UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2005

OR

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ______ to ______

Commission file number 1-13175

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 þ No o

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

The number of shares of the registrant’s only class of common stock, $0.01 par value, outstanding as of October 31, 2005 was 309,255,228.

 

 

VALERO ENERGY CORPORATION AND SUBSIDIARIES

INDEX

		Page
PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of September 30, 2005 and December 31, 2004			3
Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2005 and 2004			4
Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2005 and 2004			5
Consolidated Statements of Comprehensive Income for the Three and Nine Months Ended September 30, 2005 and 2004			6
Condensed Notes to Consolidated Financial Statements			7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			31
Item 3. Quantitative and Qualitative Disclosures About Market Risk			51
Item 4. Controls and Procedures			56
PART II — OTHER INFORMATION
Item 1. Legal Proceedings			56
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			57
Item 6. Exhibits			57
SIGNATURE			58
Certificate of Merger
Restricted Unit Agreement
Form of Restricted Stock Agreement
Statements of Computations of Ratios of Earnings to Fixed Charges and Preferred Stock Dividends
Rule 13a-14(a) Certifications
Section 1350 Certifications

PART I — FINANCIAL INFORMATION

See Condensed Notes to Consolidated Financial Statements.

See Condensed Notes to Consolidated Financial Statements.

See Condensed Notes to Consolidated Financial Statements.

VALERO ENERGY CORPORATION AND SUBSIDIARIES

VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Statement No. 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce cash flows from operating activities and increase cash flows from financing activities in periods after adoption. While Valero cannot estimate the magnitude of such amounts in the future because they depend on, among other things, when employees exercise stock options, the amounts of operating cash flows recognized for such excess tax deductions were $172 million and $48 million for the nine months ended September 30, 2005 and 2004, respectively.

Under Valero’s 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. Valero has accounted for such awards by recognizing compensation cost, if any, under APB Opinion No. 25 and pro forma compensation cost under Statement No. 123, as disclosed in Note 13, over the nominal vesting period. Upon the adoption of Statement No. 123R, Valero will change its 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 will be 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. The estimated after-tax effect related to the non-substantive vesting period approach is less than $3 million as described in Note 13.

FASB Interpretation No. 47

In March 2005, the FASB issued Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (FIN 47). FIN 47 clarifies that the term “conditional asset retirement obligation” as used in FASB Statement No. 143, “Accounting for Asset Retirement Obligations,” refers to a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the entity. Since the obligation to perform the asset retirement activity is unconditional, FIN 47 provides that a liability for the fair value of a conditional asset retirement obligation should be recognized if that fair value can be reasonably estimated, even though uncertainty exists about the timing and/or method of settlement. FIN 47 also clarifies when an entity would have sufficient information to reasonably estimate the fair value of a conditional asset retirement obligation under FASB Statement No. 143. FIN 47 is effective for fiscal years ending after December 15, 2005, and is not expected to significantly affect Valero’s financial position or results of operations.

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 is effective no later than January 1, 2006. Valero will adopt EITF No. 04-5 effective January 1, 2006, the impact of which is not expected to affect Valero’s financial position or results of operations.

VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

EITF Issue No. 04-13

Valero’s operating revenues include sales related to certain buy/sell arrangements, which involve linked purchases and sales related to crude oil contracts entered into to address location, quality or grade requirements. In some cases, to obtain crude oil of a specific grade and quantity for certain of Valero’s refineries, Valero must agree to sell crude oil of a different grade and quantity to its supplier at another location. Valero generally does not have the specific crude oil to satisfy its supplier’s needs and therefore must purchase that crude oil from a third party. Valero sells the crude oil acquired from the third party to its crude oil supplier and recognizes revenue on the sale and cost of sales at that time.

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. Valero expects to adopt 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, Valero’s buy/sell arrangements are deemed to be made in contemplation of one another. Accordingly, upon adoption of EITF No. 04-13, Valero’s buy/sell arrangements will be accounted for as one transaction in applying the principles of APB No. 29. As a result, revenues and cost of sales will cease to be recognized in connection with these arrangements upon the adoption of EITF No. 04-13 on January 1, 2006. This adoption will result in a reduction in Valero’s operating revenues in Valero’s consolidated statement of income and a corresponding reduction in cost of sales with no expected impact on operating income, net income or net income applicable to common stock. If EITF No. 04-13 had been applied by Valero for the three and nine months ended September 30, 2005 and 2004, 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.

3. ACQUISITIONS AND DISPOSITIONS

Premcor Acquisition

On September 1, 2005, Valero completed its 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.

Under the terms of the merger agreement, each outstanding share of Premcor common stock was converted into the right to receive cash or Valero common stock at the shareholder’s election, subject to proration per the terms of the merger agreement, so that 50% of the total Premcor shares (based on the number of Premcor shares outstanding at completion of the merger on a diluted basis under the treasury stock method) was acquired for cash, with the balance acquired for Valero common stock. Based on the election results, Premcor’s shareholders electing Valero common stock received 0.48233 of a share of

VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Valero common stock and $37.31 in cash for each share of Premcor common stock. Premcor shareholders electing cash and non-electing shareholders received $72.76 in cash for each share of Premcor common stock. As a result, Valero issued 42.5 million shares of Valero common stock and paid $3.4 billion of cash to Premcor shareholders.

Valero incurred approximately $27 million of transaction costs to consummate the Premcor Acquisition. In addition, Valero issued 7.1 million stock options in exchange for the 7.2 million Premcor stock options outstanding as of September 1, 2005. The stock options issued by Valero had a fair value of $596 million on the date of the merger, which was recorded in “goodwill” and “additional paid-in capital” in Valero’s consolidated balance sheet as of September 30, 2005. The fair value of these stock options issued was estimated using the Black-Scholes option-pricing model.

Valero paid the cash portion of the merger consideration from available cash and proceeds from a $1.5 billion five-year bank term loan due in August 2010 (see Note 7 for additional details related to the $1.5 billion term loan). In addition, Valero assumed Premcor’s existing debt, which had a fair value of $1.9 billion as of September 1, 2005.

The Premcor Acquisition is consistent with Valero’s general business strategy of increasing cash flow and earnings through the acquisition of assets or businesses that are a logical extension of its existing assets or businesses. The addition of Premcor’s assets has also increased the geographic diversity of Valero’s refining network by allowing Valero to expand into the midwestern United States with the addition of Premcor’s Lima and Memphis Refineries. Valero believes that Premcor’s assets provide profit improvement opportunities, which Valero believes it should be able to realize given its history of increasing the reliability, capacity and yields of previously acquired refineries.

The purchase price 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 which are currently expected to be completed by December 31, 2005. The purchase price and the preliminary purchase price allocation as of September 30, 2005 were as follows (in millions):

Unaudited Pro Forma Financial Information

The consolidated statements of income include the results of operations of the Premcor Acquisition and the Aruba Acquisition commencing on September 1, 2005 and March 5, 2004, respectively. The following unaudited pro forma financial information assumes:

	•		42.5 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 and 2004 and
	•		15.6 million shares of common stock were sold and approximately $36 million of debt was incurred in connection with the Aruba Acquisition on January 1, 2004.

Sale of Denver Refinery

On May 31, 2005, Valero sold its Denver Refinery and related assets and liabilities to Suncor Energy (U.S.A.) Inc. (Suncor) for $30 million plus approximately $15 million for working capital, including feedstock and refined product inventories. In connection with this sale, Valero recognized a pre-tax gain of $3 million, net of a reduction of $4 million for associated goodwill.

Sale of Equity Interest in Javelina Joint Venture

In September 2005, Valero entered into an agreement to sell its 20% equity interests in Javelina Company and Javelina Pipeline Company (the Javelina Companies) to MarkWest Energy Partners, L.P. (MarkWest). Javelina Company processes refinery off-gas at a plant in Corpus Christi, Texas. On November 1, 2005, the sale was consummated and Valero received proceeds of $78 million from the sale, resulting in a gain of approximately $55 million in the fourth quarter of 2005. In conjunction with the sale, Valero also entered into gas processing and hydrogen purchase agreements with MarkWest.

4. RESTRICTED CASH

Restricted cash as of September 30, 2005 and December 31, 2004 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 UDS Acquisition that occurred in December 2001. Restricted cash as of September 30, 2005 also included $67 million of cash which was restricted to satisfy debt service requirements related to certain debt assumed in the Premcor Acquisition.

5. INVENTORIES

Inventories consisted of the following (in millions):

VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

As of September 30, 2005 and December 31, 2004, the replacement cost (market value) of LIFO inventories exceeded their LIFO carrying amounts by approximately $5.9 billion and $1.2 billion, respectively.

In determining the carrying amount of Valero’s inventories as of September 30, 2005, Valero recorded a $621 million charge to “cost of sales” in September 2005 resulting from the difference between the fair market value recorded for the inventories acquired in the Premcor Acquisition under purchase accounting and the amounts required to be recorded in applying Valero’s LIFO accounting policy.

6. INVESTMENT IN AND TRANSACTIONS WITH VALERO L.P.

As of December 31, 2004, Valero owned approximately 45.7% of Valero L.P., a limited partnership that owns and operates crude oil and refined product pipeline, terminalling and storage tank assets. On July 1, 2005, Valero L.P. completed its acquisition of Kaneb Pipe Line Partners, L.P. (Kaneb Partners) and Kaneb Services LLC (together, the Kaneb Acquisition) in a transaction that included the issuance of Valero L.P. common units in exchange for Kaneb Partners’ units. As a result of the issuance of additional Valero L.P. common units for the Kaneb Acquisition, Valero’s ownership interest in Valero L.P. was reduced to 23.4%. In addition, Valero contributed $29 million to Valero L.P. to maintain Valero’s 2% general partner interest in Valero L.P. Valero’s ownership interest in Valero L.P. remained at 23.4% as of September 30, 2005, which was composed of a 2% general partner interest and a 21.4% limited partner interest represented by 627,530 common units and 9,599,322 subordinated units of Valero L.P. Financial information reported by Valero L.P. for the three and nine months ended September 30, 2005 and 2004 is summarized below (in millions):

As of September 30, 2005 and December 31, 2004, Valero’s “receivables, net” included $12 million and $4 million, respectively, from Valero L.P., representing amounts due for employee costs, insurance costs, operating expenses, administrative costs and rentals. As of September 30, 2005 and December 31, 2004, Valero’s “accounts payable” included $21 million and $19 million, respectively, to Valero L.P., representing amounts due for pipeline tariffs, terminalling fees and tank rentals and fees.

Under a services agreement, Valero provides Valero L.P. with the corporate functions of legal, accounting, treasury, engineering, information technology and other services for an administrative services fee as prescribed by the services agreement. In addition, Valero charges Valero L.P. for employee costs related to operating and maintenance services performed on certain Valero L.P. assets. Valero also pays Valero L.P. certain fees under separate throughput, handling, terminalling and service agreements with Valero L.P. The following table summarizes the results of transactions with Valero L.P. (in millions):

Historically, Valero L.P. has from time to time issued common units to the public, which have diluted Valero’s ownership percentage in Valero L.P. Such issuances have resulted in increases in Valero’s proportionate share of Valero L.P.’s capital because the issuance price per unit exceeded Valero’s carrying amount per unit at the time of issuance. SEC Staff Accounting Bulletin No. 51, “Accounting for Sales of Stock by a Subsidiary,” (SAB 51) provides guidance on accounting for the effect of issuances of a subsidiary’s stock on the parent’s investment in that subsidiary. SAB 51 allows registrants to elect an accounting policy of recording such increases or decreases in a parent’s investment (SAB 51 credits or charges, respectively) either in income or directly in equity.

As of June 30, 2005, prior to Valero L.P.’s Kaneb Acquisition, Valero had approximately $7 million in accumulated pre-tax SAB 51 credits related to its investment in Valero L.P. On July 1, 2005, the issuance of common units by Valero L.P. in connection with the Kaneb Acquisition generated an additional pre-tax SAB 51 credit of approximately $142 million for Valero. Valero has not recognized any SAB 51 credits in its consolidated financial statements through September 30, 2005 and is not permitted to do so until its subordinated units convert to common units, which is expected to occur on April 1, 2006. Valero expects to adopt its accounting policy and recognize all of its cumulative SAB 51 credits at that time.

Effective July 1, 2005, Valero acquired Martin Oil Company LLC, a wholesale motor fuel marketer in the midwestern United States, from Valero L.P. The acquisition cost was $26 million, $22 million of which represented working capital acquired in the transaction.

7. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS

During January 2005, Valero repurchased $40 million of its 7.375% notes due in March 2006 and $42 million of its 6.125% notes due in April 2007 at a premium of $4 million. In addition, during the nine months ended September 30, 2005, Valero made the following scheduled debt repayments:

	•		$46 million during February 2005 related to its 7.44% medium-term notes,
	•		$150 million during March 2005 related to its 8% medium-term notes,
	•		$200 million during June 2005 related to its 8.375% notes, and
	•		$13 million during August 2005 related to its 6.797% notes.

During the nine months ended September 30, 2005, Valero borrowed and repaid $40 million under its prior $750 million three-year revolving bank credit facility.

In August 2005, Valero replaced its two $750 million revolving bank credit facilities with a $2.5 billion five-year revolving credit facility. The new revolving credit facility matures in August 2010. Borrowings under the new credit facility bear interest at LIBOR plus a margin, or an alternate base rate as defined under the agreement. Valero will also be charged various fees and expenses in connection with the

VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

facility, including facility fees and letter of credit fees. The interest rate and fees under the revolving bank credit facility are subject to adjustment based upon the credit ratings assigned to Valero’s long-term debt. The facility includes certain restrictive covenants including a coverage ratio and a debt-to-capitalization ratio. As of September 30, 2005, there were no borrowings outstanding under the revolving credit facility and outstanding letters of credit issued under the facility totaled $514 million.

As discussed in Note 3, the cash portion of the Premcor Acquisition was partially financed with proceeds received under a new $1.5 billion five-year bank term loan entered into by Valero in August 2005. The term loan bears interest at LIBOR plus 75 basis points. During September 2005, Valero repaid $700 million of this term loan, resulting in outstanding borrowings of $800 million as of September 30, 2005. During October 2005, Valero repaid an additional $300 million of this term loan.

In connection with the Premcor Acquisition, Valero assumed the following debt obligations, which were recorded at fair value as of September 1, 2005:

Generally, the debt obligations assumed in the Premcor Acquisition are unsecured with interest payable semi-annually. During September 2005, Valero repurchased $190 million of the 7.75% senior subordinated notes due in February 2012. Also in September 2005, Valero gave notice of its intention to call for redemption the 12.5% senior notes due in January 2009. In October 2005, Valero repurchased these 12.5% senior notes for $182 million.

Valero also assumed two capital lease obligations of Premcor, which had a fair value of $14 million as of September 1, 2005.

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CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

8. STOCKHOLDERS’ EQUITY

Common Stock Issuance

As discussed in Note 3, on September 1, 2005, Valero issued 42.5 million shares of common stock as partial consideration for the Premcor Acquisition. The common stock issued was recorded at a price of $74.82 per share, representing the average price of Valero’s common stock from two days before to two days after the announcement of the Premcor Acquisition in April 2005, resulting in an aggregate recorded amount of $3.2 billion for the common stock issued. In addition, Valero issued stock options with a fair value of $596 million.

2% Mandatory Convertible Preferred Stock

During the nine months ended September 30, 2005, 6,425,743 shares of the preferred stock were converted into 6,367,905 shares of Valero common stock. During October 2005, 347,306 additional shares of the preferred stock were converted into 344,179 shares of Valero common stock.

On October 20, 2005, Valero’s board of directors declared a dividend on the mandatory convertible preferred stock of $0.125 per share payable on December 31, 2005 to holders of record at the close of business on December 30, 2005.

Common Stock Purchases

During the nine months ended September 30, 2005 and 2004, Valero purchased 2.9 million and 8.0 million shares of its common stock at a cost of $188 million and $245 million, respectively, in connection with the administration of its employee benefit plans.

Common Stock Dividends

On October 20, 2005, Valero’s board of directors declared a regular quarterly cash dividend of $0.10 per common share payable December 14, 2005 to holders of record at the close of business on November 9, 2005.

Common Stock Split

On September 15, 2005, Valero’s board of directors approved a two-for-one split of Valero’s common stock, to be effected in the form of a stock dividend, subject to shareholder approval of an amendment to Valero’s certificate of incorporation to increase the number of authorized shares. A special meeting of Valero’s shareholders is scheduled on December 1, 2005. If the amendment to Valero’s certificate of incorporation is approved, the payment of the stock dividend would occur on December 15, 2005 to stockholders of record on December 2, 2005.

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:

	•		the amounts shown above exclude changes in cash and temporary cash investments, deferred income taxes, and current portion of long-term debt and capital lease obligations;
	•		the amounts shown above exclude the current assets and current liabilities acquired in connection with the Premcor Acquisition and certain minor acquisitions in 2005 and the Aruba Acquisition in 2004, as well as the current assets and current liabilities disposed of in connection with the sale of the Denver Refinery in 2005, all of which are reflected separately in the consolidated statement of cash flows, and the effect of certain noncash investing activities discussed below; and
	•		certain differences between consolidated balance sheet changes and consolidated statement of cash flow changes reflected above result from translating foreign currency denominated amounts at different exchange rates.

Noncash investing and financing activities for the nine months ended September 30, 2005 included:

	•		the issuance of $3.2 billion (42.5 million shares) of common stock and $596 million of vested employee stock options as partial consideration for the Premcor Acquisition,
	•		the conversion of 6,425,743 shares of preferred stock into 6,367,905 shares of Valero common stock as discussed in Note 8, and
	•		the recognition of a $28 million capital lease obligation and related capital lease asset pertaining to certain equipment at Valero’s Texas City Refinery.

Noncash investing activities for the nine months ended September 30, 2005 and 2004 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 Aruba Acquisition. Noncash investing activities for the nine months ended September 30, 2004 also included adjustments to property, plant and equipment and certain current and noncurrent assets and liabilities resulting from adjustments to

11. PRICE RISK MANAGEMENT ACTIVITIES

The net gain (loss) recognized in income representing the amount of hedge ineffectiveness was as follows (in millions):

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.

For cash flow hedges, gains and losses currently reported in “accumulated other comprehensive income” in the consolidated balance sheets will be reclassified into income when the forecasted transactions affect income. During the nine months ended September 30, 2005, Valero recognized in “accumulated other comprehensive income” unrealized after-tax losses of $294 million on certain cash flow hedges, primarily related to forward sales of distillates and associated forward purchases of crude oil, with $182 million of cumulative after-tax losses on cash flow hedges remaining in “accumulated other comprehensive income” as of September 30, 2005. Valero expects that all of these cash flow hedges will be reclassified into income over the next 10 months as a result of hedged transactions that are forecasted to occur. The amount ultimately realized in income, however, will differ as commodity prices change. For the nine months ended September 30, 2005 and 2004, there were no amounts reclassified from “accumulated other comprehensive income” into income as a result of the discontinuance of cash flow hedge accounting.

Total assets by reportable segment were as follows (in millions):

The entire balance of goodwill as of September 30, 2005 and December 31, 2004 has been included in the total assets of the refining reportable segment.

13. STOCK-BASED COMPENSATION

Valero accounts for its 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.”

Because Valero accounts for its employee stock compensation plans using the intrinsic value method, compensation cost is not recognized in the consolidated statements of income for Valero’s fixed stock option plans as all options granted have an exercise price equal to the market value of the underlying

See Note 2 for a discussion of FASB Statement No. 123 (revised 2004) and the SEC’s amended Rule 4-01(a) of Regulation S-X, which will require Valero to change its accounting for stock-based compensation beginning in 2006. Upon adoption of Statement No. 123R, Valero will change its attribution approach for grants that have retirement-eligibility provisions from the nominal vesting period approach utilized in the pro forma information presented above to the non-substantive vesting period approach. If the non-substantive vesting period approach had been used by Valero, the impact on the pro forma net income applicable to common stock and pro forma net income amounts reflected above would have been less than $3 million for each of the periods presented.

Valero’s anticipated contributions to its pension plans during 2005 have not changed from amounts previously disclosed in Valero’s consolidated financial statements for the year ended December 31, 2004. Valero has no minimum required contributions to its qualified pension plans during 2005 under the Employee Retirement Income Security Act. For the nine months ended September 30, 2005 and 2004, Valero contributed $60 million and $73 million, respectively, to its qualified pension plans.

In connection with the Premcor Acquisition, Valero became the plan sponsor for three additional pension plans and two additional other postretirement benefit plans. Prior to September 1, 2005, Premcor had contributed $20 million to the former Premcor pension plans; Valero does not plan to make further contributions to these plans in 2005.

15. COMMITMENTS AND CONTINGENCIES

Accounts Receivable Sales Facility

As of December 31, 2004, Valero had an accounts receivable sales facility with a group of third-party financial institutions to sell on a revolving basis up to $600 million of eligible trade and credit card receivables, which was to mature in October 2005. In August 2005, Valero amended this agreement to, among other things: (i) remove the credit card receivables from the eligible pool of receivables,

VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

(ii) increase the size of the facility by $400 million to $1 billion, and (iii) extend the maturity date to August 2008. As of September 30, 2005 and December 31, 2004, the amount of eligible receivables sold to the third-party financial institutions was $1 billion and $600 million, respectively.

Contingent Earn-Out Agreements

In the second quarter of 2005 and 2004, Valero made earn-out contingency payments of $35 million each year to Salomon Inc in connection with Valero’s acquisition of Basis Petroleum, Inc., which were recorded as increases to “goodwill.” In January 2005, Valero also made a previously accrued earn-out payment related to the St. Charles Acquisition of $50 million.

The Delaware City Refinery was acquired by Premcor in May 2004 from Motiva Enterprises LLC (Motiva). In connection with that acquisition, 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 of refining margins for the three years following the acquisition, and (b) the achievement of certain performance criteria at the refinery’s gasification facility for the two years following the acquisition. For the first year following the acquisition, Premcor paid the $25 million annual maximum amount under the margin contingency but was not obligated to make any payment related to the gasification facility performance.

The following table summarizes the aggregate payments made by Valero and payment limitations related to the following acquisitions (in millions). The margin contingency payment for the Delaware City Refinery reflected below was made by Premcor prior to its acquisition by Valero.

Environmental Matters

The Environmental Protection Agency’s (EPA) 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 (which began in 2004) and diesel fuel sold to highway consumers (beginning in 2006). Most of Valero’s refineries are being modified to comply with the Tier II gasoline and diesel standards. Valero believes that capital expenditures of approximately $2.6 billion will be required through 2008 for its refineries to meet the Tier II specifications, of which approximately $1.8 billion has been spent through September 30, 2005. This estimate includes post-acquisition investments at the former Premcor refineries and amounts related to projects at five Valero refineries to provide hydrogen necessary for removing sulfur from gasoline and diesel. Valero expects that its cost estimates will change as additional engineering is completed and progress is made toward construction of these various projects.

VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

EPA’s Section 114 Initiative. In 2000, the EPA issued to Valero an information request pursuant to Section 114 of the Clean Air Act as part of the EPA’s National Petroleum Refinery Initiative to reduce air emissions (Initiative). On June 16, 2005, the EPA and the U.S. Department of Justice (DOJ) announced a comprehensive settlement with Valero in connection with the Initiative. The states of Colorado, Louisiana, New Jersey, Oklahoma and Texas joined the EPA in the settlement. The EPA’s consent decree (lodged June 16, 2005 in the U.S. District Court for the Western District of Texas) will require Valero to invest approximately $785 million in environmental projects through 2012 to reduce emissions across Valero’s U.S. refining system. All state and federal comment periods applicable to the consent decree have lapsed. Valero expects the court to enter the decree in the fourth quarter of 2005.

Three refineries acquired by Valero in the Premcor Acquisition (the Port Arthur, Memphis and Lima Refineries) had also received several information requests from the EPA in connection with the Initiative (the Delaware City Refinery is already subject to a Section 114 settlement). The EPA recently invited Valero to enter into Initiative settlement discussions concerning these three refineries. Valero expects to begin settlement meetings with the EPA in the near future. Valero expects to incur penalties and related expenses in connection with a potential settlement, but Valero believes that any settlement penalties will be immaterial to its results of operations and financial position. In addition, Valero expects that a settlement will require significant capital improvements or changes in operating parameters, or both, at the three refineries.

Houston/Galveston SIP . Valero’s Houston and Texas City Refineries are located in the Houston-Galveston ozone nonattainment area, which was classified as “severe” under the EPA’s one-hour ambient air quality standard for ozone. In December 2002, the Texas Commission on Environmental Quality (TCEQ) developed a plan to bring the Houston-Galveston area into compliance with the one-hour standard. The TCEQ plan requires industry sources to reduce emissions of nitrogen oxides (NOx) by an average of 80% from a 1997-1999 average actual emissions baseline, and an area-wide 64% reduction in certain “highly reactive” volatile organic compounds (HRVOCs). Per the TCEQ’s plan, Valero is required to install NOx and HRVOC controls and monitoring equipment and implement certain operating practices during 2005-2007 at its Houston and Texas City Refineries at a cost estimated by Valero to be approximately $68 million.

In April 2004, the EPA designated the Houston-Galveston area as being in “moderate” nonattainment of the EPA’s eight-hour ambient air quality standard for ozone, and established an attainment deadline (under the eight-hour standard) of 2010. Effective June 2005, the EPA revoked its one-hour standard for ozone compliance in favor of the stricter eight-hour standard. However, because of “anti-backsliding” provisions of the EPA’s eight-hour ozone regulations, the TCEQ was required to retain the NOx and HRVOC regulations established for the prior one-hour standard. Accordingly, Valero must install the NOx and HRVOC controls and monitoring equipment required under the TCEQ’s regulations for the prior one-hour standard. The EPA’s eight-hour ozone standard will require the TCEQ to design and submit to the EPA by 2007 a proposed state implementation plan for the eight-hour standard, which likely will require additional controls by 2009.

VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Litigation

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 sought a 5.75 cent per gallon royalty on all reformulated gasoline infringing on Unocal’s '393 and '126 patents as well as 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 accordance with the Federal Trade Commission’s consent decree approving Chevron Corporation’s acquisition of Unocal, Unocal’s lawsuit against Valero was required to be dismissed after completion of the acquisition on August 10, 2005. The parties’ agreed motion to dismiss was granted by the court on August 23, 2005.

MTBE Litigation

As of October 31, 2005, Valero was named as a defendant in 64 cases alleging liability related to MTBE contamination in groundwater. (Premcor, now included within “Valero,” was also separately named in 53 of these cases.) 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. Valero is named in these suits together with many other refining industry companies. Valero is being sued primarily as a refiner and marketer of MTBE and gasoline containing MTBE. Valero does 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 and attorneys’ fees. All but one of these cases have been removed to federal court by the defendants and have been 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 ). Four of these cases 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. Valero believes that it has strong defenses to these claims and is vigorously defending the cases. Valero believes that an adverse result in any one of these suits would not have a material 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 effect on Valero’s results of operations and financial 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). This class action 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: (1) persons purportedly affected by the October 7, 1994 catalyst release, but with no permanent health effects; (2) persons with medical expenses for dependents purportedly affected by the October 7, 1994 release; and (3) local residents claiming property damage or who have suffered loss of use and enjoyment of their property over a period of several years. The lawsuit was once consolidated with another purported class action, but was recently deconsolidated in anticipation of the beginning of trial. Trial began October 31, 2005. Valero believes that an adverse result in this case could have a material effect on Valero’s results of operations and financial position. An estimate of the possible loss or range of loss from an adverse result in this case cannot reasonably be made.

VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

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 possible loss, if any, cannot be estimated with a reasonable degree of precision and there can be no assurance that the resolution of any particular claim or proceeding would not have an adverse effect on Valero’s results of operations, financial position or liquidity.

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), an indirect wholly owned subsidiary of Valero Energy Corporation:

	•		9.25% senior notes due February 2010,
	•		6.75% senior notes due February 2011,
	•		6.125% senior notes due February 2011,
	•		9.5% senior notes due February 2013,
	•		6.75% senior notes due February 2014,
	•		7.5% senior notes due June 2015, and
	•		Ohio Water Development Authority Environmental Facilities Revenue Bonds due December 2031.

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 Energy Corporation 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.