Opportunity in Tesoro: Aims to Reduce Costs, Increase Shareholder Value

| About: Tesoro Corporation (TSO)

Tesoro (NYSE:TSO) is a refiner and marketer of petroleum products. Its business operation has two segments, refining and retail. Tesoro refines both heavy and light crude. This is produced mainly into gasoline and gasoline blend stocks, jet fuel, diesel fuel and heavy fuel oils. The company also produces liquefied petroleum gas, petroleum coke and asphalt. Tesoro owns and operates seven refineries, and has over 800 retail stores in the United States, that sell its products.

Tesoro is focused in the Western United States. Its refineries have a capacity of 665000 barrels a day, and retail stores are planning to increase to over 1200 this year. Tesoro operates in higher margin markets. The company has refining / marketing in key areas. Its logistics assets offer a growth platform, and it also has access to the Pacific Rim.

Last year was a better year when compared to 2009. It was a difficult time for the refining sector. A leveling off of the refining market in 2010 was a plus as the United States works its way back to pre-recession years. Although Tesoro had weaker margins, it still had decent earnings in quarters two and three. This was due to the $120 to $140 million in cost reductions. During this time the company restructured its business to improve all assets. Also in 2010, Anacortez was restarted.

Tesoro currently believes that 2011 can be a better year than the previous two. The company's main goal is to create value with in all aspects of its business, in case margins do not increase. If Tesoro can come through with its current plans, it could be one of the top United States refiners for 2011.

Tesoro is planning for a slow United States rebound. World oil demand growth is estimated at approximately 1% for gas, and 2% for diesel. US gas demand growth is estimated at .3% with diesel growing around 2%. Tesoro believes the crude oil supply will continue to trend slightly higher. Global refining capacity continues to exceed demand. Many of the alternate fuels (ethanol, hybrids) will continue to decrease gas demand in the United States.

West Coast regional crack spreads continue to outpace the Gulf Coast. These crack spreads were at all time highs in 2007, however, there should be a continued improvement through 2013. Light and Heavy differentials may start to widen, continuing this slowly, as spare coking capacities decline. The market outlook places a premium for diesel compared to gasoline. This should continue, especially in the United States. Although it will take a while to get back to 2007 levels, Tesoro expects its margins will increase through 2013.

Current regulations continue to give refiners difficulties. The EPA is currently working to tighten standards. Greenhouse gas emissions continue to be a worry for the federal government. Also, there are the low carbon fuel standards.

In response to the challenges of 2008 and 2009 , and with worries that the United States economy will not improve as quickly as expected, operational efficiencies have been added. These efficiencies continue to tighten up the business. Tesoro's emphasis will be placed on reliability, system improvements, and cost leadership. The company will also emphasize commercial excellence, financial discipline, and value-driven growth. Tesoro expects to provide increased value to shareholders. By driving cash flow, the company believes it will provide greater financial strength.

There is a black cloud over Tesoro after the Anacortes incident, however several measures have been taken to reduce the chances of a repeat. The company aims to increase increasing safety and machinery reliability through:

1. OSHA's voluntary protection program
2. DuPont's assessment of process safety practices
3. BakerRisk inspection program review underway
4. Fluor hydroprocessing review

Tesoro's Midcontinent has been an outperformer through recent memory. With North Dakota and Utah highlighted, this area has been in the top four with respect to operating margins over the past four years. Although an outperformer, Tesoro is targeting refining and marketing integration as an area of possible improvement. This location needs feedstock improvements such as running more black wax crude oil. The crude gathering system is expanding to reduce trucking costs and access more producers. The Shell (NYSE:RDS.A) contract is adding 13000 barrels a day, and Tesoro would like to increase this further, with a goal for 2011 EBITDA improvements of $35 to $40 million this year. I think this refinery will continue to lead, as the Bakken/Three Forks play is expanding.

There are several other companies that have refining margins close to that of Tesoro's Midcontinent. Holly Corp. (HOC) refinery at Woods Cross was top on the list in 2007 and through the third quarter of last year. Western Refining's (NYSE:WNR) Four Corners and El Paso have been exceptionally strong since 2009. Frontier Oil (NYSE:FTO) had two refiners at the top of the list in 2007 but have had a significant pull back since. Last year through three quarters, Valero's (NYSE:VLO) Gulf Coast operation saw operating margins that were the fifth highest. The improvements of the list are deceiving, as margins are still well below averages of 2007. Tesoro believes this is possible in upcoming years.

The Hawaii area has been lagging operational margins. Since 2007 it has been one of the bottom eight refiners with respect to margins. Tesoro would like to improve feedstock costs, low liquid yields and marketing integration at this location. Looking to the upside, the new low sulfur fuel contract pricing is a plus. Tesoro believes a net margin gain of 220% to 225% is possible. 2011 EBITDA improvements of $40 to $60 million are being targeted.

The Pacific Northwest for Tesoro needs yields and marketing integration improvements. In 2011 it will start processing alternative feedstocks. The company plans to expand ratable offtake to increase utilization rates. Pacific Rim product exports have upside over the next year. The capture of refining system synergies could help increase net margin of 10% to 15%. Possible 2011 EBITDA improvements range between $20 and $30 million.

The California area has possibilities for major improvements. Yields, operating costs, and sustaining capital all could see improvements this year and possibly create a substantial EBITDA change this year. Propane and Butane recovery will create yield improvements. Current energy efficiency projects and improved maintenance will help with operating costs. 2011 EBITDA improvements could be as high as $70 to $80 million. 20% to 25% net margin gain is a target for this year.

Tesoro is working on capital investments that will create a high return for the company in the long run. These projects are planned through 2013. There are currently 300 projects and the average payback is a little less then 2 years. EBITDA will continue to improve increasing through 2013. Tesoro is also cleaning up post retirement benefits. Reduced head count and overhead costs create an annual savings of $40 to $50 million. Life and medical benefits will also be realized to an estimated $80 to $90 million. In 2014 these changes to post retirement liabilities could reduce this area by 50%.

2011 is the beginning of a multi year commercial change. Expansion of system supply and optimization are key components of improvement. Lower feedstock costs and higher product values will increase margins. Tesoro Panama will see arbitrage, freight and storage opportunities. This could create another 2011 EBITDA improvement of $30 to $45 million.

Tesoro is seeing an opportunity created by improvements from a poor 2009 year. With 2009, being so difficult it was easy to make large cuts while reinvesting in the company as cash flow begins to improve. EBITDA growth from 2009 to last year was approximately 50%. All of these plans could come together at the same time that the sector sees large increases in production due to economic recovery.

Capital spending has been reduced in the last year due to cost savings and good management. Approximately $700 million has been removed. These reductions are seen through 2013, which will help to reduce debt to capitalization and strengthen the balance sheet.

Tesoro has advantages with respect to its peers. Higher gross margins, with lower costs and capital are all good reasons for investment. All of these advantages look to increase further by 2013. Tesoro is trying to realize over $200 million of improvements this year. Capital spending has been reduced by $700 million from the 2009 meeting. These improvements will increase cash flow. $350 million was eliminated with respect to the co-generation project at Los Angeles refinery.

Although Tesoro had a horrible accident with the Anacortes, the company is trying to make changes to make sure it never happens again. Bad press is never good for a company, but it will sometimes be the catalyst for improvement in a company. The refining sector has many reasons to be bullish. Cheaper oil is flowing in from United State's shale plays, while infrastructure is being built to transport oil in a more cost effective manner. At the same time, the economy is improving and by 2013 we could see a very tight refining market, with pricing power for the refiners. These time frames may be years out, but most of the refiners are trading at a huge discount to October of 2007. Before the recession, there was plenty of talk about not having enough refining capacity in the United States. It is my guess in the next year or two we could hear the same chatter.

Disclosure: I am long TSO, WNR.

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