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Tesoro Corporation (NYSE:TSO)

Q2 FY08 Earnings Call

July 31, 2008, 8:30 AM ET

Executives

Scott Phipps - Director of IR

Otto C. Schwethelm - Sr. VP, CFO and Treasurer

Everett Lewis - EVP and COO

Bruce A. Smith - Chairman, President and CEO

Lynn Westfall - Sr. VP, External Affairs and Chief Economist

Dan Porter - Sr. VP of Refining

Analysts

Jeff Dietert - Simmons & Company

Ann Kohler - Caris & Company

Paul Cheng - Lehman Brothers

Roger Read - Natixis Bleichroeder

Chi Chow - Tristone Capital

Neil McMahon - Sanford Bernstein

Operator

Good morning my name Dennis and I will be your conference operator today. At this time I would like to welcome everyone to the Tesoro Company's Second Quarter 2008 Earnings Conference Call. 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].

I will now turn the call over to Mr. Scott Phipps, Director of Investor Relations. Please go ahead sir.

Scott Phipps - Director of Investor Relations

Thanks Dennis. Good morning everyone and welcome to today's conference call to discuss our second quarter 2008 earnings. Joining me for today's call are Bruce Smith, Greg Wright, Everett Lewis, Otto Schwethelm, Lynn Westfall, and other members of senior management.

Before we get started I'd like to point out that we modified our earnings conference call format similar to last quarter and include an accompanying PowerPoint presentation which was filed with the SEC about 15 minutes ago. Since management will be referencing these slides throughout the call, I encourage you to have these available as we progress through this morning's material.

If you don't already have the presentation you can visit the investor section of our website at tsocorp.com in order to download them. On the website you can obtain a copy of the earnings release we issued this morning or view the company's supplemental quarterly data.

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 reviewing this information, please feel free to contact me with any questions about this material or otherwise following today's call.

Please also refer to the forward-looking statements in the appendix of the earnings slide, which says statements made during this call, they're referred to management's expectations and/or future predictions are forward-looking statements intended to be covered by the Safe Harbor provisions of the Securities Act. As there are many factors which could cause results to differ from our expectations.

With that said, I'll turn it over to Bruce... to Otto, excuse me.

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

Thanks, Scott and good morning everyone. On slide 1, you'll see that we recorded earnings of $4 million or $0.03 per share for the second quarter of 2008 versus net income of $443 million or $3.17 per share for the second quarter of 2007.

As noted in the press release, the current quarter's results include effects of some unusual items. In discussing these items I'll be referencing the impacts after applying our marginal corporate tax rate of 39%.

First, the losses associated with the derivative positions of $81 million or $0.58 a share were mainly related to the long haul group program which we suspended in May. During the first six months of this year, we have reduced feed stock and product inventories by 1.3 million barrels and recorded an after-tax LIFO gain of $48 million or $0.35 a share during the quarter.

As we discussed in our last conference call, our objective around inventory is to balance the levels we carry with consumer demand. With crude moving $40 a barrel since early June, I don't think we can accurately assess where demand will stabilize, but we do intend to further reduce inventory from where we ended the second quarter and as a result we'll continue to benefit from unlocking cash from working capital.

Finally at the Golden Eagle refinery we completed our last significant planned maintenance project for the year which included a total spend of $57 million associated with maintenance on several units including the delayed coker that was commissioned in late April.

Everett will talk more about the current operations of this unit, but we've estimated the opportunity cost of the turnaround to be after tax roughly $43 million or $0.31 a share for the quarter.

Turning to the refining segment and including the impacts discussed above, refining reported an operating profit for the quarter of $85 million versus a loss of $87 million for the first quarter of 2008. This was primarily a result of better gross refining margins and higher throughput rates outside of the Golden Eagle turnaround.

Gross refining margin of $10.10 was 54% ahead of the first quarter and followed an improved benchmark of similar levels. By product, West Coast gasoline margins failed to maintain their rally in late May and early June, but still averaged $6 per barrel over the first quarter. While the diesel margin improved over its historical highs in the first quarter to average $31 a barrel in the second quarter. We've taken advantage of these spreads especially at our California refineries.

Looking at slide 2, due to the significant size of the LIFO inventory gain, and hedge loss on the gross margins as reported in the press release tables, we've taken the opportunity to break out the impact by region. Everett will go into more detail about the regional performance later. However, here I would comment that outside of Hawaii's results the adjusted gross margins are more in line with our historical performance. This quarter Hawaii was once again impacted by the lag price effect that we've discussed in the past.

Turning to slide 3, we will see something new as start to discuss our results versus one of the internal bench marks we call the Tesoro index. This index is derived using more specific market indicators, to better reflect individual refinery configuration and market fundamentals and does not include factors embedded in the gross refining margins such as inventory impacts, derivate positions or distribution costs. This type of benchmarking is especially important as many non transportation products have not moved in tandem with crude and can reduce the benefit of what we have often used as the 321 or 5311 benchmark crack spreads, which don't include bottom of the barrel or secondary products. And as you can see in the chart, 20% of our production is non-transportation fuel. We believe the benefits of referencing the index include providing more detailed markers for our refinery configurations and market environment, giving additional depth to the modeling of capital projects and giving increased transparency of non-transportation products that are difficult to model.

On the slide you can see the system wide configuration of our refineries and comparison of the benchmark crack spreads to the Tesoro index. Our current plan is to update this number by region, each week on our website. For the quarter we purchased crude $0.91 a barrel more than the index for crude feed stock due to running a lighter crude slay and sold products $0.72 a barrel better than the product index as a result of higher rates of diesel production.

We won't spend a considerable amount of time today referencing the index, but we will use it as a key performance metric in the future. Refining, depreciation and amortization expense in the second quarter was $83 million and up $10 million versus the first quarter due to amortization of the Golden Eagle turnaround, an additional depreciation related to the newly commissioned delayed coker.

The retail segment reported an operating loss for the quarter of $11 million versus a loss of $28 million last quarter. Retail sales volumes were down 2% quarter-on-quarter totaling 343 million gallons for second quarter 2008, versus 349 million gallons during the first quarter as a result of weakening U.S. gasoline demand. Margins for the quarter averaged $0.12 per gallon equal to those in the first quarter. Corporate and unallocated expenses for the quarter were $47 million versus $62 million during the second quarter 2007 and $43 million during the first quarter of2008. The $15 million difference was primarily due to our lower stock price causing a decrease in stock based compensation expense.

Interest and financing cost were $34 million for the quarter versus $30 million a year ago. The main driver of the increase year-over-year was interest accrual on the new $500 million senior unsecured notes related to the financing of last years LA acquisition in May, 2007.

On slide 4, you can see the update to the 2008 builds and initiatives we discussed during the first quarter. As a reminder, our goal was to realize approximately $750 million to $1 billion in cash from operations through reductions in operating, administrative, and crude costs, reductions in capital expenditures, and reduced working capital with a purpose of reducing revolver borrowings and funding the revised capital program.

As you can see, as of today we are un-borrowed on the revolver with approximately $100 million of cash on the balance sheet. Additionally in the quarter we reduced inventory by roughly 3 million barrels and we intend for further reductions.

Moving on to slide 5, let's go through guidance for the third quarter. We estimate throughput to be for the Pacific Northwest 150 to 160 barrels per day, Mid-Pacific 70,000 to 80,000, Mid-Continents 110 to 120, and California 275 to 285. OpEx guidance for the third quarter, Pacific North West $4.10 per barrel, Mid-Pacific $2.90, Mid-Continent $3.30, and California $7.80. Our expected depreciation for refining is estimated at $85 million. Additional third quarter guidance items include corporate expense of $50 million, interest expense before interest income of $25 million, and a marginal tax-rate to continue at 39%.

Everett Lewis is now going to review some of the more significant operational highlights for the quarter.

Everett Lewis - Executive Vice President and Chief Operating Officer

Hey Thanks Otto and good morning everybody. While margins and subsequently our earnings improved from the first quarter, the market environment for petroleum products remains volatile and demand for gasoline continues to run at rates below a year ago.

If you turn to slide 6, you will see average first quarter crack spreads versus both 2007 in the five year range in each of our core markets. California cracks where at the low end of the band across the quarter averaging $21 per barrel versus $34 per barrel during the second quarter of 2007. North West cracks averaged $21 per barrel during the quarter versus $31 per barrel for the second quarter last year. Finally, group three cracks averaged $14 a barrel for the second quarter versus $32 per barrel during the second quarter of 2007.

West Coast gasoline inventories fell considerably during the quarter down almost $4 million barrels since the end of March. However slowing demand for domestic products and the lag of products prices to the rapid crude price increases continues to pressure margins. The trend has strong global distill demand remained a consistent theme during the second quarter and this growth margins were up year-over-year and quarter-over-quarter in all our markets. According to our latest monthly department of energy data had five diesel exports from January to May, were almost 9 million barrels higher versus the same timeframe a year ago.

If you go to slide 7, you can see that our throughput total was 610,000 barrels per day above last quarter due to better margins, but limited by the Golden Eagle turnaround. Total operating costs rose $11 million versus the prior quarter with higher energy costs offset by lower cost and employees repair and maintenance and an accrual reversal related to the retirement of the fluid coke.

Total energy cost to the system rose $27 million versus last quarter of which half was due to higher natural gas prices and the rest due to higher use in the Golden Eagle Coker for the new system.

On slide 8, you'll find the chart bridging operating income from first quarter 2008 to second quarter 2008. As you can see the available margin increased by approximately $200 million from the first quarter of 2008. This calculation is based on our index that Otto went over, and reflects the stronger margin seen in 2Q versus 1Q. We also benefited from system margin inventory draw downs as we continue to match our inventory levels to demand. However we do expect to further reduce inventories from the June 30th levels.

Net of the Golden Eagle turnaround our crude purchases and product sales versus the index accounted for a $33 million benefit versus the index. The bulk of this benefit is attributable to our product sales versus index. More specifically we have been maximizing opportunities to produce distillate at all our facilities. In the California region after finishing the turnaround work at Golden Eagle we were able to produce an incremental 30,000 barrels a day of distillates in the month of June versus the first quarter from our California refineries. During the second quarter distillate margins averaged $15 per barrel over gasoline margins. Currently the spread is widened to $25 per barrel for the month of July.

Based on current margin environment, the opportunity cost of the Golden Eagle turnaround is approximately $45 million versus the first quarter. Keep in mind that part of the turnaround activity occurred during the first quarter and that has been taken into account in this bridge.

The second quarter derivatives initiatives resulted in a negative $58 million versus the first quarter. As we stated in the interim press release most of these positions were based on a particular long haul crude strategy which was suspended at the end of May.

Operating expenses were higher by $11 million quarter-on-quarter and were mainly a result of higher energy cost as I mentioned earlier. I do want to take a moment and update you on the newly commissioned delayed coke in United Golden Eagle. Previously we've indicated the 12 month EBITDA from this project would lie in the $100 million range. Based on the unit's early operational performance we are confident that we will achieve this goal.

Looking at our expectations around operations in the second half of this year, there are few areas that should allow us to increase our rounds of lower cost crude than we had in the first half of the year. These include the delayed coker in Golden Eagle which I've mentioned earlier, increasing crude flexibility and sourcing at the Los Angeles refinery, initiatives at the Hawaii refinery and lower plant turnaround activity through out the system.

The retail operation suffered a loss in the second quarter due to the volatility on market but street prices actually went below spot prices for the period of time. A more normal relationship has existed in the third quarter to date which has returned retail market into a profitable situation. With that Bruce is going to wrap up our call.

Bruce A. Smith - Chairman, President and Chief Executive Officer

Alright, thanks Everett. Last quarter we told investors that we were going to take an aggressive and comprehensive approach to identifying ways to reduce both cost and capital. And as we've talked today Everett and Otto we have done, we have done many things and I think we have accomplished a lot. The fundamentals certainly haven't improved as we continue to see high crude prices, lower demand, and margins that don't reflect the cost to crude. In the past we have said that margins in the industry don't exist for long periods of time at the extremes. I still believe this is true but with the unprecedented marketing conditions that we have, we're not going to attempt to predict win margins will return to mid range.

What we can do is to aggressively pursue every opportunity to change our cost, run more cost advantage crude, and to fully optimize our system. We have challenged our management team to more fully engage our entire work force to identify these opportunities as well as to advance all high return, quick payout projects. In May we set two goals and as Otto reviewed with you, first we wanted to generate a substantial amount of cash and secondly we wanted to eliminate all of our short-term debt. To meet these goals we've planned to reduce budgeted cost, high grade, and lower our total capital program and is efficient in addition that Everett talked about we wanted to actively and aggressively optimize our inventory to lower our stocks to levels more consistent with demand.

The bad news is that demand continues to climb so as Everett and Otto have talked we fully expect to continually see some draw down in inventory levels. I have to say that I am very pleased with the very fast and rapid progress that we have made in such a short period of time. But this certainly isn't the time for complacency. The challenge is to exceed the expectations of our investors, that's something we have done before and I am confident that we are going to do it again. And with that we will take questions.

Question And Answer

Operator

[Operator Instructions]. Your first question will come from the line of Jeff Dietert with Simmons.

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

Good Morning.

Jeff Dietert - Simmons & Company

Good morning. With discontinuing your hedging program are you not going to attempt to manage the risk associated with the timing of the pricing of your crude and the timing of your refined product sales in the future, and will that create a situation where there's more volatility in the earning depending on the volatility within crude prices?

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

Everett, do you want to.

Everett Lewis - Executive Vice President and Chief Operating Officer

Sure. We discontinued a particular crude hedging strategy; we didn't necessarily discontinue all the hedging that we are doing. We continue to hedge those inventories that are above our target levels to reduce the kind of volatility you are talking about and we look at specific situations where we think there might be additional volatility and continue to hedge those. We simply don't automatically hedge every long haul cargo anymore, but we still do some hedging to minimize that volatility. So I don't think you are going to see a dramatic change.

Jeff Dietert - Simmons & Company

In your December analyst conference you talked about 2009 capital spending, the numbers presented there were turn around expense of $132 million, regulatory and maintenance of $455 million, capital improvement of $510 million; total was $1.1 million any change or updates to your thoughts on those capital spending levels?

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

You know Jeff, we had a Board meeting yesterday and we reviewed with the Board preliminary plans. What we have done is we have told the Board that our planning process for 2009 is going to anticipate the same type of adverse environment that we've had in 2008. We don't know whether that is going to be the case or not. I don't think anybody can predict as I said earlier, where margins are going to go at this point. But our view is that we need to continue to plan for this low demand and potentially high crude prices that don't reflect product prices.

We haven't fully wedded our capital program, we are going back and we're really taking a zero based approached. Dan Porter in the refining area has requested that we revisit the scope of every project to make sure that it's appropriate, that there is not another way of doing something, and so we've... and we found great success this year in some of the programs that we have got.

I think the bottom-line is that it certainly won't total, what we had before. I can't give you a number and won't be able to do that until we complete the work that we will present to the Board in November. But it will probably be more in the range of what we in total capital spending, probably more in the range of what we are spending this year or rather than $1.1 billion and we're on track to, we've got a number of $870 million. That probably will be something below that this year. So, I think it is safe to assume that it's going to be a lower than we gave you in that meeting, but will be November before we can actually give you the details of what it's going to be.

Jeff Dietert - Simmons & Company

Thanks for your color on that. Bruce, how significant, do you think you could reduce inventories further from what you've done in the second quarter?

Bruce A. Smith - Chairman, President and Chief Executive Officer

I think it obviously is going to depend on demand. I mean, as we look at where demand is today our targets would be to have another meaningful but not as large as 3 million barrels. But we're obviously trying to optimize to a level that we feel is really consistent with where demand is and it is something lower than where we are today and as you know the fall starts to fall off in demand and so its little hard to predict exactly where that's going to go. But our goal is to really be lean and mean around our inventories and we'll see where the market takes us and our ability to be able to liquidate some of those at the right time.

Jeff Dietert - Simmons & Company

Thank you Bruce.

Bruce A. Smith - Chairman, President and Chief Executive Officer

You're welcome.

Operator

Your next question will come from the line of Ann Kohler, with Caris.

Ann Kohler - Caris & Company

Good morning. If you could just provide I guess a little bit of color I know in the call that you... in the first quarter, indicated that you are looking for basically flat to negative gasoline demand growth over the balances of this year and into next year. Could you just sort of give us a general idea and kind of what your view is of the supply demand balance for the U.S. market over the next couple of years?

Lynn Westfall - Senior Vice President, External Affairs and Chief Economist

Sure Ann, this is Lynn.

Ann Kohler - Caris & Company

Hi Lynn.

Lynn Westfall - Senior Vice President, External Affairs and Chief Economist

I think when you look at the three main factors that have caused demand declines, one of them is just the macroeconomic effect and that's really unemployment. That's been what's really been hitting this in California versus rest of the country with California unemployment almost at 7% versus 5.5% for the rest of the country.

So unemployment has been a big factor of demand declines and that's not going to improve until the overall economy does which is certainly not going to be this year or may be next year at the earliest. The second factors of course has been the price elasticity. People who change their driving pattern because of high prices. And again, we don't look for prices to get much lower where they are, crude price I am talking about where they are now. So again I can't see any change in that going out into the earliest we see some thing significant there might be next year as well.

Then the third factor are permanent changes people have changed cars to more fuel efficient and that demand is gone forever. So bottom line is we would expect to see demand declines year-over-year for the rest of this year such as we've seen up till now may be worsening a little bit and I think it would be, the earliest would be next year some time before we might see a reversal some of that.

Ann Kohler - Caris & Company

And how about... I know Lynn you do the supply demand balance kind of looking into U.S. what do you see happening in terms of that over the next couple of years. Certainly there is some new projects that are coming on and how do you factor that into your outlook I guess, for the next decade I guess?

Lynn Westfall - Senior Vice President, External Affairs and Chief Economist

Certainly I think is as Bruce and others have mentioned, not just this year but we are planning to run our business for the next foreseeable future in a reduced margin environment. We actually saw this coming but we thought it would more on the lines of 2012 effect. We didn't know about the recession that was coming, that brought along a lot of the factors earlier. But we had already planned lot of our capital plans to be able to do the best we can for investors in a low margin environment and we really see that continuing for the foreseeable future.

Lynn Westfall - Senior Vice President, External Affairs and Chief Economist

Great. Thank you.

Operator

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

Paul Cheng - Lehman Brothers

Hi, good morning gentlemen.

Bruce A. Smith - Chairman, President and Chief Executive Officer

Good morning Paul.

Paul Cheng - Lehman Brothers

Hi Bruce, I think this is for Otto, Otto just quick one do you have, what is at the end of the second quarter working capital, your March end of your inventory in excess of the bulk and of the total debt how much is the long term debt?

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

The long term debt continues at 1.9, we got the two trenches, there is a $450 million on the GE acquisition and the $500 million on the LA acquisition. Then we have the junior notes, which are a small portion. On the excess inventory I'd have to look into the footnotes again, that's probably up in there, that's easier to arrive once we follow the cue, is that something you'd need today Paul?

Paul Cheng - Lehman Brothers

Well if you have yeah, that would be great that, I mean if you can [indiscernible]...

[Multiple Speakers]

Bruce A. Smith - Chairman, President and Chief Executive Officer

We'll get back to you Paul.

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

Paul I am not sure exactly what is the cue on that one, but again its still a significant number from the standpoint of the... because of the increasing value of the inventory that the LIFO values, that's a significant number.

Paul Cheng - Lehman Brothers

Right, do you have a number for working capital?

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

Yes, working capital actually is negative 81 Paul. Again as we've reduced the current ratio is still one but as we've reduced inventory and as we have talked historically in a rising price environment, our payables increase is faster than our receivables. And so we actually generated and once we do release the statement of cash flows a significant portion of the CapEx and revolver pay down was funded by a combination of EBITDA as well as bringing up cash through the balance sheet. About a $115 million was resulting from the inventory reductions and about another $175 odd million related to the delta between AR and AP during the quarter.

Paul Cheng - Lehman Brothers

Sure, Otto, you guys go in to say further reduce the inventory in the third quarter, is that going to trick or will that be regarded or treated as a permanent reduction or a just normal inventory change. So in other words are we are going to see another trickle into the LIFO inventory gain due to the permanent reduction in inventory?

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

It depends; again it goes back to where we automatically reduced the demand, supply demand balance. So if we continue to reduce inventories then we will continue to see that LIFO going forward. And again because of our accounting policy when we plan the end of the year inventory levels below where we started that's why we've recognized it during the second quarter.

Paul Cheng - Lehman Brothers

Right...

[Multiple Speakers]

Bruce A. Smith - Chairman, President and Chief Executive Officer

What did you say Paul?

Paul Cheng - Lehman Brothers

No I was just saying that because you expect you have a further reduction in inventory, so in your accounting policies should we assume that way it means, we are going to have a trickle [ph] and not, a inventory gain in the third quarter?

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

Again Paul it depends on where inventories end up.

Bruce A. Smith - Chairman, President and Chief Executive Officer

Yes it is. And it also depends I mean it has to be permanent pricing.

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

Correct.

Bruce A. Smith - Chairman, President and Chief Executive Officer

It has to be a permanent reduction and so I don't think that we can tell you that right now.

Paul Cheng - Lehman Brothers

Okay that... that actually is helpful.

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

Paul, quick clarification on the first hand debt, the debt is 1.4 not 1.9.

Paul Cheng - Lehman Brothers

1.4, yes the long term debt. Okay.

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

Two at 4.5 and one at 5.

Paul Cheng - Lehman Brothers

Sure, Bruce, if I look at that you have some weaker... in California which arguably is not necessarily really need to be there. Any trend, if you are really talking about raising cash, any plan to sell those assets?

Bruce A. Smith - Chairman, President and Chief Executive Officer

We don't have any plans to do anything at this time. We are as a process of looking at how we optimize all the assets we've got and really looking at the changed environment. We are going to consider looking at everything from a point of view of looking at each asset but we don't have any plans to do anything right now. We have continued to shed certain retail assets that really don't fit. They may at one time have been structurally something that we thought we could build us a broader system on. I think that there are assets that we probably will take a harder look at. California obviously it's a very meaningful asset force and the base that we have there it as something we felt strongly about accumulating so in the priority of assets that's still a good strong one.

But I think our goal is to try to make sure, here is sort of the bottom-line; I mean I think at earlier we talked a little bit about capital. I think we've made great success in strengthening our balance sheet. We have taken and rationalized our business in many different ways we got. At the end of the first quarter we barrowed cash on the balance sheet, today we have cash and we are not short-term borrowed at all. We've reduce our cost and we've got plans in 2009 to further reduce our cost by a meaningful amount.

We are going to reduce our capital, I mean I think that our goal is to remain very strong very viable and I am not; I think whatever actions we got to take we'll take to do that. If you could tell me exactly what the environment is going to be next year I could tell you more specifically what I think we' re going to do. I think we've got to find the right balance for shareholders and we have been... we've had several quarters where we have lost money. We are very pleased that this year so far, we've... the hedging programs cost us over $200 million which is in $0.91 a share.

I think that we made a lot of progress very quickly in adjusting our operations and we are going to make more progress in adjusting and what those adjustments are going to be, I thinks is now the next step in presenting that to the board and then back to our shareholders in November.

Paul Cheng - Lehman Brothers

Okay, very good. Just two final question, one if the cost for moderating mandate that you raised the Ethanol branding to 10% by the end of 2009, I' m wondering that what kind of capital requirement for you guys and any foreseeable problem on that in terms of meeting the deadline? And secondly Hawaii is always difficult that too for us, that too tracking in terms of the margin, wondering that Bruce you can give some face or parallel complain to the second quarter where is the margin spend so far?

Bruce A. Smith - Chairman, President and Chief Executive Officer

You want to talk about Hawaii?

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

I can talk about Hawaii. The Hawaii for a lot of reasons was difficult for you to model I am sure because we look at lot long haul crude there, how it gets booked into the system, creates some noise and what you see in the results relative to the actual margins that we generated there.

But generally speaking Hawaii makes a lot of distillates and it is dear to make a distillates. The distillate market is strong and so we think, the underlying margins there are actually quite good. So the trick is to understand what goes on around the economic practices there. We see we've actually generated, we estimate we have actually generated positive cash in Hawaii, in the second quarter in spite of the reported earnings there.

Paul Cheng - Lehman Brothers

Okay and...

Bruce A. Smith - Chairman, President and Chief Executive Officer

We are very pleased with the progress we've made Hawaii, we are very please with the progress we have made in Los Angeles. I mean I think that overall all the little issues that have tied us up a little bit financially, really starting to see clearer light now and I feel very good about it. On the ethanol side we just briefed the Board on that and I think there is some hay around that, you want to just quickly highlight how...

Everett Lewis - Executive Vice President and Chief Operating Officer

Yeah Paul on the ethanol side as you may or may not be aware, they ruled up kick back the carb for some administrative functions. So they have to go up around the comment period that ended the first of this month. They are going to see those comments, deal with them, and probably not have a final law until some time in September. But as you know this is new comment period has opened up the window, for lot of people to comment on the downside of Ethanol. You can pick up a report everyday that has a down side on corn based Ethanol, the water usage, the energy usage, the green house gas effect. So whereas a year ago, I think a lot of the ethanol both Federal and State laws were deemed to be pretty certain. I think there is lot more doubt right now, both Federal and State laws, how far forward they are going to go, with promoting ethanol.

Paul Cheng - Lehman Brothers

Okay, thank you.

Everett Lewis - Executive Vice President and Chief Operating Officer

You are welcome.

Operator

Your next question will come from the line of Roger Read with Natixis Bleichroeder.

Roger Read - Natixis Bleichroeder

Hey, good morning gentleman.

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

Good morning.

Roger Read - Natixis Bleichroeder

Just a couple of things, I guess may be a little more operational, a lot of the others has just been covered here. Pacific North West you are indicating volumes down in the third quarter, is that a reaction to the market situation or is there a turnaround there?

Everett Lewis - Executive Vice President and Chief Operating Officer

It's a reaction to the market situation. The North West makes a lot gasoline and depending on the crude they start to make a fair amount of fuel oil. And one of the effects of the supply demand balance on the West Coast is cracking refineries, cat cracking refineries are almost at the margin these days, similar to what happens in the Gulf Coast. So we are adjusting our operations at North West to account for that and I think... one of the things that people don't understand when they look at the North West is that we have a cat cracker there that is more capable than the average cat crack, as the cat crude is resist [ph] capable. So we are moving from a max conversion, max throughput mode to make maximum gasoline to a more of a maximum value added in the low margin environment which will include running the throughput down a little bit and changing the feedstock mix to move that to a better economic position.

Bruce A. Smith - Chairman, President and Chief Executive Officer

That's the fairly significant move. We have just started... I guess, has it been two weeks now, about two weeks. So it's another adjustment we are making, it's a rather dramatic adjustment in basically operations, and we think that that's going to improve our performance in that market.

Roger Read - Natixis Bleichroeder

Okay, so essentially a better yield into the current market environment.

Everett Lewis - Executive Vice President and Chief Operating Officer

That's correct. Those are better value yield out of a lower feedstock.

Roger Read - Natixis Bleichroeder

Okay, from an operating cost standpoint then, and the lower barrels, that why we are seeing the higher cash operating cost there?

Everett Lewis - Executive Vice President and Chief Operating Officer

On thefixed side you'll see a higher per barrel cost to the lower throughput, that's correct.

Roger Read - Natixis Bleichroeder

Okay. Looking, at a wide kind of following on prior guy's questions there, if you strip way the various other items, in the second quarter, it was still a pretty tough quarter. Is there reason or any change, as you indicated tough for us to model at a lot of times, anything going on in the third quarter that says it would be terribly different than the kind of indicators we've typically used for the Mid-Pacific region? In other words you lost money in the second quarter regardless of the change in hedging etcetera, indicators would tell me that that similar track is on place here... are on pace here for the third quarter maybe not the same magnitude, I'm just trying to understand is there anything else that is going on there or that you can impact that would change that scenario?

Everett Lewis - Executive Vice President and Chief Operating Officer

One of the things that's going on that makes it difficult for you to look Hawaii is when the crude market moves abruptly up or abruptly down, it has an extra effect on Hawaii, due to how we booked the long haul crude. So if you see crude's staying more stable in terms of pricing and not moving up as hard in the quarter you will see a substantial benefit to the Hawaii reported earnings. And so far that's what we've seen. We've actually got some benefits in July due to the decline in crude price that are positively affecting those earnings substantially so far in the second quarter. So that's one of the big changes you can see.

Bruce A. Smith - Chairman, President and Chief Executive Officer

So far third quarter.

Everett Lewis - Executive Vice President and Chief Operating Officer

Third quarter I'm sorry.

Roger Read - Natixis Bleichroeder

That's okay.

Everett Lewis - Executive Vice President and Chief Operating Officer

And so that's a big thing that tends to cloud the Hawaii performance. Otherwise we think that distillate markets are going to remain strong so the fundamentals around Hawaii and the distillate margins there should remain good.

Roger Read - Natixis Bleichroeder

Okay.

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

Perhaps it looks like I think that if you... obviously I have no way of predicting what's going to happen in the third quarter but as we look at that operation we think we've made and we look at the initiatives that we have in places where you review them with the board, and obviously a lot depends on what happens in the crude markets as well as the product markets. But that certainly looks like we may have passed the point of where at least, where we've been losing money, where we have a good chance of making money now in the third quarter. So we actually feel very good about the progress we have made. Each of the facilities regardless of what it is, each... even with the ones that have done extremely well, we have been diving down to try to find ways to improve each and everyone of those very quickly and I think we have made substantial progress along all of our initiatives.

Roger Read - Natixis Bleichroeder

Okay, good. I guess the last question I have is kind of centers around cash flow uses. If you would take a kind of bear bones look at what you think '09 CapEx could be in or what, I guess may be in another way what does the maintenance level of CapEx would have to be in 2009 and the other part of the question is where do share repurchases sit with you at this point, in this environment?

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

Again capital we are going to wait until November to give any numbers. I don't want to get ahead of myself, until we have fully completed our own review and I don't... it is the numbers that we gave last year were based on different environments, so we have got to really take a hard look at what those numbers are. I think we all would agree if we sat around the table, that our goal is try to have the right level, but the lowest level and in maintenance that's an area that you want to make sure you got it right. I mean, we emphasized safety above everything else and so when you start talking about the right maintenance level I certainly don't want to give numbers out, until we have had a full chance to review them.

And on share repurchases, our goal is to have a strong balance sheet and hold on to cash and so I just don't see, even though I believe our shares are, have been more dramatically impacted than others in the sector, I don't think there will be a share repurchase. I don't think the Board would even think about a share repurchase program.

I think its up to us and I think we've... we are at the point and mainly at the second quarter here, we have crossed it, where we've seen the worst and we are starting to get better even with the margin environment where we've got. So hopefully our share performance starts to improve as people look at the whole value and our ability to earn in this adverse environment.

Roger Read - Natixis Bleichroeder

Okay, thank you.

Operator

Your next question will come from the line Chi Chow with Tristone Capital.

Chi Chow - Tristone Capital

Thanks. Back on the hedging issue, could you give us a feel for what percentage of crude purchases are now unhedged?

Everett Lewis - Executive Vice President and Chief Operating Officer

Let's say, we used to hedge in the neighborhood of 10% of our crude, up to 20% and I think we are probably virtually none if you are our client. If there is crude they were turning again above our target inventory levels, that is how we referred going from more to long haul crude, we are buying more advance which is concrete to the direction we are going, and you'd see some. But we are buying sort of on shorter notice and we are buying shorter on crude, so you going to see less demand for that kind of hedging.

The only other place we would hedge is if we were doing something where we are going to do a third party sales which we've done on occasion and we did in the second quarter and we hedged those cargos, did the on the spot cargo basis. So virtually none on an ongoing basis.

Chi Chow - Tristone Capital

Alright, so are you taking... the crude purchase, are you buying them on the FOB basis or delivered?

Everett Lewis - Executive Vice President and Chief Operating Officer

Generally we are buying FOB.

Chi Chow - Tristone Capital

So with the decline in crude prices like $20 the last three weeks, you have taken a pretty big hit then I am assuming here in third quarter?

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

No not necessarily. I mean not a big percentage of our crude is long haul and lot of our crude pricing is based month average weighted pricing, relevant just a few days around with the old date. So in lot of it, in most cases that month average weighted pricing exceeds our delivery times so that we get not a bad price even in a declining market.

Chi Chow - Tristone Capital

But you've increased your long-haul crude's at Wilmington, supposedly a pretty large percentage, is that correct?

Everett Lewis - Executive Vice President and Chief Operating Officer

We are taking more offshore crude's in to Wilmington and they are not necessarily long-haul crude's. A lot of them are still coming out of South America.

Chi Chow - Tristone Capital

Okay and what's your delivery time you were talking about on those crude's.

Everett Lewis - Executive Vice President and Chief Operating Officer

I think they... around twelve days, I think.

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

10 to 15.

Everett Lewis - Executive Vice President and Chief Operating Officer

And they weren't in our hedging program originally because of those delivery times and the pricing terms.

Chi Chow - Tristone Capital

Okay and on the inventory situation, how much of the $48 million gain in the quarter was related to the one time permanent reduction?

Bruce A. Smith - Chairman, President and Chief Executive Officer

All of it.

Chi Chow - Tristone Capital

All, Okay and.... you got quarterly crude purchase needs of say 55 million to 60 million barrels and your current inventories are 28 million barrels, if you reduced inventories further, are you concerned that you are vulnerable to supply disruptions going forward?

Bruce A. Smith - Chairman, President and Chief Executive Officer

No.

Chi Chow - Tristone Capital

How many days covered do you have on the inventories at the end of the second quarter?

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

Chi we are getting a little specific here, may be I mean, if you have got some broader questions, but otherwise, why don't you just get back to Scott on these.

Chi Chow - Tristone Capital

Okay well... it is an important issue here, so that's why I bring it up. Now one another question I guess on diesel use, I think you laid out in prior presentation that you are planning to increase yield by about 42,000 barrels a day versus the fourth quarter, and looking at your numbers in the second quarter it looks like you capture about eight of that. When will the remainder come in and what you're thinking on that end?

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

I don't know where the eight comes from.

Chi Chow - Tristone Capital

Just looking at your stats...

Everett Lewis - Executive Vice President and Chief Operating Officer

I think we should get together with you and go through it rather than doing it on the phone because I am not sure where --

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

Maybe a little harder to tell in the second quarter because of the goal being down but, I don't think our numbers were any different than what we gave you at the time. The numbers actually in the third quarter would have been in the 30, the 30 range over 30,000 barrels a day in combination. So I don't know where the 8 came from.

Again I think we are getting into a little bit more detail, so happy to answer your question but I'd rather than tie up the phone line trying to reconcile things I'd rather move forward.

Chi Chow - Tristone Capital

Okay, I'll circle back with you later. Thanks.

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

Okay, that would be great.

Operator

And this morning's final question will come from the line of Neil Mcmahon with Sanford Bernstein.

Neil McMahon - Sanford Bernstein

Hi good morning. I will takes things right up to the fifth level. I'm just trying to bit of an education back on to unfortunately the hedging strategy, you seemed to have mentioned at the start of the call in your comments that you had stopped a specific strategy on the long haul cargos in mid May, I'm presuming you are doing still some sort of operational hedging as going on for the rest of your crude; may be you could just give us some guidelines going forward, what is your expect in terms a) what actual hedging operational strategy you are doing at the minute if any, and secondly how should that relate in a rising crude or falling crude environment from one quarter to the next?

Everett Lewis - Executive Vice President and Chief Operating Officer

I think where we are right now is we're not doing a lot of crude hedging. It's really very little crude hedging. So you won't see going forward the kind of large pluses or the large minuses that you have been seeing on the crude side. Trying to reiterate what we are doing before, if we are carrying inventory above our target levels we do those, but those are relatively small numbers on both the crude and the product side. And then we look at specific situations and we look at every crude cargo, but it is very selective. And as we've looked at pre-cargo so far we haven't seen anything that exposed us on the kind of purchases we are doing to the extent we'd want to hedge it currently. So I think you are going to see, there will be some hedging gains and losses but they are going to be a lot smaller than you have seen in the past.

Neil McMahon - Sanford Bernstein

But directionally we should assume that you are going to make losses, a load of much smaller one presumes in a rising environment especially the extreme raises we are seeing and visa-versa.

Everett Lewis - Executive Vice President and Chief Operating Officer

Directionally that's correct but there will be much smaller impacts.

Neil McMahon - Sanford Bernstein

Okay just... well thanks for that. And the second thing just trying to work out where yourself and peers are like in terms of overall inventory levels, I know you've obviously had the addition of the LA refinery from last year, but what you provided in your slides were very helpful. You showed what you were at in terms of inventories at the end of December and where you were at the end of June. If we looked at June last year on a like-for-like basis, where would you be relative to that, just in terms of reduction, are you going to take 20% from where you were, what would say as an order of magnitude?

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

I think we are probably up a little bit, still today from that level and when we bought LA, I was just looking up the numbers, but when we bought LA and this sort of goes to the heart of it, we had about 18 million barrels as I recall. LA had about 6 million and so if it is a combined company would have had about 24. Our inventories had gone up to 30 million barrels and that was for lot different reasons so both turn around and but it was much higher. So we are down and I don't know if they are looking again up by sort of scrambling here, but I think 24 million or 25 million barrels would have been more of the sort of that base level if you looked at year-to-year.

Neil McMahon - Sanford Bernstein

Okay and have you got any maybe this is a question for Lynn, has Lynn got any idea in terms of across the board from peers where people are holding inventory today versus where they would hold it in say a more normal margin environment. Just trying to get a get it a guide of obviously U.S. crude inventory levels are relatively low?

Lynn Westfall - Senior Vice President, External Affairs and Chief Economist

I really don't have any information on individual companies. But I am sure they are managing the businesses same way we are and I think we are all looking inventory on a day supply basis now, much less than just a fix number. And any measure of day supply every one should be at lower overall inventories and I think that is just being have been reflected.

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

You saw Dan. Dan Porter who runs refining...

Dan Porter - Senior Vice President of Refining

We are at 34 million barrels of inventory at the end of June last year following the acquisition of LAR and we've now brought that down to 27.6 million so that's pretty considerable reduction from that point in time and this 27.6 million is probably about where we would have targeted in the past to be at prior to the LAR acquisitions

Neil McMahon - Sanford Bernstein

Okay

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

That's right and that's what we showed the other day that we've actually including LAR we've actually taken inventories down to at or below the pre LAR levels, so we have reduced inventories.

Bruce A. Smith - Chairman, President and Chief Executive Officer

My mistake.

Neil McMahon - Sanford Bernstein

Yeah, no, no, that's why I thought. It looked that way, so that's great thanks guys.

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

Welcome.

Operator

And at this time there no further questions. Are there any closing remarks.

Otto C. Schwethelm - Senior Vice President, Chief Financial Officer and Treasurer

No, I don't think so. I think that well, thank you for participating today. It's... I will say that any time you make a small profit that it's good but we really do feel very, very positive about the direction of the company today. We look forward to having a chance to review the third quarter with you and then in November our plans would be to able to provide some of the details relative to the 2009 capital and cost which will be very important to everybody's modeling. So, we'll appreciate your patience on being able to get that together and we'll look forward to talking to you in third quarter. If you got further call... comments or questions please give Scott and his team a telephone call. Thanks again for participating.

Operator

Ladies and gentlemen that does conclude this morning's conference call. You may now disconnect.

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Source: Tesoro Corp. Q2 2008 Earnings Call
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