VIC Write-up: Tesoro (Long)

Business description:

Tesoro is a U.S. based independent petroleum refiner and marketer, meaning it manufactures and sells transportation fuels. Tesoro’s refining segment, operating 7 refineries on the West Coast and Rocky Mountain regions, buys crude oil and refines it into transportation fuels. The refining segment also includes Tesoro’s logistics assets, which includes a 38% stake in Tesoro Logistics LP (NYSE: TLLP), a publicly traded MLP, for which Tesoro serves as the general partner. Refining can be disaggregated into 3 regions: California, Mid-Continent (N. Dakota & Utah), and Pacific Northwest (Washington & Alaska). Tesoro’s retail operating segment sells transportation fuels in 18 states through a network of 2,200 retail stations. A high proportion of the transportation fuels that its retail segment sells are purchased from Tesoro refineries.

Thesis:

Tesoro is a late stage turnaround with a strong balance sheet benefitting from a structural pivot in U.S. refinery profitability. When Tesoro’s CEO took over in late 2010 the company was levered at 2.4x and viewed as a low quality refiner due to its exposure to the West Coast where the economy was weak, regulation high, and geographically advantaged crudes out of reach. The new CEO, who has unlocked significant value since joining, recently closed the acquisition of several California assets from BP. Tesoro struck the deal for the cost of inventory and logistics assets received (both quickly converted to cash). In addition, Tesoro received retail assets worth ~$250MM and a refinery that should generate ~$1,000MM of normalized EBITDA (vs.$900MM consolidated avg. EBITDA between ’02 and ’11)!

Tesoro has been a highly volatile business trading at a low multiple (9x forward EPS / 4.5x EBITDA) whose earnings are undergoing a structural transformation due to the shale oil revolution in North America, which we expect to unfold similarly to the recent shale natural gas boom.

1. A U.S. law restricting crude oil exports coupled with the unexpected explosion of U.S. crude production should result in a glut of crude supply. The U.S. will have more crude than needed, causing crude imports to decline. Refineries will consume the closest crude supplies (to minimize transportation costs), forcing geographically isolated crudes to price at a discount in order to attract buyers. This discount should benefit Tesoro as they have refinery assets located in and near a key geographically isolated region, the Bakken in N. Dakota.
2. In addition, the shale revolution is making Tesoro’s transportation assets (highly stable) more valuable, and its retail assets (also stable) have been increasing in size.
3. Tesoro’s CEO has improved refinery utilization through vertical integration (buying gas stations), reduced costs by sourcing advantaged crude, and completed tremendously accretive M&A.

The above factors together should lead to significant earnings expansion and reduced earnings volatility, which could potentially re-rate the multiple higher as its holder base transitions from renters (high frequency traders focused on short term crude differentials) to owners. The market massively underestimates post-shale revolution earnings power, underappreciates the value of Tesoro’s retail and logistics businesses despite pure play comps (retail) and publicly traded equity (logistics MLP), and fails to recognize the value created by recent capital allocation. The CEO’s strong capital allocation means we don’t need a re-rating to get paid. He has shown himself eager to return capital to shareholders.

We believe Tesoro generates normalized EBITDA of >$2,500MM. Though we’re wary of using sum-of-the-parts valuation, as it can be more theoretical than practical, many sell-side analysts already disaggregate Retail and the MLP for valuation purposes, so we felt comfortable doing so as well. Not to mention, we expect the CEO to monetize the non-refining assets over time. We value the MLP LP stake at market, the MLP GP stake at 15x Consensus GP cash distribution, apply a 6.5x multiple to Tesoro’s retail EBITDA, apply a 4.5x multiple to its Refining EBITDA, and back out the MLP’s debt. We believe Tesoro is worth $90/share.

Background:

1. U.S. Crude Supply / Demand
1. Demand Constraint #1: Environmental regulation makes new refinery builds uneconomic in the U.S.
2. Demand Constraint #2: U.S. law restricts crude oil exports, only refined product exports are allowed.
3. Pre-Shale Boom Supply (1970-2007):

1.                                                                i.      Domestic crude production was in decline.
2.                                                               ii.      Refiners import crude at the coasts to satisfy refinery demand.
3.                                                                i.      Domestic crude production increasing significantly due to technological advancements.
4.                                                               ii.      Crude imports are being displaced by domestic production.
5.                                                             iii.      Refined product exports have increased >2x since ’07.
6.                                                             iv.      N. Dakota production poorly matched with regional refining capacity (2x in ’05 to 13x ’13).

4. Post-Shale Boom Supply (2008-Today):

2. Economic Laws Governing E&P + Refiner Decisions
1. E&Ps sell their crude to the highest bidder. U.S. crude oil cannot be exported (with a few exceptions).
2. Refiners buy crude oil and use it to manufacture refined products (gasoline, diesel) which can be exported, and are thus commodities whose prices are set by the world markets.
3. A refiner’s cost of crude is the producer’s sale price + the cost to transport crude to the refinery.
4. Crude from a given basin should trade at the price of that basin’s marginal barrel sold.
5. As a result, if a refiner’s plant is closer to a production basin than the refinery buying the marginal barrel from that basin, the closer plant should capture the transportation cost delta.
6. Given its geographic exposure, the two key questions for Tesoro are: 1) Where will the marginal barrel of Bakken crude flow? 2) What will it cost to transport the marginal barrel to its destination?

1.                                                                i.      We believe the marginal barrel of Bakken crude travels to the East Coast and…
2.                                                               ii.      We believe the cost to transport crude from the Bakken to the East Coast is $16.

7. If rail to the East Coast sets the Bakken crude differentials, then all of Tesoro’s refiners will be “in the money.”

1. 3.        The Gulf Coast: The Key to the Puzzle
   1. The Gulf Coast is home to 50% of U.S. refining capacity, and given current infrastructure is the natural home for incremental domestic crude production.
   2. As a result, Gulf Coast refineries have been replacing foreign crudes with cheaper domestics.
   3. However, the Gulf Coast is nearing full displacement of foreign crudes.
   4. We believe oversupply is inevitable given current production forecasts (with a healthy margin for safety), unless:

4. Once the Gulf cannot displace additional imports, Tesoro should capture attractive transportation economics, as the marginal Bakken barrel travels to the East or West Coast…a more costly journey.

                                                               i.      Refining capacity increases:

1)       No new builds are planned.

2)       AND it takes 2-4 years for a new build to come online.

                                                              ii.      Refineries shift consumption materially toward light crudes and away from heavy crudes:

1)       Our research suggests this is more difficult than many market observers believe.

2)       As a result, we expect some heavy & medium crude imports to remain over the next 3 years despite greatly increased domestic production (primarily light).

                                                            iii.      Saudi, Mexican, and Venezuelan producers allow displacement rather than react with a price response.

                                                            iv.      Certain int’l producers (Saudi) allow their crudes to be displaced despite long term commercial arrangements. We believe 1.5-2.0MM Bbl/day (vs. 3.9MM Bbl/day imported in June) will not be backed out due to commercial arrangements.

4. Capital Allocation:
1. Carson Refinery Acquisition: The only bidder in the process, Tesoro paid BP $2.3Bn for $1.3Bn crude inventory, $1Bn of infrastructure assets that will be dropped into its MLP, $250MM of retail assets, and a refinery that generates $500MM EBITDA (pre-synergies and crude slate optimization of $500MM)! We believe this deal created >$30/share of value.
2. Other: Within the past 2 years, management has bought back ~8% of the market cap via buybacks, initiated a dividend, and successfully completed several capex projects with <2 year paybacks.

5. Valuation:
1. Trading at <8x normalized FCF with several potential asset sales at its disposal, the potential upside from TSO deploying cash intelligently is massive.
2. TSO trades at >60% discount to estimated greenfield replacement value.

Risks

1. Key Risk: The non-differential portion of crack spreads is unknowable.
   1. A crack spread measures the difference between the purchase price of crude oil and the selling price of finished products, such as gasoline and distillate fuel, that a refinery produces from the crude oil.
   2. In addition to crude differentials, crack spreads are also driven by the supply and demand of both crude oils and refined products.
   3. Crude Export Restrictions
      1. In the 1970s when Americans were highly concerned about energy independence in light of the recent Arab oil embargo that led to high gasoline prices, shortages, and long waiting lines at gas stations, the U.S. gov’t banned crude oil exports through a series of enactments.
      2. This law provides the market distortion that should allow Tesoro to sustainably enjoy profits greatly in excess of historical levels.
      3. In other words, there is an overabundance of supply of Tesoro’s key input (crude oil), yet the refiner is legally able to sell its outputs (refined products) into int’l markets where its int’l competitors (who consume higher priced non-U.S. inputs) set the price of refined products
      4. As U.S. production increases, we anticipate increasing pressure to eliminate federal controls on exporting crude oil.
      5. The relaxing of export restrictions would significantly impair Tesoro’s earnings power.
      6. U.S. & Canadian Crude Production
         1. The conventional oil and gas sector is a long-term business that requires the ability to manage huge projects over several years, sometimes decades. As a result of such a timeframe, companies calculate their expenditures and returns against a long-term oil price scenario and are less sensitive to short-term fluctuations of the market.
         2. Shale oil is a new phenomenon with its own economics and faster development and decline times.
         3. Longer-term shale decline rates (how quickly a well is depleted) and the ultimate recovery of a well are not known within a reasonable approximation until a sufficient history of observable production data is generated and knowledge and technology have achieved a significant level of consolidation. This is not the case with shale oil today.
         4. Weather (snow in the Bakken, rain in Canada) can curb production significantly in the short term.
         5. Oil Prices
            1. A significant dip in oil prices could trigger a rapid implosion of the shale oil boom.
            2. The unique characteristics of shale oil make it especially vulnerable to price declines and environmental opposition in new and populated areas.
            3. Shale oil’s estimated average break-even price is in the high-$60s (range: $40-85).
            4. Other Regulation
               1. There is an asinine law in place that if unchanged could potentially (but not likely) result in a material headwind for Tesoro (who is MUCH more protected than other refiners) in 2014, but the EPA has publicly recognized that the situation is unworkable and they are actively working on a situation.
               2. California, Tesoro’s main geography, is regulated heavy; it is possible incremental regulations are introduced reducing demand significantly and/or making business more costly. 
               3. Transportation Costs
                  1. We expect transportation costs to set the spreads between domestic crudes and int’l crude oil.
                  2. In particular, we expect rail economics to set the spread most important to Tesoro (Bakken-Brent).
                  3. The higher the cost of rail transportation the greater the spread between Bakken crude (a Tesoro input) and international crudes (the drivers of Tesoro’s output prices).
                  4. If current rail transportation costs prove unsustainable, then margins will come under pressure.

3. Even if we're right about crude differential expansion, crack spreads could compress causing Tesoro's earnings to suffer.