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On Apr 11, 2013, we downgraded independent refiner Tesoro Corp. (TSO - Analyst Report) to Neutral from Outperform, concerned by the Environmental Protection Agency’s (EPA) proposed new gasoline standards. Our revised investment thesis is supported by a Zacks Rank #3 (Hold).

Why the Downgrade?

In an effort to tighten fuel emission norms, the environmental watchdog has asked refiners to curb sulfur content in gasoline by 67% starting from 2017. Compliance with the new rules is expected to push up capital expenditures for downstream operators like Tesoro.

Detailed Analysis

The EPA – in its bid to reduce pollution – has recently outlined a proposal that would require refiners to reduce the amount of sulfur in gasoline by 67% from 2017 onwards. To comply with the new standards, refiners (including Tesoro) will have to increase their capital expenditures, which will adversely impact earnings and cash flows.

Additionally, in terms of geographic diversification, Tesoro’s lack of exposure to the other refining regions in the country weakens its competitive positioning, in our view. The company’s West Coast centric operating footprint and heavy dependence on the weak California market act as major liabilities.

Finally, with refiners being buyers of crude, an increase in oil prices can squeeze their profitability. As a result, with the commodity’s price hovering around $90–95 per barrel, we expect Tesoro’s margins to be negatively impacted due to a rise in the cost of oil it buys to make gas, jet fuel and other refined products.

Partially offsetting these negatives are the scale and diversification benefits afforded by Tesoro’s portfolio of seven refineries, benefits from the impending acquisition of BP Plc’s (BP - Analyst Report) Southern California refinery and a shareholder friendly financial policy.

Stocks that Warrant a Look

While we expect Tesoro to perform in line with its peers and industry levels in the coming months and advice investors to wait for a better entry point before accumulating shares, one can look at Calumet Specialty Products Partners L.P. (CLMT - Snapshot Report) and NGL Energy Partners L.P. (NGL - Snapshot Report) as good buying opportunities. These oil refiners and marketers – sporting a Zacks Rank #1 (Strong Buy) – have solid secular growth stories with potential to rise significantly from current levels.

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