Moody's sees UDS refinery purchase as favorable

Moody's Investors Service, New York, has confirmed the Baa2 senior unsecured ratings of Ultramar Diamond Shamrock Corp. (UDS) with a stable outlook following the company's announcement that it has agreed to purchase Tosco Corp.'s Avon refinery in the San Francisco Bay area (OGJ Online, July 6, 2000).

Moody's said its confirmation of UDS's ratings is based on the strategic benefits the company will likely derive from the deal, including "increased refining capacity, greater geographic diversification, a higher concentration in the West Coast wholesale refining market, and the opportunity to integrate vertically its Northern California retail operations.

"The stable rating outlook reflects the likelihood for continued strong average refining margins for the remainder of 2000 and management's commitment to continue to apply free cash flow to net debt reduction to improve the company's financial flexibility," said Moody's. "The stable outlook also assumes that share repurchases will be minimal until the company's financial leverage returns to pre-acquisition levels, and that UDS will continue to manage prudently its capital spending program."

Moody's noted that Avon is a complex refinery that processes mainly less-expensive, heavy California crudes that are transported to the refinery via pipelines. Tosco has operated the refinery as part of its Northern California system rather than on a stand-alone basis, but UDS plans to operate it at higher utilization levels and process more crude oil and less intermediate feedstocks, "which should improve the value of the refinery's product slate and enhance its profitability," said Moody's.

UDS also expects to achieve pretax synergies of about $25 million/year, mainly through operating expense reductions.

"On the marketing side," said Moody's, "the refinery will more than double UDS's sales volumes in California. Moreover, through Avon, UDS will be able to supply directly its approximately 150 Northern California retail branded sites, thus eliminating the need for less-efficient product exchanges."

Moody's notes, however, that the bulk of the refinery's output will continue to be sold in the California wholesale market, which it describes as volatile.

"The Avon refinery acquisition will provide numerous benefits to UDS, but the company will also face certain challenges, including enhancing the refinery's profitability and improving its environmental and safety record," said Moody's. "However, even with additional capital spending for maintenance projects, and assuming low average refining margins, Moody's expects that Avon should be able to generate some free cash flow for debt reduction."

As part of the purchase agreement, Tosco will retain responsibility for pre-existing environmental liabilities up to an agreed amount.

While Moody's notes that pending environmental regulations will likely raise required capital spending and operating costs for the refining industry, such incremental amounts will not be material for UDS in the foreseeable future, it says. At Avon and Wilmington, the company plans to substitute ethanol for methyl tertiary butyl ether to comply with California's ban on the use of MTBE in gasoline by yearend 2002. Moody's says it believes this can be achieved at a relatively low cost.