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Rating Action:

MOODY'S CONFIRMS VALERO ENERGY'S RATINGS AND UPGRADES PREMCOR'S RATINGS; OUTLOOK STABLE

31 Aug 2005
MOODY'S CONFIRMS VALERO ENERGY'S RATINGS AND UPGRADES PREMCOR'S RATINGS; OUTLOOK STABLE

Approximately $5.7 Billion of Securities Affected

New York, August 31, 2005 -- Moody's Investors Service confirmed Valero Energy Corporation's Baa3 senior unsecured ratings and upgraded The Premcor Refining Group's (Premcor) senior unsecured notes to Baa3 from Ba3. The rating actions end a review initiated on April 25, 2005 following Valero's announcement regarding its planned acquisition of Premcor Inc. for approximately $8.7 billion, including assumed debt. The transaction, which has been approved by Premcor's shareholders, remains subject to FTC approval and is expected to close on September 1, 2005.

Ratings confirmed are Valero Energy Corporation's Baa3 rated senior unsecured notes, debentures, and medium-term notes, 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.

Ratings upgraded are Premcor Refining Group's (PRG) senior unsecured notes from Ba3 to Baa3 and Port Arthur Finance Corporation's senior secured notes from Ba3 to Baa3. At the same time, Moody's withdrew Premcor Inc.'s corporate family (formerly known as Senior Implied) rating and speculative grade liquidity rating and PRG's senior secured bank facility rating and senior subordinated note rating.

The purchase consideration will be funded with approximately 50% cash and 50% Valero stock. Valero expects to fund the cash portion (approximately $3.6 billion) with a combination of cash on hand, $400 million of drawdowns under its $1 billion accounts receivables securitization facility, and a $1.5 billion senior unsecured bank term loan. At approximately $1,000 per complexity barrel, the transaction appears fully priced.

Moody's confirmation of Valero's ratings and the stable rating outlook are based on economies of scale, diversification and other strategic benefits expected to result from the merger; the current robust refining margin environment, which has resulted in stronger-than-anticipated cash builds at both Valero and Premcor since the announcement of their pending merger in April 2005, and which should facilitate planned debt reduction; senior management's stated commitment to repay term loan outstandings by the end of 2006 and to manage strategic capital expenditures and share buybacks within cash flow; through-the-cycle metrics that are consistent with a Baa3 rating, taking into consideration the size and market position of the merged entity; and the upstream/downstream guarantees to be provided at closing.

Above-average distillate margins and wide light/heavy spreads have generated larger-than expected cash balances at Valero and at Premcor at August 31, 2005. As a result, the incremental amount of balance-sheet debt required to finance the acquisition at closing is expected to be about the same (approximately $3.0 billion) as the company had originally anticipated despite the acceleration of the closing date from year-end 2005 to September 1, 2005. Valero expects incremental balance-sheet debt incurred in the acquisition to decline to about $2.3 billion by the end of 2005, as compared to management's original estimate of $2.9 billion. Moody's had stated in its press release of April 25, 2005 that incremental balance-sheet debt in excess of $2.9 billion at closing could pressure Valero's ratings.

Moody's notes that Valero's commitment to repay the term loan by the end of 2006 will be critical to maintaining a stable outlook, as it will demonstrate management's willingness to balance share repurchases and strategic growth capital spending with debt repayment, a somewhat more conservative financial strategy than in the past. In order to maintain a solid investment-grade rating, Valero will need to maintain through-the-cycle average retained cash flow to adjusted debt of at least 25%, excluding the debt of Valero L.P., a master limited partnership for which Valero is the general partner (20% including Valero L.P. debt). The Baa3 rating assumes Valero will continue to pursue acquisition opportunities.

An over-reliance on debt to fund future acquisitions could pressure Valero's ratings, unless the company finances a meaningful amount of the transaction with equity and/or proceeds from asset sales. A positive outlook would require a more conservative fiscal policy, as well as a significantly improved sustainable financial leverage profile.

The combined entity's pro-forma financial leverage at 9/1/05 is expected to be approximately $389 per complexity barrel (excluding the debt of Valero L.P.). Moody's expects adjusted debt per complexity barrel to decline to about $356 by year-end 2005, but this will still exceed the average for the company's investment-grade peers. Nevertheless, the merged entity's size and diversification (over 3 million barrels per day of distillation capacity, about $32 billion in pro-forma assets and 18 refineries) and management's plan to repay the term loan over the next 16 months help mitigate the combined entity's above-average leverage.

Valero's Baa3 rating is supported by the benefits of the Premcor acquisition, including a significant increase in refining capacity, greater geographic diversification, certain operating synergies, and increased exposure to heavy sour crudes (from 24% to 31% of total crude slate), and by management's track record with prior acquisitions in improving refinery operating performance and realizing synergies. Premcor's Memphis and Lima refineries have suffered from relatively low utilization rates, and the Delaware City Refinery has had operating problems. However, Valero has demonstrated success in improving the performance of its acquired assets.

On the other hand, the rating also considers Valero's and Premcor's heavy capital requirements in 2006 and 2007, including substantial environmental capital expenditures, and the fact that Valero's estimates for capital required to meet more stringent diesel sulfur rules have continued to rise. Nevertheless, assuming mid-cycle (2000-2004 average) refining margins in 2006 and a downturn (2002 margins) in 2007, Moody's believes the merged entity will have sufficient flexibility to reduce strategic growth capital expenditures to avoid further material increases in its debt obligations.

Premcor Inc. will be merged into Valero and its existence as a separate entity will cease. Premcor Inc.'s subsidiaries, including PRG, will become 100% owned direct and indirect subsidiaries of Valero Energy. Valero will guarantee all of the senior notes of PRG and its affiliates. At the same time, all of Valero's senior notes and debentures will be supported by upstream guarantees from PRG.

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

Premcor Inc. is an independent refining and marketing company headquartered in Old Greenwich, Connecticut.

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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