UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from                   to                       

Commission File Number 1-16417

VALERO L.P.
(Exact name of registrant as specified in its charter)

One Valero Way
San Antonio, Texas
(Address of principal executive offices)
78249
(Zip Code)

Telephone number: (210) 345-2000
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  The definition of “accelerated filer and large accelerated filer” is in Rule 12b-2 of the Securities Exchange Act. (Check one):

Large accelerated filerx                                     Accelerated filer o                              Non-accelerated filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o    No x

The number of common units outstanding as of November 1, 2006 was 46,809,749.

VALERO L.P. AND SUBSIDIARIES
FORM 10-Q

TABLE OF CONTENTS

2

PART I — FINANCIAL INFORMATION
Item 1.  Financial Statements

VALERO L.P. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Thousands of Dollars, Except Unit Data)

See Condensed Notes to Consolidated Financial Statements.

3

VALERO L.P. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
(Unaudited, Thousands of Dollars, Except Unit and Per Unit Data)

See Condensed Notes to Consolidated Financial Statements.

4

VALERO L.P. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, Thousands of Dollars)

See Condensed Notes to Consolidated Financial Statements.

5

VALERO L.P. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.  ORGANIZATION, OPERATIONS AND ACCOUNTING PRONOUNCEMENTS

Organization and Operations

Valero L.P. (NYSE: VLI) is a publicly traded Delaware limited partnership engaged in the crude oil and refined product transportation, terminalling and storage business.  Valero L.P. has terminal facilities in the United States, the Netherland Antilles, Canada, Mexico, the Netherlands and the United Kingdom.

As used in this report, references to “we,” “us,” “our” or the “Partnership” collectively refer, depending on the context, to Valero L.P. or a wholly owned subsidiary of Valero L.P.

These unaudited consolidated financial statements include the accounts of the Partnership and subsidiaries in which the Partnership has a controlling interest. Intercompany balances and transactions have been eliminated in consolidation.  Investments in 50% or less owned entities are accounted for using the equity method of accounting.

These unaudited consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities Exchange Act of 1934.  Accordingly, they do not include all of the information and notes required by GAAP for complete consolidated financial statements.  In the opinion of management, all adjustments considered necessary for a fair presentation have been included.  All such adjustments are of a normal recurring nature unless disclosed otherwise.  Financial information for the three and nine months ended September 30, 2006 and 2005 included in these Condensed Notes to Consolidated Financial Statements is derived from our unaudited consolidated financial statements.  Operating results for the three and nine months ended September 30, 2006 are not necessarily indicative of the results that may be expected for the year ending December 31, 2006.

The consolidated balance sheet as of December 31, 2005 has been derived from the audited consolidated financial statements as of that date.  You should read these consolidated financial statements in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2005.

We conduct our operations through our subsidiaries, primarily Valero Logistics Operations, L.P. (Valero Logistics) and Kaneb Pipe Line Operating Partnership, L.P. (KPOP).  We have four business segments:  refined product terminals, refined product pipelines, crude oil pipelines and crude oil storage tanks.

Our operations are managed by Valero GP, LLC. Valero GP, LLC is the general partner of Riverwalk Logistics, L.P., which is the 2% general partner of Valero L.P.  As of September 30, 2006, Valero GP, LLC and Riverwalk Logistics, L.P. were indirect wholly owned subsidiaries of Valero GP Holdings, LLC (Holdings) (NYSE: VEH).  Holdings is an approximately 59% owned subsidiary of Valero Energy Corporation (Valero Energy) (NYSE: VLO) and owned approximately 41% by the public.

Other

UDS Logistics, LLC, an indirect, wholly owned subsidiary of Valero Energy, owned 21.4% of our limited partner interests and the 2% general partner interest as of December 31, 2005.  On January 15, 2006, UDS Logistics, LLC changed its name to Valero GP Holdings, LLC.  Prior to July 19, 2006, Holdings completed certain organizational transactions resulting in Valero GP, LLC, Riverwalk Holdings, LLC, and Riverwalk Logistics, L.P. becoming wholly owned subsidiaries of Holdings.

On July 19, 2006, Holdings completed its initial public offering of 17.25 million units representing limited liability company interests at $22.00 per unit.  All of these units were sold by subsidiaries of Valero Energy.  As a result, Holdings did not receive any proceeds from this offering.  Valero Energy retains an approximate 59% ownership interest in Holdings, but has stated its intention to further reduce and ultimately sell all of its interest in Holdings, pending market conditions.

6

New Accounting Pronouncements

FASB Interpretation No. 48

In June 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109” (FIN 48).  FIN 48 clarifies the accounting for uncertain income tax positions recognized in an enterprise’s financial statements in accordance with FASB Statement No. 109, “Accounting for Income Taxes,” by defining a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.  An enterprise recognizes a tax position if it is more-likely-than-not that the tax position will be sustained, based on the technical merits of the position, upon examination.  An uncertain tax position is measured in the financial statements at the largest amount of benefit that is more-likely-than-not to be realized.  FIN 48 is effective for fiscal years beginning after December 15, 2006 and we are continuing to evaluate its effect on our financial position or results of operations.

EITF Issue No. 06-3

In June 2006, the FASB ratified its consensus on EITF Issue No. 06-3, “How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement” (EITF No. 06-3).  EITF 06-3 includes any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer and may include sales, use, value added, and some excise taxes.  These taxes should be presented on either a gross or a net basis, and if reported on a gross basis, a company should disclose amounts of those taxes in interim and annual financial statements for each period for which an income statement is presented.  The guidance in EITF No. 06-3 is effective for all periods beginning after December 15, 2006 and is not expected to significantly affect our financial position or results of operations.

FASB Statement No. 157

In September 2006, the FASB issued Statement No. 157, “Fair Value Measurements.”  Statement No. 157 defines fair value, establishes a framework for measuring fair value under GAAP, and expands disclosures about fair value measures.  Statement No. 157 is effective for fiscal years beginning after November 15, 2007, with early adoption encouraged.  The provisions of Statement No. 157 are to be applied on a prospective basis, with the exception of certain financial instruments for which retrospective application is required.  The adoption of Statement No. 157 is not expected to materially affect our financial position or results of operations.

2.  ACQUISITIONS

St. James Crude Oil Storage Facility

On September 18, 2006, we signed a definitive agreement to acquire a crude oil, storage and blending facility in St. James, Louisiana from Koch Supply and Trading, L.P. for $140 million.  The acquisition includes 17 crude oil tanks and three heated refined product tanks with a total capacity of approximately 3.3 million barrels. Additionally, the facility has a rail-loading facility and three docks with barge and ship access. The facility is located on approximately 220 acres of land on the west bank of the Mississippi River approximately 60 miles west of New Orleans and has an additional 585 acres of undeveloped land.  We expect the acquisition to close in the fourth quarter of 2006 and to fund the acquisition with borrowings under our revolving credit agreement.

On September 20, 2006, we executed a terminal services agreement (St. James Terminal Agreement) with Valero Marketing and Supply Company (VMSC), a wholly owned subsidiary of Valero Energy.  Pursuant to the St. James Terminal Agreement, we will provide crude oil storage and blending services to VMSC at the facility in St. James, Louisiana for a monthly minimum throughput fee plus per barrel throughput charges.  The St. James Terminal Agreement has an initial term of five years with an option to extend for an additional five years with a one year notice from VMSC prior to the expiration of the initial term.

Capwood Pipeline

Effective January 1, 2006, we purchased a 23.77% interest in Capwood pipeline from Valero Energy for $12.8 million, which was paid from borrowings under our existing revolving credit agreement.  The Capwood pipeline is a 57-mile crude oil pipeline that extends from Patoka, Illinois to Wood River, Illinois.  Plains All American Pipeline L.P., the operator of the Capwood pipeline, owns the remaining 76.23% interest.  Our financial statements include the results of operations of our interest in the Capwood pipeline in the crude oil pipelines segment for the three and nine months ended September 30, 2006.

7

Kaneb Acquisition

On July 1, 2005, we completed our acquisition (the Kaneb Acquisition) of Kaneb Services LLC (KSL) and Kaneb Pipe Line Partners, L.P. (KPP, and, together with KSL, Kaneb).    The Kaneb Acquisition was accounted for using the purchase method.  The purchase price and the final purchase price allocation were as follows (in thousands):

The condensed statements of income include the results of operations of the Kaneb Acquisition commencing on July 1, 2005.  As a result, information for the three months ended September 30, 2006 and 2005 and nine months ended September 30, 2006 presented below represents actual results of operations.  The unaudited pro forma financial information for the nine months ended September 30, 2005 includes the historical financial information of Kaneb and the Partnership for that period.  This financial information assumes the following:

·                  we completed the Kaneb Acquisition on January 1, 2005;

·                  we borrowed $525.0 million to purchase all of the outstanding equity securities of KSL,

·                  we issued approximately 23.8 million common units in exchange for all of the outstanding common units of KPP,

·                  we received a contribution from our general partner of $29.2 million to maintain its 2% interest; and

·                  the results of operations of Martin Oil LLC (a marketing subsidiary of KSL), our Australia and New Zealand subsidiaries, and certain assets we divested in conjunction with the Kaneb Acquisition (Held Separate Businesses), are reported as discontinued operations.

The unaudited pro forma information is not necessarily indicative of the results of future operations:

8

3.  DISPOSITION

Sale of Australia and New Zealand subsidiaries

On March 30, 2006, we sold our Australia and New Zealand subsidiaries to ANZ Terminals Pty. Ltd., for total proceeds of $70.1 million.  The proceeds were used for working capital purposes, including paying down outstanding debt.  This transaction included the sale of eight terminals with an aggregate storage capacity of 1.1 million barrels.  For the nine months ended September 30, 2006, revenues and pre-tax income related to the Australia and New Zealand subsidiaries included in income (loss) from discontinued operations totaled $5.0 million and $0.6 million, respectively.  The results of operations for the three and nine months ended September 30, 2005 have been restated to reflect the sale of the Australia and New Zealand subsidiaries as income (loss) from discontinued operations.

4.  PRODUCT IMBALANCES

Product imbalances occur when customers deliver more or less refined product volumes into our pipelines than they are entitled to receive.  We value assets and liabilities related to product imbalances at current market prices.  Included in other current assets on the consolidated balance sheets are $16.9 million and $20.0 million of product imbalance assets as of September 30, 2006 and December 31, 2005, respectively.  Included in accrued liabilities on the consolidated balance sheets are $15.2 million and $17.5 million of product imbalance liabilities as of September 30, 2006 and December 31, 2005, respectively.

5.  LONG-TERM DEBT

Credit Agreement Amendments

On June 6, 2006, we completed certain amendments to our $525 million term loan agreement ($525 Million Term Loan Agreement) and our $400 million revolving credit agreement (the $400 Million Revolving Credit Agreement).  Both agreements were amended to (i) eliminate the provision that the failure of Valero Energy to own or control our general partner constitutes a “change of control;” (ii) extend the maturities of the agreements to 2011; (iii) include certain material construction projects in the definition of “Consolidated EBITDA;” and (iv) eliminate the requirement that we maintain a minimum consolidated interest coverage ratio.  Additionally, the amendments reduced the applicable margin on LIBOR loans, which vary depending upon our credit rating.  The term loan agreement of our UK subsidiary (the UK Term Loan) was also amended to (i) extend its maturity to 2011; (ii) include certain material construction projects in the definition of “Consolidated EBITDA;” and (iii) eliminate the requirement that we maintain a minimum consolidated interest coverage ratio.

Our $525 Million Term Loan Agreement, $400 Million Revolving Credit Agreement and UK Term Loan all require that we maintain certain financial ratios and include other restrictive covenants, including a prohibition on distributions if any defaults, as defined in the agreements, exist or would result from the distribution. Our management believes that we are in compliance with all of these ratios and covenants as of September 30, 2006.

$400 Million Revolving Credit Agreement

During the nine months ended September 30, 2006, we borrowed $59.0 million under our $400 Million Revolving Credit Agreement to fund the purchase of the Capwood pipeline and a portion of our capital expenditures.  Additionally, we repaid $48.0 million during the nine months ended September 30, 2006.  The $400 Million Revolving Credit Agreement bears interest based on either an alternative base rate or LIBOR, which was 5.9% as of September 30, 2006.  As of September 30, 2006, we had $384.1 million available for borrowing under our $400 Million Revolving Credit Agreement.  Additionally, our $400 Million Revolving Credit Agreement allows us to increase the amount we can borrow to a maximum of $600 million by giving notice to the lenders, so long as we are not in default.

Interest Rate Swaps

As of September 30, 2006, the weighted-average interest rate for our interest rate swaps was 7.0%.  As of September 30, 2006 and December 31, 2005, the aggregate estimated fair value of the interest rate swaps included in other long-term liabilities on our consolidated balance sheets was $5.0 million and $4.0 million, respectively.

9

6.  COMMITMENTS AND CONTINGENCIES

Litigation and Environmental Matters

We have contingent liabilities resulting from various litigation, claims and commitments, the most significant of which are discussed below.  We record accruals for loss contingencies when losses are considered probable and can be reasonably estimated.  Legal fees associated with defending ourselves in legal matters are expensed as incurred.  As of September 30, 2006, we have recorded $2.8 million of accruals related to settled matters.  As of September 30, 2006, we have recorded accruals for contingent losses totaling $48.3 million. The actual payment of any amounts accrued and the timing of any such payments ultimately made is uncertain.  We believe that should we be unable to successfully defend ourselves in any of these unsettled matters, the ultimate payment of any or all of the amounts reserved would not have a material adverse effect on our financial position or liquidity. However, if any actual losses ultimately exceed the amounts accrued, there could be a material adverse effect on our results of operations.

Grace Energy Corporation Matter. In 1997, Grace Energy Corporation (Grace Energy) sued subsidiaries of Kaneb in Texas state court. The complaint sought recovery of the cost of remediation of fuel leaks in the 1970s from a pipeline that had once connected a former Grace Energy terminal with Otis Air Force Base in Massachusetts (Otis AFB). Grace Energy alleges the Otis AFB pipeline and related environmental liabilities had been transferred in 1978 to an entity that was part of Kaneb’s acquisition of Support Terminal Services, Inc. and its subsidiaries from Grace Energy in 1993. Kaneb contends that it did not acquire the Otis AFB pipeline and never assumed any responsibility for any associated environmental damage.

In 2000, the court entered final judgment that: (i) Grace Energy could not recover its own remediation costs of $3.5 million, (ii) Kaneb owned the Otis AFB pipeline and its related environmental liabilities and (iii) Grace Energy was awarded $1.8 million in attorney costs. Both Kaneb and Grace Energy appealed the trial court’s final judgment to the Texas Court of Appeals in Dallas. In 2001, Grace Energy filed a petition in bankruptcy, which created an automatic stay of actions against Grace Energy. Once that stay is lifted, we intend to resume vigorous prosecution of the appeal.

The Otis AFB is a part of a Superfund Site pursuant to the Comprehensive Environmental Response Compensation and Liability Act (CERCLA). The site contains a number of groundwater contamination plumes, two of which are allegedly associated with the Otis AFB pipeline.  Relying on the Texas state court’s final judgment assigning ownership of the Otis AFB pipeline to Kaneb, the U.S. Department of Justice advised Kaneb in 2001 that it intends to seek reimbursement from Kaneb for the remediation costs associated with the two spill areas. In 2002, the Department of Justice asserted that it had incurred over $49.0 million in costs and expected to incur additional costs of approximately $19.0 million for remediation of the two spill areas. The Department of Justice has not filed a lawsuit against us on this matter and we have not made any payments toward costs incurred by the Department of Justice.

Port of Vancouver Matter.  We own a chemical and refined products terminal on property owned by the Port of Vancouver, and we lease the land under the terminal from the Port of Vancouver. Under an Agreed Order entered into with the Washington Department of Ecology when Kaneb purchased the terminal in 1998, Kaneb agreed to investigate and remediate groundwater contamination by the terminal’s previous owner and operator originating from the terminal.  Investigation and remediation at the terminal are ongoing, in compliance with the Agreed Order.  In April 2006, the Washington Department of Ecology commented on our site investigation work plan and asserted that the groundwater contamination at the terminal was commingled with a groundwater contamination plume under other property owned by the Port of Vancouver.  We dispute this assertion.  No lawsuits have been filed against us in this matter, and we have not made any payments toward remediation of the allegedly commingled plume.  Factors that could affect estimated remediation costs include whether Kaneb will be found to have ultimate responsibility for some portion of the allegedly commingled plume, the Port of Vancouver’s contribution to the remediation effort and the amount the Port of Vancouver actually receives from other potentially responsible parties.

St. Eustatius Tax Agreement.  On June 1, 1989, the governments of the Netherlands Antilles and St. Eustatius approved a Free Zone and Profit Tax Agreement retroactive to January 1, 1989, which expired on December 31, 2000.  This agreement required a subsidiary of Kaneb, which we acquired on July 1, 2005, to pay the greater of 2% of taxable income, as defined therein, or 500,000 Netherlands Antilles guilders (approximately $0.3 million) per year.  The agreement further provided that any amounts paid in order to meet the minimum annual payment were available to

10

offset future tax liabilities under the agreement to the extent that the minimum annual payment is greater than 2% of taxable income.

On February 22, 2006, we entered into a revised agreement (the 2005 Tax and Maritime Agreement) with the governments of St. Eustatius and the Netherlands Antilles.  The 2005 Tax and Maritime Agreement is effective beginning January 1, 2005 and expires on December 31, 2014.  Under the terms of the 2005 Tax and Maritime Agreement, we agreed to make a one-time payment of five million Netherlands Antilles guilders (approximately $2.8 million) in full and final settlement of all of our liabilities, taxes, fees, levies, charges, or otherwise (including settlement of audits) due or potentially due to St. Eustatius.  We further agreed to pay an annual minimum profit tax to St. Eustatius of one million Netherlands Antilles guilders (approximately $0.6 million), beginning as of January 1, 2005.  We agreed to pay the minimum annual profit tax in twelve equal monthly installments.  To the extent the minimum annual profit tax exceeds 2% of taxable profit (as defined in the 2005 Tax and Maritime Agreement), we can carry forward that excess to offset future tax liabilities.  If the minimum annual profit tax is less than 2% of taxable profit, we agreed to pay that difference.

Other

We are also a party to additional claims and legal proceedings arising in the ordinary course of business. We believe the possibility is remote that the final outcome of any of these claims or proceedings to which we are a party would have a material adverse effect on our financial position, results of operations or liquidity; however, due to the inherent uncertainty of litigation, there can be no assurance that the resolution of any particular claim or proceeding would not have a material adverse effect on our results of operations, financial position or liquidity.

Commitments

On April 13, 2006, we entered into an agreement to purchase three 30,000 barrel and two 52,000 barrel tank barges over the next two years for our St. Eustatius facility.  The contract price is $34.1 million, which is subject to adjustment based on the actual cost incurred for the steel.

7.  RELATED PARTY TRANSACTIONS

We have related party transactions with Valero Energy for pipeline tariff, terminalling fee and crude oil storage tank fee revenues, which are comparable to the fees charged to third parties for similar services.   In addition, we reimburse Valero Energy for the actual costs of Valero Energy employees working solely on our behalf and for charges incurred on our behalf.

Additionally, Valero Energy charges us an administrative service fee for certain administrative functions, primarily information systems support, ad valorem taxes, risk management, and human resources administration.  If we cease to obtain such administrative services from Valero Energy, our results of operations may be adversely impacted.

The receivable from Valero Energy as of September 30, 2006 and December 31, 2005 represents amounts due for pipeline tariff, terminalling fee and crude oil storage tank fee revenues, and the payable to Valero Energy primarily represents amounts due for employee costs and the administrative service fee.

The following table summarizes information pertaining to transactions with Valero Energy:

Our share of allocated Valero Energy employee benefit plan expenses, excluding compensation expense related to restricted common units and unit options, was $8.5 million and $8.9 million for the three months ended

11

September 30, 2006 and 2005, respectively, and was $25.1 million and $15.0 million for the nine months ended September 30, 2006 and 2005, respectively.  These employee benefit plan expenses and the related payroll costs are included in operating expenses and general and administrative expenses.

Services Agreement

Effective July 1, 2005, the services agreement was amended (the 2005 Services Agreement) to account for our significant growth following the closing of the Kaneb Acquisition resulting in an increase in the administrative fee to $13.8 million for the first year from July 1, 2005 to June 30, 2006.

Effective January 1, 2006, we amended the 2005 Services Agreement (the 2006 Services Agreement) to reflect that Valero GP, LLC directly performs many of the services previously provided by Valero Energy under the 2005 Services Agreement, primarily consisting of information systems, legal, corporate development and health, safety and environmental functions.  The Valero Energy employees who had previously performed these services became employees of Valero GP, LLC, and their costs are now directly charged to us.  Accordingly, the annual fee charged to us by Valero Energy for administrative services was reduced from $13.8 million to approximately $1.9 million per year.  This annual fee will increase to approximately $2.9 million and $3.4 million in 2007 and 2008, respectively.  The annual fee will remain at approximately $3.4 million through the term of the agreement.   In addition, each annual fee will be subject to adjustments to account for Valero Energy’s annual salary increase.  Subject to approval by our Conflicts Committee, the amounts may also be adjusted for changed service levels.

The 2006 Services Agreement will expire on December 31, 2010 with automatic two-year renewal options unless terminated by either party at least six months prior to the renewal period.  We may cancel or reduce the level of services that Valero Energy provides us on 60 days prior written notice.  The 2006 Services Agreement will terminate upon the change of control of either Valero Energy or us.

Valero Energy charged us for administrative services under the services agreements in the amount of $0.3 million and $3.1 million for the three months ended September 30, 2006 and 2005, respectively, and $1.3 million and $3.5 million for the nine months ended September 2006 and 2005, respectively.

2006 Omnibus Agreement

On March 31, 2006, Valero L.P. entered into an amended and restated omnibus agreement (the 2006 Omnibus Agreement) with Valero Energy, Valero GP, LLC, Riverwalk Logistics, L.P., and Valero Logistics.  The 2006 Omnibus Agreement amended certain definitions and other provisions in the April 16, 2001 omnibus agreement, which it supersedes, to clarify the parties’ intent as to the Valero Energy ownership requirements for the application of the business restrictions described below.

Under the 2006 Omnibus Agreement, Valero Energy has agreed, and will cause its controlled affiliates to agree, for so long as Valero Energy owns 20% or more of us or our general partner, not to engage in the business of transporting crude oil and other feedstocks or refined products, including petrochemicals, or operating crude oil storage facilities or refined product terminalling assets in the United States.  This restriction does not apply to:

·                  any business retained by Ultramar Diamond Shamrock (UDS) as of April 16, 2001, the closing of our initial public offering, or any business owned by Valero Energy at the date of its acquisition of UDS on December 31, 2001;

·                  any business with a fair market value of less than $10 million;

·                  any business acquired by Valero Energy in the future that constitutes less than 50% of the fair market value of a larger acquisition, provided we have been offered and declined the opportunity to purchase the business; and

·                  any newly constructed pipeline, terminalling or storage assets that we have not offered to purchase at fair market value within one year of construction.

Also under the 2006 Omnibus Agreement, Valero Energy has agreed to indemnify us for environmental liabilities related to the assets transferred to us in connection with our initial public offering in 2001, provided that such liabilities arose prior to and are discovered within ten years after that date (excluding liabilities resulting from a change in law after April 16, 2001).

12

Non-Compete Agreement

On July 19, 2006, we entered into a non-compete agreement with Holdings, Riverwalk Logistics, L.P., and Valero GP, LLC (the Non-Compete Agreement).   The Non-Compete Agreement will not be effective until Holdings is no longer subject to the Amended and Restated Omnibus Agreement dated March 31, 2006.   Under the Non-Compete Agreement, we will have a right of first refusal with respect to the potential acquisition of assets that relate to the transportation, storage or terminalling of crude oil, feedstocks or refined petroleum products (including petrochemicals) in the United States and internationally.  Holdings will have a right of first refusal with respect to the potential acquisition of general partner and other equity interests in publicly traded partnerships under common ownership with the general partner interest.   With respect to any other business opportunities, neither the Partnership nor Holdings are prohibited from engaging in any business, even if the Partnership and Holdings would have a conflict of interest with respect to such other business opportunity.

Administration Agreement

On July 19, 2006, in connection with Holdings’ initial public offering, Valero GP, LLC entered into an administration agreement with Holdings (the Administration Agreement).  The Administration Agreement provides, among other things, that all of Holdings’ employees will be employees of Valero GP, LLC.  Valero GP, LLC will provide all executive management, accounting, legal, cash management, corporate finance and other administrative services to Holdings.  Under the Administration Agreement, Holdings will pay Valero GP, LLC $0.5 million annually.  This fee will be increased annually to reflect Valero GP, LLC’s annual merit increases.  Holdings will also reimburse Valero GP, LLC for all direct public company costs and any other direct costs, such as outside legal and accounting fees, that Valero GP, LLC incurs while providing services to Holdings pursuant to the Administration Agreement.  The Administration Agreement will terminate on December 31, 2011, with automatic two-year renewals unless terminated by either party on six months’ written notice.  Holdings may cancel or reduce the services provided by Valero GP, LLC under the Administration Agreement on 60 days’ written notice.  The Administration Agreement will terminate upon a change of control of either Holdings or Valero GP, LLC.

Amended and Restated 2000 Long-Term Incentive Plan

Effective October 1, 2006, the Valero GP, LLC 2000 Long-Term Incentive Plan was amended as follows:

·                  increase the number of units authorized for issuance under the Plan from 250,000 units (of which 223,147 have been granted to date) to 1,500,000 units;

·                  permit the “cashless-broker” exercise of options;

·                  provide that if an award under the Plan expires, is cancelled, exercised, paid or otherwise terminates without the delivery of units then the units covered by such award, to the extent of such expiration, cancellation, exercise, payment or termination, shall again be units with respect to which awards under the Plan may be granted;

·                  amend the Plan to meet the requirements of, and facilitate compliance with, Section 409A of the Internal Revenue Code; and

·                  amend the definition of “Change of Control” to reflect that as a result of its recently completed initial public offering, Valero GP Holdings, LLC is now the 100% owner of the general partner of Valero L.P.

8.  PARTNERS’ EQUITY

Allocation of Income and Income Per Unit

We identified our general partner interest and subordinated units as participating securities and we use the two-class method when calculating “income per unit applicable to limited partners,” which is based on the weighted-average number of common and subordinated units outstanding during the period.  Basic and diluted net income per unit applicable to limited partners is the same because we have no potentially dilutive securities outstanding.

During the quarter ended September 30, 2006, our general partner reimbursed us for certain charges we incurred related to services historically provided under our Services Agreement with Valero Energy.  Generally accepted accounting principles require us to record the charges as expenses and record the reimbursement as a capital contribution.

13

The following table details the calculation of net income applicable to the general partner:

Cash Distributions

On July 19, 2006, we declared a quarterly cash distribution of $0.885 per unit paid on August 14, 2006 to unitholders of record on August 7, 2006, which totaled $45.8 million.  On October 26, 2006, we declared a quarterly cash distribution of $0.915 per unit to be paid on November 14, 2006 to unitholders of record on November 7, 2006, which totaled $47.7 million.

The following table reflects the allocation of total cash distributions to the general and limited partners applicable to the period in which the distributions were earned:

Subordinated Units

Effective April 1, 2006, we satisfied all the conditions included in our partnership agreement for the subordination period to end.  Accordingly, all 9,599,322 subordinated units converted into common units on a one-for-one basis on May 8, 2006, the first business day after the record date for the distribution related to the first quarter earnings of 2006.  Riverwalk Holdings, LLC held the 9,599,322 subordinated units at the time of conversion.

14

Comprehensive Income

For the three and nine months ended September 30, 2006, the difference between our net income and our comprehensive income resulted from foreign currency translation adjustments.  Our total comprehensive income was as follows:

10.  SEGMENT INFORMATION

Our reportable segments consist of refined product terminals, refined product pipelines, crude oil pipelines and crude oil storage tanks.  The operations we acquired from Kaneb on July 1, 2005 principally involve transporting refined petroleum products and fertilizer as a common carrier, the storage of petroleum products, specialty chemicals, and other liquids, and the sale of bunker fuel at St. Eustatius in the Caribbean and Point Tupper in Nova Scotia, Canada.  The results of Kaneb’s transportation operations are included in our refined product pipelines segment.  The results of Kaneb’s storage and bunker fuel operations are included in our refined product terminals segment.

Results of operations for the reportable segments were as follows:

15

Revenues from Valero Energy by reportable segment were as follows:

Total assets by reportable segment were as follows:

16

11.  CONDENSED CONSOLIDATING FINANCIAL STATEMENTS

Valero L.P. has no operations and its assets consist mainly of its investments in Valero Logistics, KSL and KPP.  KPP is the majority owner of KPOP.  Valero Logistics and KPOP are 100% indirectly owned by Valero L.P.  Valero Logistics and KPOP own and operate pipelines, terminals and storage tanks and have issued publicly traded senior notes.  The senior notes issued by Valero Logistics were and continue to be fully and unconditionally guaranteed by Valero L.P.  In connection with the Kaneb Acquisition, effective July 1, 2005, Valero L.P. fully and unconditionally guaranteed the outstanding senior notes issued by KPOP.  Additionally, effective July 1, 2005, both Valero Logistics and KPOP fully and unconditionally guaranteed the outstanding senior notes of the other.  All guarantors are jointly and severally liable for performance under the terms of the guarantees.

As a result, the following condensed consolidating financial statements are being presented for the current year as an alternative to providing separate financial statements for Valero Logistics and KPOP.

Condensed Consolidating Balance Sheet

September 30, 2006

(Thousands of Dollars)