UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended March 31, 2006
OR
For the transition period from to
Commission file number 1-13175
VALERO ENERGY CORPORATION
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
One Valero Way
San Antonio, Texas
(Address of principal executive offices)
78249
(Zip Code)
(210) 345-2000
(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 ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one).
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The number of shares of the registrant’s only class of common stock, $0.01 par value, outstanding as of April 30, 2006 was 615,453,161.
VALERO ENERGY CORPORATION AND SUBSIDIARIES
INDEX
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of March 31, 2006 and December 31, 2005
Consolidated Statements of Income for the Three Months Ended March 31, 2006 and 2005
Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2006 and 2005
Consolidated Statements of Comprehensive Income for the Three Months Ended March 31, 2006 and 2005
Condensed Notes to Consolidated Financial Statements
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Item 4. Controls and Procedures
PART II - OTHER INFORMATION
Item 1. Legal Proceedings
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 6. Exhibits
SIGNATURE
2
CONSOLIDATED BALANCE SHEETS
(Millions of Dollars, Except Par Value)
March 31,
2006
Current assets:
Cash and temporary cash investments
Restricted cash
Receivables, net
Inventories
Deferred income taxes
Prepaid expenses and other
Total current assets
Property, plant and equipment, at cost
Accumulated depreciation
Property, plant and equipment, net
Intangible assets, net
Goodwill
Investment in Valero L.P.
Deferred charges and other assets, net
Total assets
Current liabilities:
Current portion of long-term debt and capital lease obligations
Accounts payable
Accrued expenses
Taxes other than income taxes
Income taxes payable
Total current liabilities
Long-term debt, less current portion
Capital lease obligations, less current portion
Other long-term liabilities
Commitments and contingencies (Note 15)
Stockholders’ equity:
Preferred stock, $0.01 par value; 20,000,000 shares authorized; 2,451,116 and 3,164,151 shares issued and outstanding
Common stock, $0.01 par value; 1,200,000,000 shares authorized; 622,643,499 and 621,230,266 shares issued
Additional paid-in capital
Treasury stock, at cost; 7,502,147 and 3,807,976 common shares
Retained earnings
Accumulated other comprehensive income
Total stockholders’ equity
Total liabilities and stockholders’ equity
See Condensed Notes to Consolidated Financial Statements.
3
CONSOLIDATED STATEMENTS OF INCOME
(Millions of Dollars, Except per Share Amounts and Supplemental Information)
(Unaudited)
Operating revenues (1) (2)
Costs and expenses:
Cost of sales (1)
Refining operating expenses
Retail selling expenses
General and administrative expenses
Depreciation and amortization expense
Total costs and expenses
Operating income
Equity in earnings of Valero L.P.
Other expense, net
Interest and debt expense:
Incurred
Capitalized
Income before income tax expense
Income tax expense
Net income
Preferred stock dividends
Net income applicable to common stock
Earnings per common share
Weighted-average common shares outstanding (in millions)
Earnings per common share – assuming dilution
Weighted-average common equivalent shares outstanding (in millions)
Dividends per common share
Supplemental information (billions of dollars):
(1) Includes the following amounts related to crude oil buy/sell arrangements (see Note 2, EITF Issue No. 04-13):
Operating revenues
Cost of sales
(2) Includes excise taxes on sales by our U.S. retail system
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CONSOLIDATED STATEMENTS OF CASH FLOWS
(Millions of Dollars)
Cash flows from operating activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Stock-based compensation expense
Deferred income tax expense
Changes in current assets and current liabilities
Changes in deferred charges and credits and other, net
Net cash provided by operating activities
Cash flows from investing activities:
Capital expenditures
Deferred turnaround and catalyst costs
Contingent payments in connection with acquisitions
Other investing activities, net
Net cash used in investing activities
Cash flows from financing activities:
Long-term debt borrowings, net of issuance costs
Long-term debt repayments
Issuance of common stock in connection with employee benefit plans
Benefit from tax deduction in excess of recognized stock-based compensation cost
Common and preferred stock dividends
Purchase of treasury stock
Net cash used in financing activities
Effect of foreign exchange rate changes on cash
Net increase (decrease) in cash and temporary cash investments
Cash and temporary cash investments at beginning of period
Cash and temporary cash investments at end of period
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CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
Other comprehensive income (loss):
Foreign currency translation adjustment
Net gain (loss) on derivative instruments designated and qualifying as cash flow hedges:
Net gain (loss) arising during the period, net of income tax (expense) benefit of $(1) and $122
Net (gain) loss reclassified into income, net of income tax expense (benefit) of $3 and $(23)
Net loss on cash flow hedges
Other comprehensive loss
Comprehensive income
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CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION, PRINCIPLES OF CONSOLIDATION AND SIGNIFICANT ACCOUNTING POLICIES
As used in this report, the terms “Valero,” “we,” “us,” or “our” may refer to Valero Energy Corporation, one or more of our consolidated subsidiaries, or all of them taken as a whole.
These unaudited consolidated financial statements include the accounts of Valero and subsidiaries in which Valero has a controlling interest. Intercompany balances and transactions have been eliminated in consolidation. Investments in 50% or less owned entities are accounted for using the equity method of accounting.
These unaudited consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities Exchange Act of 1934. Accordingly, they do not include all of the information and notes required by GAAP for complete consolidated financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation have been included. All such adjustments are of a normal recurring nature unless disclosed otherwise. Financial information for the three months ended March 31, 2006 and 2005 included in these Condensed Notes to Consolidated Financial Statements is derived from our unaudited consolidated financial statements. Operating results for the three months ended March 31, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.
The consolidated balance sheet as of December 31, 2005 has been derived from the audited financial statements as of that date. For further information, refer to the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2005.
Share and per share data (except par value) presented for 2005 reflect the effect of a two-for-one stock split which was effected in the form of a common stock dividend distributed on December 15, 2005, as discussed in Note 8 under “2005 Common Stock Split.”
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CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
Certain previously reported amounts have been reclassified to conform to the 2006 presentation. These reclassifications included amounts previously reported in 2005 for refining operating expenses, retail selling expenses, general and administrative expenses, and depreciation and amortization expense which were reclassified due to the following changes that took effect on January 1, 2006: (i) information services costs that were previously allocated to the operating units are now being reported as general and administrative expenses to better reflect the area responsible for such costs and (ii) Statement No. 123R (discussed in Note 2) was implemented, which resulted in amounts previously reported as amortization expense now being reported as operating, selling or general and administrative expenses. The reclassified amounts were as follows (in millions):
Previously
Reported
Currently
2. ACCOUNTING PRONOUNCEMENTS
FASB Statement No. 123 (revised 2004)
In December 2004, the Financial Accounting Standards Board (FASB) issued Statement No. 123 (revised 2004), “Share-Based Payment” (Statement No. 123R), which requires the expensing of the fair value of stock options. We adopted Statement No. 123R on January 1, 2006. The specific impact of our adoption of Statement No. 123R will depend on levels of share-based incentive awards granted in the future. Had we adopted Statement No. 123R in prior periods, the impact of that standard would have approximated the impact of Statement No. 123 as described in Note 13.
Statement No. 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported in our statements of cash flows as a financing cash flow, rather than as an operating cash flow as previously required. This requirement reduces cash flows from operating activities and increases cash flows from financing activities beginning in 2006. While we cannot estimate the specific magnitude of this change on future cash flows because it depends on, among other things, when employees exercise stock options, the cash flows recognized for such excess tax deductions were $89 million and $19 million for the three months ended March 31, 2006 and 2005, respectively.
Under our employee stock compensation plans, certain awards of stock options and restricted stock provide that employees vest in the award when they retire or will continue to vest in the award after retirement over the nominal vesting period established in the award. We previously accounted for such awards by recognizing compensation cost, if any, under APB Opinion No. 25 and pro forma compensation cost under Statement No. 123 over the nominal vesting period, as disclosed in Note 13. Upon the adoption of Statement No. 123R, we changed our method of recognizing compensation cost to the non-substantive vesting period approach for any awards that are granted after the adoption of Statement No. 123R. Under the non-substantive vesting period approach, compensation cost is recognized immediately for awards granted to retirement-eligible employees or over the period from the grant date to the date retirement eligibility is achieved if that date is expected to occur during the nominal vesting period. If the non-substantive vesting period approach had been used by us for awards granted prior to January 1, 2006, the impact on the pro forma net income applicable to common stock and pro
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forma net income amounts for the three months ended March 31, 2005, and the impact on net income applicable to common stock and net income for the three months ended March 31, 2006, would have been less than $1 million as disclosed in Note 13.
EITF Issue No. 04-5
In June 2005, the FASB ratified its consensus on Emerging Issues Task Force (EITF) Issue No. 04-5, “Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners Have Certain Rights” (EITF No. 04-5), which requires the general partner in a limited partnership to determine whether the limited partnership is controlled by, and therefore should be consolidated by, the general partner. The guidance in EITF No. 04-5 was effective after June 29, 2005 for general partners of all new partnerships formed and for existing limited partnerships for which the partnership agreements are modified. For general partners in all other limited partnerships, the guidance in EITF No. 04-5 was effective no later than January 1, 2006. We adopted EITF No. 04-5 effective January 1, 2006, the adoption of which had no impact on the accounting for our investment in Valero L.P.
EITF Issue No. 04-13
Through December 31, 2005, our operating revenues included sales related to certain buy/sell arrangements. In September 2005, the FASB ratified its consensus on EITF Issue No. 04-13, “Accounting for Purchases and Sales of Inventory with the Same Counterparty” (EITF No. 04-13), which requires that inventory purchase and sales transactions with the same counterparty that are entered into in contemplation of one another should be combined for purposes of applying AICPA Accounting Principles Board (APB) Opinion No. 29, “Accounting for Nonmonetary Transactions” (APB No. 29). The guidance in EITF No. 04-13 is effective for transactions completed in reporting periods beginning after March 15, 2006, with early application permitted. We adopted EITF No. 04-13 on January 1, 2006.
One issue addressed by EITF No. 04-13 details factors to consider in evaluating whether certain individual transactions to purchase and sell inventory are made in contemplation of one another and therefore should be viewed as one transaction when applying the principles of APB No. 29. When applying these factors, certain of our buy/sell arrangements are deemed to be made in contemplation of one another. Accordingly, commencing January 1, 2006, these buy/sell arrangements have been accounted for as one transaction in applying the principles of APB No. 29 and revenues and cost of sales ceased to be recognized in connection with these arrangements. If we had applied EITF No. 04-13 for the three months ended March 31, 2005, operating revenues and cost of sales would have been reduced by the amounts reflected in the supplemental information on the face of the consolidated statements of income.
FASB Statement No. 155
In February 2006, the FASB issued Statement No. 155, “Accounting for Certain Hybrid Financial Instruments,” which amends Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and Statement No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” Statement No. 155 is effective for all financial instruments acquired or issued after the beginning of an entity’s fiscal year that begins after September 15, 2006. The adoption of Statement No. 155 is not expected to affect our financial position or results of operations.
FASB Statement No. 156
In March 2006, the FASB issued Statement No. 156, “Accounting for Servicing of Financial Assets,” which amends Statement No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” Statement No. 156 requires the initial recognition at fair value of a
9
servicing asset or servicing liability when an obligation to service a financial asset is undertaken by entering into a servicing contract. Statement No. 156 is effective for fiscal years beginning after September 15, 2006, with early adoption permitted. The adoption of Statement No. 156 is not expected to affect our financial position or results of operations.
3. ACQUISITIONS
Premcor Acquisition
On September 1, 2005, we completed our merger with Premcor Inc. (Premcor). As used in this report, Premcor Acquisition refers to the merger of Premcor with and into Valero. Premcor was an independent petroleum refiner and supplier of unbranded transportation fuels, heating oil, petrochemical feedstocks, petroleum coke and other petroleum products with all of its operations in the United States. Premcor owned and operated refineries in Port Arthur, Texas; Lima, Ohio; Memphis, Tennessee; and Delaware City, Delaware, with a combined crude oil throughput capacity of approximately 800,000 barrels per day.
The purchase price of the Premcor Acquisition has been preliminarily allocated based on estimated fair values of the assets acquired and the liabilities assumed at the date of acquisition, pending the completion of an independent appraisal and other evaluations, including obtaining additional information related to certain legal and environmental contingencies that existed prior to the merger. The purchase price and the preliminary purchase price allocation as of March 31, 2006 were as follows (in millions):
Cash paid
Transaction costs
Less unrestricted cash acquired
Premcor Acquisition, net of cash acquired
Common stock and stock options issued
Total purchase price, excluding unrestricted cash acquired
Current assets, net of unrestricted cash acquired
Property, plant and equipment
Intangible assets
Deferred charges and other assets
Current liabilities, less current portion of long-term debt and capital lease obligations
Long-term debt assumed, including current portion
Capital lease obligation, including current portion
Purchase price, excluding unrestricted cash acquired
Unaudited Pro Forma Financial Information
The consolidated statements of income include the results of operations of the Premcor Acquisition commencing on September 1, 2005. As a result, information for the three months ended March 31, 2006 presented below represents actual results of operations.
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The following unaudited pro forma financial information assumes that the Premcor Acquisition occurred on January 1, 2005. The pro forma information assumes 85 million shares of common stock were issued, $1.5 billion of debt was incurred and $1.9 billion of available cash was utilized to fund the Premcor Acquisition on January 1, 2005.
The unaudited pro forma financial information is not necessarily indicative of the results of future operations (in millions, except per share amounts):
4. RESTRICTED CASH
Restricted cash as of March 31, 2006 and December 31, 2005 included $22 million of cash held in trust related to change-in-control payments to be made to former officers and key employees of Ultramar Diamond Shamrock Corporation (UDS) in connection with the acquisition of UDS that occurred in December 2001. Restricted cash as of March 31, 2006 and December 31, 2005 also included $8 million of cash assumed in the Premcor Acquisition, which was held in trust mainly to satisfy claims under Premcor’s directors’ and officers’ liability policy.
5. INVENTORIES
Inventories consisted of the following (in millions):
Refinery feedstocks
Refined products and blendstocks
Convenience store merchandise
Materials and supplies
As of March 31, 2006 and December 31, 2005, the replacement cost (market value) of LIFO inventories exceeded their LIFO carrying amounts by approximately $4.2 billion and $3.3 billion, respectively.
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6. INVESTMENT IN AND TRANSACTIONS WITH VALERO L.P.
Our ownership interest in Valero L.P. as of March 31, 2006 and December 31, 2005 was 23.4%, which was composed of a 2% general partner interest, incentive distribution rights and a 21.4% limited partner interest. The limited partner interest as of March 31, 2006 was represented by 627,339 common units and 9,599,322 subordinated units of Valero L.P. Financial information reported by Valero L.P. for the three months ended March 31, 2006 and 2005 is summarized below (in millions):
Revenues
Under a services agreement, we provide Valero L.P. with certain corporate functions for an annual fee as prescribed by the services agreement. In addition, we charge Valero L.P. for employee costs related to operating and maintenance services performed on certain Valero L.P. assets. We also pay Valero L.P. certain fees under separate throughput, handling, terminalling and service agreements with Valero L.P.
As of March 31, 2006 and December 31, 2005, our “receivables, net” included $9 million and $13 million, respectively, from Valero L.P., representing amounts due for employee costs, insurance costs, operating expenses, administrative costs and rentals. As of March 31, 2006 and December 31, 2005, our “accounts payable” included $20 million and $22 million, respectively, to Valero L.P., representing amounts due for pipeline tariffs, terminalling fees and tank rentals and fees. The following table summarizes the results of transactions with Valero L.P. (in millions):
Fees and expenses charged by us to Valero L.P.
Fees and expenses charged to us by Valero L.P.
On March 31, 2006, Valero GP Holdings, LLC, an indirect wholly owned subsidiary of Valero, filed a registration statement on Form S-1 with the Securities and Exchange Commission (SEC) for an initial public offering of approximately 37% of its units representing limited liability company interests. Subsidiaries of Valero GP Holdings, LLC own the general partner interest, the incentive distribution rights and a 21.4% limited partner interest in Valero L.P. After this initial public offering, if consummated, subsidiaries of Valero will hold an approximate 63% ownership interest in Valero GP Holdings, LLC. It is our intention to further reduce and ultimately sell all of our interest in Valero GP Holdings, LLC, pending market conditions. We expect to use funds from this offering for general corporate purposes, which may include acquisitions, stock repurchases and debt reduction.
7. LONG-TERM DEBT AND SHORT-TERM DEBT
During March 2006, we made a scheduled debt repayment of $220 million related to our 7.375% notes. During the three months ended March 31, 2006, we borrowed and repaid $31 million under our Canadian revolving credit facility and $3 million under a short-term uncommitted bank credit facility.
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8. STOCKHOLDERS’ EQUITY
2% Mandatory Convertible Preferred Stock
During the three months ended March 31, 2006, 713,035 shares of our 2% mandatory convertible preferred stock were converted into 1,413,233 shares of our common stock. During April 2006, 34,225 additional shares of our preferred stock were converted into 67,833 shares of our common stock.
On April 27, 2006, our board of directors declared a dividend on the mandatory convertible preferred stock of $0.125 per share payable on June 30, 2006 to holders of record at the close of business on June 29, 2006.
2005 Common Stock Split
On September 15, 2005, our board of directors approved a two-for-one split of our common stock that was effected in the form of a stock dividend. The stock dividend was distributed on December 15, 2005 to stockholders of record on December 2, 2005. In connection with the stock split, our shareholders approved on December 1, 2005, an amendment to our certificate of incorporation to increase the number of authorized common shares from 600 million to 1.2 billion.
All share and per share data (except par value) for 2005 have been adjusted to reflect the effect of the stock split. In addition, the number of shares of common stock issuable upon conversion of the mandatory convertible preferred stock, the exercise of outstanding stock options and the vesting of other stock awards were proportionately increased in accordance with the terms of those respective agreements and plans.
Treasury Stock
During the three months ended March 31, 2006 and 2005, we purchased 10.7 million and 5.6 million shares of our common stock at a cost of $590 million and $177 million, respectively, in connection with the administration of our employee benefit plans. During the three months ended March 31, 2006, we issued 7.0 million treasury shares at an average cost of $52.24 per share, and for the three months ended March 31, 2005, we issued 3.3 million treasury shares at an average cost of $17.53 per share, for our employee benefit plans.
Common Stock Dividends
On April 27, 2006, our board of directors declared a regular quarterly cash dividend of $0.08 per common share payable June 14, 2006 to holders of record at the close of business on May 17, 2006.
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9. EARNINGS PER COMMON SHARE
Earnings per common share amounts were computed as follows (dollars and shares in millions, except per share amounts):
Earnings per Common Share:
Weighted-average common shares outstanding
Earnings per Common Share – Assuming Dilution:
Net income applicable to common equivalent shares
Effect of dilutive securities:
Stock options
Performance awards and other benefit plans
Mandatory convertible preferred stock
Weighted-average common equivalent shares outstanding
10. STATEMENTS OF CASH FLOWS
In order to determine net cash provided by operating activities, net income is adjusted by, among other things, changes in current assets and current liabilities as follows (in millions):
Decrease (increase) in current assets:
Increase (decrease) in current liabilities:
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The above changes in current assets and current liabilities differ from changes between amounts reflected in the applicable consolidated balance sheets for the respective periods for the following reasons:
Noncash financing activities for the three months ended March 31, 2006 included the conversion of 713,035 shares of preferred stock into 1,413,233 shares of our common stock as discussed in Note 8. There were no significant noncash investing activities for the three months ended March 31, 2006.
Noncash investing activities for the three months ended March 31, 2005 included adjustments to property, plant and equipment and certain current and noncurrent assets and liabilities resulting from adjustments to the purchase price allocation related to the acquisition of the Aruba Refinery.
Noncash financing activities for the three months ended March 31, 2005 included:
Cash flows related to interest and income taxes were as follows (in millions):
Interest paid (net of amount capitalized)
Income taxes paid, net of tax refunds received
11. PRICE RISK MANAGEMENT ACTIVITIES
The net gain (loss) recognized in income representing the amount of hedge ineffectiveness was as follows (in millions):
Fair value hedges
Cash flow hedges
The above amounts were included in “cost of sales” in the consolidated statements of income. No component of the derivative instruments’ gains or losses was excluded from the assessment of hedge effectiveness. No amounts were recognized in income for hedged firm commitments that no longer qualify as fair value hedges.
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For cash flow hedges, gains and losses reported in “accumulated other comprehensive income” in the consolidated balance sheets are reclassified into cost of sales when the forecasted transactions affect income. During the three months ended March 31, 2005, we recognized in “accumulated other comprehensive income” unrealized after-tax losses of $226 million on certain cash flow hedges, primarily related to forward sales of distillates and associated forward purchases of crude oil. During the three months ended March 31, 2006, there were no significant gains or losses recognized in “accumulated other comprehensive income.” No amounts related to cash flow hedges remain in “accumulated other comprehensive income” as of March 31, 2006. For the three months ended March 31, 2006 and 2005, there were no amounts reclassified from “accumulated other comprehensive income” into income as a result of the discontinuance of cash flow hedge accounting.
12. SEGMENT INFORMATION
Segment information for our two reportable segments, refining and retail, was as follows (in millions):
Three months ended March 31, 2006:
Operating revenues from external customers
Intersegment revenues
Operating income (loss)
Three months ended March 31, 2005:
Total assets by reportable segment were as follows (in millions):
December 31,
2005
Refining
Retail
Corporate
Total consolidated assets
The entire balance of goodwill as of March 31, 2006 and December 31, 2005 has been included in the total assets of the refining reportable segment.
13. STOCK-BASED COMPENSATION
As discussed in Note 2, on January 1, 2006, we adopted Statement No. 123R, which requires the expensing of the fair value of stock compensation awards. Prior to our adoption of Statement No. 123R, we accounted for our employee stock compensation plans using the intrinsic value method of accounting set forth in APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations as permitted by Statement No. 123, “Accounting for Stock-Based Compensation.”
Stock-based compensation expense recognized for the three months ended March 31, 2005 was $9 million, net of a $5 million tax benefit. Because we accounted for our employee stock compensation
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plans using the intrinsic value method, compensation cost was not recognized in the consolidated statement of income for the three months ended March 31, 2005 for our fixed stock option plans as all options granted had an exercise price equal to the market value of the underlying common stock on the date of grant. Had compensation cost for our fixed stock option plans been determined based on the grant-date fair value of awards consistent with the alternative method set forth in Statement No. 123, our net income applicable to common stock, net income and earnings per common share, both with and without dilution, for the three months ended March 31, 2005 would have been reduced to the pro forma amounts indicated in the following table (in millions, except per share amounts):
Net income applicable to common stock, as reported
Deduct: Compensation expense on stock options determined under fair value method for all awards, net of related tax effects
Pro forma net income applicable to common stock
Earnings per common share:
As reported
Pro forma
Net income, as reported
Pro forma net income
Earnings per common share – assuming dilution:
Subsequent to the adoption of Statement No. 123R, our total stock-based compensation expense recognized for the three months ended March 31, 2006 was $15 million, net of an $8 million tax benefit. We adopted the fair value recognition provisions of Statement No. 123R using the modified prospective application. Accordingly, we are recognizing compensation expense for all newly granted stock options and stock options modified, repurchased, or cancelled after January 1, 2006. In addition, compensation cost for the unvested portion of stock options and other awards that were outstanding as of January 1, 2006 is being recognized over the remaining vesting period based on the fair value at date of grant and the attribution approach utilized in determining the pro forma information reflected above.
Upon adoption of Statement No. 123R, compensation expense for stock options granted on or after January 1, 2006 is being recognized on a straight-line basis, and we have changed our attribution approach for new grants that have retirement-eligibility provisions from the nominal vesting period approach to the non-substantive vesting period approach. If the non-substantive vesting period approach had been used by us for awards granted prior to January 1, 2006, the impact on the pro forma net income applicable to common stock and pro forma net income amounts reflected above for the three months ended March 31, 2005, and the impact on net income applicable to common stock and net income for the three months ended March 31, 2006, would have been less than $1 million.
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We have various fixed and performance-based stock compensation plans under which awards may currently be granted, which are summarized as follows:
In addition, we formerly maintained other stock option plans under which previously granted stock options remain outstanding. No shares are available to be awarded under these plans.
Each of our current stock-based compensation arrangements is discussed below. The tax benefit realized for the tax deductions resulting from exercises and vestings under all of our stock compensation arrangements totaled $121 million and $19 million, respectively, for the three months ended March 31, 2006 and 2005.
Stock Options
Under the terms of our various stock option plans, the exercise price of options granted is not less than the fair market value of our common stock on the date of grant. Stock options become exercisable pursuant to the individual written agreements between the participants and us, usually in three or five equal annual installments beginning one year after the date of grant, with unexercised options generally expiring seven or ten years from the date of grant.
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A summary of the status of our stock option awards is presented in the table below (in millions, except per share amounts).
Number
of StockOptions
Weighted-
Average
Exercise
Price
Per Share
Remaining
Contractual
Term
Aggregate
Intrinsic
Value
Outstanding at January 1, 2006
Granted
Exercised
Forfeited
Outstanding at March 31, 2006
Exercisable at March 31, 2006
The weighted-average fair value of stock options granted during the years ended December 31, 2005, 2004 and 2003 was $18.80, $8.02 and $3.82 per stock option, respectively. The fair value of each stock option grant was estimated on the grant date using the Black-Scholes option-pricing model with the following assumptions:
Expected volatility
Expected dividend yield
Expected life (years)
Risk-free interest rate
As of March 31, 2006, there was $74 million of unrecognized compensation cost related to outstanding unvested stock option awards, which is expected to be recognized over a weighted-average period of approximately 1.5 years. The total intrinsic value of stock options exercised during the three months ended March 31, 2006 and 2005 was $104 million and $56 million, respectively. Cash received from stock option exercises for the three months ended March 31, 2006 and 2005 was $18 million and $13 million, respectively.
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Restricted Stock
Restricted stock is granted to employees and non-employee directors. Restricted stock vests in accordance with individual written agreements between the participants and us, usually in equal annual installments over a period of three or five years beginning one year after the date of grant. A summary of the status of our restricted stock awards is presented in the table below (in millions, except per share amounts).
Number of
Shares
Grant-Date
Fair Value
Nonvested shares at January 1, 2006
Vested
Nonvested shares at March 31, 2006
As of March 31, 2006, there was $39 million of unrecognized compensation cost related to outstanding unvested restricted stock awards. That cost is expected to be recognized over a weighted-average period of approximately four years.
Performance Awards
We grant performance awards to certain key employees which vest only upon the achievement of an objective performance measure. Performance awards granted are subject to vesting in three annual amounts. The portion of each year’s amount that vests is determined by our total shareholder return over a rolling three-year period compared to the total shareholder return of a defined peer group.
During the three months ended March 31, 2006, 78,660 performance awards were granted and no awards were forfeited. The weighted-average grant-date fair value of the awards granted during the three months ended March 31, 2006 was $58.81 per share, which was based on the market price of our common stock on the date of grant reduced by the discounted present value of expected dividends over the vesting period. The total fair value of performance awards that vested during the three months ended March 31, 2006 and 2005 was $193 million and $14 million, respectively.
Restricted Stock Units
As of March 31, 2006, 671,354 unvested restricted stock units were outstanding. Restricted stock units vest in equal annual amounts over a three-year or five-year period beginning one year after the date of grant. These restricted stock units are payable in cash based on the price of our common stock on the date of vesting, and therefore they are accounted for as liability-based awards under Statement No. 123R. No restricted stock units were granted or forfeited during the three months ended March 31, 2006. Based on the price of our common stock on March 31, 2006, the fair value of the unvested restricted stock units was $40 million, $13 million of which was recognized as of March 31, 2006.
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14. EMPLOYEE BENEFIT PLANS
The components of net periodic benefit cost related to our defined benefit plans were as follows for the three months ended March 31, 2006 and 2005 (in millions):
Other Postretirement
Benefit Plans
Components of net periodic benefit cost:
Service cost
Interest cost
Expected return on plan assets
Amortization of:
Prior service cost
Net loss
Net periodic benefit cost
Our anticipated contributions to our pension plans during 2006 have not changed from amounts previously disclosed in our consolidated financial statements for the year ended December 31, 2005. Our minimum required contribution to our qualified pension plans during 2006 under the Employee Retirement Income Security Act is less than $5 million. For the three months ended March 31, 2006 and 2005, we contributed $15 million and $12 million, respectively, to our qualified pension plans.
15. COMMITMENTS AND CONTINGENCIES
Accounts Receivable Sales Facility
As of March 31, 2006, we had an accounts receivable sales facility with a group of third-party financial institutions to sell on a revolving basis up to $1 billion of eligible trade receivables, which matures in August 2008. As of March 31, 2006 and December 31, 2005, the amount of eligible receivables sold to the third-party financial institutions was $1 billion.
Contingent Earn-Out Agreements
In both January 2006 and January 2005, we made previously accrued earn-out payments related to the acquisition of the St. Charles Refinery of $50 million.
The following table summarizes the aggregate payments we have made and payment limitations related to the following acquisitions (in millions).
Payments
Made Through
March 31, 2006
Annual
Maximum
Limit
Basis Petroleum, Inc.
St. Charles Refinery
Delaware City Refinery
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Insurance Recoveries
During the third quarter of 2005, certain of our refineries experienced business interruption losses associated with Hurricanes Katrina and Rita. As a result of these losses, we have submitted claims to our insurance carriers under our insurance policies. No amounts related to these potential business interruption insurance recoveries were recognized in our consolidated financial statements as of March 31, 2006.
Environmental Matters
The Environmental Protection Agency’s (EPA) Tier II Gasoline and Diesel Standards. The EPA’s Tier II gasoline and diesel standards, adopted under the Clean Air Act, phase in limitations on the sulfur content of gasoline (which began in 2004) and diesel fuel sold to highway consumers (beginning in June 2006). All of our refineries have implemented strategies to comply with the Tier II gasoline and diesel standards. We estimate that capital expenditures of approximately $1.3 billion will be required from 2006 through 2008 for our refineries to meet the Tier II specifications. This estimate includes amounts related to projects at three refineries to provide hydrogen necessary for removing sulfur from gasoline and diesel. We expect these cost estimates to change as additional engineering is completed and progress is made toward completion of these projects.
EPA’s Section 114 Initiative. Prior to the Premcor Acquisition, our Port Arthur, Memphis and Lima Refineries received information requests from the EPA pursuant to Section 114 of the Clean Air Act as part of the EPA’s National Petroleum Refinery Initiative to reduce air emissions (Initiative). We have been engaged in settlement discussions with the EPA concerning these three refineries and are working to finalize the terms of a consent decree with the EPA. We expect to incur penalties and related expenses in connection with a potential settlement, but we believe that any settlement penalties will be immaterial to our results of operations and financial position. We expect the potential settlement to require significant capital improvements or changes in operating parameters, or both, at the three refineries.
Litigation
MTBE Litigation
As of May 1, 2006, we were named as a defendant in 70 cases alleging liability related to MTBE contamination in groundwater. The plaintiffs are generally water providers, governmental authorities and private water companies alleging that refiners and marketers of MTBE and gasoline containing MTBE are liable for manufacturing or distributing a defective product. We have been named in these suits together with many other refining industry companies. We are being sued primarily as a refiner and marketer of MTBE and gasoline containing MTBE. We do not own or operate gasoline station facilities in most of the geographic locations in which damage is alleged to have occurred. The suits generally seek individual, unquantified compensatory and punitive damages, injunctive relief and attorneys’ fees. All but one of the cases are pending in federal court and will be consolidated for pre-trial proceedings in the U.S. District Court for the Southern District of New York (Multi-District Litigation Docket No. 1358,In re: Methyl-Tertiary Butyl Ether Products Liability Litigation). Valero agreed to settle the one remaining state court case for an immaterial amount. This agreement is subject to court approval. Four of the cases Valero is involved in have been selected by the court as focus cases for discovery and pre-trial motions. Activity in the “non-focus” cases is generally stayed pending certain determinations in the focus cases. We believe that we have strong defenses to these claims and are vigorously defending the cases. We believe that an adverse result in any one of these suits would not have a material effect on our results of operations or financial position. However, we believe that an adverse result in all or a substantial number of these cases could have a material effect on our results of operations and financial
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position. An estimate of the possible loss or range of loss from an adverse result in all or substantially all of these cases cannot reasonably be made.
Rosolowski v. Clark Refining & Marketing, Inc., et al., Judicial Circuit Court, Cook County, Illinois (Case No. 95-L 014703). We assumed this class action lawsuit in the Premcor Acquisition. This lawsuit, filed October 11, 1995, relates in part to a release to the atmosphere of spent catalyst containing low levels of heavy metals from the now-closed Blue Island, Illinois refinery on October 7, 1994. The release resulted in the temporary evacuation of certain areas near the refinery. The case was certified as a class action in 2000 with three classes: (i) persons purportedly affected by the October 7, 1994 catalyst release, but with no permanent health effects; (ii) persons with medical expenses for dependents purportedly affected by the October 7, 1994 release; and (iii) local residents claiming property damage or who have suffered loss of use and enjoyment of their property over a period of several years. Following three weeks of trial, on November 21, 2005, the jury returned a verdict for the plaintiffs of $80.1 million in compensatory damages and $40 million in punitive damages. In January 2006, we filed motions for new trial, remittitur and judgment notwithstanding the verdict, citing, among other things, rampant misconduct by plaintiffs’ counsel and improper class certification. We plan to pursue all of our appeals remedies, and we believe that we will prevail in reversing the verdict or reducing the jury’s award of damages. Accordingly, we do not believe that this matter will have a material effect on our financial position or results of operations.
Other Litigation
We are also a party to additional claims and legal proceedings arising in the ordinary course of business. We believe that there is only a remote likelihood that future costs related to known contingent liabilities related to these legal proceedings would have a material adverse impact on our consolidated results of operations or financial position.
16. CONDENSED CONSOLIDATING FINANCIAL INFORMATION
In conjunction with the Premcor Acquisition on September 1, 2005, Valero Energy Corporation has fully and unconditionally guaranteed the following debt of The Premcor Refining Group Inc. (PRG), a wholly owned subsidiary of Valero Energy Corporation:
In addition, PRG has fully and unconditionally guaranteed all of the outstanding debt issued by Valero Energy Corporation.
The following condensed consolidating financial information is provided for Valero and PRG as an alternative to providing separate financial statements for PRG for the periods subsequent to the Premcor Acquisition. The accounts for all companies reflected herein are presented using the equity method of accounting for investments in subsidiaries.
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Condensed Consolidating Balance Sheet as of March 31, 2006
(unaudited, in millions)
Valero
Energy
Corporation
Other
Non-Guarantor
Subsidiaries
Income tax receivable
Investment in Valero Energy affiliates
Long-term notes receivable from affiliates
Long-term debt and capital lease obligations, less current portion
Long-term notes payable to affiliates
Preferred stock
Common stock
Treasury stock
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Condensed Consolidating Balance Sheet as of December 31, 2005
(in millions)
25
Condensed Consolidating Statements of Income for the Three Months Ended March 31, 2006
Equity in earnings of subsidiaries
Other income, net
Income tax expense (1)
26
Condensed Consolidating Statements of Cash Flows for the Three Months Ended March 31, 2006
Net cash provided by (used in) operating activities
Net intercompany receipts
Net cash provided by (used in) investing activities
Net intercompany borrowings (repayments)
Other financing activities, net
Net cash provided by (used in) financing activities
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FORWARD-LOOKING STATEMENTS
This Form 10-Q, including without limitation our discussion below under the heading “Results of Operations - Outlook,” includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. You can identify our forward-looking statements by the words “anticipate,” “believe,” “expect,” “plan,” “intend,” “estimate,” “project,” “projection,” “predict,” “budget,” “forecast,” “goal,” “guidance,” “target,” “will,” “could,” “should,” “may” and similar expressions.
These forward-looking statements include, among other things, statements regarding:
We based our forward-looking statements on our current expectations, estimates and projections about ourselves and our industry. We caution that these statements are not guarantees of future performance and involve risks, uncertainties and assumptions that we cannot predict. In addition, we based many of these forward-looking statements on assumptions about future events that may prove to be inaccurate. Accordingly, our actual results may differ materially from the future performance that we have expressed or forecast in the forward-looking statements. Differences between actual results and any future performance suggested in these forward-looking statements could result from a variety of factors, including the following:
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Any one of these factors, or a combination of these factors, could materially affect our future results of operations and whether any forward-looking statements ultimately prove to be accurate. Our 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 statements. We do not intend to update these statements unless we are required by the securities laws to do so.
All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by the foregoing. We undertake no obligation to publicly release the results 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.
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Overview
Our operations are affected by:
Our profitability is substantially determined by the spread between the price of refined products and the price of crude oil, referred to as the “refined product margin.” Since up to 70% of our total crude oil throughput represents sour crude oil and acidic sweet crude oil feedstocks that are purchased at prices less than sweet crude oil, our profitability is also significantly affected by the spread between sweet crude oil and sour crude oil prices, referred to as the “sour crude oil discount.” The strong industry fundamentals we experienced throughout 2005 continued during the first quarter of 2006. During the first quarter of 2006, heavy industry-wide turnaround activity, the implementation of more restrictive sulfur regulations on gasoline and diesel, increased use of ethanol in the reformulated gasoline pool, and limited capacity expansions due to the high cost of environmental regulations resulted in tighter supplies of refined products and continuing strong margins. We also continued to benefit from the addition of the four Premcor refineries, which generated approximately $430 million of operating income with average throughput volumes of 736,000 barrels per day during the first quarter of 2006. The strong gasoline and distillate margins combined with the higher throughput volumes due to the Premcor Acquisition contributed to a significant increase in operating results in the first quarter of 2006 compared to the prior year, resulting in earnings per share of $1.32 for the first quarter of 2006, or a 38% increase over the $0.96 earnings per share reported for the first quarter of 2005.
During the first quarter of 2006, we had major planned turnaround activities at several of our refineries. The incremental throughput volumes from the Premcor refineries were partially offset by reduced throughput volumes resulting from these turnarounds.
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RESULTS OF OPERATIONS
First Quarter 2006 Compared to First Quarter 2005
Financial Highlights
(millions of dollars, except per share amounts)
Operating revenues (b)
Cost of sales (b)
Depreciation and amortization expense:
See the footnote references on page 34.
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Operating Highlights
(millions of dollars, except per barrel and per gallon amounts)
Refining:
Throughput margin per barrel (c)
Operating costs per barrel:
Depreciation and amortization
Total operating costs per barrel
Throughput volumes (thousand barrels per day):
Feedstocks:
Heavy sour crude
Medium/light sour crude
Acidic sweet crude
Sweet crude
Residuals
Other feedstocks
Total feedstocks
Blendstocks and other
Total throughput volumes
Yields (thousand barrels per day):
Gasolines and blendstocks
Distillates
Petrochemicals
Other products (d)
Total yields
Retail – U.S.:
Company-operated fuel sites (average)
Fuel volumes (gallons per day per site)
Fuel margin per gallon
Merchandise sales
Merchandise margin (percentage of sales)
Margin on miscellaneous sales
Retail – Northeast:
Fuel volumes (thousand gallons per day)
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Refining Operating Highlights by Region (e)
(millions of dollars, except per barrel amounts)
Gulf Coast:
Throughput volumes (thousand barrels per day) (f)
Mid-Continent (g):
Northeast:
West Coast:
Throughput volumes (thousand barrels per day)
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Average Market Reference Prices and Differentials (h)
(dollars per barrel)
West Texas Intermediate (WTI) crude oil
WTI less sour crude oil at U.S. Gulf Coast (i)
WTI less Alaska North Slope (ANS) crude oil
WTI less Maya crude oil
Products:
U.S. Gulf Coast:
Conventional 87 gasoline less WTI
No. 2 fuel oil less WTI
Propylene less WTI
U.S. Mid-Continent:
Low-sulfur diesel less WTI
U.S. Northeast:
Lube oils less WTI
U.S. West Coast:
CARBOB 87 gasoline less ANS
Low-sulfur diesel less ANS
The following notes relate to references on pages 31 through 34.
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General
Operating revenues increased 40% for the first quarter of 2006 compared to the first quarter of 2005 primarily as a result of significantly higher refined product prices combined with additional throughput volumes from the former Premcor refinery operations. Operating income and net income for the three months ended March 31, 2006 increased significantly compared to the three months ended March 31, 2005. Operating income increased $487 million, or 58%, and net income increased $315 million, or 59%, from the first quarter of 2005 to the first quarter of 2006 primarily due to a $528 million increase in refining segment operating income and a $7 million increase in retail operating income, partially offset by a $48 million increase in general and administrative expenses (including corporate depreciation and amortization expense).
Operating income for our refining segment increased from $944 million for the first quarter of 2005 to $1.5 billion for the first quarter of 2006, resulting from a 30% increase in throughput volumes and an increase in refining throughput margin of $1.71 per barrel, or 20%, partially offset by increased refining operating expenses (including depreciation and amortization expense) of $424 million.
Refining total throughput margin for the first quarter of 2006 increased primarily due to the following factors:
Partially offsetting the above increases in throughput margin were lower margins on other refined products such as petroleum coke, sulfur and propylene due to a significant increase in the price of crude oil from the first quarter of 2005 to the first quarter of 2006. In addition, discounts on sour crude oil feedstocks during the first quarter of 2006 decreased slightly compared to the very strong discounts in the first quarter of 2005, but remained wide due to continued ample supplies of sour crude oils and heavy sour residual fuel oils on the world market. Discounts on sour crude oil feedstocks also continued to benefit from increased demand for sweet crude oil resulting from the lower sulfur specifications in gasoline and a global increase in refined product demand, particularly in Asia, which has resulted in higher utilization rates by refineries that require sweet crude oil as feedstock.
Refining operating expenses, excluding depreciation and amortization expense, were 60% higher for the quarter ended March 31, 2006 compared to the quarter ended March 31, 2005, due primarily to the Premcor Acquisition on September 1, 2005 and increases in maintenance expense, employee compensation and related benefits, catalyst and chemicals, and outside services. Refining depreciation and amortization expense increased 51% from the first quarter of 2005 to the first quarter of 2006 primarily due to the Premcor Acquisition, increased turnaround and catalyst amortization, and the implementation of new capital projects.
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Retail operating income was $21 million for the quarter ended March 31, 2006 compared to $14 million for the quarter ended March 31, 2005. This 50% increase in operating income was primarily attributable to increased domestic fuel volumes combined with higher U.S. retail fuel margins. This increase in operating income was partially offset by increased selling expenses in our retail operations mainly as a result of higher credit card processing fees attributable to higher retail fuel prices.
Corporate Expenses and Other
General and administrative expenses, including corporate depreciation and amortization expense, increased $48 million from the first quarter of 2005 to the first quarter of 2006. The increase was primarily due to increases in employee compensation and benefits, expenses in 2006 attributable to Premcor headquarters personnel, and the favorable resolution of a California excise tax dispute in the first quarter of 2005.
Interest and debt expense incurred increased from the first quarter of 2005 to the first quarter of 2006 primarily as a result of interest expense incurred on the debt assumed in the Premcor Acquisition. However, the increased interest incurred was more than offset by increased capitalized interest due to an increase in capital projects, including those at the four former Premcor refineries.
Income tax expense increased $181 million from the first quarter of 2005 to the first quarter of 2006 mainly as a result of higher operating income. Our effective tax rate for the quarter ended March 31, 2006 increased from the quarter ended March 31, 2005 as a lower percentage of our pre-tax income was contributed by the Aruba Refinery, the operations of which are non-taxable in Aruba through December 31, 2010.
OUTLOOK
Since the end of the first quarter of 2006, refining industry fundamentals have remained positive, resulting in a continuation of favorable refined product margins and sour crude oil discounts. For example, Gulf Coast gasoline margins for April 2006 averaged $23 per barrel compared to $12 per barrel in April 2005 and low-sulfur diesel margins averaged nearly $19 per barrel in April 2006 compared to $11 per barrel a year ago. Thus far during 2006, domestic gasoline demand has increased slightly compared to the same period in 2005. We believe refined product margins will remain favorable for the remainder of 2006 due to sustained refined product demand and supply constraints resulting from changing specifications for gasoline and diesel.
Sour crude oil discounts remained wide during the month of April 2006 and are expected to remain favorable through the summer due to ample supplies of sour crude oil and continued strong demand for sweet crude oil. As light product demand has grown, worldwide refinery production rates have also increased, leading to higher production of residual fuel oil (resid) as a by-product of the refining process. Because resid can compete with certain heavy sour crude oils as a refinery feedstock, this also serves to widen the discounts for heavy sour crude oils. The global movement to lower-sulfur fuels has contributed to increased demand for sweet crude oils rather than sour crude oils to meet those more stringent specifications. In addition, higher light product margins increase sweet crude oil demand because sweet crude oils have a higher yield of light products.
Operationally, we expect to benefit during the remainder of 2006 from the completion of significant first quarter turnaround and capital improvement projects, as well as additional strategic projects that we expect to complete during the remainder of 2006, including a 75,000 barrel-per-day expansion project at
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our Port Arthur Refinery. In addition, we will benefit during 2006 from the full-year effect of the approximate 800,000 barrels per day of throughput capacity from the Premcor Acquisition.
LIQUIDITY AND CAPITAL RESOURCES
Cash Flows for the Three Months Ended March 31, 2006 and 2005
Net cash provided by operating activities for the three months ended March 31, 2006 was $1.7 billion compared to $804 million for the three months ended March 31, 2005. The increase in cash generated from operating activities was due primarily to the significant increase in operating income discussed above under “Results of Operations” and $537 million of cash provided by working capital changes in the first quarter of 2006. Changes in cash provided by or used for working capital during the first three months of 2006 and 2005 are shown in Note 10 of Condensed Notes to Consolidated Financial Statements. Working capital was positively impacted in the first quarter of 2006 by timing differences in the billing and collection of accounts receivable in March 2006 compared to December 2005.
The net cash generated from operating activities during the first quarter of 2006, combined with $32 million of proceeds from the issuance of common stock related to our benefit plans and an $89 million benefit from tax deductions in excess of recognized stock compensation cost were used mainly to:
As discussed above, net cash provided by operating activities during the first three months of 2005 was $804 million. The net cash generated from operating activities, combined with $26 million of proceeds from the issuance of common stock related to our benefit plans and $178 million of available cash on hand, were used to:
Capital Investments
During the three months ended March 31, 2006, we expended $775 million for capital expenditures and $199 million for deferred turnaround and catalyst costs. Capital expenditures for the three months ended March 31, 2006 included $398 million of costs related to environmental projects.
In connection with our acquisitions of Basis Petroleum, Inc. in 1997 and the St. Charles Refinery in 2003, the sellers are entitled to receive payments in any of the ten years and seven years, respectively, following these acquisitions if certain average refining margins during any of those years exceed a specified level. In connection with the Premcor Acquisition in 2005, we assumed Premcor’s obligation under an earn-out contingency agreement related to Premcor’s acquisition of the Delaware City Refinery from Motiva Enterprises LLC (Motiva). Under this agreement, Motiva is entitled to receive two separate annual earn-out contingency payments depending on (a) the amount of crude oil processed at the refinery and the level
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of refining margins through May 2007, and (b) the achievement of certain performance criteria at the gasification facility through May 2006. Any payments due under these earn-out arrangements are limited based on annual and aggregate limits. In January 2006, we made an earn-out payment of $50 million related to the St. Charles Refinery. Based on margin levels through April 2006, earn-out payments of $26 million (the maximum remaining payment based on the aggregate limitation under the agreement) related to the acquisition of Basis Petroleum, Inc. and $25 million related to the acquisition of the Delaware City Refinery will be due in the second quarter of 2006.
For 2006, we expect to incur approximately $3.5 billion for capital investments, including approximately $3.0 billion for capital expenditures (approximately $1.4 billion of which is for environmental projects) and approximately $520 million for deferred turnaround and catalyst costs. The capital expenditure estimate excludes anticipated expenditures related to the earn-out contingency agreements discussed above and strategic acquisitions. We continuously evaluate our capital budget and make changes as economic conditions warrant.
Contractual Obligations
As of March 31, 2006, our contractual obligations included long-term debt, capital lease obligations, operating leases and purchase obligations. Except as discussed below, there were no significant changes to our contractual obligations during the three months ended March 31, 2006.
During March 2006, we made a scheduled debt repayment of $220 million related to our 7.375% notes.
As of March 31, 2006, our short-term and long-term purchase obligations increased by approximately $1.5 billion from the amount reported as of December 31, 2005, resulting primarily from both new crude oil supply contracts entered into in the first quarter of 2006 and higher crude oil prices as of March 31, 2006.
Our agreements do not have rating agency triggers that would automatically require us to post additional collateral. However, in the event of certain downgrades of our senior unsecured debt to below investment grade ratings by Moody’s Investors Service and Standard & Poor’s Ratings Services, the cost of borrowings under some of our bank credit facilities and other arrangements would increase. Following the completion of the Premcor Acquisition, Standard & Poor’s Ratings Services affirmed its rating of our senior unsecured debt of BBB minus and recently changed our outlook from negative to stable while Moody’s Investors Service affirmed our senior unsecured debt rating of Baa3 with a stable outlook. In February 2006, Fitch Ratings upgraded its rating of our senior unsecured debt to BBB with a stable outlook.
Other Commercial Commitments
As of March 31, 2006, our committed lines of credit included:
Borrowing
Capacity
5-year revolving credit facility
Canadian revolving credit facility
As of March 31, 2006, we had $302 million of letters of credit outstanding under our uncommitted short-term bank credit facilities, $316 million of letters of credit outstanding under our committed facilities and Cdn. $8 million of letters of credit outstanding under our Canadian facility.
As defined under our revolving bank credit facilities, our debt-to-capitalization ratio (net of cash) was 23.5% as of March 31, 2006 compared to 24.8% as of December 31, 2005.
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Proposed Sale of Investment in Valero L.P.
On March 31, 2006, Valero GP Holdings, LLC, an indirect wholly owned subsidiary of Valero, filed a registration statement on Form S-1 with the SEC for an initial public offering of approximately 37% of its units representing limited liability company interests. Subsidiaries of Valero GP Holdings, LLC own the general partner interest, the incentive distribution rights and a 21.4% limited partner interest in Valero L.P. After this initial public offering, if consummated, subsidiaries of Valero will hold an approximate 63% ownership interest in Valero GP Holdings, LLC. It is our intention to further reduce and ultimately sell all of our interest in Valero GP Holdings, LLC, pending market conditions. We expect to use funds from this offering for general corporate purposes, which may include acquisitions, stock repurchases and debt reduction.
Although our expected minimum required contribution to our qualified pension plans during 2006 is less than $5 million under the Employee Retirement Income Security Act, we expect to contribute approximately $65 million to our qualified pension plans during 2006. During the first quarter of 2006, we contributed $15 million to our qualified pension plans.
We are 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 gasolines and distillates. Because environmental laws and regulations are becoming more complex and stringent and new environmental laws and regulations are continuously being enacted or proposed, the level of future expenditures required for environmental matters could increase in the future. In addition, any major upgrades in any of our refineries could require material additional expenditures to comply with environmental laws and regulations. For additional information regarding our environmental matters, see Note 15 of Condensed Notes to Consolidated Financial Statements.
We believe that we have sufficient funds from operations and, to the extent necessary, from the public and private capital markets and bank markets, to fund our ongoing operating requirements. We expect that, to the extent necessary, we 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 us.
OFF-BALANCE SHEET ARRANGEMENTS
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CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in accordance with United States generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Our critical accounting policies are disclosed in our Annual Report on Form 10-K for the year ended December 31, 2005.
As discussed in Note 2 of Condensed Notes to Consolidated Financial Statements, certain new financial accounting pronouncements have been issued which either have already been reflected in the accompanying consolidated financial statements, or will become effective for our financial statements at various dates in the future.
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COMMODITY PRICE RISK
The following tables provide information about our derivative commodity instruments as of March 31, 2006 and December 31, 2005 (dollars in millions, except for the weighted-average pay and receive prices as described below), including:
The gain or loss on a derivative instrument designated and qualifying as a fair value hedge and the offsetting loss or gain on the hedged item are recognized currently in income in the same period. The effective portion of the gain or loss on a derivative instrument designated and qualifying as a cash flow hedge is reported as a component of “other comprehensive income” and is recorded in income in the same period or periods during which the hedged forecasted transaction affects income. The remaining ineffective portion of the gain or loss on the cash flow derivative instrument, if any, is recognized currently in income. For our economic hedges and for derivative instruments entered into by us for trading purposes, the derivative instrument is recorded at fair value and changes in the fair value of the derivative instrument are recognized currently in income.
The following tables include only open positions at the end of the reporting period, and therefore do not include amounts related to certain closed cash flow hedges for which the gain or loss remains in “accumulated other comprehensive income” pending consummation of the forecasted transactions.
Contract volumes are presented in thousands of barrels (for crude oil and refined products) or in billions of British thermal units (for natural gas). The weighted-average pay and receive prices represent amounts per barrel (for crude oil and refined products) or amounts per million British thermal units (for natural gas). Volumes shown for swaps represent notional volumes, which are used to calculate amounts due under the agreements. For futures, the contract value represents the contract price of either the long or short position multiplied by the derivative contract volume, while the market value amount represents the period-end market price of the commodity being hedged multiplied by the derivative contract volume. The fair value for futures, swaps and options represents the fair value of the derivative contract. The fair value for swaps represents the excess of the receive price over the pay price multiplied by the notional contract volumes. For futures and options, the fair value represents (i) the excess of the market value amount over the contract amount for long positions, or (ii) the excess of the contract amount over the market value amount for short positions. Additionally, for futures and options, the weighted-average pay price represents the contract price for long positions and the weighted-average receive price represents the contract price for short positions. The weighted-average pay price and weighted-average receive price for options represents their strike price.
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Contract
Volumes
Wtd Avg
Pay
Receive
Market
Pre-tax
Fair
Fair Value Hedges:
Futures – long:
2006 (crude oil and refined products)
Futures – short:
Cash Flow Hedges:
Economic Hedges:
Swaps – long:
Swaps – short:
2006 (natural gas)
2007 (natural gas)
2007 (crude oil and refined products)
Options – short:
Trading Activities:
Options – long:
Total open position pre-tax fair value
42
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INTEREST RATE RISK
The following table provides information about our long-term debt and interest rate derivative instruments (dollars in millions), all of which are sensitive to changes in interest rates. For long-term debt, principal cash flows and related weighted-average interest rates by expected maturity dates are presented. For interest rate swaps, the table presents notional amounts and weighted-average interest rates by expected (contractual) maturity dates. Notional amounts are used to calculate the contractual payments to be exchanged under the contract. Weighted-average floating rates are based on implied forward rates in the yield curve at the reporting date.
There-
after
Long-term Debt:
Fixed rate
Average interest rate
Interest Rate Swaps
Fixed to Floating:
Notional amount
Average pay rate
Average receive rate
Effective May 1, 2006, we terminated our $875 million of outstanding interest rate swap contracts for $55 million. Substantially all of this payment will be deferred and amortized over the remaining lives of the debt instruments that were being hedged.
FOREIGN CURRENCY RISK
As of March 31, 2006, we had commitments to purchase $329 million of U.S. dollars. Our market risk was minimal on these contracts, as they matured on or before April 28, 2006.
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Item 4. Controls and Procedures.
(a) Evaluation of disclosure controls and procedures.
Our management has evaluated, with the participation of our principal executive officer and principal financial officer, the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report, and has concluded that our disclosure controls and procedures were operating effectively as of March 31, 2006.
(b) Changes in internal control over financial reporting.
There has been no change in our internal control over financial reporting that occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II – OTHER INFORMATION
Item 1. Legal Proceedings.
The information below describes new proceedings or material developments in proceedings that we previously reported in our annual report on Form 10-K for the year ended December 31, 2005.
Environmental Enforcement Matters
While it is not possible to predict the outcome of the following environmental proceedings, if any one or more of them were decided against Valero, we believe that there would be no material effect on our consolidated financial position. Nevertheless, we are reporting these proceedings to comply with SEC regulations, which require us to disclose proceedings arising under federal, state or local provisions regulating the discharge of materials into the environment or protecting the environment if we reasonably believe that such proceedings will result in monetary sanctions of $100,000 or more.
Bay Area Air Quality Management District (BAAQMD) (Benicia Refinery) (this matter was last reported in our Form 10-K for the year ended December 31, 2005). In 2005, the BAAQMD issued 28 violation notices (VNs) for various incidents at our Benicia Refinery and asphalt plant, including alleged excess emissions, recordkeeping discrepancies and other matters. No penalties have been assessed for the VNs. We are negotiating a settlement with the BAAQMD for these matters. Thus far in 2006, the BAAQMD has issued an additional 11 VNs for these facilities containing allegations similar to the 2005 VNs. We plan to pursue settlement of the 2006 VNs.
City of Houston and Texas Commission on Environmental Quality (TCEQ) (Houston Refinery). In January 2006, the City of Houston issued a notice of enforcement to our Houston Refinery alleging violations of the Texas Clean Air Act and certain TCEQ regulations for past emission events that we self-reported. Subsequent discussions with the City indicate that we could be subject to penalties in excess of $100,000 to settle this matter. In March 2006, the TCEQ issued intervening notices of enforcement pertaining to the same emission events. Valero is negotiating with the City of Houston and the TCEQ to resolve this matter.
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Delaware Department of Natural Resources and Environmental Control (DDNREC) (Delaware City Refinery) (this matter was last reported in our Form 10-K for the year ended December 31, 2005). The DDNREC had issued several VNs to the Delaware City Refinery since Premcor’s acquisition of the refinery in May 2004 alleging excess air emissions and failure to obtain a state construction permit. We settled all but two of these VNs with the DDNREC in the first quarter of 2006.
New Jersey Department of Environmental Protection (NJDEP) (Paulsboro Refinery) (this matter was last reported in our Form 10-K for the year ended December 31, 2005). We are subject to 11 outstanding air-related Administrative Order and Notice of Civil Administrative Penalty Assessments (Notices) issued by the NJDEP relating to our Paulsboro Refinery. The Notices propose an aggregate penalty of $289,800. We have appealed these Notices.
South Coast Air Quality Management District (SCAQMD) (Wilmington Refinery) (this matter was last reported in our Form 10-K for the year ended December 31, 2005). The SCAQMD had issued 24 VNs to our Wilmington Refinery since May 2003 for alleged excess emissions and one permitting discrepancy. We settled all 24 VNs with the SCAQMD in the first quarter of 2006.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
(a) Unregistered Sales of Equity Securities. None.
(b) Use of Proceeds. Not applicable.
(c) Issuer Purchases of Equity Securities. The following table discloses purchases of shares of Valero’s common stock made by us or on our behalf for the periods shown below.
Period
Total Number of
Shares Purchased (1)
Average Price
Paid per Share
Shares Purchased
as Part of Publicly
Announced Plansor Programs (2)
Maximum Number (or
Approximate Dollar
Value) of Shares that May
Yet Be Purchased Under
the Plans or Programs (2)
January 2006
February 2006
March 2006
Total
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Item 6. Exhibits.
Description
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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.
(Registrant)
/s/ Michael S. Ciskowski
Executive Vice President and
Chief Financial Officer
Date: May 9, 2006
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