Tesoro's Sunken Treasure

I can't help but laugh when I hear the laundry list of side effects associated with so many prescription medications advertised today. Often, they sound so unpleasant (or even dangerous) that enduring a less serious affliction seems preferable.

When Tesoro (NYSE: TSO  ) took its medication to reduce the risk of pain from volatility in the energy sector, it appears the company failed to take the potential side effects into account.

Tesoro is expecting a $125 million loss associated with its hedging program to affect earnings in the second quarter. Providing little detail, the company stated it has historically hedged less than 20% of daily volume by matching crude price averages to the day-of-processing refining margins (a.k.a. "crack spreads").

Briefly stated, that hedging strategy has backfired substantially in the current quarter, leading Tesoro to close those positions and announce a re-evaluation of the hedging strategy. As gasoline prices have lagged the pace of crude oil increases, and crack spreads have eroded to where profitability itself has been challenged, the traditional hedging strategy morphed into one of those rare cases that pharmaceutical ads refer to in their warnings.

Adding to the malaise, Tesoro adjusted its operating costs above prior guidance by $0.30 to $0.50 per barrel, and revealed an interesting metric by which investors can track future input price stresses. For every $1 rise in the price of natural gas, Tesoro anticipates a negative impact of $100,000 per day. I believe we are still in the early stages of a long-term upward trend for natural gas.

Investors eager for a bit of good news might take solace in the fact that Tesoro is aggressively paying down the remaining $305 million debt in its revolving facility, and expects to meet its previous targets for operating cash flow.

Tesoro is not alone. Independent refiners like Valero (NYSE: VLO  ) and Western Refining (NYSE: WNR  ) are definitely feeling the pinch, and even large, integrated players like ExxonMobil (NYSE: XOM  ) and ConocoPhillips (NYSE: COP  ) are not immune to the current, brutally low crack spreads.

Gasoline prices may appear quite high to drivers, as they do to this Fool, but the unfortunate reality is that either oil prices must fall or gasoline prices must jump higher still to render refining a profitable business in the near term. I am turning bullish on the sector, with Valero my personal favorite, but only because necessity may force refiners to reduce throughput until gasoline prices correct higher relative to crude.

Further Foolishness:

If you are interested in refining knowledge and insight into profit, join the talented community of investors active within Motley Fool CAPS; it's free and fun!

Fool contributor Christopher Barker captains yachts and writes about stocks. He can also be found acting Foolishly within the CAPS community under the username TMFSinchiruna. He owns shares of Valero. The Motley Fool has a disclosure policy.


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  • Report this Comment On June 18, 2008, at 11:46 AM, leohaas wrote:

    Indeed, TSO has not done a good job hedging. So it is probably a good idea to stay away from TSO.

    However, Chris keeps on referring to "eroded" crack spreads. If you follow the link, and then the link to the source, it appears that the story of the eroded crack spreads dates to November last year. Around that time spreads were indeed very low. Today, spreads are around $15, where they have been for the past 5 weeks (with the exception of the last days of May and the first of June, when they peaked around $20). That is not quite as high as last year in the 2nd quarter (when they averaged about $24), but high enough for refiners to be profitable.

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