The refining business is a highly cyclical one, with profits determined largely by commodity prices -- specifically, by the price difference between domestic crude oil benchmarks and Brent, the global crude oil benchmark.
While many U.S. refiners have reaped windfall profits over the past few years, thanks to historically low domestic benchmark crude prices, Tesoro (NYSE: TSO ) hasn't been able to fully participate in this highly favorable refining environment.
But that's about to change as the company's extensive investments in crude-by-rail infrastructure significantly boost its access to cost-advantaged crudes, providing a big uplift to margins, EBITDA, and cash flows that could meaningfully boost its share price.
Tesoro's locational disadvantage
One of the main reasons why Tesoro hasn't benefited from wide U.S. crude oil differentials as much as its peers is because the company's refining footprint is mainly concentrated on the West Coast, especially since it acquired BP's (NYSE: BP ) 266,000-barrel-per-day Carson refinery near Los Angeles back in mid-2013.
Of the company's roughly 850 thousand barrel per day (MBD) refining capacity, about 85%, or 720 MBD, is located on the West Coast, with California alone accounting for more than 60%, or roughly 530 MBD, of total refining capacity. This West Coast concentration has put the company at a disadvantage to many of its peers due to limited access to cost-advantaged crudes and, therefore, weaker margins. Tesoro's gross refining margins in California and the Pacific Northwest averaged just $8.47 and $10.33 in 2013, as compared to its overall gross refining margin that averaged $11.19 per barrel last year.
By contrast, Midcontinent-focused refiners have enjoyed much stronger margins thanks to their preferential access to cheap inland crude. For instance, Hollyfrontier (NYSE: HFC ) , whose three Midcontinent refineries account for more than 70% of its total refining capacity, enjoyed gross margins well in excess of $20 per produced barrel over the past few years, though margins have compressed significantly in recent quarters.
Gulf Coast-focused refiners like Marathon Petroleum Corporation (NYSE: MPC ) and Valero (NYSE: VLO ) also saw relatively weak margins compared to Midcontinent refiners last year. Valero, whose Gulf Coast refineries account for 55% of total refining capacity, had an average refining throughput margin per barrel averaged $9.69 in 2013, while Marathon, whose Gulf Coast operations represent more than 60% of total capacity, posted an average gross refining margin of $13.24 per barrel last year.
Headwinds turning to tailwinds
But Tesoro's relative disadvantage should improve sharply as the company's heavy investments in projects designed to give it greater access to cost-advantaged crudes come to fruition. For instance, it started up a crude offloading facility at its 120,000 bpd refinery in Anacortes, Washington, back in 2012, which is now processing some 50,000 barrels per day of cost-advantaged Bakken crude, nearly half of its total capacity.
Tesoro is also developing a rail-to-marine crude transloading terminal in Washington state that will allow it to ship discounted crudes via rail to its West Coast refineries. Though the project has been delayed due to permitting requirements, the company expects to begin construction by late this year or early 2015, with initial volumes expected to begin moving by mid-2015.
Overall, Tesoro expects to boost its volumes of discounted crude to the West Coast by more than 300 MBD by next year. This means that WTI will account for nearly 40% of its total West Coast crude oil throughput by year-end 2015, up from 15% as of the third quarter of 2013, providing a meaningful uplift to margins and returns.
Strong EBITDA and cash flow growth on the way
As Tesoro improves its base business, grows logistics, realizes synergies from the California acquisition, and improves its gross margins, its EBITDA and cash flows should grow sharply. The company is forecasting an annual EBITDA improvement over 2013 levels of $370-430 million this year and $590-710 million in 2015, while total free cash flow generation over the period 2014-2016 is expected to total roughly $3 billion, allowing it to pursue additional growth opportunities and return cash to shareholders.
Tesoro's heavy investments in offloading facilities should greatly boost its access to cost-advantaged crudes from the Midcontinent and Canada, leading to a sharp improvement in its financial performance. Despite the company's exceptional prospects for earnings and cash flow growth, it trades at a slight discount to peers -- a discrepancy that, in my view, makes it one of the most compelling opportunities in the U.S. refining sector.
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