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Tesoro (NYSE:TSO)

Q2 2011 Earnings Call

August 04, 2011 8:30 am ET

Executives

Gregory Goff - Chief Executive Officer, President and Director

Louie Rubiola - Director of Investor Relations

G. Spendlove - Chief Financial Officer and Senior Vice President

Daniel Romasko - Executive Vice President of Operations

Analysts

Edward Westlake - Crédit Suisse AG

Evan Calio - Morgan Stanley

Mark Gilman - The Benchmark Company, LLC

Jacques Rousseau - RBC Capital Markets, LLC

Paul Cheng

Douglas Leggate - BofA Merrill Lynch

Jeffrey Dietert - Simmons & Company International

Chi Chow - Macquarie Research

Paul Sankey - Deutsche Bank AG

Blake Fernandez - Howard Weil Incorporated

Operator

Good day, ladies and gentlemen, and welcome to the Second Quarter 2011 Tesoro Corp. Earnings Conference Call. My name is Janada, and I will be your operator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Mr. Louie Rubiola, Director of Investor Relations. Please proceed.

Louie Rubiola

Thank you, Janada. Good morning, everyone, and welcome to today's conference call to discuss our second quarter 2011 earnings. Joining me today are Greg Goff, President and CEO; Dan Romasko, Executive Vice President of Operations; and Scott Spendlove, Senior Vice President and CFO. While we will not be referencing slides during the call, we do have a set of slides which was filed with the SEC today. These slides, along with other financial disclosure, should help you in analyzing our results, and can be found on our website at tsocorp.com.

Please refer to the forward-looking statements in the earnings slides, which says statements made during this call that refer to management's expectations and/or future predictions are forward-looking statements, intended to be covered by the Safe Harbor provisions of the Securities Act, as there are many factors which could cause results to differ from our expectations. With that, I will turn the call over to Greg.

Gregory Goff

Thanks, Louie. Good morning, everyone, and thanks for taking time to join us on the call today. You have our earnings release, and Scott will go over some of the details of the results in a moment. But I'm going to start with an overview of some recent highlights.

During the second quarter, we again increased refinery utilization rates, running total crude oil throughput to 578,000 barrels per day or about 87% of total capacity, the highest level since the third quarter of 2008. This allowed us to more fully capture strong crack spreads and advantage discounts on crude oil. We made good progress on our improvement initiative to drive EBITDA growth with another quarter of gross margin improvement in excess of the market gains. The combined results is reflected in our very good second quarter earnings of $1.65 per diluted share excluding special items, the most profitable quarter for Tesoro since the third quarter of 2008. This strong financial performance, along with the successful initial public offering of Tesoro Logistics during the quarter, allowed us to pay down $244 million of debt, taking us to less than 31% of total debt to total capitalization, moving closer to our goal of below 30%. We also announced our plans to take Bakken crude oil to our Anacortes refinery, allowing us to leverage our advantaged logistical position in North Dakota as well as provide a high-quality, lower-cost feedstock supply to Anacortes.

Relative to ANS crude oil, Bakken crude oil yields about 16% more clean products and less fuel oil. During the second quarter, the differential between those products was about $28 per barrel, providing a more than $4 per barrel overall advantage. Similarly, today we are announcing a project to replace the vacuum distillation unit at our Los Angeles refinery, which will allow us to improve clean product yields and reduce greenhouse gas emissions. We expect to shift just under 1% of the refinery yield from petroleum coke production to clean products. During the second quarter, the differential between those products was about $100 per barrel. These projects are good examples of how we are driving system improvements designed to achieve high returns, short payback periods and deliver sustainable earnings. Also during the quarter, we received approval from the Public Utilities Commission in Hawaii regarding the revised fuel oil supply contracts with both Hawaiian Electric Company and Kalaeloa Partners. Our priorities relative to our cash position are to: one, further strengthen our balance sheet with additional debt reduction; two, invest in business improvements designed to yield high-yield, high-sustainable returns with short payback periods; and three, maintain a prudent cash balance to continue to take advantage of commercial opportunities to drive a high capture rate.

Turning to the quarter, industry crack spreads were up year-over-year and our refining gross margin were up even more. The second quarter average Tesoro Index gained over $2 per barrel. Feedstock cost advantage, particularly in the mid-continent, drove the benchmark index higher during the quarter. West Coast benchmark crack spreads were generally flat, both sequentially and year-over-year. Incremental U.S. exports of distillates and the continued global economic recovery provided support to distillate crack spreads during the quarter. However, rising retail street prices, which peaked in early May, tempered gasoline demand. Capture rates were very strong in the quarter, driven by significantly advantaged crude oil costs relative to benchmark grades for crude oil.

On the West Coast, we continue to capture wider discounts for heavy crude oil, both domestic and foreign grades, particularly as compared to the West Coast benchmark ANS, which got expensive during the quarter. In the mid-continent, high levels of domestic crude oil inventories increased the discounts for these grades relative to benchmark such as Light Louisiana Sweet. For the quarter, our realized gross margin was $16 per barrel, excluding the gain from business interruption insurance proceeds on a Tesoro Index that averaged $12.18 per barrel. This was achieved despite turnaround activity at our Golden Eagle refinery.

As I stated earlier, throughput rates during the quarter averaged 578,000 barrels per day or 87% of total crude oil capacity. This is up from 561,000 barrels per day or 84% for the first quarter this year. This improvement marks another sequential increase in refinery utilization rates, a key priority for the company.

Manufacturing costs in the second quarter averaged $5.23 per barrel, excluding the benefit of $5 million in property damage insurance proceeds, essentially flat from the first quarter. We are making progress on lowering our operating cost and expect our per barrel number to continue to decline over time. However, we expect to see an increase in spending this year as a result of our improvement plans to strengthen asset integrity and maintain high reliability. In December of last year, we shared our plans around process safety management. Most of our asset assessment is complete, and we are implementing improvements as well as making changes based on the lessons learned from the April 2010 incident at our Anacortes refinery.

Retail marketing margins were up during the quarter, both sequentially and year-over-year. This is typical in a falling crude price environment. Retail fuel sales volumes were up 14% year-over-year, reflecting growth in the company's branded jobber and dealer segment. Same-store fuel sales during the quarter were down 2% relative to last year as a result of rising retail street prices on gasoline demand. More recently, street prices in California have fallen more than $0.45 per gallon from the early May high and are now below the $4 per gallon level. Accordingly, we started to see an improvement in sales volume through our retail stations. In July, volumes were essentially flat with last year.

As we mentioned in our earnings release, our pretax corporate and unallocated costs for the quarter were $34 million before $2 million in corporate depreciation and $18 million in noncash stock-based compensation credit primarily related to stock appreciation rights. This number is down significantly from last year and it reflects the changes we made to our corporate overhead.

Capital expenditures for the second quarter were $63 million. Turnaround spending was $46 million. We still expect -- excuse me, we still expect to spend about $380 million in capital in 2011, including regulatory, maintenance and income projects. This includes spending on our recently announced refinery projects, where most of the spending will be in 2012. We have adjusted our turnaround plan for 2011 and now expect to spend about $110 million, which is down by approximately $50 million relative to our prior guidance.

As we look forward, we remain reasonably positive about market conditions. From a crack spread perspective, the first half of the year exceeded our expectations. Additionally, seasonally typical U.S. light product inventories combined with strong exports should continue to provide support to refining margins. Putting the market aside, we are capturing opportunities to drive significant value from our existing asset base. We have established strategic priorities that are focused on driving free cash flow, strengthening the competitive position of the company and increasing shareholder value. In all, we've targeted over $225 million in EBITDA growth from these efforts in 2011. Combine that with our increased refinery runs, strong margin capture and Anacortes being back online for a full year, positions us to deliver significant EBITDA growth this year over 2010. In fact, if you look at our reported results for the first half of 2011, EBITDA is up nearly $700 million year-over-year. We recognize that the market has improved. Year-to-date, the Tesoro Index has gained $3.65 per barrel relative to the first half of last year. Using 2010 throughput rates, that would imply an incremental gross margin of about $300 million attributable to the market improvement. Similarly, if we take the year-over-year increase in throughput rates systemwide of 98,000 barrels per day at the 2011 average Tesoro Index, that would imply an incremental gross margin of about $200 million, attributable to higher run rates. The remaining $200 million in year-to-date incremental EBITDA is primarily attributable to the execution of our 2011 improvement initiative and the insurance proceeds from the Anacortes incident. With that, I'll turn the call over to Scott Spendlove, our CFO, for more detailed discussions of our quarterly results and to provide guidance for the third quarter. Scott?

G. Spendlove

Thanks, Greg. As we reported last night, second quarter net income was $218 million or $1.52 per diluted share. Adjusted for special items, we're reporting an adjusted net income of $237 million or $1.65 per diluted share. Special items that we're excluding from the quarterly results include: after-tax $23 million in business interruption and property damage insurance proceeds, $30 million related to the write-off of expenses associated with the change in scope of a cogeneration project in our Los Angeles refinery and $12 million in onetime interest expense related to the repayment of $244 million in debt during the quarter. That compares to an adjusted net income in the second quarter last year of $43 million or $0.30 per diluted share. Special items last year included after-tax benefits of $26 million related to our postretirement benefit changes, $7 million related to expense accruals in asset write-offs at our Anacortes refinery and $5 million related to a onetime state tax settlement. Our cash unit expenses before noncash credits related to stock-based compensation are coming down as we expected. We ended the quarter with a cash balance of $607 million and remained undrawn on the corporate revolver with over $1.1 billion of excess capacity. As Greg mentioned, we ended the quarter with total debt to total capitalization of less than 31%, down 6 percentage points from the first quarter due in large part to the repayment of $244 million in debt.

We already announced the redemption of the $150 million junior subordinated notes due in 2012, but during the quarter, we also retired, through open market purchases, $94 million of our 6.25% senior notes due in 2012. The decrease in cash for the quarter was $117 million and reflects EBITDA of $519 million, less working capital and other uses of $472 million, less interest and tax payments of $124 million, less capital and turnaround spending of $109 million, and a cash flow benefit of $69 million from the IPO of Tesoro Logistics, net of debt repayment and revolver borrowings during the quarter.

The use of cash from working capital in the quarter reflects mainly, timing associated with carrying a higher level of crude oil and product inventory in our system.

Much of that use of cash has already been recovered here in July, with cash at the end of the July at about $900 million. During the second quarter, we settled the property damage claim. We have collected $17 million net of the deductible, including $5 million in the second quarter. We are still negotiating a final settlement regarding the business interruption claim. We have collected $87 million net of the deductibles, including $32 million in the second quarter.

Turning to our outlook for the third quarter, high PADD finery utilization rates and lackluster gasoline demand has led to a recent build in light product inventories on the West Coast. This has resulted in West Coast product prices trading in a discount to the U.S. Gulf Coast, and created an arbitrage trading opportunity for exports. We have already began to see the market rebalance with the incremental light product exports off the West Coast in July and August. In the mid-continent, gasoline and diesel crack spreads remain strong and are up sequentially and year-over-year.

I'll close with guidance for the third quarter modeling purposes. We estimate throughput to be, in thousands of barrels per day, 160 to 170 in the Pacific Northwest, 65 to 75 in the Mid-Pacific, 110 to 120 in the mid-continent, and 240 to 250 in the California region. Manufacturing cost guidance for the third quarter, in dollars per barrel, is as follows: $3.80 in the Pacific Northwest, $2.90 in the Mid-Pacific, $3.60 in the mid-con, and $6.85 in the California region. Our depreciation for refining is estimated at $95 million. Additional third quarter guidance items include estimated corporate expense, including depreciation of $34 million, and interest expense before interest income of $36 million. And with that, I'll turn the call back over to Greg for closing comments. Greg?

Gregory Goff

Thanks, Scott. We are pleased with our very good second quarter results. This marks another quarter where we delivered on our plans and significantly improved the business as part of our strategic priorities, as we laid out in December of last year.

Looking to the third quarter, we expect to increase throughput rates, capture additional marketing opportunities to drive a higher level of refining and marketing integration, and identify and implement high-return, short-payback capital projects to strengthen our competitive position and generate additional free cash flow. We look forward to sharing progress updates as we get further into the year. With that, we'll now take your questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes the line of Ed Westlake with Crédit Suisse.

Edward Westlake - Crédit Suisse AG

I just had 2 questions. I guess the first one is around performance on CapEx. Obviously, historically, there's been a higher CapEx burden out in the West Coast but you seem to be doing a good job of sort of improving the capital efficiency. Where, as you look out today, do you see sort of the maintenance CapEx and turnaround CapEx settling out relative to perhaps prior guidance?

Gregory Goff

The turnaround that we gave, Ed, in our system is the $110 million. We've changed it around a little bit because we've tried to optimize our turnaround schedule between this year and next year, and we're currently working on our plans for turnaround for 2012. And those aren't completely developed yet so at this point in time, our guidance for 2012 isn't unchanged from what we said last year when we talked about our plans for 2012, which was higher than 2011. Maintenance CapEx across our whole system for regulatory and maintaining our asset integrity is unchanged from what we've talked about previously. I mean, we still plan to stay pretty close from a maintenance and CapEx -- maintenance and regulatory standpoint with our DD&A kind of in that targeted range across our system. And our big focus, as we've said, is to continue to find these income-producing projects that allow us to really get sustainable returns that are really short payback in that. So that's where we stand.

Edward Westlake - Crédit Suisse AG

Okay. And then a follow-up just on margins. I mean, they have come up a little bit in the West Coast recently. Is that just good utilization across the industry or are you seeing any signs of sort of California demand weakening as we start seeing some -- elsewhere in the U.S.?

Gregory Goff

Yes, I'll let Dan Romasko answer that question.

Daniel Romasko

We think it is primarily due to refinery utilization being up. When we actually look at our retail year-on-year same-store sales, we're actually seeing a recovery relative to second quarter, to the point that we're currently about 1% under on a year-over-year basis. And that includes, actually, a growth on a quarter-by-quarter basis.

Operator

Your next question comes from the line of Jeff Dietert with Simmons.

Jeffrey Dietert - Simmons & Company International

I was -- I wanted to follow up on the rail project economics and try to get a feel for what differential you need to justify that project, and what the payout period is on the project.

Gregory Goff

Yes, I think we made a couple of points during the call there. One is that, if you look at the yield advantage of Bakken to ANS crude, the numbers we feel are pretty consistent over time with the -- less we said that the Bakken crude oil will produce. So we get that yield advantage, which we believe is pretty sustainable over time. The second thing is, if you look at the transportation cost, we believe that over the longer term as the logistics in the mid-continent region work out and if the differential rating will settle around the rail cost to the Gulf Coast, the numbers are as that we can actually move Bakken crude to Anacortes at a less transportation cost than you can to the Gulf Coast. So we see a twofold advantage, one is in transportation. We have an advantage, secondly, in yield.

Jeffrey Dietert - Simmons & Company International

What is that transportation cost from Bakken to Anacortes?

Gregory Goff

If you look at the tariff from the railroads in that, there's about $1 advantage difference. It's about -- it's a little bit less than $8 to go to Bakken and a little bit more than that to the Gulf Coast, $1 more.

Jeffrey Dietert - Simmons & Company International

Great. Yet, it's a shorter distance, it appears, and the rates or lower going west than going south.

Gregory Goff

I think it has maybe to do with, somewhat, the interchange fees. We just use the one railroad going west versus going 2 railroads going south in that also.

Jeffrey Dietert - Simmons & Company International

Is there any update or any change to the Mandan expansion?

Gregory Goff

Mandan expansion is progressing extremely well, and as we've said in the past, second quarter of '12, we'll be operational. And it looks very good from everything at this point in time.

Operator

Your next question comes from the line of Paul Cheng with Barclays Capital.

Paul Cheng

Several quick questions, Greg. In Salt Lake, is there any kind of a similar opportunity for expansion as Mandan or that -- not really ?

Gregory Goff

Paul, we've -- I think we've said in the past, amongst across our whole system, we are very aggressive in looking at everything we can to make the business stronger. In Salt Lake, because of some advantaged crude supply with the black wax crude in that, it does provide opportunities that we're currently evaluating. We just haven't arrived at any conclusions yet. But there are some possibilities there that we're in the process of evaluating.

Paul Cheng

Is it in the similar scale as on Mandan? Or that may have a bigger potential?

Gregory Goff

It's probably a little bit too early to comment on that yet, but there are some good opportunities there. We just haven't completed all of our engineering work and analysis yet.

Paul Cheng

When you think that you may be able to have a more definitive view on that?

Gregory Goff

Sometime during the second half of the year, quite for sure.

Paul Cheng

So before the year end?

Gregory Goff

Yes.

Paul Cheng

And in addition to the L.A. vacuum tower, do you -- also, Greg mentioned, you're looking at, across the systems at any kind of fast payback projects. Is there anything that you can share at this point that maybe some of those projects that what you have maybe looking at?

Gregory Goff

I'm sorry, in addition to the vacuum tower project at Los Angeles are there other...

Paul Cheng

You're talking about, across the system, that you're looking very hard at how to strengthen and doing some relatively fast payback projects. I know that it's early and it may be premature, but is there anything that you can share with us that what type of projects or that you may be looking at?

Gregory Goff

It's just too early to go over those, Paul, so we can make sure we just finish our work. But we do have a few opportunities that look very encouraging and we'll be able to share those during the second half of the year. So we were advancing both our evaluation and some preliminary engineering work to get an idea about stuff. But there are some good opportunities.

Paul Cheng

In Bakken, when we're talking about 30,000 barrels per day, how are we coming up with that number? Is it a limitation on -- given the Anacortes also running some Canadian oil and all that, is that a limitation as a result that, at most, that you can very cost effectively to this space, maybe up to 30,000 barrel per day? Or is that the limitation on the railroad capacity?

Gregory Goff

No, it's just when we look at the overall system of what we acquire and the logistics by using the unit trains and turning the unit trains with the amount of 30,000 barrels over that distance in a number of rail cars that we use and being able to handle them at the refinery, the logistics kind of dictate the level of Bakken crude that we run at Anacortes.

Paul Cheng

So it's then logistics. It's not so much about how much more that Anacortes, whether that they can process more than 30,000 barrels per day of Bakken.

Gregory Goff

We could probably do more if we need -- if we get our logistics system worked out. Those rail unit train projects, they're actually pretty highly efficient in that. So even moving 30,000 barrels a day is quite -- you have 120 rail cars going pretty constantly in that. But the crude that we're -- that Bakken crude will effectively either displace foreign export, foreign imports or it would replace ANS crude. So no real differences from a crude slate standpoint.

Paul Cheng

And, Greg, and also the last 2 years, if we look at, at least based on our own benchmark indicator, California and Pacific Northwest, your margin capture rate has improved quite drastically. And I think a lot of them may be related to your crude purchase, how -- what type of crude you purchase and how you did it. And I think that you've been dramatically reduced the use of the ANS and replacing it with other type of oil. Can you try to help us to quantify that, how much is the ANS you was -- let's say, running in those 2 system before mid of 2009? And how much is that you've been running since then?

Gregory Goff

I'll let Dan address that question for you.

Daniel Romasko

Yes, sure. The -- if you take a look at those refineries, as you're aware, they're high-complexity coke refineries, so the actual crude slate is certainly weighted to the discount-heavy crudes. Our typical slate there is 70% heavy, 20% light, and the remainder is non-crude feedstocks like get gasols [ph], et cetera. The actual make up of the heavy and the light slate is dependent on the market opportunity at the time that we repurchase the crude. Subsequently, we run very little to no ANS in those plants, and I don't have at my fingertips what the volume was back in 2009, but certainly today and what we see in the ANS market going forward, that we're going to continue to run little ANS.

Paul Cheng

Dan, is that -- the information, Dan, on the historical in compared to today is that you guys would be willing to share?

Daniel Romasko

On the ANS, I believe we can.

Paul Cheng

Okay. Scott, can you give me some balance sheet data: the working capital, the market value of inventory in excess of the book and the long-term debt portion of your total debt?

G. Spendlove

Sure. Working capital was $1.152 billion, that includes cash. Without cash, it was $600 million. The excess market value over book was $1.9 billion. I'm sorry, Paul, what was the other thing you were looking for?

Paul Cheng

The long-term debt portion of your total debt.

G. Spendlove

Yes, $1.7 billion.

Paul Cheng

$1.7 billion also?

G. Spendlove

Right.

Paul Cheng

Okay. And maybe this is for either Greg or Dan. For the second half of this year and the first half next year, is there any major turnarounds we should be aware?

Gregory Goff

Regarding the third quarter, our turnaround load is relatively light. And guidance on fourth quarter and subsequent quarters, I think we'll hold off on that for the time being.

Paul Cheng

Okay. A final one. Scott, you guys have some sizable hedging gains, looks like around $83 million or about $1.80, $1.90 per barrel. And I believe that the bulk of them probably is related to your foreign long-haul supply, that time gap between when you have to fix the price and when you got delivery. And so that should not impact -- what you're doing is that you're trying to matching your report earning similar to the spot margin calculation. So I just want to make sure that our understanding is correct and that we should not need to take out those hedging gains in terms of projecting forward in our earnings estimate. And also, that within there, how much is related to the inventory hedging? And how much is the further bond crude?

Gregory Goff

Yes, you're right, Paul. About 80% of that gain in the quarter relates to long-haul crude purchases. And matching those costs with the day of refining margin, as you said, the rest actually relate mostly to our Tesoro Panama assets and protecting the value of those barrels while they're in transit through the system. And then really only a very small percentage are related to managing product inventory length.

Operator

Your next question comes from the line of Chi Chow with Macquarie Capital.

Chi Chow - Macquarie Research

A couple of questions here. On the Los Angeles project, can you explain how you can fabricate a unit, complete the installation about a year, all for $40 million? It seems almost too good to be true. What's the catch there?

Gregory Goff

Yes, sure, I'll take that. I think the short answer would be, if we had to do all those things, we couldn't. We're quite fortunate in this case in that the vacuum tower itself was purchased and built by another refinery that couldn't complete the project. So we're able to get that at a significantly discounted price. Technically, the project's quite simple. You can think of that as a simple replacement of a vessel. There's very little furnace or other modifications to install the project, and due to the emission reduction rather than an emission increase, the permitting process is streamlined significantly.

Chi Chow - Macquarie Research

Okay, great. The greenhouse gas reduction that you anticipate, does that satisfy demands under AB 32 going forward?

Daniel Romasko

No, but it contributes.

Chi Chow - Macquarie Research

It contributes, okay. Second question, any thoughts on reinstating the regular dividend?

Gregory Goff

Chi, we've come back in and done a pretty comprehensive evaluation to determine whether reinstating a dividend would be something we'd want to do. And at this point in time, we have elected not to do that for 2 reasons. One is that we have these projects to reinvest capital that are actually very, very attractive from both the return and short payback and have good sustainable earnings associated with them. And so our focus right now is to continue to de-lever, and then to reinvest in these projects as we identify them so we can really execute de-lever and to increase our profitability. And so at this point in time, we do not intend to reinstate the dividend.

Chi Chow - Macquarie Research

Okay, Greg. And final question, I think this relates to Paul's question on the Tesoro Index. Certainly in California, it's not really indicative of your performance over the last few quarters. Do you give any thought to changing that index to make it a little more useful for us and attract margins?

Gregory Goff

I mean, it's a good question, Chi. We were actually going back in and evaluating our indexes in that, and just haven't completed that evaluation to be -- make them reflective of the market in that. So we'll probably be able to share more with that, about that during the second half of the year because we're just not done with that work yet.

Operator

Your next question comes from the line of Evan Calio with Morgan Stanley.

Evan Calio - Morgan Stanley

My questions are some follow-up on the bullet train to Anacortes. Can you break down the real cost? Before, you said the less, that it was $8 a transport. I presume that's, in the BNF [ph] tariff, at $6.75 plus loading and unloading fees, is that correct?

Gregory Goff

Yes, the tariff is less than $8. And then there's loading fees and unloading fees on top of that when we have a third party that we're loading, as we've mentioned in our press release, at, in North Dakota. And then we will just incur the additional costs -- it's, I mean, just some labor costs. It's not that complicated an operation in our refinery in Anacortes.

Evan Calio - Morgan Stanley

But the loading and unloading is included in the under $8 transport?

Gregory Goff

No, it is not.

Evan Calio - Morgan Stanley

Okay, so that's additional. So you disclosed what the fees are?

Gregory Goff

No, we're not going to do that. It's...

Evan Calio - Morgan Stanley

But you'll do it when you drop it into the MLP, right?

Gregory Goff

Well, when we drop it in MLP, we'll disclose. But the market rates are right when we negotiate.

Evan Calio - Morgan Stanley

Okay. And then on the 9- to 12-month construction before permitting, when do you expect to receive first permits? And is that permitting on both ends of the system?

Gregory Goff

I'll let Dan answer that question.

Daniel Romasko

Permitting on the source end is complete. Permitting on the destination end, should we intend or hope to be complete by approximately January of 2012. We've actually designed that facility to minimize any environmental issues, which we again, hope will streamline the permitting process.

Evan Calio - Morgan Stanley

Okay. So then you'd be 9 months from that point, be receiving the advantaged crude in Anacortes or -- at the earliest, is that correct?

Daniel Romasko

That is correct.

Gregory Goff

We are very incentivized to get the project operational, so we'll do everything we can to get it operating.

Evan Calio - Morgan Stanley

And how long before the July announcement were you guys working on a rail resolution? Just trying to get a better feel for the full cycle time it takes to add rail capacity out of Bakken, to add to the 9- to 12-month construction time plus what looks like a 6-month permitting time.

Gregory Goff

Evan, we looked at -- we've been working a lot of -- because of our position with our crude gathering and trucking operations up in the Bakken, we've looked at a lot of different possibilities over time to do different things that originate there, and to deal with Anacortes was one of those things. We're just trying to find the best economic value. So probably that specific thing we've been working for just 3 or 4 months to really look at the whole economics of doing it. I think we mentioned in our press release that we had already started at the beginning of June, delivering a couple thousand barrels a day of Bakken crude there just to work through the whole system.

Evan Calio - Morgan Stanley

Okay. And then when we think about crude differentials, we're looking at Clearbrook versus -- whatever. I mean as -- I guess it goes towards the other question that, I guess, Chi had asked about in terms of the indicator margin for the West Coast. I mean, if we wanted to calc on -- if we want to put our own crack into that system, is Oriente a better crude to think about versus ANS?

Gregory Goff

I mean, Oriente is one of the possible crudes that we run there.

Evan Calio - Morgan Stanley

Okay. But -- and then Clearbrook pricing, is that accurate for, where you'll be purchasing Bakken to load? Or is that too high?

Gregory Goff

Yes, well, our desire is to be able to gather, use our assets. Our intent there -- one of the advantages is to get, use our assets, both from a trucking and pipeline gathering, to gather the crude at the least had. It's just how much of that we can accomplish. Well, we'll see how that works out.

Evan Calio - Morgan Stanley

Okay. Are the railcars MLP-able?

Daniel Romasko

Yes, they are. They are actually a lease currently. So not MLP-able from a drop-down perspective.

Evan Calio - Morgan Stanley

I understand. I do not -- I thought that you may be buying them. And what is your commitment with BNSF? Is that just a one-year type of commitment? And clearly, as the margin in the yield benefit indicate, you'll continue to make runs?

Gregory Goff

Yes, I mean, there is no real firm commitment with the BNSF as far as locking in on the tariff going overtime, so we have that option to go for some period of time. Our economics are based upon what we said earlier with the differential for Bakken to the Gulf Coast. We feel we're advantaged to do that, both transportation and yield.

Evan Calio - Morgan Stanley

Okay. And are you going to secure crude on the crude side? Are you going to, similarly like what you've done at Mandan for a producer? Are you going to enter into a supply agreement? Are you going to just take something at a wait spot?

Gregory Goff

There's a commercial arrangement that we -- we're just not going to disclose how we secure our crude.

Evan Calio - Morgan Stanley

Okay. I'll just shift one last question on your L.A. refinery project that you mentioned earlier. I mean, does -- and that solution, I presume, would mitigate EPA emission spending that was, at least as of 6 months ago, was ultimately going to be required? Is that a fair assessment?

Gregory Goff

I don't believe that it offsets any emission spending. What it does do is decrease some nominal amount of CO2 emissions.

Operator

Your next question comes from the line of Jacques Rousseau with RBC.

Jacques Rousseau - RBC Capital Markets, LLC

Most of my questions have been answered, but I just wanted to get a little more color on the Hawaii refinery, if we could, about the renegotiated contract and when you received a benefit. Was it in the second quarter? And what type of magnitude?

Gregory Goff

The actual ruling from the Hawaiian Public Utility Commission came in about the second week of May. And that became effective at the time of the ruling, it was not retroactive. And so all along, as we've gone through the negotiations, our analysis had looked at a longer period of time at the pricing differentials between the 2 different type of reference pricing for fuel oil. And over longer periods of time, that yields about, I think, we said about a $25 million advantage to us. As you're aware with the impact in Japan and what's happened to the fuel oil market, that doesn't show up in the market as clearly now so it doesn't hurt us. And from the pricing with fuel oil, but it's -- the differential isn't as great as it used to be based upon historical analysis. Although, we think that, that will come back.

Jacques Rousseau - RBC Capital Markets, LLC

Okay, great. And just lastly, you discussed some of the commentary around distillate exports. Is any of that Tesoro exporting distillate?

Gregory Goff

On the West Coast, we've consistently -- if you look at the West Coast exports, we've consistently exported both gasoline and distillate off of the West Coast.

Jacques Rousseau - RBC Capital Markets, LLC

And what type of level would the distillate at exports be?

Gregory Goff

Dan, you want to?

Daniel Romasko

Yes. About 15 a day.

Operator

Your next question comes from the line of Blake Fernandez with Howard Weil.

Blake Fernandez - Howard Weil Incorporated

Just a quick follow-up on Jacque's last question there, the 15,000 barrels a day. I'm just trying to confirm. Those barrels are going abroad and not to just other regional kind of domestic areas, correct?

Daniel Romasko

That's correct. On the diesel exports off the West Coast.

Blake Fernandez - Howard Weil Incorporated

Secondly, the Mid-Pacific guidance on costs seems to be fairly low at $2.90 a barrel. It's been a while since you've achieved that. Has something changed there? And is that a good kind of run rate going forward?

G. Spendlove

I think we expect it to be a good run rate going forward, but it's really subject to the maintenance plans that we have on a given quarter. Quarter 1 and quarter 2 were significantly out of character for Hawaii, I believe, due to some extensive cogen repair. During that timeframe when we have our cogen down, we actually have to purchase electricity instead of convert -- essentially, consume our own kerosene or jet fuel to produce electricity. So what you saw was a high optics cost, partially offset by a gross margin improvement.

Blake Fernandez - Howard Weil Incorporated

Okay, great. And then the last one for me. I just wanted to confirm, retail was obviously very strong in the quarter. Clearly, we're seeing some crude prices come off here, which typically benefits you given the lag. Is it fair to say now that we're about halfway through the third quarter that those strong results should kind of spill into 3Q as well?

Gregory Goff

We've got some marginal spilling to Q3, but I think the maturity of the lag effect between spot and street has been captured.

Operator

Your next question comes from the line of Paul Sankey with Deutsche Bank.

Paul Sankey - Deutsche Bank AG

If I could just ask a couple of questions about the market. Currently, you've also referenced that Tesoro Index may not be the perfect indicator, that what we see on the screens isn't always -- but on starting on the West Coast margins looking very weak there, I wondered if you could observe on what's kind of the problem of what should be a stronger time of year typically.

Daniel Romasko

I'll only take a shot at that, specific to the West Coast. Refinery utilization is up significantly, and we're seeing low crack if you look at ANS as your base crude. We, as we did in Q1 and Q2, expect to beat the ANS index. The real phenomenon around the West Coast that we all have to be attentive to is the net import-export. And net import-export has been favorable as the cracks drop off an absolute price on the West Coast. We actually are opening up BARTs to export even to the Gulf Coast, which is a little bit unusual. So the market's relatively liquid and it's correcting itself.

Paul Sankey - Deutsche Bank AG

Is there a global crude grade that we can use as the alternate to ANS to try to get a better idea of what your true margin is?

Daniel Romasko

I think that, as Greg said earlier, we're going to work on that in the third quarter and see if we can establish an index that better represents our true crack. And the difficulty of that is finding a reference crude that you can actually find a future on, oil that is traded publicly.

Paul Sankey - Deutsche Bank AG

Right. But, I guess, is that -- at Latin American and Asian crudes, is that -- or how do we think about it?

Gregory Goff

It compared besides the California heavy crudes. There is South American crudes that come into the West Coast. No Asian crudes to our system.

Paul Sankey - Deutsche Bank AG

Great. Got you, Greg. And then just briefly going through the other markets. The Pacific Northwest still looking fairly healthy, I guess. Mid-Con, obviously, seems to be raging. And Hawaii looks a bit rough again. Is that more or less fair?

Gregory Goff

Yes, I think that's a good characterization.

Paul Sankey - Deutsche Bank AG

Greg, on a kind of corporate strategy point, you paid down debt now towards the 30% target. I believe it's a 30% target or a 31%. Is it -- would we expect you to not pay down any debt beyond the 30% and then look for other options regarding cash?

Gregory Goff

Paul, we will probably -- we have to account -- we have the notes maturing in 2012 that will continue to -- whether we continue to pay those down or wait till maturity, that's something we'll decide as we go forward from a cash standpoint. But we will continue to pay down some debt. It's just a matter of the timing on those 2012 notes. And then -- and we're always continuing to evaluate all opportunities, particularly like I mentioned earlier to someone else's questions, on these projects that we've been identifying in the system that were really very attractive, could either help lower our crude cost or like the L.A. project that helps improve our yield in that. But we're really focused on trying to find projects. And as you can see, these are very major projects. They're around $50 million plus or minus a little bit, but they're very high return projects that we can go in and get good sustainable earnings. And that's really where we're focused on doing that with the cash that we have. And so we have a few more opportunities that we're looking at, and hopefully, we'll get those to the maturity level where we can come and talk about those during the second half of the year.

Paul Sankey - Deutsche Bank AG

Right. So we need look at the maturity schedule of your debt to understand how much further you're going to go as opposed to thinking about 30% as an ultimate target?

G. Spendlove

Yes, I think that's fair to do that. I mean, we said below 30%, so yes, I think look at the maturity and that will give you a good idea of what we're doing.

Paul Sankey - Deutsche Bank AG

The final one for me, Greg. The federal report on Anacortes was, if I remember right, you guided to be out by October last year. Firstly, any idea whatsoever why it's taking so long and when it might come out? And secondly, could you just outline what the risks are surrounding that report to the extent that you can understand them?

Gregory Goff

Yes. That report you're referring to, I think, when you say federal is the report from the Chemical Safety Board. And we really -- Paul, we don't really have a good idea of when that report will be released. There have been comments in the past in our expectation that we would've received it prior to now, but that hasn't been the case, so we continue to work with the Chemical Safety Board on their investigation. And I really can't -- we'd like to see it just like everyone else, but we don't have any really good idea when that is. We don't think there'll be any surprises. I think there was a public announcement not too long ago that confirmed what we said all along that the source of the, the cause of the incident was the high temperature hydrogen attack. And that's, I think, that's been pretty much validated with all of the different investigations. But other than that -- we're kind of -- we just need to kind of wait and see what they say. We don't feel that with everything we have done and not that there's any significant exposure, but we will wait and see the findings of that report.

Paul Sankey - Deutsche Bank AG

Great. And you just happen to have an analyst meeting late this year, right?

Gregory Goff

Yes. We will -- our analyst meeting will more than likely be around the same timeframe as last year, sometime in the first part of December.

Operator

Your next question comes from the line of Mark Gilman with Benchmark Company.

Mark Gilman - The Benchmark Company, LLC

Just a couple of things. Would I be correct in assuming that your decision to differ the $50 million in turnaround into '12 is based largely on margin outlook?

Gregory Goff

The decision really has a little bit to do with margin outlook. But to be honest with you, it has more to do with just the overall timing of the, of our overall turnaround plan. So that $50 million expense was one that was going to curve pretty close to the end of the year anyway. So it's just moving a little bit, mainly just from a workload standpoint in that.

Mark Gilman - The Benchmark Company, LLC

Okay. Can we get back -- and I'm sorry to keep beating up on this, but the rail project. I think you indicated in your answer to a prior question that the rail cars are going to be leased. Is the cost of that included in what you indicated before as the tariff?

Gregory Goff

The rail cars will be leased. And the tariff that I talked about was just the tariff, not the cost of the rail cars.

Mark Gilman - The Benchmark Company, LLC

Do you have a number for what that lease is likely to run per barrel or total dollar?

Gregory Goff

From a -- we're not going to get into all the little details of the different costs going into there. It's a very attractive way to supply, but it's financially more attractive to lease the rail cars than it is to tie up our capital and it doesn't add significant cost to the tariff.

Mark Gilman - The Benchmark Company, LLC

Did I gauge your opening comments, Greg, correctly when you characterized the project as having a $28 yield benefit offset by $24, presumably including tariff and crude price, yielding a net benefit of $4 per barrel, did I get that right?

Gregory Goff

Well, what we talked about in the opening comments was one, we talked about the yield advantage by producing less resid and more clean products and said that in the second quarter, that would -- the differential between the clean products and resid was about $28 a barrel, which gives us about approximately a $4 yield advantage. And that's kind of what we see going forward.

Mark Gilman - The Benchmark Company, LLC

I'm sorry, I'm confused between the $28 and the $4, Greg?

Gregory Goff

The $28 was the difference between clean products and resid in the second quarter. And because we're only yielding $16, 1/4 of that, the 16% of that -- excuse me, that gives you to about a $4 advantage from a yield standpoint. Is that clear?

Mark Gilman - The Benchmark Company, LLC

Okay, that's what the -- sure enough, much better. Maybe Dan could -- without getting into too much heavy technical stuff, talk to me about how it is that the replacement of the vacuum unit actually results in yield improvement and reduction in coke production in favor of light product? I just can't follow it from a process standpoint.

Daniel Romasko

Okay. I'll try to talk at a high level, which is useful because that's what I can do. The -- think of it as a replacement of small pipe with the big pipe. Vacuum -- the recovering -- the gasols out of resid requires a very, very low pressure drop, so the fatter you make the tower, the more liquid you can recover from it out of the top spick-et [ph]. And that's what this tower does.

Mark Gilman - The Benchmark Company, LLC

Okay. My understanding that you took in some Libyan crude during the quarter, Greg. I know you took one cargo, did you take any more? And was that significantly discounted?

Daniel Romasko

Mark, during the quarter, we took in one cargo of Libyan crude and it was priced attractively at the time. That's how we -- once we received approval that we could buy that Libyan crude, that's the reason we purchased it. But it was just a one spot cargo that we've been in, sitting in Asia.

Mark Gilman - The Benchmark Company, LLC

Okay. I noticed when looking at the overall system statistics in the quarter, Greg, that the crude slate overall was considerably lighter in this period than it had been in the past. Yet, the product yield slate with that lighter crude slate was somewhat heavier. Can you help me understand how that happens?

Daniel Romasko

I think what you're seeing is an impact of the turnaround we had at Golden Eagle. We lightened up our slate during that timeframe so that we'll continue to run production barrels. And then we build some heavy intermediates.

Mark Gilman - The Benchmark Company, LLC

Okay, Dan, so that is a temporary thing attributable primarily to the turn?

Daniel Romasko

That's our expectation, yes.

Operator

[Operator Instructions] Your next question comes from the line of Doug Leggate with Bank of America Merrill Lynch.

Douglas Leggate - BofA Merrill Lynch

I just got a couple of quick things, Greg, please. First of all on capital, if you're pushing back the turnarounds a wee bit into next year and you've got some additional projects, I guess, but on more of the kind of quick-hit type, your original CapEx budget, I believe, was somewhere in the region of 6, 65 from next year. Can you give us a preliminary guidance as to where you think that number ends up? And I've got a couple of follow-ups, please.

Gregory Goff

I mentioned earlier that we're actually right in the middle of our planning process to look at both our turnaround activity for 2012. I mean, you referenced both the CapEx and a turnaround number. So we're looking at our turnaround activity for 2012, and then secondly, are doing the same thing from a capital budget standpoint. I mean we're pretty comfortable that the level of capital that we need to reinvest for both regulatory and compliance is a pretty stable amount, so that changes to our capital will be entirely upon projects to enhance the overall performance of the assets. So we'd already said we are running with these small capital projects that really are high-return, short-payback periods. We've talked in our analyst meeting last year that we were going to spend a little over $100 million this year, and it's probably in ballpark the same thing next year. The change will be as it now we're doing stuff in Mandan, stuff in Anacortes and other things that we're looking at that aren't ready to be put in our budget yet. So that's kind of the best guidance I can give you at this point in time.

Douglas Leggate - BofA Merrill Lynch

Good stuff. You did, at the analyst day last year, the turnaround number, Greg, was $2.75, which is obviously, a huge step up from 2011. Is that still a good starting point or has that changed also?

Gregory Goff

That is the starting point. I mean, we'll be looking to optimize our turnaround schedule for '12 as we go through our planning. But you're exactly right, that was the number that we revealed last year. And so we'll go through and look at how we manage our turnarounds for 2012.

Douglas Leggate - BofA Merrill Lynch

Good stuff. Is the AB 32 '11 sitting there or do you have any thoughts about how you might couch the possibility that there are more regulatory expenditures required?

Gregory Goff

For '12, we don't see any significant expenditures for AB 32 because there's still so much work going on in the development of the regulations in that. But hopefully, as we progress through time, we'll get a better idea of the impact from AB 32 standpoint. But I don't see any significant impact in 2012.

Douglas Leggate - BofA Merrill Lynch

I've just got 2 final ones that are fairly quick, hopefully. Hawaii, my understanding was you were having a board meeting to -- and one of the things that was going to come up, where, I guess, was the future of Hawaii. Obviously, a great quarter in Q2, but what's the decision there? Have you reached a conclusion as to what the outlook is? And then I've just got one final one please.

Gregory Goff

Hawaii is like everything else as we're doing evaluations around how we make assets better and what the opportunities in that are. And we have not completed that work yet, but we will shortly be completed with the work around Hawaii. We're just not completely done with what we want to look at.

Douglas Leggate - BofA Merrill Lynch

Maybe by the Analyst Day?

Gregory Goff

Some time.

Douglas Leggate - BofA Merrill Lynch

Okay. Last one for me is, I think a lot of people have tried to get an answer to this, so I'm going to try it from a different angle. The crude discount or the benefit on the West Coast, I mean, obviously, you've never really ran a lot of ANS given the limitations in the supply there over the years. But can you talk about how the evolution of your relative discount to your average crude slate has moved, particularly in 2011 relative to ANS rather than telling us a different crude, nevertheless, all the rest of it? Talk maybe about what the discount has looked like and how that evolved, and what that was like currently. That would be great.

Gregory Goff

Yes, I don't think we have that with us, that we could sit down and go through that. I mean, in California, we're basically running the California heavies and California lights, and then some South American crudes. But I don't...

Douglas Leggate - BofA Merrill Lynch

The reason I'm asking is that Occidental is suggesting that they are getting fuel world market pricing on their crude in California. And I'm just wondering where the discount is coming from and how the -- I know Oriente is a part of that, but I'm trying to get an average number. And currently, could you give us an idea where that's trading relative to ANS? Is it $2 under? Is it $5 under? What should obviously it look like?

Daniel Romasko

Maybe I'll take a shot at -- I don't know if it's going to satisfy all your curiosity, but the -- if you take a look at the Cold Lake type crudes, which are a portion of our diet, they're almost $32 under -- purchasing at $32 a crack relative to say, ANS, which is about $15. But the slate changes frequently based upon what the market opportunities are, and we try to nimbly capture those.

Operator

This concludes the Q&A portion of today's call. Ladies and gentlemen, that concludes today's conference. Thank you for your participation. You may now disconnect, and have a great day.

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