Edgar Filing: VALERO ENERGY CORP/TX

VLO 6.30.12 10Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)



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

For the quarterly period ended June 30, 2012



o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the transition period from _______________ to _______________

Commission File Number 1-13175

VALERO ENERGY CORPORATION

(Exact name of registrant as specified in its charter)



Delaware		74-1828067
(State or other jurisdiction of		(I.R.S. Employer
incorporation or organization)		Identification No.)

One Valero Way

San Antonio, Texas

(Address of principal executive offices)

78249

(Zip Code)

(210) 345-2000

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes R No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.



Large accelerated filer R	Accelerated filer o	Non-accelerated filer o	Smaller reporting company o

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

Yes o No R

The number of shares of the registrant’s only class of common stock, $0.01 par value, outstanding as of July 31, 2012 was 551,605,943.

VALERO ENERGY CORPORATION AND SUBSIDIARIES

TABLE OF CONTENTS




	Page
PART I – FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of June 30, 2012 and December 31, 2011	3
Consolidated Statements of Income for the Three and Six Months Ended June 30, 2012 and 2011	4
Consolidated Statements of Comprehensive Income for the Three and Six Months Ended June 30, 2012 and 2011	5
Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2012 and 2011	6
Condensed Notes to Consolidated Financial Statements	7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	35
Item 3. Quantitative and Qualitative Disclosures About Market Risk	58
Item 4. Controls and Procedures	60
PART II – OTHER INFORMATION
Item 1. Legal Proceedings	61
Item 1A. Risk Factors	61
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	62
Item 6. Exhibits	62
SIGNATURE	63

Table of Contents

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

VALERO ENERGY CORPORATION AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(Millions of Dollars, Except Par Value)



	June 30, 2012			December 31, 2011
	(Unaudited)
ASSETS
Current assets:
Cash and temporary cash investments	$	1,295		$	1,024
Receivables, net	6,624			8,706
Inventories	5,443			5,623
Income taxes receivable	287			212
Deferred income taxes	246			283
Prepaid expenses and other	138			124
Total current assets	14,033			15,972
Property, plant and equipment, at cost	32,832			32,253
Accumulated depreciation	(7,311		)	(7,076		)
Property, plant and equipment, net	25,521			25,177
Intangible assets, net	218			227
Deferred charges and other assets, net	1,416			1,407
Total assets	$	41,188		$	42,783
LIABILITIES AND EQUITY
Current liabilities:
Current portion of debt and capital lease obligations	$	582		$	1,009
Accounts payable	7,998			9,472
Accrued expenses	527			595
Taxes other than income taxes	1,334			1,264
Income taxes payable	61			119
Deferred income taxes	296			249
Total current liabilities	10,798			12,708
Debt and capital lease obligations, less current portion	6,460			6,732
Deferred income taxes	5,411			5,017
Other long-term liabilities	1,896			1,881
Commitments and contingencies
Equity:
Valero Energy Corporation stockholders’ equity:
Common stock, $0.01 par value; 1,200,000,000 shares authorized; 673,501,593 and 673,501,593 shares issued	7			7
Additional paid-in capital	7,477			7,486
Treasury stock, at cost; 122,106,373 and 116,689,450 common shares	(6,568		)	(6,475		)
Retained earnings	15,542			15,309
Accumulated other comprehensive income	119			96
Total Valero Energy Corporation stockholders’ equity	16,577			16,423
Noncontrolling interest	46			22
Total equity	16,623			16,445
Total liabilities and equity	$	41,188		$	42,783

See Condensed Notes to Consolidated Financial Statements.

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VALERO ENERGY CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

(Millions of Dollars, Except Per Share Amounts)

(Unaudited)



	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
Operating revenues (a)	$	34,662		$	31,293		$	69,829		$	57,601
Costs and expenses:
Cost of sales	31,621			28,380			64,656			52,948
Operating expenses:
Refining	868			813			1,832			1,557
Retail	170			169			336			331
Ethanol	85			104			172			199
General and administrative expenses	171			151			335			281
Depreciation and amortization expense	386			386			770			751
Asset impairment loss	—			—			611			—
Total costs and expenses	33,301			30,003			68,712			56,067
Operating income	1,361			1,290			1,117			1,534
Other income (expense), net	(5		)	10			1			27
Interest and debt expense, net of capitalized interest	(74		)	(107		)	(173		)	(224		)
Income from continuing operations before income tax expense	1,282			1,193			945			1,337
Income tax expense	452			449			547			489
Income from continuing operations	830			744			398			848
Loss from discontinued operations, net of income taxes	—			(1		)	—			(7		)
Net income	830			743			398			841
Less: Net loss attributable to noncontrolling interest	(1		)	(1		)	(1		)	(1		)
Net income attributable to Valero Energy Corporation stockholders	$	831		$	744		$	399		$	842
Net income attributable to Valero Energy Corporation stockholders:
Continuing operations	$	831		$	745		$	399		$	849
Discontinued operations	—			(1		)	—			(7		)
Total	$	831		$	744		$	399		$	842
Earnings per common share:
Continuing operations	$	1.50		$	1.31		$	0.72		$	1.49
Discontinued operations	—			—			—			(0.01		)
Total	$	1.50		$	1.31		$	0.72		$	1.48
Weighted-average common shares outstanding (in millions)	550			567			550			567
Earnings per common share – assuming dilution:
Continuing operations	$	1.50		$	1.30		$	0.72		$	1.48
Discontinued operations	—			—			—			(0.01		)
Total	$	1.50		$	1.30		$	0.72		$	1.47
Weighted-average common shares outstanding – assuming dilution (in millions)	555			574			556			573
Dividends per common share	$	0.15		$	0.05		$	0.30		$	0.10



Supplemental information:
(a) Includes excise taxes on sales by our U.S. retail system	$	241	$	227	$	475	$	441

See Condensed Notes to Consolidated Financial Statements.

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VALERO ENERGY CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Millions of Dollars)

(Unaudited)



	Three Months Ended June 30,						Six Months Ended June 30,
	2012			2011			2012			2011
Net income	$	830		$	743		$	398		$	841

Other comprehensive income (loss):
Foreign currency translation adjustment	(91		)	20			32			112

Pension and other postretirement benefits:
(Gain) loss reclassified into income related to:
Prior service credit	(6		)	(5		)	(10		)	(10		)
Net actuarial loss	9			4			17			7
Net gain (loss) on pension and other postretirement benefits	3			(1		)	7			(3		)

Derivative instruments designated and qualifying as cash flow hedges:
Net gain (loss) arising during the period	(31		)	—			16			—
Net (gain) loss reclassified into income	12			—			(36		)	—
Loss on cash flow hedges	(19		)	—			(20		)	—

Other comprehensive income (loss), before income tax benefit	(107		)	19			19			109
Income tax benefit related to items of other comprehensive income (loss)	(5		)	—			(4		)	(1		)
Other comprehensive income (loss)	(102		)	19			23			110

Comprehensive income	728			762			421			951
Less: Comprehensive loss attributable to noncontrolling interest	(1		)	(1		)	(1		)	(1		)
Comprehensive income attributable to Valero Energy Corporation stockholders	$	729		$	763		$	422		$	952

See Condensed Notes to Consolidated Financial Statements.

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VALERO ENERGY CORPORATION AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Millions of Dollars)

(Unaudited)



	Six Months Ended June 30,
	2012			2011
Cash flows from operating activities:
Net income	$	398		$	841
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization expense	770			751
Asset impairment loss	611			—
Noncash interest expense and other income, net	11			21
Stock-based compensation expense	20			23
Deferred income tax expense	480			166
Changes in current assets and current liabilities	725			1,147
Changes in deferred charges and credits and other operating activities, net	(21		)	5
Net cash provided by operating activities	2,994			2,954
Cash flows from investing activities:
Capital expenditures	(1,420		)	(969		)
Deferred turnaround and catalyst costs	(264		)	(432		)
Advance payment related to acquisition of Pembroke Refinery	—			(37		)
Minor acquisitions	(66		)	(37		)
Other investing activities, net	9			(19		)
Net cash used in investing activities	(1,741		)	(1,494		)
Cash flows from financing activities:
Non-bank debt:
Borrowings	300			—
Repayments	(862		)	(718		)
Bank credit agreements:
Borrowings	1,100			—
Repayments	(1,100		)	—
Accounts receivable sales program:
Proceeds from the sale of receivables	1,300			—
Repayments	(1,450		)	—
Purchase of common stock for treasury	(147		)	—
Proceeds from the exercise of stock options	11			30
Common stock dividends	(166		)	(57		)
Contributions from noncontrolling interest	25			9
Other financing activities, net	(2		)	7
Net cash used in financing activities	(991		)	(729		)
Effect of foreign exchange rate changes on cash	9			42
Net increase in cash and temporary cash investments	271			773
Cash and temporary cash investments at beginning of period	1,024			3,334
Cash and temporary cash investments at end of period	$	1,295		$	4,107

See Condensed Notes to Consolidated Financial Statements.

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VALERO ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


1.	BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

General

As used in this report, the terms “Valero,” “we,” “us,” or “our” may refer to Valero Energy Corporation, one or more of its consolidated subsidiaries, or all of them taken as a whole.

These unaudited financial statements have been prepared in accordance with United States (U.S.) generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities Exchange Act of 1934. Accordingly, they do not include all of the information and notes required by U.S. GAAP for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation have been included. All such adjustments are of a normal recurring nature unless disclosed otherwise. Financial information for the three and six months ended June 30, 2012 and 2011 included in these Condensed Notes to Consolidated Financial Statements is derived from our unaudited financial statements. Operating results for the three and six months ended June 30, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012.

The balance sheet as of December 31, 2011 has been derived from our audited financial statements as of that date. For further information, refer to our financial statements and notes thereto included in our annual report on Form 10-K for the year ended December 31, 2011.

Significant Accounting Policies

Use of Estimates

The preparation of financial statements in conformity with U.S. GAAP requires us to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. On an ongoing basis, we review our estimates based on currently available information. Changes in facts and circumstances may result in revised estimates.

Comprehensive Income

Effective January 1, 2012, we adopted the provisions of Accounting Standards Codification (ASC) Topic 220, “Comprehensive Income,” and have elected to present comprehensive income in a statement that is separate from the statement of income but placed directly after the statement of income.

Fair Value Measurements

Effective January 1, 2012, we adopted the provisions of ASC Topic 820, “Fair Value Measurement,” which clarified the application of existing fair value measurement requirements and changed certain fair value measurement and disclosure requirements. The adoption of these provisions did not affect our financial position or results of operations as these requirements only affected disclosures as reflected in Note 12.

New Accounting Pronouncements

In December 2011, the provisions of ASC Topic 210, “Balance Sheet,” were amended to require an entity to disclose information about offsetting and related arrangements to enable users of its financial statements to understand the effect of these arrangements on its financial position. The guidance requires entities to disclose both gross information and net information about both instruments and transactions eligible for offset in the balance sheet and instruments and transactions subject to an agreement similar to a master

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VALERO ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

netting arrangement. These provisions are effective for interim and annual reporting periods beginning on January 1, 2013. The adoption of this guidance effective January 1, 2013 will not affect our financial position or results of operations, but may result in additional disclosures.


2.	ACQUISITIONS

The acquired refining and marketing businesses discussed below involve the production and marketing of refined petroleum products. These acquisitions are consistent with our general business strategy and complement our existing refining and marketing network.

Meraux Acquisition

On October 1, 2011, we acquired the Meraux Refinery and related logistics assets from Murphy Oil Corporation for an initial payment of $586 million, which was funded from available cash. In the fourth quarter of 2011, we recorded an adjustment related to inventories acquired that reduced the purchase price to $547 million. The assets acquired and liabilities assumed in this acquisition were recognized at their acquisition-date estimated fair values, as disclosed in Note 2 of Notes to Consolidated Financial Statements included in our annual report on Form 10-K for the year ended December 31, 2011, and no adjustments to those estimated amounts have been made during the six months ended June 30, 2012. We are, however, awaiting the completion of an independent appraisal and other evaluations of the fair values of the assets acquired and liabilities assumed.

Pembroke Acquisition

On August 1, 2011, we acquired 100 percent of the outstanding shares of Chevron Limited from a subsidiary of Chevron Corporation (Chevron), and we subsequently changed the name of Chevron Limited to Valero Energy Ltd. On the acquisition date, we initially paid $1.8 billion from available cash, of which $1.1 billion was for working capital. In the fourth quarter of 2011, we recorded adjustments to working capital (primarily inventory), resulting in an adjusted purchase price of $1.7 billion. The assets acquired and liabilities assumed in this acquisition were recognized at their acquisition-date estimated fair values, as disclosed in Note 2 of Notes to Consolidated Financial Statements included in our annual report on Form 10-K for the year ended December 31, 2011, and no adjustments to those estimated amounts have been made during the six months ended June 30, 2012. We are, however, awaiting the completion of an independent appraisal and other evaluations of the fair values of the assets acquired and liabilities assumed. This acquisition is referred to as the Pembroke Acquisition.

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VALERO ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


3.	IMPAIRMENT

In March 2012, we suspended the operations of the Aruba Refinery because of the refinery’s inability to generate positive cash flows on a sustained basis subsequent to its restart in January 2011 and the sensitivity of its profitability to sour crude oil differentials, which narrowed significantly in the fourth quarter of 2011. We considered the use of alternative feedstocks or configuration changes that might improve the refinery’s cash flows and we also considered a temporary or permanent shutdown of the refinery facilities. We ultimately decided to shut down the refinery and to maintain it in a state that would allow for operations to be resumed.

On March 28, 2012, we received a non-binding indication of interest from an unrelated interested party to purchase the Aruba Refinery for $350 million, plus working capital as of the closing date, subject to completion of due diligence and further negotiations. We accepted this offer, subject to the finalization of the purchase and sale agreement. Negotiations are currently ongoing and no final agreement has been reached to sell the refinery. The Aruba Refinery is classified as “held and used” because all of the accounting criteria required for “held for sale” classification have not been met.

Because of our decision to suspend the operations of the Aruba Refinery and the possibility that we may sell the refinery, we evaluated the refinery for potential impairment and concluded that the Aruba Refinery was impaired as of March 31, 2012. As a result, we were required to determine the fair value of the Aruba Refinery and to write down its carrying value to that amount. We determined that the best measure of the refinery’s fair value as of March 31, 2012 was the $350 million offer described above, which was based on the interested party’s specific knowledge of the refinery, experience in the refining and marketing industry, and extensive knowledge of the current economic factors of our business. The carrying value of the Aruba Refinery’s long-lived assets as of March 31, 2012 was $945 million; therefore, we recognized an asset impairment loss of $595 million in March 2012.

The operations of the Aruba Refinery remained suspended throughout the second quarter of 2012, and the interested party has continued its negotiations process, including discussions with the Government of Aruba. As a result, we updated our impairment evaluation of the Aruba Refinery as of June 30, 2012 and concluded that the refinery was not further impaired as of that date. The carrying value of the Aruba Refinery’s long-lived assets as of June 30, 2012 was $347 million, reflecting the revised carrying value of $350 million established as of March 31, 2012 less depreciation recognized in the second quarter of 2012.

There is no certainty that we will sell the refinery to the interested party, or to any other party, and if we ultimately sell the refinery, there is no certainty that we will sell it for $350 million. In addition, should we be unable to sell the refinery, we may have to recognize an additional asset impairment loss.

The variation in the customary relationship between income tax expense and income from continuing operations before income tax expense for the six months ended June 30, 2012 was primarily due to not recognizing the tax benefit associated with the asset impairment loss of $595 million related to the Aruba Refinery as we do not expect to realize this tax benefit.

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VALERO ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


4.	INVENTORIES

Inventories consisted of the following (in millions):



	June 30, 2012		December 31, 2011
Refinery feedstocks	$	2,140	$	2,474
Refined products and blendstocks	2,797		2,633
Ethanol feedstocks and products	178		195
Convenience store merchandise	105		103
Materials and supplies	223		218
Inventories	$	5,443	$	5,623

As of June 30, 2012 and December 31, 2011, the replacement cost (market value) of last in, first out (LIFO) inventories exceeded their LIFO carrying amounts by approximately $6.5 billion and $6.8 billion, respectively.


5.	DEBT

Non-Bank Debt

During the six months ended June 30, 2012, the following activity occurred:


•	in June 2012, we remarketed and received proceeds of $300 million related to the 4.0% Gulf Opportunity Zone Revenue Bonds Series 2010 issued by the Parish of St. Charles, State of Louisiana (GO Zone Bonds), which are due December 1, 2040, but are subject to mandatory tender on June 1, 2022;


•	in April 2012, we made scheduled debt repayments of $4 million related to our Series 1997A 5.45% industrial revenue bonds and $750 million related to our 6.875% notes; and


•	in March 2012, we exercised the call provisions on our Series 1997 5.6%, Series 1998 5.6%, Series 1999 5.7%, Series 2001 6.65%, and Series 1997A 5.45% industrial revenue bonds, which were redeemed on May 3, 2012 for $108 million, or 100 percent of their outstanding stated values.

During the six months ended June 30, 2011, the following activity occurred:


•	in May 2011, we made a scheduled debt repayment of $200 million related to our 6.125% senior notes;


•	in April 2011, we made scheduled debt repayments of $8 million related to out Series 1997A 5.45%, Series 1997B 5.40%, and Series 1997C 5.40% industrial revenue bonds;


•	in February 2011, we made a scheduled debt repayment of $210 million related to our 6.75% senior notes; and


•	also in February 2011, we paid $300 million to acquire the GO Zone Bonds, which were subject to mandatory tender.

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VALERO ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Bank Debt and Credit Facilities

We have a $3 billion revolving credit facility (the Revolver) that has a maturity date of December 2016. The Revolver has certain restrictive covenants, including a maximum debt-to-capitalization ratio of 60 percent. As of June 30, 2012 and December 31, 2011, our debt-to-capitalization ratios, calculated in accordance with the terms of the Revolver, were 26 percent and 29 percent, respectively. We believe that we will remain in compliance with this covenant.

In addition to the Revolver, one of our Canadian subsidiaries has a committed revolving credit facility under which it may borrow and obtain letters of credit up to C$115 million.

During the six months ended June 30, 2012, we borrowed and repaid $1.1 billion under our Revolver. During the six months ended June 30, 2011, we had no borrowings or repayments under our Revolver. We had no borrowings or repayments under the Canadian revolving credit facility during the six months ended June 30, 2012 and 2011. As of June 30, 2012 and December 31, 2011, we had no borrowings outstanding under the Revolver or the Canadian revolving credit facility.

We had outstanding letters of credit under our committed lines of credit as follows (in millions):



				Amounts Outstanding
	Borrowing Capacity		Expiration	June 30, 2012		December 31, 2011
Letter of credit facilities	$	550	June 2013	$	300	$	300
Revolver	$	3,000	December 2016	$	70	$	119
Canadian revolving credit facility	C$	115	December 2012	C$	11	C$	20

In July 2012, one of our letter of credit facilities was amended to extend its maturity date through June 2013 and to increase its borrowing capacity by $50 million. The borrowing capacity and expiration shown in the table above reflect these changes.

As of June 30, 2012 and December 31, 2011, we had $649 million and $391 million, respectively, of letters of credit outstanding under our uncommitted short-term bank credit facilities.

Accounts Receivable Sales Facility

As of June 30, 2012, we had an accounts receivable sales facility with a group of third-party entities and financial institutions to sell on a revolving basis up to $1.0 billion of eligible trade receivables. In July 2012, we amended our agreement to increase the facility to $1.5 billion and to extend the maturity date to July 2013. Proceeds from the sale of receivables under this facility are reflected as debt. Under this program, one of our marketing subsidiaries (Valero Marketing) sells eligible receivables, without recourse, to another of our subsidiaries (Valero Capital), whereupon the receivables are no longer owned by Valero Marketing. Valero Capital, in turn, sells an undivided percentage ownership interest in the eligible receivables, without recourse, to the third-party entities and financial institutions. To the extent that Valero Capital retains an ownership interest in the receivables it has purchased from Valero Marketing, such interest is included in our financial statements solely as a result of the consolidation of the financial statements of Valero Capital with those of Valero Energy Corporation; the receivables are not available to satisfy the claims of the creditors of Valero Marketing or Valero Energy Corporation.

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VALERO ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Changes in the amounts outstanding under our accounts receivable sales facility were as follows (in millions):



	Six Months Ended June 30,
	2012			2011
Balance as of beginning of period	$	250		$	100
Proceeds from the sale of receivables	1,300			—
Repayments	(1,450		)	—
Balance as of end of period	$	100		$	100

Capitalized Interest

Capitalized interest was $53 million and $33 million for the three months ended June 30, 2012 and 2011, respectively, and $105 million and $60 million for the six months ended June 30, 2012 and 2011, respectively.


6.	COMMITMENTS AND CONTINGENCIES

Environmental Matters

The U.S. Environmental Protection Agency (EPA) began regulating greenhouse gases on January 2, 2011, under the Clean Air Act Amendments of 1990 (Clean Air Act). Any new construction or material expansions will require that, among other things, a greenhouse gas permit be issued at either or both the state or federal level in accordance with the Clean Air Act and regulations, and we will be required to undertake a technology review to determine appropriate controls to be implemented with the project in order to reduce greenhouse gas emissions. The determination would be on a case by case basis, and the EPA has provided only general guidance on which controls will be required.

Furthermore, the EPA is currently developing refinery-specific greenhouse gas regulations and performance standards that are expected to impose, on new and existing operations, greenhouse gas emission limits and/or technology requirements. These control requirements may affect a wide range of refinery operations but have not yet been delineated. Any such controls, however, could result in material increased compliance costs, additional operating restrictions for our business, and an increase in the cost of the products we produce, which could have a material adverse effect on our financial position, results of operations, and liquidity.

Certain states and foreign governments have pursued regulation of greenhouse gases independent of the EPA. For example, the California Global Warming Solutions Act, also known as AB 32, directs the California Air Resources Board (CARB) to develop and issue regulations to reduce greenhouse gas emissions in California to 1990 levels by 2020. The CARB has issued a variety of regulations aimed at reaching this goal, including a Low Carbon Fuel Standard (LCFS) as well as a statewide cap-and-trade program.

•

The LCFS was scheduled to become effective in 2011, but rulings by the U.S. District Court stayed enforcement of the LCFS until certain legal challenges to the LCFS were resolved. Most notably, the court determined that the LCFS violates the Commerce Clause of the U.S. Constitution to the extent that the standard discriminates against out-of-state crude oils and corn ethanol. CARB appealed the lower court’s ruling to the U.S. Court of Appeals for the Ninth Circuit (Ninth Circuit Court).

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VALERO ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

The Ninth Circuit Court lifted the stay on April 23, 2012. We anticipate that the Ninth Circuit Court will hear arguments on the merits of the appeal this year, with a final ruling sometime thereafter.

•

A California statewide cap-and-trade program will begin in late 2012. Initially, the program will apply only to stationary sources of greenhouse gases (e.g., refinery and power plant greenhouse gas emissions). Greenhouse gas emissions from fuels that we sell in California will be covered by the program beginning in 2015. We anticipate that free allocations of credits will be available in the early years of the program to cover most of our stationary emissions, but we expect that compliance costs will increase significantly beginning in 2015, when transportation fuels are included in the program.

•

Complying with AB 32, including the LCFS and the cap-and-trade program, could result in material increased compliance costs for us, increased capital expenditures, increased operating costs, and additional operating restrictions for our business, resulting in an increase in the cost of, and decreases in the demand for, the products we produce. To the degree we are unable to recover these increased costs, these matters could have a material adverse effect on our financial position, results of operations, and liquidity.

In the first quarter of 2012, CARB adopted amendments to its Clean Fuels Outlet (CFO) Regulation. CARB states that the CFO Regulation is intended to provide outlets of clean fuel to meet the needs of alternative fuel vehicles. We understand that CARB is preparing to submit the CFO Regulation to the State Office of Administrative Law for approval. Under the regulation, projections of zero-emission vehicle availability in the California market would trigger a requirement for major refiners and importers of gasoline, including us, to install clean fuel outlets in designated areas in proportion to each refiner or importer’s share in the California gasoline market. We expect this regulation to be challenged, but we could be required to make significant capital expenditures if the regulation is implemented as presently adopted.

The EPA has disapproved certain permitting programs of the Texas Commission on Environmental Quality (TCEQ) that historically have streamlined the environmental permitting process in Texas. For example, the EPA disapproved the TCEQ pollution control standard permit, thus requiring conventional permitting for future pollution control equipment. The Fifth Circuit Court of Appeals recently overturned the EPA’s disapproval and sent it back to the EPA to re-evaluate the decision. Litigation is pending from industry groups and others against the EPA for each of these actions. In some instances, the EPA’s decisions have been initially upheld and others are still pending before the courts. The EPA has also objected to numerous Title V permits in Texas and other states, including permits at our Port Arthur, Corpus Christi East, and McKee Refineries. Environmental activist groups have filed a notice of intent to sue the EPA, seeking to require the EPA to assume control of these permits from the TCEQ. Finally, as part of its regulation of greenhouse gases discussed above, the EPA has federalized the permitting of greenhouse gas emissions in Texas. This creates a dual permitting structure that must be navigated for material projects in Texas. All of these developments have created substantial uncertainty regarding existing and future permitting. Because of this uncertainty, we are unable to determine the costs or effects of the EPA’s actions on our permitting activity. The EPA’s disruption of the Texas permitting system could result in material increased compliance costs for us, increased capital expenditures, increased operating costs, and additional operating restrictions for our business, resulting in an increase in the cost of, and decreases in the demand for, the products we produce, which could have a material adverse effect on our financial position, results of operations, and liquidity.

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VALERO ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Tax Matters

We are subject to extensive tax liabilities imposed by multiple jurisdictions, including income taxes, transactional taxes (excise/duty, sales/use, and value-added taxes), payroll taxes, franchise taxes, withholding taxes, and ad valorem taxes. New tax laws and regulations and changes in existing tax laws and regulations are continuously being enacted or proposed that could result in increased expenditures for tax liabilities in the future. Many of these liabilities are subject to periodic audits by the respective taxing authority. Subsequent changes to our tax liabilities as a result of these audits may subject us to interest and penalties.

As of June 30, 2012, the Internal Revenue Service (IRS) has ongoing tax audits related to our U.S. federal tax returns from 2002 through 2009. We have received Revenue Agent Reports on our tax years for 2002 through 2007 and we are vigorously contesting the tax positions and assertions from the IRS. Although we believe our tax liabilities are fairly stated and properly reflected in our financial statements, should the IRS eventually prevail, it could result in a material amount of our deferred tax liabilities being reclassified to current liabilities which could have a material adverse effect on our liquidity.

Litigation Matters

We are party to claims and legal proceedings arising in the ordinary course of business. We have not recorded a loss contingency liability with respect to some of these matters because we have determined that it is remote that a loss has been incurred. For other matters, we have recorded a loss contingency liability where we have determined that it is probable that a loss has been incurred and that the loss is reasonably estimable. These loss contingency liabilities are not material to our financial position. We re-evaluate and update our loss contingency liabilities as matters progress over time, and we believe that any changes to the recorded liabilities will not be material to our financial position or results of operations.

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CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


7.	EQUITY

The following is a reconciliation of the beginning and ending balances (in millions) of equity attributable to our stockholders, equity attributable to the noncontrolling interest, and total equity for the six months ended June 30, 2012 and 2011:



	2012									2011
	Valero Stockholders’ Equity			Non- controlling Interest			Total Equity			Valero Stockholders’ Equity			Non- controlling Interest			Total Equity
Balance as of beginning of period	$	16,423		$	22		$	16,445		$	15,025		$	—		$	15,025
Net income (loss)	399			(1		)	398			842			(1		)	841
Dividends	(166		)	—			(166		)	(57		)	—			(57		)
Stock-based compensation expense	20			—			20			23			—			23
Tax deduction in excess of stock-based compensation expense	3			—			3			11			—			11
Transactions in connection with stock-based compensation plans:
Stock issuances	11			—			11			30			—			30
Stock repurchases	(136		)	—			(136		)	(2		)	—			(2		)
Contributions from noncontrolling interest	—			25			25			—			11			11
Other comprehensive income	23			—			23			110			—			110
Balance as of end of period	$	16,577		$	46		$	16,623		$	15,982		$	10		$	15,992

The noncontrolling interest relates to a third-party ownership interest in Diamond Green Diesel Holdings LLC, a company whose financial statements we consolidate due to our controlling interest.

Share Activity

Activity in the number of shares of common stock and treasury stock was as follows (in millions) for the six months ended June 30, 2012 and 2011:



	2012			2011
	Common Stock	Treasury Stock		Common Stock	Treasury Stock
Balance as of beginning of period	673	(117	)	673	(105	)
Transactions in connection with stock-based compensation plans:
Stock issuances	—	1		—	2
Stock purchases	—	(6	)	—	—
Balance as of end of period	673	(122	)	673	(103	)

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CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Common Stock Dividends

On July 26, 2012, our board of directors declared a quarterly cash dividend of $0.175 per common share payable on September 12, 2012 to holders of record at the close of business on August 15, 2012.


8.	EMPLOYEE BENEFIT PLANS

The components of net periodic benefit cost related to our defined benefit plans were as follows (in millions) for the three and six months ended June 30, 2012 and 2011:



	Pension Plans						Other Postretirement Benefit Plans
	2012			2011			2012			2011
Three months ended June 30:
Service cost	$	35		$	22		$	3		$	2
Interest cost	23			22			6			5
Expected return on plan assets	(31		)	(28		)	—			—
Amortization of:
Prior service credit	—			—			(6		)	(5		)
Net actuarial loss	9			3			—			1
Net periodic benefit cost	$	36		$	19		$	3		$	3

Six months ended June 30:
Service cost	$	70		$	45		$	6		$	5
Interest cost	46			43			11			11
Expected return on plan assets	(62		)	(56		)	—			—
Amortization of:
Prior service cost (credit)	1			1			(11		)	(11		)
Net actuarial loss	17			6			—			1
Net periodic benefit cost	$	72		$	39		$	6		$	6

Our anticipated contributions to our pension plans during 2012 have not changed from amounts previously disclosed in our financial statements for the year ended December 31, 2011. During the six months ended June 30, 2012, we contributed approximately $13 million to our pension plans. There were no significant contributions made to our pension plans during the six months ended June 30, 2011. In July 2012, we contributed $50 million to our pension plans.

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CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


9.	EARNINGS PER COMMON SHARE

Earnings per common share from continuing operations were computed as follows (dollars and shares in millions, except per share amounts):



	Three Months Ended June 30,
	2012				2011
	Restricted Stock		Common Stock		Restricted Stock		Common Stock
Earnings per common share from continuing operations:
Net income attributable to Valero stockholders from continuing operations			$	831			$	745
Less dividends paid:
Common stock			82				29
Nonvested restricted stock			1				—
Undistributed earnings			$	748			$	716
Weighted-average common shares outstanding	3		550		3		567
Earnings per common share from continuing operations:
Distributed earnings	$	0.15	$	0.15	$	0.05	$	0.05
Undistributed earnings	1.35		1.35		1.26		1.26
Total earnings per common share from continuing operations	$	1.50	$	1.50	$	1.31	$	1.31

Earnings per common share from continuing operations – assuming dilution:
Net income attributable to Valero stockholders from continuing operations			$	831			$	745
Weighted-average common shares outstanding			550				567
Common equivalent shares:
Stock options			3				5
Performance awards and unvested restricted stock			2				2
Weighted-average common shares outstanding – assuming dilution			555				574
Earnings per common share from continuing operations – assuming dilution			$	1.50			$	1.30

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CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)



	Six Months Ended June 30,
	2012				2011
	Restricted Stock		Common Stock		Restricted Stock		Common Stock
Earnings per common share from continuing operations:
Net income attributable to Valero stockholders from continuing operations			$	399			$	849
Less dividends paid:
Common stock			165				57
Nonvested restricted stock			1				—
Undistributed earnings			$	233			$	792

Weighted-average common shares outstanding	3		550		3		567

Earnings per common share from continuing operations:
Distributed earnings	$	0.30	$	0.30	$	0.10	$	0.10
Undistributed earnings	0.42		0.42		1.39		1.39
Total earnings per common share from continuing operations	$	0.72	$	0.72	$	1.49	$	1.49

Earnings per common share from continuing operations – assuming dilution:
Net income attributable to Valero stockholders from continuing operations			$	399			$	849
Weighted-average common shares outstanding			550				567
Common equivalent shares:
Stock options			4				5
Performance awards and unvested restricted stock			2				1
Weighted-average common shares outstanding – assuming dilution			556				573
Earnings per common share from continuing operations – assuming dilution			$	0.72			$	1.48

The following table reflects potentially dilutive securities (in millions) that were excluded from the calculation of “earnings per common share from continuing operations – assuming dilution” as the effect of including such securities would have been antidilutive. These potentially dilutive securities included stock options for which the exercise prices were greater than the average market price of our common shares during each respective reporting period.



	Three Months Ended June 30,		Six Months Ended June 30,
	2012	2011	2012	2011
Stock options	6	6	6	6

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CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


10.	SEGMENT INFORMATION

The following table reflects activity related to continuing operations (in millions):



	Refining		Retail		Ethanol		Corporate			Total
Three months ended June 30, 2012:
Operating revenues from external customers	$	30,488	$	3,062	$	1,112	$	—		$	34,662
Intersegment revenues	2,203		—		46		—			2,249
Operating income (loss)	1,364		172		5		(180		)	1,361

Three months ended June 30, 2011:
Operating revenues from external customers	26,921		3,128		1,244		—			31,293
Intersegment revenues	2,311		—		52		—			2,363
Operating income (loss)	1,253		135		64		(162		)	1,290

Six months ended June 30, 2012:
Operating revenues from external customers	61,638		5,997		2,194		—			69,829
Intersegment revenues	4,458		—		60		—			4,518
Operating income (loss)	1,245		212		14		(354		)	1,117

Six months ended June 30, 2011:
Operating revenues from external customers	49,483		5,812		2,306		—			57,601
Intersegment revenues	4,308		—		100		—			4,408
Operating income (loss)	1,529		201		108		(304		)	1,534

Total assets by reportable segment were as follows (in millions):



	June 30, 2012		December 31, 2011
Refining	$	36,602	$	38,164
Retail	1,973		1,999
Ethanol	926		943
Corporate	1,687		1,677
Total assets	$	41,188	$	42,783

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CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


11.	SUPPLEMENTAL CASH FLOW INFORMATION

In order to determine net cash provided by operating activities, net income is adjusted by, among other things, changes in current assets and current liabilities as follows (in millions):



	Six Months Ended June 30,
	2012			2011
Decrease (increase) in current assets:
Receivables, net	$	2,087		$	(1,422	)
Inventories	198			978
Income taxes receivable	(79		)	175
Prepaid expenses and other	(15		)	(3		)
Increase (decrease) in current liabilities:
Accounts payable	(1,413		)	1,147
Accrued expenses	(60		)	202
Taxes other than income taxes	67			(52		)
Income taxes payable	(60		)	122
Changes in current assets and current liabilities	$	725		$	1,147

The above changes in current assets and current liabilities differ from changes between amounts reflected in the applicable balance sheets for the respective periods for the following reasons:


•	the amounts shown above exclude changes in cash and temporary cash investments, deferred income taxes, and current portion of debt and capital lease obligations, as well as the effect of certain noncash investing and financing activities discussed below;


•	amounts accrued for capital expenditures and deferred turnaround and catalyst costs are reflected in investing activities when such amounts are paid;


•	amounts accrued for common stock purchases in the open market that are not settled as of the balance sheet date are reflected in financing activities when the purchases are settled and paid; and


•	certain differences between balance sheet changes and the changes reflected above result from translating foreign currency denominated balances at the applicable exchange rates as of each balance sheet date.

There were no significant noncash investing or financing activities for the six months ended June 30, 2012 or 2011.

Cash flows related to interest and income taxes were as follows (in millions):



	Six Months Ended June 30,
	2012		2011
Interest paid in excess of amount capitalized	$	164	$	221
Income taxes paid, net	204		10

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VALERO ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


12.	FAIR VALUE MEASUREMENTS

General

GAAP requires that certain financial instruments, such as derivative instruments, be recognized at their fair values in our balance sheets. However, other financial instruments, such as debt obligations, are not required to be recognized at their fair values, but GAAP provides an option to elect fair value accounting for these instruments. GAAP requires the disclosure of the fair values of all financial instruments, regardless of whether they are recognized at their fair values or carrying amounts in our balance sheets. For financial instruments recognized at fair value, GAAP requires the disclosure of their fair values by type of instrument, along with other information, including changes in the fair values of certain financial instruments recognized in income or other comprehensive income, and this information is provided below under “Recurring Fair Value Measurements.” For financial instruments not recognized at fair value, the disclosure of their fair values is provided below under “Other Financial Instruments.”

Nonfinancial assets, such as property, plant and equipment, and nonfinancial liabilities are recognized at their carrying amounts in our balance sheets. GAAP does not permit nonfinancial assets and liabilities to be remeasured at their fair values. However, GAAP requires the remeasurement of such assets and liabilities to their fair values upon the occurrence of certain events, such as the impairment of property, plant and equipment. In addition, if such an event occurs, GAAP requires the disclosure of the fair value of the asset or liability along with other information, including the gain or loss recognized in income in the period the remeasurement occurred. This information is provided below under “Nonrecurring Fair Value Measurements.”

GAAP provides a framework for measuring fair value and establishes a three-level fair value hierarchy that prioritizes inputs to valuation techniques based on the degree to which objective prices in external active markets are available to measure fair value. Following is a description of each of the levels of the fair value hierarchy.


•	Level 1 - Observable inputs, such as unadjusted quoted prices in active markets for identical assets or liabilities.


•	Level 2 - Inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. These include quoted prices for similar assets or liabilities in active markets and quoted prices for identical or similar assets or liabilities in markets that are not active.

•

Level 3 - Unobservable inputs for the asset or liability for which there is little, if any, market activity at the measurement date. Unobservable inputs reflect our own assumptions about what market participants would use to price the asset or liability. The inputs are developed based on the best information available in the circumstances, which might include occasional market quotes or sales of similar instruments or our own financial data such as internally developed pricing models, discounted cash flow methodologies, as well as instruments for which the fair value determination requires significant judgment.

The financial instruments and nonfinancial assets and liabilities included in our disclosure of recurring and nonrecurring fair value measurements are categorized according to the fair value hierarchy based on the inputs used to measure their fair values.

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CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Recurring Fair Value Measurements

The tables below present information (in millions) about our financial instruments recognized at their fair values in our balance sheets categorized according to the fair value hierarchy of the inputs utilized by us to determine the fair values as of June 30, 2012 and December 31, 2011.

Cash received from brokers of $81 million and cash collateral deposits with brokers of $136 million under master netting arrangements are included in the fair value of the commodity derivatives reflected in Level 1 as of June 30, 2012 and December 31, 2011, respectively. Certain of our commodity derivative contracts under master netting arrangements include both asset and liability positions. We have elected to offset the fair value amounts recognized for multiple similar derivative instruments executed with the same counterparty, including any related cash collateral asset or obligation under the column “Netting Adjustments” below; however, fair value amounts by hierarchy level are presented on a gross basis in the tables below.



	Fair Value Measurements Using
	Quoted Prices in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)		Significant Unobservable Inputs (Level 3)		Netting Adjustments			Total Fair Value as of June 30, 2012
Assets:
Commodity derivative contracts	$	2,781	$	144	$	—	$	(2,836	)	$	89
Physical purchase contracts	—		18		—		—			18
Investments of certain benefit plans	85		—		11		—			96
Other investments	—		—		—		—			—
Liabilities:
Commodity derivative contracts	2,701		143		—		(2,836		)	8
Foreign currency contracts	5		—		—		—			5



	Fair Value Measurements Using
	Quoted Prices in Active Markets (Level 1)		Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)		Netting Adjustments			Total Fair Value as of December 31, 2011
Assets:
Commodity derivative contracts	$	2,038	$	78		$	—	$	(1,940	)	$	176
Physical purchase contracts	—		(2		)	—		—			(2		)
Investments of certain benefit plans	84		—			11		—			95
Other investments	—		—			—		—			—
Liabilities:
Commodity derivative contracts	1,864		101			—		(1,940		)	25
Foreign currency contracts	3		—			—		—			3

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VALERO ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

A description of our financial instruments and the valuation methods used to measure those instruments at fair value are as follows:

•

Commodity derivative contracts consist primarily of exchange-traded futures and swaps, and as disclosed in Note 13, some of these contracts are designated as hedging instruments. These contracts are measured at fair value using the market approach. Exchange-traded futures are valued based on quoted prices from the exchange and are categorized in Level 1 of the fair value hierarchy. Swaps are priced using third-party broker quotes, industry pricing services, and exchange-traded curves, with appropriate consideration of counterparty credit risk, but because they have contractual terms that are not identical to exchange-traded futures instruments with a comparable market price, these financial instruments are categorized in Level 2 of the fair value hierarchy.

•

Physical purchase contracts to purchase inventories represent the fair value of firm commitments to purchase crude oil feedstocks and the fair value of fixed-price corn purchase contracts, and as disclosed in Note 13, some of these contracts are designated as hedging instruments. The fair values of these firm commitments and purchase contracts are measured using a market approach based on quoted prices from the commodity exchange, but because these commitments have contractual terms that are not identical to exchange-traded futures instruments with a comparable market price, they are categorized in Level 2 of the fair value hierarchy.

•

Investments of certain benefit plans consist of investment securities held by trusts for the purpose of satisfying a portion of our obligations under certain U.S. nonqualified benefit plans. The assets categorized in Level 1 of the fair value hierarchy are measured at fair value using a market approach based on quoted prices from national securities exchanges. The assets categorized in Level 3 of the fair value hierarchy represent insurance contracts, the fair value of which is provided by the insurer.

•

Foreign currency contracts consist of foreign currency exchange and purchase contracts entered into by our international operations to manage our exposure to exchange rate fluctuations on transactions denominated in currencies other than the local (functional) currencies of those operations. These contracts are valued based on quoted prices from the exchange and are categorized in Level 1 of the fair value hierarchy.

•

Other investments consist of (i) equity securities of private companies over which we do not exercise significant influence nor whose financial statements are consolidated into our financial statements and (ii) debt securities of a private company whose financial statements are not consolidated into our financial statements. We have elected to account for these investments at their fair values. These investments are categorized in Level 3 of the fair value hierarchy as the fair values of these investments are determined using the income approach based on internally developed analyses.

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VALERO ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

The following is a reconciliation of the beginning and ending balances (in millions) for fair value measurements developed using significant unobservable inputs (Level 3) for the three and six months ended June 30, 2012 and 2011.



	2012				2011
	Investments of Certain Benefit Plans		Other Investments		Investments of Certain Benefit Plans		Other Investments
Three months ended June 30:
Balance as of beginning of period	$	11	$	—	$	11	$	—
Purchases	—		—		—		10
Total gains (losses) included in income	—		—		—		(10		)
Transfers in and/or out of Level 3	—		—		—		—
Balance as of end of period	$	11	$	—	$	11	$	—
The amount of total gains (losses) included in income attributable to the change in unrealized gains (losses) relating to assets still held at end of period	$	—	$	—	$	—	$	(10	)

Six months ended June 30:
Balance as of beginning of period	$	11	$	—	$	10	$	—
Purchases	—		—		—		16
Total gains (losses) included in income	—		—		1		(16		)
Transfers in and/or out of Level 3	—		—		—		—
Balance as of end of period	$	11	$	—	$	11	$	—
The amount of total gains (losses) included in income attributable to the change in unrealized gains (losses) relating to assets still held at end of period	$	—	$	—	$	1	$	(16	)

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VALERO ENERGY CORPORATION AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Nonrecurring Fair Value Measurements

As discussed in Note 3, we concluded that the Aruba Refinery was impaired as of March 31, 2012. As a result, we were required to determine the fair value of the Aruba Refinery and to write down its carrying value to that amount. We determined that the best measure of the refinery’s fair value as of March 31, 2012 was the $350 million offer received and accepted, subject to the finalization of the purchase and sale agreement. We believe this offer represents what a market participant would pay us for the assets in their highest and best use, as more fully discussed in Note 3. The fair value of the Aruba Refinery was measured using the market approach and was categorized in Level 3 within the fair value hierarchy. The carrying value of the Aruba Refinery’s long-lived assets as of March 31, 2012 was $945 million; therefore, we recognized an asset impairment loss of $595 million in March 2012.

We recognized an asset impairment loss of $16 million in March 2012 related to equipment associated with a capital project that was cancelled permanently in 2009. We had written down the carrying value of this equipment to fair value in 2009, but we have been unable to sell the equipment. As a result, we wrote down the carrying amount of the equipment to scrap value.

There were no assets or liabilities that were measured at fair value on a nonrecurring basis as of June 30, 2012 or December 31, 2011. During the six months ended June 30, 2012, we recognized an asset impairment loss of $611 million as described above.

Other Financial Instruments

Financial instruments that we recognize in our balance sheets at their carrying amounts are shown in the table below (in millions):



	June 30, 2012				December 31, 2011
	Carrying Amount		Fair Value		Carrying Amount		Fair Value
Financial assets:
Cash and temporary cash investments	$	1,295	$	1,295	$	1,024	$	1,024
Financial liabilities:
Debt (excluding capital leases)	6,995		8,187		7,690		9,298

The methods and significant assumptions used to estimate the fair value of these financial instruments are as follows:


•	The fair value of cash and temporary cash investments approximates the carrying value due to the low level of credit risk of these assets combined with their short maturities and market interest rates (Level 1).


•	The fair value of debt is determined primarily using the market approach based on quoted prices in active markets (Level 1).

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CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)


13.	PRICE RISK MANAGEMENT ACTIVITIES

We are exposed to market risks related to the volatility in the price of commodities, the price of financial instruments associated with governmental and regulatory compliance programs, interest rates, and foreign currency exchange rates, and we enter into derivative instruments to manage some of these risks. We also enter into derivative instruments to manage the price risk on other contractual derivatives into which we have entered. The only types of derivative instruments we enter into are those related to the various commodities we purchase or produce, financial instruments we must purchase to maintain compliance with various governmental and regulatory programs, interest rate swaps, and foreign currency exchange and purchase contracts, as described below. All derivative instruments are recorded as either assets or liabilities measured at their fair values (see Note 12).

When we enter into a derivative instrument, it is designated as a fair value hedge, a cash flow hedge, an economic hedge, or a trading derivative. The gain or loss on a derivative instrument designated and qualifying as a fair value hedge, as well as the offsetting loss or gain on the hedged item attributable to the hedged risk, is recognized currently in income in the same period. The effective portion of the gain or loss on a derivative instrument designated and qualifying as a cash flow hedge is initially reported as a component of other comprehensive income and is then recorded in income in the period or periods during which the hedged forecasted transaction affects income. The ineffective portion of the gain or loss on the cash flow derivative instrument, if any, is recognized in income as incurred. For our economic hedges (derivative instruments not designated as fair value or cash flow hedges) and for derivative instruments entered into by us for trading purposes, the derivative instrument is recorded at fair value and changes in the fair value of the derivative instrument are recognized currently in income. The cash flow effects of all of our derivative instruments are reflected in operating activities in our statements of cash flows for all periods presented.

Commodity Price Risk

We are exposed to market risks related to the volatility in the price of crude oil, refined products (primarily gasoline and distillate), grain (primarily corn), and natural gas used in our operations. To reduce the impact of price volatility on our results of operations and cash flows, we use commodity derivative instruments, including futures, swaps, and options. We use the futures markets for the available liquidity, which provides greater flexibility in transacting our hedging and trading operations. We use swaps primarily to manage our price exposure. Our positions in commodity derivative instruments are monitored and managed on a daily basis by a risk control group to ensure compliance with our stated risk management policy that has been approved by our board of directors.

For risk management purposes, we use fair value hedges, cash flow hedges, and economic hedges. In addition to the use of derivative instruments to manage commodity price risk, we also enter into certain commodity derivative instruments for trading purposes. Our objective for entering into each type of hedge or trading derivative is described below.

Fair Value Hedges

Fair value hedges are used to hedge price volatility in certain refining inventories and firm commitments to purchase inventories. The level of activity for our fair value hedges is based on the level of our operating inventories, and generally represents the amount by which our inventories differ from our previous year-end LIFO inventory levels.

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As of June 30, 2012, we had the following outstanding commodity derivative instruments that were entered into to hedge crude oil and refined product inventories and commodity derivative instruments related to the physical purchase of crude oil and refined products at a fixed price. The information presents the notional volume of outstanding contracts by type of instrument and year of maturity (volumes in thousands of barrels).



		Notional Contract Volumes by Year of Maturity
Derivative Instrument		2012
Crude oil and refined products:
Futures – long		4,869
Futures – short		9,052
Physical contracts - long		4,183

Cash Flow Hedges

Cash flow hedges are used to hedge price volatility in certain forecasted feedstock and refined product purchases, refined product sales, and natural gas purchases. The objective of our cash flow hedges is to lock in the price of forecasted feedstock, product or natural gas purchases or refined product sales at existing market prices that we deem favorable.

As of June 30, 2012, we had the following outstanding commodity derivative instruments that were entered into to hedge forecasted purchases or sales of crude oil and refined products. The information presents the notional volume of outstanding contracts by type of instrument and year of maturity (volumes in thousands of barrels).



		Notional Contract Volumes by Year of Maturity
Derivative Instrument		2012
Crude oil and refined products:
Swaps – long		5,511
Swaps – short		5,511
Futures – long		18,386
Futures – short		10,768
Physical contracts – short		7,618

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Economic Hedges

Economic hedges represent commodity derivative instruments that are not designated as fair value or cash flow hedges and are used to manage price volatility in certain (i) refinery feedstock, refined product, and corn inventories, (ii) forecasted refinery feedstock, refined product, and corn purchases, and refined product sales, and (iii) fixed-price corn purchase contracts. Our objective for entering into economic hedges is consistent with the objectives discussed above for fair value hedges and cash flow hedges. However, the economic hedges are not designated as a fair value hedge or a cash flow hedge for accounting purposes, usually due to the difficulty of establishing the required documentation at the date that the derivative instrument is entered into that would allow us to achieve “hedge deferral accounting.”

As of June 30, 2012, we had the following outstanding commodity derivative instruments that were used as economic hedges and commodity derivative instruments related to the physical purchase of corn at a fixed price. The information presents the notional volume of outstanding contracts by type of instrument and year of maturity (volumes in thousands of barrels, except those identified as corn contracts that are presented in thousands of bushels).



	Notional Contract Volumes by Year of Maturity
Derivative Instrument	2012	2013
Crude oil and refined products:
Swaps – long	30,879	—
Swaps – short	28,174	—
Futures – long	58,610	85
Futures – short	79,986	—
Corn:
Futures – long	49,750	55
Futures – short	91,035	3,375
Physical contracts – long	38,336	3,610

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Trading Derivatives

Our objective in entering into commodity derivative instruments for trading purposes is to take advantage of existing market conditions related to future results of operations and cash flows.

As of June 30, 2012, we had the following outstanding commodity derivative instruments that were entered into for trading purposes. The information presents the notional volume of outstanding contracts by type of instrument and year of maturity (volumes represent thousands of barrels, except those identified as natural gas contracts that are presented in billions of British thermal units and corn contracts that are presented in thousands of bushels).



	Notional Contract Volumes by Year of Maturity
Derivative Instrument	2012	2013
Crude oil and refined products:
Swaps – long	19,043	27,930
Swaps – short	17,917	28,321
Futures – long	101,095	18,832
Futures – short	102,208	17,760
Options – long	11,900	—
Options – short	12,271	—
Natural gas:
Futures – long	6,800	200
Futures – short	6,400	—
Corn:
Swaps - long	2,605	—
Swaps - short	12,460	1,580
Futures – long	19,360	—
Futures – short	19,360	—

Compliance Program Price Risk

We are exposed to market risks related to the volatility in the price of financial instruments associated with various governmental and regulatory compliance programs that we must purchase in the open market to comply with these programs. These programs are described below.

Obligation to Blend Biofuels

We are obligated to blend biofuels into the products we produce in most of the countries in which we operate, and these countries set annual quotas for the percentage of biofuels that must be blended into the motor fuels consumed in these countries. As a producer of motor fuels from petroleum, we are obligated to blend biofuels into the products we produce at a rate that is at least equal to the applicable quota. To the degree we are unable to blend at the applicable rate in the U.S. and the United Kingdom (U.K.), we must purchase Renewable Identification Numbers (RINs) in the U.S. and Renewable Transport Fuel Obligation certificates (RTFCs) in the U.K., and as such, we are exposed to the volatility in the market price of these financial instruments.

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We have not entered into derivative instruments to manage this risk, but we purchase RINs and RTFCs when the price of these instruments is deemed favorable. The cost of meeting our obligations under this compliance program was $59 million and $39 million for the three months ended June 30, 2012 and 2011, respectively, and $126 million and $95 million for the six months ended June 30, 2012 and 2011. These amounts are reflected in cost of sales.

Maintaining Minimum Inventory Quantities

In the U.K., we are required to maintain a minimum quantity of crude oil and refined products as a reserve against shortages or interruptions in the supply of these products. To the degree we decide not to physically hold the minimum quantity of crude oil and refined products, we must purchase Compulsory Stock Obligation (CSO) tickets from other suppliers of refined products in the U.K. or other European Union (EU) member countries, and we make economic decisions as to the cost of maintaining certain quantities of crude oil and refined products versus the cost of purchasing CSO tickets. We have not entered into derivative instruments to manage the price volatility of CSO tickets. For the three and six months ended June 30, 2012, the cost of purchasing CSO tickets to help meet our obligations under this compliance program was $1 million and $3 million, respectively and this amount was reflected in cost of sales. We had no obligations under this compliance program prior to completing the Pembroke Acquisition in 2011.

Emission Allowances

Our Pembroke Refinery is subject to a maximum amount of carbon dioxide that it can emit each year under the EU Emissions Trading Scheme. Under this cap-and-trade program, we purchase emission allowances on the open market for the difference between the amount of carbon dioxide emitted and the maximum amount allowed under the program. Therefore, we are exposed to the volatility in the market price of these allowances. For the three months ended June 30, 2012, no costs were incurred to meet our obligation under