UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2004

OR

For the transition period from                     to                    

Commission File Number 1-3473

TESORO PETROLEUM CORPORATION

300 Concord Plaza Drive, San Antonio, Texas 78216-6999
(Address of principal executive offices) (Zip Code)

210-828-8484
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

There were 66,471,192 shares of the registrant’s Common Stock outstanding at October 29, 2004.

TESORO PETROLEUM CORPORATION AND SUBSIDIARIES

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2004

TABLE OF CONTENTS

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PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

TESORO PETROLEUM CORPORATION AND SUBSIDIARIES

The accompanying notes are an integral part of these condensed consolidated financial statements.

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TESORO PETROLEUM CORPORATION AND SUBSIDIARIES

The accompanying notes are an integral part of these condensed consolidated financial statements.

4

TESORO PETROLEUM CORPORATION AND SUBSIDIARIES

The accompanying notes are an integral part of these condensed consolidated financial statements.

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TESORO PETROLEUM CORPORATION AND SUBSIDIARIES

NOTE A – BASIS OF PRESENTATION

The interim condensed consolidated financial statements and notes thereto of Tesoro Petroleum Corporation (“Tesoro”) and its subsidiaries have been prepared by management without audit pursuant to the rules and regulations of the SEC. Accordingly, the accompanying financial statements reflect all adjustments that, in the opinion of management, are necessary for a fair presentation of results for the periods presented. Such adjustments are of a normal recurring nature. The consolidated balance sheet at December 31, 2003 has been condensed from the audited consolidated financial statements at that date. Certain information and notes normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) have been condensed or omitted pursuant to the SEC’s rules and regulations. However, management believes that the disclosures presented herein are adequate to make the information not misleading. The accompanying condensed consolidated financial statements and notes should be read in conjunction with the consolidated financial statements and notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2003.

We prepare Tesoro’s condensed consolidated financial statements in conformity with U.S. GAAP, which requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods. We review our estimates on an ongoing basis, based on currently available information. Changes in facts and circumstances may result in revised estimates and actual results could differ from those estimates. The results of operations for any interim period are not necessarily indicative of results for the full year.

NOTE B – EARNINGS PER SHARE

We compute basic earnings per share by dividing net earnings by the weighted average number of common shares outstanding during the period. Diluted earnings per share include the effects of potentially dilutive shares, principally common stock options outstanding during the period and restricted stock. Earnings per share calculations are presented below (in millions except per share amounts):

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TESORO PETROLEUM CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE C – OPERATING SEGMENTS

We are an independent refiner and marketer of petroleum products and derive revenues from two operating segments, refining and retail. Prior to 2004, we also had revenues from our marine services operations, which marketed and distributed petroleum products, supplies and services to the marine and offshore exploration and production industries operating in the Gulf of Mexico. We sold substantially all of the marine services physical assets in December 2003.

We evaluate the performance of our segments and allocate resources based primarily on segment operating income. Segment operating income includes those revenues and expenses that are directly attributable to management of the respective segment. Intersegment sales from refining to retail are made at prevailing market rates. Income taxes, interest and financing costs, corporate general and administrative expenses and loss on asset sales and impairments are excluded from segment operating income. Identifiable assets are those assets utilized by the segment. Corporate assets are principally cash and other assets that are not associated with an operating segment. Segment information is as follows (in millions):

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TESORO PETROLEUM CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE D – DEBT

9% Senior Subordinated Notes Due 2008

In March 2004, we amended both our 8% senior secured notes due 2008 and senior secured term loans to permit us to prepay our 9% senior subordinated notes without the limitations previously imposed by the loan documents. On July 1, 2004, we voluntarily prepaid the remaining $297.5 million outstanding principal balance of the 9% senior subordinated notes at a call premium of 3%. The prepayment resulted in a pretax charge during the 2004 third quarter of $16 million, including $9 million for the 3% call premium and $7 million for the write-off of unamortized debt issuance and discount costs.

Senior Secured Term Loans Due 2008

On September 29, 2004, we voluntarily prepaid $100 million of our outstanding $197.5 million senior secured term loans at a prepayment premium of 3%. The prepayment resulted in a pretax charge during the 2004 third quarter of $5 million, including $3 million for the 3% prepayment premium and $2 million for the write-off of unamortized debt issuance costs.

Credit Agreement

In September 2004, we amended our credit agreement to (i) increase its capacity an additional $100 million to $750 million, (ii) modify the amount of permitted restricted payments and subordinated debt repayments and (iii) reduce the applicable margins on revolver borrowings. In addition, the amendment provides the flexibility to obtain up to $250 million in letters of credit outside of the credit agreement for foreign crude oil purchases. The credit agreement was previously amended in May 2004 to increase its capacity by $150 million to $650 million and to extend the term by one year to June 2007.

The credit agreement currently provides for borrowings (including letters of credit) up to the lesser of the agreement’s total capacity, $750 million as amended, or the amount of a periodically adjusted borrowing base ($1.1 billion as of September 30, 2004), consisting of Tesoro’s eligible cash and cash equivalents, receivables and petroleum inventories, as defined. As of September 30, 2004, we had no borrowings and $291 million in letters of credit outstanding under the revolving credit facility, resulting in total unused credit availability of $459 million or 61% of the eligible borrowing

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TESORO PETROLEUM CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

base. Borrowings under the revolving credit facility bear interest at either a base rate (4.75% at September 30, 2004) or a eurodollar rate (1.84% at September 30, 2004), plus an applicable margin. The applicable margins at September 30, 2004 were 0.0% in the case of the base rate and 1.75% in the case of the eurodollar rate and vary based on credit facility availability. Letters of credit outstanding under the revolving credit facility incur fees at an annual rate tied to the eurodollar rate applicable margin, in the range of 1.50% to 1.75% at September 30, 2004.

NOTE E – INVENTORIES

Components of inventories were as follows (in millions):

Inventories valued at LIFO cost were less than replacement cost by approximately $463 million and $210 million, at September 30, 2004 and December 31, 2003, respectively.

NOTE F – PENSION AND OTHER POSTRETIREMENT BENEFITS

Tesoro sponsors defined benefit pension plans, including a funded employee retirement plan, an unfunded executive security plan and an unfunded non-employee director retirement plan. We previously disclosed in the notes to our consolidated financial statements for the year ended December 31, 2003, that we expected to contribute $37 million to our employee retirement pension plan in 2004. During the three months and nine months ended September 30, 2004, Tesoro contributed $41 million and $53 million, respectively, to our pension plan. The additional voluntary contributions were made during the 2004 third quarter to improve the funded status of the plan. We do not anticipate additional contributions during the 2004 fourth quarter. The components of pension benefit expense included in the condensed consolidated statements of operations were (in millions):

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TESORO PETROLEUM CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Other postretirement benefit expense presented for the 2004 periods below includes the effects of the federal subsidy as defined in the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“the Act”). See Note I for further information regarding the effects of the Act and the federal subsidy. The components of postretirement benefit expense included in the condensed consolidated statements of operations were (in millions):

NOTE G – STOCK-BASED COMPENSATION

Effective January 1, 2004, we adopted the preferable fair value method of accounting for stock-based compensation, as prescribed in Statement of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation.” We selected the “modified prospective method” of adoption described in SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure.” We recognized compensation cost as if the fair value method of SFAS No. 123 had been applied from its original effective date, resulting in pretax charges during the three months and nine months ended September 30, 2004 of $2.1 million and $4.7 million, respectively.

Prior to January 1, 2004, we accounted for stock-based compensation using the intrinsic value method prescribed in Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. Accordingly, we measured compensation cost for stock options as the excess, if any, of the quoted market price of Tesoro’s common stock at the date of grant over the amount an employee must pay to acquire the stock. The following table represents the effect on net earnings and earnings per share as if we had applied the fair value method and recognition provisions of SFAS No. 123 (in millions except per share amounts):

For purposes of the pro forma disclosures above, we amortized the estimated fair value of stock options granted over the vesting period using the straight-line method. The fair value of each option was estimated on the date of grant using the Black-Scholes option-pricing model.

Restricted Stock

Pursuant to our 1993 Amended and Restated Executive Long-term Incentive Plan, we may grant restricted shares of our common stock to eligible employees subject to certain terms and conditions. In March 2004, we issued 250,000 shares of restricted stock to our chief executive officer pursuant to a December 2003 award. The shares vest in 20% annual increments beginning in February 2005, assuming continued employment at the vesting dates. In connection with our chief executive officer’s employment contract, we also issued an additional 250,000 shares of restricted stock during 2004 of which 50,000 shares were issued during the 2004 third quarter to match common stock he purchased during 2004. The matching restricted

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TESORO PETROLEUM CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

shares vest in December 2008, assuming continued employment at that date. In addition to the restricted shares issued to our chief executive officer as described above, we issued an additional 158,150 shares of restricted stock to our chief executive officer and other executives during the 2004 third quarter. These restricted shares vest in annual increments ratably over three years beginning in 2005, assuming continued employment at the vesting dates.

The total amount of restricted shares that can be awarded, pursuant to the Amended and Restated Executive Long-term Incentive Plan, is 1.5 million shares of which 1.0 million shares had been issued through September 30, 2004. The aggregate fair value of restricted stock on the dates of award of $12.7 million was recorded in the condensed consolidated balance sheet as unearned compensation, a separate component of stockholders’ equity, and is being amortized on a straight-line basis over the applicable vesting periods. For the nine months ended September 30, 2004, amortization related to our restricted stock totaled $1.2 million.

NOTE H – COMMITMENTS AND CONTINGENCIES

We are a party to various litigation and contingent loss situations, including environmental and income tax matters, arising in the ordinary course of business. Where required, we have made accruals in accordance with SFAS No. 5, “Accounting for Contingencies,” in order to provide for these matters. We cannot predict the ultimate effects of these matters with certainty, and we have made related accruals based on our best estimates, subject to future developments. We believe that the outcome of these matters will not result in a material adverse effect on our liquidity and consolidated financial position, although the resolution of certain of these matters could have a material adverse impact on interim or annual results of operations.

Tesoro is subject to audits by federal, state and local taxing authorities in the normal course of business. It is possible that tax audits could result in claims against Tesoro in excess of recorded liabilities. We believe, however, that when these matters are resolved, they will not materially affect Tesoro’s consolidated financial position or results of operations.

Tesoro is subject to extensive federal, state and local environmental laws and regulations. These laws, which change frequently, regulate the discharge of materials into the environment and may require us to remove or mitigate the environmental effects of the disposal or release of petroleum or chemical substances at various sites, install additional controls, or make other modifications or changes in use for certain emission sources.

Environmental Liabilities

As previously reported, we were involved with the EPA regarding a waste disposal site near Abbeville, Louisiana. Tesoro was named a potentially responsible party under the Federal Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA” or “Superfund”) at this location. The site was removed from the EPA’s National Priority List and the EPA entered into a settlement with third parties to remediate the site. Based on these considerations and recent discussions with the EPA, we believe that the likelihood that this matter will have any impact on our results of operations or financial position is remote.

We are currently involved in remedial responses and have incurred and expect to continue to incur cleanup expenditures associated with environmental matters at a number of sites, including certain of our owned properties. At September 30, 2004, our accruals for environmental expenses totaled approximately $35 million. Our accruals for environmental expenses include retained liabilities for previously owned or operated properties, refining, pipeline, terminal and marine services operations and retail service stations. We believe these accruals are adequate, based on currently available information, including the participation of other parties or former owners in remediation action.

Tesoro is continuing to negotiate a settlement of approximately 70 notices of violation (“NOVs”) issued by the Bay Area Air Quality Management District. The NOVs allege various violations of air quality requirements at the California refinery between May 2002 and February 2004. Tesoro is negotiating a settlement of this matter with the Bay Area Quality Management District and reserves for the settlement of the NOVs are included in the accruals

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TESORO PETROLEUM CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

totaling approximately $35 million referenced above. The reserves for this matter are not material and we believe that the resolution of this matter will not have a material adverse effect on our results of operations or financial position.

Other Environmental Matters

In the ordinary course of business, we become party to or otherwise involved in lawsuits, administrative proceedings and governmental investigations, including environmental, regulatory and other matters. Large and sometimes unspecified damages or penalties may be sought from us in some matters for which the likelihood of loss may be reasonably possible but the amount of loss is not currently estimable, and some matters may require years for us to resolve. As a result, we have not established reserves for these matters and we cannot provide assurance that an adverse resolution of one or more of the matters described below during a future reporting period will not have a material adverse effect on our financial position or results of operations in future periods. However, on the basis of existing information, we believe that the resolution of these matters, individually or in the aggregate, will not have a material adverse effect on our financial position or results of operations.

As previously disclosed, we were a defendant in eleven pending cases alleging MTBE contamination in groundwater. In October 2004 we were named as a defendant in two additional pending cases. As of June 30, 2004, we were no longer a defendant in four of the previously filed cases. The remaining plaintiffs are generally water providers, governmental authorities and private well owners alleging that refiners and suppliers of gasoline containing MTBE are liable for manufacturing or distributing a defective product. All but one of these cases were filed after September 30, 2003 in anticipation of a draft federal energy bill that contained provisions for MTBE liability protection. We are being sued primarily as a refiner, supplier and marketer of gasoline containing MTBE along with other refining industry companies. The suits generally seek individual, unquantified compensatory and punitive damages and attorney’s fees but we cannot estimate the amount or the likelihood of the ultimate resolution of these matters at this time, and accordingly have not established a reserve for these cases. We believe we have defenses to these claims and intend to vigorously defend the lawsuits.

Soil and groundwater conditions at our California refinery may require substantial expenditures over time. In connection with our acquisition of the California refinery from Ultramar, Inc. in May 2002, Ultramar assigned certain of its rights and obligations that Ultramar had acquired from Tosco Corporation in August of 2000. Tosco assumed responsibility and contractually indemnified us for up to $50 million for certain environmental liabilities arising from operations at the refinery prior to August of 2000, which are identified prior to August 31, 2010 (“Pre-Acquisition Operations”). Based on existing information, we currently estimate that the environmental liabilities arising from Pre-Acquisition Operations are approximately $43 million, including soil and groundwater conditions at the refinery in connection with various projects and including those required by the California Regional Water Quality Control Board and other government agencies. If we incur remediation liabilities in excess of the environmental liabilities for Pre-Acquisition Operations indemnified by Tosco, we expect to be reimbursed for such excess liabilities under certain environmental insurance policies. The policies provide $140 million of coverage in excess of the $50 million indemnity covering environmental liabilities arising from Pre-Acquisition Operations. Because of Tosco’s indemnification and the environmental insurance policies, we have not established a reserve for environmental liabilities arising out of the Pre-Acquisition Operations. In December 2003, we initiated arbitration proceedings against Tosco seeking damages, indemnity and a declaration that Tosco is responsible for the environmental liabilities arising from Pre-Acquisition Operations at our California refinery.

In November 2003, we filed suit in Contra Costa County Superior Court against Tosco alleging that Tosco misrepresented, concealed and failed to disclose certain additional environmental conditions at our California refinery. On March 1, 2004, the court granted Tosco’s motion to compel arbitration of our claims for these certain additional environmental conditions. In the arbitration proceedings we initiated against Tosco in December 2003, we are also seeking a determination that Tosco is liable for investigation and remediation of these certain additional environmental conditions, the amount of which is currently unknown and therefore a reserve has not been established, and which may not be covered by the $50 million indemnity for environmental liabilities arising from Pre-Acquisition Operations. In response to our arbitration claims, Tosco filed counterclaims in the Contra Costa County Superior Court action alleging that we are contractually responsible for certain environmental liabilities at our California refinery, including certain

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TESORO PETROLEUM CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

liabilities arising from Pre-Acquisition Operations. We are continuing to vigorously prosecute our claims against Tosco and to oppose Tosco’s claims against us, although we cannot provide assurance that we will prevail.

Environmental Capital Expenditures

EPA regulations related to the Clean Air Act require reductions in the sulfur content in gasoline, which began January 1, 2004. To meet the revised gasoline standard, we currently estimate we will make capital improvements of approximately $38 million through 2008, and an additional $8 million beyond 2008, of which approximately $2 million has been spent during 2004. This will permit each of our six refineries to produce gasoline meeting the sulfur limits imposed by the EPA.

EPA regulations related to the Clean Air Act also require reductions in the sulfur content in diesel fuel manufactured for on-road consumption. In general, the new diesel fuel standards will become effective on June 1, 2006. Based on our latest engineering estimates, we expect to spend approximately $54 million in capital improvements through 2006, of which approximately $13 million has been spent during 2004.

In May 2004, the EPA issued a rule regarding the sulfur content of non-road diesel fuel. The requirements of this rule, which will become effective in phases between 2007 and 2012, will reduce non-road diesel sulfur content. The cost to comply with the new non-road diesel fuel regulation is subject to review and analysis by Tesoro, and is not included in our $54 million capital improvement estimate to meet the regulations related to on-road diesel fuel.

We expect to spend approximately $45 million in capital improvements through 2006 to comply with the Maximum Achievable Control Technologies standard for petroleum refineries (“Refinery MACT II”), of which $17 million has been spent during 2004. These regulations require new emission controls at certain processing units at our refineries, including the North Dakota refinery and the Washington refinery.

In connection with our 2001 acquisition of our North Dakota and Utah refineries, Tesoro assumed the sellers’ obligations and liabilities under a consent decree among the United States, BP Exploration and Oil Co. (“BP”), Amoco Oil Company and Atlantic Richfield Company. BP entered into this consent decree for both the North Dakota and Utah refineries for various alleged violations. As the owner of these refineries, Tesoro is required to address issues, including leak detection and repair, flaring protection and sulfur recovery unit optimization. We currently estimate we will spend $7 million to comply with this consent decree, in addition to expenditures for the installation of new emission control equipment at the North Dakota refinery to meet the Refinery MACT II regulations described above. We also agreed to indemnify the sellers for all losses of any kind incurred in connection with the consent decree.

In connection with the 2002 acquisition of our California refinery, subject to certain conditions, Tesoro also assumed the seller’s obligations pursuant to settlement efforts with the EPA concerning the Section 114 refinery enforcement initiative under the Clean Air Act, except for any potential monetary penalties, which the seller retains. We believe these obligations will not have a material impact on Tesoro’s financial position or results of operations.

We will need to spend additional capital at the California refinery for reconfiguring and replacing above-ground storage tank systems and upgrading piping within the refinery. We estimate that we may spend an additional $92 million through 2008, of which $5 million has been spent during 2004. This cost estimate is subject to further review and analysis.

Conditions may develop that cause increases or decreases in future expenditures for various Tesoro sites, including, but not limited to, our refineries, tank farms, retail gasoline stations (operating and closed locations) and petroleum product terminals, and for compliance with the Clean Air Act and other federal, state and local requirements. We cannot currently determine the amounts of such future expenditures.

Other

Union Oil Company of California has asserted claims against other refining companies for infringement of patents related to the production of certain reformulated gasoline. Our California refinery produces grades of gasoline that may

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TESORO PETROLEUM CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

be subject to similar claims. We have not paid or accrued liabilities for patent royalties that may be related to our California refinery’s production, since the U.S. Patent Office and the Federal Trade Commission are evaluating the validity of those patents. We believe that the resolution of this matter will not have a material adverse effect on our results of operations or financial position.

Claims Against Third-Parties

Beginning in the early 1980s, Tesoro Hawaii Corporation, Tesoro Alaska Company and other fuel suppliers entered a series of long-term, fixed-price fuel supply contracts with the U.S. Defense Energy Support Center (“DESC”). Each of the contracts contained a provision for price adjustments by the DESC. However, the Federal Acquisition Regulations (“FAR”) limit how prices may be adjusted, and Tesoro and many of the other suppliers in separate suits in the Court of Federal Claims currently are seeking relief from the DESC’s price adjustments. Tesoro and the other suppliers allege that the DESC’s price adjustments violated FAR by not adjusting the price of fuel based on changes to the suppliers’ established prices or costs, as FAR requires. Tesoro and the other suppliers seek recovery of over $2.5 billion in underpayment for fuel. Tesoro’s share of the underpayment currently totals approximately $165 million, plus interest. The DESC responded to Tesoro’s and the other suppliers’ claims by moving for partial summary judgment. In response, Tesoro and the other suppliers cross-moved for partial summary judgment. The Court of Federal Claims granted partial summary judgment for Tesoro, held that the DESC’s fuel prices were illegal, and rejected the DESC’s assertion that Tesoro waived its right to a remedy by entering into the contracts. However, some of the other judges in the same court ruled on the cross-motions for other suppliers in conflict with the holding for Tesoro. As a result, Tesoro petitioned the Court of Appeals for the Federal Circuit to review its claims. Tesoro is seeking the Court of Appeals’ validation that the price adjustments were illegal and Tesoro did not waive its right to sue when it entered into the contracts. Tesoro expects the court to issue its decision in the first or second quarter of 2005, but Tesoro cannot predict the outcome of its claims against the DESC.

In December of 1996, Tesoro Alaska Company filed a protest of the intrastate rates charged for the transportation of its crude oil through the Trans Alaska Pipeline System (“TAPS”). Tesoro’s protest asserted that the TAPS intrastate rates were excessive and should be reduced. The Regulatory Commission of Alaska (“RCA”) opened RCA Docket No. P-97-4 to consider Tesoro’s protest of the intrastate rates for the years 1997 through 2000. Through RCA’s Order P-97-4(151), the RCA set just and reasonable final rates for the years 1997 through 2000, and held that Tesoro is entitled to receive approximately $41 million in refunds, including interest calculated as of December 31, 2003. RCA Order P-97-4(151) is currently on appeal, and we cannot give any assurances of when or whether we will prevail in the appeal.

NOTE I – NEW ACCOUNTING STANDARDS

FAS 106-1 and FAS 106-2

Tesoro sponsors a postretirement health care plan that provides prescription drug benefits. In December 2003, the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the “Act”) was passed. The Act introduces a prescription drug benefit under Medicare (Medicare Part D), as well as a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D. In January 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. FAS 106-1, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (“FAS 106-1”), which became effective for us as of December 31, 2003 and permitted an election to reflect the effects of the Act immediately or defer recognition of the Act until more definitive guidance is issued. In May 2004, the FASB issued FASB Staff Position No. FAS 106-2 (“FAS 106-2”) which provides guidance for the accounting of the federal subsidy. Further, the new accounting standard required FAS 106-1 to be superseded upon the effective date of FAS 106-2, which was July 1, 2004 for Tesoro. In accordance with FAS 106-1 and FAS 106-2, we deferred recognition of the Act through June 30, 2004. On July 1, 2004, we elected the “prospective application” of adoption for the recognition of the federal subsidy as defined in FAS 106-2. The effect of recognizing the federal subsidy in accordance with FAS 106-2 will result in an annual reduction of postretirement benefit expense of approximately $1 million.

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TESORO PETROLEUM CORPORATION AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

FIN 46 and FIN 46(R)

In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), which requires the consolidation of variable interest entities, as defined. Our implementation of FIN 46 did not result in the consolidation of any variable interest entities. In December 2003, the FASB issued Interpretation No. 46 (Revised) (“FIN 46(R)”), which provides additional guidance related to accounting for variable interest entities and became effective for us at the end of the 2004 first quarter. Implementation of FIN 46(R) did not require consolidation of any variable interest entities.

Statement of Position

In September 2003, the American Institute of CPAs Accounting Standards Executive Committee (“AcSEC”) approved for issuance a Statement of Position (“SOP”), “Accounting for Certain Costs and Activities Related to Property, Plant and Equipment,” subject to clearance by the FASB. On April 14, 2004, the FASB unanimously decided not to approve the issuance of the proposed SOP. The proposed SOP would have, among other provisions, required major maintenance activities, such as refinery turnarounds, to be expensed as incurred. AcSEC will not spend any further time on this project, and the FASB does not have definitive plans to consider the issues addressed in the proposed SOP.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Those statements in this section that are not historical in nature should be deemed forward-looking statements that are inherently uncertain. See “Forward-Looking Statements” on page 27 for a discussion of the factors that could cause actual results to differ materially from those projected in these statements.

BUSINESS STRATEGY AND OVERVIEW

Our strategy is to create a geographically focused, value-added refining and marketing business that has (i) economies of scale, (ii) a low-cost structure, (iii) superior management information systems and (iv) outstanding employees focused on operational excellence in a global market, and that seeks to provide stockholders with competitive returns in any economic environment. For 2004, our goals are focused on:

•

Improving profitability by achieving greater efficiencies;

•

Using cash flows from operations to further reduce debt; and

•

Allocating capital and turnaround spending: to maintain safe, reliable operations meeting EPA Clean Air Act standards; to high return, low cost projects; and to further development of systems and people.

During the first nine months of 2004, we achieved the following significant results relative to our 2004 goals, which are further described below under “Results of Operations” and “Capital Resources and Liquidity”:

•

Operating income improved by $377 million to $683 million compared to the first nine months of 2003, reflecting improved refined product margins, together with achieving greater operating efficiencies.

•

We used cash flows from operations to prepay both our $297.5 million outstanding principal balance of the 9% senior subordinated notes due 2008 and $100 million of our outstanding $197.5 million senior secured term loans during the 2004 third quarter, resulting in annual pretax interest savings of approximately $34 million.

•

Our capital and turnaround spending totaled approximately $110 million, of which $34 million was for Clean Air Act projects and $29 million was for reliability and safety projects.

Several factors during the first nine months of 2004 positively impacted industry margins, including improved economic fundamentals in the U.S. and Far East, heavy refining industry turnaround activity in the western U.S. during the 2004 first quarter and recent changes in product specifications. Increased demand and below average inventory levels for finished products resulted in significantly higher than average industry margins in all of our refining regions. Industry margins during the third quarter of 2004 averaged below the 2004 second quarter due to rising crude oil prices and higher finished products inventory levels reflecting reduced product demand growth. Overall, industry margins during the first nine months of 2004 in our market areas averaged above our five-year average (January 1, 1999 through December 31, 2003). We determine our “five-year average” by comparing gasoline, diesel and jet fuel prices to crude oil prices in our market areas, with volumes weighted according to our typical refinery yields, excluding heavy fuel oils. Our net earnings for the first nine months also benefited from lower interest expense as a result of debt reduction and refinancing during 2003 and additional debt prepayments in the 2004 third quarter.

Our earnings and cash flows from operations depend upon many factors, including the production and sale of refined products at margins above fixed and variable expenses. The prices of crude oil and refined products have fluctuated substantially in our markets. Our operating results can be significantly influenced by the timing of changes in crude oil costs and how quickly refined product prices adjust to reflect these changes. These price fluctuations depend on numerous factors beyond our control, including the demand for crude oil, gasoline and other refined products, which is subject to, among other things, changes in the economy and the level of foreign and domestic production of crude oil and refined products, worldwide political conditions, threatened or actual terrorist incidents or acts of war, availability of crude oil and refined product imports, the infrastructure to transport crude oil and refined products, weather conditions, earthquakes and other natural disasters, seasonal variations, government regulations and local factors, including market conditions and the level of operations of other refineries in our markets. As a result of these factors, margin fluctuations during any reporting period can have a significant impact on our results of operations, cash flows and financial position.

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RESULTS OF OPERATIONS – THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED WITH THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2003

Summary

Our net earnings were $65 million ($0.98 per basic share and $0.93 per diluted share) for the three months ended September 30, 2004 (“2004 Quarter”), compared with net earnings of $71 million ($1.09 per basic and diluted share) for the three months ended September 30, 2003 (“2003 Quarter”). For the year-to-date periods, our net earnings were $328 million ($5.02 per basic share and $4.79 per diluted share) for the nine months ended September 30, 2004 (“2004 Period”), compared with net earnings of $84 million ($1.30 per basic and diluted share) for the nine months ended September 30, 2003 (“2003 Period”). The decrease in net earnings for the 2004 Quarter reflect the financing costs associated with our voluntary debt prepayments as further discussed below, partly offset by an increase in refining operating income from improved throughput levels. During the 2004 Period, the significant increase in net earnings was primarily due to (i) higher refined product margins, (ii) increased throughput levels, (iii) lower interest expense as a result of the debt reduction and refinancing during 2003 and additional debt prepayments in the 2004 Quarter, and (iv) our continued focus on improving refining operating efficiencies. Net earnings for the 2004 Quarter and 2004 Period included debt prepayment and financing costs of $21 million pretax ($0.18 per share) and $23 million pretax ($0.20 per share), respectively. Net earnings for the 2003 Quarter and 2003 Period included the write-off of unamortized debt issuance costs of $3 million pretax ($0.03 per share) and $36 million pretax ($0.35 per share), respectively. The 2003 Quarter results also included a loss of $8 million pretax ($0.07 per share) on the sale of our marine services assets. In the 2003 Period, voluntary early retirement benefits and severance costs resulted in pretax charges of $9 million ($0.09 per share). A discussion and analysis of the factors contributing to our results of operations is presented below. The accompanying condensed consolidated financial statements, together with the following information, are intended to provide investors with a reasonable basis for assessing our historical operations, but should not serve as the only criteria for predicting our future performance.

Refining Segment

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Three Months Ended September 30, 2004 Compared with Three Months Ended September 30, 2003. Operating income from our refining segment was $187 million in the 2004 Quarter compared to $176 million for the 2003 Quarter. The $11 million increase in our operating income was primarily due to higher throughput and product sales volumes. Total gross refining margins remained flat at $8.27 per barrel in the 2004 Quarter compared to $8.24 per barrel in the 2003 Quarter. Industry margins on a national basis declined during the 2004 Quarter compared to the first six months of 2004, primarily due to increased production, rising crude oil prices and higher average inventory levels for finished products reflecting reduced growth in product demand. However, improved economic fundamentals in the U.S. and Far East continued to support above average industry margins.

On an aggregate basis, our total gross refining margins increased from $377 million in the 2003 Quarter to $403 million in the 2004 Quarter, reflecting higher refining throughput in all of our regions except for the California refinery, which began a scheduled turnaround in early September 2004. Due to the scheduled downtime at the California refinery, the percentage of lower cost heavy crude oil that we processed of total refining throughput decreased from 55% in the 2003 Quarter to 45% in the 2004 Quarter. We estimate that our refining operating income would have been approximately $34 million higher had the California refinery been fully operational during September. In addition, our refining margins at our Pacific Northwest refineries were negatively impacted during the 2004 Quarter as the increased differential between light and heavy crude oil depressed the margins for heavy oils. Total refining throughput averaged 535 thousand barrels per day (“Mbpd”) in the 2004 Quarter, an increase of 30 Mbpd or 6% from the 2003 Quarter despite the California turnaround. In the 2003 Quarter, our North Dakota refinery experienced reduced throughput during a planned major maintenance turnaround.

Revenues from sales of refined products increased 48% to $3.1 billion in the 2004 Quarter, from $2.1 billion in the 2003 Quarter, primarily due to significantly higher product sales prices and slightly higher product sales volumes. Our average product prices increased 34% to $55.11 per barrel and total product sales increased by 8% to 614 Mbpd in the 2004 Quarter from the 2003 Quarter. Costs of sales also increased, compared with the 2003 Quarter, primarily due to higher average feedstock prices and increased product sales volumes. Expenses, excluding depreciation and amortization, increased to $186 million in the 2004 Quarter, compared with $171 million in the 2003 Quarter, primarily due to increased maintenance, utilities and employee costs.

Nine Months Ended September 30, 2004 Compared with Nine Months Ended September 30, 2003. Operating income from our refining segment increased to $766 million in the 2004 Period compared to $357 million for the 2003 Period. The $409 million increase in our operating income primarily resulted from significantly higher refined product margins, combined with higher throughput levels and product sales volumes. Our total gross refining margin per barrel increased 38% to $9.73 per barrel in the 2004 Period compared to $7.04 per barrel in the 2003 Period, reflecting higher per-barrel refining margins in all of our regions. Industry margins on a national basis improved primarily due to increased demand and below average inventory levels for finished products, although margins during the 2004 Quarter decreased as described above. Improved economic fundamentals in the U.S. and Far East have resulted in increased demand and margins for finished products and reduced finished product inventory levels. Also, heavy refining industry

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turnaround activity in the western “PADD V” region during the first quarter of 2004 reduced finished product inventory levels on the U.S. West Coast.

On an aggregate basis, our total gross refining margins increased from $939 million in the 2003 Period to $1.4 billion in the 2004 Period, reflecting higher per-barrel refining margins in all of our regions and higher total refining throughput volumes. Total refining throughput averaged 523 Mbpd in the 2004 Period, an increase of 34 Mbpd or 7% from the 2003 Period, despite a scheduled turnaround at our California refinery, which began in early September 2004 and unscheduled downtime in the 2004 first quarter due to a short-term power outage and accelerated maintenance of the hydrogen plant. In the 2003 Period, our North Dakota, Utah and Alaska refineries experienced reduced throughput during planned major maintenance turnarounds.

Revenues from sales of refined products increased 35% to $8.4 billion in the 2004 Period, from $6.2 billion in the 2003 Period, primarily due to significantly higher product sales prices and slightly higher product sales volumes. Our average product prices increased 28% to $51.68 per barrel and total product sales increased by 6% to 596 Mbpd in the 2004 Period from the 2003 Period. Costs of sales also increased primarily due to higher average feedstock prices and higher product sales volumes as compared with the 2003 Period. Expenses, excluding depreciation and amortization, increased to $531 million in the 2004 Period, from $493 million in the 2003 Period, primarily due to increased maintenance, utilities and employee costs.

Retail Segment

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Three Months Ended September 30, 2004 Compared with Three Months Ended September 30, 2003. Operating income for our retail segment was $1 million in the 2004 Quarter, compared to operating income of $7 million in the 2003 Quarter. Total gross margins decreased to $31 million during the 2004 Quarter from $37 million in the 2003 Quarter reflecting lower fuel margins per gallon and lower sales volumes. Fuel margin decreased to $0.15 per gallon in the 2004 Quarter from $0.18 per gallon in the 2003 Quarter, reflecting higher prices of purchased fuel. Total gallons sold decreased to 136 million from 145 million, reflecting the decrease in average station count to 537 in the 2004 Quarter from 570 in the 2003 Quarter. The decrease in average station count reflects our continued rationalization of retail assets.

Revenues on fuel sales increased to $237 million in the 2004 Quarter, from $213 million in the 2003 Quarter, reflecting increased sales prices, partly offset by lower sales volumes. Costs of sales increased in the 2004 Quarter due to higher prices of purchased fuel, partly offset by lower sales volumes.

Nine Months Ended September 30, 2004 Compared with Nine Months Ended September 30, 2003. Operating loss for our retail segment was $5 million in the 2004 Period, compared to operating income of $9 million in the 2003 Period. Total gross margins decreased to $85 million during the 2004 Period, from $101 million in the 2003 Period, reflecting lower fuel margins per gallon and lower sales volumes. Fuel margin decreased to $0.15 per gallon in the 2004 Period from $0.17 per gallon in the 2003 Period, reflecting higher prices of purchased fuel. Total gallons sold decreased to 388 million from 439 million, reflecting the decrease in average station count to 543 in the 2004 Period from 579 in the 2003 Period due to our continued rationalization of retail assets.

Revenues on fuel sales increased to $646 million in the 2004 Period versus $617 million in the 2003 Period, reflecting increased sales prices, primarily offset by lower sales volumes. Costs of sales increased in the 2004 Period due to higher prices of purchased fuel, primarily offset by lower sales volumes.

Marine Services

In December 2003, we sold substantially all of the physical assets of marine services. Marine services operations had become increasingly immaterial, as compared to our primary refining and retail operations, and we believe that the sale of marine services assets is not significant to the historical or ongoing comparability of our primary operating results or financial position. Operating income from marine services was $2 million and $5 million for the 2003 Quarter and 2003 Period, respectively. See Note C in our condensed consolidated financial statements in Item 1 for summarized financial information related to marine services during the 2003 Quarter and 2003 Period.

Selling, General and Administrative Expenses

Selling, general and administrative expenses totaled $38 million and $107 million for the 2004 Quarter and 2004 Period, respectively, compared to $28 million and $99 million for 2003 Quarter and 2003 Period, respectively. The 2004 Quarter and 2004 Period, as compared to the 2003 Quarter and 2003 Period, included an additional $4 million and $16 million, respectively, of stock-based compensation and other incentive based compensation, as well as higher professional fees. The 2003 Period included an $8 million charge for voluntary early retirement benefits and severance costs. See Note G of the condensed consolidated financial statements in Item 1 for further information regarding the adoption of the fair value method of accounting for stock options during 2004 and the recent grants of restricted stock.

Interest and Financing Costs

Interest and financing costs amounted to $53 million and $136 million in the 2004 Quarter and 2004 Period, respectively, compared to $46 million and $171 million for the 2003 Quarter and 2003 Period, respectively. The increase during the 2004 Quarter was due to expensing premiums and unamortized debt issuance costs totaling $21 million associated with our voluntary debt prepayments totaling $397.5 million, partly offset by lower interest expense associated with debt reduction during the 2004 Quarter and 2003 Period. The decrease during the 2004 Period was due primarily to the write-off of $36 million of unamortized debt issuance costs in the 2003 Period and lower interest expense as discussed above, partly offset by financing costs totaling $23 million incurred during the 2004 Period.

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Income Tax Provision

The income tax provision totaled $43 million and $219 million for the 2004 Quarter and 2004 Period, respectively, compared to an income tax provision of $43 million and $51 million for the 2003 Quarter and 2003 Period, respectively. The increase in the 2004 Period reflects higher earnings before income taxes. The combined federal and state effective income tax rate was 40% and 38% for the 2004 Period and 2003 Period, respectively.

CAPITAL RESOURCES AND LIQUIDITY

Overview

Our primary sources of liquidity have been cash flows from operations and borrowing availability under revolving lines of credit. We believe available capital resources will be adequate to meet our capital expenditures, working capital and debt service requirements. We ended the third quarter of 2004 with $209 million of cash and cash equivalents. During the first nine months of 2004, we have paid $49 million of estimated federal and state income tax payments. We did not have any borrowings under our revolving credit facility during the 2004 Quarter. As of September 30, 2004, we had $459 million in available borrowing capacity under our credit agreement after $291 million in outstanding letters of credit. As further described below, we prepaid our $297.5 million outstanding principal balance of our 9% senior subordinated notes and $100 million of our outstanding $197.5 million senior secured term loans during the 2004 Quarter. The prepayments will result in annual pretax interest savings of approximately $34 million. Since May 2002, including the debt prepayments during the 2004 Quarter, we have reduced debt by nearly $900 million, decreasing our debt to capitalization ratio from 69% at June 30, 2002 to 48% at September 30, 2004.

We operate in an environment where our capital resources and liquidity are impacted by changes in the price of crude oil and refined petroleum products, availability of trade credit, market uncertainty and a variety of additional factors beyond our control. These risks include, among others, the level of consumer product demand, weather conditions, fluctuations in seasonal demand, governmental regulations, worldwide political conditions and overall market and economic conditions. See “Forward-Looking Statements” on page 27 for further information related to risks and other factors. Our future capital expenditures, as well as borrowings under our credit agreement and other sources of capital, will be affected by these conditions.

Capitalization

Our capital structure at September 30, 2004 was comprised of the following (in millions):

At September 30, 2004, our debt to capitalization ratio was 48% compared with 62% at year-end 2003, reflecting voluntary prepayments and scheduled payments of debt totaling $400 million and net earnings of $328 million during the 2004 Period.

Our credit agreement, senior secured term loans and senior notes impose various restrictions and covenants on us that could potentially limit our ability to respond to market conditions, raise additional debt or equity capital, or take advantage of business opportunities.

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9% Senior Subordinated Notes Due 2008

In March 2004, we amended both our 8% senior secured notes due 2008 and senior secured term loans to permit us to prepay our 9% senior subordinated notes without the limitations previously imposed by the loan documents. On July 1, 2004, we voluntarily prepaid the remaining $297.5 million outstanding principal balance of the 9% senior subordinated notes at a call premium of 3%. The prepayment resulted in a pretax charge during the 2004 third quarter of $16 million, including $9 million for the 3% call premium and $7 million for the write-off of unamortized debt issuance and discount costs.

Senior Secured Term Loans Due 2008

On September 29, 2004, we voluntarily prepaid $100 million of our outstanding $197.5 million senior secured term loans at a prepayment premium of 3%. The prepayment resulted in a pretax charge during the 2004 third quarter of $5 million, including $3 million for the 3% prepayment premium and $2 million for the write-off of unamortized debt issuance costs.

Credit Agreement

In September 2004, we amended our credit agreement to (i) increase its capacity an additional $100 million to $750 million, (ii) modify the amount of permitted restricted payments and subordinated debt repayments and (iii) reduce the applicable margins on revolver borrowings. In addition, the amendment provides the flexibility to obtain up to $250 million in letters of credit outside of the credit agreement for foreign crude oil purchases. The credit agreement was previously amended in May 2004 to increase its capacity by $150 million to $650 million and to extend the term by one year to June 2007.

The credit agreement currently provides for borrowings (including letters of credit) up to the lesser of the agreement’s total capacity, $750 million as amended, or the amount of a periodically adjusted borrowing base ($1.1 billion as of September 30, 2004), consisting of Tesoro’s eligible cash and cash equivalents, receivables and petroleum inventories, as defined. As of September 30, 2004, we had no borrowings and $291 million in letters of credit outstanding under the revolving credit facility, resulting in total unused credit availability of $459 million, or 61% of the eligible borrowing base. Borrowings under the revolving credit facility bear interest at either a base rate (4.75% at September 30, 2004) or a eurodollar rate (1.84% at September 30, 2004), plus an applicable margin. The applicable margins at September 30, 2004 were 0.0% in the case of the base rate and 1.75% in the case of the eurodollar rate and vary based on credit facility availability. Letters of credit outstanding under the revolving credit facility incur fees at an annual rate tied to the eurodollar rate applicable margin, in the range of 1.50% to 1.75% at September 30, 2004.

Cash Flow Summary

Components of our cash flows are set forth below (in millions):

Net cash from operating activities during the 2004 Period totaled $623 million, compared to $370 million from operating activities in the 2003 Period. The increase was primarily due to significantly improved earnings. Net cash used in investing activities of $85 million in the 2004 Period was primarily for capital expenditures. Net cash used in financing activities primarily reflects the debt prepayments made during the 2004 Quarter. Gross borrowings and repayments under the revolving credit facility amounted to $112 million during the 2004 Period, all of which occurred during the 2004 first quarter. Working capital totaled $417 million at September 30, 2004 compared to $337 million at

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year-end 2003, as a result of increases in cash and cash equivalents, receivables and inventories, partially offset by increases in payables, attributable to increases in sales volumes and crude and product prices.

Historical EBITDA

EBITDA represents earnings before interest and financing costs, income taxes, and depreciation and amortization. We present EBITDA because we believe some investors and analysts use EBITDA to help analyze our liquidity including our ability to satisfy principal and interest obligations with respect to our indebtedness and to use cash for other purposes, including capital expenditures. EBITDA is also used by some investors and analysts to analyze and compare companies on the basis of operating performance. EBITDA is also used for internal analysis and as a component of the fixed charge coverage financial covenant in our credit agreement. EBITDA should not be considered as an alternative to net earnings, earnings before income taxes, cash flows from operating activities, or any other measure of financial performance presented in accordance with accounting principles generally accepted in the United States of America. EBITDA may not be comparable to similarly titled measures used by other entities. Our historical EBITDA reconciled to net cash from operating activities was (in millions):

Historical EBITDA as presented above differs from EBITDA as defined under our credit agreement. The primary differences are non-cash postretirement benefit costs and loss on asset sales and impairments, which are added to net earnings under the credit agreement EBITDA calculations.

Capital Expenditures and Refinery Turnaround Spending

During the 2004 Period, our capital expenditures totaled $86 million, which included $43 million for clean air, clean fuels and other environmental projects, and $24 million for refinery improvements at our California refinery (excluding environmental projects). We spent $24 million during the 2004 Period for refinery turnaround and other major maintenance costs, primarily for the scheduled turnaround at our California refinery which began in early September.

During the remainder of 2004, we expect our capital expenditures to approximate $100 million to $110 million (excluding refinery turnaround and other major maintenance costs). Our estimated capital expenditures for the remainder of 2004 include $80 million in the refining segment, comprising $20 million for clean air and clean fuels projects and $60 million for other refinery projects, of which $25 million is related to the California refinery (excluding environmental projects). We expect to spend approximately $25 million during the remainder of 2004 for refinery turnaround and other major maintenance costs primarily related to the completion of our California turnaround which began in early September. Our 2005 capital spending budget is currently estimated to be $260 million, including refinery turnaround and other major maintenance costs.

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Fourth Quarter 2004 Outlook

Industry margins in October and early November continue to be higher than the industry average as product demand, although seasonally lower, continues to remain strong. Based on current market conditions, we expect a profitable fourth quarter despite the fact that our fourth quarter refining operating income will be reduced by approximately $60 to $65 million due to scheduled turnarounds at our California refinery.

Environmental and Other

Tesoro is subject to extensive federal, state and local environmental laws and regulations. These laws, which change frequently, regulate the discharge of materials into the environment and may require us to remove or mitigate the environmental effects of the disposal or release of petroleum or chemical substances at various sites, install additional controls, or make other modifications or changes in use for certain emission sources.

Environmental Liabilities

As previously reported, we were involved with the EPA regarding a waste disposal site near Abbeville, Louisiana. Tesoro was named a potentially responsible party under the Federal Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA” or “Superfund”) at this location. The site was removed from the EPA’s National Priority List and the EPA entered into a settlement with third parties to remediate the site. Based on these considerations and recent discussions with the EPA, we believe that the likelihood that this matter will have any impact on our results of operations or financial position is remote.

We are currently involved in remedial responses and have incurred and expect to continue to incur cleanup expenditures associated with environmental matters at a number of sites, including certain of our owned properties. At September 30, 2004, our accruals for environmental expenses totaled approximately $35 million. Our accruals for environmental expenses include retained liabilities for previously owned or operated properties, refining, pipeline, terminal and marine services operations and retail service stations. We believe these accruals are adequate, based on currently available information, including the participation of other parties or former owners in remediation action.

Tesoro is continuing to negotiate a settlement of approximately 70 notices of violation (“NOVs”) issued by the Bay Area Air Quality Management District. The NOVs allege various violations of air quality requirements at the California refinery between May 2002 and February 2004. Tesoro is negotiating a settlement of this matter with the Bay Area Quality Management District and reserves for the settlement of the NOVs are included in the accruals totaling approximately $35 million referenced above. The reserves for this matter are not material and we believe that the resolution of this matter will not have a material adverse effect on our results of operations or financial position.

Other Environmental Matters

As previously disclosed, we were a defendant in eleven pending cases alleging MTBE contamination in groundwater. In October 2004 we were named as a defendant in two additional pending cases. As of June 30, 2004, we were no longer a defendant in four of the previously filed cases. The remaining plaintiffs are generally water providers, governmental authorities and private well owners alleging that refiners and suppliers of gasoline containing MTBE are liable for manufacturing or distributing a defective product. All but one of these cases were filed after September 30, 2003 in anticipation of a draft federal energy bill that contained provisions for MTBE liability protection. We are being sued primarily as a refiner, supplier and marketer of gasoline containing MTBE along with other refining industry companies. The suits generally seek individual, unquantified compensatory and punitive damages and attorney’s fees, but we cannot estimate the amount or the likelihood of the ultimate resolution of these matters at this time, and accordingly have not established a reserve for these cases. We believe we have defenses to these claims and intend to vigorously defend the lawsuits.

Soil and groundwater conditions at our California refinery may require substantial expenditures over time. In connection with our acquisition of the California refinery from Ultramar, Inc. in May 2002, Ultramar assigned certain of its rights and obligations that Ultramar had acquired from Tosco Corporation in August of 2000. Tosco assumed responsibility and contractually indemnified us for up to $50 million for certain environmental liabilities arising from operations at the refinery prior to August of 2000, which are identified prior to August 31, 2010 (“Pre-Acquisition

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Operations”). Based on existing information, we currently estimate that the environmental liabilities arising from Pre-Acquisition Operations are approximately $43 million, including soil and groundwater conditions at the refinery in connection with various projects and including those required by the California Regional Water Quality Control Board and other government agencies. If we incur remediation liabilities in excess of the environmental liabilities for Pre-Acquisition Operations indemnified by Tosco, we expect to be reimbursed for such excess liabilities under certain environmental insurance policies. The policies provide $140 million of coverage in excess of the $50 million indemnity covering environmental liabilities arising from Pre-Acquisition Operations. Because of Tosco’s indemnification and the environmental insurance policies, we have not established a reserve for environmental liabilities arising out of the Pre-Acquisition Operations. In December 2003, we initiated arbitration proceedings against Tosco seeking damages, indemnity and a declaration that Tosco is responsible for the environmental liabilities arising from Pre-Acquisition Operations at our California refinery.

In November 2003, we filed suit in Contra Costa County Superior Court against Tosco alleging that Tosco misrepresented, concealed and failed to disclose certain additional environmental conditions at our California refinery. On March 1, 2004, the court granted Tosco’s motion to compel arbitration of our claims for these certain additional environmental conditions. In the arbitration proceedings we initiated against Tosco in December 2003, we are also seeking a determination that Tosco is liable for investigation and remediation of these certain additional environmental conditions, the amount of which is currently unknown and therefore a reserve has not been established, and which may not be covered by the $50 million indemnity for environmental liabilities arising from Pre-Acquisition Operations. In response to our arbitration claims, Tosco filed counterclaims in the Contra Costa County Superior Court action alleging that we are contractually responsible for certain environmental liabilities at our California refinery, including certain liabilities arising from Pre-Acquisition Operations. We are continuing to vigorously prosecute our claims against Tosco and to oppose Tosco’s claims against us, although we cannot provide assurance that we will prevail.

Environmental Capital Expenditures

EPA regulations related to the Clean Air Act require reductions in the sulfur content in gasoline, which began January 1, 2004. To meet the revised gasoline standard, we currently estimate we will make capital improvements of approximately $38 million through 2008, and an additional $8 million beyond 2008, of which approximately $2 million has been spent during 2004. This will permit each of our six refineries to produce gasoline meeting the sulfur limits imposed by the EPA.

EPA regulations related to the Clean Air Act also require reductions in the sulfur content in diesel fuel manufactured for on-road consumption. In general, the new diesel fuel standards will become effective on June 1, 2006. Based on our latest engineering estimates, we now expect to spend approximately $54 million in capital improvements through 2006, of which approximately $13 million has been spent during 2004.

In May 2004, the EPA issued a rule regarding the sulfur content of non-road diesel fuel. The requirements of this rule, which will become effective in phases between 2007 and 2012, will reduce non-road diesel sulfur content. The cost to comply with the new non-road diesel fuel regulation is subject to review and analysis by Tesoro, and is not included in our $54 million capital improvement estimate to meet the regulations related to on-road diesel fuel.

We expect to spend approximately $45 million in capital improvements through 2006 to comply with the Maximum Achievable Control Technologies standard for petroleum refineries (“Refinery MACT II”), of which $17 million has been spent during 2004. These regulations require new emission controls at certain processing units at our refineries, including the North Dakota refinery and the Washington refinery.

In connection with our 2001 acquisition of our North Dakota and Utah refineries, Tesoro assumed the sellers’ obligations and liabilities under a consent decree among the United States, BP Exploration and Oil Co. (“BP”), Amoco Oil Company and Atlantic Richfield Company. BP entered into this consent decree for both the North Dakota and Utah refineries for various alleged violations. As the owner of these refineries, Tesoro is required to address issues, including leak detection and repair, flaring protection and sulfur recovery unit optimization. We currently estimate we will spend $7 million to comply with this consent decree, in addition to expenditures for the installation of new emission control equipment at the North Dakota refinery to meet the MACT II regulations described above. We also agreed to indemnify the sellers for all losses of any kind incurred in connection with the consent decree.

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In connection with our 2002 acquisition of our California refinery, subject to certain conditions, Tesoro also assumed the seller’s obligations pursuant to settlement efforts with the EPA concerning the Section 114 refinery enforcement initiative under the Clean Air Act, except for any potential monetary penalties, which the seller retains. We believe these obligations will not have a material impact on Tesoro’s financial position or results of operations.

We will need to spend additional capital at the California refinery for reconfiguring and replacing above-ground storage tank systems and upgrading piping within the refinery. We estimate that we may spend an additional $92 million through 2008, of which approximately $5 million has been spent during 2004. This cost estimate is subject to further review and analysis.

Conditions may develop that cause increases or decreases in future expenditures for various Tesoro sites, including, but not limited to, our refineries, tank farms, retail gasoline stations (operating and closed locations) and petroleum product terminals, and for compliance with the Clean Air Act and other federal, state and local requirements. We cannot currently determine the amounts of such future expenditures.

Other

Union Oil Company of California has asserted claims against other refining companies for infringement of patents related to the production of certain reformulated gasoline. Our California refinery produces grades of gasoline that may be subject to similar claims. We have not paid or accrued liabilities for patent royalties that may be related to our California refinery’s production, since the U.S. Patent Office and the Federal Trade Commission are evaluating the validity of those patents. We believe that the resolution of this matter will not have a material adverse effect on our results of operations or financial position.

FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are included throughout this Form 10-Q and relate to, among other things, expectations regarding refining margins, revenues, cash flows, capital expenditures, turnaround expenses and other financial items. These statements also relate to our business strategy, goals and expectations concerning our market position, future operations, margins and profitability. We have used the words “anticipate”, “believe”, “could”, “estimate”, “expect”, “intend”, “may”, “plan”, “predict”, “project”, “will” and similar terms and phrases to identify forward-looking statements in this Quarterly Report on Form 10-Q.

Although we believe the assumptions upon which these forward-looking statements are based are reasonable, any of these assumptions could prove to be inaccurate and the forward-looking statements based on these assumptions could be incorrect. Our operations involve risks and uncertainties, many of which are outside our control, and any one of which, or a combination of which, could materially affect our results of operations and whether the forward-looking statements ultimately prove to be correct.

Actual results and trends in the future may differ materially from those suggested or implied by the forward-looking statements depending on a variety of factors including, but not limited to:

•		changes in general economic conditions;
•		the timing and extent of changes in commodity prices and underlying demand for our products;
•		the availability and costs of crude oil, other refinery feedstocks and refined products;
•		changes in our cash flow from operations;
•		changes in the cost or availability of third-party vessels, pipelines and other means of transporting feedstocks and products;
•		disruptions due to equipment interruption or failure at our facilities or third-party facilities;
•		actions of customers and competitors;
•		changes in capital requirements or in execution of planned capital projects;
•		availability of trade credit;
•		increased interest rates and the condition of the capital markets;

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•		direct or indirect effects on our business resulting from actual or threatened terrorist incidents or acts of war;
•		political developments in foreign countries;
•		changes in our inventory levels and carrying costs;
•		seasonal variations in demand for refined products;
•		changes in fuel and utility costs for our facilities;
•		state and federal environmental, economic, safety and other policies and regulations, any changes therein, and any legal or regulatory delays or other factors beyond our control;
•		adverse rulings, judgments, or settlements in litigation or other legal or tax matters, including unexpected environmental remediation costs in excess of any reserves;
•		weather conditions affecting our operations or the areas in which our products are marketed; and
•		earthquakes or other natural disasters affecting operations.

Many of these factors are described in greater detail in our filings with the SEC. All future written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the previous statements. We undertake no obligation to update any information contained herein or to publicly release the results of any revisions to any forward-looking statements that may be made to reflect events or circumstances that occur, or that we become aware of, after the date of this Quarterly Report on Form 10-Q.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Changes in commodity prices and interest rates are our primary sources of market risk. We have a risk management committee responsible for managing risks arising from transactions and commitments related to the sale and purchase of energy commodities.

Commodity Price Risks

Our earnings and cash flows from operations depend on the margin above fixed and variable expenses (including the costs of crude oil and other feedstocks) at which we are able to sell refined products. The prices of crude oil and refined products have fluctuated substantially in recent years. These prices depend on many factors, including the demand for crude oil, gasoline and other refined products, which in turn depend on, among other factors, changes in the economy, the level of foreign and domestic production of crude oil and refined products, worldwide political conditions, threatened or actual terrorist incidents or acts of war, the availability of imports of crude oil and refined products, the marketing of alternative and competing fuels and the impact of government regulations. The prices we receive for refined products are also affected by local factors such as local market conditions and the level of operations of other refineries in our markets.

The prices at which we sell our refined products are influenced by the commodity price of crude oil. Generally, an increase or decrease in the price of crude oil results in a corresponding increase or decrease in the price of gasoline and other refined products. The timing of the relative movement of the prices, however, can impact profit margins which could significantly affect our earnings and cash flows. In addition, the majority of our crude oil supply contracts are short-term in nature with market-responsive pricing provisions. Our financial results can be affected significantly by price level changes during the period between purchasing refinery feedstocks and selling the manufactured refined products from such feedstocks. We also purchase refined products manufactured by others for resale to our customers. Our financial results can be affected significantly by price level changes during the periods between purchasing and selling such products. Assuming all other factors remained constant, a $1.00 per barrel change in average gross refining margins based on our 2004 year-to-date average throughput of 523 Mbpd would change annualized pretax operating income by approximately $191 million.

We maintain inventories of crude oil, intermediate products and refined products, the values of which are subject to fluctuations in market prices. Our inventories of refinery feedstocks and refined products totaled 22.8 million barrels and 18.8 million barrels at September 30, 2004 and December 31, 2003, respectively. The average LIFO cost of our refinery feedstocks and refined products as of September 30, 2004 was approximately $28.50 per barrel. If market

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prices for refined products decline to a level below the average cost of these inventories, we may be required to write down the carrying value of our inventory.

We periodically enter into derivative type arrangements on a limited basis as part of our programs to acquire refinery feedstocks at reasonable costs and to manage margins on certain refined product sales. We also engage in limited non-hedging activities which are marked-to-market. Gains and losses on these transactions, including changes in the fair value of derivative instruments, are recognized in earnings. During the third quarter of 2004, we settled futures and options contracts, which due to significant price volatility resulted in losses of $18 million, primarily for 6 million barrels of crude oil and 2 million barrels of heating oil. At September 30, 2004, we recorded an unrealized mark-to-market loss of approximately $15 million primarily for 3 million barrels of open crude oil futures contracts due to significant price volatility.

Interest Rate Risk

At September 30, 2004, we had $97.5 million of outstanding floating-rate debt under our senior secured term loans and $1.1 billion of fixed-rate debt. The interest rate on our floating-rate debt was 7.26% at September 30, 2004, 5.5% of which was fixed. The impact on annual cash flow of an additional 1% (100 basis points) in the floating-rate component for our senior secured term loans would be approximately $1 million.

The fair market values of our senior secured loans, senior secured notes and senior subordinated notes are based on transactions and bid quotes. The fair market values of our junior subordinated notes and capital lease obligations approximate their carrying values. The fair market values of our fixed and variable rate debt were approximately $121 million and $4 million, respectively, more than their carrying values at September 30, 2004.

ITEM 4. CONTROLS AND PROCEDURES

We carried out an evaluation required by the Securities Exchange Act of 1934, as amended (the “Exchange Act”), under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Rule Ba-15 under the Exchange Act as of the end of the period. Based upon that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to the Company and required to be included in our periodic filings under the Exchange Act. During the period covered by this report, there have been no changes in our internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

As previously disclosed, we were a defendant in eleven pending cases alleging MTBE contamination in groundwater. In October 2004 we were named as a defendant in two additional pending cases. As of June 30, 2004, we were no longer a defendant in four of the previously filed cases. The remaining plaintiffs are generally water providers, governmental authorities and private well owners alleging that refiners and suppliers of gasoline containing MTBE are liable for manufacturing or distributing a defective product. All but one of these cases were filed after September 30, 2003 in anticipation of a draft federal energy bill that contained provisions for MTBE liability protection. We are being sued primarily as a refiner, supplier and marketer of gasoline containing MTBE along with other refining industry companies. The suits generally seek individual, unquantified compensatory and punitive damages and attorney’s fees, but we cannot estimate the amount or the likelihood of the ultimate resolution of these matters at this time, and accordingly have not established a reserve for these cases. We believe we have defenses to these claims and intend to vigorously defend the lawsuits.

ITEM 6. EXHIBITS

(a)

Exhibits

31.1		Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1		Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2		Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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EXHIBIT INDEX

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