Is Tesoro Running Out of Gas?
Shas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
The overall refining industry has been going through a fortunate phase, with the overall increase in prices along with the oversupply conditions due to the mid-continent oil boom. This supply glut seen in the accumulation of inventories of Cushing, Oklahoma and the WTI-Brent Spread will be relieved in due course. Nonetheless the refineries with geographically favorable locations will continue to have access to cheaper crude in the short term. Even as the oversupply conditions ease out, the refining industry only stands to gain.
Tesoro (NYSE: TSO) has been one of the biggest gainers from the aforementioned conditions and has already returned nearly 80% returns (ttm) over the past year.
Refining Is the Key
Tesoro operates via two main business segments: refining and retailing transportation fuels. It has seven refineries in the US with a total capacity of around 665,000 bpd, refining crude oil, gasoline, jet fuel, liquefied petroleum gas, etc. The retail operation consists of more than 1,200 stations under several marques, comprising Tesoro, Shell, and USA Gasoline, and sells transportation fuel and products in 18 states. The bulk of Tesoro’s revenue, $29 billion, comes from its refining operation, which accounts for more than 95% of the total revenue. In 2011, the refining business generated nearly $1.18 billion of the company’s operating income, while the retail business could only make around $89 million in operating profit.
WTI Brent and Bakken Spreads
The refiners rode the wave of the WTI Brent spread to new heights, especially those who could refine a larger percentage of WTI priced crude. This has also resulted in these refiners enjoying higher crack spreads. Tesoro’s North Dakota and Utah facilities refine advantageous feedstock coming out of the mid-continent region. This has also helped Tesoro complete an expansion of its North Dakota refinery by some 68,000 bpd in the previous quarter, effectively doubling the capacity of the refinery.
Tesoro is already transporting Bakken crude to its refinery in Anacortes, Washington. Transportation costs come out to roughly $9.75/barrel to Washington. Tesoro is planning to rail Bakken crude to Carson, California, which would cost $14/barrel. Since the Brent Bakken spread is around $25, Bakken is even more profitable for refiners than WTI, even considering the higher transportation costs.
Recently, even WTIC crack spreads have contracted, and eventually these crack spreads will converge to Brent crack spreads, which have also narrowed of late.
The spread between WTI and Brent is always at risk. The Brent WTI Spread has been fluctuating between $10 and $27 in the past two years and has recently lowered to $17. Again, WTI is not going to price lower than Brent forever. The Seaway pipeline, which was reversed during 2012 to lessen excess supply in Cushing, will start taking effect in 2013. It is also expected that capacity will increase almost three-fold, from 150,000 bpd to 400,000 bpd. Apart from this, a similar project is being planned to expand capacity to around 850,000 bpd by mid-2014. Once these capacities come online, the current WTI Brent spreads will get nullified, and WTI feedstock will once again be priced at about the same as Brent.
Not only has the WTI based crack spread narrowed, but the Brent-based crack spread has also fallen steeply and has recently seen a substantial weakening. This deterioration is not yet accounted for in the refiners' estimates, and it's likely that this spread compression has not yet been factored into the prices of the stocks.
A Good Refining Business Acquisition
As an effective balancer to narrowing spreads, and to provide for future growth, Tesoro acquired the refining assets of BP’s Carson. The $1.175 billion acquisition has been seen as a big positive for Tesoro, as it would reinforce the company’s West Coast business with increasing yields and lower refining & distribution costs. Tesoro is also expected to achieve annual synergies of $250 million from the deal.
In 2013, post-acquisition EBITDA was estimated to be around $2.13 billion, a growth of 29% over 2012, and the post-deal net income is expected to be $842 million, resulting in an EPS of $5.99.
After the acquisition, Tesoro plans to sell the associated logistics assets to Tesoro Logistics LP, of which it owns 52%, for a consideration of $1,000 million. This makes the net purchase price of the refinery look cheap. The acquired refineries have a capacity of 266,000 bpd, thereby increasing Tesoro's total capacity to 931,000 bpd.
Comparable Multiples Valuation
In terms of operating performance, HollyFrontier (NYSE: HFC) seems to be the best when compared to Tesoro and Valero Energy (NYSE: VLO). Over the past 12 months, HollyFrontier had the highest operating and net margins of 13% and 7.83% respectively. Valero's margins are the lowest at 3% and 0.8% respectively. All three refiners are priced at quite low valuations, with Tesoro being priced at 10.9 times its earnings, as compared to the industry average of 21.8 times P/E. Even on the P/S parameter, Tesoro is priced at a meager 0.2 compared to an industry average of 6.
The stock has BUY or OUTPERFROM ratings from 11 out of 20 analysts following the stock according to Reuters data. The stock is cheap at just over 7x forward earnings and six times operating cash flow. The high margins prevailing in the refining industry, coupled with Tesoro’s acquisition of BP’s assets at a considerable discount and its relatively low valuations, currently make Tesoro a definite buy for the short term. The stock is expected to scale to new highs, at least until the high spreads disappear from the industry.
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