FORM 10-K

(Mark One)

For the fiscal year ended December 31, 2003

OR

For the transition period from             to

Commission file number 1-13175

VALERO ENERGY CORPORATION

Registrant’s telephone number, including area code (210) 370-2000

Securities registered pursuant to Section 12(b) of the Act: Common stock, $0.01 par value, and Preferred Share Purchase Rights, listed on the New York Stock Exchange.

Securities registered pursuant to Section 12(g) of the Act: None.

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [  ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [X]   No   [   ]

The aggregate market value of the voting and non-voting common stock held by non-affiliates was approximately $4.1 billion based on the last sales price quoted as of June 30, 2003, the last business day of the registrant’s most recently completed second fiscal quarter.

As of February 29, 2004, 129,889,750 shares of the registrant’s common stock were issued and outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Valero intends to file with the Securities and Exchange Commission before April 30, 2004 a definitive Proxy Statement for Valero’s Annual Meeting of Stockholders scheduled for April 29, 2004, at which directors of Valero will be elected. Portions of the 2004 Proxy Statement are incorporated by reference in Part III of this Form 10-K and are deemed to be a part of this report.

Copies of all documents incorporated by reference, other than exhibits to such documents, will be provided without charge to each person who receives a copy of this Form 10-K upon written request to Jay D. Browning, Vice President and Corporate Secretary, Valero Energy Corporation, P.O. Box 500, San Antonio, Texas 78292-0500.

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CONTENTS

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CAUTIONARY STATEMENTS RELEVANT TO FORWARD-LOOKING INFORMATION FOR THE PURPOSE OF SAFE HARBOR PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995.

This Form 10-K contains certain estimates, predictions, projections, assumptions 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 in this report. These forward-looking statements generally can be identified by the words “anticipate,” “believe,” “expect,” “plan,” “intend,” “estimate,” “project,” “budget,” “forecast,” “will,” “could,” “should,” “may” and similar expressions.

Some important factors (but not necessarily all factors) that could affect Valero’s sales, growth, profitability and operating results, or that otherwise could cause actual results to differ materially from those forecasted by Valero are discussed in (a) Part I of this report under the headings “Competition” and “Environmental Matters,” (b) Part II of this report under the heading “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the caption “Forward-Looking Statements,” and (c) Valero’s other filings with the Securities and Exchange Commission. Valero does not intend to update these statements unless the securities laws require Valero to do so, and Valero does not undertake to release publicly the result of any revisions to any forward-looking statements that may be made to reflect events or circumstances after the date of this Form 10-K or to reflect the occurrence of unanticipated events.

Valero is also a leading marketer of refined products. Valero markets branded and unbranded refined products on a wholesale basis in the United States and Canada through an extensive bulk and rack marketing network. Valero also sells refined products through a network of more than 4,500 retail and wholesale branded outlets in the United States, Canada and Aruba. Valero’s retail operations include approximately 1,600 company- operated sites that sell transportation fuels and convenience store merchandise. Valero’s primary wholesale and retail brand names include Diamond Shamrock ^® , Shamrock ^® , Ultramar ^® , Valero ^® and Beacon ^® .

Through agreements with Valero L.P., Valero also has access to a logistics system that complements Valero’s refining and marketing assets primarily in the U.S. Gulf Coast, West Coast and Mid-Continent regions. Valero owns approximately 46% (including the 2% general partner interest) of Valero L.P., a master limited partnership that owns and operates crude oil pipelines, crude oil and intermediate feedstock storage facilities, and refined product pipelines and terminals primarily in Texas, California, Oklahoma, New Mexico and Colorado. Limited partner units of Valero L.P. are listed on the NYSE under the symbol “VLI.”

RECENT DEVELOPMENTS

Aruba Refinery. On March 5, 2004, Valero acquired El Paso Corporation’s 315,000 BPD Aruba refinery and certain related businesses. Valero paid $465 million for the refinery and related marine, bunkering and marketing operations, and $162 million for working capital. The working capital amount excludes certain inventories owned by a third-party marketing firm under an existing agreement, which Valero plans to acquire upon termination of such agreement (which will occur on or about May 4, 2004) for an amount estimated to be approximately $40 million based on volumes and prices as of March 4, 2004. The refinery is located on the island of Aruba in the Caribbean Sea. It generally processes heavy, sour crude oil, and produces a variety of gasoline blendstocks, intermediate feedstocks and finished distillate products. Valero plans to use significant amounts of the refinery’s feedstock production for processing in Valero’s other refineries in the Gulf Coast, West Coast and Northeast regions. The Aruba Refinery receives crude oil by ship at its two deepwater marine docks which can berth ultra-large crude carriers. The refinery’s products are delivered by ship into markets in the U.S. Gulf Coast, Florida, the New York Harbor and the Caribbean. Valero financed the acquisition with $200 million in cash, approximately $21 million in borrowings under its existing credit facilities, and approximately $406 million in net proceeds from the issuance of common equity through a public offering in February 2004. The additional inventory to be purchased from the third-party marketing firm described above will be funded through borrowings under Valero’s existing credit facilities.

St. Charles Refinery. Effective July 1, 2003, Valero purchased a refinery in St. Charles Parish, Louisiana, from Orion Refining Corporation. The refinery’s total feedstock throughput capacity at the end of 2003 was approximately 215,000 BPD. The purchase price for the refinery was $400 million, plus approximately $149 million for refinery hydrocarbon inventories. Consideration for the purchase, including various transaction costs incurred and warehouse inventories acquired, consisted of $309 million in cash and $250 million stated value of 2% mandatory convertible preferred stock (10 million shares with a stated value of $25.00 per share). See Notes 2 and 15 of Notes to Consolidated Financial Statements for a further discussion of the acquisition and issuance of preferred stock.

Cameron Highway Oil Pipeline Project. Effective July 10, 2003, Valero and GulfTerra Energy Partners, L.P. (GulfTerra, formerly El Paso Energy Partners, L.P.) each became a 50% interest owner in the Cameron Highway Oil Pipeline Company, a general partnership formed to construct and operate a crude oil pipeline (the Cameron Highway Oil Pipeline Project). The project involves the construction and operation of a 390-mile crude oil pipeline that is expected to deliver up to 500,000 BPD from the Gulf of Mexico to the major refining areas of Port Arthur and Texas City, Texas. GulfTerra will build and operate the pipeline, which is scheduled for completion during the third quarter of 2004. For the year ended December 31, 2003, Valero’s investment

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in the Cameron Highway Oil Pipeline Project totaled $106.1 million. Financing for completion of the pipeline is provided pursuant to nonrecourse loans made by financial institutions to the partnership.

Valero L.P. Effective March 18, 2003, Valero L.P. issued 5,750,000 common units to the public for aggregate proceeds of approximately $211 million and completed a private placement of $250 million of debt. The net proceeds from those offerings, combined with borrowings under Valero L.P.’s credit facility, were used to fund a redemption of common units from Valero and the acquisition of certain storage tanks and a pipeline system from Valero. On March 18, 2003, Valero L.P. redeemed approximately 3.8 million of its common units from Valero, which, combined with the common unit issuance, reduced Valero’s ownership of Valero L.P. from approximately 73% to 49.5% at that time. On the same date, Valero L.P. also amended its partnership agreement to state that the general partner of Valero L.P. may be removed by the vote of the holders of at least 58% of Valero L.P.’s common and subordinated units, excluding the units held by affiliates of its general partner.

As a result of the partnership agreement changes and the issuance and redemption of Valero L.P. common units on March 18, 2003, Valero ceased consolidation of Valero L.P. as of that date, and began using the equity method to account for its investment in Valero L.P. Following the equity and debt offerings and the common unit redemption discussed above, Valero contributed to Valero L.P. certain crude oil and intermediate feedstock storage tanks for approximately $200 million in cash. Valero also contributed to Valero L.P. a refined products pipeline system for approximately $150 million in cash. In connection with these contributions, Valero entered into certain throughput, handling, terminalling and service agreements with Valero L.P.

In March 2004, various amendments to Valero L.P.’s partnership agreement were approved. On March 11, 2004, in an effort to encourage additional investment in Valero L.P., the board of directors of Valero agreed that the general partner’s incentive distribution provided for in Valero L.P.’s partnership agreement would be capped at 25%. In addition, effective March 11, 2004, Valero L.P. amended its partnership agreement to reduce the minimum vote required to remove the general partner from 58% to a majority of Valero L.P.’s outstanding common and subordinated units, excluding the units held by affiliates of Valero. Valero’s investment in and transactions with Valero L.P. are discussed further in Note 9 of Notes to Consolidated Financial Statements.

SEGMENTS

Valero’s reportable business segments are refining and retail. Valero’s refining segment includes refining operations, wholesale marketing, product supply and distribution, and transportation operations. The refining segment is segregated geographically into the Gulf Coast, Mid-Continent, West Coast and Northeast regions.

Valero’s retail segment includes company-operated convenience stores, Canadian dealers/jobbers, truckstop facilities, cardlock facilities and home heating oil operations. The retail segment is also segregated geographically. Valero’s retail operations in the northeastern United States (which comprised a home heating oil business that was sold in July 2003) combined with its retail operations in eastern Canada are referred to as the Northeast System. Valero’s remaining retail operations in the United States are referred to as the U.S. System. See Note 21 of Notes to Consolidated Financial Statements for financial information about Valero’s segments.

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VALERO’S OPERATIONS

REFINING

As of December 31, 2003, Valero’s refining operations included 14 refineries in the United States and Canada with a combined total throughput capacity of approximately 2.1 million BPD. The following table lists the location of each of these refineries and its respective feedstock throughput capacity. These capacities exclude throughput enhancements completed after December 31, 2003.

As of 12-31-2003

Valero processes a wide slate of feedstocks, including sour crude oils, intermediates and resid which can typically be purchased at a discount to West Texas Intermediate, a benchmark crude oil. In 2003, sour crude oils and resid represented 49% of Valero’s feedstock slate, sweet crude oils represented 35%, and the remaining 16% was composed of blendstocks and other feedstocks.

Valero’s refineries produce gasolines, distillates, asphalt and other refined products. In 2003, gasolines and blendstocks represented 54% of Valero’s refined product slate. Distillates – such as home heating oil, diesel fuel and jet fuel – represented 28%, while asphalt, lubricants, petrochemicals and other heavy products comprised the remaining 18%. Of the gasoline that Valero produces, about 30% is reformulated gasoline and CARB gasoline, which sell at a premium over conventional grades of gasoline. About 80% of Valero’s distillate slate is low-sulfur diesel, CARB diesel and jet fuel, which sell at a premium over high-sulfur heating oil.

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      GULF COAST

Valero’s Gulf Coast refining region includes the Corpus Christi East and West Refineries, the Texas City Refinery, the St. Charles Refinery, the Houston Refinery, the Three Rivers Refinery and the Krotz Springs Refinery. The following table presents the percentages of principal feedstock charges and product yields (on a combined basis) for the seven refineries in this region for the year ended December 31, 2003.

Combined Gulf Coast Region Feedstocks and Products
2003 Actual

Corpus Christi East and West Refineries . The Corpus Christi East and West Refineries are located along the Corpus Christi Ship Channel on the Texas Gulf Coast. Valero’s flagship West Refinery is a highly complex refinery that specializes in processing primarily lower-cost sour crude oil and residual fuel oil (resid) into premium products such as RFG and RBOB. ¹ The East Refinery is also a complex refinery that processes heavy, high-sulfur crude oil into conventional gasoline, diesel, jet fuel, asphalt, aromatics and other light products. Valero has been operating the East Refinery since 2001, and has substantially integrated the operations of the West Refinery and the East Refinery, allowing for the transfer of various feedstocks and blending components between the two refineries and the sharing of resources. The refineries typically receive and deliver feedstocks and products by tanker and barge via deepwater docking facilities along the Corpus Christi Ship Channel. In addition, the facility has an eight-bay truck rack for servicing local markets. The refineries use the Colonial, Explorer, Valley and other major pipelines – including Valero L.P.’s pipelines – for distribution of refined products.

Texas City Refinery . The Texas City Refinery is located approximately 40 miles southeast of Houston on the Texas City Ship Channel. The Texas City Refinery processes primarily sour crude oils into a wide slate of products. A new 45,000 BPD coking unit and related facilities began operations at the refinery in the fourth quarter of 2003, and enables the refinery to process heavier, lower-cost crude oils. The refinery typically receives and delivers its feedstocks and products by tanker and barge via deepwater docking facilities along the Texas City Ship Channel and also has access to the Colonial, Explorer and TEPPCO pipelines for distribution of its products.

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St. Charles Refinery . The St. Charles Refinery is located approximately 15 miles from New Orleans along the Mississippi River. The refinery processes sour crude oils and other feedstocks into a high percentage of gasoline, distillates and other light products. The refinery receives crude oil over five marine docks and has access to the Louisiana Offshore Oil Port where it can receive crude oil through a 24-inch pipeline. Finished products can be shipped over these docks or by pipeline into either the Plantation or Colonial pipeline network for distribution to the eastern United States.

Houston Refinery . The Houston Refinery is located on the Houston Ship Channel. It generally processes sour crude oils and low-sulfur resid into conventional gasoline and distillates. The plant also produces roofing-grade asphalt. The refinery typically receives its feedstocks via tanker at deepwater docking facilities along the Houston Ship Channel. The refinery primarily delivers its products through major refined-product pipelines, including the Colonial, Explorer and TEPPCO pipelines.

Three Rivers Refinery . The Three Rivers Refinery is located in South Texas between Corpus Christi and San Antonio. It generally processes heavy sweet and sour crude oils into conventional gasoline and distillates. The Three Rivers Refinery has access to crude oil from foreign sources delivered to the Texas Gulf Coast at Corpus Christi as well as crude oil from domestic sources through third-party pipelines. A 70-mile pipeline that can deliver 120,000 BPD of crude oil connects the Three Rivers Refinery to Corpus Christi. Valero distributes refined products produced at this refinery primarily through pipelines owned by Valero L.P.

Krotz Springs Refinery . The Krotz Springs Refinery is located between Baton Rouge and Lafayette, Louisiana on the Atchafalaya River. It generally processes sweet crude oils (received primarily by pipeline and barge) into conventional gasoline and distillates. The refinery’s location provides access to upriver markets on the Mississippi River, and its docking facilities along the Atchafalaya River are sufficiently deep to allow barge access. The facility also uses the Colonial pipeline to transport products to markets in the Southeast and Northeast.

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      WEST COAST

Valero’s West Coast refining region includes the Benicia Refinery and the Wilmington Refinery. The following table presents the percentages of principal feedstock charges and product yields (on a combined basis) for the two refineries in this region for the year ended December 31, 2003.

Combined West Coast Region Feedstocks and Products
2003 Actual

Benicia Refinery . The Benicia Refinery is located northeast of San Francisco on the Carquinez Straits of San Francisco Bay. It is a highly complex refinery that processes sour crude oils into a high percentage of premium products, primarily CARB gasoline. The refinery can receive crude oil supplies via a deepwater dock that can berth large crude oil carriers and a 20-inch crude oil pipeline connected to a southern California crude oil delivery system. Most of the refinery’s products are distributed via the Kinder Morgan pipeline in California.

Wilmington Refinery . The Wilmington Refinery is located near Los Angeles, California. The refinery processes a blend of lower-cost heavy and high-sulfur crude oils. The refinery can produce all of its gasoline as CARB gasoline. The refinery is connected by pipeline to marine terminals and associated dock facilities that can move and store crude oil and other feedstocks. Refined products are distributed via a third-party pipeline and terminals in southern California, Nevada and Arizona.

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      MID-CONTINENT

Valero’s Mid-Continent refining region includes the McKee Refinery, the Ardmore Refinery and the Denver Refinery. The following table presents the percentages of principal feedstock charges and product yields (on a combined basis) for the three refineries in this region for the year ended December 31, 2003.

Combined Mid-Continent Region Feedstocks and Products
2003 Actual

McKee Refinery . The McKee Refinery is located in the Texas Panhandle. It generally processes heavy sweet and sour crude oils into conventional gasoline, RFG, low-sulfur diesel, jet fuels and asphalt. The McKee Refinery has access to crude oil from Texas, Oklahoma, Kansas and Colorado through Valero L.P.’s pipelines and third-party pipelines. The refinery also has access at Wichita Falls, Texas to third-party pipelines that transport crude oil from the Texas Gulf Coast and West Texas to the Mid-Continent region. The refinery distributes its products primarily via Valero L.P.’s pipelines to markets in North Texas, New Mexico, Arizona, Colorado and Oklahoma.

Ardmore Refinery . The Ardmore Refinery is located in Ardmore, Oklahoma, approximately 90 miles from Oklahoma City. It generally processes heavy sweet and sour crude oils into conventional gasoline, low-sulfur diesel and asphalt. Crude oil is delivered to the refinery through Valero L.P.’s crude oil gathering and trunkline systems, third-party pipelines and trucking operations. Refined products are transported via pipelines, railcars and trucks.

Denver Refinery . The Denver Refinery is located outside Denver, Colorado. It generally processes heavy sweet crude oils into conventional gasoline and distillates. Crude oil for the refinery is supplied by a third-party pipeline and by truck. The refinery benefits from a refined product pipeline that runs from the McKee Refinery, which enhances flexibility of operations at both refineries.

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      NORTHEAST

Valero’s Northeast refining region includes the Jean Gaulin Refinery in Quebec, Canada and the Paulsboro Refinery in New Jersey. The following table presents the percentages of principal feedstock charges and product yields (on a combined basis) for the two refineries in this region for the year ended December 31, 2003.

Combined Northeast Region Feedstocks and Products
2003 Actual

Jean Gaulin Refinery . The Jean Gaulin Refinery is located in Lévis, Canada (near Quebec City). It generally processes lower-quality, light sweet acidic crude oils and sour crude oils into conventional gasoline, low-sulfur diesel, jet fuels, heating oil and propane. The refinery receives crude oil by ship at its deepwater dock on the St. Lawrence River. Valero charters large ice-strengthened, double-hulled crude oil tankers that can navigate the St. Lawrence River year-round. The refinery’s production is transported primarily by unit trains to markets in Quebec and New Brunswick, and by tankers and trucks primarily to markets in Canada’s Atlantic Provinces.

Paulsboro Refinery . The Paulsboro Refinery is located in Paulsboro, New Jersey, approximately 15 miles south of Philadelphia on the Delaware River. The refinery processes primarily sour crude oils into a wide slate of products including gasoline, distillates, a variety of lube oil basestocks, asphalt and fuel oil. Feedstocks and refined products are typically transported by tanker and barge via refinery-owned dock facilities along the Delaware River, Exxon Mobil Corporation’s product distribution system, an onsite truck rack, railcars and the Colonial pipeline, which allows products to be sold into the New York Harbor market.

      FEEDSTOCK SUPPLY

Approximately 70% of Valero’s crude oil feedstock requirements are purchased through term contracts while the remaining requirements are generally purchased on the spot market. Valero’s term supply agreements include arrangements to purchase feedstocks directly or indirectly from various foreign national oil companies (including feedstocks originating in Saudi Arabia, Mexico, Iraq, Kuwait, Venezuela, Ecuador and Africa) as well as international and domestic oil companies at market-related prices. Approximately 80% of Valero’s crude oil feedstocks are imported from foreign sources and approximately 20% are domestic.

The U.S. network of crude oil pipelines and terminals (including those facilities owned by Valero L.P.) allows Valero to acquire crude oil from producing leases, domestic crude oil trading centers and ships delivering cargoes of foreign and domestic crude oil. Access to the Valero L.P. network also allows Valero to transport crude oil supplies to many of its U.S. refineries at a competitive cost (compared to facilities that lack proprietary supply networks). Valero’s Jean Gaulin Refinery relies on foreign crude oil that is delivered to its St. Lawrence River dock facility by ship.

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Valero’s cost to acquire feedstocks, and the price for which Valero ultimately can sell refined products, depend on a number of factors beyond Valero’s control, including regional and global supply of and demand for crude oil, gasoline, diesel and other feedstocks and refined products. These in turn are dependent upon, among other things, the availability of imports, the production levels of domestic and foreign suppliers, U.S. relationships with foreign governments, political affairs and the extent of governmental regulation. Valero uses the futures market to manage the price risk inherent in purchasing crude oil in advance of its delivery date and in maintaining Valero’s inventories.

      REFINING SEGMENT SALES

Valero’s refining segment includes sales of refined products in both the wholesale rack and bulk markets. These sales include refined products that are manufactured in Valero’s refining operations as well as refined products purchased or received on exchange from third parties. Most of Valero’s refineries have access to deepwater transportation facilities and interconnect with common-carrier pipeline systems, allowing Valero to sell products in most major geographic regions of the United States and eastern Canada. No customer accounted for more than 10% of Valero’s total operating revenues in 2003.

           Wholesale Marketing

Valero is a leading wholesale marketer of branded and unbranded transportation fuels. Valero markets on a wholesale basis in about 40 U.S. states and Canada primarily through an extensive rack marketing network. The principal purchasers of Valero’s transportation fuels from terminal truck racks are wholesalers, distributors, retailers and truck-delivered end users throughout the United States.

The majority of Valero’s rack volumes are sold through unbranded channels. The remainder is sold to distributors and dealers that are members of the Valero brand family. In the United States, these distributors and dealers operate approximately 2,400 branded sites (representing currently branded sites and sites under contract for branding with Valero). These sites are independently owned and are supplied by Valero under multi-year contracts. Valero is consolidating the number of brands used in its various markets. For wholesale branded sites, Valero promotes its Valero ^® and Beacon ^® brands in California, and its Valero ^® and Shamrock ^® brands on the U.S. east coast. In the Mid-Continent and Southwest regions, Valero promotes its Diamond Shamrock ^® and Shamrock ^® brands. Valero’s Canadian wholesale operations use the Ultramar ^® brand.

Valero also sells a variety of other products produced at its refineries including asphalt, lube base oils and commodity petrochemicals. These products are transported via pipelines, barges, trucks and railcars.

In connection with the ability of Valero’s refineries to process significant amounts of heavy sour crude oil, Valero produces approximately 60,000 BPD of asphalt which is sold to customers in the paving and roofing industries. Valero is the second largest producer of asphalt in the United States. Valero produces asphalt at nine refineries and markets asphalt in 20 states through 13 terminal facilities.

Lubricant base oils and process oils are produced at Valero’s Paulsboro Refinery. The refinery can produce 12,000 BPD of highly refined paraffinic and aromatic oils for use in a variety of lubricant and process applications. These products are sold to a variety of customers, including ExxonMobil under a long-term agreement. ExxonMobil purchases about 50% of the Paulsboro Refinery’s lubricant oil production with the balance sold to independent blenders, additive manufacturers, and industrial and marine customers.

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Valero produces and markets a variety of commodity petrochemicals including aromatic solvents (benzene, toluene and xylene), refinery- and chemical-grade propylene and anhydrous ammonia. Aromatic solvents and propylene are sold to customers in the chemical industry for further processing into such products as paints, plastics and adhesives. Ammonia, produced at Valero’s McKee Refinery, is sold to customers in the agriculture industry to be used as fertilizer. Valero also sells petroleum coke and sulfur to domestic and international customers principally in the utility and agricultural sectors, respectively.

           Product Supply and Trading

Valero sells a significant portion of its gasoline and distillate production through bulk sales channels. Valero’s bulk sales are made to various oil companies and traders as well as certain bulk end-users such as railroads, airlines and utilities. Valero’s bulk sales are transported primarily by pipeline, barges and tankers to major tank farms and trading hubs.

Valero also enters into refined product exchange and purchase agreements. These agreements enable Valero to minimize transportation costs, optimize refinery utilization, balance refined product availability, broaden geographic distribution and sell to markets not connected to Valero L.P.’s refined product pipeline system. Exchange agreements provide for the delivery of refined products by Valero to unaffiliated companies at Valero’s and third parties’ terminals in exchange for delivery of a similar amount of refined products to Valero by these unaffiliated companies at specified locations. Purchase agreements involve Valero’s purchase of refined products from third parties with delivery occurring at specified locations. Most of these agreements are long-standing arrangements. However, they generally can be terminated with 30 to 90 days notice. Valero does not anticipate an interruption in its ability to exchange or purchase refined products in the near future.

      LOGISTICS

Through agreements with Valero L.P., Valero has access to a logistics system that complements its refining and marketing business primarily in the U.S. Gulf Coast, West Coast and Mid-Continent regions. Valero L.P. is a publicly traded master limited partnership that, as of December 31, 2003, owned almost 800 miles of crude oil pipelines (with related storage and batching facilities), approximately 3,800 miles of refined product pipelines and a 25-mile hydrogen pipeline. Valero L.P. also owned 19 refined product terminals with 166 tanks that have storage capacity of approximately 4 million barrels, and it owned 58 crude oil and intermediate feedstock storage tanks and related assets with a storage capacity of approximately 11 million barrels. Valero assumed its ownership interest in Valero L.P. (formerly known as “Shamrock Logistics, L.P.”) upon completion of the UDS Acquisition. Valero owns approximately 46% of Valero L.P., which includes its 2% general partner interest.

Valero L.P.’s refined product pipelines transport refined products from Valero’s McKee, Three Rivers, Ardmore and Corpus Christi Refineries, directly or indirectly, to markets in the Mid-Continent, Southwest and the Texas-Mexico border region of the United States. In addition, Valero L.P.’s crude oil pipelines and storage facilities supply Valero’s Corpus Christi West, Texas City, McKee, Three Rivers, Ardmore and Benicia Refineries with crude oil and other feedstocks and provide access to domestic and foreign crude oil sources.

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RETAIL

Valero’s retail segment operations involve the sale of transportation fuels at retail stores and unattended self-service cardlocks, the sale of convenience store merchandise in retail stores, and the sale of home heating oil to residential customers. Valero is one of the largest independent retailers of refined products in the central and southwest United States, with strong brand identification in an 11-state retail area, including Texas, California, Colorado and Arizona, and in eastern Canada. Valero’s retail operations are supported by Valero’s proprietary credit card program which had approximately 700,000 accounts as of December 31, 2003. Valero uses electronic point-of-sale (POS) credit card processing at substantially all of its company- and dealer-operated stores. Valero added satellite technology at selected locations in 2003 to enhance its credit card processing. Valero’s retail operations are segregated geographically into two groups: the U.S. System and the Northeast System.

      U.S. SYSTEM

Sales in the U.S. System represent sales of refined products and convenience store merchandise through Valero’s company-operated retail sites. For the year ended December 31, 2003, total sales of refined products through the U.S. System’s retail sites averaged approximately 129,000 BPD. Valero has approximately 1,150 company-operated sites in its U.S. System; of these sites, about one-half are owned and one-half are leased. Company-operated stores are operated under a variety of brand names including Corner Store ^® , Ultramart ^® and Stop N Go ^® . Stores in Valero’s U.S. System sell gasoline and diesel fuel under several brand names. In Valero’s California retail facilities, Valero promotes its Valero ^® brand. In Valero’s Mid-Continent and Southwest retail facilities, Valero promotes its Diamond Shamrock ^® brand.

Company-operated convenience stores sell, in addition to gasoline and diesel fuels, a wide variety of immediately consumable products such as snacks, candy, beer, fast foods, cigarettes and fountain drinks. Valero has an ongoing program to modernize and upgrade the convenience stores it operates. These efforts are focused primarily on improving the uniformity and appearance of existing stores. Improvements generally include new exterior signage, lighting and canopies, and pump and interior store upgrades. Valero continues to review its retail network to identify appropriate markets for further investment and to identify under-performing stores where future investment is deemed non-strategic. In 2003, Valero re-imaged and upgraded 150 stores and closed or divested 122 stores.

      NORTHEAST SYSTEM

Sales in Valero’s Northeast System represent sales of refined products and convenience store merchandise through Valero’s company-operated retail sites and cardlocks, sales of refined products through sites owned by independent dealers and jobbers, and sales of home heating oil to residential customers. Valero’s Northeast System includes retail operations in eastern Canada where Valero is a major supplier of refined products serving Quebec, Ontario and the Atlantic Provinces of Newfoundland, Nova Scotia, New Brunswick and Prince Edward Island. For the year ended December 31, 2003, total retail sales of refined products through the Northeast System averaged approximately 79,000 BPD. Gasoline and diesel fuel are sold under the Ultramar ^® brand through a network of approximately 1,050 outlets throughout eastern Canada. As of December 31, 2003, Valero owned or leased approximately 475 retail stores and distributed gasoline to approximately 575 dealers and independent jobbers. In addition, the Northeast System operates 86 cardlocks, which are card- or key-activated, self-service, unattended stations that allow commercial, trucking and governmental fleets to buy gasoline and diesel fuel 24 hours a day.

The Northeast System operations also include a large home heating oil business. Valero sells home heating oil under the Ultramar ^® brand to approximately 163,000 households in eastern Canada. Valero’s home heating oil business tends to be seasonal to the extent of increased demand for home heating oil during the winter.

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COMPETITION

The refining and marketing industry continues to be highly competitive. Valero’s competitors include fully integrated major oil companies ( e.g. , ExxonMobil and ConocoPhillips) and other independent refining and marketing entities ( e.g. , Sunoco and Premcor) that operate in all of Valero’s market areas. Many of Valero’s competitors are engaged on a national or international basis in many segments of the petroleum business, including exploration, production, transportation, refining and marketing, on scales much larger than Valero’s. These competitors may have greater flexibility in responding to or absorbing market changes occurring in one or more of these segments. All of Valero’s crude oil and feedstock supplies are purchased from third-party sources, while some competitors have proprietary sources of crude oil available for their own refineries.

Financial returns in the refining and marketing industry depend largely on refining margins and retail fuel margins, both of which fluctuate significantly. Refining margins are impacted by levels of refined product inventories, the balance of refined product supply and demand, quantities of refined product imports, and utilization rates of domestic refineries. Historically, refining margins have been volatile, and they are likely to continue to be volatile in the future. Valero’s ability to process significant amounts of sour crude oils enhances Valero’s competitive position in the industry as sour crude oils typically can be purchased at a discount to sweet crude oils.

Valero’s retail business faces competition from fully integrated major oil companies that have increased their efforts to capture retail market share in recent years. Valero also competes with large grocery stores and other merchandisers (the so-called “hypermarts”) that often sell gasoline at aggressively competitive prices in order to attract customers to their sites. In Quebec, Canada and in the adjacent Atlantic Provinces, Valero is the largest independent retailer of gasoline.

ENVIRONMENTAL MATTERS

The principal environmental risks associated with Valero’s operations are emissions into the air and releases into the soil, surface water or groundwater. Valero’s operations are subject to environmental regulation by the U.S. Environmental Protection Agency (EPA) and numerous federal, state and local authorities under extensive federal, state and local environmental laws and regulations, including those relating to the discharge of materials into the environment, waste management, pollution prevention and characteristics and compositions of fuels. The significant federal laws applicable to Valero’s operations include the Clean Air Act, the Clean Water Act, the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), and the Solid Waste Disposal Act, as amended by the Resource Conservation and Recovery Act (RCRA). A discussion of significant environmental regulations affecting Valero’s operations follows.

EPA’s “Tier II” Gasoline and Diesel Standards . The EPA’s Tier II standards, adopted under the Clean Air Act, phase in limitations on the sulfur content of gasoline beginning in 2004 and the sulfur content of diesel fuel sold to highway consumers beginning in 2006. Modifications will be required at most of Valero’s refineries as a result of the Tier II gasoline and diesel standards. Valero believes that capital expenditures of approximately $1.5 billion will be required through 2006 for Valero to meet the new Tier II specifications, of which approximately $500 million was expended by the end of 2003. The aggregate estimate of expenditures includes amounts related to projects at two Valero refineries to improve refinery yield and octane balance and to provide hydrogen as part of the process of removing sulfur from gasoline and diesel. Valero expects that such estimates will change as additional engineering is completed and progress is made toward construction of these various projects. Factors that will affect the impact of these regulations on Valero include its ultimate selection of specific technologies to meet the Tier II standards and uncertainties related to timing, permitting and construction of specific units. Valero expects to meet all Tier II gasoline and diesel standards by their respective effective dates.

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EPA’s Section 114 Initiative. 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 all of its refineries owned at that time. Valero has completed its response to the request. Several other refiners have reached settlements with the EPA regarding this enforcement initiative. Though Valero has not been named in any proceeding, it also has been discussing the possibility of settlement with the EPA regarding this initiative. Based in part upon announced settlements and evaluation of its relative position, Valero expects to incur penalties and related expenses in connection with a potential settlement of this enforcement initiative. Valero believes that any potential settlement penalties will be immaterial to its results of operations and financial position. However, Valero believes that any potential settlement with the EPA in this matter will require various capital improvements or changes in operating parameters, or both, at some or all of its refineries which could be material in the aggregate.

Houston/Galveston SIP . Valero’s Houston and Texas City Refineries are located in the Houston/Galveston area, which is classified as “severe nonattainment” for compliance with EPA air-quality standards for ozone. In October 2001, the EPA approved a State Implementation Plan (SIP) to bring the Houston/Galveston area into compliance with the EPA’s ozone standards by 2007. The EPA-approved plan was based on a requirement for industry sources to reduce emissions of nitrogen oxides (NOx) by 90% from a 1997-1999 average actual emissions baseline. Certain industry and business groups challenged the plan based on technical feasibility of the 90% NOx control and its effectiveness in meeting the ozone standard. In December 2002, the Texas Commission on Environmental Quality (TCEQ) adopted a revised approach for the Houston/Galveston SIP. This alternative plan requires an 80% reduction in NOx emissions and a 64% reduction in so-called highly reactive volatile organic compounds (HRVOC). This alternative plan is subject to EPA scrutiny and approval. Valero’s Texas City and Houston Refineries will be required to install NOx and HRVOC control and monitoring equipment and practices by 2007, at a cost estimated by Valero to be approximately $60 million based on the proposed TCEQ approach.

MTBE Restrictions. The presence of MTBE in some water supplies in California and other states, resulting from gasoline leaks primarily from underground storage tanks, has led to public concern that MTBE poses a possible health risk. As a result of heightened public concern, California banned the use of MTBE as a gasoline component in California beginning January 1, 2004, and the California Air Resources Board’s specifications for CARB Phase III gasoline became effective on that date. Valero’s costs to permit and modify its California refineries to comply with CARB Phase III gasoline specifications and eliminate MTBE as a gasoline component were approximately $60 million. Other states and the EPA also have either passed or proposed or are considering proposals to restrict or ban the use of MTBE. If MTBE were to be restricted or banned throughout the United States, Valero believes that it can modify its remaining non-California MTBE-producing facilities to produce other octane enhancing products for an immaterial capital investment.

Capital Expenditures Attributable to Compliance with Environmental Regulations . In 2003, Valero’s capital expenditures attributable to compliance with environmental regulations were approximately $540 million, and are currently estimated to be approximately $625 million for 2004 and approximately $770 million for 2005. These estimates for 2004 and 2005 do not include amounts related to constructed facilities for which the portion of expenditures relating to compliance with environmental regulations is not determinable.

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Governmental regulations are complex, are subject to different interpretations and are becoming increasingly more stringent. Therefore, future legislative action and regulatory initiatives could result in changes to operating permits, additional remedial actions or increased capital expenditures and operating costs that cannot be assessed with certainty at this time. In addition, because certain air emissions at Valero’s refineries have been grandfathered under particular environmental laws, any major upgrades at any of its refineries could require potentially material additional expenditures to comply with environmental laws and regulations.

EMPLOYEES

As of February 29, 2004, Valero had 19,621 employees, including salaried and hourly employees, of which 16,136 were employed in the United States and 3,485 were employed in Canada.

Mr. Greehey has served as Chairman of the Board and Chief Executive Officer, and at various times, President of Valero and its former parent company since 1979. Most recently, he was President of Valero from the end of 1998 to January 2003. Mr. Greehey is also Chairman of the Board of the managing general partner of Valero L.P.

Mr. King was elected President in January 2003. He previously served as Executive Vice President and General Counsel since September 2001, and prior to that time he served as Executive Vice President and Chief Operating Officer since January 2001. Mr. King was Senior Vice President and Chief Operating Officer from 1999 to January 2001. He was elected Vice President and General Counsel of Valero in 1997. He joined Valero’s former parent in 1993 as Associate General Counsel and prior to that was a partner in the Houston law firm of Bracewell and Patterson. Mr. King is also a director of the managing general partner of Valero L.P.

Mr. Booke was elected Executive Vice President and Chief Administrative Officer in January 2001. He was first elected as Chief Administrative Officer in 1999. Prior to that, he had served as Vice President-Administration and Human Resources of Valero since 1998, Vice President-Administration of Valero since 1997 and Vice President-Investor Relations of Valero’s former parent since 1994. He joined Valero’s former parent in 1983.

Mr. Ciskowski was elected Chief Financial Officer in August 2003. Before that, he served as Executive Vice President-Corporate Development since April 2003, and Senior Vice President in charge of business and corporate development since 2001. He was elected Vice President of Valero in 1998. He joined Valero’s former parent in 1985, and held several positions in financial planning, corporate development and investor relations for Valero and its former parent.

Mr. Klesse was elected Executive Vice President and Chief Operating Officer in January 2003. He previously served as Executive Vice President – Refining and Commercial Operations of Valero since the closing of the UDS Acquisition on December 31, 2001. He had served as Executive Vice President, Operations of UDS from January 1999 through December 2001. Prior to that he served as an Executive Vice President for UDS since February 1995, overseeing operations, refining, product supply and logistics. Mr. Klesse is also a director of the managing general partner of Valero L.P.

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ITEM 3. LEGAL PROCEEDINGS

      Unocal

Union Oil Company of California v. Valero Energy Corporation , United States District Court, Central District of California (filed January 22, 2002). In 2002, Union Oil Company of California (Unocal) sued Valero alleging patent infringement. The complaint seeks a 5.75 cent per gallon royalty on all reformulated gasoline infringing on Unocal’s '393 and '126 patents. These patents cover certain compositions of cleaner-burning gasoline. The complaint seeks treble damages for Valero’s alleged willful infringement of Unocal’s patents and Valero’s alleged conduct to induce others to infringe the patents. In a previous lawsuit involving its '393 patent, Unocal prevailed against five other major refiners.

In 2001, the Federal Trade Commission (FTC) began an antitrust investigation concerning Unocal’s misconduct with a joint industry research group and regulators during the time that Unocal was prosecuting its patents at the U.S. Patent and Trademark Office (PTO). In 2003, the FTC filed a complaint against Unocal for antitrust violations. The FTC’s complaint seeks an injunction against any future '393 or '126 patent enforcement activity by Unocal. In November 2003, an administrative law judge dismissed the FTC’s case against Unocal, which the FTC staff appealed to the full Commission. Oral argument for that appeal occurred on March 10, 2004.

Each of the '393 and '126 patents is being reexamined by the PTO. The PTO has issued notices of rejection of all claims of each of these patents. These rejections are subject to additional proceedings, including administrative appeal by Unocal, followed by an appeal in federal district court or the court of appeals. Ultimate invalidation would preclude Unocal from pursuing claims based on the '393 or '126 patents.

Unocal’s patent lawsuit against Valero is indefinitely stayed as a result of the PTO reexamination proceedings. Notwithstanding the judgment against the other refiners in the previous litigation, Valero believes that it has several strong defenses to Unocal’s lawsuit, including those arising from Unocal’s misconduct, and Valero believes it will prevail in the lawsuit. However, due to the inherent uncertainty of litigation, it is reasonably possible that Valero will not prevail in the lawsuit, and an adverse result could have a material adverse effect on Valero’s results of operations and financial position.

      MTBE Litigation

Valero is a defendant in more than 50 cases pending in at least 15 states alleging MTBE contamination in groundwater. The plaintiffs are generally water providers, governmental authorities and private well owners alleging that refiners and suppliers of gasoline containing MTBE are liable for manufacturing or distributing a defective product. Almost all of these cases have been filed since September 30, 2003 in anticipation of a pending federal energy bill that may contain provisions for MTBE liability protection. Valero is named in these suits together with many other refining industry companies. Valero is being sued primarily as a refiner, supplier and marketer of gasoline containing MTBE. Valero does not own or operate physical facilities in most of the states where the suits are filed. The suits generally seek individual, unquantified compensatory and punitive damages and attorneys’ fees. Valero believes that it has several strong defenses to these claims and intends to vigorously defend the lawsuits. Exhibit 99.02 to this report contains a list of the MTBE suits in which Valero has been served or has been furnished a copy of the petition. Although an adverse result in one or more of these suits is reasonably possible (as defined in FASB Statement No. 5), Valero believes that such an outcome in any one of these suits would not have a material adverse effect on its results of operations or financial position. However, Valero believes that an adverse result in all or a substantial number of these cases could have a material adverse effect on Valero’s results of operations and financial position.

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      Environmental Proceedings

United States Environmental Protection Agency Region II, In the Matter of: Mobil Oil Corporation, Notice of Violation CAA-02-2001-1305 (May 15, 2001) (Paulsboro Refinery). The EPA issued notices of violation (NOVs) relating to Mobil Oil Corporation’s operation of the Paulsboro Refinery prior to Valero’s ownership of the refinery. Valero purchased the refinery from Mobil in 1998. The NOVs allege that Mobil performed certain actions on the refinery’s fluid catalytic cracking unit (FCCU) without satisfying certain permitting and other requirements under the New Source Review (NSR) provisions of the Clean Air Act. Mobil tendered the NOVs to Valero for indemnification under the refinery purchase agreement between Mobil and Valero. Valero has assumed the defense of these NOVs. The EPA has not asserted a specific demand for administrative or civil penalties or equitable relief under the NOVs, but potential penalties under the NOVs could exceed $100,000. Valero believes that it has various legal and equitable defenses in support of its position that no material liability should be borne by Valero with respect to these NOVs.

Bay Area Air Quality Management District (BAAQMD) (Benicia Refinery). Valero received 60 violation notices (VNs) from April 2002 through March 4, 2004 from the BAAQMD for incidents at Valero’s Benicia Refinery and asphalt plant. Forty of the VNs relate to alleged excess emissions from fugitive leaks, fire, process upset or instrument malfunction. Twelve VNs were issued for alleged visible emissions resulting from power failure, operational upset or instrument malfunction. Three VNs were for alleged public nuisances resulting from fire, power failure or release. The remaining five VNs relate to alleged recordkeeping discrepancies for late reporting or failure to meet a permit condition, or odor associated with a process upset. No penalties have been assessed for the violations. Valero is negotiating with the BAAQMD to resolve all of these matters. Valero expects to settle all 58 VNs for an amount immaterial to Valero, but in excess of $100,000.

City of Houston Bureau of Air Quality Control (HBAQC), et al. (Houston Refinery). The HBAQC, the Harris County Pollution Control District (HCPCD) and the Texas Commission on Environmental Quality (TCEQ) issued 21 violations from February 2002 to November 2003 to the Houston refinery for various alleged noncompliance issues. The HBAQC issued 17 violations for alleged incidents related to or resulting from excess emissions. Two violations were issued by the HCPCD for an alleged emissions event and unauthorized wastewater discharge. The TCEQ issued two violations for excess emissions and failure to monitor/report upset emissions. No penalties have been assessed for the violations, except for two HBAQC violations that state proposed penalties of $8,750 each. Valero is negotiating with the agencies to resolve these violations. Valero expects to settle all 21 violations for an amount immaterial to Valero, but in excess of $100,000.

New Jersey Department of Environmental Protection (NJDEP) (Paulsboro Refinery). Valero has received 27 NJDEP Administrative Orders and Notices of Civil Administrative Penalty Assessments (Orders) from February 2002 through January 2004 for alleged incidents at Valero’s Paulsboro Refinery. Thirteen of the Orders relate to excess emissions, for which the NJDEP has proposed penalties totaling $207,950. Eight of the Orders relate to failure to repair fugitive leaks or tank seals, for which penalties of $408,800 are proposed. Two Orders are for alleged hazardous waste discharges (proposed penalties of $15,000), two are for alleged Title V permit deviations (proposed penalties of $36,000), and two are for alleged failures to operate according to approved plans or permit conditions (proposed penalties of $7,000). Valero is currently negotiating a settlement with the NJDEP and expects to settle all 27 Orders for an amount immaterial to Valero, but in excess of $100,000.

New Mexico Environment Department (Tucumcari terminal). Valero received a revised notice of violation on June 15, 2003 from the New Mexico Environment Department (NMED) concerning an alleged violation of Title V of the Clean Air Act at Valero L.P.’s refined products terminal in Tucumcari, New Mexico. NMED alleges that the terminal operated as a Title V source from December 14, 1994 through September 6, 1998,

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and that the terminal failed to apply for a Title V permit during that time period. In January 2004, NMED further revised the notice of violation assessing a penalty of $312,120. Valero is currently negotiating a settlement with the NMED and expects to settle this matter for an amount immaterial to Valero, but in excess of $100,000. Because this matter relates to a period prior to Valero L.P.’s ownership of the Tucumcari terminal, Valero will remain responsible for any costs related to resolution of the matter.

Proposition 65 Litigation. McAdam, on behalf of the general public, and Communities for a Better Environment, a California non-profit organization v. Tosco Corporation, Ultramar Inc., et al. , Superior Court of the State of California for the County of San Francisco, Case No. 300595 (filed January 19, 1999). Communities for a Better Environment (CBE) is a non-profit organization that brought this lawsuit under California’s Safe Drinking Water and Toxic Enforcement Act of 1986, also known as California Proposition 65. Any individual acting in the public interest may enforce Proposition 65 by filing a lawsuit against a business alleged to be in violation of this law. CBE has sued several energy companies, including Valero, alleging violations of the Safe Drinking Water and Toxic Enforcement Act of 1986 at several sites in California, including alleged releases of benzene and toluene into groundwater. Thirty-three Valero sites are named in this proceeding. Plaintiffs seek, among other things, unquantified property damages, remediation, installation of monitoring equipment and attorneys’ fees. Valero is negotiating with the plaintiffs to settle this matter based on settlement criteria offered by the plaintiffs and the settlement provisions of other defendants. Valero expects to settle this matter for an amount immaterial to Valero, but in excess of $100,000.

Texas Commission on Environmental Quality (TCEQ) (Texas City Refinery). Valero received a notice of enforcement dated July 18, 2003 from the TCEQ relating to its wastewater treatment facility at the Texas City Refinery. The notice alleged noncompliance with certain effluent limitations and monitoring requirements in 2002, and assessed an administrative penalty of $146,850 (the amount last reported in Valero’s Quarterly Report on Form 10-Q for the quarter ended June 30, 2003). Valero settled the NOE in January 2004 for $75,150.

      Other Litigation

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 financial position, results of operations or liquidity; however, due to the inherent uncertainty of litigation, the range of any possible loss cannot be estimated with a reasonable degree of precision and Valero cannot provide assurance that the resolution of any particular claim or proceeding would not have an adverse effect on its results of operations, financial position or liquidity.

PART II

ITEM 6. SELECTED FINANCIAL DATA

The consolidated selected financial data for the five-year period ended December 31, 2003 was derived from Valero’s audited consolidated financial statements. Certain previously reported amounts have been reclassified to conform to the 2003 presentation. The following table should be read together with the historical consolidated financial statements and accompanying notes included in Item 8, “Financial Statements and Supplementary Data” and with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

The following summaries are in millions of dollars except for per share amounts:

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following review of the results of operations and financial condition of Valero should be read in conjunction with Items 1 & 2, “Business & Properties” and Item 8, “Financial Statements and Supplementary Data” included in this report. In the discussions that follow, all per-share amounts assume dilution.

FORWARD-LOOKING STATEMENTS

This Form 10-K, including without limitation the discussion below under the heading “Results of Operations - Outlook,” contains certain estimates, predictions, projections, assumptions 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 in this report. 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:

	•		future refining margins, including gasoline and heating oil margins;
	•		future retail margins, including gasoline, diesel, home heating oil and convenience store merchandise margins;
	•		expectations regarding feedstock costs, including crude oil discounts, and operating expenses;
	•		anticipated levels of crude oil and refined product inventories;
	•		Valero’s anticipated level of capital investments, including deferred refinery turnaround and catalyst costs and capital expenditures for environmental and other purposes, and the effect of those capital investments on Valero’s results of operations;
	•		anticipated trends in the supply of and demand for crude oil and other feedstocks and refined products in the United States, Canada and elsewhere;
	•		expectations regarding environmental and other regulatory initiatives; and
	•		the effect of general economic and other conditions on refining and retail 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:

	•		acts of terrorism aimed at either Valero’s facilities or other facilities that could impair Valero’s ability to produce and/or transport refined products or receive foreign feedstocks;
	•		political conditions in crude oil producing regions, including the Middle East and South America;
	•		the domestic and foreign supplies of refined products such as gasoline, diesel fuel, jet fuel, home heating oil and petrochemicals;
	•		the domestic and foreign supplies of crude oil and other feedstocks;
	•		the ability of the members of the Organization of Petroleum Exporting Countries (OPEC) to agree on and to maintain crude oil price and production controls;
	•		the level of consumer demand, including seasonal fluctuations;
	•		refinery overcapacity or undercapacity;
	•		the actions taken by competitors, including both pricing and the expansion and retirement of refining capacity in response to market conditions;
	•		environmental and other regulations at both the state and federal levels and in foreign countries;

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	•		the level of foreign imports of refined products;
	•		accidents or other unscheduled shutdowns affecting Valero’s refineries, machinery, pipelines or equipment, or those of Valero’s suppliers or customers;
	•		changes in the cost or availability of transportation for feedstocks and refined products;
	•		the price, availability and acceptance of alternative fuels and alternative-fuel vehicles;
	•		cancellation of or failure to implement planned capital projects and realize the various assumptions and benefits projected for such projects or cost overruns in constructing such planned capital projects;
	•		earthquakes, hurricanes, tornadoes and irregular weather, which can unforeseeably affect the price or availability of natural gas, crude oil and other feedstocks and refined products;
	•		rulings, judgments or settlements in litigation or other legal or regulatory matters, including unexpected environmental remediation costs in excess of any reserves or insurance coverage;
	•		the introduction or enactment of federal or state legislation which may adversely affect Valero’s business or operations;
	•		changes in the credit ratings assigned to Valero’s debt securities and trade credit;
	•		changes in the value of the Canadian dollar relative to the U.S. dollar; and
	•		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 statements. 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.

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Overview

As of December 31, 2003, Valero owned and operated 14 refineries in the United States and Canada with a combined throughput capacity, including crude oil and other feedstocks, of approximately 2.1 million barrels per day. Valero markets refined products through an extensive bulk and rack marketing network and a network of more than 4,500 retail and wholesale branded outlets in the United States and eastern Canada. Valero’s operations are affected by:

	•		company-specific factors, primarily refinery utilization rates and refinery maintenance turnarounds,
	•		seasonal factors, such as the demand for refined products, and
	•		industry factors, such as movements in and the absolute price of crude oil, the demand for and prices of refined products, industry supply capacity and competitor refinery maintenance turnarounds.

Valero’s profitability is determined in large part by the spread between the price of refined products and the price of crude oil, or the refined product margin. Additionally, since almost 50% of Valero’s throughput represents sour crude oil feedstocks, Valero’s 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. During 2003, both refined product margins and sour crude oil discounts improved significantly from 2002 levels. Due to various factors, including strong refined product demand in both domestic and foreign markets and an anticipated reduction in supply attributable to various factors, including the ban on MTBE in certain areas of the United States and implementation of the new clean-fuel Tier II regulations, Valero believes that the outlook for both refined product margins and sour crude oil discounts is favorable.

The positive 2003 results from Valero’s operations, as well as certain investing and financing activities during 2003, are expected to favorably position Valero to meet its objectives of increased shareholder return, continued growth and improved earnings stability.

During 2003, Valero reduced its debt by approximately $726 million, resulting in a decrease in its debt-to-capitalization ratio (net of cash) from approximately 50% at December 31, 2002 to approximately 40% at the end of 2003. During 2003, Valero’s debt and debt-to-capitalization ratio were positively impacted by the following:

	•		the generation of $1.8 billion of cash from operating activities;
	•		the ceasing of consolidation of Valero L.P., which removed Valero L.P.’s debt from Valero’s consolidated balance sheet, and the receipt of $380 million of proceeds resulting from the subsequent contribution and sale of certain assets to Valero L.P.;
	•		the issuance of 6.3 million shares of Valero common stock, the proceeds of which were used for repayments of borrowings under Valero’s revolving bank credit facilities; and
	•		the issuance of 4.9 million shares of Valero common stock resulting from the settlement of purchase contracts associated with the $172.5 million of Premium Equity Participating Security Units (PEPS Units).

In addition during 2003, Valero continued its strategic growth through the acquisition of the St. Charles Refinery and the start-up of a 45,000 barrel-per-day coker unit at the Texas City Refinery. The St. Charles Refinery operated at 95% of capacity, averaging almost 200,000 barrels per day of throughput, since Valero acquired it on July 1, 2003. The St. Charles Refinery contributed approximately $39 million to Valero’s operating income for the last six months of 2003. The 45,000 barrel-per-day coker unit at the Texas City Refinery began operations late in the fourth quarter of 2003 and will enable the refinery to process heavier, lower-cost crude oil. The ability to process the lower-cost crude oil is expected to significantly lower the refinery’s average feedstock costs. Going forward, the St. Charles Acquisition and the start-up of the coker unit at the Texas City Refinery are expected to further enable Valero to benefit from wider sour crude oil discounts that Valero believes will occur. Valero believes that it has significantly improved its feedstock flexibility and leverage to benefit from an expected continuation of good refining industry fundamentals.

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RESULTS OF OPERATIONS

2003 Compared to 2002

Financial Highlights (millions of dollars, except per share amounts)

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The following notes relate to references on pages 28 through 31.

(a)		Includes the operations of the St. Charles Refinery commencing on July 1, 2003.
(b)		On March 18, 2003, Valero’s ownership interest in Valero L.P. decreased from 73.6% to 49.5%. As a result of this decrease in ownership of Valero L.P. combined with certain other partnership governance changes, Valero ceased consolidating Valero L.P. as of that date and began using the equity method to account for its investment in the partnership.
(c)		EBITDA is a non-GAAP measure. The reconciliation of net income to EBITDA is included in “Results of Operations – Corporate Expenses and Other” on page 34.
(d)		The ratio of EBITDA to interest incurred is a non-GAAP measure. The calculation for this ratio is included in “Results of Operations – Corporate Expenses and Other” on page 34.
(e)		Throughput margin per barrel represents operating revenues less cost of sales divided by throughput volumes.
(f)		The Gulf Coast refining region includes the Corpus Christi East, Corpus Christi West, Texas City, Houston, Three Rivers, Krotz Springs and St. Charles Refineries; the Mid-Continent refining region includes the McKee, Ardmore and Denver Refineries; the Northeast refining region includes the Quebec and Paulsboro Refineries; and the West Coast refining region includes the Benicia and Wilmington Refineries.
(g)		The average market reference prices and differentials, with the exception of the propylene and lube oil differentials, are based on posted prices from Platt’s Oilgram. The propylene differential is based on posted propylene prices in Chemical Market Associates, Inc. and the lube oil differential is based on Exxon Mobil Corporation postings provided by Independent Commodity Information Services-London Oil Reports. The average market reference prices and differentials are presented to provide users of the consolidated financial statements with economic indicators that significantly affect Valero’s operations and profitability.
(h)		The market reference differential for sour crude oil is based on 50% Arab Medium and 50% Arab Light posted prices.

General

Valero’s net income for the year ended December 31, 2003 was $621.5 million, or $5.09 per share, compared to $91.5 million, or $0.83 per share, for the year ended December 31, 2002. For the fourth quarter of 2003, Valero’s net income was $131.6 million, or $1.01 per share, compared to $89.0 million, or $0.81 per share, for the fourth quarter of 2002.

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Operating revenues increased 31% from the year ended December 31, 2002 to the year ended December 31, 2003 primarily as a result of higher refined product prices combined with additional throughput volumes from refinery operations. The increase in operating income from $470.9 million for 2002 to $1.2 billion for 2003 was attributable primarily to improved fundamentals for Valero’s refining segment as discussed below.

Refining

Operating income for Valero’s refining segment was $1.4 billion for the year ended December 31, 2003, an increase of $744.8 million from the year ended December 31, 2002. The increase in refining segment operating income resulted primarily from a 28% increase in refining throughput margin per barrel and a 15% increase in refining throughput volumes, partially offset by an increase in operating expenses.

Refining total throughput margin for 2003 increased due to the following factors:

	•		Gasoline and distillate margins improved significantly during 2003 compared to 2002 due to strong demand and lower inventory levels. Demand for distillates improved significantly in 2003 due to colder winter weather in the Northeast and fuel switching demand in early 2003 caused by high natural gas prices. Refined product inventories were lower than the inventory levels that existed during most of 2002 due to the stronger demand combined with lower refinery production rates resulting from a large number of maintenance turnarounds in the refining industry in the first quarter of 2003 and the continuing impact of the oil workers’ strike in Venezuela in early 2003, which also reduced production rates. The high inventory levels in 2002 were caused by weaker economic conditions, an unusually warm winter in the northeastern part of the United States and in Europe, and lower jet fuel demand.
	•		Discounts on Valero’s sour crude oil feedstocks increased for the year ended December 31, 2003 compared to the year ended December 31, 2002 due mainly to the resumption of higher crude oil production rates by OPEC.
	•		Valero’s throughput volumes for 2003 increased from 2002 due to incremental volumes from the St. Charles Refinery commencing in July 2003 and increased refinery utilization rates during 2003, as eight of Valero’s refineries were affected by turnaround activities during 2002. Also during 2002, production at several refineries was reduced at various times during the year due to uneconomic operating conditions.

The above increases in throughput margin for 2003 were partially offset by the effects of:

	•		a net benefit of approximately $76 million in 2002 resulting from the settlement of petroleum products purchase agreements and related hedges,
	•		a $39 million benefit from the liquidation of certain of Valero’s LIFO inventories in 2002,
	•		approximately $62 million resulting from Valero ceasing consolidation of Valero L.P. commencing in March 2003, and
	•		an increase in unplanned downtime during 2003 at certain of Valero’s refineries.

Refining operating expenses were 24% higher for the year ended December 31, 2003 compared to the year ended December 31, 2002 due primarily to the acquisition of the St. Charles Refinery in July 2003, higher energy costs (primarily related to natural gas), an increase in employee compensation expense including increased variable compensation, and increased maintenance expense associated with unplanned downtime. However, the increase in refining operating expenses on a per barrel basis was only 8% from 2002 to 2003 due to an increase in throughput volumes for the reasons discussed above. Refining depreciation and amortization expense increased 7% from the year ended December 31, 2002 to the year ended December 31, 2003 due mainly to depreciation expense related to the acquisition of the St. Charles Refinery and increased turnaround and catalyst amortization.

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Retail

Retail operating income was $211.7 million for the year ended December 31, 2003, an increase of $83.2 million from the year ended December 31, 2002 as a result of higher retail fuel margins in both the U.S. and Northeast retail systems and operational improvements. During 2003, Valero continued to implement its U.S. retail strategy that commenced in 2002 of investing in certain key stores and disposing of certain underperforming or non-strategic stores. During 2003, Valero reimaged and upgraded 150 stores and closed or divested 122 stores. These changes contributed to improved operating income for the retail segment in 2003.

Corporate Expenses and Other

Administrative expenses, including depreciation and amortization expense, increased $76.9 million for the year ended December 31, 2003 as compared to the year ended December 31, 2002. Part of the increase was due to the recognition of increased variable compensation expense of approximately $21 million in 2003 as a result of improved financial performance in 2003 as compared to 2002. Also, in December 2003, a $25.8 million impairment charge was recognized and reflected in administrative depreciation and amortization expense to write down the carrying value of Valero’s current headquarters facilities to fair value less selling costs, as described further in Note 6 of Notes to Consolidated Financial Statements. The remainder of the increase was attributable primarily to increases in salary and benefits expenses, ad valorem taxes and litigation costs.

Equity in earnings of Valero L.P. represents Valero’s equity interest in the earnings of Valero L.P. after March 18, 2003. On March 18, 2003, Valero’s ownership interest in Valero L.P. decreased from 73.6% to 49.5%. As a result of this decrease in ownership of Valero L.P. combined with certain other partnership governance changes, Valero ceased consolidating Valero L.P. as of that date and began using the equity method to account for its investment in Valero L.P. Valero’s ownership interest in Valero L.P. has been further reduced to 45.7% as of December 31, 2003 primarily as a result of the issuance of additional common units by Valero L.P. in April and August 2003. Prior to March 18, 2003, Valero consolidated the operations of Valero L.P. The minority interest in net income of Valero L.P. represented the minority unitholders’ share of the net income of Valero L.P. during the periods that Valero consolidated such operations.

The increase in other income, net from 2002 to 2003 is due mainly to a gain of $17.0 million related to the sale of notes receivable from Tesoro Refining and Marketing Company (Tesoro) in connection with the sale of the Golden Eagle Refinery and related assets in 2002. This gain was offset by a $7.1 million decrease in equity income from joint ventures and the initial recognition of an asset retirement obligation of $4.2 million.

Net interest expense decreased $24.4 million from 2002 to 2003 primarily due to a decrease in debt levels from $5 billion as of December 31, 2002 to $4.2 billion as of December 31, 2003 and an increase in capitalized interest attributable to a larger capital investment program.

Distributions on preferred securities of subsidiary trusts decreased $13.2 million from the year ended December 31, 2002 to the year ended December 31, 2003 due to the redemption of the 8.32% Trust Originated Preferred Securities (TOPrS) in June 2003 and the settlement of the PEPS Units in August 2003.

Income tax expense increased from $58.2 million in 2002 to $365.1 million in 2003 due to the significant increase in pre-tax income.

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The following is a reconciliation of net income to EBITDA (in millions):

Valero utilizes the financial measure of earnings before interest, income taxes, depreciation and amortization (EBITDA), which is not defined under United States generally accepted accounting principles. Management presents EBITDA in its filings under the Securities Exchange Act of 1934 and its press releases. Management uses this financial measure because it is a widely accepted financial indicator used by some investors and analysts to analyze and compare companies on the basis of operating performance. In addition, EBITDA is used in the computation of certain debt covenant ratios included in Valero’s various debt agreements. EBITDA is not intended to represent cash flows for the period, nor is it presented as an alternative to operating income or income before income taxes. It should not be considered in isolation or as a substitute for a measure of performance prepared in accordance with United States generally accepted accounting principles. Valero’s method of computation of EBITDA may or may not be comparable to other similarly titled measures used by other companies.

The following is the computation of the ratio of EBITDA to interest incurred (in millions):

Valero utilizes the ratio of EBITDA to interest incurred, which is not defined under United States generally accepted accounting principles. Management uses the ratio of EBITDA to interest incurred as the basis for the computation of certain debt covenant ratios included in Valero’s various debt agreements. This ratio should not be considered in isolation or as a substitute for a measure of performance prepared in accordance with United States generally accepted accounting principles. Valero’s method of computation of the ratio of EBITDA to interest incurred may or may not be comparable to other similarly titled measures used by other companies.

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