UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

(Mark One)

þ		ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2006

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

TESORO CORPORATION

Delaware (State or other jurisdiction of incorporation or organization)		95-0862768 (I.R.S. Employer Identification No.)

300 Concord Plaza Drive San Antonio, Texas (Address of principal executive offices)		78216-6999 (Zip Code)

Title of each class		Name of each exchange on which registered
Common Stock, $0.16 2/3 par value		New York Stock Exchange

     Indicate by check mark if the registrant is a well-known seasoned issuer as defined in Rule 405 of the Securities Act.

Yes þ   No o

     Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

Yes o   Noþ

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.     Yes þ   No o

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   þ

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

     Large accelerated filer þ          Accelerated filer o          Non-accelerated filer o

     Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Act).

     Yes o   Noþ

     At June 30, 2006, the aggregate market value of the voting common stock held by non-affiliates of the registrant was approximately $5,069,518,000 based upon the closing price of its common stock on the New York Stock Exchange Composite tape. At February 21, 2007, there were 68,215,252 shares of the registrant’s common stock outstanding.

     Portions of the registrant’s Proxy Statement to be filed pursuant to Regulation 14A pertaining to the 2007 Annual Meeting of Stockholders are incorporated by reference into Part III hereof. The Company intends to file such Proxy Statement no later than 120 days after the end of the fiscal year covered by this Form 10-K.

 

 

TESORO CORPORATION
ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS

				Page
		PART I
Items 1. and 2.		Business and Properties			2
		Pending Acquisitions			2
		Refining			3
		Retail			9
		Competition and Other			10
		Government Regulation and Legislation			10
		Employees			12
		Properties			13
		Executive Officers of the Registrant			13
		Board of Directors of the Registrant			15
Item 1A.		Risk Factors			16
Item 1B.		Unresolved Staff Comments			19
Item 3.		Legal Proceedings			19
Item 4.		Submission of Matters to a Vote of Security Holders			20
		PART II
Item 5.		Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities			20
Item 6.		Selected Financial Data			22
Item 7.		Management’s Discussion and Analysis of Financial Condition and Results of Operations			24
		Business Strategy and Overview			24
		Results of Operations			27
		Capital Resources and Liquidity			33
		Accounting Standards			43
		Forward-Looking Statements			45
Item 7A.		Quantitative and Qualitative Disclosures about Market Risk			46
Item 8.		Financial Statements and Supplementary Data			47
Item 9.		Changes in and Disagreements with Accountants on Accounting and Financial Disclosure			82
Item 9A.		Controls and Procedures			82
Item 9B.		Other Information			84
		PART III
Item 10.		Directors, Executive Officers and Corporate Governance			84
Item 11.		Executive Compensation			84
Item 12.		Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters			84
Item 13.		Certain Relationships and Related Transactions, and Director Independence			84
Item 14.		Principal Accounting Fees and Services			84
		PART IV
Item 15.		Exhibits and Financial Statement Schedules			84
		Signatures			91
Management Stability Agreement
Management Stability Agreement
Subsidiaries
Consent of Independent Registered Public Accounting Firm
Certification Pursuant to Section 302
Certification Pursuant to Section 302
Certification Pursuant to Section 906
Certification Pursuant to Section 906

     This Annual Report on Form 10-K (including documents incorporated by reference herein) contains statements with respect to our expectations or beliefs as to future events. These types of statements are “forward-looking” and subject to uncertainties. See “Forward-Looking Statements” on page 45.

     When used in this Annual Report on Form 10-K, the terms “Tesoro”, “we”, “our” and “us”, except as otherwise indicated or as the context otherwise indicates, refer to Tesoro Corporation and its subsidiaries.

PART I

ITEMS 1. AND 2. BUSINESS AND PROPERTIES

          Tesoro Corporation (“Tesoro”) is based in San Antonio, Texas. We were incorporated in Delaware in 1968 under the name Tesoro Petroleum Corporation, which was subsequently changed in 2004 to Tesoro Corporation. We are one of the largest independent petroleum refiners and marketers in the United States with two operating segments — (1) refining crude oil and other feedstocks at our six refineries in the western and mid-continental United States and selling refined products in bulk and wholesale markets (“refining”) and (2) selling motor fuels and convenience products in the retail market (“retail”) through our 460 branded retail stations in 18 states. Through our refining segment, we produce refined products, primarily gasoline and gasoline blendstocks, jet fuel, diesel fuel and heavy fuel oils for sale to a wide variety of commercial customers in the western and mid-continental United States. Our retail segment distributes motor fuels through a network of retail stations, primarily under the Tesoro^® and Mirastar^® brands. See Notes C and N in our consolidated financial statements in Item 8 for additional information on our operating segments and properties.

          Our principal executive offices are located at 300 Concord Plaza Drive, San Antonio, Texas 78216-6999 and our telephone number is (210) 828-8484. We file reports with the SEC, including annual reports on Form 10-K, quarterly reports on Form 10-Q and other reports from time to time. The public may read and copy any materials that we file with the SEC at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. Our SEC filings are also available to the public on the SEC’s Internet site at http://www.sec.gov and our website at http://www.tsocorp.com as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. You may receive a copy of our Annual Report on Form 10-K, including the financial statements, free of charge by writing to Tesoro Corporation, Attention: Investor Relations, 300 Concord Plaza Drive, San Antonio, Texas 78216-6999. We also post our corporate governance guidelines, code of business conduct, code of ethics for senior financial officers and our Board of Director committee charters on our website. Our governance documents are available in print by writing to the address above. We submitted to the New York Stock Exchange on May 25, 2006 our annual certification concerning corporate governance pursuant to Section 303A.12 (a) of the New York Stock Exchange Listed Company Manual.

PENDING ACQUISITIONS

          On January 29, 2007, we entered into agreements with Shell Oil Products US (“Shell”) to purchase a 100,000 barrel per day (“bpd”) refinery and a 42,000 bpd refined products terminal located south of Los Angeles, California along with approximately 250 Shell-branded retail stations located throughout Southern California (collectively, the “Los Angeles Assets”). The purchase includes a long-term agreement allowing us to continue to operate the retail stations under the Shell^® brand. The purchase price for the Los Angeles Assets is $1.63 billion, plus the value of petroleum inventories at the time of closing, which is estimated to be $180 million to $200 million based on January 2007 prices. Upon closing of the acquisitions, Shell has agreed, subject to certain limitations, to retain certain obligations, responsibilities, liabilities, costs and expenses, including environmental matters arising out of the pre-closing operations of the assets. We have agreed to assume certain obligations, responsibilities, liabilities, costs and expenses arising out of or incurred in connection with decrees, orders and settlements the seller entered into with governmental and non-governmental entities prior to closing. The transaction, which will require regulatory approval from the Federal Trade Commission and the Attorney General of the State of California, is expected to be completed in the second quarter of 2007.

          On January 26, 2007, we entered into an agreement with USA Petroleum to purchase 140 retail stations located primarily in California and a terminal located in New Mexico. The purchase price of the assets and the USA^® brand is $277 million, plus the value of inventories at the time of closing which is estimated to be $10 million to $15 million based on January 2007 prices. Tesoro will assume the obligations under the seller’s leases, contracts, permits or other agreements arising after the closing date. USA Petroleum will retain certain pre-closing liabilities, including environmental matters. The transaction requires regulatory approval from the Federal Trade Commission and the Attorney General of the State of California and is expected to be completed in the second quarter of 2007.

          The acquisitions of the Los Angeles Assets and USA Petroleum retail stations will be paid with a combination of debt and cash on-hand, which at December 31, 2006 was $986 million. The exact amount of debt and cash is yet to be determined.

REFINING

          We currently own and operate six petroleum refineries, located in California (the Golden Eagle refinery in the “California” region), Alaska and Washington (“Pacific Northwest” region), Hawaii (“Mid-Pacific” region) and North Dakota and Utah (“Mid-Continent” region), and sell refined products to a wide variety of customers in the western and mid-continental United States. Our refineries produce a high proportion of our refined product sales volumes, and we purchase the remainder from other refiners and suppliers. Our six refineries have a combined crude oil capacity of 563,000 bpd. We operate the largest refineries in Hawaii and Utah, the second largest refineries in northern California and Alaska, and the only refinery in North Dakota. Capacity and throughput rates of crude oil and other feedstocks by refinery are as follows:

		Crude Oil
		Capacity (a)				Throughput (bpd)
Refinery		(bpd)				2006				2005				2004
California
Golden Eagle			166,000				164,900				164,600				152,800
Pacific Northwest
Washington			115,000				111,300				110,500				117,200
Alaska			72,000				55,800				60,200				57,200
Mid-Pacific
Hawaii			94,000				84,600				82,700				84,500
Mid-Continent
North Dakota			58,000				56,300				58,100				56,200
Utah			58,000				56,100				53,500				52,500
Total			563,000				529,000				529,600				520,400

          We experienced reduced throughput during scheduled refinery maintenance (“turnarounds”) at our Golden Eagle, Washington and Alaska refineries in 2006, our Golden Eagle, Washington and Hawaii refineries in 2005 and our Golden Eagle refinery in 2004. Throughput exceeded our Washington refinery’s crude oil capacity in 2004 due to processing other feedstocks in addition to crude oil.

          Feedstock Supply. We purchase crude oil and other feedstocks for our refineries from a diversified supply of domestic and foreign sources through term agreements with renewal provisions and in the spot market. Prices under the term agreements generally fluctuate with market prices. We purchase approximately 43% of our crude oil supplies under term contracts, which are primarily short-term agreements with market-related prices, and we purchase the remainder in the spot market. In 2006, we received 53% of our crude oil input from domestic sources (including 16% from Alaska’s North Slope) and 47% from foreign sources (including 14% from Canada). Actual throughput volumes by feedstock type are summarized below (in thousand bpd):

		2006								2005								2004
		Volume				%				Volume				%				Volume				%
California
Heavy crude (a)			153				93	%			151				91	%			128				84	%
Light crude			3				2				6				4				14				9
Other feedstocks			9				5				8				5				11				7
Total			165				100	%			165				100	%			153				100	%
Pacific Northwest
Heavy crude (a)			81				49	%			85				50	%			89				51	%
Light crude			81				49				78				45				81				47
Other feedstocks			5				2				8				5				4				2
Total			167				100	%			171				100	%			174				100	%

		2006								2005								2004
		Volume				%				Volume				%				Volume				%
Mid-Pacific
Heavy crude (a)			27				32	%			29				35	%			42				50	%
Light crude			58				68				54				65				42				50
Total			85				100	%			83				100	%			84				100	%
Mid-Continent
Light crude			108				96	%			107				96	%			104				95	%
Other feedstocks			4				4				4				4				5				5
Total			112				100	%			111				100	%			109				100	%
Total Refining Throughput
Heavy crude (a)			261				49	%			265				50	%			259				50	%
Light crude			250				47				245				46				241				46
Other feedstocks			18				4				20				4				20				4
Total			529				100	%			530				100	%			520				100	%

          Refined Products. Refining yield represents production volumes of refined products consisting primarily of gasoline and gasoline blendstocks, jet fuel, diesel fuel and heavy fuel oils. We also manufacture other refined products, including liquefied petroleum gas, petroleum coke and asphalt. Our refining yields, in volumes, are summarized below (in thousand bpd):

		2006								2005								2004
		Volume				%				Volume				%				Volume				%
California
Gasoline and gasoline blendstocks			96				55	%			93				54	%			96				59	%
Diesel fuel			49				28				49				28				38				24
Heavy oils, residual products, internally produced fuel and other			30				17				31				18				28				17
Total			175				100	%			173				100	%			162				100	%
Pacific Northwest
Gasoline and gasoline blendstocks			67				39	%			74				42	%			74				42	%
Jet fuel			31				18				31				18				31				17
Diesel fuel			27				16				25				14				27				15
Heavy oils, residual products, internally produced fuel and other			47				27				46				26				47				26
Total			172				100	%			176				100	%			179				100	%
Mid-Pacific
Gasoline and gasoline blendstocks			20				23	%			20				24	%			21				25	%
Jet fuel			26				30				26				31				24				28
Diesel fuel			13				15				12				14				15				17
Heavy oils, residual products, internally produced fuel and other			27				32				26				31				26				30
Total			86				100	%			84				100	%			86				100	%

		2006								2005								2004
		Volume				%				Volume				%				Volume				%
Mid-Continent
Gasoline and gasoline blendstocks			62				53	%			61				53	%			60				53	%
Jet fuel			11				10				11				9				11				10
Diesel fuel			32				27				32				28				30				27
Heavy oils, residual products, internally produced fuel and other			11				10				12				10				12				10
Total			116				100	%			116				100	%			113				100	%
Total Refining Yield
Gasoline and gasoline blendstocks			245				45	%			248				45	%			251				47	%
Jet fuel			68				12				68				12				66				12
Diesel fuel			121				22				118				22				110				20
Heavy oils, residual products, internally produced fuel and other			115				21				115				21				113				21
Total			549				100	%			549				100	%			540				100	%

          Transportation and Terminals. To optimize the transportation of crude oil and refined products within our refinery system and secure shipping capacity, we currently term-charter five U.S. flag tankers and five foreign-flag tankers, nine of which are double-hulled and one of which is double-bottomed. Our term charters expire between 2007 and 2010. We have also entered into term-charters for four U.S. flag tankers beginning in 2009 and 2010 with three year terms and options to renew. For our Hawaii and Washington operations, we charter several tugs and product barges over varying terms ending in 2007 through 2015, with options to renew. We also have arrangements to transport crude oil in double-hulled tankers from certain regions. Other tankers and ocean-going barges are also chartered on a short-term basis to transport crude oil and refined products. We also receive crude oils and ship refined products through owned and third-party pipelines as further described below.

          We operate refined products terminals at our refineries and at several other locations in California, Hawaii, Alaska, Washington and Idaho. We also distribute products through third-party terminals, truck racks and rail cars, which are supplied by our refineries and through purchases and exchange agreements with other refining and marketing companies.

     Golden Eagle Refinery

          Refining. Our Golden Eagle refinery, located in Martinez, California on 2,206 acres about 30 miles east of San Francisco, is a highly complex refinery with a crude oil capacity of 166,000 bpd. We source our Golden Eagle refinery’s crude oil from California, Alaska and foreign locations. Major refined product upgrading units at the refinery include fluid catalytic cracking (“FCC”), fluid coking, hydrocracking, naphtha reforming, vacuum distillation, hydrotreating and alkylation units. These units enable the refinery to produce a high proportion of motor fuels, including cleaner-burning California Air Resources Board (“CARB”) gasoline and CARB diesel, as well as conventional gasoline and diesel. The refinery also produces heavy fuel oils, liquefied petroleum gas and petroleum coke. We have commenced a project at the refinery to modify the existing fluid coking unit into a delayed coking unit which will enable us to comply with the terms of an abatement order to lower emissions while also enhancing the refinery’s capabilities in terms of reliability, lengthening turnaround cycles and reducing operating costs. We anticipate this project will be substantially completed during the first quarter of 2008.

          Transportation. Our Golden Eagle refinery has waterborne access through the San Francisco Bay that enables us to receive crude oil and ship refined products through our marine terminals. In addition, the refinery can receive crude oil through a third-party marine terminal at Martinez. We also receive California crude oils and ship refined products from the refinery through third-party pipeline systems.

          Terminals. We operate a refined products terminal at Stockton, California and a refined products terminal at the refinery. We also distribute refined products through third-party terminals, which are supplied by our refinery and through purchases and exchange arrangements with other refining and marketing companies. We also lease approximately 800,000 barrels of storage capacity with waterborne access in southern California.

     Pacific Northwest Refineries

     Washington

          Refining. Our Washington refinery, located in Anacortes on the Puget Sound on 917 acres about 60 miles north of Seattle, has a total crude oil capacity of 115,000 bpd. We source our Washington refinery’s crude oil from Alaska, Canada and other foreign locations. The Washington refinery also processes intermediate feedstocks, primarily heavy vacuum gas oil, provided by some of our other refineries and by spot-market purchases from third-parties. Major refined product upgrading units at the refinery include the FCC, alkylation, hydrotreating, vacuum distillation, deasphalting and naphtha reforming units, which enable our Washington refinery to produce a high proportion of light products, such as gasoline (including CARB gasoline and components for CARB gasoline), diesel and jet fuel. The refinery also produces heavy fuel oils, liquefied petroleum gas and asphalt. In the first quarter of 2006, we completed the modification of a 25,000 bpd diesel desulfurizer unit, which allows our Washington refinery to manufacture ultra-low sulfur diesel pursuant to regulations mandated by the EPA.

          Transportation. Our Washington refinery receives Canadian crude oil through a third-party pipeline originating in Edmonton, Alberta, Canada. We receive other crude oil through our Washington refinery’s marine terminal. Our Washington refinery ships products (gasoline, jet fuel and diesel) through a third-party pipeline system, which serves western Washington and Portland, Oregon. We also deliver gasoline and diesel fuel through a neighboring refinery’s truck rack and distribute diesel fuel through a truck rack at our refinery. We deliver refined products, including CARB gasoline and components for CARB gasoline, through our marine terminal to ships and barges and sell liquefied petroleum gas and asphalt at our refinery.

          Terminals. We operate refined products terminals at Anacortes, Port Angeles and Vancouver, Washington, supplied primarily by our Washington refinery. We also distribute refined products through third-party terminals in our market areas, supplied by our refinery and through purchases and exchange arrangements with other refining and marketing companies.

     Alaska

          Refining. Our Alaska refinery is located near Kenai on the Cook Inlet on 488 acres approximately 70 miles southwest of Anchorage. Our Alaska refinery processes crude oil from Alaska and, to a lesser extent, foreign locations. The refinery has a total crude oil capacity of 72,000 bpd, and its refined product upgrading units include vacuum distillation, distillate hydrocracking, hydrotreating, naphtha reforming and light naphtha isomerization units. Our Alaska refinery produces gasoline and gasoline blendstocks, jet fuel, diesel fuel, heating oil, heavy fuel oils, liquefied petroleum gas and asphalt. We are installing a 10,000 bpd diesel desulfurizer unit at the refinery, which will allow us to manufacture ultra-low sulfur diesel to meet the increasing demand for cleaner fuels in Alaska. We anticipate that this project will be substantially completed in the second quarter of 2007.

          Transportation. We receive crude oil by tanker and through our owned and operated crude oil pipeline at our marine terminal. Our crude oil pipeline is a 24-mile common carrier pipeline, which is connected to the Eastside Cook Inlet oil field. We also own and operate a common-carrier refined products pipeline that runs from the Alaska refinery to our terminal facilities in Anchorage and to the Anchorage airport. This 71-mile pipeline has the capacity to transport approximately 40,000 bpd of refined products and allows us to transport gasoline, diesel and jet fuel to the terminal facilities. Both of our owned pipelines are subject to regulation by various federal, state and local agencies, including the Federal Energy Regulatory Commission (“FERC”). Refined products are also distributed by tankers and barges from our marine terminal.

          Terminals. We operate refined products terminals at Kenai and Anchorage, which are supplied by our Alaska refinery. We also distribute refined products through a third-party terminal near Fairbanks, which is supplied through a purchase and exchange arrangement with another refining company.

     Mid-Pacific Refinery

     Hawaii

          Refining. Our 94,000 bpd Hawaii refinery is located at Kapolei on 131 acres about 22 miles west of Honolulu. We supply the Hawaii refinery with crude oil from Southeast Asia, the Middle East and other foreign sources. Major refined product upgrading units include the vacuum distillation, hydrocracking, hydrotreating, visbreaking and naphtha reforming units. The Hawaii refinery produces gasoline and gasoline blendstocks, jet fuel, diesel fuel, heavy fuel oils, liquefied petroleum gas and asphalt.

          Transportation. We transport crude oil to Hawaii by tankers, which discharge through our single-point mooring terminal, 1.5 miles offshore from our refinery. Three underwater pipelines from the single-point mooring terminal allow crude oil and refined products to be transferred to and from the refinery’s storage tanks. We distribute refined products to customers on the island of Oahu through owned and third-party pipeline systems. Our refined products pipelines also connect the Hawaii refinery to Barbers Point Harbor, 2.5 miles away, where refined products are transferred to ships and barges.

          Terminals. We also distribute refined products from our refinery to customers through third-party terminals at Honolulu International Airport and Honolulu Harbor and by barge to our owned and third-party terminal facilities on the islands of Oahu, Maui, Kauai and Hawaii.

     Mid-Continent Refineries

     North Dakota

          Refining. Our 58,000 bpd North Dakota refinery is located near Mandan on 960 acres. We supply our North Dakota refinery primarily with Williston Basin sweet crude oil. The refinery also can access other supplies, including Canadian crude oil. Major refined product upgrading units at the refinery include the FCC, naphtha reforming, hydrotreating and alkylation units. The North Dakota refinery produces gasoline, diesel fuel, jet fuel, heavy fuel oils and liquefied petroleum gas.

          Transportation. We own a crude oil pipeline system, consisting of over 700 miles of pipeline that delivers all of the crude oil to our North Dakota refinery. Our crude oil pipeline system gathers crude oil from the Williston Basin and adjacent production areas in North Dakota and Montana and transports it to our refinery and has the capability to transport crude oil to other regional points where there is additional demand. Our crude oil pipeline system is a common carrier subject to regulation by various federal, state and local agencies, including the FERC. We distribute approximately 85% of our refinery’s production through a third-party refined products pipeline system which serves various areas from Bismarck, North Dakota to Minneapolis, Minnesota. All gasoline and distillate products from our refinery, with the exception of railroad-spec diesel fuel, can be shipped through that pipeline to third-party terminals.

          Terminals. We operate a refined products terminal at the North Dakota refinery. We also distribute refined products through a third-party refined products pipeline system which connects to third-party terminals located in North Dakota and Minnesota. We distribute refined products from our refinery to customers primarily through these third-party terminals.

     Utah

          Refining. Our 58,000 bpd Utah refinery is located in Salt Lake City on 145 acres. Our Utah refinery processes crude oils from Utah, Colorado, Wyoming and Canada. Major refined product upgrading units include the FCC, naphtha reforming, alkylation and hydrotreating units. The Utah refinery produces gasoline, diesel fuel, jet fuel, heavy fuel oils and liquefied petroleum gas.

          Transportation. Our Utah refinery receives crude oil primarily by third-party pipelines from fields in Utah, Colorado, Wyoming and Canada. We distribute the refinery’s production through a system of both owned and third-party terminals and third-party pipeline connections, primarily in Utah, Idaho and eastern Washington, with some refined product delivered in Nevada and Wyoming.

          Terminals. In addition to sales at the refinery, we distribute refined products to customers through a third-party pipeline to our owned terminals in Boise and Burley, Idaho and to third-party terminals in Pocatello, Idaho and Pasco, Washington.

     Wholesale Marketing and Refined Product Distribution

          We sell refined products including gasoline and gasoline blendstocks, jet fuel, diesel fuel, heavy fuel oils and residual products in both the bulk and wholesale markets. The majority of our wholesale volumes are sold in 10 states to independent unbranded distributors that sell refined products purchased through our owned and third-party terminals. Our bulk volumes are primarily sold to independent and other oil companies, electric power producers, railroads, airlines and marine and industrial end-users, which are distributed by pipelines, ships, railcars and trucks. In addition, we sell refined products that we manufacture, purchase or receive on exchange from third parties. Exchange agreements provide for the delivery of our refined products primarily to third-party terminals in exchange for the delivery of refined products from the third parties at specific locations. Our refined product sales, including intersegment sales to our retail operations, consisted of:

		2006				2005				2004
Refined Product Sales (thousand bpd) (a)
Gasoline and gasoline blendstocks			280				294				300
Jet fuel			91				101				90
Diesel fuel			128				139				133
Heavy oils, residual products and other			87				75				81
Total Refined Product Sales			586				609				604

          Gasoline and Gasoline Blendstocks. We sell gasoline and gasoline blendstocks in both the bulk and wholesale markets in the western and mid-continental United States. The demand for gasoline is seasonal in many of our markets, with lowest demand during the winter months. We also sell gasoline to wholesale customers and several major independent and other oil companies under various supply agreements. We sell, at wholesale, to unbranded distributors and high-volume retailers, and we distribute refined product through owned and third party terminals. Gasoline also is delivered to refiners and marketers in exchange for refined product received at other locations in our markets.

          Jet Fuel. We supply jet fuel to passenger and cargo airlines at airports in Alaska, Hawaii, California, Washington, Utah and other western states. We also supply jet fuel to the U.S. military in certain of our markets.

          Diesel Fuel. We sell our diesel fuel production primarily on a wholesale basis for marine, transportation, industrial and agricultural use. We sell lesser amounts to end-users through marine terminals and for power generation in Hawaii and Washington. Upon completion of certain capital projects in 2007 at our Alaska refinery, we will be able to manufacture ultra-low sulfur diesel (“ULSD”) at all of our refineries and become the sole producer of ULSD in both Alaska and Hawaii.

          Heavy Fuel Oils and Residual Products. We sell heavy fuel oils to other refineries, third-party resellers, electric power producers and marine and industrial end-users. Our refineries supply substantially all of the marine fuels that we sell through leased facilities at Port Angeles and Seattle, Washington, and Portland, Oregon, and through owned and leased facilities in Alaska and Hawaii. Our Golden Eagle refinery produces petroleum coke that we sell to industrial end-users.

          Sales of Purchased Products. In the normal course of business to meet local market demands, we purchase refined products manufactured by others for resale to our customers. We purchase these refined products, primarily gasoline, jet fuel, diesel fuel and industrial and marine fuel blendstocks, mainly in the spot market. We conduct our gasoline and diesel fuel purchase and resale activity primarily on the U.S. West Coast. Our jet fuel activity primarily consists of supplying markets in Alaska, California and Hawaii. We also purchase a lesser amount of gasoline and other refined products that are sold outside of our refineries’ local markets.

RETAIL

          Through our network of retail stations, we sell gasoline and diesel fuel in the western and mid-continental United States. The demand for gasoline is seasonal in a majority of our markets, with highest demand for gasoline during the summer driving season. We sell gasoline and diesel to retail customers through company-operated retail stations and agreements with third-party branded distributors (or “jobber/dealers”). As of December 31, 2006, our retail segment included a network of 460 branded retail stations (under the Tesoro^® and Mirastar^® brands), comprising 194 company-operated retail stations and 266 jobber/dealer retail stations. Our retail network provides a committed outlet for a portion of the motor fuels produced by our refineries. Most of our company-operated retail stations include 2-Go Tesoro^® brand convenience stores that sell a wide variety of merchandise items. The following table summarizes our retail operations:

		2006				2005				2004
Number of Branded Retail Stations (end of period)
Tesoro®
Company-operated			117				133				137
Jobber/dealer			266				268				292
Mirastar®
Company-operated			77				77				78
Total Branded Retail Stations
Company-operated(a)			194				210				215
Jobber/dealer(b)			266				268				292
Total			460				478				507
Average Number of Branded Retail Stations (during year)
Company-operated			204				213				222
Jobber/dealer			261				281				316
Total Average Retail Stations			465				494				538
Total Fuel Volume (millions of gallons)
Company-operated			248				258				290
Jobber/dealer			186				191				220
Total Fuel Volumes			434				449				510
Average Fuel Volume Per Month Per Retail Station (thousands of gallons)
Company-operated			101				101				109
Jobber/dealer			60				57				58
Total retail stations			78				76				79
Fuel Revenues (in millions)
Company-operated		$	674			$	609			$	566
Jobber/dealer			386				335				297
Total Fuel Revenues		$	1,060			$	944			$	863
Merchandise and Other Revenues (in millions)		$	144			$	141			$	131
Merchandise Margin (percent of revenues)			27	%			26	%			28	%

COMPETITION AND OTHER

          We compete on a global basis with a number of major integrated oil companies who produce crude oil for use in their refining operations and other companies that may have greater financial and other resources. The availability and cost of crude oil is affected by global supply and demand dynamics. Similarly, the supply and prices of refined products are impacted by global dynamics. Our Golden Eagle and Washington refineries compete with several refineries on the U.S. West Coast. In addition, products flow into the West Coast from the Gulf Coast and other parts of the world. Our Hawaii refinery competes primarily with one other refinery in Hawaii, owned by a major integrated oil company that also is located at Kapolei and has a crude oil capacity of 54,000 bpd. The Alaska refinery competes with other refineries in Alaska and on the U.S. West Coast. Our refining competition in Alaska includes two refineries near Fairbanks and a refinery near Valdez. We estimate that the other Alaska refineries have a combined capacity to process approximately 270,000 bpd of crude oil. Our North Dakota refinery is the only refinery in North Dakota. Refineries in Wyoming, Montana, the Midwest and the United States Gulf Coast region are the primary competitors with our North Dakota refinery. Our Utah refinery is the largest of five refineries located in Utah. We estimate that these other refineries have a combined capacity to process approximately 107,500 bpd of crude oil. These five refineries collectively supply a high proportion of the gasoline and distillate products consumed in the states of Utah and Idaho, with additional supplies provided from refineries in surrounding states. Our Golden Eagle, Washington, Hawaii and Alaska refineries also compete with companies that import refined products from other parts of the world, including the Far East and Europe.

          Our jet fuel sales in Alaska are concentrated in Anchorage, where we are one of the principal suppliers to the Anchorage International Airport, a major hub for air cargo traffic between manufacturing regions in the Far East and markets in the United States and Europe. In Hawaii, jet fuel sales are concentrated in Honolulu, where we are the principal supplier to the Honolulu International Airport. We also serve four airports on other islands in Hawaii. In Washington, jet fuel sales are concentrated at the Seattle/Tacoma International Airport. We also supply jet fuel to customers in Portland, Oregon; Los Angeles, San Francisco and San Diego, California; Las Vegas and Reno, Nevada; and Phoenix, Arizona. Other suppliers compete for sales at all of these airports. In Utah, our jet fuel sales are concentrated in Salt Lake City, and we also supply jet fuel to customers in Boise, Burley and Pocatello, Idaho. The North Dakota refinery supplies jet fuel to customers in Minneapolis/St. Paul and Moorhead, Minnesota and in Bismarck and Jamestown, North Dakota. We compete with other suppliers for U.S. military contracts in Alaska, Hawaii and North Dakota. Both the Alaska and Hawaii markets periodically require additional jet fuel supplies from outside the state to meet demand.

          We sell our diesel fuel production primarily on a wholesale basis, competing with other suppliers in all of our market areas. Refined products from foreign sources, including Canada, also compete for distillate customers in our market areas.

          We sell gasoline in Alaska, California, Hawaii, North Dakota, Utah, Washington and other western and mid-continental states through a network of company-operated retail stations and branded and unbranded jobber/dealers. From time-to-time we also sell refined product to other refiners. Competitive factors that affect retail marketing include price, station appearance, location and brand awareness. Our retail marketing operations compete with other independent marketing companies, integrated oil companies and high-volume retailers.

GOVERNMENT REGULATION AND LEGISLATION

     Environmental Controls and Expenditures

          All of our operations, like those of other companies engaged in similar businesses, are subject to extensive and frequently changing federal, state, regional and local laws, regulations and ordinances relating to the protection of the environment, including those governing emissions or discharges to the air and water, the handling and disposal of solid and hazardous wastes and the remediation of contamination. While we believe our facilities are in substantial compliance with current requirements, our facilities will continue to be engaged in meeting new requirements promulgated by the U.S. Environmental Protection Agency (“EPA”) and the states and local jurisdictions in which we operate as described below.

          Changes in fuel standards, including those related to gasoline and diesel fuel sulfur concentrations, also affect our operations. EPA regulations related to the Clean Air Act require reductions in the sulfur content in gasoline. Our Golden Eagle, Washington, Hawaii, Alaska and North Dakota refineries will not require additional capital spending to meet the low sulfur gasoline standards. We are currently evaluating alternative projects that will satisfy the requirements to meet the regulations at our Utah refinery.

          EPA regulations related to the Clean Air Act also require reductions in the sulfur content in diesel fuel manufactured for on-road consumption. In general, the new on-road diesel fuel standards became effective on June 1, 2006. In May 2004, the EPA issued a rule regarding the sulfur content of non-road diesel fuel. The requirements to reduce non-road diesel sulfur content will become effective in phases between 2007 and 2010. We spent $61 million in 2006 to meet the revised diesel fuel standards, and we have budgeted an additional $18 million in 2007 to complete our diesel desulfurizer unit to manufacture additional ultra-low sulfur diesel at our Alaska refinery. Our Golden Eagle, Washington and Hawaii refineries will not require additional capital spending to meet the new diesel fuel standards. We are currently evaluating alternative projects that will satisfy the future requirements under existing regulations at both our North Dakota and Utah refineries.

          In connection with our 2001 acquisition of our North Dakota and Utah refineries, Tesoro assumed the seller’s obligations and liabilities under a consent decree among the United States, BP Exploration and Oil Co. (“BP”), Amoco Oil Company and Atlantic Richfield Company. BP entered into this consent decree for both the North Dakota and Utah refineries for various alleged violations. As the owner of these refineries, Tesoro is required to address issues to reduce air emissions. We spent $3 million during 2006 and we have budgeted an additional $18 million through 2009 to comply with this consent decree. We also agreed to indemnify the sellers for all losses of any kind incurred in connection with the consent decree.

          In connection with the 2002 acquisition of our Golden Eagle refinery, subject to certain conditions, we assumed the seller’s obligations pursuant to settlement efforts with the EPA concerning the Section 114 refinery enforcement initiative under the Clean Air Act, except for any potential monetary penalties, which the seller retains. In November 2005, the Consent Decree was entered by the District Court for the Western District of Texas in which we agreed to undertake projects at our Golden Eagle refinery to reduce air emissions. To satisfy the requirements of the Consent Decree, we spent $3 million during 2006 and we have budgeted an additional $25 million through 2010.

          In December 2006, we proposed an alternative monitoring plan and a schedule for removing atmospheric blowdown towers at the Golden Eagle refinery to the Bay Area Air Quality Management District in response to a notice of violation (“NOV”) received from that agency in August 2006. We have budgeted $88 million through 2010 to remove the atmospheric blowdown towers.

          During the fourth quarter of 2005, we received approval by the Hearing Board for the Bay Area Air Quality Management District to modify our existing fluid coker unit to a delayed coker at our Golden Eagle refinery which is designed to lower emissions while also enhancing the refinery’s capabilities in terms of reliability, lengthening turnaround cycles and reducing operating costs. We negotiated the terms and conditions of the Second Conditional Abatement Order with the District in response to the January 2005 mechanical failure of the fluid coker boiler at the Golden Eagle refinery. The total capital budget for this project is $503 million, which includes budgeted spending of $231 million in 2007 and $145 million in 2008. The project is currently scheduled to be substantially completed during the first quarter of 2008, with spending through the first half of 2008. We have spent $127 million from inception of the project, of which $124 million was spent in 2006.

          We will also spend capital at the Golden Eagle refinery for reconfiguring and replacing above-ground storage tank systems and upgrading piping within the refinery. We spent $26 million during 2006 and we have budgeted an additional $110 million through 2011 to complete the project. Our capital budget also includes spending of $29 million through 2010 to upgrade a marine oil terminal at the Golden Eagle refinery to meet engineering and maintenance standards issued by the State of California in February 2006.

          Conditions may develop that cause increases or decreases in future expenditures for our various sites, including, but not limited to, our refineries, tank farms, retail stations (operating and closed locations) and refined products terminals, and for compliance with the Clean Air Act and other federal, state and local requirements. We cannot currently determine the amounts of such future expenditures. For further information on environmental matters and other contingencies, see Note N in our consolidated financial statements in Item 8.

     Environmental Controls and Expenditures — Pending Acquisition of the Los Angeles Assets

          The Los Angeles Assets are subject to extensive environmental requirements. If we consummate the purchase of the Los Angeles Assets, we anticipate spending approximately $375 million to $400 million between 2007 and 2011 for various environmental projects at the refinery primarily to lower air emissions. These cost estimates will be further reviewed and analyzed after the transaction is completed and we acquire additional information through the operation of the assets.

     Oil Spill Prevention and Response

          We operate in environmentally sensitive coastal waters, where tanker, pipeline and refined product transportation operations are closely regulated by federal, state and local agencies and monitored by environmental interest groups. The transportation of crude oil and refined product over water involves risk and subjects us to the provisions of the Federal Oil Pollution Act of 1990 and related state regulations, which require that most oil refining, transport and storage companies maintain and update various oil spill prevention and oil spill contingency plans. We have submitted these plans and received federal and state approvals necessary to comply with the Federal Oil Pollution Act of 1990 and related regulations. Our oil spill prevention plans and procedures are frequently reviewed and modified to prevent oil and refined product releases and to minimize potential impacts should a release occur.

          We currently charter tankers to ship crude oil from foreign and domestic sources to our Golden Eagle, Mid-Pacific and Pacific Northwest refineries. The Federal Oil Pollution Act of 1990 requires, as a condition of operation, that we demonstrate the capability to respond to the “worst case discharge” to the maximum extent practicable. As an example, the State of Alaska requires us to provide spill-response capability to contain or control and cleanup amounts equal to 50,000 barrels of crude oil for a tanker carrying fewer than 500,000 barrels and 300,000 barrels for a tanker carrying more than 500,000 barrels. To meet these requirements, we have entered into contracts with various parties to provide spill response services. We have entered into spill-response agreements with (1) Cook Inlet Spill Prevention and Response, Incorporated (for which we fund approximately 82% of expenditures) and Alyeska Pipeline Service Company for spill-response services in Alaska and (2) Clean Islands Council for response services throughout the State of Hawaii. In addition, for larger spill contingency capabilities, we have entered into contracts with Marine Spill Response Corporation for Hawaii, the San Francisco Bay and Puget Sound. We believe these contracts, and those with other regional spill-response organizations that are in place on a location by location basis, provide the additional services necessary to meet spill-response requirements established by state and federal law.

     Regulation of Pipelines

          Our crude oil pipeline system in North Dakota and our pipeline systems in Alaska are common carriers subject to regulation by various federal, state and local agencies, including the FERC under the Interstate Commerce Act. The Interstate Commerce Act provides that, to be lawful, the rates of common carrier petroleum pipelines must be “just and reasonable” and not unduly discriminatory.

          The intrastate operations of our crude oil pipeline system are subject to regulation by the North Dakota Public Services Commission. The intrastate operations of our Alaska pipelines are subject to regulation by the Regulatory Commission of Alaska. Like the FERC, the state regulatory authorities require that we notify shippers of proposed intrastate tariff increases and they have an opportunity to protest the increases. The North Dakota Public Services Commission also files with the state authorities copies of interstate tariff charges filed with the FERC. In addition to challenges to new or proposed rates, challenges to intrastate rates that have already become effective are permitted by complaint of an interested person or by independent action of the appropriate regulatory authority.

EMPLOYEES

          At December 31, 2006, we had approximately 3,950 full-time employees — 1,125 of whom are covered by collective bargaining agreements with terms expiring on January 31, 2009. We consider our relations with our employees to be satisfactory.

PROPERTIES

          Our principal properties are described above under the captions “Refining” and “Retail”. In addition, we own feedstock and refined product storage facilities at our refinery and terminal locations. We believe that our properties and facilities are generally adequate for our operations and that our facilities are maintained in a good state of repair. We are the lessee under a number of cancelable and non-cancelable leases for certain properties, including office facilities, retail facilities, ship charters and equipment used in the storage, transportation and production of feedstocks and refined products. See Notes D and N in our consolidated financial statements in Item 8.

          We conduct our retail business under the Tesoro^®, Tesoro Alaska^®, Mirastar^®, and 2-Go Tesoro^® brands. Our retail marketing system under these brands includes 460 branded retail stations, of which 194 are company-operated.

EXECUTIVE OFFICERS OF THE REGISTRANT

          The following is a list of our executive officers, their ages and their positions at Tesoro as of February 1, 2007.

Name		Age				Position		Position Held Since
Bruce A. Smith			63			Chairman of the Board of Directors, President and Chief Executive Officer		June 1996
William J. Finnerty			58			Executive Vice President and Chief Operating Officer		February 2006
Everett D. Lewis			59			Executive Vice President, Strategy and Asset Management		January 2007
Gregory A. Wright			57			Executive Vice President and Chief Financial Officer		December 2003
W. Eugene Burden			58			Senior Vice President, Government Affairs		February 2006
Claude A. Flagg			53			Senior Vice President, Strategy		January 2007
J. William Haywood			54			Senior Vice President, Refining		March 2005
Joseph M. Monroe			52			Senior Vice President, Business Development and Logistics		January 2007
Charles S. Parrish			49			Senior Vice President, General Counsel and Secretary		May 2006
Daniel J. Porter			51			Senior Vice President, Marketing		April 2005
Lynn D. Westfall			54			Senior Vice President, External Affairs and Chief Economist		January 2007
Arlen O. Glenewinkel, Jr.			50			Vice President and Controller		December 2006
Susan A. Lerette			48			Vice President, Human Resources		May 2005
Otto C. Schwethelm			52			Vice President, Finance and Treasurer		March 2006
Sarah S. Simpson			37			Vice President, Corporate Communications		June 2005
G. Scott Spendlove			43			Vice President, Strategy and Long-Term Planning		December 2006

          There are no family relationships among the officers listed, and there are no arrangements or understandings pursuant to which any of them were elected as officers. Officers are elected annually by our Board of Directors at their first meeting following the annual meeting of stockholders. The term of each office runs until the corresponding meeting of the Board of Directors in the next year or until a successor has been elected or qualified. Positions held for at least the past five years for each of our executive officers is described below (positions, unless otherwise specified, are with Tesoro).

          Bruce A. Smith was named Chairman of the Board of Directors, President and Chief Executive Officer in June 1996.

          William J. Finnerty was named Executive Vice President and Chief Operating Officer in February 2006. Prior to that, he served as Executive Vice President, Operations beginning in January 2005 and Senior Vice President, Supply and Distribution of Tesoro Refining and Marketing Company beginning in February 2004. He joined Tesoro in December 2003 as Vice President, Crude Oil and Logistics, of Tesoro Refining and Marketing Company. Prior to joining Tesoro, Mr. Finnerty served as Vice President, Trading North America Crude, for ChevronTexaco from October 2001 to November 2003.

          Everett D. Lewis was named Executive Vice President, Strategy and Asset Management in January 2007. Prior to that, he served as Executive Vice President, Strategy beginning in January 2005 and Senior Vice President, Corporate Strategic Planning from November 2004 to January 2005. Mr. Lewis served as Senior Vice President, Planning and Optimization from February 2003 to November 2004 and Senior Vice President, Planning and Risk Management from April 2001 to February 2003.

          Gregory A. Wright was named Executive Vice President and Chief Financial Officer in December 2003. Prior to that, he served as Senior Vice President and Chief Financial Officer from April 2001 to December 2003.

          W. Eugene Burden was named Senior Vice President, Government Affairs in February 2006. Prior to that, he served as Senior Vice President, External Affairs from November 2004 to February 2006, Senior Vice President, Human Resources and Government Relations from June 2002 to November 2004, President of Tesoro Alaska Company from February 2001 to June 2002, and Senior Vice President and President, Northwest Region of Tesoro Refining and Marketing Company from September 2001 until June 2002.

          Claude A. Flagg was named Senior Vice President, Strategy in January 2007. Prior to that, he served as Senior Vice President, Supply and Optimization beginning in February 2005. He joined Tesoro in January 2005 as Senior Vice President, Planning and Optimization. Prior to joining Tesoro, he served as General Manager of Supply Optimization at Shell Oil Products U.S. from January 2003 to December 2004. From May 2002 to January 2003, Mr. Flagg was General Manager of Supply Optimization at Equilon Enterprises, LLC. He was General Manager of Equilon Enterprises, LLC’s Bay/Valley Refining Complex from April 1999 to May 2002.

          J. William Haywood was named Senior Vice President, Refining in March 2005. He joined Tesoro in May 2002 as Senior Vice President and also became President of the California Region of Tesoro Refining and Marketing Company in September 2002. Prior to joining Tesoro, Mr. Haywood served as Regional Vice President of Ultramar Diamond Shamrock Corporation, responsible for California refineries from September 2000 to May 2002.

          Joseph M. Monroe was named Senior Vice President, Business Development and Logistics in January 2007. Prior to that, he served as Senior Vice President, Corporate Development beginning in February 2006, Senior Vice President, Business Integration and Analysis from February 2005 to February 2006 and Senior Vice President, Organizational Effectiveness from November 2004 to February 2005. Mr. Monroe served as Senior Vice President, Strategic Planning and Business Development of Tesoro Petroleum Companies, Inc. from February 2004 to November 2004 and as Senior Vice President, Supply and Distribution, of Tesoro Refining and Marketing Company from May 2002 to February 2004. Prior to joining Tesoro, he was Vice President, Pipelines and Terminals of Unocal Corporation and President of Unocal Pipeline Company from January 1999 through May 2002.

          Charles S. Parrish was named Senior Vice President, General Counsel and Secretary in May 2006. Prior to that, he served as Vice President, General Counsel and Secretary beginning in March 2005 and as Vice President, Assistant General Counsel and Secretary beginning in November 2004. Mr. Parrish served as Vice President, Assistant General Counsel of Tesoro Petroleum Companies, Inc. from March 2003 to November 2004. From 1995 through March 2003, he served numerous roles in the Company’s legal department, primarily focused on matters related to the Company’s capital structure and Securities Act reporting.

          Daniel J. Porter was named Senior Vice President, Marketing in April 2005. Prior to that, he served as President of the Northwest Region of Tesoro Refining and Marketing Company and Anacortes Refinery Manager from June 2002 to April 2005. He was also President of the Northern Great Plains Region and Mandan Refinery Manager from September 2001 to June 2002.

          Lynn D. Westfall was named Senior Vice President, External Affairs and Chief Economist in January 2007. Prior to that, he served as Senior Vice President, Chief Economist beginning in May 2006, Vice President, Chief Economist from August 2005 to May 2006 and as Vice President, Development and Business Analysis from January 2002 to August 2005.

          Arlen O. Glenewinkel, Jr. was named Vice President and Controller in December 2006. Prior to that, Mr. Glenewinkel served as Vice President, Enterprise Risk beginning in April 2005, Vice President, Internal Audit, from August 2002 to April 2005 and Director, Business Processes from July 2001 to August 2002.

          Susan A. Lerette was named Vice President, Human Resources in May 2005. Prior to that, she served as Vice President, Human Resources and Communications from May 2004 to May 2005. From April 2001 to May 2004, she served as Vice President, Communications.

          Otto C. Schwethelm was named Vice President, Finance and Treasurer in March 2006. Prior to that, he served as Vice President and Controller from February 2003 to March 2006 and as Vice President and Operations Controller from September 2002 to February 2003. From December 2001 to September 2002, Mr. Schwethelm served as Vice President, Shared Services of Tesoro Petroleum Companies, Inc.

          Sarah S. Simpson was named Vice President of Corporate Communications in June 2005. Prior to joining Tesoro, she served as Director of Corporate Communications and Community Relations at Cemex, Inc. from November 2004 to June 2005. From July 2000 to November 2004, she served as Director of Corporate Communications at Waste Management, Inc.

          G. Scott Spendlove was named Vice President, Strategy and Long-Term Planning in December 2006. Prior to that, he served as Vice President and Controller beginning in March 2006 and Vice President, Finance and Treasurer from May 2003 to March 2006. Mr. Spendlove also served as Vice President, Finance from January 2002 to May 2003.

BOARD OF DIRECTORS OF THE REGISTRANT

          The following is a list of our Board of Directors:

Bruce A. Smith		Chairman, President and Chief Executive Officer of Tesoro Corporation
Steven H. Grapstein		Lead Director of Tesoro Corporation; Chief Executive Officer of Kuo Investment Company
John F. Bookout, III		Retired Director of McKinsey & Company; Senior Advisor to First Reserve Corporation
Rodney F. Chase		Chairman of Petrofac, Ltd. and Senior Advisor to Lehman Brothers, Inc.
Robert W. Goldman		Vice President, Finance for World Petroleum Council; Retired Chief Financial Officer of Conoco, Inc.
William J. Johnson		Petroleum Consultant; President of JonLoc, Inc.
A. Maurice Myers		Retired Chairman, President and Chief Executive Officer of Waste Management, Inc.

Donald H. Schmude		Retired Vice President of Texaco and President and Chief Executive Officer of Texaco Refining & Marketing, Inc.
Patrick J. Ward		Retired Chairman, President and Chief Executive Officer of Caltex Petroleum Corporation
Michael E. Wiley		Retired Chairman, President and Chief Executive Officer of Baker Hughes, Inc.

ITEM 1A. RISK FACTORS

The volatility of crude oil prices, refined product prices and natural gas and electrical power prices may have a material adverse effect on our cash flow and results of operations.

          Our earnings and cash flows from our refining and wholesale marketing operations depend on a number of factors, including fixed and variable expenses (including the cost of crude oil and other refinery feedstocks) and the margin above those expenses at which we are able to sell refined products. In recent years, the prices of crude oil and refined products have fluctuated substantially. These prices depend on numerous factors beyond our control, including the global supply and demand for crude oil, gasoline and other refined products, which are subject to, among other things:

	•		changes in the global economy and the level of foreign and domestic production of crude oil and refined products;
	•		threatened or actual terrorist incidents, acts of war, and other global political conditions;
	•		availability of crude oil and refined products and the infrastructure to transport crude oil and refined products;
	•		weather conditions, hurricanes or other natural disasters;
	•		government regulations; and
	•		local factors, including market conditions, the level of operations of other refineries in our markets, and the volume of refined products imports.

          Prices for refined products are influenced by the price of crude oil. We do not produce crude oil and must purchase all of our crude oil, the price of which fluctuates on worldwide market conditions. Generally, an increase or decrease in the price of crude oil affects the price of gasoline and other refined products. However, the prices for crude oil and prices for our refined products can fluctuate in different directions based on global market conditions. In addition, the timing of the relative movement of the prices (both among different classes of refined products and among various global markets for similar refined products) as well as the overall change in refined product prices, can reduce profit margins and could have a significant impact on our refining and wholesale marketing operations, earnings and cash flow. Also, crude oil supply contracts are generally term contracts with market-responsive pricing provisions. We purchase our refinery feedstocks weeks before manufacturing and selling the refined products. Price level changes during the period between purchasing feedstocks and selling the manufactured refined products from these feedstocks could have a significant effect on our financial results. We also purchase refined products manufactured by others for sale to our customers. Price level changes during the periods between purchasing and selling these refined products also could have a material adverse effect on our business, financial condition and results of operations.

          Volatile prices for natural gas and electrical power used by our refineries and other operations have affected manufacturing and operating costs. Natural gas and electricity prices have been and will continue to be affected by supply and demand for fuel and utility services in both local and regional markets.

Our business is impacted by risks inherent in refining operations.

          The operation of refineries, pipelines and refined products terminals is inherently subject to spills, discharges or other releases of petroleum or hazardous substances. If any of these events had previously occurred or occurs in the future in connection with any of our refineries, pipelines or refined products terminals, or in connection with any

adopted or imposed in the future. We also may be required to address information or conditions that may be discovered in the future and that require a response.

          Assembly Bill 32, a California bill that creates a statewide cap on greenhouse gas emissions and requires that the state return to 1990 emission levels by 2020, was passed by the California legislature and was signed by Governor Schwarzenegger on September 27, 2006. The bill focuses on using market mechanisms, such as offsets and cap-and-trade programs, to achieve the targets. Regulations under the bill have not yet been promulgated. The bill specifies that any established greenhouse gas allowances will be assigned to the entity regulated under the cap. Implementation is slated to begin January 1, 2010 with full implementation to occur by 2020. The implementation and implications of this legislation will take many years to realize, and we cannot predict at this time what impact, if any, this legislation will have on our business.

          Currently, various legislative and regulatory measures to address greenhouse gas emissions (including carbon dioxide, nitrogen oxides and sulfur dioxide) are in various phases of discussion or implementation. These include proposed federal legislation and state actions to develop statewide or regional programs, each of which have imposed or would impose reductions in greenhouse gas emissions. These actions could result in increased costs to (i) operate and maintain our facilities, (ii) install new emission controls on our facilities and (iii) administer and manage any greenhouse gas emissions program. These actions could also impact the consumption of refined products, thereby affecting our operations.

          We are subject to interruptions of supply and increased costs as a result of our reliance on third-party transportation of crude oil and refined products.

          Our Washington refinery receives all of its Canadian crude oil and delivers a high proportion of its gasoline, diesel and jet fuel through third-party pipelines and the balance through marine vessels. Our Hawaii and Alaska refineries receive most of their crude oil and transport a substantial portion of refined products through ships and barges. Our Utah refinery receives substantially all of its crude oil and delivers substantially all of its refined products through third-party pipelines. Our North Dakota refinery delivers substantially all of its refined products through a third-party pipeline system. Our Golden Eagle refinery receives approximately one-third of its crude oil through pipelines and the balance through marine vessels. Substantially all of our Golden Eagle refinery’s production is delivered through third-party pipelines, ships and barges. In addition to environmental risks discussed above, we could experience an interruption of supply or an increased cost to deliver refined products to market if the ability of the pipelines or vessels to transport crude oil or refined products is upset because of accidents, governmental regulation or third-party action. A prolonged upset of the ability of a pipeline or vessels to transport crude oil or refined product could have a material adverse effect on our business, financial condition and results of operations.

          The pending acquisitions of the Los Angeles Assets and of the USA Petroleum retail stations are subject to regulatory approvals that could delay or prevent us from acquiring the assets.

          The consummation of the acquisitions of the Los Angeles Assets and of the USA Petroleum retail stations are subject to approval by the Federal Trade Commission and the Attorney General of the State of California. The failure to obtain these approvals could delay or prevent the consummations of either or both of these acquisitions.

Terrorist attacks and threats or actual war may negatively impact our business.

          Our business is affected by global economic conditions and fluctuations in consumer confidence and spending, which can decline as a result of numerous factors outside of our control, such as actual or threatened terrorist attacks and acts of war. Terrorist attacks, as well as events occurring in response to or in connection with them, including future terrorist attacks against U.S. targets, rumors or threats of war, actual conflicts involving the United States or its allies, or military or trade disruptions impacting our suppliers or our customers or energy markets in general, may adversely impact our operations. As a result, there could be delays or losses in the delivery of supplies and raw materials to us, delays in our delivery of refined products, decreased sales of our refined products and extension of time for payment of accounts receivable from our customers. Strategic targets such as energy-related assets (which could include refineries such as ours) may be at greater risk of future terrorist attacks than other targets in the United States. These occurrences could significantly impact energy prices, including prices for our crude oil and refined products, and have a material adverse impact on the margins from our refining and wholesale marketing operations. In addition, disruption or significant increases in energy prices could result in government-imposed price controls.

Any one of, or a combination of, these occurrences could have a material adverse effect on our business, financial condition and results of operations.

Our operating results are seasonal and generally are lower in the first and fourth quarters of the year.

          Demand for gasoline is higher during the spring and summer months than during the winter months in most of our markets due to seasonal increases in highway traffic. As a result, our operating results for the first and fourth quarters are generally lower than for those in the second and third quarters.

ITEM 1B. UNRESOLVED STAFF COMMENTS

          None.

ITEM 3. LEGAL PROCEEDINGS

          In the ordinary course of business, we become party to or otherwise involved in lawsuits, administrative proceedings and governmental investigations, including environmental, regulatory and other matters. Large and sometimes unspecified damages or penalties may be sought from us in some matters and some matters may require years for us to resolve. We cannot provide assurance that an adverse resolution of one or more of the matters described below during a future reporting period will not have a material adverse effect on our financial position or results of operations in future periods. However, on the basis of existing information, we believe that the resolution of these matters, individually or in the aggregate, will not have a material adverse effect on our financial position or results of operations.

          In November 2003, we filed suit in Contra Costa County Superior Court against Tosco alleging that Tosco misrepresented, concealed and failed to disclose certain additional environmental conditions at our Golden Eagle refinery. The court granted Tosco’s motion to compel arbitration of our claims for these certain additional environmental conditions. In the arbitration proceedings we initiated against Tosco in December 2003, we are also seeking a determination that Tosco is liable for investigation and remediation of these certain additional environmental conditions, the amount of which is currently unknown and therefore a reserve has not been established, and which may not be covered by the $50 million indemnity for the defined environmental liabilities arising from pre-acquisition operations. In response to our arbitration claims, Tosco filed counterclaims in the Contra Costa County Superior Court action alleging that we are contractually responsible for additional environmental liabilities at our Golden Eagle refinery, including the defined environmental liabilities arising from pre-acquisition operations. The arbitration is scheduled to begin during March 2007. We intend to vigorously prosecute our claims against Tosco and to oppose Tosco’s claims against us, although we cannot provide assurance that we will prevail. For further information related to the claims, see Note N in our consolidated financial statements in Item 8.

          As previously disclosed, we are a defendant, along with other manufacturing, supply and marketing defendants, in ten pending cases alleging MTBE contamination in groundwater. The defendants are being sued for having manufactured MTBE and having manufactured, supplied and distributed gasoline containing MTBE. The plaintiffs, all in California, are generally water providers, governmental authorities and private well owners alleging, in part, the defendants are liable for manufacturing or distributing a defective product. The suits generally seek individual, unquantified compensatory and punitive damages and attorney’s fees, but we cannot estimate the amount or likelihood of the ultimate resolution of these matters at this time, and accordingly, we have not established a reserve for these cases. We believe we have defenses to these claims and intend to vigorously defend the lawsuits.

          In October 2005, we received a NOV from the United Stated Environmental Protection Agency (“EPA”). The EPA alleges certain modifications made to the fluid catalytic cracking unit at our Washington refinery prior to our acquisition of the refinery were made in violation of the Clean Air Act. We have investigated the allegations and believe the ultimate resolution of the NOV will not have a material adverse effect on our financial position or results of operations.

          In September 2006, we reached an agreement with the Bay Area Air Quality Management District (the “District”) to settle 28 NOVs issued to Tesoro from January 2004 to September 2004 alleging violations of various air quality requirements at the Golden Eagle refinery. The settlement agreement was executed on October 11, 2006 and Tesoro made a cash payment of $200,000 to the District during the fourth quarter of 2006. Pursuant to the terms of the settlement agreement, Tesoro will undertake a supplemental project valued at approximately $100,000.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

          None.

PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

          The following performance graph and related information shall not be deemed “soliciting material” or to be “filed” with the Securities and Exchange Commission, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933 or Securities Exchange Act of 1934, each as amended, except to the extent that Tesoro specifically incorporates it by reference into such filing.

          The performance graph below compares the cumulative total return of our common stock to the cumulative total return of the S&P Composite Index and to a composite peer group of companies. The composite peer group (the “Peer Group”) includes the following: Alon USA Energy, Inc., Frontier Oil Corporation, Holly Corporation, Marathon Oil Corporation, Sunoco, Inc., and Valero Energy Corporation. The graph below is for the period of five years commencing December 31, 2001 and ending December 31, 2006.

Comparison of Five Year Cumulative Total Return*
Among the Company, the S&P 500 Index and Composite Peer Group

		12/31/2001				12/31/2002				12/31/2003				12/31/2004				12/31/2005				12/31/2006
Tesoro		$	100			$	34			$	111			$	243			$	471			$	507
S&P 500		$	100			$	78			$	100			$	111			$	116			$	134
Peer Group		$	100			$	79			$	122			$	165			$	334			$	371

Note: The stock price performance shown on the graph is not necessarily indicative of future performance.

          Our common stock is listed under the symbol “TSO” on the New York Stock Exchange. Summarized below are high and low sales prices of and dividends declared on our common stock on the New York Stock Exchange during 2006 and 2005. Quarterly cash dividends have been declared for each quarter beginning in June 2005. Prior to June 2005, we had not paid dividends on our common stock since 1986.

		Sales Prices per								Dividends
		Common Share								Per
Quarter Ended		High				Low				Common Share
December 31, 2006		$	73.10			$	54.66			$	0.10
September 30, 2006		$	76.80			$	52.95			$	0.10
June 30, 2006		$	75.74			$	60.32			$	0.10
March 31, 2006		$	73.98			$	57.67			$	0.10
December 31, 2005		$	69.30			$	52.03			$	0.10
September 30, 2005		$	71.82			$	46.11			$	0.05
June 30, 2005		$	49.87			$	34.05			$	0.05
March 31, 2005		$	38.20			$	28.25			$	—

          On January 26, 2007, our Board of Directors declared a quarterly cash dividend on common stock of $0.10 per share, payable on March 15, 2007 to shareholders of record on March 1, 2007. At February 21, 2007, there were approximately 1,849 holders of record of our 68,215,252 outstanding shares of common stock. For information regarding restrictions on future dividend payments and stock repurchases, see Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7 and Notes D and E in our consolidated financial statements in Item 8.

          The 2007 annual meeting of stockholders will be held at 5:00 P.M. Pacific Daylight Time on Tuesday, May 1, 2007, at The Four Seasons Hotel, 1260 Channel Drive, Santa Barbara, California. Holders of common stock of record at the close of business on March 13, 2007 are entitled to notice of and to vote at the annual meeting.

          The following table summarizes, as of December 31, 2006, certain information regarding equity compensation to our employees, officers, directors and other persons under our equity compensation plans.

Equity Compensation Plan Information

Number of Securities

Remaining Available for

Future Issuance under

Number of Securities to be

Weighted-Average Exercise

Equity Compensation

Issued upon Exercise of

Price of Outstanding

Plans (Excluding

Outstanding Options,

Options, Warrants

Securities Reflected in

Plan Category

Warrants and Rights

and Rights

the Second Column)

Equity compensation plans approved by security holders

3,573,004

$

26.45

1,755,685

Equity compensation plans not approved by security holders(a)

190,869

$

9.82

—

Total

3,763,873

$

25.61

1,755,685

          The table below provides a summary of all repurchases by Tesoro of its common stock during the three-month period ended December 31, 2006.

Approximate Dollar

Total Number of

Value of Shares

Shares Purchased as

That May Yet Be

Total Number

Average Price

Part of Publicly

Purchased Under the

of Shares

Paid Per

Announced Plans or

Plans or

Period

Purchased

Share

Programs*

Programs*

October 2006

240,000

$

57.78

240,000

$38 million

November 2006

—

—

—

$38 million

December 2006

—

—

—

$38 million

Total

240,000

$

57.78

240,000

ITEM 6. SELECTED FINANCIAL DATA

          The following table sets forth certain selected consolidated financial and operating data of Tesoro as of and for each of the five years in the period ended December 31, 2006. The selected consolidated financial information presented below has been derived from our historical financial statements. Our financial results include the results of our California operations since mid-May 2002. The following table should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations in Item 7 and our consolidated financial statements in Item 8.

		Years Ended December 31,
		2006				2005				2004				2003				2002
		(Dollars in millions except per share amounts)
Statement of Operations Data
Total Revenues		$	18,104			$	16,581			$	12,262			$	8,846			$	7,119
Net Earnings (Loss) (a)		$	801			$	507			$	328			$	76			$	(117	)
Net Earnings (Loss)
Basic		$	11.78			$	7.44			$	5.01			$	1.18			$	(1.93	)
Diluted		$	11.46			$	7.20			$	4.76			$	1.17			$	(1.93	)
Weighted Shares Outstanding (millions): (b)
Basic			68.0				68.1				65.5				64.6				60.5
Diluted			69.9				70.4				68.9				65.1				60.5
Dividends per share (c)		$	0.40			$	0.20			$	—			$	—			$	—
Balance Sheet Data
Current Assets		$	2,811			$	2,215			$	1,393			$	1,024			$	1,054
Property, Plant and Equipment, Net		$	2,687			$	2,467			$	2,304			$	2,252			$	2,303
Total Assets		$	5,904			$	5,097			$	4,075			$	3,661			$	3,759
Current Liabilities		$	1,672			$	1,502			$	993			$	687			$	608
Total Debt (d)		$	1,046			$	1,047			$	1,218			$	1,609			$	1,977
Stockholders’ Equity (b)		$	2,502			$	1,887			$	1,327			$	965			$	888
Current Ratio			1.7:1				1.5:1				1.4:1				1.5:1				1.7:1
Working Capital		$	1,139			$	713			$	400			$	337			$	446
Total Debt to Capitalization (b) (d)			29	%			36	%			48	%			62	%			69	%
Common Stock Outstanding (millions of shares)(b)			67.9				69.3				66.8				64.8				64.6
Book Value Per Common Share		$	36.85			$	27.23			$	19.87			$	14.89			$	13.74

		Years Ended December 31,
		2006				2005				2004				2003				2002
Cash Flows From (Used In)
Operating Activities		$	1,139			$	758			$	681			$	447			$	58
Investing Activities			(430	)			(254	)			(174	)			(70	)			(941	)
Financing Activities (b) (c) (d)			(163	)			(249	)			(399	)			(410	)			941
Increase (Decrease) in Cash and Cash Equivalents		$	546			$	255			$	108			$	(33	)		$	58
Capital Expenditures (e)		$	453			$	262			$	179			$	101			$	204
Operating Data
Refining Throughput (thousand barrels per day) (f)
California
Golden Eagle			165				165				153				156				95
Pacific Northwest
Washington			111				111				117				112				104
Alaska			56				60				57				49				53
Mid-Pacific
Hawaii			85				83				84				80				82
Mid-Continent
North Dakota			56				58				56				48				51
Utah			56				53				53				43				50
Total Refining Throughput			529				530				520				488				435
Refining Yield (thousand barrels per day) (f)
Gasoline and gasoline blendstocks			245				248				251				239				204
Jet fuel			68				68				66				58				64
Diesel fuel			121				118				110				103				87
Heavy oils, residual products, internally produced fuel and other			115				115				113				107				95
Total Refining Yield			549				549				540				507				450
Refined Product Sales (thousand barrels per day) (f) (g)
Gasoline and gasoline blendstocks			280				294				300				280				264
Jet fuel			91				101				90				84				94
Diesel fuel			128				139				133				121				115
Heavy oils, residual products and other			87				75				81				72				72
Total Refined Product Sales			586				609				604				557				545
Retail Fuel Sales (millions of gallons)			434				449				510				568				790
Number of Branded Retail Stations (end of period)			460				478				507				557				593

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

          Those statements in this section that are not historical in nature should be deemed forward-looking statements that are inherently uncertain. See “Forward-Looking Statements” on page 45 and “Risk Factors” on page 16 for a discussion of the factors that could cause actual results to differ materially from those projected in these statements.

BUSINESS STRATEGY AND OVERVIEW

          Our strategy is to create a value-added refining and marketing business that has (i) economies of scale, (ii) a low-cost structure, (iii) effective management information systems and (iv) outstanding employees focused on achieving operational excellence in a global market in order to provide stockholders with competitive returns in any economic environment.

          Our goals are focused on: (i) operating our facilities in a safe, reliable, and environmentally responsible way; (ii) improving cash flow by achieving greater operational and administrative efficiencies; and (iii) using excess cash flows from operations in a balanced way to create further shareholder value. During 2006, we achieved the following significant results relative to our goals, which are further described below under “Results of Operations” and “Capital Resources & Liquidity”:

	•		We had record net earnings of $801 million, or $11.46 per diluted share, compared to 2005 net earnings of $507 million, or $7.20 per diluted share.
	•		Our cash flows from operating activities were $1.1 billion, an increase of $381 million from 2005.
	•		We achieved average throughput of 529,000 barrels per day (“bpd”), which was just below the 529,600 bpd record set in 2005.
	•		Our capital and turnaround spending totaled $570 million, including $225 million for economic projects, and $68 million for safety and reliability projects.
	•		We posted the lowest recordable OSHA incident rate in our history.

	•		We paid cash dividends on common stock totaling $27 million or $0.40 per share.
	•		We repurchased 2.4 million shares of common stock under our share repurchase program for $148 million.

Pending Acquisitions

          On January 29, 2007, we entered into agreements with Shell Oil Products US (“Shell”) to purchase a 100,000 bpd refinery and a 42,000 bpd refined products terminal located south of Los Angeles, California along with approximately 250 Shell-branded retail stations located throughout Southern California (collectively, the “Los Angeles Assets”). The purchase includes a long-term agreement allowing us to continue to operate the retail stations under the Shell^® brand. The purchase price of the Los Angeles Assets is $1.63 billion, plus the value of petroleum inventories at the time of closing, which is estimated to be $180 million to $200 million based on January 2007 prices. Upon closing of the acquisitions Shell has agreed, subject to certain limitations, to retain certain obligations, responsibilities, liabilities, costs and expenses, including environmental matters arising out of the pre-closing operations of the assets. We have agreed to assume certain obligations, responsibilities, liabilities, costs and expenses arising out of or incurred in connection with decrees, orders and settlements the seller entered into with governmental and non-governmental entities prior to closing . This transaction, which will require regulatory approval from the Federal Trade Commission and the Attorney General of the State of California, is expected to be completed in the second quarter of 2007.

          We expect to realize synergies by optimizing the output of our refineries to maximize the production of clean fuel products for the California market as well as through our crude oil purchasing and unique shipping logistics. In addition, we expect to increase reliability, throughput levels and the production of clean products at the refinery by spending approximately $325 million to $350 million between 2007 and 2011. We also plan to lower air emissions as well as improve fuel efficiency at the refinery by spending an additional $375 million to $400 million between 2007 and 2011. These cost estimates will be further reviewed and analyzed after the transaction is completed and we acquire additional information through operation of the assets.

          On January 26, 2007, we entered into an agreement to purchase 140 USA Petroleum retail stations located primarily in California and a terminal located in New Mexico. The purchase price of the assets and the USA^® brand is $277 million, plus the value of inventory at the time of closing, which is estimated to be $10 million to $15 million based on January 2007 prices. Tesoro will assume the obligations under the seller’s leases, contracts, permits or other agreements arising after the closing date. USA Petroleum will retain certain pre-closing liabilities, including environmental matters. The acquisition will provide us with retail stations near our refineries in California that will enable us to run the refineries at full capacity, invest in refinery improvements and deliver more clean products into the market. This transaction, which will require regulatory approval from the Federal Trade Commission and the Attorney General of the State of California, is expected to be completed in the second quarter of 2007.

          The acquisitions of the Los Angeles Assets and the USA Petroleum retail stations will be paid for with a combination of debt and cash on-hand, which at December 31, 2006 was $986 million. The exact amount of debt and cash is yet to be determined, but our debt-to-capitalization ratio is expected to be less than 50% at the time of closing. We plan to reduce debt through internally generated cash flow and have set a goal to reduce our debt-to-capitalization ratio to 40% by the end of 2007.

          Strategic Capital Projects

          During 2007 we will continue to focus on capital projects that improve safety and reliability, enhance our crude oil flexibility, improve clean product yields and increase energy efficiency. In December 2006, our Board of Directors approved the 2007 capital budget, which is approximately $650 million (including refinery turnarounds and other maintenance costs of approximately $92 million). The capital budget does not include any capital spending for the pending acquisitions discussed above. See “Capital Resources and Liquidity” for additional information related to capital spending, including the estimated spending in 2007 for each of the capital projects described below.

          Golden Eagle Coker Modification Project

          The coker modification project at our Golden Eagle refinery is currently scheduled to be substantially completed during the first quarter of 2008. The modification of our existing fluid coker unit to a delayed coker unit will enable

us to comply with the terms of an abatement order to lower air emissions while also enhancing the refinery’s capabilities in terms of reliability, lengthening turnaround cycles and reducing operating costs. By extending the typical coker turnaround cycle from 2.5 years to 5 years, we will effectively increase clean fuels production and significantly reduce the duration and costs of coker turnarounds.

          Washington Sulfur Handling Projects

          Our 2007 capital budget includes sulfur handling projects at our Washington refinery which will allow us to process a greater percentage of sour crude oils beginning in 2008. The sulfur handling projects were a component of the 25,000 bpd delayed coker unit project at our Washington refinery which was cancelled in July 2006. We estimate the sulfur handling projects will allow our Washington refinery to capture up to 15% of the original benefit of the delayed coker. The delayed coker unit was designed to process a larger portion of lower-cost heavy crude oils or manufacture a larger percentage of higher-value refined products. The project, originally estimated to cost approximately $250 million, had experienced significant cost escalations in engineering, materials and labor and no longer met our rate of return objectives. The cost escalations were similar to those that had been announced on other projects both within and outside the energy sector. Our decision to terminate the project is consistent with our commitment to high return projects. The termination of the delayed coker project resulted in pretax charges of $28 million in 2006.

          Other Strategic Capital Projects

          During the 2007 second quarter, we are scheduled to complete the following three strategic projects: (i) a 10,000 bpd diesel desulfurizer unit at our Alaska refinery; (ii) a process control modernization project at our Golden Eagle refinery; and (iii) a wharf expansion project also at our Golden Eagle refinery. The diesel desulfurizer unit will allow us to manufacture ultra-low sulfur diesel (“ULSD”) and become the sole producer of ULSD in Alaska. The control modernization project will convert our older refinery control technologies at the Golden Eagle refinery to a modern digital system. The wharf expansion project will increase our crude oil flexibility by enabling us to supply all of the Golden Eagle refinery’s crude oil requirements by water.

          Industry Overview

          The global fundamentals of the refining industry remained strong during 2006. Continued demand growth in developing areas such as India and China and global political concerns supported high prices for crude oil and refined products. In the U.S., refining margins remained above historical levels during 2006 and improved as compared to 2005, in part due to the following:

	•		continued high gasoline and diesel demand coupled with limited production capacity;
	•		higher than normal industry maintenance during the first half of 2006 reflecting turnarounds which were postponed in 2005 due to hurricanes Katrina and Rita;
	•		the introduction of new lower sulfur requirements for gasoline in January 2006 and diesel in June 2006 and the removal of MTBE as a blendstock nationwide;
	•		stronger reliance on gasoline imports;
	•		the extended downtime at three refineries damaged by the hurricanes and other incidents; and
	•		extensive industry maintenance and unplanned downtime on the U.S. West Coast during the fourth quarter.

          Anticipated lower overall crude oil and refined product prices, along with relative price stability, should lead to increases in refined product demand. With little incremental refining capacity being added during the year, existing refineries will likely continue to run at high utilization levels and U.S. refined product imports are expected to increase to meet rising demand requirements. In addition, higher than normal maintenance schedules are planned during the first and second quarters, further reducing U.S. supplies. For all of these reasons, our outlook for the refining industry remains strong.

RESULTS OF OPERATIONS

     Summary

          Our net earnings for 2006 were $801 million ($11.46 per diluted share), compared with net earnings of $507 million ($7.20 per diluted share) for 2005. The significant increase in net earnings during 2006 was primarily due to higher refined product margins and lower interest expense as a result of debt reduction and refinancing in 2005. Net earnings for 2006 included an after-tax charge of $17 million ($0.24 per share) related to the termination of the delayed coker project at our Washington refinery. Net earnings for 2005 included charges for debt refinancing and prepayment costs of $58 million after-tax or $0.82 per share, and executive termination and retirement costs of $6 million after-tax, or $0.09 per share.

Net earnings for 2005 were $507 million ($7.20 per diluted share), compared with net earnings of $328 million ($4.76 per diluted share) for 2004. The significant increase in earnings during 2005 was primarily due to higher refined product margins, record high throughput levels and realizing our operating income improvement initiatives. Net earnings for 2004 included debt prepayment and financing costs of $14 million after-tax, or $0.20 per share, and charges for executive retirement costs of $1 million after-tax, or $0.01 per share.

          A discussion and analysis of the factors contributing to our results of operations is presented hereafter. The accompanying consolidated financial statements in Item 8, together with the following information, are intended to provide investors with a reasonable basis for assessing our historical operations, but should not serve as the only criteria for predicting our future performance.

     Refining Segment

		2006				2005				2004
		(Dollars in millions except per
		barrel amounts)
Revenues
Refined products (a)		$	17,323			$	15,587			$	11,633
Crude oil resales and other			564				782				419
Total Revenues		$	17,887			$	16,369			$	12,052
Refining Throughput (thousand barrels per day) (b)
California
Golden Eagle			165				165				153
Pacific Northwest
Washington			111				111				117
Alaska			56				60				57
Mid-Pacific
Hawaii			85				83				84
Mid-Continent
North Dakota			56				58				56
Utah			56				53				53
Total Refining Throughput			529				530				520
% Heavy Crude Oil of Total Refining Throughput (c)			49	%			50	%			50	%
Yield (thousand barrels per day)
Gasoline and gasoline blendstocks			245				248				251
Jet Fuel			68				68				66
Diesel Fuel			121				118				110
Heavy oils, residual products, internally produced fuel and other			115				115				113
Total Yield			549				549				540