Back to GetFilings.com

Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended June 30, 2003

OR

For the transition period from              to             

Commission file number 1-6841

SUNOCO, INC.

(Exact name of registrant as specified in its charter)

TEN PENN CENTER, 1801 MARKET STREET, PHILADELPHIA, PA 19103-1699

(Address of principal executive offices)

(Zip Code)

(215) 977-3000

(Registrant’s telephone number, including area code)

NOT APPLICABLE

(Former name, former address and former fiscal year, if changed since last report)

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.    YES  x    NO  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    YES  x    NO  ¨

At June 30, 2003, there were 76,930,470 shares of Common Stock, $1 par value outstanding.

Table of Contents

SUNOCO, INC.

INDEX

Table of Contents

PART I

FINANCIAL INFORMATION

Item 1. Financial Statements

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

Sunoco, Inc. and Subsidiaries

(Millions of Dollars and Shares Except Per Share Amounts)

(See Accompanying Notes)

1

Table of Contents

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

Sunoco, Inc. and Subsidiaries

(Millions of Dollars and Shares Except Per Share Amounts)

(See Accompanying Notes)

2

Table of Contents

CONDENSED CONSOLIDATED BALANCE SHEETS

Sunoco, Inc. and Subsidiaries

(Millions of Dollars)

(See Accompanying Notes)

3

Table of Contents

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

Sunoco, Inc. and Subsidiaries

(Millions of Dollars)

(See Accompanying Notes)

4

Table of Contents

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

The accompanying condensed consolidated financial statements are presented in accordance with the requirements of Form 10-Q and accounting principles generally accepted in the United States for interim financial reporting. They do not include all disclosures normally made in financial statements contained in Form 10-K. In management’s opinion, all adjustments necessary for a fair presentation of the results of operations, financial position and cash flows for the periods shown have been made. All such adjustments are of a normal recurring nature except for the provision for write-down of assets and other matters (Note 4). Results for the three and six months ended June 30, 2003 are not necessarily indicative of results for the full year 2003.

Cokemaking Operations

In July 2002, Sunoco transferred an additional interest in its Indiana Harbor cokemaking operations to a third-party investor for $215 million in cash. Since 1995, Sunoco has received $724 million in exchange for interests in its Indiana Harbor and Jewell cokemaking operations in four separate transactions. Sunoco did not recognize any gain at the dates of these transactions as the third-party investors are entitled to a preferential return on their investments, currently equal to 98 percent of the cash flows and tax benefits from the respective cokemaking operations, during a preferential return period which continues until they recover their investments and achieve a cumulative return that averages approximately 10 percent after tax thereon. Income is recognized as coke production and sales generate cash flows and tax benefits which are allocated to Sunoco and the third-party investors, while expense is recognized to reflect the investors’ preferential returns.

The preferential return period for the Jewell operation is expected to end in 2011. The preferential return period for the first investor in the Indiana Harbor operation ended in July 2002, at which time the first investor’s interest in the cash flows and tax benefits from Indiana Harbor decreased from 95 percent to 5 percent. As a result of the additional investment in July 2002, third-party investors’ interests increased from 5 percent to 98 percent. The new investor’s preferential return period for the Indiana Harbor operation is expected to end in 2007. The estimated lengths of these preferential return periods are based upon the Company’s current expectations of future operations, including sales volumes and prices, raw material and operating costs and capital expenditure levels. Better-than-expected results will shorten the investors’ preferential return periods, while lower-than-expected results will lengthen the periods.

After these preferential return periods, the investor in the Jewell operation will be entitled to a minority interest in the cash flows and tax benefits from Jewell amounting to 18 percent, while the investors in the Indiana Harbor operation will be entitled to a minority interest in the cash flows and tax benefits from Indiana Harbor initially amounting to 34 percent and declining to 10 percent by 2038.

5

Table of Contents

The following table sets forth the minority interest balances and the changes in these balances attributable to the third-party investors’ interests in cokemaking operations for the six-month periods ended June 30, 2003 and 2002 (in millions of dollars):

__________

In each of the four transactions in which the Company transferred interests in its cokemaking operations to third-party investors, Sunoco has provided tax indemnifications to the third parties for certain tax benefits allocated to them during the preferential return periods. In certain of these cases, the Company also has the option to purchase the third-party investors’ interests. These indemnifications would require the Company to make payments in the event the Internal Revenue Service disallows the tax deductions and benefits allocated to the third parties or if there is a change in the tax laws that reduces the amount of nonconventional fuel tax credits which would be available to them. These tax indemnifications are in effect until the applicable tax returns are no longer subject to Internal Revenue Service review. Although the Company believes it is remote that it will be required to make any payments under these indemnifications, at June 30, 2003, the maximum potential payment under the tax indemnifications and the options to purchase the third-party investors’ interests, if exercised, would have been approximately $860 million. If this were to occur, the minority interest balance would be reduced by approximately $310 million.

Logistics Operations

On February 8, 2002, the Company contributed a substantial portion of its Logistics business to Sunoco Logistics Partners L.P., a master limited partnership formed in 2001 (the “Partnership”), in exchange for a 73.2 percent limited partnership interest, a 2 percent general partnership interest, incentive distribution rights and a special distribution, representing the net proceeds from the Partnership’s issuance of $250 million of ten-year 7.25 percent senior notes. The Partnership concurrently issued 5.75 million limited partnership units, representing a 24.8 percent interest in the Partnership, in an initial public offering at a price of $20.25 per unit. Proceeds from the offering were used by the Partnership to establish working capital that was not contributed to the Partnership by Sunoco. Sunoco liquidated this retained working capital subsequent to the

6

Table of Contents

Partnership’s formation. The accounts of the Partnership continue to be included in Sunoco’s consolidated financial statements. No gain or loss was recognized on this transaction.

Concurrent with the offering, Sunoco entered into various agreements with the Partnership which require Sunoco to pay for minimum storage and throughput usage of certain Partnership assets. These agreements also establish fees for administrative services provided by Sunoco to the Partnership and indemnifications by Sunoco for certain environmental, toxic tort and other liabilities.

The following table sets forth the minority interest balance and the changes to this balance attributable to the third-party investors’ interests in Sunoco Logistics Partners L.P. for the six-month periods ended June 30, 2003 and 2002 (in millions of dollars):

__________

Asset Retirement Obligations

Effective January 1, 2003, Sunoco adopted the provisions of Statement of Financial Accounting Standards No. 143, “Accounting for Asset Retirement Obligations” (“SFAS No. 143”). This statement significantly changed the method of accruing for costs that an entity is legally obligated to incur associated with the retirement of fixed assets. Under SFAS No. 143, the fair value of a liability for an asset retirement obligation is recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The associated asset retirement costs are capitalized as part of the carrying amount of the fixed asset and depreciated over its estimated useful life. Prior to January 1, 2003, a liability for an asset retirement obligation was recognized using a cost-accumulation measurement approach.

In conjunction with the adoption of SFAS No. 143 in January 2003, Sunoco recorded an increase in asset retirement obligations of $5 million and a related increase in net properties, plants and equipment of $3 million related to certain of its branded marketing retail sites, coal and cokemaking facilities and chemical assets. The $2 million cumulative effect of this accounting change ($1 million after tax) has been included in cost of products sold and operating expenses in the condensed consolidated statement of operations. Sunoco did not

7

Table of Contents

reflect the $1 million after-tax charge as a cumulative effect of accounting change as it was not material. Other than the cumulative effect, this change did not have a significant impact on Sunoco’s results of operations during the first half of 2003. At June 30, 2003, Sunoco’s liability for asset retirement obligations amounted to $8 million. Sunoco has legal asset retirement obligations for several other assets, including its refineries, pipelines and terminals, for which it is not possible to estimate when the obligations will be settled. Consequently, the retirement obligations for these assets cannot be measured at this time.

Exit or Disposal Activities

In July 2002, Statement of Financial Accounting Standards No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“SFAS No. 146”), was issued. SFAS No. 146 supersedes Emerging Issues Task Force (“EITF”) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. SFAS No. 146 also establishes fair value as the objective for initial measurement of the liability. The provisions of SFAS No. 146 are effective for exit or disposal activities that are initiated after December 31, 2002. Under prior accounting principles, certain costs associated with restructuring plans were recognized as of the date of commitment to the plan. This new standard had no impact on Sunoco’s condensed consolidated financial statements during the first half of 2003.

Guarantees

In November 2002, FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FASB Interpretation No. 45”), was issued. The accounting recognition provisions of FASB Interpretation No. 45 became effective January 1, 2003 on a prospective basis. They require that a guarantor recognize, at the inception of a guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. Under prior accounting principles, a guarantee would not have been recognized as a liability until a loss was probable and reasonably estimable. Adoption of the accounting recognition provisions of FASB Interpretation No. 45 had no impact on Sunoco’s condensed consolidated financial statements during the first half of 2003.

Stock-Based Compensation

During the fourth quarter of 2002, Sunoco adopted the fair value method of accounting for employee stock compensation plans as prescribed by Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” and amended by Statement of Financial Accounting Standards No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure” (“SFAS No. 148”). The Company recognized $6 million of expense ($4 million after tax) in 2002 for all unvested stock options attributable to the vesting that occurred in 2002, retroactive to January 1, 2002, using the “modified prospective method” transition rules of SFAS No. 148. Of this amount,

8

Table of Contents

$3 million ($2 million after tax) was recognized in the first half of 2002. Prior to January 1, 2002, the Company followed the intrinsic value method of accounting for employee stock compensation plans prescribed by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”). Under APB No. 25, the Company did not recognize compensation expense for stock options because the exercise price for the options equaled the market price of the underlying stock on the date of grant.

During the second quarter of 2002, Sunoco announced that it would shut down a polypropylene line at its LaPorte, TX plant during the third quarter of 2002. Sunoco also announced its intention to shut down certain processing units at its Toledo refinery. The Company decided to shut down these facilities to eliminate less efficient production capacity. In connection with these shutdowns, in the second quarter of 2002, Sunoco recorded provisions to write off the affected units and established accruals for related exit costs, which amounted to $18 million ($12 million after tax) for the LaPorte, TX polypropylene plant and $4 million ($2 million after tax) for the Toledo refinery. In addition, during the second quarter of 2002, the Company established a $4 million accrual ($3 million after tax) relating to a lawsuit concerning the Puerto Rico refinery, which was divested in December 2001.

The following table sets forth the reconciliation of the weighted average number of common shares used to compute basic earnings per share (“EPS”) to those used to compute diluted EPS for the six-month and three-month periods ended June 30, 2003 and 2002 (in millions):

__________

Effective March 31, 2003, Sunoco formed a limited partnership with Equistar Chemicals, L.P. (“Equistar”) involving Equistar’s ethylene facility in LaPorte, TX. Equistar is a joint venture between Lyondell Chemical Company and Millennium Chemicals Inc. In connection with this transaction, Equistar and the new partnership entered into a 700

9

Table of Contents

million pounds-per-year, 15-year propylene supply contract with Sunoco. Of this amount, 500 million pounds per year will be priced on a cost-based formula that includes a fixed discount that declines over the life of the contract, while the remaining 200 million pounds per year will be based on market prices. Sunoco also purchased Equistar’s Bayport polypropylene facility at Pasadena, TX. The purchase price to form the partnership and acquire the Bayport facility consisted of $194 million of cash and $4 million of seller financing and included $11 million for polypropylene inventory.

Through the new partnership, the Company believes it has secured a favorable long-term supply of propylene for its Gulf Coast polypropylene business, while the acquisition of the Bayport facility has increased the Company’s polypropylene capacity. This transaction complements and enhances the Company’s polypropylene business and strengthens its market position.

The purchase price has been tentatively allocated to the assets acquired and liabilities assumed based on their relative estimated fair market values at the acquisition date. The following is a summary of the effects of the transaction on Sunoco’s consolidated financial position (in millions of dollars):

__________

In the second quarter of 2003, Sunoco completed the purchase of 193 direct Speedway retail gasoline sites from a subsidiary of Marathon Ashland Petroleum LLC for $162 million, including inventory. The sites, which are located primarily in Florida and South Carolina, are all company-operated locations with convenience stores. Of the 193 outlets, Sunoco is the lessee for 54 sites under long-term lease agreements.

The Company believes this acquisition fits its long-term strategy to build a retail and convenience store network that will provide attractive long-term returns. The addition of these high-volume convenience stores gives Sunoco critical mass in the high-growth market in the Southeast.

10

Table of Contents

The purchase price has been tentatively allocated to the assets acquired and liabilities assumed based on their relative estimated fair market values at the acquisition date. The following is a summary of the effects of the transaction on Sunoco’s consolidated financial position (in millions of dollars):

The unaudited pro forma sales and other operating revenue, net income (loss) and net income (loss) per share of common stock of Sunoco, as if the acquisition of the Bayport polypropylene facility and the 193 service stations in the Southeast had occurred on January 1, 2002, are as follows (in millions of dollars, except per share amounts):

The pro forma amounts above do not include any effects attributable to the propylene supply contract or the related partnership.

The pro forma information does not purport to be indicative of the results that actually would have been obtained if the Bayport polypropylene facility and the 193 service stations in the Southeast had been part of Sunoco’s businesses during the periods presented and is not intended to be a projection of future results. Accordingly, the pro forma results do not reflect any restructuring costs, changes in operating levels, or potential cost savings and other synergies.

Sunoco is contingently liable under an arrangement, which guarantees a $120 million term loan due in 2006 of the Epsilon Products Company, LLC polypropylene joint venture in which the Company is a partner. Under this arrangement, Sunoco also guarantees borrowings under the joint venture’s $40 million revolving credit facility, which amounted to $29 million at June 30, 2003. Sunoco is also contingently liable under various other arrangements, which guarantee debt of other third parties aggregating approximately $13 million at June 30, 2003. At this time, management does not believe that it is likely that the Company will have to perform under any of these guarantees.

Over the years, Sunoco has sold thousands of retail gasoline outlets as well as refineries, coal mines, oil and gas properties and various other assets. In connection with these sales, the Company has indemnified the purchasers for potential environmental and other contingent liabilities related to the period prior to the transaction

11

Table of Contents

dates. In most cases, the effect of these arrangements was to afford protection for the purchasers with respect to obligations for which the Company was already primarily liable. While some of these indemnities have spending thresholds, which must be exceeded before they become operative, or limits on Sunoco’s maximum exposure, they generally are not limited. The Company accrues for any obligations under these agreements when a loss is probable and reasonably estimable. The Company cannot reasonably estimate the maximum potential amount of future payments under these agreements.

Sunoco is subject to extensive and frequently changing federal, state and local laws and regulations, including, but not limited to, those relating to the discharge of materials into the environment or that otherwise deal with the protection of the environment, waste management and the characteristics and composition of fuels. As with the industry generally, compliance with existing and anticipated laws and regulations increases the overall cost of operating Sunoco’s businesses, including the capital costs to construct, maintain and upgrade equipment and facilities. Existing laws and regulations result in liabilities and loss contingencies for remediation at Sunoco’s facilities and at third-party or formerly owned sites. The accrued liability for environmental remediation is classified in the condensed consolidated balance sheets as follows (in millions of dollars):

The following table summarizes the changes in the accrued liability for environmental remediation activities by category for the six-month periods ended June 30, 2003 and 2002 (in millions of dollars):

Sunoco’s accruals for environmental remediation activities reflect its estimates of the most likely costs that will be incurred over an extended period to remediate identified conditions for which the costs are both probable and reasonably estimable. Engineering studies,

12

Table of Contents

historical experience and other factors are used to identify and evaluate remediation alternatives and their related costs in determining the estimated accruals for environmental remediation activities. Losses attributable to unasserted claims are also reflected in the accruals to the extent they are probable of occurrence and reasonably estimable.

Total future costs for the environmental remediation activities identified above will depend upon, among other things, the identification of any additional sites, the determination of the extent of the contamination at each site, the timing and nature of required remedial actions, the technology available and needed to meet the various existing legal requirements, the nature and terms of cost sharing arrangements with other potentially responsible parties, the availability of insurance coverage, the nature and extent of future environmental laws, inflation rates and the determination of Sunoco’s liability at the sites, if any, in light of the number, participation level and financial viability of the other parties. Management believes it is reasonably possible (i.e., less than probable but greater than remote) that additional environmental remediation losses will be incurred. At June 30, 2003, the aggregate of the estimated maximum additional reasonably possible losses, which relate to numerous individual sites, totaled $95 million. However, the Company believes it is very unlikely that it will realize the maximum loss at every site. Furthermore, the recognition of additional losses, if and when they were to occur, would likely extend over many years and, therefore, would not have a material impact on the Company’s financial position.

Under various environmental laws, including the Resource Conservation and Recovery Act (“RCRA”), Sunoco has initiated corrective remedial action at its facilities, formerly owned facilities and third-party sites. At the Company’s major manufacturing facilities, Sunoco has consistently assumed continued industrial use and a containment/ remediation strategy focused on eliminating unacceptable risks to human health or the environment. The remediation accruals for these sites reflect that strategy. Accruals include amounts to prevent off-site migration and to contain the impact on the facility property, as well as to address known, discrete areas requiring remediation within the plants. Activities include closure of RCRA solid waste management units, recovery of hydrocarbons, handling of impacted soil, mitigation of surface water impacts and prevention of off-site migration.

Many of Sunoco’s current terminals are being addressed with the above containment/remediation strategy. At some smaller or less impacted facilities and some previously divested terminals, the focus is on remediating discrete interior areas to attain regulatory closure.

Future costs for environmental remediation activities at the Company’s marketing sites also will be influenced by the extent of MTBE contamination of groundwater aquifers, the cleanup of which will be driven by thresholds based on drinking water protection. Though not all groundwater is used for drinking, several states have initiated or proposed more stringent MTBE cleanup requirements. Cost increases result directly from extended remedial operations and maintenance on sites that, under prior standards, could otherwise have been completed, installation of additional remedial or monitoring wells and purchase of more expensive equipment because of the presence of MTBE.

13

Table of Contents

While actual cleanup costs for specific sites are variable and depend on many of the factors discussed above, expansion of similar MTBE remediation thresholds to additional states or adoption of even more stringent requirements for MTBE remediation would result in further cost increases.

The accrued liability for hazardous waste sites in the table above is attributable to potential obligations to remove or mitigate the environmental effects of the disposal or release of certain pollutants at third-party sites pursuant to the Comprehensive Environmental Response Compensation and Liability Act (“CERCLA”). Under CERCLA, Sunoco is potentially subject to joint and several liability for the costs of remediation at sites at which it has been identified as a “potentially responsible party” (“PRP”). As of June 30, 2003, Sunoco had been named as a PRP at 50 sites identified or potentially identifiable as “Superfund” sites under federal and state law. The Company is usually one of a number of companies identified as a PRP at a site. Sunoco has reviewed the nature and extent of its involvement at each site and other relevant circumstances and, based upon the other parties involved or Sunoco’s negligible participation therein, believes that its potential liability associated with such sites will not be significant.

Management believes that none of the current remediation locations, which are in various stages of ongoing remediation, is individually material to Sunoco as its largest accrual for any one Superfund site, operable unit or remediation area is less than $7 million at June 30, 2003. As a result, Sunoco’s exposure to adverse developments with respect to any individual site is not expected to be material. However, if changes in environmental regulations occur, such changes could impact multiple Sunoco facilities and formerly owned and third-party sites at the same time. As a result, from time to time, significant charges against income for environmental remediation may occur.

The Company maintains insurance programs that cover certain of its existing or potential environmental liabilities, which programs vary by year, type and extent of coverage. For underground storage tank remediations, the Company can also seek reimbursement through various state funds of certain remediation costs above a deductible amount. For certain acquired properties, the Company has entered into arrangements with the sellers or others that allocate environmental liabilities and provide indemnities to the Company for remediating contamination that occurred prior to the acquisition dates. Some of these environmental indemnifications are subject to caps and limits. No accruals have been recorded for any potential contingent liabilities that will be funded by the prior owners as management does not believe, based on current information, that it is likely that any of the former owners will not perform under any of these agreements. Other than the preceding arrangements, the Company has not entered into any arrangements with third parties to mitigate its exposure to loss from environmental contamination. Claims for recovery of environmental liabilities that are probable of realization totaled $29 million at June 30, 2003 and are included primarily in deferred charges and other assets in the condensed consolidated balance sheets.

In December 1999, the U.S. Environmental Protection Agency (“EPA”) adopted a rule under the Clean Air Act which phases in limitations on

14

Table of Contents

the sulfur content of gasoline beginning in 2004 and, in January 2001, adopted another rule which will require limitations on the allowable sulfur content of on-road diesel fuel beginning in 2006. The rules include banking and trading credit systems, which could provide refiners flexibility until 2006 for the low-sulfur gasoline and until 2010 for the on-road low-sulfur diesel. These rules are expected to have a significant impact on Sunoco and its operations, primarily with respect to the capital and operating expenditures at its four refineries. Most of the capital spending is likely to occur in the 2003-2006 period, while the higher operating costs will be incurred when the low-sulfur fuels are produced. The Company estimates that the total capital outlays to comply with the new gasoline and diesel requirements will be in the range of $300-$400 million, of which approximately $30 million is expected to be spent in 2003. The ultimate impact of the rules may be affected by such factors as technology selection, the effectiveness of the systems pertaining to banking and trading credits, timing uncertainties created by permitting requirements and construction schedules and any effect on prices created by changes in the level of gasoline and diesel fuel production.

In April 2002, the EPA issued regulations implementing Phase II of the petroleum refinery Maximum Achievable Control Technology (“MACT II”) rule under the Clean Air Act. This rule regulates emissions of hazardous air pollutants (including organics, reduced sulfur compounds, inorganics and particulate metals) from certain sources at petroleum refineries, including catalytic cracking and reforming units and sulfur recovery units. The rule requires all petroleum refineries that are major sources of hazardous air pollutants to meet emission standards reflecting the application of the maximum achievable control technology at the affected sources by 2005. Analysis of this rule to determine its impact is ongoing. Although the ultimate impact of the rule cannot be determined at this time, it could have a significant impact on Sunoco and its operations, primarily with respect to capital expenditures at its refineries.

Since the late 1990s, the EPA has undertaken significant enforcement initiatives under authority of the Clean Air Act, targeting industries with large manufacturing facilities that are significant sources of emissions, including the refining industry. The EPA has asserted that many of these facilities have modified or expanded their operations over time without complying with New Source Review regulations that require permits and new emission controls in connection with any significant facility modifications or expansions that could increase emissions above certain thresholds, and have violated various other provisions of the Clean Air Act, including the New Source Review and Prevention of Significant Deterioration (“NSR/PSD”) Program, Benzene Waste Operations National Emissions Standards for Hazardous Air Pollutants (“NESHAP”), Leak Detection and Repair (“LDAR”) and flaring requirements. As part of this enforcement initiative, the EPA has entered into consent agreements with several refiners that require them to pay civil fines and penalties and make significant capital expenditures to install emissions control equipment at selected facilities. For some of these refineries, the cost of the required emissions control equipment is significant, depending on the size, age and configuration of the refinery. Sunoco received information requests in 2000, 2001 and 2002 in connection with the enforcement initiative pertaining to its four current refineries, the Puerto Rico

15

Table of Contents

refinery divested in 2001 and its phenol facility in Philadelphia, PA. Sunoco has completed its responses to the EPA. In 2003, Sunoco received an additional information request at its phenol plant in Philadelphia.

Sunoco has received Notices of Violation and Findings of Violation from the EPA relating to its Marcus Hook, Philadelphia and Toledo refineries. The Notices and Findings of Violation allege failure to comply with certain requirements relating to benzene wastewater emissions at the Company’s Marcus Hook, Toledo and Philadelphia refineries and failure to comply with certain requirements relating to leak detection and repair at the Toledo refinery. In addition, the EPA has alleged that: at the Company’s Philadelphia refinery, certain modifications were made to one of the fluid catalytic cracking units in 1992 and 1998 without obtaining requisite permits; at the Company’s Marcus Hook refinery, certain modifications were made to the fluid catalytic cracking unit in 1990 and 1996 without obtaining requisite permits; and at the Company’s Toledo refinery, certain physical and operational changes were made to the fluid catalytic cracking unit in 1985 without obtaining requisite permits. The EPA has also alleged that at the Company’s Toledo refinery, certain physical and operational changes were made to the sulfur plant in 1995, 1998 and 1999 without obtaining requisite permits; certain physical and operational changes were made to a flare system without obtaining requisite permits; and that the flare system was not being operated in compliance with the Clean Air Act. Sunoco has met with representatives of the EPA on these Notices and Findings of Violation and is currently evaluating its position. Although Sunoco does not believe that it has violated any Clean Air Act requirements, as part of this initiative, Sunoco could be required to make significant capital expenditures, operate these refineries at reduced levels and pay significant penalties. There are no liabilities accrued at June 30, 2003 in connection with this initiative.

Energy policy legislation continues to be debated in the 2003 Congressional session and uncertainty remains over federal action on fuels standards. The U.S. House and Senate have recently passed different versions of energy legislation. Both versions repeal the oxygenate mandate, and set certain requirements (although at different levels) for ethanol or renewable fuels usage. However, among other differences, the U.S. House energy bill does not ban MTBE, while the U.S. Senate version provides for a ban of this gasoline additive. A conference committee will be formed to resolve the differences in the legislation. During the 2002 Congressional session, the Senate and House both approved bills; however, a conference committee was unable to resolve differences between the two pieces of legislation. Sunoco uses MTBE and ethanol as oxygenates in different geographic areas of its refining and marketing system. While federal action is uncertain, some states, including California, New York and Connecticut, are scheduled to begin enforcing MTBE bans in January 2004. Sunoco does not market in California but is preparing to comply with the bans in New York and Connecticut. These bans, which will result in unique gasoline blends, could have a significant impact on market conditions depending on the details of future regulations, the impact on gasoline supplies, the cost and availability of alternate oxygenates if the minimum oxygenate requirements remain in effect, and the ability of Sunoco and the industry in general to recover their costs in the

16

Table of Contents

marketplace. A number of additional states are considering bans on MTBE although no immediate action is anticipated.

Sunoco is a one-third partner in Belvieu Environmental Fuels (“BEF”), a joint venture that owns and operates an MTBE production facility in Mont Belvieu, TX. The joint venture is currently evaluating alternative uses for this facility in the event MTBE is banned, including the conversion from the production of MTBE to the production of alkylate or some other gasoline blending component. If the Company determines that it is not economical to convert the facility, the write-down of its $48 million investment in this operation may be necessary.

Sunoco is a defendant in various cases alleging MTBE contamination in groundwater. The plaintiffs generally allege that refiners, manufacturers and sellers of gasoline containing MTBE are liable for manufacturing a defective product and that owners and operators of retail gasoline sites have allowed MTBE to be discharged into the groundwater. In New York, one such case has been brought by a county and its water authority and another case has been brought by numerous litigants. Among other things, plaintiffs in these two cases are seeking injunctive relief and compensatory and punitive damages. Based on its review of the limited available information, at this time, the Company cannot estimate the impact of these lawsuits but does not believe that the outcome of either of these cases will be material in relation to its consolidated financial position.

Many other legal and administrative proceedings are pending or possible against Sunoco from its current and past operations, including proceedings related to commercial and tax disputes, product liability, antitrust, employment claims, leaks from pipelines and underground storage tanks, natural resource damage claims, premises-liability claims, allegations of exposures of third parties to toxic substances (such as benzene or asbestos) and general environmental claims. The ultimate outcome of these proceedings and the matters discussed above cannot be ascertained at this time; however, it is reasonably possible that some of them could be resolved unfavorably to Sunoco. Management believes that these matters could have a significant impact on results of operations for any future quarter or year. However, management does not believe that any additional liabilities which may arise pertaining to such matters would be material in relation to the consolidated financial position of Sunoco at June 30, 2003. Furthermore, management does not believe that the overall costs for environmental activities will have a material impact over an extended period of time on Sunoco’s cash flows or liquidity.

17

Table of Contents

The following table sets forth Sunoco’s comprehensive income (loss) for the six-month periods ended June 30, 2003 and 2002 (in millions of dollars):

The following table sets forth certain income statement information concerning Sunoco’s business segments for the six-month and three-month periods ended June 30, 2003 and 2002 (in millions of dollars):

__________

18

Table of Contents

__________

In January 2003, FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FASB Interpretation No. 46”), was issued. It clarifies the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements”, to certain entities in which the equity investors do not have a controlling financial interest or do not have sufficient equity at risk. FASB Interpretation No. 46 became effective on January 31, 2003 for entities acquired after such date. The effective date for entities acquired on or before January 31, 2003 is July 1, 2003. Sunoco has not completed its evaluation of FASB Interpretation No. 46 and, therefore, is unable to estimate its impact on the Company’s consolidated financial statements at this time. However, it is reasonably possible that Sunoco will be required to consolidate its investment in the Epsilon Products Company, LLC polypropylene joint venture.

19

Table of Contents

RESULTS OF OPERATIONS—SIX MONTHS

Earnings Profile of Sunoco Businesses (after tax)

Analysis of Earnings Profile of Sunoco Businesses

In the six-month period ended June 30, 2003, Sunoco earned $167 million, or $2.16 per share of common stock on a diluted basis, compared to a net loss of $98 million, or $1.29 per share, for the first half of 2002.

Refining and Supply—Refining and Supply earned $143 million in the current half versus a loss of $61 million in the first half of 2002. The $204 million improvement in results was primarily due to significantly higher margins in the Northeast and Toledo refining centers ($234 million) and a 2 percent increase in total production volumes ($9 million). Partially offsetting these positive factors were higher expenses ($28 million), primarily refinery fuel and utility costs and employee-related expenses, and lower results at the Tulsa refinery ($11 million), largely due to higher natural gas costs and lower margins for lubricant base oil products.

In Sunoco’s Northeast refining system, realized margins were $5.04 per barrel, up $3.30 per barrel from the 2002 first-half level. Margins were higher for most products, particularly for heating oil and other distillates and residual fuels due to the exceptionally cold winter and high natural gas prices. Despite some cold-weather-induced reliability

20

Table of Contents

issues during the first quarter, input to crude units averaged 97 percent of rated capacity and production was up 1 percent versus the year-ago period.

Results were also much improved at the Toledo refinery. Realized margins averaged $4.55 per barrel, up over $1.80 per barrel from the comparable 2002 half. Operating performance was also improved as crude inputs averaged 99 percent of rated capacity during the first half of 2003 and production was 3 percent higher than the 2002 first half.

In April 2003, Sunoco signed a letter of intent to acquire El Paso Corporation’s 150 thousand barrels-per-day Eagle Point refinery and related assets located in Westville, NJ near the Company’s existing Northeast Refining operations. The related assets include certain pipeline and other logistics assets associated with the refinery which Sunoco intends to make available to Sunoco Logistics Partners L.P., a 75 percent owned master limited partnership formed in 2001. The purchase price is $130 million plus the fair market value of crude oil and refined product inventories at time of closing. The transaction is subject to the satisfaction of certain conditions including regulatory approval and negotiation of final definitive agreements. In June 2003, the Federal Trade Commission requested additional information regarding this transaction. The Company is in the process of complying with this request and believes that the acquisition will be completed by the end of 2003.

For many years, sulfur gas generated during the refining process at Sunoco’s Marcus Hook refinery has been sent to a third party, General Chemical, for processing into sulfur. In 2002, General Chemical experienced a series of operating failures. As a result of these incidents, Sunoco entered into a consent decree with the Delaware Department of Natural Resources and Environmental Control which, among other things, imposes penalties of up to $10 thousand per day if Sunoco incinerates sulfur gas as a result of General Chemical’s failure to accept the gas. Sunoco believes it is in full compliance with the consent decree. In October 2002, General Chemical’s parent company, GenTek, filed for Chapter 11 bankruptcy reorganization. As part of this proceeding, General Chemical petitioned the court in February 2003, seeking to close the sulfur processing portion of its facility on or about September 30, 2003. As a result, Sunoco entered into an agreement for construction and delivery of two modular sulfur plants at Marcus Hook by September 30, 2003 at an expected cost of $50-$60 million. However, this is an extremely aggressive project schedule, and Sunoco filed objections to General Chemical’s petition in an effort to postpone the sulfur plant closure. In July 2003, the parties reached a settlement agreement under which Sunoco agreed to give up its claims against General Chemical, and General Chemical agreed to operate the plant until November 11, 2003, if needed, at no additional cost to Sunoco. The final settlement has been submitted to the court for approval. Barring unforeseen circumstances, the settlement agreement between Sunoco and General Chemical should provide Sunoco with additional time, if needed, to bring on-line the new sulfur recovery units. Sunoco is working with the State of Delaware to obtain the necessary permits.

Retail Marketing—Retail Marketing earned $46 million in the current half versus $1 million in the first half of 2002. The $45 million increase in earnings was primarily due to higher retail gasoline margins ($48 million). Average retail gasoline margins were 10.0 cents per gallon during the first half of 2003, up almost 4 cents per gallon compared to the prior-year half. Also contributing to the improvement were higher retail distillate margins

21

Table of Contents

($4 million) and higher gasoline and distillate sales volumes ($4 million). Partially offsetting these positive factors were higher planned expenses ($12 million). The acquisition of Speedway retail sites from a subsidiary of Marathon Ashland Petroleum LLC (“Marathon”) (see below) had a minimal impact on earnings for the first half.

In the second quarter of 2003, Sunoco completed the purchase of 193 direct retail gasoline sites from Marathon for $162 million, including inventory. The sites, which are located primarily in Florida and South Carolina, are all company-operated locations with convenience stores. Of the 193 outlets, Sunoco is the lessee for 54 sites under long-term lease agreements. (See Note 6 to the condensed consolidated financial statements.)

In April 2003, Sunoco announced its intention to sell its interest in 190 direct-supplied retail sites in Michigan and the southern Ohio markets of Columbus, Dayton and Cincinnati. Sunoco intends to continue to supply branded gasoline to the outlets by securing long-term supply agreements with distributors. The sales effort is expected to take 12-18 months to complete.

Chemicals—Chemicals earned $6 million in the first half of 2003 versus income of $1 million in the prior-year half. The $5 million increase in earnings was due largely to higher margins for both phenol and polypropylene ($21 million) and $5 million of after-tax income related to a supply agreement with Equistar Chemicals, L.P. (“Equistar”) and from the polypropylene facility acquired from Equistar (see below). Partially offsetting the positive variances were higher fuel costs ($5 million), lower sales volumes ($5 million) and lower equity income from Belvieu Environmental Fuels (“BEF”), the Company’s MTBE joint venture ($7 million), due to weakness in MTBE demand. The first half of 2003 also includes after-tax charges totaling $3 million primarily related to a fire at the Company’s LaPorte, TX facility and employee terminations in connection with a productivity improvement plan.

Effective March 31, 2003, Sunoco formed a limited partnership with Equistar involving Equistar’s ethylene facility in LaPorte, TX. Equistar is a joint venture between Lyondell Chemical Company and Millennium Chemicals Inc. In connection with this transaction, Equistar and the new partnership entered into a 700 million pounds-per-year, 15-year propylene supply contract with Sunoco. Of this amount, 500 million pounds per year will be priced on a cost-based formula that includes a fixed discount, while the remaining 200 million pounds per year will be based on market prices. Sunoco also purchased Equistar’s 400 million pounds-per-year Bayport polypropylene facility at Pasadena, TX. The purchase price to form the partnership and acquire the Bayport facility consisted of $194 million of cash and $4 million of seller financing and included $11 million for polypropylene inventory. (See Note 6 to the condensed consolidated financial statements.)

In April 2003, Sunoco signed a letter of intent to sell its plasticizer operations to BASF. The sale will include the Company’s Pasadena, TX, site, including the land, phthalic anhydride and oxo-alcohol manufacturing plants, plus the plasticizer esters, 2-ethylhexanol and phthalic anhydride businesses. Sunoco’s investment in the business, including inventory, is approximately $100 million. Although the Company’s Neville Island, PA, site is not part of the transaction, it will produce plasticizers for BASF under a tolling agreement. The transaction is subject to satisfaction of certain conditions including regulatory approval. In June 2003, the Federal Trade Commission requested additional information regarding this transaction. The

22

Table of Contents

Company is in the process of complying with this request and believes that the sale will be completed by the end of 2003.

Logistics—Sunoco’s Logistics business, which is now comprised of Sunoco’s 75-percent interest in Sunoco Logistics Partners L.P. as well as certain other assets and joint venture interests, earned $20 million in the first half of 2003 versus $17 million in the year-ago period. The $3 million increase was due largely to improved Western crude operations and increased joint-venture income associated with assets acquired in November 2002.

Coke—Coke earned $21 million in the first half of 2003 versus $16 million in the first half of 2002. The $5 million increase in earnings was primarily due to higher coke prices at Jewell Coke and the absence of a $4 million after-tax write-off of accounts receivable from National Steel Corporation, Jewell’s former long-term contract customer, which was recognized in the first quarter of 2002, partially offset by lower tax benefits from Jewell Coke operations. Jewell’s 2002 coke sales were made into lower-value spot markets due to National’s bankruptcy. In October 2002, the Coke business entered into a three-year sales contract with International Steel Group (“ISG”) under which the Coke business is providing ISG approximately 700,000 tons of Jewell’s production annually through 2005.

In April 2003, Sun Coke agreed with three major steel companies and a major iron ore producer to build and operate a coke production facility and associated cogeneration power plant in Vitória, Brazil. The companies have agreed to long-term commitments whereby Sun Coke will produce coke for the customers under a tolling agreement, and each customer will purchase a pro-rata share of the power produced at the facility. Sun Coke’s commitment to this project is subject to a number of contingencies including: approval by Sunoco’s Board of Directors; finalization of the construction cost; obtaining all requisite permits; and obtaining financing satisfactory to Sunoco. If these contingencies are satisfied, construction of the facilities, which is estimated to cost approximately $300-$350 million, would begin in 2004, and the facilities would be operational in 2006.

Corporate and Other

Corporate Expenses—Corporate administrative expenses were $19 million after tax in the current half versus $14 million in the first half of 2002. The $5 million increase was largely due to higher employee-related expenses, including pension and performance-related incentive compensation.

Net Financing Expenses and Other—Net financing expenses and other were $50 million after tax in the first half of 2003 versus $41 million in the year-ago period. The $9 million increase was primarily due to higher after-tax expense attributable to the preferential return of third-party investors in Sunoco’s cokemaking operations. In July 2002, Sunoco transferred an additional interest in its Indiana Harbor cokemaking operation to a third-party investor for $215 million in cash.

Write-Down of Assets and Other Matters—During the first half of 2002, Sunoco recorded a $17 million after-tax provision primarily for asset write-downs and associated charges related to the shutdown of a production line at the LaPorte, TX polypropylene plant ($12 million after tax) and the shutdown of certain processing units at the Company’s Toledo refinery ($2 million after tax). Also included in the provision was a $3 million after-tax accrual relating to a lawsuit concerning the Puerto Rico refinery,

23

Table of Contents

which was divested in December 2001. (See Note 4 to the condensed consolidated financial statements.)

Analysis of Condensed Consolidated Statements of Operations

Revenues—Total revenues were $8.76 billion in the first half of 2003 compared to $6.49 billion in the first half of 2002. The 35 percent increase was primarily due to significantly higher refined product prices. Also contributing to the increase were higher crude oil sales in connection with the crude oil gathering and marketing activities of the Company’s Logistics operations.

Costs and Expenses—Total pretax costs and expenses were $8.50 billion in the first half of 2003 compared to $6.64 billion in the first half of 2002. The 28 percent increase was primarily due to significantly higher crude oil and refined product acquisition costs, largely as a result of crude oil price increases. Also contributing to the increase were higher crude oil costs in connection with the crude oil gathering and marketing activities of the Company’s Logistics operations.

RESULTS OF OPERATIONS—THREE MONTHS

Earnings Profile of Sunoco Businesses (after tax)