ITEM 1A.
RISK FACTORS
The volatility of crude oil prices, refined product prices and natural gas and electrical power prices may have a material adverse effect on our cash flow and results of operations.
Our earnings and cash flows from our refining and wholesale marketing operations depend on a number of factors, including fixed and variable expenses (including the cost of refinery feedstocks) and the margin above those expenses at which we are able to sell refined products. In recent years, the prices of crude oil and refined products have fluctuated substantially. These prices depend on numerous factors beyond our control, including the demand for crude oil, gasoline and other refined products, which are subject to, among other things:
•
changes in the global economy and the level of foreign and domestic production of crude oil and refined products;
•
threatened or actual terrorist incidents, acts of war, and other worldwide political conditions;
•
availability of crude oil and refined products and the infrastructure to transport crude oil and refined products;
•
weather conditions, hurricanes or other natural disasters;
•
government regulations; and
•
local factors, including market conditions and the level of operations of other refineries in our markets.
Prices for refined products are influenced by the price of crude oil. We do not produce crude oil and must purchase all of our crude oil, the price of which fluctuates on worldwide market conditions. Generally, an increase or decrease in the price of crude oil affects the price of gasoline and other refined products. However, the prices for crude oil and prices for our refined products can fluctuate in different directions based on worldwide market conditions. In addition, the timing of the relative movement of the prices, as well as the overall change in product prices, can reduce profit margins and could have a significant impact on our refining and wholesale marketing operations, earnings and cash flow. Also, crude oil supply contracts are generally term contracts with market-responsive pricing provisions. We purchase our refinery feedstocks before manufacturing and selling the refined products. Price level changes during the period between purchasing feedstocks and selling the manufactured refined products from these feedstocks could have a significant effect on our financial results. We also purchase refined products manufactured by others for sale to our customers. Price level changes during the periods between purchasing and selling these products also could have a material adverse effect on our business, financial condition and results of operations.
Volatile prices for natural gas and electrical power used by our refineries and other operations have affected manufacturing and operating costs. Natural gas and electricity prices have been and will continue to be affected by supply and demand for fuel and utility services in both local and regional markets.
Our business is impacted by risks inherent in petroleum refining operations.
The operation of refineries, pipelines and product terminals is inherently subject to spills, discharges or other releases of petroleum or hazardous substances. If any of these events had previously occurred or occurs
in the future in connection with any of our refineries, pipelines or product terminals, or in connection with any facilities to which we sent wastes or by-products for treatment or disposal, other than events for which we are indemnified, we could be liable for all costs and penalties associated with their remediation under federal, state and local environmental laws or common law, and could be liable for property damage to third parties caused by contamination from releases and spills. The penalties and clean-up costs that we may have to pay for releases or spills, or the amounts that we may have to pay to third parties for damage to their property, could be significant and the payment of these amounts could have a material adverse effect on our business, financial condition and results of operations.
We operate in environmentally sensitive coastal waters, where tanker, pipeline and refined product transportation operations are closely regulated by federal, state and local agencies and monitored by environmental interest groups. Our California, Mid-Pacific and Pacific Northwest refineries import crude oil feedstocks by tanker. Transportation of crude oil and refined products over water involves inherent risk and subjects us to the provisions of the Federal Oil Pollution Act of 1990 and state laws in California, Hawaii, Washington and Alaska. Among other things, these laws require us to demonstrate in some situations our capacity to respond to a “worst case discharge” to the maximum extent possible. We have contracted with various spill response service companies in the areas in which we transport crude oil and refined products to meet the requirements of the Federal Oil Pollution Act of 1990 and state laws. However, there may be accidents involving tankers transporting crude oil or refined products, and response services may not respond to a “worst case discharge” in a manner that will adequately contain that discharge, or we may be subject to liability in connection with a discharge.
The dangers inherent in our operations and the potential limits on insurance coverage could expose us to potentially significant liability costs.
Our operations are subject to hazards and risks inherent in refining operations and in transporting and storing crude oil and refined products, such as fires, natural disasters, explosions, pipeline ruptures and spills and mechanical failure of equipment at our or third-party facilities, any of which can result in personal injury claims and other damage to our properties and the properties of others. In addition, we operate six petroleum refineries, any of which could experience a major accident, be damaged by severe weather or other natural disaster, or otherwise be forced to shut down. Any such unplanned shutdown could have a material adverse effect on our business, financial condition and results of operations. While we carry property, casualty and business interruption insurance, we do not maintain insurance coverage against all potential losses, and we could suffer losses for uninsurable or uninsured risks or in amounts in excess of existing insurance coverage. The occurrence of an event that is not fully covered by insurance could have a material adverse effect on our business, financial condition and results of operations.
Our operations are subject to general environmental risks, expenses and liabilities which could affect our results of operations.
From time to time we have been, and presently are, subject to litigation and investigations with respect to environmental and related matters, including product liability claims related to the oxygenate MTBE. We may become involved in further litigation or other proceedings, or we may be held responsible in any existing or future litigation or proceedings, the costs of which could be material.
We have in the past operated service stations with underground storage tanks in various jurisdictions, and currently operate service stations that have underground storage tanks in 18 states in the mid-continental and western United States. Federal and state regulations and legislation govern the storage tanks, and compliance with these requirements can be costly. The operation of underground storage tanks also poses certain other risks, including damages associated with soil and groundwater contamination. Leaks from underground storage tanks which may occur at one or more of our service stations, or which may have occurred at our previously operated service stations, may impact soil or groundwater and could result in fines or civil liability for us.
Consistent with the experience of other U.S. refineries, environmental laws and regulations have raised operating costs and require significant capital investments at our refineries. We believe that existing physical facilities at our refineries are substantially adequate to maintain compliance with existing applicable laws and regulatory requirements. However, potentially material expenditures could be required in the future. For example, we may be required to comply with evolving environmental, health and safety laws, regulations or requirements that may be adopted or imposed in the future. We also may be required to address information or conditions that may be discovered in the future and that require a response.
We are subject to interruptions of supply and increased costs as a result of our reliance on third-party transportation of crude oil and refined products.
Our Washington refinery receives all of its Canadian crude oil and delivers a high proportion of its gasoline, diesel and jet fuel through third-party pipelines. Our Hawaii and Alaska refineries receive most of their crude oil and transport a substantial portion of refined products through ships and barges. Our Utah refinery receives substantially all of its crude oil and delivers substantially all of its products through third-party pipelines. Our North Dakota refinery delivers substantially all of its products through a third-party pipeline system. Our California refinery receives approximately one-third of its crude oil through pipelines and the balance through marine vessels. Substantially all of our California refinery’s production is delivered through third-party pipelines, ships and barges. In addition to environmental risks discussed above, we could experience an interruption of supply or an increased cost to deliver refined products to market if the ability of the pipelines or vessels to transport crude oil or refined products is upset because of accidents, governmental regulation or third-party action. A prolonged upset of the ability of a pipeline or vessels to transport crude oil or product could have a material adverse effect on our business, financial condition and results of operations.
Terrorist attacks and threats or actual war may negatively impact our business.
Our business is affected by general economic conditions and fluctuations in consumer confidence and spending, which can decline as a result of numerous factors outside of our control, such as actual or threatened terrorist attacks and acts of war. Terrorist attacks, as well as events occurring in response to or in connection with them, including future terrorist attacks against U.S. targets, rumors or threats of war, actual conflicts involving the United States or its allies, or military or trade disruptions impacting our suppliers or our customers or energy markets generally, may adversely impact our operations. As a result, there could be delays or losses in the delivery of supplies and raw materials to us, delays in our delivery of refined products, decreased sales of our products and extension of time for payment of accounts receivable from our customers. Strategic targets such as energy-related assets (which could include refineries such as ours) may be at greater risk of future terrorist attacks than other targets in the United States. These occurrences could significantly impact energy prices, including prices for our crude oil and refined products, and have a material adverse impact on the margins from our refining and wholesale marketing operations. In addition, disruption or significant increases in energy prices could result in government-imposed price controls. Any one of, or a combination of, these occurrences could have a material adverse effect on our business, financial condition and results of operations.
Our operating results are seasonal and generally are lower in the first and fourth quarters of the year.
Demand for gasoline is higher during the spring and summer months than during the winter months in most of our markets due to seasonal increases in highway traffic. As a result, our operating results for the first and fourth quarters are generally lower than for those in the second and third quarters.
ITEM 1B.
ITEM 1B.
UNRESOLVED STAFF COMMENTS
None.
ITEM 3.
ITEM 3.
LEGAL PROCEEDINGS
In the ordinary course of business, we become party to or otherwise involved in lawsuits, administrative proceedings and governmental investigations, including environmental, regulatory and other matters. Large and sometimes unspecified damages or penalties may be sought from us in some matters and some matters may require years for us to resolve. We cannot provide assurance that an adverse resolution of one or more of the matters described below during a future reporting period will not have a material adverse effect on our financial position or results of operations in future periods. However, on the basis of existing information, we believe that the resolution of these matters, individually or in the aggregate, will not have a material adverse effect on our financial position or results of operations.
In November 2003, we filed suit in Contra Costa County Superior Court against Tosco alleging that Tosco misrepresented, concealed and failed to disclose certain additional environmental conditions at our California refinery. The court granted Tosco’s motion to compel arbitration of our claims for these certain additional environmental conditions. In the arbitration proceedings we initiated against Tosco in December 2003, we are also seeking a determination that Tosco is liable for investigation and remediation of these certain additional environmental conditions, the amount of which is currently unknown and therefore a reserve has not been established, and which may not be covered by the $50 million indemnity for the defined environmental liabilities arising from pre-acquisition operations. In response to our arbitration claims, Tosco filed counterclaims in the Contra Costa County Superior Court action alleging that we are contractually responsible for additional environmental liabilities at our California refinery, including the defined environmental liabilities arising from pre-acquisition operations. In February 2005, the parties agreed to stay the arbitration proceedings to pursue settlement discussions. In June 2005, the parties agreed in principle to settle their claims, including the defined environmental liabilities arising from pre-acquisition operations and certain additional environmental conditions, pending negotiation and execution of a final written settlement agreement. In the event we are unable to finalize the settlement, we intend to vigorously prosecute our claims against Tosco and to oppose Tosco’s claims against us, although we cannot provide assurance that we will prevail. For further information related to the claims, see Note O in our consolidated financial statements in Item 8.
During the fourth quarter of 2005, we received approval by the Hearing Board for the Bay Area Air Quality Management District to modify our existing fluid coker unit to a delayed coker at our California refinery. We negotiated the terms and conditions of the Second Conditional Abatement Order with the District in response to the January 2005 mechanical failure of one of our boilers at the California refinery. We also received two notices of violation (“NOV”) from the Bay Area Air Quality Management District as a result of the January 2005 mechanical failure. On January 26, 2006, we entered into a Settlement Agreement and Release with the District and the District Attorney of Contra Costa County, California. In exchange for the release of allegations based upon certain air quality emission limits and provisions of the California Health and Safety Code, we paid a civil penalty of $1.1 million.
As previously disclosed, we were a defendant, along with other manufacturing, supply and marketing defendants, in ten pending cases alleging MTBE contamination in groundwater. During the 2005 fourth quarter, we were named as a defendant in one additional case. The defendants are being sued for having manufactured MTBE and having manufactured, supplied and distributed gasoline containing MTBE. The plaintiffs in each of the 11 pending cases, all in California, are generally water providers, governmental authorities and private well owners alleging that, in part, the defendants are liable for manufacturing or distributing a defective product. The suits generally seek individual, unquantified compensatory and punitive damages and attorney’s fees, but we cannot estimate the amount or likelihood of the ultimate resolution of these matters at this time, and accordingly, we have not established a reserve for these cases. We believe we have defenses to these claims and intend to vigorously defend the lawsuits.
On October 24, 2005, we received an NOV from the EPA. The EPA alleges certain modifications made to the fluid catalytic cracking unit at our Washington refinery prior to our acquisition of the refinery were made without a permit in violation of the Clean Air Act. We are investigating the allegations and believe the
ultimate resolution of the NOV will not have a material adverse effect on our financial position or results of operations.
During the first quarter of 2005, we negotiated a settlement of 70 NOVs from the Bay Area Air Quality Management District. The NOVs alleged various violations of air quality requirements at the California refinery between June 2002 and February 2004. We paid a civil penalty of $575,000 to resolve the matter.
On February 28, 2006, we received an offer of settlement from the Bay Area Air Quality Management District. The District has offered to settle 28 NOVs issued to Tesoro from January 2004 to September 2004 for $275,000. The NOVs allege violations of various air quality requirements at the California refinery.
As previously reported, during the first quarter of 2005 we began settlement discussions with the California Air Resources Board (“CARB”) concerning an NOV we received in October 2004. The NOV, issued by CARB, alleges we offered for sale eleven batches of gasoline in California that did not meet CARB’s gasoline exhaust emission limits. In January 2006, we executed a Settlement Agreement and Release with CARB which requires us to pay a civil penalty of $325,000 to resolve this matter.
ITEM 4.
ITEM 4.
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5.
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock is listed under the symbol “TSO” on the New York Stock Exchange and the Pacific Exchange. Summarized below are high and low sales prices of and dividends declared on our common stock on the New York Stock Exchange during 2005 and 2004. Quarterly cash dividends have been declared for each quarter beginning in June 2005. Prior to June 2005, we had not paid dividends on our common stock since 1986.
On February 2, 2006, our Board of Directors declared a quarterly cash dividend on common stock of $0.10 per share, payable on March 15, 2006 to shareholders of record on March 1, 2006. At March 1, 2006, there were approximately 1,978 holders of record of our 69,006,300 outstanding shares of common stock. For information regarding restrictions on future dividend payments and stock repurchases, see Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7 and Notes E and F in our consolidated financial statements in Item 8.
The 2006 annual meeting of stockholders will be held at 8:00 A.M. Pacific Daylight Time on Wednesday, May 3, 2006, at The Four Seasons Hotel, 757 Market Street, San Francisco, California. Holders of common stock of record at the close of business on March 14, 2006 are entitled to notice of and to vote at the annual meeting.
The following table summarizes, as of December 31, 2005, certain information regarding equity compensation to our employees, officers, directors and other persons under our equity compensation plans.
Equity Compensation Plan Information
(a)
The Key Employee Stock Option Plan was approved by our Board of Directors in November 1999 and provided for stock option grants to eligible employees who are not our executive officers. The options expire ten years after the date of grant. Our Board of Directors has suspended any future grants under this plan.
The table below provides a summary of all repurchases by Tesoro of its common stock during the three-month period ended December 31, 2005.
*
Tesoro’s existing stock repurchase program was publicly announced on November 3, 2005. The program authorizes Tesoro to purchase up to $200 million aggregate purchase price of shares of Tesoro’s common stock.
ITEM 6.
ITEM 6.
SELECTED FINANCIAL DATA
The following table sets forth certain selected consolidated financial and operating data of Tesoro as of the end of and for each of the five years in the period ended December 31, 2005. The selected consolidated financial information presented below has been derived from our historical financial statements. Our financial results include the post-acquisition results of our California operations since mid-May 2002 and our Mid-Continent operations since September 2001. The following table should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Those statements in this section that are not historical in nature should be deemed forward-looking statements that are inherently uncertain. See “Forward-Looking Statements” on page 46 and “Risk Factors” on page 16 for a discussion of the factors that could cause actual results to differ materially from those projected in these statements.
BUSINESS STRATEGY AND OVERVIEW
Our strategy is to create a value-added refining and marketing business that has (i) economies of scale, (ii) a low-cost structure, (iii) effective management information systems and (iv) outstanding employees focused on business excellence in a global market, that can provide stockholders with competitive returns in any economic environment.
Our goals are focused on: (i) operating our facilities in a safe, reliable, and environmentally responsible way; (ii) improving profitability by achieving greater operational and administrative efficiencies; and (iii) using excess cash flows from operations in a balanced way to create further shareholder value.
In November 2005, our Board of Directors approved the 2006 capital budget, which is currently estimated to be $670 million (including refinery turnaround and other maintenance costs of approximately $105 million). The 2006 capital budget includes the modification of our existing fluid coker unit to a delayed coker unit at our California refinery which is designed to (i) lower emissions as required by the Bay Area Air Quality Management District (see “Environmental and Other”) and (ii) increase overall efficiency by lowering operating costs. We currently expect to spend approximately $275 million through the fourth quarter of 2007 for this project, of which $3 million was spent in 2005. We anticipate spending $133 million in 2006, $138 million in 2007 and the remainder in 2008. This cost estimate is subject to further review and analysis.
Our Board of Directors has approved certain high return and strategic capital projects, including installing a 25,000 bpd delayed coker unit at our Washington refinery and a 10,000 bpd diesel desulfurizer unit at our Alaska refinery. The delayed coker unit will allow our Washington refinery to process a larger proportion of lower-cost heavy crude oils and manufacture a larger percentage of higher-value products. We expect to spend approximately $250 million through the fourth quarter of 2007 for this project, of which we spent $2 million in 2005. We anticipate spending $110 million in 2006 and the remainder in 2007. The diesel desulfurizer unit, which will allow us to manufacture additional quantities of low sulfur diesel at our Alaska refinery, will require us to spend approximately $55 million through the 2007 second quarter, of which we spent $4 million in 2005. We anticipate spending $39 million in 2006 and the remainder in 2007. These cost estimates are subject to further review and analysis.
In 2005, Tesoro’s incentive compensation program included two financial goals focused on improving profitability by achieving greater operational and administrative efficiencies: (i) achieve earnings of at least $3.85 per diluted share for executives and $3.50 per diluted share for all other eligible employees and (ii) realize $62 million of operating income improvements through business improvement initiatives that are principally generated by intellectual capital rather than capital investment. During 2005, we achieved the following significant results relative to our goals, which are further described below under “Results of Operations” and “Capital Resources & Liquidity”:
•
We had record net earnings of $507 million, or $7.20 per diluted share, compared to 2004 net earnings of $328 million, or $4.76 per diluted share.
•
We achieved record throughput of 529,600 bpd and operating income of $1 billion, which includes the realization of approximately $80 million of operating income through business improvement initiatives. The majority of the improvements were the result of the diversification of our crude oil purchases, together with yield improvements.
•
We used cash flows from operations to prepay debt totaling $191 million. Our debt to capitalization ratio was reduced to 36% at year-end, compared to 48% at the end of 2004.
•
In November we refinanced nearly $1 billion of debt. We replaced $366 million of our secured debt with unsecured debt, reduced our interest rates and extended the maturity dates. The refinancing and prepayments of debt during 2005 will result in annual pretax interest savings of approximately $40 million.
•
We initiated a quarterly cash dividend on common stock of $0.05 per share which was paid in both June and September. We then doubled the quarterly cash dividend paid in December to $0.10 per share.
•
In November, our Board of Directors authorized a $200 million share repurchase program, which represented approximately 5% of the shares then outstanding. In 2005, we repurchased 240,000 shares of common stock for $14 million under the program.
•
Our capital and turnaround spending totaled $327 million of which $96 million was for Clean Air projects and $45 million was for reliability and safety projects.
Industry refining margins remained strong during 2005 and improved as compared to 2004. Factors positively impacting industry refining margins during 2005 included:
•
continued increased demand due to improved economic fundamentals worldwide;
•
tight finished product inventories and inadequate refining capacity to meet demand growth;
•
third quarter production and supply disruptions on the U.S. Gulf Coast caused by hurricanes Katrina and Rita;
•
heavy refining industry turnaround activity in the western U.S. primarily during the first quarter;
•
unplanned refining industry downtime on the U.S. West Coast during the third quarter; and
•
the 2005 and 2004 changes in product specifications related to sulfur reductions in gasoline and the elimination of MTBE.
RESULTS OF OPERATIONS
Summary
Our net earnings for 2005 were $507 million ($7.44 per basic share and $7.20 per diluted share), compared with net earnings of $328 million ($5.01 per basic share and $4.76 per diluted share) for 2004. The significant increase in net earnings during 2005 was primarily due to (i) higher refined product margins, (ii) record high throughput levels, and (iii) realizing our operating income improvement initiatives. Net earnings for 2005 included charges for debt refinancing and prepayment costs of $58 million after-tax or $0.82 per share, and executive termination and retirement costs of $6 million after-tax, or $0.09 per share. Net earnings for 2004 included debt prepayment and financing costs of $14 million after-tax, or $0.20 per share, and charges for executive retirement costs of $1 million after-tax, or $0.01 per share.
Our net earnings for 2004 were $328 million ($5.01 per basic share and $4.76 per diluted share), compared with net earnings of $76 million ($1.18 per basic share and $1.17 per diluted share) for 2003. The significant increase in net earnings during 2004 was primarily due to (i) higher refined product margins, (ii) increased throughput levels, (iii) lower interest expense as a result of debt reduction and refinancing in 2003 and additional debt prepayments during 2004, and (iv) our continued focus on capturing business improvement initiatives. Net earnings for 2003 included the write-off of unamortized debt issuance costs of $23 million after-tax, or $0.35 per share. Our 2003 results also included losses on the sale of our marine services assets and certain retail asset impairments of $6 million after-tax, or $0.09 per share, voluntary early retirement benefits and severance costs of $6 million after-tax, or $0.09 per share, and a charge related to the termination of our funded executive security plan of $6 million after-tax, or $0.08 per share.
A discussion and analysis of the factors contributing to our results of operations is presented below. The accompanying consolidated financial statements in Item 8, together with the following information, are intended to provide investors with a reasonable basis for assessing our historical operations, but should not serve as the only criteria for predicting our future performance.
Refining Segment
(a)
Includes intersegment sales to our retail segment, at prices which approximate market of $873 million, $784 million and $696 million in 2005, 2004 and 2003, respectively. Intersegment product sales volumes totaled 16,900 bpd, 19,000 bpd and 20,200 bpd in 2005, 2004 and 2003, respectively.
(b)
We experienced reduced throughput during scheduled maintenance turnarounds for the following refineries: the California, Washington and Hawaii refineries during 2005; the California refinery during 2004; and the Alaska, North Dakota and Utah refineries during 2003.
(c)
We define “heavy” crude oil as Alaska North Slope or crude oil with an American Petroleum Institute specific gravity of 32 degrees or less.
(d)
Management uses gross refining margin per barrel to evaluate performance, allocate resources and compare profitability to other companies in the industry. Gross refining margin per barrel is calculated by dividing gross refining margin before inventory changes by total refining throughput and may not be calculated similarly by other companies. Management uses manufacturing costs per barrel to evaluate the efficiency of refinery operations and allocate resources. Manufacturing costs per barrel may not be comparable to similarly titled measures used by other companies. Investors and analysts use these financial measures to help analyze and compare companies in the industry on the basis of operating performance. These financial measures should not be considered as alternatives to segment operating income, revenues, costs of sales and operating expenses or any other measure of financial performance presented in accordance with accounting principles generally accepted in the United States of America.
(e)
Gross refining margin is calculated as revenues less costs of feedstocks, purchased products, transportation and distribution. Gross refining margin approximates total refining segment throughput times gross refining margin per barrel, adjusted for changes in refined product inventory due to selling a volume and mix of product that is different than actual volumes manufactured. Gross refining margin also includes the effect of intersegment sales to the retail segment at prices which approximate market.
(f)
Includes manufacturing depreciation and amortization per throughput barrel of approximately $0.75, $0.61 and $0.59 for 2005, 2004 and 2003, respectively.
(g)
Sources of total product sales include products manufactured at the refineries and products purchased from third parties. Total product sales margin includes margins on sales of manufactured and purchased products and the effects of inventory changes.
2005 Compared to 2004 - Operating income from our refining segment was $1.2 billion in 2005 compared to $830 million in 2004. The increase in operating income of $364 million was primarily due to higher gross refining margins, combined with higher throughput levels, partially offset by higher operating expenses. Total gross refining margins increased 29% to $11.81 per barrel in 2005 compared to $9.12 per barrel in 2004, reflecting higher per-barrel gross refining margins in all our regions. Industry margins on a national basis improved during 2005 compared to 2004, primarily due to the continued increased demand for finished products due to improved economic fundamentals worldwide, an active hurricane season and higher than normal industry maintenance particularly in the western United States during the first half of 2005. Industry margins were also impacted by unplanned industry downtime on the U.S. West Coast during the 2005 third quarter.
On an aggregate basis, our total gross refining margins increased to $2.2 billion in 2005 from $1.7 billion in 2004, reflecting higher per-barrel gross refining margins and increased total refining throughput. Total refining throughput averaged 530,000 bpd in 2005 compared to 520,000 bpd during 2004, reflecting record high throughput during the 2005 third and fourth quarters. Our record high throughput during the last half of 2005 reflects improved operational efficiencies resulting from scheduled maintenance turnarounds at our three largest refineries during the first half of 2005. We estimate that our refining operating income was reduced by approximately $75 million as a result of both scheduled and unscheduled downtime at our California and Washington refineries during the 2005 first quarter. During the 2004 third and fourth quarters, our California refinery experienced reduced throughput during a scheduled maintenance turnaround, in which we estimate that our refining operating income was reduced by approximately $99 million. In addition, our gross refining margins in our Pacific Northwest region during the first half of 2005 and the 2004 third and fourth quarters
were negatively impacted as the increased differential between light and heavy crude oil depressed the margins for heavy fuel oils.
Revenues from sales of refined products increased 34% to $15.6 billion in 2005 from $11.6 billion in 2004, primarily due to significantly higher average product sales prices combined with slightly higher product sales volumes. Our average product prices increased 33% to $70.20 per barrel reflecting the continued strength in market fundamentals and the active hurricane season. Total product sales averaged 609,000 bpd in 2005, compared to 604,000 bpd in 2004. Our average costs of sales increased 35% to $60.28 per barrel during 2005, reflecting significantly higher average feedstock prices and increased purchases of refined products due to scheduled and unscheduled downtime at certain refineries. Expenses, excluding depreciation and amortization, increased to $892 million in 2005, compared with $746 million in 2004, primarily due to higher utilities of $48 million, higher employee costs of $13 million, increased maintenance costs of $12 million and increased insurance costs of $8 million primarily due to property insurance premium surcharges resulting from hurricanes Katrina and Rita. Expenses included the allocation of certain information technology costs totaling $24 million that were previously classified as corporate and unallocated costs. Depreciation and amortization increased to $160 million in 2005, compared to $130 million in 2004, primarily reflecting increasing capital expenditures. In addition, during the fourth quarter of 2005, we shortened the estimated lives of the fluid coker unit and certain tanks at our California refinery and recorded asset retirement obligations (see Note A in our consolidated financial statements in Item 8), resulting in additional depreciation of $12 million. The existing fluid coker unit will be modified to a delayed coker unit, which is scheduled to be completed during the fourth quarter of 2007. The tanks will be retired between 2006 and 2019 to comply with applicable regulations. The shortened asset lives and recorded asset retirement obligations will increase depreciation in 2006 by approximately $45 million.
Refining throughput and yields in 2006 will be affected by scheduled maintenance turnarounds at our California, Washington, Alaska and North Dakota refineries. We currently expect total refining throughput to average approximately 525,000 to 535,000 bpd in 2006.
2004 Compared to 2003 - Operating income from our refining segment increased to $830 million in 2004 compared to $405 million in 2003. The $425 million increase in our operating income primarily resulted from significantly higher refined product margins, combined with higher throughput levels and product sales volumes. Our total gross refining margin per barrel increased 36% to $9.12 per barrel in 2004 compared to $6.73 per barrel in 2003, reflecting higher per-barrel refining margins in all of our regions. Industry margins on a national basis improved primarily due to increased demand and below average inventory levels for finished products. Improved economic fundamentals in the U.S. and Far East resulted in increased demand and margins for finished products and reduced finished product inventory levels. Heavy refining industry turnaround activity in the PADD V region during the first quarter of 2004 reduced finished product inventory levels on the U.S. West Coast. Furthermore, U.S. West Coast gasoline supplies tightened in part due to the elimination of the oxygenate MTBE. Margins were lower in all of our refining regions excluding California for the fourth quarter of 2004, compared to the third quarter, primarily due to lower seasonal demand for refined products and higher average crude oil prices. While refining margins in the California region increased during the fourth quarter as compared to the third quarter, we were unable to fully capture these margins due to scheduled downtime at the California refinery as discussed below.
On an aggregate basis, our total gross refining margins increased from $1.2 billion in 2003 to $1.7 billion in 2004, reflecting higher per-barrel gross refining margins in all of our regions and higher total refining throughput volumes. Total refining throughput averaged 520,000 bpd in 2004, an increase of 32,000 bpd or 7% from 2003, despite scheduled turnarounds at our California refinery, which were completed during the 2004 fourth quarter, and unscheduled downtime in the 2004 first quarter due to a short-term power outage and accelerated maintenance of the hydrogen plant. Primarily due to the scheduled and unscheduled downtime at the California refinery, the percentage of lower cost heavy crude oil that we processed of total refining throughput decreased from 58% in 2003 to 50% in 2004. In 2003, our Alaska, North Dakota and Utah refineries experienced reduced throughput during scheduled maintenance turnarounds.
Revenues from sales of refined products increased 43% to $11.6 billion in 2004 from $8.1 billion in 2003, primarily due to significantly higher average product sales prices and slightly higher product sales volumes. Our average product prices increased 32% to $52.65 per barrel and total product sales increased by 8% to average 604,000 bpd in 2004 from 2003. Costs of sales also increased primarily due to higher average feedstock prices and slightly higher product sales volumes as compared with 2003. Expenses, excluding depreciation and amortization, increased to $746 million in 2004 from $671 million in 2003, primarily due to increased maintenance, utilities and employee costs of approximately $57 million and the write-off of certain refinery assets that were replaced in connection with the California refinery turnaround of $8 million. We estimate that the scheduled turnarounds at our California refinery during 2004 resulted in additional operating expenses of approximately $10 million in 2004.
Retail Segment
(a)
Management uses fuel margin per gallon to compare profitability to other companies in the industry. Fuel margin per gallon is calculated by dividing fuel gross margin by fuel sales volumes and may not be calculated similarly by other companies. Investors and analysts use fuel margin per gallon to help analyze and compare companies in the industry on the basis of operating performance. This financial measure should not be considered as an alternative to segment operating income and revenues or any other financial measure of financial performance presented in accordance with accounting principles generally accepted in the United States of America.
(b)
Includes the effect of intersegment purchases from our refining segment at prices which approximate market.
2005 Compared to 2004 - The operating loss for our retail segment was $31 million in 2005, compared to an operating loss of $6 million in 2004. Total gross margins decreased to $110 million during 2005 from $118 million in 2004 due to lower sales volumes. Fuel margin remained flat at $0.16 per gallon in both 2005 and 2004. Total gallons sold decreased to 449 million from 510 million, reflecting the decrease in average station count to 494 in 2005 from 538 in 2004. The decrease in average station count reflects our continued rationalization of retail assets.
Revenues on fuel sales increased to $944 million in 2005, from $863 million in 2004, reflecting increased sales prices, partly offset by lower sales volumes. Costs of sales increased in 2005 due to higher average prices of purchased fuel, partly offset by lower sales volumes. Operating expenses for 2005 included the allocation of certain information technology costs of $5 million that were previously classified as corporate and unallocated costs and higher insurance costs of $2 million. The increase in loss on asset disposals and impairments to $9 million in 2005 from $4 million in 2004 primarily reflects charges for the impairment of certain retail sites.
2004 Compared to 2003 - The operating loss for our retail segment was $6 million in 2004 compared to operating income of $13 million in 2003. Total gross margins decreased to $118 million during 2004 from $136 million in 2003, reflecting lower fuel margins per gallon and lower sales volumes. Fuel margin decreased to $0.16 per gallon in 2004 from $0.18 per gallon in 2003, reflecting higher average prices of purchased fuel. Total gallons sold decreased to 510 million from 568 million, reflecting the decrease in average station count to 538 in 2004 from 575 in 2003 due to our continued rationalization of retail assets.
Revenues on fuel sales increased to $863 million in 2004 from $797 million in 2003, reflecting increased sales prices, primarily offset by lower sales volumes. Costs of sales increased in 2004 due to higher average prices of purchased fuel, partly offset by lower sales volumes. Operating, selling, general and administrative expenses remained flat in 2004, as compared to 2003.
Selling, General and Administrative Expenses
Selling, general and administrative expenses of $179 million in 2005 increased from $152 million in 2004. During 2005, we allocated certain information technology costs previously reported as selling, general and administrative expenses to costs of sales and operating expenses totaling $29 million (see Notes A and D of the condensed consolidated financial statements in Item 8). The increase during 2005 was primarily due to increased employee and contract labor expenses of $28 million, charges for the termination and retirement of certain executive officers of $11 million and additional stock-based compensation expenses of $8 million. The increase in employee and contract labor expenses during 2005 primarily reflects costs associated with implementing and supporting systems and process improvements.
Selling, general and administrative expenses of $152 million in 2004 increased from $138 million in 2003. During 2004, we incurred an additional $20 million for stock-based and other incentive-based compensation, higher professional fees of approximately $11 million for projects related to driving business excellence and charges associated with the retirement of certain executive officers totaling $2 million. During 2003, we incurred charges totaling $17 million for voluntary early retirement benefits, severance costs and the termination of our funded executive security plan.
Interest and Financing Costs
Interest and financing costs were $211 million in 2005 compared to $171 million in 2004. The increase was due to debt refinancing and prepayment costs totaling $92 million associated with the refinancing of our 8% senior secured notes and 95/8% senior subordinated notes, and charges of $3 million in connection with the voluntary prepayment of our senior secured term loans during 2005. During 2004, debt prepayment and financing costs totaled $23 million, primarily associated with voluntary debt prepayments. Excluding these refinancing and prepayment costs, interest and financing costs decreased by $32 million during 2005, primarily due to lower interest expense associated with debt reduction totaling $401 million during 2004 and $191 million during 2005.
Interest and financing costs were $171 million in 2004 compared to $213 million in 2003. The $42 million decrease in 2004 was due primarily to lower interest expense associated with debt reduction during 2004 and 2003 totaling $778 million. The decrease was also due to the write-off of $36 million of unamortized debt issuance costs in 2003 in connection with the replacement of our previous credit facility and voluntary prepayments of other debt. The decrease during 2004 was partly offset by debt prepayment and financing costs totaling $23 million as discussed above.
Income Tax Provision
The income tax provision amounted to $324 million in 2005 compared to $219 million in 2004 and $47 million in 2003. The increases reflect significantly higher earnings before income taxes. The combined federal and state effective income tax rates were approximately 39%, 40% and 38% in 2005, 2004 and 2003, respectively. The decrease in our federal and state effective income tax rate during 2005 was primarily a result of a new tax deduction for domestic manufacturing activities, which became available in 2005. The increase in our federal and state effective income tax rate during 2004 was primarily due to a change in California state tax law, which eliminated an investment tax credit that had been available in previous years.
CAPITAL RESOURCES AND LIQUIDITY
Overview
We operate in an environment where our capital resources and liquidity are impacted by changes in the price of crude oil and refined petroleum products, availability of trade credit, market uncertainty and a variety of additional factors beyond our control. These risks include, among others, the level of consumer product demand, weather conditions, fluctuations in seasonal demand, governmental regulations, worldwide geo-political conditions and overall market and economic conditions. See “Forward-Looking Statements” on page 46 and “Risk Factors” on page 16 for further information related to risks and other factors. Future capital expenditures, as well as borrowings under our credit agreement and other sources of capital, may be affected by these conditions.
Our primary sources of liquidity have been cash flows from operations and borrowing availability under revolving lines of credit. We ended 2005 with $440 million of cash and cash equivalents, no borrowings under our revolving credit facility, and $482 million in available borrowing capacity under our credit agreement after $268 million in outstanding letters of credit. We also have a separate letters of credit agreement of which we had $77 million available after $88 million in outstanding letters of credit as of December 31, 2005. As further described below, in November 2005 we refinanced nearly $1 billion principal amount of our outstanding 8% senior secured notes and 95/8% senior subordinated notes through a $900 million notes offering and prepaid an additional $92 million with cash on-hand. In April 2005, we voluntarily prepaid the remaining $96 million outstanding principal balance of our senior secured term loans. The refinancing and debt prepayments will result in annual pretax interest savings of approximately $40 million. Since May 2002, including the debt prepayments during 2005, we have reduced debt by approximately $1.1 billion, decreasing our debt to capitalization ratio from 69% at June 30, 2002 to 36% at December 31, 2005. We believe available capital resources will be adequate to meet our capital expenditures, working capital and debt service requirements.
Capitalization
On November 16, 2005, Tesoro issued $450 million principal amount of 61/4% senior notes due 2012 and $450 million principal amount of 65/8% senior notes due 2015 (the “notes offering”). The proceeds from the notes offering, including cash on-hand, were used to repurchase through cash tender offers the following principal amounts of our existing notes: (i) $189 million of our outstanding $211 million 95/8% senior subordinated notes due 2008; (ii) $415 million of our outstanding $429 million 95/8% senior subordinated notes due 2012; and (iii) $366 million principal amount of our $375 million 8% senior secured notes due 2008. We redeemed the remaining $22 million principal amount of the 95/8% senior subordinated notes due 2008 at a redemption price of 104.8% on December 16, 2005. The refinancing of nearly $1 billion and prepayments
totaling $92 million resulted in a pretax charge of $92 million, consisting of tender and redemption premiums of $74 million and the write-off of unamortized debt issuance costs and discount of $18 million. The remaining $9 million outstanding balance of the 8% senior secured notes are callable beginning April 15, 2006 at a redemption price of 104%. The remaining $14 million outstanding balance of the 95/8% senior subordinated notes are callable beginning April 1, 2007 at a redemption price of 104.8%.
Our capital structure at December 31, 2005 was comprised of (in millions):
At December 31, 2005, our debt to capitalization ratio was 36%, compared to 48% at year-end 2004, reflecting net earnings of $507 million during 2005, voluntary prepayments of debt and scheduled capital lease payments totaling $191 million and an increase in additional paid-in capital of $76 million during 2005 primarily due to stock options exercised.
Our credit agreement and senior notes impose various restrictions and covenants as described below that could potentially limit our ability to respond to market conditions, raise additional debt or equity capital, or take advantage of business opportunities.
Credit Agreement
In May 2005, we amended our credit agreement to extend the term by one year to June 2008 and reduce letter of credit fees and revolver borrowing interest. The credit agreement currently provides for borrowings (including letters of credit) up to the lesser of the agreement’s total capacity, $750 million as amended, or the amount of a periodically adjusted borrowing base ($1.5 billion as of December 31, 2005), consisting of Tesoro’s eligible cash and cash equivalents, receivables and petroleum inventories, as defined. As of December 31, 2005, we had no borrowings and $268 million in letters of credit outstanding under the revolving credit facility, resulting in total unused credit availability of $482 million or 64% of the eligible borrowing base. Borrowings under the revolving credit facility bear interest at either a base rate (7.25% at December 31, 2005) or a eurodollar rate (4.39% at December 31, 2005), plus an applicable margin. The applicable margin at December 31, 2005 was 1.50% in the case of the eurodollar rate, but varies based on credit facility availability. Letters of credit outstanding under the revolving credit facility incur fees at an annual rate tied to the eurodollar rate applicable margin (1.50% at December 31, 2005).
The credit agreement allows up to $250 million in letters of credit outside the credit agreement for crude oil purchases from non-U.S. vendors. In September 2005, we entered into a separate letters of credit agreement that provides up to $165 million in letters of credit for the purchase of foreign crude oil. The agreement is secured by our petroleum inventories supported by letters of credit issued under the agreement and will remain in effect until terminated by either party. Letters of credit outstanding under this agreement incur fees at an annual rate of 1.25% while secured or 1.38% while unsecured. As of December 31, 2005, we had $88 million in letters of credit outstanding under this agreement.
The credit agreement contains covenants and conditions that, among other things, limit our ability to pay cash dividends, incur indebtedness, create liens and make investments. Tesoro is also required to maintain
specified levels of fixed charge coverage and tangible net worth. We are not required to maintain the fixed charge coverage ratio if unused credit availability exceeds 15% of the eligible borrowing base. The credit agreement is guaranteed by substantially all of Tesoro’s active subsidiaries and is secured by substantially all of Tesoro’s cash and cash equivalents, petroleum inventories and receivables.
61/4% Senior Notes Due 2012
On November 16, 2005, Tesoro issued $450 million aggregate principal amount of 61/4% senior notes due November 1, 2012. The notes have a seven-year maturity with no sinking fund requirements and are not callable. We have the right to redeem up to 35% of the aggregate principal amount at a redemption price of 106% with proceeds from certain equity issuances through November 1, 2008. The indenture for the notes contains covenants and restrictions that are customary for notes of this nature and are identical to the covenants in the indenture for Tesoro’s 65/8% senior notes due 2015. Substantially all of these covenants will terminate before the notes mature if one of two specified ratings agencies assigns the notes an investment grade rating and no events of default exist under the indenture. The terminated covenants will not be restored even if the credit rating assigned to the notes subsequently falls below investment grade. The notes are unsecured and are guaranteed by substantially all of Tesoro’s active subsidiaries.
65/8% Senior Notes Due 2015
On November 16, 2005, Tesoro issued $450 million aggregate principal amount of 65/8% senior notes due November 1, 2015. The notes have a ten-year maturity with no sinking fund requirements and are subject to optional redemption by Tesoro beginning November 1, 2010 at premiums of 3.3% through October 31, 2011, 2.2% from November 1, 2011 to October 31, 2012, 1.1% from November 1, 2012 to October 31, 2013, and at par thereafter. We have the right to redeem up to 35% of the aggregate principal amount at a redemption price of 106% with proceeds from certain equity issuances through November 1, 2008. The indenture for the notes contains covenants and restrictions that are customary for notes of this nature and are identical to the covenants in the indenture for Tesoro’s 61/4% senior notes due 2012. Substantially all of these covenants will terminate before the notes mature if one of two specified ratings agencies assigns the notes an investment grade rating and no events of default exist under the indenture. The terminated covenants will not be restored even if the credit rating assigned to the notes subsequently falls below investment grade. The notes are unsecured and are guaranteed by substantially all of Tesoro’s active subsidiaries.
The indentures for our senior notes contain covenants and restrictions which are customary for notes of this nature. These covenants and restrictions limit, among other things, our ability to:
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pay dividends and other distributions with respect to our capital stock and purchase, redeem or retire our capital stock;
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incur additional indebtedness and issue preferred stock;
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sell assets unless the proceeds from those sales are used to repay debt or are reinvested in our business;
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incur liens on assets to secure certain debt;
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engage in certain business activities;
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engage in certain merger or consolidations and transfers of assets; and
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enter into transactions with affiliates.
The indentures also limit our subsidiaries’ ability to create restrictions on making certain payments and distributions. The senior notes are guaranteed by substantially all of our active domestic subsidiaries.
Senior Secured Term Loans
In April 2005, we voluntarily prepaid the remaining $96 million outstanding principal balance of our senior secured term loans at a prepayment premium of 1%. The prepayment resulted in a pretax charge during
the 2005 second quarter of $3 million, consisting of the write-off of unamortized debt issuance costs and the 1% prepayment premium.
8% Senior Secured Notes Due 2008
In April 2003, Tesoro issued $375 million aggregate principal amount of 8% senior secured notes due April 15, 2008. On November 16, 2005, Tesoro repurchased $366 million of the notes in connection with the notes offering described above. In addition, the indenture for the notes was amended to remove substantially all of the covenants. The remaining $9 million outstanding balance of the notes has no sinking fund requirements and is subject to optional redemption by Tesoro, beginning April 15, 2006, at a premium of 4% through April 14, 2007, and at par thereafter. The notes are secured by substantially all of Tesoro’s refining property, plant and equipment and are guaranteed by substantially all of Tesoro’s active subsidiaries. The notes were issued at 98.994% of par, resulting in net proceeds of $371.2 million before debt issuance costs. The effective interest rate on the notes is 8.25%, after giving effect to the discount.
95/8% Senior Subordinated Notes Due 2012
In April 2002, Tesoro issued $450 million principal amount of 95/8% senior subordinated notes due April 1, 2012. On November 16, 2005, Tesoro repurchased $415 million of the outstanding $429 million notes, in connection with the notes offering described above. In addition, the indenture for the notes was amended to remove substantially all of the covenants. The remaining $14 million outstanding balance of the notes matures in April 2012, has no sinking fund requirements and is subject to optional redemption by Tesoro, beginning April 1, 2007 at premiums of 4.8% through March 31, 2008. The notes are guaranteed by substantially all of Tesoro’s active domestic subsidiaries.
Junior Subordinated Notes Due 2012
In connection with our acquisition of the California refinery, we issued to the seller two ten-year junior subordinated notes with face amounts aggregating $150 million. The notes consist of: (i) a $100 million junior subordinated note, due July 2012, which is non-interest bearing through May 16, 2007 and carries a 7.5% interest rate thereafter, and (ii) a $50 million junior subordinated note, due July 2012, which bears interest at 7.47% from May 17, 2003 through May 16, 2007 and 7.5% thereafter. The junior subordinated notes were recorded initially at a combined present value of approximately $61 million, discounted at a rate of 15.625% and 14.375%, respectively. The discount is being amortized over the term of the notes.
Common Stock Repurchase Program
In November 2005, our Board of Directors authorized a $200 million share repurchase program, which represented approximately 5% of our common stock then outstanding. Under the program, we will repurchase our common stock from time to time in the open market. Purchases will depend on price, market conditions and other factors. During 2005, we repurchased 240,000 shares of common stock under the program for $14 million, or an average cost per share of $58.83. During January and February 2006, we repurchased an additional 421,800 shares of common stock under the program at a cost of $26 million.
Cash Flow Summary
Components of our cash flows are set forth below (in millions):
Net cash from operating activities during 2005 totaled $758 million, compared to $681 million from operating activities in 2004. The increase was primarily due to significantly improved earnings, partly offset by increased working capital requirements. Net cash used in investing activities of $254 million in 2005 was primarily for capital expenditures. Net cash used in financing activities primarily reflects our voluntary prepayment of the senior secured term loans, prepayments of our outstanding 8% senior secured notes and 95/8% senior subordinated notes in connection with the refinancing, and associated debt refinancing and prepayment costs. We also repurchased $15 million of common stock (including $14 million associated with the common stock repurchase program) and paid $14 million of dividends to stockholders. Gross borrowings and repayments under the revolving credit facility each amounted to $463 million during 2005. Working capital totaled $713 million at December 31, 2005 compared to $400 million at December 31, 2004, primarily as a result of the $255 million increase in cash and cash equivalents.
Net cash from operating activities during 2004 totaled $681 million, compared to $447 million from operating activities in 2003. The increase was primarily due to significantly improved earnings. Net cash used in investing activities of $174 million in 2004 was primarily for capital expenditures. Net cash used in financing activities of $399 million in 2004 primarily reflects the debt prepayments made during the year. Gross borrowings and repayments under the revolving credit facility each amounted to $112 million during 2004, all of which occurred during the 2004 first quarter. Working capital totaled $400 million at December 31, 2004 compared to $337 million at December 31, 2003, as a result of increases in cash and cash equivalents, receivables and inventories, partially offset by increases in payables, attributable to increases in sales volumes and crude and product prices.
Net cash from operating activities during 2003 totaled $447 million. Net cash used in investing activities of $70 million in 2003 was primarily for capital expenditures partially offset by proceeds from the sale of marine services assets. Net cash used in financing activities of $410 million in 2003 was primarily for voluntary debt prepayments under a previous term loan, other debt repayments, and financing costs related to the credit agreement. Gross borrowings and repayments under revolving credit lines each amounted to $1.0 billion during 2003.
Historical EBITDA
EBITDA represents earnings before interest and financing costs, interest income and other, income taxes, and depreciation and amortization. We present EBITDA because we believe some investors and analysts use EBITDA to help analyze our liquidity including our ability to satisfy principal and interest obligations with respect to our indebtedness and to use cash for other purposes, including capital expenditures. EBITDA is also used by some investors and analysts to analyze and compare companies on the basis of operating performance. EBITDA is also used by management for internal analysis and as a component of the fixed charge coverage financial covenant in our credit agreement. EBITDA should not be considered as an alternative to net earnings, earnings before income taxes, cash flows from operating activities or any other measure of financial performance presented in accordance with accounting principles generally accepted in the United States of
America. EBITDA may not be comparable to similarly titled measures used by other entities. Our annual historical EBITDA reconciled to net cash from operating activities was (in millions):
Historical EBITDA as presented above differs from EBITDA as defined under our credit agreement. The primary differences are non-cash postretirement benefit costs and loss on asset disposals and impairments, which are added to net earnings under the credit agreement EBITDA calculations.
Capital Expenditures and Refinery Turnaround Spending
Our capital expenditures and refinery turnaround spending totaled $327 million during 2005, compared to $229 million in 2004 as discussed below.
Capital Expenditures
During 2005, our capital expenditures, including accruals, totaled $262 million (excluding refinery turnaround and other maintenance costs of $65 million) and included clean air, clean fuels and other environmental projects of $126 million, refinery improvements at our California refinery of $54 million (excluding environmental projects), corporate capital expenditures of $42 million and retail projects totaling $6 million. See “Environmental and Other” below for additional information regarding capital spending for our clean air, clean fuels and other environmental projects.
In May 2005, our Board of Directors approved an incremental capital spending program for 2005 of approximately $42 million designed to capture strategic profit improvement opportunities in crude flexibility, yield improvements and cost reductions and $13 million to study environmental projects at our California and Alaska refineries. The capital projects include the installation of a delayed coker unit at our Washington refinery and a diesel desulfurizer unit at our Alaska refinery, both projected to be completed during 2007 (see “Business Strategy and Environment”). During 2005, we spent $2 million for the delayed coker unit and $4 million for the diesel desulfurizer unit.
Our 2006 capital budget is currently estimated to be approximately $565 million (excluding refinery turnaround and other maintenance costs of approximately $105 million). The capital budget includes $133 million for the delayed coker modification at our California refinery, $110 million for the delayed coker unit at our Washington refinery, $39 million for the diesel desulfurizer unit at our Alaska refinery, $160 million for sustaining and environmental, health and safety projects and $13 million for retail projects (see “Business Strategy and Environment”). Our preliminary capital expenditure estimates for 2007 and 2008 are $490 million and $190 million, respectively (excluding refinery turnaround and other maintenance costs of
approximately $50 million in 2007 and $60 million in 2008). We continue to evaluate additional projects for 2007 and 2008. As a result, these capital expenditure estimates are preliminary and subject to change.
Refinery Turnaround and Other Maintenance
During 2005, we spent $50 million for refinery turnarounds, primarily at our California, Washington and Hawaii refineries, and an additional $15 million for other maintenance. In 2006, we expect to spend approximately $81 million for refinery turnarounds, primarily at our California, Washington, Alaska and North Dakota refineries, and an additional $24 million for other maintenance. Based on our latest estimates, we expect our annual spending for refinery turnarounds to be as follows (excludes other maintenance) (in millions):
Long-Term Commitments
Contractual Commitments
We have numerous contractual commitments for purchases of crude oil feedstocks, services associated with the operation of our refineries, debt service and leases (see Notes E and O in our consolidated financial statements in Item 8). We also have contractual commitments for capital spending requirements related primarily to refinery improvements and environmental projects.
The following table summarizes our annual contractual commitments as of December 31, 2005 (in millions):
(1)
Includes maturities of principal and interest payments, excluding capital lease obligations. Amounts and timing may be different from our estimated commitments due to potential voluntary debt prepayments.
(2)
Represents our future minimum lease commitments for operating leases. Lease commitments for 2006 include lease arrangements with initial terms of less than one year.
(3)
Represents an estimate of our contractual purchase commitments for the supply of crude oil feedstocks, with remaining terms ranging from two months to 18 months. Prices under these term agreements generally fluctuate with market-responsive pricing provisions. To estimate our annual commitments under these contracts, we estimated crude oil prices using actual market prices, ranging from $54 per
barrel to $64 per barrel, as of December 31, 2005, and volumes based on the contract’s minimum purchase requirements. We also purchase additional crude oil feedstocks under short-term renewable contracts and in the spot market, which are not included in the table above.
(4)
Represents primarily long-term commitments to purchase services, including chemical supplies and power. These purchase obligations are based on the contract’s minimum volume requirements. We estimated our commitments to purchase power at our California refinery, which has variable pricing provisions, using estimated future market prices. Actual purchases of electricity at our California refinery typically exceed the required minimum volumes. Our commitments also include a final payment of $30 million in 2006 related to terminating the deactivated MTBE plant lease at our California refinery and annual payments of $5 million for a lease beginning in the fourth quarter of 2006 with an initial term through 2014.
(5)
Although we have no minimum required contribution obligation to our pension plan under applicable laws and regulations, we currently project to voluntarily contribute approximately $25 million in 2006, of which we contributed $6 million in February. Amounts are subject to change based on the performance of the assets in the plan, the discount rate used to determine the obligation, and other actuarial assumptions. See “Critical Accounting Policies” for further information related to our pension plan. We are unable to project benefit contributions beyond 2010.
As of December 31, 2005, we leased our corporate headquarters from a limited partnership in which we owned a 50% limited interest. In February 2006, the limited partnership sold the building to a third-party resulting in a gain to Tesoro of $5 million. We continue to lease our corporate headquarters from the third-party with an initial term through 2014 with two five-year renewal options. Our lease payments and operating costs paid to the partnership totaled $4 million, $3 million and $3 million in 2005, 2004, and 2003, respectively, and our future lease commitments are included in operating leases in the table above. We accounted for our interest in the partnership using the equity method of accounting. As such, we did not include the partnership’s assets, primarily land and buildings, totaling approximately $16 million and debt of approximately $13 million, in our consolidated financial statements.
Environmental and Other
Tesoro is subject to extensive federal, state and local environmental laws and regulations. These laws, which change frequently, regulate the discharge of materials into the environment and may require us to remove or mitigate the environmental effects of the disposal or release of petroleum or chemical substances at various sites, install additional controls, or make other modifications or changes in use for certain emission sources.
Environmental Liabilities
We are currently involved in remedial responses and have incurred and expect to continue to incur cleanup expenditures associated with environmental matters at a number of sites, including certain of our previously owned properties. At December 31, 2005, our accruals for environmental expenses totaled $32 million. Our accruals for environmental expenses include retained liabilities for previously owned or operated properties, refining, pipeline and terminal operations and retail service stations. We believe these accruals are adequate, based on currently available information, including the participation of other parties or former owners in remediation action.
During 2005, we continued settlement discussions with the California Air Resources Board (“CARB”) concerning a notice of violation (“NOV”) we received in October 2004. The NOV, issued by CARB, alleges that Tesoro offered eleven batches of gasoline for sale in California that did not meet CARB’s gasoline exhaust emission limits. In January 2006, we executed a Settlement Agreement and Release with CARB which requires us to pay a civil penalty of $325,000 to resolve this matter. A reserve for the settlement of the NOV is included in the $32 million of environmental accruals referenced above.
In 2005, we received two NOVs from the Bay Area Air Quality Management District. The Bay Area Air Quality Management District alleged we violated certain air quality emission limits as a result of a mechanical
failure of one of our boilers at our California refinery in January 2005. On January 26, 2006, we entered into a Settlement Agreement and Release with the District and the District Attorney of Contra Costa County, California. In exchange for the release of allegations based upon certain air quality emission limits and provisions of the California Health and Safety Code, we paid a civil penalty of $1.1 million. A reserve for the settlement of the NOVs is included in the $32 million of environmental accruals referenced above.
We have undertaken an investigation of environmental conditions at certain active wastewater treatment units at our California refinery. This investigation is driven by an order from the San Francisco Bay Regional Water Quality Control Board that names us as well as two previous owners of the California refinery. Based on our spending in 2005, the remaining cost estimate for the active wastewater units investigation is approximately $300,000. A reserve for this matter is included in the $32 million of environmental accruals referenced above.
On October 24, 2005, we received an NOV from the EPA. The EPA alleges certain modifications made to the fluid catalytic cracking unit at our Washington refinery prior to our acquisition of the refinery were made without a permit in violation of the Clean Air Act. We are investigating the allegations and believe the ultimate resolution of the NOV will not have a material adverse effect on our financial position or results of operations. A reserve for the settlement of the NOV is included in the $32 million of environmental accruals referenced above.
On February 28, 2006, we received an offer of settlement from the Bay Area Air Quality Management District. The District has offered to settle 28 NOVs issued to Tesoro from January 2004 to September 2004 for $275,000. The NOVs allege violations of various air quality requirements at the California refinery. A reserve for the settlement of the NOVs is included in the $32 million of environmental accruals referenced above.
Other Environmental Matters
In the ordinary course of business, we become party to or otherwise involved in lawsuits, administrative proceedings and governmental investigations, including environmental, regulatory and other matters. Large and sometimes unspecified damages or penalties may be sought from us in some matters for which the likelihood of loss may be reasonably possible but the amount of loss is not currently estimable, and some matters may require years for us to resolve. As a result, we have not established reserves for these matters. On the basis of existing information, we believe that the resolution of these matters, individually or in the aggregate, will not have a material adverse effect on our financial position or results of operations. However, we cannot provide assurance that an adverse resolution of one or more of the matters described below during a future reporting period will not have a material adverse effect on our financial position or results of operations in future periods.
We are a defendant, along with other manufacturing, supply and marketing defendants, in eleven pending cases alleging MTBE contamination in groundwater. The defendants are being sued for having manufactured MTBE and having manufactured, supplied and distributed gasoline containing MTBE. The plaintiffs, all in California, are generally water providers, governmental authorities and private well owners alleging, in part, the defendants are liable for manufacturing or distributing a defective product. The suits generally seek individual, unquantified compensatory and punitive damages and attorney’s fees, but we cannot estimate the amount or the likelihood of the ultimate resolution of these matters at this time, and accordingly have not established a reserve for these cases. We believe we have defenses to these claims and intend to vigorously defend the lawsuits.
Soil and groundwater conditions at our California refinery may require substantial expenditures over time. In connection with our acquisition of the California refinery from Ultramar, Inc. in May 2002, Ultramar assigned certain of its rights and obligations that Ultramar had acquired from Tosco Corporation in August of 2000. Tosco assumed responsibility and contractually indemnified us for up to $50 million for certain environmental liabilities arising from operations at the refinery prior to August of 2000, which are identified prior to August 31, 2010 (“Pre-Acquisition Operations”). Based on existing information, we currently estimate that the known environmental liabilities arising from Pre-Acquisition Operations are approximately
$41 million, including soil and groundwater conditions at the refinery in connection with various projects and including those required by the California Regional Water Quality Control Board and other government agencies. If we incur remediation liabilities in excess of the defined environmental liabilities for Pre-Acquisition Operations indemnified by Tosco, we expect to be reimbursed for such excess liabilities under certain environmental insurance policies. The policies provide $140 million of coverage in excess of the $50 million indemnity covering the defined environmental liabilities arising from Pre-Acquisition Operations. Because of Tosco’s indemnification and the environmental insurance policies, we have not established a reserve for these defined environmental liabilities arising out of the Pre-Acquisition Operations. In December 2003, we initiated arbitration proceedings against Tosco seeking damages, indemnity and a declaration that Tosco is responsible for the defined environmental liabilities arising from Pre-Acquisition Operations at our California refinery.
In November 2003, we filed suit in Contra Costa County Superior Court against Tosco alleging that Tosco misrepresented, concealed and failed to disclose certain additional environmental conditions at our California refinery. The court granted Tosco’s motion to compel arbitration of our claims for these certain additional environmental conditions. In the arbitration proceedings we initiated against Tosco in December 2003, we are also seeking a determination that Tosco is liable for investigation and remediation of these certain additional environmental conditions, the amount of which is currently unknown and therefore a reserve has not been established, and which may not be covered by the $50 million indemnity for the defined environmental liabilities arising from Pre-Acquisition Operations. In response to our arbitration claims, Tosco filed counterclaims in the Contra Costa County Superior Court action alleging that we are contractually responsible for additional environmental liabilities at our California refinery, including the defined environmental liabilities arising from Pre-Acquisition Operations. In February 2005, the parties agreed to stay the arbitration proceedings to pursue settlement discussions. In June 2005, the parties agreed in principle to settle their claims, including the defined environmental liabilities arising from Pre-Acquisition Operations and certain additional environmental conditions, both discussed above, pending negotiation and execution of a final written settlement agreement. In the event we are unable to finalize the settlement, we intend to vigorously prosecute our claims against Tosco and to oppose Tosco’s claims against us, although we cannot provide assurance that we will prevail.
Environmental Capital Expenditures
EPA regulations related to the Clean Air Act require reductions in the sulfur content in gasoline. To meet the revised gasoline standard, we spent $28 million in 2005. Our California, Washington, Hawaii, Alaska and North Dakota refineries will not require additional capital spending to meet the low sulfur gasoline standards. We currently estimate we will make additional capital improvements of approximately $8 million at our Utah refinery from 2008 through 2009, that will permit the Utah refinery to produce gasoline meeting the sulfur limits imposed by the EPA.
EPA regulations related to the Clean Air Act also require reductions in the sulfur content in diesel fuel manufactured for on-road consumption. In general, the new on-road diesel fuel standards will become effective on June 1, 2006. In May 2004, the EPA issued a rule regarding the sulfur content of non-road diesel fuel. The requirements to reduce non-road diesel sulfur content will become effective in phases between 2007 and 2010. We spent $46 million in 2005 to meet the revised diesel fuel standards, and based on our latest engineering estimates, we expect to spend approximately $71 million in additional capital improvements through 2007. Included in the estimate are capital projects to manufacture additional quantities of low sulfur diesel at our Alaska refinery, for which we expect to spend approximately $53 million through 2007. These cost estimates are subject to further review and analysis. Our California, Washington and North Dakota refineries will not require additional capital spending to meet the new non-road diesel fuel standards.
We expect to spend approximately $1 million in capital improvements in 2006 at our Washington refinery to comply with the Maximum Achievable Control Technologies standard for petroleum refineries (“Refinery MACT II”). We spent approximately $17 million during 2005.
In connection with the 2002 acquisition of our California refinery, subject to certain conditions, we assumed the seller’s obligations pursuant to settlement efforts with the EPA concerning the Section 114 refinery enforcement initiative under the Clean Air Act, except for any potential monetary penalties, which the seller retains. In November 2005, the Consent Decree was entered by the District Court for the Western District of Texas in which we agreed to undertake projects at our California refinery to reduce air emissions. We spent $2 million in 2005, and we currently estimate we will make additional capital improvements of approximately $30 million through 2010 to satisfy the requirements of the Consent Decree. This cost estimate is subject to further review and analysis.
During the fourth quarter of 2005, we received approval by the Hearing Board for the Bay Area Air Quality Management District to modify our existing fluid coker unit to a delayed coker at our California refinery which is designed to (i) lower emissions and (ii) increase overall efficiency by lowering operating costs. We negotiated the terms and conditions of the Second Conditional Abatement Order with the District in response to the January 2005 mechanical failure of one of our boilers at the California refinery. We spent $3 million during 2005 for this project, and we currently estimate that we will spend approximately $272 million through the fourth quarter of 2007. This cost estimate is subject to further review and analysis.
Actual and estimated capital expenditures described above to comply with the Clean Air Act and California air regulations are summarized in the table below (in millions).
In connection with our 2001 acquisition of our North Dakota and Utah refineries, Tesoro assumed the sellers’ obligations and liabilities under a consent decree among the United States, BP Exploration and Oil Co. (“BP”), Amoco Oil Company and Atlantic Richfield Company. BP entered into this consent decree for both the North Dakota and Utah refineries for various alleged violations. As the owner of these refineries, Tesoro is required to address issues that include leak detection and repair, flaring protection, and sulfur recovery unit optimization. We currently estimate we will spend $5 million over the next three years to comply with this consent decree. We also agreed to indemnify the sellers for all losses of any kind incurred in connection with the consent decree.
We will spend additional capital at the California refinery for reconfiguring and replacing above-ground storage tank systems and upgrading piping within the refinery. We spent $15 million in 2005 for these related projects at our California refinery, and we currently estimate that we will make additional capital improvements of approximately $109 million through 2010. This cost estimate is subject to further review and analysis.
Conditions may develop that cause increases or decreases in future expenditures for our various sites, including, but not limited to, our refineries, tank farms, retail gasoline stations (operating and closed locations) and petroleum product terminals, and for compliance with the Clean Air Act and other federal, state and local requirements. We cannot currently determine the amounts of such future expenditures.
For further information on environmental matters and other contingencies, see Note O in our consolidated financial statements in Item 8.
Pension Funding
For all eligible employees, we provide a qualified defined benefit retirement plan with benefits based on years of service and compensation. Our long-term expected return on plan assets is 8.5%, and our funded employee pension plan assets experienced a return of $13 million in 2005 and $12 million in 2004. Based on a 5.5% discount rate and fair values of plan assets as of December 31, 2005, the fair value of the assets in our funded employee pension plan were equal to approximately 98% of the projected benefit obligation as of the end of 2005. However, the funded employee pension plan was 112% funded based on its “current liability,” which is a funding measure defined under applicable pension regulations. Although Tesoro had no minimum required contribution obligation to its funded employee pension plan under applicable laws and regulations in 2005, we voluntarily contributed $95 million to improve the funded status of the plan. We have no minimum required contribution obligation to our funded employee pension plan under applicable laws and regulations in 2006, however, we currently project to contribute approximately $25 million in 2006, including $6 million contributed in February. Future contributions are affected by returns on plan assets, employee demographics and other factors. See Note M in our consolidated financial statements in Item 8 for further discussion.
Claims Against Third-Parties
Beginning in the early 1980s, Tesoro Hawaii Corporation, Tesoro Alaska Company and other fuel suppliers entered into a series of long-term, fixed-price fuel supply contracts with the U.S. Defense Energy Support Center (“DESC”). Each of the contracts contained a provision for price adjustments by the DESC. The federal acquisition regulations control how prices may be adjusted, and we and many other suppliers have filed in separate suits in the Court of Federal Claims contesting the DESC’s price adjustments prior to 1999. We and the other suppliers seek recovery of approximately $3 billion in underpayment for fuel. Our share of that underpayment totals approximately $165 million, plus interest. We alleged that the DESC’s price adjustments violated federal regulations by not adjusting the sales price of fuel based on changes to each supplier’s established prices or costs, as the Court of Federal Claims had held in prior rulings on similar contracts. The Court of Federal Claims granted partial summary judgment in our favor on that issue, but the Court of Appeals for the Federal Circuit has reversed and ruled that DESC’s prices did not need to be tied to changes in a specific supplier’s prices or costs. We have also asserted other grounds to challenge the DESC contract pricing formulas, and we are evaluating our position with respect to further litigation on those additional grounds. We cannot predict the outcome of these further actions.
In 1996, Tesoro Alaska Company filed a protest of the intrastate rates charged for the transportation of its crude oil through the Trans Alaska Pipeline System (“TAPS”). Our protest asserted that the TAPS intrastate rates were excessive and should be reduced. The Regulatory Commission of Alaska (“RCA”) considered our protest of the intrastate rates for the years 1997 through 2000. The RCA set just and reasonable final rates for the years 1997 through 2000, and held that we are entitled to receive approximately $52 million in refunds, including interest through the expected conclusion of appeals in December 2007. The RCA’s ruling is currently on appeal in the Alaska courts, and we cannot give any assurances of when or whether we will prevail in the appeal.
In 2002, the RCA rejected the TAPS Carriers’ proposed intrastate rate increases for 2001-2003 and maintained the permanent rate of $1.96 to the Valdez Marine Terminal. That ruling is currently on appeal to the Alaska Superior Court, and the TAPS Carriers did not move to prevent the rate decrease. The rate decrease has been in effect since June 2003. If the RCA’s decision is upheld on appeal, we could be entitled to refunds resulting from our shipments from January 2001 through mid-June 2003. If the RCA’s decision is not upheld on appeal, we could have to pay additional shipping charges resulting from our shipments from mid-June 2003 through December 2005. We cannot give any assurances of when or whether we will prevail in the appeal. We also believe that, should we not prevail on appeal, the amount of additional shipping charges cannot reasonably be estimated since it is not possible to estimate the permanent rate which the RCA could set, and the appellate courts approve, for each year. In addition, depending upon the level of such rates, there is a reasonable possibility that any refunds for the period January 2001 through mid-June 2003 could offset some or all of any repayments due for the period mid-June 2003 through December 2005.
In July 2005, the TAPS Carriers filed a proceeding at the Federal Energy Regulatory Commission (“FERC”), seeking to have the FERC assume jurisdiction over future rates for intrastate transportation on TAPS. We have filed a protest in that proceeding, which has now been consolidated with another FERC proceeding seeking to set just and reasonable rates for future interstate transportation on TAPS. If the TAPS carriers should prevail, then the rates charged for all shipments of Alaska North Slope crude oil on TAPS could be revised by the FERC, but any FERC changes to rates for intrastate transportation of crude oil supplies for our Alaska refinery should be prospective only and should not affect prior intrastate rates, refunds or repayments.
ACCOUNTING STANDARDS
Critical Accounting Policies
Our accounting policies are described in Note A in our consolidated financial statements in Item 8. We prepare our consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, which require us to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the year. Actual results could differ from those estimates. We consider the following policies to be the most critical in understanding the judgments that are involved in preparing our financial statements and the uncertainties that could impact our financial condition and results of operations.
Receivables - Our trade receivables are stated at their invoiced amounts, less an allowance for potentially uncollectible amounts. We monitor the credit and payment experience of our customers and manage our loss exposure through our credit policies and procedures. The estimated allowance for doubtful accounts is based on our general loss experience and identified loss exposures on individual accounts. Although actual losses have not been significant to our results of operations, economic conditions and the related credit environment could change, and actual losses could vary from estimates.
Inventory - Our inventories are stated at the lower of cost or market. We use the LIFO method to determine the cost of our crude oil and refined product inventories. The LIFO cost of these inventories is usually much less than current market value, however a significant decline in market values of petroleum products could impair the carrying values of these inventories. We had 28 million barrels of crude oil and refined product inventories at December 31, 2005 with an average cost of approximately $36 per barrel on a
LIFO basis. If refined product prices decline below the average cost, then we would be required to write down the value of our inventories in future periods.
Property, Plant and Equipment - We calculate depreciation and amortization using the straight-line method based on estimated useful lives and salvage values of our assets. When assets are placed into service, we make estimates with respect to their useful lives that we believe are reasonable. However, factors such as maintenance levels, economic conditions impacting the demand for these assets, and regulation or environmental matters could cause us to change our estimates, thus impacting the future calculation of depreciation and amortization. We evaluate property, plant and equipment for potential impairment by identifying whether indicators of impairment exist and, if so, assessing whether the assets are recoverable from estimated future undiscounted cash flows. The actual amount of impairment loss, if any, to be recorded is equal to the amount by which the asset’s carrying value exceeds its fair value. Estimates of future undiscounted cash flows and fair value of assets require subjective assumptions with regard to several factors, including an assessment of market conditions and future operating results. Actual results could differ from those estimates.
Goodwill and Acquired Intangibles - As of December 31, 2005, we had $89 million of goodwill included in Other Noncurrent Assets. Goodwill is not amortized, but is tested for impairment annually or more frequently when indicators of impairment exist. We review the recorded value of our goodwill for impairment annually during the fourth quarter, or sooner if events or changes in circumstances indicate the carrying amount may exceed fair value. Recoverability is determined by comparing the estimated fair value of a reporting unit to the carrying value, including the related goodwill, of that reporting unit. We use the present value of expected net cash flows to determine the estimated fair value of our reporting units. In 2003, we wrote off the Marine Services goodwill of $2 million in connection with the sale of that operation. The impairment test is susceptible to change from period to period as it requires us to make cash flow assumptions including, among other things, future margins, volumes, operating costs, capital expenditures and discount rates. Our assumptions regarding future margins and volumes require significant judgment as actual margins and volumes have fluctuated in the past and will likely continue to do so. For the impairment test performed during the fourth quarter of 2005, we assumed that future margins in our geographic areas will approximate average levels during the period from July 2003 through June 2005 adjusted for other industry factors. Changes in market conditions could result in impairment charges in the future.
As of December 31, 2005, we included $119 million of acquired intangible assets in Other Noncurrent Assets. The valuation of these intangible assets required us to use our judgment, including estimates with respect to their useful lives. We review acquired intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. The assessment of impairment is based on the estimated undiscounted future cash flows from operating activities, compared with the carrying value of the assets. The actual amount of impairment loss, if any, to be recorded is equal to the amount by which the asset’s carrying value exceeds its fair value. Estimates of future undiscounted cash flows and fair values of assets require subjective assumptions with regard to several factors, including an assessment of market conditions, discount rates and future operating results. Actual results could differ from those estimates.
Deferred Maintenance Costs - We record the cost of major scheduled refinery turnarounds, long-lived catalysts used in refinery process units, and periodic maintenance on ships, tugs and barges (“drydocking”) as deferred charges in Other Noncurrent Assets which totaled $113 million at December 31, 2005. We amortize these deferred charges over the expected periods of benefit, generally ranging from two to six years.
Contingencies - We record an estimated loss from a contingency when information available before issuing our financial statements indicates that (a) it is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements and (b) the amount of the loss can be reasonably estimated. We are required to use our judgment to account for contingencies such as environmental, legal and income tax matters. While we believe that our accruals for these matters are adequate, the actual loss may differ from our estimated loss, and we would record the necessary adjustments in future periods. We do not record the benefits of contingent recoveries or gains until the amount is determinable and recovery is assured.
Income Taxes - As part of the process of preparing consolidated financial statements, we must assess the likelihood that our deferred income tax assets will be recovered through future taxable income. To the extent we believe that recovery is not likely, a valuation allowance must be established. Significant management judgment is required in determining any valuation allowance recorded against net deferred income tax assets. Based on our estimates of taxable income in each jurisdiction in which we operate and the period over which deferred income tax assets will be recoverable, we have not recorded a valuation allowance as of December 31, 2005. In the event that actual results differ from these estimates or we make adjustments to these estimates in future periods, we may need to establish a valuation allowance.
Asset Retirement Obligations - We record asset retirement obligations in the period in which the obligations are incurred and a reasonable estimate of fair value can be made. We use the present value of expected cash flows to estimate fair value. The calculation of fair value is based on several estimates and assumptions, including, among other things, projected cash flows, a credit-adjusted risk-free rate, the settlement dates or a range of potential settlement dates and the probabilities associated with the potential settlement dates. Actual results could differ from those estimates. During the fourth quarter of 2005, we recorded asset retirement obligations totaling $44 million associated with our decision to retire certain tanks and modify our existing coker to comply with certain state regulations. Our asset retirement obligations totaled $46 million and $1 million at December 31, 2005 and 2004, respectively. We cannot currently make reasonable estimates of the fair values of some retirement obligations, principally those associated with our refineries, pipeline rights-of-way and certain terminals and retail sites, because the related assets have indeterminate useful lives which preclude development of assumptions about the potential timing of settlement dates. Such obligations will be recognized in the period in which sufficient information exists to estimate a range of potential settlement dates.
Pension and Other Postretirement Benefits - Accounting for pensions and other postretirement benefits involves several assumptions and estimates including discount rates, health care cost trends, inflation, retirement rates and mortality rates. We must also assume a rate of return on funded pension plan assets in order to estimate our obligations under our defined benefit plans. Due to the nature of these calculations, we engage an actuarial firm to assist with the determination of these estimates and the calculation of certain employee benefit expenses. We record a liability for the cost of the plans based on the actuarially determined amounts, less any plan assets. While we believe that the assumptions used are appropriate, significant differences in the actual experience or significant changes in assumptions would affect pension and other postretirement benefits costs and obligations. A one-percentage-point change in the expected return on plan assets and discount rate for the pension plans would have had the following effects in 2005 (in millions):
See Note M in our consolidated financial statements in Item 8 for more information regarding costs and assumptions.
New Accounting Standards and Disclosures
See Note A in our consolidated financial statements in Item 8.
FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are included throughout this Form 10-K and relate to, among other things, expectations regarding refining margins, revenues, cash flows, capital
expenditures, turnaround expenses, and other financial items. These statements also relate to our business strategy, goals and expectations concerning our market position, future operations, margins and profitability. We have used the words “anticipate”, “believe”, “could”, “estimate”, “expect”, “intend”, “may”, “plan”, “predict”, “project”, “will” and similar terms and phrases to identify forward-looking statements in this Annual Report on Form 10-K.
Although we believe the assumptions upon which these forward-looking statements are based are reasonable, any of these assumptions could prove to be inaccurate and the forward-looking statements based on these assumptions could be incorrect. Our operations involve risks and uncertainties, many of which are outside our control, and any one of which, or a combination of which, could materially affect our results of operations and whether the forward-looking statements ultimately prove to be correct.
Actual results and trends in the future may differ materially from those suggested or implied by the forward-looking statements depending on a variety of factors including, but not limited to:
•
changes in general economic conditions;
•
the timing and extent of changes in commodity prices and underlying demand for our products;
•
the availability and costs of crude oil, other refinery feedstocks and refined products;
•
changes in our cash flow from operations;
•
changes in the cost or availability of third-party vessels, pipelines and other means of transporting feedstocks and products;
•
disruptions due to equipment interruption or failure at our facilities or third-party facilities;
•
actions of customers and competitors;
•
changes in capital requirements or in execution of planned capital projects;
•
direct or indirect effects on our business resulting from actual or threatened terrorist incidents or acts of war;
•
political developments in foreign countries;
•
changes in our inventory levels and carrying costs;
•
seasonal variations in demand for refined products;
•
changes in fuel and utility costs for our facilities;
•
state and federal environmental, economic, safety and other policies and regulations, any changes therein, and any legal or regulatory delays or other factors beyond our control;
•
adverse rulings, judgments, or settlements in litigation or other legal or tax matters, including unexpected environmental remediation costs in excess of any reserves;
•
weather conditions affecting our operations or the areas in which our products are marketed; and
•
earthquakes or other natural disasters affecting operations.
Many of these factors are described in greater detail in “Competition and Other” on page 9 and “Risk Factors” on page 16. All future written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the previous statements. We undertake no obligation to update any information contained herein or to publicly release the results of any revisions to any forward-looking statements that may be made to reflect events or circumstances that occur, or that we become aware of, after the date of this Annual Report on Form 10-K.
ITEM 7A.
ITEM 7A.
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Changes in commodity prices and interest rates are our primary sources of market risk. We have a risk management committee responsible for reviewing risks arising from transactions and commitments related to the sale and purchase of energy commodities and making recommendations to executive management.
Commodity Price Risks
Our earnings and cash flows from operations depend on the margin above fixed and variable expenses (including the costs of crude oil and other feedstocks) at which we are able to sell refined products. The prices of crude oil and refined products have fluctuated substantially in recent years. These prices depend on many factors, including the demand for crude oil, gasoline and other refined products, which in turn depend on, among other factors, changes in the economy, the level of foreign and domestic production of crude oil and refined products, worldwide geo-political conditions, the availability of imports of crude oil and refined products, the marketing of alternative and competing fuels and the impact of government regulations. The prices we receive for refined products are also affected by local factors such as local market conditions and the level of operations of other refineries in our markets.
The prices at which we sell our refined products are influenced by the commodity price of crude oil. Generally, an increase or decrease in the price of crude oil results in a corresponding increase or decrease in the price of gasoline and other refined products. The timing of the relative movement of the prices, however, can impact profit margins which could significantly affect our earnings and cash flows. In addition, the majority of our crude oil supply contracts are short-term in nature with market-responsive pricing provisions. Our financial results can be affected significantly by price level changes during the period between purchasing refinery feedstocks and selling the manufactured refined products from such feedstocks. We also purchase refined products manufactured by others for resale to our customers. Our financial results can be affected significantly by price level changes during the periods between purchasing and selling such products. Assuming all other factors remained constant, a $1.00 per barrel change in average gross refining margins, based on our 2005 average throughput of 530 Mbpd, would change annualized pretax operating income by approximately $193 million.
We maintain inventories of crude oil, intermediate products and refined products, the values of which are subject to fluctuations in market prices. Our inventories of refinery feedstocks and refined products totaled 28 million barrels and 22 million barrels at December 31, 2005 and 2004, respectively. The average cost of our refinery feedstocks and refined products at December 31, 2005 was approximately $36 per barrel on a LIFO basis, compared to market prices of approximately $65 per barrel. If market prices decline to a level below the average cost of these inventories, we would be required to write down the carrying value of our inventory.
Tesoro periodically enters into non-trading derivative arrangements primarily to manage exposure to commodity price risks associated with the purchase of crude oil and the purchase and sale of manufactured and purchased refined products. To manage these risks, we typically enter into exchange-traded futures and over-the-counter swaps, generally with durations of one year or less. We mark to market our non-hedging derivative instruments and recognize the changes in their fair values in earnings. We include the carrying amounts of our derivatives in other current assets or accrued liabilities in the consolidated balance sheets. We did not designate or account for any derivative instruments as hedges during 2005. Accordingly, no change in the value of the related underlying physical asset is recorded. During 2005, we settled futures and swaps positions of approximately 71 million barrels of crude oil and refined products, which due to significant price volatility resulted in losses of $23 million. At December 31, 2005, we had open net futures contracts of 2 million barrels and swap positions of 5 million barrels, which will expire at various times during 2006. We recorded the fair value of our open positions, which resulted in an unrealized mark-to-market gain of $2 million at December 31, 2005.
We prepared a sensitivity analysis to estimate our exposure to market risk associated with our derivative instruments. This analysis may differ from actual results. The fair value of each derivative instrument was based on quoted market prices. Based on our open net short positions of 7 million barrels as of December 31,
2005, a $1.00 per-barrel change in quoted market prices of our derivative instruments, assuming all other factors remain constant, would change the fair value of our derivative instruments and pretax operating income by $7 million. As of December 31, 2004, a $1.00 per-barrel change in quoted market prices for our derivative instruments, assuming all other factors remain constant, would have changed the fair value of our derivative instruments and pretax operating income by $1 million.
Interest Rate Risk
At December 31, 2005 all of our outstanding debt was at fixed rates and we had no borrowings under our revolving credit facility, which bears interest at variable rates. The fair market value of our senior notes, senior secured notes and senior subordinated notes, which is based on transactions and bid quotes, was approximately $5 million more than its carrying value at December 31, 2005. The fair market values of our junior subordinated notes and capital lease obligations approximate their carrying values.
ITEM 8.
ITEM 8.
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Tesoro Corporation
We have audited the accompanying consolidated balance sheets of Tesoro Corporation and subsidiaries (the “Company”) as of December 31, 2005 and 2004, and the related consolidated statements of operations, comprehensive income and stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2005. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Tesoro Corporation and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2005, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note A to the consolidated financial statements, as of January 1, 2004, the Company changed its method of accounting for stock options.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 6, 2006, expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
/s/ Deloitte & Touche LLP
San Antonio, Texas
March 6, 2006
TESORO CORPORATION
STATEMENTS OF CONSOLIDATED OPERATIONS
The accompanying notes are an integral part of these consolidated financial statements.
TESORO CORPORATION
CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these consolidated financial statements.
TESORO CORPORATION
STATEMENTS OF CONSOLIDATED COMPREHENSIVE INCOME AND
STOCKHOLDERS’ EQUITY
The accompanying notes are an integral part of these consolidated financial statements.
TESORO CORPORATION
STATEMENTS OF CONSOLIDATED CASH FLOWS
The accompanying notes are an integral part of these consolidated financial statements.
TESORO CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE A - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description and Nature of Business
Tesoro Corporation (“Tesoro”) was incorporated in Delaware in 1968 and is an independent refiner and marketer of petroleum products. We own and operate six petroleum refineries in the western and mid-continental United States with a combined crude oil throughput capacity of 563,000 barrels per day (“bpd”), and we sell refined products to a wide variety of customers. We market products to wholesale and retail customers, as well as commercial end-users. Our retail business includes a network of 478 branded retail stations operated by Tesoro or independent dealers.
Tesoro’s earnings, cash flows from operations and liquidity depend upon many factors, including producing and selling refined products at margins above fixed and variable expenses. The prices of crude oil and refined products have fluctuated substantially in our markets. Our operating results have been significantly influenced by the timing of changes in crude oil costs and how quickly refined product prices adjust to reflect these changes. These price fluctuations depend on numerous factors beyond our control, including the demand for crude oil, gasoline and other refined products, which is subject to, among other things, changes in the economy and the level of foreign and domestic production of crude oil and refined products, worldwide geo-political conditions, threatened or actual terrorist incidents or acts of war, availability of crude oil and refined product imports, the infrastructure to transport crude oil and refined products, weather conditions, earthquakes and other natural disasters, seasonal variations, government regulations and local factors, including market conditions and the level of operations of other refineries in our markets. As a result of these factors, margin fluctuations during any reporting period can have a significant impact on our results of operations, cash flows, liquidity and financial position.
Principles of Consolidation and Basis of Presentation
The accompanying consolidated financial statements include the accounts of Tesoro and its subsidiaries. All intercompany accounts and transactions have been eliminated. Investments in entities in which we have the ability to exercise significant influence, but not control, are accounted for using the equity method, while other investments are carried at cost. These investments are not material, either individually or in the aggregate, to Tesoro’s financial position, results of operations or cash flows. See Note O for information related to a 50% limited partnership interest, which we accounted for using the equity method.
Separate financial statements of Tesoro’s subsidiary guarantors are not included because these subsidiary guarantors are jointly and severally liable for Tesoro’s outstanding senior notes, senior secured notes and senior subordinated notes. Further, net assets, results of operations and equity of the subsidiary guarantors are substantially equivalent to Tesoro’s consolidated net assets, results of operations and equity.
We have reclassified certain previously reported amounts to conform to the 2005 presentation. In addition, during 2005 we began to allocate certain information technology costs, previously reported as selling, general and administrative expenses, to costs of sales and operating expenses in order to better reflect costs directly attributable to our segment operations (see Note D).
Use of Estimates
We prepare Tesoro’s consolidated financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”), which requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the year. We review our estimates on an ongoing basis, based on currently available information. Changes in facts and circumstances may result in revised estimates and actual results could differ from those estimates.
TESORO CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Cash and Cash Equivalents
We consider all highly-liquid instruments, such as temporary cash investments, with a maturity of three months or less at the time of purchase to be cash equivalents. Cash equivalents are stated at cost, which approximates market value.
Financial Instruments
The carrying amounts of financial instruments, including cash and cash equivalents, receivables, accounts payable and certain accrued liabilities, approximate fair value because of the short maturities of these instruments. The carrying amounts of Tesoro’s debt and other obligations may vary from our estimates of the fair value of such items. We estimate that the fair market value of our senior notes, senior secured notes, and senior subordinated notes at December 31, 2005, was approximately $5 million more than its total book value of $923 million.
Inventories
Inventories are stated at the lower of cost or market. We use last-in, first-out (“LIFO”) as the primary method to determine the cost of crude oil and refined product inventories in our refining and retail segments. We determine the carrying value of inventories of oxygenates and by-products using the first-in, first-out (“FIFO”) cost method. We value merchandise and materials and supplies at average cost.
Property, Plant and Equipment
We capitalize the cost of additions, major improvements and modifications to property, plant and equipment. We compute depreciation of property, plant and equipment on the straight-line method, based on the estimated useful life of each asset. The weighted average lives range from 24 to 27 years for refineries, 7 to 16 years for terminals, 12 to 16 years for retail stations, 5 to 28 years for transportation assets and 4 to 17 years for corporate assets. We record property under capital leases at the present value of minimum lease payments using Tesoro’s incremental borrowing rate. We amortize property under capital leases over the term of each lease.
We capitalize interest as part of the cost of major projects during extended construction periods. Capitalized interest, which is a reduction to interest and financing costs in the statements of consolidated operations, totaled $8 million, $4 million and $2 million during 2005, 2004 and 2003, respectively.
Asset Retirement Obligations
We accrue for asset retirement obligations in the period in which the obligations are incurred and a reasonable estimate of fair value can be made. We accrue these costs at estimated fair value. When the related liability is initially recorded, we capitalize the cost by increasing the carrying amount of the related long-lived asset. Over time, the liability is accreted to its settlement value and the capitalized cost is depreciated over the useful life of the related asset. Upon settlement of the liability, we recognize a gain or loss for any difference between the settlement amount and the liability recorded. We have recorded asset retirement obligations for requirements imposed by certain regulations pertaining primarily to hazardous materials disposal and other cleanup obligations associated with projects at our California refinery to retire certain above-ground storage tanks between 2006 and 2019 and modify our existing coker unit to a delayed coker (see Note O). Our asset retirement obligations also include contractual removal obligations as required by certain lease agreements associated with our retail and terminal operations.
We cannot currently make reasonable estimates of the fair values of some retirement obligations. These retirement obligations primarily include (i) hazardous materials disposal (such as petroleum manufacturing by-products, chemical catalysts and sealed insulation material containing asbestos), site restoration, removal
TESORO CORPORATION
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or dismantlement requirements associated with the closure of our refining and terminal facilities or pipelines, (ii) hazardous materials disposal and other removal requirements associated with the demolition of certain major processing units, buildings, tanks or other equipment and (iii) removal of tanks at our owned retail sites at or near the time of closure. We cannot estimate the fair value for these obligations primarily because we cannot reasonably estimate settlement dates or a range of settlement dates associated with these assets. Such obligations will be recognized in the period in which sufficient information exists to determine a reasonable estimate. We believe that these assets have indeterminate useful lives which preclude development of assumptions about the potential timing of settlement dates based on the following: (i) there are no plans or expectations of plans to retire or dispose of these core assets; (ii) we plan on extending these core assets’ estimated economic lives through scheduled maintenance projects at our refineries and other normal repair and maintenance and by continuing to make improvements based on technological advances; (iii) we have rarely or never retired similar assets in the past; and (iv) industry practice for similar assets has historically been to extend the economic lives through regular repair and maintenance and technological advances. Also, we have not historically incurred significant retirement obligations for hazardous materials disposal or other removal costs associated with our scheduled maintenance projects.
During the fourth quarter of 2005, we recorded asset retirement obligations totaling $44 million associated with our decision to retire certain tanks and modify our existing coker to comply with certain regulations. Changes in asset retirement obligations for the years ended December 31, 2005 and 2004 were as follows (in millions):
In March 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (“FIN 47”) which is an interpretation of Statement of Financial Accounting Standards (“SFAS”) No. 143, “Accounting for Asset Retirement Obligations.” FIN 47 requires recognition of a liability for the fair value of a conditional asset retirement obligation if the fair value of the liability can be reasonably estimated, even though uncertainty exists about the timing and/or method of settlement. FIN 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of an asset retirement obligation under SFAS No. 143. We adopted the provisions of FIN 47 as of December 31, 2005, which had no impact on our financial position or results of operations.
Environmental Expenditures
We capitalize environmental expenditures that extend the life or increase the capacity of facilities, as well as expenditures that mitigate or prevent environmental contamination that is yet to occur. We charge to expense costs that relate to an existing condition caused by past operations and that do not contribute to current or future revenue generation. We record liabilities when environmental assessments and/or remedial efforts are probable and can be reasonably estimated. Cost estimates are based on the expected timing and the extent of remedial actions required by applicable governing agencies, experience gained from similar sites on which environmental assessments or remediation have been completed, and the amount of our anticipated liability considering the proportional liability and financial abilities of other responsible parties. Generally, the
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timing of these accruals coincides with the completion of a feasibility study or our commitment to a formal plan of action. Estimated liabilities are not discounted to present value.
Goodwill and Acquired Intangibles
Goodwill represents the excess of cost (purchase price) over the fair value of net assets acquired. Under SFAS No. 142, “Goodwill and Other Intangible Assets,” we ceased amortizing goodwill on January 1, 2002. Acquired intangibles consist primarily of air emissions credits, permits and plans, and customer agreements and contracts, which we recorded at fair value as of the date acquired. We compute amortization on a straight-line basis over estimated useful lives of 2 to 28 years, and we include amortization of acquired intangibles in depreciation and amortization expense.
Other Assets
We periodically shut down refinery processing units for scheduled maintenance, or turnarounds. Certain catalysts are used in refinery process units for periods exceeding one year. Also, we drydock ships, tugs and barges for periodic maintenance. We defer turnaround, catalyst and drydocking costs and amortize the costs on a straight-line basis over the expected periods of benefit, generally ranging from 2 to 6 years. Amortization of such deferred costs, which is included in depreciation and amortization expense, amounted to $50 million, $34 million and $31 million in 2005, 2004 and 2003, respectively.
We defer debt issuance costs related to our credit agreement and senior notes and amortize the costs over the estimated terms of each instrument. We include the amortization in interest and financing costs in our statements of consolidated operations. We evaluate the carrying value of debt issuance costs when modifications are made to the related debt instruments (see Note E).
Impairment of Long-Lived Assets
We review property, plant and equipment and other long-lived assets, including acquired intangible assets for impairment whenever events or changes in business circumstances indicate the carrying values of the assets may not be recoverable. We would record impairment losses if the undiscounted cash flows estimated to be generated by those assets were less than the carrying amount of those assets. Factors that would indicate potential impairment include, but are not limited to, significant decreases in the market value of a long-lived asset, a significant change in the long-lived asset’s physical condition, and operating or cash flow losses associated with the use of the long-lived asset. We review goodwill balances for impairment annually or more frequently, if events or changes in business circumstances indicate the carrying values of the assets may not be recoverable.
Revenue Recognition
We recognize revenues from product sales upon delivery to customers, which is the point at which title to the products is transferred, and when payment has either been received or collection is reasonably assured. We include certain crude oil and product purchases and resales used for trading purposes in revenues on a net basis. Nonmonetary product and crude oil exchange transactions, which are entered into primarily to optimize our refinery supply requirements, are included in costs of sales and operating expenses on a net basis. We include transportation fees charged to customers in revenues, and we include the related costs in costs of sales in our statements of consolidated operations. We have also entered into a limited number of refined product sales and purchases transactions with the same counterparty that have been entered into in contemplation with one another. These sales and purchases have been recorded on a gross basis in revenues and costs of sales. Beginning January 1, 2006, we will record these transactions on a net basis in connection with the adoption of the Emerging Issues Task Force (“EITF”) Issue No. 04-13, “Accounting for Purchases and Sales of Inventory with the Same Counterparty,” (see “New Accounting Standards and Disclosures” for further
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information). In our retail segment, revenues and costs of sales include federal excise and state motor fuel taxes collected from customers and remitted to governmental agencies. These taxes, primarily related to sales of gasoline and diesel fuel, totaled $108 million, $123 million and $128 million in 2005, 2004 and 2003, respectively. In our refining segment, excise taxes on sales are not included in revenues and costs of sales.
Income Taxes
We record deferred tax assets and liabilities for future income tax consequences that are attributable to differences between financial statement carrying amounts of assets and liabilities and their income tax bases. We base the measurement of deferred tax assets and liabilities on enacted tax rates that we expect will apply to taxable income in the year when we expect to settle or recover those temporary differences. We recognize the effect on deferred tax assets and liabilities of any change in income tax rates in the period that includes the enactment date. We provide a valuation allowance for deferred tax assets if it is more likely than not that those items will either expire before we are able to realize their benefit or their future deductibility is uncertain.
Stock-Based Compensation
Effective January 1, 2004, we adopted the preferable fair value method of accounting for our stock options, as prescribed in SFAS No. 123, “Accounting for Stock-Based Compensation.” We selected the “modified prospective method” of adoption described in SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure.” On January 1, 2005 we adopted SFAS No. 123 (Revised 2004), “Share-Based Payment,” which is a revision of SFAS No. 123, and supersedes Accounting Principles Board (“APB”) Opinion No. 25. Among other items, SFAS No. 123 (Revised 2004) eliminates the use of APB Opinion No. 25 and the intrinsic value method of accounting, and requires companies to recognize the cost of employee services received in exchange for awards of equity instruments, based on the grant date fair value of those awards, in the financial statements. On January 1, 2005, we adopted the fair value method for our outstanding phantom stock options resulting in an after-tax charge of $0.2 million. These awards were previously valued using the intrinsic value method prescribed in APB Opinion No. 25.
Prior to January 1, 2004, we accounted for stock options using the intrinsic value method prescribed in APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Under the intrinsic value method, we did not recognize compensation costs for our stock options as all options granted had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table represents the effect on net earnings and earnings per share as if we had applied the fair value method and recognition provisions of SFAS No. 123 to our stock options during 2003 (in millions except per share amounts):
See Note N for further information on Tesoro’s stock-based employee compensation plans.
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Derivative Instruments
We account for derivative instruments in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended and interpreted. Tesoro periodically enters into non-trading derivative arrangements primarily to manage exposure to commodity price risks associated with the purchase of crude oil and the purchase and sale of manufactured and purchased refined products. To manage these risks, we typically enter into exchange-traded futures and over-the-counter swaps, generally with durations of one year or less.
We mark to market our non-hedging derivative instruments and recognize the changes in their fair values in earnings. We include the carrying amounts of our derivatives in other current assets or accrued liabilities in the consolidated balance sheets. We did not designate or account for any derivative instruments as hedges during 2005, 2004 or 2003. Accordingly, no change in the value of the related underlying physical asset is recorded. During 2005, we settled futures and swaps positions of approximately 71 million barrels of crude oil and refined products, which due to significant price volatility resulted in losses of $23 million. At December 31, 2005, we had open net futures contracts of 2 million barrels and swap positions of 5 million barrels, which will expire at various times during 2006. We recorded the fair value of our open positions, which resulted in an unrealized mark-to-market gain of $2 million at December 31, 2005.
New Accounting Standards and Disclosures
SFAS No. 153
In December 2004, the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets - An Amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions.” SFAS No. 153 eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29, “Accounting for Nonmonetary Transactions,” and replaces it with an exception for exchanges that do not have commercial substance. SFAS No. 153 specifies that a nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. We adopted the provisions of SFAS No. 153 on July 1, 2005, which had no impact on our financial position or results of operations.
EITF Issue No. 04-13
In September 2005, the EITF reached a consensus on EITF Issue No. 04-13, “Accounting for Purchases and Sales of Inventory with the Same Counterparty.” EITF Issue No. 04-13 requires that two or more exchange transactions involving inventory with the same counterparty entered into in contemplation of one another should be reported net in the statement of operations. The inventory could be raw materials, work-in-process or finished goods. We have entered into a limited number of refined product purchases and sales transactions with the same counterparty as described in EITF Issue No. 04-13 which have been reported on a gross basis in revenues and costs of sales and operating expenses in the statements of consolidated operations. Refined product sales associated with these arrangements totaled $670 million and $623 million in 2005 and 2004, respectively. Related purchases of refined products totaled $637 million and $619 million for 2005 and 2004, respectively. Sales and purchases information was unavailable for 2003. The provisions of this EITF issue also require the exchange of finished goods for raw materials or work-in-process inventories within the same line of business to be accounted for at fair value if the fair value is determinable within reasonable limits and the transaction has commercial substance as described in SFAS No. 153. Tesoro has historically not exchanged finished goods for raw materials. We adopted the provisions of EITF Issue No. 04-13 on January 1, 2006 for new arrangements entered into, and modifications or renewals of existing arrangements, which did not have a material impact on our financial position or results of operations.
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SFAS No. 154
In May 2005, the FASB issued SFAS No. 154, “Accounting Changes and Error Corrections” which replaces APB Opinion No. 20, “Accounting Changes” and SFAS No. 3, “Reporting Accounting Changes in Interim Financial Statements.” SFAS No. 154 requires retrospective application of a voluntary change in accounting principle, unless it is impracticable to do so. This statement carries forward without change the guidance in APB Opinion No. 20 for reporting the correction of an error in previously issued financial statements and a change in accounting estimate. SFAS No. 154 is effective for changes in accounting principle made in fiscal years beginning after December 15, 2005. We adopted the provisions of SFAS No. 154 as of January 1, 2006, which had no impact on our financial position or results of operations.
NOTE B - EARNINGS PER SHARE
We compute basic earnings per share by dividing net earnings by the weighted average number of common shares outstanding during the period. Diluted earnings per share include the effects of potentially dilutive shares, principally common stock options and unvested restricted stock outstanding during the period. Earnings per share calculations are presented below (in millions, except per share amounts):
NOTE C - DIVESTITURES
On December 23, 2003, we sold substantially all of the physical assets, including inventories, of our marine services operations for $32 million in cash. Tesoro recognized a pretax loss on the sale of $8 million. We included this charge in loss on asset disposals and impairments in our statements of consolidated operations due to the immateriality of marine services operations as compared to our historical and ongoing refining and retail operations.
NOTE D - OPERATING SEGMENTS
The Company’s revenues are derived from two operating segments: (i) refining and (ii) retail. Our refining segment owns and operates six petroleum refineries located in California, Washington, Alaska, Hawaii, North Dakota and Utah. These refineries manufacture gasoline and gasoline blendstocks, jet fuel, diesel fuel, residual fuel oils and other refined products. We sell these products, together with products purchased from third parties, at wholesale through terminal facilities and other locations, primarily in Alaska, California, Nevada, Hawaii, Idaho, Minnesota, North Dakota, Utah, Oregon and Washington. Our refining segment also sells petroleum products to unbranded marketers and occasionally exports products to other
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markets in the Asia/ Pacific area. Our retail segment sells gasoline, diesel fuel and convenience store items through company-operated retail stations and branded jobber/dealers in 18 western states from Minnesota to Alaska and Hawaii. Retail operates under the Tesoro®, Mirastar® and 2-Go Tesoro® brands. We developed our Mirastar® brand exclusively for use at Wal-Mart stores in an agreement covering 14 western states. Prior to 2004, we also had revenues from our marine services operations, which marketed and distributed petroleum products, supplies and services to the marine and offshore exploration and production industries operating in the Gulf of Mexico. We sold substantially all of the marine services physical assets in December 2003 (see Note C).
The operating segments adhere to the accounting policies used for Tesoro’s consolidated financial statements, as described in the summary of significant accounting policies in Note A. We evaluate the performance of our segments and allocate resources based primarily on segment operating income. Segment operating income includes those revenues and expenses that are directly attributable to management of the respective segment. Intersegment sales are primarily from refining to retail made at prevailing market rates. Income taxes, interest and financing costs, interest income and other, and corporate and general and administrative expenses are not included in determining segment operating income. Beginning in 2005, we allocated certain information technology costs, previously reported as corporate and unallocated costs, to segment operating income in order to better reflect costs directly attributable to our segment operations. Identifiable assets are those utilized by the segment. Corporate assets are principally cash and other assets that are not associated with a specific operating segment. Segment information as of and for each of the three years ended December 31, 2005 is as follows (in millions):
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(a)
To balance or optimize our refinery supply requirements, we sell certain crude oil that we purchase under our supply contracts.
(b)
During 2005, we allocated certain information technology costs totaling $29 million from corporate and unallocated costs to segment operating income. The costs allocated to the refining segment and retail segment totaled $24 million and $5 million, respectively.
(c)
Operating income in 2003 included charges of $8 million, included in corporate and unallocated costs, for the termination of Tesoro’s funded executive security plan (see Note M) and $9 million in voluntary early retirement benefits and severance costs. The $9 million charge included $3 million in refining, $1 million in retail and $5 million in corporate.
(d)
Capital expenditures do not include refinery turnaround and other maintenance costs of $65 million, $50 million and $51 million in 2005, 2004 and 2003, respectively.
NOTE E - DEBT
On November 16, 2005, Tesoro issued $450 million principal amount of 61/4% senior notes due 2012 and $450 million principal amount of 65/8% senior notes due 2015 (the “notes offering”). The proceeds from the notes offering and cash on-hand were used to repurchase through cash tender offers the following principal amounts of our existing notes: (i) $189 million of our outstanding $211 million 95/8% senior subordinated notes due 2008; (ii) $415 million of our outstanding $429 million 95/8% senior subordinated notes due 2012; and (iii) $366 million principal amount of our $375 million 8% senior secured notes due 2008. We redeemed the remaining $22 million principal amount of the 95/8% senior subordinated notes due 2008 at a redemption price
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of 104.8% on December 16, 2005. The refinancing of $900 million and prepayments totaling $92 million resulted in a pretax charge of $92 million, consisting of tender and redemption premiums of $74 million and the write-off of unamortized debt issuance costs and discount of $18 million. The remaining $9 million outstanding balance of the 8% senior secured notes are callable beginning April 15, 2006 at a redemption price of 104%. The remaining $14 million outstanding balance of the 95/8% senior subordinated notes are callable beginning April 1, 2007 at a redemption price of 104.8%.
At December 31, 2005 and 2004, debt consisted of (in millions):
The aggregate maturities of Tesoro’s debt for each of the five years following December 31, 2005 were: 2006 - $3 million; 2007 - $2 million; 2008 - $11 million; 2009 - $2 million; and 2010 - $2 million.
Credit Agreement
In May 2005, we amended our credit agreement to extend the term by one year to June 2008 and reduce letter of credit fees and revolver borrowing interest. The credit agreement currently provides for borrowings (including letters of credit) up to the lesser of the agreement’s total capacity, $750 million as amended, or the amount of a periodically adjusted borrowing base ($1.5 billion as of December 31, 2005), consisting of Tesoro’s eligible cash and cash equivalents, receivables and petroleum inventories, as defined. As of December 31, 2005, we had no borrowings and $268 million in letters of credit outstanding under the revolving credit facility, resulting in total unused credit availability of $482 million or 64% of the eligible borrowing base. Borrowings under the revolving credit facility bear interest at either a base rate (7.25% at December 31, 2005) or a eurodollar rate (4.39% at December 31, 2005), plus an applicable margin. The applicable margin at December 31, 2005 was 1.50% in the case of the eurodollar rate, but varies based on credit facility availability. Letters of credit outstanding under the revolving credit facility incur fees at an annual rate tied to the eurodollar rate applicable margin (1.50% at December 31, 2005).
The credit agreement allows up to $250 million in letters of credit outside the credit agreement for crude oil purchases from non-U.S. vendors. In September 2005, we entered into a separate letters of credit agreement that provides up to $165 million in letters of credit for the purchase of foreign crude oil. The agreement is secured by our petroleum inventories supported by letters of credit issued under the agreement and will remain in effect until terminated by either party. Letters of credit outstanding under this agreement
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incur fees at an annual rate of 1.25% while secured or 1.38% while unsecured. As of December 31, 2005, we had $88 million in letters of credit outstanding under this agreement.
The credit agreement contains covenants and conditions that, among other things, limit our ability to pay cash dividends, incur indebtedness, create liens and make investments. Tesoro is also required to maintain specified levels of fixed charge coverage and tangible net worth. We are not required to maintain the fixed charge coverage ratio if unused credit availability exceeds 15% of the eligible borrowing base. The credit agreement is guaranteed by substantially all of Tesoro’s active subsidiaries and is secured by substantially all of Tesoro’s cash and cash equivalents, petroleum inventories and receivables.
61/4% Senior Notes Due 2012
On November 16, 2005, Tesoro issued $450 million aggregate principal amount of 61/4% senior notes due November 1, 2012. The notes have a seven-year maturity with no sinking fund requirements and are not callable. We have the right to redeem up to 35% of the aggregate principal amount at a redemption price of 106% with proceeds from certain equity issuances through November 1, 2008. The indenture for the notes contains covenants and restrictions that are customary for notes of this nature and are identical to the covenants in the indenture for Tesoro’s 65/8% senior notes due 2015. Substantially all of these covenants will terminate before the notes mature if one of two specified ratings agencies assigns the notes an investment grade rating and no events of default exist under the indenture. The terminated covenants will not be restored even if the credit rating assigned to the notes subsequently falls below investment grade. The notes are unsecured and are guaranteed by substantially all of Tesoro’s active subsidiaries.
65/8% Senior Notes Due 2015
On November 16, 2005, Tesoro issued $450 million aggregate principal amount of 65/8% senior notes due November 1, 2015. The notes have a ten-year maturity with no sinking fund requirements and are subject to optional redemption by Tesoro beginning November 1, 2010 at premiums of 3.3% through October 31, 2011, 2.2% from November 1, 2011 to October 31, 2012, 1.1% from November 1, 2012 to October 31, 2013, and at par thereafter. We have the right to redeem up to 35% of the aggregate principal amount at a redemption price of 106% with proceeds from certain equity issuances through November 1, 2008. The indenture for the notes contains covenants and restrictions that are customary for notes of this nature and are identical to the covenants in the indenture for Tesoro’s 61/4% senior notes due 2012. Substantially all of these covenants will terminate before the notes mature if one of two specified ratings agencies assigns the notes an investment grade rating and no events of default exist under the indenture. The terminated covenants will not be restored even if the credit rating assigned to the notes subsequently falls below investment grade. The notes are unsecured and are guaranteed by substantially all of Tesoro’s active subsidiaries.
Senior Secured Term Loans
In April 2005, we voluntarily prepaid the remaining $96 million outstanding principal balance of our senior secured term loans at a prepayment premium of 1%. The prepayment resulted in a pretax charge during the 2005 second quarter of approximately $3 million, consisting of the write-off of unamortized debt issuance costs and the 1% prepayment premium.
8% Senior Secured Notes Due 2008
In April 2003, Tesoro issued $375 million aggregate principal amount of 8% senior secured notes due April 15, 2008. On November 16, 2005, Tesoro repurchased $366 million of the notes, in connection with the notes offering described above. In addition, the indenture for the notes was amended to remove substantially all of the covenants. The remaining $9 million outstanding balance of the notes has no sinking fund requirements and is subject to optional redemption by Tesoro, beginning April 15, 2006, at a premium of 4%
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through April 14, 2007, and at par thereafter. The notes are secured by substantially all of Tesoro’s refining property, plant and equipment and are guaranteed by substantially all of Tesoro’s active subsidiaries. The notes were issued at 98.994% of par, resulting in net proceeds of $371.2 million before debt issuance costs. The effective interest rate on the notes is 8.25%, after giving effect to the discount.
95/8% Senior Subordinated Notes Due 2012
In April 2002, Tesoro issued $450 million principal amount of 95/8% senior subordinated notes due April 1, 2012. On November 16, 2005, Tesoro repurchased $415 million of the outstanding $429 million notes, in connection with the notes offering described above. In addition, the indenture for the notes was amended to remove substantially all of the covenants. The remaining $14 million outstanding balance of the notes matures in April 2012, has no sinking fund requirements and is subject to optional redemption by Tesoro, beginning April 1, 2007 at premiums of 4.8% through March 31, 2008. The notes are guaranteed by substantially all of Tesoro’s active domestic subsidiaries.
Junior Subordinated Notes Due 2012
In connection with our acquisition of the California refinery, Tesoro issued to the seller two ten-year junior subordinated notes with face amounts totaling $150 million. The notes consist of: (i) a $100 million junior subordinated note, due July 2012, which is non-interest bearing through May 16, 2007, and carries a 7.5% interest rate thereafter, and (ii) a $50 million junior subordinated note, due July 2012, which bears interest at 7.47% from May 17, 2003 through May 16, 2007 and 7.5% thereafter. We initially recorded these two notes at a combined present value of approximately $61 million, discounted at rates of 15.625% and 14.375%, respectively. We are amortizing the discount over the term of the notes.
Capital Lease Obligations
Our capital lease obligations are comprised primarily of 30 retail stations that we sold and leased-back in 2002 with initial terms of 17 years, with four 5-year renewal options. The portions of the leases attributable to land are classified as operating leases, and the portions attributable to depreciable buildings and equipment are classified as capital leases. The combined present value of minimum lease payments related to the leased buildings and equipment totaled $22 million at December 31, 2005. Tesoro also has other capital leases for tugs and barges used to transport petroleum products, over varying terms ending in 2006 through 2010, in which the combined present value of minimum lease payments totaled $8 million at December 31, 2005. Capital lease obligations included in debt totaled $31 million and $26 million at December 31, 2005 and 2004, respectively.
At December 31, 2005 and 2004, the total cost of assets under capital leases was $41 million gross (accumulated amortization of $14 million) and $35 million gross (accumulated amortization of $12 million), respectively. We include amortization of the cost of assets under capital leases in depreciation and amortization.
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Future minimum annual lease payments, including interest, as of December 31, 2005 for capital leases were (in millions):
NOTE F - STOCKHOLDERS’ EQUITY
Our credit agreement and senior notes each limit our ability to pay cash dividends or repurchase stock. The limitation in each of our debt agreements is based on limits on restricted payments (as defined in our debt agreements), which include dividends, stock repurchases or voluntary prepayments of subordinate debt. The aggregate amount of restricted payments cannot exceed an amount defined in each of the debt agreements. We do not believe that the limitations will restrict our ability to pay dividends or repurchase stock under our current programs.
Common Stock Repurchase Program
In November 2005, our Board of Directors authorized a $200 million share repurchase program, which represented approximately 5% of our common stock then outstanding. Under the program, we will repurchase our common stock from time to time in the open market. Purchases will depend on price, market conditions and other factors. During 2005, we repurchased 240,000 shares of common stock for $14 million under the program, or an average cost per share of $58.83.
Cash Dividends
On February 2, 2006, our Board of Directors declared a quarterly cash dividend on common stock of $0.10 per share, payable on March 15, 2006 to shareholders of record on March 1, 2006. In both June and September 2005, we paid a quarterly cash dividend on common stock of $0.05 per share and in December 2005, we paid a quarterly cash dividend on common stock of $0.10 per share.
See Note N for information relating to stock-based compensation and common stock reserved for exercise of options.
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NOTE G - INCOME TAXES
The income tax provision was comprised of (in millions):
We provide deferred income taxes and benefits for differences between financial statement carrying amounts of assets and liabilities and their respective tax bases. Temporary differences and the resulting deferred tax assets and liabilities at December 31, 2005 and 2004 were (in millions):
The net deferred income tax liability is classified in the consolidated balance sheets as follows (in millions):
The realization of deferred tax assets depends on Tesoro’s ability to generate future taxable income. Although realization is not assured, we believe it is more likely than not that we will realize the deferred tax assets, and therefore, we did not record a valuation allowance as of December 31, 2005 or 2004.
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The reconciliation of income tax expense at the U.S. statutory rate to the income tax expense follows (in millions):
As of December 31, 2005, Tesoro had approximately $56 million of alternative minimum tax credits that we carry forward indefinitely and no Federal net operating loss carry-forwards. Our filing of the 2002 tax return and the carryback of the net operating loss resulted in the receipt of refunds of $51 million during 2003.
NOTE H - RECEIVABLES
Concentrations of credit risk with respect to accounts receivable are influenced by the large number of customers comprising Tesoro’s customer base and their dispersion across various industry groups and geographic areas of operations. We perform ongoing credit evaluations of our customers’ financial condition, and in certain circumstances, require prepayments, letters of credit or other collateral arrangements. We include an allowance for doubtful accounts as a reduction in our trade receivables, which amounted to $5 million at both December 31, 2005 and 2004, respectively.
NOTE I - INVENTORIES
Components of inventories at December 31, 2005 and 2004 were (in millions):
Inventories valued at LIFO cost were less than replacement cost by approximately $687 million and $385 million, at December 31, 2005 and 2004, respectively.
NOTE J - GOODWILL AND ACQUIRED INTANGIBLES
SFAS No. 142 requires that goodwill and other intangibles determined to have an indefinite life are no longer to be amortized but are to be tested for impairment at least annually. We review the recorded value of goodwill for impairment during the fourth quarter of each year, or sooner if events or changes in circumstances indicate the carrying amount may exceed fair value. Our annual evaluation of goodwill impairment requires us to make significant estimates to determine the fair value of our reporting units. Our estimates may change from period to period because we must make assumptions about future cash flows, profitability and other matters. It is reasonably possible that future changes in our estimates could have a material effect on the
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carrying amount of goodwill. Goodwill included $84 million in refining and $5 million in retail at both December 31, 2005 and 2004.
The following table provides the gross carrying amount and accumulated amortization for each major class of acquired intangible assets, excluding goodwill (in millions):
The weighted average estimated lives of acquired intangible assets are: air emission credits - 28 years; refinery permits and plans - 22 years; customer agreements and contracts - 14 years; and other intangible assets - 20 years. Amortization expense of acquired intangible assets amounted to $8 million, $11 million and $10 million for the years ended December 31, 2005, 2004 and 2003, respectively. Our estimated amortization expense for each of the following five years is: 2006 - $7 million; 2007 - $6 million; 2008 - $6 million; 2009 - $6 million; and 2010 - $6 million.
NOTE K - OTHER NONCURRENT ASSETS
Other noncurrent assets at December 31, 2005 and 2004 consisted of (in millions):
Prepaid pension costs as of December 31, 2005 reflect our contributions made to our pension plan that exceeded amounts that were recognized as pension expense during 2005 (see Note M). Notes receivable from employees includes two non-interest bearing notes due from an employee who subsequently became an executive officer with remaining terms of 3 and 5 years. These two notes, which totaled approximately $1 million at both December 31, 2005 and 2004, were assumed in connection with the acquisition of our California refinery in May 2002.
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NOTE L - ACCRUED LIABILITIES
The Company’s current accrued liabilities and noncurrent other liabilities at December 31, 2005 and 2004 included (in millions):
As part of our California refinery acquisition in 2002, we acquired an operating lease for an MTBE production facility. We accrued the termination obligation because California state regulations required the phase-out of MTBE on December 31, 2003. During the 2005 fourth quarter, we made the determination to terminate the MTBE facility lease during the first quarter of 2006. Under the terms of the lease agreement, we will make a final payment of approximately $30 million upon termination, which is included in current accrued liabilities above.
NOTE M - BENEFIT PLANS
Pension and Other Postretirement Benefits
Tesoro sponsors defined benefit pension plans, including a funded employee retirement plan, an unfunded executive security plan and an unfunded non-employee director retirement plan. We provide a qualified noncontributory retirement plan for all eligible employees. Benefits are based on years of service and compensation. Although Tesoro has no minimum required contribution obligation to its funded employee retirement plan under applicable laws and regulations in 2006, we expect to contribute approximately $25 million to the plan in 2006. We also had no minimum required obligation in 2005, however, we voluntarily contributed $95 million in 2005. Plan assets are primarily comprised of common stock and bond funds.
Tesoro’s unfunded executive security plan provides certain executive officers and other key personnel with supplemental death or retirement benefits. These benefits are provided by a nonqualified, noncontributory plan and are based on years of service and compensation. During December 2003, we terminated our funded executive security plan, resulting in a write-off of unamortized prepaid pension costs of $7 million and a plan curtailment contribution of $1 million. We made additional contributions of $3 million to the funded plan in 2003.
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Tesoro had previously established an unfunded non-employee director retirement plan that provided eligible directors retirement payments upon meeting certain age and other requirements. In 1997, that plan was frozen with accrued benefits of current directors transferred to the board of directors phantom stock plan (see Note N). After the amendment and transfer, only those retired directors or beneficiaries who had begun to receive benefits remained participants in the previous plan.
Tesoro provides to retirees who met certain service requirements and were participating in our group insurance program at retirement, health care benefits and, to those who qualify, life insurance benefits. Health care is available to qualified dependents of participating retirees. These benefits are provided through unfunded, defined benefit plans or through contracts with area health-providers on a premium basis. The health care plans are contributory, with retiree contributions adjusted periodically, and contain other cost-sharing features such as deductibles and coinsurance. The life insurance plan is noncontributory. We fund Tesoro’s share of the cost of postretirement health care and life insurance benefits on a pay-as-you go basis.
Our retiree medical plan provides prescription drug benefits, which were affected by the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”), signed in to law in December 2003. The Act introduced a prescription drug benefit under Medicare (Medicare Part D), as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. The effect of the subsidy resulted in a $10 million reduction in our benefit obligation as of December 31, 2004 and is included as an actuarial gain in other postretirement benefits in the table below. We expect to receive approximately $200,000 annually in federal subsidy receipts for the years 2006 through 2010 and an aggregate $2 million for the years 2011 through 2015.
We use December 31 as the measurement date for all of our defined benefit pension and post retirement plans. Changes in benefit obligations, plan assets and the funded status of the pension plans and other postretirement benefits, reconciled to amounts in the consolidated balance sheets as of December 31, 2005 and 2004, were (in millions):
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The combined accumulated benefit obligations for our retirement plans was $209 million and $169 million at December 31, 2005 and 2004, respectively. At December 31, 2005, our contributions to the funded employee retirement plan exceeded the plan’s associated net periodic benefit expense resulting in a prepaid pension cost asset of $47 million. Further, the accumulated benefit obligation of the executive security plan exceeded the fair value of plan assets resulting in the recognition of an additional minimum liability of $8 million, an intangible asset of $5 million and accumulated other comprehensive loss, net of tax benefit of $2 million. At December 31, 2004 the accumulated benefit obligation of the funded employee retirement plan and executive security plan exceeded the fair value of plan assets, and we recognized an additional minimum liability and an intangible asset of $6 million.
The components of pension and postretirement benefit expense included in the consolidated statements of operations for the years ended December 31, 2005, 2004 and 2003 were (in millions):
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Significant assumptions included in estimating Tesoro’s pension and other postretirement benefits obligations were:
The expected return on plan assets reflects the weighted-average of the expected long-term rates of return for the broad categories of investments held in the plans. The expected long-term rate of return is adjusted when there are fundamental changes in expected returns on the plan’s investments.
The assumed health care cost trend rates used to determine the projected postretirement benefit obligation are as follows:
Assumed health care cost trend rates have a significant effect on the amounts reported for the health care and life insurance plans. A one-percentage-point change in assumed health care cost trend rates could have the following effects (in millions):
Our pension plans follow an investment return approach in which investments are allocated to broad investment categories, including equities, debt and real estate, to maximize the long-term return of the plan assets at a prudent level of risk. The target allocations for the pension plan’s assets were 70% equity securities (with sub-category allocation targets), 24% debt securities and 6% real estate. The weighted-average asset allocations in our pension plans at December 31, 2005 and 2004, were:
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Our other postretirement benefit plans contained no assets at December 31, 2005 and 2004.
The following estimated future benefit payments, which reflect expected future service, as appropriate, are expected to be paid in the years indicated (in millions):
Thrift Plan and Retail Savings Plan
Tesoro sponsors an employee thrift plan that provides for contributions, subject to certain limitations, by eligible employees into designated investment funds with a matching contribution by Tesoro. Employees may elect tax-deferred treatment in accordance with the provisions of Section 401(k) of the Internal Revenue Code. Tesoro matches 100% of employee contributions, up to 7% of the employee’s eligible earnings, with at least 50% of the matching contribution directed for initial investment in Tesoro’s common stock. The maximum matching contribution is 6% for employees covered by the collective bargaining agreement at the California refinery. Participants are eligible to transfer out of Tesoro’s common stock at any time, on an unlimited basis. Tesoro’s contributions to the thrift plan amounted to $15 million, $13 million and $11 million during 2005, 2004 and 2003, respectively, of which $8 million, $6 million and $1 million consisted of treasury stock reissuances in 2005, 2004 and 2003, respectively.
Tesoro sponsors a savings plan, in lieu of the thrift plan, for eligible retail employees who have completed one year of service and have worked at least 1,000 hours within that time. Eligible employees receive a mandatory employer contribution equal to 3% of eligible earnings. If employees elect to make pretax contributions, Tesoro also contributes an employer match contribution equal to $0.50 for each $1.00 of employee contributions, up to 6% of eligible earnings. At least 50% of the matching employer contributions must be directed for initial investment in Tesoro common stock. Participants are eligible to transfer out of Tesoro’s common stock at any time, on an unlimited basis. Tesoro’s contributions amounted to $0.4 million during 2005, 2004 and 2003, of which $0.1 million consisted of treasury stock reissuances in 2005 and 2004.
NOTE N - STOCK-BASED COMPENSATION
Effective January 1, 2004, we adopted the preferable fair value method of accounting for stock-based compensation, as prescribed in SFAS No. 123. We selected the “modified prospective method” of adoption described in SFAS No. 148 recognizing compensation cost as if the fair value method of SFAS No. 123 had been applied from its original effective date. Prior to January 1, 2004, we accounted for stock options using the intrinsic value method prescribed in APB Opinion No. 25. Under the intrinsic value method, we did not recognize compensation cost for our stock options. See Note A for additional information, including the pro forma effects, had compensation cost been determined based on fair values at the grant dates of awards during 2003 in accordance with SFAS No. 123. On January 1, 2005, we adopted the provisions of SFAS No. 123 (Revised 2004), which requires companies to recognize the cost of employee services received in exchange for awards of equity instruments, based on the grant date fair value of those awards, in the financial statements. In connection with this standard, we adopted the fair value method for our outstanding phantom stock options resulting in an after-tax charge of $0.2 million during 2005. Total compensation expense for all stock-based
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awards for 2005 and 2004 totaled $26 million and $14 million, respectively. Stock-based compensation included charges totaling $5 million and $2 million during 2005 and 2004, respectively, associated with the termination and retirement of certain executive officers. The income tax benefit realized from tax deductions associated with option exercises totaled $27 million and $4 million during 2005 and 2004, respectively.
Incentive Stock Plans
We have two employee incentive stock plans, the Amended and Restated Executive Long-Term Incentive Plan and the Key Employee Stock Option Plan, as amended. We also have the 1995 Non-Employee Director Stock Option Plan, as amended. At December 31, 2005, Tesoro had 5,041,010 shares of unissued common stock reserved for these plans.
Under the Amended and Restated Executive Long-Term Incentive Plan, shares of common stock may be granted in a variety of forms, including restricted stock, nonqualified stock options, stock appreciation rights and performance share and performance unit awards. Tesoro may grant up to 9,250,000 shares under this plan, of which up to 1,500,000 shares in the aggregate may be granted as restricted stock, performance shares and performance units. Stock options may be granted at exercise prices not less than the fair market value on the date the options are granted. The options granted generally become exercisable after one year in 25% or 33% annual increments and expire ten years from the date of grant. Options granted under the plan may not be repriced without stockholder approval. The plan will expire, unless earlier terminated, as to the issuance of awards in September 2008. At December 31, 2005, Tesoro had 762,359 shares available for future grants under this plan.
The Key Employee Stock Option Plan provided stock option grants to eligible employees who were not executive officers of Tesoro. We granted stock options to purchase 797,000 shares of common stock, of which 236,719 shares were outstanding at December 31, 2005, which become exercisable one year after grant in 25% annual increments. The options expire ten years after the date of grant. The board of directors has suspended any future grants under this plan.
The 1995 Non-Employee Director Stock Option Plan provides for the grant of up to 450,000 nonqualified stock options over the life of the plan to eligible non-employee directors of Tesoro. These automatic, non-discretionary stock options are granted at an exercise price equal to the fair market value per share of Tesoro’s common stock at the date of grant. The term of each option is ten years, and an option becomes exercisable six months after it is granted. This plan will expire, unless earlier terminated, as to the issuance of awards in February 2010. At December 31, 2005, Tesoro had 136,000 options outstanding and 242,000 shares available for future grants under this plan.
A summary of stock option activity for all plans is set forth below (shares in thousands):
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Total compensation cost recognized for all outstanding stock options totaled $15 million and $8 million during 2005 and 2004, respectively. Prior to 2004 we accounted for stock options using the intrinsic value method and therefore did not record compensation costs for our stock options. Total unrecognized compensation cost related to non-vested stock options totaled $15 million as of December 31, 2005, which is expected to be recognized over a weighted-average period of 1.9 years.
We amortize the estimated fair value of stock options granted over the vesting period using the straight-line method. The estimated weighted-average grant-date fair value per share of options granted during 2005, 2004 and 2003 was $18.52, $13.01 and $6.73, respectively. The total intrinsic value for options exercised during 2005, 2004 and 2003 was $70 million, $15 million and $0.3 million, respectively. We estimated the fair value of each option on the date of grant using the Black-Scholes option-pricing model. Expected volatilities are based on the historical volatility of our stock. We use historical data to estimate option exercise and employee termination within the valuation model. The expected life of options granted is based on historical data and represents the period of time that options granted are expected to be outstanding. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.
Tesoro’s weighted average assumptions are presented below:
In June 2005, we began paying a quarterly cash dividend on common stock of $0.05 per share which was increased to $0.10 per share in December 2005. The expected dividend yield from June 2005 through December 2005 ranged from 0.16% to 0.24%.
Restricted Stock
Pursuant to our Amended and Restated Executive Long-Term Incentive Plan, we may grant up to 1,500,000 restricted shares of our common stock to eligible employees subject to certain terms and conditions. We amortize the estimated fair value of our restricted stock granted over the vesting period using the straight-line method. The fair value of each restricted share on the date of grant is equal to its fair market price. Our restricted shares vest in three and five year increments assuming continued employment at the vesting dates. Effective January 1, 2005 in connection with the requirements of SFAS No. 123, we eliminated unearned compensation of $11 million against additional paid-in capital and common stock in the December 31, 2004 consolidated balance sheet and statements of consolidated stockholders’ equity. A summary of our restricted stock activity is set forth below (shares in thousands):
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Total compensation cost recognized for our outstanding restricted stock totaled $4 million and $2 million during 2005 and 2004, respectively. Total unrecognized compensation cost related to non-vested restricted stock totaled $9 million as of December 31, 2005, which is expected to be recognized over a weighted-average period of 1.9 years. The total fair value of restricted shares vested during 2005 was $4 million.
Director Compensation Plan
The 2005 Director Compensation Plan was approved at Tesoro’s annual meeting of stockholders held in May 2005. The plan provides for the grant of up to 50,000 shares of common stock to eligible non-employee directors of Tesoro. We granted 1,631 shares of common stock during 2005 at a weighted-average grant-date price per share of $53.94.
Non-Employee Director Phantom Stock Plan
Under the Non-Employee Director Phantom Stock Plan, a yearly credit of $7,250 is made in units to an account of each non-employee director, based upon the closing market price of Tesoro’s common stock on the date of credit, which vests with three years of service. A director also may elect to have the value of his cash retainer fee deposited quarterly into the account as units that are immediately vested. Retiring directors who are committee chairpersons receive an additional $5,000 credit to their accounts. Certain non-employee directors also received a credit in their accounts in 1997, arising from the transfer of their lump-sum accrued benefit under the frozen Director Retirement Plan. The value of each vested account balance, which is a function of changes in market value of Tesoro’s common stock, is payable in cash commencing at termination or at retirement, death or disability. Payments may be made as a total distribution or in annual installments, not to exceed ten years. The Non-Employee Director Phantom Stock Plan resulted in expenses of $2 million, $1 million, 0.5 million for the years 2005, 2004 and 2003, respectively.
Phantom Stock Options
Pursuant to our Amended and Restated Executive Long-Term Incentive Plan, Tesoro’s chief executive officer also holds 175,000 phantom stock options, which were granted in 1997 with a term of ten years at 100% of the fair value of Tesoro’s common stock on the grant date, or $16.9844 per share. At December 31, 2005, all of the phantom stock options were exercisable. Upon exercise, the chief executive officer would be entitled to receive, in cash, the difference between the fair market value of the common stock on the date of the phantom stock option grant and the fair market value of common stock on the date of exercise. At the discretion of the Compensation Committee of the Board of Directors, these phantom stock options may be converted to traditional stock options under the Amended and Restated Executive Long-Term Incentive Plan. Total compensation expense recognized for this award during 2005 and 2004 amounted to $5 million and $3 million, respectively. No compensation expense had been recorded for this award prior to 2004, as our stock price had not exceeded the grant date price for this award.
2006 Long-Term Stock Appreciation Rights Plan
In February 2006, our Board of Directors approved the 2006 Long-Term Stock Appreciation Rights Plan (the “SAR Plan”). The SAR Plan permits the grant of stock appreciation rights (“SARs”) to key managers and other employees of Tesoro. A SAR granted under the SAR Plan entitles an employee to receive cash in an amount equal to the excess of the fair market value of one share of common stock on the date of exercise over the grant price of the SAR. Unless otherwise specified, all SARs under the SAR Plan vest ratably during a three-year period following the date of grant. The term of a SAR granted under the SAR Plan shall be determined by the Compensation Committee provided that no SAR shall be exercisable on or after the tenth anniversary date of its grant. In February 2006, we granted 314,110 SARs at 100% of the fair value of Tesoro’s common stock on the grant date of $66.61 per share.
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NOTE O -
COMMITMENTS AND CONTINGENCIES
Operating Leases
Tesoro has various cancellable and noncancellable operating leases related to land, office and retail facilities, ship charters and equipment and other facilities used in the storage, transportation, production and sale of feedstocks and refined products. These leases have remaining primary terms up to 38 years, with terms of certain rights-of-way extending up to 25 years, and generally contain multiple renewal options.
We have long-term charters with remaining terms up through May 2010 for three U.S. flagged ships and two foreign-flagged ships, used to transport crude oil and products. The aggregate annual commitments on these charters range from $29 million to $61 million over the remaining terms.
Tesoro has operating leases for most of its retail gas station sites with primary remaining terms up to 38 years, and generally containing renewal options. Our aggregate annual lease commitments for the sites total approximately $8 million to $10 million over the next five years. These leases include the 30 retail stations that we sold and leased back in 2002 with initial terms of 17 years and four five-year renewal options. We classified the portion of each lease attributable to land as an operating lease, and the portion attributable to depreciable buildings and equipment as a capital lease (See Note E). Tesoro also has an agreement with Wal-Mart to build and operate retail gas stations at selected existing and future Wal-Mart stores in the western United States. Under the agreement, each site is subject to a lease with a ten-year primary term and an option, exercisable at our discretion, to extend a site’s lease for two additional five-year options.
As of December 31, 2005, we leased Tesoro’s corporate headquarters from a limited partnership, in which we owned a 50% limited interest. In February 2006, the limited partnership sold the building to a third-party resulting in a gain to Tesoro of $5 million. We continue to lease our corporate headquarters from the third-party with an initial lease term through 2014 and two five-year renewal options. Our total rent expense includes lease payments and operating costs paid to the partnership totaling $4 million, $3 million and $3 million in 2005, 2004 and 2003, respectively. We accounted for Tesoro’s interest in the partnership using the equity method of accounting, and our consolidated balance sheets did not include the partnership’s assets, primarily land and buildings, totaling approximately $16 million and debt of approximately $13 million.
Tesoro’s minimum annual lease payments as of December 31, 2005, for operating leases having initial or remaining noncancellable lease terms in excess of one year were (in millions):
Total rental expense for short-term and long-term operating leases, excluding marine charters, amounted to approximately $52 million in 2005, $44 million in 2004, and $49 million in 2003. We also enter into various short-term charters for vessels to transport refined products to and from our refineries and terminals and to deliver products to customers. Total marine charter expense was $117 million in 2005, $68 million in 2004 and $61 million in 2003. See Note E for information related to capital leases.
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Purchase Obligations and Other Commitments
Tesoro’s contractual purchase commitments consist primarily of crude oil supply contracts for our refineries from several suppliers with noncancellable remaining terms ranging up to 18 months with renewal provisions. Prices under the term agreements generally fluctuate with market prices. Assuming actual market crude oil prices as of December 31, 2005, ranging from $54 per barrel to $64 per barrel, our minimum crude supply commitments, for the next two years would approximate $4.2 billion in 2006 and $389 million in 2007. We also purchase crude oil at market prices under short-term renewable agreements and in the spot market. In addition to these purchase commitments, we also have contractual capital spending commitments, primarily for refinery improvements and environmental projects totaling approximately $63 million in 2006.
We also have long-term take-or-pay commitments to purchase services associated with the operation of our refineries, primarily for chemical supplies. We also will make a final payment of $30 million in 2006 related to terminating a deactivated MTBE plant lease located at our California refinery (see Note L). In addition, we have a power supply agreement through 2012 at the California refinery, which requires minimum payments through July 2007 that vary based on market prices for electricity. Assuming estimated future market prices of electricity, minimum payments for the next two years would approximate $50 million in 2006 and $28 million in 2007. The minimum annual payments under our service contracts, including the termination payment for the deactivated MTBE plant and the power supply agreement are estimated to total $106 million in 2006, $58 million in 2007, $30 million in 2008, $29 million in 2009, and $28 million in 2010. The remaining minimum commitment totals approximately $89 million over 15 years. Tesoro paid approximately $90 million, $92 million and $92 million in 2005, 2004 and 2003, respectively, under these take-or-pay contracts.
Environmental and Other Matters
We are a party to various litigation and contingent loss situations, including environmental and income tax matters, arising in the ordinary course of business. Where required, we have made accruals in accordance with SFAS No. 5, “Accounting for Contingencies,” in order to provide for these matters. We cannot predict the ultimate effects of these matters with certainty, and we have made related accruals based on our best estimates, subject to future developments. We believe that the outcome of these matters will not result in a material adverse effect on our liquidity and consolidated financial position, although the resolution of certain of these matters could have a material adverse impact on interim or annual results of operations.
Tesoro is subject to audits by federal, state and local taxing authorities in the normal course of business. It is possible that tax audits could result in claims against Tesoro in excess of recorded liabilities. We believe, however, that when these matters are resolved, they will not materially affect Tesoro’s consolidated financial position or results of operations.
Tesoro is subject to extensive federal, state and local environmental laws and regulations. These laws, which change frequently, regulate the discharge of materials into the environment and may require us to remove or mitigate the environmental effects of the disposal or release of petroleum or chemical substances at various sites, install additional controls, or make other modifications or changes in use for certain emission sources.
Environmental Liabilities
We are currently involved in remedial responses and have incurred and expect to continue to incur cleanup expenditures associated with environmental matters at a number of sites, including certain of our previously owned properties. At December 31, 2005, our accruals for environmental expenses totaled $32 million. Our accruals for environmental expenses include retained liabilities for previously owned or operated properties, refining, pipeline and terminal operations and retail service stations. We believe these
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accruals are adequate, based on currently available information, including the participation of other parties or former owners in remediation action.
During 2005, we continued settlement discussions with the California Air Resources Board (“CARB”) concerning a notice of violation (“NOV”) we received in October 2004. The NOV, issued by CARB, alleges that Tesoro offered eleven batches of gasoline for sale in California that did not meet CARB’s gasoline exhaust emission limits. In January 2006, we executed a Settlement Agreement and Release with CARB which requires us to pay a civil penalty of $325,000 to resolve this matter. A reserve for the settlement of the NOV is included in the $32 million of environmental accruals referenced above.
In 2005, we received two NOVs from the Bay Area Air Quality Management District. The Bay Area Air Quality Management District alleged we violated certain air quality emission limits as a result of a mechanical failure of one of our boilers at our California refinery in January 2005. On January 26, 2006, we entered into a Settlement Agreement and Release with the District and the District Attorney of Contra Costa County, California. In exchange for the release of allegations based upon certain air quality emission limits and provisions of the California Health and Safety Code, we paid a civil penalty of $1.1 million. A reserve for the settlement of the NOVs is included in the $32 million of environmental accruals referenced above.
We have undertaken an investigation of environmental conditions at certain active wastewater treatment units at our California refinery. This investigation is driven by an order from the San Francisco Bay Regional Water Quality Control Board that names us as well as two previous owners of the California refinery. Based on our spending in 2005, the remaining cost estimate for the active wastewater units investigation is approximately $300,000. A reserve for this matter is included in the $32 million of environmental accruals referenced above.
On October 24, 2005, we received an NOV from the EPA. The EPA alleges certain modifications made to the fluid catalytic cracking unit at our Washington refinery prior to our acquisition of the refinery were made without a permit in violation of the Clean Air Act. We are investigating the allegations and believe the ultimate resolution of the NOV will not have a material adverse effect on our financial position or results of operations. A reserve for the settlement of the NOV is included in the $32 million of environmental accruals referenced above.
On February 28, 2006, we received an offer of settlement from the Bay Area Air Quality Management District. The District has offered to settle 28 NOVs issued to Tesoro from January 2004 to September 2004 for $275,000. The NOVs allege violations of various air quality requirements at the California refinery. A reserve for the settlement of the NOVs is included in the $32 million of environmental accruals referenced above.
Other Environmental Matters
In the ordinary course of business, we become party to or otherwise involved in lawsuits, administrative proceedings and governmental investigations, including environmental, regulatory and other matters. Large and sometimes unspecified damages or penalties may be sought from us in some matters for which the likelihood of loss may be reasonably possible but the amount of loss is not currently estimable, and some matters may require years for us to resolve. As a result, we have not established reserves for these matters. On the basis of existing information, we believe that the resolution of these matters, individually or in the aggregate, will not have a material adverse effect on our financial position or results of operations. However, we cannot provide assurance that an adverse resolution of one or more of the matters described below during a future reporting period will not have a material adverse effect on our financial position or results of operations in future periods.
We are a defendant, along with other manufacturing, supply and marketing defendants, in eleven pending cases alleging MTBE contamination in groundwater. The defendants are being sued for having manufactured
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MTBE and having manufactured, supplied and distributed gasoline containing MTBE. The plaintiffs, all in California, are generally water providers, governmental authorities and private well owners alleging, in part, the defendants are liable for manufacturing or distributing a defective product. The suits generally seek individual, unquantified compensatory and punitive damages and attorney’s fees, but we cannot estimate the amount or the likelihood of the ultimate resolution of these matters at this time, and accordingly have not established a reserve for these cases. We believe we have defenses to these claims and intend to vigorously defend the lawsuits.
Soil and groundwater conditions at our California refinery may require substantial expenditures over time. In connection with our acquisition of the California refinery from Ultramar, Inc. in May 2002, Ultramar assigned certain of its rights and obligations that Ultramar had acquired from Tosco Corporation in August of 2000. Tosco assumed responsibility and contractually indemnified us for up to $50 million for certain environmental liabilities arising from operations at the refinery prior to August of 2000, which are identified prior to August 31, 2010 (“Pre-Acquisition Operations”). Based on existing information, we currently estimate that the known environmental liabilities arising from Pre-Acquisition Operations are approximately $41 million, including soil and groundwater conditions at the refinery in connection with various projects and including those required by the California Regional Water Quality Control Board and other government agencies. If we incur remediation liabilities in excess of the defined environmental liabilities for Pre-Acquisition Operations indemnified by Tosco, we expect to be reimbursed for such excess liabilities under certain environmental insurance policies. The policies provide $140 million of coverage in excess of the $50 million indemnity covering the defined environmental liabilities arising from Pre-Acquisition Operations. Because of Tosco’s indemnification and the environmental insurance policies, we have not established a reserve for these defined environmental liabilities arising out of the Pre-Acquisition Operations. In December 2003, we initiated arbitration proceedings against Tosco seeking damages, indemnity and a declaration that Tosco is responsible for the defined environmental liabilities arising from Pre-Acquisition Operations at our California refinery.
In November 2003, we filed suit in Contra Costa County Superior Court against Tosco alleging that Tosco misrepresented, concealed and failed to disclose certain additional environmental conditions at our California refinery. The court granted Tosco’s motion to compel arbitration of our claims for these certain additional environmental conditions. In the arbitration proceedings we initiated against Tosco in December 2003, we are also seeking a determination that Tosco is liable for investigation and remediation of these certain additional environmental conditions, the amount of which is currently unknown and therefore a reserve has not been established, and which may not be covered by the $50 million indemnity for the defined environmental liabilities arising from Pre-Acquisition Operations. In response to our arbitration claims, Tosco filed counterclaims in the Contra Costa County Superior Court action alleging that we are contractually responsible for additional environmental liabilities at our California refinery, including the defined environmental liabilities arising from Pre-Acquisition Operations. In February 2005, the parties agreed to stay the arbitration proceedings to pursue settlement discussions.
In June 2005, the parties agreed in principle to settle their claims, including the defined environmental liabilities arising from Pre-Acquisition Operations and certain additional environmental conditions, both discussed above, pending negotiation and execution of a final written settlement agreement. In the event we are unable to finalize the settlement, we intend to vigorously prosecute our claims against Tosco and to oppose Tosco’s claims against us, although we cannot provide assurance that we will prevail.
Environmental Capital Expenditures
EPA regulations related to the Clean Air Act require reductions in the sulfur content in gasoline. To meet the revised gasoline standard, we spent $28 million in 2005. Our California, Washington, Hawaii, Alaska and North Dakota refineries will not require additional capital spending to meet the low sulfur gasoline standards.
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We currently estimate we will make additional capital improvements of approximately $8 million at our Utah refinery from 2008 through 2009, that will permit the Utah refinery to produce gasoline meeting the sulfur limits imposed by the EPA.
EPA regulations related to the Clean Air Act also require reductions in the sulfur content in diesel fuel manufactured for on-road consumption. In general, the new on-road diesel fuel standards will become effective on June 1, 2006. In May 2004, the EPA issued a rule regarding the sulfur content of non-road diesel fuel. The requirements to reduce non-road diesel sulfur content will become effective in phases between 2007 and 2010. We spent $46 million in 2005 to meet the revised diesel fuel standards, and based on our latest engineering estimates, we expect to spend approximately $71 million in additional capital improvements through 2007. Included in the estimate are capital projects to manufacture additional quantities of low sulfur diesel at our Alaska refinery, for which we expect to spend approximately $53 million through 2007. These cost estimates are subject to further review and analysis. Our California, Washington and North Dakota refineries will not require additional capital spending to meet the new non-road diesel fuel standards.
We expect to spend approximately $1 million in capital improvements in 2006 at our Washington refinery to comply with the Maximum Achievable Control Technologies standard for petroleum refineries (“Refinery MACT II”). We spent approximately $17 million during 2005.
In connection with our 2001 acquisition of our North Dakota and Utah refineries, Tesoro assumed the sellers’ obligations and liabilities under a consent decree among the United States, BP Exploration and Oil Co. (“BP”), Amoco Oil Company and Atlantic Richfield Company. BP entered into this consent decree for both the North Dakota and Utah refineries for various alleged violations. As the owner of these refineries, Tesoro is required to address issues that include leak detection and repair, flaring protection, and sulfur recovery unit optimization. We currently estimate we will spend $5 million over the next three years to comply with this consent decree. We also agreed to indemnify the sellers for all losses of any kind incurred in connection with the consent decree.
In connection with the 2002 acquisition of our California refinery, subject to certain conditions, we assumed the seller’s obligations pursuant to settlement efforts with the EPA concerning the Section 114 refinery enforcement initiative under the Clean Air Act, except for any potential monetary penalties, which the seller retains. In November 2005, the Consent Decree was entered by the District Court for the Western District of Texas in which we agreed to undertake projects at our California refinery to reduce air emissions. We spent $2 million in 2005 and currently estimate we will make additional capital improvements of approximately $30 million through 2010 to satisfy the requirements of the Consent Decree. This cost estimate is subject to further review and analysis.
During the fourth quarter of 2005, we received approval by the Hearing Board for the Bay Area Air Quality Management District to modify our existing fluid coker unit to a delayed coker at our California refinery which is designed to (i) lower emissions and (ii) increase overall efficiency by lowering operating costs. We negotiated the terms and conditions of the Second Conditional Abatement Order with the District in response to the January 2005 mechanical failure of one of our boilers at the California refinery. We spent $3 million during 2005 for this project, and we currently estimate that we will spend approximately $272 million through the fourth quarter of 2007. This cost estimate is subject to further review and analysis.
We will spend additional capital at the California refinery for reconfiguring and replacing above-ground storage tank systems and upgrading piping within the refinery. We spent $15 million in 2005 for these related projects at our California refinery, and we currently estimate that we will make additional capital improvements of approximately $109 million through 2010. This cost estimate is subject to further review and analysis.
Conditions may develop that cause increases or decreases in future expenditures for our various sites, including, but not limited to, our refineries, tank farms, retail gasoline stations (operating and closed
TESORO CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
locations) and petroleum product terminals, and for compliance with the Clean Air Act and other federal, state and local requirements. We cannot currently determine the amounts of such future expenditures.
Claims Against Third-Parties
Beginning in the early 1980s, Tesoro Hawaii Corporation, Tesoro Alaska Company and other fuel suppliers entered into a series of long-term, fixed-price fuel supply contracts with the U.S. Defense Energy Support Center (“DESC”). Each of the contracts contained a provision for price adjustments by the DESC. The federal acquisition regulations control how prices may be adjusted, and we and many other suppliers have filed in separate suits in the Court of Federal Claims contesting the DESC’s price adjustments prior to 1999. We and the other suppliers seek recovery of approximately $3 billion in underpayment for fuel. Our share of that underpayment totals approximately $165 million, plus interest. We alleged that the DESC’s price adjustments violated federal regulations by not adjusting the sales price of fuel based on changes to each supplier’s established prices or costs, as the Court of Federal Claims had held in prior rulings on similar contracts. The Court of Federal Claims granted partial summary judgment in our favor on that issue, but the Court of Appeals for the Federal Circuit has reversed and ruled that DESC’s prices did not need to be tied to changes in a specific supplier’s prices or costs. We have also asserted other grounds to challenge the DESC contract pricing formulas, and we are evaluating our position with respect to further litigation on those additional grounds. We cannot predict the outcome of these further actions.
In 1996, Tesoro Alaska Company filed a protest of the intrastate rates charged for the transportation of its crude oil through the Trans Alaska Pipeline System (“TAPS”). Our protest asserted that the TAPS intrastate rates were excessive and should be reduced. The Regulatory Commission of Alaska (“RCA”) considered our protest of the intrastate rates for the years 1997 through 2000. The RCA set just and reasonable final rates for the years 1997 through 2000, and held that we are entitled to receive approximately $52 million in refunds, including interest through the expected conclusion of appeals in December 2007. The RCA’s ruling is currently on appeal in the Alaska courts, and we cannot give any assurances of when or whether we will prevail in the appeal.
In 2002, the RCA rejected the TAPS Carriers’ proposed intrastate rate increases for 2001-2003 and maintained the permanent rate of $1.96 to the Valdez Marine Terminal. That ruling is currently on appeal to the Alaska Superior Court, and the TAPS Carriers did not move to prevent the rate decrease. The rate decrease has been in effect since June 2003. If the RCA’s decision is upheld on appeal, we could be entitled to refunds resulting from our shipments from January 2001 through mid-June 2003. If the RCA’s decision is not upheld on appeal, we could have to pay additional shipping charges resulting from our shipments from mid-June 2003 through December 2005. We cannot give any assurances of when or whether we will prevail in the appeal. We also believe that, should we not prevail on appeal, the amount of additional shipping charges cannot reasonably be estimated since it is not possible to estimate the permanent rate which the RCA could set, and the appellate courts approve, for each year. In addition, depending upon the level of such rates, there is a reasonable possibility that any refunds for the period January 2001 through mid-June 2003 could offset some or all of any repayments due for the period mid-June 2003 through December 2005.
In July 2005, the TAPS Carriers filed a proceeding at the Federal Energy Regulatory Commission (“FERC”), seeking to have the FERC assume jurisdiction over future rates for intrastate transportation on TAPS. We have filed a protest in that proceeding, which has now been consolidated with another FERC proceeding seeking to set just and reasonable rates for future interstate transportation on TAPS. If the TAPS carriers should prevail, then the rates charged for all shipments of Alaska North Slope crude oil on TAPS could be revised by the FERC, but any FERC changes to rates for intrastate transportation of crude oil supplies for our Alaska refinery should be prospective only and should not affect prior intrastate rates, refunds or repayments.
TESORO CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
NOTE P -
QUARTERLY FINANCIAL DATA (UNAUDITED)
During the fourth quarter of 2005, we incurred pretax charges of $92 million consisting of tender and redemption premiums and the write-off of unamortized debt issuance costs and discount in connection with the refinancing of our 95/8% senior subordinated notes and 8% senior secured notes (see Note E). During the fourth quarter of 2004, we incurred stock-based compensation expenses related to the announced retirement of certain executive officers totaling $2 million.
ITEM 9.
ITEM 9.
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A.
CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
We carried out an evaluation required by the Securities Exchange Act of 1934, as amended (the “Exchange Act”), under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule 13a-15 under the Exchange Act as of the end of the year. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to the Company and required to be included in our periodic filings under the Exchange Act. During the fourth quarter of 2005, there have been no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Management Report on Internal Control over Financial Reporting
We, as management of Tesoro Corporation and its subsidiaries (the “Company”), are responsible for establishing and maintaining adequate internal control over financial reporting as defined in the Securities Exchange Act of 1934, Rule 13a-15(f). The Company’s internal control system is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles in the United States of America.
Due to its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
Management assessed the effectiveness of internal controls over financial reporting as of December 31, 2005, using the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control - Integrated Framework. Based on such assessment, we believe that as of December 31, 2005, the Company’s internal control over financial reporting is effective. The independent registered public accounting firm of Deloitte & Touche LLP, as auditors of the Company’s consolidated financial statements, has issued an attestation report on management’s assessment of the effectiveness of the Company’s internal control over financial reporting, included herein.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Tesoro Corporation
We have audited management’s assessment, included in the accompanying Management Report on Internal Control over Financial Reporting, that Tesoro Corporation and subsidiaries (the “Company”) maintained effective internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated financial statements as of and for the year ended December 31, 2005 of the Company and our report dated March 6, 2006, expressed an unqualified opinion on those financial statements.
/s/ Deloitte & Touche LLP
San Antonio, Texas
March 6, 2006
ITEM 9B.
ITEM 9B.
OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10.
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information required under this Item will be contained in the Company’s 2006 Proxy Statement, incorporated herein by reference. See also Executive Officers of the Registrant under Business in Item 1 hereof.
You can access our code of business conduct and ethics for senior financial executives on our website at www.tsocorp.com, and you may receive a copy, free of charge by writing to Tesoro Corporation, Attention: Investor Relations, 300 Concord Plaza Drive, San Antonio, Texas 78216-6999.
ITEM 11.
ITEM 11.
EXECUTIVE COMPENSATION
Information required under this Item will be contained in the Company’s 2006 Proxy Statement, incorporated herein by reference.
ITEM 12.
ITEM 12.
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Information required under this Item will be contained in the Company’s 2006 Proxy Statement, incorporated herein by reference.
ITEM 13.
ITEM 13.
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information required under this Item will be contained in the Company’s 2006 Proxy Statement, incorporated herein by reference.
ITEM 14.
ITEM 14.
PRINCIPAL ACCOUNTING FEES AND SERVICES
Information required under this Item will be contained in the Company’s 2006 Proxy Statement, incorporated herein by reference.
PART IV
ITEM 15.
ITEM 15.
EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a)1. Financial Statements
The following consolidated financial statements of Tesoro Corporation and its subsidiaries are included in Part II, Item 8 of this Form 10-K:
2. Financial Statement Schedules
No financial statement schedules are submitted because of the absence of the conditions under which they are required or because the required information is included in the consolidated financial statements.
3. Exhibits
*
Filed herewith.

Identifies management contracts or compensatory plans or arrangements required to be filed as an exhibit hereto pursuant to Item 15(a)(3) of Form 10-K.
Schedules not listed above are omitted because of the absence of the conditions under which they are required or because the information required by such omitted schedules is set forth in the financial statements or the notes thereto.
Copies of exhibits filed as part of this Form 10-K may be obtained by stockholders of record at a charge of $0.15 per page, minimum $5.00 each request. Direct inquiries to the Corporate Secretary, Tesoro Corporation, 300 Concord Plaza Drive, San Antonio, Texas, 78216-6999.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized
TESORO CORPORATION
By
/s/ BRUCE A. SMITH
Bruce A. Smith
Chairman of the Board of Directors,
President and Chief Executive Officer
Dated: March 7, 2006
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.