1998 Annual Report
Contents || Corporate ListingsManagement's Discussion and Analysis
General
The Company experiences stronger demand for its refined products, particularly gasoline and asphalt, during the summer months due to seasonal increases in highway traffic and road construction work. As a result, the Company's 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 its business, the Company invests in working capital during the first half of the year and recovers working capital investment in the second half of the year.
Results of Operations
1998 Compared with 1997. The Company 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 1997 and prior operating results for the Company's oil and gas exploration and production segment have been presented as discontinued operations in the accompanying financial statements. Frontier's primary continuing operation is its refining operation in the Rocky Mountain region of the United States.
Operating income increased $4.0 million in 1998 as compared to 1997 due to an increase in the refined product spread (revenues less material costs) of $9.5 million offset by a decrease in other income of $621,000 and increases in refining operating expenses of $3.1 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 $6.09 per bbl compared to $5.78 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 costs offset by an increase in operating expenses. Material costs per bbl decreased 33% or $6.48 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 $3.1 million in 1998 as compared to 1997, and refining operating expense per bbl increased $.04 per bbl to $3.34 per bbl in 1998. The increase in refining operating expenses during 1998 was due to higher natural gas usage during the turnaround, increased chemical usage due to unit operating problems which were corrected during the turnaround and increased transportation costs for asphalt and other product sales. Although focus to reduce refining operating expenses will continue, maintenance problems may arise in the future, resulting in downtime of certain processing units and reduced yields which may increase operating expenses and negatively impact profitability. A turnaround is scheduled in the spring of 1999 on the crude unit. This unit is scheduled to be down for 14 days, which will decrease average yields during that time. Other turnaround work is scheduled for sev-eral Refinery units during 1999, but this work should not materially impact yields.
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 has 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 are major factors contributing to the current decline in the light/heavy spread. 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.
The Company is dependent upon regional and Canadian crude oil for its refinery. Should low crude oil prices continue into 1999, the Company expects the supply of heavy crude oil to continue to decline which should cause the price of such heavy crude oil to increase. Consequently, the light/heavy spread will decline. The Company plans to increase its use of lighter crude oil, should prices stay at current levels, to offset declining heavy crude oil supply. Since the Company is dependent upon regional and Canadian crude oil, it is possible at current prices the Company may not be able to obtain the quantity of crude oil it desires which will result in reduced refinery crude oil charge rates and negatively impact profitability. Based on contracts for 1999 heavy crude oil averaging approximately 14,000 bpd, the light/heavy spread will average $1.50 to $2.00 per bbl less than 1998. Because of the higher cost of heavy crude oil, fewer bbls have been contracted for at a fixed price above postings than in prior years and the length of the 1999 contracts shortened to mainly average three to six months. Consequently, any sustained improvement in crude oil prices may enable the Company to benefit from an improvement in the light/heavy spread.
1997 Compared with 1996. The Company had net income for the year ended December 31, 1997 of $19.1 million or $.69 per share, compared to a loss of $6.9 million or ($.25) per share for 1996. The 1997 results include a $23.3 million gain resulting from the Canadian disposition which closed on June 16, 1997, a $9.9 million reduction to income in recognition of the cumulative translation adjustment and a $3.9 million extraordinary loss on early retirement of debt.
Operating income increased by $16.1 million in the year ended December 31, 1997 as compared to 1996 due to an increase in the refined product spread (revenues less materials cost) of $19.5 million and an increase in other income of $1.1 million, offset by an increase in refining operating expenses of $2.6 million and selling and general costs of $1.8 million.
Refined product revenues and refining operating costs are impacted by changes in the price of crude oil. The price of crude oil was lower in 1997 than in 1996. The refined product spread for 1997 was $5.78 per bbl compared to $4.48 per bbl for 1996. The refined product spread increased due to better light product margins, primarily gasoline, and an improved light/heavy spread despite the first quarter 1997 inventory losses of approximately $4.0 million from a decline in crude oil prices of more than $6.00 per bbl. Inventories are recorded at the lower of cost on a FIFO basis or market. Refined product revenues decreased $8.0 million or 2% in 1997 as compared to 1996. The decrease in refined product revenues resulted primarily from $1.67 per bbl decrease in average diesel sales prices offset by a $.05 per bbl increase in average gasoline sales prices. Refined product sales volumes were nearly the same for the 1997 and 1996 periods.
Other income, which consists primarily of processing fees, increased $1.1 million to $2.3 million for the year ended December 31, 1997 as compared to 1996 mostly due to gains on foreign currency swaps of $522,000 related to the Canadian sales proceeds and higher processing fees.
Refining operating costs decreased $25.0 million or 7% in the year ended December 31, 1997 from 1996 due to a $27.6 million decrease in material costs partially offset by an increase in refining operating expenses of $2.6 million. Material costs per bbl decreased 9%, or $2.01 per bbl in 1997 due to lower oil prices, lower crude oil charges, increased use of heavy crude oil and an increase in the light/heavy spread. The crude oil charge rate (or the volume of crude oil processed by the crude unit), declined by 870 bpd in 1997 due to turnaround work conducted on the crude unit in the fourth quarter of 1997. During 1997, Frontier increased its use of heavy crude oil by 1% and the heavy crude oil utilization rate expressed as a percent of total crude oil increased to 91% in 1997 from 88% in 1996. In addition, the light/heavy spread increased 38%, to average $3.54 per bbl for the year ended December 31, 1997 because the Company contracted approximately 30,000 bpd of Wyoming and Canadian heavy crude oil for much of 1997 at a light/heavy spread substantially better than it obtained for the same period in 1996. For 1998 the Company contracted an average of 29,000 bpd of Wyoming and Canadian heavy crude at a light/heavy spread ranging from $4.80 to $5.25 per bbl. Refining operating expenses per bbl increased by $.15, to $3.30 per bbl due to higher maintenance and turnaround costs and lease equipment costs offset by decreased natural gas and utility costs compared to operating expenses for the prior year, which were reduced by a $1.3 million settlement of repair costs related to a 1995 pipeline gas explosion.
Selling and general expenses increased $1.8 million or 28% for the year ended December 31, 1997 reflecting increases in salaries and benefits. Included in 1996 is $.2 million of salary and salary-related expenses of cer- tain employees who were not retained after March 31, 1996, in connection with the U.S. disposition in late 1995 and a corporate reorganization to reduce the number of corporate employees and to transfer some job functions to other locations in early 1996.
Depreciation increased $152,000 or 2% for the year ended December 31, 1997 as compared to 1996. Such increase was attributable to ongoing capital investment in the Refinery.
Net interest expense decreased by $3.3 million, or 19% in the year ended December 31, 1997 as compared to 1996. Such decrease was attributable to interest income of $2 million earned primarily on the sale proceeds of the Canadian disposition and reduced interest expense of $1.3 million due to early retirement of debt. On October 1, 1997, the Company retired $7.5 million of its 10 3/4% Subordinated Debentures, and by the end of 1997, $72.4 million principal amount of its 12% Senior Notes was retired. Average debt decreased from $154 million for the year ended December 31, 1996 to $138 million in 1997.
Income from discontinued oil and gas operations includes the Company's Canadian oil and gas operation through May 5, 1997. Income from discontinued operations was $1.7 million for the year ended December 31, 1997 as compared to $4.8 million for 1996.
Liquidity and Capital Resources
On February 9, 1998, the Company 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 have been repurchased by the Company for $651,000.
On September 1, 1998, the Company announced that the board of directors had approved a stock repurchase program of up to three million shares of common stock. Through December 31, 1998, an additional 469,700 shares of common stock have been purchased by the Company for $2.3 million.
Net cash provided by operating activities was $31.3 million, $12.5 million and $8.5 million for 1998, 1997 and 1996, respectively. Working capital changes provided $1.7 million of cash flows in 1998 while requiring $9.9 million and $2.6 million of cash flows for 1997 and 1996, respectively. During 1998, significant declines occurred in receivables, inventory and payables due to declining crude oil prices. The Company was able to increase cash flows from working capital changes by reducing inventory quantities of unfinished products and timing of receivable collections. The major use of cash for working capital changes was the reduction in accrued liabilities for the 1998 turnaround work. Consistent with the seasonality of its business, the Company invests in working capital during the first half of the year and recovers working capital investment in the second half of the year.
At December 31, 1998, the Company had $33.6 million of cash and $6.8 million available under the Refinery line of credit. The Company had working capital of $30.1 million at December 31, 1998.
Additions to property and equipment during 1998 of $16.8 million, increased $7.8 million from 1997 attributable to an increase of $11.1 million in Refinery capital expenditures in 1998 offset by the 1997 discontinued Canadian oil and gas operations capital expenditures of $3.3 million. Refinery capital expenditures of $9.0 million are planned in 1999. It is anticipated that cash generated from operating activities will be sufficient to meet its 1999 investment requirements.
Under certain conditions, the Refinery's revolving credit facility restricts the transfer of cash in the form of dividends, loans or advances to the Company from the Refinery. The Company does not believe these restrictions limit its current operating plans.
Market Risks
Impact of Changing Prices. The Company's 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 Refinery's inventory.
Hedging Activities. The Company, at times, engages in futures transactions in its refining operations for the purpose of hedging its refining position. To date, the use of futures transactions has been limited to protect against price declines for excess inventory volumes. No futures transactions were entered into during 1998 to hedge excess inventories. In addition, the Company, at times, engages in futures transactions for the purchase of natural gas at fixed prices. Natural gas is consumed by the Refinery 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. In 1998, the Company recognized a net loss from forward purchases of natural gas of $644,000. As of December 31, 1998, the Company had entered into futures contracts to purchase through April 1999 an average of 6,000 mcf per day of natural gas at an average futures price of $2.47 per mcf per the New York Mercantile Exchange. The estimated fair value of the Company's open natural gas contracts at December 31, 1998 was $(371,000). Futures contracts and options may also, in the future, be used to fix margins in its refining and marketing operations.
(1) Discontinued operations reflected in the above periods represent the Company's Canadian oil and gas operating segment. On June 16, 1997, the Company completed the Canadian disposition.
(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 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.
Interest Rate Risk. Borrowings under the Refinery credit facility are generally repaid monthly and bear a current market rate of interest. The average effective interest rate was 8% during 1998. The Company's $70.0 million of 9 1/8% Senior Notes, due 2006, have a fixed interest rate and the Company has no current plans to redeem these notes. Thus the Company's 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, 1998 was $65.1 million.
Environmental
Numerous local, state and federal laws, rules and regulations relating to the environment are applicable to the Company's operations. As a result, the Company falls under the jurisdic- tion of numerous state and federal agencies for administration and is exposed to the possibility of judicial or administrative actions for remediation and/or penalties brought by those agencies. Among these requirements are regulations recently promulgated by the EPA under the authority of Title III of the Clean Air Act Amendments. The Company expended approximately $600,000 by the regulatory compliance deadline of August 1, 1998 to improve the Frontier Refinery's control of emissions of hazardous air pollutants. Subsequent rule making authorized by this or other titles of the Clean Air Act Amendments or similar laws may necessitate additional expenditures in future years.
(1) 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.
(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 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.
Because other refineries will be required to make similar expenditures, the Company does not expect such expenditures to materially adversely impact its competitive position. Frontier is party to one consent decree requiring the investigation and, in certain instances, mitigation of environmental impacts resulting from past operational activities. The Company has been and will be responsible for costs related to compliance with or remediations resulting from environmental regulations. 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.
Year 2000 Issues
Many of the computer systems used by the Company today were designed and developed using two digits, rather than four, to specify the year. As a result, such systems will recognize the year 2000 as "00". This could cause many computer applications to fail completely or to create erroneous results unless corrective measures are taken. The Company utilizes software and related information technology ("IT") essential to its operations that may be affected by the Year 2000 issue. The Company also relies on non-IT systems in its daily operations, such as fax machines, radios, voice mail systems, alarms, monitors and other miscellaneous systems. Additionally, the Company is dependent upon third party relationships with both suppliers and customers.
The Company initiated a company-wide task force to assess and resolve the business risks associated with the Year 2000 issues. The process implemented by the task force included identification of possibly effected systems, assessment of probability of and implications of noncompliance, alternative modifications to or replacements of existing systems or technology and cost and timetables for completion. The analysis is being substantially completed by internal resources with third party vendor verification when available.
The Company has completed a preliminary review of its IT, accounting and operational, systems for Year 2000 compliance. The review of the Company's primary financial computer systems, including its accounting system, indicated only minor modifications will be required to make them Year 2000 compliant. The process control system has been documented as Year 2000 compliant by the vendor literature, but further testing is being pursued to verify this. The Company believes it will be able to implement the necessary corrections to all of its critical information technology and non-IT systems by mid 1999. Systems identified as noncritical noncompliant will be addressed at later dates.
The Company does significant business with and is dependent upon various third party entities. These relationships include customers, critical suppliers of products and utilities, financial institutions, transportation companies and others. The Company is also reviewing the possible impact of Year 2000 noncompliance by its outside providers. Communications with critical third parties regarding their plans and progress addressing the Year 2000 has been initiated and continues. The Company is dependent upon the reliability and completeness of the third parties representations in assessing their Year 2000 readiness.
The estimated costs of the software and hardware modifications and some consultant support identified to date will be between $125,000 to $350,000 to implement and will be financed from operating cash flows. Expenditures through January 31, 1999 totaled approximately $18,000. The Company does not separately track the internal costs for the Year 2000 project, and such costs are principally the related payroll costs for its information systems group.
The Company's refinery operations are very dependent upon outside providers and in certain areas an alternative to the Company is not available. Failure to correct a material Year 2000 issue could result in an interruption in, or a failure of, certain normal business activities or operations. Although the Company is taking steps to reduce the likelihood of interruption or failure of normal operations, there can be no guarantee that other companies' systems, on which our systems rely, will be timely Year 2000 compliant. To date, the Company is not aware of any significant Year 2000 problems with these outside providers that would have a material adverse effect on the Company's business or results of operations, liquidity and financial operations.
The Company is in the process of developing contingency plans to address issues associated with the reasonably likely worst case scenarios. The Company expects to have such contingency plans formulated by the end of August 1999.