TEXT-S&P affirms Tesoro Corp after acquisition announcement

Mon Aug 13, 2012 9:30pm GMT
 

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.

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