Attached files

file filename
EX-32.1 - CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO SECTION 906 - ANDEAVORtso3q2014-ex321.htm
EX-4.6 - SUPPLEMENTAL INDENTURE - ANDEAVORtso3q2014-ex46.htm
EX-31.1 - CERTIFICATION OF CHIEF EXECUTIVE OFFICER PURSUANT TO SECTION 302 - ANDEAVORtso3q2014-ex311.htm
EX-31.2 - CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 302 - ANDEAVORtso3q2014-ex312.htm
EX-4.3 - INDENTURE - ANDEAVORtso3q2014-ex43.htm
EX-4.5 - SUPPLEMENTAL INDENTURE - ANDEAVORtso3q2014-ex45.htm
EX-4.4 - REGISTRATION RIGHTS AGREEMENT - ANDEAVORtso3q2014-ex44.htm
EXCEL - IDEA: XBRL DOCUMENT - ANDEAVORFinancial_Report.xls
EX-32.2 - CERTIFICATION OF CHIEF FINANCIAL OFFICER PURSUANT TO SECTION 906 - ANDEAVORtso3q2014-ex322.htm

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10‑Q
(Mark One)
þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2014
or

¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from_____________________to__________

Commission File Number 1‑3473

TESORO CORPORATION
(Exact name of registrant as specified in its charter)
Delaware
 
95‑0862768
(State or other jurisdiction of
 
(I.R.S. Employer
incorporation or organization)
 
Identification No.)
 
 
 
19100 Ridgewood Pkwy, San Antonio, Texas 78259-1828
(Address of principal executive offices) (Zip Code)
210-626-6000
(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. Yes þ No ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer
þ
 
Accelerated filer
¨
 
 
Non-accelerated filer
¨  (Do not check if a smaller reporting company)
 
Smaller reporting company
¨
 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No þ

There were 126,245,340 shares of the registrant’s Common Stock outstanding at October 28, 2014.

 



TESORO CORPORATION

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2014

TABLE OF CONTENTS




PART I. FINANCIAL INFORMATION
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
PART II. OTHER INFORMATION
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


2

PART I — FINANCIAL INFORMATION


ITEM 1. FINANCIAL STATEMENTS

TESORO CORPORATION
CONDENSED STATEMENTS OF CONSOLIDATED OPERATIONS
(Unaudited)
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
 
(In millions, except per share amounts)
REVENUES (a)
$
11,151

 
$
11,241

 
$
32,188

 
$
27,485

COSTS AND EXPENSES:
 
 
 
 
 
 
 
Cost of sales (a)
9,594

 
10,355

 
28,409

 
24,827

Operating expenses
624

 
542

 
1,813

 
1,351

Selling, general and administrative expenses
86

 
54

 
209

 
229

Depreciation and amortization expense
144

 
140

 
409

 
356

(Gain) loss on asset disposals and impairments
1

 
4

 
(2
)
 
19

OPERATING INCOME
702

 
146

 
1,350

 
703

Interest and financing costs, net
(51
)
 
(47
)
 
(169
)
 
(110
)
Other income, net
12

 
22

 
14

 
78

EARNINGS BEFORE INCOME TAXES
663

 
121

 
1,195

 
671

Income tax expense
249

 
47

 
437

 
243

NET EARNINGS FROM CONTINUING OPERATIONS
414

 
74

 
758

 
428

Earnings (loss) from discontinued operations, net of tax
(1
)
 
35

 
(2
)
 
23

NET EARNINGS
413

 
109

 
756

 
451

Less: Net earnings from continuing operations attributable to
   noncontrolling interest
17

 
10

 
58

 
32

NET EARNINGS ATTRIBUTABLE TO TESORO
   CORPORATION
$
396

 
$
99

 
$
698

 
$
419

 
 
 
 
 
 
 
 
NET EARNINGS (LOSS) ATTRIBUTABLE TO TESORO
   CORPORATION
 
 
 
 
 
 
 
Continuing operations
$
397

 
$
64

 
$
700

 
$
396

Discontinued operations
(1
)
 
35

 
(2
)
 
23

Total
$
396

 
$
99

 
$
698

 
$
419

NET EARNINGS (LOSS) PER SHARE - BASIC:
 
 
 
 
 
 
 
Continuing operations
$
3.11

 
$
0.48

 
$
5.41

 
$
2.92

Discontinued operations
(0.01
)
 
0.26

 
(0.02
)
 
0.17

Total
$
3.10

 
$
0.74

 
$
5.39

 
$
3.09

Weighted average common shares outstanding - Basic
127.9

 
134.6

 
129.5

 
135.8

NET EARNINGS (LOSS) PER SHARE - DILUTED:
 
 
 
 
 
 
 
Continuing operations
$
3.06

 
$
0.46

 
$
5.32

 
$
2.86

Discontinued operations
(0.01
)
 
0.26

 
(0.02
)
 
0.17

Total
$
3.05

 
$
0.72

 
$
5.30

 
$
3.03

Weighted average common shares outstanding - Diluted
129.7

 
136.8

 
131.7

 
138.1

 
 
 
 
 
 
 
 
DIVIDENDS PER SHARE
$
0.30

 
$
0.25

 
$
0.80

 
$
0.65

 
 
 
 
 
 
 
 
SUPPLEMENTAL INFORMATION:
 
 
 
 
 
 
 
(a) Includes excise taxes collected by our retail segment
         (excluding credits)
$
148

 
$
151

 
$
441

 
$
423


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

3


TESORO CORPORATION
CONDENSED STATEMENTS OF CONSOLIDATED COMPREHENSIVE INCOME
(Unaudited)
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2014
 
2013
 
2014
 
2013
 
(In millions)
COMPREHENSIVE INCOME
 
 
 
 
 
 
 
Net Earnings
$
413

 
$
109

 
$
756

 
$
451

Pension and other postretirement benefit liability adjustments,
   net of tax expense of $48 million

 

 

 
73

Total comprehensive income
413

 
109

 
756

 
524

Less: Noncontrolling interest in comprehensive income
17

 
10

 
58

 
32

COMPREHENSIVE INCOME ATTRIBUTABLE TO
   TESORO CORPORATION
$
396

 
$
99

 
$
698

 
$
492


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

4


TESORO CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
 
September 30,
2014
 
December 31,
2013
 
(Dollars in millions, except per share amounts)
ASSETS
CURRENT ASSETS
 
 
 
Cash and cash equivalents (TLLP: $3 and $23, respectively)
$
1,530

 
$
1,238

Receivables, less allowance for doubtful accounts
1,578

 
1,313

Inventories
2,674

 
2,565

Prepayments and other current assets
182

 
210

Total Current Assets
5,964

 
5,326

NET PROPERTY, PLANT AND EQUIPMENT (TLLP: $1,489 and $1,398, respectively)
7,088

 
6,875

OTHER NONCURRENT ASSETS, NET
1,173

 
1,188

Total Assets
$
14,225

 
$
13,389

 
 
 
 
LIABILITIES AND EQUITY
CURRENT LIABILITIES
 
 
 
Accounts payable
$
2,737

 
$
2,596

Other current liabilities
931

 
812

Total Current Liabilities
3,668

 
3,408

DEFERRED INCOME TAXES
1,167

 
1,018

OTHER NONCURRENT LIABILITIES
560

 
655

DEBT (TLLP: $1,276 and $1,164, respectively)
2,938

 
2,823

COMMITMENTS AND CONTINGENCIES (Note L)


 


EQUITY
 
 
 
TESORO CORPORATION STOCKHOLDERS’ EQUITY
 
 
 
Common stock, par value $0.162/3; authorized 200,000,000 shares; 156,447,233 shares issued (154,712,627 in 2013)
26

 
26

Additional paid-in capital
1,265

 
1,186

Retained earnings
4,534

 
3,940

Treasury stock, 29,525,051 common shares (22,907,890 in 2013), at cost
(1,170
)
 
(798
)
Accumulated other comprehensive loss
(52
)
 
(52
)
Total Tesoro Corporation Stockholders’ Equity
4,603

 
4,302

NONCONTROLLING INTEREST
1,289

 
1,183

Total Equity
5,892

 
5,485

Total Liabilities and Equity
$
14,225

 
$
13,389


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

5


TESORO CORPORATION
CONDENSED STATEMENTS OF CONSOLIDATED CASH FLOWS
(Unaudited)
 
Nine Months Ended
September 30,
 
2014
 
2013
 
(Dollars in millions)
CASH FLOWS FROM (USED IN) OPERATING ACTIVITIES
 
 
 
Net earnings
$
756

 
$
451

Adjustments to reconcile net earnings to net cash from (used in) operating activities:
 
 
 
Depreciation and amortization expense
409

 
357

Debt redemption charges
41

 

Gain on sale of Hawaii Business


 
(80
)
Stock-based compensation expense
20

 
34

Deferred income taxes
227

 
222

Deferred charges
(119
)
 
(333
)
Other non-cash operating activities
(59
)
 
(46
)
Changes in current assets and current liabilities
(228
)
 
65

Net cash from operating activities
1,047

 
670

CASH FLOWS FROM (USED IN) INVESTING ACTIVITIES
 
 
 
Capital expenditures
(477
)
 
(447
)
Acquisitions
(17
)
 
(2,615
)
Proceeds from sale of Hawaii Business


 
539

Other investing activities
11

 

Net cash used in investing activities
(483
)
 
(2,523
)
CASH FLOWS FROM (USED IN) FINANCING ACTIVITIES
 
 
 
Borrowings under revolving credit agreements
295

 
2,068

Borrowings under term loan credit agreement

 
500

Proceeds from debt offering
300

 
550

Repayments on revolving credit agreements
(52
)
 
(1,368
)
Repayments of debt
(433
)
 
(6
)
Dividend payments
(104
)
 
(88
)
Proceeds from stock options exercised
14

 
69

Net proceeds from issuance of Tesoro Logistics LP common units
156

 
392

Distributions to noncontrolling interest
(63
)
 
(43
)
Purchases of common stock
(350
)
 
(341
)
Taxes paid related to net share settlement of equity awards
(22
)
 
(5
)
Other financing activities
(13
)
 
(22
)
Net cash from (used in) financing activities
(272
)
 
1,706

INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
292

 
(147
)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD
1,238

 
1,639

CASH AND CASH EQUIVALENTS, END OF PERIOD
$
1,530

 
$
1,492


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

6

TESORO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


NOTE A – BASIS OF PRESENTATION

As used in this report, the terms “Tesoro,” “we,” “us” or “our” may refer to Tesoro Corporation, one or more of its consolidated subsidiaries or all of them taken as a whole. The words “we,” “us” or “our” generally include Tesoro Logistics LP (“TLLP”) and its subsidiaries as consolidated subsidiaries of Tesoro Corporation with certain exceptions where there are transactions or obligations between TLLP and Tesoro Corporation or its other subsidiaries. When used in descriptions of agreements and transactions, “TLLP” or the “Partnership” refers to TLLP and its consolidated subsidiaries.

The interim condensed consolidated financial statements and notes thereto of Tesoro Corporation and its subsidiaries have been prepared by management without audit according to the rules and regulations of the Securities and Exchange Commission (“SEC”). The accompanying condensed consolidated 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, unless otherwise disclosed.

The consolidated balance sheet at December 31, 2013 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 present the information fairly. The accompanying condensed consolidated financial statements and notes should be read in conjunction with our Annual Report on Form 10-K for the year ended December 31, 2013.

We prepare our condensed consolidated financial statements in conformity with U.S. GAAP, which requires management to make estimates and assumptions that affect the reported amounts and disclosures of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the periods presented. We review our estimates on an ongoing basis. 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. Certain prior year balances have been aggregated or disaggregated in order to conform to the current year presentation.

Our consolidated financial statements include TLLP, a variable interest entity. As the general partner of TLLP, we have the sole ability to direct the activities of TLLP that most significantly impact its economic performance. We are also considered to be the primary beneficiary for accounting purposes and are TLLP’s primary customer. Under our various long-term, fee-based commercial agreements with TLLP, transactions with us accounted for 86% and 87% of TLLP’s total revenues for the three and nine months ended September 30, 2014, respectively. TLLP does not derive a significant amount of revenue from third parties. However, in the event TLLP incurs a loss, our operating results will reflect TLLP’s loss, net of intercompany eliminations. See Note C for additional information relating to TLLP.

On September 25, 2013, we completed the sale of all of our interest in Tesoro Hawaii, LLC, which operated a 94 thousand barrel per day (“Mbpd”) Hawaii refinery, retail stations and associated logistics assets (the “Hawaii Business”). Unless otherwise noted, the information in the notes to the condensed consolidated financial statements relates to our continuing operations.

New Accounting Standards and Disclosures

Revenue Recognition

The Financial Accounting Standards Board (“FASB”) issued an Accounting Standards Update (“ASU”) in May 2014, which provides accounting guidance for all revenue arising from contracts to provide goods or services to customers. The requirements from the new ASU are effective for interim and annual periods beginning after December 15, 2016, and early adoption is not permitted. The standard allows for either full retrospective adoption or modified retrospective adoption. At this time, we are evaluating the guidance to determine the method of adoption and the impact of this ASU on our financial statements and related disclosures.


7

TESORO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE B - ACQUISITIONS

Los Angeles Acquisition

We acquired BP’s integrated Southern California refining, marketing and logistics business on June 1, 2013 from BP West Coast Products, LLC and other affiliated sellers (the “Los Angeles Acquisition”) consistent with our business strategy and providing us with an opportunity to combine two West Coast refining, marketing and logistics businesses resulting in a more efficient integrated refining, marketing and logistics system. The acquired assets include the 266 Mbpd Carson refinery located adjacent to our Wilmington refinery, related marine terminals, land terminals and pipelines. The assets also include the ARCO® brand and associated registered trademarks, as well as a master franchisee license for the ampm® convenience store brand and the supply rights to approximately 835 branded dealer-operated and branded wholesale stations in central and southern California, Nevada and Arizona. Additionally, we acquired an anode coke calcining operation and a 51% ownership in the Watson cogeneration facility, both located at the Carson refinery. We also assumed certain environmental liabilities, primarily remediation obligations. For additional information regarding the assumed environmental liabilities, see Note L.

Our allocation of the Los Angeles Acquisition's $2.33 billion purchase price was final as of June 30, 2014. The table below presents the final acquisition date purchase price allocation (in millions):
Receivables
$
197

Inventories
1,096

Prepayments and other current assets
14

Property, plant and equipment
1,088

Acquired intangibles, net
63

Other noncurrent assets, net
112

Other current liabilities
(25
)
Other noncurrent liabilities
(182
)
Debt
(36
)
Total purchase price
$
2,327


If the Los Angeles Acquisition had occurred prior to 2013, our pro forma revenues and net earnings would have been $33.4 billion and $515 million for the nine months ended September 30, 2013, respectively.

NOTE C – TESORO LOGISTICS LP

TLLP is a publicly traded limited partnership that was formed to own, operate, develop and acquire logistics assets. Its assets are integral to the success of Tesoro’s refining and marketing operations and generate revenue by charging fees for gathering crude oil using its High Plains System and for terminalling, transporting and storing crude oil and refined products using terminal facilities and pipelines in the western United States. Tesoro Logistics GP, LLC (“TLGP”), a fully consolidated subsidiary, serves as the general partner of TLLP. We held an approximate 35% and 36% interest in TLLP at September 30, 2014 and December 31, 2013, respectively, including the general partner interest. This interest at September 30, 2014 includes 19,481,557 common units and 1,163,138 general partner units. During the second quarter of 2014, all subordinated units converted to common units. All intercompany transactions with TLLP are eliminated upon consolidation.

TLLP provides us with various pipeline transportation, trucking, terminal distribution, storage and coke-handling services under long-term, fee-based commercial agreements. Each of these agreements, with the exception of the storage and transportation services agreement, contain minimum volume commitments. We do not provide financial or equity support through any liquidity arrangements or financial guarantees to TLLP.


8

TESORO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

QEPFS Acquisition

On October 19, 2014, TLLP reached a definitive agreement (“QEPFS Purchase Agreement”) to acquire the natural gas gathering, processing, treating and transportation and crude oil gathering business of QEP Resources, Inc.’s wholly-owned subsidiary, QEP Field Services Company, LLC (“QEPFS”), with operations in Wyoming, Colorado, Utah and the Williston Basin in North Dakota (the “QEPFS Acquisition”). QEPFS also provides natural gas liquids fractionation and transportation services for its producer customers through QEPFS’ direct ownership and operation of two gathering systems and two processing complexes. The acquisition transforms TLLP into a full-service logistics company with assets allowing geographic diversification in support of our strategic initiatives. As part of the transaction, TLLP will acquire 56% of the limited partner interests in QEP Midstream Partners, LP (“QEP Midstream”). Additionally, TLLP is acquiring the general partner of QEP Midstream including its 2% general partner interest and 100% of the incentive distribution rights. TLLP expects to pay total consideration of approximately $2.5 billion, including $230 million to refinance QEP Midstream’s outstanding debt. The transaction is subject to regulatory approval and other closing conditions. The QEPFS Purchase Agreement provides for us to pay a break-up fee of $150 million in the event that we terminate the agreement, except for termination for specified reasons.

On October 24, 2014, in connection with the QEPFS Acquisition, TLLP closed a registered public offering of 23 million common units, including an over-allotment option that was exercised allowing the underwriters to purchase an additional 3 million common units, representing limited partner interests in TLLP (the “October Equity Offering”) to raise $1.3 billion, including the purchase of common units by Tesoro of an amount equal to $500 million and TLGP’s $27 million contribution to maintain its 2% general partner interest in TLLP. Additionally, on October 29, 2014, TLLP completed a private offering of $1.3 billion aggregate principal amount of senior notes (the “Senior Notes Offering”) pursuant to a private placement transaction conducted under Rule 144A and Regulation S of the Securities Act of 1933, as amended. The Senior Notes Offering consists of tranches for 5.50% senior notes due in 2019 and 6.25% senior notes due in 2022. TLLP intends to use the proceeds from the October Equity Offering, Senior Notes Offering, and the general partner contribution to repay amounts outstanding under its existing revolving credit facility with the remainder, including amounts to be borrowed under TLLP’s expanded revolving credit facility, to be used primarily to fund the QEPFS acquisition and payment of related fees and expenses. Refer to Note J for further information on the Senior Notes Offering and expansion of TLLP’s revolving credit facility.

Other Transactions

During the three months ended September 30, 2014, TLLP purchased certain terminalling and pipeline assets owned by Tesoro and two of our subsidiaries for total consideration of $270 million. On July 1, 2014, TLLP closed on the purchase of the first portion consisting of three marketing terminals and a storage facility in exchange for consideration of $241 million, comprised of approximately $214 million in cash financed with borrowings under TLLP’s revolving credit facility, and the issuance of equity to us with a fair value of $27 million.  On September 30, 2014, TLLP completed the second portion by acquiring Tesoro Alaska Pipeline Company LLC, which owns a refined products pipeline located in Alaska, for total cash consideration of $29 million, financed with borrowings under TLLP’s revolving credit facility.

On August 22, 2014, TLLP completed a public offering of 2.1 million common units for net proceeds of $142 million. Using the proceeds from the offering, TLLP redeemed an aggregate principal amount of $130 million of its 5.875% Senior Notes due 2020 (the “2020 Notes”) at a premium. TLLP recorded charges for premiums paid due to the early redemption and expensing of unamortized debt issuance costs totaling $10 million. We reimbursed TLLP through a capital contribution of $8 million related to the early debt redemption premiums.

On June 25, 2014, TLLP filed a prospectus supplement to its shelf registration statement filed with the SEC in 2012, authorizing the continuous issuance of up to an aggregate of $200 million of common units, in amounts, at prices and on terms to be determined by market conditions and other factors at the time of its offerings. During the three months ended September 30, 2014, TLLP issued 193,900 common units under this program for net proceeds of $14 million.


9

TESORO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE D - DISCONTINUED OPERATIONS

On September 25, 2013, we completed the sale of our Hawaii Business and received gross proceeds of $539 million, including $75 million from the sale of assets and $464 million from the sale of inventory and other net working capital. Additional contingent consideration includes an earnout arrangement payable over three years for an aggregate amount of up to $40 million based on consolidated gross margins. Any income related to the earnout arrangement will not be recorded until it is considered realizable. We have also agreed to indemnify the purchaser for up to $15 million of environmental remediation costs related to the Hawaii Business, subject to limitations described in the purchase agreement, and retained responsibility for the resolution of certain Clean Air Act allegations as described in Note L. The asset retirement obligations were assumed by the purchaser upon close of the transaction; therefore, we will not incur any removal or other closure costs for this business.

The results of operations for this business have been presented as discontinued operations in the condensed statements of consolidated operations for the three and nine months ended September 30, 2014 and 2013. There were no revenues for the three and nine months ended September 30, 2014. Revenues from the discontinued Hawaii Business for the three and nine months ended September 30, 2013 were $585 million and $2.0 billion, respectively. We recorded losses, before and after tax, of $2 million and $1 million, respectively, for the three months ended September 30, 2014 and $3 million and $2 million, respectively, for the nine months ended September 30, 2014 related to the Hawaii Business. We recorded income, before and after tax of $56 million and $35 million, respectively, including a pre-tax gain on sale of $80 million, for the three months ended September 30, 2013 and $39 million and $23 million, respectively, for the nine months ended September 30, 2013 related to the Hawaii Business.

Cash flows related to the discontinued Hawaii Business have been combined with the cash flows from continuing operations in the condensed statements of consolidated cash flows for both periods presented. Cash flows used in operating activities were $2 million for the nine months ended September 30, 2014. Cash flows provided by operating activities were $74 million and cash flows used in investing activities were $537 million for the nine months ended September 30, 2013.

NOTE E – EARNINGS PER SHARE

We compute basic earnings per share by dividing net earnings attributable to Tesoro Corporation stockholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share include the effects of potentially dilutive shares outstanding during the period. Our share calculations are presented below (in millions):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2014
 
2013
 
2014
 
2013
Weighted average common shares outstanding
127.9

 
134.6
 
129.5

 
135.8
Common stock equivalents
1.8

 
2.2
 
2.2

 
2.3
Total diluted shares
129.7

 
136.8
 
131.7

 
138.1

Potentially dilutive common stock equivalents are excluded from the calculation of diluted earnings per share if the effect of including such securities in the calculation would have been anti-dilutive. Anti-dilutive securities were 0.1 million and 0.2 million for the three months ended September 30, 2014 and 2013, respectively, and 0.1 million for both the nine months ended September 30, 2014 and 2013, respectively.


10

TESORO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE F – INVENTORIES

Components of inventories were as follows (in millions):
 
September 30,
2014
 
December 31,
2013
Domestic crude oil and refined products
$
2,200

 
$
1,847

Foreign subsidiary crude oil
282

 
523

Other inventories
192

 
195

Total Inventories
$
2,674

 
$
2,565


The total carrying value of our crude oil and refined product inventories was less than replacement cost by approximately$1.6 billion and $1.7 billion at September 30, 2014 and December 31, 2013, respectively.

NOTE G - PROPERTY, PLANT AND EQUIPMENT

Property, plant and equipment, at cost, is as follows (in millions):
 
September 30,
2014
 
December 31,
2013
Refining
$
6,820

 
$
6,546

TLLP
1,710

 
1,569

Retail
812

 
778

Corporate
242

 
230

Property, plant and equipment, at cost
9,584

 
9,123

Accumulated depreciation
(2,496
)
 
(2,248
)
Net property, plant and equipment
$
7,088

 
$
6,875


We capitalize interest as part of the cost of major projects during the construction period. Capitalized interest totaled $7 million and $3 million for the three months ended September 30, 2014 and 2013, respectively, and $17 million and $12 million for the nine months ended September 30, 2014 and 2013, respectively, and is recorded as a reduction to net interest and financing costs in our condensed statements of consolidated operations.

NOTE H - DERIVATIVE INSTRUMENTS

In the ordinary course of business, our profit margins, earnings and cash flows are impacted by the timing, direction and overall change in pricing for commodities used throughout our operations. We use non-trading derivative instruments to manage our exposure to the following:

price risks associated with the purchase or sale of feedstocks, refined products and energy supplies to or from our refineries, terminals, retail operations and customers;
price risks associated with inventories above or below our target levels;
future emission credit requirements; and
exchange rate fluctuations on our purchases of Canadian crude oil.

Our accounting for derivative instruments depends on whether the underlying commodity will be used or sold in the normal course of business. For contracts where the crude oil or refined products are expected to be used or sold in the normal course of business, we apply the normal purchase normal sale exception and follow the accrual method of accounting. All other derivative instruments are recorded at fair value using mark-to-market accounting.


11

TESORO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Our derivative instruments include forward purchase and sale contracts (“Forward Contracts”), exchange-traded futures (“Futures Contracts”), over-the-counter swaps (“OTC Swap Contracts”), options (“Options”), and over-the-counter options (“OTC Option Contracts”). Forward Contracts are agreements to buy or sell the commodity at a predetermined price at a specified future date. Futures Contracts are standardized agreements, traded on a futures exchange, to buy or sell the commodity at a predetermined price at a specified future date. Options provide the right, but not the obligation to buy or sell the commodity at a specified price in the future. OTC Swap Contracts and OTC Option Contracts require cash settlement for the commodity based on the difference between a contracted fixed or floating price and the market price on the settlement date. Certain of these contracts require cash collateral if our liability position exceeds specified thresholds. We believe that we have minimal credit risk with respect to our counterparties.

The following table presents the fair value (in millions) of our derivative instruments as of September 30, 2014 and December 31, 2013. The fair value amounts below are presented on a gross basis and do not reflect the netting of asset and liability positions permitted under the terms of our master netting arrangements including cash collateral on deposit with, or received from, brokers. We offset the recognized fair value amounts for multiple derivative instruments executed with the same counterparty in our financial statements when a legal right of offset exists. As a result, the asset and liability amounts below will not agree with the amounts presented in our condensed consolidated balance sheets.
 
 
 
Derivative Assets
 
Derivative Liabilities
 
Balance Sheet Location
 
September 30,
2014
 
December 31,
2013
 
September 30,
2014
 
December 31,
2013
Commodity Futures Contracts (a)
Prepayments and other current assets
 
$
373

 
$
140

 
$
324

 
$
158

Commodity Forward Contracts
Receivables
 
1

 

 

 

Commodity Forward Contracts
Accounts payable
 

 

 
1

 
1

Foreign Currency Forward
   Contracts
Accounts payable
 

 

 
1

 

Total Gross Mark-to-Market
   Derivatives
 
 
374

 
140

 
326

 
159

Less: Counterparty Netting and
   Cash Collateral (b)
 
 
(302
)
 
(72
)
 
(324
)
 
(137
)
Total Net Fair Value of Derivatives
 
 
$
72

 
$
68

 
$
2

 
$
22

________________
(a)
We had derivative assets totaling $7 million and $3 million at September 30, 2014 and December 31, 2013, respectively, related to corn futures used to manage our biofuel exposure. Additionally, we had derivative liabilities totaling $3 million and $1 million at September 30, 2014 and December 31, 2013, respectively, related to corn futures.
(b)
As of September 30, 2014 and December 31, 2013, cash collateral amounts of $22 million and $65 million, respectively, are netted with mark-to-market derivative assets.

Gains (losses) for our mark-to market derivatives for the three and nine months ended September 30, 2014 and 2013 were as follows (in millions):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2014
 
2013
 
2014
 
2013
Commodity Futures Contracts
$
167

 
$
(73
)
 
$
90

 
$
(89
)
Commodity OTC Swap Contracts
(2
)
 

 
(5
)
 

Commodity Forward Contracts
1

 
7

 
5

 
3

Foreign Currency Forward Contracts
(3
)
 

 
(3
)
 
(4
)
Total Gain (Loss) on Mark-to-Market Derivatives
$
163

 
$
(66
)
 
$
87

 
$
(90
)


12

TESORO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

The income statement location of gains (losses) for our mark-to market derivatives above were as follows (in millions):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2014
 
2013
 
2014
 
2013
Revenues
$
6

 
$
(10
)
 
$
7

 
$

Cost of sales
160

 
(45
)
 
83

 
(65
)
Other income, net
(3
)
 

 
(3
)
 
(4
)
Net loss from discontinued operations

 
(11
)
 

 
(21
)
Total Gain (Loss) on Mark-to-Market Derivatives
$
163

 
$
(66
)
 
$
87

 
$
(90
)

Open Long (Short) Positions

The information below presents the net volume of outstanding commodity and other contracts by type of instrument, year of maturity and unit of measure as of September 30, 2014 (units in thousands):
 
 
Contract Volumes by Year of Maturity
 
 
Mark-to-Market Derivative Instrument
 
2014
 
2015
 
2016
 
2017
 
Unit of Measure
Crude oil, refined products and blending products:
 
 
 
 
 
 
 
 
 
 
Futures - short
 
(8,625)
 
(116)
 
 
 
Barrels
OTC Swaps - long
 
200
 
 
 
 
Barrels
Forwards - short
 
(272)
 
 
 
 
Barrels
Carbon credits:
 
 
 
 
 
 
 
 
 
 
Futures - long
 
 
 
1,000
 
1,000
 
Tons
Renewable identification numbers:
 
 
 
 
 
 
 
 
 
 
Futures - short
 
(500)
 
 
 
 
Gallons
Corn:
 
 
 
 
 
 
 
 
 
 
Futures - short
 
(2,720)
 
 
 
 
Bushels

At September 30, 2014, we had open Forward Contracts to purchase CAD $66 million that matured on October 24, 2014.

NOTE I – FAIR VALUE MEASUREMENTS

We classify financial assets and liabilities according to the fair value hierarchy. Financial assets and liabilities classified as level 1 instruments are valued based on quoted prices in active markets for identical assets and liabilities. Level 2 instruments are valued based on quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices, such as liquidity, that are observable for the asset or liability. These instruments include derivative instruments that are valued using market quotations from independent price reporting agencies, third-party broker quotes and price curves derived from commodity exchange postings that are corroborated with market data. Level 3 instruments are valued based on unobservable inputs that are supported by little or no market activity and that are significant to the fair value of the assets or liabilities. We do not have any financial assets or liabilities classified as level 3 at September 30, 2014 or December 31, 2013.

Our financial assets and liabilities measured at fair value on a recurring basis include derivative instruments along with obligations for Renewable Identification Numbers (“RINs”) and cap and trade emission credits for the state of California (together with RINs, our “Environmental Credit Obligations”). See Note H for further information on our derivative instruments. Our Environmental Credit Obligations represent the fair value of our deficit at each balance sheet date for RINs and California cap and trade credits needed to satisfy requirements mandated by the U.S. Environmental Protection Agency (“EPA”) and the state of California, respectively. RINs are assigned to biofuels produced or imported into the U.S. as required by the EPA, which sets annual quotas for the percentage of biofuels that must be blended into transportation fuels consumed in the U.S. As a producer of petroleum transportation fuels, we are required to blend biofuels into the products we produce at a rate that will meet the EPA’s quota. If we are unable to blend at that rate, we must purchase RINs in the open market to satisfy the requirement. Our liability for cap and trade emission credits for the state of California represent our deficit of credits to satisfy emission reduction requirements mandated in California’s Assembly Bill 32 in each period for which our carbon emissions exceed the level allowed by the regulation.


13

TESORO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Financial assets and liabilities recognized at fair value in our condensed consolidated balance sheets by level within the fair value hierarchy were as follows (in millions):
 
September 30, 2014

Level 1

Level 2

Level 3
 
Netting and Collateral (a)
 
Total
Assets:





 
 
 
 
Commodity Futures Contracts
$
360

 
$
13

 
$

 
$
(302
)
 
$
71

Commodity Forward Contracts

 
1

 

 

 
1

Total Assets
$
360

 
$
14

 
$

 
$
(302
)
 
$
72










 
 
 
 
Liabilities:








 
 
 
 
Commodity Futures Contracts
$
316

 
$
8

 
$

 
$
(324
)
 
$

Commodity Forward Contracts

 
1

 

 

 
1

Foreign Currency Forward Contracts

 
1

 

 

 
1

Environmental Credit Obligations

 
18

 

 

 
18

Total Liabilities
$
316

 
$
28

 
$

 
$
(324
)
 
$
20


 
December 31, 2013
 
Level 1
 
Level 2
 
Level 3
 
Netting and Collateral (a)
 
Total
Assets:
 
 
 
 
 
 
 
 
 
Commodity Futures Contracts
$
136

 
$
4

 
$

 
$
(72
)
 
$
68

Total Assets
$
136

 
$
4

 
$

 
$
(72
)
 
$
68

 
 
 
 
 
 
 
 
 
 
Liabilities:
 
 
 
 
 
 
 
 
 
Commodity Futures Contracts
$
156

 
$
2

 
$

 
$
(137
)
 
$
21

Commodity Forward Contracts

 
1

 

 

 
1

Environmental Credit Obligations

 
5

 

 

 
5

Total Liabilities
$
156

 
$
8

 
$

 
$
(137
)
 
$
27

________________
(a)
Certain of our derivative contracts, under master netting arrangements, include both asset and liability positions. We offset both the fair value amounts and any related cash collateral amounts recognized for multiple derivative instruments executed with the same counterparty when there is a legally enforceable right and an intention to settle net or simultaneously. As of September 30, 2014 and December 31, 2013, cash collateral amounts of $22 million and $65 million, respectively, are netted with mark-to-market derivative assets.

We believe the carrying value of our other financial instruments, including cash and cash equivalents, receivables, accounts payable and certain accrued liabilities approximate fair value. Our fair value assessment incorporates a variety of considerations, including the short-term duration of the instruments (less than one percent of our trade receivables and payables are outstanding for greater than 90 days), and the expected future insignificance of bad debt expense, which includes an evaluation of counterparty credit risk. The borrowings under the Tesoro Corporation revolving credit facility (the “Revolving Credit Facility”), the TLLP senior secured revolving credit agreement (the “TLLP Revolving Credit Facility”) and our term loan credit facility agreement (the “Term Loan Credit Facility”), which include variable interest rates, approximate fair value. The fair value of our fixed rate debt is based on prices from recent trade activity and is categorized in level 2 of the fair value hierarchy. The carrying and fair value of our debt were both approximately $2.9 billion at September 30, 2014. The carrying value and fair value of our debt were approximately $2.8 billion and $2.9 billion, respectively, at December 31, 2013.


14

TESORO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE J – DEBT

Our total debt balance at September 30, 2014 and December 31, 2013 was as follows (in millions):
 
September 30,
2014
 
December 31,
2013
Total debt (a)
$
2,944

 
$
2,829

Less: Current maturities
6

 
6

Debt, less current maturities
$
2,938

 
$
2,823

________________
(a)
Total debt related to TLLP, which is non-recourse to Tesoro, except for TLGP, was $1.3 billion and $1.2 billion at September 30, 2014 and December 31, 2013, respectively.

TLLP Senior Notes due 2019 and 2022

On October 29, 2014, TLLP completed the Senior Notes Offering with tranches of $500 million of 5.50% senior notes due in 2019 (the “TLLP 2019 Notes”) and $800 million of 6.25% senior notes due in 2022 (the “TLLP 2022 Notes”). Interest on each series of notes will be payable semi-annually on each April 15 and October 15, beginning April 15, 2015. The proceeds from the TLLP 2019 Notes were used to repay amounts outstanding under the TLLP Revolving Credit Facility related to its recent acquisition of logistics assets from Tesoro during the third quarter of 2014. The TLLP 2022 Notes closed into escrow to fund the QEPFS Acquisition. The remaining net proceeds from the TLLP 2019 Notes, the TLLP 2022 Notes and borrowings under the revolving credit facility will be a source of funding for the QEPFS Acquisition. The escrowed proceeds from the TLLP 2022 Notes will be released to fund the QEPFS Acquisition upon TLLP’s closing of the acquisition and other customary conditions outlined in the debt agreement. If these conditions are not satisfied by December 31, 2014 (subject to monthly extensions until February 28, 2015), the TLLP 2022 Notes can be redeemed at 100% of their initial issue price, plus accrued and unpaid interest.

TLLP Senior Note Redemption

During the three months ended September 30, 2014, using the proceeds from its August 2014 offering, TLLP redeemed an aggregate principal amount of $130 million of the 2020 Notes at a premium. TLLP recorded charges totaling $10 million as net interest and financing costs in our condensed statement of consolidated operations for premiums paid due to the early redemption and expensing of unamortized debt issuance costs. Refer to Note C for additional information on TLLP’s senior note redemption.

Exchange Offer

TLLP entered into a registration rights agreement in connection with the December 2013 private offering of $250 million of unregistered 2020 Notes (the “Unregistered Notes”). On July 25, 2014, TLLP completed an offer to exchange the Unregistered Notes for notes registered under the Securities Act of 1933, as amended (the “Exchange Notes”). In accordance with the terms of the Exchange Notes, each holder of the Unregistered Notes were entitled to receive Exchange Notes, which are identical in all material respects to the Unregistered Notes (including principal amount, interest rate, maturity and redemption rights), except that the Exchange Notes generally are not subject to transfer restrictions.


15

TESORO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

5.125% Senior Notes due 2024

Effective March 18, 2014, we issued $300 million aggregate principal amount of 5.125% Senior Notes due 2024 (the “2024 Notes”).  The 2024 Notes have a ten-year maturity and are subject to optional redemption by Tesoro beginning April 1, 2019 at premiums of 2.563% through March 31, 2020; 1.708% from April 1, 2020 through March 31, 2021; 0.854% from April 1, 2021 through March 31, 2022; and at par thereafter, or at a make-whole plus accrued and unpaid interest before April 1, 2019. In addition, at any time prior to April 1, 2017, we may redeem up to 35% of the aggregate principal amount at 105.125% of face value with proceeds from certain equity issuances. The terms of the 2024 Notes are generally less restrictive than those contained in our senior notes due in 2017 and 2022, and exclude some limitations on restricted payments, asset sales and other transactions that are included in those senior notes. These notes are unsecured obligations and guaranteed by certain of our domestic subsidiaries, excluding TLGP and TLLP and its subsidiaries. The proceeds from the issuance of the 2024 Notes, together with cash on hand, were used to pay for fees and expenses related to the note issuance and to redeem all outstanding 9.750% Senior Notes due 2019 (the “2019 Notes”) for an aggregate purchase price of $329 million, including accrued interest and premiums. In connection with the redemption of the 2019 Notes, we incurred charges totaling $31 million comprised of premiums paid on the 2019 Notes of $19 million and non-cash charges associated with the expensing of $8 million and $4 million of unamortized debt discount and issuance costs, respectively. Our debt redemption charges for the 2019 Notes are recorded in net interest and financing costs in our condensed statements of consolidated operations.

Credit Facilities Overview

We had available capacity under our credit facilities as follows at September 30, 2014 (in millions):
 
Total
Capacity
 
Amount Borrowed as of September 30, 2014
 
Outstanding
Letters of Credit
 
Available Capacity
 
Expiration
Tesoro Corporation Revolving
Credit Facility (a)
$
3,000

 
$

 
$
824

 
$
2,176

 
January 4, 2018
TLLP Revolving Credit Facility
575

 
243

 

 
332

 
December 31, 2017
Term Loan Credit Facility
398

 
398

 

 

 
May 30, 2016
Letter of Credit Facilities
1,837

 

 
784

 
1,053

 
 
Total credit facilities
$
5,810

 
$
641

 
$
1,608

 
$
3,561

 
 
________________
(a)
Borrowing base is the lesser of the amount of the periodically adjusted borrowing base or the facility’s total capacity.

As of September 30, 2014, our credit facilities were subject to the following expenses and fees:
Credit Facility
 
30 day Eurodollar (LIBOR) Rate
 
Eurodollar Margin
 
Base Rate
 
Base Rate Margin
 
Commitment Fee
(unused portion)
Tesoro Corporation Revolving Credit Facility
   ($3.0 billion) (b)
 
0.16%
 
1.50%
 
3.25%
 
0.50%
 
0.375%
TLLP Revolving Credit Facility ($575 million) (c)
 
0.16%
 
2.50%
 
3.25%
 
1.50%
 
0.50%
Term Loan Credit Facility ($398 million) (b)
 
0.16%
 
2.25%
 
3.25%
 
1.25%
 
—%
________________
(b)
We can elect the interest rate to apply to the facility between a base rate plus the base rate margin, or a Eurodollar rate, for the applicable term, plus the Eurodollar margin at the time of the borrowing. The applicable margin on the Revolving Credit Facility varies primarily based upon our credit ratings. Letters of credit outstanding under the Revolving Credit Facility incur fees at the Eurodollar margin rate.
(c)
TLLP has the option to elect if the borrowings will bear interest at either, a base rate plus the base rate margin or a Eurodollar rate, for the applicable period, plus the Eurodollar margin at the time of the borrowing. The applicable margin varies based upon a certain leverage ratio, as defined by the TLLP Revolving Credit Facility. TLLP incurs commitment fees for the unused portion of the TLLP Revolving Credit Facility. Letters of credit outstanding under the Revolving Credit Facility incur fees at the Eurodollar margin rate.


16

TESORO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Tesoro Corporation Revolving Credit Facility

At September 30, 2014, our Revolving Credit Facility provided for borrowings (including letters of credit) up to the lesser of the amount of a periodically adjusted borrowing base of approximately $4.4 billion, consisting of Tesoro’s eligible cash and cash equivalents, receivables and petroleum inventories, net of the standard reserve as defined, or the Revolving Credit Facility’s total capacity of $3.0 billion. The total available capacity can be increased up to an aggregate amount of $4.0 billion, subject to receiving increased commitments from the lenders; however, we must offer to reduce the commitments by at least $500 million on or prior to November 21, 2014, and by an additional $500 million on or prior to May 21, 2015. We had unused credit availability of approximately 73% of the eligible borrowing base at September 30, 2014.

TLLP Revolving Credit Facility

The TLLP Revolving Credit Facility provided for total loan availability of $575 million as of September 30, 2014, and TLLP may request that the loan availability be increased up to an aggregate of $650 million, subject to receiving increased commitments from the lenders. The TLLP Revolving Credit Facility is non-recourse to Tesoro, except for TLGP, and is guaranteed by all of TLLP’s subsidiaries and secured by substantially all of TLLP’s assets. Borrowings are available under the TLLP Revolving Credit Facility up to the total loan availability of the facility. There were $243 million in borrowings outstanding under the TLLP Revolving Credit Facility, which incurred interest at a weighted average interest rate of 2.65% at September 30, 2014. In conjunction with the announcement of the QEPFS Acquisition, TLLP executed a commitment letter to amend and restate the TLLP Revolving Credit Facility to increase the total loan availability to $900 million and extend the maturity date five years from the date the facility is amended and restated.

Term Loan Credit Facility

We entered into the Term Loan Credit Facility in January 2013, which allowed us to borrow up to an aggregate of $500 million. We borrowed $500 million on May 30, 2013 to fund a portion of the Los Angeles Acquisition. The obligations under the Term Loan Credit Facility are secured by all equity interests of Tesoro Refining & Marketing Company LLC and Tesoro Alaska Company LLC, the Tesoro and USA Gasoline trademarks and those trademarks containing the name “ARCO” acquired in the Los Angeles Acquisition and junior liens on certain assets. The Term Loan Credit Facility may be repaid at any time but amounts may not be re-borrowed. The borrowings under our Term Loan Credit Facility incurred interest at a rate of 2.40% as of September 30, 2014.

Our Revolving Credit Facility, senior notes and Term Loan Credit Facility each limit our ability to make certain restricted payments (as defined in our debt agreements), which include dividends, purchases of our stock or voluntary prepayments of subordinate debt. The aggregate amount of restricted payments cannot exceed an amount defined in each of the debt agreements. The indentures for our senior notes also limit certain of our subsidiaries’ ability to make certain payments and distributions.

Letter of Credit Agreements

The Revolving Credit Facility allows us to obtain letters of credit under separate letter of credit agreements for foreign crude oil purchases. Our uncommitted letter of credit agreements had $784 million outstanding as of September 30, 2014. Capacity under these letter of credit agreements is available on an uncommitted basis and can be terminated by either party at any time.

NOTE K – BENEFIT PLANS

Tesoro sponsors four defined benefit pension plans, including one funded qualified employee retirement plan and three unfunded nonqualified executive plans. Although our funded employee retirement plan fully meets all funding requirements under applicable laws and regulations, we voluntarily contributed $60 million during the nine months ended September 30, 2014 to improve the funded status of the plan. Tesoro also provides other postretirement health care benefits to retirees who met certain service requirements and were participating in our group health insurance program at retirement.


17

TESORO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

The components of pension and other postretirement benefit expense (income) for the three and nine months ended September 30, 2014 and 2013 were (in millions):
 
Pension Benefits
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2014
 
2013
 
2014
 
2013
Service cost
$
12

 
$
13

 
$
38

 
$
27

Interest cost
7

 
9

 
24

 
22

Expected return on plan assets
(6
)
 
(6
)
 
(21
)
 
(18
)
Amortization of prior service cost

 
1

 
1

 
1

Recognized net actuarial loss
3

 
3

 
10

 
16

Net Periodic Benefit Expense
$
16

 
$
20

 
$
52

 
$
48

 
 
 
 
 
 
 
 
 
Other Postretirement Benefits
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2014
 
2013
 
2014
 
2013
Service cost
$

 
$

 
$
2

 
$
3

Interest cost
1

 
1

 
2

 
2

Amortization of prior service credit
(8
)
 
(8
)
 
(25
)
 
(27
)
Recognized net actuarial loss
1

 
1

 
4

 
6

Recognized curtailment gain

 
(17
)
 

 
(17
)
Net Periodic Benefit Income
$
(6
)
 
$
(23
)
 
$
(17
)
 
$
(33
)

NOTE L - COMMITMENTS AND CONTINGENCIES

Environmental Matters

We are 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 to certain emission sources, equipment or facilities.

We are incurring and expect to continue to incur expenses for environmental remediation liabilities at a number of currently and previously owned or operated refining, pipeline, terminal and retail station properties. We have accrued liabilities for these expenses and believe these accruals are adequate based on current information and projections that can be reasonably estimated. Additionally, we have recognized environmental remediation liabilities assumed in past acquisitions from the prior owners that include amounts estimated for site cleanup and monitoring activities arising from operations at refineries, certain terminals and pipelines, and retail stations prior to the dates of our acquisitions. Our environmental accruals are based on estimates including engineering assessments, and it is possible that our projections will change and that additional costs will be recorded as more information becomes available.


18

TESORO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Our accruals for environmental expenditures totaled $261 million and $262 million at September 30, 2014 and December 31, 2013, respectively, including $21 million and $24 million for TLLP, respectively. These accruals include $218 million and $216 million at September 30, 2014 and December 31, 2013, respectively, related to amounts estimated for site cleanup activities arising from operations at our Martinez refinery prior to August 2000 and operations of assets acquired in the Los Angeles Acquisition prior to June 1, 2013. We cannot reasonably determine the full extent of remedial activities that may be required at the Martinez refinery and for assets acquired in the Los Angeles Acquisition, and it is possible that we will identify additional investigation and remediation costs for site cleanup activities as more information becomes available. Our estimates for site cleanup activities reflect amounts for which we are responsible under applicable cost-sharing arrangements. We also have insurance policies related to certain matters at our Martinez refinery that provide coverage up to $190 million for expenditures in excess of $50 million in self-insurance. We have not recognized possible insurance recoveries and the insurer has challenged coverage and filed a declaratory relief action in federal court.

Washington Refinery Fire

The naphtha hydrotreater unit at our Washington refinery was involved in a fire in April 2010, which fatally injured seven employees and rendered the unit inoperable. The Washington State Department of Labor & Industries (“L&I”), the U.S. Chemical Safety and Hazard Investigation Board (“CSB”) and the EPA initiated separate investigations of the incident. L&I completed its investigation in October 2010, issued citations and assessed a $2.4 million fine, which we appealed. L&I reassumed jurisdiction of the citation and affirmed the allegations in December 2010. We disagree with L&I’s characterizations of operations at our Washington refinery and believe, based on available evidence and scientific reviews, that many of the agency’s conclusions are mistaken. We filed an appeal of the citation in January 2011. In separate September 2013 and November 2013 orders, the Board of Industrial Insurance Appeals granted partial summary judgment in our favor and dismissed most of the citations. We have established an accrual for this matter although we cannot currently estimate the final amount or timing of its resolution. The outcome of this matter will not have a material impact on our liquidity, financial position, or results of operations.

On May 1, 2014, the CSB finalized its investigation report on the April 2010 naphtha hydrotreater unit fire at our Washington refinery. In the report, the CSB made recommendations to federal and state agencies, the American Petroleum Industry and us. In response to the recommendations made to us, we have communicated to the CSB the actions we are and will be taking. Our completion of those actions will not have a material impact on our liquidity, financial position, or results of operations.

On August 15, 2014, the U.S. Department of Justice (“DOJ”) announced the closure of its investigation of the Washington naphtha hydrotreater fire. In the announcement, the DOJ, who conducted the investigation in conjunction with EPA, stated it declined to bring criminal charges.

We received a notice of violation (“NOV”) from the EPA alleging 46 violations of the Clean Air Act Risk Management Plan requirements at our Washington refinery on November 20, 2013. The EPA conducted an investigation of the refinery in 2011, following the April 2010 fire in the naphtha hydrotreater unit. While we have submitted a response to the EPA and requested clarification of certain allegations, we cannot currently estimate the amount or timing of the resolution of this matter. We believe the outcome will not have a material impact on our liquidity, financial position, or results of operations.

Other Matters

In the ordinary course of business, we become party to 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. We have not established accruals for these matters unless a loss is probable, and the amount of loss is currently estimable.

Legal

We are a defendant, along with other manufacturing, supply and marketing defendants, in a lawsuit brought by the Orange County Water District, alleging methyl tertiary butyl ether (“MTBE”) contamination in groundwater. The lawsuit is proceeding in the United States District Court of the Southern District of New York and the defendants are being sued for having manufactured MTBE and having manufactured, supplied and distributed gasoline containing MTBE. The plaintiff alleges, in part, that the defendants are liable for manufacturing or distributing a defective product. The suit generally seeks individual, unquantified compensatory and punitive damages and attorney’s fees. We intend to vigorously assert our defenses against this claim. While we cannot currently estimate the final amount or timing of the resolution of this matter, we have established an accrual and believe that the outcome will not have a material impact on our liquidity, financial position, or results of operations.


19

TESORO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Environmental

The EPA has alleged that we have violated certain Clean Air Act regulations at our Alaska, Washington, Martinez, North Dakota and Utah refineries. We also retained the responsibility for resolving similar allegations relating to our former Hawaii refinery, which we sold in September 2013. We previously received a NOV in March 2011 from the EPA alleging violations of Title V of the Clean Air Act at our Alaska refinery, which arose from a 2007 state of Alaska inspection and inspections by the EPA in 2008 and 2010. We also previously received NOVs in 2005 and 2008 alleging violations of the Clean Air Act at our Washington refinery. We are continuing discussions of all EPA claims with the EPA and the DOJ. The ultimate resolution of these matters could have a material impact on our future interim or annual results of operations, as we may be required to incur material capital expenditures and/or civil penalties. However, we do not believe that the outcome will have a material impact on our liquidity or financial position.

We have investigated conditions at certain active wastewater treatment units at our Martinez refinery pursuant to an order received in 2004 from the San Francisco Bay Regional Water Quality Control Board that named us as well as two previous owners of the Martinez refinery. We cannot currently estimate the amount of the ultimate resolution of the order, but we believe it will not have a material adverse impact on our liquidity, financial position, or results of operations.

Tax

We are subject to extensive federal, state and foreign tax laws and regulations. Newly enacted tax laws and regulations, and changes in existing tax laws and regulations, could result in increased expenditures in the future. We are also subject to audits by federal, state and foreign taxing authorities in the normal course of business. It is possible that tax audits could result in claims against us in excess of recorded liabilities. However, we believe that resolution of any such claim(s) would not have a material impact on our liquidity, financial position, or results of operations. It is reasonably possible that unrecognized tax benefits may decrease by as much as $8 million in the next twelve months, related primarily to state apportionment matters. However, since the tax was fully paid in prior years, the unrecognized tax benefit would be eliminated without impacting expense.


20

TESORO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE M - STOCKHOLDERS’ EQUITY

Changes to equity during the nine months ended September 30, 2014 are presented below (in millions):
 
Tesoro
Corporation
Stockholders’
Equity
 
Noncontrolling
 Interest
 
Total Equity
Balance at December 31, 2013 (a)
$
4,302

 
$
1,183

 
$
5,485

Net earnings
698

 
58

 
756

Purchases of common stock
(350
)
 

 
(350
)
Dividend payments
(104
)
 

 
(104
)
Shares issued for equity-based compensation awards (b)
14

 

 
14

Amortization of equity settled awards
20

 
1

 
21

Excess tax benefits from stock-based compensation arrangements, net
18

 

 
18

Taxes paid related to net share settlement of equity awards
(22
)
 

 
(22
)
Net proceeds from issuance of Tesoro Logistics LP common units

 
156

 
156

Distributions to noncontrolling interest

 
(63
)
 
(63
)
Other
27

 
(46
)
 
(19
)
Balance at September 30, 2014 (a)
$
4,603

 
$
1,289

 
$
5,892

________________
(a)
We have 5.0 million shares of preferred stock authorized with no par value per share. No shares of preferred stock were outstanding as of September 30, 2014 and December 31, 2013.
(b)
We issued approximately 0.5 million shares and 2.0 million shares for proceeds of $14 million and $69 million primarily for stock option exercises under our equity-based compensation plans during the nine months ended September 30, 2014 and 2013, respectively.

Share Repurchases

We are authorized by our Board to purchase shares of our common stock in open market transactions at our discretion. The Board’s authorization has no time limit and may be suspended or discontinued at any time. Purchases of our common stock can also be made to offset the dilutive effect of stock-based compensation awards and to meet our obligations under employee benefit and compensation plans, including the exercise of stock options and vesting of restricted stock and to fulfill other stock compensation requirements. We purchased approximately 6.2 million shares and 6.4 million shares of our common stock for approximately $350 million and $336 million during the nine months ended September 30, 2014 and 2013, respectively. On July 30, 2014, our Board approved a new $1.0 billion share repurchase program to become effective upon the full completion of our current $1.0 billion share repurchase authorization.

Cash Dividends

We paid cash dividends totaling $39 million and $104 million for the three and nine months ended September 30, 2014, respectively, based on a $0.30 per share and $0.25 per share quarterly cash dividend on common stock in the third quarter and the first two quarters, respectively. We paid cash dividends totaling $33 million and $88 million for the three and nine months ended September 30, 2013, respectively, based on a $0.25 per share quarterly cash dividend on common stock in the third quarter and a $0.20 per share quarterly cash dividend on common stock in the first and second quarters. On October 30, 2014, our Board declared a cash dividend of $0.30 per share, payable on December 15, 2014 to shareholders of record on November 28, 2014.

NOTE N - STOCK-BASED COMPENSATION

Stock-based compensation expense (benefit), including discontinued operations, was as follows (in millions):
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2014
 
2013
 
2014
 
2013
Stock appreciation rights (a)
$
4

 
$
(18
)
 
$
(2
)
 
$
6

Performance share awards (b)
3

 

 
7

 
10

Market stock units (c)
4

 
5

 
12

 
13

Other stock-based awards (d)
1

 

 
3

 
5

Total Stock-Based Compensation Expense (Benefit)
$
12

 
$
(13
)
 
$
20

 
$
34

________________
(a)
We paid cash of $22 million and $32 million to settle 0.8 million and 1.4 million SARs that were exercised during the nine months ended September 30, 2014 and 2013, respectively. We had $53 million and $76 million recorded in accrued liabilities associated with our SARs awards at September 30, 2014 and December 31, 2013, respectively.
(b)
We granted 0.2 million performance share awards, including awards with performance and market conditions, at a weighted average grant date fair value of $53.89 per share under the amended and restated 2011 Long-Term Incentive Plan (“2011 Plan”) during the nine months ended September 30, 2014.
(c)
We granted 0.5 million market stock units at a weighted average grant date fair value of $59.83 per unit under the 2011 Plan during the nine months ended September 30, 2014.
(d)
We have aggregated expenses for certain award types as they are not considered significant.

The income tax effect recognized in the income statement for stock-based compensation was a benefit of $7 million and an expense of $5 million for the three months ended September 30, 2014 and 2013, respectively, and a benefit of $9 million and $12 million for the nine months ended September 30, 2014 and 2013, respectively. The reduction in current taxes payable recognized from tax deductions resulting from exercises and vestings under all of our stock-based compensation arrangements totaled $7 million and $1 million for the three months ended September 30, 2014 and 2013, respectively, and $41 million and $39 million for the nine months ended September 30, 2014 and 2013, respectively.


21

TESORO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE O - OPERATING SEGMENTS

The Company’s revenues are derived from three operating segments: refining, TLLP and retail. We own and operate six petroleum refineries located in California, Washington, Alaska, North Dakota and Utah that manufacture gasoline and gasoline blendstocks, jet fuel, diesel fuel, residual fuel oil and other refined products. We sell these refined products, together with refined products purchased from third parties, at wholesale through terminal facilities and other locations and opportunistically export refined products to foreign markets. TLLP’s assets and operations include certain crude oil gathering assets and crude oil and refined products terminalling and transportation assets acquired from Tesoro and other third parties. Revenues from the TLLP segment are generated by charging fees for gathering crude oil and for terminalling, transporting and storing crude oil and refined products. Our retail segment sells gasoline, diesel fuel and convenience store items through company-operated retail stations and branded jobber/dealers in 16 states. Since we do not have significant operations in foreign countries, revenue generated and long-lived assets located in foreign countries are not material to our operations.

We evaluate the performance of our segments 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 prices which approximate market. TLLP revenues include intersegment transactions with our refining segment at prices which we believe are no less favorable to either party than those that could have been negotiated with unaffiliated parties with respect to similar services. Income taxes, other income, net, interest and financing costs, net, corporate depreciation and corporate general and administrative expenses are excluded from segment operating income.


22

TESORO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Segment information related to continuing operations is as follows:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
2014
 
2013
 
2014
 
2013
 
(In millions)
Revenues
 
 
 
 
 
 
 
Refining:
 
 
 
 
 
 
 
Refined products
$
10,409

 
$
10,674

 
$
30,429

 
$
25,564

Crude oil resales and other
434

 
358

 
1,060

 
1,425

TLLP:
 
 
 
 
 
 
 
Crude oil gathering
32

 
24

 
84

 
66

Terminalling and transportation
118

 
73

 
326

 
146

Retail:
 
 
 
 
 
 
 
Fuel (a)
3,382

 
3,362

 
9,929

 
7,087

Merchandise and other
73

 
70

 
203

 
177

Intersegment sales
(3,297
)
 
(3,320
)
 
(9,843
)
 
(6,980
)
Total Revenues
$
11,151

 
$
11,241

 
$
32,188

 
$
27,485

Segment Operating Income
 
 
 
 
 
 
 
Refining (b)
$
578

 
$
128

 
$
1,137

 
$
766

TLLP (c)
61

 
13

 
169

 
53

Retail
138

 
56

 
229

 
96

Total Segment Operating Income
777

 
197

 
1,535

 
915

Corporate and unallocated costs (d)
(75
)
 
(51
)
 
(185
)
 
(212
)
Operating Income
702

 
146

 
1,350

 
703

Interest and financing costs, net (e)
(51
)
 
(47
)
 
(169
)
 
(110
)
Other income, net (f)
12

 
22

 
14

 
78

Earnings Before Income Taxes
$
663

 
$
121

 
$
1,195

 
$
671

Depreciation and Amortization Expense
 
 
 
 
 
 
 
Refining
$
112

 
$
109

 
$
317

 
$
286

TLLP
18

 
16

 
51

 
28

Retail
10

 
9

 
30

 
26

Corporate
4

 
6

 
11

 
16

Total Depreciation and Amortization Expense
$
144

 
$
140

 
$
409

 
$
356

Capital Expenditures
 
 
 
 
 
 
 
Refining
$
118

 
$
88

 
$
280

 
$
317

TLLP
63

 
23

 
137

 
59

Retail
9

 
10

 
27

 
26

Corporate
4

 
2

 
20

 
10

Total Capital Expenditures
$
194

 
$
123

 
$
464

 
$
412

___________________________
(a)
Federal and state motor fuel taxes on sales by our retail segment are included in both revenues and cost of sales in our condensed statements of consolidated operations. These taxes totaled $148 million and $151 million for the three months ended September 30, 2014 and 2013, respectively, and $441 million and $423 million for the nine months ended September 30, 2014 and 2013, respectively.
(b)
Includes $16 million in business interruption insurance recoveries for the three and nine months ended September 30, 2013.
(c)
We present TLLP’s segment operating income net of general and administrative expenses totaling $6 million and $4 million representing TLLP’s corporate costs for the three months ended September 30, 2014 and 2013, respectively, and $14 million and $12 million for the nine months ended September 30, 2014 and 2013, respectively that are not allocated to TLLP’s operating segments.
(d)
Includes stock-based compensation expense of $12 million and benefit of $12 million for the three months ended September 30, 2014 and 2013, respectively, and expense of $20 million and $33 million for the nine months ended September 30, 2014 and 2013, respectively. The significant impact to stock-based compensation expense during the three and nine months ended September 30, 2014 compared to the prior period is primarily a result of changes in Tesoro’s stock price.
(e)
Includes charges totaling $10 million and $41 million for premiums and unamortized debt issuance costs associated with the redemption of the 2019 Notes and 2020 Notes during the three and nine months ended September 30, 2014.
(f)
Includes $54 million in refunds from a settlement of a rate proceeding from the California Public Utilities Commission for the nine months ended September 30, 2013 and the release of a $16 million legal reserve as a result of the favorable settlement of litigation for the three and nine months ended September 30, 2013.


23

TESORO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

NOTE P - CONDENSED CONSOLIDATING FINANCIAL INFORMATION

Separate condensed consolidating financial information of Tesoro Corporation (the “Parent”), subsidiary guarantors and non-guarantors is presented below. At September 30, 2014, Tesoro and certain subsidiary guarantors have fully and unconditionally guaranteed our 4.250% Senior Notes due 2017, 5.375% Senior Notes due 2022, and 2024 Notes. TLLP, in which we had a 35% ownership interest as of September 30, 2014, and other subsidiaries have not guaranteed these obligations. As a result of these guarantee arrangements, we are required to present the following condensed consolidating financial information, which should be read in conjunction with the accompanying condensed consolidated financial statements and notes thereto. This information is provided as an alternative to providing separate financial statements for guarantor subsidiaries. Separate financial statements of Tesoro’s subsidiary guarantors are not included because the guarantees are full and unconditional and these subsidiary guarantors are 100% owned and are jointly and severally liable for Tesoro’s outstanding senior notes. The information is presented using the equity method of accounting for investments in subsidiaries. Intercompany transactions between subsidiaries are presented gross and eliminated in the eliminations column. Additionally, the results of operations of the Hawaii Business have been reported as discontinued operations in these condensed consolidating statements of operations and comprehensive income for the three and nine months ended September 30, 2014 and 2013.

Condensed Consolidating Statement of Operations
for the Three Months Ended September 30, 2014
(In millions)
 
Parent
Guarantor
Subsidiaries
Non-
Guarantors
Eliminations
Consolidated
REVENUES
$

$
12,528

$
1,671

$
(3,048
)
$
11,151

COSTS AND EXPENSES:
 
 
 
 
 
Cost of sales

11,076

1,504

(2,986
)
9,594

Operating, selling, general and administrative expenses
2

692

78

(62
)
710

Depreciation and amortization expense

125

19


144

Loss on asset disposals and impairments

1



1

OPERATING INCOME (LOSS)
(2
)
634

70


702

Equity in earnings of subsidiaries
405

11


(416
)

Interest and financing costs, net
(10
)
(23
)
(28
)
10

(51
)
Other income, net


12

10

(10
)
12

EARNINGS BEFORE INCOME TAXES
393

634

52

(416
)
663

Income tax expense (benefit) (a)
(3
)
241

11


249

NET EARNINGS FROM CONTINUING OPERATIONS
396

393

41

(416
)
414

Loss from discontinued operations, net of tax

(1
)


(1
)
NET EARNINGS
396

392

41

(416
)
413

Less: Net earnings from continuing operations attributable to
   noncontrolling interest


17


17

NET EARNINGS ATTRIBUTABLE TO TESORO
   CORPORATION
$
396

$
392

$
24

$
(416
)
$
396

 
 
 
 
 
 
COMPREHENSIVE INCOME
 
 
 
 
 
Total comprehensive income
$
396

$
392

$
41

$
(416
)
$
413

Less: Noncontrolling interest in comprehensive income


17


17

COMPREHENSIVE INCOME ATTRIBUTABLE TO
   TESORO CORPORATION
$
396

$
392

$
24

$
(416
)
$
396

_________________
(a)
The income tax expense (benefit) reflected in each column does not include any tax effect of the equity in earnings from corporate subsidiaries, but does include the tax effect of the corporate partners’ share of partnership income.


24

TESORO CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)


Condensed Consolidating Statement of Operations
for the Three Months Ended September 30, 2013
(In millions)
 
Parent
Guarantor
Subsidiaries
Non-
Guarantors
Eliminations
Consolidated
REVENUES
$

$
13,233

$
1,514

$
(3,506
)
$
11,241

COSTS AND EXPENSES:
 
 
 
 
 
Cost of sales

12,436

1,424

(3,505
)
10,355

Operating, selling, general and administrative expenses
1

544

52

(1
)
596

Depreciation and amortization expense

126

14


140

Loss on asset disposals and impairments

4



4

OPERATING INCOME (LOSS)
(1
)
123

24


146

Equity in earnings of subsidiaries (a)
56

10


(66
)

Interest and financing costs, net
(7
)
(34
)
(12
)
6

(47
)
Other income, net

22

6

(6
)
22

EARNINGS BEFORE INCOME TAXES
48

121

18

(66
)
121

Income tax expense (benefit) (b)
(2
)
50

(1
)

47

NET EARNINGS FROM CONTINUING OPERATIONS
50

71

19

(66
)
74

Earnings (loss) from discontinued operations, net of tax
49

(14
)


35

NET EARNINGS
99

57

19

(66
)
109

Less: Net earnings from continuing operations attributable to
   noncontrolling interest


10


10

NET EARNINGS ATTRIBUTABLE TO TESORO
   CORPORATION
$
99

$
57

$
9

$
(66
)
$
99

 
 
 
 
 
 
COMPREHENSIVE INCOME
 
 
 
 
 
Total comprehensive income
$
99

$
57

$
19

$
(66
)
$
109

Less: Noncontrolling interest in comprehensive income


10


10

COMPREHENSIVE INCOME ATTRIBUTABLE TO
   TESORO CORPORATION
$
99

$
57

$
9

$
(66
)