================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2001
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
----------- -----------
Commission file number 1-13175
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VALERO ENERGY CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 74-1828067
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
One Valero Place
San Antonio, Texas
(Address of principal executive offices)
78212
(Zip Code)
(210) 370-2000
(Registrant's telephone number, including area code)
----------
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 X No
--- ---
----------
Indicated below is the number of shares outstanding of the registrant's
only class of common stock, as of November 1, 2001.
<Table>
<Caption>
Number of
Shares
Title of Class Outstanding
- ---------------------------- -----------
Common Stock, $.01 Par Value 60,643,466
</Table>
VALERO ENERGY CORPORATION AND SUBSIDIARIES
INDEX
<Table>
<Caption>
PAGE
----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets - September 30, 2001 and December 31, 2000................................ 3
Consolidated Statements of Income - for the Three Months Ended and
Nine Months Ended September 30, 2001 and 2000..................................................... 4
Consolidated Statements of Cash Flows - for the Nine Months Ended
September 30, 2001 and 2000....................................................................... 5
Notes to Consolidated Financial Statements............................................................ 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations............................................................................. 25
Item 3. Quantitative and Qualitative Disclosures About Market Risk....................................... 39
PART II. OTHER INFORMATION................................................................................. 43
Item 1. Legal Proceedings................................................................................ 43
Item 4. Submission of Matters to a Vote of Security Holders.............................................. 43
Item 6. Exhibits and Reports on Form 8-K................................................................. 44
SIGNATURE................................................................................................... 45
</Table>
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(THOUSANDS OF DOLLARS)
<Table>
<Caption>
September 30,
2001 December 31,
(Unaudited) 2000
------------- ------------
ASSETS
CURRENT ASSETS:
Cash and temporary cash investments ..................................... $ 91,157 $ 14,596
Receivables, less allowance for doubtful accounts of
$7,914 (2001) and $5,612 (2000) ....................................... 780,008 585,892
Inventories ............................................................. 704,173 539,882
Current deferred income tax assets ...................................... 68,051 105,817
Prepaid expenses and other .............................................. 26,535 38,880
----------- -----------
1,669,924 1,285,067
----------- -----------
PROPERTY, PLANT AND EQUIPMENT - including
construction in progress of $213,802 (2001)
and $158,445 (2000), at cost ............................................ 4,156,375 3,481,117
Less: Accumulated depreciation ....................................... 905,294 804,437
----------- -----------
3,251,081 2,676,680
----------- -----------
DEFERRED CHARGES AND OTHER ASSETS ......................................... 407,710 345,957
----------- -----------
$ 5,328,715 $ 4,307,704
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Short-term debt ......................................................... $ -- $ 27,000
Accounts payable ........................................................ 761,468 806,879
Accrued expenses ........................................................ 226,221 176,880
Income taxes payable .................................................... 96,592 28,233
----------- -----------
1,084,281 1,038,992
----------- -----------
LONG-TERM DEBT ............................................................ 1,041,536 1,042,417
----------- -----------
CAPITAL LEASE OBLIGATIONS ................................................. 286,830 --
----------- -----------
DEFERRED INCOME TAXES ..................................................... 559,341 406,634
----------- -----------
DEFERRED CREDITS AND OTHER LIABILITIES .................................... 142,926 120,106
----------- -----------
VALERO-OBLIGATED MANDATORILY REDEEMABLE
PREFERRED CAPITAL TRUST SECURITIES OF SUBSIDIARY
TRUST HOLDING SOLELY VALERO SENIOR NOTES ................................ 172,500 172,500
----------- -----------
COMMON STOCKHOLDERS' EQUITY:
Common stock, $.01 par value - 150,000,000 shares authorized;
issued 62,311,166 (2001 and 2000) shares .............................. 623 623
Additional paid-in capital .............................................. 1,249,586 1,249,127
Retained earnings ....................................................... 818,886 321,566
Accumulated other comprehensive income - net gains on
cash flow hedges ...................................................... 28,827 --
Treasury stock, 1,561,375 (2001) and 1,472,698 (2000) shares, at cost ... (56,621) (44,261)
----------- -----------
2,041,301 1,527,055
----------- -----------
$ 5,328,715 $ 4,307,704
=========== ===========
</Table>
See Notes to Consolidated Financial Statements.
3
VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(THOUSANDS OF DOLLARS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
<Table>
<Caption>
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------ ------------------------------
2001 2000 2001 2000
------------ ------------ ------------ ------------
OPERATING REVENUES .............................................. $ 3,858,734 $ 4,248,831 $ 12,127,130 $ 10,549,950
------------ ------------ ------------ ------------
COSTS AND EXPENSES:
Cost of sales and operating expenses ........................ 3,597,178 3,951,733 11,008,747 9,942,073
Selling and administrative expenses ......................... 37,619 42,901 127,823 86,653
Depreciation expense ........................................ 35,597 30,287 100,878 81,155
------------ ------------ ------------ ------------
Total .................................................... 3,670,394 4,024,921 11,237,448 10,109,881
------------ ------------ ------------ ------------
OPERATING INCOME ................................................ 188,340 223,910 889,682 440,069
OTHER INCOME (EXPENSE), NET ..................................... (307) (357) (1,368) 1,846
INTEREST AND DEBT EXPENSE:
Incurred .................................................... (26,359) (23,894) (70,200) (62,551)
Capitalized ................................................. 2,482 2,141 7,071 5,565
DISTRIBUTIONS ON PREFERRED SECURITIES
OF SUBSIDIARY TRUST ......................................... (3,343) (3,344) (10,027) (3,454)
------------ ------------ ------------ ------------
INCOME BEFORE INCOME TAXES ...................................... 160,813 198,456 815,158 381,475
INCOME TAX EXPENSE .............................................. 59,800 71,100 303,200 135,700
------------ ------------ ------------ ------------
NET INCOME ...................................................... $ 101,013 $ 127,356 $ 511,958 $ 245,775
============ ============ ============ ============
EARNINGS PER SHARE OF COMMON STOCK .............................. $ 1.66 $ 2.08 $ 8.40 $ 4.26
Weighted average common shares outstanding (in thousands) ... 60,725 61,186 60,975 57,745
EARNINGS PER SHARE OF COMMON STOCK -
ASSUMING DILUTION ........................................... $ 1.58 $ 2.01 $ 7.96 $ 4.12
Weighted average common shares outstanding (in thousands) ... 63,878 63,242 64,323 59,621
DIVIDENDS PER SHARE OF COMMON STOCK ............................. $ .08 $ .08 $ .24 $ .24
</Table>
See Notes to Consolidated Financial Statements.
4
VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(THOUSANDS OF DOLLARS)
(UNAUDITED)
<Table>
<Caption>
Nine Months Ended
September 30,
----------------------------
2001 2000
----------- -----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income ....................................................................... $ 511,958 $ 245,775
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense ......................................................... 100,878 81,155
Amortization of deferred charges and other, net .............................. 81,046 38,565
Changes in current assets and current liabilities ............................ (145,170) (86,158)
Deferred income tax expense .................................................. 173,900 99,200
Changes in deferred items and other, net ..................................... (22,790) (8,592)
----------- -----------
Net cash provided by operating activities .................................. 699,822 369,945
----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures ............................................................. (228,577) (131,478)
Deferred turnaround and catalyst costs ........................................... (115,076) (72,515)
Purchase of inventories in connection with acquisition of El Paso facilities ..... (108,631) --
Acquisition of Huntway ........................................................... (75,718) --
Earn-out payment in connection with acquisition of Basis ......................... (35,000) --
Benicia Acquisition .............................................................. -- (889,730)
Investment in joint ventures and other, net ...................................... (1,234) (1,877)
----------- -----------
Net cash used in investing activities .......................................... (564,236) (1,095,600)
----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Increase (decrease) in short-term debt, net ...................................... (27,000) 93,000
Long-term borrowings, including proceeds from senior notes offering in 2000 ...... 18,095 1,899,367
Long-term debt reduction ......................................................... (18,500) (1,597,000)
Proceeds from common stock offering, net ......................................... -- 166,763
Issuance of common stock in connection with employee benefit plans ............... 27,606 13,328
Proceeds from offering of preferred securities of subsidiary trust, net .......... -- 166,729
Common stock dividends ........................................................... (14,638) (13,825)
Purchase of treasury stock ....................................................... (44,588) (49,809)
----------- -----------
Net cash provided by (used in) financing activities ............................ (59,025) 678,553
----------- -----------
NET INCREASE (DECREASE) IN CASH AND TEMPORARY
CASH INVESTMENTS ................................................................. 76,561 (47,102)
CASH AND TEMPORARY CASH INVESTMENTS AT
BEGINNING OF PERIOD .............................................................. 14,596 60,087
----------- -----------
CASH AND TEMPORARY CASH INVESTMENTS AT
END OF PERIOD .................................................................... $ 91,157 $ 12,985
=========== ===========
</Table>
See Notes to Consolidated Financial Statements.
5
VALERO ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
As used in this report, the term "Valero" may refer, depending upon the
context, to Valero Energy Corporation, one or more of its consolidated
subsidiaries, or all of them taken as a whole.
The consolidated financial statements included in this report have been
prepared by Valero without audit, in accordance with the rules and regulations
of the Securities and Exchange Commission, or SEC. However, all adjustments have
been made to these financial statements which are, in the opinion of Valero's
management, necessary for a fair presentation of Valero's results of operations
for the periods covered. Certain information and footnote disclosures normally
included in financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted as permitted under the
SEC's rules and regulations, although Valero believes that the disclosures are
adequate to make the information presented not misleading. Certain prior period
amounts have been reclassified for comparative purposes.
2. PROPOSED MERGER WITH ULTRAMAR DIAMOND SHAMROCK
On May 7, 2001, Valero and Ultramar Diamond Shamrock Corporation ("UDS")
jointly announced that they had entered into an agreement and plan of merger,
dated as of May 6, 2001, under which UDS will merge with and into Valero, with
Valero as the surviving corporation. The boards of directors of both companies
have approved the merger, and on September 27, 2001, the shareholders of both
companies approved the merger. Under the terms of the merger agreement, each
outstanding share of UDS common stock, with limited exceptions, will be
converted into the right to receive, at the shareholder's election but subject
to proration, either (i) cash, (ii) a number of shares of Valero common stock,
or (iii) a combination of cash and Valero stock, in each case having a value
equal to the sum of $27.50 and .614 shares of Valero common stock (valued at the
average closing Valero common stock price over a ten trading-day period ending
three days prior to the merger). Based on average per share prices for Valero
and UDS common stock for the ten trading-day period ending April 26, 2001, the
total consideration to be paid to UDS shareholders in the merger would have been
approximately $4 billion, representing an approximate 30% premium to the average
UDS share price. Valero is also assuming UDS's outstanding debt at the date of
closing, the balance of which was approximately $1.4 billion at September 30,
2001. The merger is expected to close by the end of the fourth quarter of 2001,
subject to regulatory approval.
UDS is an independent refiner and retailer of refined products and
convenience store merchandise in the central, southwest and northeast regions of
the United States and eastern Canada. UDS's operations consist of refineries,
convenience stores, pipelines and terminals, a home heating oil business, and
petrochemical and natural gas liquids operations. UDS owns and operates seven
refineries, including two in Texas, two in California and one each in Oklahoma,
Colorado, and Quebec, Canada, with a combined throughput capacity of
approximately 850,000 barrels per day. UDS markets refined products
6
VALERO ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
and a broad range of convenience store merchandise through a network of
approximately 4,600 convenience stores under the Diamond Shamrock(R), Beacon(R),
Ultramar(R), and Total(R) brand names in the United States and eastern Canada.
UDS's Northeast operations also include the marketing of refined products
through 85 cardlocks and a retail home heating oil business that sells heating
oil to approximately 250,000 households.
Valero expects to finance the cash portion of the merger consideration,
currently estimated to be approximately $2 billion, with proceeds from a $1.5
billion bridge loan facility and borrowings under two new $750 million revolving
bank credit facilities. Valero anticipates finalizing both the bridge loan
facility and the two revolving bank credit facilities prior to completing the
merger, but expects that borrowing under these facilities will be simultaneous
with and contingent upon completion of the merger. If Valero is unable to
finalize any of these facilities, it could seek to negotiate with alternative
lenders, undertake capital market issuances of debt securities or a combination
of those options. Arrangement of financing for the cash portion of the merger
consideration is not a condition to closing the transaction.
The bridge loan facility is expected to have a one-year maturity at
interest rates and on other terms presently being negotiated. Valero expects to
repay the bridge loan facility after the merger via a combination of proceeds
from capital market issuances of debt securities and cash flow from operations
of the combined company.
Valero expects the two revolving bank credit facilities to provide for
commitments of $750 million for a five-year term and $750 million for a 364-day
term, respectively, and, subject to the commitment amounts and terms, to provide
for borrowings thereunder to be made at various amounts, maturities and interest
rates, at the option of Valero. Valero expects to use the revolving bank credit
facilities after the merger to finance the combined company's working capital
and other cash requirements. Valero expects to repay amounts borrowed under the
credit facilities with cash flow from operations of the combined company.
In May 2001, Valero filed a registration statement on Form S-4 with the
SEC, which was declared effective on August 24, 2001, to register the shares of
Valero common stock that may be issued or become issuable to UDS shareholders in
connection with the merger.
Upon completion, the merger will be accounted for under the purchase method
of accounting. Accordingly, the results of UDS's operations will be included in
the consolidated financial statements of Valero beginning on the effective date
of the transaction.
7
VALERO ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
3. ACQUISITIONS
HUNTWAY REFINING COMPANY
Effective June 1, 2001, Valero completed the acquisition of Huntway
Refining Company, a leading supplier of asphalt in California. Huntway owns and
operates two California refineries at Benicia and Wilmington, which primarily
process California crude oil to produce liquid asphalt for use in road
construction and repair, primarily in California and Nevada, as well as smaller
amounts of gas oil, naphtha, kerosene distillate and bunker fuels. The purchase
price, net of Huntway's cash balance on the date of acquisition, was
approximately $76 million and included payment to Huntway's common stockholders
of $1.90 per share, as well as amounts required to retire Huntway's outstanding
debt and satisfy payment obligations under outstanding stock options.
The acquisition of Huntway was accounted for under the purchase method of
accounting, with the purchase price allocated to the assets acquired and
liabilities assumed based on estimated fair values pending the completion of
independent appraisals and other evaluations. In accordance with the purchase
method, the accompanying Consolidated Statement of Income for the nine months
ended September 30, 2001 includes the results of Huntway's operations beginning
June 1, 2001.
The preliminary purchase price allocation was as follows (in thousands):
<Table>
Current assets ..................................................... $ 32,770
Property, plant and equipment ...................................... 58,642
Deferred charges and other assets .................................. 278
Current liabilities ................................................ (13,794)
Deferred income taxes and deferred credits and other liabilities ... (2,178)
--------
$ 75,718
========
</Table>
EL PASO REFINERY AND RELATED PRODUCT LOGISTICS BUSINESS
Effective June 1, 2001, Valero completed the acquisition of El Paso
Corporation's Corpus Christi, Texas refinery and related product logistics
business through lease agreements entered into with certain wholly owned
subsidiaries of El Paso. The lease agreements, which are being accounted for as
capital leases, are for a term of 20 years and provide for Valero to make annual
lease payments of $18.5 million for the first two years and increased amounts
thereafter. Valero has an option to purchase the facilities for approximately
$294 million at the end of the second year of the lease, and for increasing
amounts in each succeeding year through the end of the lease term. As part of
the acquisition, Valero also purchased inventories for approximately $109
million and assumed certain environmental liabilities.
8
VALERO ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
The El Paso Corpus Christi refinery, which is located near Valero's
existing Corpus Christi refinery, is a high-complexity refinery capable of
processing approximately 110,000 barrels per day of heavy, high-sulfur crude
oil. Approximately 70% of the refinery's production is light products, including
conventional gasoline, diesel, jet fuel, petrochemicals, propane, butane and
light naphthas. In addition, the refinery produces multiple grades of asphalt
and petroleum coke. The product logistics facilities consist of three intrastate
common carrier pipelines and related terminal facilities that enable refined
products to be shipped from Corpus Christi to markets in Houston, San Antonio,
Victoria, and the Rio Grande Valley.
The acquisition of El Paso's Corpus Christi refinery and related product
logistics business was accounted for under the purchase method of accounting,
with the purchase price allocated to the assets acquired and liabilities assumed
based on estimated fair values pending the completion of independent appraisals
and other evaluations. The preliminary purchase price allocation was as follows:
inventories of approximately $109 million as noted above, property, plant and
equipment of approximately $324 million, and deferred credits and other
liabilities of approximately $38 million related primarily to an estimate of
assumed environmental liabilities as noted above and described in Note 12. The
inventories were purchased with cash from operations while the remaining net
assets were acquired through capital lease obligations of approximately $286
million. The accompanying Consolidated Statement of Income for the nine months
ended September 30, 2001 reflects the results of operations of the El Paso
Corpus Christi refinery and product logistics business beginning June 1, 2001.
CALIFORNIA REFINING AND MARKETING ASSETS
During the second quarter of 2000, Valero completed the acquisition of
Exxon Mobil Corporation's Benicia, California refinery (the "Benicia Refinery")
and Exxon-branded California retail assets, which consisted of approximately 80
service stations (the "Service Stations") and branded supplier relationships
with over 260 Exxon-branded service stations (the "Distribution Assets")
(collectively, the "Benicia Acquisition"). The purchase price for the Benicia
Refinery, the Service Stations and the Distribution Assets was $895 million,
plus approximately $150 million for refinery inventories acquired in the
transaction and certain costs incurred in connection with the acquisition.
The Benicia Acquisition was funded through a $400 million senior notes
offering, a $172.5 million offering of premium equity participating security
units ("PEPS Units"), a common stock offering totaling approximately $174.2
million and borrowings under Valero's existing bank credit facilities. In
addition, Valero entered into a $155 million structured lease arrangement for
the Service Stations and the Benicia Refinery's dock facility. The structured
lease has a five-year non-cancelable lease term and is being accounted for as an
operating lease. After the initial five-year lease term, the lease may be
extended by agreement of Valero and the lessor, or Valero may arrange for the
sale of the leased properties to one or more third parties, in which case the
lease provides for a maximum residual value guarantee equal to 85% of the
appraised value of the leased properties at the end of the lease term, as
determined at the inception of the lease. Valero also has an option to purchase
all or a portion of the leased properties at any time during
9
VALERO ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
the lease term for a price that approximates fair value.
The Service Stations, which were leased by Valero under the structured
lease arrangement as noted above, included 10 company-operated service stations
and approximately 70 dealer-operated service stations subleased from Valero, all
of which are in the greater San Francisco Bay area. In July 2000, the dealers
were offered an option to purchase at fair value the stations that they were
leasing and enter into a new fuels purchase agreement with Valero for a term of
15 years. In connection with this option, 49 stations were purchased by these
dealers during the second and third quarters of 2001.
The acquisition of the Benicia Refinery and Distribution Assets was
accounted for under the purchase method of accounting, with the purchase price
allocated to the assets acquired and liabilities assumed based on estimated fair
values as determined by independent appraisals and other valuations. In
accordance with the purchase method, the accompanying Consolidated Statement of
Income for the nine months ended September 30, 2000 includes the results of
operations related to the Benicia Refinery and the Distribution Assets beginning
May 16, 2000 and the results of operations related to the Service Stations
beginning June 16, 2000.
PRO FORMA FINANCIAL INFORMATION
The following unaudited pro forma financial information of Valero for the
nine months ended September 30, 2001 and 2000 assumes that the acquisition of
Huntway and the acquisition of the El Paso Corpus Christi refinery and related
product logistics business occurred at the beginning of each respective year,
and that the Benicia Acquisition and related financings occurred at the
beginning of 2000. This pro forma information is not necessarily indicative of
the results of future operations. (Dollars in thousands, except per share
amounts.)
<Table>
<Caption>
Nine Months Ended
September 30,
---------------------------
2001 2000
----------- -----------
Operating revenues .............................. $12,631,974 $12,335,477
Operating income ................................ 925,790 453,027
Net income ...................................... 528,484 221,588
Earnings per common share ....................... 8.67 3.59
Earnings per common share - assuming dilution ... 8.22 3.49
</Table>
10
VALERO ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
4. INVENTORIES
Inventories are carried at the lower of cost or market. The cost of
refinery feedstocks purchased for processing and produced products are
determined primarily under the last-in, first-out ("LIFO") method of inventory
pricing, and the cost of feedstocks and products purchased for resale are
determined under the weighted average cost method. At September 30, 2001, the
replacement cost of Valero's LIFO inventories exceeded their LIFO carrying
values by approximately $35 million. The cost of materials and supplies is
determined principally under the weighted average cost method. Inventories as of
September 30, 2001 and December 31, 2000 were as follows (in thousands):
<Table>
<Caption>
September 30, December 31,
2001 2000
------------- ------------
Refinery feedstocks ................ $171,199 $142,522
Refined products and blendstocks ... 455,000 332,653
Materials and supplies ............. 77,974 64,707
-------- --------
$704,173 $539,882
======== ========
</Table>
5. STATEMENTS OF CASH FLOWS
In order to determine net cash provided by operating activities, net income
has been adjusted by, among other things, changes in current assets and current
liabilities. The changes in Valero's current assets and current liabilities are
shown in the following table as an (increase)/decrease in current assets and an
increase/(decrease) in current liabilities (in thousands). These amounts exclude
changes in "Cash and temporary cash investments," "Current deferred income tax
assets," and "Short-term debt." Also excluded from the following amounts are the
current assets and current liabilities acquired in connection with the Huntway
and El Paso transactions in 2001 and the Benicia acquisition in 2000 (see Note 3
above), all of which are reflected separately in the Statement of Cash Flows.
<Table>
<Caption>
Nine Months Ended
September 30,
------------------------
2001 2000
--------- ---------
Receivables, net ............. $(156,060) $(279,041)
Inventories .................. (37,125) (21,133)
Prepaid expenses and other ... 14,304 (9,859)
Accounts payable ............. (86,065) 149,137
Accrued expenses ............. 43,258 59,986
Income taxes payable ......... 76,518 14,752
--------- ---------
Total .................... $(145,170) $ (86,158)
========= =========
</Table>
11
VALERO ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Cash flows related to interest and income taxes were as follows (in
thousands):
<Table>
<Caption>
Nine Months Ended
September 30,
-------------------
2001 2000
------- -------
Interest paid (net of amount capitalized) ... $49,726 $46,382
Income taxes paid ........................... 54,764 23,995
Income tax refunds received ................. 2,011 384
</Table>
Noncash investing and financing activities for the nine months ended
September 30, 2001 included (i) increases to property, plant and equipment,
deferred credits and other liabilities, and capital lease obligations resulting
from the acquisition of the El Paso Corpus Christi refinery and related product
logistics business as described above in Note 3 and (ii) an increase to
property, plant and equipment resulting from the accrual of a $20 million
earn-out contingency payment made to Mobil (now ExxonMobil) in October 2001 in
connection with Valero's 1998 acquisition of the Paulsboro Refinery.
6. LONG-TERM DEBT
In March 2001, Valero refinanced its $18.5 million of Series 1998 taxable,
variable-rate Waste Disposal Revenue Bonds with tax-exempt, fixed-rate bonds.
These Series 2001 tax-exempt bonds have a fixed interest rate of 6.65% and
mature on April 1, 2032.
7. COMMON STOCK
In connection with the proposed merger with UDS described in Note 2, on
September 27, 2001, Valero's stockholders approved an amendment to Valero's
certificate of incorporation increasing the number of authorized shares of
Valero common stock from 150 million to 300 million.
8. EARNINGS PER SHARE
The computation of basic and diluted per share amounts, as required by the
Financial Accounting Standards Board's ("FASB") Statement No. 128, is as follows
(dollars and shares in thousands, except per share amounts):
12
VALERO ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
<Table>
<Caption>
Three Months Ended September 30,
-----------------------------------------------------------------------
2001 2000
------------------------------- -----------------------------------
Per Per
Net Share Net Share
Income Shares Amount Income Shares Amount
-------- -------- ------ -------- -------- ---------
Net income ................................... $101,013 $127,356
======== ========
BASIC EARNINGS PER SHARE:
Net income available to
common stockholders ........................ $101,013 60,725 $1.66 $127,356 61,186 $ 2.08
===== =========
EFFECT OF DILUTIVE SECURITIES:
Stock options ................................ -- 1,713 -- 1,360
Performance and other benefit plan awards .... -- 991 -- 696
PEPS units ................................... -- 449 -- --
-------- -------- -------- --------
DILUTED EARNINGS PER SHARE:
Net income available to
common stockholders
plus assumed conversions ................... $101,013 63,878 $1.58 $127,356 63,242 $ 2.01
======== ======== ===== ======== ======== =========
</Table>
<Table>
<Caption>
Nine Months Ended September 30,
-----------------------------------------------------------------------
2001 2000
-------------------------------- -----------------------------------
Per Per
Net Share Net Share
Income Shares Amount Income Shares Amount
-------- -------- ------ -------- -------- ---------
Net income ............................... $511,958 $245,775
======== ========
BASIC EARNINGS PER SHARE:
Net income available to
common stockholders .................... $511,958 60,975 $8.40 $245,775 57,745 $ 4.26
===== =========
EFFECT OF DILUTIVE SECURITIES:
Stock options ............................ -- 1,914 -- 1,188
Performance and other benefit plan awards -- 985 -- 688
PEPS units ............................... -- 449 -- --
-------- -------- -------- --------
DILUTED EARNINGS PER SHARE:
Net income available to
common stockholders
plus assumed conversions ............... $511,958 64,323 $7.96 $245,775 59,621 $ 4.12
======== ======== ===== ======== ======== =========
</Table>
13
VALERO ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
9. NEW ACCOUNTING PRONOUNCEMENTS
FASB 144
In August 2001, the FASB issued Statement No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." This statement supersedes FASB
Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of," and the accounting and reporting
provisions of APB Opinion No. 30, "Reporting the Results of
Operations--Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions," and
establishes accounting standards for the impairment and disposal of long-lived
assets and criteria for determining when a long-lived asset is held for sale.
The statement removes the requirement to allocate goodwill to long-lived assets
to be tested for impairment, requires that the depreciable life of a long-lived
asset to be abandoned be revised in accordance with APB Opinion No. 20,
"Accounting Changes," provides that one accounting model be used for long-lived
assets to be disposed of by sale, whether previously held and used or newly
acquired, and broadens the presentation of discontinued operations to include
more disposal transactions. FASB 144 will be effective for Valero's financial
statements beginning January 1, 2002, with earlier application encouraged.
Valero is currently evaluating the impact on its financial statements of
adopting this statement.
FASB 143
In June 2001, the FASB issued Statement No. 143, "Accounting for Asset
Retirement Obligations." FASB 143 requires entities to record the fair value of
a liability for an asset retirement obligation in the period in which it is
incurred. The statement requires that the amount recorded as a liability be
capitalized by increasing the carrying amount of the related long-lived asset.
Subsequent to initial measurement, the liability is accreted to the ultimate
amount anticipated to be paid, and is also adjusted for revisions to the timing
or amount of estimated cash flows. The capitalized cost is depreciated over the
useful life of the related asset. Upon settlement of the liability, an entity
either settles the obligation for its recorded amount or incurs a gain or loss
upon settlement. FASB 143 will be effective for Valero's financial statements
beginning January 1, 2003, with earlier application encouraged. Valero is
currently evaluating the impact on its financial statements of adopting this
statement.
FASB 142
In June 2001, the FASB issued Statement No. 142, "Goodwill and Other
Intangible Assets." This statement, which supersedes APB Opinion No. 17,
"Intangible Assets," provides that goodwill and other intangible assets that
have indefinite useful lives will not be amortized but instead will be tested at
least annually for impairment. Intangible assets that have finite useful lives
will continue to be amortized over their useful lives, but such lives will not
be limited by an arbitrary ceiling. The statement provides specific guidance for
testing goodwill and other nonamortized intangible assets for impairment.
14
VALERO ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Additionally, the statement requires certain disclosures about goodwill and
other intangible assets subsequent to their acquisition, including changes in
the carrying amount of goodwill from period to period, the carrying amount of
intangible assets by major intangible asset class for those assets subject to
amortization and for those not subject to amortization, and the estimated
intangible asset amortization expense for the next five years. The provisions of
this statement must be applied in Valero's financial statements beginning
January 1, 2002, except that any goodwill and other intangible assets acquired
after June 30, 2001 will be subject immediately to the amortization provisions
of this statement. Since Valero does not currently have any goodwill or other
intangible assets with indefinite useful lives recognized in its financial
statements, the adoption of this statement will not affect its existing
consolidated financial statements. Any goodwill or other intangible assets
acquired in connection with Valero's proposed merger with UDS described in Note
2 would be accounted for in accordance with the provisions of this statement.
Accordingly, any goodwill recognized will not be amortized.
FASB 141
Also in June 2001, the FASB issued Statement No. 141, "Business
Combinations." This statement, which supersedes APB Opinion No. 16, "Business
Combinations" and FASB Statement No. 38, "Accounting for Preacquisition
Contingencies of Purchased Enterprises," requires that all business combinations
be accounted for by the purchase method. FASB 141 also requires that acquired
intangible assets should be recognized as assets apart from goodwill if they
meet one of two specified criteria. Additionally, the statement adds certain
disclosure requirements to those required by APB 16, including disclosure of the
primary reasons for the business combination and the allocation of the purchase
price paid to the assets acquired and liabilities assumed by major balance sheet
caption. This statement is required to be applied to all business combinations
initiated after June 30, 2001 and to all business combinations accounted for
using the purchase method for which the date of acquisition is July 1, 2001 or
later. As described in Note 2, Valero's proposed merger with UDS would be
accounted for under the purchase method of accounting.
FASB 140
In September 2000, the FASB issued Statement No. 140, "Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of Liabilities."
This statement replaced FASB 125 with the same name. FASB 140 revised the
standards for accounting for securitizations and other transfers of financial
assets and collateral and requires certain disclosures, but carried over most of
FASB 125's provisions without reconsideration. FASB 140 is effective for
transfers and servicing of financial assets and extinguishments of liabilities
occurring after March 31, 2001. In addition, certain provisions regarding the
recognition and reclassification of collateral and certain disclosures relating
to securitization transactions and collateral became effective for Valero's
financial statements for the year ended December 31, 2000. The adoption of this
statement did not have a material effect on Valero's consolidated financial
statements.
15
VALERO ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
FASB 133
In June 1998, the FASB issued Statement No. 133, "Accounting for Derivative
Instruments and Hedging Activities." In June 1999, the FASB issued Statement No.
137 which delayed the effective date of FASB 133 for one year to fiscal years
beginning after June 15, 2000. In June 2000, the FASB issued Statement No. 138
which amended various provisions of FASB 133. FASB 133, as amended, became
effective for Valero's consolidated financial statements beginning January 1,
2001. See Note 10 below for a detailed discussion of FASB 133 and its effect on
Valero's accounting for its price risk management activities.
10. PRICE RISK MANAGEMENT ACTIVITIES
Valero is exposed to market risks related to the volatility of crude oil
and refined product prices, as well as volatility in the price of natural gas
used in its refining operations. In order to reduce the impact of this price
volatility, Valero enters into fair value hedges (see below under New Accounting
Pronouncement) using derivative commodity instruments to hedge its exposure to
changes in the fair value of a portion of its refinery feedstock and refined
product inventories and a portion of its unrecognized firm commitments to
purchase these inventories. In order to reduce the impact of price volatility on
certain forecasted transactions such as forecasted feedstock and natural gas
purchases and product sales, Valero enters into cash flow hedges (see below
under New Accounting Pronouncement) using derivative commodity instruments to
hedge its exposure to changes in the cash flows of these forecasted
transactions. In addition, Valero uses derivative commodity instruments to
manage its exposure to price volatility on a portion of its refined product
inventories and on certain forecasted feedstock and refined product purchases
that do not receive hedge accounting treatment under FASB 133 (see below under
New Accounting Pronouncement). These derivative instruments are considered
economic hedges for which changes in their fair value are reported currently in
earnings. Finally, Valero uses derivative commodity instruments for trading
purposes using its fundamental and technical analysis of market conditions to
earn additional income.
The types of derivative commodity instruments used in Valero's hedging and
trading activities described above include swaps, futures and options. Valero's
positions in derivative commodity instruments are monitored and managed on a
daily basis by a risk control group to ensure compliance with Valero's stated
risk management policy which has been approved by Valero's Board of Directors.
NEW ACCOUNTING PRONOUNCEMENT
As discussed in Note 9, effective January 1, 2001, Valero adopted FASB 133
which establishes accounting and reporting standards requiring that every
derivative instrument, including certain derivative instruments embedded in
hybrid instruments, be recorded in the balance sheet as either an asset or
16
VALERO ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
liability measured at its fair value. The statement also requires that changes
in a derivative's fair value be recognized currently in earnings unless specific
hedge accounting criteria are met.
FASB 133 allows special hedge accounting for derivative instruments
designated and qualifying as a fair value hedge or a cash flow hedge. A fair
value hedge is a hedge of the exposure to changes in the fair value of a
recognized asset or liability, or of an unrecognized firm commitment,
attributable to a particular risk. A cash flow hedge is a hedge of the exposure
to variability in the cash flows of a recognized asset or liability, or of a
forecasted transaction, attributable to a particular risk. FASB 133 provides
that the gain or loss on a derivative instrument designated and qualifying as a
fair value hedge, as well as the offsetting loss or gain on the hedged item
attributable to the hedged risk, be recognized currently in earnings in the same
accounting period. FASB 133 also provides that the effective portion of the gain
or loss on a derivative instrument designated and qualifying as a cash flow
hedge be reported outside earnings as a component of other comprehensive income
and be reclassified into earnings in the same period or periods during which the
hedged forecasted transaction affects earnings. The remaining ineffective
portion of the gain or loss on the derivative instrument, if any, must be
recognized currently in earnings. FASB 133 requires that a company must formally
document, designate, and assess the effectiveness of transactions that receive
hedge accounting.
FASB 133 is not allowed to be applied retroactively to financial statements
of prior periods. The adoption of this statement has not resulted in any
significant changes in Valero's business practices, including its hedging and
trading activities as described above; however, various systems modifications
have been required.
ACCOUNTING POLICIES
The accounting policies described below reflect the policies followed by
Valero with respect to its price risk management activities subsequent to the
adoption, effective January 1, 2001, of FASB 133.
At the time Valero enters into a derivative commodity instrument, the
derivative is designated as either a fair value hedge, a cash flow hedge, an
economic hedge or a trading instrument. For those derivatives designated as fair
value or cash flow hedges, Valero formally documents the hedging relationship
and its risk management objective and strategy for undertaking the hedge. This
documentation includes specific identification of the hedging instrument, the
hedged asset, liability, firm commitment, or forecasted transaction, the nature
of the risk being hedged, and the method Valero will use to assess the hedging
instrument's effectiveness in offsetting changes in fair value or cash flows
attributable to the hedged risk. Valero formally measures the effectiveness of
its fair value and cash flow hedging relationships both at the inception of the
hedge and on an ongoing basis using a method that is consistent with the risk
management strategy documented for each particular hedging relationship.
17
VALERO ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Valero accounts for its hedging relationships designated and qualifying as
fair value hedges or cash flow hedges in accordance with the requirements of
FASB 133 as discussed above. For Valero's economic hedging relationships, the
derivative commodity instrument is recorded at fair value and the gain or loss
on the derivative is recognized currently in earnings. For derivative commodity
instruments entered into by Valero for trading purposes, the derivative is
recorded at fair value and the gain or loss on the derivative is recognized
currently in earnings.
Valero discontinues hedge accounting prospectively if (i) it is determined
that the derivative is no longer highly effective in offsetting changes in fair
value or cash flows attributable to the hedged risk, (ii) the derivative expires
or is sold, terminated, or exercised, or (iii) the derivative is no longer
designated as a hedging instrument. In any of these circumstances, Valero may
designate prospectively a new hedging relationship with a new hedging instrument
or, in the case of (i) or (iii), a different hedged item or hedged transaction.
When a cash flow hedge is discontinued, Valero continues to report the
related net derivative gain or loss in accumulated other comprehensive income
until the hedged forecasted transaction affects earnings, at which time the net
derivative gain or loss is reclassified into earnings. However, if it is
probable that the forecasted transaction will not occur either by the end of the
originally specified time period or within two months thereafter, Valero
reclassifies the related derivative gain or loss from accumulated other
comprehensive income into earnings immediately.
CURRENT PERIOD DISCLOSURES
The transition adjustments recorded by Valero in connection with its
adoption of FASB 133 had the following effect on its financial statements as of
January 1, 2001 (in thousands):
<Table>
<Caption>
Amount
Balance sheet Debit (Credit)
- ------------- --------------
Inventories .................................... $ 3,215
Deferred charges, deferred credits and other ... 42,865
Accounts payable ............................... (2,536)
Deferred income taxes .......................... (15,240)
Other comprehensive income, net of tax ......... (28,304)
</Table>
During the three months and nine months ended September 30, 2001, the net
gain (loss) recognized in earnings representing the amount of hedge
ineffectiveness was $9.8 million and $3.4 million, respectively, for fair value
hedges and $.6 million and $(15.3) million, respectively, for cash flow hedges.
These amounts are included in "Cost of sales and operating expenses" in the
accompanying Consolidated Statements of Income. Valero did not exclude any
component of the derivative
18
VALERO ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
instruments' gain or loss from the assessment of hedge effectiveness. No amounts
were recognized in earnings for hedged firm commitments no longer qualifying as
fair value hedges.
For cash flow hedges, gains and losses currently reported in accumulated
other comprehensive income will be reclassified into earnings when the
forecasted feedstock or natural gas purchase or product sale affects earnings.
The estimated amount of existing net gains included in accumulated other
comprehensive income as of September 30, 2001 that is expected to be
reclassified into earnings within the next 12 months is $28.8 million. As of
September 30, 2001, the maximum length of time over which Valero was hedging its
exposure to the variability in future cash flows for forecasted transactions was
15 months. During the three months and nine months ended September 30, 2001, no
amounts were reclassified from accumulated other comprehensive income into
earnings as a result of the discontinuance of cash flow hedge accounting.
11. COMPREHENSIVE INCOME
Comprehensive income consists of net income and other gains and losses
affecting stockholders' equity that, under generally accepted accounting
principles, are excluded from net income, such as foreign currency translation
adjustments, minimum pension liability adjustments, unrealized gains and losses
on certain investments in debt and equity securities, and gains and losses
related to certain derivative instruments.
The following is a summary of Valero's comprehensive income for the three
months and nine months ended September 30, 2001 and 2000 (in thousands):
<Table>
<Caption>
Three Months Ended
September 30,
------------------------
2001 2000
--------- ---------
Net income ..................................................................... $ 101,013 $ 127,356
--------- ---------
Other comprehensive loss, net of tax benefit:
Net loss on derivative instruments designated and qualifying as cash flow
hedging instruments:
Net loss arising during the period (net of tax benefit of $9,107) ....... (16,913) --
Net amount of reclassifications into earnings (net of tax benefit
of $8,626) ............................................................ 16,020 --
--------- ---------
Total net loss on cash flow hedges .......................................... (893) --
--------- ---------
Other comprehensive loss ....................................................... (893) --
--------- ---------
Comprehensive income ........................................................... $ 100,120 $ 127,356
========= =========
</Table>
19
VALERO ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
<Table>
<Caption>
Nine Months Ended
September 30,
------------------------
2001 2000
--------- ---------
Net income ..................................................................... $ 511,958 $ 245,775
--------- ---------
Other comprehensive income, net of tax:
Net gain on derivative instruments designated and qualifying as cash flow
hedging instruments:
FASB transition adjustment (net of tax expense of $15,240) .............. 28,304 --
Net loss arising during the period (net of tax benefit of $12,275) ...... (22,798) --
Net amount of reclassifications into earnings (net of tax benefit
of $12,557) ........................................................... 23,321 --
--------- ---------
Total net gains on cash flow hedges ......................................... 28,827 --
--------- ---------
Other comprehensive income ..................................................... 28,827 --
--------- ---------
Comprehensive income ........................................................... $ 540,785 $ 245,775
========= =========
</Table>
12. ENVIRONMENTAL MATTERS
Liabilities for future remediation costs are recorded when environmental
assessments and/or remedial efforts are probable and the costs can be reasonably
estimated. Other than for assessments, the timing and magnitude of these
accruals are generally based on the completion of investigations or other
studies or a commitment to a formal plan of action. Environmental liabilities
are based on best estimates of probable undiscounted future costs using
currently available technology and applying current regulations, as well as
Valero's own internal environmental policies.
In connection with Valero's acquisition of El Paso Corporation's Corpus
Christi refinery and product logistics business described in Note 3, Valero
assumed all environmental liabilities related to the facilities with certain
exceptions. El Paso retained liabilities for, and agreed to indemnify Valero
against (a) all environmental claims and costs related to offsite hazardous
materials on or under certain adjacent properties, and all claims and costs
pertaining to offsite environmental conditions arising under the requirements of
an agreed final judgment dated April 1, 1998 between the State of Texas and
Coastal Refining and Marketing, Inc. (a subsidiary of El Paso), (b) any
environmental claim or cost related to the transportation or offsite disposal of
any hazardous substance related to the facilities prior to June 1, 2001, (c)
bodily injury and property damage resulting from exposure to or contamination by
hazardous materials arising from El Paso's operation and use of the facilities
prior to June 1, 2001, and (d) environmental claims and costs relating to the
presence of hazardous materials resulting from El Paso's continued use of its
assets that are located at or adjacent to the site of the facilities leased by
Valero. El Paso also retained liabilities for all third-party claims relating to
or arising out of the operation of the refinery prior to June 1, 2001 and for
any pre-existing orders, judgments or citations that El Paso failed to disclose
prior to June 1, 2001. Valero's assumed liabilities include certain
environmental remediation obligations relating primarily to soil and groundwater
contamination at the leased facilities.
20
VALERO ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
As of September 30, 2001, approximately $32 million has been accrued in
"Deferred credits and other liabilities" representing an estimate of the costs
to be incurred in connection with Valero's assumption of these environmental
liabilities.
In 2000, the EPA issued to a majority of refiners operating in the United
States a series of information requests pursuant to Section 114 of the Clean Air
Act as part of an enforcement initiative. Valero received a Section 114
information request pertaining to its refineries. Valero has completed its
response to the request and has provided additional clarification requested by
the EPA. Valero has not been named in any proceeding. However, based in part
upon recently announced settlements and evaluation of its relative position,
Valero expects total penalties and related expenses of less than $5 million in
connection with this enforcement initiative. Valero's estimate of expenses to be
incurred related to this issue, which has been provided for in the accompanying
consolidated financial statements, is immaterial to its financial position and
results of operations. Valero believes that any settlement with the EPA in this
matter may require various capital improvements or changes in operating
parameters or both at some or all of its refineries.
In connection with the Benicia Acquisition, Valero assumed all
environmental liabilities of ExxonMobil related to the acquired assets with
certain exceptions. Valero's assumed liabilities include remediation obligations
relating primarily to clean-up costs associated with refinery and terminal soil
and groundwater contamination. As of September 30, 2001, approximately $2
million had been accrued in "Deferred credits and other liabilities" in
connection with Valero's assumption of these environmental liabilities.
In connection with the acquisition of the Paulsboro refinery, Mobil Oil
Corporation (now ExxonMobil) agreed to indemnify Valero for certain
environmental matters and conditions existing on or prior to the acquisition
date and Valero agreed to assume Mobil's environmental liabilities, with certain
limited exceptions. Valero's assumed liabilities include remediation obligations
to the New Jersey Department of Environmental Protection relating primarily to
clean-up costs associated with groundwater contamination, landfill closure and
post-closure monitoring costs, and tank farm spill prevention costs. As of
September 30, 2001, approximately $17 million is included in "Accrued expenses"
and "Deferred credits and other liabilities" representing Valero's best estimate
of its remaining costs to be borne related to these remediation obligations. The
majority of these costs are expected to be incurred in relatively level amounts
over the next 17 years.
In connection with the acquisition of Basis Petroleum, Inc. from Salomon
Inc in 1997, Valero received $9.5 million from Salomon in settlement of certain
contingent environmental obligations previously assumed by Salomon, and recorded
an accrual for the amount received. As of September 30, 2001, approximately $5.6
million of this accrual remained outstanding.
21
VALERO ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
Valero believes that it has adequately provided for its environmental
exposures with the accruals referred to above. These liabilities have not been
reduced by possible recoveries from insurance carriers or other third parties.
Environmental liabilities are difficult to assess and estimate due to unknown
factors such as the magnitude of possible contamination, the timing and extent
of remediation, the determination of Valero's liability in proportion to other
parties, improvements in cleanup technologies, and the extent to which
environmental laws and regulations may change in the future. Although
environmental costs may have a significant impact on results of operations for a
single period, Valero believes that these costs will not have a material adverse
effect on its financial position.
13. LITIGATION AND CONTINGENCIES
Prior to July 31, 1997, Valero was a wholly owned subsidiary of a separate
corporation named at that time Valero Energy Corporation, or Old Valero. Old
Valero was engaged in both the refining and marketing business and the natural
gas related services business. On July 31, 1997, Old Valero spun off Valero to
Old Valero's stockholders and, with its remaining natural gas related services
business, merged with a wholly owned subsidiary of PG&E Corporation (the
"Restructuring"). Old Valero, together with certain of its natural gas related
subsidiaries, and Valero were sued by Teco Pipeline Company regarding the
operation of a 340-mile pipeline in West Texas in which a subsidiary of Old
Valero holds a 50% undivided interest. The case was filed April 24, 1996. In
1985, a subsidiary of Old Valero sold a 50% undivided interest in the pipeline
and entered into a joint venture, through an ownership agreement and an
operating agreement, with the purchaser of the interest. In 1988, Teco succeeded
to that purchaser's 50% interest. A subsidiary of Old Valero has at all times
been the operator of the pipeline. The plaintiff contends that the defendants
acted in bad faith and negatively affected the economics of the joint venture in
order to provide financial advantages to facilities or entities owned by the
defendants, and by allegedly taking for the defendants' own benefit certain
opportunities available to the joint venture. The plaintiff asserts causes of
action for breach of fiduciary duty, fraud, tortious interference with business
relationships, professional malpractice and other claims. Under the terms of the
Restructuring, Valero is responsible for a portion of the amount of any final
judgment or settlement. Arbitration of the matter began on February 5, 2001, and
has proceeded intermittently throughout much of 2001. The arbitration hearing
has recently concluded and Valero expects the arbitration panel to render its
decision by the end of the fourth quarter of 2001. Valero believes that the
final outcome of this matter will be immaterial to its consolidated financial
statements.
In 1986, Valero filed suit against M.W. Kellogg Company for damages arising
from certain alleged design and construction defects in connection with a major
construction project at the Corpus Christi Refinery. Ingersoll-Rand Company was
added as a defendant in 1989. In 1991, the trial court granted summary judgment
against Valero based in part on certain exculpatory provisions in various
agreements connected with the project. In 1993, the court of appeals affirmed
the summary judgment and the Texas Supreme Court denied review. Subsequent to
the summary judgment, Kellogg and Ingersoll-Rand brought indemnity claims
against Valero for attorneys' fees and expenses incurred in defending the
22
VALERO ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
original action. In 1996, the trial court rendered summary judgment against
Kellogg and Ingersoll-Rand based on procedural grounds, and the court of appeals
affirmed that ruling in 1997. However, in 1999, the Texas Supreme Court reversed
the court of appeals and remanded Kellogg's and Ingersoll-Rand's claims for
attorneys' fees and expenses to the trial court. The case went to trial in
August 2000. During trial, the claims of Ingersoll-Rand were settled for an
immaterial amount. The jury returned a verdict on Kellogg's claims that resulted
in a judgment of $6.3 million. Valero had appealed the judgment, but the parties
recently reached a settlement of this dispute on terms immaterial to Valero's
consolidated financial statements.
Valero had previously received notice of, but was not served with, a
complaint filed April 28, 2000 in federal court by Texas City Railway Company
alleging that several companies, including Valero, are liable under the
Comprehensive Environmental Response, Compensation and Liability Act (CERCLA),
other environmental laws and tort law theories for alleged contamination of the
plaintiff's marine loading and tankering facilities. The parties reached a
settlement of this dispute on terms immaterial to Valero's consolidated
financial statements.
On May 24, 2000, Valero was served with a complaint seeking to certify a
class action that alleged that numerous gasoline suppliers, including Valero,
contaminated groundwater in New York with MTBE. The Judicial Panel on
Multidistrict Litigation, or MDL, consolidated this matter with certain other
MTBE lawsuits brought in New York federal courts. In addition, certain
individual plaintiffs later joined the MDL proceeding by filing separate, but
related lawsuits for individual damages. All of the complaints allege that the
defendants produced and/or distributed gasoline that is allegedly defective
because it contained MTBE. On August 20, 2001, the MDL judge dismissed the
consolidated class-action complaints. The related individual lawsuits are still
pending. Discovery has been allowed and is proceeding. In addition to the MDL
MTBE lawsuits, Valero has been sued in other forums in lawsuits also alleging
that Valero produced and/or distributed gasoline that is alleged to be defective
because it contained MTBE. At this time, Valero believes it is unlikely that the
final outcome of any of these claims or proceedings, collectively or
individually, would have a material adverse effect on its consolidated financial
statements.
On May 14, 2001, the City of Dallas added Valero as a named defendant in a
suit filed previously against Explorer Pipeline Company, Inc. and certain other
refiners and suppliers who transport gasoline through Explorer's petroleum
products pipeline in North Texas. On March 9, 2000, Explorer's pipeline ruptured
and discharged gasoline into East Caddo Creek in Hunt County, Texas. The
plaintiff alleges that its source of water supply from Lake Tawakoni (located
approximately 28 miles from the site of the pipeline rupture) was contaminated
by gasoline containing MTBE causing the plaintiff to discontinue the use of
water from Lake Tawakoni as a source of water supply, and requiring the
construction of an emergency water supply pipeline from another source. The
plaintiff asserts causes of action for negligence, nuisance, strict product
liability, and gross negligence, and seeks the recovery of an unspecified amount
of actual and punitive damages, including costs for the construction of the
alternate
23
VALERO ENERGY CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)
supply pipeline. In addition, Valero has been added to certain lawsuits brought
by land owners along the East Caddo Creek who allege certain unquantified
property damages purportedly caused by the March 9, 2000 rupture of the Explorer
pipeline.
Valero is also a party to additional claims and legal proceedings arising
in the ordinary course of business. Valero believes it is unlikely that the
final outcome of any of the claims or proceedings to which it is a party would
have a material adverse effect on its consolidated financial statements;
however, due to the inherent uncertainty of litigation, the range of possible
loss, if any, cannot be estimated with a reasonable degree of precision and
there can be no assurance that the resolution of any particular claim or
proceeding would not have an adverse effect on Valero's results of operations,
financial position or liquidity.
14. SUBSEQUENT EVENTS
On October 18, 2001, Valero's Board of Directors approved an increase in
Valero's regular quarterly cash dividend on common stock from $.08 per common
share to $.10 per common share, effective with the dividend payable December 12,
2001, to holders of record at the close of business on November 14, 2001.
24
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
In the discussions that follow, all "per share" amounts are on a diluted
basis.
FORWARD-LOOKING STATEMENTS
This Form 10-Q, including without limitation the discussion below under
the heading "Results of Operations - Outlook," contains certain estimates,
predictions, projections and other "forward-looking statements" (as defined in
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934) that involve various risks and uncertainties. While these
forward-looking statements, and any assumptions upon which they are based, are
made in good faith and reflect Valero's current judgment regarding the direction
of its business, actual results will almost always vary, sometimes materially,
from any estimates, predictions, projections, assumptions, or other future
performance suggested herein. These forward-looking statements can generally be
identified by the words "anticipate," "believe," "expect," "plan," "intend,"
"estimate," "project," "budget," "forecast," "will," "could," "should," "may"
and similar expressions. These forward-looking statements include, among other
things, statements regarding:
o the proposed merger with UDS;
o future refining margins, including gasoline and heating oil margins;
o expectations regarding feedstock costs, including crude oil discounts, and
operating costs;
o anticipated levels of crude oil and refined product inventories;
o Valero's anticipated level of capital investments, including deferred
turnaround and catalyst costs and capital expenditures for environmental and
other purposes, and the effect of these capital investments on Valero's
results of operations;
o anticipated trends in the supply and demand for crude oil feedstocks and
refined products in the United States and elsewhere;
o expectations regarding environmental and other regulatory initiatives; and
o the effect of general economic and other conditions on refining industry
fundamentals.
Valero's forward-looking statements are based on its beliefs and
assumptions derived from information available at the time the statements are
made. Differences between actual results and any future performance suggested in
these forward-looking statements could result from a variety of factors,
including the following:
o political conditions in oil producing regions, including the Middle East;
o the domestic and foreign supplies of refined products such as gasoline,
diesel, heating oil and petrochemicals;
o the domestic and foreign supplies of crude oil and other feedstocks;
o the ability of the members of the Organization of Petroleum Exporting
Countries to agree on and to maintain oil price and production controls;
o the level of consumer demand, including seasonal fluctuations;
o refinery overcapacity or undercapacity;
o the actions taken by competitors, including both pricing and the expansion
and retirement of refining capacity in response to market conditions;
25
o environmental and other regulations at both the state and federal levels and
in foreign countries;
o the level of foreign imports;
o accidents or other unscheduled shutdowns affecting Valero's plants,
machinery, pipelines or equipment, or those of Valero's suppliers or
customers;
o changes in the cost or availability of transportation for feedstocks and
refined products;
o the price, availability and acceptance of alternative fuels and
alternative-fuel vehicles;
o cancellation of or failure to implement planned capital projects and realize
the various assumptions and benefits projected for such projects;
o irregular weather, which can unforeseeably affect the price or availability
of feedstocks and refined products;
o rulings, judgments, or settlements in litigation or other legal or
regulatory matters, including unexpected environmental remediation costs in
excess of any reserves;
o the introduction or enactment of federal or state legislation which may
adversely affect Valero's business or operations;
o changes in the credit ratings assigned to Valero's debt securities and trade
credit; and
o overall economic conditions.
Any one of these factors, or a combination of these factors, could
materially affect Valero's future results of operations and whether any
forward-looking statements ultimately prove to be accurate. Valero's
forward-looking statements are not guarantees of future performance, and actual
results and future performance may differ materially from those suggested in any
forward-looking statement. Valero does not intend to update these statements
unless it is required by the securities laws to do so.
All subsequent written and oral forward-looking statements attributable
to Valero or persons acting on its behalf are expressly qualified in their
entirety by the foregoing. Valero undertakes no obligation to publicly release
the result of any revisions to any such forward-looking statements that may be
made to reflect events or circumstances after the date of this report or to
reflect the occurrence of unanticipated events.
26
RESULTS OF OPERATIONS
THIRD QUARTER 2001 COMPARED TO THIRD QUARTER 2000
FINANCIAL HIGHLIGHTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<Table>
<Caption>
Three Months Ended September 30,
-----------------------------------------------------------
Change
---------------------------
2001 2000 Amount %
----------- ----------- ----------- -----------
Operating revenues .............................................. $ 3,858,734 $ 4,248,831 $ (390,097) (9)%
Cost of sales ................................................... (3,352,851) (3,741,769) 388,918 10
Operating costs:
Cash (fixed and variable) ................................... (218,672) (194,065) (24,607) (13)
Depreciation and amortization ............................... (58,829) (44,620) (14,209) (32)
Selling and administrative expenses (including related
depreciation expense) ....................................... (40,042) (44,467) 4,425 10
----------- ----------- -----------
Total operating income .................................. $ 188,340 $ 223,910 $ (35,570) (16)
=========== =========== ===========
Other income (expense), net ..................................... $ (307) $ (357) $ 50 14
Interest and debt expense, net .................................. $ (23,877) $ (21,753) $ (2,124) (10)
Distributions on preferred securities of subsidiary trust ....... $ (3,343) $ (3,344) $ 1 --
Income tax expense .............................................. $ (59,800) $ (71,100) $ 11,300 16
Net income ...................................................... $ 101,013 $ 127,356 $ (26,343) (21)
Earnings per share of common stock - assuming dilution .......... $ 1.58 $ 2.01 $ (.43) (21)
Earnings before interest, taxes, depreciation
and amortization ("EBITDA") (a) ............................. $ 250,941 $ 271,444 $ (20,503) (8)
Ratio of EBITDA to interest incurred (a) ........................ 8.4x 10.0x (1.6)x (16)
</Table>
- ----------
(a) For purposes of this calculation, distributions on preferred securities
of subsidiary trust are included in interest incurred.
27
OPERATING HIGHLIGHTS
<Table>
<Caption>
Three Months Ended September 30,
------------------------------------------------------------
Change
----------------------------
2001 2000 Amount %
----------- ----------- ----------- -----------
Sales volumes (Mbbls per day) .................... 1,406 1,235 171 14%
Throughput volumes (Mbbls per day) ............... 1,013 933 80 9
Average throughput margin per barrel ............. $ 5.43 $ 5.91 $ (.48) (8)
Operating costs per barrel:
Cash (fixed and variable) .................... $ 2.32 $ 2.26 $ .06 3
Depreciation and amortization ................ .62 .52 .10 19
----------- ----------- -----------
Total operating costs per barrel ......... $ 2.94 $ 2.78 $ .16 6
=========== =========== ===========
Charges:
Crude oils:
Sour ..................................... 61% 57% 4% 7
Heavy sweet .............................. 4 8 (4) (50)
Light sweet .............................. 6 7 (1) (14)
----------- ----------- -----------
Total crude oils ..................... 71 72 (1) (1)
High-sulfur residual fuel oil, or "resid" .... 6 3 3 100
Low-sulfur resid ............................. 4 3 1 33
Other feedstocks and blendstocks ............. 19 22 (3) (14)
----------- ----------- -----------
Total charges ............................ 100% 100% --% --
=========== =========== ===========
Yields:
Gasolines and blendstocks .................... 52% 54% (2)% (4)
Distillates .................................. 26 27 (1) (4)
Petrochemicals ............................... 3 3 -- --
Lubes and asphalts ........................... 5 3 2 67
Other products ............................... 14 13 1 8
----------- ----------- -----------
Total yields ............................. 100% 100% --% --
=========== =========== ===========
</Table>
AVERAGE MARKET REFERENCE PRICES AND DIFFERENTIALS (DOLLARS PER BARREL)
<Table>
<Caption>
Three Months Ended September 30,
--------------------------------------------------------------
Change
----------------------------
2001 2000 Amount %
----------- ----------- ----------- -----------
Feedstocks (at U.S. Gulf Coast, except as noted):
West Texas Intermediate, or "WTI," crude oil ...... $ 26.69 $ 31.69 $ (5.00) (16)%
WTI less sour crude oil (a) (c) ................... $ 4.37 $ 4.01 $ .36 9
WTI less ANS (U.S. West Coast) .................... $ 2.67 $ 1.93 $ .74 38
WTI less sweet crude oil (b) ...................... $ (.31) $ (.32) $ .01 3
Products:
U.S. Gulf Coast:
Conventional 87 gasoline less WTI ............. $ 3.98 $ 4.46 $ (.48) (11)
No. 2 fuel oil less WTI ....................... $ 2.87 $ 4.74 $ (1.87) (39)
Propylene less WTI ............................ $ (2.56) $ .92 $ (3.48) --(d)
U.S. East Coast:
Conventional 87 gasoline less WTI ............. $ 4.27 $ 5.96 $ (1.69) (28)
No. 2 fuel oil less WTI ....................... $ 3.44 $ 5.50 $ (2.06) (37)
Lube oils less WTI (c) ........................ $ 25.67 $ 20.75 $ 4.92 24
U.S. West Coast:
CARB 87 gasoline less ANS ..................... $ 13.76 $ 20.48 $ (6.72) (33)
Low-sulfur diesel less ANS .................... $ 9.32 $ 11.94 $ (2.62) (22)
</Table>
- ----------
(a) The market reference differential for sour crude oil is based on posted
prices for 50% Arab medium and 50% Arab light crude oils.
(b) The market reference differential for sweet crude oil is based on posted
prices for 50% light Louisiana sweet, or "LLS," and 50% Cusiana crude oils,
with LLS adjusted for backwardation.
(c) The market reference differential for the 2000 period has been restated from
the amount reported in Valero's September 30, 2000 Form 10-Q to conform to
the components used in the 2001 period.
(d) Percentage variance is greater than 100%.
28
Valero reported net income for the third quarter of 2001 of $101.0
million, or $1.58 per share, compared to net income of $127.4 million, or $2.01
per share, for the third quarter of 2000. The decrease in third quarter results
was due primarily to lower operating income resulting from a decrease in
industry refining margins and higher operating costs, partially offset by
improved sour crude oil discounts and higher throughput volumes.
Operating revenues decreased $390.1 million, or 9%, to $3.9 billion
during the third quarter of 2001 compared to the same period in 2000 due
primarily to a 20% decrease in the average sales price per barrel, partially
offset by a 14% increase in average daily sales volumes. The decrease in average
sales prices resulted mainly from unusually high gasoline inventories at the end
of the second quarter. These high inventory levels were attributable to
increased production and higher than normal levels of imports early in the
second quarter, combined with a decrease in demand during that quarter resulting
from higher retail gasoline prices and a slowing economy. Although prices
recovered somewhat during the third quarter due to improved demand resulting
from lower retail gasoline prices and reduced supply resulting from refinery
production cuts, they still remained well below third quarter 2000 levels. The
increase in sales volumes was due primarily to (i) an increase in the sale of
feedstocks and products purchased for resale and (ii) higher throughput volumes
resulting primarily from the contribution of the Huntway and El Paso refineries
acquired in the second quarter of 2001 and capacity expansions at various
refineries since the third quarter of 2000.
Operating income decreased $35.6 million to $188.3 million during the
third quarter of 2001 compared to the third quarter of 2000 due to an
approximate $39 million increase in operating costs (including a $25 million
increase in cash operating costs and a $14 million increase in depreciation and
amortization expense) and a decrease in total throughput margins of
approximately $1 million (discussed below). These decreases in operating income
were partially offset by an approximate $4 million decrease in selling and
administrative expenses (including related depreciation expense). Cash operating
costs were higher due primarily to the operations of the El Paso and Huntway
refineries in the 2001 quarter. Depreciation and amortization expense was higher
due primarily to an increase in turnaround and catalyst amortization. Selling
and administrative expenses (including related depreciation expense) decreased
primarily as a result of costs associated with litigation recorded in the 2000
quarter.
As noted above, total throughput margins (operating revenues less cost
of sales) for the third quarter of 2001 were essentially unchanged from the
third quarter of 2000, due primarily to the offsetting unfavorable and favorable
effects on margins discussed below. Total throughput margins were unfavorably
affected by (i) lower gasoline and distillate margins, when compared to
exceptionally high margins in the third quarter of 2000, due to strong demand
and low inventories in the 2000 quarter and unusually high gasoline inventory
levels in the early part of the third quarter of 2001 caused by the factors
noted above in the discussion of operating revenues, and (ii) significantly
lower margins for propylene and other petrochemical feedstocks due to slowing
economic activity throughout the world. Offsetting the decreases in total
throughput margins resulting from these factors were (i) the effect of higher
throughput volumes resulting from the factors noted above in the discussion of
operating revenues, including a significant increase in the volume of Valero's
sour crude oil charges during the quarter to take advantage of higher sour crude
discounts discussed below and (ii) higher per barrel feedstock discounts for
sour crude oil resulting primarily from an increase in supplies of heavier
crudes without a
29
corresponding increase in demand while at the same time demand for sweeter
crudes increased to meet lower sulfur requirements for certain refined products
without a corresponding increase in supply.
Net interest and debt expense increased $2.1 million to $23.9 million
in the third quarter of 2001 compared to the same period in 2000 due primarily
to interest recognized in connection with the capital leases associated with the
El Paso acquisition which was effective June 1, 2001, partially offset by a
decrease in bank borrowings resulting from Valero's strong earnings and cash
flow.
Income tax expense decreased $11.3 million to $59.8 million during the
third quarter of 2001 compared to the same period in 2000 due primarily to the
decrease in pre-tax income.
30
YEAR-TO-DATE 2001 COMPARED TO YEAR-TO-DATE 2000
FINANCIAL HIGHLIGHTS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<Table>
<Caption>
Nine Months Ended September 30,
------------------------------------------------------------
Change
----------------------------
2001(a) 2000(b) Amount %
------------ ------------ ------------ ------------
Operating revenues ........................................... $ 12,127,130 $ 10,549,950 $ 1,577,180 15%
Cost of sales ................................................ (10,306,100) (9,423,003) (883,097) (9)
Operating costs:
Cash (fixed and variable) ................................ (634,987) (480,628) (154,359) (32)
Depreciation and amortization ............................ (162,133) (115,167) (46,966) (41)
Selling and administrative expenses (including related
depreciation expense) .................................... (134,228) (91,083) (43,145) (47)
------------ ------------ ------------
Total operating income ............................... $ 889,682 $ 440,069 $ 449,613 --(c)
============ ============ ============
Other income (expense), net .................................. $ (1,368) $ 1,846 $ (3,214) --(c)
Interest and debt expense, net ............................... $ (63,129) $ (56,986) $ (6,143) (11)
Distributions on preferred securities of subsidiary trust .... $ (10,027) $ (3,454) $ (6,573) --(c)
Income tax expense ........................................... $ (303,200) $ (135,700) $ (167,500) --(c)
Net income ................................................... $ 511,958 $ 245,775 $ 266,183 --(c)
Earnings per share of common stock - assuming dilution ....... $ 7.96 $ 4.12 $ 3.84 93
Earnings before interest, taxes, depreciation
and amortization ("EBITDA") (d) .......................... $ 1,061,661 $ 564,384 $ 497,277 88
Ratio of EBITDA to interest incurred (d) ..................... 13.2x 8.6x 4.6x 53
</Table>
- ----------
(a) Includes the operations of Huntway and the operations related to the El
Paso Corpus Christi refinery and product logistics business beginning June
1, 2001.
(b) Includes the operations related to the Benicia Refinery and the Distribution
Assets beginning May 16, 2000 and the operations related to the Service
Stations beginning June 16, 2000.
(c) Percentage variance is greater than 100%.
(d) For purposes of this calculation, distributions on preferred securities of
subsidiary trust are included in interest incurred.
31
OPERATING HIGHLIGHTS
<Table>
<Caption>
Nine Months Ended September 30,
------------------------------------------------------------
Change
----------------------------
2001(a) 2000(b) Amount %
----------- ----------- ----------- -----------
Sales volumes (Mbbls per day) ............... 1,360 1,108 252 23%
Throughput volumes (Mbbls per day) .......... 979 833 146 18
Average throughput margin per barrel ........ $ 6.82 $ 4.94 $ 1.88 38
Operating costs per barrel:
Cash (fixed and variable) ............... $ 2.36 $ 2.11 $ .25 12
Depreciation and amortization ........... .60 .50 .10 20
----------- ----------- ----------
Total operating costs per barrel .... $ 2.96 $ 2.61 $ .35 13
=========== =========== ==========
Charges:
Crude oils:
Sour ................................ 61% 53% 8% 15
Heavy sweet ......................... 4 9 (5) (56)
Light sweet ......................... 7 8 (1) (13)
----------- ----------- ----------
Total crude oils ................ 72 70 2 3
High-sulfur resid ....................... 5 4 1 25
Low-sulfur resid ........................ 4 4 -- --
Other feedstocks and blendstocks ........ 19 22 (3) (14)
----------- ----------- ----------
Total charges ....................... 100% 100% --% --
=========== =========== ==========
Yields:
Gasolines and blendstocks ............... 53% 52% 1% 2
Distillates ............................. 27 28 (1) (4)
Petrochemicals .......................... 3 4 (1) (25)
Lubes and asphalts ...................... 4 3 1 33
Other products .......................... 13 13 -- --
----------- ----------- ----------
Total yields ........................ 100% 100% --% --
=========== =========== ==========
</Table>
AVERAGE MARKET REFERENCE PRICES AND DIFFERENTIALS (DOLLARS PER BARREL)
<Table>
<Caption>
Nine Months Ended September 30,
-----------------------------------------------------------
Change
---------------------------
2001 2000 Amount %
----------- ----------- ----------- ----------
Feedstocks (at U.S. Gulf Coast, except as noted):
WTI crude oil ..................................... $ 27.80 $ 29.82 $ (2.02) (7)%
WTI less sour crude oil (c) (e) ................... $ 5.27 $ 3.18 $ 2.09 66
WTI less ANS (U.S. West Coast) .................... $ 2.75 $ 1.90 $ .85 45
WTI less sweet crude oil (d) ...................... $ (.19) $ (.48) $ .29 60
Products:
U.S. Gulf Coast:
Conventional 87 gasoline less WTI ............. $ 6.20 $ 5.39 $ .81 15
No. 2 fuel oil less WTI ....................... $ 3.19 $ 2.71 $ .48 18
Propylene less WTI ............................ $ (2.22) $ 5.91 $ (8.13) --(f)
U.S. East Coast:
Conventional 87 gasoline less WTI ............. $ 5.91 $ 6.03 $ (.12) (2)
No. 2 fuel oil less WTI ....................... $ 3.99 $ 4.57 $ (.58) (13)
Lube oils less WTI (e) ........................ $ 26.16 $ 15.04 $ 11.12 74
U.S. West Coast:
CARB 87 gasoline less ANS ..................... $ 17.93 $ 14.85 $ 3.08 21
Low-sulfur diesel less ANS .................... $ 9.56 $ 8.80 $ .76 9
</Table>
- ----------
(a) Includes the operations of Huntway and the operations related to the El Paso
Corpus Christi refinery and product logistics business beginning June 1,
2001.
(b) Includes the operations related to the Benicia Refinery and the Distribution
Assets beginning May 16, 2000 and the operations related to the Service
Stations beginning June 16, 2000.
(c) The market reference differential for sour crude oil is based on posted
prices for 50% Arab medium and 50% Arab light crude oils.
(d) The market reference differential for sweet crude oil is based on posted
prices for 50% LLS and 50% Cusiana crude oils, with LLS adjusted for
backwardation.
(e) The market reference differential for the 2000 period has been restated from
the amount reported in Valero's September 30, 2000 Form 10-Q to conform to
the components used in the 2001 period.
(f) Percentage variance is greater than 100%.
32
Valero reported net income for the first nine months of 2001 of $512.0
million, or $7.96 per share, compared to net income of $245.8 million, or $4.12
per share, for the first nine months of 2000. The substantial increase in
year-to-date results was due primarily to the full period contribution from the
Benicia Acquisition which was completed during the second quarter of 2000, a
substantial improvement in sour crude oil discounts, and higher throughput
volumes for Valero's operations excluding Benicia resulting largely from the
acquisitions of the El Paso and Huntway refineries. Partially offsetting the
increase in throughput margins for Valero's operations excluding Benicia were
higher operating costs and selling and administrative expenses and an increase
in income tax expense.
Operating revenues increased $1.6 billion, or 15%, to $12.1 billion
during the first nine months of 2001 compared to the same period in 2000 due
primarily to a 23% increase in average daily sales volumes, partially offset by
a 6% decrease in the average sales price per barrel. The increase in average
daily sales volumes was due primarily to additional volumes attributable to the
Benicia Acquisition and the other factors noted in the quarter-to-quarter
discussion. The decrease in average sales prices was due mainly to the increase
in gasoline inventories noted in the quarter-to-quarter discussion and lower
prices for petrochemicals, partially offset by the effect of higher priced sales
of CARB gasoline and other products in the California market in connection with
the Benicia Acquisition.
Operating income increased $449.6 million to $889.7 million during the
first nine months of 2001 compared to the first nine months of 2000 due in part
to the above-noted contribution from the Benicia Acquisition which resulted in
an increase in operating income of approximately $121 million. Excluding the
effect of the Benicia Acquisition, operating income increased due to an
approximate $458 million increase in total throughput margins (discussed below),
partially offset by an approximate $98 million increase in operating costs
(including a $66 million increase in cash operating costs and a $32 million
increase in depreciation and amortization expense), and an approximate $31
million increase in selling and administrative expenses (including related
depreciation expense). Cash operating costs and depreciation and amortization
expense were higher due to the factors noted above in the quarter-to-quarter
discussion. In addition, cash operating costs were higher due to an increase in
employee salaries, benefits and variable compensation and increases in
electricity and maintenance costs and ad valorem taxes. Selling and
administrative expenses (including related depreciation expense) were higher
primarily as a result of an increase in employee salaries, benefits, and
variable compensation.
Total throughput margins, excluding the effect of the Benicia
Acquisition, increased due to (i) substantially higher feedstock discounts for
sour crude oil, (ii) the effect of higher throughput volumes, and (iii) higher
lube oil margins resulting mainly from improved market conditions. Partially
offsetting these increases in total throughput margins were lower petrochemical
margins and the effect of higher natural gas, hydrogen and methanol feedstock
costs.
Other income (expense), net, decreased $3.2 million, from income of
$1.8 million during the first nine months of 2000 to expense of $1.4 million
during the first nine months of 2001, due to reduced results from Valero's 20%
equity interest in the Javelina off-gas processing plant in Corpus Christi
attributable primarily to higher natural gas feedstock costs and lower product
prices resulting from a weak petrochemical market. Partially offsetting the
reduced results from the Javelina plant was an increase in interest income
earned on excess cash balances and lower costs related to the agreement entered
into by Valero in September 1999 to sell a portion of its accounts receivable.
33
Net interest and debt expense increased $6.1 million, or 11%, to $63.1
million in the first nine months of 2001 compared to the same period in 2000 due
primarily to a full period of interest in 2001 on borrowings incurred to fund
the Benicia Acquisition, including interest on the senior notes issued in June
2000, and interest recognized in connection with the capital leases associated
with the El Paso acquisition which was effective June 1, 2001, partially offset
by a decrease in bank borrowings resulting from Valero's strong earnings and
cash flow.
Distributions on preferred securities of subsidiary trust increased
from $3.5 million in the first nine months of 2000 to $10.0 million in the first
nine months of 2001 due to distributions on the PEPS Units issued in June 2000
in connection with funding the Benicia Acquisition.
Income tax expense increased $167.5 million to $303.2 million during
the first nine months of 2001 compared to the same period in 2000 due primarily
to the significant increase in pre-tax income.
OUTLOOK
The economy has continued to weaken over the second half of the year
and the decline has accelerated after the events of September 11. As a result,
the worldwide demand for crude oil has declined causing prices to decline from
over $26.00 per barrel to around $21.00 per barrel. In the U.S., the demand for
jet fuel has been affected the most and is down around 10 to 12 percent since
the terrorist attacks. Jet fuel production has been subsequently reduced but
offset by higher production of distillates and gasoline. U.S. gasoline demand is
up slightly since the attacks as lower pump prices have offset the effects of
the weaker economy; however, weaker worldwide demand increases the available
barrels for imports into the U.S. Although the weakening economy has not to date
had a significant effect on Valero's business, a continuation or worsening of
these economic conditions could adversely affect Valero's results of operations
going forward.
Thus far in the fourth quarter of 2001, average Gulf Coast and East
Coast gasoline margins are lower than third quarter margins due to a seasonal
decline in margins resulting from the end of the summer driving season magnified
by higher than normal inventories as refinery production and imports of gasoline
and blendstocks have outpaced demand. Gasoline production typically increases in
the fourth quarter due to the higher volumes of butane that can be blended due
to the higher wintertime specifications for reid vapor pressure, which is higher
in volatility. A weak worldwide demand for petrochemicals for most of 2001 has
also increased gasoline production in the U.S. Margins in the fourth quarter are
lower than fourth quarter 2000 levels due to an increase in inventories
attributable to the higher production and imports. Average West Coast gasoline
margins remained firm in October 2001 but have since declined in November to
levels below both third quarter 2001 and fourth quarter 2000. Similar to Gulf
Coast and East Coast gasoline margins, average premiums for RFG have declined
thus far in the fourth quarter from third quarter levels and are lower than
fourth quarter 2000 premiums. Average distillate margins thus far in the fourth
quarter of 2001 are higher than third quarter margins due to increased demand
but are significantly below the exceptionally strong margins experienced in the
fourth quarter of 2000 due to a substantial increase in inventories. With regard
to other products, average lube oil margins continue to remain strong and are in
excess of both third quarter 2001 and fourth quarter 2000 levels due primarily
to declining crude oil prices. Average Gulf Coast propylene margins have
improved dramatically thus far in the fourth quarter of 2001, increasing from a
negative margin of over $3 a barrel in the third quarter to a positive margin of
over $6 a barrel due to lower crude oil prices and reduced inventories as
production declined due to extremely depressed margins earlier in 2001. Fourth
quarter 2001 margins are also higher than fourth quarter 2000 margins.
Average discounts for sour crude oil for October deliveries increased
from third quarter levels due to an increase in the availability of sour crude
oil, including the effect of the resumption of Iraqi production during the third
quarter, but have declined for November and December deliveries due to the
decline in crude oil prices and stronger resid prices relative to crude, which
narrowed the light to heavy differential. Sour crude oil discounts for November
and December deliveries are somewhat below fourth quarter 2000 discounts.
Although sweet crude oil continues to trade at a premium to WTI due to
increasing demand for sweet crudes resulting from the implementation in 2000 of
lower sulfur
34
requirements in fuel, thus far in the fourth quarter of 2001, this premium is
lower than fourth quarter 2000 levels due to the current decline in margins for
light products and reduced crude runs by refiners. Valero expects to continue to
recognize significant benefits from its ability to meet current fuel
specifications using predominantly sour crude oil feedstocks as the supply of
sour crudes and the demand for sweet crudes continue to increase in the future.
Valero completed an upgrade of the lubricants crude unit and lubricants
plant at the Paulsboro Refinery early in the fourth quarter of 2001 in
conjunction with a scheduled turnaround. At the Corpus Christi refinery acquired
from El Paso, a 25-day scheduled turnaround of the FCCU is currently being
completed. No other turnarounds are currently scheduled during the remainder of
the 2001 fourth quarter.
LIQUIDITY AND CAPITAL RESOURCES
Net cash provided by operating activities increased $329.9 million to
$699.8 million during the first nine months of 2001 compared to the same period
in 2000 due primarily to the significant increase in earnings discussed above
under "Results of Operations." During the first nine months of 2001, $867.8
million of cash was generated from earnings, approximately $168.0 million of
which was used for other operating activities, primarily working capital
requirements. As detailed in Note 5 of Notes to Consolidated Financial
Statements, the major increase in working capital resulted from an increase in
receivables resulting from a $75 million decrease in the amount outstanding
under the agreement entered into by Valero in September 1999 to sell a portion
of its accounts receivable and from increased sales volumes, partially offset by
a decrease in commodity prices from December 31, 2000 to September 30, 2001.
Also, payables decreased primarily due to the decrease in commodity prices from
December 31, 2000 to September 30, 2001, as well as the redelivery to the
Strategic Petroleum Reserve of approximately one million barrels of crude oil in
settlement of a time exchange of crude oil entered into in the fourth quarter of
2000. Partially offsetting these increased working capital requirements was an
increase in federal income taxes payable due to the significant increase in
earnings. During the first nine months of 2001, cash and temporary cash
investments increased $76.6 million as cash provided by operating activities and
issuances of common stock related to Valero's benefit plans exceeded amounts
required to (i) fund capital expenditures, deferred turnaround and catalyst
costs and the earn-out contingency payment to Salomon Inc discussed below, (ii)
fund the acquisition of Huntway and inventories related to the acquisition of El
Paso's Corpus Christi refinery and related product logistics business, (iii)
reduce short-term bank borrowings, (iv) repurchase shares of Valero common
stock, and (v) pay common stock dividends.
Valero currently maintains an unsecured $835 million revolving bank
credit and letter of credit facility which matures in November 2002 and is
available for general corporate purposes including working capital needs and
letters of credit. Borrowings under this facility bear interest at either LIBOR
plus a margin, a base rate or a money market rate. Valero is also charged
various fees and expenses in connection with this facility, including a facility
fee and various letter of credit fees. The interest rate and fees under this
credit facility are subject to adjustment based upon the credit ratings assigned
to Valero's long-term debt. The credit facility includes certain restrictive
covenants including a coverage ratio, a capitalization ratio, and a minimum net
worth test. As of September 30, 2001, there were no outstanding borrowings under
this committed facility, while letters of credit outstanding were approximately
35
$40 million. Valero also currently has certain uncommitted short-term bank
credit facilities and various uncommitted bank letter of credit facilities. As
of September 30, 2001, there were no outstanding borrowings under the short-term
bank credit facilities, while letters of credit totaling approximately $110
million were outstanding under the uncommitted letter of credit facilities.
See Note 2 of Notes to Consolidated Financial Statements for a detailed
description of Valero's anticipated financing plans with respect to its proposed
merger with UDS, including the establishment of a bridge loan facility and two
new revolving bank credit facilities to finance the cash portion of the merger
consideration, and the registration of common stock in connection with the
issuance of shares to UDS shareholders for the stock portion of the merger
consideration.
During the first nine months of 2001, Valero reduced its exposure to
increases in interest rates by refinancing its $18.5 million of taxable,
variable-rate industrial revenue bonds with tax-exempt fixed-rate bonds that
bear interest at 6.65%. See Note 6 of Notes to Consolidated Financial
Statements.
As of September 30, 2001, Valero's debt-to-capitalization ratio was
38.5%, which includes the effect of completing both the Huntway and El Paso
acquisitions in the second quarter of 2001. Despite the inclusion of these
transactions, Valero's debt-to-capitalization ratio at September 30, 2001
decreased from 39.9% at December 31, 2000. (Note: For purposes of these
debt-to-capitalization ratio computations, 20% of the aggregate liquidation
amount of trust preferred securities issued as part of the PEPS Units is deemed
to be debt).
In May 2001, Valero made a $35 million earn-out contingency payment to
Salomon Inc in connection with Valero's 1997 acquisition of Basis Petroleum,
Inc. In addition, Valero made an earn-out contingency payment to Mobil (now
ExxonMobil) of $20 million in October 2001 in connection with Valero's 1998
acquisition of the Paulsboro Refinery. Valero accounts for any payments under
these arrangements as an additional cost of the respective acquisition which is
depreciated over the remaining lives of the assets to which the additional cost
is allocated.
As discussed in Note 3 of Notes to Consolidated Financial Statements,
effective June 1, 2001, Valero completed the acquisition of Huntway Refining
Company for a total cost of approximately $76 million. Also effective June 1,
2001, Valero purchased for approximately $109 million inventories related to the
acquisition of El Paso Corporation's Corpus Christi, Texas refinery and related
product logistics business. These expenditures were funded by cash from
operations.
The following discussion of capital investments excludes (i) the
earn-out contingency payments to Salomon and ExxonMobil described above, (ii)
the acquisition cost of Huntway, and (iii) the acquisition cost of El Paso's
Corpus Christi refinery and related product logistics business. During the first
nine months of 2001, Valero expended approximately $344 million for capital
investments, including capital expenditures of $229 million and deferred
turnaround and catalyst costs of $115 million. Capital expenditures included
approximately $23 million for environmental projects (excluding approximately
$29 million of costs related to a flue gas scrubber at the Texas City Refinery
which is being financed through a lease arrangement). These environmental
projects include new equipment and improvements to existing equipment that
prevent or reduce the likelihood of environmental contamination from future
operations. For total year 2001, Valero currently expects to incur approximately
$510 million for capital
36
investments, including approximately $370 million for capital expenditures and
approximately $140 million for deferred turnaround and catalyst costs. The
capital expenditure estimate includes approximately $35 million for
environmental projects.
Valero is subject to extensive federal, state and local environmental
laws and regulations, including those relating to the discharge of materials
into the environment, waste management, pollution prevention measures and
characteristics and composition of gasoline and diesel fuels. If Valero violates
or fails to comply with these laws and regulations, it could be fined or
otherwise sanctioned. Because environmental laws and regulations are
increasingly becoming more stringent and new environmental laws and regulations
are continuously being enacted or proposed (such as the Environmental Protection
Agency's, or EPA's, Tier II gasoline and distillate standards discussed further
below), the level of future expenditures required for environmental matters
could increase in the future. In addition, any major upgrades in any of Valero's
refineries could require material additional expenditures to comply with
environmental laws and regulations. Although environmental costs may have a
significant impact on results of operations for a single period, Valero believes
that these costs will not have a material adverse effect on its financial
position or liquidity.
In February 2000, the EPA's "Tier II" gasoline standard was published
in final form under the Clean Air Act. The standard will ultimately require the
sulfur content in gasoline to be reduced from approximately 300 parts per
million to 30 parts per million. The regulation will be phased in beginning in
2004. In addition, the EPA finalized its Tier II distillate standard to reduce
the sulfur content of diesel fuel sold to highway consumers by 97%, from 500
parts per million to 15 parts per million, beginning June 1, 2006. The new Tier
II specifications for the reduction of sulfur in both gasoline and distillates
are expected to cost the refining industry as much as $16 billion. Valero has
determined that modifications will be required at each of its refineries as a
result of the Tier II standards. Based on its latest estimates, Valero believes
that the new Tier II gasoline and distillate specifications could require up to
approximately $230 million and $140 million, respectively, in capital
expenditures for Valero's refineries to comply, excluding the cost to install
hydrogen production facilities. However, Valero also believes that these capital
expenditure estimates could be reduced as a result of its multi-refinery
purchasing leverage and potential improvements in technology.
Under common stock repurchase programs approved by Valero's Board of
Directors, Valero repurchases shares of its common stock from time to time for
use in connection with its employee benefit plans and other general corporate
purposes. During the third quarter and first nine months of 2001, Valero
repurchased shares of its common stock under these programs at a cost of
approximately $9 million and $45 million, respectively. Thus far in the fourth
quarter of 2001 (through October 31), Valero has repurchased additional common
shares under these programs at a cost of approximately $8 million.
Valero believes it has sufficient funds from operations, and to the
extent necessary, from the public and private capital markets and bank markets,
to fund its ongoing operating requirements. Valero expects that, to the extent
necessary, it can raise additional funds from time to time through equity or
debt financings. However, there can be no assurances regarding the availability
of any future financings or whether such financings can be made available on
terms acceptable to Valero.
37
NEW ACCOUNTING PRONOUNCEMENTS
As discussed in Note 9 of Notes to Consolidated Financial Statements,
certain new financial accounting pronouncements have been issued by the FASB
which either have already been reflected in the accompanying consolidated
financial statements, or will become effective for Valero's financial statements
in the future. Except for FASB Statement No. 144, "Accounting for the Impairment
or Disposal of Long-Lived Assets," and FASB Statement No. 143, "Accounting for
Asset Retirement Obligations," for which the effect on Valero's consolidated
financial statements has not yet been determined, and FASB Statement No. 133,
"Accounting for Derivative Instruments and Hedging Activities," the effect of
which is discussed in Note 10 of Notes to Consolidated Financial Statements, the
adoption of these pronouncements has not had, or is not expected to have, a
material effect on Valero's consolidated financial statements.
38
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
COMMODITY PRICE RISK
Valero is exposed to market risks related to the volatility of crude
oil and refined product prices, as well as volatility in the price of natural
gas used in its refining operations. In order to reduce the risks of these price
fluctuations, Valero uses derivative commodity instruments to hedge a portion of
its refinery feedstock and refined product inventories and a portion of its
unrecognized firm commitments to purchase these inventories (fair value hedges).
Valero also uses derivative commodity instruments to hedge the price risk of
forecasted transactions such as forecasted feedstock and natural gas purchases
and product sales (cash flow hedges). In addition, Valero uses derivative
commodity instruments to manage its exposure to price volatility on a portion of
its refined product inventories and on certain forecasted feedstock and refined
product purchases that do not receive hedge accounting treatment under FASB 133.
These derivative instruments are considered economic hedges for which changes in
their fair value are reported currently in earnings. Finally, Valero uses
derivative commodity instruments for trading purposes using its fundamental and
technical analysis of market conditions to earn additional income.
The types of instruments used in Valero's hedging and trading
activities described above include swaps, futures and options. Valero's
positions in derivative commodity instruments are monitored and managed on a
daily basis by a risk control group to ensure compliance with Valero's stated
risk management policy which has been approved by Valero's Board of Directors.
In the tables below detailing Valero's open derivative commodity
instruments as of September 30, 2001, the total gain or (loss) on swaps is the
net of the fixed price payor and receiver fair value amounts, while the total
gain or (loss) on futures and options is (i) the excess of the fair value amount
over the contract amount for fixed price payor positions, combined with (ii) the
excess of the contract amount over the fair value amount for fixed price
receiver positions. See Note 10 of Notes to Consolidated Financial Statements
for a discussion of Valero's accounting policies related to its derivative
commodity instrument transactions, including Valero's adoption of FASB Statement
No. 133, "Accounting for Derivative Instruments and Hedging Activities,"
effective January 1, 2001.
HEDGING ACTIVITIES
The following table provides information about Valero's derivative
commodity instruments (i) designated and qualifying as fair value hedges and
held to hedge refining inventories and unrecognized firm commitments, and (ii)
used in economic hedging relationships and held to manage price volatility in
refined product inventories, as of September 30, 2001 (which mature in 2001 and
2002) (dollars in thousands, except amounts per barrel, or bbl, or per million
British thermal units, or MMBtus).
39
<Table>
<Caption>
Mature in 2001 Mature in 2002
---------------------------- ----------------------------
Fixed Price Fixed Price
---------------------------- ----------------------------
Payor Receiver Payor Receiver
------------ ------------ ------------ ------------
Futures:
Volumes (Mbbls) ......................... 15,798 24,033 53 1
Weighted average price (per bbl) ........ $ 25.08 $ 24.94 $ 31.08 $ 33.26
Contract amount ......................... $ 396,251 $ 599,271 $ 1,647 $ 33
Fair value .............................. $ 384,471 $ 593,178 $ 1,482 $ 29
Volumes (BBtus) ......................... -- 300 -- 200
Weighted average price (per MMBtu) ...... -- $ 2.65 -- $ 2.86
Contract amount ......................... -- $ 796 -- $ 571
Fair value .............................. -- $ 770 -- $ 563
</Table>
The following table provides information about Valero's derivative
commodity instruments (i) designated and qualifying as cash flow hedges and held
to hedge forecasted feedstock purchases and product sales, and (ii) used in
economic hedging relationships and held to manage price volatility in forecasted
feedstock and refined product purchases, as of September 30, 2001 (which mature
in 2001 and 2002) (dollars in thousands, except amounts per barrel or per
million British thermal units). Volumes shown for swaps represent notional
volumes which are used to calculate amounts due under the agreements.
<Table>
<Caption>
Mature in 2001 Mature in 2002
-------------------------- --------------------------
Fixed Price Fixed Price
-------------------------- --------------------------
Payor Receiver Payor Receiver
----------- ----------- ----------- -----------
Swaps:
Notional volumes (Mbbls) ......................... 75 3,800 -- 3,300
Weighted average pay price (per bbl) ............. $ 2.00 $ 3.48 -- $ 3.49
Weighted average receive price (per bbl) ......... $ 3.37 $ 3.91 -- $ 4.10
Fair value (gain) ................................ $ 103 $ 1,651 -- $ 2,025
Notional volumes (BBtus) ......................... 460 1,075 -- --
Weighted average pay price (per MMBtu) ........... $ 4.66 $ 2.47 -- --
Weighted average receive price (per MMBtu) ....... $ 2.38 $ 3.47 -- --
Fair value (gain (loss)) ......................... $ (1,048) $ 1,081 -- --
Futures:
Volumes (Mbbls) .................................. 5,219 1,454 710 600
Weighted average price (per bbl) ................. $ 27.74 $ 28.69 $ 26.10 $ 29.71
Contract amount .................................. $ 144,794 $ 41,708 $ 18,532 $ 17,827
Fair value ....................................... $ 141,992 $ 39,581 $ 17,186 $ 16,409
</Table>
40
<Table>
<Caption>
Mature in 2001 Mature in 2002
--------------------------- -------------------------
Fixed Price Fixed Price
--------------------------- -------------------------
Payor Receiver Payor Receiver
----------- ----------- ----------- -----------
Options:
Volumes (Mbbls) .................................. -- 1,950 -- --
Weighted average strike price (per bbl) .......... -- $ 4.52 -- --
Contract amount .................................. -- $ 1,568 -- --
Fair value ....................................... -- $ 78 -- --
Volumes (BBtus) .................................. 2,760 -- -- --
Weighted average strike price (per MMBtu) ........ $ 4.63 -- -- --
Contract amount .................................. $ (1,771) -- -- --
Fair value ....................................... $ (6,184) -- -- --
</Table>
In addition to the above, as of September 30, 2001, Valero was the
fixed price payor under certain swap contracts held to hedge forecasted
purchases of refinery feedstocks and refined products that mature in 2002, have
notional volumes totaling approximately 7.5 million barrels, and have a weighted
average pay price of $20.11 per barrel. As of September 30, 2001, these swaps
had a weighted average receive price of $23.18 per barrel and a net after-tax
gain recorded in other comprehensive income of approximately $30 million.
TRADING ACTIVITIES
The following table provides information about Valero's derivative
commodity instruments held or issued for trading purposes as of September 30,
2001 (which mature in 2001 or 2002) (dollars in thousands, except amounts per
barrel or per million British thermal units). Volumes shown for swaps represent
notional volumes which are used to calculate amounts due under the agreements.
<Table>
<Caption>
Mature in 2001 Mature in 2002
--------------------------- -------------------------
Fixed Price Fixed Price
--------------------------- ---------------------------
Payor Receiver Payor Receiver
----------- ----------- ----------- -----------
Swaps:
Notional volumes (Mbbls) ......................... 2,600 4,219 1,725 3,150
Weighted average pay price (per bbl) ............. $ 3.67 $ 8.26 $ 4.55 $ 2.65
Weighted average receive price (per bbl) ......... $ 3.02 $ 8.72 $ 4.20 $ 2.89
Fair value (gain (loss)) ......................... $ (1,683) $ 1,939 $ (592) $ 752
Notional volumes (BBtus) ......................... 460 460 -- --
Weighted average pay price (per MMBtu) ........... $ 4.68 $ 2.38 -- --
Weighted average receive price (per MMBtu) ....... $ 2.38 $ 4.89 -- --
Fair value (gain (loss)) ......................... $ (1,057) $ 1,154 -- --
</Table>
41
<Table>
<Caption>
Mature in 2001 Mature in 2002
----------------------------- ----------------------------
Fixed Price Fixed Price
----------------------------- ----------------------------
Payor Receiver Payor Receiver
------------ ------------ ------------ ------------
Futures:
Volumes (Mbbls) .................................. 5,444 4,325 958 950
Weighted average price (per bbl) ................. $ 25.82 $ 26.16 $ 26.59 $ 27.21
Contract amount .................................. $ 140,563 $ 113,141 $ 25,470 $ 25,848
Fair value ....................................... $ 132,575 $ 107,279 $ 23,920 $ 24,497
Volumes (BBtus) .................................. 1,040 1,040 -- --
Weighted average price (per MMBtu) ............... $ 5.12 $ 5.31 -- --
Contract amount .................................. $ 5,329 $ 5,517 -- --
Fair value ....................................... $ 2,530 $ 2,530 -- --
Options:
Volumes (Mbbls) .................................. 450 -- -- 150
Weighted average strike price (per bbl) .......... $ 3.72 -- -- $ 6.00
Contract amount .................................. $ (255) -- -- $ 96
Fair value ....................................... $ (149) -- -- $ --
</Table>
INTEREST RATE RISK
Valero's primary market risk exposure for changes in interest rates
relates to its long-term debt obligations. Valero manages its exposure to
changing interest rates principally through the use of a combination of fixed
and floating rate debt and currently does not use derivative financial
instruments to manage such risk.
42
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
Valero Energy Corporation, et al. v. M.W. Kellogg, et al., 117th
Judicial District Court, Nueces County, Texas (filed July 11, 1986). In 1986,
Valero filed suit against M.W. Kellogg Company for damages arising from certain
alleged design and construction defects in connection with a major construction
project at Valero's Corpus Christi refinery. Ingersoll-Rand Company was added as
a defendant in 1989. In 1991, the trial court granted summary judgment against
Valero based in part on certain exculpatory provisions in various agreements
connected with the project. Subsequent to the summary judgment, Kellogg and
Ingersoll-Rand brought indemnity claims against Valero for attorneys' fees and
expenses incurred in defending the original action. In 1996, the trial court
rendered summary judgment against Kellogg and Ingersoll-Rand based on procedural
grounds, and the court of appeals affirmed that ruling in 1997. However, in
1999, the Texas Supreme Court reversed the court of appeals and remanded
Kellogg's and Ingersoll-Rand's claims for attorneys' fees and expenses to the
trial court. The case went to trial in August 2000. During trial, the claims of
Ingersoll-Rand were settled for an immaterial amount. The jury returned a
verdict on Kellogg's claims that resulted in a judgment of $6.3 million. Valero
had appealed the judgment, but the parties recently reached a settlement of the
dispute on terms immaterial to Valero's consolidated financial statements.
Texas City Terminal Railway Company d/b/a Port of Texas City v.
Marathon Ashland Petroleum, LLC, et al., Civil Action No. G-00-239, United
States District Court for the Southern District of Texas (Galveston Division).
Valero had previously received notice of a complaint filed April 28, 2000 in
federal court by Texas City Railway Company alleging that several companies,
including Valero, were liable under various environmental laws and tort law
theories for alleged contamination of the plaintiff's marine loading and
tankering facilities. The parties recently reached a settlement of this dispute
on terms immaterial to Valero's consolidated financial statements.
La Susa, et al. v. Amerada Hess Corp., et al., Case No.
00-CIV-1898-[SAS], United States District Court for the Southern District of New
York (formerly styled as Berisha, et al. v. Amerada Hess Corp., et al.) (most
recently reported in Valero's Annual Report on Form 10-K for the year ended
December 31, 2000). On May 24, 2000, Valero was served with a complaint seeking
to certify a class action that alleged that numerous gasoline suppliers,
including Valero, contaminated groundwater in New York with MTBE. The Judicial
Panel on Multidistrict Litigation, or MDL, consolidated this matter with certain
other MTBE class-action lawsuits brought in New York federal courts. On August
20, 2001, the MDL judge dismissed the consolidated class-action complaints.
Although these class-action complaints were dismissed, certain separate but
related individual lawsuits are still pending, namely Berisha and O'Brien v.
Amerada Hess Corporation, et al., Case No. MDL 1358, Master File C.A. No.
1:00-1898 [SAS], United States District Court for the Southern District of New
York (most recently reported in Valero's Quarterly Report on Form 10-Q for the
quarter ended March 31, 2001).
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
A special meeting of the Company's stockholders was held September 27,
2001. Matters voted on at the meeting and the results thereof were (i) a
proposal to adopt the Agreement and Plan of Merger, dated as of May 6, 2001,
between Valero and Ultramar Diamond Shamrock Corporation, and the merger
43
contemplated thereby (approved with 42,439,458 affirmative votes, 145,490
negative votes, and 164,618 abstentions); and (ii) a proposal to amend Valero's
certificate of incorporation to increase the number of authorized shares of
common stock from 150 million shares to 300 million shares (approved with
50,776,331 affirmative votes, 3,585,714 negative votes, and 96,730 abstentions).
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits.
None.
(b) Reports on Form 8-K.
(i) On August 17, 2001, Valero filed an amendment to its
Current Report on Form 8-K/A dated May 15, 2000 and filed with the SEC on June
1, 2000. The Form 8-K/A filed June 1, 2000 provided the financial statements and
the pro forma financial information required under Item 7 of Form 8-K pertaining
to Valero's acquisition of assets from Exxon Mobil Corporation. The amended
report filed on August 17, 2001 amended the pro forma financial information
included in the report filed June 1, 2000, and included the following financial
statements and pro forma financial information.
(1) EXXON CALIFORNIA REFINERY, TERMINAL AND RETAIL ASSETS BUSINESS (as
defined in the Sale and Purchase Agreement between Exxon Mobil
Corporation and Valero Refining Company-California)
Report of Independent Accountants
Balance Sheet as of December 31, 1999 and 1998
Statement of Income for the Years Ended December 31, 1999, 1998 and
1997
Statement of Cash Flows for the Years Ended December 31, 1999, 1998 and
1997
Statement of Changes in Exxon Mobil Corporation Net Investment
Notes to Financial Statements as of December 31, 1999
Balance Sheet as of March 31, 2000 (unaudited) and December 31, 1999
Statement of Income for the Three Months Ended March 31, 2000 and 1999
(unaudited)
Statement of Cash Flows for the Three Months Ended March 31, 2000 and
1999 (unaudited)
Notes to Financial Statements as of March 31, 2000
(2) UNAUDITED PRO FORMA COMBINED FINANCIAL STATEMENTS
Unaudited Pro Forma Combined Balance Sheet as of March 31, 2000
Unaudited Pro Forma Combined Statement of Income for the Three Months
Ended March 31, 2000
Unaudited Pro Forma Combined Statement of Income for the Year Ended
December 31, 1999
Notes to Unaudited Pro Forma Combined Financial Statements
(ii) On September 6, 2001, Valero filed a Current Report on
Form 8-K dated September 4, 2001, reporting Item 5 (Other Events) to file a
press release in connection with Valero's estimates for third quarter and full
year 2001 earnings. Financial statements were not filed with this report.
44
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
VALERO ENERGY CORPORATION
(Registrant)
By: /s/ John D. Gibbons
-------------------------------------------
John D. Gibbons
Executive Vice President and Chief
Financial Officer
(Duly Authorized Officer and Principal
Financial and Accounting Officer)
Date: November 13, 2001
45