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Wall Street Breakfast

Tesoro Corporation (TSO)

Q2 2007 Earnings Call

August 7, 2007 10:30 am ET

Executives

Scott Phipps - Manager of IR

Bruce Smith - President and CEO

Bill Finnerty - EVP and COO

Lynn Westfall - SVP of External Affairs and Chief Economist

Greg Wright - Chief Administrative Officer

Otto Schwethelm - CFO

Analysts

Mark Flannery - Credit Suisse

Doug Leggate - Citigroup

Doug Terreson - Morgan Stanley

Paul Sankey - Deutsche Bank

Jeff Dietert - Simmons & Company

Paul Cheng - Lehman Brothers

Roger Read - Natexis Bleichroeder

Ann Kohler - Caris

Neil McMahon - Sanford Bernstein

Presentation

Operator

Good morning, my name is Crystal and I will be your conference operator today. At this time, I would like to welcome everyone to the Second Quarter Earnings Release Conference Call for Tesoro Corporation. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions).

Thank you. Mr. Phipps, you may begin your conference call.

Scott Phipps

Thanks, Crystal. Well, good morning everybody, and welcome to today's conference call to discuss our second quarter earnings. Joining me today are Bruce Smith, Greg Wright, our new Chief Administrative Officer, Bill Finnerty, Otto Schwethelm, our CFO, Lynn Westfall, Arlen Glenewinkel, Phillip Anderson our new treasurer.

If you need a copy of the earnings release we issued this morning or to view the company's supplemental quarterly data you may obtain it from the investor relation section of our website at tsocorp.com. The earnings release contains additional information in the attached tables on our business. In addition, we have updated the other supplemental financial and operational information on our website that is not included in the release. After viewing this information please feel free to contact me with any questions about this material or otherwise following today's call.

I would like to remind everybody that the 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 are many factors which could cause results to differ from our expectations. And with that set-up, I'll turn the call over to Bruce.

Bruce Smith

Thanks, Scott. And welcome to the second quarter conference call. As you noticed in Scott's introductions in the second quarter we have made a number of title changes. For those who just -- to beginning of the changes that we did make, operationally we closed on our purchase of over 400 USA and Shell retail sites and we successfully integrated them into our retail operation.

In addition, we completed the acquisition, integration and assumed operational control of the Los Angeles refinery and executed two turnarounds after we closed.

And finally, we completed the construction of the 10,000 barrel a day diesel desulphurization unit in Alaska. And we did all of these while maintaining excellent performance in our existing operations as we set a new super record of 612,000 barrels a day.

In our press release, we reported net second quarter income of $443 million or $3.17 per share. Finn is going to provide you with more details about our first several months at Los Angeles, and Greg is going to talk about the refineries financial contribution. But the strength of the quarter came from the heart of our existing operation.

Fact -- supported by the statistic that 90% of our operating income was generated by our non-Los Angeles operations. So, stating the obvious, the quarter would have been much stronger with another 40 days of contribution from Los Angeles and/or without the impact of two turnarounds at that facility.

We realized the stub period of our ownership, combined with the rebuilding of inventory plus the effect of turnarounds, makes it complicated to understand how Los Angeles would have performed in the quarter. As you know in the second quarter, the Los Angeles refinery underwent extensive maintenance by performing a turnaround on the FCCU unit principally during Shell's ownership. And then we completed maintenance on a hydrotreater in the hydrogen generation unit.

Consequently, second quarter run rates were not as useful of a predictive tool as we would like and of course it's reasonable to assume that lower throughput rates at Los Angeles positively impacted margins. On June 29th all the maintenance work was finished and in the month of July throughput averaged over 100,000 barrels per day, which is at the high end of that facility's production history and above the rate that Shell gave us in their post turnaround financial plan.

We haven't closed the books for July, but we expect per barrel operating cost to be between $7 and $7.50, and our capture rate to be between 85% and 88% of the 3-2-1 West Coast benchmark crack spread.

Using July's crude throughput rate and the July estimates for cost and capture rates and the actual second quarter West Coast crack spread of $33.87, which admitted at least the most hypothetical part of the calculation, but the Los Angeles refinery would have contributed between $190 and $205 million of net refining income without turnarounds, but including the impact of rebuilding inventory.

Year-to-date operating income surpassed $1 billion and much of the growth can be attributed to the improvements in the Mid-Continent and Pacific Northwest regions where operating income rose by 91% and 68% respectively.

While crack spreads were higher quarterly, throughput rates at Mandan was up 6% or 7400 barrels per day and Anacortes' throughput increased by 4300 barrels per day or 8% over years ago. Alaska was also improved, but turnaround last year in validates that comparison.

When we purchased the Shell and USA assets in May we borrowed $500 million on a revolver, but with the excellent performance of all of our non-Los Angeles refineries of the second quarter we generated more cash than expected, enabling us to repay that debt and achieve our 40% debt-to-capital goal well ahead of schedule. At June 30th, our pro forma debt to cap is 33%. This capital structure put us in a position to meet another financial goal, that is becoming an investment grade company.

During the quarter, we also funded $229 million of capital and turnaround expenditures and year-to-date we have spend a total of $435 million, which may surprise those of you who thought we might struggle to achieve our debt reduction goal, and at the same time fund our $900 million capital budget. Once again, these results clearly demonstrate that as a corporation, we set realistic goals ones that we can achieve.

At the end of the call, I'll briefly discuss some future plans, but first I want Finn to review some of the operating highlights for the second quarter and then Finnerty will also give everyone an update on our capital program.

Bill Finnerty

Thanks, Bruce. Let me start with what we are experiencing on the operation side at the Los Angeles refinery. As Bruce said, operational performance has been good. In fact since we took over operations, we completed a modification to the hydrocracker, which has enabled us to increase the CARB gasoline production by about 10%. We did however, experienced turnaround activity throughout the second quarter and an external power failure, which impacted overall throughput.

Our safety record has been excellent and across all levels of the organization at the refinery ideas are being generated to improve the plants performance. This is due to the experienced team we have assembled, the enthusiasm of the entire employee base, and their ability to react and manage issues, so that they have the smallest impact on operations.

We recognized from the beginning it will take both time and money to improve and sustain the reliability of the refinery. We shared with the street during the acquisition announcement the $1 billion capital program we plan to spend over the next five years to address improvement areas.

To facilitate this, we have established a project management team based on Long Beach, California. This team has been assembled close to our major projects to coordinate and manage with a clear and direct line of site. We understand that our capital program is a critical part of the shareholder value, we are committed to growing, and we are managing these projects with the people and processes to deliver this value.

Based on early indications, we are on track to capture the $100 million of synergies noted in our initial guidance. One of the first opportunities, we identified was around crude logistics with Goldman Eagle. We have already secured cargos of larger quantities, and lower costs then we had with just Golden Eagle. We were also able to move into immediate product between Los Angeles and Golden Eagle during the turnaround to increase efficient production of clean products during planned lower crude ones.

These are just a few examples of synergies we are continuing to discover as we integrate Los Angeles into our system. Elsewhere in the system in June, we completed our dock and blend tankage program at Golden Eagle, which in the past we have referred to as our crude flexibility project. And we immediately started realizing benefits related to logistics and blend flexibility.

At Salt Lake City, we had a very successful FCCU turnaround and are realizing improved yield production with the heavier feed. Bruce has already mentioned the successful start-up of the DDU at Kenai, and I would like to point out that Tesoro completed the project on schedule, and it is now the sole producer of ultra-low sulfur diesel in Alaska.

With regards to retail acquisition from Shell and USA, there has been substantial work completed to integrate these facilities into Tesoro. The process had gone smoothly and cost and margins are consistent with our expectations. Work is in progress to see how we can enhance overall system performance as we select and implement best practices from across the organization.

Product supply and optimization teams continue to optimize our feedstock selection for the system. We continue to expand our global reach and diversify our raw material supply base heading new crude grades.

Operationally, the reliability and maintenance programs we have put in place have enabled the system to perform well, allowing us to capture the strong margins we experienced in the second quarter.

With that I will turn it back over to Bruce.

Bruce Smith

Thanks, Finn. Finn's comments complete our operational review for the second quarter. I want Lynn to next provide some color on the market conditions that existed during the second quarter and then give us his take on where we may be going. Lynn?

Lynn Westfall

Thanks, Bruce. Record high industry margins in the second quarter of 2007 had origins in both demand and the supply side. Gasoline demand continued to grow at 1.1% versus 2006, diesel increased by 2.2%. The combination of plan and unplanned down time at US refineries lower utilization rates during the quarter by 1.5% to just above 89%.

We delivered over 300,000 barrels per day from supply on average for the entire quarter. With turnaround activity in Europe as well imports not filling the supply gap resulted in gasoline inventories, at the end of the quarter there was some 12 million barrels below last year. This represented a decline of over 7% on a day supply basis. Likewise diesel inventories end of the quarter over 300,000 barrel below last year or 5% lower on the day supply basis.

It should be remembered that some of the reported high margin in the second quarter were only available to those with the process WTI crude. With the shutdown of Midwest refining capacity and the inability to physically move WTI crude to other locations, WTI pricing which is the basis for most industry crack calculations widen compared to other crudes.

As an example, during 2006 LLS crude priced at an average of $61 over WTI, but for the second quarter of 2007 that differential average was $5.41 over WTI. Therefore, it appears at approximately $3.80 have reported cracks were not available to most of the industry during the quarter. Some of these discounts on WTI crude are beginning to disappear with the LLS differential now reduced by $0.75 a barrel, which partially explains the current decline in reported industry cracks.

Looking ahead to the third quarter, many of the fundamentals remain strong. Preliminary demand data shows gasoline growth at the same level of the second quarter at 1.1% and diesel outpacing the second quarter at 4% growth. US refineries are still operating below last year's utilization by about 0.5% on a four week moving average basis.

Gasoline inventories currently stand at 600 million barrels below last year or 4% lower. At current production levels reaching the same day supply inventory level by the end of September, we required gasoline imports to average almost 1.5 million barrels a day for the remainder of the quarter, which current prices would be uneconomic. There should be some 25% above the imports received in August and September 2006 and will represent the highest import levels of 2007 to-date.

Likewise diesel inventories now stand at 6 million barrels below last year or 12% lower. To reach the same inventory levels as last September there must be a build over the next two months of approximately 22 million barrels; double last year's build of 10.4 million barrels. With that, back to you, Bruce.

Bruce Smith

Thanks Lynn. And with Lynn's colorful third quarter as a backdrop, Greg, will you take us through the performance metrics that are going to be important for investors to know in the third quarter?

Greg Wright

Sure, Bruce. As I didn't with the guidance for the second quarter, I will break out results for the Los Angeles refinery. At the Los Angeles refinery throughput for the quarter was 89,000 barrels a day for just the 51 days we operated the facility. During the quarter, per barrel operating expense at the plant was $7.72 per barrel. Total refinery operating income with LAR was $23 million, but that includes a $30 million negative associated with the working capital requirement.

Our throughput guidance by region for the third quarter then is as follows. California 270 to 275,000 barrels per day, Pacific Northwest 185 to 190,000 barrels per day, Mid-Pacific would be 80 to 85, Mid-Continent 110 to 115, and that would give us a total, which would be a new record, of 645 to 665,000 barrels per day.

We would expect the overall operating expenses to be in line with second quarter results except for in the California region, which includes higher throughput, and no turnaround activity. By region again, on a dollar per barrel basis, California would be $6.50, Pacific Northwest $2.75, the Mid-Pacific region $1.85, and Mid-Continent $2.80.

Depreciation and amortization for refining is expected to be around $90 million for both the third and fourth quarter. Depreciation and amortization for retail is expected to now be around $9 billion again for both the third and fourth quarters. The corporate and unallocated expense, which excludes depreciation, is expected to be roughly $50 million in the third quarter.

Net interest expense was lower than our guidance based on the larger amount of cash needs for the acquisition, and the quick debt pay down that Bruce referenced. Going forward, we expect our interest expense before interest income to be around $27 million, and finally we expect our tax rate to continue around 38%. Bruce?

Bruce Smith

Based on July's market conditions, to say that the current quarter will be more challenging than the second is a gross understatement. As we look forward, we continue to believe that the long-term margin environment will exceed the five year average driven mostly by slower supply growth relative to rising global demand.

Using that as a base assumption, our assets should continue to generate significant cash flow, which will give us the opportunity to pursue excellent reinvestment opportunities.

In past years, our investment strategy has been to acquire assets, and then to use cash to repay the debt associated with the purchase. Once we reduce debt, we use cash flow to pursue accommodation of organic capital projects, we repurchased shares, and we pay dividends.

Historically, our investment strategy did not emphasize long lead time capital projects because we believe acquisitions that generate immediate returns for our shareholders would add more value. Without a doubt, we have created substantial value for our shareholders by following the strategy.

It deliberately shows a focused asset acquisition investment strategy because we believe that the priority of the investment sequence was first to obtain good refining and marketing assets, assets that couldn't be easily replaced. The core area of this capital investment strategy meant that we did not fully pursue some of the low-hanging fruit that might have been left by previous owners, and keep in mind in our most recent acquisitions we acquired assets that have been at the low end of the former owners' capital allocation process. That, and in some cases performance problems are reasons resold.

As a result of our growth we believe our current size and expected future cash flow gives us the ability to pursue a broader portfolio investment strategy that includes both organic projects and acquisitions what we can fully control our opportunity as opportunistic acquisitions, but today we can begin to more fully unlock the total value of these acquisitions by focusing on organic projects, which use investors can model and value.

To prepare for and execute this organic growth base last year we reorganized staff and redesign the procedures of our capital project group. One the first projects the team tackled, although the project was already in progress, was our most significant investment today: the coker modification project to Golden Eagle.

We have learned a lot from this project and as Finn discussed earlier, our project management team has centralized and it has the size and most importantly the people and the ability and experience to execute notable projects.

In addition to improving the execution of projects to currently, since beginning of this year we have engaged and challenged our entire organization to develop new organic projects. Nearest to say I expect returns from these projects to be consistent with what our shareholders have come to expect and that they will add value to corporation above that, which the commodity market provides.

The capital harvesting effort is being rolled into the long-term financial plan, that will be presented at the Board in November and then with their approval we will be prepared to discuss our future investment plans during an Analyst Day in New York towards the end of this year. At that meeting we will also review the status of the major capital projects in progress, some of which should be completed in the third quarter.

In summary, the first half of 2007 has already made a great year. With the completion of several projects in the last half of the year and the synergies associated with the newly acquired assets will position to deliver better earnings that analysts are currently forecasting.

Last quarter, I said Tesoro had four goals. First, to safely integrate the new assets, which we have completed, I want to acknowledge the great effort of that team. Over 100 people participated in what was the seamless transition, which in part was made possible by Shell employees and I want to thank those individuals at Shell who have made this possible. The team effort and a sense of urgency positioned us to capture future margins.

The second goal was to reduce our debt to capital ratio to less than 40%, which we have also accomplished. Third goal was to capture a $100 million in synergies. This is a 12-month goal and as Finn said we are on track to meet that goal.

And finally, the fourth goal was to identify additional organic projects, which I discussed today, which will give us the basis to compare alternative investment decisions. Deciding how to allocate capital, the future programs that can create new value for our shareholders would be critical, since our expect source, free cash flow to continue to grow for many years due to the quality of our assets and the ingenuity of our people.

I am confident that we will continue to make good decisions just as we have in the past.

With that Crystal, we will open it up for questions.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Mark Flannery with Credit Suisse.

Mark Flannery - Credit Suisse

Hi, I have got a couple of questions. First is on geographic focus -- this question comes up repeatedly, but could you outline what you think about expansion to other geographic areas. How you would characterize approaching maybe more niche markets versus more merchant markets like the Gulf Coast assuming assets are equally available in both areas? And I have a follow-up after that.

Bruce Smith

Mark, we talked a little bit about this in the past. A couple of years ago, two or three years ago, I would have said that just moving outside of the West Coast region want to focus at all. For the past several years, we've retooled our M&A area, the L.A. acquisition came out of that effort. But it was something that had been in progress for really -- we've been targeting Shell for a long time about that particular asset.

The world and our operations have become global. The staff that we have has operated globally. I think that today there really isn't a geographical barrier to us doing something in another market. We've looked at a lot of opportunities. We haven't seen anything outside of the geographic area.

But part of that just basic education, some to reconfirm what we think, and some ways it's to find out areas in particularly cultural areas tax sort of things. I mean areas that obviously that would be new for us. And so, we've been working to understand the world in its global nature a little bit better to understand the ebb and flows. Lynn's spend a lot of time in expanding his model to make sure that we have a little greater look at some of the bigger geographies.

So, I don't think today that there is an impediment to us finding an asset. The problem is really finding one that we think is something that will add, well, we can add some value. And obviously that's where the difficulty comes in, and we've been working on some initiatives and some strategies around that to be prepared. I think it's a matter of the right opportunity. So, nothing that we've got we would say that we're moving whether it's in the United States whether it's outside of the United States, but we clearly have a broader acquisition agenda then we did in several years ago.

Mark Flannery - Credit Suisse

Great. My follow-up question is really about ethanol, a lot of ethanol coming in the second half of the year and into 2008. I guess this question is for Lynn, how do you see that impacting Tesoro's market view particularly, obviously for gasoline margin, as we go forward?

Lynn Westfall

Of course in California right now we are not able to take advantage of any more ethanol, we're only adding 5.7%, and it won't be going up to 10% till several years now, when CARB comes in. So, I really see anything above the legal mandate of how much ethanol we have to add will only be purchased if it's worth its octane value.

So, I really don't see that really affecting that much the margin or the flow of gasoline, again it's going to have the economic uptaking level or the industry will add it. I think you are also going to see a lot of shake out in the business. I wouldn't add that all the new plant capacities is a net addition because I think there are lot of inefficient plans that will probably shutdown. So, I'm not really sure how much more of our really net is coming on the market again because I see lot of these plants shutting down.

Mark Flannery - Credit Suisse

Okay. Thank you very much.

Operator

Your next question comes from a line of Doug Leggate with Citigroup.

Doug Leggate - Citigroup

Hi, good morning guys. Can you hear me?

Bruce Smith

Yeah, we can. Good morning.

Doug Leggate - Citigroup

A couple of things from me I guess. First, just to make sure we are not reading the wrong message here, when you talk about the entering the organic growth base, should we interpret saying that really the acquisition is much less attractive compare to the kind of returns you can get building up your existing assets. Is that fair to think about that way?

Bruce Smith

I won't say that that's the direct result of my comments. I think that what we did in the past, I think it was really a focus of -- we wanted to save our resources, our debt capacity, our cash flow to be able to make acquisitions. And that was first and foremost in our mind all the time. We did some capital projects, but we really didn't stimulate that process inside the corporation.

It's too hard to get people cranked up and then say we were not going to do it, because we've done an acquisition. I think we just too small to do both. I think the reason I would give it is that I don't think the acquisition market is becoming more difficult.

I think in my comments earlier that we are looking more broadly and you can interpret that is, it is more difficult. But I think that there are going to be enough things are come along in that market, the question is will they fit our pistol, but one thing we do know, we think we would be able to do a larger acquisition today and still stay true to course of more fully developing the assets we have got.

We think that their assets for energy saving, their reliability, their conversion assets, our conversion opportunities that we just haven't take an advantage of because that in our overall design in our investment strategy.

So, I think we are going back now to set a new investment whole rate for ourselves in that way we can compare that to anything else that we see because we can control that over a period of years. Some of our willingness to do that, to take that approach Doug, is really based on the fact we think acquisitions are going to be more difficult. But also it gives us just a basis for starting to really talk more fully to the street about things, they can see relative to incremental earnings growth.

And in the past it has been, I think for one of the difficulties for the company has been, it's really been whatever the commodity market gives us and then waiting for the acquisition to come along. I think this would be a better sequencing now we have both tools that we are using and our goal here has been to really develop that more fully for the first time.

One of the things that I would make a comment on, in the past, if you go back four, five years ago, and if we were talking about investing capital, our long-term view was not as strong as it is today. And I think that one of the big fundamental changes, and that's going around to inside the cooperation to stimulate these capital project ideas, is our belief that now that this environment is going to last for a longer period of time, whereas before there was a greater concern on our part that you would just complete the investment process, as margins were beginning to turn.

Doug Leggate - Citigroup

Okay. That sounds very clear. I just have one more, but I am afraid and I get a little detail. If we can go back to some of the comments you made which were really helpful and the contribution from L.A., I think Otto you said 190 to 205 x the inventory effect, so let's say 220 to 235 I guess would be the range?

Otto Schwethelm

Right.

Doug Leggate - Citigroup

But clearly, second quarter was quite an extraordinary quarter. If we can expurgate that for last two year, let's say about very extraordinary levels and compare it to your guidance when you made the acquisition, the 365 of EBITDA which was an '04 through '06 average crack environment, if it look like these facilities probably a little less than perhaps you had anticipated. What's your comment around that and maybe give us some -- steer us to what the whole things might look like in terms of old target or 365 target going forward?

Otto Schwethelm

I don't know that I could do that. I mean, I think we've got a long way to go. We've owned this facility for just a few days, and we've really, we started the quarter trying to say how we wanted to talk about it. This -- I think the 200 million and your numbers are right. I mean, because we are taking out a number of different fractional points, and we cobbled them together in this hypothetical example. And so, I know how accurate it really is.

But the problem is that with all these things were happening these one-time events you don't get a very good reflection of what we think the earning capacity of the refinery is. It's clearly the second quarter was on a half good peak, and what appears to be the year third quarter if you look at where the cracks are today they are substantially below the $33 number that we had in the second quarter.

So, on average, I don't know how this is going to look. We said that we've thought the number historically was going to be sort of 450, and then $100 million of synergies, we feel we could get 550 out of it. I think the $100 million, so far what we've seen, we feel very good about the pace of that, the number for the base facility of 450. We had a half-way good quarter, if we would have been running although some of that benefit was probably derived from the fact that we won't running, which makes it more complicated.

This quarter it doesn't look like it's going to be obviously nearly as strong. So, I think it's a little early for us to try and judge where we think it. But we've got a peak going in one quarter, and the value going, we believe based on Lynn's comments, where imports are going to start to dry up based on the current crack spread. So, we expect to see a rebound. So, I don't know even how the third quarter will portray it.

So, I think what we try to do is to give you a view of what could have been possible and it's going to take us a year. I think before we were able to say compared to the base number that we've thought. I mean, we were running today as the point Doug there has been say, we are running over a 100,000 barrels a day, and this refineries only done that infrequently.

Can we run it to that level for long period of time or converting more barrels in to CARB gasoline? I think there is just -- we need some time in Seattle here. I don't think -- we are not declaring success nor failure here in the first several months. I mean, we're still very confident overall that this refinery is going to perform like we thought, it was going to perform.

Doug Leggate - Citigroup

Great, that's all I have. Thanks very much.

Operator

Your next question comes from the line of Doug Terreson with Morgan Stanley.

Doug Terreson - Morgan Stanley

Congratulations, Bruce and company.

Bruce Smith

Thank you, Doug. How are you this morning?

Doug Terreson - Morgan Stanley

I am doing fine.

Bruce Smith

Good.

Doug Terreson - Morgan Stanley

I also have a question on the capital management program and specifically during the past several years already for shareholder front has been capital investment acquisition and then share repurchases in that order for what I can tell. Although with the recent weakness in the stock and you guys have been -- management team has been oriented towards the shareholders, the outlook for the acquisition market that you highlighted in the conference, if you guys spells in our outlook.

Can you envision and that's a lot there -- but can you envision a scenario where about you would re-bounce the capital management program towards less emphasis on spending in acquisitions and voluntary repurchases and why you are not? So if you could just talk a little bit about how you guys think about those balances Bruce, you haven't taken too much time on repurchases today?

Bruce Smith

No, we haven't. And I think that the -- just starting from the beginning, as we completed the acquisition our first goal again you're talking about how you send messages to the organization. Our first goal was to make sure we got a debt down quickly and we did that. Currently with our whole process, we if you look it our capital programs we've done a few economic programs.

One large one in the coker modification projects Golden Eagle, some other ones that are significant not large dollar amounts. And then we have spent historically, we spent more on maintenance. The part as we bought some plants that had a real maintenance need they were some neglect obviously things even like the blow down standards that you've got, atmospheric blowdown standards that we are spending money there, were exciting facilities things have been non-productive capital. So when we look at how we had to spend the money in the past, we have not really focused on income improvement projects.

Doug Terreson - Morgan Stanley

Sure.

Bruce Smith

So what we've done as we've gone out, let's get a baseline. Let's go out and let's see what we've got, with the facilities in particular -- with the two new facilities that can work together, let's understand what that income improvement baseline will look like and what those returns look like. So that we can sit down and talk to the Board about investment strategy. That strategy if we always I think you have to come back and take a look at the opportunity to buyback your own shares.

And I, like you, I continue to look at our stock performance relative to the companies that I think we more closely approximate, right now I see big a difference. That fact to me there is a huge gab, but I'm not in a position to recommend that we can do something until I think we fully harvest all this other information. So we can take a look at it say to the Board on a factual basis, here is we think we can do it drive, what we can do it drive new income usually we have to invest in obviously maintenance and other reliability safety and regulatory capital.

And then we can make some reasonable determination of what I think the allocate capital and I think the combination of those events probably comes together in November for the Board and our feeling is it is something we then discuss with investors towards the end of the year. So I think we are just -- we've got a gap of a few months and I'm not prepared to jump off a bridge, for example, right now but.

Doug Terreson - Morgan Stanley

Good thing.

Bruce Smith

I really think that we are just trying to get the facts to understand the right thing to do with capital.

Doug Terreson - Morgan Stanley

Okay, Bruce. That's a good answer. Thanks a lot.

Bruce Smith

Sure.

Operator

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

Paul Sankey - Deutsche Bank

Hi. Good morning, everyone.

Bruce Smith

Good morning, Paul.

Paul Sankey - Deutsche Bank

Hi, Bruce you have been pretty clear about L.A. and how much it made in the peak quarter, and we've began to get towards the idea of the fact that we are now and something of valley. Could you perhaps -- what Doug Leggate was asking you. Could you talk a little bit about what the run rate is now for the refinery to make, if we stay in this valley, so that we can at least get the range between peak and trough, and how much this refinery can make? Thanks.

Bruce Smith

Yeah, Finn.

Bill Finnerty

Paul this is Finn. I think Bruce related to you the increased throughput in July. We had the turnaround for the hydrotreater primarily in the month of May all the way through June 29th. July was their first test month that we had to see what the refinery can do. And as Bruce referenced throughput, total throughput was over 100,000 barrels a day, which we were very pleased with it.

And once again it takes a lot of work at the facility to make sure things are in concert. But based on the feedback we're getting from the plant manager and the team out there, we're expecting good performance going forward. Now, we've indicated to you in the past that there is a lot of work underway, maintenance work underway, and we may see something that's materialize. But right now after the first full months of operation, we are encouraged by what we see.

Bruce Smith

I think Paul, that's what makes it so difficult for us. We had a $33 crack in that quarter, we've got a $12 roughly $12 crack today. We blend those two together, and we've got a $22 crack, which is about what we said we were going to do in our acquisition economics more under little higher rates the boy, the extremes are difficult right now. I mean, we've gone from a peak to a valley, and so as we sit here today, where it's a little bit awkward what the right level is.

But we don't think either one of those levels is sustainable, obviously 33 we don't think 12 is. And so, we think it will migrate back to where cracks will probably be more around the acquisition economics. The thing that we do control is conversion, and as Finn said we've done a good job of getting more conversion, and we're running at higher rates. And so, in a very perverse way right now, I feel pretty good about Los Angles. I just wish obviously, we were seeing a little stronger market.

Bill Finnerty

I would also add Paul and in addition to the good operational performance we're seeing mechanically at the plant that we've been able to do a lot relative to the raw material supply going in. We're bringing in the early timeframe a more diverse slate, and with more foreign crude's coming in. We're also doing some blending of these grades prior to going into the facility, which is enabling us to run at the higher throughput rates, and reach some of the maximum constraints that you have at the facility. So, once again operationally from the raw material supply and from the mechanical operation of the plant, July was a very good month.

Paul Sankey - Deutsche Bank

Right. So, you seem to be saying that the 100 million of synergies is very achievable but maybe the 450 is a bit high allowing for the site offsetting that you are able to run the refinery more strongly?

Bruce Smith

I think, I'm still confident that over the course of the year, I mean, I have done more -- confident that if you 12 months that we're going to produce the type of income, we had no acquisition economics. I don't see anything like that, unless Lynn all of a sudden was saying something different about the economic environment.

But based on what we see in the economic environment and where margins are, we don't think $12 is stainable and so the question is how fast is it go backup, I know that there is a feeling that we are get into summer time end of the -- obviously the fall were gasoline demand drops, but we're so low in inventory that just our read on it is that if the margins are going to come back up, and so I don't think we're ready to, as I said earlier, I don't think we're declaring success nor do I think we're saying defeat here in the matter of -- just what's a matter of couple of months.

Paul Sankey - Deutsche Bank

That's great, thanks. Just to continue on Lynn inventory scene, Lynn you make an argument that inventories are low and therefore alongside imports we are likely to see correction upwards, but I guess the same argument could have been made before we saw this downward lurch that we had, that is to say inventories are relatively low, but we've collapsed why do you think -- what's your perspective on why margins are falling so far so fast with a situation were inventories look actually quite tight?

Lynn Westfall

Well, we had amazingly good refinery operations for about last month, the best we've had all year long, so I think that contributed somewhat to the fall. I think people are looking ahead obviously and thinking about third quarter and forgetting about the second quarter. I think my point on the inventory is, with inventories this low we are very much at risk for a pretty substantial upside correction if anything it all happens and we've certainly seen over the course of not only this year. But the last couple of years for a variety of reasons refinery as a whole operation have been less than the hour historically, refineries are more at risk for unscheduled down time these days predominately because of the change in the specifications.

So, my point is that our cushion has gone and in the past all the surprises have been on the upside from refinery operations that sort of thing. A lot of the deterioration that we've seen in cracks has been this unprecedented run up in crude, just about everybody is attributing right now simply to the cash flow from investments not from fundamental of the business.

Nothing happened in the fundamentals of crude in the last month. That would have been an explanation for these run up. So, I think a lot of the margin improvement we are going to see is going from reduction in crude cost not necessarily it is the strength in the products.

Paul Sankey - Deutsche Bank

Yeah absolutely and if I could just have one final part of the -- I guess the old debate which is to say, forgive me if you have mentioned this, but if you could talk a little bit about turnaround and downtime not only you run in the second half but also the way you see your markets, your rivals any observations there and I believe that's it, thanks a lot.

Bruce Smith

Okay, there is not a whole lot of data available right now in the industry about third and fourth quarter turnaround, I would expect with all the turnaround activity we had and all the unplanned downtime we had in the first half of this year, it may be a light turnaround schedule for the rest of the year, but again we do have a lot of our inventory we've got to rebuild and that either is going to come from imports or from refinery operations.

Bill Finnerty

Yes. Paul this is Finn, as you know, we've completed the turnaround within our system for the balance of the year so, we are in good stay as we go through the rest of 2007, and it is not a public information out there, you can go out and see what the turnaround schedule is for the West coast but we do have the numbers, significant turnaround that will start in August on the West Coast.

Paul Sankey - Deutsche Bank

Okay. Thank you, gentlemen.

Operator

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

Jeff Dietert - Simmons & Company

I appreciate the comments on Wilmington, the markets obviously concerned about it. I am going to shift towards Golden Eagle and the work expansion when was that completed?

Bruce Smith

She was mechanically completed the 1st of June.

Jeff Dietert - Simmons & Company

Okay. And so you've been able to shift your feedstock away from again answering that period of time what's the feedstock slate look like now with the work in place?

Greg Wright

I won't get into specific grades, Jeff. But I'll tell you that we're capitalizing on the discounts that we're seeing from South America, whether or not from Brazil, Columbia or from Ecuador. And that complements obviously the slate of California domestic crude's that we bring in. But in essence what the project has enabled us to do is bring in multiple batches and blend to the specifications to reach our limits at the refinery. And it's just in the month of June provided some good benefits for us. So, we're excited about the project.

Jeff Dietert - Simmons & Company

That's all. I will leave it here. Thanks.

Operator

Your next question comes from the line of Paul Cheng with Lehman Brothers.

Paul Cheng - Lehman Brothers

Hi, good morning gentlemen.

Bruce Smith

Good morning, Paul.

Paul Cheng - Lehman Brothers

Bruce just several quick ones, do you have an update on what your capital program looks like in 2008? And also, that with order changes and new addition in L.A. and also with some additional we just saw, what may be a good maintenance or sustainable capital program that we should expect it now that $400 million or still it's in the $300, what kind of number should we be expecting?

Bruce Smith

Paul, we don't have a new number for '08 yet. Again as part of this rollout of our capital so much of that would be in future years that until we sit down and go through that with the Board and updated, we won't have any revisions to it. So, it's probably towards the end of the year, we'll have a number.

But right now, the only thing we can tell you is that we still remain well on track this year for about $900 million of capital. Its capital is getting to be -- it still gets to be there with some difficulties with estimating capital. Even we -- the pace of spending this year has been, we have been able to spend some dollars faster on the coker project. We really haven't had cost overruns. We've just had some ability to get things done move faster than we thought.

But we still think $900 million is the right number this year. But as we shift money into this year from the coker project I think, obviously it's going to effect what we think we are spending in 2008. So, we'll get back to you at end of the year. We'll give you numbers for probably the next several years.

Paul Cheng - Lehman Brothers

How about in terms of what may be on a sustainable or maintenance capital requirement going forward. Are we looking at organization they found a new addition now, just more like in the 400 or still in the 300 million?

Bruce Smith

Again, I think that till we complete this review I don't want to get out and start talking about old numbers. I don't want to mislead anybody. Our goal is to really shift to have a greater percentage of our dollars going into income producing projects. And so, we're going to have some -- I have to get back to you when we actually complete the analysis.

Paul Cheng - Lehman Brothers

Okay. I think that you've already pretty much done with all your turnaround with the exception of the Golden Eagle coker in the second half. How about in the first half of next year that do you have any quick guidance in terms of, is it going to be a happy kind of wrong season for you or that is going to be pretty light?

Bruce Smith

Finn, turnarounds, the next question.

Bill Finnerty

Turnarounds as we look into the next year should be fairly light for us for 2008.

Paul Cheng - Lehman Brothers

And Bruce, looking at that, it looks like you guys had some form of inventory loss of the run in the $57 million for the quarter. I think you indicate that partly is about $30 million is relate to LA, you need fill up the inventory. How of that 57, I mean is that any portion of them we may see the reversal in the third quarter?

Bruce Smith

I think what happened with Shell as we took over that facility, obviously they had -- they didn't turnaround, they depleted their inventories and we have to build them back up to a little higher level. I think it's probably reasonable that there is going to be some of that that may come back, but we had to build inventories. They were at a lower level. So I think that I wouldn't count how much, but if we report at the end of the third quarter that we had a little bit more benefit there, it wouldn't surprise me.

Paul Cheng - Lehman Brothers

Okay. A final question on the West Coast, I think Greg gave a number, say 650 for the cash operating cost. Is that going to be a reasonable part a number that we use on a going forward basis or that you are still in the transition and you think, you may be able to join that number down substantially more double quarter down the road?

Bruce Smith

My feeling on jumping here about feeling, Bill you want to?

Bill Finnerty

This is Finn. I think if you look at the 650, it's a reasonable representation of our expectation for the balance of the year. I mean what we were try to do is, as Bruce said earlier improve upon what we are doing at Los Angeles. But as mentioned previously, we've got a lot of maintenance work and activity underway at that facility. So, it's probably going to take us a while before we can start to see some improvement in that combined California 650 number.

Paul Cheng - Lehman Brothers

Okay, final question, this is for Lynn. I was surprised that to heard some ethanol producer talking about that you have some of our competitor they didn't mention, who but they are saying that some major oil company kind of foreigners are already talking and branding more ethanol in the kind of foreign market perhaps that as early as in the fourth quarter. I wondering that if there is any market intelligence you can provide I was quite surprised that you hear that?

Lynn Westfall

I would be surprised with the common logistic system in the West Coast have to use and anybody can have a greater gasoline a much different in anybody else's. If they did they can only offer their refinery rack. So the Kinder Morgan system is not set up to handle anything other than the 5.7% ethanol grade right now?

Paul Cheng - Lehman Brothers

So that you have not hurt anyone, that just related having the discussion. I assume that you guys do know how to plan and when that you guys may start thinking about the brand more.

Lynn Westfall

In the regulation goes into effect, theoretically the end of 2009, but a lot of people are going to require capital expenditures are probably taken after 2011, 2012 before the industry really makes the shift to the 10% grade, anybody does it before that is again it just going to be potential offer their own refinery rack but not very widespread I don't think.

Paul Cheng - Lehman Brothers

That's it, very good. Thank you.

Operator

Your next question comes from the line of Roger Read with Natexis Bleichroeder.

Roger Read - Natexis Bleichroeder

Hi, gentlemen.

Bruce Smith

Good morning.

Roger Read - Natexis Bleichroeder

Quick question for you, I know you haven't wanted to go into a whole lot of detail on it Bruce, but you talked about this new way to look at your capital investments. Could you talk a little bit about kind of how your return criteria has been set before and besides the desire that more CapEx goes into truly enhancing projects.

What you see is the return criteria in terms of like what is the actual rate of return you would want to earn, is that change, is that increase, decrease I mean you've talked about the market is one that now allows you to feel much better about making an investment and actually seeing it last for a period of time as opposed to the --

Bruce Smith

Yeah.

Roger Read - Natexis Bleichroeder

Historical market, just kind of, I want to get a feeling for what you are seeing there?

Bruce Smith

Yeah, I think that our past criteria was really strict and it was because of what I mentioned earlier that we didn't have the same strong belief that strong margins were going to prevail for as long as we do now. So, we were looking for things at a very rapid payout. So, hence they had very, very high rates of return.

We didn't have anything expect regulatory project or something that was a more series maintenance. But for instance, the coker project which is a combination of regulatory project, and an economic project, but even that has got double digit returns. But we had to do it. That was only the one that probably broke the rule of the sort of the 2.5 year payout.

So, we are going to revise those downward, I mean, I think that what we are looking for good solid returns with reasonable payback period, again, something that we can then create a benchmark for measuring other activities.

Going back to the question just about acquisitions, I mean what is that we can do in capital internally to improve our earnings and to grow shareholder value relative to the opportunities that we see outside. The question that was asked about share repurchases, I mean, there is another measure of how we use capital.

So, I think it's really in the past. It was short. It was quick. It was very high returns. I would expect these are going to be a little longer returns, and obviously lower. But still something that will I mean far exceed our costs of capital and obviously they need to be better than what we look at share repurchases or other activities.

Roger Read - Natexis Bleichroeder

Okay. And then my second question is for Lynn, kind of following on that, I am guessing his outlook is that there is a little more constrain on kind of, let's say industry capacity growth. I was wondering Lynn if you can give us an idea looking out for the next 12 or 18 months what you see for '08 in terms of growth domestically in imports will be withheld be, but may be what you can see in our own backyard here?

Lynn Westfall

Certainly what we're seeing is that hasn't been any let up at all and the constraints necessary for any kind of a major project, they may be leveling off, but they are certainly not getting any better in terms of the material, the engineers, and the fabrication shops that you need to do anything significant.

So, I can't foresee over the next 12 to 18 months any meaningful capacity will be added from construction work. I think that's more of a four to five year timeframe going out and maybe you will stretch longer then out. And as part of the reason that Bruce is saying we've got a lot more confidence in our outlook now is that the constraints on the industry on a worldwide basis of doing anything significant or as bad as they have ever been probably worsen they have ever been in the past.

So, the ability to add new capacity either here or on a worldwide basis is going to be very constrained for quite a while.

Roger Read - Natexis Bleichroeder

Okay. Thank you.

Operator

Your next question comes from the line of Ann Kohler with Caris.

Ann Kohler - Caris

Good morning. Thank you, gentlemen. I think it was Finn or Lynn, if you have any more detail on the second half turnaround activity within the state of California. Do you have any more detail on that?

Bill Finnerty

We don't like to give out that information, Ann. I think you can go to some public sources and get what the various companies are planning for the third quarter. But there are some significant turnarounds that are planned.

Ann Kohler - Caris

Do you have an estimate of what type of impact that has in terms of percentage or throughput for the quarter with the second half?

Bill Finnerty

I prefer not to comment on that.

Ann Kohler - Caris

Okay. Thank you.

Operator

Your next question comes from the line of Neil McMahon with Sanford Bernstein.

Neil McMahon - Sanford Bernstein

Hi, good morning.

Bruce Smith

Hi, Neil.

Neil McMahon - Sanford Bernstein

Hi. I've got three questions for you. The first one is really what benefits did you see from, I suppose bottleneck crude in the Mid-Continent in the second quarter obviously at your refineries in Utah and Dakota that there is a benefit being isolated. I'm just wondering if you could quantify that and what is your outlook for the next two years in terms of pipeline capacity on those two areas of crude situation opens up a bit? And I have got another question as well.

Bruce Smith

Neil, I think in the second quarter we did see some contraction in the differential that were out there, previously Wyoming suite was differential above $10 its coming during the second quarter to more long line to-date North Dakota suite also came in a little bit. But obviously there is sizeable discount relative to prior years.

So, yes we did enjoy that as far as put looking forward in the future. We don't see any significant pipeline project, that going to adjust that type of climate for those domestic grades. And as you are well aware complemented with that domestic production, which we continue to see expansion on drill rigs is our ability both of our refineries taking Canadian crudes as well.

Neil McMahon - Sanford Bernstein

Okay great. The second question is really on the L.A. refinery. From the shareholders presentation in May you outlined that the capital budget going forward Bruce, I think you put down 1.1 billion in the presentation slide. And you outlined the 350 million for the improvements, which I presume around the electrical system after refinery. Can you break out $750 million over the next five years, I'm presuming a good chunk of that is towards for environmental cost to get the refinery up to scratch there, but maybe if you are seeing inflation in any of those whole areas as well that will be interesting?

Bruce Smith

Neil, after we complete the review with the Board in November we will be providing a detail capital program to the street. The estimates that we provided in the past, obviously the economic projects, but we are now in the engineering and permitting stages and they take place during later stages over the five year period, which we have identified, but we will give you more detailed thing in November.

Neil McMahon - Sanford Bernstein

Okay, great. I wait for them.

Bruce Smith

That's the last question, operator?

Operator

Yes, sir. It is.

Bruce Smith

Scott, do you want to say something?

Scott Phipps

Sure. We will be having an Analyst Day presentation roughly first part of December in New York City, where after the Board reviews our capital projects we'll hope to update everybody on what we presented there.

Bruce Smith

Again, I think that our goal in the meeting will be certainly to provide a little bit transparency on some of the capital that we plan to allocate projects for multiyear period of time. So we look forward to the quarterly call before that, but we will get that some detail out to everyone about our plans as Scott finalizing those. And we will look forward to then talking to you in third quarter and also at this conference.

Thank you again for participating today. And if you have any follow-up questions, I know, Scott would be glad to answering them for you.

Operator

This concludes today's conference call. You may now disconnect.

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