Refining the Business
Will Tesoro's recent acquisition spur a new kind of M&A?
The number alone, 292 stores, was significant. The buyer, Tesoro, a refiner-marketer not known—at least in recent years—for dramatic retail acquisitions, would make this past fall’s deal an attention grabber, shining new light on the role of petroleum supply in c-store M&A. For the San Antonio-based downstream company, the move was a further guarantee of distribution for its refined products, a critical piece of its business model.
In a broader context, Tesoro’s move may be a harbinger of what the refinermarketer paradigm will mean going forward. Just this year, two major integrated companies split their production-exploration and refining-marketing segments so the entities could thrive individually. And with the larger supply infrastructure of pipelines and terminals also changing hands, the competitiveness of gasoline logistics may further shuffle the retail deck.
Tesoro, in many ways, is a classic example of the effect this business model may have on c-store M&A. Without exploration and production ties like those of the major integrated oil companies, Tesoro relies strictly on profit from its seven refineries and its approximately 1,500 retail outlets in the Southwest and West, and Alaska and Hawaii.
So unlike an integrated major who benefits when the price of crude rises, Tesoro stomachs the added cost. “One of the ways we can improve our overall performance is to increase utilization of refineries in ensuring we have outlets for products,” says Mike Marcy, external affairs manager for Tesoro Corp. “[The deal] is just another way to increase integration between the refining and marketing ends of our business.”
Factors driving deals such as Tesoro’s are much like those of other refinermarketers, including the following:
Geographic high ground. Expansion efforts such as this one focus on markets where supply capabilities provide an advantage.
C-stores as a hedge. Annually, the highs and lows of c-store profitability are far more stable and less costly on an operational level than refineries, especially in recent years.
Higher margins. The ability to sell its own higher-margin, branded product helps meet profit projections.
Tesoro’s retail growth is actually a normal stage in the life cycle of any refinermarketer, says Andy Weber, president of Corner Capital Partners, Santa Barbara, Calif. It all starts with brand building. Branded refiners initially supply unbranded product at a cheaper price but eventually move to where the proprietary brand can command a higher dollar. This is a story akin to a fellow San Antonian, Valero, which a decade ago initiated a major expansion of its brand to complement a vibrant unbranded business.
“They (Tesoro) start out moving product in bulk with big accounts, mass retailers and commercial business, and migrate into developing their brand,” Weber says. “So they’re moving away from [selling] in bulk … to [higher] margin channels.”
Having done consulting work with Tesoro, Weber describes the company as “nimble and entrepreneurial,” embracing c-store operations as well as typical oil-company fuel distribution. Prior to the recent retail purchase, the company operated 375 of its own stores, a number that will certainly go up as the company assesses its latest acquisition.
The 2007 purchase of a chain in California helped Tesoro become “far more nimble than you would expect” a refinermarketer to be, Weber says. So much so that today, “they’ve done a good job with coffee and food, and the technological implementation for foodservice.” Other analysts agree. Fadel Gheit, managing director of oil and gas research for Oppenheimer & Co., New York, says the experience of Greg Goff, Tesoro’s president and CEO and a former executive at Houston-based ConocoPhillips, has provided the company with insight into what a refiner-marketer needs to truly thrive.
“[Tesoro is] accelerating their exposure into the marketing side of the business,” says Gheit. “Basically, in order for the company to be fully integrated, they like to balance their refining with their marketing—not being predominantly a refining or a retail [operation].”
This past September, the company announced two separate deals involving Eden Prairie, Minn.-based Supervalu Inc. and Santa Fe Springs, Calif.-based Thrifty Oil Co. that would add 292 locations to its network and boost what it described as its refining and marketing “integration” by 12%.
The emphasis on improving refining capabilities came through in Goff ’s press statement, saying the separate purchase and lease agreements bring “profitable and secure outlets for our refined products,” as well as improve “our company’s overall portfolio of retail assets.”
In the Supervalu deal, Tesoro will purchase 51 Fuel Express stations from the Albertsons grocery chain for $34 million, intending to invest $5 million in branding capital. The stations are in Washington, Oregon, California, Nevada, Idaho, Utah and Wyoming, with total fuel sales of more than 5,000 barrels per day.
In the second deal, Tesoro will lease 241 retail stations from Thrifty for an initial term of 10 years, and it will invest $28 million in branding capital. These sites, in Southern California, yield fuel sales of 25,000 to 30,000 barrels per day. Tesoro will take over the stations during a three-year period, with about 190 in 2012 and the balance of about 50 by 2014.
The majority of both the purchased and leased stations will be marketed under Tesoro’s existing brands, which include Tesoro, Shell and USA gasoline brands.
Despite many major oil companies leaving retail, a good number of refinermarketers have embraced their stores, says Prentiss Searles, marketing issues manager for American Petroleum Institute (API), Washington, D.C. “There are people who have looked up and said, ‘I can run this business,’ ” Searles says. “That’s why it’s an individual decision. It depends on [a company’s] business plan and what they see as profitable. I don’t think anyone would undertake a business they wouldn’t make money on.”
Coming of Age
Tesoro’s evolution into one of the largest independent petroleum refiner-marketers in the western United States truly began three-quarters of the way into its 43-year history. As Weber of Corner Capital pointed out, Tesoro’s history reflects a natural progression that started with a dramatic change in focus in the late 1990s. That’s when the company, founded in 1968, made significant efforts to withdraw from production and exploration and move into downstream; from 1998 to 2002, Tesoro accumulated five more refineries. (See sidebar on p. 98.)
Then 2007 came as a watershed year. Tesoro acquired its Los Angeles refinery and almost 400 retail locations, 139 from Thousand Oaks, Calif.-based USA Gasoline and 250 from Houston-based Shell. Together over the years, the refi nery acquisitions expanded Tesoro’s capacity to approximately 664,000 barrels per day. Expansion of retail was steady and continuous. Weber says the company gained a reputation for creative fi nancing, including joint-venture structures, outright purchases and sale-leaseback deals. “They would do creative transactions that allow them to gain ratable (meaning contracted or booked) throughput for their refi nery,” he says. “They’re not so concerned about the real estate; they just want access to that corner for a long period of time with their brand.” Tesoro got the USA chain after San Ramon, Calif.-based Chevron made a run for the company the year prior. The Federal Trade Commission, fearing less competition and too much market share in the hands of Chevron, quashed the deal.
“That really brought a lot of good people and expertise to what Tesoro does with its merchandising efforts,” Weber says. “They’ve been able to integrate that pretty well … and you’ll fi nd they don’t have as much overhead and are more responsive because they’re smaller” than a major oil company.
The idea that exploration and production should exist separately from refi ning and marketing got a big boost this summer when Marathon Oil and ConocoPhillips announced the split of their assets, with each company creating two stand-alone units. The leaders of both companies said the reason for the split would be long-term value, with the two parts being worth more than the whole.
Part of the reason lies in the capitalintensive nature of refining. “So if you have a profitable c-store chain, those profits can get dried up by the refining company,” says Roger Woodman, managing director of Morgan Keegan, Memphis, Tenn. On the other hand, he says, other refi ner-marketers “enjoy the integrated model.” The creation of stand-alone refi nermarketers in these two cases can only stimulate what many have come to see as an active M&A market, with the new entities seeking to further secure distribution of their refi ned products.
“All the refiners want supply near where their refi neries are, so shipping and transport is less, but also so they can have as many contracted takers for their family of brands,” Weber says, pointing out that Albertsons’ footprint was attractive because Tesoro had refi neries in California, Alaska and Salt Lake City. “They’re trying to have product on both a captive and branded basis so as to increase margin and overall profi tability.”
The pressure to make money comes from all sides, including regulatory. Speaking of refi ners in general, Tupper Hull, vice president of communications for the Western States Petroleum Association, Sacramento, Calif., says a recent rule on emissions regulation in California could “make fuel more expensive and impose additional cost among refiners.” The overall pressure on profitability also makes assets that fit into a refinermarketer’s supply chain compelling. A relatively recent example is the sale of the bankrupt Gas City assets in Chicago, says Tom Kelso, managing director and principal for Matrix Capital Markets Group Inc., Richmond, Va. Alimentation Couche-Tard had been expected to walk away with nearly 50 sites in that auction, but the tables turned: Speedway, which is part of Marathon’s retail arm, swooped in as the highest bidder, taking 27 locations.
“I have to believe everybody is thinking about: How do I increase profitability, or how do I get my product at lower prices?” Kelso says. “How do I gain competitive advantage on the street, either with more cents per gallon or [moving] more gallons than I am today?”
“Sometimes it’s a combination of wanting distribution and not wanting some competitors in certain spaces,” says Dennis Ruben, managing director of NRC Realty & Capital Advisors, Chicago. “Marathon paid dearly to lock up that market.”
The heat is especially turned up for Philadelphia-based Sunoco, which earlier this fall announced the planned sale of its two Pennsylvania refineries, with its intent being to focus on retail.
“We have made progress in increasing the efficiency of our refineries ... but given the unacceptable financial performance of these assets, it is clear that it is in the best interests of shareholders to exit this business and focus on our profitable retail and logistics businesses which have higher returns, growth potential and provide steady, ratable cash flow,” Sunoco CEO Lynn Elsenhans said in a statement.
Essentially, much of the petroleum supply chain is in play, Kelso says, especially after the major-oil pullout of recent years. “When the majors started to divest in retail, they also had gone through and divested their refineries,” he says. “So there are opportunities at a refinery level and the buying and selling of terminal assets. What used to be controlled by major refiners and major oil companies, today they have less interest in.”
As a result, others have come in to link retail networks with refineries, such as Tesoro, Marathon, Delek and, to the degree that logistics are involved, even Sunoco. (See sidebar on p. 97.)
“There are a number of companies, not explorers and producers, but essentially marketers and refiners [whose] … retail networks have an advantage,” Kelso says, citing how much potential exists in refining the petroleum and getting it most efficiently to retail. “The goal is eliminating as much cost and increasing opportunity for profit in that space.”
Where C-Stores Fit
What Kelso and others see going forward is a broad range of investment, not just among retailers but also between retailers and refiners.
“The last couple of years, it’s been about Couche-Tard [trying to buy] Casey’s and the sale of major oils’ [retail assets that have] dominated headlines,” Kelso says. “I think that going forward, there’ll be different dynamics.”
He wouldn’t be surprised if the more established c-store chains investigated refining or supply assets such as terminals. These ventures may not even be exclusively owned, with Kelso envisioning retail chains owning partial interest in refining assets. In other cases, a refiner may opt to invest in a retailer.
“As people want to grow, you’re going to see different types of business combinations,” Kelso says, predicting a lot of activity in the near future. “It’s not going to be one c-store company buying another, but refining, retailing and logistics all partnering to make people more competitive and profitable.”
Amid the larger picture of declining demand for fuel and a growing call for alternative options, Tesoro is taking an aggressive stand, says Weber.
“They’re a regional refiner trying to improve their business and footprint,” he says.
“They’re taking opportunities from the majors or other players by being a direct operator and acquiring direct operations, essentially building in a market that’s flat.”
Tesoro Corp.’s roots in exploration and production eventually evolved downstream. Founded in 1968, the company started out in petroleum exploration and production, but it took on its fi rst refi nery near Kenai, Alaska, the next year. In the late 1990s, Tesoro began what Bruce Smith, its chairman, president and CEO at the time, called its “transformation,” growing through a series of acquisitions and strategic initiatives that began its pull away from exploration and production. The company sold those business segments in 1999, and its marine services in 2003.
At the same time, Tesoro made a series of refi nery acquisitions that boosted its capacity output and positioned it for future expansion in western U.S. growth markets.
In 1998, Tesoro acquired refineries in Kapolei, Hawaii; and Anacortes, Wash. In 2001, the company purchased refineries in Mandan, N.D., and Salt Lake City. In 2002, it was the Golden Eagle refi nery in Martinez, Calif. Its Los Angeles refi nery came from a purchase in 2007 that involved retail locations.