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Tesoro (NYSE:TSO) reported preliminary Q4 2009 EPS of .60 to .75, based on throughput of 555,000 barrels per day. Earnings were higher than I anticipated, and in re-examining my calculations, I see confirmation for my investment thesis, that TSO will be able to outperform based on its optionality around feed-stocks and outputs. Specifically, they are performing better against the crack spread than they have in the past.

Projections for a refinery cannot be done based on estimated revenues: the proper method of doing them is to use estimated throughput and the crack spread to arrive at gross margin in dollars. Another important variable would be the capture rate: the amount of the crack spread that the company is able to realize. This is a function of many variables, such as the type and cost of feed-stocks and the mix and prices realized for outputs, inventory gains and losses, etc.

Tesoro provides quite a bit of information on their website. What I use is “Supplemental Financial and Operational Information,” Exhibit 7. This presents each quarter's results starting with gross refining margin in $/barrel and moving on down to EPS. I have been working off this document, developing a projection into which I enter the gross refining margin (estimated as crack spread X capture rate) and estimated throughputs.

They also provide what they call the Tesoro Index, publicly available information on the crack spreads which apply in their operating areas, both for the current year and historical data. Crack spreads are not always and everywhere the same; they vary by region according the the price and types of feedstock available and the demand for various outputs. By comparing a weighted average of this information to their reported gross refining margins, I was able to come up with an historical average capture rate of 63%, so that, given the crack spreads for the quarter, I can estimate EPS.

The idea is, if I saw a surprise coming, I could enlarge my position ahead of the earnings. I had done the work for the quarter, didn't see anything remarkable, and put it aside. When the earnings estimate came in, it was higher than I was looking for, so I went back to my projection. The reason for the difference is that the capture rate is quite a bit higher than what I was looking for based on historical averages.

To quote from the press release: “The Company estimates its fourth quarter 2008 gross margin, excluding the significant one-time adjustments, will be approximately $12.00 to $12.50 per barrel or 135% of the TSO benchmark index of $9.21 per barrel.” My estimate comparable to the 9.21 was 9.48, so my assumptions tie to their figures fairly well.

In the process of doing my projections, I tested the correlation between crack spreads and reported gross refining margin, noting that the 3rd quarter 2008 seemed like something of an outlier: refining margin was much better than I would have looked for given the other data. Now we have a second quarter of the same phenomenon and an explanation from the company.

Tesoro's last investor presentation, available on their website, indicates that they expect to improve their capture rate by 22% in 2009 compared to 2008. They just raised the bar getting it up to 135%. So far, so good: it's improving. I attribute the improvements to well thought out capex increasing the complexity of their refineries. Curiously, they haven't published capture rates until recently – the earliest references I could locate at the SEC web site were in presentations on Q2 and Q3 2008 earnings. I was able to tie both the Q2 and Q3 capture rates presented to my estimates. It's a good common sense idea to evaluate performance against an objective criterion such as the crack spread.

Investment Implications

If Tesoro continues to outperform the crack spread, based on historical averages and current rates of throughput, average EPS would be around 8 per share. It is unlikely that crack spreads will be as generous going forward as they have been in the past, or that Tesoro can consistently get a capture rate of 135%. At an average EPS of 4, with a P/E of 10, I get a target price of $40 per share for a stock trading in the area of 14. Bear in mind, this stock has traded as high as $65 per share within the past two years. All in all, there is quite of bit of potential upside, hard to quantify.

I plan to hold my position and monitor earnings quarterly, with special attention to the capture rate. A continuation of recent trends on this metric would be a very large positive and call for enlarging my holdings further.

Disclosure: I am long TSO.

Source: Tesoro Outperforming the Crack Spread