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Sunoco, Inc. (NYSE:SUN)

Q2 2007 Earnings Call

August 2, 2007 3:00 pm ET

Executives

Terence P. Delaney - Vice President, Investor Relations and Planning

Thomas W. Hofmann - Senior Vice President, Chief Financial Officer

Analysts

Neil McMahon - Sanford Bernstein

Nicole Decker - Bear Stearns

Doug Leggate - Citigroup

Arjun Murti - Goldman Sachs

Jeff Dietert - Simmons

Mark Gillman - Benchmark

Paul Cheng - Lehman Brothers

Robert Puon - Golden City Financial

Richard Voliva - Deutsche Bank

Paul Sankey - Deutsche Bank

Presentation

Operator

Good afternoon. My name is Marcus and I will be your conference operator today. At this time, I would like to welcome everyone to the Sunoco second quarter 2007 earnings release conference call. (Operator Instructions) Mr. Delaney, you may begin your conference.

Terence P. Delaney

Thank you, Marcus and good afternoon and welcome to Sunoco's quarterly conference call where we will be discussing the company’s second quarter earnings that were reported last evening. With me today are Tom Hofmann, our Senior Vice President and Chief Financial Officer, and Tom Harr, Manager of Investor Relations.

As part of this call, I would direct you to our website, www.sunocoinc.com, where we have posted a number of presentation slides. I will be making reference to a number of them today to help highlight and supplement some of the commentary and statistics that were included in our release, so if you haven’t already done so I would suggest that you go there now and be ready to refer to them as I progress through my remarks.

To start, for purposes of facilitating a good discussion, I would refer you to the Safe Harbor statement referenced in slide 2 and as included in last night’s earnings release. In the course of our remarks and in the subsequent Q&A, we may be making some forward-looking statements. While we feel that the assumptions underlying these statements are reasonable, our company and our businesses are subject to a variety of risks and uncertainties, which are highlighted there on slide 2.

I will also note that here and in our remarks and in our financial and operating statistics, we refer to various external market indicators for our businesses. Let me remind you that these indicators experience significant volatility and are not to be taken as future projections on our behalf. While helpful in considering market changes, the correlation of our actual results with these external benchmarks can and certainly does vary from quarter to quarter due to a variety of factors.

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With that said, let me make a few comments on our second quarter results. As shown in slide 3, Sunoco reported record second quarter ’07 net income of $509 million, or $4.20 a share. Earnings in our refining and supply business were $482 million, also a record quarterly result, on the strength of very good margins for refined products and despite significant scheduled turnaround and capital project related downtime in both our Northeast and MidContinent systems.

I will discuss both refining margins and the capital projects a bit later, but first let me make a few comments about our non-refining businesses, which earned $59 million during the quarter.

If you turn now to slide 4, I will comment on each of these businesses individually. First, retail marketing, which earned $30 million in the second quarter. Retail gasoline margins averaged a little over $0.10 a gallon across our retail system for the quarter and once again experienced significant volatility throughout the period. Margins were weak in April and early May as wholesale gasoline prices increased sharply. However, when the wholesale gasoline prices stabilized and later fell in late May and early June, retail margins did recover and earnings improved for this business during the second half of the quarter.

Total retail sales volume for all channels for us were about flat versus a year ago, although sales of gasoline at Sunoco Direct locations -- that is, the locations where we own or lease the site, sales at those locations were up approximately 6% per site from the second quarter of last year.

Also included in our second quarter retail marketing results were $12 million of after tax divestment gains. While these gains were larger than usual, I would say that some level of divestment activity is a normal part of our retail portfolio management program.

In chemicals, we earned $6 million for the quarter. I think our earnings release speaks to the variances versus the second quarter of last year versus the first quarter of ’07 when we earned $9 million. Sales volumes were 7% higher but increases in feedstock costs, particularly for propylene, further squeezed margins in both our polypropylene and phenol businesses. Similar margin pressures have continued into the third quarter as well.

Logistics and coke continue to provide fairly ratable income. Logistics earned $10 million and coke earned $13 million in the second quarter. You will notice in the statistics provided in our earnings release and on our website that we had coke production of approximately 237,000 tons from the newly constructed facility in Vitoria, Brazil, which continued its start-up during the quarter. As of early July, all four coke batteries in the Brazil plant had completed start-up and were in operation. This facility is expected to produce approximately $1.7 million tons of coke annually and provide Sunoco and Sun Coke Energy with approximately $8 million of annual net income from technology and operating fees. We are currently 1% owners of the Brazil plant, with an option to increase the ownership to 20%, and are in discussions with our venture partners on the final deal structure.

Construction also continued during the quarter on the previously announced second Haverhill project at our Haverhill, Ohio facility and we continue to target a second half ’08 start-up for that plant. As with the first Haverhill plant, we will be 100% owners of the Haverhill 2 facility.

Finishing out the non-refining discussion, corporate expenses were $18 million after tax and net financing expenses were $14 million after tax in the second quarter. The increase in corporate costs were primarily related to higher accruals for stock and performance-related incentive compensation during the quarter.

Now if you will turn to slide 5, into refining and supply which, as I mentioned, earned $482 million in the second quarter. There are two main topics about which I will comment -- Sunoco's realized margins during the quarter and the progress of our announced capital projects.

First, speaking to refining margins, as we did last quarter, if you look at slides 6 to 9, we have included some detail of the realized refining margin versus our reported market benchmark for each of our geographic refining regions. Rather than walk through each slide in too much detail, let me make a few summary comments.

In the Northeast, our realized gross margin for the quarter was $12.32 a barrel, which was up about $0.75 a barrel from last year’s very strong second quarter, and was also about $0.73 a barrel better than our standard 6321 benchmark. On the input side, realized crude costs in the second quarter were $1.66 a barrel higher than our Dated Brent plus $1.25 a barrel benchmark. So still reflective of a very expensive market for light sweet crude in the Atlantic basin, but improved from the first quarter of this year.

While the premium for the West African crude versus Dated Brent was higher in the second quarter than in the first, improved timing of purchases, lower transportation costs and, as we’ll get to in a minute, lower crude costs associated with the newly modified Philadelphia catcracker allowed us to more than offset this increase during the quarter.

On the sales side, the product margin realization in the Northeast versus the benchmark were, as expected, significantly improved from the first quarter, as value-added premiums for RBOB-blended gasoline, ultra low sulfur diesel and jet fuel all improved significantly from earlier in the year. Versus the second quarter of last year, while realized margins were higher, the differential versus benchmark was lower as this year’s margin strength was captured more in the very strong margins for conventional gasoline included in our benchmark crack spread.

I would note that just as a note, in the appendix to our conference call slides, and in the statistical supplement sheets on our website, we have begun to report an additional benchmark crack spread for our Northeast refining operations that better reflects our actual production output and the premium uplifts available to us for RBOB gasoline over conventional, and diesel and jet fuel over heating oil. We refer to this as the 6321 value-added benchmark and in this marker we include 50% of the three for gasoline is RBOB, and 75% of the two for distillate is either ultra low sulfur diesel or jet and kero fuel. So while the same variety of factors, such as actual product mix, timing of sales and purchases, inventory changes, et cetera, will continue to impact our realization versus this or any benchmark, we feel this value-added benchmark will correlate much better to our actual revenue realizations and as a result we’ll likely begin using this marker to greater degree in our discussions with you about Northeast refining margins.

If I can turn now to the MidContinent region, where industry downtime had a more significant market impact, our realized gross margin in the second quarter was $22.14 a barrel, up over $7 a barrel from the second quarter of last year but about $6 a barrel lower than our standard WTI based 321 benchmark. Again, on the crude side, actual crude costs were $2.17 a barrel above the WTI plus $0.75 a barrel marker, as WTI continued to be a weak relative benchmark.

Additionally, the price of Canadian syncrude, which accounts for about half of our crude slate at Toledo, traded at an increased premium to WTI during the quarter, due largely to upgrade or maintenance and other downtime among Canadian producers.

On the product side in the MidContinent, our realization was almost $4 a barrel below the benchmark. This correlation, also seen in last year’s second quarter, is fairly typical of periods when gasoline crack spreads are very strong. This is primarily because the 321 marker we use implicitly assumes that two-thirds of our MidContinent refinery production is gasoline when it actually averages more like about a half.

So let me say in summary, putting all those numbers and relationships aside, clearly second quarter refining margins were very strong by any historical measure.

More currently, while third quarter crude costs remain high and margins have fallen from the record second quarter levels, particularly in the Northeast, underlying fundamentals and the longer term outlook for refining continue to be very favorable.

Now let’s turn to a major capital project activity in the second quarter. If you turn to slide 10, a few comments on our Philadelphia catcracker expansion and modification project. As a reminder, work on the project, which began in early February, was completed in late April. Final tie-in work during April reduced second quarter production in the Northeast by approximately 1.5 million barrels.

Now, through the months of May and June, we spent a great deal of time lining out the unit, testing limits on rate, temperature, catalyst usage, resid input and crude slate. We demonstrated the compliance of our new environmental equipment installed during the project and ran a number of trials in various operating scenarios.

Now, versus the pre-expansion capacity of 70,000 barrels a day, with residual fuel upgrading which on average was approximately 5,000 barrels a day, the expansion and modification benefits are significant. While we were in operation for the maximum rate, we’ve been able to increase unit feed to 85,000 barrels a day, and while in operation for maximum resid cracking, we’ve been able to process over 25,000 barrels a day of residual fuel as part of the feed.

I would also note that in conjunction with the expanded rate and upgrade capabilities, this project has significantly enhanced the flexibility of our entire Northeast refining complex to run a broader mix of slightly heavier crudes. In this mode, we can purchase more resid rich lower priced crudes and capture the project benefits, not so much from production for sale upgrades as from the crude cost benefits.

Now, during the trial and phase-in periods of May and June, unit rates averaged 75,000 barrels a day of input, including 23,000 barrels a day of residual fuel input. The income contribution, as measured versus the pre-expansion standards, as estimated by either the increased residual fuel feed to the unit or by our increased use of slightly heavier lower cost crude, was approximately $15 million after tax for the months of May and June.

While product margins have come off in July, the crude and resid cracking benefits for this unit remain significant and for the third quarter, we expect unit rates to average near 85,000 barrels a day.

Turning to slide 11 and the MidContinent, there were two major capital project activities during the quarter, both of which were completed in early July. First in Toledo, we completed the final tie-in work for the crude unit, the bottleneck project, which had only minimal production impact on second quarter. As you may recall, this project increases the effective nameplate capacity and crude unit capacity at the facility by 20,000 barrels a day, with project economics expecting 15,000 barrels a day of additional production, namely jet fuel.

We completed tie-in work for this project in early July and began to increase rates on the unit as the project was completed. Like with the Northeast project, we’ve put the system here through some testing, including performance using different crude inputs, and the new equipment has run well, with crude rates over 170,000 barrels a day and the incremental production largely jet fuel and all products on spec.

Going forward, we expect to achieve average annual light product production of about 15,000 barrels a day more than previously achieved levels.

In Tulsa, the refinery was shut down for scheduled turnaround maintenance for essentially all of June, with an impact on second quarter production of approximately 2.3 million barrels. The production impact for July for the completion of the work was approximately 600,000 barrels at the beginning of the month.

The Tulsa facility is also back to full operation and going forward, we believe that the work done in Tulsa should modestly improve the operational performance, things like distillate and lubricant yields and the reliability of the refinery.

In summary, the second quarter was a record quarter for Sunoco. Our non-refining businesses made a solid contribution, with particular strength in retail marketing. In refining and supply, despite a significant amount of project activity, there was less planned downtime than in the first quarter, which enabled us to benefit from the very strong refining margins afforded by the market.

Looking towards the second half of the year and beyond, the margin environment for refining will obviously remain volatile but we believe constructive longer term. We have completed all of our major capital project work for 2007 and expect that these investments will add to our earnings power in future quarters.

With that, that completes my comments. I would ask Marcus to open the lines up for any questions you may have.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Neil McMahon with Sanford Bernstein.

Neil McMahon - Sanford Bernstein

Good afternoon. Just a few questions; the first one is really when you look at the shape of the oil curve going forward, we’ve had various comments from some oil companies in terms of what they are doing with their inventory levels. Do you see a change in terms of the way you are going to hold inventory, given the move to backwardation? Maybe you could comment on if you are changing any sort of activity or crude purchases based on what is happening with the flip between WTI and Brent in terms of pricing differentials.

Terence P. Delaney

We are always looking at the market structure and our opportunities to build and hold some products, when the Katanga market will allow for that. We are always trying to optimize our crude purchases.

But from a materials standpoint, the biggest thing for the third quarter for us is to run these facilities now that we are out of the maintenance mode, at peak operating capability and to use, for instance, in the Northeast system, the flexibility we now have to buy crude not just from West Africa but from some other locations. But nothing in a material way to give to you in a different modeling perspective, if you will.

Neil McMahon - Sanford Bernstein

Okay, maybe just a question related to your new capacity. Could you give us an idea of your entire operations, what would you say your maximum gasoline production capacity is and diesel capacity is? Just roughly, given the new investments?

Terence P. Delaney

What I would say is incrementally, let me go incrementally off of, if you will, average realized quarters from before. Incrementally in the Northeast, again depending upon what mode we are running, the expanded catcracker unit, we could be doing 10,000 to 15,000 barrels a day more gasoline and distillate in lieu of residual fuel. And in the MidContinent, incrementally, particularly with respect to the Toledo Crude Debottlenecking project, we should be doing similarly 10,000 to 15,000 barrels a day more of crude input. That would result in largely more jet fuel and maybe a little bit more gasoline with it.

So I would look at it more as an incremental improvement over best previously achieved quarters.

Neil McMahon - Sanford Bernstein

Okay, great. Thanks.

Operator

Your next question comes from Nicole Decker with Bear Stearns.

Nicole Decker - Bear Stearns

Good afternoon, Terry. On your coke segment, maybe you could help us; it looks like some of these activities that you have undertaken are going to meaningfully impact earnings in the upcoming quarters. Could you just give us some guidance as to how earnings might ramp up?

Terence P. Delaney

Yes, Nicki and actually, as a matter of fact, we’ve added some disclosure in the 10-Q this quarter that speaks to our expectations for next year, and that’s really when the more significant changes will occur. Not so much in the second half of this year but next year, there are changes that happen to the tax credits related to section 29, but there are also changes that happen to some of our contracts. Brazil will be on for a full year and we are looking for income next year -- instead of the 50 or so we are going to make this year, income next year of the $70 million to $75 million range.

As we exit next year, after we complete that second Haverhill project, we would be looking for income in the $90 million to $95 million range, for projects in hand, if you would now, as we go into 2009.

But for the second half of this year, I wouldn’t look for much of a change relative to the first half. We will pick up a little bit with more full production from Brazil but the bigger changes are next year.

Nicole Decker - Bear Stearns

That’s very helpful. I think at your last strategy presentation, you had given an aspiration for $150 million in earnings in this segment by 2009. Are you still looking to augment with acquisitions or maybe other activities?

Terence P. Delaney

Right, Nicki. What we were hoping for is to leave 2009 with a run-rate of about $150 million of earnings from coke. As I said, with the completion of the second Haverhill project at the end of next year, we will have about $95 million booked, if you will. So to get to that $150 million may require us to do a couple more projects where we are 100% owners, similar to the size of the Haverhill project.

We continue to work a lot of development prospects and continue to be very optimistic of that potential but I do not have anything new to report on that at this time.

Essentially, it is the need to close out a couple more new projects in the coke business.

Nicole Decker - Bear Stearns

Thanks, Terry.

Operator

Your next question comes from Doug Leggate with Citigroup.

Doug Leggate - Citigroup

Thank you. A couple of things for me, Terry, please. Can you summarize the high acid on heavy crude runs, or heavier crude runs that you had in the quarter and maybe give some guidance on what you expect over the balance of the year?

Terence P. Delaney

On the high acid side, in the first quarter we ran about 50,000 barrels a day in the Northeast, and again in the second quarter, we ran a rate like that. Again, part of that -- that was lower than what we will average in the third quarter. In the third quarter, we should be back up to the 75 to 80 kind of run-rate that we’ve achieved in prior quarters. Again, in conjunction with that Philadelphia catcracker project, there was also that big crude unit that connected with it was also down for turnaround in the first quarter and didn’t come up until into April, so that impacted the amount that we used in the first half of the year. But going forward, we’ll be back to looking for 75 to 80 a day.

Doug Leggate - Citigroup

What about the heavier grades that you referred to in your prepared comments?

Terence P. Delaney

You mean the ones that we kind of ramped up a little bit as we brought on the project?

Doug Leggate - Citigroup

Yes.

Terence P. Delaney

Well, our experience in May and June were that we backed out about 100,000 to 125,000 barrels a day of the lighter sweet crude that we ran and substituted some crudes that we get from either Canada or the Caspian Sea, so again, depending upon the economics and what operating mode we want to be in, we could continue to do that as well.

Doug Leggate - Citigroup

And that is something we should think about as a run-rate going forward?

Terence P. Delaney

It could be. Again, there may be times where we will go back to wanting to run maximum light sweet crudes and have maximum feed to the catcracker to make maximum gasoline, if you will. But that is the kind of potential that we do have and I think on average, we probably will be broadening the portfolio of crudes we run and on average, using more of the slightly higher sulfur sweet crudes.

Doug Leggate - Citigroup

And just a couple of other quick ones. Any idea of the opportunity cost of the downtime in the second quarter?

Terence P. Delaney

I will let you put a number on it. I would say that we were -- obviously we were down for the whole month of June in Tulsa, so that is about 2.3 million barrels during a pretty rich margin period.

We were down for about 1.5 million barrels in April in the Northeast as we completed the turnaround work and the expansion work, and we probably lost about 600,000 barrels of production in May and June as we completed the Toledo project.

So all in all, about 4.5 million barrels less than optimum production as we completed these projects in the second quarter. You can put the margin potentials on it as you think see fit.

Doug Leggate - Citigroup

And a final one from me; now that you’ve got these major capital projects behind you, could you just update us on your expectations for capital expenditures over the balance of the year and perhaps dovetail that with some comments on your expectations for share buy-backs?

Terence P. Delaney

I’ll speak to the capital and I’ll ask Tom to speak to the buy-back. On the capital, we’ve spent I think about $633 million in the first six months of this year, and in the second-half, we are pretty much still in line with what we laid out at the beginning of the year, which would mean we probably have about another $600 million that we would expect to spend in the second-half of this year. Now, included in that $600 million is $100 million or so of spending towards that Haverhill coke project and about $50 million or so of capital projects associated with Sunoco Logistics, our MLT.

So there’s about 450 yet to be spent I refining, marketing and chemicals, if you will. But that is still pretty much in line with what we laid out at the beginning of the year.

As to share repurchase, Tom.

Thomas W. Hofmann

Doug, we did buy 100 back in the second quarter and we ended the quarter, as you can see, with a very, very strong balance sheet, so we will continue to look at that program and really, nothing has changed in our strategy of looking at that. To the extent that we find opportunities to build the business, we will spend money to expand, and to the extent that we don’t have those opportunities, we will buy shares back.

Doug Leggate - Citigroup

That’s great. Thanks, guys.

Operator

Your next question comes from Arjun Murti with Goldman Sachs.

Arjun Murti - Goldman Sachs

Thank you. You commented on the expansion opportunities in coal and coke. Could you just talk about how you are seeing your other non-refining businesses? Can we assume that any additional gains from marketing or chemicals is more likely to be margin related or not? I think you had an overall goal to double your non-refining earnings over the next couple of years, but I guess it kind of seems like coal and coke is on its way to do that and maybe some of these other businesses, it is less clear.

Thomas W. Hofmann

You’ve got coal and coke down. As far as the logistics business, they have grown that pretty significantly, have some pretty good organic growth and part of that would have to be acquisitions as well. Debbie [Fratts] has spoken about that quite a bit to the analyst community.

Marketing, I think you are right there. There are opportunities to expand at times to make some acquisitions, but that is going to be more of a margin play.

And in chemicals, we’ve run that well. The volumes are decent but that is going to have to be where margins come back strongly. We had said back in December that we are looking at opportunities for chemicals because we’ve not been happy with the returns. So we will continue to pursue that strategically.

I don’t have anything else to say about that but if you are looking at that $400 million of earnings that we expect from the other businesses, a significant part would have to come from a return to margins in our chemical businesses.

Arjun Murti - Goldman Sachs

Thank you. And maybe one follow-up on the stock buy-back, do you have a target debt-to-cap or some other metric of debt that you are comfortable with that you can share with us?

Thomas W. Hofmann

We’ve said historically that we feel that -- now this is on a revolver covenant basis, okay and let’s look at it that way. In that 40% to 45% range, we feel very comfortable. The other thing obviously we have to look at is funds flow to total debt. That’s a key measure for the agencies and we continued to look at that, but the simplest measure and one that is very easy to calculate is debt-to-capital, and in the 40% to 45% range, we feel very good about that.

Arjun Murti - Goldman Sachs

That’s great. Thank you very much.

Operator

Your next question comes from Jeff Dietert with Simmons.

Jeff Dietert - Simmons

Following up on Doug’s question on feed stocks at Toledo with syncrude trading at a steep premium, as you mentioned, were there any feed stock changes there during the quarter or expected in the third quarter?

Terence P. Delaney

Nothing substantial there. I mean, that facility runs well on that diet. It most definitely was expensive relative to WTI but we still ran about 75 a day or so of syncrude there. The ability to replace it is not that simple logistically all the time.

Jeff Dietert - Simmons

Shifting to your chemical business, it seems that phenol and [cumene] are heavily integrated with your Philadelphia and Eagle Point refineries, and phenol with Haverhill. Is the polypropylene analysis a separate analyst from the phenol and [cumene] analysis, as far as strategic options?

Terence P. Delaney

I would not necessarily conclude that, Jeff. I would say although they might be a little bit more standalone, certainly we have a Gulf Coast polypropylene operation that gets supplies separate from Sunoco's refining system and has production separate from that and we have the same in the MidContinent region.

I think both have some integration but also are capable of being separated from our refining operations and that is how we measure their profitability. We try to do it on an arm’s length basis. Certainly in the Northeast the refining system benefits to some extent to having a steady outlet for its benzene and propylene, but on the other hand the chemical business benefits from having a secure supply that they don’t have to pay for transportation from the Gulf Coast, so there is some integration there that is beneficial for sure.

Jeff Dietert - Simmons

Thank you.

Operator

Your next question comes from Mark Gillman with Benchmark Company.

Mark Gillman - Benchmark

Good afternoon. I have a couple of things. On the coke side, what did you do in the quarter regarding the tax credits, in the second quarter, that is? And what is underlying, Tom or Terry, regarding oil price level and its impact on revised tax credit levels in terms of those ’08, ’09 numbers you mentioned?

Terence P. Delaney

On the first one, Mark, through the first half of this year we did not have to accrue for, if you will, or crude prices were below the threshold price, so we did not -- we weren’t at a point where we would lose any credits. Given the run-up in crude prices in July and here in August, we probably have some exposure in the second half, depending upon what crude ends up averaging.

The benchmark price where we start to lose some of these tax credits is when WTI averages something over $63 a barrel for the year. So we will have to see how it shakes out in the second half. 63 to 78 is the phase-out range, and our total exposure on an annual basis for ’07 is $30 million. So we will see where things shake out the rest of the year. If prices were to stay exactly where they are today until the end of the year, in this upper 70 level, we could potentially lose probably around $10 million of tax credits.

Mark Gillman - Benchmark

And underlying the forecasts that were mentioned for ’08 and ’09?

Terence P. Delaney

The tax credits that would be in there would be not crude price affected. We lose the section 29 credits at the end of this year and then the credits that would continue on are what is know as section 45 and there is no phase-out for those associated with crude price.

Mark Gillman - Benchmark

Let me shift to another one, if I could; how much WTI or WTS do you actually run in the MidContinent?

Terence P. Delaney

About 120,000 barrels a day. Most all of Tulsa is WTI or WTI priced, and some in Toledo.

Mark Gillman - Benchmark

The $15 million net income contribution from the expansion of the catcracker at Philadelphia, are there any incremental operating costs, Terry, associated with running at a higher rate?

Thomas W. Hofmann

There are some incremental higher operating costs but most of it actually is benefited by the fact that it is a net savings, so there is actually a cash credit offset by depreciation. It is included in the $15 million number that we has as the net income number. That includes the associated expenses

Mark Gillman - Benchmark

And that is net of the incremental depreciation as well?

Thomas W. Hofmann

Yes.

Mark Gillman - Benchmark

If you were to recomputed that number based on spreads in place today, do you have any idea what it might look like?

Terence P. Delaney

Actually, as we looked at how it should help us in July, it would be similar numbers. Again, Mark, we can get this either through some crude savings or for the upgrade of, if you will, replacing the input to the unit as being resid instead of gas oil.

So incrementally -- and of course, we are running the unit a little bit harder in July as well, so I don’t think the variability to what the unit can contribute is going to be that great. It certainly will be market-dependent but because of the flexibility it affords us, I think we are going to be successful in pretty much any market in getting a good contribution.

Mark Gillman - Benchmark

So despite the fact that the resid gasoline spread is, I don’t know, $15 lower as we speak today than in the second quarter, you say that the contribution would not change?

Terence P. Delaney

That’s right because we may still get it in the crude differentials between West African crudes and the other kinds of crudes we might run and at the end of the process, not really make more gasoline but make more light cycle oil that we blend off into the distillate pool.

I’m just talking directionally and materially. There’s a number of different ways where the unit can contribute to us.

Mark Gillman - Benchmark

Okay, guys. Thanks very much.

Operator

Your next question comes from Paul Cheng with Lehman Brothers.

Paul Cheng - Lehman Brothers

Hey, guys. Hopefully a short question; Terry, last quarter in the first quarter you have an inventory loss of about $40 million, $45 million pretax. Is there any inventory gain or loss in the second quarter?

Terence P. Delaney

Good question, Paul. No, not really of any material nature. If you recall, in the first quarter we had a significant draw-down of product in part associated with the turnaround activities, and then we had a reserve for it at the end of the quarter.

During the second quarter here, although year-to-date we are still in a net draw position for refined products, instead of being 4.5 million of reserving barrels, we are down to 1.5 million barrels of reserve. Now, the reserve price for that did increase so we took a little bit of a charge for that but on the other hand, the net change in the inventory mix offset that and I would tell you that our second quarter results are not significantly impacted at all by what we call inventory noise.

Paul Cheng - Lehman Brothers

Earlier though I think when you talked about retail, you are talking about a 6% year-over-year gain, I think on the sales. Is that an apples-to-apples on those stores over 12 months, or are you just talking about the system as a whole?

Terence P. Delaney

Good question too, Paul. It was the second quarter to second quarter, and I guess it wasn’t an apples-to-apples in the context of -- although we are 6% -- for all the sites that we own or lease, the volumes are up 6% year-on-year. But again, part of what happens as part of this retail portfolio management program that you’ve heard us talk about for a number of years is more and more of the sites that we own or lease that are at the bottom of the list, if you will, as far as volumes and earnings, we’ve been moving them out of our ownership into the ownership of other hands, either the dealers or the distributors on them. So there is a different mix of sites in that pool.

If we look at just the sites that we own or lease, that were open both years, so that is more of an apples-to-apples, we were up about 2.5% second quarter to second quarter. Does that help?

Paul Cheng - Lehman Brothers

Absolutely. And in your coke business, the percent in Brazil, just starting up -- what is the earning contribution in the second quarter?

Terence P. Delaney

For Brazil, is that what you said, Paul?

Paul Cheng - Lehman Brothers

Yes.

Terence P. Delaney

For the second quarter, it was a little bit less than $1 million. As I said, going forward, it will be about $2 million a quarter until we ultimately conclude whether or not we are going to move our ownership up from 1% or 20% or otherwise structure the deal a little bit differently to give us some kind of comparable value.

Paul Cheng - Lehman Brothers

And you have indicated that there is not any additional major turnaround you plan for the second half, but let’s say under a not so favorable market condition, if margins continue to slide from here, is there any meaningful turnaround you can push for to be able to conduct over the next two months?

Terence P. Delaney

Probably not, Paul. We have really had a very busy maintenance program in the first six months of this year and practically, I don’t -- no, there is nothing we would move up in the next few months.

Paul Cheng - Lehman Brothers

Okay. In chemical, maybe I see it wrong but it doesn’t look like the cash cost sequentially maybe up about $10 million to $11 million from the second quarter. I think partly it is related to energy. Can you break down between what is the component increase related to energy and what are the other things?

Terence P. Delaney

Part of it is energy, Paul. I don’t have all the specific numbers. Part of it is they get their allocation of, as I alluded to, anything that is stock price related. Compensation, that was higher in the second quarter than the first because our share price was up $7. Performance related compensation accruals were up on the basis of a very strong second quarter, and more fuel usage and utility price. They were the main components.

The other thing is your number may be off a little bit because our actual tax rate may have changed from quarter to quarter. I don’t think our actual expenses were up $10 million, but you can circle back with Tom more specifically on that.

Paul Cheng - Lehman Brothers

Okay. Tom, if you don’t mind, give me a call or send me an e-mail with the breakdown?

Thomas W. Hofmann

Sure.

Paul Cheng - Lehman Brothers

Also, this is probably for Tom; Tom, what is the sustainable maintenance capital requirement on a 12-month basis for your system, if you can break down between refining, retail marketing and chemical.

Thomas W. Hofmann

Paul, what we’ve historically looked at there is it is pretty close to depreciation rates. If you look at everything in total, and depreciation is running in the 450, 500 a year range, that is probably not a bad -- that is system wide, including everything that we do -- that is probably not a bad run-rate from a requirement for maintenance.

Paul Cheng - Lehman Brothers

So it is about in the $450 million to $500 million?

Thomas W. Hofmann

Yes.

Paul Cheng - Lehman Brothers

Okay, and then --

Thomas W. Hofmann

And obviously there’s some timing in there for the turnarounds, but that’s a pretty decent rate.

Paul Cheng - Lehman Brothers

Okay. Final question -- Tom, or maybe this is for Terry, if I look at the traditional 6321 market indicator in the Northeast and I think that when we take into consideration the premium portal, the reforming gasoline, those that the premium has been coming down compared to the second quarter level, maybe that’s off by say $0.50 to $1 per barrel. But on the other hand, I was wondering more as it accrues and they give you about $0.50 benefit, so net net, if we are still looking at the 6321 crack spread, is that a reasonable proxy in terms of the second to third quarter, that what kind of margin realization changes that we should be looking at? Or are there any other things that we should take into consideration?

Terence P. Delaney

I think that is reasonable. Crude premiums continue to be quite high, but as you alluded to, Paul, we do have some other flexibility. More and more, as I alluded to in the comments, Paul, I think we are going to wean ourselves off of that -- I’ll call it the old 6321 benchmark and get to more of the value-added 6321 that we put in -- I don’t know what, slide 21 here in these conference call slides. And when we do that, I think the product realization discussion that we have to have will be minimal, because this does a better job of capturing that and we will focus the differences more on what is happening in the crude market.

But your overall conclusion is fair.

Paul Cheng - Lehman Brothers

Okay, how about in the MidContinent system?

Terence P. Delaney

Same thing there. I’d say there’s a lot of moving parts but for now, the best guidance I could give you is as that benchmark moves, so will our realized margins move, second to third quarter.

Paul Cheng - Lehman Brothers

Very good. Thank you.

Operator

Your next question comes from Robert [Puon] with Golden City Financial.

Robert Puon - Golden City Financial

Based on today’s pricing on the crude oil and the [inaudible], the next quarter, if you [inaudible] on WTI, the profit margin is only about $12 or maybe $14 the most. Is it -- what is the break-even part --

Thomas W. Hofmann

We can’t hear you.

Terence P. Delaney

Your question is really breaking up. We can’t hear you.

Robert Puon - Golden City Financial

Okay. I have to hang up the other phone. Then it might be a little bit better. Just one second.

Terence P. Delaney

Marcus, we can move on to the next one --

Robert Puon - Golden City Financial

It’s okay now. Based on today’s market trading on the crude oil, if the crude oil doesn’t come down, does it mean not much money to make on the next quarter, on this coming quarter?

Terence P. Delaney

I am not going to get into projecting what the quarter will end up being. Crude prices are high and margins, as we talked about in the Northeast, are certainly lower than they were in the second quarter but there is clearly still profit opportunity in the MidContinent. Our retail business is doing well and there’s a lot of time and a lot of season and a lot of potential weather and other changes that could happen as the quarter rolls out. We won’t be making any projections here today.

Robert Puon - Golden City Financial

Okay. Thanks.

Operator

Your next question is a follow-up from Mark Gillman with Benchmark.

Mark Gillman - Benchmark

Give us an update on what you are thinking regarding hydro cracker conversion projects at this point?

Terence P. Delaney

Still progressing with the engineering and the timetable for that, both in Toledo and in Philly. We will have more to say on that, Mark, probably late this year when we probably do another update, as we’ve done in others. Again, those projects are really late ’08 at the earliest, early ’09 kind of projects. But they are both still looking attractive to us but there is some work yet to be done on them.

Mark Gillman - Benchmark

Thanks, Terry.

Operator

Your next question comes from Richard Voliva with Deutsche Bank.

Richard Voliva - Deutsche Bank

Good afternoon. Just a quick question on diesel and heating oil inventories. There is obviously a lot of noise in the [dealer stats] right now with all the switches between non-road and everything. Can you give us a little bit of a flavor for what you are seeing in terms of heating oil inventory or distillate inventories as we head into the fall hear, particularly I guess in pad one?

Terence P. Delaney

Although heating oil inventories look low year-on-year and versus normal, and they probably really are to some extent, I think it is a little early to get too excited about that. It doesn’t take a whole lot to replenish those. And given the changes in off-road data, I’m not sure how much is really heating oil and how much isn’t, so I don’t have much more to add to that, Rich, other than although heating oil looks a little low right now, it is not getting us terribly excited that you can count on a great winter season yet. On that one too there is a lot left to be written, if you will.

Richard Voliva - Deutsche Bank

That’s fair. The with the new Philly, the catcracker there, you have a lot of flexibility is what you are basically saying between flipping back and forth between diesel and heating oil and what not, right?

Terence P. Delaney

Yes.

Richard Voliva - Deutsche Bank

Okay. Perfect.

Terence P. Delaney

Yes, and the future hydro cracker project in Philadelphia can be a very much big addition to that, because that can really help us convert a lot of heating oil to on-road diesel. So if we do that project and get that on in ’09, that might give us the capability of doing another 45 or 50 a day of such.

Richard Voliva - Deutsche Bank

Great. Thanks.

Operator

Your next question comes from Paul Sankey with Deutsche Bank.

Paul Sankey - Deutsche Bank

Yes, it’s another Deutsche Bank one for you. I have a question there from Rich.

Terence P. Delaney

You’re not together, I gather?

Paul Sankey - Deutsche Bank

No, I was a bit worried that we might be breaking up like the previous questioner as well, so I asked Rich to get on there. On the market firstly, is there going to be any impact from natural gas and the very big disconnect between natural gas and oil that we’ve seen this quarter, do you think, or is that not an issue at all?

Terence P. Delaney

In our reported results, Paul?

Paul Sankey - Deutsche Bank

Yes, I was just wondering if what we are seeing, this very big disconnect between nat gas is going to be a material issue for you guys or whether it is really not one to think about.

Terence P. Delaney

Not that material. We end up obviously buying a little bit more natural gas and using a little bit of our own fuel gas, a little bit more, sell some more of that, as gas is cheap relative to that. But from an overall profit perspective, it is not a big item.

Paul Sankey - Deutsche Bank

I guess one that is important and people have been asking a little bit about it but not quite parsing it directly is the fact that margins have collapsed, I guess basically because product prices have fallen but crude prices have risen. What is going on there? What is your perspective on why we would have this issue? Do you think it is related to the way the curves are shaped? Any observations you’ve got would be interesting. Thanks.

Terence P. Delaney

You might or might not think they’d be that interesting, Paul. I’ll let you be the judge.

A lot of what happens is, in my opinion, seasonal. We are in the second half now. The driving season inventories are on the rebuilding mode. Refineries are coming back to operation, so some of it I think, particularly on the product margin side, should be expected.

I think as we’ve seen, particularly over the last several years, when the financial money is coming into the market, it kind of amplifies the physical fundamentals and when that financial money tends to leave the market, it tends to amplify the downward correction, if you will.

On the crude side, I don’t know that I really have anything to add to the discussions on that as to why that might be going up at the same time. I just don’t have anything to add there, Paul.

Paul Sankey - Deutsche Bank

But you seem to be hinting that you think that it is financial money that is coming in, it is financial flows that are coming in to drive up the price, rather than a real physical need.

Terence P. Delaney

I think they play a part. Again, everybody has their own opinion. Sometimes that -- we tend to talk internally here that they more amplify some physical fundamental but they can also lead sometimes too. But they definitely play a part.

Paul Sankey - Deutsche Bank

And, further to Neil McMahon’s original question, you seem to be answering that you tend to play Katanga with products but not with crude. Is that a fair statement or did I just misunderstand the way you answered?

Terence P. Delaney

No, that’s a fair statement, Paul.

Paul Sankey - Deutsche Bank

Interesting. Okay, final one for me; you had some quite significant management change in the quarter. Is there anything that you would take the opportunity to add on the way that the management structures or at least personnel has changed?

Terence P. Delaney

Sure, Paul. You are alluding to Joel’s change in role from the EVP head of refining and supply to being a strategic advisor. No, it is exactly as we’ve talked about. Vince Kelly and Mike Hennigan have been Senior Vice Presidents in charge of refinery operations and commercial for the past year-and-a-half, and have worked for Joel and with the company for a number, for the last six or seven years. So I think it was a normal transition and a personal choice of Joel’s.

Joel is still around as an advisor and Vince and Mike have worked with him and continue to do so to this day.

Paul Sankey - Deutsche Bank

Okay, great. I’ll leave it there. Thank you very much.

Operator

(Operator Instructions) At this time, Mr. Delaney, you have no further questions.

Terence P. Delaney

All right. Thank you, Marcus and again, I appreciate everybody’s participation, and either myself or Tom Harr will be available for further questions. Thank you.

Operator

This concludes today’s conference. You may now disconnect.

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