After a positive surprise with its fourth quarter earningsperformance, Phillips Petroleum continued to astonish observersover the weekend, buying Tosco Corp. in a $7 billion stocktransaction that will make Phillips the second-largest refiningcompany in the United States with a capacity of 1.7 MMbbl/d.

The deal transforms Phillips into a more balanced majorintegrated oil company and contrasts with its recent efforts —and the recent industry trend — to expand more profitableexploration and production operations and shed low-margin refining.

Phillips’ Alaska purchase last year from BP doubled its reservesto 4.4 billion barrels of oil equivalent (boe) and left manyobservers expecting more action on the upstream side this year. TheTosco deal, which amounts to a significant bet that refiningmargins won’t collapse, apparently came a shock to investors.Shares of Phillips were down nearly $6, or more than 10%, to $52.94by mid-day yesterday on the New York Stock Exchange.

The deal will give Bartlesville, OK-based Phillips another 1.35MMbbl/d of refining capacity and 6,400 more gasoline stations. It’sa side of the business many analysts expected Phillips to shun infavor of bulking up exploration and production.

Under the terms of the agreement, Phillips will issue 0.8Phillips shares for each Tosco share and will also assume $2billion of Tosco’s debt. The transaction is expected to close bythe end of the third quarter. Phillips’ board of directors also hasauthorized a $1 billion share buyback program.

“This strategic acquisition completes our foundation foraccelerated and sustainable profitable growth. With our balancedportfolio of assets, scale, and financial flexibility, we candeliver the growth and value that our shareholders expect. We nowhave positioned our business to fully compete in the domesticRM&T marketplace, which, when combined with our strong E&Poperations, puts us among the leaders in the integrated oilindustry,” said Jim Mulva, Phillips’ chairman. “We are acquiringthe assets and expertise of the country’s largest independentrefiner and marketer, and combining the complementary skills of thetwo companies, including Tosco’s refining capabilities andconvenience store expertise along with Phillips’ branded wholesaleskills and expertise in refining and fuel technologies.”

Phillips expects the transaction to be accretive to earnings pershare, taking into account anticipated annual pre-tax synergies of$250 million and the stock buyback. It will also improve net cashflow. The transaction will be accounted for under purchaseaccounting. Based on current consensus investment communityestimates, year-end 2001 debt-to-capital ratio would be in therange of 37%.

The combined company’s RM&T headquarters will be located inTempe, AZ, with certain functions, including research anddevelopment, being located in Bartlesville.

“This is a tremendous transaction. Tosco has an excellent trackrecord as both an operator of assets and a builder of value,” saidMulva. “The combination will enhance our supply chain flexibility,balance our RM&T market portfolio, and enable us to benefitfrom both scale and synergies.

Phillips has 12,400 employees and $20.6 billion of assets, andhad $21.2 billion of revenues in 2000. Greenwich, CT-based Toscomarkets gasoline under the 76 and Circle K brands. Tosco currentlyhas $28 billion in annualized revenues.

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