COLUMN-Tesoro doubles down on tricky Calif. oil market: Campbell

Mon Aug 13, 2012 7:31pm IST

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By Robert Campbell

NEW YORK Aug 13 (Reuters) - Independent oil refiner Tesoro Corp is doubling its bet on California, boosting its exposure to a niche oil market where heavy regulation and geographic isolation can make for big profits but also big costs. (Full story: nL4E8JD3BE)

Tesoro said Monday that it would pay $1.18 billion plus the cost of inventories for oil major BP Plc's 266,000-barrel-per-day Carson City refinery and its associated marketing network.

If completed, the transaction would make Tesoro the largest refiner on the U.S. West Coast.

California already has the tightest regulation over oil refineries, and a thicket of new rules has deterred some buyers, according to industry analysts.

The new regulations are believed to be part of the reason why BP has opted to exit the California market while maintaining a presence on the West Coast with another plant in Washington state.

For instance, the oil industry is already blaming California's low-carbon fuels initiative for effectively blocking the import of some Canadian and Russian crudes into the state, which the companies say raises their costs.

The new regulations and a declining market for gasoline have led many industry observers to speculate that more refineries on the U.S. West Coast may be vulnerable to closure.

But for those who know how to operate there, the situation can also be a gold mine, particularly when a competitor suffers an unplanned shutdown.

Twice this year, Los Angeles-area wholesale gasoline prices have traded at 50 cents a gallon over front-month RBOB gasoline futures, as refinery outages spurred panic buying.

Such blowout profits are hard to achieve elsewhere, since opportunities to import needed products are relatively plentiful.

The West Coast, on the other hand, is almost an island. Most South American refineries cannot make fuel that meets California's exacting standards, and plants in Asia that can make California-grade fuel are a long way off by ship.

This geographic isolation cuts both ways: The high cost of operating in California gets painful fast when demand is soft.

Tesoro reported a big loss in the fourth quarter, largely due to weak refining margins in California.

West Coast refineries also have little access to the cheap crude oil produced in the Midwest.

But that keeps the playing field level. Refiners are geographically cut off from cheap crude, but their customers are also cut off from cheap refined products. West Coast refiners operate in a pre-shale world.

SHALE AND OTHER RISKS

This is not to say that the shale oil revolution poses no threat to West Coast plants. Already refineries in West Texas, New Mexico and Utah are chipping away at premium markets in fast-growing states such as Nevada and Arizona.

Holly Energy Partners new UNEV pipeline, for instance, provides direct access to Las Vegas for Utah refiners running cheap Midwestern crude, allowing them to undercut the California fuel that has traditionally supplied that market.

West Coast plants are already trying to tie themselves into the "crude by rail" phenomenon to cut their oil costs, but this may only offer a partial solution.

California refineries also face challenges from other U.S. plants. The new low-carbon fuel rules discourage the use of crude oils that are determined to be "high-carbon intensity" because of the heavy flaring of associated natural gas.

The oils in question include those from Canada's oil sands, Russia and even some Middle Eastern producers such as Oman.

The rules' reach may even extend to oil produced in California, where steam injection is used to extract viscous crude from old fields.

This is problematic, especially given the steady decline in Alaskan oil production, once a major source of crude for the West Coast.

All this may force California refineries to fight each other for a dwindling number of "low-carbon" crudes, which will raise costs and leave the companies vulnerable to being undercut in some markets by out-of-state rivals.

No wonder BP is opting to keep its Washington refinery. It will probably benefit as new rules in California raise operating costs for competitors there.

But there is some hope for California refiners. The state has shale oil potential of its own, and the U.S. Geological Survey has identified a lot of promising acreage in Alaska, where hydraulic fracturing could revive the local industry.

Due to low energy inputs in production, shale oil is likely to avoid being designated "high-carbon," which may offer some relief to West Coast refiners.

However, other environmental obstacles may be considerable in both California and Alaska, although activists may eventually come to see oil from fracking as less menacing than Canadian oil sands.

Given all of the challenges of operating in the region, bulking up is a logical response. Declining fuel demand and higher costs will force some competitors out of business eventually.

That will make it more profitable to operate in California. The big players, led by Tesoro, will probably get bigger.

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