Tesoro's Margins Snap, Crackle, and Pop

Like children holding their ears to a musical bowl of cereal, investors have been listening carefully as oil refiners warned of contracting margins affecting their profitability. Those with their heads closest to the bowl may have just blown an eardrum, though, because Tesoro (NYSE: TSO  ) replaced whispers with a loss-touting bullhorn.

Tesoro's first-quarter results were as sour as a barrel of low-grade crude. After recording gains of $116 million in the first quarter of 2007, the company reversed course, posting an $82 million loss. More disturbing still, that loss factors in a $45 million, one-time benefit from the settlement of a lawsuit. The loss is worse than analysts had feared, but because so many investors have been following the story of contracting margins for refiners, the worst-case scenario appears to have been priced into the stock before the news from Tuesday.

As painful as the increases at the gas pump have been, every investor with a vehicle to fill knows that gasoline has lagged significantly behind the pace of the rise in crude oil. Obviously, this phenomenon hits refiners on their bottom line as operating margins per barrel of oil refined, or "crack spreads," grow ever more minuscule. Given the converse relationship between revenue and earnings that Tesoro just exhibited, it appears that refining oil has finally become a losing proposition for the company.

Accordingly, Tesoro announced that it may curtail production of refined products to intentionally operate below refining capacity. While on the surface, such action may appear to be a fully negative development for the company, to this Fool, it sounds like the faint snap, crackle, and pop of future pricing power. If other independent refiners like Valero (NYSE: VLO  ) and Holly (NYSE: HOC  ) were to join Tesoro in reducing throughput just as the summer driving season heats up, I think the effect would be to rapidly close the gap between oil prices and gas prices.

Unfortunately for the consumer, and despite the political rhetoric focused on gas prices, I think we have just peered into the crystal ball and seen much higher gas prices. For refiners like Tesoro and Valero, I think there might be a frosted side to this particular bowl of cereal, because valuations and expectations are both Foolishly low.

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  • Report this Comment On May 23, 2008, at 12:44 AM, dexion10 wrote:

    Good article.

    Wouldn't touch Tesoro - that balance sheet is scary.


    Lacking Cash

    Lacking Income

    Valero and MRO are probably the best ways to play now that FTO has run on takeover chatter.

    Tesoro certainly could catch up as the replacement cost of it's facilities is probably around $80 a share... but replacement costs only matter if a biz is desirable over the mid-term and refining may not be.

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