Tesoro Walks the Neutral Lane

We are maintaining our long-term Neutral recommendation on Tesoro Corporation ( TSO - Analyst Report ) , an independent refiner and marketer of refined petroleum products in the western U.S.

The San Antonio, Texas-based company is characterized by a line-up of superior refineries, crude oil supply expansion plans and accretive acquisitions. However, we remain apprehensive about the volatility of the refining business and weak product demand.

We believe that Tesoro enjoys a solid long-term competitive position in the supply-constrained California market, owing to the benefits afforded by its portfolio of seven refineries. Hence, Tesoro remains better positioned to navigate through the current cyclical downturn than most of its peers.

Looking into the coming quarters, management is paying greater attention to improving business processes, reducing operating costs, enhancing the integration of the refining portfolio and investing in organic growth.

Tesoro is currently involved in a number of high-return projects that are expected to be cost effective. These projects will not only boost Tesoro’s competitive position among its peer group, but will also provide significant earnings and cash flow growth visibility.

We also appreciate Tesoro’s strategy of boosting its crude oil supply via rail from the Bakken Shale play in North Dakota to its refinery in Anacortes, Washington (expected to be completed in third quarter 2012). This increased supply capacity will enable the company to accelerate drilling activities and drive higher production in the Bakken Shale as well as strengthen its strong foothold in the energy sector, through the enhancement of its refining and marketing business.

However, with domestic refining fundamentals remaining weak, we are concerned about Tesoro’s performance in the near-to-medium term. The lackluster economic growth in the U.S. poses as a major threat for the domestic refiners, limiting their upside potential.

We also believe that high unemployment in California – Tesoro’s core business region – and excess refining capacity in the U.S. will continue to weigh on the company’s margins.

Additionally, Tesoro exhibits a weak geographic diversification as it lacks exposure to the other refining regions in the country. The company’s West Coast centric operating footprint and heavy dependence on certain market act as major liabilities.

Given these factors, we expect Tesoro shares to perform in line with the broader market. Tesoro operates in the ‘Oil & Gas Refining & Marketing’ sector with other players such as Valero Energy Corp. ( VLO - Analyst Report ) and Western Refining Inc. ( WNR - Analyst Report ) .