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We have learned a lot from trying to understand how the profitability of some independent refiners behaves relative to refining margins, and maybe we will be similarly educated by trying to understand what is happening at Tesoro (NYSE:TSO), the independent refiner and retailer operating in the western third of the country.

By applying the same refining margin and refinery utilization model that we used with Valero Energy (NYSE:VLO) and Frontier Oil (NYSE:FTO), we get the following:

Keep in mind that we are working with NOI, which does not include corporate allocations, writeoffs, and other things that might affect EPS. R-squared for TSO for this relationship was 0.69 (1.0 being perfect) which is between Valero (.66) and Frontier (.82) and conceptually, that is about what the company is. They run 7 refineries out west, and are about three times bigger than Frontier, and they also do their own retailing out there, which gives them some of the attributes of Valero. They're still much smaller than Valero and there is no pipeline or ethanol situation ...

(Click to enlarge)

If you plot the NOI of these three companies for the last few years you get the expected result that VLO tends to make or lose a lot more than its smaller competitor FTO, which is what you would expect based on size, and also that TSO was able to still hang in there and make a little money in the fourth quarter of 2008 when their competitors were struggling. Since then, the struggle has been on the other foot, so to speak.

So what's going on?

If you look at two things, the feedstock usage and the product mix of the three companies, you get the following:

TSO is using a higher percentage of heavy crude, which makes sense because a higher percentage of its products come out of the lower end of the reactor, In periods, like now, when the differential between light and heavy crude is small, Their conversion costs are a bit lower than their competitors, also an artifact of product mix. TSO is also into jet fuel and what they call "other heavy oils" (they have operations in Alaska and Hawaii), and they were able to get that one last reasonable quarter out in 2008.

So, in the grand scheme of things, would you be happy to be an investor in TSO rather than the other two? Well, the overall refining margin situation has improved in the last quarter, as of this morning, the WTI/weighted average products crack was about $11.50 and that suggests that all things being equal, these guys "should" be able to make some money this quarter ... The model even suggests that a quarter like the third quarter of 2007 is possible when they made 34 cents a share. But, only the really optimistic analysts think that this will be the case.

There was a "reliability engineering" issue in early April, an explosion and fire at Anacortes WA that caused several fatalities, and caused the plant to be shut down. At current industry utilization rates, the lost production from this facility would approximately make TSO a breakeven company at the current margins according to reports, the plant will be shut down until September at least ...

TSO also has a number of other refinery turnarounds and other issues currently in play. Secondly, is the ongoing problem of the airline industry .... demand for jet fuel nationwide is down about 21 percent since 2008, which is the economists' definition of a major depression in this industry and with restructuring it may be a long time before this comes back, if ever.In fact, if you just look at the PADD V/West Coast production, which is where TSO is operating, jet fuel is down over 30% in that same period.

Tesoro recently appointed a new CEO and his options are tied to the stock price of TSO as of early May, and there is certainly nothing like getting in on the ground floor, because there is enormous upside potential. These guys do tend to overachieve when times are good, and because this stock is less diluted than its competitors there is a chance for some pretty significant earnings appreciation, like there is in the other companies in this thankless business.

So it comes down to a couple of things: What is the likelihood of an improvement in the airline industry (or the ability of the company to diversify out of it), and to what extent are the engineers and reliability people able to keep the system working? Weigh those risks against the possible upside. We will check back with them in the fall to see how they are doing.

Disclosure: No positions

Source: Tesoro: Outlook 'Up in the Air'