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Rating Action:

MOODY'S AFFIRMS VALERO ENERGY CORPORATION'S Baa3 SENIOR UNSECURED RATING; OUTLOOK POSITIVE

22 Dec 2004
MOODY'S AFFIRMS VALERO ENERGY CORPORATION'S Baa3 SENIOR UNSECURED RATING; OUTLOOK POSITIVE

Approximately $4.8 Billion of Securities Affected

New York, December 22, 2004 -- Moody's Investors Service affirmed Valero Energy Corporation's Baa3 senior unsecured debt rating and revised the company's rating outlook from stable to positive. The change in outlook reflects Moody's expectations for a reasonably supportive refining margin environment in the near term, management's plans to reduce the company's debt burden with free cash flow, the company's increased size and diversification as a result of refinery acquisitions that have outperformed expectations, and management's recent track record of issuing common equity or mandatorily convertible preferred stock to finance acquisitions.

An upgrade of Valero's ratings will be a function of the extent to which management strengthens the company's financial cushion through debt repayment. Moody's believes the company needs to achieve average Retained Cash Flow/Adjusted debt in the low-to-mid 20% range on a sustainable basis through a refining cycle in order to merit a higher rating. A rating upgrade would also depend upon Valero's commitment to maintaining conservative financial policies, including managing share buybacks prudently and financing at least 50% of material acquisitions with common equity. Moody's notes that Valero remains acquisitive and that it factors event risk into the company's ratings.

Refining margins are highly volatile and cyclical, and average margins could narrow in 2005. Moody's will change Valero's rating outlook back to stable if management is not successful in carrying out its debt reduction plans or if the company or its controlled affiliate, Valero LP, make material acquisitions (other than Valero L.P.'s pending acquisition of Kaneb) that are financed with a large debt component.

For the first nine months of 2004, Valero generated $2.17 billion of operating income, as compared to $990 million during the same period last year, largely due to continued high average refining margins and wide differentials between sweet and heavy/sour crude oil. However, despite strong free cash flow of approximately $1.1 billion, because of elevated capital spending, synthetic lease buybacks, share repurchases and acquisitions, Valero did not reduce Adjusted Debt by more than $167 million over this period. In fact, pro-forma for the pending merger of Kaneb with Valero L.P., for which Valero remains the general partner, Moody's expects Valero's Adjusted Debt including the consolidated acquisition debt to increase by approximately $1.3 billion once the merger closes, which is expected to occur during the first quarter of 2005.

Valero estimates it will need to spend $1.8 billion from 2003-2008 to comply with new sulfur limits for gasoline and diesel. Of this amount, $697 million has already been spent, with about $500 million earmarked for 2005, which could reduce free cash flow available for debt reduction if average refining margins were to weaken materially from current levels. However, if margins remain above mid-cycle levels, Valero should be able to generate sufficient free cash flow in 2005 to repay debt and reduce its financial leverage.

Valero financed more than 85% of its $465 million March 2004 acquisition of the Aruba refinery (net of inventories) with common stock and the majority of its $400 million July 2003 acquisition of the St. Charles (formerly Orion) refinery (net of inventories) with mandatorily convertible preferred stock.

While these refineries have increased Valero's exposure to the Gulf Coast market (about 60% of 2004 year-to-date operating income), they have helped diversify the company's feedstock and product slate. Valero now has the largest and most complex refining system among its independent refining company peers, with total throughput capacity of over 2 million barrels per day and a Nelson complexity of approximately 11.6. Both St. Charles and Aruba are able to process heavy sour crudes and, as a result, their earnings and cash flow have benefited from the widening in average heavy sour crude discounts during 2004. As a result of the St. Charles and Aruba acquisitions, about 63% of Valero's crude slate now consists of heavy sour crudes as compared to 57% in 2002. Moody's believes current global supply/demand fundamentals will support wider average heavy sour crude discounts for the foreseeable future.

The St. Charles refinery, which had a poor performance history prior to its acquisition by Valero, has outperformed management's expectations. As a result of a first quarter 2004 expansion project, in 2005 Valero expects St. Charles to be on a par with its Corpus Christi refinery, which up until now has been the largest contributor to its earnings and cash flow (21% of operating income during the first 9 months of 2004).

The Aruba refinery has reliability and energy cost issues and does not produce gasoline, but it has been able to generate incremental earnings for Valero through its ability to take advantage of sour crude discounts and supply intermediate feedstocks to Valero's Gulf Coast and East Coast refineries. Valero pays no income taxes on the refinery and has limited its environmental cleanup exposure through annual payments of approximately $350,000 into a trust fund.

Ratings affirmed are Valero Energy Corporation's Baa3 rated senior unsecured notes, debentures, medium-term notes, and bank debt, its Ba1 rated subordinated debentures, its shelf registration for senior unsecured debt/subordinated debt/preferred stock rated (P)Baa3/(P)Ba1/(P)Ba2, and its Ba2 rated mandatory convertible preferred stock.

Valero Energy Corporation is the largest independent refining and marketing company in the United States and is headquartered in San Antonio, Texas.

New York
John Diaz
Managing Director
Corporate Finance Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

New York
Alexandra S. Parker
Senior Vice President
Corporate Finance Group
Moody's Investors Service
JOURNALISTS: 212-553-0376
SUBSCRIBERS: 212-553-1653

No Related Data.
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