Valero Energy (VLO) Joseph W. Gorder on Q2 2016 Results - Earnings Call Transcript

| About: Valero Energy (VLO)

Valero Energy Corp. (NYSE:VLO)

Q2 2016 Earnings Call

July 26, 2016 11:00 am ET

Executives

John Locke - Vice President–Investor Relations

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Gary K. Simmons - Senior Vice President-Supply, International Operations and Systems Optimization

Jay D. Browning - Executive Vice President & General Counsel

Michael S. Ciskowski - Chief Financial Officer & Executive Vice President

R. Lane Riggs - Executive Vice President, Refining Operations & Engineering

Analysts

Neil Mehta - Goldman Sachs & Co.

Evan Calio - Morgan Stanley & Co. LLC

Paul Cheng - Barclays Capital, Inc.

Phil M. Gresh - JPMorgan Securities LLC

Roger D. Read - Wells Fargo Securities LLC

Doug Leggate - Bank of America Merrill Lynch

Blake Fernandez - Howard Weil

Jeffery Alan Dietert - Simmons & Company International

Edward George Westlake - Credit Suisse Securities (NYSE:USA) LLC (Broker)

Paul Sankey - Wolfe Research LLC

Faisel H. Khan - Citigroup Global Markets, Inc. (Broker)

Chi Chow - Tudor, Pickering, Holt & Co. Securities, Inc.

Brad Heffern - RBC Capital Markets LLC

Spiro M. Dounis - UBS Securities LLC

Operator

Welcome to the Valero Energy Corporation Reports 2016 Second Quarter Earnings Results Conference Call. My name is Vanessa, and I'll be your operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Please note this conference is being recorded.

And I will now turn the call over to Mr. John Locke, Vice President of Investor Relations. You may begin.

John Locke - Vice President–Investor Relations

Good morning. And welcome to Valero Energy Corporation's second quarter 2016 earnings conference call.

With me today are Joe Gorder, our Chairman, President and Chief Executive Officer; Mike Ciskowski, our Executive Vice President and CFO; Lane Riggs, our Executive Vice President of Refining Operations and Engineering; Jay Browning, our Executive Vice President and General Counsel; and several other members of Valero's senior management team. If you've not received the earnings release and would like a copy, you can find one on our website at valero.com.

Also attached to the earnings release are tables that provide additional financial information on our business segments. If you have any questions after reviewing these tables, please feel free to contact our investor relations team after the call.

I would like to direct your attention now to the forward-looking statement disclaimer contained in the press release.

In summary, it says that statements in the press release and on this conference call that state the company's or management's expectations or predictions of the future are forward-looking statements intended to be covered by the safe harbor provisions under the federal securities laws. There're many factors that could cause actual results to differ from our expectations, including those we've described in our filings with the SEC.

Now, I'll turn the call over to Joe for a few opening remarks.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Well, thanks, John, and good morning everyone. In the second quarter, we continue to face a challenging margin environment, which was further complicated by high compliance cost headwinds, but our team performed well, running safely and reliably while maintaining our cost-efficient operations.

Turning to the markets, sweet crude discounts in the second quarter remained narrow as shale crude production continued to slow. Unplanned crude production outages caused by wildfires in Canada led to the tightening of medium and heavy sour crude discounts relative to Brent. More recently, with the resumption of crude production in Canada and the continued flow of foreign medium sour crudes to the U.S. Gulf Coast, we've seen discounts widening versus Brent. We expect medium, heavy and sour crude oils to remain attractive.

On the products side, margins improved compared to the first quarter, and product demand in domestic and export markets remain robust. In fact, we exported record volumes of distillate and gasoline combined for the second quarter.

Turning to our refining growth strategy, we successfully commissioned the new Houston crude unit in June. In addition, the Corpus Christi crude unit, which was completed late last year, ran well at above planned rates. We continued engineering and procurement work on the $300 million Houston alkylation unit, which we expect to complete in the first half of 2019. We also continued to develop other strategic projects that will provide octane enhancement, feedstock flexibility and cogeneration to create higher value products and reduce cost.

Also in June, we acquired the remaining 50% interest in the Parkway Pipeline, which connects our St. Charles refinery to the Plantation pipeline. With 100% ownership interest in this pipeline and the planned connection to the Colonial pipeline, we've enhanced our product supply options to the U.S. East Coast. This transaction fits our strategy to optimize through investments in logistics assets, which we expect to be eligible for future drop to Valero Energy Partners LP, our sponsored MLP.

With respect to VLP, last week we announced the distribution increase of 7.4% for the second quarter, which keeps us on pace for an annual distribution growth rate of 25%. And finally, despite the lower margin environment, we generated solid cash flow from operations and stepped up our return of cash to stockholders through our buyback program.

So, with that, John, I'll hand it back over to you.

John Locke - Vice President–Investor Relations

Thank you, Joe.

For the quarter, net income attributable to Valero stockholders was $814 million or $1.73 per share, which compares to $1.4 billion or $2.66 per share in the second quarter of 2015. Excluding an after-tax lower of cost or market inventory valuation benefit of $367 million or $0.78 per share and an asset impairment loss of $56 million or $0.12 per share, second quarter 2016 adjusted net income was $503 million or $1.07 per share. Please refer to the reconciliations of actual to adjusted amounts that begin on page three of the financial tables that accompany our release.

Operating income for the refining segment in the second quarter of 2016 was $1.3 billion and adjusted operating income was $954 million, which was $1.2 billion lower than the second quarter of 2015. Primary drivers of the decline were weaker gasoline and distillate margins, due to lingering high product inventories and lower discounts for sweet crude oils relative to Brent crude oil. Higher RIN prices also created additional earnings headwinds in the second quarter of 2016.

Refining throughput volumes averaged 2.8 million barrels per day in the second quarter of 2016, which was in line with the second quarter of 2015. Our refineries operated at 94% throughput capacity utilization, which was impacted by a turnaround at our Texas City refinery. Refining cash operating expenses of $3.51 per barrel in the second quarter of 2016 were $0.15 per barrel lower compared to the second quarter of 2015, largely driven by lower energy costs.

The ethanol segment generated $69 million of operating income in the second quarter of 2016, and adjusted operating income of $49 million, which was $59 million lower than in the second quarter of 2015, due primarily to lower gross margin per gallon driven by higher corn prices in the second quarter of 2016.

Additionally for the second quarter of 2016, general and administrative expenses, excluding corporate depreciation, were $159 million and net interest expense was $111 million. Depreciation and amortization expense was $471 million and the effective tax rate was 26% in the second quarter of 2016. The effective tax rate was lower than expected and lower than in the second quarter of 2015, primarily due to the positive change in the company's lower of cost or market inventory valuation reserve in the second quarter of 2016, which contributed to a stronger relative earnings contribution from international operations with lower statutory tax rates.

With respect to our balance sheet at quarter end, total debt was $7.5 billion, and cash and temporary cash investments were $4.9 billion, of which $67 million was held by VLP. Valero's debt to capitalization ratio, net of $2 billion in cash, was 21%. We had $5.3 billion of available liquidity, excluding cash, of which $436 million was only available to VLP. We generated $2.3 billion of cash from operating activities in the second quarter. Of which, $1.3 billion was due to favorable working capital changes, primarily increases in accounts and taxes payable and a reduction in inventories.

With regard to investing activities, we made $461 million of capital investments, of which $164 million was for turnarounds and catalyst. This amount excludes our purchase of the remaining 50% interest in the Parkway Pipeline from Kinder Morgan.

Moving to financing activities, we returned $683 million in cash to stockholders in the second quarter, which included $282 million in dividend payments and $401 million for the purchase of over 7.5 million shares of Valero common stock. As of June 30, we had approximately $700 million of share repurchase authorization remaining.

For 2016, we expect to invest $1.6 billion to maintain the business, and another $1 billion for refining asset optimization and logistics projects, which are expected to drive long-term earnings growth.

For modeling our third quarter operations, we expect throughput volumes to fall within the following ranges. U.S. Gulf Coast at 1.6 million barrels per day to 1.65 million barrels per day; U.S. Mid-Continent at 415,000 barrels per day to 435,000 barrels per day, U.S. West Coast at 260,000 barrels per day to 280,000 barrels per day; and the North Atlantic at 460,000 barrels per day to 480,000 barrels per day. The guidance range for the U.S. Gulf Coast reflects the previously announced major turnaround at the Port Arthur refinery, which occurs once every five years.

Refining cash operating expenses are estimated at approximately $3.70 per barrel in the third quarter. We continue to expect costs related to meeting our biofuel blending obligations, primarily related to RINs in the U.S., to be between $750 million and $850 million for 2016. Costs will likely end up in the upper end of that range based on recent RIN prices.

The ethanol segment is expected to produce a total of 3.9 million gallons per day. Operating expenses should average $0.37 per gallon, which includes $0.05 per gallon for non-cash costs such as depreciation and amortization.

G&A expenses for the third quarter, excluding corporate depreciation, are expected to be around $180 million and net interest expense should be about $110 million. Total depreciation and amortization expense should be approximately $465 million and our effective tax rate should be around 30%.

That concludes our opening remarks. Before we open the call to questions, we ask that callers adhere to our protocol in the Q&A to two questions. This will help us ensure that other callers have time to ask their question. If you have more than two questions, please rejoin the queue as time permits.

Question-and-Answer Session

Operator

And thank you. We will now begin the question-and-answer session. And we have our first question from Neil Mehta with Goldman Sachs.

Neil Mehta - Goldman Sachs & Co.

Good morning, guys. Congrats on the strong cash flow quarter here. Want to kick it off on the product side. Clearly, product margins are a concern for investors as we think about both the refining stocks and then also as we think about the flat price per crude. So, two questions on that basis. One, Joe, do you think there's just too much refining capacity in the world here? Is there a structural oversupply in capacity? And then, do you expect that we're going to see run cuts this fall here in the U.S. or elsewhere in the world?

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Morning, Neil, and thanks for your comments. Why don't I let Gary take a crack at this?

Gary K. Simmons - Senior Vice President-Supply, International Operations and Systems Optimization

Yeah, Neil. I think despite the fact that we've seen very strong product demand, obviously, the refinery utilization has been such that supply has been able to keep up and even outpace demand. So, ultimately, we're going to need a rebalancing and see lower refinery utilization moving forward. So, I do believe that you'll see some refinery run cuts as we head into the third quarter and fourth quarter.

I think that some of what happened this year is that with the steep contango in the market, especially early in the year, some marginal refining capacity that typically you would see cut in the winter had incentive to go ahead and run and produce the summer grade of gasoline. And so, it caused utilization to be very high, especially like in the January, February timeframe. And that's where we built the large overhang of products that we've really had to manage the rest of this year.

Neil Mehta - Goldman Sachs & Co.

I appreciate those comments. And then secondly, on RINs here, you maintained the guidance of $750 million to $850 million, but is it fair to say there's some upward bias to the midpoint of the range? Joe, can you just talk about what you ultimately see as the resolution to this RINs issue? I know it's something that you've been talking to the EPA about quite a lot. And then just how you see the RINs issue evolving from here.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Okay, Neil. That's a good question. And I'll speak just briefly about the lawsuit really, and then if we have procedural questions, Jay can help me with that. But our action with the EPA is really focused on dealing with the current structure of the system. The current system, as you know, misaligns the RIN obligation with the ability to comply by blending. So, what's happened, it's enabled speculators to drive up RIN prices, which really distorts the markets. And it facilitates opportunities for RIN fraud, which we've seen a fair amount of.

Moving to point of obligation really would address these issues, and then it would enable the penetration of biofuel products into the marketplace to increase their blending. So, that's really the emphasis for us on trying to push this just to try to fix a structure that we think really is misaligned and infeasible today. And then, Jay, on process, any comments?

Jay D. Browning - Executive Vice President & General Counsel

Yeah. As everyone knows, if you're engaged in litigation we're only in a position to control our own efforts and timing. And we are doing everything possible that we can to bring attention to the issue. We have filed the lawsuits, we filed the petition for reconsideration, and we've engaged in a lot of effort to educate other affected parties as well as EPA officials. Ideally, we would like to see EPA of its own accord engage in a rulemaking process. And if they were to do so, you can go to the EPA website and see basically how long it takes for them to put out a proposed rule, gather comments and finalize a rule. Short of that, we're having to fall back on timing of the process of litigation, which is very difficult to speculate.

Neil Mehta - Goldman Sachs & Co.

All right, guys. Thanks for the comments.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Thanks, Neil.

Operator

And thank you. Our next question comes from Evan Calio with Morgan Stanley.

Evan Calio - Morgan Stanley & Co. LLC

Hey. Good morning, guys.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Good morning, Evan.

Evan Calio - Morgan Stanley & Co. LLC

Hey, I know you guys raised your dividend early in the first quarter and your indicative yield today is higher than it was in 2008 and 2009. Can you discuss how you stress the dividend when you establish or decide to raise that earlier this year and how you view the sustainability of your yield?

Michael S. Ciskowski - Chief Financial Officer & Executive Vice President

Okay, Evan. Our dividend is a commitment to our shareholders and we do consider it non-discretionary. With our cash position and nearly $5 billion of liquidity we have available to us, we're quite comfortable with the sustainability of our current dividend and also the payout target of at least 75% of net income. And in addition, we're not concerned with the funding of our capital program.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

And Evan, we did take a good hard look at this. And obviously margins can be volatile, right? That's a understatement for the year. Last year they were strong, this year they're weaker. And so, we ran cases before we presented to the board the dividend increase, which really looked at different margin scenarios. And that's how we got our comfort level with it. I mean, we stressed it pretty hard. And, obviously, in this low-margin environment and with earnings where they are, we're still in a good position on the dividend. So, obviously, we did a thorough job on that.

Evan Calio - Morgan Stanley & Co. LLC

Yeah. No, that makes sense. And that should help support in this environment, your stock. Maybe a follow-up on the distribution comment. I mean, you're running above the 75% payout target year-to-date in 2Q. How should we think about that target going forward and does the higher distribution reflect your view on an improving outlook or the cash generating abilities of your assets?

Michael S. Ciskowski - Chief Financial Officer & Executive Vice President

Our target is based on net income, but we do understand in this lower earnings environment that we have to consider our cash flow generating capabilities and then also the drops to the VLP. So through June, we have paid out 156% of adjusted net income and that's about 42% of our cash flow.

Evan Calio - Morgan Stanley & Co. LLC

Got it. Appreciate it, guys.

John Locke - Vice President–Investor Relations

Good. Thanks, Evan.

Operator

And thank you. Our next question comes from Paul Cheng with Barclays.

Paul Cheng - Barclays Capital, Inc.

Hey, guys. Good morning.

John Locke - Vice President–Investor Relations

Good morning, Paul.

Paul Cheng - Barclays Capital, Inc.

Couple question. Mike, do you have any preliminary 2017, 2018 CapEx that you can share? And if the margins stay close to where we are over the next one or two years, then, how quickly you can adjust those number?

Michael S. Ciskowski - Chief Financial Officer & Executive Vice President

Okay, Paul. We haven't disclosed our 2017 capital budget yet. But notionally, we're going to be spending $1.4 billion to $1.6 billion on maintenance capital and roughly $1 billion on growth. Obviously, there's more flexibility in the growth category, but the projects that we're identifying are attractive, and you'd want us to complete these at those rates, at those hurdle rate. So, today we have lots of cash like I just mentioned, and a lot of liquidity and we're quite comfortable in funding our capital expenditures at those levels.

Paul Cheng - Barclays Capital, Inc.

Joe, just curious then, with the refining market, I think, weaker than people expected. When you're looking at the M&A market, have you seen any change in the (20:02) in the last several months?

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Paul, I would tell you, I don't think we've seen any major change. I mean, obviously, in a down market if seller doesn't want to sell for what the valuations might be, and a buyer doesn't want to pay for assets based on what we've experienced in the past. And so, it's always a negotiation when you're looking at it. But you raised the question on M&A, and if I could, I just want to stress the fact that M&A is a component of our capital allocation framework, it is not the component of our capital allocation framework.

And unfortunately, in our last call, we gave the impression that there was a greater emphasis on M&A than there had been in the past, which we really never intended to do. We've consistently shared that we look at opportunities all the time. So, a transaction like the Parkway Pipeline acquisition wouldn't come as a surprise. But any M&A transactions will need to compete for cash with our growth capital projects and our buybacks. So, just to be clear, there's no greater emphasis on M&A today than there was two years ago. And our commitment to the other components of our capital allocation framework is really unchanged.

Paul Cheng - Barclays Capital, Inc.

Thank you.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

You bet.

Operator

And thank you. Our next question comes from Philip Gresh from JPMorgan.

Phil M. Gresh - JPMorgan Securities LLC

Hey, good morning.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Morning.

Phil M. Gresh - JPMorgan Securities LLC

Just following up on the CapEx side of things. You're tracking well below for the full year. Were you always expecting to be a little bit more back half loaded because of the turnarounds, or would you say maybe there is some degree of conservatism in the capital budget outlook being maintained in the $2.6 billion for the year?

John Locke - Vice President–Investor Relations

Well, we are tracking a little bit below the $2.6 billion. I mean, Lane, do you have any idea on the timing of some of these projects?

R. Lane Riggs - Executive Vice President, Refining Operations & Engineering

Yeah. What I would say, with what we've disclosed and we have a large turnaround at Port Arthur in the third quarter and fourth quarter, that's obvious. That's a big, big turnaround and that is a known quantity. In terms of our, sort of, ratable spend, I would say we're still holding for this $2.6 billion, but we'll see, because, in terms of capital projects, the ratability is such that November, December it's difficult to spend a lot of money during that time of year. So, and I'll just leave it at that.

Phil M. Gresh - JPMorgan Securities LLC

Okay. And then, the second question, the return of capital discussion, you mentioned cash available via drops. Some of your peers have been pretty active with capital raises and drops so far this year. Feels like the market is opening up for quality MLPs, maybe with the pull back in oil now maybe a little less, we'll see. But how are you thinking about the back half of the year on this front?

John Locke - Vice President–Investor Relations

As far as the drop?

Phil M. Gresh - JPMorgan Securities LLC

Yeah. In terms of desire to raise capital and do drops.

John Locke - Vice President–Investor Relations

Okay. Right now we have no change to the strategy to grow our LP primarily through the dropdown. We do believe a measured pace is prudent, and our guidance is still $500 million to $750 million that we gave in the first quarter call. We will continue to look at third-party logistics still that support Valero's core business. And again, in regard to the capital markets on the equity side, obviously, they've been improving and they have improved throughout the quarter. Debt markets look very good.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

So, I guess, we'll continue to keep an eye on it. We're not prepared right now to change what we've shared that we're planning to do. Phil, we're all watching this to see, are we dealing with a new normal or are we dealing with just a spike in the market that was driven by the financial situation we had last year. And so, we'll continue to eyeball it. We've got, again, plenty of assets that we could drop. We got significant EBITDA there. We continue to look for opportunities to grow the LP with potential joint ventures and some smaller acquisitions. But, we're very attentive to it.

Phil M. Gresh - JPMorgan Securities LLC

Okay. Thanks.

Operator

And thank you. Our next question comes from Roger Read with Wells Fargo.

Roger D. Read - Wells Fargo Securities LLC

Hey, good morning.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Good morning.

Roger D. Read - Wells Fargo Securities LLC

I guess, some of the main topics have been hit. If maybe we could dive just a little bit deeper into the concern about run cuts and then maybe the outlook for turnarounds beyond just Port Arthur for you as we're looking into the fall.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Run cuts.

John Locke - Vice President–Investor Relations

Yeah. So, I guess, on run cuts, we continue to have margin to run in our system. We feel good about the fact that we have this natural gas advantage and feedstock cost advantage in the Gulf that puts us in a very good position globally in the refining industry. So, we're not feeling any pressure for run cuts, but I do agree that we're going to need some rebalancing in the market. So, going forward, I think you'll see some run cuts in the third quarter and fourth quarter. I'm not sure where those will occur. Probably Northwest Europe and some of them in the northeastern United States where you're already starting to hear some in the press of run cuts in today's market. I'll let Lane comment on the future turnarounds.

R. Lane Riggs - Executive Vice President, Refining Operations & Engineering

Yeah. Roger, we disclosed the Port Arthur turnaround just because it was so material and we wanted to make sure it was out there. It's not a normal way we communicate in terms of providing any additional information on our forward-looking statements with respect to our turnarounds.

Roger D. Read - Wells Fargo Securities LLC

Okay. Maybe a broader question about turnarounds and experience where we've had these oversupply situations. Is it Valero's experience or would you say it's maybe the industry broadly that when you have a weak margin environment you'll take advantage of opportunities, given that economic costs are much lower of doing a turnaround, or that maybe you don't try to force product through the non-crude unit, if you have a big crude unit turnaround?

Just sort of curious of, do you take advantage in a situation where we've come off several years of high margins and a big economic cost to turnaround. Do you see that – is that one of the ways the industry sort of corrects the imbalance here?

R. Lane Riggs - Executive Vice President, Refining Operations & Engineering

So, first, I'll comment on Valero. So, we have a strategy of planning our turnarounds a couple of years in advance and executing our turnarounds as they come up. We have a big system, and we feel like we, by virtue of being disciplined in doing that, we don't try to move our turnarounds based on what prompt economics are. Now, (27:07) rest of the industry, there may be some of that. I can't say that there's not. I'm sure that people are looking at whether the refineries are struggling from a maintenance perspective, they may bring the maintenance forward and just fix whatever it is. And if you want to call that a turnaround you might say that. I would say that's essentially about all that there is.

Roger D. Read - Wells Fargo Securities LLC

Okay. Thank you.

Operator

And thank you. Our next question comes from Doug Leggate with Bank of America.

Doug Leggate - Bank of America Merrill Lynch

Thank you. Good morning everybody.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Morning, Doug.

Doug Leggate - Bank of America Merrill Lynch

Joe, I guess, my first one might be for Mike. Mike, I just wonder if you could help us understand the strength of the cash flow in the quarter, just as it relates to reported income and DD&A. It looks like there's some other moving parts in there. And my follow-up is on the industry, please.

Michael S. Ciskowski - Chief Financial Officer & Executive Vice President

Okay. So, on the cash flow, we had a change in cash of building (28:11) cash for the quarter of $1.1 billion. But of that amount, $1.3 million was due to favorable working capital changes. So, we had an increase in our payables and receivables, and you net those together, it's about $600 million benefit. We had an increase in our taxes payable of roughly $300 million and then we decreased our inventories in the quarter by about $300 million. So that nets to the $1.2 billion of working capital benefit.

Doug Leggate - Bank of America Merrill Lynch

Great. That helps me close the gap. Thanks. Joe, my follow-up is on, I guess, it's more of a kind of margin question in terms of the octane premium that hasn't appeared to materialize this summer. You mentioned in your prepared remarks, octane enhancement or projects might be something that Valero continues to look at. Is 2016 just a one-off or do you still think that there is going to be a call for increased alkylate production or whatever it happens to be in the future? And I'll leave it there. Thanks.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Thank you, Doug. Okay. So, Gary or Lane, you guys want to tag team it?

Gary K. Simmons - Senior Vice President-Supply, International Operations and Systems Optimization

Yeah. I'll start, Doug, and then let Lane talk about the projects a little bit. So, what we've seen in the market is actually the octane premiums on the West Coast in the Mid-Continent in the Group 3 market have been stronger this year than what they were last year. However, in the U.S. Gulf Coast and the New York Harbor we've seen weaker octane premiums.

And so, if you kind of try to get your mind around what's going on, I think a lot of that is the fact that where you really can store gasoline is in the U.S. Gulf Coast and the New York Harbor. So, when we had that steep contango earlier in the year, people were storing gasoline, they were largely storing premium grade summer gasoline and high octane blend components. So, in those markets, in the Harbor and the Gulf Coast, as that inventory's come out, it's kind of caused the premiums to be a little weaker this year than what we saw in the past. However, in the Group 3 market, the West Coast market where you don't have a lot of capabilities to store gasoline, the octane values have actually been stronger than what we saw last year.

R. Lane Riggs - Executive Vice President, Refining Operations & Engineering

So, Doug, this is Lane. We still have a strategic view that octane has value. And it's really in the context of Tier 3 is going to destroy a lot of octane. And, of course, the autos, on a go-forward basis, are looking at higher compression engines. So, they may, in fact, want higher octane fuel. And the best way to make that, we believe is, it's finding to find a way to get NGL into the transportation fuel and then convert that to octane. So that's why we like our Houston alkylation project. And with that strategic view, we look at other projects to, if it meets our hurdle rates to produce additional octane in our system.

Doug Leggate - Bank of America Merrill Lynch

Appreciate the full answer, guys. That's really helpful. Thank you.

Operator

And thank you. Our next question comes from Blake Fernandez with Howard Weil.

Blake Fernandez - Howard Weil

Hey, guys. Good morning.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Hi.

Blake Fernandez - Howard Weil

Question for you. I guess, it's kind of macro and also company specific, but you obviously hit record levels on the export side. At the same time, we're seeing increased gasoline imports into the U.S. And so, I'm just trying to get a sense of exactly what's going on. Is this more of a regional dynamic where Gulf Coast is really sending product to other parts of the world and Europe is basically penetrating the East Coast? Or just basically any color you can give us on that framework.

Gary K. Simmons - Senior Vice President-Supply, International Operations and Systems Optimization

Yeah, Blake. This is Gary. I think it's exactly what you said. We see, especially on gasoline exports, that we have a competitive advantage going to Mexico and South America. And then largely due to Jones Act shipping, we're not as competitive going to the New York Harbor as maybe Northwest Europe are. So, the natural flow of our barrels is to go south into South America, and there's been an incentive to send barrels from Northwest Europe into the Harbor.

Blake Fernandez - Howard Weil

Okay. And just to clarify, is Houston – the startup of Houston, is that contributing to those exports or is that not really that material in the quarter?

Gary K. Simmons - Senior Vice President-Supply, International Operations and Systems Optimization

No, it really didn't have any material impact at all in the quarter.

Blake Fernandez - Howard Weil

Okay. And if you don't mind, just a final point of clarity. I know you said on the economic run cuts, you're not necessarily providing, I guess, an outlook on exactly where it would occur, but if I heard the guidance correctly on Mid-Con, it looks like a pretty decent rollover quarter-to-quarter. Would that guidance contemplate any economic run cuts that you're planning to do inland?

R. Lane Riggs - Executive Vice President, Refining Operations & Engineering

Blake, this is Lane. And the way I'll answer that is, today we have positive economics in the Mid-Con. Obviously, the region is landlocked. So, we get into seasonal product containments potentially in sort of the fourth quarter and first quarter if that happens about every year.

Blake Fernandez - Howard Weil

Okay. Fair enough. Thank you.

Operator

And thank you. Our next question comes from Jeff Dietert with Simmons & Company.

Jeffery Alan Dietert - Simmons & Company International

Good morning.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Good morning, Jeff.

Jeffery Alan Dietert - Simmons & Company International

My question is on summer grade gasoline. With the gasoline inventory overhang that we've got, are you worried about moving your summer grade gasoline at a premium? Are you concerned that that might compress as we get closer to the end of the summer driving season? We've heard some discussion about already shifting to winter grade gasoline production. Does that make any sense?

Gary K. Simmons - Senior Vice President-Supply, International Operations and Systems Optimization

Yeah, Jeff. This is Gary. I don't think there's really a concern on being able to clear out the overhang of the summer grade spec gasoline and moving it out to the market. And, I guess, to your second comment, yes, we are hearing that there are people starting to put some winter grade gasoline into some of the markets, especially into the Harbor.

Jeffery Alan Dietert - Simmons & Company International

And secondly, you reported, I think, record light product yield gasoline yield. We saw 49.3%, up 1.3% year-on-year. Industry to DOE stats show it up maybe slightly more than that. What would you attribute the increase in gasoline yield to in the second quarter? What were the primary factors?

R. Lane Riggs - Executive Vice President, Refining Operations & Engineering

Hey. So, Jeff, this is Lane. I would say, we've been in a strong maximum gasoline signal for the most part, up until about a month ago. And so, our assets, we just had them pointed to try to make as much gasoline as possible. When you compare it year-over-year, there were times last year we maybe didn't have a strong signal to maximize our reformers as much as we have this year and it's really the naphtha discount. But I would just say that's sort of the year-over-year difference.

Jeffery Alan Dietert - Simmons & Company International

Great. Thanks for your comments.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

You bet.

Operator

And thank you. Our next question comes from Ed Westlake with Credit Suisse.

Edward George Westlake - Credit Suisse Securities (USA) LLC (Broker)

Yeah. Good morning. You shouted out on the front page ample supplies of medium and heavy sour crude, obviously which your system can process better than others. Is that a comment about the sort of OPEC barrels? Or are you seeing things like in Venezuela, I mean as they run out of power, are they having to puke out some sort of real heavy rubbish at cheap discounts that you can run and others can't?

John Locke - Vice President–Investor Relations

I think we see good supplies in the Middle East, South America and Canada, as well. I don't know that we've seen a lot in terms of change in behavior from Venezuela. We continue to see good supply and will from Venezuela. The grades are a little bit different, so we see a lot more what we call diluted crude oil, or DCO, and less of some of the synthetic barrels (36:01) that type of thing. That's the only change that we've seen.

Edward George Westlake - Credit Suisse Securities (USA) LLC (Broker)

Right. But presumably those DCOs, you can run through your system at a better economics than the synthetic barrels?

John Locke - Vice President–Investor Relations

Yes, typically. They have more difficulty placing the DCO than they would a synthetic barrel.

Edward George Westlake - Credit Suisse Securities (USA) LLC (Broker)

That makes sense. Okay, and then a separate question. With the cash pile plus organic free cash flow, we'll obviously see how refining works out in the second half. And your inventory in VLP, a question about sort of how you plan to kind of grow the EBITDA inventory that you could then subsequently drop down into VLP. Obviously, you're doing $500 million to $750 million of dropdowns, but should we think of that number being the same number as how you want to grow the top of the funnel of logistics inventory at the parent? I'm trying to think about sort of medium-term CapEx allocation to logistics.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Yeah. No, and that's a good question. So, we have a lot of activity underway right now, both for kind of organic projects, which tend to be smaller in their nature, but also some opportunity to acquire assets, really to extend the supply chain into – in all of our refineries. And so, Ed, we made it a point really not to get out over our skis and talk about the specific opportunities until we were comfortable how the business case looked and really to firm up the opportunity. But we do have a lot going on. So we are focused on continuing to expand the logistics side of the business, and obviously those assets would be those that support the system would bring to VLP some third party volumes, and then continue to expand the dropdown inventory.

Edward George Westlake - Credit Suisse Securities (USA) LLC (Broker)

Okay. Thanks so much.

Operator

And thank you. Our next question is from Paul Sankey with Wolfe Research.

Paul Sankey - Wolfe Research LLC

Hi, good morning, everyone.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Hey, Paul.

Paul Sankey - Wolfe Research LLC

I had a couple of questions which actually were the first questions asked about half-an-hour ago. So, I appreciate the details. I was going to ask about RINs. I just wanted – as a follow-up, is there an alternate strategy if the lawsuit fails? I mean, what really is the next recourse after that?

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Well, you know, Paul, the obvious operating strategy is to try to go ahead and continue to find ways to blend more, right? So, expansion of our wholesale marketing business is something that we've got a key eye on. Obviously acquiring terminaling assets would provide that opportunity. And then continuing to try to build the export markets to try to alleviate some of the burden of the RIN. Those are all things that we look at regularly and really ongoing. Other than that, you just continue to bang away on the rock and you try to get people to recognize the fact that the system that we have today is broken, that it is creating windfalls for some and it's creating disadvantages for others, and the playing field isn't level. And I can tell you that based on the conversations that we have, there's an understanding of this issue and there's an understanding that the RFS isn't intending what it was intended to do, which was increase the amount of biofuels blended. And we believe that that's caused by the structural problem that we've talked about earlier. So we're not going to give up the fight. We'll continue to push it, both from a regulatory and a legislative perspective, and then from an operating perspective.

Paul Sankey - Wolfe Research LLC

Yep, understood. Good luck with that. And then the other one was again pretty much the first question you answered, which is regarding the market environment. If the demand is higher this year than last year in the U.S., is it a function of extra refineries being added, do you think, globally new capacity? Or is it more that the competitive advantage of the Atlantic Basin non-U.S. refiners has improved and therefore they're running stronger, or I would imagine it's a combination of both, but any sort of market commentary you have on that would be great? Thanks.

John Locke - Vice President–Investor Relations

Yeah, I would say a lot of it is really more a result of utilization, especially utilization in periods where typically we see refineries cut. So as I talked about, typically you get refineries cutting in the fourth quarter and the first quarter, and this year we saw refineries running very high utilization rates. And a lot of that was just due to the steep contango that was in the market.

Paul Sankey - Wolfe Research LLC

Yeah, understood. And then finally from me, the demand side, it seems to be sort of being revised lower in the U.S. Is that a concern for you guys? Do you think that the demand is being overstated or do you really think that this is a supply problem? Thank you.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

I can just comment on what we're seeing through our wholesale demand domestically, and we're seeing good demand through that wholesale channel. So, year-over-year, our gasoline volumes through wholesale are up 3%, and even on the distillate side, we're moving about 1% more through the wholesale channel of diesel than what we did last year.

Paul Sankey - Wolfe Research LLC

Great. That's helpful. Thank you.

Operator

And thank you. Our next question is from Faisel Khan with Citigroup.

Faisel H. Khan - Citigroup Global Markets, Inc. (Broker)

Thanks, good morning.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Hi, Faisel.

Faisel H. Khan - Citigroup Global Markets, Inc. (Broker)

Hi, Joe. Just going back to the question that Jeff Dietert asked on the sort of switching from summer grade to winter grade and people already putting gasoline in inventory for the winter. Do you think that's a risk or do you think this is a one-off that hopefully we don't carry this excess inventory from the summer into the winter?

Joseph W. Gorder - Chairman, President & Chief Executive Officer

It certainly is a risk. It's always a risk that's out there and will depend on what the market structure is, but I think after we've gone through this period where the market's been weaker this year, I don't think it's as great a risk as what we saw in the winter where people were storing the summer grade.

Faisel H. Khan - Citigroup Global Markets, Inc. (Broker)

Okay. Got you. And then, just with the outages in Canada that we saw over the summer, early in the summer. Have you seen those volumes completely recover and how are you dealing with that disruption, and how is that evolving as production ramps back up for you guys?

John Locke - Vice President–Investor Relations

Yeah, so I think for us, on the Canadian heavy side, we pretty much are seeing all the volume back available to us. And the Canadian heavy barrels are being priced very competitively versus either another heavy sour alternative or medium sour alternative. So I would say that we've fully recovered from those fires so far.

Faisel H. Khan - Citigroup Global Markets, Inc. (Broker)

Okay, great. Thanks for the time, guys.

Operator

And thank you. Our next question comes from Chi Chow with Tudor, Pickering, Holt.

Chi Chow - Tudor, Pickering, Holt & Co. Securities, Inc.

Hey, thanks. Good morning.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Hi, Chi.

Chi Chow - Tudor, Pickering, Holt & Co. Securities, Inc.

Hi, Joe. This question may be the same as Paul's, couple questions ago. But just this RIN issue is kind of cropping back up this year. Do you think there's any vulnerability to the merchant refining model that you have longer term, given the RIN issue or anything else that may be out there?

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Well, it would probably be hard to say that the RIN was helpful to the merchant refining model. Okay? Obviously, it's not. But then you get into what are the options for dealing with it, and I think I mentioned those earlier, Chi. Specifically from Valero's perspective, the retail marketing business isn't something that's currently on our radar screen. We believe there's better ways to deal with the issue. And so I really don't have anything to add to that, but I think certainly it's an issue that we're working very hard to deal with because it does. It puts an expense on the merchant refiner that he shouldn't be bearing today. And so that creates a real problem. It creates an unlevel playing field in the marketplace, and that's never good. So, anyway, we'll continue to address it the way we are.

Chi Chow - Tudor, Pickering, Holt & Co. Securities, Inc.

Yeah. Thanks, Joe, for those thoughts. Maybe a question on Aruba. There's been a lot of industry chatter about Venezuela's interest in Aruba lately. But you've written the whole asset off at this point. So are you suggesting that there's no option going forward to sell or transfer the plant to another operator?

Joseph W. Gorder - Chairman, President & Chief Executive Officer

I'm looking at Jay to see what we say about this.

Jay D. Browning - Executive Vice President & General Counsel

The option to transfer, it's still there. I mean, it's just a function of the financial requirements we've chosen to write off.

Chi Chow - Tudor, Pickering, Holt & Co. Securities, Inc.

Okay. So you can still transfer, but for free basically, is that kind of what you're signaling?

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Yeah, I guess so.

Chi Chow - Tudor, Pickering, Holt & Co. Securities, Inc.

Okay. Great. Thanks for that.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Okay, Chi.

Operator

And thank you. Our next question comes from Brad Heffern with RBC Capital Markets.

Brad Heffern - RBC Capital Markets LLC

Good morning, everyone.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Morning, Brad.

Brad Heffern - RBC Capital Markets LLC

Just a follow-up to Jeff's question a little while ago on yield. Lane, you mentioned the system's been running at maximum gasoline yield for quite a while now, and I think there was maybe an implication which you said that you're not running quite at maximum gasoline anymore. I'm curious just how you're thinking about your yield decisions these days. I would assume that given the incentives in the market at the moment, you're probably running a little more distillate, with more of a distillate focus than you had been, but how are you thinking about making catalyst decisions and so on that affect the next 18 months, 24 months?

R. Lane Riggs - Executive Vice President, Refining Operations & Engineering

So, we are currently in, I would say, max-jet mode, so the decision you make there is between our cut point between jet and naphtha. And naphtha shows up in our sort of our overall results as a gasoline although it's not really. We export it. For maximizing jet – we're still actually maximizing gasoline is the next step, and it's largely due to butane blending economics. And it has to do with what we would call the swing cut (46:29) between the heavy part of cat gasoline and LTO and there's drilling (46:34) economics as well, to bring butane into the pull, so that's how we're postured today. But we're very close on all these things just because of where the relative cracks are.

In terms of catalyst choices, FCCs, we can change relatively quickly. I would say, if we want – most of the time there we make a decision on whether we want to try to fill our alkylation capacity catalytically with like VSM5 (46:58) and not run as much rate. And that's normally what we do in the winter, and we're certainly looking at that, and I would be surprised if we didn't end up there.

And on hydrocrackers, every three years we make that decision and that really is a choice between – it's not really gasoline and diesel in our hydrocrackers, it's really naphtha and diesel. And so we're still biased on the side of making distillate out of our big hydrocrackers.

Brad Heffern - RBC Capital Markets LLC

Okay, got it. Thanks for that color. And then I was curious if you could talk a little bit about the results in the North Atlantic this quarter. The indicator was up $3 sequentially, but the margin was down. What were the contributing factors to the performance?

Gary K. Simmons - Senior Vice President-Supply, International Operations and Systems Optimization

Yeah, Brad, this is Gary. I would tell you that the big factor that we saw there, if you're looking year-over-year, was our feedstock costs. So as you're aware, last year we had a pretty good incentive to move U.S. Gulf Coast barrels to Quebec, and we had a very good feedstock advantage doing that, but with the Brent TIR coming in, we lost a lot of that advantage, and it's impacted our North Atlantic Basin results.

Brad Heffern - RBC Capital Markets LLC

Okay. Is that an yard (48:11) that you're still taking advantage of in the first quarter? I'm just thinking about it on a sequential basis versus the first quarter and the margin was down as well.

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Yeah, so – yeah, so we move an occasional cargo to Quebec. But even when we're moving it, it's not near the margin that we saw last year when the yard (48:32) was much wider.

Brad Heffern - RBC Capital Markets LLC

Okay, I'll leave it at that. Thanks.

Operator

And thank you. Our next question comes from Spiro Dounis with UBS.

Spiro M. Dounis - UBS Securities LLC

Hey, good morning, gentlemen. Thanks for taking the question. Just two quick ones, hopefully. First, just on the OpEx. Figures are pretty strong this quarter, despite I guess slightly lower utilization. I guess just wondering how repeatable that is. I know next quarter it sounds like going to tick up a bit just given the turnarounds. But beyond that, just wondering if there is sort of belt-tightening going on and how much more we could see of that?

R. Lane Riggs - Executive Vice President, Refining Operations & Engineering

So, this is Lane. We're always belt-tightening. I mean, we run our business very disciplined, we're always very attentive to all of our costs, and that's just the way we run our business. I would say our throughput is largely drive the – when you sort of compare quarter-to-quarter, year over year, it has to do with what our relative throughputs were through that timeframe that affects things, and obviously natural gas has a big hand in this. But those are really the two. When you start really looking at our – at least our cash operating expenses, it's really the energy and it has to do with our throughput.

Spiro M. Dounis - UBS Securities LLC

Got it. That makes sense. And then just second one, seems like West Coast was a bit of a bright spot over the last quarter both on margins and cost. And I guess just focusing on margins, I guess how sustainable is that? I guess, over the last few weeks, they've come in a bit, but I know driving in the West Coast has been pretty strong and seems like demand there is pretty strong. And on top of that, I think some of the stockpile levels are a bit better than the rest of the U.S. I'm just wondering how you're viewing that market.

John Locke - Vice President–Investor Relations

Yeah, I think we feel pretty good about the West Coast. It's a unique grade of gasoline in that market, so it limits some of the stockpiling of barrels, and certainly with the increased demand, the production – the supply/demand balance is much tighter than it used to be.

Spiro M. Dounis - UBS Securities LLC

Got it. Appreciate the color. Thanks, guys.

Operator

And thank you. We have a follow-up question from Paul Cheng with Barclays.

Paul Cheng - Barclays Capital, Inc.

Hey. This is for Gary and Lane. When you decide whether you want to stretch the yield between distillate and gasoline, do you looking at the spot economic or that you also take into consideration of the future curve?

Joseph W. Gorder - Chairman, President & Chief Executive Officer

Do you want to take that one?

John Locke - Vice President–Investor Relations

I would say we do a combination of both, Paul. As you look, we certainly – we're making cut-points decision, it's more done on a spot economic basis. But when you talk about catalyst changes, then we're looking more – using the forward curve for those type of decisions.

Paul Cheng - Barclays Capital, Inc.

Okay. So, just for the cut of the temperature and that would be just on the spot. You won't be looking at, say, the next two months or three months what is the futures curve may suggest?

John Locke - Vice President–Investor Relations

It comes into play, but for the most part, we're looking at spot economics on making cut point changes because we can do that day to day in our refining system.

Paul Cheng - Barclays Capital, Inc.

And a final one, if I may. Maybe this is either for Lane and Gary also. If I'm looking at – if the third quarter market conditions would be extended the same as the second quarter, given your expectation of your runs, should we assume that your margin capture rate versus your Valero index would be roughly about the same or that is something that we should be consider?

R. Lane Riggs - Executive Vice President, Refining Operations & Engineering

Paul, this is Lane. I would say it's going to be roughly the same with the exception of where feedstocks are. I mean, that's really the only real major variable in terms of our capture rates. We'll start into butane blending at the end of the third quarter. That will affect it a little bit, as well.

Paul Cheng - Barclays Capital, Inc.

But that it won't start until September, right? The butane blending. The butane blending won't start until September, I presume?

R. Lane Riggs - Executive Vice President, Refining Operations & Engineering

Right. And then – but it'll – so there'll be a little bit of that impact. And the other one is, we do – as we've said earlier, we've disclosed that we have a big turnaround at the Gulf (52:44) in our Port Arthur refinery starting in the third quarter.

Paul Cheng - Barclays Capital, Inc.

Is that a full planned turnaround?

R. Lane Riggs - Executive Vice President, Refining Operations & Engineering

Over the course of the timeframe, most of the refineries, with the exception of – of our conversion units, will all be down. But it's really the crude and coking complex that will be coming down.

Paul Cheng - Barclays Capital, Inc.

Okay, thank you.

Operator

And thank you. We have no further questions at this time. I will now turn the call back over to John Locke for closing remarks.

John Locke - Vice President–Investor Relations

Thank you, Vanessa. We appreciate everyone joining us today. Please contact Karen Ngo or me if you have any additional questions. Thank you.

Operator

And thank you, ladies and gentlemen. This concludes today's conference. We thank you for participating and you may now disconnect.

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