Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

Believe me when I tell you that a webcast about merging two refining, marketing and logistics companies isn't a guaranteed thrill-fest. The best bit on Thursday's one to announce Tesoro Inc.'s acquisition of Western Refining Inc. was when an analyst asked management to "put meat on the bones" about the "low-hanging fruit" from the deal.

Dull is probably just how Tesoro likes it, though.

These are tough times for U.S. refiners battling low margins and punitive costs to comply with renewable fuel standards.

Both Barrels
It's been a tough 2016 for U.S. refining stocks
Source: Bloomberg
Note: Performance indexed to 100

So a $6.4 billion acquisition is best presented in as humdrum a manner as possible. M&A standards such as cost synergies and diversification -- Tesoro needs to reduce its reliance on West Coast markets -- featured heavily in the presentation.

Even so, there has to be more to life -- especially considering the multiple Tesoro is paying.

Excitement
At 20.7 times earnings, Tesoro is paying a premium of almost 50 percent to its own valuation for Western
Source: Bloomberg
Note: Valuations as at close of Nov. 16th 2016, except for Western Refining, which uses the offer of $37.30 per share.

Tesoro can justify this partly through sheer timing. The sector's struggles mean, in absolute terms, Western Refining isn't even getting paid its 52-week high; the $37.30 per share deal price only gets you back to where the stock traded as recently as January. Hence the reason for both sides to take an almost all-stock deal.

The valuation disparity does put the onus on delivering those synergies, however. The annual target is a range of $350 million to $425 million within two years of closing. Assuming upfront costs of one year's worth of synergies and a 10 percent discount rate, achieving the midpoint of that range is worth about $1.7 billion in today's money. Based on Tesoro's shareholders owning around three-quarters of the combined company, this would drop the effective multiple being paid to about 14.5 times earnings. That's much more middle-of-the-road.

Lurking beneath that straightforward story, though, lurks the potential for some interesting sequels.

One concerns the two master limited partnerships the companies control, Tesoro Logistics LP and Western Refining Logistics LP.

While the companies wouldn't be drawn out on future plans for these, an obvious route would be to combine them at some point. This could generate cost synergies of its own, especially if Tesoro, as the general partner, also took the opportunity to restructure incentive distribution rights, lowering the cost of equity for a combined MLP.

In logistical terms, merging the two would create a pipeline and terminals network spanning much of the western U.S. In particular, Western Refining Logistics brings a gathering and processing system tied to something that really does set hearts racing in the broader oil business: The Delaware basin within the Permian shale formation. In the context of resilient output and spiraling land values there as E&P companies snap up acreage, this aspect of the deal is all about growth, not defensiveness. It also complements Tesoro Logistics' existing position further north, in the Bakken shale.

Now throw in the fact that merging the two retail fuel businesses also sets up the tantalizing prospect of selling or spinning off that business down the road. It's almost like Tesoro buried the lead on this one.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in New York at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net