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Valero Energy Corp. (NYSE:VLO)

Q1 FY08 Earnings Call

April 29, 2008, 11:00 AM ET

Executives

Ashley Smith - Director of IR

Mike Ciskowski - EVP and CFO

Bill Klesse - CEO and Chairman

Rich Marcogliese - EVP and COO

Joe Gorder - EVP Marketing and Supply

Analysts

Mark Flannery - Credit Suisse

Paul Cheng - Lehman Brothers

Roger Read - Natexis Bleichroeder

Chi Chow - Tristone Capital

Anne Kohler - Caris

Mark Gilman - Benchmark

Operator

Good morning my name is Rebecca and I will be your conference operator today. At this time, I would like to welcome everyone to the Valero Energy Corporation's First Quarter Results Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions].

Thank you. Mr. Smith, you may begin your conference.

Ashley Smith - Director of Investor Relations

Thank you, Rebecca. Good morning and welcome to Valero Energy Corporation's first quarter 2008 earnings conference call. With me today are Bill Klesse our Chairman and CEO; Mike Ciskowski, our CFO and other members of our executive management team.

If you have 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 Investor Relations after the call.

Before we get started, I would like to direct your attention to the forward-looking statements disclaimer contained in the press release. In summary, it says that statements in the press release and on this conference call that states 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 Federal Securities Laws. There are many factors that could cause actual results to differ from expectations, including those we've described in our filings with the SEC.

Now I will turn the call over to Mike.

Mike Ciskowski - Executive Vice President and Chief Financial Officer

Thanks Ashley and thank you for joining us today. As noted in the release, our first quarter 2008 earnings came in at $0.48 per share. The earnings include a benefit of $0.12 per share arising from the business interruption insurance recovery related to the fire at the McKee refinery in the first quarter of 2007.

$101 million pre-tax benefit from the insurance recovery is reflected in the Mid-Continent throughput margins for the first quarter of 2008. This incident has been settled and there will be no further recovery. First quarter 2008 operating income was $472 million or $371 million excluding the previously mentioned insurance recovery. This compares to $1.7 billion reported in the same period of last year.

The decrease in operating income was obviously due to the lower throughput margin per barrel of $8.48, which was down $3.67 per barrel versus the first quarter of 2007. The key driver of the decline was lower margins for gasoline and our other products such as asphalt, fuel oils, petroleum coke and petrochemical feedstock. These margins compressed in the first quarter as the prices for those products did not increase proportionately with the increase in crude costs.

When comparing the first quarter of 2008 to 2007, the average margins for many of these secondary products declined between $10 and $40 per barrel, which had a negative price impact on throughput margins of around $700 million on a pre-tax basis.

However, our throughput margins have benefited from strong margins on diesel and jet fuel and from wide differentials for the heavy and sour feedstock that we are able to run. First quarter 2008 operating income was also affected by $180 million increase in refinery operating expenses from the first quarter of 2007. This was mainly due to higher energy costs from the increase in the cost of natural gas and higher maintenance expenses including those related to the repairs to the coke drums at our Port Author refinery and the vacuum tower at our Aruba refinery.

First quarter operating income was also affected by lower throughput volumes that averaged around 2.6 million barrels per day or 138,000 barrels per day lower than the first quarter of 2007 and nearly 200,000 barrels per day below the prior quarter. The reduction was mostly because of the previously mentioned maintenance activity.

General and administrative expenses excluding corporate depreciation were $135 million. The $29 million decrease from the fourth quarter was mainly due to a decrease in incentive-based compensation expense. For the first quarter, total depreciation and amortization expense was $367 million. Net interest expense was $97 million and our effective tax rate on continuing operations was 34% in line with guidance from the prior quarter.

Regarding cash flows for the quarter, capital spending was approximately $640 million, which includes $103 million of turnaround expenditures. In the first quarter, we continued our stock buyback program by spending $518 million to purchase 8.8 million shares of our common stock and we currently have approximately 3.8 billion of repurchased authorization in addition to our ongoing anti-dilution program.

With respect to our balance sheet, at the end of March, our total debt was $6.5 billion. During the quarter, we used approximately $375 million to pay down debt. We ended the quarter with a cash balance of $1.4 billion and a debt-to-capitalization ratio net of cash of 21.7%.

As to second quarter operations, the following guidance assumes that no divestitures close in the second quarter. So for modeling purposes, you should expect Gulf Coast refinery throughput of approximately 1.45 million to 1.5 million barrels per day. Gulf Coast throughputs will be affected by maintenance, especially at our Port Arthur refinery where we are completing the work on coke drums and at the Aruba refinery as we are completing repairs to the vacuum tower. We expect both of these repair projects to be completed in mid-May.

Mid-Continent throughput should be about 430,000 barrels per day. West Coast throughput should average between 275,000 and 285,000 barrels per day and the Northeast system should average in the range of 530,000 to 540,000 barrels per day.

On operating expenses, due to the higher expected energy costs and completing the repairs at Port Arthur and Aruba refinery cash operating expenses, are expected to be about $4.70 per barrel.

With respect to some of the other items for the second quarter, we anticipate G&A expense to be around $150 million, net interest expense should be around $80 million. Total depreciation and amortization expense should be around $370 million and for the second quarter, you should be using a 34% tax rate for modeling purposes.

And finally, we are updating our guidance for our 2008 capital spending including turnarounds, which we now estimate should be around $4.2 billion versus our prior guidance of $4.5 billion. The decrease is mainly due to updates on the timing of some of our major projects.

Now I will turn it over to Bill.

Bill Klesse - Chief Executive Officer and Chairman

Thank you, Mike. Good morning. As Mike said, we entered the first quarter in great financial position, even after taking into consideration the challenging margins for gasoline and other products, plus the operating issues we experienced.

Looking at gasoline, fundamentals have been improving as inventories have declined over the last six weeks and gasoline demand has been good. Accordingly, the average April Gulf Coast gasoline products has more than double versus March going [ph] from around $3 to $6.50 per barrel. We still expect a good summer driving season. We also continue to see strong on-road diesel cracks which have averaged close to $30 per barrel in April because of strong global demand. We believe that diesel cracks will stay excellent for the foreseeable future, given the difficulty in meeting tighter sulfur specs worldwide and strong demand worldwide.

On the feedstock side, we continue to realize wide differentials from medium and heavy sour crude oil and other feedstock. And we expect these discounts to remain wide for the rest of year. Recently, Maya crude oil has priced around $23 below WTI and Mars crude oil has priced nearly $10 below WTI. These differentials have increased in part due to strong demand for light sweet crude oil, because of their higher plain product yields especially diesel.

As mentioned previously that we are working closely with the potential buyer for our Aruba refinery. And we expect to complete the process in the second quarter after the repairs vacuum tower are complete. For our Memphis and Clark Springs refineries, we are currently negotiating with selective bidders. We have been very pleased by the higher level of interest these assets have generated. We have also initiated the progress to review strategic alternatives for our Ardmore refinery and we expect to conclude that process this year as well.

In closing, I'd be the first to admit that the gasoline season hasn't been impressive. The current refined product prices are difficult for our consumers. But diesel [ph] margins are excellent. As to our performance, the issues have been isolated to basically 3 of our 17 refineries.

Our financial results have also been negatively impacted by very poor margins for other products, which are about 20% of our refined product yields. With time, I think there will be an adjustment to the pricing of these other products.

Concerning reliability, the Port Arthur coke drum repair we have undertaken should work. But ultimately the drums will be replaced in the first or fourth quarter of 2009 or at best, or in a best case the first quarter of 2010. The new drums should be at our side by year end.

We realized it is hard to stay but we are improving our plans and the resultant reliability. With proceeds from the potential asset sales and from our operations, we will continue to take a balanced approach to allocating cash among gross investments at and around our coal refineries, stock buyback, dividend increases and high coupon gas repayments.

Valero continues to be the best value in our industry because our balance sheet is strong, because we have the most geographic diversification, the most processing complexity and a highest growth margin potential and lots of self help opportunities.

We'll now open the call up for questions.

Ashley Smith - Director of Investor Relations

Rebecca we are ready for Q&A.

Question And Answer

Operator

[Operator Instructions]. Your first question comes from Mark Flannery with Credit Suisse. Sir you have the floor.

Mark Flannery - Credit Suisse

Thanks. If you... I would like to talk about CapEx and if you run like a generic 321 NYMEX crack for the rest of the year, that's sort of around 11-ish right now and just assume nothing changes, do you think the... this year's $4.2 billion and next year's $5 billion worth of CapEx is appropriate or would you look to make some adjustments to that?

Bill Klesse - Chief Executive Officer and Chairman

We think it's appropriate because obviously we have some asset sales underway.

Mark Flannery - Credit Suisse

Right. So basically in the absence of asset sales you wouldn't necessarily feel so confident about that number. Is that right?

Bill Klesse - Chief Executive Officer and Chairman

Well we also have a very strong balance sheet since we haven't run that case, but these projects that we are undertaking are very good for the long term and we have a lot of shareholder value.

Mark Flannery - Credit Suisse

Okay great. That's it. Thanks very much.

Operator

Your next question comes from Paul Cheng with Lehman Brothers. Sir you have the floor.

Paul Cheng - Lehman Brothers

Hi, good morning. Asset sale you're saying that the proceed is going to be allocated accordingly. Should we assume that the bulk of the asset sales is going for the share buyback and what if there is a shortfall in funding for your CapEx that you will use the debt to fill the gap or that not really a reasonable assumption?

Mike Ciskowski - Executive Vice President and Chief Financial Officer

I think what you are asking Paul is we will have cash flow from operations. We have the asset sales that we are working and making good progress on and will generate excess cash. I have told everyone that we intend to take out another $250 million, almost $300 million of high coupon debt this year. So we will do that. We already bought 8.8 million shares of stock. We've also disclosed that we have a plan to buy more of our shares, but you'll see us maintain a balanced approach. We'll also hold some additional liquidity because of the current market situation we see. So I think you just should soon that you are going to get what you've been getting from us.

Paul Cheng - Lehman Brothers

I see okay. Mike a point of sales of Aruba and let's assume that they close sometimes this quarter. What will be the effective tax rate going forward may look like. You said about backup into the 38% to 40%?

Mike Ciskowski - Executive Vice President and Chief Financial Officer

No, I think the last numbers I saw would be about 36% if we sell Aruba.

Paul Cheng - Lehman Brothers

Okay and I have to apologize that earlier that you were talking about the throughput in Mid-Continent what's the number again?

Mike Ciskowski - Executive Vice President and Chief Financial Officer

Yes, our Mid-Continent is going to be about 430,000 barrels a day.

Paul Cheng - Lehman Brothers

And that two final questions short one; on the Mid-Con I don't know whether you guys on co-purchase are you using the P+1 method and if you do, is there any significant loss in the quarter and also that you are in this quarter you are seeing any meaningful inventory gain or loss trading or hedging gain or loss?

Bill Klesse - Chief Executive Officer and Chairman

I guess what you are asking are we using a posted price purchasing in the Mid-Continent?

Paul Cheng - Lehman Brothers

That's correct, yes sir.

Bill Klesse - Chief Executive Officer and Chairman

No we still do our purchasing and hedging in the Mid-Continent and I'll just anticipate the question that we get for Mark, it cost us about $15 million in the quarter.

Paul Cheng - Lehman Brothers

15.

Bill Klesse - Chief Executive Officer and Chairman

Becauseof the hedge but we don't do P plus purchasing, we do on. We just buy a lot of crude on market and go and exchange.

Paul Cheng - Lehman Brothers

Correct. And Bill you are saying 15 or 50? I am sorry.

Bill Klesse - Chief Executive Officer and Chairman

15

Paul Cheng - Lehman Brothers

15, okay.

Bill Klesse - Chief Executive Officer and Chairman

Right and then, on the hedging there is nothing meaningful.

Paul Cheng - Lehman Brothers

And there is nothing meaningful on the inventory I'd presume?

Mike Ciskowski - Executive Vice President and Chief Financial Officer

Nothing on inventory.

Paul Cheng - Lehman Brothers

Thank you.

Operator

[Operator Instructions]. Your next question comes from Roger Read with Natixis Bleichroeder. You have the floor sir.

Roger Read - Natexis Bleichroeder

Good morning. Natexis Bleichroeder but I understand the difficulties. Regards to the 20% of the refine product yield that you said lower value product, with a much lower yield. Is there anything you are viewing internally to adjust to that or anything you can't do internally, should we consider that the sale or potential sales of refineries that you've highlighted will help that process or is it simply a factor of how the market needs to work its way out here?

Mike Ciskowski - Executive Vice President and Chief Financial Officer

Think of it's a general statement. The market has to work its way out. The products we are talking about are asphalt, petroleum, coke, lubricant, propylene, propane, fuel oil, resins. And if you think about petroleum coke, if we sell Aruba as planned obviously we are going to make less petroleum coke. But as a general statement these products either have not kept up with the rise in crude oil price or in the case of propane, propylene those types are compete against in a way natural gas and of course. So you wind up a little different competitive things here.

Roger Read - Natexis Bleichroeder

Okay, so that means nothing... basically it is what it is and we are going to have to just roll through all that nothing bottom of the yield is bottom of the yield, I guess

Mike Ciskowski - Executive Vice President and Chief Financial Officer

Yes, I think I mean obviously we try to minimize problems right.

Roger Read - Natexis Bleichroeder

Sure.

Bill Klesse - Chief Executive Officer and Chairman

So, Roger I tell you eventually its going to work its way through the system and also depends on crude oil price we have been extremely rapid rise in crude oil prices here since the beginning of the year.

Roger Read - Natexis Bleichroeder

Sure. One final question just on the demand side, if I look at your retail fuel volume sales year-over-year relative to the number of stationed opened, fairly flat yet we look at the fiscal numbers from the government or some of the other services that indicate down, could you kind of walk us through may be what's different between your retail, what you are seeing in your retail and what we are seeing in sort of the national numbers?

Bill Klesse - Chief Executive Officer and Chairman

Well year-to-date and our retail same store this should be company operated retail, down about eight-tens of 1% so 1% but its part of it is where we are located. Obviously when a lot of our stores are in Texas, New Mexico, Arizona, Colorado and the company outside of this and I would assume, the economy is still a little better in those markets. So we haven't seen some of the numbers that you have heard, however nationally some of the statistics only show the gasoline is down. Just around 1% but remains to be seen.

Roger Read - Natexis Bleichroeder

Right, what I was trying to make a little bit of an adjustment for the number of stations, not just the flat number of it

Unidentified Company Representative

I gave you the same store per station I gave you as a volume per same store it's down eight tenths of percent and the store counts only three different 953 versus 950 this year.

Roger Read - Natexis Bleichroeder

I'm sorry, I did not have 963 as a number there, and I'm looking at the statement not the model as it was last year?

Bill Klesse - Chief Executive Officer and Chairman

Well it is 950 this year

Roger Read - Natexis Bleichroeder

Yeah 950 down from 963 in the press release

Unidentified Company Representative

Okay 963 then.

Roger Read - Natexis Bleichroeder

Okay thank you.

Operator

Your next question comes from Chi Chow with Tristone Capital. You have the floor sir.

Chi Chow - Tristone Capital

Good morning, given the wide disparity between the gasoline and diesel crash right now, how are you optimizing your production of each products as well as crude runs?

Rich Marcogliese - Executive Vice President and Chief Operating Officer

Yes Chi, I'll answer that. We have been tracking this situation for a number of months. We constantly update planning models and basically on a fractionation basis, we are trying to recover as much distillate blowing range of production as we possibly can. Our Cantrell [ph] program, will be put in hydro treating capacity over the last couple of years of... positions us pretty well to do that and process the additional recovery. In addition we are now looking for feedstock we can purchase of higher sulfur just a little materials what we can run through some of our.

Beyond that we have got a number of longer range depths on the outlook top this high diesel crack environment will continue which involves things like changing catalyst formulations there on a making physical hardware improvements somewhat so

Chi Chow - Tristone Capital

Are those chances longer term and is that something we are going to see potentially this year?

Rich Marcogliese - Executive Vice President and Chief Operating Officer

Well is sort of a combination of the distillation changes you can do right away. You can change head cracking severity which we have done right away, is a risk or other immediate term or longer term you can change catalyst formulation and cat cracker you can see that in the next six months if you have to make physical revisions to units that's probably more of a two year out tons a year. You know what I will say you know in terms of volume metrics in this general area, there is probably from where we were last year some 200,000 barrels a day of recoverable distiller which we could move out of the gasoline pool and we are trying to capture every bit of that.

Chi Chow - Tristone Capital

Thanks Rich. Are you still cutting back on FCC runs at this point.

Rich Marcogliese - Executive Vice President and Chief Operating Officer

Yes we still are cut back in a couple of locations and we really take a look at the marginal value of gasoline versus the marginal cost of acquiring low sulfur cavity. As a result of running lower throughput or cat cracker for the St. Charles refinery. We also took the controllable shutdown of our small cat cracker in the east plant with Corpus Christi which is a 20,000 barrel a day cat cracker.

Chi Chow - Tristone Capital

Thanks, can you give us some general comments on kind of the state of the diesel market now. Obviously the crack are extremely high but how much of this is supported by the export market versus what's going on with demand here domestically?

Rich Marcogliese - Executive Vice President and Chief Operating Officer

Well I think the export market is keeping diesel prices very high not only in the Europe, Latin America or strike at and other important require more diesel deals reported in the UK. So I think that's the big driver for barrels in the US and even the especially low sulfur barrels are very high for now.

Mike Ciskowski - Executive Vice President and Chief Financial Officer

Chi we've said it before we've been pretty active in that export market also and it is still very strong.

Chi Chow - Tristone Capital

How are you seeing demand here domestically, it seems like things are slowing down, you see some data points on EPS and on the railcars being parked up in Montana. Are you seeing weakness here domestically though?

Mike Ciskowski - Executive Vice President and Chief Financial Officer

Yeah, we are seeing weakness in the U.S. markets but I think it is more than offset by the export market though.

Chi Chow - Tristone Capital

Okay, thanks to you.

Operator

Your next question comes from Anne Kohler with Caris. You have the floor ma'am.

Anne Kohler - Caris

Morning. I just wanted to point of clarification when are you are in New York last month, you... if I recall correctly, you indicated that you wanted to receive certain valuation for the assets that you had up for sales specifically at this point Memphis and Clark Springs and that you are unable to achieve that price you would reconsider on selling those assets, is that correct?

Bill Klesse - Chief Executive Officer and Chairman

That's correct.

Anne Kohler - Caris

Great, thank you.

Operator

[Operators instructions]. Your next question comes from Mark Gilman with Benchmark. Sir you have the floor.

Mark Gilman - Benchmark

Good morning guys, Bill I just want to express my sincere appreciation for asking and answering my primary questions but I do have others.

Bill Klesse - Chief Executive Officer and Chairman

Thank you.

Mark Gilman - Benchmark

Give us an update where your mindset is on Paulsboro noting that Ardmore has now been added to the list regarding strategic alternatives?

Bill Klesse - Chief Executive Officer and Chairman

We are still taking a good look at that and no decision has been made.

Mark Gilman - Benchmark

Okay, could I ask you why is that it just seems in discussions like this that Three Rivers is consider a keeper?

Bill Klesse - Chief Executive Officer and Chairman

Because we make benzene at Three Rivers where it does gives exposure to the petrochemical business and it also tied indirectly with our Corpus Christi complex. We have a piece of pipe we optimize between the two. We support our marketing in the San Antonio out of that facility. So if you look at the pipeline networking those owned by new star, it flows from Corpus through there as well as Rio Grande Valley to Laredo and into San Antonio. So we look at as an integrated business the same is true for Houston. We look at Houston the same way tied to such facility and we just made a completed last year the very large mild hydro cracker in Houston where we shipped products from Texas City up to the Houston market hydro treating. So we try to operate those two examples as a combined facility even though they are separated by some models.

Mark Gilman - Benchmark

Okay, Bill, if I could one more, give us... given pricing relationships have changed a fair amount over the course of the first quarter what if any capital you are achieving regarding the ethanol gasoline spread?

Joe Gorder - Executive Vice President Marketing and Supply

Well, yeah I mean will, except we can't markedly out this... we've blended this market we can and that is except we can blend conventional we are doing that also with our system on the way we market, selling into this spot market its bit tough to capture that.

Bill Klesse - Chief Executive Officer and Chairman

Again am sure exactly what you are asking, against its economic blend any price that we are or have accessed the facility to blend we are blending. So if that's what you are asking we are doing now there is a lot of our places either in San Antonio we can't use this because we are in 7.8 pound here but in a lot of markets current if the infrastructure there but clearly economic there are favorite volumes.

Joe Gorder - Executive Vice President Marketing and Supply

We are converting internal expenses now to do that all

Mark Gilman - Benchmark

Okay guys thanks very much, appreciate it.

Operator

Your next question comes from Rohit Aggarwal with Miller Tabak [ph]. You have the floor sir.

Unidentified Analyst

Hi, thanks for taking my questions. Quick question just to follow up on the previous one. If the ethanol captures in your favor and you are getting value out of it, have you ever given thought to actually bringing one of those ethanol producers in house or are you comfortable having that logistic chain out of your operation system?

Bill Klesse - Chief Executive Officer and Chairman

Well it's clearly a make versus buy and when you look at the supply chain or value chain right now all the economic rents being taken by the former and or the blender in the blender and we are capturing it where we can as we I said in the last question and I think you have to decide when do you think the rents is going to be taken by the ethanol producer and right now we don't see that at least for the foreseeable future.

Unidentified Analyst

Understood, just one follow-up if you may permit me. When you said make versus buy I am assuming there is some discount to be applied to making because it does take some timeframe to make an asset I guess?

Mike Ciskowski - Executive Vice President and Chief Financial Officer

Well I think it is the right out production costs and ethanol plants probably don't even cover the price point in our so we don't see any profit fee generator there and particularly we return on investments.

Bill Klesse - Chief Executive Officer and Chairman

I think... if you look at where all the money has been made is been made on the front end and that's why so many of the ethanol plants are struggling economically or financially. But is the make versus buy for us ... at least when we look at from the plant, to the hubs.

Unidentified Analyst

Thank you.

Operator

This concludes today's Q&A session. You may begin with your closing remarks.

Mike Ciskowski - Executive Vice President and Chief Financial Officer

Okay, thank you Rebecca. Just want to thank everyone for listening to today's call if you have any additional questions please feel free to call Investor Relations department. Thank you.

Operator

This concludes today's conference call. You may now disconnect.

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