In Tesoro's buy of Western Refining, a bet on Texas

Posted by Joseph Keefe November 18, 2016

U.S. oil refiner Tesoro Corp's $4.1 billion purchase of Western Refining Inc is a bet on many things, but above all it may be a bet on Texas.

The largest refining acquisition since 2011, announced earlier on Thursday, will make Tesoro the fourth-biggest U.S. refiner by capacity. The acquisition fills a hole in Tesoro's portfolio by giving it access to pipelines and refineries that connect to Texas' lucrative Permian shale basin. In the formation, lower-cost drilling has helped boost activity substantially as production has rebounded in 2016 after a two-year rout.

The Permian was one of the best-performing shale formations during crude's two-year price rout. This year is expected to be the weakest for U.S. refiners since 2011, when the shale revolution began, due to sinking margins for converting crude to fuel. Access to the region and exposure to its growth is expected to be a boon for Tesoro.

"It fills a gap in Tesoro's midstream business; they didn't have any Permian exposure," said Sam Margolin, an analyst at Cowen & Co. Western's primary business in the formation is gathering - collecting oil from remote fields, pooling it together and bringing it to a hub, he said. The company also processes Permian oil at its El Paso, Texas, refinery.

The acquisition adds refineries in the Southwest and upper Midwest as well as pipelines and gathering systems in basins besides the Permian, such as the Bakken in North Dakota.

Oil rigs operating in the United States hit a seven-year low of 318 rigs in May. Since then, the number has increased by more than 130 rigs, with 85 of those added in the Permian alone, according to Baker Hughes data. Nearly half of the United States' operating oil rigs are in the Permian.

The Permian Basin, located primarily in western Texas, has the lowest break-even costs of the major U.S. shale formations, making drilling there more lucrative and exposure to the basin critical. Some wells are considered profitable with oil trading as low as $30 a barrel, according to Pioneer Natural Resources (PXD), a major driller there.

As oil production in the Delaware basin - a subsection of the Permian - comes online in the next two to three years, outpacing pipeline infrastructure and driving up profit, Western is well-positioned, the company's CEO, Jeff Stevens, told analysts on a conference call.

Tesoro's acquisition reflects the conviction that refiners with pipelines and other logistical assets can be profitable through volatile price cycles of crude oil and refined products.

"The combined scale with the addition of Western's assets will improve our domestic crude oil supply opportunities, and should increase working capital efficiencies for both crude oil and refined products," said Greg Goff, Tesoro's chief executive since 2010, said on the call.

The company's scale will also help brace against challenges in the sector, analysts said. Goff had expanded the company's portfolio even before Thursday's deal, buying two refineries, three logistics units and a biofuels firm.

The deal is the biggest in the sector since 2011, when refiners Holly Corp and Frontier Oil merged.

Western Refining shareholders will receive 0.4350 Tesoro share for each share they own, or $37.30 in cash. The offer is a 22 percent premium to Western's close on Wednesday at $30.50.

The total deal is valued at about $6.4 billion, including about $1.7 billion of Western Refining's debt and $605 million for a noncontrolling interest in Western Refining Logistics LP.