11 Min Read
Overview -- U.S. refining company Tesoro Corp. announced plans to purchase BP PLC's Southern California refining and marketing business in Carson City for $1.2 billion plus the value of the inventory ($1.3 billion at current prices). -- We are affirming our 'BB+' corporate credit rating on Tesoro and are maintaining our stable rating outlook. We are also affirming our 'BB+' senior unsecured and 'BBB' senior secured ratings. -- The stable outlook reflects our expectations that Tesoro will successfully integrate the Carson City refining and logistics operations while maintaining moderate financial leverage and managing upcoming carbon tax regulation in California that could pressure profitability. Rating Action On Aug. 13, 2012, Standard & Poor's Rating Services affirmed its 'BB+' corporate credit rating on Tesoro Corp. and maintained the stable outlook. We also affirmed our 'BB+' senior unsecured and 'BBB' senior secured issue-level ratings. As of June 30, 2012, Tesoro had nearly $1.7 billion of total debt. We base the ratings on U.S.-based Tesoro on our view of the company's "fair" business risk profile as a larger, albeit geographically concentrated independent oil refiner, and its "intermediate" degree of financial risk. Standard & Poor's assessment of Tesoro's business risk profile incorporates the inherent risks Tesoro faces in the highly volatile and capital-intensive refining industry. Tesoro is subject to difficult industry conditions, including excess refining capacity globally, volatile feedstock costs, and persisting weak end-user demand for gasoline. Rationale The acquisition of BP's Carson City refinery assets increases Tesoro's refining capacity by about 265,000 barrels per day, while adding production flexibility to Tesoro's West Coast refining operations. The refinery is complex, with a 13.3 Nelson complexity score, but moreover is adjacent to Tesoro's existing Wilmington refinery, which should provide operational efficiencies and allow the combined refineries to produce a greater proportion of distillates (as opposed to gasoline), for which demand is higher. In addition to the refinery, Tesoro will be acquiring significant logistics assets. In fact, the company ascribes roughly $1 billion of the $1.3 billion acquisition price to the logistics assets. They have considerable synergies with the company's existing logistics operations and will also help the refineries gain access to discounted crudes while reducing product distribution costs to some of its customers. We expect that the logistics assets (which include three marine terminals, a very large crude carrier-capable dock and more than 114 miles of pipeline) will generate stable, fee-based revenues while giving Tesoro the opportunity to eventually monetize these cash flows by dropping assets down (i.e., selling them) to their master limited partnership (MLP), Tesoro Logistics. In addition, we also ascribe some value to about 800 retail stores of the "ARCO" and "ampm" brands, and accompanying assets that include a 51% ownership of the 400 megawatt power plant, and an anode-grade coke-producing unit. Offsetting these strengths is the greater concentration of cash flows from California (where about 60% of Tesoro's refining capacity will be located pro forma the acquisition). In our view, refining margins may come under pressure starting in 2015, due to implementation of carbon taxes, per regulation AB32. Under this regulation, California refineries will be held accountable for emissions stemming from the use of the transportation fuel they produce, primarily automobile emissions. The related cost burden could be substantial for Tesoro and some of its peers, depending partly on how the state ultimately implements the program. (See "California Set To Launch Ambitious Cap And Trade System As Federal Efforts On Pollution Control Falter," published Jan. 13, 2011, on RatingsDirect.) Historically, Tesoro's refineries in California generated above-average margins given their ability to meet fuel specifications imposed by the California Air Resources Board that most refineries outside the PADD V region were unable to supply economically. However, Tesoro's refineries in California have not been as efficient as some of its direct competitors. If integrated properly, the combined Carson City-Wilmington refineries should position Tesoro more favorably, given the increased scale and greater distillate focus. As such, the two refineries could be less vulnerable to an industry shake-out if AB32 hurts California's refining industry. Tesoro's two smaller Mid-Continent refineries in Utah and North Dakota continue to perform well, benefiting from cheaper crude oil feedstocks and limited crude and refined product pipeline capacity that provides market insulation that coastal markets do not enjoy. The extent of these advantages could diminish over time as regional crude oil transportation constraints are addressed. We expect the company to fund this transaction largely with cash-on-hand, and with proceeds from selling its Hawaii refinery, which it had announced earlier. The company also expects to drop down some of the logistics assets to Tesoro Logistics, which could raise as much as $1 billion in the first year of the acquisition. Typically, MLPs fund acquisitions with a balanced mix of debt and equity. Tesoro also expects to reduce some inventory during this process. Overall, we expect these actions to result in a manageable level of additional debt at Tesoro. Given the cash flows coming from the refining and logistics operations and our view of additional synergies available from these assets, we expect Tesoro's credit measures to stay in the current range, with debt/EBITDA roughly at 1.5x to 2x. For this we assume Tesoro will maintain current margins until the transaction is complete in 2013. However, we recognize that refining margins are highly volatile and that Tesoro's credit ratios and profitability will vary widely throughout the refining cycle. Liquidity We view Tesoro's liquidity as "adequate". On a stand-alone basis, Tesoro has cash sources of about $2.3 billion, consisting of $1.3 billion of cash (management has indicated publicly that the company's cash position target is $600 million, on average), $946 million of revolving credit facility availability, and roughly $1.5 billion of funds from operations, given the current margin environment. Uses consist of capital spending in the $600 million area, current debt maturities of $299 million, and some distributions. The company has not announced all the details associated with the interim financing of the proposed acquisition, but we expect that its liquidity will remain at least adequate (i.e., with a sources divided by uses ratio of 1.2x) at the transaction's close. Recovery analysis Our issue-level rating on Tesoro's secured revolving credit facility is 'BBB' (two notches higher than the 'BB+' corporate credit rating), and the recovery rating is '1', indicating our expectation for very high recovery (90% to 100%) in the event of a default. The issue-level rating on the senior unsecured notes is 'BB+' (the same as the corporate credit rating on the company). The recovery rating is '3', which indicates our expectation for meaningful (50% to 70%) recovery in the event of a payment default. Although numerically our analysis indicates recovery of 70% to 90% for the senior notes, the recovery ratings on unsecured debt issued by entities with corporate credit ratings in the 'BB' category are capped at '3', given the potential for changes to the capital structure and asset protection levels in advance of a default. We will evaluate the recovery ratings when the transaction closes, but believe they will not likely change, given our expectation of debt levels and the value of the Carson City refinery. Outlook The stable rating outlook reflects our expectations that Tesoro will successfully integrate the Carson City refining and logistics operations while maintaining moderate financial leverage and managing upcoming carbon tax regulation in California that could pressure profitability. Although greater scale and possible synergies strengthen the credit, we continue to have concerns regarding longer-range profit potential amid a weak economy and the quantitative impact of regulatory issues in California. We currently view the likelihood of a rating upgrade as limited in the near term. In the interim, we believe there is significant leeway in the rating to sustain periods of subpar financial performance owing to cyclical factors, although we could reassess the rating if--contrary to our current expectations--we came to believe that the company's adjusted debt to EBITDA would rise above 3x assuming a normalized refining margin environment. Related Criteria And Research -- Standard & Poor's Raises Its U. S. Natural Gas Price Assumptions; Oil Price Assumptions Are Unchanged, July 24, 2012 -- Why U.S. Refiners In The Midwest And Rockies Should Outperform Peers in 2012, Dec. 7, 2011 -- Key Credit Factors: Criteria For Rating The Global Oil Refining Industry, Nov. 28, 2011 -- Methodology And Assumptions: Liquidity Descriptors For Global Corporate Issuers, Sept. 28, 2011 -- Playing It Safe: The Importance Of Safety Measures To Corporate Credit Quality, Aug. 23, 2011 -- Strong Margins For U.S. Refiners Are Unlikely To Last, March 24, 2011 -- Assumptions For Assigning Recovery Ratings To The Debt of U.S. Oil Refining Companies, March 14, 2011 -- Principles Of Credit Ratings, Feb. 16, 2011 -- California Set To Launch Ambitious Cap And Trade System As Federal Efforts On Pollution Control Falter, Jan. 13, 2011 -- Criteria Methodology: Business Risk/Financial Risk Matrix Expanded, May 27, 2009 -- 2008 Corporate Criteria: Analytical Methodology, April 15, 2008 -- For U.S. Oil Refiner Ratings, 'Crack Spread' And Differential Assumptions Are Crucial, Feb. 13, 2007 -- European Refining Business Risks: What Drives Cycles and Profits?, Oct. 16, 2006 Ratings List Ratings Affirmed; Outlook Stable Tesoro Corp. Corporate Credit Rating BB+/Stable/-- Senior Secured BBB Recovery Rating 1 Senior Unsecured BB+ Recovery Rating 3 Complete ratings information is available to subscribers of RatingsDirect on the Global Credit Portal at www.globalcreditportal.com. All ratings affected by this rating action can be found on Standard & Poor's public Web site at www.standardandpoors.com. Use the Ratings search box located in the left column.