10-Q 1 vlo6301210q.htm VALERO ENERGY CORPORATION JUNE 30, 2012 FORM 10-Q VLO 6.30.12 10Q
 
 
 
 
 
 
 
 
 
 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
R
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2012
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
VALERO ENERGY CORPORATION
(Exact name of registrant as specified in its charter)
Delaware
 
74-1828067
(State or other jurisdiction of
 
(I.R.S. Employer
incorporation or organization)
 
Identification No.)
One Valero 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 R No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes R No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer R
Accelerated filer o
Non-accelerated filer o
Smaller reporting company 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 R
The number of shares of the registrant’s only class of common stock, $0.01 par value, outstanding as of July 31, 2012 was 551,605,943.
 
 
 
 
 



VALERO ENERGY CORPORATION AND SUBSIDIARIES
TABLE OF CONTENTS
 
 
 
Page
 
 
June 30, 2012 and 2011
June 30, 2012 and 2011
 
 
 
 
 
 
 
 
 
 
 





2


PART I – FINANCIAL INFORMATION
Item 1. Financial Statements

VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Millions of Dollars, Except Par Value)

 
June 30,
2012
 
December 31,
2011
 
(Unaudited)
 
 
ASSETS
 
 
 
Current assets:
 
 
 
Cash and temporary cash investments
$
1,295

 
$
1,024

Receivables, net
6,624

 
8,706

Inventories
5,443

 
5,623

Income taxes receivable
287

 
212

Deferred income taxes
246

 
283

Prepaid expenses and other
138

 
124

Total current assets
14,033

 
15,972

Property, plant and equipment, at cost
32,832

 
32,253

Accumulated depreciation
(7,311
)
 
(7,076
)
Property, plant and equipment, net
25,521

 
25,177

Intangible assets, net
218

 
227

Deferred charges and other assets, net
1,416

 
1,407

Total assets
$
41,188

 
$
42,783

LIABILITIES AND EQUITY
 
 
 
Current liabilities:
 
 
 
Current portion of debt and capital lease obligations
$
582

 
$
1,009

Accounts payable
7,998

 
9,472

Accrued expenses
527

 
595

Taxes other than income taxes
1,334

 
1,264

Income taxes payable
61

 
119

Deferred income taxes
296

 
249

Total current liabilities
10,798

 
12,708

Debt and capital lease obligations, less current portion
6,460

 
6,732

Deferred income taxes
5,411

 
5,017

Other long-term liabilities
1,896

 
1,881

Commitments and contingencies

 

Equity:
 
 
 
Valero Energy Corporation stockholders’ equity:
 
 
 
Common stock, $0.01 par value; 1,200,000,000 shares authorized;
673,501,593 and 673,501,593 shares issued
7

 
7

Additional paid-in capital
7,477

 
7,486

Treasury stock, at cost; 122,106,373 and 116,689,450 common shares
(6,568
)
 
(6,475
)
Retained earnings
15,542

 
15,309

Accumulated other comprehensive income
119

 
96

Total Valero Energy Corporation stockholders’ equity
16,577

 
16,423

Noncontrolling interest
46

 
22

Total equity
16,623

 
16,445

Total liabilities and equity
$
41,188

 
$
42,783

See Condensed Notes to Consolidated Financial Statements.



3


VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Millions of Dollars, Except Per Share Amounts)
(Unaudited)
 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2012
 
2011
 
2012
 
2011
Operating revenues (a)
$
34,662

 
$
31,293

 
$
69,829

 
$
57,601

Costs and expenses:
 
 
 
 
 
 
 
Cost of sales
31,621

 
28,380

 
64,656

 
52,948

Operating expenses:
 
 
 
 
 
 
 
Refining
868

 
813

 
1,832

 
1,557

Retail
170

 
169

 
336

 
331

Ethanol
85

 
104

 
172

 
199

General and administrative expenses
171

 
151

 
335

 
281

Depreciation and amortization expense
386

 
386

 
770

 
751

Asset impairment loss

 

 
611

 

Total costs and expenses
33,301

 
30,003

 
68,712

 
56,067

Operating income
1,361

 
1,290

 
1,117

 
1,534

Other income (expense), net
(5
)
 
10

 
1

 
27

Interest and debt expense, net of capitalized interest
(74
)
 
(107
)
 
(173
)
 
(224
)
Income from continuing operations before income tax expense
1,282

 
1,193

 
945

 
1,337

Income tax expense
452

 
449

 
547

 
489

Income from continuing operations
830

 
744

 
398

 
848

Loss from discontinued operations, net of income taxes

 
(1
)
 

 
(7
)
Net income
830

 
743

 
398

 
841

Less: Net loss attributable to noncontrolling interest
(1
)
 
(1
)
 
(1
)
 
(1
)
Net income attributable to Valero Energy Corporation stockholders
$
831

 
$
744

 
$
399

 
$
842

Net income attributable to Valero Energy Corporation stockholders:
 
 
 
 
 
 
 
Continuing operations
$
831

 
$
745

 
$
399

 
$
849

Discontinued operations

 
(1
)
 

 
(7
)
Total
$
831

 
$
744

 
$
399

 
$
842

Earnings per common share:
 
 
 
 
 
 
 
Continuing operations
$
1.50

 
$
1.31

 
$
0.72

 
$
1.49

Discontinued operations

 

 

 
(0.01
)
Total
$
1.50

 
$
1.31

 
$
0.72

 
$
1.48

Weighted-average common shares outstanding (in millions)
550

 
567

 
550

 
567

Earnings per common share – assuming dilution:
 
 
 
 
 
 
 
Continuing operations
$
1.50

 
$
1.30

 
$
0.72

 
$
1.48

Discontinued operations

 

 

 
(0.01
)
Total
$
1.50

 
$
1.30

 
$
0.72

 
$
1.47

Weighted-average common shares outstanding –
assuming dilution (in millions)
555

 
574

 
556

 
573

Dividends per common share
$
0.15

 
$
0.05

 
$
0.30

 
$
0.10

Supplemental information:
 
 
 
 
 
 
 
(a) Includes excise taxes on sales by our U.S. retail system
$
241

 
$
227

 
$
475

 
$
441

See Condensed Notes to Consolidated Financial Statements.



4


VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Millions of Dollars)
(Unaudited)

 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2012
 
2011
 
2012
 
2011
Net income
$
830

 
$
743

 
$
398

 
$
841

 
 
 
 
 
 
 
 
Other comprehensive income (loss):
 
 
 
 
 
 
 
Foreign currency translation adjustment
(91
)
 
20

 
32

 
112

 
 
 
 
 
 
 
 
Pension and other postretirement benefits:
 
 
 
 
 
 
 
(Gain) loss reclassified into income related to:
 
 
 
 
 
 
 
Prior service credit
(6
)
 
(5
)
 
(10
)
 
(10
)
Net actuarial loss
9

 
4

 
17

 
7

Net gain (loss) on pension
and other postretirement benefits
3

 
(1
)
 
7

 
(3
)
 
 
 
 
 
 
 
 
Derivative instruments designated
and qualifying as cash flow hedges:
 
 
 
 
 
 
 
Net gain (loss) arising during the period
(31
)
 

 
16

 

Net (gain) loss reclassified into income
12

 

 
(36
)
 

Loss on cash flow hedges
(19
)
 

 
(20
)
 

 
 
 
 
 
 
 
 
Other comprehensive income (loss),
before income tax benefit
(107
)
 
19

 
19

 
109

Income tax benefit related to items of other
comprehensive income (loss)
(5
)
 

 
(4
)
 
(1
)
Other comprehensive income (loss)
(102
)
 
19

 
23

 
110

 
 
 
 
 
 
 
 
Comprehensive income
728

 
762

 
421

 
951

Less: Comprehensive loss attributable to
noncontrolling interest
(1
)
 
(1
)
 
(1
)
 
(1
)
Comprehensive income attributable to
Valero Energy Corporation stockholders
$
729

 
$
763

 
$
422

 
$
952

See Condensed Notes to Consolidated Financial Statements.



5


VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Millions of Dollars)
(Unaudited)

 
Six Months Ended June 30,
 
2012
 
2011
Cash flows from operating activities:
 
 
 
Net income
$
398

 
$
841

Adjustments to reconcile net income to net cash provided by
operating activities:
 
 
 
Depreciation and amortization expense
770

 
751

Asset impairment loss
611

 

Noncash interest expense and other income, net
11

 
21

Stock-based compensation expense
20

 
23

Deferred income tax expense
480

 
166

Changes in current assets and current liabilities
725

 
1,147

Changes in deferred charges and credits and other operating activities, net
(21
)
 
5

Net cash provided by operating activities
2,994

 
2,954

Cash flows from investing activities:
 
 
 
Capital expenditures
(1,420
)
 
(969
)
Deferred turnaround and catalyst costs
(264
)
 
(432
)
Advance payment related to acquisition of Pembroke Refinery

 
(37
)
Minor acquisitions
(66
)
 
(37
)
Other investing activities, net
9

 
(19
)
Net cash used in investing activities
(1,741
)
 
(1,494
)
Cash flows from financing activities:
 
 
 
Non-bank debt:
 
 
 
Borrowings
300

 

Repayments
(862
)
 
(718
)
Bank credit agreements:
 
 
 
Borrowings
1,100

 

Repayments
(1,100
)
 

Accounts receivable sales program:
 
 
 
Proceeds from the sale of receivables
1,300

 

Repayments
(1,450
)
 

Purchase of common stock for treasury
(147
)
 

Proceeds from the exercise of stock options
11

 
30

Common stock dividends
(166
)
 
(57
)
Contributions from noncontrolling interest
25

 
9

Other financing activities, net
(2
)
 
7

Net cash used in financing activities
(991
)
 
(729
)
Effect of foreign exchange rate changes on cash
9

 
42

Net increase in cash and temporary cash investments
271

 
773

Cash and temporary cash investments at beginning of period
1,024

 
3,334

Cash and temporary cash investments at end of period
$
1,295

 
$
4,107


See Condensed Notes to Consolidated Financial Statements.



6




VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


1.
BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
General
As used in this report, the terms “Valero,” “we,” “us,” or “our” may refer to Valero Energy Corporation, one or more of its consolidated subsidiaries, or all of them taken as a whole.
These unaudited financial statements have been prepared in accordance with United States (U.S.) generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities Exchange Act of 1934. Accordingly, they do not include all of the information and notes required by U.S. GAAP for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation have been included. All such adjustments are of a normal recurring nature unless disclosed otherwise. Financial information for the three and six months ended June 30, 2012 and 2011 included in these Condensed Notes to Consolidated Financial Statements is derived from our unaudited financial statements. Operating results for the three and six months ended June 30, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012.

The balance sheet as of December 31, 2011 has been derived from our audited financial statements as of that date. For further information, refer to our financial statements and notes thereto included in our annual report on Form 10-K for the year ended December 31, 2011.
Significant Accounting Policies
Use of Estimates
The preparation of financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. On an ongoing basis, we review our estimates based on currently available information. Changes in facts and circumstances may result in revised estimates.

Comprehensive Income
Effective January 1, 2012, we adopted the provisions of Accounting Standards Codification (ASC) Topic 220, “Comprehensive Income,” and have elected to present comprehensive income in a statement that is separate from the statement of income but placed directly after the statement of income.

Fair Value Measurements
Effective January 1, 2012, we adopted the provisions of ASC Topic 820, “Fair Value Measurement,” which clarified the application of existing fair value measurement requirements and changed certain fair value measurement and disclosure requirements. The adoption of these provisions did not affect our financial position or results of operations as these requirements only affected disclosures as reflected in Note 12.

New Accounting Pronouncements
In December 2011, the provisions of ASC Topic 210, “Balance Sheet,” were amended to require an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of these arrangements on its financial position. The guidance requires entities to disclose both gross information and net information about both instruments and transactions eligible for offset in the balance sheet and instruments and transactions subject to an agreement similar to a master



7




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

netting arrangement. These provisions are effective for interim and annual reporting periods beginning on January 1, 2013. The adoption of this guidance effective January 1, 2013 will not affect our financial position or results of operations, but may result in additional disclosures.

2.
ACQUISITIONS

The acquired refining and marketing businesses discussed below involve the production and marketing of refined petroleum products. These acquisitions are consistent with our general business strategy and complement our existing refining and marketing network.

Meraux Acquisition
On October 1, 2011, we acquired the Meraux Refinery and related logistics assets from Murphy Oil Corporation for an initial payment of $586 million, which was funded from available cash. In the fourth quarter of 2011, we recorded an adjustment related to inventories acquired that reduced the purchase price to $547 million. The assets acquired and liabilities assumed in this acquisition were recognized at their acquisition-date estimated fair values, as disclosed in Note 2 of Notes to Consolidated Financial Statements included in our annual report on Form 10-K for the year ended December 31, 2011, and no adjustments to those estimated amounts have been made during the six months ended June 30, 2012. We are, however, awaiting the completion of an independent appraisal and other evaluations of the fair values of the assets acquired and liabilities assumed.

Pembroke Acquisition
On August 1, 2011, we acquired 100 percent of the outstanding shares of Chevron Limited from a subsidiary of Chevron Corporation (Chevron), and we subsequently changed the name of Chevron Limited to Valero Energy Ltd. On the acquisition date, we initially paid $1.8 billion from available cash, of which $1.1 billion was for working capital. In the fourth quarter of 2011, we recorded adjustments to working capital (primarily inventory), resulting in an adjusted purchase price of $1.7 billion. The assets acquired and liabilities assumed in this acquisition were recognized at their acquisition-date estimated fair values, as disclosed in Note 2 of Notes to Consolidated Financial Statements included in our annual report on Form 10-K for the year ended December 31, 2011, and no adjustments to those estimated amounts have been made during the six months ended June 30, 2012. We are, however, awaiting the completion of an independent appraisal and other evaluations of the fair values of the assets acquired and liabilities assumed. This acquisition is referred to as the Pembroke Acquisition.





8




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

3.
IMPAIRMENT

In March 2012, we suspended the operations of the Aruba Refinery because of the refinery’s inability to generate positive cash flows on a sustained basis subsequent to its restart in January 2011 and the sensitivity of its profitability to sour crude oil differentials, which narrowed significantly in the fourth quarter of 2011. We considered the use of alternative feedstocks or configuration changes that might improve the refinery’s cash flows and we also considered a temporary or permanent shutdown of the refinery facilities. We ultimately decided to shut down the refinery and to maintain it in a state that would allow for operations to be resumed.

On March 28, 2012, we received a non-binding indication of interest from an unrelated interested party to purchase the Aruba Refinery for $350 million, plus working capital as of the closing date, subject to completion of due diligence and further negotiations. We accepted this offer, subject to the finalization of the purchase and sale agreement. Negotiations are currently ongoing and no final agreement has been reached to sell the refinery. The Aruba Refinery is classified as “held and used” because all of the accounting criteria required for “held for sale” classification have not been met.

Because of our decision to suspend the operations of the Aruba Refinery and the possibility that we may sell the refinery, we evaluated the refinery for potential impairment and concluded that the Aruba Refinery was impaired as of March 31, 2012. As a result, we were required to determine the fair value of the Aruba Refinery and to write down its carrying value to that amount. We determined that the best measure of the refinery’s fair value as of March 31, 2012 was the $350 million offer described above, which was based on the interested party’s specific knowledge of the refinery, experience in the refining and marketing industry, and extensive knowledge of the current economic factors of our business. The carrying value of the Aruba Refinery’s long-lived assets as of March 31, 2012 was $945 million; therefore, we recognized an asset impairment loss of $595 million in March 2012.

The operations of the Aruba Refinery remained suspended throughout the second quarter of 2012, and the interested party has continued its negotiations process, including discussions with the Government of Aruba. As a result, we updated our impairment evaluation of the Aruba Refinery as of June 30, 2012 and concluded that the refinery was not further impaired as of that date. The carrying value of the Aruba Refinery’s long-lived assets as of June 30, 2012 was $347 million, reflecting the revised carrying value of $350 million established as of March 31, 2012 less depreciation recognized in the second quarter of 2012.

There is no certainty that we will sell the refinery to the interested party, or to any other party, and if we ultimately sell the refinery, there is no certainty that we will sell it for $350 million. In addition, should we be unable to sell the refinery, we may have to recognize an additional asset impairment loss.

The variation in the customary relationship between income tax expense and income from continuing operations before income tax expense for the six months ended June 30, 2012 was primarily due to not recognizing the tax benefit associated with the asset impairment loss of $595 million related to the Aruba Refinery as we do not expect to realize this tax benefit.




9




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

4.
INVENTORIES

Inventories consisted of the following (in millions):
 
June 30,
2012
 
December 31,
2011
Refinery feedstocks
$
2,140

 
$
2,474

Refined products and blendstocks
2,797

 
2,633

Ethanol feedstocks and products
178

 
195

Convenience store merchandise
105

 
103

Materials and supplies
223

 
218

Inventories
$
5,443

 
$
5,623


As of June 30, 2012 and December 31, 2011, the replacement cost (market value) of last in, first out (LIFO) inventories exceeded their LIFO carrying amounts by approximately $6.5 billion and $6.8 billion, respectively.

5.
DEBT
Non-Bank Debt
During the six months ended June 30, 2012, the following activity occurred:
in June 2012, we remarketed and received proceeds of $300 million related to the 4.0% Gulf Opportunity Zone Revenue Bonds Series 2010 issued by the Parish of St. Charles, State of Louisiana (GO Zone Bonds), which are due December 1, 2040, but are subject to mandatory tender on June 1, 2022;
in April 2012, we made scheduled debt repayments of $4 million  related to our Series 1997A 5.45% industrial revenue bonds and $750 million related to our 6.875% notes; and
in March 2012, we exercised the call provisions on our Series 1997 5.6%, Series 1998 5.6%, Series 1999 5.7%, Series 2001 6.65%, and Series 1997A 5.45% industrial revenue bonds, which were redeemed on May 3, 2012 for $108 million, or 100 percent of their outstanding stated values.

During the six months ended June 30, 2011, the following activity occurred:
in May 2011, we made a scheduled debt repayment of $200 million related to our 6.125% senior notes;
in April 2011, we made scheduled debt repayments of $8 million related to out Series 1997A 5.45%, Series 1997B 5.40%, and Series 1997C 5.40% industrial revenue bonds;
in February 2011, we made a scheduled debt repayment of $210 million related to our 6.75% senior notes; and
also in February 2011, we paid $300 million to acquire the GO Zone Bonds, which were subject to mandatory tender.




10




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

Bank Debt and Credit Facilities
We have a $3 billion revolving credit facility (the Revolver) that has a maturity date of December 2016. The Revolver has certain restrictive covenants, including a maximum debt-to-capitalization ratio of 60 percent. As of June 30, 2012 and December 31, 2011, our debt-to-capitalization ratios, calculated in accordance with the terms of the Revolver, were 26 percent and 29 percent, respectively. We believe that we will remain in compliance with this covenant.

In addition to the Revolver, one of our Canadian subsidiaries has a committed revolving credit facility under which it may borrow and obtain letters of credit up to C$115 million.

During the six months ended June 30, 2012, we borrowed and repaid $1.1 billion under our Revolver. During the six months ended June 30, 2011, we had no borrowings or repayments under our Revolver. We had no borrowings or repayments under the Canadian revolving credit facility during the six months ended June 30, 2012 and 2011. As of June 30, 2012 and December 31, 2011, we had no borrowings outstanding under the Revolver or the Canadian revolving credit facility.

We had outstanding letters of credit under our committed lines of credit as follows (in millions):
 
 
 
 
 
 
Amounts Outstanding
 
 
Borrowing
Capacity
 
Expiration
 
June 30,
2012
 
December 31,
2011
Letter of credit facilities
 
$
550

 
June 2013
 
$
300

 
$
300

Revolver
 
$
3,000

 
December 2016
 
$
70

 
$
119

Canadian revolving credit facility
 
C$
115

 
December 2012
 
C$
11

 
C$
20


In July 2012, one of our letter of credit facilities was amended to extend its maturity date through June 2013 and to increase its borrowing capacity by $50 million. The borrowing capacity and expiration shown in the table above reflect these changes.

As of June 30, 2012 and December 31, 2011, we had $649 million and $391 million, respectively, of letters of credit outstanding under our uncommitted short-term bank credit facilities.

Accounts Receivable Sales Facility
As of June 30, 2012, we had an accounts receivable sales facility with a group of third-party entities and financial institutions to sell on a revolving basis up to $1.0 billion of eligible trade receivables. In July 2012, we amended our agreement to increase the facility to $1.5 billion and to extend the maturity date to July 2013. Proceeds from the sale of receivables under this facility are reflected as debt. Under this program, one of our marketing subsidiaries (Valero Marketing) sells eligible receivables, without recourse, to another of our subsidiaries (Valero Capital), whereupon the receivables are no longer owned by Valero Marketing. Valero Capital, in turn, sells an undivided percentage ownership interest in the eligible receivables, without recourse, to the third-party entities and financial institutions. To the extent that Valero Capital retains an ownership interest in the receivables it has purchased from Valero Marketing, such interest is included in our financial statements solely as a result of the consolidation of the financial statements of Valero Capital with those of Valero Energy Corporation; the receivables are not available to satisfy the claims of the creditors of Valero Marketing or Valero Energy Corporation.



11




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

Changes in the amounts outstanding under our accounts receivable sales facility were as follows (in millions):

 
Six Months Ended
June 30,
 
2012
 
2011
Balance as of beginning of period
$
250

 
$
100

Proceeds from the sale of receivables
1,300

 

Repayments
(1,450
)
 

Balance as of end of period
$
100

 
$
100


Capitalized Interest
Capitalized interest was $53 million and $33 million for the three months ended June 30, 2012 and 2011, respectively, and $105 million and $60 million for the six months ended June 30, 2012 and 2011, respectively.

6.
COMMITMENTS AND CONTINGENCIES

Environmental Matters
The U.S. Environmental Protection Agency (EPA) began regulating greenhouse gases on January 2, 2011, under the Clean Air Act Amendments of 1990 (Clean Air Act). Any new construction or material expansions will require that, among other things, a greenhouse gas permit be issued at either or both the state or federal level in accordance with the Clean Air Act and regulations, and we will be required to undertake a technology review to determine appropriate controls to be implemented with the project in order to reduce greenhouse gas emissions. The determination would be on a case by case basis, and the EPA has provided only general guidance on which controls will be required.

Furthermore, the EPA is currently developing refinery-specific greenhouse gas regulations and performance standards that are expected to impose, on new and existing operations, greenhouse gas emission limits and/or technology requirements. These control requirements may affect a wide range of refinery operations but have not yet been delineated. Any such controls, however, could result in material increased compliance costs, additional operating restrictions for our business, and an increase in the cost of the products we produce, which could have a material adverse effect on our financial position, results of operations, and liquidity.

Certain states and foreign governments have pursued regulation of greenhouse gases independent of the EPA. For example, the California Global Warming Solutions Act, also known as AB 32, directs the California Air Resources Board (CARB) to develop and issue regulations to reduce greenhouse gas emissions in California to 1990 levels by 2020. The CARB has issued a variety of regulations aimed at reaching this goal, including a Low Carbon Fuel Standard (LCFS) as well as a statewide cap-and-trade program.
The LCFS was scheduled to become effective in 2011, but rulings by the U.S. District Court stayed enforcement of the LCFS until certain legal challenges to the LCFS were resolved. Most notably, the court determined that the LCFS violates the Commerce Clause of the U.S. Constitution to the extent that the standard discriminates against out-of-state crude oils and corn ethanol. CARB appealed the lower court’s ruling to the U.S. Court of Appeals for the Ninth Circuit (Ninth Circuit Court).




12




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

The Ninth Circuit Court lifted the stay on April 23, 2012. We anticipate that the Ninth Circuit Court will hear arguments on the merits of the appeal this year, with a final ruling sometime thereafter.
A California statewide cap-and-trade program will begin in late 2012. Initially, the program will apply only to stationary sources of greenhouse gases (e.g., refinery and power plant greenhouse gas emissions). Greenhouse gas emissions from fuels that we sell in California will be covered by the program beginning in 2015. We anticipate that free allocations of credits will be available in the early years of the program to cover most of our stationary emissions, but we expect that compliance costs will increase significantly beginning in 2015, when transportation fuels are included in the program.
Complying with AB 32, including the LCFS and the cap-and-trade program, could result in material increased compliance costs for us, increased capital expenditures, increased operating costs, and additional operating restrictions for our business, resulting in an increase in the cost of, and decreases in the demand for, the products we produce. To the degree we are unable to recover these increased costs, these matters could have a material adverse effect on our financial position, results of operations, and liquidity.

In the first quarter of 2012, CARB adopted amendments to its Clean Fuels Outlet (CFO) Regulation. CARB states that the CFO Regulation is intended to provide outlets of clean fuel to meet the needs of alternative fuel vehicles. We understand that CARB is preparing to submit the CFO Regulation to the State Office of Administrative Law for approval. Under the regulation, projections of zero-emission vehicle availability in the California market would trigger a requirement for major refiners and importers of gasoline, including us, to install clean fuel outlets in designated areas in proportion to each refiner or importer’s share in the California gasoline market. We expect this regulation to be challenged, but we could be required to make significant capital expenditures if the regulation is implemented as presently adopted.

The EPA has disapproved certain permitting programs of the Texas Commission on Environmental Quality (TCEQ) that historically have streamlined the environmental permitting process in Texas. For example, the EPA disapproved the TCEQ pollution control standard permit, thus requiring conventional permitting for future pollution control equipment. The Fifth Circuit Court of Appeals recently overturned the EPA’s disapproval and sent it back to the EPA to re-evaluate the decision. Litigation is pending from industry groups and others against the EPA for each of these actions. In some instances, the EPA’s decisions have been initially upheld and others are still pending before the courts. The EPA has also objected to numerous Title V permits in Texas and other states, including permits at our Port Arthur, Corpus Christi East, and McKee Refineries. Environmental activist groups have filed a notice of intent to sue the EPA, seeking to require the EPA to assume control of these permits from the TCEQ. Finally, as part of its regulation of greenhouse gases discussed above, the EPA has federalized the permitting of greenhouse gas emissions in Texas. This creates a dual permitting structure that must be navigated for material projects in Texas. All of these developments have created substantial uncertainty regarding existing and future permitting. Because of this uncertainty, we are unable to determine the costs or effects of the EPA’s actions on our permitting activity. The EPA’s disruption of the Texas permitting system could result in material increased compliance costs for us, increased capital expenditures, increased operating costs, and additional operating restrictions for our business, resulting in an increase in the cost of, and decreases in the demand for, the products we produce, which could have a material adverse effect on our financial position, results of operations, and liquidity.




13




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

Tax Matters
We are subject to extensive tax liabilities imposed by multiple jurisdictions, including income taxes, transactional taxes (excise/duty, sales/use, and value-added taxes), payroll taxes, franchise taxes, withholding taxes, and ad valorem taxes. New tax laws and regulations and changes in existing tax laws and regulations are continuously being enacted or proposed that could result in increased expenditures for tax liabilities in the future. Many of these liabilities are subject to periodic audits by the respective taxing authority. Subsequent changes to our tax liabilities as a result of these audits may subject us to interest and penalties.

As of June 30, 2012, the Internal Revenue Service (IRS) has ongoing tax audits related to our U.S. federal tax returns from 2002 through 2009. We have received Revenue Agent Reports on our tax years for 2002 through 2007 and we are vigorously contesting the tax positions and assertions from the IRS. Although we believe our tax liabilities are fairly stated and properly reflected in our financial statements, should the IRS eventually prevail, it could result in a material amount of our deferred tax liabilities being reclassified to current liabilities which could have a material adverse effect on our liquidity.
Litigation Matters
We are party to claims and legal proceedings arising in the ordinary course of business. We have not recorded a loss contingency liability with respect to some of these matters because we have determined that it is remote that a loss has been incurred.  For other matters, we have recorded a loss contingency liability where we have determined that it is probable that a loss has been incurred and that the loss is reasonably estimable.  These loss contingency liabilities are not material to our financial position. We re-evaluate and update our loss contingency liabilities as matters progress over time, and we believe that any changes to the recorded liabilities will not be material to our financial position or results of operations.




14




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

7.
EQUITY

The following is a reconciliation of the beginning and ending balances (in millions) of equity attributable to our stockholders, equity attributable to the noncontrolling interest, and total equity for the six months ended June 30, 2012 and 2011:
 
 
2012
 
2011
 
 
Valero
Stockholders
Equity
 
Non-
controlling
Interest
 
Total
Equity
 
Valero
Stockholders
Equity
 
Non-
controlling
Interest
 
Total
Equity
Balance as of beginning of period
 
$
16,423

 
$
22

 
$
16,445

 
$
15,025

 
$

 
$
15,025

Net income (loss)
 
399

 
(1
)
 
398

 
842

 
(1
)
 
841

Dividends
 
(166
)
 

 
(166
)
 
(57
)
 

 
(57
)
Stock-based compensation expense
 
20

 

 
20

 
23

 

 
23

Tax deduction in excess of stock-based compensation expense
 
3

 

 
3

 
11

 

 
11

Transactions in connection with stock-based compensation plans:
 
 
 
 
 
 
 
 
 
 
 
 
Stock issuances
 
11

 

 
11

 
30

 

 
30

Stock repurchases
 
(136
)
 

 
(136
)
 
(2
)
 

 
(2
)
Contributions from noncontrolling interest
 

 
25

 
25

 

 
11

 
11

Other comprehensive income
 
23

 

 
23

 
110

 

 
110

Balance as of end of period
 
$
16,577

 
$
46

 
$
16,623

 
$
15,982

 
$
10

 
$
15,992


The noncontrolling interest relates to a third-party ownership interest in Diamond Green Diesel Holdings LLC, a company whose financial statements we consolidate due to our controlling interest.

Share Activity
Activity in the number of shares of common stock and treasury stock was as follows (in millions) for the six months ended June 30, 2012 and 2011:
 
2012
 
2011
 
Common
Stock
 
Treasury
Stock
 
Common
Stock
 
Treasury
Stock
Balance as of beginning of period
673

 
(117
)
 
673

 
(105
)
Transactions in connection with
stock-based compensation plans:
 
 
 
 
 
 
 
Stock issuances

 
1

 

 
2

Stock purchases

 
(6
)
 

 

Balance as of end of period
673

 
(122
)
 
673

 
(103
)




15




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

Common Stock Dividends
On July 26, 2012, our board of directors declared a quarterly cash dividend of $0.175 per common share payable on September 12, 2012 to holders of record at the close of business on August 15, 2012.

8.
EMPLOYEE BENEFIT PLANS

The components of net periodic benefit cost related to our defined benefit plans were as follows (in millions) for the three and six months ended June 30, 2012 and 2011:
 
Pension Plans
 
Other Postretirement
Benefit Plans
 
2012
 
2011
 
2012
 
2011
Three months ended June 30:
 
 
 
 
 
 
 
Service cost
$
35

 
$
22

 
$
3

 
$
2

Interest cost
23

 
22

 
6

 
5

Expected return on plan assets
(31
)
 
(28
)
 

 

Amortization of:
 
 
 
 
 
 
 
Prior service credit

 

 
(6
)
 
(5
)
Net actuarial loss
9

 
3

 

 
1

Net periodic benefit cost
$
36

 
$
19

 
$
3

 
$
3

 
 
 
 
 
 
 
 
Six months ended June 30:
 
 
 
 
 
 
 
Service cost
$
70

 
$
45

 
$
6

 
$
5

Interest cost
46

 
43

 
11

 
11

Expected return on plan assets
(62
)
 
(56
)
 

 

Amortization of:
 
 
 
 
 
 
 
Prior service cost (credit)
1

 
1

 
(11
)
 
(11
)
Net actuarial loss
17

 
6

 

 
1

Net periodic benefit cost
$
72

 
$
39

 
$
6

 
$
6


Our anticipated contributions to our pension plans during 2012 have not changed from amounts previously disclosed in our financial statements for the year ended December 31, 2011. During the six months ended June 30, 2012, we contributed approximately $13 million to our pension plans. There were no significant contributions made to our pension plans during the six months ended June 30, 2011. In July 2012, we contributed $50 million to our pension plans.




16




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

9.
EARNINGS PER COMMON SHARE

Earnings per common share from continuing operations were computed as follows (dollars and shares in millions, except per share amounts):
 
Three Months Ended June 30,
 
2012
 
2011
 
Restricted 
Stock
 
Common
Stock 
 
Restricted
Stock 
 
 Common
Stock
Earnings per common share from
continuing operations:
 
 
 
 
 
 
 
Net income attributable to Valero stockholders
from continuing operations
 
 
$
831

 
 
 
$
745

Less dividends paid:
 
 
 
 
 
 
 
Common stock
 
 
82

 

 
29

Nonvested restricted stock
 
 
1

 

 

Undistributed earnings
 
 
$
748

 

 
$
716

Weighted-average common shares outstanding
3

 
550

 
3

 
567

Earnings per common share from
continuing operations:
 
 
 
 
 
 
 
Distributed earnings
$
0.15

 
$
0.15

 
$
0.05

 
$
0.05

Undistributed earnings
1.35

 
1.35

 
1.26

 
1.26

Total earnings per common share from
continuing operations
$
1.50

 
$
1.50

 
$
1.31

 
$
1.31

 
 
 
 
 
 
 
 
Earnings per common share from
continuing operations – assuming dilution:
 
 
 
 
 
 
 
Net income attributable to Valero stockholders
from continuing operations
 
 
$
831

 
 
 
$
745

Weighted-average common shares outstanding
 
 
550

 
 
 
567

Common equivalent shares:
 
 

 
 
 
 
Stock options
 
 
3

 
 
 
5

Performance awards and
unvested restricted stock
 
 
2

 
 
 
2

Weighted-average common shares outstanding –
assuming dilution
 
 
555

 
 
 
574

Earnings per common share from
continuing operations – assuming dilution
 
 
$
1.50

 
 
 
$
1.30





17




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

 
Six Months Ended June 30,
 
2012
 
2011
 
Restricted 
Stock
 
Common
Stock 
 
Restricted
Stock 
 
 Common
Stock
Earnings per common share from
continuing operations:
 
 
 
 
 
 
 
Net income attributable to Valero stockholders
from continuing operations
 
 
$
399

 
 
 
$
849

Less dividends paid:
 
 
 
 
 
 
 
Common stock
 
 
165

 
 
 
57

Nonvested restricted stock
 
 
1

 
 
 

Undistributed earnings
 
 
$
233

 
 
 
$
792

 
 
 
 
 
 
 
 
Weighted-average common shares outstanding
3

 
550

 
3

 
567

 
 
 
 
 
 
 
 
Earnings per common share from
continuing operations:
 
 
 
 
 
 
 
Distributed earnings
$
0.30

 
$
0.30

 
$
0.10

 
$
0.10

Undistributed earnings
0.42

 
0.42

 
1.39

 
1.39

Total earnings per common share from
continuing operations
$
0.72

 
$
0.72

 
$
1.49

 
$
1.49

 
 
 
 
 
 
 
 
Earnings per common share from
continuing operations – assuming dilution:
 
 
 
 
 
 
 
Net income attributable to Valero stockholders
from continuing operations
 
 
$
399

 
 
 
$
849

Weighted-average common shares outstanding
 
 
550

 
 
 
567

Common equivalent shares:
 
 
 
 
 
 
 
Stock options
 
 
4

 
 
 
5

Performance awards and
unvested restricted stock
 
 
2

 
 
 
1

Weighted-average common shares outstanding –
assuming dilution
 
 
556

 
 
 
573

Earnings per common share from
continuing operations – assuming dilution
 
 
$
0.72

 
 
 
$
1.48


The following table reflects potentially dilutive securities (in millions) that were excluded from the calculation of “earnings per common share from continuing operations – assuming dilution” as the effect of including such securities would have been antidilutive. These potentially dilutive securities included stock options for which the exercise prices were greater than the average market price of our common shares during each respective reporting period.

 
Three Months Ended
June 30,
 
Six Months Ended
June 30,
 
2012
 
2011
 
2012
 
2011
Stock options
6

 
6

 
6

 
6




18




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

10.
SEGMENT INFORMATION

The following table reflects activity related to continuing operations (in millions):
 
 
Refining
 
Retail
 
Ethanol
 
Corporate
 
Total
Three months ended June 30, 2012:
 
 
 
 
 
 
 
 
 
 
Operating revenues from external
  customers
 
$
30,488

 
$
3,062

 
$
1,112

 
$

 
$
34,662

Intersegment revenues
 
2,203

 

 
46

 

 
2,249

Operating income (loss)
 
1,364

 
172

 
5

 
(180
)
 
1,361

 
 
 
 
 
 
 
 
 
 
 
Three months ended June 30, 2011:
 
 
 
 
 
 
 
 
 
 
Operating revenues from external
  customers
 
26,921

 
3,128

 
1,244

 

 
31,293

Intersegment revenues
 
2,311

 

 
52

 

 
2,363

Operating income (loss)
 
1,253

 
135

 
64

 
(162
)
 
1,290

 
 
 
 
 
 
 
 
 
 
 
Six months ended June 30, 2012:
 
 
 
 
 
 
 
 
 
 
Operating revenues from external
  customers
 
61,638

 
5,997

 
2,194

 

 
69,829

Intersegment revenues
 
4,458

 

 
60

 

 
4,518

Operating income (loss)
 
1,245

 
212

 
14

 
(354
)
 
1,117

 
 
 
 
 
 
 
 
 
 
 
Six months ended June 30, 2011:
 
 
 
 
 
 
 
 
 
 
Operating revenues from external
  customers
 
49,483

 
5,812

 
2,306

 

 
57,601

Intersegment revenues
 
4,308

 

 
100

 

 
4,408

Operating income (loss)
 
1,529

 
201

 
108

 
(304
)
 
1,534


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

 
June 30,
2012
 
December 31,
2011
Refining
$
36,602

 
$
38,164

Retail
1,973

 
1,999

Ethanol
926

 
943

Corporate
1,687

 
1,677

Total assets
$
41,188

 
$
42,783





19




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

11.
SUPPLEMENTAL CASH FLOW INFORMATION

In order to determine net cash provided by operating activities, net income is adjusted by, among other things, changes in current assets and current liabilities as follows (in millions):
 
Six Months Ended June 30,
 
2012
 
2011
Decrease (increase) in current assets:
 
 
 
Receivables, net
$
2,087

 
$
(1,422
)
Inventories
198

 
978

Income taxes receivable
(79
)
 
175

Prepaid expenses and other
(15
)
 
(3
)
Increase (decrease) in current liabilities:
 
 
 
Accounts payable
(1,413
)
 
1,147

Accrued expenses
(60
)
 
202

Taxes other than income taxes
67

 
(52
)
Income taxes payable
(60
)
 
122

Changes in current assets and current liabilities
$
725

 
$
1,147


The above changes in current assets and current liabilities differ from changes between amounts reflected in the applicable 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 debt and capital lease obligations, as well as the effect of certain noncash investing and financing activities discussed below;
amounts accrued for capital expenditures and deferred turnaround and catalyst costs are reflected in investing activities when such amounts are paid;
amounts accrued for common stock purchases in the open market that are not settled as of the balance sheet date are reflected in financing activities when the purchases are settled and paid; and
certain differences between balance sheet changes and the changes reflected above result from translating foreign currency denominated balances at the applicable exchange rates as of each balance sheet date.
There were no significant noncash investing or financing activities for the six months ended June 30, 2012 or 2011.

Cash flows related to interest and income taxes were as follows (in millions):
 
Six Months Ended June 30,
 
2012
 
2011
Interest paid in excess of amount capitalized
$
164

 
$
221

Income taxes paid, net
204

 
10




20




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

12.
FAIR VALUE MEASUREMENTS

General
GAAP requires that certain financial instruments, such as derivative instruments, be recognized at their fair values in our balance sheets. However, other financial instruments, such as debt obligations, are not required to be recognized at their fair values, but GAAP provides an option to elect fair value accounting for these instruments. GAAP requires the disclosure of the fair values of all financial instruments, regardless of whether they are recognized at their fair values or carrying amounts in our balance sheets. For financial instruments recognized at fair value, GAAP requires the disclosure of their fair values by type of instrument, along with other information, including changes in the fair values of certain financial instruments recognized in income or other comprehensive income, and this information is provided below under “Recurring Fair Value Measurements.” For financial instruments not recognized at fair value, the disclosure of their fair values is provided below under “Other Financial Instruments.”

Nonfinancial assets, such as property, plant and equipment, and nonfinancial liabilities are recognized at their carrying amounts in our balance sheets. GAAP does not permit nonfinancial assets and liabilities to be remeasured at their fair values. However, GAAP requires the remeasurement of such assets and liabilities to their fair values upon the occurrence of certain events, such as the impairment of property, plant and equipment. In addition, if such an event occurs, GAAP requires the disclosure of the fair value of the asset or liability along with other information, including the gain or loss recognized in income in the period the remeasurement occurred. This information is provided below under “Nonrecurring Fair Value Measurements.”

GAAP provides a framework for measuring fair value and establishes a three-level fair value hierarchy that prioritizes inputs to valuation techniques based on the degree to which objective prices in external active markets are available to measure fair value. Following is a description of each of the levels of the fair value hierarchy.
Level 1 - Observable inputs, such as unadjusted quoted prices in active markets for identical assets or liabilities.
Level 2 - Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. These include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active.
Level 3 - Unobservable inputs for the asset or liability for which there is little, if any, market activity at the measurement date. Unobservable inputs reflect our own assumptions about what market participants would use to price the asset or liability. The inputs are developed based on the best information available in the circumstances, which might include occasional market quotes or sales of similar instruments or our own financial data such as internally developed pricing models, discounted cash flow methodologies, as well as instruments for which the fair value determination requires significant judgment.

The financial instruments and nonfinancial assets and liabilities included in our disclosure of recurring and nonrecurring fair value measurements are categorized according to the fair value hierarchy based on the inputs used to measure their fair values.




21




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

Recurring Fair Value Measurements
The tables below present information (in millions) about our financial instruments recognized at their fair values in our balance sheets categorized according to the fair value hierarchy of the inputs utilized by us to determine the fair values as of June 30, 2012 and December 31, 2011.
Cash received from brokers of $81 million and cash collateral deposits with brokers of $136 million under master netting arrangements are included in the fair value of the commodity derivatives reflected in Level 1 as of June 30, 2012 and December 31, 2011, respectively. Certain of our commodity derivative contracts under master netting arrangements include both asset and liability positions. We have elected to offset the fair value amounts recognized for multiple similar derivative instruments executed with the same counterparty, including any related cash collateral asset or obligation under the column “Netting Adjustments” below; however, fair value amounts by hierarchy level are presented on a gross basis in the tables below.

 
Fair Value Measurements Using
 
 
 
 
 
Quoted
Prices in
Active
Markets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
 
Netting
Adjustments
 
Total
Fair Value
as of
June 30,
2012
Assets:
 
 
 
 
 
 
 
 
 
Commodity derivative contracts
$
2,781

 
$
144

 
$

 
$
(2,836
)
 
$
89

Physical purchase contracts

 
18

 

 

 
18

Investments of certain benefit plans
85

 

 
11

 

 
96

Other investments

 

 

 

 

Liabilities:
 
 
 
 
 
 
 
 
 
Commodity derivative contracts
2,701

 
143

 

 
(2,836
)
 
8

Foreign currency contracts
5

 

 

 

 
5


 
Fair Value Measurements Using
 
 
 
 
 
Quoted
Prices in
Active
Markets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
 
Netting
Adjustments
 
Total
Fair Value
as of
December 31,
2011
Assets:
 
 
 
 
 
 
 
 
 
Commodity derivative contracts
$
2,038

 
$
78

 
$

 
$
(1,940
)
 
$
176

Physical purchase contracts

 
(2
)
 

 

 
(2
)
Investments of certain benefit plans
84

 

 
11

 

 
95

Other investments

 

 

 

 

Liabilities:
 
 
 
 
 
 
 
 
 
Commodity derivative contracts
1,864

 
101

 

 
(1,940
)
 
25

Foreign currency contracts
3

 

 

 

 
3




22




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

A description of our financial instruments and the valuation methods used to measure those instruments at fair value are as follows:
Commodity derivative contracts consist primarily of exchange-traded futures and swaps, and as disclosed in Note 13, some of these contracts are designated as hedging instruments. These contracts are measured at fair value using the market approach. Exchange-traded futures are valued based on quoted prices from the exchange and are categorized in Level 1 of the fair value hierarchy. Swaps are priced using third-party broker quotes, industry pricing services, and exchange-traded curves, with appropriate consideration of counterparty credit risk, but because they have contractual terms that are not identical to exchange-traded futures instruments with a comparable market price, these financial instruments are categorized in Level 2 of the fair value hierarchy.
Physical purchase contracts to purchase inventories represent the fair value of firm commitments to purchase crude oil feedstocks and the fair value of fixed-price corn purchase contracts, and as disclosed in Note 13, some of these contracts are designated as hedging instruments. The fair values of these firm commitments and purchase contracts are measured using a market approach based on quoted prices from the commodity exchange, but because these commitments have contractual terms that are not identical to exchange-traded futures instruments with a comparable market price, they are categorized in Level 2 of the fair value hierarchy.
Investments of certain benefit plans consist of investment securities held by trusts for the purpose of satisfying a portion of our obligations under certain U.S. nonqualified benefit plans. The assets categorized in Level 1 of the fair value hierarchy are measured at fair value using a market approach based on quoted prices from national securities exchanges. The assets categorized in Level 3 of the fair value hierarchy represent insurance contracts, the fair value of which is provided by the insurer.
Foreign currency contracts consist of foreign currency exchange and purchase contracts entered into by our international operations to manage our exposure to exchange rate fluctuations on transactions denominated in currencies other than the local (functional) currencies of those operations. These contracts are valued based on quoted prices from the exchange and are categorized in Level 1 of the fair value hierarchy.
Other investments consist of (i) equity securities of private companies over which we do not exercise significant influence nor whose financial statements are consolidated into our financial statements and (ii) debt securities of a private company whose financial statements are not consolidated into our financial statements. We have elected to account for these investments at their fair values. These investments are categorized in Level 3 of the fair value hierarchy as the fair values of these investments are determined using the income approach based on internally developed analyses.




23




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

The following is a reconciliation of the beginning and ending balances (in millions) for fair value measurements developed using significant unobservable inputs (Level 3) for the three and six months ended June 30, 2012 and 2011.
 
2012
 
2011
 
Investments
of Certain
Benefit
Plans
 
Other
Investments
 
Investments
of Certain
Benefit
Plans
 
Other
Investments
Three months ended June 30:
 
 
 
 
 
 
 
Balance as of beginning of period
$
11

 
$

 
$
11

 
$

Purchases

 

 

 
10

Total gains (losses) included in income

 

 

 
(10
)
Transfers in and/or out of Level 3

 

 

 

Balance as of end of period
$
11

 
$

 
$
11

 
$

The amount of total gains (losses)
included in income attributable to
the change in unrealized gains (losses)
relating to assets still held at
end of period
$

 
$

 
$

 
$
(10
)
 
 
 
 
 
 
 
 
Six months ended June 30:
 
 
 
 
 
 
 
Balance as of beginning of period
$
11

 
$

 
$
10

 
$

Purchases

 

 

 
16

Total gains (losses) included in income

 

 
1

 
(16
)
Transfers in and/or out of Level 3

 

 

 

Balance as of end of period
$
11

 
$

 
$
11

 
$

The amount of total gains (losses)
included in income attributable to
the change in unrealized gains (losses)
relating to assets still held at
end of period
$

 
$

 
$
1

 
$
(16
)



24




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

Nonrecurring Fair Value Measurements
As discussed in Note 3, we concluded that the Aruba Refinery was impaired as of March 31, 2012. As a result, we were required to determine the fair value of the Aruba Refinery and to write down its carrying value to that amount. We determined that the best measure of the refinery’s fair value as of March 31, 2012 was the $350 million offer received and accepted, subject to the finalization of the purchase and sale agreement. We believe this offer represents what a market participant would pay us for the assets in their highest and best use, as more fully discussed in Note 3. The fair value of the Aruba Refinery was measured using the market approach and was categorized in Level 3 within the fair value hierarchy. The carrying value of the Aruba Refinery’s long-lived assets as of March 31, 2012 was $945 million; therefore, we recognized an asset impairment loss of $595 million in March 2012.

We recognized an asset impairment loss of $16 million in March 2012 related to equipment associated with a capital project that was cancelled permanently in 2009. We had written down the carrying value of this equipment to fair value in 2009, but we have been unable to sell the equipment. As a result, we wrote down the carrying amount of the equipment to scrap value.

There were no assets or liabilities that were measured at fair value on a nonrecurring basis as of June 30, 2012 or December 31, 2011. During the six months ended June 30, 2012, we recognized an asset impairment loss of $611 million as described above.
 
 
 
 
 
 
 
 
 
 
Other Financial Instruments
Financial instruments that we recognize in our balance sheets at their carrying amounts are shown in the table below (in millions):

 
June 30, 2012
 
December 31, 2011
 
Carrying
Amount
 
Fair
Value
 
Carrying
Amount

 
Fair
Value

Financial assets:
 
 
 
 
 
 
 
Cash and temporary cash investments
$
1,295

 
$
1,295

 
$
1,024

 
$
1,024

Financial liabilities:
 
 
 
 
 
 
 
Debt (excluding capital leases)
6,995

 
8,187

 
7,690

 
9,298


The methods and significant assumptions used to estimate the fair value of these financial instruments are as follows:
The fair value of cash and temporary cash investments approximates the carrying value due to the low level of credit risk of these assets combined with their short maturities and market interest rates (Level 1).
The fair value of debt is determined primarily using the market approach based on quoted prices in active markets (Level 1).




25




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

13.
PRICE RISK MANAGEMENT ACTIVITIES
We are exposed to market risks related to the volatility in the price of commodities, the price of financial instruments associated with governmental and regulatory compliance programs, interest rates, and foreign currency exchange rates, and we enter into derivative instruments to manage some of these risks. We also enter into derivative instruments to manage the price risk on other contractual derivatives into which we have entered. The only types of derivative instruments we enter into are those related to the various commodities we purchase or produce, financial instruments we must purchase to maintain compliance with various governmental and regulatory programs, interest rate swaps, and foreign currency exchange and purchase contracts, as described below. All derivative instruments are recorded as either assets or liabilities measured at their fair values (see Note 12).
When we enter into a derivative instrument, it is designated as a fair value hedge, a cash flow hedge, an economic hedge, or a trading derivative. The gain or loss on a derivative instrument designated and qualifying as a fair value hedge, as well as the offsetting loss or gain on the hedged item attributable to the hedged risk, is recognized currently in income in the same period. The effective portion of the gain or loss on a derivative instrument designated and qualifying as a cash flow hedge is initially reported as a component of other comprehensive income and is then recorded in income in the period or periods during which the hedged forecasted transaction affects income. The ineffective portion of the gain or loss on the cash flow derivative instrument, if any, is recognized in income as incurred. For our economic hedges (derivative instruments not designated as fair value or cash flow hedges) and for derivative instruments entered into by us for trading purposes, the derivative instrument is recorded at fair value and changes in the fair value of the derivative instrument are recognized currently in income. The cash flow effects of all of our derivative instruments are reflected in operating activities in our statements of cash flows for all periods presented.

Commodity Price Risk
We are exposed to market risks related to the volatility in the price of crude oil, refined products (primarily gasoline and distillate), grain (primarily corn), and natural gas used in our operations. To reduce the impact of price volatility on our results of operations and cash flows, we use commodity derivative instruments, including futures, swaps, and options. We use the futures markets for the available liquidity, which provides greater flexibility in transacting our hedging and trading operations. We use swaps primarily to manage our price exposure. Our positions in commodity derivative instruments are monitored and managed on a daily basis by a risk control group to ensure compliance with our stated risk management policy that has been approved by our board of directors.

For risk management purposes, we use fair value hedges, cash flow hedges, and economic hedges. In addition to the use of derivative instruments to manage commodity price risk, we also enter into certain commodity derivative instruments for trading purposes. Our objective for entering into each type of hedge or trading derivative is described below.

Fair Value Hedges
Fair value hedges are used to hedge price volatility in certain refining inventories and firm commitments to purchase inventories. The level of activity for our fair value hedges is based on the level of our operating inventories, and generally represents the amount by which our inventories differ from our previous year-end LIFO inventory levels.



26




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

As of June 30, 2012, we had the following outstanding commodity derivative instruments that were entered into to hedge crude oil and refined product inventories and commodity derivative instruments related to the physical purchase of crude oil and refined products at a fixed price. The information presents the notional volume of outstanding contracts by type of instrument and year of maturity (volumes in thousands of barrels).

 
 
Notional
Contract
Volumes by
Year of
Maturity
Derivative Instrument
 
2012
Crude oil and refined products:
 
 
Futures – long
 
4,869

Futures – short
 
9,052

Physical contracts - long
 
4,183

Cash Flow Hedges
Cash flow hedges are used to hedge price volatility in certain forecasted feedstock and refined product purchases, refined product sales, and natural gas purchases. The objective of our cash flow hedges is to lock in the price of forecasted feedstock, product or natural gas purchases or refined product sales at existing market prices that we deem favorable.

As of June 30, 2012, we had the following outstanding commodity derivative instruments that were entered into to hedge forecasted purchases or sales of crude oil and refined products. The information presents the notional volume of outstanding contracts by type of instrument and year of maturity (volumes in thousands of barrels).

 
 
Notional
Contract
Volumes by
Year of
Maturity
Derivative Instrument
 
2012
Crude oil and refined products:
 
 
Swaps – long
 
5,511

Swaps – short
 
5,511

Futures – long
 
18,386

Futures – short
 
10,768

Physical contracts – short
 
7,618





27




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

Economic Hedges
Economic hedges represent commodity derivative instruments that are not designated as fair value or cash flow hedges and are used to manage price volatility in certain (i) refinery feedstock, refined product, and corn inventories, (ii) forecasted refinery feedstock, refined product, and corn purchases, and refined product sales, and (iii) fixed-price corn purchase contracts. Our objective for entering into economic hedges is consistent with the objectives discussed above for fair value hedges and cash flow hedges. However, the economic hedges are not designated as a fair value hedge or a cash flow hedge for accounting purposes, usually due to the difficulty of establishing the required documentation at the date that the derivative instrument is entered into that would allow us to achieve “hedge deferral accounting.”
As of June 30, 2012, we had the following outstanding commodity derivative instruments that were used as economic hedges and commodity derivative instruments related to the physical purchase of corn at a fixed price. The information presents the notional volume of outstanding contracts by type of instrument and year of maturity (volumes in thousands of barrels, except those identified as corn contracts that are presented in thousands of bushels).

 
 
Notional Contract Volumes by
Year of Maturity
Derivative Instrument
 
2012
 
2013
Crude oil and refined products:
 
 
 
 
Swaps – long
 
30,879

 

Swaps – short
 
28,174

 

Futures – long
 
58,610

 
85

Futures – short
 
79,986

 

Corn:
 
 
 
 
Futures – long
 
49,750

 
55

Futures – short
 
91,035

 
3,375

Physical contracts – long
 
38,336

 
3,610




28




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

Trading Derivatives
Our objective in entering into commodity derivative instruments for trading purposes is to take advantage of existing market conditions related to future results of operations and cash flows.

As of June 30, 2012, we had the following outstanding commodity derivative instruments that were entered into for trading purposes. The information presents the notional volume of outstanding contracts by type of instrument and year of maturity (volumes represent thousands of barrels, except those identified as natural gas contracts that are presented in billions of British thermal units and corn contracts that are presented in thousands of bushels).

 
 
Notional Contract Volumes by
Year of Maturity
Derivative Instrument
 
2012
 
2013
Crude oil and refined products:
 
 
 
 
Swaps – long
 
19,043

 
27,930

Swaps – short
 
17,917

 
28,321

Futures – long
 
101,095

 
18,832

Futures – short
 
102,208

 
17,760

Options – long
 
11,900

 

Options – short
 
12,271

 

Natural gas:
 
 
 
 
Futures – long
 
6,800

 
200

Futures – short
 
6,400

 

Corn:
 
 
 
 
Swaps - long
 
2,605

 

Swaps - short
 
12,460

 
1,580

Futures – long
 
19,360

 

Futures – short
 
19,360

 


Compliance Program Price Risk
We are exposed to market risks related to the volatility in the price of financial instruments associated with various governmental and regulatory compliance programs that we must purchase in the open market to comply with these programs. These programs are described below.

Obligation to Blend Biofuels
We are obligated to blend biofuels into the products we produce in most of the countries in which we operate, and these countries set annual quotas for the percentage of biofuels that must be blended into the motor fuels consumed in these countries. As a producer of motor fuels from petroleum, we are obligated to blend biofuels into the products we produce at a rate that is at least equal to the applicable quota. To the degree we are unable to blend at the applicable rate in the U.S. and the United Kingdom (U.K.), we must purchase Renewable Identification Numbers (RINs) in the U.S. and Renewable Transport Fuel Obligation certificates (RTFCs) in the U.K., and as such, we are exposed to the volatility in the market price of these financial instruments.



29




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

We have not entered into derivative instruments to manage this risk, but we purchase RINs and RTFCs when the price of these instruments is deemed favorable. The cost of meeting our obligations under this compliance program was $59 million and $39 million for the three months ended June 30, 2012 and 2011, respectively, and $126 million and $95 million for the six months ended June 30, 2012 and 2011. These amounts are reflected in cost of sales.

Maintaining Minimum Inventory Quantities
In the U.K., we are required to maintain a minimum quantity of crude oil and refined products as a reserve against shortages or interruptions in the supply of these products. To the degree we decide not to physically hold the minimum quantity of crude oil and refined products, we must purchase Compulsory Stock Obligation (CSO) tickets from other suppliers of refined products in the U.K. or other European Union (EU) member countries, and we make economic decisions as to the cost of maintaining certain quantities of crude oil and refined products versus the cost of purchasing CSO tickets. We have not entered into derivative instruments to manage the price volatility of CSO tickets. For the three and six months ended June 30, 2012, the cost of purchasing CSO tickets to help meet our obligations under this compliance program was $1 million and $3 million, respectively and this amount was reflected in cost of sales. We had no obligations under this compliance program prior to completing the Pembroke Acquisition in 2011.

Emission Allowances
Our Pembroke Refinery is subject to a maximum amount of carbon dioxide that it can emit each year under the EU Emissions Trading Scheme. Under this cap-and-trade program, we purchase emission allowances on the open market for the difference between the amount of carbon dioxide emitted and the maximum amount allowed under the program. Therefore, we are exposed to the volatility in the market price of these allowances. For the three months ended June 30, 2012, no costs were incurred to meet our obligation under this compliance program. For the six months ended June 30, 2012, the cost of meeting our obligation under this compliance program was $1 million, which is reflected in refining operating expenses. We had no obligations under this compliance program prior to completing the Pembroke Acquisition in 2011.

We enter into derivative instruments (futures) to reduce the impact of this risk on our results of operations and cash flows. Our positions in these derivative instruments are monitored and managed on a daily basis by a risk control group to ensure compliance with our stated risk management policy that has been approved b