economic conditions and supply and demand balance. Product values and crude oil costs are set by the market and are outside of the control of independent refiners.

West Coast Average Key Commodity Prices and Differentials
(Dollars per barrel)

[[Image Removed]]

Crude Oil and Product Price Analysis

Nationwide unemployment fell to its lowest level in over three years at the end of the third quarter of 2012. In California, a key market area for Tesoro, unemployment dropped to 10.2% at the end of the third quarter of 2012, down from 11.7% at the end of the third quarter of 2011. The drop in unemployment, higher retail margins and unplanned refinery outages contributed to the improved market conditions on the U.S. West Coast. Additionally, emerging markets, primarily in Latin America, have provided an export opportunity for diesel and other light products.

Significant turnaround activity and unplanned refinery outages on the U.S. West Coast reduced production during the first nine months of 2012. The resulting low inventories supported U.S. West Coast benchmark gasoline and distillate margins during the third quarter of 2012. U.S. West Coast benchmark gasoline margins increased to about $19 per barrel in the third quarter of 2012, or a 92% increase from the third quarter of 2011. Similarly, U.S. West Coast diesel fuel margins rose 44% to nearly $23 per barrel, compared to the third quarter of 2011. Crude oil delivery disruptions and maintenance activities in our California region limited our realization of these improved benchmark margins.


Table of Contents

Mid-Continent Average Key Commodity Prices and Differentials
(Dollars per barrel)

[[Image Removed]]

Our Mid-Continent and Pacific Northwest refineries have benefited from processing crude oils from inland U.S. and Canada, many of which are priced off West Texas Intermediate ("WTI") crude oil. This benefit is a result of a significant discount on the price of these crude oils compared to the crude oils processed at our California and Mid-Pacific refineries, many of which are priced off Brent crude oil ("Brent"). Historically, the price of WTI crude oil was comparable to Brent, but beginning in 2011 WTI has priced at a significant discount to Brent.

The WTI discount to Brent decreased nearly $7 during the third quarter of 2012 to approximately $17 per barrel, compared to the third quarter of 2011. This decrease was offset by increased discounts during the third quarter of 2012 of Bakken and Canadian crude oil to WTI. We supply our North Dakota refinery exclusively with Bakken crude oil and our Washington refinery with Canadian Light Sweet crude oil. During the third quarter of 2012, the average discount of Bakken crude oil to WTI increased about $7 per barrel, compared to the third quarter of 2011. The average discount of Canadian Light Sweet crude oil to WTI increased approximately $6 per barrel during the third quarter of 2012 compared to the third quarter of 2011. We did not recognize the full benefit from these improved benchmark margins as pipeline constraints restricted the amount of Canadian crude oil we supplied to our Washington refinery in the third quarter of 2012.

Product Supply and Demand Factors

There are long-term factors, in addition to current market conditions, that may impact the supply and demand of refined products in the U.S. including:

• world crude oil prices;

• increased federal fuel efficiency standards for motor vehicles;

• increased volumes of renewable fuels, mandated by the Federal Clean Air Act;

• various regulations of greenhouse gas emissions from stationary and mobile sources by the U.S. Environmental Protection Agency ("EPA") pursuant to the Federal Clean Air Act and California statute;

• potential enactment of federal climate change legislation; and

• possible promulgation of national regulations relative to gasoline composition and ozone standards under the Federal Clean Air Act.


Table of Contents

RESULTS OF OPERATIONS

A discussion and analysis of the factors contributing to our results of operations is presented below. The accompanying condensed consolidated financial statements, together with the following information, are intended to provide investors with a reasonable basis for assessing our historical operations, but should not serve as the only criteria for predicting our future performance. Revenue and income generated by TLLP was not material to our consolidated results of operations.

Summary

Our net earnings were $273 million ($1.92 per diluted share) for the three months ended September 30, 2012 ("2012 Quarter"), compared with net earnings of $345 million ($2.39 per diluted share) for the three months ended September 30, 2011 ("2011 Quarter"). The decrease in net earnings of $72 million during the 2012 Quarter was primarily due to the following:

• an $89 million increase in stock and incentive-based compensation expense, primarily resulting from a significant increase in Tesoro's stock price during the 2012 Quarter as compared to the 2011 Quarter; and

• a $28 million increase in interest and financing costs primarily due to charges in the 2012 Quarter for premiums and debt issuance costs associated with the early redemption of our 6.625% Senior Notes and 6.500% Senior Notes.

The decrease in net earnings during the 2012 Quarter relative to the 2011 Quarter was partially offset by an increase in gross refining margins of $21 million driven by feedstock advantages partially offset by derivative losses and other losses as a result of crude oil delivery disruptions, maintenance activity and lower pricing for petroleum coke in California in the 2012 Quarter.

For the year-to-date periods, our net earnings were $716 million ($5.06 per diluted share) for the nine months ended September 30, 2012 ("2012 Period"), compared to net earnings of $670 million ($4.65 per diluted share) for the nine months ended September 30, 2011 ("2011 Period"). The increase in net earnings of $46 million during the 2012 Period was primarily due to the following:

• an increase in gross refining margins of $80 million driven by feedstock advantages partially offset by derivative losses in the 2012 Period;

• a $48 million impairment charge in the 2011 Period related to a change in scope of a capital project at our Wilmington refinery;

• a $41 million decrease in manufacturing costs related to lower energy costs during the 2012 Period; and

• a $26 million increase in retail segment operating income during the 2012 Period as a result of improved market conditions during 2012.

The increase in net earnings during the 2012 Period relative to the 2011 Period was partially offset by the following:

• a $78 million increase in stock and incentive-based compensation expense, primarily resulting from a significant increase in Tesoro's stock price during the 2012 Period as compared to the 2011 Period;

• $37 million of property and business interruption insurance recoveries related to the Washington refinery incident collected in the 2011 Period; and

• net expense of $18 million related to legal matters in the 2012 Period.


Table of Contents

Refining Segment
                                                  Three Months Ended September 30,           Nine Months Ended September 30,
                                                     2012                   2011                2012                 2011
                                                               (Dollars in millions except per barrel amounts)
Revenues
Refined products (a)                          $         8,451         $         7,745     $       23,793       $       21,650
Crude oil resales and other (b)                           171                     227                462                  568
Total Revenues                                $         8,622         $         7,972     $       24,255       $       22,218
Throughput (thousand barrels per day)
Heavy crude (c)                                           176                     188                164                  178
Light crude                                               413                     386                379                  369
Other feedstocks                                           37                      35                 35                   36
Total Throughput                                          626                     609                578                  583
% Heavy Crude Oil of Total Refining
Throughput (c)                                             28 %                    31 %               28 %                 31 %
Yield (thousand barrels per day)
Gasoline and gasoline blendstocks                         296                     293                282                  286
Jet fuel                                                   93                      82                 83                   79
Diesel fuel                                               150                     144                128                  134
Heavy fuel oils, residual products,
internally produced fuel and other                        121                     123                116                  116
Total Yield                                               660                     642                609                  615
Gross refining margin ($/throughput barrel)
(d)                                           $         18.32         $         18.43     $        17.11       $        16.53
Manufacturing Cost before Depreciation and
Amortization Expense ($/throughput barrel)
(d)                                           $          4.42         $          4.57     $         4.72       $         4.96


________________


(a) Refined products sales includes intersegment sales to our retail segment at prices, which approximate market of $1.6 billion and $1.3 billion for the three months ended September 30, 2012 and 2011, respectively, and $4.2 billion and $3.6 billion for the nine months ended September 30, 2012 and 2011, respectively.

(b) Crude oil resales and other includes third-party revenues earned by TLLP.

(c) We define heavy crude oil as crude oil with an American Petroleum Institute gravity of 24 degrees or less.

(d) Management uses gross refining margin per barrel to evaluate performance and compare profitability to other companies in the industry. There are a variety of ways to calculate gross refining margin per barrel; different companies may calculate it in different ways. We calculate gross refining margin per barrel by dividing gross refining margin (revenues less costs of feedstocks, purchased refined products, transportation and distribution) by total refining throughput. Management uses manufacturing costs per barrel to evaluate the efficiency of refining operations. There are a variety of ways to calculate manufacturing costs per barrel; different companies may calculate it in different ways. We calculate manufacturing costs per barrel by dividing manufacturing costs by total refining throughput. Management uses refined product sales margin per barrel to evaluate the profitability of manufactured and purchased refined products sales. There are a variety of ways to calculate refined product sales margin per barrel; different companies may calculate it in different ways. We calculate refined products sales margin per barrel by dividing refined product sales and refined product cost of sales by total refining throughput, and subtracting refined product cost of sales per barrel from refined product sales per barrel. Investors and analysts use these financial measures to help analyze and compare companies in the industry on the basis of operating performance. These financial measures should not be considered alternatives to segment operating income, revenues, costs of sales and operating expenses or any other measure of financial performance presented in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP").


Table of Contents

Refining Segment
                                                 Three Months Ended           Nine Months Ended
                                                    September 30,               September 30,
                                                  2012          2011          2012          2011
                                                 (Dollars in millions except per barrel amounts)
Segment Operating Income
Gross refining margin (e)                     $    1,055     $  1,034     $    2,711     $  2,631
Expenses
Manufacturing costs                                  254          256            748          789
Other operating expenses                              79           69            194          176
Selling, general and administrative expenses          12           16             31           32
Depreciation and amortization expense (f)             97           91            282          276
Loss on asset disposals and impairments                3            2             10           56
Segment Operating Income                      $      610     $    600     $    1,446     $  1,302
Refined Product Sales (thousand barrels per
day) (g)
Gasoline and gasoline blendstocks                    373          355            358          341
Jet fuel                                             108           94             98           90
Diesel fuel                                          176          152            153          140
Heavy fuel oils, residual products and other          83           86             84           82
Total Refined Product Sales                          740          687            693          653
Refined Product Sales Margin ($/barrel) (d)
(g)
Average sales price                           $   124.40     $ 122.78     $   125.52     $ 121.82
Average costs of sales                            109.18       109.13         112.46       108.93
Refined Product Sales Margin                  $    15.22     $  13.65     $    13.06     $  12.89


________________


(e) Consolidated gross refining margin combines gross refining margin for each of our regions adjusted for other amounts not directly attributable to a specific region. Other amounts resulted in an increase of $1 million for the three months ended September 30, 2011 and increases of $2 million and $4 million for the nine months ended September 30, 2012 and 2011, respectively. Gross refining margin includes the effect of intersegment sales to the retail segment at prices, which approximate market. Gross refining margin approximates total refining throughput multiplied by the gross refining margin per barrel.

(f) Includes manufacturing depreciation and amortization expense per throughput barrel of approximately $1.60 and $1.55 for the three months ended September 30, 2012 and 2011, respectively, and $1.69 and $1.66 for . . .

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