STOCK-BASED COMPENSATION

Stock-Based Compensation Plans

We issue stock-based awards as described below to employees under the 2011 Long-Term Incentive Plan (“2011 Plan”). We also have outstanding awards under our 2006 Long-Term Incentive Plan (“2006 Plan”), Amended and Restated Executive Long-Term Incentive Plan, Non-Employee Director Stock Plan and Key Employee Stock Option Plan. Tesoro had 5,938,797 shares available for future grants under our plans at December 31, 2011. Generally, when stock options are exercised or when restricted common stock is granted we issue new shares rather than issuing treasury shares. Our plans are described below.

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The 2011 Plan permits the grant of options, stock appreciation rights, restricted common stock, restricted stock units, and incentive bonuses (which may be paid in cash, stock, or a combination thereof), any of which may be performance-based. The 2011 Plan became effective in May 2011 and no awards may be granted under the 2011 Plan on or after February 2021. Stock options may be granted at exercise prices not less than the fair market value on the date the options are granted.

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The 2006 Plan permits the grant of options, restricted common stock, deferred stock units, performance stock awards, other stock-based awards and cash-based awards. The 2006 Plan became effective in May 2006 and no awards may be granted under the 2006 Plan on or after May 2016. Stock options may be granted at exercise prices not less than the fair market value on the date the options are granted. Options granted become exercisable after one year in 33% annual increments and expire ten years from the date of grant.


•	The Amended and Restated Executive Long-Term Incentive Plan, which expired in May 2006, allowed grants in a variety of forms, including restricted stock, nonqualified stock options, stock appreciation rights and performance share and performance unit awards.

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The 1995 Non-Employee Director Stock Option Plan provided for the grant of nonqualified stock options over the life of the plan to eligible non-employee directors of Tesoro. These automatic, non-discretionary stock options were granted at an exercise price equal to the fair market value per share of Tesoro’s common stock at the date of grant. The term of each option is ten years, and an option becomes exercisable six months after it is granted. The plan expired in February 2010 and no further options may be granted under the plan.

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The Key Employee Stock Option Plan provided stock option grants to eligible employees who were not executive officers of Tesoro. The options, which become exercisable one year after grant in 25% annual increments, expire ten years after the date of grant. Our Board of Directors suspended future grants under this plan in 2003. All outstanding options were exercised during 2011 and there were no options outstanding under this plan as of December 31, 2011.

Additionally, our wholly owned subsidiary and the general partner of TLLP, Tesoro Logistics GP, LLC (“TLGP”), maintains a unit-based compensation plan for officers and directors of TLGP and its affiliates. The TLLP 2011 Long-Term Incentive Plan (“TLLP Plan”) permits the grant of options, restricted units, phantom units, unit appreciation rights, distribution equivalent rights, unit awards, and other unit-based awards. Awards granted during 2011 under the TLLP Plan will be settled with TLLP units. Compensation cost for these awards were not material to the consolidated financial statements for the year ended December 31, 2011.

Stock-based compensation expense included in our condensed statements of consolidated operations was as follows (in millions):



	2011		2010		2009
Stock appreciation rights	$	27	$	26	$	11
Restricted common stock	8		13		13
Phantom stock options	5		11		7
Market stock units	4		—		—
Performance units	3		1		—
Performance share awards	2		—		—
Stock options	2		6		15
Other	2		1		—
Total Stock-Based Compensation Expense	$	53	$	58	$	46

We have aggregated expenses for certain award types as they are not considered significant. The income tax benefit recognized in the income statement for stock-based compensation was $18 million, $23 million, $17 million for the years ended December 31, 2011, 2010 and 2009, respectively. The income tax benefit recognized from tax deductions resulting from exercises and vestings under all of our stock-based compensation arrangements totaled $29 million, $6 million and $3 million for the years ended December 31, 2011, 2010 and 2009, respectively.

Stock Appreciation Rights

A SAR entitles an employee to receive cash in an amount equal to the excess of the fair market value of one share of common stock on the date of exercise over the grant price of the SAR. The fair value of each SAR is estimated at the end of each reporting period using the Black-Scholes option-pricing model. We did not grant SARs to our employees during the year ended December 31, 2011. We paid cash of $11 million to settle SARs exercised during 2011. We had $55 million and $39 million recorded in accrued liabilities associated with our SARs awards at December 31, 2011 and 2010, respectively.

A summary of our SAR activity for the year ended December 31, 2011, is set forth below (shares in thousands):



	Number of SARs		Weighted Average Exercise Price	Weighted Average Remaining Contractual Term
Outstanding at January 1, 2011	7,372		$22.34	4.6 years
Exercised	(1,043	)	14.09
Forfeited	(292	)	23.16
Outstanding at December 31, 2011	6,037		23.72	3.5 years
Vested or expected to vest at December 31, 2011	6,037		23.72	3.5 years
Exercisable at December 31, 2011	4,345		27.53	3.2 years

The expected life of SARs granted is based on historical data and represents the period of time that the awards are expected to be outstanding. Expected volatilities are based on the historical volatility of our stock. We use historical data to estimate SAR exercise and employee termination within the valuation model. Expected dividend yield is based on annualized dividends at the date of valuation. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the date of valuation. The assumptions used to value our SARs as of December 31, 2011, 2010 and 2009 are presented below:



	2011	2010	2009
Expected life from date of grant (years)	6	6	6
Expected volatility	58%	57%	59%
Expected dividend yield	—%	—%	1.4%
Risk-free interest rate	1.2%	1.7%	3.0%

Restricted Common Stock

The fair value of each restricted share on the grant date is equal to the market price of our common stock on that date. The estimated fair value of our restricted common stock is amortized over the vesting period primarily using the straight-line method. These awards primarily vest in annual increments ratably over three years. The total fair value of restricted shares vested in 2011, 2010 and 2009 was $18 million, $7 million and $6 million, respectively. The weighted average grant date fair value per share of restricted common stock granted during 2011, 2010 and 2009 was $22.01, $12.94 and $14.13, respectively. Unrecognized compensation cost related to our non-vested restricted common stock totaled $11 million as of December 31, 2011. This cost is expected to be recognized over a weighted-average period of 1.4 years. The fair value of non-vested restricted common stock, as of December 31, 2011, totaled $23 million.

A summary of our restricted common stock activity is set forth below (shares in thousands):



	Number of Restricted Shares		Weighted-Average Grant-Date Fair Value
Nonvested at January 1, 2011	1,762		$15.46
Granted	133		22.01
Vested	(761	)	18.34
Forfeited	(148	)	13.41
Nonvested at December 31, 2011	986		14.43

Executive Phantom Stock Options

The fair value of each phantom stock option is estimated at the end of each reporting period using the Black-Scholes option-pricing model. We did not grant phantom stock options to our executive officers during the year ended December 31, 2011. We paid cash of $18 million to settle phantom stock options exercised during 2011. There were no liabilities recorded related to these awards as of December 31, 2011, as there were no remaining options outstanding. We had $15 million accrued in other noncurrent liabilities associated with these executive phantom stock option awards at December 31, 2010.

A summary of our executive phantom stock option activity is set forth below (shares in thousands):



	Number of Options		Weighted Average Exercise Price	Weighted Average Remaining Contractual Term
Outstanding at January 1, 2011	1,487		$14.13	4.9 years
Exercised	(1,421	)	14.13
Forfeited	(66	)	14.13
Outstanding at December 31, 2011	—		—	—
Vested or expected to vest at December 31, 2011	—		—	—
Exercisable at December 31, 2011	—		—	—

The expected life of phantom stock options granted is based on historical data and represents the period of time that the awards are expected to be outstanding. Expected volatilities are based on the historical volatility of our stock. We use historical employee forfeiture and termination information to estimate phantom stock option exercises in the valuation model. Expected dividend yield is based on annualized dividends at the date of valuation. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the date of valuation. The assumptions used to value our phantom stock options as of December 31, 2010 and 2009, are presented below:



	2010	2009
Expected life from date of grant (years)	7	9
Expected volatility	56%	59%
Expected dividend yield	—%	1.4%
Risk-free interest rate	1.9%	3.0%

Market Stock Units

We granted market stock units under the 2011 Plan in May 2011. These market stock units represent the right to receive a target number of shares that will vest at the end of a three-year performance period. The number of shares ultimately issued will be based on Tesoro's stock price changes over the performance period. The market stock units' potential payout can range from 50-200% of targeted award value, unless the average closing stock price at vesting has decreased more than 50% from the average closing stock price at the grant date, then no market stock units will be paid out. The fair value of each market stock unit is estimated on the grant date using a Monte Carlo simulation model. The estimated fair value of these market stock units is amortized over a three-year vesting period using the straight-line method. As of December 31, 2011, the estimated weighted average payout percentage for these awards was 87%. Total unrecognized compensation cost related to non-vested market stock units totaled $10 million as of December 31, 2011, which is expected to be recognized over a weighted average period of 2.3 years. A summary of our market stock unit award activity, assuming a 100% payout, is set forth below (units in thousands):



	Number of Units		Weighted Average Grant-Date Fair Value	Intrinsic Value
				(In millions)
Nonvested at January 1, 2011	—		$—	$—
Granted	435		34.23
Forfeited	(11	)	34.45
Nonvested at December 31, 2011	424		34.22	9

Expected volatilities are based on the historical volatility of our stock. We use historical data to estimate employee termination within the valuation model. Expected dividend yield is based on annualized dividends at the date of grant. The risk-free rate for periods within the performance period is based on the U.S. Treasury yield curve in effect at the time of grant. Tesoro’s weighted average assumptions are presented below:



		2011
Expected volatility		68%
Expected dividend yield		—%
Risk-free interest rate		0.95%

Performance Units

We granted performance units to certain officers and other key employees during 2010. These performance units represent the right to receive a cash payment at the end of the performance period depending on Tesoro’s achievement of pre-established performance measures and will vest at the end of a 33-month performance period. The value of the award ultimately paid will be based on our relative total shareholder return against the performance peer group and the S&P 500 index as well as the absolute total shareholder return of Tesoro’s common stock over the performance period. The performance units are settled in cash and can range from 0-200% of targeted award value. The fair value of each performance unit is estimated at the end of each reporting period using a Monte Carlo simulation model. We had $3 million and $1 million recorded in accrued liabilities associated with our performance units at December 31, 2011 and 2010, respectively. A summary of our performance unit activity is set forth below (units in thousands):



	Number of Performance Units		Fair Value per Unit at End of Period
Nonvested at January 1, 2011	4,984		$0.74
Granted	—
Forfeited	(689	)
Nonvested at December 31, 2011	4,295		1.20

Expected volatilities are based on the historical volatility over the most recent three-year period. Expected dividend yield is based on annualized dividends at the date of valuation. The risk-free rate is based on the U.S. Treasury yield curve in effect at the date of valuation. The assumptions used in the Monte Carlo simulation used to value our performance units as of December 31, 2011 and 2010, are presented below:



	2011	2010
Expected volatility	49%	50%
Expected dividend yield	—%	—%
Risk-free interest rate	0.3%	0.6%

Performance Share Awards

Performance Conditions

We granted performance condition performance share awards under the 2011 Plan in May 2011. The vesting percentages of these equity awards, range from 0-200%, and are tied to performance conditions over a three-year period. These performance share awards vest at the end of the performance period. The fair value of performance share awards tied to performance measures is estimated using the market price of our common stock on the grant date. The estimated fair value of these performance share awards is amortized over a three year vesting period using the straight-line method. The value of the award ultimately paid will be based on return on capital employed, which is measured against the performance peer group.

Market Conditions

We granted market condition performance share awards under the 2011 Plan in May 2011. The vesting percentages of these equity awards, range from 0-200%, and are tied to market conditions over a three-year performance period. These performance share awards vest at the end of the performance period. The fair value of each performance share award is estimated using a Monte Carlo simulation model and is estimated at the end of each reporting period. The estimated fair value of these performance share awards is amortized over a three year vesting period using the straight-line method. The value of the award ultimately paid will be based on relative total shareholder return, which is measured against the performance peer group and the S&P 500 Index.

Expected volatilities are based on the historical volatility over the most recent three year period. Expected dividend yield is based on annualized dividends at the date of valuation. The risk-free rate is based on the U.S. Treasury yield curve in effect at the date of valuation. The assumptions used in the Monte Carlo simulation used to value our market condition performance share awards as of December 31, 2011, are presented below:



		2011
Expected volatility		52%
Expected dividend yield		—%
Risk-free interest rate		0.4%

Total unrecognized compensation cost related to all non-vested performance share awards totaled $6 million as of December 31, 2011, which is expected to be recognized over a weighted average period of 2.3 years. As of December 31, 2011, the estimated weighted average payout percentage for these awards was approximately 163%. A summary of our performance share award activity, assuming a 100% payout, is set forth below (shares in thousands):



	Number of Shares		Weighted Average Grant-Date Fair Value

Nonvested at January 1, 2011	—		$—
Granted	278		31.53
Forfeited	(4	)	31.90
Nonvested at December 31, 2011	274		31.53

Stock Options

Under the terms of our stock option plans, the exercise price of options granted is equal to the fair market value of our common stock on the date of grant. The fair value of each option is estimated on the grant date using the Black-Scholes option-pricing model. The estimated fair value of these stock options is amortized over the vesting period using the straight-line method. The estimated weighted-average grant-date fair value per share of options granted during 2011, 2010 and 2009 was $12.07, $7.36 and $6.45, respectively.

Our options generally become exercisable after one year in 33% annual increments and expire ten years from the date of grant. Stock options granted in connection with the inducement awards of the CEO Agreement will vest 30% on each of the first two anniversaries of the grant date and 40% on the third anniversary of the grant date. The total intrinsic value for options exercised during 2011, 2010 and 2009 was $31 million, $7 million and $5 million, respectively. Total unrecognized compensation cost related to non-vested stock options totaled $2 million as of December 31, 2011, which is expected to be recognized over a weighted-average period of 1.4 years. The income tax benefit realized from tax deductions associated with stock options exercised during 2011 totaled $12 million.

A summary of stock option activity for all plans is set forth below (options in thousands):



	Number of Options		Weighted-Average Exercise Price	Weighted-Average Remaining Contractual Term	Aggregate Intrinsic Value
					(In millions)
Outstanding at January 1, 2011	7,428		$23.23	5.0 years	$31
Granted	70		22.05
Exercised	(1,644	)	7.49
Forfeited or expired	(186	)	22.69
Outstanding at December 31, 2011	5,668		27.80	4.8 years	24
Vested or expected to vest at December 31, 2011	5,668		27.80	4.8 years	24
Exercisable at December 31, 2011	5,170		29.08	4.4 years	20

The expected life of options granted is based on historical data and represents the period of time that options granted are expected to be outstanding. Expected volatilities are based on the historical volatility of our stock. We use historical data to estimate option exercise and employee termination within the valuation model. Expected dividend yield is based on annualized dividends at the date of grant. The risk-free rate for periods within the contractual life of the option is based on the U.S. Treasury yield curve in effect at the time of grant. Tesoro’s weighted average assumptions are presented below:



	2011	2010	2009
Expected life from date of grant (years)	6	6	6
Expected volatility	58%	59%	58%
Expected dividend yield	—%	—%	2.1%
Risk-free interest rate	1.8%	2.7%	2.0%

Board of Directors Deferred Compensation Plan

Our Non-Employee Director Phantom Stock Plan was amended and restated as the Board of Directors Deferred Compensation Plan, effective May 1, 2009. Under this plan, half of a director’s annual retainer will be paid in cash or deferred (as elected) in a cash account or a stock account. The other half of a director’s annual retainer will be mandatorily deferred into the stock account for three years. The annual retainer is paid or deferred on the last business day of each calendar quarter. New directors will receive sign-on awards that will be mandatorily deferred into the stock account. The portion of the annual retainer that is deferred into the stock account will be converted into units, based on the closing market price of Tesoro’s common stock on the date of credit. The value of each stock account is a function of the changes in the market value of Tesoro’s common stock, which is payable in cash commencing at the separation of service, death, disability or in the case of elective deferrals, an in-service lump sum. Payments may be made as a total distribution or in annual installments, not to exceed ten years.