Tesoro Petroleum was set to grow through acquisitions. In 1997 management decided to divest assets related to exploration and production, and focus exclusively on downstream businesses—moving oil through refineries to produce jet fuel, diesel, and gasoline, and operating retail gas stations.
One year later, Tesoro went on a spending spree, paying an aggregate $1.3 billion over the course of three years to expand its refinery portfolio from one to four plants. The company issued common equity, sold convertible preferred bonds, and took on debt to finance its spree, said Gregory Wright, the company’s chief financial officer. “Our debt wasn’t as high as it was about to go, but we were at a point where we had to focus on paying it down.”
Relative success followed. The preferred bonds converted to common stock, and “we had a pretty good looking balance sheet coming into 2001,” Wright added. But the September 11 attacks left the oil business flat, along with Tesoro’s prospects.
Five days before the attacks, Tesoro had closed a $756-million, two-refinery deal with British Petroleum, the third and fourth refinery purchases in the company’s aggressive asset acquisition strategy. “We had structured [the deal] to close with all debt,” noted Wright. The problem, he recalled, was that the company was carrying a 60 percent debt-to-capitalization load, and now faced an uncertain future regarding refining margins.
Things would get worse for the company that now generates $16.5 billion in revenues. The finance chief remembers waking up in the middle of the night wondering if he would be remembered as the “dumbest CFO in America.” Wright sat down with CFO.com recently to recount his tale that involves digging a deep debt hole, splitting collateral, and being rescued by asset-backed lenders.
CFO.com: After the September 11 attacks, airline traffic slowed, jet fuel demand sank, and gasoline sales lagged. Your refining margins were extremely low, and you were running up debt from recent acquisitions. What made you buy another plant?
In early 2002, Valero Energy’s Golden Eagle refinery went up for sale after the Federal Trade Commission told the company it would have to divest the plant to complete a merger. We look at our asset portfolio and realize that this California refinery could be our flagship plant, because California has the highest refining margins around. So we decide to bid on it. It winds up being a $1 billion deal for us, which is quite a bit for a company our size [$5 billion in revenues at the time.]
What was your next financial move?
Having just put a lot of debt on the balance sheet, it was incumbent upon us to push a lot of equity out the door. We got the equity sold, [which caused] the stock to trade down a little, so we topped up the rest with debt. By the time we closed the [Golden Eagle] transaction in May of 2002, we had $2.1 billion of debt on the balance sheet which brought our debt-to-capitalization level to 70 percent—a little high, even for a company that has made recent acquisitions.
Did the credit rating agencies beat you up after looking at your debt load?
Beat us up? No. I think the rating agencies are comfortable allowing debt to go up that high as long as you perform and bring it back down in an expeditious manner. But they put us on credit watch, and ultimately lowered our ratings, which is the proper thing to do. Again, the problem was not the Golden Eagle asset, the problem was the low margin environment in 2002. We weren’t producing enough cash flow to pay down debt. The company’s total cash flow, or EBITDA, in 2001 was approximately $100 million. Last year, the company’s EBITDA, operating with the same group of assets, was $1.2 billion.
How did the debt load affect your access to capital?
At the time we bought Golden Eagle, the best I could do was secure a $250 million revolving credit facility, which I could either borrow or post letters of credit against to buy crude oil [Tesoro’s feedstock]. The covenants around the credit facility were all cash flow related. As I said earlier, we did not have much cash flow that year, so we were immediately in a position of having to amend our credit facility.
How did your trade credit problems affect operations?
Essentially, we were running the company as a cash business in 2002. We were stuck with a small revolver and pre-paying for crude [oil] purchases, which is not the way a refining business should operate. But it was the only way to produce income. At that point our stock price was down to $1.21 because the market has lost confidence in us. It became obvious that we could have continued to operate like [a cash business] and pray for margins to turn around, or we could focus on a financial solution.
You chose the financial solution, no doubt.
Yes, but at first we didn’t think outside of the box. We thought we could probably get a bank, or a group of banks, to set up a letter of credit along side our existing revolver, so we could stop pre-funding our crude purchases with cash. At the time, I had between $100 million to $200 million of cash tied up supporting my trade credit. I thought that if I could spring that cash free, I’d be able to pay down some debt. But the banks wanted collateral for the new letter of credit, and all we had were our refineries.
Did you decide to pledge your refineries as collateral?
I remember waking up in the middle of the night, in early February  thinking that I was about to become the dumbest CFO in America if I went down that path. I was about to take six refineries, with a market value, back then, of nearly $2 billion, and pledge them against maybe a $200 million letter of credit facility. I said that there’s got to be a better way.
I remembered reading about other deals in which companies split their collateral into two pieces. We talked to our lead bank at the time, BankOne which is now JPMorgan, and Goldman Sachs. We proposed replacing most of our debt — both the revolving credit facility, and some the long-term loans — with new debt. The idea was to collateralize new letters of credit with liquid assets, such as inventories and receivables, and use our hard assets to collateralize a loan. [The bankers] came back to us with an asset-backed-loan structure for our credit facility.
At that time, the ABL market was known as a lender of last resort. Did you feel the company was caught in a death spiral?
We were having some problems, but the company wasn’t in severe financial distress. I didn’t really know about the ABL market at the time, but the more we learned about it, the more we thought is was a great structure for the refinery business. Basically, when crude prices are lower, you don’t need to borrow, and have less in the way of a commitment fee to pay. When crude prices are higher, you float up to the top of the commitment. The other important point is that [loan] terms were what I call “covenant light.” It had virtually no covenants, and what they did have were not tied to cash flow.
What were the covenants tied to?
We put up our receivables and inventory as collateral. Also, the guys that lend into [the ABL] market could care less about me as a manager or the company’s strategy and direction. Month-to-month they only care about whether their collateral is there. If you meet your debt service, they are perfectly happy.
How long did it take for the new debt structure to make a difference?
We closed the deal in April of 2003, and suddenly, refining margins started to pick up. I immediately start posting letters of credit to buy crude, and suddenly that cash starts to come back to me [in revenues]. I start paying back more debt, the stock starts moving up, and everything turns around.
What was the key to the turnaround?
We harnessed the power of the collateral, and put it against the right kinds of loans for the company. Before that, we were just being very inefficient about how we looked at our collateral.
What do you mean by inefficient?
If I did it the traditional way, just collateralizing another letter of credit, I still would have had the revolving facility with the cash-flow covenant. In hindsight, that facility was really too small for the business. It was a $250 million revolving credit facility, and today I operate with a $750 million facility.
What is your debt situation now?
Since June 2002, we’ve paid down $2.1 billion of debt. During that time our debt-to-capitalization ratio has dropped from about 69 percent to 36 percent. Our stock is sitting at around $70 today.
Has your job gotten easier since then?
In some sense, the job was easier before. Once we figured out a way to start paying down debt, the next two and a half years were basically consumed with doing just that. The one and only decision that had to be made was which piece of debt were we going to pay down. Last November we paid down all the legacy debt that remained, and refinanced all the other debt. The refinancing took us from a single interest rate of 9 5/8 percent to two tranches of debt, one at 6 1/4 percent and one at 6 5/8 percent, so our interest expense is way down also.
Other than debt service, where is your free cash flow flowing these days?
That’s clearly what shareholders want to know. What we’ve said for quite a while is that we will approach the use of free cash flow in a balance manner. For example, in the Spring of 2005, we announced a [$0.05] dividend on the common stock. Tesoro hasn’t had a dividend on common stock since the early 1980s. We had enough cash flow [last year] that the board was comfortable doubling the dividend in November. The board also agreed to a $200-million share repurchase program, which we have accomplished about half of thus far. And lastly, we will be pursuing capital projects that will produce more cash flow. When we were financially distressed, we only pursued environmental, safety, and reliability projects. Now we’re asking employees to suggest projects that will earn a good return.
Are you anxious to get into an acquisition mode again?
We grew through acquisitions. We would like to continue to grow. But we have to be mindful that its a very different refining margin environment now. [The earlier acquisitions] have already paid for themselves. Today’s refineries, if they are purchased, will be going for much higher prices. As a result, I think you’ll see record prices being paid for refineries, and the people bidding on the assets will have to justify the deal economics by identifying corporate synergies. So we’ll just have to evaluate new refinery acquisitions on a case-by-case basis.