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We have seen two press releases from Tesoro (TSO) in the last two weeks, one of which was particularly bad news. Here is a quote:

Tesoro Corporation today announced that the Company expects to report a net loss per diluted share in the range of $0.55 to $0.80 for the fourth quarter 2011. Contributing to the net loss was an extremely weak margin environment in California and the collapse of the West Texas Intermediate (WTI) to Brent crude oil spread.

I was positive on Tesoro when I wrote this article last November, we have done a lot of work to understand the issues in this industry, and it is worth a few minutes to try to figure out what happened.

First of all, the collapse of the WTI/Brent spread after the Libyan oil started flowing again was predictable, and Tesoro is not going to be alone in having reduced refining group earnings.

Chevron (CVX) put out a similar announcement this week and we can expect similar announcements from many of these companies. The refiners, especially those with operations in the US Midwest had been the beneficiaries of unusually low feedstock prices in their region, and were able to sell their products at the global prices, and so despite demand for the products still being depressed by the weak economy, these companies enjoyed an uprecedented, and short lived, period of high refining margins.

Tesoro's problems are based on their refinery locations and product mix. They report refinery operations by segment: California, Pacific Northwest, Mid Pacific (their Hawaii operation) and the US Midwest, which is particularly interesting because their Mandan facility can take advantage of landlocked Bakken crude oil.

Tesoro's production at the moment is weighted toward selling gasoline in California.

Crude Oil Total Throughput Gasoline Gasoline %
California 269 136 51%
Pacific NW 169 70 41%
Hawaii 76 19 25%
Mid Continent 123 68 55%
Total 637 293 46%

42% of the company's throughput is in the Los Angeles area, and that throughput is weighted toward gasoline, such that 21% of the company's throughput is gasoline in California.

Here is a table of the company's crude oil consumption in TBPD

Crude Oil by Type Heavy Light Other
California 172 50 25
Pacific NW 4 159 6
Hawaii 12 62 0
Mid Continent 0 115 4

Using some published data on pricing for the finished products in these regions, the differences in production costs for Tesoro as published in their refining segment summary, as well as the feedstock costs and other costs, we can reconstruct what is happening to the business in each of these regions as of right now, as follows:

Price Factor California Washington Midwest Hawaii
Gasoline Retail Price/Gallon 3.60 3.44 3.26 4.03
Taxes 0.64 0.375 0.26 0.5
Distribution Costs 0.21 0.21 0.25 0.25
Net Wholesale Price/Gallon 2.75 2.855 2.75 3.28
Net Wholesale Price/Barrel 115.50 119.91 115.50 137.76
Conversion Cost/Barrel 6.50 3.32 3.33 2.93
Net Gross Variable Margin 109.00 116.59 112.17 134.83
Crude Oil Type Calif Heavy North Slope Midwest Global
Current Crude Oil Price 109.60 111 90 120
Net Margin $/bbl -0.6 5.59 22.17 14.83
3Q Net Margin 14.90 14.99 33.51 13.58
TBPD Gasoline Production 136 70 68 19

California is enjoying an unusual period of relatively low gas prices, and because of the fact that the California refineries are using heavy California crude oil, which is more expensive, and have a higher operating conversion cost, the company is selling at approximately zero net margin at the moment, and it is likely that in early November, when the margins collapsed generally, this could have been on the order of a two-digit loss per barrel of gasoline. Note that the company's operations in the Pacific Northwest have a similar problem, and because the North Slope crude oil price is quoted FOB Alaska, the operation in Washington that uses this feedstock is probably also at roughly zero profit on gasoline at the moment because of transportation costs.

So, the company's two biggest operations, most heavily weighted toward gasoline, have some short term pricing imbalance problems.

The news is not all bad, though. Diesel prices are quite high right now. Here is the calculation for diesel in California:

Diesel Retail Price, California 4.09
Taxes 0.40
Distribution Costs 0.21
Net Wholesale Price/Gallon 3.48
Net Wholesale Price/Barrel 146.16
Conversion Cost/Barrel 6.5
Net Gross Variable Margin 139.66
Current California Heavy Crude Price 109
Net Margin $/bbl 30.66
3Q Net Margin 14.9

The net impact of all of this? The company reported an operating income of $597M in the third quarter, and are now projecting a net loss of somewhere between $80 and $120M, so a net swing of $700M from one quarter to the next. Tesoro is also going to use the opportunity to take a $15M writeoff over and above what their operations are doing.

Note on the above chart that the operating results in Hawaii are indeed not all that bad, despite the fact that the refinery is located a long way from crude oil sources, the isolated nature of the market is such that the gasoline margins have been relatively stable, and so that explains Tesoros's other announcement, the pending sale of this operation.

The company points out correctly that this is a well functioning plant in a protected market, the pricing should be relatively attractive for anyone who wants this business, and its sale will give the company an opportunity to upgrade their operations in the Midwest.

So, what about the opportunity?

The opportunity is in Tesoro Logistics (TLLP), the stock of which was the subject of an IPO in April, and whose stock price started to take off at exactly the same time as the refinery margin collapse above, and we can see why: The company's mission in life is to transport crude oil from the Bakken in North Dakota to Anacortes Washington to offset the crude oil pricing differential you can see in the above chart, and this will be a nice steady business for as long as the pricing imbalance exists between the US Midwest and the rest of the global markets.

The current price is around 31.50, it is near its high, and the risk, of course, is that the refining margins will go back up, the urgency to ship feedstock halfway across the North American continent will be lessened, and the company will have less of a potential profit margin to extract from the market.

As to what to do if you are a shareholder of Tesoro: The two announcements did not panic the market very much, the stock is off of its 2009 low price but at 22 is nowhere near the 60 that it traded for in 2008. They do have some positives, including the diesel exports and the opportunity in Mandan, so your actions will probably be driven by whether or not you think refining margins and/or demand for the finished products manages to improve. US Jet fuel demand is still down 15% from the equivalent week in 2008, distillate demand is down 17% since then, and you have to go back to 2001 to find an equivalent week in early January with such low gasoline demand.

The world is chaotic, and there are no guarantees on anything. The opportunity right now appears to be in shipping the feedstock and not producing the products.

Disclosure: I am still long CLMT because of their dividend yield.

Source: Tesoro's Pacific Problem - And How To Profit From It