-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, VlYc7G0nV3KR46ImjHRF5Pi3iDJv33R79Xx89uBkrXRa0XkzTLYyjtlcjiW1hJnU C8iniKWe7mf1oUJgWlVODQ== 0000050104-96-000024.txt : 19960517 0000050104-96-000024.hdr.sgml : 19960517 ACCESSION NUMBER: 0000050104-96-000024 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 19960331 FILED AS OF DATE: 19960515 SROS: NYSE SROS: PSE FILER: COMPANY DATA: COMPANY CONFORMED NAME: TESORO PETROLEUM CORP /NEW/ CENTRAL INDEX KEY: 0000050104 STANDARD INDUSTRIAL CLASSIFICATION: PETROLEUM REFINING [2911] IRS NUMBER: 950862768 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-03473 FILM NUMBER: 96567353 BUSINESS ADDRESS: STREET 1: 8700 TESORO DR CITY: SAN ANTONIO STATE: TX ZIP: 78217 BUSINESS PHONE: 2108288484 10-Q 1 10Q FOR QUARTER ENDED 3/31/96 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 1996 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 PETROLEUM 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.) 8700 Tesoro Drive, San Antonio, Texas 78217 (Address of Principal Executive Offices) (Zip Code) 210-828-8484 (Registrant's Telephone Number, Including Area Code) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /X/ No / / There were 25,973,388 shares of the Registrant's Common Stock outstanding at April 30, 1996. TESORO PETROLEUM CORPORATION AND SUBSIDIARIES INDEX TO FORM 10-Q FOR THE QUARTERLY PERIOD ENDED MARCH 31, 1996 PART I. FINANCIAL INFORMATION Page Item 1. Financial Statements (Unaudited) Condensed Consolidated Balance Sheets - March 31, 1996 and December 31, 1995 . . . . . . . . . . . . . . . . 3 Condensed Statements of Consolidated Operations - Three Months Ended March 31, 1996 and 1995. . . . . . . . . 4 Condensed Statements of Consolidated Cash Flows - Three Months Ended March 31, 1996 and 1995. . . . . . . . . 5 Notes to Condensed Consolidated Financial Statements. . 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. . . . . 10 PART II. OTHER INFORMATION Item 1. Legal Proceedings. . . . . . . . . . . . . . . . 21 Item 6. Exhibits and Reports on Form 8-K . . . . . . . . 23 SIGNATURES . . . . . . . . . . . . . . . . . . . . . . . . 24 2 PART I - FINANCIAL INFORMATION Item 1. Financial Statements TESORO PETROLEUM CORPORATION AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited) (Dollars in thousands except per share amounts) March 31, December 31, 1996 1995* ---- ---- ASSETS CURRENT ASSETS: Cash and cash equivalents. . . . . . . . . . $ 6,976 13,941 Receivables, less allowance for doubtful accounts of $2,434 ($1,842 at December 31, 1995). . . . . . . . . . . . . 94,400 77,534 Receivable from Tennessee Gas Pipeline Company (Note 3). . . . . . . . . . . . . . 57,201 - Inventories: Crude oil and wholesale refined products, at LIFO. . . . . . . . . . . . . . . . . . 54,977 70,406 Merchandise and retail refined products . . 5,008 5,153 Materials and supplies. . . . . . . . . . . 5,131 4,894 Prepayments and other. . . . . . . . . . . . 12,407 10,536 --------- --------- Total Current Assets. . . . . . . . . . . . 236,100 182,464 --------- --------- PROPERTY, PLANT AND EQUIPMENT: Refining and marketing . . . . . . . . . . . 323,557 322,023 Exploration and production: Oil and gas (full cost method of accounting) 136,853 124,954 Gas transportation. . . . . . . . . . . . . 6,703 6,703 Marine services. . . . . . . . . . . . . . . 27,846 12,757 Corporate. . . . . . . . . . . . . . . . . . 12,289 12,443 --------- --------- 507,248 478,880 Less accumulated depreciation, depletion and amortization . . . . . . . . . . . . . 227,206 217,191 --------- --------- Net Property, Plant and Equipment . . . . 280,042 261,689 --------- --------- RECEIVABLE FROM TENNESSEE GAS PIPELINE COMPANY (Note 3). . . . . . . . . . . . . . . - 50,680 OTHER ASSETS . . . . . . . . . . . . . . . . . 26,269 24,320 --------- --------- TOTAL ASSETS. . . . . . . . . . . . . . $ 542,411 519,153 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable . . . . . . . . . . . . . . $ 62,582 61,389 Accrued liabilities. . . . . . . . . . . . . 37,536 34,073 Current portion of long-term debt and other obligations . . . . . . . . . . . . . . . . 9,726 9,473 --------- --------- Total Current Liabilities. . . . . . . . . 109,844 104,935 --------- --------- DEFERRED INCOME TAXES. . . . . . . . . . . . . 7,308 5,389 --------- --------- OTHER LIABILITIES. . . . . . . . . . . . . . . 38,428 37,308 --------- --------- LONG-TERM DEBT AND OTHER OBLIGATIONS, LESS CURRENT PORTION. . . . . . . . . . . . . . . 154,653 155,007 --------- --------- COMMITMENTS AND CONTINGENCIES (Note 3) STOCKHOLDERS' EQUITY: Common Stock, par value $.16-2/3; authorized 50,000,000 shares; 25,912,310 shares issued and outstanding (24,780,134 in 1995) . . . . 4,318 4,130 Additional paid-in capital . . . . . . . . . 186,105 176,599 Retained earnings. . . . . . . . . . . . . . 41,755 35,785 --------- --------- Total Stockholders' Equity. . . . . . . . . 232,178 216,514 --------- --------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 542,411 519,153 ========= ========= The accompanying notes are an integral part of these condensed consolidated financial statements. * The balance sheet at December 31, 1995 has been taken from the audited consolidated financial statements at that date and condensed. 3 TESORO PETROLEUM CORPORATION AND SUBSIDIARIES CONDENSED STATEMENTS OF CONSOLIDATED OPERATIONS (Unaudited) (In thousands except per share amounts) Three Months Ended March 31, ------------------------- 1996 1995 ---- ---- REVENUES: Refining and marketing. . . . . . . . . . . . $ 187,779 185,047 Exploration and production. . . . . . . . . . 27,521 31,784 Marine services . . . . . . . . . . . . . . . 23,282 17,165 Other income (Note 4) . . . . . . . . . . . . 5,005 16 --------- --------- Total Revenues . . . . . . . . . . . . . . . 243,587 234,012 --------- --------- OPERATING COSTS AND EXPENSES: Refining and marketing. . . . . . . . . . . . 187,422 186,731 Exploration and production. . . . . . . . . . 3,406 4,846 Marine services . . . . . . . . . . . . . . . 22,481 18,399 Depreciation, depletion and amortization. . . 9,767 11,664 --------- --------- Total Operating Costs and Expenses . . . . . 223,076 221,640 --------- --------- OPERATING PROFIT . . . . . . . . . . . . . . . 20,511 12,372 General and Administrative . . . . . . . . . . (2,971) (3,814) Interest Expense . . . . . . . . . . . . . . . (3,945) (5,293) Interest Income. . . . . . . . . . . . . . . . 409 236 Other Expense, Net (Note 5). . . . . . . . . . (5,267) (1,031) --------- --------- Earnings Before Income Taxes . . . . . . . . . 8,737 2,470 Income Tax Provision . . . . . . . . . . . . . 2,767 710 --------- --------- NET EARNINGS . . . . . . . . . . . . . . . . . $ 5,970 1,760 ========= ========= EARNINGS PER SHARE . . . . . . . . . . . . . . $ .23 .07 ========= ========= WEIGHTED AVERAGE OUTSTANDING COMMON AND COMMON EQUIVALENT SHARES. . . . . . . . . . . 25,674 25,119 ========= ========= The accompanying notes are an integral part of these condensed consolidated financial statements. 4 TESORO PETROLEUM CORPORATION AND SUBSIDIARIES CONDENSED STATEMENTS OF CONSOLIDATED CASH FLOWS (Unaudited) (In thousands) Three Months Ended March 31, ------------------------- 1996 1995 ---- ---- CASH FLOWS FROM (USED IN) OPERATING ACTIVITIES: Net earnings . . . . . . . . . . . . . . . . . $ 5,970 1,760 Adjustments to reconcile net earnings to net cash from operating activities: Depreciation, depletion and amortization. . . 9,979 11,915 Amortization of deferred charges and other. . 404 440 Changes in operating assets and liabilities: Receivable from Tennessee Gas Pipeline Company. . . . . . . . . . . . . . . . . . (6,521) (11,429) Receivables, other trade . . . . . . . . . . (8,929) 16,193 Inventories. . . . . . . . . . . . . . . . . 16,582 (7,223) Other assets . . . . . . . . . . . . . . . . 297 (628) Accounts payable and other current liabilities. . . . . . . . . . . . . . . . (1,396) (1,417) Obligation payments to State of Alaska . . . (940) (629) Other liabilities and obligations. . . . . . 2,588 1,601 --------- --------- Net cash from operating activities. . . . . 18,034 10,583 --------- --------- CASH FLOWS FROM (USED IN) INVESTING ACTIVITIES: Capital expenditures . . . . . . . . . . . . . (14,249) (16,527) Acquisition of Coastwide Energy Services, Inc. (7,720) - Other. . . . . . . . . . . . . . . . . . . . . (2,042) (1,989) --------- --------- Net cash used in investing activities . . . (24,011) (18,516) --------- --------- CASH FLOWS FROM (USED IN) FINANCING ACTIVITIES: Repayments, net of borrowings of $4,200 in 1996 and $52,000 in 1995, under revolving credit facilities. . . . . . . . . . . . . . . . . . - - Payments of long-term debt . . . . . . . . . . (1,004) (545) Other. . . . . . . . . . . . . . . . . . . . . 16 10 --------- --------- Net cash used in financing activities . . . (988) (535) --------- --------- DECREASE IN CASH AND CASH EQUIVALENTS. . . . . . (6,965) (8,468) CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 13,941 14,018 --------- --------- CASH AND CASH EQUIVALENTS AT END OF PERIOD . . . $ 6,976 5,550 ========= ========= SUPPLEMENTAL CASH FLOW DISCLOSURES: Interest paid. . . . . . . . . . . . . . . . . $ 2,988 5,359 ========= ========= Income taxes paid . . . . . . . . . . . . . . $ 835 805 ========= ========= The accompanying notes are an integral part of these condensed consolidated financial statements. 5 TESORO PETROLEUM CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) NOTE 1 - BASIS OF PRESENTATION The interim condensed consolidated financial statements of Tesoro Petroleum Corporation and its subsidiaries (collectively, the "Company" or "Tesoro") are unaudited but, in the opinion of management, incorporate all adjustments necessary for a fair presentation of results for such periods. Such adjustments are of a normal recurring nature. The preparation of these condensed consolidated financial statements required the use of management's best estimates and judgment that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the quarter. 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. The accompanying condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto contained in the Company's Annual Report on Form 10-K for the year ended December 31, 1995. NOTE 2 - ACQUISITION In February 1996, the Company purchased 100% of the capital stock of Coastwide Energy Services, Inc. ("Coastwide"). The consideration for the stock of Coastwide includes approximately 1.4 million shares of Tesoro's Common Stock and $7.7 million in cash. The market price of Tesoro's Common Stock was $9.00 per share at closing of this transaction. In addition, upon closing, Tesoro repaid approximately $4.5 million of Coastwide's outstanding debt. Coastwide is primarily a provider of services and a wholesale distributor of diesel fuel and lubricants to the offshore drilling industry in the Gulf of Mexico. The Company has combined its existing marine petroleum distribution operations with Coastwide, forming a Marine Services segment. The acquisition of Coastwide was accounted for as a purchase whereby the purchase price was allocated to the assets acquired and liabilities assumed based upon their estimated fair values at the date of acquisition. Operating results of Coastwide, which have been included in the Company's consolidation since the date of acquisition, did not have a material impact on the Company's consolidated results of operations for the 1996 first quarter. NOTE 3 - COMMITMENTS AND CONTINGENCIES Gas Purchase and Sales Contract The Company is selling a portion of the gas produced from its Bob West Field to Tennessee Gas Pipeline Company ("Tennessee Gas") under a Gas Purchase and Sales Agreement ("Tennessee Gas Contract") which provides that the price of gas shall be the maximum price as calculated in accordance with Section 102(b)(2) ("Contract Price") of the Natural Gas Policy Act of 1978 ("NGPA"). In August 1990, Tennessee Gas filed suit against the Company in the District Court of Bexar County, Texas, alleging that the Tennessee Gas Contract is not applicable to the Company's properties and that the gas sales price should be the price calculated under the provisions of Section 101 of the NGPA rather than the Contract Price. During the month of March 1996, the Contract Price was $8.25 per Mcf and the average spot market price was $1.84 per Mcf. For the three months ended March 31, 1996, approximately 15% of the Company's net U.S. natural gas production was sold under the Tennessee Gas Contract. Tennessee Gas also claimed that the contract should be considered an "output contract" under Section 2.306 of the Texas Uniform Commercial Code ("UCC") and that the increases in volumes tendered under the contract exceeded those allowable for an output contract. The District Court judge returned a verdict in favor of the Company on all issues. On appeal by Tennessee Gas, the Court of Appeals for the Fourth Supreme Judicial District of Texas affirmed the validity of the Tennessee Gas Contract as to the Company's properties and held that the price payable by Tennessee Gas for the gas was the Contract Price. The Court of Appeals remanded the case to the trial court based on its determination (i) that the Tennessee Gas Contract was an output contract and (ii) that a fact issue existed as to whether the increases in the volumes of gas tendered to Tennessee Gas under the contract were made in bad faith or were unreasonably disproportionate to prior tenders. The Company sought review of the appellate court ruling on the output contract issue in the Supreme Court of Texas. Tennessee Gas also sought review of the appellate court ruling denying the remaining Tennessee Gas claims in the Supreme Court of Texas. The appellate court decision was the first 6 decision reported in Texas holding that a take-or-pay contract was an output contract. The Supreme Court of Texas heard arguments in December 1994 regarding the output contract issue and certain of the issues raised by Tennessee Gas. On August 1, 1995, the Supreme Court of Texas, in a divided opinion, affirmed the decision of the appellate court on all issues, including that the price under the Tennessee Gas Contract is the Contract Price, and determined that the Tennessee Gas Contract was an output contract and remanded the case to the trial court for determination of whether gas volumes tendered by the Company to Tennessee Gas were tendered in good faith and were not unreasonably disproportionate to any normal or otherwise comparable prior output or stated estimates in accordance with the UCC. The Company filed a motion for rehearing before the Texas Supreme Court on the issue of whether the Tennessee Gas Contract is an output contract. On April 18, 1996, the Texas Supreme Court reversed its earlier ruling on the output contract issue and held that the Tennessee Gas Contract was not an output contract. The Supreme Court affirmed its earlier decision in favor of the Company on all other issues. Tennessee Gas has until June 3, 1996 to file a motion for rehearing. The Company will respond to any motion for rehearing filed by Tennessee Gas. The Company believes that, if this issue is tried, the gas volumes tendered to Tennessee Gas will be found to have been in good faith and otherwise in accordance with the requirements of the UCC. However, there can be no assurance as to the ultimate outcome at trial. In conjunction with the District Court judgment and on behalf of all sellers under the Tennessee Gas Contract, Tennessee Gas is presently required to post a supersedeas bond in the amount of $206 million. Under the terms of this bond, for the period September 17, 1994 through April 30, 1996, Tennessee Gas was required to take at least its entire monthly take-or-pay obligation and pay for gas taken at $3.00 per Mmbtu, which approximates $3.00 per Mcf ("Bond Price"). The $206 million bond represents an amount which together with anticipated sales of natural gas at the Bond Price will equal the anticipated value of the Tennessee Gas Contract from September 17, 1994 through April 30, 1996. Except for the period September 17, 1994 through August 13, 1995, the difference between the spot market price and the Bond Price is refundable in the event Tennessee Gas ultimately prevails in the litigation. The Company retains the right to receive the Contract Price for all gas sold to Tennessee Gas. The bond shall remain in place until the Supreme Court issues its mandate on Tennessee Gas' motion for rehearing. After April 30, 1996, the Company will invoice Tennessee Gas at the Contract Price for all purchases of gas under the Tennessee Gas Contract. Through March 31, 1996, under the Tennessee Gas Contract, the Company recognized cumulative net revenues in excess of spot market prices totaling approximately $125.2 million. Of the $125.2 million incremental net revenues, the Company has received $11.0 million that is nonrefundable and $57.0 million which the Company could be required to repay in the event of an adverse ruling. The remaining $57.2 million of incremental net revenues is classified in the Company's Consolidated Balance Sheet as a current receivable at March 31, 1996 and represents the unpaid difference between the Contract Price and the Bond Price as described above. An adverse outcome of this litigation could require the Company to reverse as much as $114.2 million of the incremental revenues and could require the Company to repay as much as $57.0 million for amounts received above spot prices, plus interest if awarded by the court. Environmental The Company is subject to extensive federal, state and local environmental laws and regulations. These laws, which change frequently, regulate the discharge of materials into the environment and may require the Company to remove or mitigate the environmental effects of the disposal or release of petroleum or chemical substances at various sites or install additional controls or other modifications or changes in use for certain emission sources. The Company is currently involved with a waste disposal site near Abbeville, Louisiana, at which it has been named a potentially responsible party under the Federal Superfund law. Although this law might impose joint and several liability upon each party at each site, the extent of the Company's allocated financial contributions to the cleanup of the site is expected to be limited based upon the number of companies and the volumes of waste involved. The Company believes that its liability at the Abbeville, Louisiana site will be limited based upon the payment by the Company of a de minimis settlement amount of $2,500 at a similar site in Louisiana. The Company is also involved in remedial responses and has incurred cleanup expenditures associated with environmental matters at a number of sites, including certain of its own properties. In addition, the Company has entered into a consent decree with the Department of Justice ("DOJ") concerning the assessment of penalties with respect to 7 certain alleged violations of regulations promulgated under the Clean Air Act as discussed below. In March 1992, the Company received a Compliance Order and Notice of Violation from the Environmental Protection Agency ("EPA") alleging violations by the Company of the New Source Performance Standards under the Clean Air Act at its Alaska refinery. These allegations include failure to install, maintain and operate monitoring equipment over a period of approximately six years, failure to perform accuracy testing on monitoring equipment, and failure to install certain pollution control equipment. The Company has denied these allegations. From March 1992 to July 1993, the EPA and the Company exchanged information relevant to these allegations. In addition, the EPA conducted an environmental audit of the Company's refinery in May 1992. As a result of this audit, the EPA is also alleging violation of certain regulations related to asbestos materials. In October 1993, the EPA referred these matters to the DOJ. Subject to approval by the U.S. District Court of Alaska, the Company and the DOJ have entered into a consent decree that includes a penalty assessment of approximately $1.3 million and the agreement by the Company to incur $200,000 in costs to complete a supplemental environmental project. At March 31, 1996, the Company's accruals for environmental matters, including the alleged violations of the Clean Air Act, amounted to $9.1 million. Also included in this amount is a noncurrent liability of approximately $4 million for remediation of Kenai Pipe Line Company's ("KPL") properties, which liability has been funded by the former owners of KPL through a restricted escrow deposit. Based on currently available information, including the participation of other parties or former owners in remediation actions, the Company believes these accruals are adequate. In addition, to comply with environmental laws and regulations, the Company anticipates that it will be required to make capital improvements in 1996 of approximately $3 million, primarily for the removal and upgrading of underground storage tanks. Environmental regulations would also have required the Company to make capital improvements starting in 1996 of approximately $8 million for the installation of dike liners. However, on April 18, 1996, the Alaska Department of Environmental Conservation ("ADEC") delayed the requirement of the installation of dike liners in secondary containment systems for existing petroleum storage tanks. The April 18, 1996 ADEC Memorandum granting the delay recognizes that secondary containment options other than synthetic dike liners are appropriate, but cannot be implemented until ADEC completes guidelines addressing alternative approaches to secondary containment. The Company has applied for an alternative compliance schedule with ADEC to maintain compliance by the Company's existing storage tank facilities with the state regulations. The Company cannot presently determine when an alternative schedule will be granted. Conditions that require additional expenditures may exist for various Company sites, including, but not limited to, the Company's refinery, retail gasoline outlets (current and closed locations) and petroleum product terminals, and for compliance with the Clean Air Act. The amount of such future expenditures cannot currently be determined by the Company. Refund Claim In July 1994, a former customer of the Company ("Customer") filed suit against the Company in the United States District Court for the District of New Mexico for a refund in the amount of approximately $1.2 million, plus interest of approximately $4.4 million and attorney's fees, related to a gasoline purchase from the Company in 1979. The Customer also alleges entitlement to treble damages and punitive damages in the aggregate amount of $16.8 million. The refund claim is based on allegations that the Company renegotiated the acquisition price of gasoline sold to the Customer and failed to pass on the benefit of the renegotiated price to the Customer in violation of Department of Energy price and allocation controls then in effect. In May 1995, the court issued an order granting the Company's motion for summary judgment and dismissed with prejudice all the claims in the Customer's complaint. In June 1995, the Customer filed a notice of appeal with the U.S. Court of Appeals for the Federal Circuit. The Company cannot predict the ultimate resolution of this matter but believes the claim is without merit. 8 NOTE 4 - SEVERANCE TAX EXEMPTION In February 1996, the Texas Railroad Commission certified substantially all of the Company's proved producing reserves in the Bob West Field as high-cost gas from a designated tight formation. As a result of the Railroad Commission's certification, the Texas Comptroller's office has issued certificates for the majority of these wells, indicating that the wells have been classified as high-cost gas wells that are exempt from state severance taxes from the date of first production through August 2001. During the first quarter of 1996, based on approved severance tax exemption certificates received to date by the Company from the Texas Comptroller's office, the Company recorded $5 million of income for retroactive refunds. These exemptions also had the effect of increasing the pretax present value of the Company's year-end U.S. proved reserves by $7.7 million to $176.4 million. No current severance taxes will be recorded for production from exempt wells during 1996. NOTE 5 - CONSENT SOLICITATION During the three months ended March 31, 1996, the Company incurred costs of $2.3 million related to a recently resolved shareholder consent solicitation. See Part II, Item 1, Legal Proceedings, contained herein. 9 Item 2. TESORO PETROLEUM CORPORATION AND SUBSIDIARIES MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS RESULTS OF OPERATIONS - THREE MONTHS ENDED MARCH 31, 1996 COMPARED WITH THREE MONTHS ENDED MARCH 31, 1995 Net earnings of $6.0 million, or $.23 per share, for the three months ended March 31, 1996 ("1996 quarter") compare with net earnings of $1.8 million, or $.07 per share, for the three months ended March 31, 1995 ("1995 quarter"). Net earnings for the 1996 quarter benefited from retroactive state severance tax exemptions totaling $5 million from the Company's Bob West Field production, which were partially offset by charges of approximately $4 million primarily related to the recently resolved shareholder consent solicitation and employee termination costs. Excluding these transactions, the increase in pretax earnings in the 1996 quarter was attributable to improved operating results from all three of the Company's business segments together with reduced general and administrative expenses and interest expense. A discussion and analysis of the factors contributing to these results are presented below. 10 Refining and Marketing Three Months Ended March 31, ------------------------- (Dollars in millions except per unit amounts) 1996 1995 ---- ---- Gross Operating Revenues: Refined products . . . . . . . . . . . . . . . $ 146.7 153.6 Other, primarily crude oil resales and merchandise. . . . . . . . . . . . . . . . . 41.0 31.5 ------- ------- Gross Operating Revenues. . . . . . . . . . . $ 187.7 185.1 ======= ======= Operating Profit (Loss): Gross margin - refined products. . . . . . . . $ 19.7 15.1 Gross margin - other . . . . . . . . . . . . . 2.7 2.5 -------- -------- Gross margin. . . . . . . . . . . . . . . . . 22.4 17.6 Operating expenses . . . . . . . . . . . . . . 22.0 19.2 Depreciation and amortization. . . . . . . . . 3.0 3.0 -------- -------- Operating Loss. . . . . . . . . . . . . . . . $ (2.6) (4.6) ======== ======== Capital Expenditures . . . . . . . . . . . . . . $ 1.8 2.3 ======== ======== Refinery Operations - Throughput (average daily barrels). . . . . . . . . . . . . . . . . . . . 45,047 45,572 ======== ======== Refinery Operations - Production (average daily barrels): Gasoline . . . . . . . . . . . . . . . . . . . 13,714 12,770 Middle distillates and other . . . . . . . . . 20,837 21,714 Heavy oils and residual product. . . . . . . . 12,321 12,424 -------- -------- Total Refinery Production . . . . . . . . . . 46,872 46,908 ======== ======== Refinery Operations - Product Spread ($/barrel): Average yield value of products manufactured . $ 21.81 19.70 Cost of raw materials. . . . . . . . . . . . . 17.92 16.75 -------- -------- Refinery Product Spread . . . . . . . . . . . $ 3.89 2.95 ======== ======== Refining and Marketing - Total Product Sales (average daily barrels): Gasoline. . . . . . . . . . . . . . . . . . . . 20,022 23,328 Middle distillates. . . . . . . . . . . . . . . 29,355 38,219 Heavy oils and residual product.. . . . . . . . 17,086 13,817 -------- -------- Total Product Sales . . . . . . . . . . . . . 66,463 75,364 ======== ======== Refining and Marketing - Total Product Sales Prices ($/barrel): Gasoline. . . . . . . . . . . . . . . . . . . $ 27.66 26.84 Middle distillates. . . . . . . . . . . . . . $ 25.81 23.68 Heavy oils and residual product . . . . . . . $ 17.63 12.65 Refining and Marketing - Gross Margins on Total Product Sales ($/barrel): Average sales price . . . . . . . . . . . . . $ 24.26 22.63 Average costs of sales. . . . . . . . . . . . 21.22 20.41 -------- -------- Gross margin. . . . . . . . . . . . . . . . $ 3.04 2.22 ======== ======== The refinery product spread presented above represents the excess of yield value of the products manufactured at the refinery over the cost of raw materials used to manufacture such products. Sources of total product sales include products manufactured at the refinery, existing inventory balances and products purchased from third parties. Margins on sales of purchased products, together with the effect of changes in inventories, are included in the gross margin on total product sales presented above. During the three months ended March 31, 1996 and 1995, the Company's purchases of refined products for resale approximated 11,000 and 26,500 average daily barrels, respectively. 11 Three Months Ended March 31, 1996 Compared With Three Months Ended March 31, 1995. For the 1996 quarter, the Company was able to narrow its refining and marketing operating loss to $2.6 million, as compared to a loss of $4.6 million in the 1995 quarter. This improvement was largely due to higher margins, when compared to the 1995 quarter, and increased operating efficiencies implemented in late 1995. Partially offsetting this improvement was a charge of approximately $1.5 million, primarily related to employee termination costs and ongoing losses of several West Coast terminals. Due to market conditions, the Company is currently in the process of discontinuing its operations in California and intends to sell three Company-owned facilities. Revenues from sales of refined products were lower in the 1996 quarter as compared to the 1995 quarter due primarily to a 12% decrease in sales volumes. Total refined product sales volumes averaged 66,463 barrels per day in the 1996 quarter as compared to 75,364 barrels per day in the 1995 quarter. This decrease reflected the Company's withdrawal from certain West Coast markets, which also reduced the Company's purchases from other refiners and suppliers to 11,000 barrels per day as compared to 26,500 barrels per day in the 1995 quarter. The decrease in revenues was partially offset by higher refined product sales prices and increased sales of crude oil. To optimize the refinery's feedstock mix and in response to market conditions, the Company from time to time resells previously purchased crude oil which yielded revenues totaling $34.5 million in the 1996 quarter as compared to $25.0 million in the 1995 quarter. Costs of sales were lower in the 1996 quarter due to the lower volumes of refined products, partially offset by higher prices for crude oil and refined products. Operating expenses increased by $2.8 million primarily due to employee termination costs incurred in the 1996 quarter together with the impact of a reduction in an environmental accrual during the 1995 quarter. During the latter part of the 1996 quarter, the Company's refining and marketing segment was negatively impacted by rapidly rising crude oil prices relative to changes in refined product prices. For the month of March 1996, for example, the Company's Refining and Marketing segment's crude oil feedstock costs increased by 15%, whereas its yield value of products manufactured increased by only 6%. Entering the 1996 second quarter, the Company's refinery product spread has improved, but remains volatile due to market conditions. 12 Exploration and Production Three Months Ended March 31, ------------------------- (Dollars in millions except per unit amounts) 1996 1995 ---- ---- U.S. Oil and Gas: Gross operating revenues . . . . . . . . . . . $ 23.1 28.1 Other income - severance tax refunds . . . . . 5.0 - Production costs . . . . . . . . . . . . . . . 1.4 3.4 Other operating expenses . . . . . . . . . . . 1.0 .5 Depreciation, depletion and amortization . . . 6.3 8.6 -------- -------- Operating Profit - U.S. Oil and Gas . . . . . 19.4 15.6 -------- -------- U.S. Gas Transportation: Gross operating revenues . . . . . . . . . . . 1.4 1.0 Operating expenses . . . . . . . . . . . . . . .1 - Depreciation and amortization. . . . . . . . . .1 - -------- -------- Operating Profit - U.S. Gas Transportation . 1.2 1.0 -------- -------- Bolivia: Gross operating revenues . . . . . . . . . . . 3.1 2.6 Production costs . . . . . . . . . . . . . . . .2 .2 Other operating expenses . . . . . . . . . . . .7 .7 Depreciation, depletion and amortization . . . .3 - -------- -------- Operating Profit - Bolivia. . . . . . . . . . 1.9 1.7 -------- -------- Total Operating Profit - Exploration and Production. . . . . . . . . . . . . . . . . . $ 22.5 18.3 ======== ======== U.S.: Capital expenditures . . . . . . . . . . . . . $ 9.5 14.0 ======== ======== Net natural gas production (average daily Mcf) - Spot market and other . . . . . . . . . . . . 79,642 80,275 Tennessee Gas Contract(1) . . . . . . . . . . 14,452 25,603 -------- -------- Total production. . . . . . . . . . . . . . 94,094 105,878 ======== ======== Average natural gas sales ($/Mcf) - Spot market (2) . . . . . . . . . . . . . . . $ 1.70 1.26 Tennessee Gas Contract(1) . . . . . . . . . . $ 8.17 8.24 Average . . . . . . . . . . . . . . . . . . . $ 2.69 2.95 Average operating expenses ($/Mcf) - Lease operating expenses. . . . . . . . . . . $ .13 .17 Severance taxes . . . . . . . . . . . . . . . .03 .19 -------- -------- Total production costs. . . . . . . . . . . .16 .36 Administrative support and other. . . . . . . .12 .05 -------- -------- Total operating expenses. . . . . . . . . . $ .28 .41 ======== ======== Depletion ($/Mcf). . . . . . . . . . . . . . . $ .73 .90 Bolivia: Capital expenditures . . . . . . . . . . . . . $ 2.1 - Net natural gas production (average daily Mcf). 19,058 16,912 Average natural gas sales price ($/Mcf). . . . $ 1.32 1.25 Net crude oil (condensate) production (average daily barrels) . . . . . . . . . . . . . . . 550 552 Average crude oil price ($/barrel) . . . . . . $ 15.72 14.70 Average operating expenses ($/NeMcf) - Production costs. . . . . . . . . . . . . . . $ .10 .09 Value-added taxes . . . . . . . . . . . . . . .07 .04 Administrative support and other. . . . . . . .30 .34 -------- -------- Total operating expenses. . . . . . . . . . $ .47 .47 ======== ======== Depletion ($/NeMcf). . . . . . . . . . . . . . $ .13 - - ---------------- (1) The Company is involved in litigation with Tennessee Gas relating to a natural gas sales contract. See "Capital Resources and Liquidity--Tennessee Gas Contract," "Legal Proceedings--Tennessee Gas Contract" and Note 3 of Notes to Condensed 13 Consolidated Financial Statements. (2) Includes effects of the Company's natural gas price swaps which amounted to a loss of $.08 per Mcf and a gain of $.06 per Mcf for the three months ended March 31, 1996 and 1995, respectively. (3) Mcf is defined as one thousand cubic feet; NeMcf is defined as net equivalent one thousand cubic feet. United States Three Months Ended March 31, 1996 Compared With Three Months Ended March 31, 1995. Operating profit of $19.4 million in the 1996 quarter from the Company's U.S. oil and gas operations benefited from retroactive state severance tax exemptions totaling approximately $5 million from its Bob West Field production. Substantially all of the Company's proved producing reserves in the Bob West Field were certified by the Texas Railroad Commission as high-cost gas from a designated tight formation, eligible for state severance tax exemptions from the date of first production through August 2001. These exemptions also had the effect of increasing the pretax present value of the Company's year-end U.S. proved reserves by $7.7 million to $176.4 million. No current severance taxes will be recorded for production from exempt wells during 1996. Excluding this income of $5 million, operating profit from these operations would have been $14.4 million in the 1996 quarter, a decrease of $1.2 million from the 1995 quarter. The Company's U.S. natural gas production sold into the spot market in the 1996 quarter was essentially unchanged from the 1995 quarter; however, production sold under the Tennessee Gas Contract decreased by 43%, reflecting higher takes by Tennessee Gas during the 1995 quarter together with a decline in contract deliverability. Revenues decreased by $5.0 million due to the lower volumes sold to Tennessee Gas and a 9% decrease in the Company's weighted average sales price. Although the spot market natural gas sales price realized by the Company improved by 35%, the Company's weighted average sales price decreased to $2.69 per Mcf in the 1996 quarter, reflecting a lower percentage of production sold to Tennessee Gas at above-market prices. In the 1996 quarter, approximately 15% of the Company's total U.S. production was sold to Tennessee Gas compared to 24% in the 1995 quarter. Total production costs were lower in the 1996 quarter primarily due to lower severance taxes resulting from exemptions discussed above and lower production volumes. On an Mcf basis, the production costs were reduced to $.16 per Mcf compared to $.36 per Mcf due primarily to the exemption of severance taxes. Depreciation, depletion and amortization was lower in the 1996 quarter, primarily due to lower production volumes together with a reduced depletion rate which benefited from additions to proved reserves and elimination of certain future development costs since the 1995 quarter. The Company enters into commodity price swap agreements to reduce the risk caused by fluctuations in the prices of natural gas in the spot market. During the 1996 and 1995 quarters, the Company used such arrangements to set the price of 42% and 21%, respectively, of the natural gas production that it sold in the spot market. During the 1996 and 1995 quarters, the Company realized a loss of $.6 million (or $.08 per Mcf) and a gain of $.4 million (or $.06 per Mcf) from these price swap arrangements, respectively. As of March 31, 1996, the Company has entered into such price swaps for the remainder of 1996 production totaling 5.3 billion cubic feet for an average Houston Ship Channel price of $1.73 per Mcf. In the 1996 quarter, the Company's average spot market wellhead price per Mcf was approximately $.25 less than the average Houston Ship Channel index, the difference representing transportation and marketing costs from the wellhead in South Texas. In addition to the natural gas producing activities, during the 1996 quarter the Company's results included revenues of $1.4 million and operating profit of $1.2 million for transportation of natural gas to common carrier pipelines in the South Texas area, of which approximately 52% relates to transportation of the Company's production. Bolivia Three Months Ended March 31, 1996 Compared With Three Months Ended March 31, 1995. Operating profit from the Company's Bolivian operations improved by $.2 million during the 1996 quarter primarily due to a 13% increase in average daily natural gas production, together with an approximate 6% increase in the average prices received for both natural gas and condensate. The increase in the Company's natural gas production was primarily related to increased demand from the Bolivian state-owned oil and gas company for higher quality natural gas, in order to meet contract specifications for its exports to Argentina. Partially offsetting the increase 14 in revenues was depreciation, depletion and amortization of $.3 million recorded in the 1996 quarter. On April 30, 1996, a new Bolivian Hydrocarbons Law was approved by the Bolivian government. The Company is assessing the impact of this new law on its Bolivian operations. Marine Services Three Months Ended March 31, ------------------------- (Dollars in millions) 1996 1995 ---- ---- Gross Operating Revenues . . . . . . . . . . . . $ 23.3 17.2 Costs of Sales . . . . . . . . . . . . . . . . . 18.6 15.1 -------- -------- Gross Margin . . . . . . . . . . . . . . . . . 4.7 2.1 Operating Expenses and Other . . . . . . . . . . 4.0 3.3 Depreciation and Amortization. . . . . . . . . . .1 .1 -------- -------- Operating Profit (Loss). . . . . . . . . . . . $ .6 (1.3) ======== ======== Capital Expenditures . . . . . . . . . . . . . . $ .7 - ======== ======== Refined Product Sales (average daily barrels). . 7,954 6,930 ======== ======== Three Months Ended March 31, 1996 Compared With Three Months Ended March 31, 1995. On February 20, 1996, the Company acquired Coastwide Energy Services, Inc. ("Coastwide") and combined these operations with its marine petroleum products distribution business, forming a Marine Service segment. As a combined operation, the Marine Services segment is a wholesale distributor of diesel fuel and lubricants and a provider of services to the offshore drilling industry in the Gulf of Mexico. Operating results from Coastwide have been included in the Company's Marine Services segment since the date of acquisition. The improvement in operating results in the 1996 quarter was largely attributable to increased volumes related to the acquisition together with improved margins and initiatives to improve operating efficiencies. General and Administrative Expenses General and administrative expenses of $3.0 million in the 1996 quarter compare with $3.8 million in the 1995 quarter. The 21% decrease was primarily due to lower employee costs resulting from cost reduction measures implemented by the Company in late 1995. Interest Expense Interest expense of $3.9 million in the 1996 quarter compares with $5.3 million in the 1995 quarter. In December 1995, the Company redeemed $34.6 million of its 12-3/4% Subordinated Debentures which, together with lower borrowings under the Company's Revolving Credit Facility, resulted in interest expense savings of approximately $1.3 million during the 1996 quarter as compared to the 1995 quarter. Other Expense Other expense of $5.3 million in the 1996 quarter compares with $1.0 million in the 1995 quarter. Included in other expense in the 1996 quarter were costs of $2.3 million related to the recently resolved shareholder consent solicitation (see Part II, Item 1, Legal Proceedings, contained herein). The remaining increase of $2.0 million was primarily due to employee termination costs and write-off of deferred financing costs. Income Taxes Income taxes of $2.8 million in the 1996 quarter compare with $.7 million in the 1995 quarter. The increase was primarily due to a higher total effective tax rate for the Company during the 1996 quarter as earnings subject to U.S. tax exceeded available net operating loss and tax credit carryforwards. 15 IMPACT OF CHANGING PRICES The Company's operating results and cash flows are sensitive to the volatile changes in energy prices. Major shifts in the cost of crude oil used for refinery feedstocks and the price of refined products can result in a change in gross margin from the refining and marketing operations, as prices received for refined products may or may not keep pace with changes in crude oil costs. These energy prices, together with volume levels, also determine the carrying value of crude oil and refined product inventory. Likewise, changes in natural gas prices impact revenues and the present value of estimated future net revenues and cash flows from the Company's exploration and production operations. From time to time, the Company may increase or decrease its natural gas production in response to market conditions. The carrying value of oil and gas assets may also be subject to noncash write-downs based on changes in natural gas prices and other determining factors. CAPITAL RESOURCES AND LIQUIDITY The Company operates in an environment where markets for crude oil, natural gas and refined products historically have been volatile and are likely to continue to be volatile in the future. The Company's liquidity and capital resources are significantly impacted by changes in the supply of and demand for crude oil, natural gas and refined petroleum products, market uncertainty and a variety of additional factors that are beyond the control of the Company. These factors include, among others, the level of consumer product demand, weather conditions, the proximity of the Company's natural gas reserves to pipelines, the capacities of such pipelines, fluctuations in seasonal demand, governmental regulations, the price and availability of alternative fuels and overall economic conditions. The Company cannot predict the future markets and prices for its natural gas or refined products and the resulting future impact on earnings and cash flows. The Company's future capital expenditures, borrowings under its credit arrangements and other sources of capital will be affected by these conditions. Although the Company expects continued market improvement, the Company's operations in the past have been adversely affected by depressed market conditions. During the 1996 quarter, the Company achieved improvement in profitability from each of its business segments as well as costs savings at the corporate level. Furthermore, the Texas Supreme Court's recent decision in April 1996 on the litigation with Tennessee Gas may remove a major financial uncertainty from the Company's capital structure that could improve the predictability of the Company's cash flow and provide for additional financial flexibility. Tennessee Gas has until June 3, 1996, to file a request for rehearing of the court's decision. See "Capital Resources and Liquidity - Tennessee Gas Contract." The Company continues to assess its existing asset base in order to maximize returns and financial flexibility through diversification, acquisitions and divestitures in all of its operating segments. This ongoing assessment includes, in the Exploration and Production segment, evaluating ways in which the Company might diversify the mix of its oil and gas assets and reduce the asset concentration associated with the Bob West Field. In the Refining and Marketing segment, the Company has been engaged in an ongoing effort to evaluate these assets and operations and has considered possible joint ventures, strategic alliances or business combinations; however, such evaluations have not resulted in any transaction. The Company continues to assess its Marine Services segment, pursuing opportunities to consolidate operations and improve efficiencies. In these regards, during the 1996 quarter, the Company completed its acquisition of Coastwide for approximately 1.4 million shares of Tesoro's Common Stock and $7.7 million in cash (see Note 2 of Notes to Condensed Consolidated Financial Statements). Credit Arrangements The Company has financing and credit arrangements with a consortium of ten banks under a three-year corporate Revolving Credit Facility ("Facility"), which is scheduled to expire in April of 1997. The Facility, which is subject to a borrowing base, provides for (i) the issuance of letters of credit up to the full amount of the borrowing base and (ii) cash borrowings up to the amount of the borrowing base attributable to domestic oil and gas reserves. At March 31, 1996, the Company had available commitments under the Facility of $90 million which included 16 a domestic oil and gas reserve component of $40 million. At March 31, 1996, the Company had outstanding letters of credit under the Facility of approximately $50 million and no cash borrowings outstanding, with remaining unused available commitments of $40 million. For the three months ended March 31, 1996, the Company's gross borrowings and repayments under the Facility totaled $4 million, which were used on a short-term basis to finance working capital requirements and capital expenditures. Outstanding obligations under the Facility are secured by liens on substantially all of the Company's trade accounts receivable and product inventory and by mortgages on the Company's refinery and South Texas natural gas reserves. Under the terms of the Facility, which has been amended from time to time, the Company is required to maintain specified levels of working capital, tangible net worth, consolidated cash flow and refining and marketing cash flow, as defined. Among other matters, the Facility contains certain restrictions with respect to (i) capital expenditures, (ii) incurrence of additional indebtedness, and (iii) dividends on capital stock. The Facility contains other covenants customary in credit arrangements of this kind. Compliance with certain financial covenants is primarily dependent on the Company's maintenance of specified levels of cash flows from operations, capital expenditures, levels of borrowings and the value of the Company's domestic oil and gas reserves. With less than a year remaining under the terms of the Facility, the Company has initiated discussions with several financial institutions with regard to providing a long-term credit facility to replace the existing Facility. Based on these discussions, the Company believes it will be able to enter into a long-term credit facility in mid-1996 with terms more favorable than the existing Facility. Debt and Other Obligations The Company's funded debt obligations at March 31, 1996 include $30 million principal amount of 12-3/4% Subordinated Debentures ("Subordinated Debentures"), which is due March 15, 2001 and bears interest at 12-3/4% per annum, and $44.1 million principal amount of 13 % Exchange Notes ("Exchange Notes"), which bear interest at 13% per annum and become due December 1, 2000. The Subordinated Debentures and Exchange Notes are redeemable at the option of the Company at 100% of principal amount, plus accrued interest. The Company continuously reviews financing alternatives with respect to its Subordinated Debentures and Exchange Notes and may, upon a final resolution of the Tennessee Gas litigation, have the opportunity to redeem the Subordinated Debentures and Exchange Notes. However, there can be no assurance whether or when the Company would propose other refinancings or would be able to retire such indebtedness. The indenture governing the Subordinated Debentures contains certain covenants, including a restriction that prevents the current payment of cash dividends on Common Stock and currently limits the Company's ability to purchase or redeem any shares of its capital stock. The limitation of dividend payments included in the indenture governing the Exchange Notes is less restrictive than the limitation imposed by the Subordinated Debentures. Capital Expenditures Capital spending for 1996 is expected to be financed through a combination of cash flows from operations, available cash reserves and borrowings under credit arrangements. For the year 1996, the Company has under consideration total capital expenditures of approximately $58 million (excluding amounts related to the purchase of Coastwide). The exploration and production segment accounts for $44 million of the budgeted expenditures with $38 million planned for U.S. activities and $6 million for Bolivia. The planned U.S. expenditures include $24 million for exploration, development and acquisition outside of the Bob West Field and $14 million for development of the Bob West Field which the Company expects to substantially complete in 1996. In Bolivia, the drilling program includes two exploratory wells. Capital spending for the refining and marketing segment is projected to be $11 million, which includes amounts for installation of facilities to allow the Company to begin producing and marketing asphalt in Alaska and for improvements and upgrades at the Company's refinery and convenience store operations. During the 1996 quarter, capital expenditures totaled $14 million (excluding amounts related to Coastwide) which were funded primarily by cash flows from operations and available cash reserves. Capital expenditures for U.S. oil and gas activities totaled $10 million for the 1996 quarter, principally for drilling and completion of three 17 development wells, participation in the drilling of three exploratory wells which are in progress and the acquisition of other working interests. In Bolivia, the Company's capital expenditures of $2 million during the 1996 quarter primarily related to an exploratory well which was completed and resulted in a discovery of oil and gas reserves. Another exploratory well in Bolivia began drilling in April 1996. Capital expenditures for the Company's refining and marketing segment totaled $2 million for the 1996 quarter, primarily for expansion of its retail marketing facilities. Cash Flows From Operating, Investing and Financing At March 31, 1996, the Company's working capital totaled $126.3 million, which included a receivable from Tennessee Gas of $57.2 million and cash of $7.0 million. For information on litigation related to a natural gas sales contract and the related impact on the Company's cash flows from operations, see "Tennessee Gas Contract" below and Note 3 of Notes to Condensed Consolidated Financial Statements. Components of the Company's cash flows are set forth below (in millions): Three Months Ended March 31, ------------------------- 1996 1995 ---- ---- Cash Flows From (Used In): Operating Activities . . . . . . . . . . . . $ 18.0 10.6 Investing Activities . . . . . . . . . . . . (24.0) (18.5) Financing Activities . . . . . . . . . . . . (1.0) (.6) -------- -------- Decrease in Cash and Cash Equivalents. . . . . $ (7.0) (8.5) ======== ======== Net cash from operating activities of $18 million during the 1996 quarter, which compares to $11 million for the 1995 quarter, included higher net earnings and changes in working capital. Net cash used in investing activities during the 1996 quarter of $24 million included capital expenditures of $14 million and cash consideration of $8 million for the acquisition of Coastwide. Such capital expenditures for the 1996 quarter included $10 million for the Company's exploration and production activities in South Texas. Net cash used in financing activities of $1 million during the 1996 quarter was primarily related to payments of long-term debt. The Company's gross borrowings and repayments under its Revolving Credit Facility totaled $4.2 million during the 1996 quarter. Tennessee Gas Contract The Company is selling a portion of the gas produced from its Bob West Field to Tennessee Gas Pipeline Company ("Tennessee Gas") under a Gas Purchase and Sales Agreement ("Tennessee Gas Contract") which provides that the price of gas shall be the maximum price as calculated in accordance with Section 102(b)(2) ("Contract Price") of the Natural Gas Policy Act of 1978 ("NGPA"). In August 1990, Tennessee Gas filed suit against the Company in the District Court of Bexar County, Texas, alleging that the Tennessee Gas Contract is not applicable to the Company's properties and that the gas sales price should be the price calculated under the provisions of Section 101 of the NGPA rather than the Contract Price. During the month of March 1996, the Contract Price was $8.25 per Mcf and the average spot market price was $1.84 per Mcf. For the three months ended March 31, 1996, approximately 15% of the Company's net U.S. natural gas production was sold under the Tennessee Gas Contract. Tennessee Gas also claimed that the contract should be considered an "output contract" under Section 2.306 of the Texas Uniform Commercial Code ("UCC") and that the increases in volumes tendered under the contract exceeded those allowable for an output contract. The District Court judge returned a verdict in favor of the Company on all issues. On appeal by Tennessee Gas, the Court of Appeals for the Fourth Supreme Judicial District of Texas affirmed the validity of the Tennessee Gas Contract as to the Company's properties and held that the price payable by Tennessee Gas for the gas was the Contract Price. The Court of Appeals remanded the case to the trial court based on its determination (i) that the Tennessee Gas Contract was an output contract and (ii) that a fact issue existed as to whether the increases in the volumes of gas tendered to Tennessee Gas under the contract were made in bad faith or were unreasonably disproportionate to prior tenders. The Company sought review of the appellate court ruling on the output contract issue in the Supreme Court of Texas. Tennessee Gas also sought review of the appellate court ruling denying the remaining Tennessee Gas claims in the Supreme Court of Texas. The appellate court decision was the first decision reported in Texas holding that a take-or-pay contract was an output contract. The Supreme Court of 18 Texas heard arguments in December 1994 regarding the output contract issue and certain of the issues raised by Tennessee Gas. On August 1, 1995, the Supreme Court of Texas, in a divided opinion, affirmed the decision of the appellate court on all issues, including that the price under the Tennessee Gas Contract is the Contract Price, and determined that the Tennessee Gas Contract was an output contract and remanded the case to the trial court for determination of whether gas volumes tendered by the Company to Tennessee Gas were tendered in good faith and were not unreasonably disproportionate to any normal or otherwise comparable prior output or stated estimates in accordance with the UCC. The Company filed a motion for rehearing before the Texas Supreme Court on the issue of whether the Tennessee Gas Contract is an output contract. On April 18, 1996, the Texas Supreme Court reversed its earlier ruling on the output contract issue and held that the Tennessee Gas Contract was not an output contract. The Supreme Court affirmed its earlier decision in favor of the Company on all other issues. Tennessee Gas has until June 3, 1996 to file a motion for rehearing. The Company will respond to any motion for rehearing filed by Tennessee Gas. The Company believes that, if this issue is tried, the gas volumes tendered to Tennessee Gas will be found to have been in good faith and otherwise in accordance with the requirements of the UCC. However, there can be no assurance as to the ultimate outcome at trial. In conjunction with the District Court judgment and on behalf of all sellers under the Tennessee Gas Contract, Tennessee Gas is presently required to post a supersedeas bond in the amount of $206 million. Under the terms of this bond, for the period September 17, 1994 through April 30, 1996, Tennessee Gas was required to take at least its entire monthly take-or-pay obligation and pay for gas taken at $3.00 per Mmbtu, which approximates $3.00 per Mcf ("Bond Price"). The $206 million bond represents an amount which together with anticipated sales of natural gas at the Bond Price will equal the anticipated value of the Tennessee Gas Contract from September 17, 1994 through April 30, 1996. Except for the period September 17, 1994 through August 13, 1995, the difference between the spot market price and the Bond Price is refundable in the event Tennessee Gas ultimately prevails in the litigation. The Company retains the right to receive the Contract Price for all gas sold to Tennessee Gas. The bond shall remain in place until the Supreme Court issues its mandate on Tennessee Gas' motion for rehearing. After April 30, 1996, the Company will invoice Tennessee Gas at the Contract Price for all purchases of gas under the Tennessee Gas Contract. Through March 31, 1996, under the Tennessee Gas Contract, the Company recognized cumulative net revenues in excess of spot market prices totaling approximately $125.2 million. Of the $125.2 million incremental net revenues, the Company has received $11.0 million that is nonrefundable and $57.0 million which the Company could be required to repay in the event of an adverse ruling. The remaining $57.2 million of incremental net revenues is classified in the Company's Consolidated Balance Sheet as a current receivable at March 31, 1996 and represents the unpaid difference between the Contract Price and the Bond Price as described above. An adverse outcome of this litigation could require the Company to reverse as much as $114.2 million of the incremental revenues and could require the Company to repay as much as $57.0 million for amounts received above spot prices, plus interest if awarded by the court. Tennessee Gas could elect, and from time to time has elected, not to take gas under the Tennessee Gas Contract. The Company recognizes revenues under the Tennessee Gas Contract based on the quantity of natural gas actually taken by Tennessee Gas. While Tennessee Gas has the right to elect not to take gas during any contract year, this right is subject to an obligation to pay within 60 days after the end of such contract year for gas not taken, subject to the provisions of the bond posting. The contract year ends on January 31 of each year. Although the failure to take gas could adversely affect the Company's income and cash flows from operating activities within a contract year, the Company should recover reduced cash flows shortly after the end of the contract year under the take-or-pay provisions of the Tennessee Gas Contract. Environmental and Other Matters The Company is subject to extensive federal, state and local environmental laws and regulations. These laws, which change frequently, regulate the discharge of materials into the environment and may require the Company to remove or mitigate the environmental effects of the disposal or release of petroleum or chemical substances at various sites or install additional controls or other modifications or changes in use for certain emission sources. The Company is currently involved in remedial responses and has incurred cleanup expenditures associated with environmental matters at a number of sites, including certain of its own properties. At March 31, 1996 the Company's accruals for 19 environmental matters, including the alleged violations of the Clean Air Act, amounted to $9.1 million. Also included in this amount is a noncurrent liability of approximately $4 million for remediation of Kenai Pipe Line Company's ("KPL") properties, which liability has been funded by the former owners of KPL through a restricted escrow deposit. Based on currently available information, including the participation of other parties or former owners in remediation actions, the Company believes these accruals are adequate. In addition, to comply with environmental laws and regulations, the Company anticipates that it will be required to make capital improvements in 1996 of approximately $3 million, primarily for the removal and upgrading of underground storage tanks. Environmental regulations would also have required the Company to make capital improvements starting in 1996 of approximately $8 million for the installation of dike liners. However, on April 18, 1996, the Alaska Department of Environmental Conservation ("ADEC") delayed the requirement of the installation of dike liners in secondary containment systems for existing petroleum storage tanks. The April 18, 1996 ADEC Memorandum granting the delay recognizes that secondary containment options other than synthetic dike liners are appropriate, but cannot be implemented until ADEC completes guidelines addressing alternative approaches to secondary containment. The Company has applied for an alternative compliance schedule with ADEC to maintain compliance by the Company's existing storage tank facilities with the state regulations. The Company cannot presently determine when an alternative schedule will be granted. Conditions that require additional expenditures may exist for various Company sites, including, but not limited to, the Company's refinery, retail gasoline outlets (current and closed locations) and petroleum product terminals, and for compliance with the Clean Air Act. The amount of such future expenditures cannot currently be determined by the Company. For further information on environmental contingencies, see Note 3 of Notes to Condensed Consolidated Financial Statements. As discussed in Note 3 of Notes to Condensed Consolidated Financial Statements, the Company is involved with other litigation and claims, none of which is expected to have a material adverse effect on the financial condition of the Company. 20 PART II - OTHER INFORMATION Item 1. Legal Proceedings Tennessee Gas Contract. The Company is selling a portion of the gas produced from its Bob West Field to Tennessee Gas Pipeline Company ("Tennessee Gas") under a Gas Purchase and Sales Agreement ("Tennessee Gas Contract") which provides that the price of gas shall be the maximum price as calculated in accordance with Section 102(b)(2) ("Contract Price") of the Natural Gas Policy Act of 1978 ("NGPA"). In August 1990, Tennessee Gas filed suit against the Company in the District Court of Bexar County, Texas, alleging that the Tennessee Gas Contract is not applicable to the Company's properties and that the gas sales price should be the price calculated under the provisions of Section 101 of the NGPA rather than the Contract Price. During the month of March 1996, the Contract Price was $8.25 per Mcf and the average spot market price was $1.84 per Mcf. For the three months ended March 31, 1996, approximately 15% of the Company's net U.S. natural gas production was sold under the Tennessee Gas Contract. Tennessee Gas also claimed that the contract should be considered an "output contract" under Section 2.306 of the Texas Uniform Commercial Code ("UCC") and that the increases in volumes tendered under the contract exceeded those allowable for an output contract. The District Court judge returned a verdict in favor of the Company on all issues. On appeal by Tennessee Gas, the Court of Appeals for the Fourth Supreme Judicial District of Texas affirmed the validity of the Tennessee Gas Contract as to the Company's properties and held that the price payable by Tennessee Gas for the gas was the Contract Price. The Court of Appeals remanded the case to the trial court based on its determination (i) that the Tennessee Gas Contract was an output contract and (ii) that a fact issue existed as to whether the increases in the volumes of gas tendered to Tennessee Gas under the contract were made in bad faith or were unreasonably disproportionate to prior tenders. The Company sought review of the appellate court ruling on the output contract issue in the Supreme Court of Texas. Tennessee Gas also sought review of the appellate court ruling denying the remaining Tennessee Gas claims in the Supreme Court of Texas. The appellate court decision was the first decision reported in Texas holding that a take-or-pay contract was an output contract. The Supreme Court of Texas heard arguments in December 1994 regarding the output contract issue and certain of the issues raised by Tennessee Gas. On August 1, 1995, the Supreme Court of Texas, in a divided opinion, affirmed the decision of the appellate court on all issues, including that the price under the Tennessee Gas Contract is the Contract Price, and determined that the Tennessee Gas Contract was an output contract and remanded the case to the trial court for determination of whether gas volumes tendered by the Company to Tennessee Gas were tendered in good faith and were not unreasonably disproportionate to any normal or otherwise comparable prior output or stated estimates in accordance with the UCC. The Company filed a motion for rehearing before the Texas Supreme Court on the issue of whether the Tennessee Gas Contract is an output contract. On April 18, 1996, the Texas Supreme Court reversed its earlier ruling on the output contract issue and held that the Tennessee Gas Contract was not an output contract. The Supreme Court affirmed its earlier decision in favor of the Company on all other issues. Tennessee Gas has until June 3, 1996 to file a motion for rehearing. The Company will respond to any motion for rehearing filed by Tennessee Gas. The Company believes that, if this issue is tried, the gas volumes tendered to Tennessee Gas will be found to have been in good faith and otherwise in accordance with the requirements of the UCC. However, there can be no assurance as to the ultimate outcome at trial. In conjunction with the District Court judgment and on behalf of all sellers under the Tennessee Gas Contract, Tennessee Gas is presently required to post a supersedeas bond in the amount of $206 million. Under the terms of this bond, for the period September 17, 1994 through April 30, 1996, Tennessee Gas was required to take at least its entire monthly take-or-pay obligation and pay for gas taken at $3.00 per Mmbtu, which approximates $3.00 per Mcf ("Bond Price"). The $206 million bond represents an amount which together with anticipated sales of natural gas at the Bond Price will equal the anticipated value of the Tennessee Gas Contract from September 17, 1994 through April 30, 1996. Except for the period September 17, 1994 through August 13, 1995, the difference between the spot market price and the Bond Price is refundable in the event Tennessee Gas ultimately prevails in the litigation. The Company retains the right to receive the Contract Price for all gas sold to Tennessee Gas. The bond shall remain in place until the Supreme Court issues its mandate on Tennessee Gas' motion for rehearing. After April 30, 1996, the Company will invoice Tennessee Gas at the Contract Price for all purchases of gas under the Tennessee Gas Contract. Through March 31, 1996, under the Tennessee Gas Contract, the Company recognized cumulative net revenues in excess of spot market prices totaling approximately $125.2 million. Of the $125.2 million incremental net revenues, the Company has received $11.0 million that is nonrefundable and $57.0 million which the Company could be required to repay in the event of an adverse ruling. The remaining $57.2 million of incremental net revenues is classified in the Company's Consolidated Balance Sheet as a current receivable at March 31, 1996 21 and represents the unpaid difference between the Contract Price and the Bond Price as described above. An adverse outcome of this litigation could require the Company to reverse as much as $114.2 million of the incremental revenues and could require the Company to repay as much as $57.0 million for amounts received above spot prices, plus interest if awarded by the court. Consent Solicitation. On December 26, 1995, the Stockholders' Committee for New Management of Tesoro Petroleum Corporation (the "Committee"), comprised of five holders of the Company's Common Stock, announced its intention to engage in a solicitation (the "Solicitation") of written consents for the primary purpose of removing the then current members of the Board and replacing them with a new board. In connection therewith, the Committee filed with the Securities and Exchange Commission ("SEC") Schedule 13D and preliminary Schedule 14A statements relating thereto. Also, on December 26, 1995, in a related action the Committee filed suit in the U.S. District Court for the Western District of Texas against Tesoro and its Chief Executive Officer, Bruce A. Smith. On January 8, 1996, the defendants filed their answer to the lawsuit, and the Company asserted various counterclaims relating to the Solicitation, including an allegation that Ardsley Advisory Partners ("Ardsley"), one of the Company's largest stockholders, was part of the Committee. On March 1, 1996, the Committee filed a definitive Schedule 14A with the SEC and thereafter commenced the Solicitation. The Company responded with its own materials seeking revocation of consents. On April 4, 1996, a settlement was reached between the Committee and certain related parties (the "Solicitation Parties"), the Company and Ardsley. Pursuant to the settlement, the parties filed a stipulation of dismissal, without prejudice and costs, of all claims in the U.S. District Court and the Solicitation Parties terminated the Solicitation and withdrew its alternate slate of directors for the 1996 annual meeting. The settlement further provides that (i) the Solicitation Parties severally have agreed, among other things, that for a period beginning as of April 4, 1996, and ending on the earlier of the day after the Company's 1999 annual meeting or June 30, 1999 (the "Standstill Period"), he or it shall not in any way, directly or indirectly, without the approval of the Board, make, encourage, participate or assist in (a) any attempt to take control of the Company, (b) any consent solicitation to remove any member of the Company's Board of Directors, (c) any solicitation of proxies to vote or become a participant in any election contest to remove any member of the Company's Board of Directors, (d) the nomination or election of any alternate director or slate of directors proposed from the floor at any meeting of the Company's stockholders, or (e) any offers or indications of interest with respect to the acquisition or disposition of the Company or any of its business units; (ii) Tesoro's Board of Directors will be expanded to nine members with the addition of Alan Kaufman, M.D., a Committee member, Sanford B. Prater, a Partner of Ardsley, one of the Company's largest stockholders, and a third individual to be selected by the Governance Committee of the Board of Directors by July 31, 1996, who will have no prior connection to the Company, the Solicitation Parties or Ardsley (Dr. Kaufman and Mr. Prater became members of the Board effective April 12, 1996); each of these persons will be nominated for election as part of the Board's recommended slate throughout the Standstill Period, except that (a) in the case of Dr. Kaufman, he shall not be replaced if he dies, resigns or is removed pursuant to the terms of the settlement agreement (in the event any of the Solicitation Parties breaches the terms of the standstill, confidentiality and non-disparagement provisions of the settlement agreement or in the event Dr. Kaufman reduces his holdings of Company Common Stock below 400,000 shares or votes for any nominee for director other than those supported by a majority of the Board), or (b) in the case of Ardsley, its designee shall not be replaced if such director resigns or is removed pursuant to the terms of the settlement agreement (in the event of a breach by Ardsley of the confidentiality provisions of the settlement agreement, or in the event that Ardsley's holdings of Company Common Stock are reduced to 50 percent or less of the number of shares held as of April 4, 1996, or Ardsley agrees or takes any action to support a change of control of Tesoro or the election to the Board of any person other than a Board nominee); (iii) Ardsley shall vote all shares owned by Ardsley in favor of the entire slate proposed for election at the 1996 annual meeting; (iv) in consideration of the above and in order to eliminate future legal fees and expenses associated with continued protracted litigation and the Solicitation, the Company agreed, subject to its right to examine all invoices, to reimburse the Solicitation Parties for a portion of their reasonable out-of-pocket expenses and legal fees incurred in connection with the lawsuit and the Solicitation (up to a maximum of $700,000) and to reimburse Ardsley for a portion of its reasonable expenses and legal fees incurred in the lawsuit up to a maximum of $200,000; and (v) provided that the parties have complied with all material obligations under the settlement agreement, at the conclusion of the Standstill Period mutual releases will be exchanged with respect to all claims and counterclaims asserted in the U.S. District Court, and in the interim the parties covenant not to sue each other and to toll the running of any applicable statutes of limitation with respect to any such claims. Environmental Matters. In March 1992, the Company received a Compliance Order and Notice of Violation from the Environmental Protection Agency ("EPA") alleging violations by the Company of the New Source Performance Standards under the Clean Air Act at its Alaska refinery. These allegations include failure to install, 22 maintain and operate monitoring equipment over a period of approximately six years, failure to perform accuracy testing on monitoring equipment, and failure to install certain pollution control equipment. The Company has denied these allegations. From March 1992 to July 1993, the EPA and the Company exchanged information relevant to these allegations. In addition, the EPA conducted an environmental audit of the Company's refinery in May 1992. As a result of this audit, the EPA is also alleging violation of certain regulations related to asbestos materials. In October 1993, the EPA referred these matters to the Department of Justice ("DOJ"). Subject to approval by the U.S. District Court of Alaska, the Company and the DOJ have entered into a consent decree that includes a penalty assessment of approximately $1.3 million and the agreement by the Company to incur $200,000 in costs to complete a supplemental environmental project. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits See the Exhibit Index immediately preceding the exhibits filed herewith. (b) Reports on Form 8-K A Current Report on Form 8-K, dated January 30, 1996, was filed on January 31, 1996, reporting under Item 5, Other Events, that the Company announced earnings for the year ended December 31, 1995 and information regarding its natural gas reserves and 1996 capital budget. No financial statements were filed as part of the Current Report. 23 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. TESORO PETROLEUM CORPORATION Registrant Date: May 15, 1996 /s/ BRUCE A. SMITH Bruce A. Smith President and Chief Executive Officer Date: May 15, 1996 /s/ WILLIAM T. VAN KLEEF William T. Van Kleef Senior Vice President and Chief Financial Officer 24 EXHIBIT INDEX Exhibit Number 27 Financial Data Schedule. 99 Settlement and Standstill Agreement, dated as of April 4, 1996, among Kevin S. Flannery, Alan Kaufman, Robert S. Washburn, James H. Stone, George F. Baker, Douglas Thompson, Gale E. Galloway, Whelan Management Corp., Ardsley Advisory Partners and Tesoro Petroleum Corporation. 25 EX-27 2 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM TESORO PETROLEUM CORPORATION'S FINANCIAL STATEMENTS AS OF AND FOR THE THREE MONTH PERIOD ENDED MARCH 31, 1996, AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 3-MOS DEC-31-1996 MAR-31-1996 6,976 0 154,035 2,434 65,116 236,100 507,248 227,206 542,411 109,844 154,653 4,318 0 0 227,860 542,411 238,582 243,587 213,309 213,309 9,979 0 3,945 8,737 2,767 5,970 0 0 0 5,970 .23 .23
EX-99 3 SETTLEMENT AND STANDSTILL AGREEMENT EXHIBIT 99 SETTLEMENT AND STANDSTILL AGREEMENT ----------------------------------- This Agreement, dated as of April 4, 1996, is among Kevin S. Flannery, Alan Kaufman, Robert S. Washburn, James H. Stone, George F. Baker, Douglas Thompson, Gale E. Galloway, and Whelan Management Corp. (together, the "Solicitation Parties"), Ardsley Advisory Partners ("Ardsley"), and Tesoro Petroleum Corporation ("Tesoro"). WHEREAS, on or about December 26, 1995, The Stockholders Committee for New Management of Tesoro Petroleum Corporation, comprised of Messrs. Flannery, Kaufman, Washburn, Stone and Baker (the "Committee), announced its intention to engage in a solicitation (the "Solicitation") of written consents for the purpose, inter alia, of removing the current members of the Board of Directors of Tesoro and replacing them with a new Board comprised of Messrs. Kaufman, Stone, Baker, Thompson and Galloway, and in connection therewith filed with the Securities and Exchange Commission ("SEC") Schedule 13D and preliminary Schedule 14A statements relating thereto; and WHEREAS, on or about December 26, 1995, the Committee commenced an action in the United States District Court for the Western District of Texas (C.A. No. SA-95-CA-1298) (the "Pending Action") against Tesoro and its Chief Executive Officer Bruce A. Smith; and WHEREAS, on or about January 8, 1996, defendants in the Pending Action filed their answer to the amended complaint, and defendant Tesoro asserted various counterclaims against the Solicitation Parties and others relating, inter alia, to the Solicitation; and WHEREAS, on or about March 1, 1996, the Committee filed a definitive Schedule 14A (the "Committee Schedule") with the SEC, and thereafter commenced the Solicitation pursuant thereto; and WHEREAS, the parties hereto have agreed to the terms of a proposed settlement that would result in the dismissal of the Pending Action and termination of the Solicitation substantially in accord with the terms set forth below; NOW, THEREFORE, in order to effectuate the settlement, and for other good and valuable consideration, the receipt of which is hereby acknowledged, the parties hereto agree as follows: 1. The parties shall execute and file with the Court as soon as practicable a stipulation of dismissal without prejudice or costs to either side, encompassing all claims and counterclaims in the Pending Action. All discovery and other proceedings in the Pending Action shall be suspended in the interim. 2. The Solicitation Parties hereby agree to terminate the Solicitation by, among other things, (a) promptly filing an amended Schedule 13D Statement announcing the termination of the Solicitation, (b) promptly issuing, or causing to be issued, with Tesoro a joint press release announcing the settlement and termination of the Solicitation, and (c) executing such other documents as may be necessary or appropriate to accomplish the settlement set forth herein. In addition, by executing this Agreement Kevin S. Flannery hereby revokes all notices to Tesoro of his intention to submit a slate of candidates at the Company's 1996 annual meeting. 3. For a period beginning on the date hereof and ending on the earlier of the day after Tesoro's 1999 annual meeting or June 30, 1999 (the "Standstill Period"), each of the Solicitation Parties severally agrees on behalf of himself or itself and his or its affiliates, agents, representatives, or any person or entity controlled or under common control with any such member, that he or it shall not, directly or indirectly, (a) make, or in any way participate or assist in, or otherwise encourage any attempt to take control of Tesoro, without the approval of the Board, whether through the acquisition of shares of capital stock during a tender offer for the common stock of Tesoro, exercising voting rights with respect to shares of capital stock or otherwise, provided, however, that this provision shall not preclude any of the Solicitation Parties from tendering shares in response to a tender offer for Tesoro shares that is made without the participation, assistance or encouragement of any of the Solicitation Parties; (b) solicit any consent or participate or assist in any way or otherwise encourage any consent solicitation seeking, without the approval of the Board, to remove any member of the Tesoro Board of Directors and/or to elect one or more new directors or to take any other action which would have the effect of removing any member of the Tesoro Board of Directors; (c) commence, support (including without limitation by giving a proxy or voting) or otherwise encourage any "solicitation" of "proxies" to vote (as such terms are defined in Rule 14a-1 of the Securities Exchange Act of 1934) or become a "participant" in any "election contest" (as such terms are defined in Rule 14a-11 of the Securities Exchange Act of 1934) in connection with any annual or special meeting of stockholders seeking, without the approval of the Board, to remove any member of the Tesoro Board of Directors and/or to elect one or more new directors not nominated for election by the Tesoro Board of Directors; (d) nominate, support (including without limitation by giving a proxy or voting) or otherwise encourage the nomination or election of any alternate director or slate of directors proposed from the 2 floor at any annual or special meeting of Tesoro stockholders; or (e) without the approval of the Board, solicit, support or otherwise encourage any offers or indications of interest with respect to the acquisition or disposition of Tesoro or any of its business units. 4. Tesoro's Board of Directors shall be expanded to include nine members. Dr. Alan Kaufman shall be added to the Tesoro Board of Directors on or before April 12, 1996. Tesoro further agrees that Dr. Kaufman shall be nominated for election as part of the Board of Directors' recommended slate throughout the Standstill Period unless he dies, resigns or is removed pursuant to paragraph 9 below. Dr. Kaufman agrees to serve as a director, if elected by the requisite vote of shareholders, throughout the Standstill Period unless he dies, resigns or is removed pursuant to paragraph 9 below. 5. Tesoro also agrees to add to its Board of Directors throughout the Standstill Period another independent director with no prior relationship or connection to Tesoro, Ardsley or any of the Solicitation Parties, who shall be selected by the Board of Directors in accordance with governance procedures that have been adopted by the Board. Tesoro agrees that the individual selected pursuant to this paragraph shall be proposed for election as soon as possible but in no event later than July 31, 1996. In the event that the independent director selected pursuant to this paragraph shall at any time during the Standstill Period die, resign or be removed from the Board of Directors (for any reason other than the failure to receive the requisite vote of shareholders), Tesoro agrees to replace such director with another independent director selected in accordance with the Company' By-laws and governance procedures then in effect. 6. Tesoro also agrees to provide Ardsley during the Standstill Period with the right to designate one of its employees (who shall not include any of the Solicitation Parties or any affiliate, agent or representative of, or other person or entity controlled by or under common control with, any of the Solicitation Parties) as a nominee for election to Tesoro's Board of Directors, subject to a normal background check. Tesoro agrees that the person designated by Ardsley pursuant to this paragraph will be added to the Tesoro Board on or before April 12, 1996. Tesoro further agrees that the employee designated by Ardsley pursuant to this paragraph shall be nominated for election as part of the Board's recommended slate throughout the Standstill Period unless he dies, resigns or is removed pursuant to paragraph 10 below. If such employee dies or resigns, Ardsley shall be entitled to designate another employee to become a director, subject to a normal background check. 3 7. Dr. Kaufman hereby agrees not to disclose without the consent of Tesoro any non-public information or trade secrets of Tesoro obtained in his capacity as a director of Tesoro to any unauthorized person including without limitation any of the Solicitation Parties, except as may be required by law. 8. Ardsley hereby agrees that the person designated pursuant to paragraph 6 above shall not disclose without the consent of Tesoro any non-public information or trade secrets of Tesoro obtained in his capacity as a director of Tesoro to any unauthorized person including without limitation any of the Solicitation Parties, except as may be required by law. 9. In the event of a breach of the provisions set forth in paragraphs 2, 3, 7, 12 or 13 of this Agreement by any of the Solicitation Parties, or in the event that the total common stock holdings of Dr. Kaufman shall at any time during the Standstill Period be reduced to less than 400,000 shares, or in the event that Dr. Kaufman shall, at any time during the Standstill Period, while he is a member of Tesoro's Board of Directors, announce his intention to vote or vote his shares of Tesoro common stock for any candidate other than the nominees for election to the Board of Directors of Tesoro proposed by a majority of Tesoro's Board, Dr. Kaufman shall immediately tender his resignation and, at the option of Tesoro, be removed from the Tesoro Board. The death, resignation or removal pursuant to the terms of this Agreement of Dr. Alan Kaufman from the Tesoro Board shall not relieve any of the Solicitation Parties from their obligations hereunder, which shall continue and remain in effect until the conclusion of the Standstill Period. 10. In the event of a breach of the provisions set forth in paragraph 8 above, or in the event that at any time during the Standstill Period (a) the total common stock holdings of Ardsley shall at any time be reduced to 50 percent or less of the number of shares held as of the date hereof, or (b) Ardsley agrees or takes any action to support a change of control of Tesoro or the election to the Tesoro Board of any person other than a Board nominee, the director designated by Ardsley pursuant to paragraph 6 above shall immediately tender his resignation and, at the option of Tesoro, be removed from the Tesoro Board. Ardsley agrees to vote all shares of common stock of Tesoro owned by Ardsley or with respect to which it or its affiliates have voting discretion in favor of the entire slate of candidates proposed for election at Tesoro's 1996 annual meeting, provided it includes the individuals selected pursuant to paragraphs 4 and 6 above. For purposes of this paragraph, Ardsley shall be deemed the owner as of the date hereof of all shares covered by the option granted to Whelan Management Corp. on November 18, 1995, unless the 4 option is exercised, in whole or in part, by Whelan or any other of the Solicitation Parties, in which case Ardsley shall not be deemed the owner as of the date hereof of any shares acquired pursuant to the exercise of such option. 11. In consideration of the above and in order to eliminate future legal fees and expenses associated with continued protracted litigation and the Solicitation, Tesoro agrees to pay the Solicitation Parties each of their reasonable out-of-pocket costs (including reasonable attorneys' fees) actually incurred in connection with the Pending Action and/or the Solicitation, up to a maximum of $700,000. Tesoro also agrees to pay Ardsley its reasonable out-of-pocket costs (including reasonable attorneys' fees) actually incurred in connection with the Pending Action, up to a maximum of $200,000. Tesoro hereby agrees to pay $500,000 to the Solicitation Parties and $140,000 to Ardsley upon execution of this Agreement and issuance of the joint press release required by paragraph 2 of this Agreement, with the balance to be paid within 15 days of receipt of the documentation required by the succeeding sentence. Tesoro shall have the right to examine all invoices and other documentation necessary to substantiate the amount and reasonableness of any fees and expenses incurred. In the event of any dispute regarding the amount of expenses to be reimbursed pursuant to this paragraph, the parties agree to submit the dispute to binding arbitration. The arbitrator shall be Dean John Feerick of Fordham Law School or, if he declines or is unable to serve, a mutually agreeable person of similar standing in the legal community. The decision of the arbitrator shall be rendered within 90 days from the date submitted to the arbitrator and the decision shall be final, conclusive and not subject to appeal. In any such arbitration, the prevailing party (i.e., the party to whom the arbitrator awards the largest portion of the amount in dispute) shall recover his or its reasonable attorneys' fees in connection therewith. 12. Each of the Solicitation Parties, Ardsley and Tesoro severally agrees that during the Standstill Period neither he nor it nor any affiliate shall make any statement or take any action that is critical or disparaging of each other or the management or performance of Tesoro. Each of the Solicitation Parties and Ardsley further severally agrees that throughout the Standstill Period neither he nor it nor any of his or its affiliates will issue any press release, knowingly make any statements to the press or other news media, or make any critical or disparaging statement to any securities analyst or institutional investor regarding the management or performance of Tesoro. 13. Each of the Solicitation Parties has delivered herewith a Revocation of Consent (the "Revocation"), revoking 5 all consents previously executed by such member or his affiliates, agents, representatives, or any person or entity controlled by or under common control with such member, if any, and such member represents and warrants to such effect to Tesoro. Each of such members, on behalf of himself or itself and his or its affiliates, agents, representatives, and any person controlled by or under common control with him, agrees to the following: A. Except as contemplated by paragraph C of this Section 13, neither he nor it nor any of his or its affiliates, agents, representatives, or any person or entity controlled by or under common control with such member, will sign or deliver any consents relating to any of the matters (the "Matters") as to which consents are, were or are proposed to be solicited pursuant to the Committee Schedule. B. Neither he nor it nor any of his or its affiliates, agents, representatives, or any person or entity controlled by or under common control with such member, will take any action to revoke the Revocation. C. Neither he nor it nor any of his or its affiliates, agents, representatives, or any person or entity controlled by or under common control with such member, will deliver to Tesoro any consents relating to any of the Matters, except the consent dated April 1, 1996, relating to 100 shares of common stock of Tesoro held in the name of Kevin S. Flannery, which consent is covered and revoked by the Revocation. D. He and it and his and its affiliates, agents, representatives, and any person or entity controlled by or under common control with such member, will immediately cease soliciting consents relating to the Matters, will not encourage, and, in response to any inquiry will specifically discourage, all other persons with respect to the delivery to Tesoro of consents relating to any of the Matters. 14. The parties hereto agree that any breach of the this Agreement shall constitute irreparable harm and entitle any party to obtain immediate injunctive relief to enforce compliance with the terms hereof. The failure of any party to seek or obtain immediate relief shall not constitute a waiver of, and shall not relieve any party from, his or its obligations hereunder. 15. In the event that Tesoro or the Board of Directors of Tesoro shall breach the provisions of paragraphs 4, 5, 6 or 12 of this Agreement, the Solicitation Parties shall be relieved of their obligations pursuant to paragraphs 6 3 and 12 of this Agreement for the balance of the Standstill Period. In the event any of the Solicitation Parties shall breach the provisions of paragraphs 2, 3, 7, 12 or 13, Tesoro shall be relieved of its obligations pursuant to paragraphs 4, 5 and 12 of this Agreement. In the event that Tesoro or the Board of Directors of Tesoro shall breach the provisions of paragraphs 6 or 12 of this Agreement, Ardsley shall be relieved of its obligations pursuant to paragraphs 10 and 12 of this Agreement for the balance of the Standstill Period. In the event that Ardsley shall breach the provisions of paragraphs 8, 10 or 12, Tesoro shall be relieved of its obligations pursuant to paragraphs 6 and 12 of this Agreement. 16. Immediately following the end of the Standstill Period, provided that the parties shall have complied with the provisions of this Agreement in all material respects, the parties hereto shall exchange mutual general releases with respect to all claims or counterclaims which have or could have been asserted, or which arise out of any of the acts, transactions or events alleged, in the Pending Action (the "Released Claims"). Tesoro hereby covenants not to sue any or each of the Solicitation Parties or Ardsley during the Standstill Period with respect to any Released Claim provided that such Solicitation Party or Ardsley, as the case may be, complies with his or its respective obligations pursuant to paragraphs 2, 3, 7, 12 and 13 above. Each of the Solicitation Parties hereby covenants not to sue Tesoro during the Standstill Period with respect to any Released Claim provided that Tesoro complies with its obligations pursuant to paragraphs 4, 5, 6 and 12 above. Each of the parties hereto hereby agrees to toll the running of the applicable statutes of limitations with respect to the Released Claims until the conclusion of the Standstill Period. The provisions of this paragraph shall not operate as a bar to an action to enforce the terms of this Agreement. 17. Except as otherwise provided herein, this Agreement shall remain in full force and effect throughout the Standstill Period, unless all of the parties hereto agree in writing to terminate this Agreement prior to the conclusion of the Standstill Period. 18. No modification, amendment or waiver of the terms of this Agreement shall be enforceable against any party hereto absent a written agreement signed by Tesoro and such other party. 19. If for any reason the settlement provided for herein is not consummated, all negotiations and proceedings relating to the settlement shall be without prejudice to the rights of the parties hereto, who shall be restored to the status quo existing as of the date of this agreement. 7 20. Neither this Agreement, nor the fact of its existence nor any of the terms hereof, nor any negotiations or proceedings relating thereto, shall be offered or received in evidence in the Pending Action or in any other action or proceeding, other than an action to enforce the terms hereof, nor shall they be deemed to constitute any evidence or admission of liability or wrongdoing on the part of any party to the Pending Action, all of which is expressly denied, it being understood that the parties have agreed to enter into this Agreement and the settlement contemplated hereunder solely to avoid the expense, distraction and inconvenience of further protracted litigation and other proceedings. 21. This Agreement shall inure to the benefit of and is binding upon the parties and their respective officers, directors, employees, partners, heirs, executors, successors, representatives, agents and assigns. 22. This Agreement shall be governed by the laws of the State of New York, exclusive of the law on conflicts of laws. 8 23. This Agreement may be executed in any number of counterparts, each of which when so executed and delivered shall be an original. The executed signature pages from each actual or telecopied counterpart may be joined together and attached to such original and shall constitute one and the same instrument. Whelan Management Corp. /s/ Kevin S. Flannery ----------------------------- Kevin S. Flannery By: /s/ Kevin S. Flannery /s/ Alan Kaufman ------------------------------- ----------------------------- Title: President Alan Kaufman Ardsley Advisory Partners /s/ Robert S. Washburn ----------------------------- Robert S. Washburn By: /s/ Kevin M. McCormack /s/ James H. Stone ------------------------------- ----------------------------- Title: Partner James H. Stone Tesoro Petroleum Corp. /s/ George F. Baker ----------------------------- George F. Baker By: /s/ Bruce A. Smith /s/ Douglas Thompson ------------------------------- ----------------------------- Title: President and Douglas Thompson Chief Executive Officer /s/ Gale E. Galloway ----------------------------- Gale E. Galloway 9 -----END PRIVACY-ENHANCED MESSAGE-----