FRONTIER OIL CORPORATION 1 9 9 9 Annual Report

1 9 9 9 Annual Report
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Management's Discussion and Analysis

General

The terms "Frontier" and "we" refer to Frontier Oil Corporation and its subsidiaries. On November 16, 1999, we acquired the 110,000 barrels per day crude oil refinery located in El Dorado, Kansas from Equilon Enterprises LLC ("Equilon"). Operating results for this refinery have been included in our financial information from November 17, 1999.

We experience stronger demand for our refined products, particularly gasoline and asphalt, during the summer months due to seasonal increases in highway traffic and road construction work. As a result, our operating results for the first and fourth calendar quarters are generally lower than those for the second and third quarters. Demand for diesel is more stable, but reduced road construction and agricultural work during the winter months does have an impact on demand for diesel. Consistent with the seasonality of our business, we invest in working capital during the first half of the year and recover working capital investment in the second half of the year.

Result of Operations

1999 Compared with 1998. We had a net loss for the year ended December 31, 1999 of $17.1 million, or $.62 per share, compared to net income from continuing operations of $18.8 million, or $.65 per diluted share for 1998. Net income for the year ended December 31, 1998 was $15.8 million, or $.55 per diluted share. The results for the year ended December 31, 1998 included a $3.0 million extraordinary loss on early retirement of debt.

Operating income decreased $30.9 million in 1999 versus 1998 due to a decrease in the refined product spread (revenues less material, freight and other costs) of $17.6 million, increases in refinery operating expenses of $10.2 million, depreciation of $2.3 million, and selling and general costs of $1.2 million, offset by an increase in other income of $456,000.

The refined product spread was $3.42 per barrel for the year ended December 31, 1999 compared to $5.77 per barrel in 1998. This decrease was due to significantly lower light product margins, a significant decrease in the light/heavy crude spread and lower by-product margins due to higher crude oil prices, offset by inventory profits. High nationwide levels of gasoline and diesel inventories kept margins at their lowest levels since 1995 during the first six months of 1999. Although margins improved during the third quarter of 1999, they again turned downward in the fourth quarter. An industry publication reported that refining margins may prove to be the worst of the decade. High crude oil prices and weak weather-related product demand have caused extremely low to negative fourth quarter margins.

The light/heavy crude spread for the Cheyenne Refinery was $2.17 per barrel for the year ended December 31, 1999, the lowest ever experienced by Frontier for such a lengthy period. In comparison, the light/heavy spread for 1998 was $4.15 per barrel. The tightening spread was caused by low crude oil prices during 1998 and the resulting reduced supply of heavy crude oil as certain heavy crude oil was uneconomic to produce. Although crude oil prices began to increase in the second quarter of 1999, the light/heavy spread has been slow to widen. The heavy crude oil spread for the Cheyenne Refinery is directly linked to pricing of Canadian heavy crude oil. Late in the fourth quarter, the Canadian heavy crude oil price spread began to widen due to seasonal declines in asphalt needs. However, demand for Canadian heavy crude oil remains strong into 2000 as it is attractively priced versus other foreign supplies. We expect that for 2000, the heavy crude oil spread for the Cheyenne Refinery will widen, but whether it will widen to more historical pricing relationships based on current crude oil prices will depend on Canadian and other worldwide heavy crude oil supplies.

The price of crude oil reached its low point in December 1998, when crude closed at below $10.75 per barrel on the New York Mercantile Exchange and stayed at or below $13.00 per barrel during January and February 1999. Commencing in March 1999, with the announcement of OPEC production cuts, the price of crude oil increased and ended December at $25.60 per barrel. For the year ended December 31, 1999, we realized a benefit to the refined product spread for the Cheyenne Refinery for inventory profits of approximately $13.2 million because of increasing crude oil prices. For the year ended December 31, 1998, we realized a reduction to the refined product spread of approximately $5.0 million because of declines in crude oil prices. Inventories are recorded at the lower of cost on a first in, first out (FIFO) basis or market.

Refined product revenues increased $203.8 million or 68% for the year ended December 31, 1999 compared to 1998 due to increased sales prices and increased sales volumes from the El Dorado Refinery acquisition. Average gasoline prices increased $5.09 per barrel, average diesel prices increased $6.02 per barrel and there was a 36% overall increase in sales volumes. Yields of gasoline increased 58% while yields of diesel increased 32% in 1999 compared to 1998.

Other income increased $456,000 to $2.2 million for the year ended December 31, 1999 compared to the same period in 1998 due to a $516,000 legal settlement received in 1999.

Refining operating costs increased $231.6 million or 91% for the year ended December 31, 1999 compared to 1998 due to the El Dorado Refinery acquisition and increases in material, freight and other costs and refinery operating expenses. Material, freight and other costs were $20.31 per barrel in 1999 compared to $13.33 per barrel in 1998 primarily due to higher crude oil prices, the use of a lower percentage of less expensive heavy crude oil and a lower light/heavy spread. Expressed as a percentage of the total crude oil charge, the Cheyenne Refinery heavy crude oil utilization rate decreased to 87% in the year ended December 31, 1999 from 94% in 1998. The light/heavy spread for the Cheyenne Refinery decreased 48% to average $2.17 per barrel for 1999. Refinery operating expenses averaged $2.71 per barrel consisting of $2.52 per barrel at the El Dorado Refinery (including chemical operations) and $2.77 per barrel for the Cheyenne Refinery. The Cheyenne Refinery operating expense per barrel decreased $.25 per barrel to $2.77 per barrel in 1999 due to higher throughput, lower chemical usage and lower maintenance costs.

Selling and general expenses increased $1.2 million or 15% for the year ended December 31, 1999 because of increased staffing needs and other costs resulting from the El Dorado Refinery acquisition and increases in salaries and benefits.

Depreciation increased $2.3 million or 22% for the year ended December 31, 1999 as compared to 1998 because of the El Dorado acquisition and increases in capital investment. The 1998 depreciation provision also included a write-off of certain equipment replaced in connection with turnaround work.

The interest expense increase of $3.2 million or 48% for the year ended December 31, 1999 was attributable to higher debt levels used to purchase the El Dorado Refinery and the crude oil, intermediate and finished product inventory of the El Dorado Refinery. Average debt increased to $108.1 million for the year ended December 31, 1999 from 679.2 million for the year ended December 31, 1998.

Income tax expense of $1.9 million for the year ended December 31, 1999 was for deferred state income taxes. In accordance with Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", deferred taxes are provided for the tax effect of cumulative to date net taxable book-tax differences, offset by available net operating losses. While we have substantial net operating losses available to offset federal income taxes, the El Dorado Refinery acquisition will result in a significant portion of future taxable income being apportioned to Kansas for state income tax purposes.

1998 Compared with 1997. We had net income for the year ended December 31, 1998 of $15.8 million, or $.55 per diluted share, compared to net income of $19.1 million, or $.69 per diluted share for 1997. The 1998 results include a $3.0 million extraordinary loss on early retirement of debt. The 1997 results included a $23.3 million gain on the sale of the Canadian oil and gas operations which closed on June 16, 1997, a $9.9 million reduction to income in recognition of the cumulative translation adjustment, a $3.9 million extraordinary loss on retirement of debt and $1.7 million of income from the discontinued Canadian oil and gas operations. Income from continuing operations for the year ended December 31, 1998 was $18.8 million compared to $7.8 million for 1997. The sale of the Canadian oil and gas operations closed on June 16, 1997, thus the 1997 operating results for the Company's oil and gas exploration and production segment have been presented as discontinued operations in the accompanying financial statements.

Operating income increased $4.0 million in 1998 as compared to 1997 due to an increase in the refined product spread (revenues less material, freight and other costs) of $8.2 million offset by a decrease in other income of $621,000 and increases in refinery operating expenses of $1.8 million, selling and general expenses of $175,000 and depreciation of $1.5 million.

Refined product revenues and refining operating costs are impacted by changes in the price of crude oil. The price of crude oil was significantly lower in 1998 than in 1997.

The refined product spread was $5.77 per bbl compared to $5.53 per bbl in 1997. The 1998 refined product spread increased due to an improved light/heavy crude oil spread and better by-product margins from lower crude oil prices. Light product margins were approximately 14% lower than in 1997 which reduced the refined product spread. Both periods' refined product spreads were negatively impacted by declines in crude oil prices totaling approximately $3.7 million in the first quarter and $1.1 million in the fourth quarter of 1998 and approximately $4.0 million in the first quarter of 1997. Inventories are recorded at the lower of cost on a first in, first out (FIFO) basis or market. Refined product revenues decreased $76.4 million or 20%. The decrease in refined product revenues resulted from a $7.31 per bbl decrease in average gasoline sales prices and a $7.32 per bbl decrease in average diesel sales prices. Refined product sales volumes increased 5% in 1998 over 1997 levels. Yields of gasoline decreased by 8% while yields of diesel increased 2% in 1998 compared to 1997. The decrease in gasoline yields was due to the major turnaround, which commenced April 19, 1998 and was completed May 15, 1998, on the fluid catalytic cracking unit and alkylation and related units.

Other income, which consists primarily of processing fees, decreased $621,000 to $1.7 million in 1998 as compared to 1997. Other income for 1997 included a gain on foreign currency swaps of $522,000 related to the Canadian sale proceeds while other income for 1998 includes sulfur credit sales of $360,000.

Refining operating costs decreased $82.8 million or 25% in the year ended December 31, 1998 from 1997 levels due to a decrease in material, freight and other costs offset by an increase in refinery operating expenses. Material, freight and other costs per bbl decreased 32% or $6.41 per bbl in 1998 due to lower oil prices, increased percentage use of heavy crude oil, an increase in the light/heavy spread and a 2% decrease in refinery charge rates. During 1998, the refinery heavy crude oil utilization rate expressed as a percentage of total crude oil increased to 94% from 91% in 1997. The light/heavy spread increased 17% to average $4.15 per bbl in 1998. Refinery operating expenses increased $1.9 million in 1998 as compared to 1997, and refinery operating expense per bbl decreased $.03 per bbl to $3.02 per bbl in 1998. The increase in refinery operating expenses during 1998 was due to higher natural gas usage during the turnaround and increased chemical usage due Go unit operating problems which were corrected during the turnaround.

Selling and general expenses increased $175,000 or 2% for the year ended December 31, 1998 reflecting increases in salaries and benefits.

Depreciation increased $1.5 million or 17% for the year ended December 31, 1998 as compared to 1997, attributable to increases in capital investment and the write-off of certain equipment replaced in connection with the turnaround work.

The interest expense decrease of $7.2 million or 52% in 1998 was attributable to utilizing Canadian sale proceeds to retire debt during the third and fourth quarters of 1997. Average debt decreased from $138 million in 1997 to $79 million in 1998.

During 1998, the price of light crude oil declined by approximately $6.00 per bbl to $12.05 per bbl at December 31, 1998. The price of heavy crude oil likewise declined. The low price of crude oil caused the production of some heavy crude oil in both Wyoming and Canada to become uneconomical. The reduced supply of heavy crude oil and the high demand for heavy crude oil due to attractive asphalt margins were major factors contributing to the decline in the light/heavy spread during 1998. During the third and fourth quarters of 1998, the Company experienced a shortfall in contracted heavy crude oil deliveries from Wyoming of approximately 5,100 bpd which required the Company to buy additional heavy Canadian crude oil at spot prices. The price of heavy crude oil purchased at spot prices was substantially higher than contracted Wyoming and Canadian crude oil resulting in the decline of the light/heavy spread from $4.81 per bbl in the second quarter of 1998 to $3.66 per bbl in the third quarter of 1998, and to $3.40 per bbl in the fourth quarter of 1998.

LIQUIDITY AND CAPITAL RESOURCES

On November 5, 1999, we issued $190 million principal amount of 11 3/4% Senior Notes due 2009. The Notes were issued at a price of 98.562%. Net proceeds of the offering were approximately $181.0 million. We used the net proceeds to fund the $170 million purchase price of the El Dorado Refinery and for general corporate purposes. We also purchased the crude oil, intermediate product and the refined product inventory of the El Dorado Refinery at closing for $53.1 million. We borrowed under the credit facility to help finance the inventory purchases.

On February 9, 1998, we issued $70 million of 9 1/8% Senior Notes due 2006 and received net proceeds of approximately $67.9 million. On February 10, 1998, the Company called for redemption the remaining $24.8 million of its 12% Senior Notes and $46 million of its 7 3/4% Convertible Subordinated Debentures. This redemption was completed on March 12, 1998 resulting in the payment of $71.4 million, including redemption premiums and the issuance of 83,535 shares of common stock. Under a stock repurchase plan, approved by the board of directors to purchase the approximate number of shares issued upon conversion of the Convertible Debentures, 83,500 shares of common stock were repurchased by the Company for $651,000.

On September 1, 1998, we announced that the Board of Directors had approved a stock repurchase program of up to three million shares of common stock. In 1998, 469,700 shares of common stock were purchased for $2.3 million. In 1999, an additional 627,700 shares of common stock were purchased for $3.4 million.

Net cash used by operating activities was $11.3 million for the year ended December 31, 1999 while $31.3 million cash was provided by operating activities for the year ended December 31, 1998. Working capital changes required $9.7 million of cash flows in 1999 while providing $1.7 million of cash flows in 1998. The 1999 use reflects the purchase of crude oil, intermediate product and finished product inventory of the El Dorado Refinery. At December 31, 1999, we had $38.3 million of cash and $45.7 million available under the revolving credit facility line of credit. We had working capital of $24.8 million at December 31, 1999. Under revolving credit facility conditions, we are required to maintain $25 mil-lion in cash through March 31, 2001. However, if EBITDA (earnings before interest, taxes, depreciation and amortization) for the six months ended June 30, 2000 is at least $40 million, the requirement will be reduced to $12.5 million, and if EBITDA for the nine months ended September 30, 2000 is at least $50 million, the requirement will be eliminated.

Capital expenditures for 1999 were $171.6 million for the El Dorado Refinery acquisition and $9.2 million for other capital expenditures. Capital expenditures for 1998 were $16.8 million. Capital expenditures of approximately $13.2 million are planned for 2000.

We are highly leveraged. As of December 31, 1999, we have $283 million of total consolidated debt and shareholders(1) equity of $50.7 million. It is anticipated that cash generated from operating activities will be sufficient to meet our 2000 investment and debt obligations. If we cannot generate sufficient cash from operating activities to meet our obligations we may reduce capital expenditures, sell assets, raise capital or refinance our debt obligations. We anticipate first quarter 2000 cash flows from operating activities will be negative. We believe we have sufficient cash and available borrowing capacity under the revolving credit facility to meet our obligations until seasonal and industry improvements begin.

Under certain conditions, the revolving credit facility restricts the transfer of cash in the form of dividends, loans or advances to the Company from its subsidiaries. We do not believe these restrictions limit our current operating plans.

MARKET RISKS

Impact of Changing Prices. Our revenues and cash flows, as well as estimates of future cash flows are very sensitive to changes in energy prices. Major shifts in the cost of crude oil and the price of refined products can result in large changes in the operating margin from refining operations. Energy prices also determine the carrying value of the refineries’ inventory.

Hedging Activities. At times, we engage in futures transactions in our refining operations for the purpose of hedging our refining position. We accomplish this by purchasing forward crude oil supply contracts, but we generally have not hedged refined product prices. However, we may in the future hedge refined product prices in some of the new markets served by the El Dorado Refinery. To date, the use of futures transactions has been limited to protect against price declines for excess inventory volumes and foreign crude oil purchases. No futures transactions were entered into during 1999 to hedge excess inventories. Since the El Dorado Refinery acquisition we use futures transactions to price foreign crude oil at the price when the crude oil is processed by the El Dorado Refinery instead of when purchased. Foreign crude oil delivery times can exceed one month from when the purchase is made. In addition, we, at times, engage in futures transactions for the purchase of natural gas at fixed prices. The refineries consume natural gas for energy purposes. Gains and losses on futures contracts designated as hedges are recognized in refinery operating costs when the associated hedge transaction is consummated. Futures contracts and options may also, in the future, be used to fix margins in our refining and marketing operations. In 1999, we recognized losses on futures transactions to purchase foreign crude oil of $3.6 million and from forward purchases of natural gas of $62,000. As of December 31, 1999 we had entered into futures contracts for the purchase of foreign crude oil and purchase of natural gas. We had sold approximately 1.5 million barrels of crude oil on the New York Mercantile Exchange at an average price of $25.86 for repurchase through March 2000. We had also purchased an average 7,000 mcf per day of natural gas through March 2000 at $2.13 per mcf. The estimated fair value of our open crude oil futures contracts and natural gas futures contracts at December 31, 1999 were $456,000 and $122,000, respectively.

Interest Rate Risk. Borrowings under our revolving credit facility bear a current market rate of interest. Our $70.0 million of 9 1/8% Senior Notes, due 2006, have a fixed interest rate, and we have no current plans to redeem these notes. Our $190.0 million of 11 3/4% Senior Notes, due 2009, also have a fixed interest rate. Accordingly, our long-term debt is not exposed to cash flow or fair value risk from interest rate changes. The estimated fair value of the 9 1/8% Senior Notes at December 31, 1999 was $63 million and the estimated fair value of the 11 3/4% Senior Notes was $187.2 million.

SELECTED QUARTERLY FINANCIAL AND OPERATING DATA

(1) Includes El Dorado Refinery financial and operating data from November 17, 1999.
(2) EBITDA represents income from continuing operations before interest expense, income tax and depreciation and amortization. EBITDA is not a calculation based upon generally accepted accounting principles; however, the amounts included in the EBITDA calculation are derived from amounts included in the consolidated financial statements. In addition, EBITDA should not be considered as an alternative to net income or operating income, as an indication of operating performance or as an alternative to operating cash flow as a measure of liquidity.

ENVIRONMENTAL

Numerous local, state and federal laws, rules and regulations relating to the environment are applicable to our operations. As a result, we fall under the jurisdiction of numerous state and federal agencies for administration and are exposed to the possibility of judicial or administrative actions for remediation and/or penalties brought by those agencies. The Cheyenne Refinery is party to one consent decree requiring the investigation and, in certain instances, mitigation of environmental impacts resulting from past operational activities. The El Dorado Refinery is party to a consent decree regarding the implementation of a groundwater management program. Equilon will be responsible for the cost of continued compliance with this order. We have obtained a ten-year insurance policy with $25 million coverage for environmental liabilities, with a $500,000 deductible. This insurance will reimburse us for losses related to some known and some unknown pre-existing conditions at the El Dorado Refinery. Equilon and Frontier will share the premium costs of this policy. In addition, Equilon will be responsible for up to $5 million in costs (including insurance premiums) relating to safety, health and environmental conditions that are not covered under the ten-year insurance policy. There are currently no identified environmental remediation projects of which the costs can be reasonably estimated. However, the continuation of the present investigative process, other more extensive investigations over time or changes in regulatory requirements could result in future liabilities. The effects to the future consolidated financial position, results of operations or capital expenditures is unknown.

FIVE - YEAR FINANCIAL DATA

(1) Includes El Dorado Refinery financial data from November 17, 1999.
(2) Discontinued operations reflected in the above periods represent the Company’s oil and gas operating segment, comprising the Canadian and United States oil and gas properties. On June 16, 1997, the Company completed the Canadian disposition. The Company completed the U.S. disposition during 1995.
(3) EBITDA represents income from continuing operations before interest expense, income tax and depreciation and amortization. EBITDA is not a calculation based upon generally accepted accounting principles; however, the amounts included in the EBITDA calculation are derived from amounts included in the consolidated financial statements of the Company. In addition, EBITDA should not be considered as an alternative to net income or operating income, as an indication of operating performance of the Company or as an alternative to operating cash flow as a measure of liquidity.

CANADIAN TAX ASSESSMENT

Prior to the sale of our Canadian oil and gas operations in June 1997, we conducted business in Canada. As a result of an audit in 1999 of our Canadian tax returns for the years 1995, 1996 and 1997 conducted by the Canada Customs and Revenue Agency (formerly Revenue Canada), we were assessed for approximately C$27 million of additional taxes. More than C$20 million of this assess-ment relates to certain foreign exploration and development expenditure deductions. The Department of Finance in Canada has drafted and released proposed legislation that would eliminate this portion of the assessment. Approximately C$5 million of the assessment relates to the deductibility of certain interest costs in 1995, which were not challenged by the Canada Customs and Revenue Agency in its audits of previous periods. Other deductions of approximately C$2 million comprise the balance of the assessment. We have filed a Notice of Objection to portions of the assessment totaling approximately C$25 million and additionally, are awaiting, as is the Canada Customs and Revenue Agency, the passing of legislation that will resolve the foreign exploration and development expenditure deduction portion of the assessment, before arguing the remaining assessment. We intend to vigorously contest the tax assessment and believe that we will be successful in our appeal, either at the regulatory level or before the Courts. While we acknowledge the uncertainties associated with tax disputes, management currently believes that this matter will be resolved without a material effect on our financial position or results of operations.

YEAR 2000 ISSUES

Many of the computer systems used by us today were designed and developed using two digits, rather than four, to specify the year. At January 1, 2000, it was anticipated this could cause many computer applications to fail completely or to create erroneous results unless corrective measures were taken. The Year 2000 issue has caused no disruption to our operations and only minor disruption to our computer applications, the cost of which has been insignificant. There may be Year 2000 related problems that may yet occur, but we believe they will not have a material effect on our operations and will not create material costs.

FIVE - YEAR OPERATING DATA

(1) Includes El Dorado Refinery operating data from November 17, 1999.
(2) Includes intermediate varieties of crude oil used by the El Dorado Refinery.
(3) Prior year data restated to conform to current year presentation.