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Form 10-K For The Period Ended December 31, 2004
Table of Contents
Index to Financial Statements

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

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

 

For the year ended December 31, 2004

 

OR

 

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

 

Commission File Number 1-16417

 

VALERO L.P.

(Exact name of registrant as specified in its charter)

 

Delaware   74-2956831

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

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)

 

Securities registered pursuant to Section 12(b) of the Act: Common Units representing limited partnership interests listed on the New York Stock Exchange.

 

Securities registered pursuant to 12(g) of the Act: None.

 

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 ¨

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of the Form 10-K or any amendment to this Form 10-K. x

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes x No ¨

 

As of June 30, 2004, the last day of the registrant’s most recently completed second fiscal quarter, the aggregate market value of common units held by non-affiliates based on the last sales price as quoted on the New York Stock Exchange was $626.5 million.

 

The number of common and subordinated units outstanding as of February 1, 2005 was 13,442,072 and 9,599,322, respectively.

 



Table of Contents
Index to Financial Statements

 

TABLE OF CONTENTS

 

          Page

     PART I     

Items 1. & 2.

  

Business and Properties

   3
    

Segments

   3
    

Valero L.P.’s Relationship with Valero Energy

   10
    

Recent Developments

   12
    

Competition

   13
    

Regulation

   14
    

Properties

   16
    

Employees

   16

Item 3.

  

Legal Proceedings

   16

Item 4.

  

Submission of Matters to a Vote of Security Holders

   16
     PART II     

Item 5.

  

Market for Registrant’s Common Units, Related Unitholder Matters and Issuer Purchases of Common Units

   17

Item 6.

  

Selected Financial Data

   19

Item 7.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   21

Item 7A.

  

Quantitative and Qualitative Disclosures About Market Risk

   38

Item 8.

  

Financial Statements and Supplementary Data

   39

Item 9.

  

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

   74

Item 9A.

  

Controls and Procedures

   74

Item 9B.

  

Other Information

   74
     PART III     

Item 10.

   Directors and Executive Officers of the Registrant    75

Item 11.

   Executive Compensation    79

Item 12.

   Security Ownership of Certain Beneficial Owners and Management and Related Unitholder Matters    84

Item 13.

   Certain Relationships and Related Transactions    86

Item 14.

   Principal Accountant Fees and Services    87
     PART IV     

Item 15.

   Exhibits and Financial Statement Schedules    89

Signatures

   96

 

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Table of Contents
Index to Financial Statements

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING INFORMATION

 

This Form 10-K contains certain estimates, predictions, projections, assumptions and other forward-looking statements that involve various risks and uncertainties. While these forward-looking statements, and any assumptions upon which they are based, are made in good faith and reflect Valero L.P.’s current judgment regarding the direction of its business, actual results will almost always vary, sometimes materially, from any estimates, predictions, projections, assumptions or other future performance suggested in this report. These forward-looking statements can generally be identified by the words “anticipates,” “believes,” “expects,” “plans,” “intends,” “estimates,” “forecasts,” “budgets,” “projects,” “will,” “could,” “should,” “may” and similar expressions. These statements reflect Valero L.P.’s current views with regard to future events and are subject to various risks, uncertainties and assumptions, including:

 

    Any reduction in the quantities of crude oil and refined products transported in Valero L.P.’s pipelines or handled at Valero L.P.’s terminals and storage tanks;

 

    Any significant decrease in the demand for refined products in the markets served by Valero L.P.’s pipelines and terminals;

 

    Any material decline in production by any of Valero Energy’s (as defined below) McKee, Three Rivers, Corpus Christi East, Corpus Christi West, Texas City, Paulsboro, Benicia or Ardmore refineries;

 

    Any downward pressure on market prices caused by new competing refined product pipelines that could cause Valero Energy to decrease the volumes transported in Valero L.P.’s pipelines;

 

    Any challenges to Valero L.P.’s tariffs or changes in state or federal ratemaking methodology;

 

    Any changes in laws and regulations to which Valero L.P. is subject, including federal, state and local tax laws, safety, environmental and employment laws;

 

    Overall economic conditions;

 

    Any material decrease in the supply of or material increase in the price of crude oil available for transport through Valero L.P.’s pipelines and storage in Valero L.P.’s storage tanks;

 

    Inability to expand Valero L.P.’s business and acquire new assets as well as to attract third-party shippers;

 

    Conflicts of interest with Valero Energy;

 

    The loss of Valero Energy as a customer or a significant reduction in its current level of throughput and storage with Valero L.P.;

 

    Any inability to borrow additional funds;

 

    Any substantial costs related to environmental risks, including increased costs of compliance;

 

    Any change in the credit ratings assigned to Valero Logistics’ (as defined below) indebtedness;

 

    Any change in the credit rating assigned to Valero Energy’s indebtedness;

 

    Any reductions in space allocated to Valero L.P. in interconnecting third-party pipelines;

 

    Any material increase in the price of natural gas;

 

    Inability to successfully complete the announced mergers with Kaneb Services LLC and Kaneb Pipe Line Partners, L.P. (together, Kaneb) or integrate Kaneb’s operations;

 

    Terrorist attacks, threats of war or terrorist attacks or political or other disruptions that limit crude oil production; and

 

    Accidents or unscheduled shutdowns affecting Valero L.P.’s pipelines, terminals, machinery, or equipment, or those of Valero Energy.

 

If one or more of these risks or uncertainties materialize, or if the underlying assumptions prove incorrect, Valero L.P.’s actual results may vary materially from those described in any forward-looking statement. Readers are cautioned not to place undue reliance on this forward-looking information, which is as of the date of the Form 10-K. Valero L.P. does not intend to update these statements unless it is required by the securities laws to do so, and it undertakes no obligation to publicly release the result of any revisions to any such forward-looking statements that may be made to reflect events or circumstances after the date of this report or to reflect the occurrence of unanticipated events.

 

2


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Index to Financial Statements

 

PART I

 

ITEMS 1. & 2. BUSINESS AND PROPERTIES

 

Valero L.P.1 is a Delaware limited partnership formed in 1999 that completed its initial public offering of common units on April 16, 2001. Valero L.P.’s common units are traded on the New York Stock Exchange (NYSE) under the symbol “VLI.” Valero L.P.’s principal executive offices are located at One Valero Way, San Antonio, Texas 78249 and its telephone number is (210) 345-2000.

 

When used in this report, the term “Valero L.P.” may refer, depending on the context, to Valero L.P., to one or more of its consolidated subsidiaries, or to all of them taken as a whole. Valero L.P.’s operations are conducted through a subsidiary, Valero Logistics Operations, L.P. (Valero Logistics), and its operations are controlled and managed by Valero GP, LLC. Valero GP, LLC is the general partner of Riverwalk Logistics, L.P. (Riverwalk Logistics), the general partner of Valero L.P. and an indirect wholly owned subsidiary of Valero Energy Corporation. Valero Energy Corporation, a publicly traded Delaware corporation (NYSE symbol “VLO”), currently owns an aggregate 43.7% limited partner interest, as well as the 2% general partner interest, in Valero L.P. As used in this report, the term “Valero Energy” may refer, depending on the context, to Valero Energy Corporation, to one or more of its consolidated subsidiaries or to all of them taken as a whole, but excludes Valero L.P. and its subsidiaries.

 

Valero L.P.’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed with (or furnished to) the Securities and Exchange Commission (the SEC) are available free of charge on Valero L.P.’s website at http://www.valerolp.com (in the “Investor Relations” section) as soon as reasonably practicable after Valero L.P. files or furnishes such material. Valero L.P. also posts its corporate governance guidelines, code of business conduct and ethics, code of ethics for senior financial officers and the charter of the audit committee of Valero GP, LLC in the same website location. Valero L.P.’s governance documents are also available in print to any unitholder of record that makes a written request to Corporate Secretary, Valero L.P., P.O. Box 696000, San Antonio, Texas 78269.

 

Valero L.P. generates revenue by charging tariffs for transporting crude oil and refined products through its pipelines and by charging a fee for use of its terminals and the services provided by its crude oil storage tanks. Valero L.P.’s primary customer for its crude oil pipelines, refined product pipelines, refined product terminals and crude oil storage tank operations is Valero Energy, which accounted for 99% of Valero L.P.’s $220.8 million in revenues for the year ended December 31, 2004. Valero Energy is discussed further in this Item under the caption “Valero L.P.’s Relationship with Valero Energy.” Valero L.P.’s assets support nine of Valero Energy’s refineries, including the McKee, Three Rivers, Texas City, Corpus Christi East and Corpus Christ West refineries in Texas, the Paulsboro refinery in New Jersey, the Denver refinery in Colorado, the Ardmore refinery in Oklahoma and the Benicia refinery in California.

 

The term “throughput” as used in this document generally refers to the crude oil or refined product barrels, as applicable, that pass through each pipeline, even if those barrels are also transported in other Valero L.P. pipelines (for which separate tariffs are charged).

 

SEGMENTS

 

Valero L.P.’s four reportable business segments are refined product pipelines, crude oil pipelines, crude oil storage tanks and refined product terminals.


1 On December 31, 2001, Valero Energy Corporation acquired Ultramar Diamond Shamrock Corporation (UDS), the parent company of Shamrock Logistics, L.P. (the name under which Valero L.P. was formed), and on January 1, 2002, Shamrock Logistics, L.P. changed its name to Valero L.P.

 

3


Table of Contents
Index to Financial Statements

 

REFINED PRODUCT PIPELINES

 

Valero L.P. has an ownership interest in 24 refined product pipelines with an aggregate length of 3,795 miles, and it also owns a 25-mile crude hydrogen pipeline. Valero L.P.’s refined product pipelines transport refined products from Valero Energy’s McKee, Three Rivers, Corpus Christi East, Corpus Christi West and Ardmore refineries to Valero L.P.’s terminals or to interconnections with third-party pipelines for distribution to markets in Texas, Oklahoma, Colorado, New Mexico, Arizona and other mid-continent states. The refined products transported in these pipelines include gasoline, distillates (including diesel and jet fuel), natural gas liquids (such as propane and butane), blendstocks and petrochemicals such as toluene, xylene and raffinate. During the year ended December 31, 2004, gasoline and distillates represented approximately 61% and 30%, respectively, of the total throughput in Valero L.P.’s refined product pipelines. Valero L.P. charges tariffs on a per barrel basis for transporting refined products in its refined product pipelines.

 

The following table sets forth the average number of barrels of refined products Valero L.P. transported daily through its refined product pipelines, in the aggregate, in each of the years presented.

 

    

Aggregate Throughput

Years Ended December 31,


     2004

   2003

   2002

   2001

   2000

     (barrels/day)

Refined product

   442,596    392,145    295,456    308,047    309,803

 

4


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Index to Financial Statements

The following table sets forth information about each of Valero L.P.’s refined product pipelines. In instances where Valero L.P. owns less than 100% of a pipeline, its ownership percentage is indicated, and the capacity, throughput and capacity utilization information reflects only its ownership interest in these pipelines.

 

                    

Year Ended

December 31, 2004


 

Origin and Destination


   Length

   Ownership

    Capacity

   Throughput

   Capacity
Utilization


 
     (miles)          (barrels/day)    (barrels/day)       

McKee to El Paso, TX

   408    67 %   40,000    30,786    77 %

McKee to Colorado Springs, CO (1)

   256    100 %   52,000    10,903    30 %

Colorado Springs, CO to Airport

   2    100 %   14,000    1,232    9 %

Colorado Springs to Denver, CO

   101    100 %   32,000    5,807    18 %

McKee to Denver, CO

   321    30 %   12,450    11,759    94 %

McKee to Amarillo, TX (6”) (1)(2)

   49    100 %   51,000    34,149    84 %

McKee to Amarillo, TX (8”) (1)(2)

   49    100 %                

Amarillo to Abernathy, TX (1)

   102    67 %   11,733    8,277    71 %

Amarillo, TX to Albuquerque, NM

   293    50 %   17,150    10,918    64 %

Abernathy to Lubbock, TX (1)

   19    46 %   8,029    3,159    39 %

McKee to Skellytown, TX

   53    100 %   52,000    7,419    14 %

Skellytown to Mont Belvieu,TX

   572    50 %   26,000    11,805    45 %

McKee to Southlake, TX

   375    100 %   27,300    21,808    80 %

Three Rivers to San Antonio, TX

   81    100 %   33,600    26,650    79 %

Three Rivers to US/Mexico International Border near Laredo, TX

   108    100 %   16,800    17,042    101 %

Corpus Christi to Three Rivers, TX

   68    100 %   32,000    1,910    6 %

Three Rivers to Corpus Christi, TX

   72    100 %   15,000    6,634    44 %

Three Rivers to Pettus to San Antonio, TX

   103    100 %   24,000    23,091    96 %

Three Rivers to Pettus to Corpus Christi, TX

   89    100 %   15,000    11,059    74 %

Ardmore to Wynnewood, OK

   31    100 %   90,000    58,828    65 %

El Paso, TX to Kinder Morgan

   12    67 %   40,000    20,878    52 %

Corpus Christi to Pasadena, TX

   208    100 %   105,000    95,904    91 %

Corpus Christi to Edinburg, TX

   134    100 %   27,100    22,578    83 %

Other refined product pipeline (3)

   289    50 %   N/A    N/A    N/A  
    
        
  
      
     3,795          741,162    442,596    61 %
    
        
  
      

 

(1) This pipeline transports barrels relating to two tariff routes, one of which begins at this pipeline’s origin and ends at this pipeline’s destination and one of which is a longer tariff route with an origin or destination on another pipeline of Valero L.P.’s that connects to this pipeline. Throughput disclosed above for this pipeline reflects only the barrels subject to the tariff route beginning at this pipeline’s origin and ending at this pipeline’s destination. To accurately determine the actual capacity utilization of the pipeline, as well as aggregate capacity utilization, all barrels passing through the pipeline have been taken into account.

 

(2) The throughput, capacity and capacity utilization information disclosed above for the McKee to Amarillo 6-inch pipeline reflects both McKee to Amarillo pipelines on a combined basis.

 

(3) This category consists of the temporarily idled 6-inch Amarillo, TX to Albuquerque, NM refined product pipeline.

 

5


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Index to Financial Statements

 

CRUDE OIL PIPELINES

 

Valero L.P. has an ownership interest in nine crude oil pipelines with an aggregate length of 783 miles. Valero L.P.’s crude oil pipelines deliver crude oil and other feedstocks, such as gas oil, from various points in Texas, Oklahoma, Kansas and Colorado to Valero Energy’s McKee, Three Rivers and Ardmore refineries. Also included in this segment are Valero L.P.’s four crude oil storage facilities in Texas and Oklahoma that are located along the crude oil pipelines and in which crude oil may be stored and batched prior to shipment in the crude oil pipelines. Valero L.P. charges tariffs on a per barrel basis for transporting crude oil and other feedstocks in its crude oil pipelines. With the exception of the crude oil storage tanks at Corpus Christi discussed below in Crude Oil Storage Tanks, Valero L.P. does not generate any separate revenue from the crude oil storage facilities. Instead, the costs associated with the storage facilities are considered in establishing the tariffs charged for transporting crude oil from the storage facilities to the refineries.

 

The following table sets forth the average daily number of barrels of crude oil and other feedstocks Valero L.P. transported through its crude oil pipelines, in the aggregate, in each of the years presented:

 

    

Aggregate Throughput

Years Ended December 31,


     2004

   2003

   2002

   2001

   2000

     (barrels/day)

Crude oil and other feedstocks

   381,358    355,008    348,023    303,811    294,784

 

6


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Index to Financial Statements

The following table sets forth information about each of Valero L.P.’s crude oil pipelines:

 

                    

Year Ended

December 31, 2004


 

Origin and Destination


   Length

   Ownership

    Capacity

   Throughput

   Capacity
Utilization


 
     (miles)          (barrels/day)    (barrels/day)       

Cheyenne Wells, CO to McKee

   252    100 %   17,500    10,277    59 %

Dixon, TX to McKee

   44    100 %   85,000    36,745    43 %

Hooker, OK to Clawson, TX (1)

   41    50 %   22,000    18,799    85 %

Clawson, TX to McKee (2)

   31    100 %   36,000    11,157    83 %

Wichita Falls, TX to McKee

   272    100 %   110,000    78,412    71 %

Corpus Christi, TX to Three Rivers

   70    100 %   120,000    78,338    65 %

Ringgold, TX to Wasson, OK (2)

   44    100 %   90,000    37,472    42 %

Healdton to Ringling, OK

   4    100 %   52,000    27,223    52 %

Wasson, OK to Ardmore (8”-10”)(3)

   24    100 %   90,000    77,045    86 %

Wasson, OK to Ardmore (8”)(3)

   15    100 %   40,000    5,890    15 %
    
        
  
      
     797          662,500    381,358    60 %
    
        
  
      

 

(1) Valero L.P. receives 50% of the tariff with respect to 100% of the barrels transported in the Hooker, OK to Clawson, TX pipeline. Accordingly, the capacity, throughput and capacity utilization are given with respect to 100% of the pipeline.

 

(2) This pipeline transports barrels relating to two tariff routes, one beginning at the pipeline’s origin and ending at its destination, and one with an origin or destination on another connecting Valero L.P. pipeline. Throughput disclosed above for this pipeline reflects only the barrels subject to the tariff route beginning at this pipeline’s origin and ending at this pipeline’s destination. To accurately determine the actual capacity utilization of the pipeline, as well as aggregate capacity utilization, all barrels passing through the pipeline have been taken into account.

 

(3) The Wasson, OK to Ardmore pipelines referred to above originate at Wasson as two pipelines but merge into one pipeline prior to reaching Ardmore.

 

7


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Index to Financial Statements

The following table sets forth information about Valero L.P.’s crude oil storage facilities associated with the crude oil pipeline segment:

 

Location


   Capacity

   Number
of Tanks


  

Mode of

Receipt


  

Mode of

Delivery


  

Average

Throughput

Year Ended

December 31,

2004


     (barrels)                   (barrels/day)

Dixon, TX

   240,000    3    pipeline    pipeline    36,745

Ringgold, TX (1)

   600,000    2    pipeline    pipeline    37,472

Wichita Falls, TX

   660,000    4    pipeline    pipeline    78,412

Wasson, OK

   225,000    2    pipeline    pipeline    82,935
    
  
            
     1,725,000    11              235,564
    
  
            

 

(1) Valero L.P. owns the Ringgold, TX crude oil storage facility but leases the underlying land under a long-term operating lease.

 

CRUDE OIL STORAGE TANKS

 

Valero L.P. owns 60 crude oil and intermediate feedstock storage tanks and related assets with aggregate storage capacity of approximately 12.5 million barrels. The land underlying these tanks is subject to long-term operating leases. Valero L.P.’s storage tanks serve the needs of Valero Energy’s Benicia, Corpus Christi and Texas City refineries. Valero L.P. charges a fee for each barrel of crude oil or certain other feedstocks that it delivers to Valero Energy’s Benicia, Corpus Christi and Texas City refineries.

 

The following table sets forth the average daily number of barrels of crude oil and other feedstocks Valero L.P. delivered to Valero Energy’s Benicia, Corpus Christi West and Texas City refineries, in the aggregate, in each of the years presented:

 

     Aggregate Throughput
Years Ended December 31,


     2004

   2003

     (barrels/day)

Crude oil and other feedstocks

   473,714    366,986

 

The following table sets forth information about Valero L.P.’s crude oil storage tanks:

 

Location


   Capacity

   Number
of Tanks


  

Mode of

Receipt


  

Mode of

Delivery


  

Average

Throughput

Year Ended

December 31,

2004


     (barrels)                   (barrels/day)

Benicia, CA

   3,815,000    16    marine/pipeline    pipeline    125,414

Corpus Christi, TX (West)

   4,023,000    26    marine    pipeline    144,164

Texas City, TX

   3,087,000    14    marine    pipeline    204,136

Corpus Christi, TX (North Beach)(1)

   1,600,000    4    marine    pipeline    —  
    
  
            
     12,525,000    60              473,714
    
  
            

 

(1) Valero L.P. does not report throughput for the Corpus Christi North Beach storage facility, as revenues for this facility are based on a lease agreement with Valero Energy.

 

8


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Index to Financial Statements

 

REFINED PRODUCT TERMINALS

 

Valero L.P. owns 22 refined product terminals in Texas, Colorado, New Mexico, California, Oklahoma, New Jersey and Nuevo Laredo, Mexico. These terminals have a total of 204 tanks with a combined capacity of 4.5 million barrels. Most of Valero L.P.’s refined product terminals have automated loading facilities and are available 24 hours a day. At its terminals, Valero L.P. charges a per barrel handling fee, as well as a per barrel fee for refined product blending or filtering.

 

The following table sets forth the average daily number of barrels of refined products Valero L.P. handled at its refined product terminals, in the aggregate, in each of the years presented.

 

    

Aggregate Throughput

Years Ended December 31,


     2004

   2003

   2002

   2001

   2000

     (barrels/day)

Refined product

   256,576    225,426    175,559    176,771    165,653

 

9


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Index to Financial Statements

The following table sets forth information about each of Valero L.P.’s refined product terminals:

 

Location


   Capacity

   Number
of Tanks


   Mode of
Receipt


   Mode of Delivery

  

Average

Throughput
Year Ended

December 31,
2004


     (barrels)                   (barrels/day)

Abernathy, TX

   171,000    11    pipeline    truck    8,797

Amarillo, TX

   271,000    14    pipeline    truck/pipeline    25,556

Albuquerque, NM

   193,000    10    pipeline    truck/pipeline    9,574

Catoosa, OK (asphalt) (1) (3)

   340,000    24    truck/rail/barge    truck/rail    2,464

Colorado Springs, CO (1)

   324,000    8    pipeline    truck/pipeline    10,913

Corpus Christi, TX (1)

   371,000    15    pipeline    marine/pipeline    9,220

Denver, CO

   111,000    10    pipeline    truck    17,127

Edinburg, TX

   184,600    7    pipeline    truck    22,578

El Paso, TX (2)

   347,000    22    pipeline    truck/pipeline    32,657

Harlingen, TX (1)

   314,000    7    marine    truck    8,273

Houston, TX (Hobby Airport)

   107,100    6    pipeline    truck/pipeline    4,714

Houston, TX (asphalt)

   75,000    3    marine    truck    2,481

Laredo, TX

   203,000    6    pipeline    truck    14,023

Nuevo Laredo, Mexico (4)

   34,300    5    pipeline    truck    —  

Paulsboro, NJ

   90,800    6    pipeline    truck    22,966

Pittsburg, CA (asphalt)

   380,000    8    rail    truck    1,558

Placedo, TX

   98,000    4    pipeline    truck    3,086

Rosario, NM (asphalt) (1) (3)

   160,000    8    rail    truck    322

San Antonio (east), TX

   148,200    8    pipeline    truck/pipeline    22,170

San Antonio (south), TX

   221,000    10    pipeline    truck    18,158

Southlake, TX

   286,000    6    pipeline    truck    19,939

Almeda, TX (idle)

   105,800    6    pipeline    truck    N/A
    
  
            
     4,535,800    204              256,576
    
  
            

 

(1) Valero L.P. owns the Colorado Springs, CO, Corpus Christi, TX, Harlingen, TX, Houston, TX (Hobby Airport), Catoosa, OK and Rosario, NM refined product terminals but leases the realty under long-term operating leases.

 

(2) Valero L.P. owns a 66.67% undivided interest in the El Paso refined product terminal. The capacity and throughput amounts represent the proportionate share of capacity and throughput attributable to Valero L.P.’s ownership interest. The throughput represents barrels distributed from the El Paso refined product terminal and delivered to a third-party refined product pipeline.

 

(3) Valero L.P. acquired the Catoosa, OK terminal and the Rosario, NM terminal on February 20, 2004. The throughput barrels in the above table represent the total throughput from the date of acquisition divided by 366 days.

 

(4) The average throughput for the year ended December 31, 2004 for the Nuevo Laredo, Mexico propane terminal, 3,048 barrels per day, is not included in the total here, since these terminal barrels and related revenues are included in the tariff for the Three Rivers to US/Mexico International Border refined product pipeline.

 

VALERO L.P.’S RELATIONSHIP WITH VALERO ENERGY

 

Valero L.P.’s operations are strategically located within Valero Energy’s refining and marketing supply chain in Texas, Oklahoma, California, Colorado, New Jersey, New Mexico, Arizona and other mid-continent states in the United States. Valero L.P. itself does not own or operate any refining or marketing operations. Valero L.P. is dependent on Valero Energy to provide substantially all the throughput for Valero L.P.’s pipelines, terminals and storage tanks and the ability of Valero Energy’s refineries to maintain their production of refined products. During the year ended December 31, 2004, Valero Energy accounted for 99% of Valero L.P.’s revenues.

 

As of December 31, 2004, Valero Energy, through its wholly owned subsidiaries, owned 9,599,322 subordinated units, 664,119 common units and the 2% general partner interest in Valero L.P., representing an aggregate 45.7% ownership interest.

 

10


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VALERO ENERGY’S BUSINESS

 

Valero Energy owns and operates 15 refineries in the United States, Canada and the island of Aruba, nine of which are served by Valero L.P.’s pipelines, terminals or storage assets. As of December 31, 2004, the total throughput capacity of each of those nine refineries was as follows:

 

Refinery


   Location

  

Total

Throughput

Capacity


          (barrels/day)

Texas City

   Texas    250,000

Corpus Christi West

   Texas    225,000

Paulsboro

   New Jersey    195,000

Benicia

   California    185,000

McKee

   Texas    170,000

Corpus Christi East

   Texas    115,000

Three Rivers

   Texas    98,000

Ardmore

   Oklahoma    85,000

Denver

   Colorado    30,000

 

Valero Energy markets the refined products produced by these refineries primarily in Texas, Oklahoma, Colorado, New Mexico, Arizona, California, New Jersey and several other mid-continent states through wholesale and spot market sales and exchange agreements, as well as through a network of company-operated and dealer-operated convenience stores.

 

MAJOR AGREEMENTS WITH VALERO ENERGY

 

Valero L.P.’s relationship with Valero Energy is governed by several significant agreements, which are described in Note 11 of Notes to Consolidated Financial Statements.

 

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RECENT DEVELOPMENTS

 

PROPOSED KANEB MERGERS

 

On October 31, 2004, Valero L.P. and Kaneb Services LLC (KSL), a Delaware limited liability company (and parent company of the general partner of Kaneb Pipe Line Partners, L.P.), and certain of Valero L.P.’s affiliated parties entered into a definitive merger agreement (the KSL Agreement), pursuant to which a wholly owned subsidiary of Valero L.P. will merge with KSL, with the surviving entity being a wholly owned subsidiary of Valero L.P. (the KSL Merger). Under the terms of the KSL Agreement, upon completion of the KSL Merger each KSL common share will be converted into the right to receive $43.31 in cash.

 

Also on October 31, 2004, Valero L.P. and Kaneb Pipe Line Partners, L.P., a Delaware limited partnership (KPP) and certain of their respective affiliated parties entered into a separate definitive merger agreement (the KPP Agreement), pursuant to which a wholly owned subsidiary of Valero L.P. will merge with KPP, with the surviving entity being a wholly owned subsidiary of Valero L.P. (the KPP Merger, and, together with the KSL Merger, the Kaneb Mergers). Under the terms of the KPP Agreement, upon completion of the KPP Merger each KPP unit will be converted into the right to receive a number of Valero L.P. common units based on an exchange ratio formula providing Valero L.P. common units worth $61.50 per KPP unit within a specified “collar” range of Valero L.P. common unit market prices (plus or minus five percent of $57.25), measured over a period prior to closing. Should Valero L.P.’s average per unit price during the measurement period be equal to or less than $54.39 per unit, the exchange ratio will be fixed at 1.1307 Valero L.P. common units for each KPP unit. Should Valero L.P.’s average per unit price during the measurement period be equal to or greater than $60.11 per unit, the exchange ratio will be fixed at 1.0231 Valero L.P. common units for each KPP unit.

 

On March 11, 2005, Valero L.P. unitholders holding a majority of Valero L.P.’s outstanding units voted to approve the issuance of the Valero L.P. common units in the KPP Merger. Also on March 11, 2005, the KPP unitholders and the KSL shareholders (other than Valero L.P., KSL, KPP and their respective affiliates) holding a majority of the oustanding KPP units and the KSL shares voted to approve the Kaneb Mergers.

 

Both of the Kaneb Mergers are contingent upon the completion of the other and are subject to customary regulatory approvals, including those under the Hart-Scott-Rodino Antitrust Improvements Act, as well as other customary conditions. There can be no assurances as to whether, or on what date, Valero L.P., KSL and KPP will obtain the required regulatory approvals or satisfy the other conditions to the Kaneb Mergers, or that Valero L.P., KSL or KPP will complete the Kaneb Mergers on the contemplated schedule.

 

REGISTRATION OF COMMON UNITS

 

On January 25, 2005, the SEC declared effective an amended registration statement on Form S-4 filed by Valero L.P. to register 26,268,524 Valero L.P. common units to be issued to the unitholders of KPP as described above in “Proposed Kaneb Mergers” if the KPP Merger is completed as planned.

 

2005 REVOLVING CREDIT AGREEMENT

 

On December 20, 2004, Valero Logistics and Valero L.P. entered into a 5-Year Revolving Credit Agreement (the 2005 Revolving Credit Agreement) with certain lenders with an initial aggregate commitment of $400 million, subject to completion of the Kaneb Mergers. Valero Logistics’ obligations under the 2005 Revolving Credit Agreement are unsecured and will be guaranteed by Valero L.P. and certain subsidiaries of Valero L.P. Generally, the lenders will not be obligated to make any loans under the 2005 Revolving Credit Agreement until the Kaneb Mergers are completed. Upon the closing of the 2005 Revolving Credit Agreement, the amounts outstanding under Valero L.P.’s $175.0 million revolving credit facility (described in Note 7 of Notes to Consolidated Financial Statements) will be paid in full, and that facility will be terminated.

 

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ACQUISITION

 

On February 20, 2004, Valero L.P. acquired two asphalt terminals located in Catoosa, Oklahoma (near Tulsa) and Rosario, New Mexico (near Santa Fe) from Royal Trading Company (Royal) for $28.1 million. These terminals have an aggregate storage capacity of 500,000 barrels in 32 tanks and six loading stations.

 

AMENDMENT TO SERVICES AGREEMENT

 

Under the Services Agreement, the costs related to employees of Valero Energy who perform services directly on Valero L.P.’s behalf, including salary, wages and employee benefits, are charged by Valero Energy to Valero L.P. In addition, Valero L.P. receives certain administrative services such as legal, accounting, treasury, engineering, information technology and other corporate functions from Valero Energy. Due to Valero L.P.’s significant growth and increased need for personnel to work directly on its behalf, the Services Agreement was amended effective April 1, 2004. The amended Services Agreement is described in detail in Note 11 of Notes to Consolidated Financial Statements.

 

AMENDMENTS TO PARTNERSHIP AGREEMENT

 

Effective March 11, 2004, Valero L.P.’s partnership agreement was amended to reduce the percentage of the vote required to remove Valero L.P.’s general partner from 58% to a simple majority (excluding any units held by the general partner or its affiliates). In addition, the partnership agreement was amended to lower the general partner’s incentive distribution rights with respect to distributions of available cash from 48% to 23% of the amount of any quarterly distribution that exceeds $0.90 per unit (The general partner’s 2% distribution was not affected by this amendment). Cash distributions are discussed in Note 13 of Notes to Consolidated Financial Statements.

 

COMPETITION

 

As a result of Valero L.P.’s physical integration with Valero Energy’s refining and marketing operations and its contractual relationships with Valero Energy, management of Valero L.P. believes that it will not face significant competition for barrels of crude oil transported to, and barrels of refined products transported from, the various Valero Energy refineries served by Valero L.P.’s assets, particularly during the terms of the various agreements between Valero L.P. and Valero Energy described in Note 11 to Notes to Consolidated Financial Statements.

 

However, Valero L.P. faces competition from other pipelines that may be able to supply Valero Energy’s end-user markets with refined products on a more competitive basis. If Valero Energy reduced its retail sales of refined products or its wholesale customers reduced their purchases of refined products, the volumes transported through Valero L.P.’s pipelines would be reduced, which would cause a decrease in cash and revenues generated from its operations.

 

While Valero L.P. believes the capital requirements, tariff regulation, environmental and safety considerations and problems acquiring rights-of-way associated with its business decrease the likelihood that competitors will build pipeline systems of comparable size and scope in the near future, competing pipelines may be built in markets where growing demand and attractive tariffs support such additional capacity.

 

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REGULATION

 

RATE REGULATION

 

Several of Valero L.P.’s pipelines are interstate common carrier pipelines, which are subject to regulation by the Federal Energy Regulatory Commission (the FERC) under the Interstate Commerce Act (ICA) and the Energy Policy Act of 1992 (the EP Act). The ICA and its implementing regulations generally require the rates and practices of interstate oil pipelines to be reasonable and nondiscriminatory. The EP Act deemed certain rates in effect prior to its passage to be reasonable and allows interstate common carrier oil pipelines to change their rates within a defined range. Additionally, the rates and practices for Valero L.P.’s intrastate common carrier pipelines are subject to regulation by state commissions. The applicable state statutes and regulations generally require that pipeline rates and practices be reasonable and nondiscriminatory. Shippers may challenge Valero L.P.’s tariff rates and practices on its pipelines in certain instances.

 

Valero L.P.’s Pipelines Rates

 

Neither the FERC nor the state commissions have investigated Valero L.P.’s rates or practices. Valero L.P. does not believe that it is likely that there will be a challenge to its tariffs by a current shipper that would materially affect its revenues or cash flows because Valero Energy is currently the only shipper in the majority of Valero L.P.’s pipelines. Valero Energy has committed to refrain from challenging Valero L.P.’s tariffs until at least April 2008. Valero Energy has also agreed to be responsible for any ICA liabilities with respect to activities or conduct occurring during periods prior to April 16, 2001. However, the FERC or a state regulatory commission could investigate Valero L.P.’s tariffs at the urging of a third party. Also, because Valero L.P.’s pipelines are common carrier pipelines, Valero L.P. may be required to accept new shippers who wish to transport in its pipelines and who could potentially decide to challenge Valero L.P.’s tariffs. If any tariff challenge or challenges are successful, cash available for distribution to unitholders could be materially reduced.

 

ENVIRONMENTAL AND SAFETY REGULATION

 

General

 

Valero L.P.’s operations are subject to extensive federal, state and local environmental laws and regulations, including those relating to the discharge of materials into the environment, waste management and pollution prevention measures, and to environmental regulation by several federal, state and local authorities. The principal environmental risks associated with Valero L.P.’s operations relate to unauthorized emissions into the air and unauthorized releases into soil, surface water or groundwater. Valero L.P.’s operations are also subject to extensive federal and state health and safety laws and regulations, including those relating to pipeline safety. Compliance with these laws, regulations and permits increases Valero L.P.’s capital expenditures and its overall cost of business, and violations of these laws, regulations and/or permits can result in significant civil and criminal liabilities, injunctions or other penalties. Accordingly, Valero L.P. has adopted policies, practices and procedures in the areas of pollution control, pipeline integrity, operator qualifications, public relations and education, product safety, occupational health and the handling, storage, use and disposal of hazardous materials that are designed to prevent material environmental or other damage, to ensure the safety of its pipelines, its employees, the public and the environment and to limit the financial liability that could result from such events. Future governmental action and regulatory initiatives could result in changes to expected operating permits, additional remedial actions or increased capital expenditures and operating costs that cannot be assessed with certainty at this time. In addition, contamination resulting from spills of crude oil and refined products occurs within the industry. Risks of additional costs and liabilities are inherent within the industry, and there can be no assurances that significant costs and liabilities will not be incurred in the future.

 

Water

 

The Federal Water Pollution Control Act of 1972, as amended, also known as the Clean Water Act, and analogous state statutes impose restrictions and strict controls regarding the discharge of pollutants into state waters or waters of the United States. The discharge of pollutants into state waters or waters of the United States is prohibited, except in accordance with the terms of a permit issued by applicable federal or state authorities. The Oil Pollution Act, enacted in 1990, amends provisions of the Clean Water Act as they pertain to prevention and response to oil spills. Spill prevention control and countermeasure requirements of the Clean Water Act and some state laws require diking and similar structures to help prevent contamination of navigable waters in the event of overflow or release.

 

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Air Emissions

 

Valero L.P.’s operations are subject to the Federal Clean Air Act and analogous state and local statutes. Numerous amendments to the Federal Clean Air Act were enacted in 1990. These amendments may result in the imposition over the next several years of certain pollution control requirements with respect to air emissions from the operations of Valero L.P.’s pipelines, storage tanks and terminals. The Environmental Protection Agency (EPA) is developing, over a period of many years, regulations to implement these requirements. Depending on the nature of those regulations, and upon requirements that may be imposed by state and local regulatory authorities, Valero L.P. may be required to incur certain capital expenditures over the next several years for air pollution control equipment in connection with maintaining or obtaining operating permits and approvals and addressing other air emission-related issues.

 

Due to the broad scope of the issues involved and the complex nature of the regulations, full development and implementation of many Clean Air Act regulations have been delayed. Until such time as the new Clean Air Act requirements are implemented, Valero L.P. is unable to estimate the effect on its financial condition or results of operations or the amount and timing of such required expenditures. At this time, however, Valero L.P. does not believe that it will be materially affected by any such requirements.

 

Solid Waste

 

Valero L.P. generates non-hazardous solid wastes that are subject to the requirements of the Federal Resource Conservation and Recovery Act (FRCRA) and analogous state statutes. FRCRA also governs the disposal of hazardous wastes. Valero L.P. is not currently required to comply with a substantial portion of FRCRA requirements because its operations generate minimal quantities of hazardous wastes. However, it is possible that additional wastes, which could include wastes currently generated during operations, will in the future be designated as “hazardous wastes.” Hazardous wastes are subject to more rigorous and costly disposal requirements than are non-hazardous wastes.

 

Hazardous Substances

 

The Comprehensive Environmental Response, Compensation and Liability Act, referred to as CERCLA and also known as Superfund, and analogous state laws, imposes liability, without regard to fault or the legality of the original act, on some classes of persons that contributed to the release of a “hazardous substance” into the environment. These persons include the owner or operator of the site and entities that disposed or arranged for the disposal of the hazardous substances found at the site. CERCLA also authorizes the EPA and, in some instances, third parties to act in response to threats to the public health or the environment and to seek to recover from the responsible classes of persons the costs that they incur. In the course of Valero L.P.’s ordinary operations, it may generate waste that falls within CERCLA’s definition of a “hazardous substance.” While Valero L.P. responsibly manages the hazardous substances that it controls, the intervening acts of third parties may expose Valero L.P. to joint and several liability under CERCLA for all or part of the costs required to clean up sites at which these hazardous substances have been disposed of or released into the environment.

 

Valero L.P. currently owns or leases, and has in the past owned or leased, properties where hydrocarbons are being or have been handled. Although Valero L.P. has utilized operating and disposal practices that were standard in the industry at the time, hydrocarbons or other wastes may have been disposed of or released on or under the properties owned or leased by Valero L.P. or on or under other locations where these wastes have been taken for disposal. In addition, many of these properties have been operated by third parties whose treatment and disposal or release of hydrocarbons or other wastes was not under Valero L.P.’s control. These properties and wastes disposed thereon may be subject to CERCLA, the FRCRA and analogous state laws. Under these laws, Valero L.P. could be required to remove or remediate previously disposed wastes (including wastes disposed of or released by prior owners or operators), to clean up contaminated property (including contaminated groundwater) or to perform remedial operations to prevent future contamination.

 

Pipeline Integrity and Safety

 

Valero L.P.’s pipelines are subject to extensive laws and regulations governing pipeline integrity and safety. The Pipeline Safety Improvement Act of 2002 and its implementing regulations (collectively, PSIA) generally require pipeline operators to maintain qualification programs for key pipeline operating personnel, to review and update their existing pipeline safety public education programs, to provide information for the National Pipeline Mapping System, to maintain spill response plans and conduct spill response training and to implement integrity management programs for pipelines that could affect high consequence areas (i.e., areas with concentrated populations, navigable waterways and other unusually sensitive areas). While compliance with PSIA may affect Valero L.P.’s capital expenditures and operating expenses, Valero L.P. believes that the cost of such compliance will not materially affect its competitive position and will not have a material effect on its financial condition or results of operations.

 

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PROPERTIES

 

Valero L.P.’s principal properties are described above under the caption “Segments.” Valero L.P. believes that it has satisfactory title to all of its assets. Although title to these properties is subject to encumbrances in some cases, such as customary interests generally retained in connection with acquisition of real property, liens related to environmental liabilities associated with historical operations, liens for current taxes and other burdens and minor easements, restrictions and other encumbrances to which the underlying properties were subject at the time of acquisition by Valero L.P. or its predecessors, Valero L.P. believes that none of these burdens will materially detract from the value of these properties or from its interest in these properties or will materially interfere with their use in the operation of Valero L.P.’s business. In addition, Valero L.P. believes that it has obtained sufficient right-of-way grants and permits from public authorities and private parties for it to operate its business in all material respects as described in this report. Valero L.P. performs scheduled maintenance on all of its pipelines, terminals, crude oil tanks and related equipment and makes repairs and replacements when necessary or appropriate. Valero L.P. believes that all of its pipelines, terminals, crude oil tanks and related equipment have been constructed and are maintained in all material respects in accordance with applicable federal, state and local laws and the regulations and standards prescribed by the American Petroleum Institute, the Department of Transportation and accepted industry practice.

 

EMPLOYEES

 

Valero L.P. has no employees. Riverwalk Logistics, the general partner of Valero L.P., is responsible for the management of Valero L.P. Valero GP, LLC, the general partner of Riverwalk Logistics, is responsible for managing the affairs of Riverwalk Logistics, and through it, the affairs of Valero L.P. and Valero Logistics. As of February 1, 2005, Valero GP, LLC employed approximately 285 individuals who perform services for Valero L.P.

 

ITEM 3. LEGAL PROCEEDINGS

 

Valero L.P. is a party to various claims and legal actions that have arisen in the ordinary course of its business. Valero L.P. believes it is unlikely that the final outcome of any claims or proceedings to which it is a party will have a material adverse effect on its financial position, results of operations or liquidity; however, due to the inherent uncertainty of litigation, the range of any possible loss cannot be estimated with a reasonable degree of precision and Valero L.P. cannot provide assurance that the resolution of any particular claim or proceeding would not have an adverse effect on its results of operations, financial position or liquidity.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

No matters were submitted to a vote of the unitholders, through solicitation of proxies or otherwise, during the fourth quarter of the year ended December 31, 2004.

 

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PART II

 

ITEM 5. MARKET FOR REGISTRANT’S COMMON UNITS, RELATED UNITHOLDER MATTERS AND ISSUER PURCHASES OF COMMON UNITS

 

Market Information, Holders and Distributions

 

Valero L.P.’s common units are listed and traded on the New York Stock Exchange under the symbol “VLI.” At the close of business on February 1, 2005, Valero L.P. had 135 holders of record of its common units. The high and low sales prices (composite transactions) by quarter for the years ended December 31, 2004 and 2003 were as follows:

 

     Price Range of
Common Unit


     High

   Low

Year 2004

             

4th Quarter

   $ 61.75    $ 54.00

3rd Quarter

     56.01      49.00

2nd Quarter

     55.30      43.60

1st Quarter

     55.25      48.40

Year 2003

             

4th Quarter

   $ 50.25    $ 43.22

3rd Quarter

     44.80      40.75

2nd Quarter

     44.20      36.41

1st Quarter

     40.64      35.00

 

The cash distributions applicable to each of the quarters in the years ended December 31, 2004 and 2003 were as follows:

 

     Record Date

   Payment Date

   Amount
Per Unit


Year 2004

                

4th Quarter

   February 7, 2005    February 14, 2005    $ 0.80

3rd Quarter

   November 8, 2004    November 12, 2004      0.80

2nd Quarter

   August 6, 2004    August 13, 2004      0.80

1st Quarter

   May 7, 2004    May 14, 2004      0.80

Year 2003

                

4th Quarter

   February 6, 2004    February 13, 2004    $ 0.75

3rd Quarter

   November 6, 2003    November 14, 2003      0.75

2nd Quarter

   August 5, 2003    August 14, 2003      0.75

1st Quarter

   May 6, 2003    May 15, 2003      0.70

 

Valero L.P. has also issued and outstanding 9,599,322 subordinated units, all of which are held by UDS Logistics, LLC, the limited partner of Riverwalk Logistics and a wholly owned subsidiary of Valero Energy, for which there is no established public trading market. The issuance of subordinated units was exempt from registration with the SEC under Section 4(2) of the Securities Act of 1933. During the subordination period, the holders of the common units are entitled to receive each quarter a minimum quarterly distribution of $0.60 per unit ($2.40 annualized) prior to any distribution of available cash to holders of the subordinated units. The subordination period is defined generally as the period that will end on the first day of any quarter beginning after March 31, 2006 if (1) Valero L.P. has distributed at least the minimum quarterly distribution on all outstanding units with respect to each of the immediately preceding three consecutive, non-overlapping four-quarter periods and (2) Valero L.P.’s adjusted operating surplus, as defined in its partnership agreement, during such periods equals or exceeds the amount that would have been sufficient to enable it to distribute the minimum quarterly distribution on all outstanding units on a diluted basis and the related distribution on the 2% general partner interest during those periods. If the subordination period ends, the rights of the holders of subordinated units will no

 

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longer be subordinated to the rights of the holders of common units and the subordinated units will be converted into common units, on a one-for-one basis.

 

During the subordination period, Valero L.P.’s cash is first distributed 98% to the holders of common units and 2% to the general partner until there has been distributed to the holders of common units an amount equal to the minimum quarterly distribution and arrearages in the payment of the minimum quarterly distribution on the common units for any prior quarter. Secondly, cash is distributed 98% to the holders of subordinated units and 2% to the general partner until there has been distributed to the holders of subordinated units an amount equal to the minimum quarterly distribution. Thirdly, cash in excess of the minimum quarterly distributions is distributed to the unitholders and the general partner based on the percentages shown below.

 

The general partner, Riverwalk Logistics, is entitled to incentive distributions if the amount that Valero L.P. distributes with respect to any quarter exceeds specified target levels shown below:

 

     Percentage of Distribution

 

Quarterly Distribution Amount per Unit


   Unitholders

    General
Partner


 

Up to $0.60

   98 %   2 %

Above $0.60 up to $0.66

   90 %   10 %

Above $0.66

   75 %   25 %

 

The general partner’s incentive distributions for the years ended December 31, 2004 and 2003 totaled $4.4 million and $2.6 million, respectively. The general partner’s share of Valero L.P.’s net income for the years ended December 31, 2004 and 2003 was 7.6% and 5.7%, respectively, due to the impact of the incentive distributions.

 

Effective March 11, 2004, Valero L.P.’s partnership agreement was amended to lower the general partner’s incentive distribution rights with respect to distributions of available cash from 48% to 23% of the amount of any quarterly distribution that exceeds $0.90 per unit. The general partner will continue to receive a 2% distribution with respect to its general partner interest.

 

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ITEM 6. SELECTED FINANCIAL DATA

 

The following table contains selected financial data derived from the audited financial statements of Valero L.P. and its predecessor (as defined below). The selected financial data for the years ended December 31, 2004, 2003, 2002 and 2001 and the six months ended December 31, 2000 represent the consolidated operations of Valero L.P.

 

     Successor (1)

   Predecessor (1)

     Years Ended December 31,

   Six Months
Ended
December 31,
2000


   Six Months
Ended
June 30, 2000


     2004

   2003 (2)

   2002

   2001

     
     (in thousands, except per unit data and barrel/day information)

Statement of Income Data:

                                         

Revenues

   $ 220,792    $ 181,450    $ 118,458    $ 98,827    $ 47,550    $ 44,503

Operating income

     98,024      83,037      57,230      46,505      23,484      17,665

Income from continuing operations (3)

     78,418      69,593      55,143      45,873      20,687      49,970

Basic and diluted income from continuing operations per unit applicable to limited partners (4)

     3.15      3.02      2.72      1.82              

Cash distributions per unit applicable to limited partners

     3.20      2.95      2.75      1.70              

 

     Successor (1)

     December 31,

     2004

   2003 (2)

   2002

   2001(5)

   2000

     (in thousands)

Balance Sheet Data:

                                  

Property and equipment, net

   $ 784,999    $ 765,002    $ 349,276    $ 349,012    $ 280,017

Total assets

     857,507      827,557      415,508      387,070      329,484

Long-term debt, including debt due to parent (less current portion)

     384,171      353,257      108,911      25,660      117,752

Partners’ equity / net parent investment (5)

     438,311      438,163      293,895      342,166      204,838

 

(1) Prior to July 1, 2000, Valero L.P.’s pipeline, terminalling and storage assets were owned and operated by Ultramar Diamond Shamrock Corporation (UDS), now part of Valero Energy. These assets and their related operations are referred to herein as the Ultramar Diamond Shamrock Logistics Business and that business is referred to as the “Predecessor” in the above table. The selected financial data for the six months ended June 30, 2000 reflects the operations of the Ultramar Diamond Shamrock Logistics Business as if it had existed as a single separate entity of UDS.

 

Effective July 1, 2000, UDS transferred the Ultramar Diamond Shamrock Logistics Business to Shamrock Logistics Operations, L.P. (Shamrock Logistics Operations), a wholly owned subsidiary of Shamrock Logistics, L.P. (Shamrock Logistics). Shamrock Logistics was wholly owned by UDS. Shamrock Logistics is referred to as the “Successor” in the above table. The transfer of the Ultramar Diamond Shamrock Logistics Business to Shamrock Logistics Operations represented a reorganization of entities under common control and was recorded at historical cost.

 

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On April 16, 2001, Shamrock Logistics completed its initial public offering of common units, which represented 26.4% of its outstanding partnership interests.

 

Effective on December 31, 2001, UDS merged with and into Valero Energy. That acquisition included the acquisition of UDS’ majority ownership interest in Shamrock Logistics. The consolidated balance sheet of Shamrock Logistics as of December 31, 2001 was not adjusted to fair value due to the significant level of public ownership interest in Shamrock Logistics. Effective January 1, 2002, Shamrock Logistics became Valero L.P.

 

(2) On March 18, 2003, Valero Energy contributed the South Texas Pipeline and Terminal Business and certain feedstock storage tanks to Valero L.P. for $350.3 million, including transaction costs.

 

(3) Income from continuing operations for the six months ended June 30, 2000 includes $30.8 million of income tax benefit. Effective July 1, 2000, UDS transferred the Ultramar Diamond Shamrock Logistics Business to Shamrock Logistics Operations. As a limited partnership, Shamrock Logistics Operations was not subject to federal or state income taxes. Due to this change in tax status, the deferred income tax liability of $38.2 million as of June 30, 2000 was written off in the statement of income of the Ultramar Diamond Shamrock Logistics Business for the six months ended June 30, 2000. The resulting income tax benefit of $30.8 million for the six months ended June 30, 2000 includes the write-off of the deferred income tax liability less income tax expense of $7.4 million for the six months ended June 30, 2000. The income tax expense for periods prior to July 1, 2000 was based on the effective income tax rate for the Ultramar Diamond Shamrock Logistics Business of 38%. The effective income tax rate exceeds the U.S. federal statutory income tax rate due to state income taxes.

 

(4) Income from continuing operations per unit applicable to limited partners is computed by dividing income from continuing operations applicable to limited partners, after deduction of the general partner’s 2% interest and incentive distributions, by the weighted average number of limited partnership units outstanding for each class of unitholder. Basic and diluted income from continuing operations per unit applicable to limited partners is the same because Valero L.P. has no potentially dilutive securities outstanding. Income from continuing operations per unit applicable to limited partners for periods prior to April 16, 2001, the date of Shamrock Logistics’ initial public offering, is not shown as units had not been issued.

 

(5) The selected financial data as of December 31, 2001 includes the acquisition of the Wichita Falls Business, which Valero L.P. acquired on February 1, 2002 from Valero Energy. Because Valero L.P. and the Wichita Falls Business came under the common control of Valero Energy commencing on December 31, 2001, the acquisition represented a reorganization of entities under common control and therefore required a restatement of the December 31, 2001 consolidated balance sheet of Valero L.P. to include the Wichita Falls Business as if it had been combined with Valero L.P. as of December 31, 2001. The partners’ equity amount as of December 31, 2001 includes $50.6 million of net parent investment resulting from Valero L.P.’s acquisition of the Wichita Falls Business. Upon execution of the acquisition on February 1, 2002, partners’ equity/net parent investment was reduced by $51.3 million.

 

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

Overview

 

Valero L.P.’s operations provide transportation and storage services to Valero Energy and other unrelated customers. Valero L.P. provides these services with its crude oil and refined product pipelines, refined product terminals and crude oil storage tanks located near or connected to nine of Valero Energy’s refineries.

 

Valero L.P. completed the following acquisitions, which have more than doubled its size in the past three years:

 

    In 2002, Valero L.P. acquired the Wichita Falls to McKee crude oil pipeline and related Wichita Falls crude oil storage facility on February 1, 2002 and the Texas City crude hydrogen pipeline on May 29, 2002 for a combined total cost of $75.0 million;

 

    In 2003, Valero L.P. acquired the Telfer asphalt terminal on January 7, 2003, the South Texas Pipelines and Terminals and the Crude Oil Storage Tanks on March 18, 2003, the Shell pipeline interest on May 1, 2003, the Southlake refined product pipeline effective August 1, 2003 and the Paulsboro refined product terminal on September 3, 2003 for a combined total cost of $411.2 million; and

 

    On February 20, 2004, Valero L.P. acquired the Royal Trading asphalt terminals for $28.1 million.

 

To fund these acquisitions as well as the redemption of $134.1 million of common units (3,809,750 common units) in March 2003, Valero L.P. used a combination of sources as follows:

 

    In 2002, Valero Logistics issued $100.0 million of 6.875% senior notes;

 

    In 2003, Valero Logistics issued $250.0 million of 6.05% senior notes and Valero L.P. issued 7,567,250 common units for $272.5 million, including general partner contributions; and

 

    Borrowings under the revolving credit facility.

 

Proposed Transaction

 

On October 31, 2004, Valero L.P. and Kaneb Services LLC (KSL), a Delaware limited liability company (and parent company of the general partner of Kaneb Pipe Line Partners, L.P.), and certain of Valero L.P.’s affiliated parties entered into a definitive merger agreement (the KSL Agreement), pursuant to which a wholly owned subsidiary of Valero L.P. will merge with KSL, with the surviving entity being a wholly owned subsidiary of Valero L.P. (the KSL Merger) Under the terms of the KSL Agreement, upon completion of the KSL Merger each KSL common share will be converted into the right to receive $43.31 in cash.

 

Also on October 31, 2004, Valero L.P. and Kaneb Pipe Line Partners, L.P., a Delaware limited partnership (KPP) and certain of their respective affiliated parties entered into a separate definitive merger agreement (the KPP Agreement), pursuant to which a wholly owned subsidiary of Valero L.P. will merge with KPP, with the surviving entity being a wholly owned subsidiary of Valero L.P. (the KPP Merger, and, together with the KSL Merger, the Kaneb Mergers) Under the terms of the KPP Agreement, upon completion of the KPP Merger each KPP unit will be converted into the right to receive a number of Valero L.P. common units based on an exchange ratio formula providing Valero L.P. common units worth $61.50 per KPP unit within a specified “collar” range of Valero L.P. common unit market prices (plus or minus five percent of $57.25), measured over a period prior to closing. Should Valero L.P.’s average per unit price during the measurement period be equal to or less than $54.39 per unit, the exchange ratio will be fixed at 1.1307 Valero L.P. common units for each KPP unit. Should Valero L.P.’s average per unit price during the measurement period be equal to or greater than $60.11 per unit, the exchange ratio will be fixed at 1.0231 Valero L.P. common units for each KPP unit.

 

On March 11, 2005, Valero L.P. unitholders holding a majority of Valero L.P.’s outstanding units voted to approve the issuance of the Valero L.P. common units in the KPP Merger. Also on March 11, 2005, the KPP unitholders and the KSL shareholders (other than Valero L.P., KSL, KPP and their respective affiliates) holding a majority of the oustanding KPP units and the KSL shares voted to approve the Kaneb Mergers.

 

Both of the Kaneb Mergers are contingent upon the completion of the other and are subject to customary regulatory approvals, including those under the Hart-Scott-Rodino Antitrust Improvements Act, as well as other customary conditions. There can be no assurances as to whether, or on what date, Valero L.P., KSL and KPP will obtain the required regulatory approvals or satisfy the other conditions to the Kaneb Mergers, or that Valero L.P., KSL or KPP will complete the Kaneb Mergers on the contemplated schedule.

 

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Results of Operations

 

Year Ended December 31, 2004 Compared to Year Ended December 31, 2003

 

Financial Highlights

(in thousands)

 

     Years Ended December 31,

 
     2004

    2003

 

Statement of Income Data:

                

Revenues

   $ 220,792     $ 181,450  
    


 


Costs and expenses:

                

Operating expenses

     78,298       64,609  

General and administrative expenses

     11,321       7,537  

Depreciation and amortization

     33,149       26,267  
    


 


Total costs and expenses

     122,768       98,413  
    


 


Operating income

     98,024       83,037  

Equity income from Skelly-Belvieu Pipeline Company

     1,344       2,416  

Interest and other expense, net

     (20,950 )     (15,860 )
    


 


Net income

     78,418       69,593  

Less net income applicable to general partner

     (5,927 )     (3,959 )
    


 


Net income applicable to the limited partners’ interest

   $ 72,491     $ 65,634  
    


 


     December 31,

 
     2004

    2003

 

Balance Sheet Data:

                

Long-term debt, including current portion (1)

   $ 385,161     $ 354,192  

Partners’ equity (2)

     438,311       438,163  

Debt-to-capitalization ratio (1) / ((1) + (2))

     46.8 %     44.7 %

 

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Segment Operating Highlights

(in thousands, except barrel/day information)

 

     Years Ended December 31,

     2004

   2003

Crude Oil Pipelines:

             

Throughput (barrels/day)

     381,358      355,008

Revenues

   $ 52,462    $ 50,741

Operating expenses

     15,468      15,196

Depreciation and amortization

     4,499      5,379
    

  

Segment operating income

   $ 32,495    $ 30,166
    

  

Refined Product Pipelines:

             

Throughput (barrels/day)(a)

     442,596      392,145

Revenues

   $ 86,418    $ 72,276

Operating expenses

     37,332      28,914

Depreciation and amortization

     14,715      12,380
    

  

Segment operating income

   $ 34,371    $ 30,982
    

  

Refined Product Terminals:

             

Throughput (barrels/day)(a)

     256,576      225,426

Revenues

   $ 39,984    $ 31,269

Operating expenses

     18,365      15,447

Depreciation and amortization

     6,471      3,508
    

  

Segment operating income

   $ 15,148    $ 12,314
    

  

Crude Oil Storage Tanks:

             

Throughput (barrels/day)(a)

     473,714      366,986

Revenues

   $ 41,928    $ 27,164

Operating expenses

     7,133      5,052

Depreciation and amortization

     7,464      5,000
    

  

Segment operating income

   $ 27,331    $ 17,112
    

  

Consolidated Information:

             

Revenues

   $ 220,792    $ 181,450

Operating expenses

     78,298      64,609

Depreciation and amortization

     33,149      26,267
    

  

Segment operating income

     109,345      90,574

General and administrative expenses

     11,321      7,537
    

  

Consolidated operating income

   $ 98,024    $ 83,037
    

  

 

(a) During the years ended December 31, 2004 and 2003, Valero L.P. completed several acquisitions as discussed above. The throughput related to these newly acquired assets included in the table above is calculated based on throughput for the period from the date of acquisition through December 31 of the year of acquisition divided by the number of days in the applicable year.

 

Annual Highlights

 

Net income for the year ended December 31, 2004 increased $8.8 million or 13% compared to the year ended December 31, 2003. This increase was primarily attributable to the following:

 

    The acquisitions of the South Texas Pipelines and Terminals and the crude oil storage tanks in March 2003, the Southlake pipeline in August 2003 and the Paulsboro terminal in September 2003. These assets were included in the results of operations for a full year in 2004 compared to a partial year in 2003;

 

    The acquisition of the Royal Trading asphalt terminals in February 2004;

 

    The commencement of operations in June 2004 of the Dos Laredos pipeline system, which ships propane to the Nuevo Laredo, Mexico propane terminal;

 

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    Valero Energy’s addition of a new crude unit at its Texas City refinery in the fourth quarter of 2003, which allowed that refinery to process more throughput, which benefited our storage tank business;

 

    Increased tariff rates effective April 2004 and the implementation of a Corpus Christi North Beach storage facility lease agreement effective January 2004; and

 

    Lower throughput volumes in 2003 due to economic-based production cuts at Valero Energy’s McKee refinery, a major turnaround at Valero Energy’s Ardmore refinery and planned and unplanned crude unit outages at the Texas City refinery.

 

Partially offsetting the above increases to net income were the following:

 

    Crude unit outages at Valero Energy’s McKee refinery in the second and third quarters of 2004 and a turnaround at Valero Energy’s Benicia refinery in the fourth quarter of 2004;

 

    Increased operating expense due to the following (excluding the impact of 2003 and 2004 acquisitions):

 

    Higher incentive compensation expense,

 

    Higher power costs as a result of higher natural gas prices, and

 

    Increased internal overhead costs due to the amendment to the Services Agreement, under which overhead previously allocated to Valero Energy is now borne by Valero L.P.

 

    Higher general and administrative expense primarily due to the amendment to the Services Agreement effective April 1, 2004, between Valero L.P. and Valero Energy for services rendered by Valero Energy corporate employees. In addition, general and administrative expenses in 2004 were higher due to increased external public company expenses, incentive compensation and headcount;

 

    Less equity income from Skelly-Belvieu Pipeline Company due primarily to a 21% decline in throughput barrels in the Skellytown to Mont Belvieu refined product pipeline in addition to higher maintenance expenses associated with pipeline integrity inspection costs; and

 

    Higher interest expense, which resulted from several factors, including (a) a full year of interest expense in 2004 related to the $250.0 million of 6.05% senior notes issued in March 2003; (b) borrowings of $43.0 million under the revolving credit facility in the first quarter of 2004 to fund the acquisition of the Royal Trading asphalt terminals and a portion of the construction costs related to the Dos Laredos pipelines and terminal; and (c) less interest income from interest rate swaps as interest rates increased in 2004.

 

On a per unit basis, net income per unit applicable to the limited partners’ interest increased 4% or $0.13 per limited partner unit for the year ended December 31, 2004 compared to the year ended December 31, 2003. This per unit increase was attributable to the above reasons, however, the increase in the per unit amount was partially offset by an increase in the number of common units outstanding as a result of the equity offerings completed in 2003.

 

Crude Oil Pipelines

 

Although Valero Energy’s McKee refinery had a crude unit down during a portion of the second and third quarter of 2004, throughput for the crude oil pipelines that supply the McKee refinery were slightly higher for 2004 compared to 2003. Throughputs were reduced in 2003 because Valero Energy initiated economic-based refinery production cuts at its McKee refinery in the first quarter of 2003, which contributed to lower throughputs for the crude oil pipelines that supply the McKee refinery.

 

Revenues for the crude oil pipelines increased $1.7 million or 3% for the year ended December 31, 2004 compared to the year ended December 31, 2003 due primarily to increased revenues related to the Ardmore crude oil pipelines. During the second quarter of 2003, Valero Energy’s Ardmore refinery experienced a major refinery turnaround for most of April, resulting in lower throughput and revenues in the Ringgold to Wasson to Ardmore crude oil pipelines for 2003 as compared to 2004.

 

Although operating expenses for the crude oil pipelines segment were comparable in the aggregate for the year ended December 31, 2004 and the year ended December 31, 2003, certain components of operating expenses increased while others decreased. Power costs were higher during 2004 due to higher electricity rates as a result of higher natural gas prices and an expansion of the Wichita Falls crude oil pipeline by adding a pump station in the fourth quarter of 2003. In addition, higher employee benefit costs in 2004 were related to higher incentive compensation. These operating expense increases were offset by the transfer of the Corpus Christi North Beach storage facility, including its operating expense, from the crude oil pipeline segment to the crude oil storage tank segment effective January 1, 2004.

 

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Depreciation and amortization expense for the crude oil pipelines decreased due to the transfer of the Corpus Christi North Beach storage facility from the crude oil pipeline segment to the crude oil storage tank segment effective January 1, 2004.

 

Refined Product Pipelines

 

Revenues for the refined product pipelines segment increased $14.1 million or 20% for the year ended December 31, 2004 compared to the year ended December 31, 2003 due to a 13% increase in throughput resulting primarily from Valero L.P.’s acquisition of the South Texas Pipelines on March 18, 2003 and the Southlake refined product pipeline on August 1, 2003. Revenues for the South Texas Pipelines and Southlake refined product pipeline were $31.6 million for the year ended December 31, 2004 compared to revenue of $22.5 million from the dates of acquisition through December 31, 2003. In addition, the Dos Laredos pipeline system, which began shipping propane to the Nuevo Laredo, Mexico propane terminal on June 1, 2004, contributed revenues of $2.6 million in 2004.

 

Operating expenses for the refined product pipelines segment increased $8.4 million or 29% for the year ended December 31, 2004 compared to the year ended December 31, 2003 primarily due to expenses associated with a full year of operations of the South Texas Pipelines acquired on March 18, 2003 and the Southlake refined product pipeline acquired on August 1, 2003, in addition to higher power costs and increased employee benefit costs related to higher incentive compensation.

 

Depreciation and amortization expense for the refined product pipelines segment increased $2.3 million or 19% for the year ended December 31, 2004 compared to the year ended December 31, 2003 due to the acquisition of the South Texas Pipelines on March 18, 2003 and the Southlake refined product pipeline effective August 1, 2003 as well as the commencement of operations of the Dos Laredos pipeline system on June 1, 2004.

 

Refined Product Terminals

 

Revenues for the refined product terminals segment increased $8.7 million or 28% for the year ended December 31, 2004 compared to the year ended December 31, 2003 primarily due to a full year of operations of the South Texas Terminals acquired on March 18, 2003 and the Paulsboro refined product terminal acquired on September 3, 2003 and due to the acquisition of the Royal Trading asphalt terminals on February 20, 2004. Revenues for the above-mentioned acquired terminals were $15.5 million for the year ended December 31, 2004 compared to revenues of $6.5 million from dates of acquisition through December 31, 2003.

 

Operating expenses for the refined product terminals segment increased $2.9 million or 19% for the year ended December 31, 2004 compared to the year ended December 31, 2003 due primarily to expenses associated with the 2003 and 2004 acquisitions. Operating expenses for the above-mentioned acquired terminals were $6.1 million for the year ended December 31, 2004 compared to $2.9 from the dates of acquisition through December 31, 2003.

 

Depreciation and amortization expense for the refined product terminals segment increased $3.0 million for the year ended December 31, 2004 compared to the year ended December 31, 2003 due to the acquisitions completed in 2003 and 2004 as well as the June 1, 2004 startup of the Nuevo Laredo terminal, which is connected to the Dos Laredos pipeline system.

 

Crude Oil Storage Tanks

 

Revenues for the crude oil storage tanks segment increased $14.8 million or 54% for the year ended December 31, 2004 compared to the year ended December 31, 2003 due to a 29% increase in throughput attributable to the following:

 

    Valero L.P.’s ownership of the crude oil storage tanks for only 288 days of the year ended December 31 2003, compared to 366 days in the year ended December 31, 2004; and

 

    Valero Energy’s addition of a new crude unit at its Texas City refinery in the fourth quarter of 2003, which allowed that refinery to process more throughput in 2004. In addition, there were several planned and unplanned crude unit outages at the Texas City refinery in 2003 which lowered the amount of throughput processed in 2003.

 

Partially offsetting the above increases in 2004 was a plant-wide turnaround at Valero Energy’s Benicia refinery in the fourth quarter of 2004, which lowered throughput in 2004.

 

In addition, effective January 1, 2004, Valero L.P. transferred the operations of its Corpus Christi North Beach storage facility to the crude oil storage tanks segment from the crude oil pipelines segment. Prior to the transfer, Valero L.P. had included the use of this storage facility as a part of the crude oil pipeline tariff for the Corpus Christi to Three Rivers crude oil pipeline. Valero L.P. and Valero Energy entered into a one-year shell barrel capacity lease agreement, which is

 

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Index to Financial Statements

renewable for one-year terms, for the l.6 million barrels of capacity at the facility and raised the dockage and wharfage fees. Revenues for the year ended December 31, 2004 for the Corpus Christi North Beach storage facility totaled $7.7 million, which included $5.7 million of rental income and $2.0 million of dockage and wharfage fees.

 

Operating expenses and depreciation and amortization expense for the crude oil storage tanks segment increased by $2.1 million and $2.5 million, respectively, due to Valero L.P.’s ownership of the crude oil storage tanks for the full year of 2004 and the transfer of the Corpus Christi North Beach storage facility for the year ended December 31, 2004.

 

Year Ended December 31, 2003 Compared to Year Ended December 31, 2002

 

Financial Highlights

(in thousands)

 

     Years Ended December 31,

 
     2003

    2002

 

Statement of Income Data:

                

Revenues

   $ 181,450     $ 118,458  
    


 


Costs and expenses:

                

Operating expenses

     64,609       37,838  

General and administrative expenses

     7,537       6,950  

Depreciation and amortization

     26,267       16,440  
    


 


Total costs and expenses

     98,413       61,228  
    


 


Operating income

     83,037       57,230  

Equity income from Skelly-Belvieu Pipeline Company

     2,416       3,188  

Interest expense, net

     (15,860 )     (4,880 )
    


 


Income before income tax expense

     69,593       55,538  

Income tax expense

     —         (395 )
    


 


Net income

     69,593       55,143  

Less net income applicable to general partner

     (3,959 )     (2,187 )

Less net income related to the Wichita Falls Business for the month ended January 31, 2002

     —         (650 )
    


 


Net income applicable to the limited partners’ interest

   $ 65,634     $ 52,306  
    


 


     December 31,

 
     2003

    2002

 

Balance Sheet Data:

                

Long-term debt, including current portion (1)

   $ 354,192     $ 109,658  

Partners’ equity (2)

     438,163       293,895  

Debt-to-capitalization ratio (1) / ((1) + (2))

     44.7 %     27.2 %

 

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Segment Operating Highlights

(in thousands, except barrel/day information)

 

     Years Ended December 31,

     2003

   2002

Crude Oil Pipelines:

             

Throughput (barrels/day)

     355,008      348,023

Revenues

   $ 50,741    $ 47,925

Operating expenses

     15,196      13,541

Depreciation and amortization

     5,379      5,618
    

  

Segment operating income

   $ 30,166    $ 28,766
    

  

Refined Product Pipelines:

             

Throughput (barrels/day)(a)

     392,145      295,456

Revenues

   $ 72,276    $ 52,302

Operating expenses

     28,914      16,202

Depreciation and amortization

     12,380      8,051
    

  

Segment operating income

   $ 30,982    $ 28,049
    

  

Refined Product Terminals:

             

Throughput (barrels/day)(a)

     225,426      175,559

Revenues

   $ 31,269    $ 18,231

Operating expenses

     15,447      8,095

Depreciation and amortization

     3,508      2,771
    

  

Segment operating income

   $ 12,314    $ 7,365
    

  

Crude Oil Storage Tanks:

             

Throughput (barrels/day)(a)

     366,986      —  

Revenues

   $ 27,164    $ —  

Operating expenses

     5,052      —  

Depreciation and amortization

     5,000      —  
    

  

Segment operating income

   $ 17,112    $ —  
    

  

Consolidated Information:

             

Revenues

   $ 181,450    $ 118,458

Operating expenses

     64,609      37,838

Depreciation and amortization

     26,267      16,440
    

  

Segment operating income

     90,574      64,180

General and administrative expenses

     7,537      6,950
    

  

Consolidated operating income

   $ 83,037    $ 57,230
    

  

 

(a) During the years ended December 31, 2003 and 2002, Valero L.P. completed several acquisitions as discussed above. The throughput related to these newly acquired assets included in the table above is calculated based on throughput for the period from the date of acquisition through December 31, divided by 365 days.

 

Annual Highlights

 

Net income for the year ended December 31, 2003 was $69.6 million compared to $55.1 million for the year ended December 31, 2002, an increase of 26%. This increase was primarily attributable to the additional operating income generated from the various acquisitions completed during 2003.

 

Partially offsetting the increase in net income were the following:

 

    Higher general and administrative expenses due primarily to an increase in external public company expenses and higher compensation expense;

 

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    Less equity income from Skelly-Belvieu Pipeline Company due to an 11% decrease in throughput barrels in the Skellytown to Mont Belvieu refined product pipeline and higher integrity maintenance expenses incurred in 2003; and

 

    Higher interest expense due to interest expense related to the $250.0 million of 6.05% senior notes issued in March 2003. Partially offsetting the higher interest expense in 2003 is the effect of interest rate swaps entered into during the first four months of 2003.

 

On a per unit basis, net income per unit applicable to the limited partners’ interest increased 11% or $0.30 per unit for the year ended December 31, 2003 compared to the year ended December 31, 2002. This per unit increase was also attributable to the acquisitions completed during the year ended December 31, 2003, partially offset by an increase in the number of common units outstanding as a result of the equity offerings completed in 2003 to fund a portion of the acquisition costs.

 

Crude Oil Pipelines

 

Revenues for the crude oil pipelines increased $2.8 million due primarily to increased revenues for the Wichita Falls to McKee and the Corpus Christi to Three Rivers crude oil pipelines as a result of a combined 7% increase in throughput barrels. Revenues and throughput for Valero L.P.’s other crude oil pipelines for 2003 were comparable to 2002.

 

Operating expenses for the crude oil pipelines increased $1.7 million or 12% due to increased chemical expenses related to drag reducing agents to transport higher volumes of heavier sour crude oil and increased utility costs to transport the higher throughput in 2003 as compared to 2002. Utility costs were higher during 2003 due to higher electricity rates as a result of higher natural gas prices.

 

Depreciation and amortization expense for the crude oil pipelines for the year ended December 31, 2003 remained level with the amount recognized for the year ended December 31, 2002 due to no significant changes in the underlying property and equipment balances.

 

Refined Product Pipelines

 

Revenues for the refined product pipelines increased $20.0 million and throughput increased 33% due primarily to the acquisition of the South Texas Pipelines on March 18, 2003 and the Southlake refined product pipeline on August 1, 2003. Revenues for the South Texas Pipelines and Southlake refined product pipeline were $22.5 million and throughput totaled 102,650 barrels per day, on a basis of 365 days, from date of acquisition through December 31, 2003. Partially offsetting the increased revenues related to the acquisitions was a $4.5 million decrease in revenues related to the McKee to Colorado Springs to Denver pipeline resulting from Valero Energy maximizing production at its Denver refinery and lower jet fuel sales by Valero Energy in Colorado Springs, resulting in lower throughput in this pipeline.

 

Operating expenses for the refined product pipelines increased $12.7 million or 78% due primarily to the expenses associated with the operations of the South Texas Pipelines and the Southlake refined product pipeline. Operating expenses for the South Texas Pipelines and Southlake refined product pipeline were $11.4 million from the date of acquisition through December 31, 2003. In addition, Valero L.P. incurred higher pipeline inspection and repair costs during 2003 as compared to 2002 primarily for the Amarillo to Albuquerque refined product pipeline and the Three Rivers to San Antonio refined product pipeline, and increased utility costs due to higher electricity rates as a result of higher natural gas prices during 2003.

 

Depreciation and amortization expense for the refined product pipelines increased 54% or $4.3 million for the year ended December 31, 2003 as compared to the year ended December 31, 2002 due to the acquisitions completed during 2003.

 

Refined Product Terminals

 

Revenues for the refined product terminals increased $13.0 million and throughput increased 28% due primarily to the acquisitions of the Telfer asphalt terminal on January 7, 2003, the South Texas Terminals on March 18, 2003 and the Paulsboro refined product terminal on September 3, 2003. Revenues for the acquired terminals were $10.8 million and throughput totaled 47,761 barrels per day, on a basis of 365 days, from the date of acquisition through December 31, 2003. Revenues for the other refined product terminals increased $2.2 million due primarily to an increase in the additive blending fee from $0.04 per barrel to $0.12 per barrel effective January 1, 2003.

 

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Operating expenses for the refined product terminals increased $7.4 million or 91% due primarily to the expenses associated with the operations of the South Texas Terminals, the Telfer asphalt terminal and the Paulsboro refined product terminal. Operating expenses for the South Texas Terminals, the Telfer asphalt terminal and the Paulsboro refined product terminal were $5.3 million from the date of acquisition through December 31, 2003. In addition, chemical expenses related to gasoline additives increased by $1.0 million, as a result of Valero L.P. purchasing the additives during 2003 versus customers supplying the additives in 2002.

 

Depreciation and amortization expense increased 27% or $0.7 million for the year ended December 31, 2003 as compared to the year ended December 31, 2002 due to the acquisitions completed during 2003.

 

Crude Oil Storage Tanks

 

Revenues for the crude oil storage tanks represent revenues earned on the throughput barrels from the date of acquisition, March 18, 2003, through December 31, 2003. Operating expenses for the crude oil storage tanks consist primarily of the fees charged by Valero Energy for the personnel providing operating and routine maintenance services, and rent expense charged by Valero Energy under the lease and access agreements. Depreciation and amortization expense was recognized for the period from March 18, 2003 through December 31, 2003.

 

Liquidity and Capital Resources

 

Valero L.P.’s primary cash requirements are for reliability and expansion capital expenditures, acquisitions, distributions to partners, debt service and normal operating expenses. Valero L.P. expects to fund its short-term needs for such items as reliability capital expenditures and quarterly distributions to the partners from operating cash flows. Long-term capital requirements are expected to be funded from a variety of sources including cash flows from operating activities, borrowings under the $175.0 million revolving credit facility, the 2005 Revolving Credit Agreement (upon closing of the Kaneb Mergers) the issuance of additional common units or debt securities and other capital market transactions.

 

Revolving Credit Facility

 

On March 6, 2003, Valero Logistics amended its December 2000 revolving credit facility, increasing its credit limit to $175.0 million. The revolving credit facility expires on January 15, 2006. At Valero Logistics’ option, borrowings under the revolving credit facility bear interest based on either an alternative base rate or LIBOR, which was 3.4% as of December 31, 2004. Borrowings to fund distributions to unitholders are limited to $40.0 million. All borrowings designated as borrowings subject to the $40.0 million sublimit must be reduced to zero for a period of at least 15 consecutive days during each fiscal year. The revolving credit facility also allows Valero Logistics to issue letters of credit for an aggregate of $75.0 million. The borrowings under the revolving credit facility are unsecured and rank equally with all of Valero Logistics’ outstanding unsecured and unsubordinated debt. The revolving credit facility is irrevocably and unconditionally guaranteed by Valero L.P. Valero L.P.’s guarantee ranks equally with all of its existing and future unsecured senior obligations.

 

The revolving credit facility requires that Valero Logistics maintain certain financial ratios, as defined in the revolving credit facility, including a consolidated debt coverage ratio not to exceed 4.0 to 1.0 and a consolidated interest coverage ratio no less than 3.5 to 1.0. The revolving credit facility includes other restrictive covenants, including a prohibition on distributions by Valero Logistics to Valero L.P. if any default, as defined in the revolving credit facility, exists or would result from the distribution. The revolving credit facility also includes a change-in-control provision, which requires that Valero Energy continue to own, directly or indirectly, 51% of Valero L.P.’s general partner interest or Valero Energy and/or Valero L.P. own 100% of the general partner interest in Valero Logistics or 100% of the outstanding limited partner interests in Valero Logistics. Management believes that Valero Logistics is in compliance with all of these ratios and covenants.

 

On March 18, 2003, Valero Logistics borrowed $25.0 million under the revolving credit facility to partially fund the purchase of the South Texas Pipelines and Terminals from Valero Energy. Valero Logistics repaid the borrowings during the second quarter of 2003, primarily from proceeds from the common unit offerings completed by Valero L.P.

 

As of December 31, 2004, Valero Logistics had $147.0 million of available borrowing capacity under its $175.0 million revolving credit facility. During 2004, Valero Logistics borrowed $28.0 million under the revolving credit facility to fund the purchase of the Royal Trading asphalt terminals and borrowed an additional $15.0 million to partially fund

 

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construction of the Nuevo Laredo, Mexico propane terminal and related pipelines. Valero Logistics repaid $15.0 million of the borrowings under the revolving credit facility in the third and fourth quarters of 2004.

 

On December 20, 2004, Valero Logistics and Valero L.P. entered into a 5-Year Revolving Credit Agreement (the 2005 Revolving Credit Agreement) with certain lenders with an initial aggregate commitment of $400 million, subject to completion of the Kaneb Mergers. Valero Logistics’ obligations under the 2005 Revolving Credit Agreement are unsecured and will be guaranteed by Valero L.P. and certain subsidiaries of Valero L.P. Generally, the lenders will not be obligated to make any loans under the 2005 Revolving Credit Agreement until the Kaneb Mergers are completed. Upon closing of the 2005 Revolving Credit Agreement, the amounts outstanding under the $175.0 million revolving credit facility will be paid in full, and that facility will be terminated.

 

Senior Notes

 

On July 15, 2002, Valero Logistics issued $100.0 million of 6.875% senior notes due July 15, 2012 with interest payable in arrears on January 15 and July 15 of each year. The net proceeds were used to repay the $91.0 million then outstanding under the revolving credit facility.

 

On March 18, 2003, Valero Logistics issued, in a private placement to institutional investors, $250.0 million of 6.05% senior notes, due March 15, 2013, with interest payable in arrears on March 15 and September 15 of each year beginning September 15, 2003. The net proceeds of $247.3 million were used to redeem 3,809,750 common units held by UDS Logistics, LLC ($134.1 million), redeem a related portion of the general partner interest ($2.9 million) and partially fund the South Texas Pipelines and Terminals acquisition cost. On July 10, 2003, Valero Logistics exchanged all of the $250.0 million of privately issued 6.05% senior notes for a like principal amount of 6.05% senior notes that were registered under the Securities Act of 1933.

 

Neither series of senior notes have sinking fund requirements. The 6.05% senior notes rank equally with all other existing senior unsecured indebtedness of Valero Logistics, including indebtedness under the revolving credit facility and the 6.875% senior notes. Both series of senior notes contain restrictions on Valero Logistics’ ability to incur secured indebtedness unless the same security is also provided for the benefit of holders of the senior notes. In addition, the senior notes limit Valero Logistics’ ability to incur indebtedness secured by certain liens and to engage in certain sale-leaseback transactions. Also, both series of senior notes are irrevocably and unconditionally guaranteed on a senior unsecured basis by Valero L.P. The guarantee by Valero L.P. ranks equally with all of its existing unsecured and unsubordinated indebtedness and is required to rank equally with any future unsecured and unsubordinated indebtedness. At the option of Valero Logistics, each of the series of senior notes may be redeemed in whole or in part at any time at a redemption price, which includes a make-whole premium, plus accrued and unpaid interest to the redemption date.

 

The senior notes also include change-in-control provisions, which require (1) that Valero Energy or an investment grade entity own, directly or indirectly, 51% of the general partner interests of Valero L.P. and (2) that Valero L.P. or an investment grade entity own, directly or indirectly, all of the general partner and limited partner interests in Valero Logistics. Otherwise, Valero Logistics must offer to purchase the senior notes at a price equal to 100% of their outstanding principal balance plus accrued interest through the date of purchase.

 

Other Long-term Debt

 

During 2004, Valero Logistics repaid $0.5 million on the note payable to the Port of Corpus Christi Authority of Nueces County, Texas. The note payable is due in annual installments of $1.2 million through December 31, 2015 and is collateralized by the Corpus Christi North Beach crude oil storage facility.

 

Interest Rate Swaps

 

During 2003, Valero Logistics entered into interest rate swap agreements to manage its exposure to changes in interest rates. The interest rate swap agreements have an aggregate notional amount of $167.5 million, of which $60.0 million is tied to the maturity of the 6.875% senior notes and $107.5 million is tied to the maturity of the 6.05% senior notes. Under the terms of the interest rate swap agreements, Valero Logistics will receive a fixed rate (6.875% and 6.05%, respectively) and will pay a variable rate based on LIBOR plus a percentage that varies with each agreement. Valero Logistics accounts for the interest rate swaps as fair value hedges, with changes in the fair value of each swap and the related debt instrument recorded as an adjustment to interest expense in the consolidated statements of income.

 

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Common Unit Offerings

 

On March 18, 2003, Valero L.P. sold 5,750,000 common units in a public offering for net proceeds of $204.6 million, including a $4.3 million general partner contribution from Riverwalk Logistics to maintain its 2% general partner interest. Valero L.P. used the net proceeds primarily to fund the acquisition of the Crude Oil Storage Tanks. On April 16, 2003, Valero L.P. sold 581,000 common units for net proceeds of $20.9 million, including a $0.5 million general partner contribution, upon the exercise of a portion of the underwriters’ over-allotment option. Valero L.P. used the net proceeds to pay down the then outstanding balance due under the revolving credit facility.

 

On August 11, 2003, Valero L.P. sold 1,236,250 common units in a public offering, which included 161,250 common units related to an over-allotment option, for net proceeds of $49.3 million, including a $1.0 million general partner contribution. Valero L.P. used the net proceeds primarily to fund the acquisitions of the Southlake refined product pipeline and the Paulsboro refined product terminal.

 

Shelf Registration Statement

 

On October 2, 2003, the SEC declared effective a shelf registration statement on Form S-3 filed by Valero L.P. and Valero Logistics to register $750.0 million of securities for potential future issuance. Valero L.P. may, in one or more offerings, offer and sell common units representing limited partner interests in Valero L.P. Valero Logistics may, in one or more offerings, offer and sell debt securities, which will be fully and unconditionally guaranteed by Valero L.P. The full balance of the $750.0 million universal shelf registration statement is available as of December 31, 2004.

 

Distributions

 

Valero L.P.’s partnership agreement, as amended, determines the amount and priority of cash distributions that Valero L.P.’s common unitholders, subordinated unitholders and general partner may receive. During the subordination period, if there is sufficient available cash, the holders of Valero L.P.’s common units are entitled to receive each quarter a minimum distribution of $0.60 per unit ($2.40 annualized) prior to any distribution of available cash to holders of Valero L.P.’s subordinated units. In addition, the general partner is entitled to incentive distributions, as defined below, if the amount Valero L.P. distributes with respect to any quarter exceeds $0.60 per unit. Effective March 11, 2004, the partnership agreement was amended to lower the general partner’s incentive distribution rights with respect to distributions of available cash from 48% to 23% of the amount of any quarterly distribution that exceeds $0.90 per unit. The general partner will continue to receive a 2% distribution with respect to its general partner interest.

 

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

 

     Years Ended December 31,

     2004

   2003

   2002

     (in thousands, except per unit data)

General partner interest

   $ 1,595    $ 1,404    $ 1,103

General partner incentive distribution

     4,449      2,620      1,103
    

  

  

Total general partner distribution

     6,044      4,024      2,206

Limited partners’ distribution

     73,733      66,179      52,969
    

  

  

Total cash distributions

   $ 79,777    $ 70,203    $ 55,175
    

  

  

Cash distributions per unit applicable to limited partners

   $ 3.20    $ 2.95    $ 2.75
    

  

  

 

On February 14, 2005, Valero L.P. paid a quarterly cash distribution of $0.80 per unit for the fourth quarter of 2004.

 

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Capital Requirements

 

The petroleum pipeline and terminalling industry is capital-intensive, requiring significant investments to maintain, upgrade or enhance existing operations and to comply with environmental and safety laws and regulations. Valero L.P.’s capital expenditures consist primarily of:

 

    reliability capital expenditures (formerly referred to as maintenance capital expenditures), such as those required to maintain equipment reliability and safety and to address environmental and safety regulations; and

 

    expansion capital expenditures, such as those to expand and upgrade pipeline capacity and to construct new pipelines, terminals and storage tanks. In addition, expansion capital expenditures may include acquisitions of pipelines, terminals or storage tank assets.

 

During the year ended December 31, 2004, Valero L.P. incurred reliability capital expenditures of $9.7 million primarily related to pipeline replacements along the Corpus Christi to Pasadena and the Three Rivers to Corpus Christi refined product pipelines as well as system automation projects related to terminal and pipeline management software. Expansion capital expenditures for the year ended December 31, 2004 of $19.7 million were primarily related to the construction of the Nuevo Laredo, Mexico propane terminal and related pipelines, the expansion of the Corpus Christi to Edinburg refined product pipeline and the project to increase the capacity of the Wasson to Ardmore crude oil pipeline.

 

On February 20, 2004, Valero L.P. acquired two asphalt terminals, one in Catoosa, Oklahoma near Tulsa and one in Rosario, New Mexico near Santa Fe, from Royal Trading Company (Royal Trading) for $28.1 million, which was funded with borrowings under Valero Logistics’ $175.0 million revolving credit facility. These terminals have an aggregate storage capacity of 500,000 barrels in 32 tanks and six loading stations.

 

During the year ended December 31, 2003, Valero L.P. incurred reliability capital expenditures of $10.4 million primarily related to pipeline replacements along the Corpus Christi to Pasadena refined product pipeline, tank and pipeline pump station upgrades at several locations and system automation projects related to terminal and pipeline management software. Expansion capital expenditures of $21.2 million were primarily related to the construction of the Nuevo Laredo, Mexico propane terminal and related pipeline, the addition of new pumps on the Wichita Falls to McKee crude oil pipeline and the expansion of the Corpus Christi to Edinburg refined product pipeline. Also during 2003, Valero L.P. completed $411.2 million of acquisitions, which included the following:

 

    South Texas Pipelines and Terminals from Valero Energy for $150.1 million,

 

    Crude Oil Storage Tanks from Valero Energy for $200.2 million,

 

    Southlake refined product pipeline from Valero Energy for $29.9 million,

 

    Telfer asphalt terminal from Telfer Oil Company for $15.3 million,

 

    Paulsboro refined product terminal from ExxonMobil Oil Corporation for $14.1 million, and

 

    Shell pipeline interest from Shell Pipeline Company, LP for $1.6 million.

 

During the year ended December 31, 2002, Valero L.P. incurred reliability capital expenditures of $3.9 million primarily related to tank and automation upgrades at both the refined product terminals and the crude oil storage facilities and corrosion protection and automation upgrades for refined product pipelines. Expansion capital expenditures of $1.8 million were primarily related to the completion of the Amarillo to Albuquerque refined product pipeline expansion, which is net of ConocoPhillips’ 50% share of costs. Also during 2002, Valero L.P. completed $75.0 million of acquisitions, which included the following:

 

    Wichita Falls Business (consisting of the Wichita Falls to McKee crude oil pipeline and related storage facility) from Valero Energy for $64.0 million, and

 

    Crude hydrogen pipeline from Valero Energy for $11.0 million.

 

For 2005, Valero L.P. expects to incur approximately $67.4 million of capital expenditures, including $18.9 million for reliability capital projects and $48.5 million for expansion capital projects. Valero L.P. continuously evaluates its capital budget and makes changes as economic conditions warrant.

 

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Long-Term Contractual Obligations

 

The following table presents long-term contractual obligations and commitments of Valero L.P. and the related payments due, in total and by period, as of December 31, 2004.

 

     Payments Due by Period

     Less Than
1 Year


   1-3
Years


   4-5
Years


   Over 5
Years


   Total

     (in thousands)

Long-term debt (stated maturities)

   $ 990    $ 29,837    $ 1,483    $ 352,851    $ 385,161

Operating leases

     1,596      4,259      2,206      16,117      24,178

Rights of way payments

     31      91      59      343      524

Catoosa, OK asphalt terminal purchase obligation

     26      77      51      76      230

 

The operating lease amounts in the above table include minimum rentals due under the various land leases for the refined product terminals and the crude oil storage tanks.

 

A purchase obligation is an enforceable and legally binding agreement to purchase goods or services that specifies significant terms, including (i) fixed or minimum quantities to be purchased, (ii) fixed, minimum or variable price provisions, and (iii) the approximate timing of the transaction. Valero L.P.’s only purchase obligation relates to a minimum quantity guarantee for the wharfage and tollage payments at the Catoosa, OK asphalt terminal.

 

Valero L.P. does not have any long-term contractual obligations related to its investment in the Skelly-Belvieu Pipeline Company, other than the requirement to operate the pipeline on behalf of the members and to fund Valero L.P.’s 50% share of capital expenditures as they arise. Skelly-Belvieu Pipeline Company does not have any outstanding debt as of December 31, 2004.

 

Related Party Transactions

 

In addition to owning a combined 45.7% general and limited partner interest in Valero L.P., Valero L.P. and Valero Energy have entered into a number of operating agreements, which govern the required services provided to and from Valero Energy. Most of the operating agreements include adjustment provisions, which allow Valero L.P. to increase the handling, storage and throughput fees charged by Valero L.P. to Valero Energy based on a consumer price index. In addition, the pipeline tariffs charged by Valero L.P. are reviewed annually and adjusted based on an inflation index and may also be adjusted to take into consideration additional costs incurred to provide the transportation services. The following is a summary of the significant requirements of the individual agreements.

 

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Services Agreement

 

Valero L.P. does not have any employees. Under the Services Agreement, the costs related to employees of Valero Energy who perform services directly on Valero L.P.’s behalf (direct services), including salary, wages and employee benefits are charged by Valero Energy to Valero, L.P. In addition, Valero L.P. receives certain administrative services such as legal, accounting, treasury, engineering, information technology and other corporate functions from Valero Energy. Under the provisions of the Services Agreement Valero L.P. paid Valero Energy an annual fee of $5.2 million related to these administrative services. Due to the significant growth of Valero L.P. and the increased need for personnel to work directly on behalf of Valero L.P. who were previously performing administrative services, the terms of the Services Agreement were amended effective April 1, 2004.

 

Under the terms of the amended Services Agreement, Valero L.P. continues to reimburse Valero Energy for the direct costs of employees working on behalf of Valero L.P. The number of employees who perform services directly on behalf of Valero L.P. was increased, thereby increasing the direct service charge, while the administrative services fee was reduced to an initial $1.2 million per year from $5.2 million per year. Each year over the next four years, the administrative services fee will be increased by $1.2 million and further increased by Valero Energy’s average percentage increase in salaries. The administrative services fee may also be adjusted to account for changes in service levels due to Valero L.P.’s acquisition, sale or construction of assets. The Conflicts Committee of the Board of Directors of Valero GP, LLC approved the amendment to the Services Agreement in March 2004. These fees are in addition to general and administrative costs incurred from third parties for services Valero Energy does not provide under the Services Agreement.

 

Pipelines and Terminals Usage Agreement - McKee, Three Rivers and Ardmore

 

Under the terms of the Pipelines and Terminals Usage Agreement, Valero L.P. provides transportation services that support Valero Energy’s refining and marketing operations relating to the McKee, Three Rivers and Ardmore refineries. Pursuant to the agreement, Valero Energy has agreed through April 2008:

 

    To transport in Valero L.P.’s crude oil pipelines at least 75% of the aggregate volumes of crude oil shipped to the McKee, Three Rivers and Ardmore refineries;

 

    To transport in Valero L.P.’s refined product pipelines at least 75% of the aggregate volumes of refined products shipped from the McKee, Three Rivers and Ardmore refineries; and

 

    To use Valero L.P.’s refined product terminals for terminalling services for at least 50% of the refined products shipped from the McKee, Three Rivers and Ardmore refineries.

 

In the event Valero Energy does not transport in Valero L.P.’s pipelines or use Valero L.P.’s terminals to handle the minimum volume requirements and if its obligation has not been suspended under the terms of the agreement, Valero Energy will be required to make a cash payment determined by multiplying the shortfall in volume by the applicable weighted-average pipeline tariff or terminal fee. During the year ended December 31, 2004, Valero Energy exceeded its obligations under the Pipelines and Terminals Usage Agreement. Additionally, Valero Energy has agreed not to challenge, or cause others to challenge Valero L.P.’s interstate or intrastate tariffs for the transportation of crude oil and refined products until at least April 2008.

 

Crude Oil Storage Tanks Agreements

 

In connection with the crude oil storage tank contribution, Valero L.P. and Valero Energy entered into the following agreements related to the operations of the crude oil storage tanks.

 

    Handling and Throughput Agreement – Valero Energy has agreed to pay Valero L.P. a fee, for an initial period of ten years, for all crude oil and certain other feedstocks delivered to each of the Corpus Christi West refinery, the Texas City refinery and the Benicia refinery and to use Valero L.P. for handling all deliveries to these refineries. The throughput fees are adjustable annually, generally based on 75% of the regional consumer price index applicable to the location of each refinery. The agreement may be extended by Valero Energy for up to an additional five years.

 

    Services and Secondment Agreements – Valero Energy has agreed to provide to Valero L.P. personnel who perform operating and routine maintenance services related to the crude oil storage tank operations. The annual reimbursement for services is an aggregate $3.5 million for the initial year and is subject to adjustment based on the actual expenses incurred and increases in the regional consumer price index. The initial term of the Services and Secondment Agreements is ten years with a Valero L.P. option to extend for an additional five years. In addition to the fees Valero L.P. has agreed to pay, Valero L.P. is responsible for operating expenses and specified capital expenditures related to the tank assets that are not addressed in the agreement. These operating expenses and capital expenditures include tank safety inspections, maintenance and repairs, certain environmental expenses, insurance premiums and ad valorem taxes.

 

    Lease and Access Agreements – Valero L.P. leases from Valero Energy the real property on which the crude oil storage tanks are located for an aggregate of $0.7 million per year. The initial term of each lease is 25 years, subject to automatic renewal for successive one-year periods thereafter.

 

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South Texas Pipelines and Terminals Agreements

 

In connection with the South Texas Pipelines and Terminals contribution, Valero L.P. and Valero Energy entered into the following agreements related to the operations of the pipelines and terminals:

 

    A terminalling agreement pursuant to which Valero Energy agreed, during the initial period of five years, to pay a terminalling fee for each barrel of refined product stored or handled by or on behalf of Valero Energy at the terminals, including an additive fee for gasoline additive blended at the terminals. At the Houston Hobby Airport terminal, Valero Energy agreed to pay a filtering fee for each barrel of jet fuel stored or handled at the terminal.

 

    A throughput commitment agreement pursuant to which Valero Energy agreed, for an initial period of seven years:

 

    to transport in the Houston and Valley pipeline systems an aggregate of 40% of the Corpus Christi refineries’ gasoline and distillate production but only if the combined throughput in these pipelines is less than 110,000 barrels per day;

 

    to transport in the Pettus to San Antonio refined product pipeline 25% of the Three Rivers refinery gasoline and distillate production and in the Pettus to Corpus Christi refined product pipeline 90% of the Three Rivers refinery raffinate production;

 

    to use the Houston asphalt terminal for an aggregate of 7% of the asphalt production of the Corpus Christi refineries;

 

    to use the Edinburg refined product terminal for an aggregate of 7% of the gasoline and distillate production of the Corpus Christi refineries, but only if the throughput at this terminal is less than 20,000 barrels per day; and

 

    to use the San Antonio east terminal for 75% of the throughput in the Pettus to San Antonio refined product pipeline.

 

In the event Valero Energy does not transport in Valero L.P.’s pipelines or use Valero L.P.’s terminals to handle the minimum volume requirements and if its obligation has not been suspended under the terms of the agreement, Valero Energy will be required to make a cash payment determined by multiplying the shortfall in volume by the applicable weighted-average pipeline tariff or terminal fee. In 2003, Valero Energy indicated to Valero L.P. that the segment of the Corpus Christi to Edinburg refined product pipeline that runs approximately 60 miles south from Corpus Christi to Seeligson Station required repair and replacement. Valero Energy agreed to indemnify Valero L.P. for any costs Valero L.P. incurs to repair and replace this segment in excess of $1.5 million, excluding costs to upgrade the size of the pipe, which is Valero L.P.’s responsibility. This repair and replacement project became operational in the fourth quarter of 2004.

 

Other Agreements

 

Other agreements between Valero L.P. and Valero Energy include:

 

    A hydrogen tolling agreement, which provides that Valero Energy will pay Valero L.P. minimum annual revenues of $1.4 million for transporting crude hydrogen from BOC’s chemical facility in Clear Lake, Texas to Valero Energy’s Texas City refinery.

 

    A terminal storage and throughput agreement related to the Pittsburg asphalt terminal, which provides that Valero Energy will pay Valero L.P. a monthly lease fee of $0.2 million, a minimum annual throughput fee of $0.4 million and will reimburse Valero L.P. for utility costs.

 

    In conjunction with the Royal Trading acquisition in February 2004, Valero L.P. entered into a five-year terminal storage and throughput agreement with Valero Energy. The agreement provides a base throughput and blending fee schedule with volume incentive discounts once certain thresholds are met. In addition, Valero Energy has agreed to utilize the acquired terminals for a minimum of 18.5% of the McKee and Ardmore refineries’ asphalt production.

 

    Valero L.P. and Valero Energy entered into a one-year shell barrel capacity lease agreement on January 1, 2004 for the 1.6 million barrels of capacity at the Corpus Christi North Beach storage facility, renewable annually. The use of this storage facility was previously included as part of the crude oil pipeline tariff for the Corpus Christi to Three Rivers crude oil pipeline.

 

Equity Ownership

 

As of December 31, 2004, UDS Logistics, LLC, an indirect wholly owned subsidiary of Valero Energy, owns 614,572 of Valero L.P.’s outstanding common units and all 9,599,322 of Valero L.P.’s outstanding subordinated units. In addition, Valero GP, LLC, also an indirect wholly owned subsidiary of Valero Energy, owns 49,547 of Valero L.P.’s outstanding common units. As a result, Valero Energy owns a 43.7% limited partner interest in Valero L.P. and the 2% general partner interest held by Riverwalk Logistics.

 

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Environmental, Health and Safety

 

Valero L.P. is subject to extensive federal, state and local environmental and safety laws and regulations, including those relating to the discharge of materials into the environment, waste management, pollution prevention measures, pipeline integrity and operator qualifications, among others. Because environmental and safety laws and regulations are becoming more complex and stringent and new environmental and safety laws and regulations are continuously being enacted or proposed, the level of future expenditures required for environmental, health and safety matters is expected to increase.

 

Valero Energy has agreed to indemnify Valero L.P. for a period of approximately 10 years from the date of acquisition, for pre-acquisition environmental liabilities related to the assets transferred or otherwise acquired by Valero L.P. from Valero Energy or UDS. These indemnifications do not include liabilities that result from a change in environmental law subsequent to acquisition. As an operator or owner of the assets, Valero L.P. could be held liable for pre-acquisition environmental liabilities should Valero Energy be unable to fulfill its obligation. However, Valero L.P. believes that such a situation is remote given Valero Energy’s financial condition. As of December 31, 2004 and 2003, Valero L.P. had accrued $0.3 million and $0.1 million, respectively, for environmental matters, which is expected to be spent over the next two years.

 

Critical Accounting Policies and Estimates

 

The preparation of financial statements in accordance with United States generally accepted accounting principles requires management to select accounting policies and to make estimates and assumptions related thereto that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. The following summary provides further information about Valero L.P.’s critical accounting policies and should be read in conjunction with Note 2 of the Consolidated Financial Statements, which summarizes Valero L.P.’s significant accounting policies.

 

Revenue Recognition

 

Revenues are derived from interstate and intrastate pipeline transportation of crude oil and refined products, the storage and throughput of crude oil and the terminalling and blending of refined products. Transportation revenues are based on pipeline tariffs that are subject to extensive federal and/or state regulation. Terminalling and blending revenues are based on fees which Valero L.P. believes are market based. Reductions to the current pipeline tariffs or terminalling and blending fees charged could have a material adverse effect on Valero L.P.’s results of operations. For the year ended December 31, 2004, 99% of Valero L.P.’s revenues were derived from Valero Energy and Valero Energy has agreed not to challenge certain of Valero L.P.’s pipeline tariffs or terminalling fees until at least April 2008. See Note 11 of the Consolidated Financial Statements for a discussion of Valero L.P.’s relationship with Valero Energy.

 

Depreciation

 

Depreciation expense is calculated using the straight-line method over the estimated useful lives of Valero L.P.’s property and equipment. Because of the expected long useful lives of the property and equipment, Valero L.P. depreciates its property and equipment over periods ranging from 3 years to 40 years. Changes in the estimated useful lives of the property and equipment could have a material adverse effect on Valero L.P.’s results of operations.

 

Impairment of Long-Lived Assets and Goodwill

 

Long-lived assets are required to be tested for recoverability whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. Goodwill must be tested for impairment annually or more frequently if events or changes in circumstances indicate that the related asset might be impaired. An impairment loss should be recognized only if the carrying amount of the asset/goodwill is not recoverable and exceeds its fair value.

 

In order to test for recoverability, management must make estimates of projected cash flows related to the asset which include, but are not limited to, assumptions about the use or disposition of the asset, estimated remaining life of the asset, and future expenditures necessary to maintain the asset’s existing service potential. In order to determine fair value, management must make certain estimates and assumptions including, among other things, an assessment of market conditions, projected cash flows, investment rates, interest/equity rates and growth rates, that could significantly impact the fair value of the long-lived asset or goodwill. Due to the subjectivity of the assumptions used to test for recoverability and to determine fair value, significant impairment charges could result in the future, thus affecting Valero L.P.’s future reported net income.

 

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Asset Retirement Obligation

 

Effective January 1, 2003, Valero L.P. adopted Statement No. 143, “Accounting for Asset Retirement Obligations,” which established accounting standards for recognition and measurement of a liability for an asset retirement obligation and the associated asset retirement cost. An entity is required to recognize the fair value of a liability for an asset retirement obligation in the period in which it is incurred if a reasonable estimate of fair value can be made. If a reasonable estimate of fair value cannot be made in the period the asset retirement obligation is incurred, the liability should be recognized when a reasonable estimate of fair value can be made.

 

In order to determine fair value, management must make certain estimates and assumptions including, among other things, projected cash flows, a credit-adjusted risk-free rate, and an assessment of market conditions that could significantly impact the estimated fair value of the asset retirement obligation. These estimates and assumptions are very subjective. Valero L.P. has determined that it is obligated by contractual or regulatory requirements to remove assets or perform other remediation upon retirement of certain assets. However, the fair value of the asset retirement obligation cannot currently be reasonably estimated because the settlement dates are indeterminate. Valero L.P. will record an asset retirement obligation in the periods in which it can reasonably determine the settlement dates.

 

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ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

The principal market risk (i.e., the risk of loss arising from adverse changes in market rates and prices) to which Valero L.P. is exposed is interest rate risk on its debt. Valero L.P. manages its debt considering various financing alternatives available in the market and manages its exposure to changing interest rates principally through the use of a combination of fixed-rate debt and variable-rate debt. In addition, Valero L.P. utilizes interest rate swap agreements to manage a portion of the exposure to changing interest rates by converting certain fixed-rate debt to variable-rate debt.

 

Borrowings under the revolving credit facility expose Valero Logistics to increases in the benchmark interest rate underlying its variable rate revolving credit facility.

 

The following table provides information about Valero L.P.’s long-term debt and interest rate derivative instruments, all of which are sensitive to changes in interest rates. For long-term debt, principal cash flows and related weighted-average interest rates by expected maturity dates are presented. For interest rate swaps, the table presents notional amounts and weighted-average interest rates by expected (contractual) maturity dates. Weighted-average variable rates are based on implied forward interest rates in the yield curve at the reporting date.

 

     December 31, 2004

 
     Expected Maturity Dates

    Total

   

Fair

Value


 
     2005

    2006

    2007

    2008

    2009

   

There-

after


     
     (in thousands, except interest rates)  

Long-term Debt:

                                                                

Fixed rate

   $ 990     $ 566     $ 611     $ 660     $ 713     $ 355,652     $ 359,192     $ 389,933  

Average interest rate

     8.0 %     8.0 %     8.0 %     8.0 %     8.0 %     6.3 %     6.3 %        

Variable rate

   $ —       $ 28,000     $ —       $ —       $ —       $ —       $ 28,000     $ 28,000  

Average interest rate

     —         3.4 %     —         —         —         —         3.4 %        

Interest Rate Swaps Fixed to Variable:

                                                                

Notional amount

   $ —       $ —       $ —       $ —       $ —       $ 167,500     $ 167,500     $ (1,217 )

Average pay rate

     5.1 %     5.7 %     6.0 %     6.2 %     6.6 %     7.0 %     6.4 %        

Average receive rate

     6.3 %     6.3 %     6.3 %     6.3 %     6.3 %     6.3 %     6.3 %        
     December 31, 2003

 
     Expected Maturity Dates

    Total

   

Fair

Value


 
     2004

    2005

    2006

    2007

    2008

   

There-

after


     
     (in thousands, except interest rates)  

Long-term Debt:

                                                                

Fixed rate

   $ 935     $ 524     $ 566     $ 611     $ 660     $ 356,364     $ 359,660     $ 377,217  

Average interest rate

     8.0 %     8.0 %     8.0 %     8.0 %     8.0 %     6.3 %     6.3 %        

Variable rate

   $ —       $ —       $ —       $ —       $ —       $ —       $ —       $ —    

Average interest rate

     —         —         —         —         —         —         —            

Interest Rate Swaps Fixed to Variable:

                                                                

Notional amount

   $ —       $ —       $ —       $ —       $ —       $ 167,500     $ 167,500     $ (4,553 )

Average pay rate

     3.5 %     5.0 %     6.0 %     6.8 %     7.1 %     7.7 %     6.7 %        

Average receive rate

     6.3 %     6.3 %     6.3 %     6.3 %     6.3 %     6.5 %     6.4 %        

 

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Index to Financial Statements

 

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

Management’s Report on Internal Control over Financial Reporting

 

Valero L.P.’s management is responsible for establishing and maintaining adequate “internal control over financial reporting” (as defined in Rule 13a-15(f) under the Exchange Act) for Valero L.P. Valero L.P.’s management evaluated the effectiveness of Valero L.P.’s internal control over financial reporting as of December 31, 2004. In its evaluation, Valero L.P.’s management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework.

 

Management believes that as of December 31, 2004, Valero L.P.’s internal control over financial reporting was effective based on those criteria. Valero L.P.’s independent registered public accounting firm has issued an attestation report on management’s assessment of Valero L.P.’s internal control over financial reporting.

 

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Report of Independent Registered Public Accounting Firm

 

The Board of Directors of Valero GP, LLC

and Unitholders of Valero L.P.:

 

We have audited the accompanying consolidated balance sheet of Valero L.P. and subsidiaries (a Delaware limited partnership) (the Partnership) as of December 31, 2004, and the related consolidated statements of income, cash flows and partners’ equity for the year then ended. These consolidated financial statements are the responsibility of the Partnership’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States) (the PCAOB). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Valero L.P. and subsidiaries as of December 31, 2004, and the results of their operations and their cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States.

 

We also have audited, in accordance with the standards of the PCAOB, the effectiveness of Valero L.P. and subsidiaries’ internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 11, 2005 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

 

/s/ KPMG LLP

 

San Antonio, Texas

March 11, 2005

 

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Report of Independent Registered Public Accounting Firm

 

The Board of Directors of Valero GP, LLC

and Unitholders of Valero L.P.:

 

We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting for the year ended December 31, 2004, that Valero L.P. and subsidiaries (the Partnership) maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Partnership’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Partnership’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States) (the PCAOB). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

 

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

 

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

In our opinion, management’s assessment that Valero L.P. and subsidiaries maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by COSO. Also, in our opinion, Valero L.P. and subsidiaries maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control—Integrated Framework issued by COSO.

 

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Index to Financial Statements

We also have audited, in accordance with the standards of the PCAOB, the consolidated balance sheet of Valero L.P. and subsidiaries as of December 31, 2004, and the related consolidated statements of income, partners’ equity, and cash flows for the year then ended, and our report dated March 11, 2005 expressed an unqualified opinion on those consolidated financial statements.

 

/s/ KPMG LLP

 

San Antonio, Texas

March 11, 2005

 

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Report of Independent Registered Public Accounting Firm

 

To the Board of Directors of Valero GP, LLC and Unitholders of Valero L.P.

 

We have audited the accompanying consolidated balance sheets of Valero L.P. and subsidiaries (a Delaware limited partnership, “the Partnership”) as of December 31, 2003, and the related consolidated statements of income, cash flows and partners’ equity for the years ended December 31, 2003 and 2002. These financial statements are the responsibility of the Partnership’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

 

We conducted our audits in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Partnership’s internal control over financial reporting. An audit includes consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Partnership’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Valero L.P. and subsidiaries as of December 31, 2003, and the results of its operations and its cash flows for each of the two years in the period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States.

 

/s/ ERNST & YOUNG LLP

 

San Antonio, Texas

March 11, 2004

 

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VALERO L.P. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(in thousands, except unit data)

 

     December 31,

 
     2004

    2003

 
Assets                 

Current assets:

                

Cash and cash equivalents

   $ 16,147     $ 15,745  

Receivable from Valero Energy

     19,195       15,781  

Accounts receivable

     3,395       5,333  

Other current assets

     1,242       1,275  
    


 


Total current assets

     39,979       38,134  
    


 


Property and equipment

     981,360       928,886  

Less accumulated depreciation and amortization

     (196,361 )     (163,884 )
    


 


Property and equipment, net

     784,999       765,002  

Goodwill

     4,715       4,715  

Investment in Skelly-Belvieu Pipeline Company

     15,674       15,703  

Other noncurrent assets, net of accumulated amortization of $2,064 and $1,040 as of 2004 and 2003, respectively

     12,140       4,003  
    


 


Total assets

   $ 857,507     $ 827,557  
    


 


Liabilities and Partners’ Equity                 

Current liabilities:

                

Current portion of long-term debt

   $ 990     $ 935  

Payable to Valero Energy

     4,166       9,849  

Accounts payable and other accrued liabilities

     16,055       8,499  

Accrued interest payable

     7,693       7,646  

Taxes other than income taxes

     4,705       4,441  
    


 


Total current liabilities

     33,609       31,370  
    


 


Long-term debt, less current portion

     384,171       353,257  

Other long-term liabilities

     1,416       4,767  

Commitments and contingencies (see note 9)

                

Partners’ equity:

                

Common units (13,442,072 outstanding as of 2004 and 2003)

     310,507       310,589  

Subordinated units (9,599,322 outstanding as of 2004 and 2003)

     117,968       118,005  

General partner’s equity

     9,836       9,569  
    


 


Total partners’ equity

     438,311       438,163  
    


 


Total liabilities and partners’ equity

   $ 857,507     $ 827,557  
    


 


 

See accompanying notes to consolidated financial statements.

 

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VALERO L.P. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(in thousands, except unit and per unit data)

 

     Years Ended December 31,

 
     2004

    2003

    2002

 

Revenues

   $ 220,792     $ 181,450     $ 118,458  
    


 


 


Costs and expenses:

                        

Operating expenses

     78,298       64,609       37,838  

General and administrative expenses

     11,321       7,537       6,950  

Depreciation and amortization

     33,149       26,267       16,440  
    


 


 


Total costs and expenses

     122,768       98,413       61,228  
    


 


 


Operating income

     98,024       83,037       57,230  

Equity income from Skelly-Belvieu Pipeline Company

     1,344       2,416       3,188  

Interest and other expense, net

     (20,950 )     (15,860 )     (4,880 )
    


 


 


Income before income tax expense

     78,418       69,593       55,538  

Income tax expense

     —         —         (395 )
    


 


 


Net income

   $ 78,418     $ 69,593     $ 55,143  
    


 


 


Allocation of net income:

                        

Net income

   $ 78,418     $ 69,593     $ 55,143  

Less net income applicable to the Wichita Falls Business for the month ended January 31, 2002

     —         —         (650 )
    


 


 


Net income applicable to the general and limited partners’ interest

     78,418       69,593       54,493  

General partner’s interest in net income

     (5,927 )     (3,959 )     (2,187 )
    


 


 


Limited partners’ interest in net income

   $ 72,491     $ 65,634     $ 52,306  
    


 


 


Basic and diluted net income per unit applicable to limited partners

   $ 3.15     $ 3.02     $ 2.72  
    


 


 


Weighted average number of basic and diluted units outstanding

     23,041,394       21,706,164       19,250,867  
    


 


 


 

See accompanying notes to consolidated financial statements.

 

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VALERO L.P. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

 

     Years Ended December 31,

 
     2004

    2003

    2002

 

Cash Flows from Operating Activities:

                        

Net income

   $ 78,418     $ 69,593     $ 55,143  

Adjustments to reconcile net income to net cash provided by operating activities:

                        

Depreciation and amortization

     33,149       26,267       16,440  

Equity income from Skelly-Belvieu Pipeline Company

     (1,344 )     (2,416 )     (3,188 )

Distributions of equity income from Skelly-Belvieu Pipeline Company

     1,344       2,416       3,493  

Changes in operating assets and liabilities:

                        

Increase in receivable from Valero Energy

     (3,414 )     (7,299 )     (2,666 )

Decrease (increase) in accounts receivable

     1,938       (3,831 )     1,353  

Increase in other current assets

     (260 )     (1,098 )     (177 )

Increase (decrease) in payable to Valero Energy

     (5,683 )     9,849       —    

Increase in accrued interest payable

     47       4,441       3,188  

Increase in accounts payable and other accrued liabilities

     4,457       3,571       770  

Increase in taxes other than income taxes

     264       644       2,369  

Other, net

     705       3,451       931  
    


 


 


Net cash provided by operating activities

     109,621       105,588       77,656  
    


 


 


Cash Flows from Investing Activities:

                        

Reliability capital expenditures

     (9,701 )     (10,353 )     (3,943 )

Expansion capital expenditures

     (19,702 )     (21,208 )     (1,761 )

Acquisitions

     (28,085 )     (411,176 )     (75,000 )

Transaction costs related to the proposed acquisition of Kaneb Services, LLC and Kaneb Pipeline Partners, L.P.

     (1,098 )     —         —    

Proceeds from dispositions of property and equipment and other assets

     46       —         —    

Distributions in excess of equity income from Skelly-Belvieu Pipeline Company

     29       387       97  
    


 


 


Net cash used in investing activities

     (58,511 )     (442,350 )     (80,607 )
    


 


 


Cash Flows from Financing Activities:

                        

Proceeds from 6.05% senior note offering, net of discount and issuance costs

     —         247,297       —    

Proceeds from 6.875% senior note offering, net of discount and issuance costs

     —         —         98,207  

Proceeds from other long-term debt borrowings

     43,000       25,000       75,000  

Repayment of long-term debt

     (15,468 )     (25,298 )     (91,164 )

Distributions to unitholders and general partner

     (78,240 )     (65,916 )     (52,843 )

Redemption of common units held by UDS Logistics, LLC

     —         (134,065 )     —    

General partner contributions, net of redemption

     —         2,930       —    

Proceeds from sale of common units to the public, net of issuance costs

     —         269,026       —    

Other

     —         —         (512 )
    


 


 


Net cash provided by (used in) financing activities

     (50,708 )     318,974       28,688  
    


 


 


Net increase (decrease) in cash and cash equivalents

     402       (17,788 )     25,737  

Cash and cash equivalents as of the beginning of year

     15,745       33,533       7,796  
    


 


 


Cash and cash equivalents as of the end of year

   $ 16,147     $ 15,745     $ 33,533  
    


 


 


Supplemental cash flow information:

                        

Cash paid for interest

   $ 24,120     $ 15,701     $ 1,988  

Non-cash adjustment related to the transfer of the Wichita Falls Business to Valero L.P. by Valero Energy:

                        

Property and equipment

   $ —       $ —       $ 64,160  

Accrued liabilities and taxes other than income taxes

     —         —         (382 )

Deferred income tax liabilities

     —         —         (13,147 )

Net parent investment

     —         —         (50,631 )

 

See accompanying notes to consolidated financial statements.

 

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VALERO L.P. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF PARTNERS’ EQUITY

Years Ended December 31, 2004, 2003 and 2002

(in thousands)

 

     Limited Partners

    General
Partner


    Net Parent
Investment


    Total
Partners’
Equity


 
     Common

    Subordinated

       

Balance as of January 1, 2002

   $ 169,305     $ 116,399     $ 5,831     $ 50,631     $ 342,166  

Net income

     26,225       26,081       2,187       650       55,143  

Cash distributions to partners

     (25,585 )     (25,438 )     (1,820 )     —         (52,843 )

Adjustment resulting from the acquisition of the Wichita Falls Business on February 1, 2002

     —         —         —         (51,281 )     (51,281 )

Other

     710       —         —         —         710  
    


 


 


 


 


Balance as of December 31, 2002

     170,655       117,042       6,198       —         293,895  

Net income

     36,832       28,802       3,959       —         69,593  

Cash distributions to partners

     (34,559 )     (27,839 )     (3,518 )     —         (65,916 )

Sales of 7,567,250 common units to the public in March, April and August 2003 and related general partner interest contributions

     269,026       —         5,787       —         274,813  

Redemption of 3,809,750 common units held by UDS Logistics, LLC and related general partner interest redemption

     (134,065 )     —         (2,857 )     —         (136,922 )

Other

     2,700       —         —         —         2,700  
    


 


 


 


 


Balance as of December 31, 2003

     310,589       118,005       9,569       —         438,163  

Net income

     42,290       30,201       5,927       —         78,418  

Cash distributions to partners

     (42,342 )     (30,238 )     (5,660 )     —         (78,240 )

Other

     (30 )     —         —         —         (30 )
    


 


 


 


 


Balance as of December 31, 2004

   $ 310,507     $ 117,968     $ 9,836     $ —       $ 438,311  
    


 


 


 


 


 

See accompanying notes to consolidated financial statements.

 

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VALERO L.P. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Years Ended December 31, 2004, 2003 and 2002

 

NOTE 1: Organization, Operations and Significant Organizational Transactions

 

Organization

 

Valero L.P., a Delaware limited partnership, through its wholly owned subsidiary, Valero Logistics Operations, L.P. (Valero Logistics), owns and operates crude oil and refined product pipeline and terminalling assets that serve Valero Energy Corporation’s (Valero Energy) McKee, Three Rivers, Corpus Christi East and Corpus Christi West refineries located in Texas, the Paulsboro refinery located in New Jersey, the Denver refinery in Colorado and the Ardmore refinery located in Oklahoma. Valero Logistics also owns and operates crude oil storage tanks that serve Valero Energy’s Corpus Christi West and Texas City refineries located in Texas and the Benicia refinery located in California. The pipeline, terminalling and storage tank assets provide for the transportation of crude oil and other feedstocks to the refineries and the transportation of refined products from the refineries to terminals or third-party pipelines for further distribution. Revenues of Valero L.P. and its subsidiaries are earned primarily from providing these services to Valero Energy (see Note 11: Related Party Transactions).

 

As used in this report, the term Valero L.P. may refer, depending on the context, to Valero L.P., Valero Logistics, or both of them taken as a whole. Riverwalk Logistics, L.P., a wholly owned subsidiary of Valero Energy, is the 2% general partner of Valero L.P. Valero Energy, through various affiliates, is also a limited partner in Valero L.P., resulting in a combined limited partner ownership of 43.7%. The remaining 54.3% limited partnership interest is held by public unitholders.

 

Valero Energy, an independent refining and marketing company, owns and operates 15 refineries with a combined total throughput capacity as of December 31, 2004 of approximately 2.5 million barrels per day. Valero Energy’s refining operations rely on various logistics assets (pipelines, terminals, marine dock facilities, bulk storage facilities, refinery delivery racks and rail car loading equipment) that support its refining and retail operations, including the logistics assets owned and operated by Valero L.P. Valero Energy markets the refined products produced at its McKee, Three Rivers, Corpus Christi East, Corpus Christi West, Texas City, Benicia, Paulsboro, Denver and Ardmore refineries primarily in Texas, Oklahoma, Colorado, New Mexico, Arizona, California, New Jersey and several other mid-continent states through a network of company-operated and dealer-operated convenience stores, as well as through other wholesale and spot market sales and exchange agreements.

 

Operations

 

Valero L.P.’s operations include interstate and intrastate pipelines, which are subject to extensive federal and state environmental and safety regulations. In addition, the pipeline tariffs and practices under which Valero L.P. offers interstate and intrastate transportation services with its pipelines are subject to regulation by the Federal Energy Regulatory Commission (FERC), the Texas Railroad Commission or the Colorado Public Utility Commission, depending on the location of the pipeline. Tariffs and practices for each pipeline are required to be filed with the respective commission upon completion of a pipeline and when a tariff is being revised. In addition, the regulations include annual reporting requirements for each pipeline.

 

Valero L.P. has an ownership interest in 24 refined product pipelines with an aggregate length of 3,795 miles and a 25-mile crude hydrogen pipeline. Valero L.P. also has an ownership interest in 9 crude oil pipelines with an aggregate length of 783 miles and 4 crude oil storage facilities with a total storage capacity of 1.7 million barrels that are connected to the crude oil pipelines. Valero L.P. operates all but three of the pipelines.

 

Valero L.P. owns 22 refined product terminals with a total storage capacity of 4.5 million barrels in 204 tanks. Valero L.P. also owns an additional 4 crude oil storage tank operations with a total storage capacity of 12.5 million barrels in 60 tanks.

 

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Table of Contents
Index to Financial Statements

VALERO L.P. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

Significant Organizational Transactions

 

On February 1, 2002, Valero L.P. acquired the Wichita Falls Crude Oil Pipeline and Storage Business (the Wichita Falls Business) from Valero Energy for $64.0 million. Since Valero L.P. and the Wichita Falls Business came under the common control of Valero Energy commencing on December 31, 2001, the acquisition represented a reorganization of entities under common control. As a result, the statements of income and cash flows for the year ended December 31, 2002 reflect the operations of the Wichita Falls Business for the entire year.

 

On March 31, 2003, Valero Logistics and its general partner, Valero GP, Inc., formed Valero Internacional, S .de R.L. de C.V., a Mexican limited liability company, to own and operate a propane terminal in Nuevo Laredo, Mexico. The propane terminal became operational on June 1, 2004.

 

Proposed Transaction

 

On October 31, 2004, Valero L.P. and Kaneb Services LLC (KSL), a Delaware limited liability company (and parent company of the general partner of Kaneb Pipe Line Partners, L.P.), and certain of their respective affiliated parties entered into a definitive merger agreement (the KSL Agreement), pursuant to which a wholly owned subsidiary of Valero L.P. will merge with KSL, with the surviving entity being a wholly owned subsidiary of Valero L.P. (the KSL Merger) Under the terms of the KSL Agreement, upon completion of the KSL Merger each KSL common share will be converted into the right to receive $43.31 in cash.

 

Also on October 31, 2004, Valero L.P. and Kaneb Pipe Line Partners, L.P., a Delaware limited partnership (KPP) and certain of their respective affiliated parties entered into a separate definitive merger agreement (the KPP Agreement), pursuant to which a wholly owned subsidiary of Valero L.P. will merge with KPP, with the surviving entity being a wholly owned subsidiary of Valero L.P. (the KPP Merger, and together with the KSL Merger, the Kaneb Mergers) Under the terms of the KPP Agreement, upon completion of the KPP Merger each KPP unit will be converted into the right to receive a number of Valero L.P. common units based on an exchange ratio formula providing Valero L.P. common units worth $61.50 per KPP unit within a specified “collar” range of Valero L.P. common unit market prices (plus or minus five percent of $57.25), measured over a period prior to closing. Should Valero L.P.’s average per unit price during the measurement period be equal to or less than $54.39 per unit, the exchange ratio will be fixed at 1.1307 Valero L.P. common units for each KPP unit. Should Valero L.P.’s average per unit price during the measurement period be equal to or exceed $60.11 per unit, the exchange ratio will be fixed at 1.0231 Valero L.P. common units for each KPP unit.

 

The completion of each of the KPP Merger and the KSL Merger is subject to the approval of a majority of the unitholders of each of Valero L.P. and KPP, as well as a majority of the shareholders of KSL, respectively (see Note 16: Subsequent Events). Further, the Kaneb Mergers are both contingent upon each other and are subject to customary regulatory approvals including those under the Hart-Scott-Rodino Antitrust Improvements Act.

 

NOTE 2: Summary of Significant Accounting Policies

 

Consolidation: The accompanying consolidated financial statements represent the consolidated operations of Valero L.P. and its subsidiaries. All inter-partnership transactions have been eliminated in consolidation. In addition, the operations of certain crude oil and refined product pipelines and refined product terminals in which Valero L.P. owns an undivided interest, are proportionately consolidated in the accompanying consolidated financial statements.

 

Use of Estimates: The preparation of consolidated financial statements in accordance with United States generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. On an ongoing basis, management reviews its estimates based on currently available information. Changes in facts and circumstances may result in revised estimates.

 

Cash and Cash Equivalents: All highly liquid investments with an original maturity of three months or less when purchased are considered to be cash equivalents.

 

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Index to Financial Statements

VALERO L.P. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

Property and Equipment: Property and equipment is stated at cost. Additions to property and equipment, including reliability and expansion capital expenditures and capitalized interest, are recorded at cost. Reliability capital expenditures represent capital expenditures to replace partially or fully depreciated assets to maintain the existing operating capacity of existing assets and extend their useful lives. Expansion capital expenditures represent capital expenditures to expand the operating capacity of existing assets, whether through construction or acquisition. Repair and maintenance costs associated with existing assets that are minor in nature and do not extend the useful life of existing assets are charged to operating expenses as incurred. Depreciation is provided using the straight-line method over the estimated useful lives of the related assets. When property and equipment is retired or otherwise disposed of, the difference between the carrying value and the net proceeds is recognized as gain or loss in the consolidated statement of income in the year retired.

 

Impairment of Long-Lived Assets: Long-lived assets, including property and equipment, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. The evaluation of recoverability is performed using undiscounted estimated net cash flows generated by the related asset. If an asset is deemed to be impaired, the amount of impairment is determined as the amount by which the net carrying value exceeds discounted estimated net cash flows.

 

Asset Retirement Obligations: Effective January 1, 2003, Valero L.P. adopted Statement No. 143, “Accounting for Asset Retirement Obligations,” which establishes financial accounting and reporting standards for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The provisions of this statement apply to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and/or the normal operation of a long-lived asset, except for certain obligations of lessees.

 

Valero L.P. has determined that it is obligated by contractual or regulatory requirements to remove assets or perform other remediation upon retirement of certain assets. However, the fair value of the asset retirement obligation cannot currently be reasonably estimated as of December 31, 2004, because the settlement dates are indeterminate. Valero L.P. will record an asset retirement obligation in the periods in which it can reasonably determine the settlement dates. Accordingly, neither Valero L.P.’s financial position as of December 31, 2004 nor its results of operations for the years ended December 31, 2004 and 2003 have been impacted.

 

Goodwill: Goodwill represents the excess of cost over the fair value of net assets acquired in 1997. Beginning January 1, 2002, goodwill is not amortized but is tested for impairment annually or more frequently if events or changes in circumstances indicate that the goodwill might be impaired. Valero L.P. uses October 1 of each year as its annual valuation date for the impairment test. Based on the results of the impairment tests performed as of October 1, 2004, 2003 and 2002, no impairment had occurred.

 

Investment in Skelly-Belvieu Pipeline Company, LLC: Formed in 1993, the Skelly-Belvieu Pipeline Company, LLC (Skelly-Belvieu Pipeline Company) owns a liquefied petroleum gas pipeline that begins in Skellytown, Texas and extends to Mont Belvieu, Texas near Houston. Skelly-Belvieu Pipeline Company is owned 50% by Valero L.P. and 50% by ConocoPhillips. Valero L.P. accounts for this investment under the equity method of accounting.

 

Deferred Financing Costs: Deferred financing costs are amortized over the life of the related debt obligation using the effective interest method and are included in other noncurrent assets in the consolidated balance sheets.

 

Environmental Remediation Costs: Environmental remediation costs are expensed and an associated accrual established when site restoration and environmental remediation and cleanup obligations are either known or considered probable and can be reasonably estimated. Accrued liabilities are based on estimates of probable undiscounted future costs over a 20-year time period using currently available technology and applying current regulations, as well as Valero L.P.’s own internal environmental policies. The environmental liabilities have not been reduced by possible recoveries from third parties. Environmental costs include initial site surveys, costs for remediation and restoration and ongoing monitoring costs, as well as fines, damages and

 

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Table of Contents
Index to Financial Statements

VALERO L.P. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

other costs, when estimable. Adjustments to initial estimates are recorded, from time to time, to reflect changing circumstances and estimates based upon additional information developed in subsequent periods.

 

Revenue Recognition: Revenues are derived from interstate and intrastate pipeline transportation of refined products and crude oil, terminalling, blending and filtering of refined products and the movement of crude oil and other refinery feedstocks through crude oil storage tanks (see Note 11: Related Party Transactions).

 

Transportation revenues (based on pipeline tariffs) are recognized as refined product or crude oil is delivered through the pipelines. The costs of the four crude oil storage facilities associated with the crude oil pipelines are considered in establishing the tariffs charged for transporting crude oil from the storage facilities to the refineries.

 

Terminalling revenues (based on a terminalling fee) are recognized as refined products move through the terminal and as additives are blended with refined products. In addition to the throughput fee, Valero L.P. also charges a storage capacity fee at the Pittsburg asphalt terminal and a filtering fee for jet fuel terminalled at the Houston Hobby Airport terminal.

 

Crude oil storage tank revenues are recognized as crude oil and certain other refinery feedstocks are received by the related refinery.

 

Federal and State Income Taxes: Valero L.P. and Valero Logistics are limited partnerships and are not subject to federal or state income taxes. Accordingly, the taxable income or loss of Valero L.P. and Valero Logistics, which may vary substantially from income or loss reported for financial reporting purposes, is generally includable in the federal and state income tax returns of the individual partners. For transfers of publicly held units subsequent to the initial public offering, Valero L.P. has made an election permitted by section 754 of the Internal Revenue Code to adjust the common unit purchaser’s tax basis in Valero L.P.’s underlying assets to reflect the purchase price of the units. This results in an allocation of taxable income and expense to the purchaser of the common units, including depreciation deductions and gains and losses on sales of assets, based upon the new unitholder’s purchase price for the common units.

 

The Wichita Falls Business was included in UDS’ (now Valero Energy’s) consolidated federal and state income tax returns. Deferred income taxes were computed based on recognition of future tax expense or benefits, measured by enacted tax rates that were attributable to taxable or deductible temporary differences between financial statement and income tax reporting bases of assets and liabilities. No recognition was given to federal or state income taxes associated with the Wichita Falls Business for financial statement purposes for periods subsequent to its acquisition by Valero L.P. The deferred income tax liabilities related to the Wichita Falls Business as of February 1, 2002 were retained by Valero Energy and were credited to net parent investment upon the transfer of the Wichita Falls Business to Valero L.P.

 

Partners’ Equity: Valero L.P.’s partners’ equity consists of common units, primarily held by public unitholders, subordinated units held by UDS Logistics, LLC, a wholly owned subsidiary of Valero Energy, and a 2% general partner interest held by Riverwalk Logistics, L.P. In addition, Valero GP, LLC, the general partner of Riverwalk Logistics, L.P. and an affiliate of Valero Energy, holds Valero L.P. common units to settle awards of restricted common units previously issued to employees, officers and directors of Valero GP, LLC. UDS Logistics, LLC also holds common units. The common units held by the public represent a 54.3% ownership interest in Valero L.P. as of December 31, 2004.

 

Net Parent Investment: The net parent investment as of January 1, 2002 as reflected on the Consolidated Statements of Partners’ Equity represents the historical cost to Valero Energy, net of deferred income tax liabilities and certain other accrued liabilities, related to the Wichita Falls Business. The Wichita Falls Business was consolidated with Valero L.P. as of December 31, 2001 as a result of a reorganization of entities under common control in connection with the acquisition of the Wichita Falls Business by Valero L.P. (see Note 1: Organization, Operations and Significant Organizational Transactions).

 

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Index to Financial Statements

VALERO L.P. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

Income Allocation: Valero L.P.’s net income for each quarterly reporting period is first allocated to the general partner in an amount equal to the general partner’s incentive distribution declared for the respective reporting period. The remaining net income is allocated among the limited and general partners in accordance with their respective 98% and 2% interests.

 

Net Income per Unit Applicable to Limited Partners: Valero L.P. has identified the general partner and the subordinated units as participating securities and uses the two-class method when calculating the net income per unit applicable to limited partners, which is based on the weighted-average number of common and subordinated units outstanding during the period. Net income per unit applicable to limited partners is computed by dividing net income applicable to limited partners, after deducting the general partner’s 2% interest and incentive distributions, by the weighted-average number of limited partnership units outstanding. Basic and diluted net income per unit applicable to limited partners is the same because Valero L.P. has no potentially dilutive securities outstanding. The general partner’s incentive distribution allocation for the years ended December 31, 2004, 2003 and 2002 was $4.4 million, $2.6 million and $1.1 million, respectively. The amount of net income per unit allocated to common units was equal to the amount allocated to the subordinated units for the years presented (see Note 13: Partners’ Equity, Allocations of Net Income and Cash Distributions).

 

Risk Management Activities: Beginning in 2003, Valero L.P. entered into interest rate swap agreements for the purpose of hedging the interest rate risk associated with a portion of its fixed-rate senior notes. Valero L.P. accounts for the interest rate swaps as fair value hedges and recognizes the fair value of each interest rate swap in the consolidated balance sheet as either an asset or liability. Changes in the fair value of the interest rate swaps, along with the offsetting gain or loss on the debt that is being hedged, are recognized currently in the consolidated statement of income as an adjustment to interest expense.

 

Reclassifications: Certain previously reported amounts in the 2003 consolidated financial statements have been reclassified to conform to the 2004 presentation.

 

NOTE 3: Equity and Debt Offerings, Redemption of Common Units and Related Transactions

 

March 2003 Common Unit Offering

 

On March 18, 2003, Valero L.P. consummated a public offering of common units, selling 5,750,000 common units to the public at $36.75 per unit, before underwriters’ discount of $1.56 per unit. Net proceeds were $202.3 million, or $35.19 per unit, before offering expenses of $2.0 million. In order to maintain a 2% general partner interest, Riverwalk Logistics, L.P. contributed $4.3 million to Valero L.P. The net proceeds of the common unit offering and the general partner contribution were primarily used to fund the acquisition of the Crude Oil Storage Tanks (see Note 4: Acquisitions).

 

On April 16, 2003, Valero L.P. closed on the exercise of a portion of the underwriters’ over-allotment option, by selling 581,000 common units at $35.19 per unit. Net proceeds from this sale were $20.4 million and Riverwalk Logistics, L.P. contributed $0.5 million to maintain its 2% general partner interest. The common unit proceeds and general partner contribution were used to pay down the then outstanding balance on the revolving credit facility.

 

Private Placement of 6.05% Senior Notes and Revolving Credit Facility

 

Also on March 18, 2003, concurrent with the closing of the common unit offering, Valero Logistics issued, in a private placement to institutional investors, $250.0 million of 6.05% senior notes, at a price of 99.719% before consideration of debt issuance costs of $2.0 million. In addition, Valero Logistics borrowed $25.0 million under its $175.0 million revolving credit facility. The net proceeds from the 6.05% senior notes and borrowings under the revolving credit facility were used to redeem common units held by UDS Logistics, LLC, redeem a related portion of the general partner interest and partially fund the acquisition of the South Texas Pipelines and Terminals (see Note 4: Acquisitions).

 

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Index to Financial Statements

VALERO L.P. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

Redemption of Common Units and Amendment to Partnership Agreement

 

On March 18, 2003, subsequent to the common unit offering and private placement of 6.05% senior notes discussed above, Valero L.P. redeemed from UDS Logistics, LLC 3,809,750 common units at a total cost of $134.1 million, or $35.19 per unit. In order to maintain a 2% general partner interest, Valero L.P. redeemed a portion of Riverwalk Logistics, L.P.’s general partner interest at a total cost of $2.9 million. In addition to the redemption transaction, Valero L.P. amended its partnership agreement to reduce the vote required to remove the general partner from 66 2/3% to 58% of its outstanding units and to exclude from participating in such a vote the common and subordinated units held by affiliates of the general partner.

 

August 2003 Common Unit Offering

 

On August 11, 2003, Valero L.P. consummated a public offering of common units, selling 1,236,250 common units, which included 161,250 common units related to the underwriter’s over-allotment option, to the public at $41.15 per unit, before underwriter’s discount of $1.85 per unit. Net proceeds were $48.6 million, or $39.30 per unit, before offering expenses of $0.3 million. In order to maintain its 2% general partner interest, Riverwalk Logistics, L.P. contributed $1.0 million to Valero L.P. The net proceeds of the common unit offering and the general partner contribution were primarily used to fund the acquisitions of the Southlake refined product pipeline and the Paulsboro refined product terminal (see Note 4: Acquisitions).

 

Summary of 2003 Transactions

 

The net proceeds from the 2003 common unit offerings, the private placement of 6.05% senior notes and the borrowings under the revolving credit facility were used to redeem common units held by UDS Logistics, LLC, repay the outstanding balance under the revolving credit facility and pay for asset and business acquisitions completed during 2003. A summary of the proceeds received and use of proceeds is as follows (in thousands):

 

Proceeds received:

        

March, April and August sales of common units to the public, including underwriters’ over-allotment options

   $ 271,372  

Private placement of 6.05% senior notes

     249,298  

Borrowings under the revolving credit facility

     25,000  

General partner contributions

     5,787  
    


Total proceeds

     551,457  
    


Use of proceeds:

        

South Texas Pipelines and Terminals

     150,115  

Crude Oil Storage Tanks

     200,198  

Southlake Refined Product Pipeline

     29,911  

Paulsboro Refined Product Terminal

     14,055  

Redemption of common units

     134,065  

Repayment of borrowings under the revolving credit facility

     25,000  

Redemption of general partner interest

     2,857  

Professional fees and other costs of equity issuance

     2,346  

Debt issuance costs

     2,001  
    


Total use of proceeds

     560,548  
    


Net cash on hand paid out

   $ (9,091 )
    


 

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Index to Financial Statements

VALERO L.P. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

NOTE 4: Acquisitions

 

Completed During 2004

 

Royal Trading Asphalt Terminals

 

On February 20, 2004, Valero L.P. acquired two asphalt terminals, one in Catoosa, Oklahoma near Tulsa and one in Rosario, New Mexico near Santa Fe, from Royal Trading Company (Royal Trading) for $28.1 million. These terminals have an aggregate storage capacity of 500,000 barrels in 32 tanks and six loading stations. The purchase price was allocated to the individual tangible and identifiable intangible assets acquired based on their fair values as determined by an independent appraisal.

 

In conjunction with the Royal Trading acquisition, Valero L.P. entered into a five-year terminal storage and throughput agreement with Valero Energy. The agreement provides a base throughput and blending fee schedule with volume incentive discounts once certain thresholds are met. In addition, Valero Energy has agreed to utilize the acquired terminals for a minimum of 18.5% of the McKee and Ardmore refineries’ asphalt production. The results of operations for these two terminals are included in the consolidated statements of income commencing on February 20, 2004.

 

The pro forma financial information for the years ended December 31, 2004 and 2003 that give effect to the acquisition of Royal Trading as of January 1, 2004 and 2003 has not been disclosed, as the effect is not significant.

 

Completed During 2003

 

Telfer Asphalt Terminal

 

On January 7, 2003, Valero L.P. completed its acquisition of Telfer Oil Company’s (Telfer) Pittsburg, California asphalt terminal for $15.3 million. The asphalt terminal includes two storage tanks with a combined storage capacity of 350,000 barrels, six 5,000-barrel polymer modified asphalt tanks, a truck rack, rail facilities and various other tanks and equipment. In conjunction with the Telfer acquisition, Valero L.P. entered into a six-year Terminal Storage and Throughput Agreement with Valero Energy. A portion of the purchase price represented payment to the principal owner of Telfer for a non-compete agreement and for the lease of certain facilities adjacent to the terminal operations.

 

South Texas Pipelines and Terminals

 

On March 18, 2003, Valero Energy contributed the South Texas pipeline system to Valero L.P. for $150.1 million, including transaction costs. The South Texas pipeline system was comprised of the Houston pipeline system, the Valley pipeline system and the San Antonio pipeline system (together referred to as the South Texas Pipelines and Terminals). In conjunction with the South Texas Pipelines and Terminals acquisition, Valero L.P. entered into several agreements with Valero Energy (see Note 11: Related Party Transactions).

 

The following unaudited pro forma financial information assumes that the South Texas Pipelines and Terminals acquisition was funded with $111.0 million of net proceeds from the issuance of the 6.05% senior notes, $25.0 million of borrowings under the revolving credit facility, $6.7 million of net proceeds from the issuance of 185,422 common units and the related general partner capital contribution and $7.4 million of available cash.

 

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Index to Financial Statements

VALERO L.P. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

The unaudited pro forma financial information for the years ended December 31, 2003 and 2002, assumes that the South Texas Pipelines and Terminals acquisition occurred on January 1, 2003 and 2002, respectively.

 

     Years Ended December 31,

     2003

   2002

     (in thousands, except per unit data)

Revenues

   $ 187,294    $ 146,355

Operating income

     85,028      63,072

Net income

     69,930      53,500

Net income per unit applicable to limited partners

     3.03      2.61

 

Crude Oil Storage Tanks

 

On March 18, 2003, Valero Energy contributed 58 crude oil storage tanks and related assets (the Crude Oil Storage Tanks) to Valero L.P. for $200.2 million, including transaction costs. The Crude Oil Storage Tanks consisted of certain tank shells, foundations, tank valves, tank gauges, pressure equipment, temperature equipment, corrosion protection, leak detection, tank lighting and related equipment located at Valero Energy’s Corpus Christi West refinery, Texas City refinery and Benicia refinery.

 

Historically, the Crude Oil Storage Tanks were operated as part of Valero Energy’s refining operations and, as a result, no separate fee was charged related to these assets and, accordingly, no revenues were recorded by Valero Energy. The Crude Oil Storage Tanks were not accounted for separately by Valero Energy and were not operated as an autonomous business unit. As a result, the purchase of the Crude Oil Storage Tanks represented an asset acquisition and, therefore, no pro forma impact of this transaction has been included above. In conjunction with the Crude Oil Storage Tanks acquisition, Valero L.P. entered into several agreements with Valero Energy (see Note 11: Related Party Transactions).

 

Shell Pipeline Interest

 

On May 1, 2003, Valero L.P. acquired Shell Pipeline Company, LP’s (Shell) 28% undivided interest in the Amarillo to Abernathy refined product pipeline and Shell’s 46% undivided interest in the Abernathy to Lubbock refined product pipeline for $1.6 million. After this acquisition, Valero L.P. owns a 67% undivided interest and ConocoPhillips owns the remaining 33% undivided interest in the Amarillo to Abernathy refined product pipeline and Valero L.P. owns a 46% undivided interest and ConocoPhillips owns the remaining 54% undivided interest in the Abernathy to Lubbock refined product pipeline.

 

Southlake Refined Product Pipeline

 

Effective August 1, 2003, Valero L.P. acquired the Southlake refined product pipeline from Valero Energy for $29.9 million. The pipeline, which has a capacity of 27,300 barrels per day, is a 375-mile pipeline connecting Valero Energy’s McKee refinery to Valero L.P.’s Southlake refined product terminal near Dallas, Texas.

 

Paulsboro Refined Product Terminal

 

On September 3, 2003, Valero L.P. acquired the Paulsboro refined product terminal from ExxonMobil Oil Corporation for $14.1 million. The Paulsboro refined product terminal is located in Paulsboro, New Jersey, next to Valero Energy’s Paulsboro refinery. The terminal has a storage capacity of 90,800 barrels.

 

Purchase Price Allocations for 2003 Acquisitions

 

The purchase prices for the Telfer, South Texas Pipelines and Terminals, Crude Oil Storage Tanks, Shell, Southlake and Paulsboro acquisitions were allocated based on the fair values of the individual assets acquired at the date of acquisition.

 

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Index to Financial Statements

VALERO L.P. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

The South Texas Pipelines and Terminals and the Crude Oil Storage Tanks acquisitions were approved by the conflicts committee of the board of directors of Valero GP, LLC, the general partner of Riverwalk Logistics, L.P., based in part on an opinion from its independent financial advisor that the consideration paid by Valero L.P. was fair, from a financial point of view, to Valero L.P. and its public unitholders. The conflicts committee also approved the acquisition of the Southlake refined product pipeline by Valero L.P. from Valero Energy.

 

The following summarizes the purchase price allocation of the assets acquired in 2003:

 

     Property
and
equipment


   Intangible
assets


   Total

     (in thousands)

Telfer (Pittsburg) Asphalt Terminal

   $ 15,047    $ 250    $ 15,297

South Texas Pipelines and Terminals

     149,575      540      150,115

Crude Oil Storage Tanks

     200,198      —        200,198

Shell Pipeline Interest

     1,600      —        1,600

Southlake Refined Product Pipeline

     29,911      —        29,911

Paulsboro Refined Product Terminal

     14,055      —        14,055
    

  

  

Total Purchase Price Allocations

   $ 410,386    $ 790    $ 411,176
    

  

  

 

Completed During 2002

 

Wichita Falls Business

 

On February 1, 2002, Valero L.P. acquired the Wichita Falls Business from Valero Energy for a total cost of $64.0 million, which Valero L.P. had an option to purchase pursuant to the Omnibus Agreement between Valero L.P. and Valero Energy (see Note 11: Related Party Transactions). The purchase price was funded with borrowings under Valero Logistics’ revolving credit facility.

 

The Wichita Falls Business consisted of the following assets:

 

    A 272-mile crude oil pipeline originating in Wichita Falls, Texas and ending at Valero Energy’s McKee refinery in Dumas, Texas. The Wichita Falls crude oil pipeline connects to third-party pipelines that originate along the Texas Gulf Coast; and

 

    Four crude oil storage tanks located in Wichita Falls, Texas.

 

Since the acquisition of the Wichita Falls Business represented the transfer of a business between entities under the common control of Valero Energy, the consolidated balance sheet as of December 31, 2001 and the statements of income and cash flows for the month ended January 31, 2002 (preceding the acquisition date) were restated to include the Wichita Falls Business.

 

As discussed in Note 2: Summary of Significant Accounting Policies, Valero L.P. and Valero Logistics are limited partnerships and are not subject to federal or state income taxes. However, the Wichita Falls Business was subject to federal and state income taxes prior to its acquisition on February 1, 2002. The $0.4 million of income tax expense included in the consolidated statement of income for the year ended December 31, 2002 represents the Wichita Falls Business’ income tax expense for the month ended January 31, 2002, which was calculated as if the Wichita Falls Business filed a separate federal and state income tax return.

 

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Index to Financial Statements

VALERO L.P. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

The balance sheet of the Wichita Falls Business as of December 31, 2001, which was included in the consolidated balance sheet of Valero L.P. as of December 31, 2001, is summarized below, as well as, a reconciliation to the adjustment recorded when the acquisition was consummated on February 1, 2002.

 

    

Wichita Falls

Business


 
     (in thousands)  

Balance Sheet as of December 31, 2001:

        

Property and equipment

   $ 64,160  

Accounts payable and accrued liabilities

     (131 )

Taxes other than income taxes

     (251 )

Deferred income tax liabilities

     (13,147 )
    


Net parent investment as of December 31, 2001

     50,631  

Net income for the month ended January 31, 2002

     650  
    


Adjustment resulting from the acquisition of the Wichita Falls Business on February 1, 2002

   $ 51,281  
    


 

Crude Hydrogen Pipeline

 

In May 2002, Valero Energy completed the construction of a 30-mile pure hydrogen pipeline, which originates at Valero Energy’s Texas City refinery and ends at Praxair, Inc.’s La Porte, Texas plant. The total cost to construct the pipeline was $11.0 million.

 

On May 29, 2002, Valero L.P. acquired the 30-mile pure hydrogen pipeline from Valero Energy for $11.0 million, which was funded with borrowings under Valero Logistics’ revolving credit facility. Valero L.P. then exchanged, on May 29, 2002, this 30-mile pure hydrogen pipeline for Praxair, Inc.’s 25-mile crude hydrogen pipeline, which originates at BOC’s (successor to Celanese Ltd.) chemical facility in Clear Lake, Texas and ends at Valero Energy’s Texas City refinery in Texas City, Texas, under an exchange agreement previously negotiated between Valero Energy and Praxair, Inc. In conjunction with the exchange, Valero L.P. entered into an operating agreement with Praxair, Inc. whereby Praxair, Inc. will operate the pipeline for an annual fee of $0.1 million, plus reimbursement of repair, replacement and relocation costs.

 

Valero Energy owns the crude hydrogen transported in the pipeline, and the transportation services provided by Valero L.P. to Valero Energy are subject to a hydrogen tolling agreement. The hydrogen tolling agreement provides that Valero Energy will pay Valero L.P. minimum annual revenues of $1.4 million for transporting crude hydrogen.

 

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Index to Financial Statements

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

NOTE 5: Property and Equipment

 

Property and equipment, at cost, consisted of the following:

 

     Estimated
Useful
Lives


   December 31,

 
        2004

    2003

 
     (years)    (in thousands)  

Land

   -    $ 8,526     $ 6,151  

Land and leasehold improvements

   20      3,942       341  

Buildings

   35      10,464       10,319  

Pipeline and equipment

   3 - 40      876,905       828,247  

Rights of way

   20 - 35      68,446       50,087  

Construction in progress

   -      13,077       33,741  
         


 


Total

          981,360       928,886  

Less accumulated depreciation and amortization

          (196,361 )     (163,884 )
         


 


Property and equipment, net

        $ 784,999     $ 765,002  
         


 


 

Capitalized interest costs included in property and equipment were $0.2 million, $0.1 million and $0.3 million for the years ended December 31, 2004, 2003 and 2002, respectively.

 

NOTE 6: Investment in Skelly-Belvieu Pipeline Company

 

The following presents summarized unaudited financial information related to Skelly-Belvieu Pipeline Company as of December 31, 2004 and 2003 and for the years ended December 31, 2004, 2003 and 2002:

 

     December 31,

     2004

   2003

     (in thousands)

Balance Sheet Information:

             

Current assets

   $ 2,928    $ 1,712

Property, plant and equipment, net

     45,235      47,254
    

  

Total assets

   $ 48,163    $ 48,966
    

  

Current liabilities

   $ 378    $ 351

Members’ equity

     47,785      48,615
    

  

Total liabilities and members’ equity

   $ 48,163    $ 48,966
    

  

 

     Years Ended December 31,

     2004

   2003

   2002

     (in thousands)

Statement of Income Information:

                    

Revenues

   $ 9,355    $ 11,613    $ 12,849

Net income

     1,916      4,062      5,605

Valero L.P.’s share of net income

     1,344      2,416      3,188

Valero L.P.’s share of distributions

     1,373      2,803      3,590

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

The excess of Valero L.P.’s 50% share of members’ equity over the carrying value of its investment is attributable to the step-up in basis to fair value of property and equipment of the initial contribution to Skelly-Belvieu Pipeline Company. This excess, which totaled $8.2 million as of December 31, 2004 and $8.6 million as of December 31, 2003, is being accreted into income over the average life of the assets held by Skelly-Belvieu, or 33 years.

 

NOTE 7: Long-term Debt

 

Long-term debt consisted of the following:

 

     December 31,

 
     2004

    2003

 
     (in thousands)  

6.05% senior notes due 2013, net of unamortized discount of $577 in 2004 and $647 in 2003 and a fair value adjustment of $441 in 2004 and $2,759 in 2003

   $ 248,982     $ 246,594  

6.875% senior notes due 2012, net of unamortized discount of $237 in 2004 and $268 in 2003 and a fair value adjustment of $776 in 2004 and $1,794 in 2003

     98,987       97,938  

Port Authority of Corpus Christi note payable

     9,192       9,660  

Revolving credit facility (3.4% borrowing rate at December 31, 2004)

     28,000       —    
    


 


Total debt

     385,161       354,192  

Less current portion

     (990 )     (935 )
    


 


Long-term debt, less current portion

   $ 384,171     $ 353,257  
    


 


 

The long-term debt repayments are due as follows (in thousands):

 

2005

   $ 990  

2006

     28,566  

2007

     611  

2008

     660  

2009

     713  

Thereafter

     355,652  
    


Total repayments

     387,192  

Less unamortized discount and fair value adjustment

     (2,031 )
    


Total debt

   $ 385,161  
    


 

Interest payments totaled $24.1 million, $15.7 million and $2.0 million for the years ended December 31, 2004, 2003 and 2002, respectively.

 

Valero L.P. has no operations and its assets consist mainly of its investment in Valero Logistics, which owns and operates pipelines, terminals and storage tanks. Valero L.P. has fully and unconditionally guaranteed the senior notes issued by Valero Logistics and any obligations under Valero Logistics’ revolving credit facility.

 

6.05% Senior Notes

 

On March 18, 2003, Valero Logistics completed the sale of $250.0 million of 6.05% senior notes, issued in a private placement to institutional investors, for total proceeds of $249.3 million, before debt issuance costs of $2.0 million. The 6.05% senior notes do not have sinking fund requirements. Interest on the 6.05% senior notes is payable semi-annually in arrears on March 15th and September 15th of each year beginning September 15, 2003.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

Although the 6.05% senior notes were not initially registered under the Securities Act of 1933 or any other securities laws, Valero Logistics closed on the exchange of the outstanding $250.0 million 6.05% senior notes that were not registered for $250.0 million of 6.05% senior notes that have been registered under the Securities Act of 1933 in July 2003.

 

6.875% Senior Notes

 

On July 15, 2002, Valero Logistics completed the sale of $100.0 million of 6.875% senior notes for total proceeds of $99.7 million before debt issuance costs of $1.5 million. The net proceeds were used to repay the $91.0 million then outstanding under the revolving credit facility. The 6.875% senior notes do not have sinking fund requirements. Interest on the 6.875% senior notes is payable semi-annually in arrears on January 15 and July 15 of each year.

 

Both Series of Senior Notes

 

The 6.05% senior notes and the 6.875% senior notes rank equally with existing senior unsecured indebtedness of Valero Logistics, including indebtedness under the revolving credit facility. Both series of senior notes contain restrictions on Valero Logistics’ ability to incur secured indebtedness unless the same security is also provided for the benefit of holders of the senior notes. In addition, the senior notes limit Valero Logistics’ ability to incur indebtedness secured by certain liens and to engage in certain sale-leaseback transactions. Also, both series of senior notes are irrevocably and unconditionally guaranteed on a senior unsecured basis by Valero L.P. The guarantee by Valero L.P. ranks equally with all of its existing unsecured and unsubordinated indebtedness and is required to rank equally with any future unsecured and unsubordinated indebtedness. At the option of Valero Logistics, each of the series of senior notes may be redeemed in whole or in part at any time at a redemption price, which includes a make-whole premium, plus accrued and unpaid interest to the redemption date.

 

The senior notes also include a change-in-control provision, which requires (1) that Valero Energy or an investment grade entity own, directly or indirectly, 51% of the general partner interests of Valero L.P. and (2) that Valero L.P. or an investment grade entity own, directly or indirectly, all of the general partner and limited partner interests in Valero Logistics. Otherwise, Valero Logistics must offer to purchase the senior notes at a price equal to 100% of their outstanding principal balance plus accrued interest through the date of purchase.

 

Revolving Credit Facility

 

On December 15, 2000, Valero Logistics entered into a $120.0 million revolving credit facility, which expires on January 15, 2006. At Valero Logistics’ option, borrowings under the revolving credit facility bear interest based on either an alternative base rate or LIBOR, which was 3.4% as of December 31, 2004. Valero Logistics also incurs a facility fee on the aggregate commitments of lenders under the revolving credit facility, whether used or unused. Borrowings under the revolving credit facility may be used for working capital and general partnership purposes. Borrowings to fund distributions to unitholders, however, were originally limited to $25.0 million with such borrowings required to be reduced to zero for a period of at least 15 consecutive days during each fiscal year.

 

On March 6, 2003, Valero Logistics entered into an amended revolving credit facility with the various banks included in the existing revolving credit facility and with a group of new banks to increase the revolving credit facility to $175.0 million. The amount that may be borrowed to fund distributions to unitholders was increased from $25.0 million to $40.0 million, the “Total Debt to EBITDA Ratio” as defined in the revolving credit facility was changed such that the ratio may not exceed 4.0 to 1.0 (as opposed to 3.0 to 1.0 in the original facility), and Valero L.P. guarantees the revolving credit facility. The amounts available under the revolving credit facility are not subject to a borrowing base computation. As of December 31, 2004, Valero Logistics had $147.0 million available under its revolving credit agreement.

 

The revolving credit facility requires that Valero Logistics maintain certain financial ratios and includes other restrictive covenants, including a prohibition on distributions by Valero Logistics if any default, as defined in the revolving credit facility, exists or would result from the distribution. The revolving credit facility also includes a change-in-control provision, which requires that Valero Energy continue to own, directly or indirectly, 51% of Valero L.P.’s general partner interest or Valero Energy and/or Valero L.P. own 100% of the general partner interest

 

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Index to Financial Statements

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

in Valero Logistics or 100% of the outstanding limited partner interest in Valero Logistics. Management believes that Valero Logistics is in compliance with all of these ratios and covenants.

 

On December 20, 2004, Valero Logistics and Valero L.P. entered into a 5-Year Revolving Credit Agreement (the 2005 Revolving Credit Agreement) with certain lenders with an initial aggregate commitment of $400 million, subject to completion of the Kaneb Mergers. Valero Logistics’ obligations under the 2005 Revolving Credit Agreement are unsecured and will be guaranteed by Valero L.P. and certain subsidiaries of Valero L.P. Generally, the Lenders will not be obligated to make any loans under the 2005 Revolving Credit Agreement until the Kaneb Mergers are completed. Upon closing of the 2005 Revolving Credit Agreement, the amounts outstanding under the $175.0 million revolving credit facility will be paid in full, and that facility will be terminated.

 

Port Authority of Corpus Christi Note Payable

 

The proceeds from the original $12.0 million note payable due to the Port of Corpus Christi Authority of Nueces County, Texas (Port Authority of Corpus Christi) were used for the construction of a crude oil storage facility in Corpus Christi, Texas. The note payable is due in annual installments of $1.2 million through December 31, 2015 and is collateralized by the crude oil storage facility. Interest on the unpaid principal balance accrues at a rate of 8% per annum. The land on which the crude oil storage facility was constructed is leased from the Port Authority of Corpus Christi (see Note 9: Commitments and Contingencies).

 

Interest Rate Swaps

 

During 2003, Valero Logistics entered into interest rate swap agreements to manage its exposure to changes in interest rates. The interest rate swap agreements have an aggregate notional amount of $167.5 million, of which $60.0 million is tied to the maturity of the 6.875% senior notes and $107.5 million is tied to the maturity of the 6.05% senior notes. Under the terms of the interest rate swap agreements, Valero Logistics will receive a fixed rate (6.875% and 6.05% for the $60.0 million and $107.5 million of interest rate swap agreements, respectively) and will pay a variable rate based on LIBOR plus a percentage that varies with each agreement. As of December 31, 2004 and 2003, the weighted average effective interest rate for the interest rate swaps was 4.7% and 3.1%, respectively. As of December 31, 2004 and 2003, the aggregate estimated fair value of the interest rate swaps included in other long-term liabilities in the consolidated balance sheet was $1.2 million and $4.6 million, respectively.

 

NOTE 8: Health, Safety and Environmental Matters

 

Valero L.P.’s operations are subject to extensive federal, state and local environmental and safety laws and regulations. Although Valero L.P. believes its operations are in substantial compliance with applicable environmental and safety laws and regulations, risks of additional costs and liabilities are inherent in pipeline, terminalling and storage operations, and there can be no assurance that significant costs and liabilities will not be incurred. Moreover, it is possible that other developments, such as increasingly stringent environmental and safety laws, regulations and enforcement policies thereunder, and claims for damages to property or persons resulting from the operations, could result in substantial costs and liabilities. Accordingly, Valero L.P. has adopted policies, practices and procedures in the areas of pollution control, pipeline integrity, operator qualifications, public relations and education, product safety, occupational health and the handling, storage, use and disposal of hazardous materials that are designed to prevent material environmental or other damage, and to limit the financial liability which could result from such events. However, some risk of environmental or other damage is inherent in pipeline, terminalling and storage operations, as it is with other entities engaged in similar businesses.

 

Valero Energy has agreed to indemnify Valero L.P. for a period of 10 years from the date of acquisition for pre-acquisition environmental liabilities related to assets transferred or otherwise acquired by Valero L.P. from Valero Energy or UDS. Excluded from this indemnification are liabilities that result from a change in environmental law after the date of acquisition.

 

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Index to Financial Statements

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

Additionally, ExxonMobil has agreed to indemnify Valero L.P. for pre-acquisition environmental liabilities in connection with off site disposal activities performed prior to September 4, 2003 related to the Paulsboro refined product terminal acquisition (see note 4: Acquisitions).

 

As an operator or owner of the assets, Valero L.P. could be held liable for pre-acquisition environmental liabilities should Valero Energy or ExxonMobil be unable to fulfill their obligation. However, Valero L.P. believes that such a situation is unlikely.

 

Environmental and safety exposures and liabilities are difficult to assess and estimate due to unknown factors such as the timing and extent of remediation, the determination of Valero L.P.’s liability in proportion to other parties, improvements in cleanup technologies and the extent to which environmental and safety laws and regulations may change in the future. Although environmental and safety costs may have a significant impact on the results of operations for any single period, Valero L.P. believes that such costs will not have a material adverse effect on its financial position. During the years ended December 31, 2004 and 2003, Valero L.P. incurred $0.7 million and $0.5 million, respectively of environmental remediation costs, including $0.3 million accrued for future remediation related to two new matters in 2004 and $0.1 million accrued for future remediation related to two matters in 2003. The current portion accrued is included in accounts payable and accrued liabilities and the long-term portion is included in other long-term liabilities. For the year ended December 31, 2002, Valero L.P. had not incurred any material environmental or safety liabilities.

 

NOTE 9: Commitments and Contingencies

 

Valero L.P. has several agreements with the Port Authority of Corpus Christi including a crude oil dock user agreement, a land lease agreement and a note agreement. The crude oil dock user agreement, which renews annually in May, allows Valero L.P. to operate and manage a crude oil dock in Corpus Christi. Valero L.P. shares use of the crude oil dock with two other users, and operating costs are split evenly among the three users. The crude oil dock user agreement requires that Valero L.P. collect wharfage fees, based on the quantity of barrels offloaded from each vessel, and dockage fees, based on vessels berthing at the dock. These fees are remitted to the Port Authority of Corpus Christi. The wharfage and one-half of the dockage fees that Valero L.P. pays for the use of the crude oil dock reduces the annual amount it owes to the Port Authority of Corpus Christi under the note agreement discussed in Note 7: Long-term Debt. The wharfage and dockage fees for Valero L.P.’s use of the crude oil dock totaled $1.4 million, $1.2 million and $1.1 million for the years ended December 31, 2004, 2003 and 2002, respectively.

 

Valero L.P. has a refined product dock user agreement, which renews annually in April, with the Port Authority of Corpus Christi to use a refined product dock. Valero L.P. shares use of the refined product dock with one other user, and operating costs are split evenly between the two users. The refined product dock user agreement requires that Valero L.P. collect and remit the wharfage and dockage fees to the Port Authority of Corpus Christi. The wharfage and dockage fees for Valero L.P.’s use of the refined product dock totaled $0.3 million, $0.2 million and $0.2 million for the years ended December 31, 2004, 2003 and 2002, respectively.

 

The crude oil and the refined product docks in Corpus Christi provide Valero Energy’s Three Rivers refinery access to marine facilities to receive crude oil and deliver refined products. For the years ended December 31, 2004, 2003 and 2002, the Three Rivers refinery received 82%, 81% and 86%, respectively, of its crude oil requirements from crude oil received at the crude oil dock. Also, for the years ended December 31, 2004, 2003 and 2002, 7%, 7% and 6%, respectively, of the refined products produced at the Three Rivers refinery were transported via pipeline to the Corpus Christi refined product dock.

 

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Index to Financial Statements

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

Valero L.P. has the following land leases related to refined product terminals, crude oil storage facilities and the crude oil storage tank operations:

 

    Corpus Christi crude oil storage facility: a 20-year noncancellable operating lease through 2014, at which time the lease is renewable every five years, for a total of 20 renewable years.

 

    Corpus Christi refined product terminal: a five-year noncancellable operating lease through 2006, and a five-year noncancellable operating lease through 2007, at which time the agreements are renewable for at least two five-year periods.

 

    Harlingen refined product terminal: a 13-year noncancellable operating lease through 2008, and a 30-year noncancellable operating lease through 2008.

 

    Hobby airport terminal in Houston, Tx: a 40-year operating lease through 2022.

 

    Colorado Springs airport terminal: a 50-year noncancellable operating lease through 2043, at which time the lease is renewable for another 50-year period.

 

    Corpus Christi West crude oil storage tanks: a 25-year operating lease through 2027, at which time the lease is renewable for successive one-year periods thereafter.

 

    Texas City crude oil storage tanks: a 25-year operating lease through 2027, at which time the lease is renewable for successive one-year periods thereafter.

 

    Benicia crude oil storage tanks: a 25-year operating lease through 2027, at which time the lease is renewable for successive one-year periods thereafter.

 

    Catoosa, OK asphalt terminal lease: a 15-year operating lease through 2014, at which time the lease is renewable for three successive five-year periods.

 

    Rosario, NM asphalt terminal lease: a 25-year operating lease through 2025, at which time the lease is renewable for another 25-year period.

 

All of Valero L.P.’s land leases require monthly payments totaling $0.1 million. Future minimum rental payments applicable to all noncancellable operating leases as of December 31, 2004, are as follows (in thousands):

 

2005

   $ 1,596

2006

     1,582

2007

     1,574

2008

     1,103

2009

     1,103

Thereafter

     17,220
    

Future minimum lease payments

   $ 24,178
    

 

Rental expense for all operating leases totaled $1.2 million, $0.9 million and $0.3 million for the years ended December 31, 2004, 2003 and 2002, respectively.

 

Valero L.P. is involved in various lawsuits, claims and regulatory proceedings incidental to its business. In the opinion of management, the outcome of such matters will not have a material adverse effect on Valero L.P.’s financial position or results of operations.

 

NOTE 10: Risk Management Activities

 

Interest Rate Risk

 

The estimated fair value of Valero L.P.’s fixed-rate debt as of December 31, 2004 and 2003 was $389.9 million and $377.2 million, respectively, as compared to the carrying amount of $357.2 million and $354.2 million, respectively. These fair values were estimated using discounted cash flow analysis, based on Valero L.P.’s current incremental borrowing rates for similar types of borrowing arrangements.

 

Valero L.P. is exposed to market risk for changes in interest rates related to its long-term debt obligations. Interest rate swap agreements, which were entered into during 2003, are used to manage a portion of the exposure to

 

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changing interest rates by converting certain fixed-rate debt to variable-rate debt. Interest rates on borrowings under the revolving credit facility float with market rates and thus the carrying amount approximates fair value.

 

Concentration of Credit Risk

 

Substantially all of Valero L.P.’s revenues are derived from Valero Energy and its subsidiaries. Valero Energy transports crude oil to six of its refineries using Valero L.P.’s various crude oil pipelines and storage facilities and the crude oil storage tanks, and transports refined products from seven of its refineries to its company-owned retail operations or wholesale customers using Valero L.P.’s various refined product pipelines and terminals. Valero Energy and its subsidiaries are investment grade customers; therefore, Valero L.P. does not believe that the trade receivable from Valero Energy represents a significant credit risk. However, the concentration of business with Valero Energy, which is a large refining and retail marketing company, has the potential to impact Valero L.P., both positively and negatively, to changes in the refining and marketing industry.

 

NOTE 11: Related Party Transactions

 

Valero L.P. has related party transactions with Valero Energy for pipeline tariff, terminalling fee and crude oil storage tank fee revenues, certain employee costs, insurance costs, administrative costs, and rent expense. The receivable from Valero Energy as of December 31, 2004 and 2003 represents amounts due for pipeline tariff, terminalling fee and crude oil storage tank fee revenues and the payable to Valero Energy represents amounts due for employee costs, insurance costs, operating expenses, administrative costs and rent expense.

 

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

 

     Years Ended December 31,

     2004

   2003

   2002

     (in thousands)

Revenues

   $ 217,608    $ 178,605    $ 117,804

Operating expenses

     31,960      24,196      13,795

General and administrative expenses

     10,367      6,110      5,921

 

Services Agreement

 

Valero L.P. does not have any employees. Under the Services Agreement, the costs related to employees of Valero Energy who perform services directly on Valero L.P.’s behalf (direct services), including salary, wages and employee benefits are charged by Valero Energy to Valero, L.P. In addition, Valero L.P. receives certain administrative services such as legal, accounting, treasury, engineering, information technology and other corporate functions from Valero Energy. Under the provisions of the Services Agreement Valero L.P. paid Valero Energy an annual fee of $5.2 million related to these administrative services. Due to the significant growth of Valero L.P. and the increased need for personnel to work directly on behalf of Valero L.P. who were previously performing administrative services, the terms of the Services Agreement were amended effective April 1, 2004.

 

Under the terms of the amended Services Agreement, Valero L.P. continues to reimburse Valero Energy for the direct costs of employees working on behalf of Valero L.P. The number of employees who perform services directly on behalf of Valero L.P. was increased, thereby increasing the direct service charge, while the administrative services fee was reduced to an initial $1.2 million per year from $5.2 million per year. Each year over the next four years, the administrative services fee will be increased by $1.2 million and further increased by Valero Energy’s average percentage increase in salaries. The administrative services fee may also be adjusted to account for changes in service levels due to Valero L.P.’s acquisition, sale or construction of assets. The Conflicts Committee of the Board of Directors of Valero GP, LLC approved the amendment to the Services Agreement in March 2004. These fees are in addition to general and administrative costs incurred from third parties for services Valero Energy does not provide under the Services Agreement.

 

A portion of Valero L.P.’s general and administrative costs is passed on to third parties, which jointly own certain pipelines and terminals with Valero L.P. The net amount of general and administrative costs allocated to partners of

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

jointly owned pipelines totaled $0.7 million, $0.5 million and $0.7 million for the years ended December 31, 2004, 2003 and 2002, respectively.

 

Pipelines and Terminals Usage Agreement - McKee, Three Rivers and Ardmore

 

Under the terms of the Pipeline and Terminals Usage Agreement entered into on April 16, 2001, Valero Energy has agreed to use Valero L.P.’s pipelines to transport at least 75% of the crude oil shipped to and at least 75% of the refined products shipped from Valero Energy’s McKee, Three Rivers and Ardmore refineries and to use the related refined product terminals for terminalling services for at least 50% of all refined products shipped from the McKee, Three Rivers and Ardmore refineries until at least April 2008. For the year ended December 31, 2004, Valero Energy used Valero L.P.’s pipelines to transport 98% of its crude oil shipped to and 85% of the refined products shipped from the McKee, Three Rivers and Ardmore refineries, and Valero Energy used Valero L.P.’s terminalling services for 54% of all refined products shipped from these refineries.

 

If market conditions change with respect to the transportation of crude oil or refined products, or to the end markets in which Valero Energy sells refined products, in a material manner such that Valero Energy would suffer a material adverse effect if it were to continue to use Valero L.P.’s pipelines and terminals that service the McKee, Three Rivers and Ardmore refineries at the required levels, Valero Energy’s obligation to Valero L.P. will be suspended during the period of the change in market conditions to the extent required to avoid the material adverse effect.

 

In the event Valero Energy does not transport in Valero L.P.’s pipelines or use Valero L.P.’s terminals to handle the minimum volume requirements and if its obligation has not been suspended under the terms of the agreement, Valero Energy will be required to make a cash payment determined by multiplying the shortfall in volume by the applicable weighted average pipeline tariff or terminal fee.

 

South Texas Pipelines and Terminals Agreements

 

In conjunction with the acquisition of the South Texas Pipelines and Terminals in March 2003, Valero L.P. and Valero Energy entered into the following agreements:

 

    Throughput commitment agreement pursuant to which Valero Energy agreed, for an initial period of seven years:

 

    to transport in the Houston and Valley pipeline systems an aggregate of 40% of the Corpus Christi refineries’ gasoline and distillate production but only if the combined throughput in these pipelines is less than 110,000 barrels per day;

 

    to transport in the Pettus to San Antonio refined product pipeline 25% of the Three Rivers refinery gasoline and distillate production and in the Pettus to Corpus Christi refined product pipeline 90% of the Three Rivers refinery raffinate production;

 

    to use the Houston asphalt terminal for an aggregate of 7% of the asphalt production of the Corpus Christi refineries;

 

    to use the Edinburg refined product terminal for an aggregate of 7% of the gasoline and distillate production of the Corpus Christi refineries, but only if the throughput at this terminal is less than 20,000 barrels per day; and

 

    to use the San Antonio East terminal for 75% of the throughput in the Pettus to San Antonio refined product pipeline.

 

In the event Valero Energy does not transport in Valero L.P.’s pipelines or use Valero L.P.’s terminals to handle the minimum volume requirements and if its obligation has not been suspended under the terms of the agreement, it will be required to make a cash payment determined by multiplying the shortfall in volume by the applicable weighted average pipeline tariff or terminal fee.

 

In 2003, Valero Energy indicated to Valero L.P. that the segment of the Corpus Christi to Edinburg refined product pipeline that runs approximately 60 miles south from Corpus Christi to Seeligson Station required repair and replacement. Valero Energy agreed to indemnify Valero L.P. for any costs Valero L.P. incurred to repair and replace this segment in excess of $1.5 million, excluding costs to upgrade the size of the pipe, which is

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS – (Continued)

 

Valero L.P.’s responsibility. This repair and replacement project became operational in the fourth quarter of 2004.

 

    Terminalling agreement pursuant to which Valero Energy has agreed, during the initial period of five years, to pay a terminalling fee for each barrel of refined product stored or handled by or on behalf of Valero Energy at the terminals included in the South Texas Pipelines and Terminals, including an additive fee for gasoline additive blended at the terminals. At the Houston Hobby Airport terminal, Valero Energy will pay a filtering fee for each barrel of jet fuel stored or handled at the terminal.

 

Crude Oil Storage Tank Agreements

 

In conjunction with the acquisition of the Crude Oil Storage Tanks in March 2003, Valero L.P. and Valero Energy entered into the following agreements:

 

    Handling and throughput agreement pursuant to which Valero Energy agreed to pay Valero L.P. a fee for 100% of crude oil and certain other feedstocks delivered to each of the Corpus Christi West refinery, the Texas City refinery and the Benicia refinery and to use Valero L.P. for handling all deliveries to these refineries. The throughput fees are adjustable annually, generally based on 75% of the regional consumer price index applicable to the location of each refinery. The initial term of the handling and throughput agreement is ten years, which may be extended by Valero Energy for up to an additional five years.

 

    Services and secondment agreements pursuant to which Valero Energy agreed to provide to Valero L.P. personnel who perform operating and routine maintenance services related to the crude oil storage tank operations. The annual reimbursement for services is an aggregate $3.5 million. The initial term of the services and secondment agreements is ten years which Valero L.P. has the option to extend for an additional five years. In addition to the fees Valero L.P. has agreed to pay Valero Energy under the services and secondment agreements, Valero L.P. is responsible for operating expenses and specified capital expenditures related to the tank assets that are not addressed in the services and secondment agreements. These operating expenses and capital expenditures include tank safety inspections, maintenance and repairs, certain environmental expenses, insurance premiums and ad valorem taxes.

 

    Lease and access agreements pursuant to which Valero Energy leases to Valero L.P. the land on which the crude oil storage tanks are located for an aggregate of $0.7 million per year. The initial term of each lease is 25 years, subject to automatic renewal for successive one-year periods thereafter. Valero L.P. may terminate any of these leases upon 30 days notice after the initial term or at the end of a renewal period. In addition, Valero L.P. may terminate any of these leases upon 180 days notice prior to the expiration of the current term if Valero L.P. ceases to operate the crude oil storage tanks or ceases business operations.

 

Royal Trading Throughput Agreement

 

In conjunction with the Royal Trading acquisition, Valero L.P. entered into a five-year terminal storage and throughput agreement with Valero Energy. The agreement provides a base throughput and blending fee schedule with volume incentive discounts once certain thresholds are met. In addition, Valero Energy has agreed to utilize the acquired terminals for a minimum of 18.5% of the combined McKee and Ardmore refineries’ asphalt production.

 

Corpus Christi North Beach Storage Facility Lease

 

Valero L.P. and Valero Energy entered into a one-year shell barrel capacity lease agreement on January 1, 2004 for the 1.6 million barrels of capacity at the Corpus Christi North Beach storage facility. This lease automatically renews for additional one-year terms unless either party terminates it with a 90-day written notice. The use of this storage facility was previously included as part of the crude oil pipeline tariff for the Corpus Christi to Three Rivers crude oil pipeline.

 

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Omnibus Agreement

 

The Omnibus Agreement governs potential competition between Valero Energy and Valero L.P. Under the Omnibus Agreement, Valero Energy has agreed, and will cause its controlled affiliates to agree, for so long as Valero Energy controls the 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 UDS as of April 16, 2001, the closing of Valero L.P.’s 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 Valero L.P. has been offered and declined the opportunity to purchase the business; and

 

    any newly constructed pipeline, terminalling or storage assets that Valero L.P. has not offered to purchase at fair market value within one year of construction.

 

Also under the Omnibus Agreement, Valero Energy has agreed to indemnify Valero L.P. for environmental liabilities related to the assets transferred to Valero L.P. in connection with Valero L.P.’s initial public offering, provided that such liabilities arose prior to and are discovered within 10 years after that date (excluding liabilities resulting from a change in law after April 16, 2001).

 

NOTE 12: Employee Benefit Plans

 

Valero L.P., which has no employees, relies on employees of Valero Energy and its affiliates to provide the necessary services to operate Valero L.P.’s assets. Effective January 1, 2003, most of the employees providing operational services to Valero L.P. became employees of Valero GP, LLC, a wholly owned subsidiary of Valero Energy and the general partner of Riverwalk Logistics, L.P. The Valero GP, LLC employees are included in the various employee benefit plans of Valero Energy and its affiliates. These plans include qualified, non-contributory defined benefit retirement plans, defined contribution 401(k) plans, employee and retiree medical, dental and life insurance plans, bonus plans, long-term incentive plans (i.e. unit options and restricted common units) and other such benefits.

 

Valero L.P.’s share of allocated Valero Energy employee benefit plan expenses, excluding the compensation expense related to the contractual rights to receive common units, restricted units and unit options, was $11.2 million, $4.8 million and $1.7 million for the years ended December 31, 2004, 2003 and 2002, respectively. These employee benefit plan expenses are included in operating expenses with the related payroll costs.

 

Long-Term Incentive Plans

 

Valero GP, LLC has adopted the 2000 Long-Term Incentive Plan (the LTIP) under which Valero GP, LLC may award up to 250,000 common units to certain key employees of Valero Energy’s affiliates providing services to Valero L.P. and to directors and officers of Valero GP, LLC. Awards under the LTIP can include unit options, restricted common units, distribution equivalent rights (DERs) and contractual rights to receive common units.

 

In June 2003, Valero GP, LLC adopted the 2003 Employee Unit Incentive Plan (the UIP) under which Valero GP, LLC may award up to 500,000 common units to employees of Valero GP, LLC or its affiliates, excluding officers and directors of Valero GP, LLC and its affiliates. Awards under the UIP can include unit options, unit appreciation rights, restricted units, performance awards, unit compensation and other unit-based awards.

 

In addition, Valero GP, LLC has adopted the 2002 Unit Option Plan (the UOP) under which Valero GP, LLC may award up to 200,000 unit options to officers and directors of Valero GP, LLC or its affiliates.

 

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In January 2002, under the LTIP, Valero GP, LLC granted 55,250 contractual rights to receive common units and DERs to its officers, certain key employees of its affiliates and its outside directors. In conjunction with the grant of contractual rights to receive common units under the LTIP, Valero L.P. issued 55,250 common units to Valero GP, LLC on January 21, 2002 for total consideration of $2.3 million (based on the then $40.95 market price per common unit). The contractual rights to receive common units vest one-third at the end of each year of a three-year vesting period. In January 2003 and 2004, one-third of the 55,250 contractual rights to receive common units vested and Valero GP, LLC distributed actual Valero L.P. common units to the officers and directors.

 

In 2002, Valero GP, LLC granted 131,800 unit options under the UOP and 44,400 unit options under the LTIP. These unit option grants vest one-third at the end of each year of a three-year vesting period. Effective March 18, 2003, unit options are accounted for at fair value and the compensation expense related to Valero GP, LLC employees is reimbursed by Valero L.P. to Valero GP, LLC.

 

On January 24, 2003, under the LTIP, Valero GP, LLC granted 30,000 contractual rights to receive common units and DERs to its eligible recipients, excluding the outside directors. In conjunction with the grant of contractual rights to receive common units under the LTIP, Valero GP, LLC purchased 30,000 newly issued Valero L.P. common units from Valero L.P. for total consideration of $1.1 million (based on the then $38.30 market price per common unit).

 

In October 2003, Valero GP, LLC granted 1,440 restricted units under the UIP, 32,000 unit options under the UOP and 2,280 restricted units and 28,625 unit options under the LTIP. These October 2003 grants vest one-fifth at the end of each year of a five-year vesting period.

 

In July 2004, Valero GP, LLC granted 579 restricted units under the LTIP, which vest one-third at the end of each year of a three-year vesting period.

 

In October 2004, Valero GP, LLC granted 2,680 restricted units and 49,575 unit options under the UIP, 23,775 unit options under the UOP and 9,425 restricted units under the LTIP. These October 2004 grants vest one-fifth at the end of each year of a five-year vesting period.

 

Valero L.P.’s share of compensation expense related to the contractual rights to receive common units, restricted units and unit options issued under the LTIP, the UIP and the UOP was $0.7 million, $0.9 million and $0.7 million, respectively, for the years ended December 31, 2004, 2003 and 2002 and such amounts have been included in general and administrative expenses in the consolidated statements of income for those years.

 

NOTE 13: Partners’ Equity, Allocations of Net Income and Cash Distributions

 

Partners’ Equity

 

As of December 31, 2002, Valero Energy and its affiliates owned 73.6% of Valero L.P.’s outstanding partners’ equity, including the 2% general partner interest. After giving effect to the redemption of common units in March 2003, the March and August 2003 common unit offerings and the April 2003 over-allotment option exercise, outstanding partners’ equity of Valero L.P. as of December 31, 2004 includes 13,442,072 common units (664,119 of which are held by affiliates of Valero Energy), 9,599,322 subordinated units held by UDS Logistics, LLC and a 2% general partner interest held by Riverwalk Logistics, L.P. UDS Logistics, LLC is a wholly owned subsidiary of Valero Energy and the limited partner of Riverwalk Logistics, L.P. As a result of the above 2003 equity transactions, Valero Energy and its affiliates now own 45.7% of Valero L.P., including the 2% general partner interest.

 

There is no established public market for the trading of the subordinated units. In addition, all of the subordinated units may convert to common units on a one-for-one basis if Valero L.P. meets the tests set forth in the partnership agreement as discussed below. If the subordination period ends, the rights of the holders of subordinated units will

 

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no longer be subordinated to the rights of the holders of common units and the subordinated units will be converted into common units.

 

Effective March 11, 2004, the partnership agreement was amended to reduce the percentage of the vote required to remove Valero L.P.’s general partner from 58% to a simple majority (excluding any vote by the general partner and its affiliates).

 

Allocations of Net Income

 

Valero L.P.’s partnership agreement, as amended, sets forth the calculation to be used to determine the amount and priority of cash distributions that the common unitholders, subordinated unitholders and general partner will receive. The partnership agreement also contains provisions for the allocation of net income and loss to the unitholders and the general partner. For purposes of maintaining partner capital accounts, the partnership agreement specifies that items of income and loss shall be allocated among the partners in accordance with their respective percentage interests. Normal allocations according to percentage interests are done after giving effect, if any, to priority income allocations in an amount equal to incentive cash distributions allocated 100% to the general partner.

 

Cash Distributions

 

Valero L.P. makes quarterly distributions of 100% of its available cash, generally defined as cash receipts less cash disbursements and cash reserves established by the general partner, in its sole discretion. These quarterly distributions are declared and paid within 45 days subsequent to each quarter-end. During the subordination period, the holders of Valero L.P.’s common units are entitled to receive each quarter a minimum quarterly distribution of $0.60 per unit ($2.40 annualized) prior to any distribution of available cash to holders of Valero L.P.’s subordinated units. The subordination period is defined generally as the period that will end on the first day of any quarter beginning after March 31, 2006 if (1) Valero L.P. has distributed at least the minimum quarterly distribution on all outstanding units with respect to each of the immediately preceding three consecutive, non-overlapping four-quarter periods and (2) Valero L.P.’s adjusted operating surplus, as defined in the partnership agreement, during such periods equals or exceeds the amount that would have been sufficient to enable Valero L.P. to distribute the minimum quarterly distribution on all outstanding units on a diluted basis and the related distribution on the 2% general partner interest during those periods.

 

During the subordination period, Valero L.P.’s cash is first distributed 98% to the holders of common units and 2% to the general partner until there has been distributed to the holders of common units an amount equal to the minimum quarterly distribution and arrearages in the payment of the minimum quarterly distribution on the common units for any prior quarter. Secondly, cash is distributed 98% to the holders of subordinated units and 2% to the general partner until there has been distributed to the holders of subordinated units an amount equal to the minimum quarterly distribution. Thirdly, cash in excess of the minimum quarterly distributions is distributed to the unitholders and the general partner based on the percentages shown below.

 

The general partner is entitled to incentive distributions if the amount Valero L.P. distributes with respect to any quarter exceeds specified target levels shown below:

 

     Percentage of Distribution

 

Quarterly Distribution Amount per Unit


   Unitholders

    General
Partner


 

Up to $0.60

   98 %   2 %

Above $0.60 up to $0.66

   90 %   10 %

Above $0.66

   75 %   25 %

 

Effective March 11, 2004, Valero L.P.’s partnership agreement was amended to lower the general partner’s incentive distribution rights with respect to distributions of available cash from 48% to 23% of the amount of any quarterly distribution that exceeds $0.90 per unit. The general partner will continue to receive a 2% distribution with respect to its general partner interest.

 

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

 

     Years Ended December 31,

     2004

   2003

   2002

     (in thousands, except per unit data)

General partner interest

   $ 1,595    $ 1,404    $ 1,103

General partner incentive distribution

     4,449      2,620      1,103
    

  

  

Total general partner distribution

     6,044      4,024      2,206

Limited partners’ distribution

     73,733      66,179      52,969
    

  

  

Total cash distributions

   $ 79,777    $ 70,203    $ 55,175
    

  

  

Cash distributions per unit applicable to limited partners

   $ 3.20    $ 2.95    $ 2.75
    

  

  

 

On January 27, 2005, Valero L.P. declared a quarterly distribution of $0.80 per unit payable on February 14, 2005 to unitholders of record on February 7, 2005. This distribution related to the fourth quarter of 2004 and totaled $19.9 million, of which $1.5 million represented the general partner’s share of such distribution. The general partner’s distribution included a $1.1 million incentive distribution.

 

NOTE 14: Segment Information

 

Valero L.P.’s operating segments include refined product pipelines, crude oil pipelines, refined product terminals and crude oil storage tanks. These reportable segments are strategic business units that offer different services and performance is evaluated based on operating income, before general and administrative expenses. General and administrative expenses are not allocated to the operating segments since those expenses relate primarily to the overall management at the entity level. Valero L.P.’s principal services include providing pipeline transportation services, terminalling services and crude oil storage handling services. Valero L.P.’s services have been provided primarily to Valero Energy, from which Valero L.P. derived $217.6 million or 98.6% of its revenues for the year ended December 31, 2004.

 

The refined product pipelines segment revenues are earned by charging tariffs for the transportation of refined product volumes (per barrel) moved through the pipelines. For the year ended December 31, 2004, 97.1% of the refined product pipelines segment revenues were earned from services provided to Valero Energy. The crude oil pipelines segment revenues are earned by charging a tariff for the transportation of crude oil and other refinery feedstock volumes (per barrel) moved through the pipelines. The cost of the crude oil storage facilities connected to the various crude oil pipelines is included in the determination of the crude oil pipeline tariffs. For the year ended December 31, 2004, all of the revenues for the crude oil pipelines segment were earned from services provided to Valero Energy. The two largest operating expense items of both pipeline segments are labor and utility costs.

 

The refined product terminals segment revenues are earned by charging a fee for refined product volumes (per barrel) handled at the terminals and certain terminals charge additional fees for barrels that are blended with additives or for barrels that are filtered. For the year ended December 31, 2004, 98.3% of the refined product terminals segment revenues were earned from services provided to Valero Energy. The two largest operating expense items for the refined product terminals segment are labor and utility costs.

 

The crude oil storage tanks segment revenues are earned by charging a fee for each barrel of crude oil and certain other refinery feedstock delivered to the related refinery. For the year ended December 31, 2004, all of the revenues for the crude oil storage tanks segment were earned from services provided to Valero Energy. The two largest

 

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operating expense items for the crude oil storage tanks segment are the fees paid to Valero Energy under the services and secondment agreements and regulatory inspection and repair costs.

 

Results of operations for the reportable segments were as follows:

 

     Years Ended December 31,

     2004

   2003

   2002

     (in thousands)

Revenues:

                    

Crude oil pipelines

   $ 52,462    $ 50,741    $ 47,925

Refined product pipelines

     86,418      72,276      52,302

Refined product terminals

     39,984      31,269      18,231

Crude oil storage tanks

     41,928      27,164      —  
    

  

  

Total revenues

   $ 220,792    $ 181,450    $ 118,458
    

  

  

Operating expenses:

                    

Crude oil pipelines

   $ 15,468    $ 15,196    $ 13,541

Refined product pipelines

     37,332      28,914      16,202

Refined product terminals

     18,365      15,447      8,095

Crude oil storage tanks

     7,133      5,052      —  
    

  

  

Total operating expenses

   $ 78,298    $ 64,609    $ 37,838
    

  

  

Depreciation and amortization:

                    

Crude oil pipelines

   $ 4,499    $ 5,379    $ 5,618

Refined product pipelines

     14,715      12,380      8,051

Refined product terminals

     6,471      3,508      2,771

Crude oil storage tanks

     7,464      5,000      —  
    

  

  

Total depreciation and amortization

   $ 33,149    $ 26,267    $ 16,440
    

  

  

Operating income:

                    

Crude oil pipelines

   $ 32,495    $ 30,166    $ 28,766

Refined product pipelines

     34,371      30,982      28,049

Refined product terminals

     15,148      12,314      7,365

Crude oil storage tanks

     27,331      17,112      —  
    

  

  

Total segment operating income

     109,345      90,574      64,180

General and administrative expenses

     11,321      7,537      6,950
    

  

  

Total operating income

   $ 98,024    $ 83,037    $ 57,230
    

  

  

 

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Total assets by reportable segment were as follows:

 

     December 31,

     2004

   2003

     (in thousands)

Crude oil pipelines

   $ 127,668    $ 146,338

Refined product pipelines

     347,008      358,257

Refined product terminals

     145,966      102,854

Crude oil storage tanks

     209,919      198,191
    

  

Total segment assets

     830,561      805,640

Other partnership assets (including current assets and other noncurrent assets)

     26,946      21,917
    

  

Total consolidated assets

   $ 857,507    $ 827,557
    

  

 

Effective January 1, 2004, Valero L.P.’s Corpus Christi North Beach storage facility was transferred from the crude oil pipelines segment to the crude oil storage tanks segment. Valero L.P. and Valero Energy entered into a one-year shell barrel capacity lease agreement for the 1.6 million barrels of capacity at the facility. The use of this storage facility was previously included as part of the crude oil pipeline tariff for the Corpus Christi to Three Rivers crude oil pipeline. As of December 31, 2003, the assets related to the Corpus Christi North Beach storage facility totaled $18.0 million. Goodwill is allocated to two of Valero L.P.’s segments, crude oil pipelines and refined product pipelines. The Investment in Skelly-Belvieu Pipeline Company is included in the refined product pipelines segment.

 

Capital expenditures, including acquisitions, by reportable segment were as follows:

 

     Years Ended December 31,

     2004

   2003

   2002

     (in thousands)

Crude oil pipelines

   $ 3,275    $ 2,656    $ 65,070

Refined product pipelines

     12,009      176,956      13,444

Refined product terminals

     41,148      62,927      2,190

Crude oil storage tanks

     1,056      200,198      —  
    

  

  

Total capital expenditures

   $ 57,488    $ 442,737    $ 80,704
    

  

  

 

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NOTE 15: Quarterly Financial Data (unaudited)

 

     First
Quarter


   Second
Quarter


   Third
Quarter


   Fourth
Quarter


   Total

     (in thousands, except per unit data)

2004:

                                  

Revenues

   $ 52,324    $ 55,707    $ 58,075    $ 54,686    $ 220,792

Operating income

     24,543      24,600      24,448      24,433      98,024

Net income

     19,970      19,706      19,387      19,355      78,418

Net income per unit applicable to limited partners

     0.80      0.79      0.78      0.78