The overall refining industry has been going through a fortunate phase, with the overall increase in prices along with the oversupply conditions due to the mid-continent oil boom. This supply glut seen in the accumulation of inventories of Cushing, Oklahoma and the WTI-Brent Spread will be relieved in due course. Nonetheless the refineries with geographically favorable locations will continue to have access to cheaper crude in the short term. Even as the oversupply conditions ease out, the refining industry only stands to gain.

Tesoro Corporation (NYSE:TSO) has been one of the biggest gainers from the aforementioned conditions and has already returned nearly 80% returns (ttm) over the past year.

Refining Is the Key

Tesoro operates via two main business segments: refining and retailing transportation fuels. It has seven refineries in the US with a total capacity of around 665,000 bpd, refining crude oil, gasoline, jet fuel, liquefied petroleum gas, etc. The retail operation consists of more than 1,200 stations under several marques, comprising Tesoro, Shell, and USA Gasoline, and sells transportation fuel and products in 18 states. The bulk of Tesoro’s revenue, $29 billion, comes from its refining operation, which accounts for more than 95% of the total revenue. In 2011, the refining business generated nearly $1.18 billion of the company’s operating income, while the retail business could only make around $89 million in operating profit.

WTI Brent and Bakken Spreads

The refiners rode the wave of the WTI Brent spread to new heights, especially those who could refine a larger percentage of WTI priced crude. This has also resulted in these refiners enjoying higher crack spreads. Tesoro’s North Dakota and Utah facilities refine advantageous feedstock coming out of the mid-continent region. This has also helped Tesoro complete an expansion of its North Dakota refinery by some 68,000 bpd in the previous quarter, effectively doubling the capacity of the refinery.

Tesoro is already transporting Bakken crude to its refinery in Anacortes, Washington. Transportation costs come out to roughly $9.75/barrel to Washington. Tesoro is planning to rail Bakken crude to Carson, California, which would cost $14/barrel. Since the Brent Bakken spread is around $25, Bakken is even more profitable for refiners than WTI, even considering the higher transportation costs.

Thinning Spreads

Recently, even WTIC crack spreads have contracted, and eventually these crack spreads will converge to Brent crack spreads, which have also narrowed of late.

The spread between WTI and Brent is always at risk. The Brent WTI Spread has been fluctuating between $10 and $27 in the past two years and has recently lowered to $17. Again, WTI is not going to price lower than Brent forever. The Seaway pipeline, which was reversed during 2012 to lessen excess supply in Cushing, will start taking effect in 2013. It is also expected that capacity will increase almost three-fold, from 150,000 bpd to 400,000 bpd. Apart from this, a similar project is being planned to expand capacity to around 850,000 bpd by mid-2014. Once these capacities come online, the current WTI Brent spreads will get nullified, and WTI feedstock will once again be priced at about the same as Brent.

Not only has the WTI based crack spread narrowed, but the Brent-based crack spread has also fallen steeply and has recently seen a substantial weakening. This deterioration is not yet accounted for in the refiners' estimates, and it's likely that this spread compression has not yet been factored into the prices of the stocks.