10-Q 1 vlo9301210q.htm 10-Q VLO 9.30.12 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 September 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 October 31, 2012 was 553,540,069.
 
 
 
 
 



VALERO ENERGY CORPORATION AND SUBSIDIARIES
TABLE OF CONTENTS
 
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 





i


PART I – FINANCIAL INFORMATION
Item 1. Financial Statements

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

 
September 30,
2012
 
December 31,
2011
 
(Unaudited)
 
 
ASSETS
 
 
 
Current assets:
 
 
 
Cash and temporary cash investments
$
2,549

 
$
1,024

Receivables, net
7,451

 
8,706

Inventories
5,787

 
5,623

Income taxes receivable
40

 
212

Deferred income taxes
292

 
283

Prepaid expenses and other
148

 
124

Total current assets
16,267

 
15,972

Property, plant and equipment, at cost
33,454

 
32,253

Accumulated depreciation
(7,581
)
 
(7,076
)
Property, plant and equipment, net
25,873

 
25,177

Intangible assets, net
216

 
227

Deferred charges and other assets, net
1,436

 
1,407

Total assets
$
43,792

 
$
42,783

LIABILITIES AND EQUITY
 
 
 
Current liabilities:
 
 
 
Current portion of debt and capital lease obligations
$
585

 
$
1,009

Accounts payable
9,286

 
9,472

Accrued expenses
612

 
595

Taxes other than income taxes
1,349

 
1,264

Income taxes payable
234

 
119

Deferred income taxes
185

 
249

Total current liabilities
12,251

 
12,708

Debt and capital lease obligations, less current portion
6,463

 
6,732

Deferred income taxes
5,758

 
5,017

Other long-term liabilities
1,934

 
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
7,409

 
7,486

Treasury stock, at cost; 120,035,210 and 116,689,450 common shares
(6,455
)
 
(6,475
)
Retained earnings
16,119

 
15,309

Accumulated other comprehensive income
252

 
96

Total Valero Energy Corporation stockholders’ equity
17,332

 
16,423

Noncontrolling interest
54

 
22

Total equity
17,386

 
16,445

Total liabilities and equity
$
43,792

 
$
42,783

See Condensed Notes to Consolidated Financial Statements.



1


VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Millions of Dollars, Except Per Share Amounts)
(Unaudited)
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Operating revenues (a)
$
34,726

 
$
33,713

 
$
104,555

 
$
91,314

Costs and expenses:
 
 
 
 
 
 
 
Cost of sales
31,312

 
30,033

 
95,968

 
82,981

Operating expenses:
 
 
 
 
 
 
 
Refining
930

 
870

 
2,762

 
2,427

Retail
178

 
177

 
514

 
508

Ethanol
76

 
103

 
248

 
302

General and administrative expenses
174

 
161

 
509

 
442

Depreciation and amortization expense
402

 
390

 
1,172

 
1,141

Asset impairment loss
345

 

 
956

 

Total costs and expenses
33,417

 
31,734

 
102,129

 
87,801

Operating income
1,309

 
1,979

 
2,426

 
3,513

Other income (expense), net
(2
)
 
1

 
(1
)
 
28

Interest and debt expense, net of capitalized interest
(70
)
 
(88
)
 
(243
)
 
(312
)
Income from continuing operations before income tax expense
1,237

 
1,892

 
2,182

 
3,229

Income tax expense
564

 
689

 
1,111

 
1,178

Income from continuing operations
673

 
1,203

 
1,071

 
2,051

Loss from discontinued operations, net of income taxes

 

 

 
(7
)
Net income
673

 
1,203

 
1,071

 
2,044

Less: Net loss attributable to noncontrolling interest
(1
)
 

 
(2
)
 
(1
)
Net income attributable to Valero Energy Corporation stockholders
$
674

 
$
1,203

 
$
1,073

 
$
2,045

Net income attributable to Valero Energy Corporation stockholders:
 
 
 
 
 
 
 
Continuing operations
$
674

 
$
1,203

 
$
1,073

 
$
2,052

Discontinued operations

 

 

 
(7
)
Total
$
674

 
$
1,203

 
$
1,073

 
$
2,045

Earnings per common share:
 
 
 
 
 
 
 
Continuing operations
$
1.22

 
$
2.12

 
$
1.94

 
$
3.61

Discontinued operations

 

 

 
(0.01
)
Total
$
1.22

 
$
2.12

 
$
1.94

 
$
3.60

Weighted-average common shares outstanding (in millions)
549

 
564

 
550

 
566

Earnings per common share – assuming dilution:
 
 
 
 
 
 
 
Continuing operations
$
1.21

 
$
2.11

 
$
1.93

 
$
3.59

Discontinued operations

 

 

 
(0.01
)
Total
$
1.21

 
$
2.11

 
$
1.93

 
$
3.58

Weighted-average common shares outstanding –
assuming dilution (in millions)
556

 
569

 
556

 
572

Dividends per common share
$
0.175

 
$
0.050

 
$
0.475

 
$
0.150

Supplemental information:
 
 
 
 
 
 
 
(a) Includes excise taxes on sales by our U.S. retail system
$
248

 
$
229

 
$
723

 
$
670

See Condensed Notes to Consolidated Financial Statements.



2


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

 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Net income
$
673

 
$
1,203

 
$
1,071

 
$
2,044

 
 
 
 
 
 
 
 
Other comprehensive income (loss):
 
 
 
 
 
 
 
Foreign currency translation adjustment
143

 
(278
)
 
175

 
(166
)
 
 
 
 
 
 
 
 
Pension and other postretirement benefits:
 
 
 
 
 
 
 
(Gain) loss reclassified into income related to:
 
 
 
 
 
 
 
Prior service credit
(5
)
 
(5
)
 
(15
)
 
(15
)
Net actuarial loss
8

 
3

 
25

 
10

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

 
(2
)
 
10

 
(5
)
 
 
 
 
 
 
 
 
Derivative instruments designated
and qualifying as cash flow hedges:
 
 
 
 
 
 
 
Net gain arising during the period
27

 
20

 
43

 
20

Net gain reclassified into income
(45
)
 

 
(81
)
 

Net gain (loss) on cash flow hedges
(18
)
 
20

 
(38
)
 
20

 
 
 
 
 
 
 
 
Other comprehensive income (loss),
before income tax expense (benefit)
128

 
(260
)
 
147

 
(151
)
Income tax expense (benefit) related to items of other
comprehensive income (loss)
(5
)
 
6

 
(9
)
 
5

Other comprehensive income (loss)
133

 
(266
)
 
156

 
(156
)
 
 
 
 
 
 
 
 
Comprehensive income
806

 
937

 
1,227

 
1,888

Less: Comprehensive loss attributable to
noncontrolling interest
(1
)
 

 
(2
)
 
(1
)
Comprehensive income attributable to
Valero Energy Corporation stockholders
$
807

 
$
937

 
$
1,229

 
$
1,889

See Condensed Notes to Consolidated Financial Statements.



3


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

 
Nine Months Ended
September 30,
 
2012
 
2011
Cash flows from operating activities:
 
 
 
Net income
$
1,071

 
$
2,044

Adjustments to reconcile net income to net cash provided by
operating activities:
 
 
 
Depreciation and amortization expense
1,172

 
1,141

Asset impairment loss
956

 

Noncash interest expense and other income, net
18

 
20

Stock-based compensation expense
29

 
34

Deferred income tax expense
576

 
393

Changes in current assets and current liabilities
1,351

 
840

Changes in deferred charges and credits and other operating activities, net
(66
)
 
(144
)
Net cash provided by operating activities
5,107

 
4,328

Cash flows from investing activities:
 
 
 
Capital expenditures
(2,129
)
 
(1,584
)
Deferred turnaround and catalyst costs
(339
)
 
(501
)
Acquisition of Pembroke Refinery, net of cash acquired

 
(1,675
)
Minor acquisitions
(77
)
 
(37
)
Other investing activities, net
(28
)
 
(24
)
Net cash used in investing activities
(2,573
)
 
(3,821
)
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
1,500

 

Repayments
(1,650
)
 

Purchase of common stock for treasury
(148
)
 
(270
)
Proceeds from the exercise of stock options
36

 
42

Common stock dividends
(263
)
 
(85
)
Contributions from noncontrolling interest
34

 
12

Other financing activities, net
8

 
17

Net cash used in financing activities
(1,045
)
 
(1,002
)
Effect of foreign exchange rate changes on cash
36

 
(10
)
Net increase (decrease) in cash and temporary cash investments
1,525

 
(505
)
Cash and temporary cash investments at beginning of period
1,024

 
3,334

Cash and temporary cash investments at end of period
$
2,549

 
$
2,829


See Condensed Notes to Consolidated Financial Statements.



4




VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


1.
BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
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 nine months ended September 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 nine months ended September 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 netting arrangement. These provisions are effective for interim and annual reporting periods beginning on



5




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

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 nine months ended September 30, 2012.

Pembroke Acquisition
On August 1, 2011, we acquired 100 percent of the outstanding shares of Chevron Limited from a subsidiary of Chevron Corporation, 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. Subsequent to the acquisition date, we recorded adjustments to working capital (primarily inventory), resulting in an adjusted purchase price of $1.7 billion. This acquisition is referred to as the Pembroke Acquisition.




6




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

In the third quarter of 2012, an independent appraisal of the assets acquired and liabilities assumed and certain other evaluations of the fair values related to the Pembroke Acquisition were completed and finalized. The purchase price of the Pembroke Acquisition was allocated based on the fair values of the assets acquired and the liabilities assumed at the date of acquisition resulting from this final appraisal and other evaluations. The primary adjustments to the preliminary purchase price allocation 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 consisted of a $143 million increase in property, plant and equipment, a $124 million increase in deferred income tax liabilities, and a $17 million increase in other long-term liabilities. The final amounts assigned to the assets acquired and liabilities assumed in the Pembroke Acquisition were recognized at their acquisition-date fair values and are as follows (in millions):

Current assets, net of cash acquired
$
2,215

Property, plant and equipment
947

Intangible assets
22

Deferred charges and other assets, net
37

Current liabilities, less current portion of debt
and capital lease obligations
(1,294
)
Debt and capital leases assumed, including current portion
(12
)
Deferred income taxes
(159
)
Other long-term liabilities
(60
)
Noncontrolling interest
(5
)
Purchase price, net of cash acquired
$
1,691


Because of the adjustment to property, plant and equipment discussed above, we recorded an additional $6 million of depreciation expense in the third quarter of 2012 to true-up depreciation expense for the period from the date of the Pembroke Acquisition (August 1, 2011) through July 31, 2012.

3.
IMPAIRMENTS

Aruba Refinery
In September 2012, we decided to reorganize the Aruba Refinery into a crude oil and refined products terminal in response to the withdrawal of a non-binding offer to purchase the refinery. We had received the offer on March 28, 2012, and had accepted it, subject to the finalization of a purchase and sale agreement, but the interested party withdrew its offer on August 14, 2012.

We suspended the operations of the Aruba Refinery in March 2012 because of its 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 had narrowed significantly in the fourth quarter of 2011. Shortly thereafter, we received the non-binding offer to purchase the refinery for $350 million, plus working capital as of the closing date. Because of our decision to suspend operations and the possibility of selling the refinery, we evaluated the refinery for potential impairment as of March 31, 2012 and concluded that it was impaired. We wrote down the refinery’s net book value (carrying value) of $945 million to its estimated fair value of $350 million, resulting in an asset impairment loss of $595 million that was recorded in March 2012. We determined that the best measure of the refinery’s fair value at that time was the $350 million offer because



7




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

it was based on the interested party’s specific knowledge of the refinery, experience in the refining and marketing industry, and extensive knowledge of the economic factors affecting our business. We did not, however, classify the Aruba Refinery as “held for sale” in our balance sheet because all of the accounting criteria required for that classification had not been met.

Because of our recent decision to reorganize the Aruba Refinery into a crude oil and refined products terminal, we bifurcated the idled crude oil processing units and related infrastructure (refining assets) from the terminal assets and evaluated the refining assets for potential impairment as of September 30, 2012. We concluded that the refining assets were impaired and determined that their carrying value of $308 million was not recoverable through the future operations and disposition of the refinery. We determined that these refining assets had no value after considering estimated salvage costs, resulting in an asset impairment loss of $308 million that was recorded in September 2012. We also recognized an asset impairment loss of $25 million related to materials and supplies inventories that supported the refining operations, resulting in a total asset impairment loss of $333 million that was recognized in September 2012 related to the Aruba Refinery. The terminal assets, which had a carrying value of $37 million as of September 30, 2012, were not impaired.

We currently intend to maintain the refining assets to allow them to be restarted and do not consider them to be abandoned. Therefore, we have not reflected the Aruba Refinery as a discontinued operation in our financial statements. It is possible, however, that we may abandon these assets in the future. Should we ultimately decide to abandon these assets, we may be required under our land lease agreement with the Government of Aruba to recognize an asset retirement obligation, and the amount recognized would be immediately charged to expense. We do not expect these amounts to be material to our financial position or results of operations.

The variation in the customary relationship between income tax expense and income from continuing operations before income tax expense for the three and nine months ended September 30, 2012 was primarily due to not recognizing a tax benefit associated with the asset impairment loss of $333 million and $928 million, respectively, related to the Aruba Refinery as we do not expect to realize this tax benefit.

See Note 6 for a discussion of the severance liability for employees who will be terminated in connection with the Aruba reorganization.

Other Assets
In March 2012, we wrote down the carrying value of equipment associated with a permanently cancelled capital project at one of our refineries, resulting in an asset impairment loss of $16 million that was recorded in March 2012.

We evaluated certain convenience stores operated by our retail segment for potential impairment as of September 30, 2012 and concluded that they were impaired. We wrote down the carrying values of these stores to their estimated fair values, which totaled $5 million, resulting in an asset impairment loss of $12 million that was recorded in September 2012.




8




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

4.
INVENTORIES

Inventories consisted of the following (in millions):
 
September 30,
2012
 
December 31,
2011
Refinery feedstocks
$
2,423

 
$
2,474

Refined products and blendstocks
2,904

 
2,633

Ethanol feedstocks and products
152

 
195

Convenience store merchandise
102

 
103

Materials and supplies
206

 
218

Inventories
$
5,787

 
$
5,623


As of September 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 $8.7 billion and $6.8 billion, respectively.

5.
DEBT
Non-Bank Debt
During the nine months ended September 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 nine months ended September 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 our 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.




9




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 September 30, 2012 and December 31, 2011, our debt-to-capitalization ratios, calculated in accordance with the terms of the Revolver, were 21 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 nine months ended September 30, 2012, we borrowed and repaid $1.1 billion under our Revolver. During the nine months ended September 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 nine months ended September 30, 2012 and 2011. As of September 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
 
September 30,
2012
 
December 31,
2011
Letter of credit facilities
 
$
550

 
June 2013
 
$
337

 
$
300

Revolver
 
$
3,000

 
December 2016
 
$
64

 
$
119

Canadian revolving credit facility
 
C$
115

 
December 2012
 
C$
10

 
C$
20


As of September 30, 2012 and December 31, 2011, we had $403 million and $391 million, respectively, of letters of credit outstanding under our uncommitted short-term bank credit facilities.

Accounts Receivable Sales Facility
We have an accounts receivable sales facility with a group of third-party entities and financial institutions to sell eligible trade receivables on a revolving basis. In July 2012, we amended our agreement to increase the facility from $1.0 billion to $1.5 billion and extended 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.



10




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):

 
Nine Months Ended
September 30,
 
2012
 
2011
Balance as of beginning of period
$
250

 
$
100

Proceeds from the sale of receivables
1,500

 

Repayments
(1,650
)
 

Balance as of end of period
$
100

 
$
100


Capitalized Interest
Capitalized interest was $59 million and $42 million for the three months ended September 30, 2012 and 2011, respectively, and $164 million and $102 million for the nine months ended September 30, 2012 and 2011, respectively.

6.
COMMITMENTS AND CONTINGENCIES

One-Time Severance Benefits
As described in Note 3, we decided to reorganize the Aruba Refinery into a crude oil and refined products terminal in September 2012 resulting in a decrease in required personnel for our operations in Aruba. We notified 495 employees in September 2012 of the termination of their employment effective November 15, 2012. Each terminated employee will receive benefits consisting primarily of a cash payment based on a formula that considers the employee’s current compensation and years of service, among other factors. We expect to pay these benefits in November 2012. We recognized a severance liability of $41 million in September 2012, which approximates fair value, and the entire amount was outstanding as of September 30, 2012. Because of the short discount period, the recorded liability of $41 million is not materially different from its fair value. The severance expense of $41 million is included in refining operating expenses for the three and nine months ended September 30, 2012 and relates to our refining segment.

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.



11




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

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), which lifted the stay on April 23, 2012. The Ninth Circuit Court heard arguments on the merits of the appeal in October 2012. We await the court’s final ruling on the merits.
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 or provided greater operational flexibility in Texas. For example, the EPA disapproved the TCEQ flexible permit program and pollution control standard permit, thus requiring the conversion of flexible permits to a more conventional permitting program and precluding the prompt authorization of pollution control equipment. The Fifth Circuit Court of Appeals overturned the EPA’s disapproval of the flexible permit program and pollution control standard permit and sent them back to the EPA for reconsideration consistent with the court’s decision. In other instances, the EPA’s decisions have been initially upheld and others are still pending before the courts. Regardless of the EPA’s response to the courts’ various rulings, further litigation is probable. The EPA has also objected to numerous Title V permits in Texas and other states, including permits at our Port Arthur,



12




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

Texas City, Meraux, Corpus Christi East, and McKee Refineries. Environmental activist groups have filed notices 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 greenhouse gas permitting regime and 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.

Tax Matters
We are subject to extensive tax liabilities imposed by multiple jurisdictions, including income taxes, indirect taxes (excise/duty, sales/use, gross receipts, 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 September 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 certain 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.




13




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 nine months ended September 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)
 
1,073

 
(2
)
 
1,071

 
2,045

 
(1
)
 
2,044

Dividends
 
(263
)
 

 
(263
)
 
(85
)
 

 
(85
)
Stock-based compensation expense
 
29

 

 
29

 
34

 

 
34

Tax deduction in excess of
stock-based compensation
expense
 
16

 

 
16

 
19

 

 
19

Transactions
in connection with
stock-based
compensation plans:
 
 
 
 
 
 
 
 
 
 
 
 
Stock issuances
 
36

 

 
36

 
42

 

 
42

Stock repurchases
 
(138
)
 

 
(138
)
 
(270
)
 

 
(270
)
Contributions from noncontrolling interest
 

 
34

 
34

 

 
14

 
14

Recognition of
noncontrolling interest
in connection with
Pembroke Acquisition
 

 

 

 

 
3

 
3

Other comprehensive
income (loss)
 
156

 

 
156

 
(156
)
 

 
(156
)
Balance as of end of period
 
$
17,332

 
$
54

 
$
17,386

 
$
16,654

 
$
16

 
$
16,670


The noncontrolling interests relate to third-party ownership interests in Diamond Green Diesel Holdings LLC and Mainline Pipelines Limited (MLP), companies whose financial statements we consolidate due to our controlling interests. In the fourth quarter of 2011, we acquired the noncontrolling interest in MLP.




14




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

Share Activity
Activity in the number of shares of common stock and treasury stock was as follows (in millions) for the nine months ended September 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

 
3

 

 
4

Stock purchases

 
(6
)
 

 
(14
)
Balance as of end of period
673

 
(120
)
 
673

 
(115
)

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 nine months ended September 30, 2012 and 2011:
 
Pension Plans
 
Other Postretirement
Benefit Plans
 
2012
 
2011
 
2012
 
2011
Three months ended September 30:
 
 
 
 
 
 
 
Service cost
$
35

 
$
28

 
$
3

 
$
4

Interest cost
23

 
21

 
5

 
5

Expected return on plan assets
(31
)
 
(28
)
 

 

Amortization of:
 
 
 
 
 
 
 
Prior service cost (credit)
1

 
1

 
(6
)
 
(6
)
Net actuarial loss
8

 
3

 

 

Net periodic benefit cost
$
36

 
$
25

 
$
2

 
$
3

 
 
 
 
 
 
 
 
Nine months ended September 30:
 
 
 
 
 
 
 
Service cost
$
105

 
$
73

 
$
9

 
$
9

Interest cost
69

 
64

 
16

 
16

Expected return on plan assets
(93
)
 
(84
)
 

 

Amortization of:
 
 
 
 
 
 
 
Prior service cost (credit)
2

 
2

 
(17
)
 
(17
)
Net actuarial loss
25

 
9

 

 
1

Net periodic benefit cost
$
108

 
$
64

 
$
8

 
$
9


During the nine months ended September 30, 2012 and 2011, we contributed $132 million and $207 million, respectively, to our pension plans.



15




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 September 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
 
 
$
674

 
 
 
$
1,203

Less dividends paid:
 
 
 
 
 
 
 
Common stock
 
 
96

 

 
28

Nonvested restricted stock
 
 
1

 

 

Undistributed earnings
 
 
$
577

 

 
$
1,175

Weighted-average common shares outstanding
3

 
549

 
3

 
564

Earnings per common share from
continuing operations:
 
 
 
 
 
 
 
Distributed earnings
$
0.18

 
$
0.18

 
$
0.05

 
$
0.05

Undistributed earnings
1.04

 
1.04

 
2.07

 
2.07

Total earnings per common share from
continuing operations
$
1.22

 
$
1.22

 
$
2.12

 
$
2.12

 
 
 
 
 
 
 
 
Earnings per common share from
continuing operations – assuming dilution:
 
 
 
 
 
 
 
Net income attributable to Valero stockholders
from continuing operations
 
 
$
674

 
 
 
$
1,203

Weighted-average common shares outstanding
 
 
549

 
 
 
564

Common equivalent shares:
 
 

 
 
 
 
Stock options
 
 
4

 
 
 
3

Performance awards and
nonvested restricted stock
 
 
3

 
 
 
2

Weighted-average common shares outstanding –
assuming dilution
 
 
556

 
 
 
569

Earnings per common share from
continuing operations – assuming dilution
 
 
$
1.21

 
 
 
$
2.11





16




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

 
Nine Months Ended September 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
 
 
$
1,073

 
 
 
$
2,052

Less dividends paid:
 
 
 
 
 
 
 
Common stock
 
 
261

 
 
 
85

Nonvested restricted stock
 
 
2

 
 
 

Undistributed earnings
 
 
$
810

 
 
 
$
1,967

 
 
 
 
 
 
 
 
Weighted-average common shares outstanding
3

 
550

 
3

 
566

 
 
 
 
 
 
 
 
Earnings per common share from
continuing operations:
 
 
 
 
 
 
 
Distributed earnings
$
0.48

 
$
0.48

 
$
0.15

 
$
0.15

Undistributed earnings
1.46

 
1.46

 
3.46

 
3.46

Total earnings per common share from
continuing operations
$
1.94

 
$
1.94

 
$
3.61

 
$
3.61

 
 
 
 
 
 
 
 
Earnings per common share from
continuing operations – assuming dilution:
 
 
 
 
 
 
 
Net income attributable to Valero stockholders
from continuing operations
 
 
$
1,073

 
 
 
$
2,052

Weighted-average common shares outstanding
 
 
550

 
 
 
566

Common equivalent shares:
 
 
 
 
 
 
 
Stock options
 
 
4

 
 
 
4

Performance awards and
nonvested restricted stock
 
 
2

 
 
 
2

Weighted-average common shares outstanding –
assuming dilution
 
 
556

 
 
 
572

Earnings per common share from
continuing operations – assuming dilution
 
 
$
1.93

 
 
 
$
3.59


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
September 30,
 
Nine Months Ended
September 30,
 
2012
 
2011
 
2012
 
2011
Stock options
5

 
6

 
6

 
6




17




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 September 30, 2012:
 
 
 
 
 
 
 
 
 
 
Operating revenues from external
  customers
 
$
30,543

 
$
3,092

 
$
1,091

 
$

 
$
34,726

Intersegment revenues
 
2,348

 

 
15

 

 
2,363

Operating income (loss)
 
1,528

 
41

 
(73
)
 
(187
)
 
1,309

 
 
 
 
 
 
 
 
 
 
 
Three months ended September 30, 2011:
 
 
 
 
 
 
 
 
 
 
Operating revenues from external
  customers
 
29,177

 
3,053

 
1,483

 

 
33,713

Intersegment revenues
 
2,258

 

 
25

 

 
2,283

Operating income (loss)
 
1,947

 
97

 
107

 
(172
)
 
1,979

 
 
 
 
 
 
 
 
 
 
 
Nine Months Ended September 30, 2012:
 
 
 
 
 
 
 
 
 
 
Operating revenues from external
  customers
 
92,181

 
9,089

 
3,285

 

 
104,555

Intersegment revenues
 
6,806

 

 
75

 

 
6,881

Operating income (loss)
 
2,773

 
253

 
(59
)
 
(541
)
 
2,426

 
 
 
 
 
 
 
 
 
 
 
Nine Months Ended September 30, 2011:
 
 
 
 
 
 
 
 
 
 
Operating revenues from external
  customers
 
78,660

 
8,865

 
3,789

 

 
91,314

Intersegment revenues
 
6,566

 

 
125

 

 
6,691

Operating income (loss)
 
3,476

 
298

 
215

 
(476
)
 
3,513


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

 
September 30,
2012
 
December 31,
2011
Refining
$
38,198

 
$
38,164

Retail
2,098

 
1,999

Ethanol
900

 
943

Corporate
2,596

 
1,677

Total assets
$
43,792

 
$
42,783




18




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

Possible Divestiture of Retail Business
In July 2012, we announced our intention to pursue a plan to separate our retail business from Valero. We are currently reviewing several potential separation transactions, including a tax-efficient distribution of the retail business to our shareholders.

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):
 
Nine Months Ended
September 30,
 
2012
 
2011
Decrease (increase) in current assets:
 
 
 
Receivables, net
$
1,293

 
$
(1,963
)
Inventories
(116
)
 
891

Income taxes receivable
172

 
333

Prepaid expenses and other
(25
)
 
12

Increase (decrease) in current liabilities:
 
 
 
Accounts payable
(150
)
 
1,191

Accrued expenses
10

 
137

Taxes other than income taxes
55

 
99

Income taxes payable
112

 
140

Changes in current assets and current liabilities
$
1,351

 
$
840


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;
the amounts shown above exclude the current assets and current liabilities acquired in connection with the Pembroke Acquisition in August 2011;
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 nine months ended September 30, 2012 and 2011.




19




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

Cash flows related to interest and income taxes were as follows (in millions):

 
Nine Months Ended
September 30,
 
2012
 
2011
Interest paid in excess of amount capitalized
$
206

 
$
276

Income taxes paid, net
238

 
289


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



20




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

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.

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 September 30, 2012 and December 31, 2011.
Cash collateral deposits of $213 million and $136 million with brokers under master netting arrangements are included in the fair value of the commodity derivatives reflected in Level 1 as of September 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
September 30,
2012
Assets:
 
 
 
 
 
 
 
 
 
Commodity derivative contracts
$
3,351

 
$
105

 
$

 
$
(3,292
)
 
$
164

Physical purchase contracts

 
3

 

 

 
3

Investments of certain benefit plans
88

 

 
11

 

 
99

Foreign currency contracts
3

 

 

 

 
3

Other investments

 

 

 

 

Liabilities:
 
 
 
 
 
 
 
 
 
Commodity derivative contracts
3,191

 
117

 

 
(3,292
)
 
16

Biofuels blending obligation
6

 

 

 

 
6

Foreign currency contracts
1

 

 

 

 
1





21




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

 
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


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



22




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

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.
Our biofuels blending obligation represents a liability for the purchase of RINs and RTFCs, as defined and described in Note 13 under “Compliance Program Price Risk,” to satisfy our obligation to blend biofuels into the products we produce. Our obligation is based on our deficiency in RINs and RTFCs and the price of these instruments as of the balance sheet date. Our obligation is categorized in Level 1 of the fair value hierarchy and is measured at fair value using the market approach based on quoted prices from an independent pricing service.

During the nine months ended September 30, 2012 and 2011, there were no transfers between assets classified as Level 1 and Level 2.



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 nine months ended September 30, 2012 and 2011.
 
2012
 
2011
 
Investments
of Certain
Benefit
Plans
 
Other
Investments
 
Investments
of Certain
Benefit
Plans
 
Other
Investments
Three months ended September 30:
 
 
 
 
 
 
 
Balance as of beginning of period
$
11

 
$

 
$
11

 
$

Purchases

 

 

 
5

Total gains (losses):
 
 
 
 
 
 
 
Included in refining operating expenses

 

 

 
(5
)
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
$

 
$

 
$

 
$
(5
)
 
 
 
 
 
 
 
 
Nine months ended September 30:
 
 
 
 
 
 
 
Balance as of beginning of period
$
11

 
$

 
$
10

 
$

Purchases

 

 

 
21

Total gains (losses):
 
 
 
 
 
 
 
Included in refining operating expenses

 

 
1

 
(21
)
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

 
$
(21
)



24




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

Nonrecurring Fair Value Measurements
The table below presents the fair value (in millions) of our nonfinancial assets measured on a nonrecurring basis during the nine months ended September 30, 2012 and categorized according to the fair value hierarchy of the inputs utilized by us to determine the fair values as of September 30, 2012.

 
Fair Value Measurements Using
 
 
 
Total Loss
Recognized
During the
Nine Months
Ended
September 30, 2012
 
Quoted
Prices in
Active
Markets
(Level 1)
 
Significant
Other
Observable
Inputs
(Level 2)
 
Significant
Unobservable
Inputs
(Level 3)
 
Total
Fair Value
as of
September 30,
2012
 
Assets:
 
 
 
 
 
 
 
 
 
Long-lived assets of
the Aruba Refinery
$

 
$

 
$

 
$

 
$
903

Materials and supplies inventories of
the Aruba Refinery

 

 

 

 
25

Cancelled capital project

 

 
2

 
2

 
16

Property, plant and equipment of
convenience stores

 

 
5

 
5

 
12


There were no liabilities that were measured at fair value on a nonrecurring basis during the nine months ended September 30, 2012. There were no assets or liabilities that were measured at fair value on a nonrecurring basis during the nine months ended September 30, 2011.

Aruba Refinery
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. 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.

As further discussed in Note 3, in September 2012, we decided to reorganize the Aruba Refinery into a crude oil and refined products terminal in response to the August 2012 withdrawal of a non-binding offer to purchase the refinery. Because of our decision to reorganize the Aruba Refinery into a crude oil and refined products terminal, we evaluated the refining assets for potential impairment as of September 30, 2012. We concluded that these refining assets were impaired and determined that their carrying value of $308 million was not recoverable through the future operations and disposition of the refinery. We determined that these refining assets had no value after considering estimated salvage costs, resulting in an asset impairment loss of $308 million that was recorded in September 2012. We also recognized an asset impairment loss of $25 million related to materials and supplies inventories that supported the refining operations, resulting in a total asset impairment loss of $333 million in September 2012.



25




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

Other Assets
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 had been unable to sell the equipment. As a result, we wrote down the carrying amount of the equipment to scrap value.

We evaluated certain convenience stores operated by our retail segment for potential impairment as of September 30, 2012 and concluded that they were impaired. We wrote down the carrying values of these stores to their estimated fair values, which totaled $5 million, resulting in an asset impairment loss of $12 million that was recorded in September 2012.

Other Financial Instruments
Financial instruments that we recognize in our balance sheets at their carrying amounts are shown in the table below (in millions):

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

 
Fair
Value

Financial assets:
 
 
 
 
 
 
 
Cash and temporary cash investments
$
2,549

 
$
2,549

 
$
1,024

 
$
1,024

Financial liabilities:
 
 
 
 
 
 
 
Debt (excluding capital leases)
6,997

 
8,576

 
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 provided by third-party brokers and vendor pricing services, but are not exchange-traded (Level 2).



26




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.



27




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

As of September 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
 
776

Futures – short
 
4,691

Physical contracts - long
 
3,915

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, refined product, or natural gas purchases or refined product sales at existing market prices that we deem favorable.

As of September 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