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FORM 10-K
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

(Mark One)

x

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

For the year ended December 31, 2002

OR

o

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

For the transition period from                 to                

Commission File Number 1-16417

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

One Valero Place
San Antonio, Texas
(Address of principal executive offices)
78212
(Zip Code)

Telephone number: (210) 370-2000
(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 28, 2002, 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 $188,887,500.

The number of common units outstanding as of February 1, 2003 was 9,684,572.

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VALERO L.P. AND SUBSIDIARIES
FORM 10-K
DECEMBER 31, 2002

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Cautionary Statement Regarding Forward-Looking Information

     This report includes forward-looking statements regarding future events and the future financial performance of the Partnership (as defined below). All forward-looking statements are based on the Partnership’s beliefs as well as assumptions made by and information currently available to the Partnership. Words such as “believes”, “expects”, “intends”, “forecasts”, “projects” and similar expressions, identify forward-looking statements within the meaning of the Securities Litigation Reform Act of 1995. These statements reflect the Partnership’s current views with respect 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 the Partnership’s pipelines and handled at the Partnership’s terminals and storage facilities;
•		Any significant decrease in the demand for refined products in the markets served by the Partnership’s pipelines;
•		Any material decline in production by any of Valero Energy’s (as defined below) McKee, Three Rivers, 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 the Partnership’s pipelines;
•		Any challenges to the Partnership’s tariff rates or changes in the FERC’s ratemaking methodology;
•		Any material decrease in the supply of or material increase in the price of crude oil available for transport through the Partnership’s pipelines;
•		Inability to expand the Partnership’s business and acquire new assets as well as to attract third party shippers;
•		Conflicts of interest with Valero Energy;
•		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’ indebtedness;
•		Any change in the credit rating assigned to Valero Energy’s indebtedness;
•		Any reductions in space allocated to our customers in interconnecting third party pipelines;
•		Any material increase in the price of natural gas;
•		War, terrorist attacks, threats of war or terrorist attacks or political or other disruptions that limit oil production;
•		The Partnership’s former use of Arthur Andersen LLP; and
•		Proposed changes in federal income tax law.

If one or more of these risks or uncertainties materialize, or if the underlying assumptions prove incorrect, actual results may vary materially from those described in the forward-looking statement. Readers are cautioned not to place undue reliance on this forward-looking information, which is as of the date of this Form 10-K, and the Partnership undertakes no obligation to update publicly or revise any forward-looking information, whether as a result of new information, future events or otherwise.

PART I

Items 1. and 2. Business and Properties

General

Valero L.P. is a Delaware limited partnership that was formed December 7, 1999. Valero L.P.’s principal executive offices are located at One Valero Place, San Antonio, Texas 78212 and its telephone number is (210) 370-2000. The operations are conducted through a subsidiary entity, Valero Logistics Operations, L.P (Valero Logistics). As used in this report, the term “Partnership” refers to Valero L.P. and its operating subsidiary, Valero Logistics.

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Valero L.P. was originally formed under the name of “Shamrock Logistics, L.P.,” and changed its name to “Valero L.P.” effective January 1, 2002, following completion of Valero Energy Corporation’s acquisition of Ultramar Diamond Shamrock Corporation (UDS) on December 31, 2001. In addition, Valero Logistics changed its name from “Shamrock Logistics Operations, L.P.” effective January 1, 2002. 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 operating subsidiary.

On April 16, 2001, Valero L.P. completed its initial public offering of 5,175,000 common units, representing approximately 26% of its outstanding units. Valero L.P.’s common units are listed on the New York Stock Exchange under the symbol “VLI.”

Valero Energy, through its wholly owned subsidiaries, currently owns a total of 4,497,641 common units and 9,599,322 subordinated units, representing an aggregate 71.6% limited partner interest in Valero L.P. Valero Energy owns and controls Valero L.P.’s general partner, Riverwalk Logistics, L.P., which owns a 2% interest in Valero L.P. and has incentive distribution rights giving it higher percentages of Valero L.P.’s quarterly cash distributions as various target distribution levels are met.

The Partnership generates revenue from its pipeline operations by charging tariffs for transporting crude oil, other refinery feedstocks and refined products through its pipelines. The Partnership also generates revenue through its terminalling operations by charging a terminalling fee to its customers. The terminalling fee is earned when refined products enter the terminal and includes the cost of transferring the refined products from the terminal to trucks. An additional fee is charged at the refined product terminals for blending additives into various refined products. The Partnership currently does not generate any separate revenue from its crude oil storage facilities. Instead, the costs associated with these facilities were considered in establishing the tariff rates charged for transporting crude oil from the storage facilities to the refineries. The Partnership’s primary customer for its pipelines and its terminalling operations is Valero Energy, which accounted for 99% of the Partnership’s revenues for the year ended December 31, 2002.

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 also are transported in another of the Partnership’s pipelines for which a separate tariff is charged.

Pipeline Operations

     General

The Partnership has an ownership interest in nine crude oil pipelines with an aggregate length of approximately 783 miles and 19 refined product pipelines with an aggregate length of approximately 2,846 miles. The Partnership also owns a 25-mile-long crude hydrogen pipeline. The Partnership operates all but three of the pipelines. For the pipelines in which the Partnership owns less than a 100% ownership interest, the Partnership funds capital expenditures in proportion to its respective ownership percentage.

For all but two of the pipelines, Valero Energy is the only customer for transportation of crude oil or refined products.

     Crude Oil Pipelines

The Partnership’s crude oil pipelines deliver crude oil and other feedstocks, such as gas oil and normal butane, from various points in Texas, Oklahoma, Kansas and Colorado to Valero Energy’s McKee, Three Rivers and Ardmore refineries. The following table sets forth the average daily number of barrels of crude oil and other feedstocks the Partnership transported through its crude oil pipelines, in the aggregate, in each of the years presented.

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The following table sets forth information about each of the Partnership’s crude oil pipelines.

     Refined Product Pipelines

The Partnership’s refined product pipelines transport refined products from Valero Energy’s McKee, Three Rivers and Ardmore refineries to the Partnership’s terminals or to interconnections with third-party pipelines, for distributions in 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 petrochemical raw materials such as toluene, xylene and raffinate. During the year ended December 31, 2002, gasoline and distillates represented approximately 65% and 23%, respectively, of the total throughput in the Partnership’s refined product pipelines.

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

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The following table sets forth information about each of the Partnership’s refined product pipelines. In instances where the Partnership 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.

Storage and Terminalling Operations

The Partnership owns a total of five crude oil storage facilities in Texas and Oklahoma. These facilities have a total of 15 tanks with a capacity of 3,326,000 barrels. The Partnership also owns 12 refined products terminals in Texas, Colorado, New Mexico and California, including an asphalt terminal in Pittsburg, California that it acquired in January 2003. See Items 1. and 2. Business and Properties, “Recent Developments in 2000.” These terminals have a total of 136 tanks with a combined capacity of 3,192,000 barrels.

     Crude Oil Storage Facilities

The Partnership’s crude oil storage facilities serve the needs of Valero Energy’s McKee, Three Rivers and Ardmore refineries.

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The following table sets forth information about the crude oil storage facilities:

     Refined Product Terminals

The Partnership’s 12 refined product terminals have automated loading facilities available 24 hours a day. Billing of Valero Energy’s customers is electronically accomplished by the Fuels Automation and Nomination System (FANS). This automatic system provides for control of allocations, credit and carrier certification by remote input of data by customers. All terminals have an electronic monitoring and control system that monitors the effectiveness of the ground protection and vapor control and will cause an automated shutdown of the terminal operations if necessary. For environmental and safety protection, all terminals have primary vapor control systems consisting of flares, vapor combustors or carbon absorption vapor recovery units.

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The following table sets forth information about each of the Partnership’s refined product terminals:

Pipeline, Storage Facility, and Terminal Control Operations

All of the Partnership’s crude oil and refined product pipelines are operated via satellite communication systems from one of two central control rooms located in San Antonio and Dumas, Texas near Valero Energy’s McKee refinery. Each control center can provide backup capability for the other, and each center is capable of monitoring and controlling all of the pipelines. There is also a backup control center located at the San Antonio refined product terminal approximately 25 miles from the primary control center in San Antonio.

The control centers operate with modern, state-of-the-art System Control and Data Acquisition systems (SCADA). The control centers are equipped with computer systems designed to continuously monitor real time operational data, including crude oil and refined product throughput, flow rates and pressures. In addition, the control centers monitor alarms and throughput balances. The control centers operate remote pumps, motors, engines and valves associated with the delivery of crude oil and refined products. The computer systems are designed to enhance leak-detection capabilities, sound automatic alarms if operational conditions outside pre-established parameters occur and provide for remote-controlled shutdown of pump stations on the pipelines. Pump stations, crude oil storage facilities and meter-measurement points along the pipelines are linked by satellite or telephone communication systems for remote monitoring and control.

A number of the Partnership’s crude oil storage facilities and refined product terminals are also operated through the central control centers. Other crude oil storage facilities and refined product terminals are modern, automated facilities but are locally controlled.

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The Partnership’s Relationship with Valero Energy

     General

Valero Energy owns and operates 12 refineries, three of which are served by the Partnership’s pipelines and terminals:

•		the McKee refinery, which has a current total capacity to process approximately 170,000 barrels per day of crude oil and other feedstocks, making it the largest refinery located between the Texas Gulf Coast and the West Coast;
•		the Three Rivers refinery, which has a current total capacity to process approximately 98,000 barrels per day of crude oil and other feedstocks; and
•		the Ardmore refinery, which has a current total capacity to process approximately 85,000 barrels per day of crude oil and other feedstocks.

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

During the year ended December 31, 2002, the Partnership generated revenues of $118,458,000, with Valero Energy accounting for 99% of this amount. Although the Partnership intends to pursue strategic third-party acquisitions as opportunities may arise, management expects to continue to derive most of the Partnership’s revenues from Valero Energy for the foreseeable future.

     Pipelines and Terminals Usage Agreement

The Partnership’s operations are strategically located within Valero Energy’s refining and marketing supply chain, but the Partnership does not own or operate any refining or marketing assets. Valero Energy is dependent upon the Partnership to provide transportation services that support the refining and marketing operations in the markets served by Valero Energy’s McKee, Three Rivers and Ardmore refineries. Under a Pipelines and Terminals Usage Agreement, Valero Energy has agreed through April 2008:

•		to transport in the Partnership’s crude oil pipelines at least 75% of the aggregate volumes of the crude oil shipped to the McKee, Three Rivers and Ardmore refineries;
•		to transport in the Partnership’s refined product pipelines at least 75% of the aggregate volumes of the refined products (excluding residual oils, primarily asphalt and fuel oil) shipped from these refineries; and
•		to use the Partnership’s refined product terminals for terminalling services for at least 50% of the refined products (excluding residual oils, primarily asphalt and fuel oil) shipped from these refineries.

Valero Energy met and exceeded its obligations under the Pipelines and Terminals Usage Agreement during the year ended December 31, 2002. In addition, Valero Energy has agreed to remain the shipper for crude oil and refined products owned by it that are transported through the Partnership pipelines, and neither challenge, nor cause others to challenge, the Partnership’s interstate or intrastate tariff rates for the transportation of crude oil and refined products until at least April 1, 2008.

Valero Energy’s obligation to use the Partnership’s crude oil and refined product pipelines and terminals may be suspended if Valero Energy ceases to own the refineries, if material changes in the market conditions occur for the transportation of crude oil and refined products, or in the markets served by these refineries, that have a material adverse effect on Valero Energy, or if the Partnership is unable to handle the volumes Valero Energy requests to be transported due to operational difficulties with the pipelines or terminals. In the event Valero Energy does not transport in the Partnership’s pipelines or use the Partnership’s terminals to store and ship the minimum volume requirements and its obligation to do so has not been suspended under the terms of the agreement, it is required to make a cash payment determined by multiplying the shortfall in volume by the weighted average tariff rate or terminal fee charged.

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     Services Agreement

The Partnership does not have any employees. Under a Services Agreement with Valero Energy, employees of Valero Energy perform services on the Partnership’s behalf, and Valero Energy is reimbursed for the services rendered by its employees. In addition, the Partnership pays Valero Energy and its affiliates an annual fee of $5,200,000 under the Services Agreement to perform and provide other services, including legal, accounting, treasury, engineering and information technology. The fee is adjustable annually based on the Consumer Price Index published by the U.S. Department of Labor and may be adjusted to take into account additional service levels required by the acquisition or construction of additional assets.

     Omnibus Agreement

The Omnibus Agreement governs potential competition between Valero Energy and the Partnership. Under the Omnibus Agreement, Valero Energy has agreed, for so long as Valero Energy controls the general partner, not to engage in, whether by acquisition or otherwise, 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 (and now part of Valero Energy) as of April 16, 2001, the closing of the Partnership’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 the Partnership has been offered and declined the opportunity to purchase the business; and
	•		any newly constructed pipeline, terminalling or storage assets that the Partnership 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 the Partnership for environmental liabilities related to the assets transferred to the Partnership in connection with the Partnership’s initial public offering that arose prior to April 16, 2001 and are discovered within 10 years after April 16, 2001 (excluding liabilities resulting from a change in law after April 16, 2001).

Significant Developments in 2002

     Senior Note Offering

On July 15, 2002, Valero Logistics completed the sale of $100,000,000 aggregate principal amount of its 6.875% senior notes due 2012 for net proceeds of $98,207,000, of which $91,000,000 was used to pay off the then outstanding balance under the revolving credit facility. For a more detailed description of the senior notes, please read Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations- Liquidity and Capital Resources- Financing.”

     Reorganization of General Partner Ownership.

On May 30, 2002, Valero L.P. and Valero GP, LLC, the general partner of Riverwalk Logistics, L.P. (Riverwalk Logistics) (at that time the general partner of each of Valero L.P. and Valero Logistics), reorganized the general partner ownership interest in Valero Logistics. As a result of the reorganization, Riverwalk Logistics is the general partner of Valero L.P., owning a 2% general partnership interest, and Valero L.P. now holds a 99.99% limited partnership interest in Valero Logistics. Valero L.P. formed Valero GP, Inc., a Delaware corporation wholly owned by Valero L.P., which is Valero Logistics’ new general partner with a 0.01% general partner interest. As a result of the reorganization, Valero Logistics is a 100%-owned subsidiary of Valero L.P.

     Acquisition of the 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 in Texas City, Texas and ends at Praxair, Inc.’s plant in La Porte, Texas. The cost of the pipeline construction was $11,000,000. On May 29, 2002, the Partnership purchased the newly constructed pipeline from Valero Energy for $11,000,000 and exchanged that pipeline for a 25-mile crude hydrogen pipeline owned by Praxair, Inc. under an asset exchange agreement previously negotiated between Valero Energy and Praxair, Inc. The crude hydrogen pipeline originates at a chemical facility of BOC (successor to Celanese Ltd.) in Clear Lake, Texas and ends at Valero

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Energy’s Texas City refinery. The pipeline supplies crude hydrogen to the refinery under a long-term supply arrangement between Valero Energy and BOC.

In conjunction with the exchange, the Partnership entered into a Hydrogen Tolling Agreement with Valero Energy for the transportation of crude hydrogen for a fixed annual fee. In addition, the Partnership assumed an operating agreement with Praxair, Inc. whereby Praxair, Inc. will operate the crude hydrogen pipeline. The Partnership may terminate the operating agreement upon 180 days notice.

     Acquisition of the Wichita Falls Business

On February 1, 2002, the Partnership acquired the Wichita Falls Crude Oil Pipeline and Storage Business (the Wichita Falls Business) from Valero Energy for $64,000,000. The Wichita Falls Business owns and operates the Wichita Falls to McKee crude oil pipeline and the Wichita Falls crude oil storage facility, which the Partnership had an option to purchase from Valero Energy under the Omnibus Agreement.

Because of Valero L.P.’s affiliate relationship with the Wichita Falls Business, the acquisition of the Wichita Falls Business on February 1, 2002 constituted a reorganization of entities under common control. Accordingly, the acquisition was recorded at Valero Energy’s historical net book value related to the Wichita Falls Business, which approximated fair value as a result of Valero Energy’s acquisition of UDS on December 31, 2001. In addition, the consolidated financial statements and notes thereto of Valero L.P. as of December 31, 2001 have been restated to include the Wichita Falls Business as if it had been combined with Valero L.P. effective December 31, 2001.

Recent Developments in 2003

     Acquisition of the Telfer Asphalt Terminal

In January 2003, the Partnership purchased an asphalt terminal in Pittsburg, California from Telfer Oil Company (Telfer) for $15,000,000. The asphalt terminal assets include 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, various other tanks and equipment. In conjunction with the Telfer acquisition, the Partnership entered into a six-year terminal storage and throughput agreement with Valero Energy. The agreement includes (a) an exclusive lease by Valero Energy of the asphalt storage tanks and related equipment for a monthly fee per barrel of storage capacity, (b) Valero Energy’s right to move asphalt through the terminal for a per barrel throughput fee with a guaranteed minimum annual throughput of 280,000 barrels, and (c) Valero Energy’s reimbursement of the Partnership for certain costs, including utilities.

     Amended Revolving Credit Facility

On March 6, 2003, Valero Logistics amended its five-year revolving credit facility, increasing its limit to$175,000,000. The revolving credit facility, as amended, expires January 15, 2006.

Borrowings under the credit facility may be used for working capital and general partnership purposes; however, borrowings to fund distributions to the Partnership’s unitholders are limited to $40,000,000. The revolving credit facility also allows Valero Logistics to issue letters of credit for an aggregate amount of $75,000,000. The borrowings under the revolving credit facility are unsecured and rank equally with all of Valero Logistics’ outstanding unsecured and unsubordinated debt.

For a more detailed description of Valero Logistics’ amended revolving credit facility, please read Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations —Liquidity and Capital Resources.”

     Crude Oil Tank Contribution

The Partnership has entered into two contribution agreements with Valero Energy pursuant to which, upon satisfaction of the closing conditions, Valero Energy will contribute 58 crude oil and intermediate feedstock storage tanks and related assets to the Partnership for $200,000,000 in cash.

The tank assets consist of all of the tank shells, foundations, tank valves, tank gauges, pressure equipment, temperature equipment, corrosion protection, leak detection, tank lighting and related equipment and appurtenances associated with the specified crude oil tanks and intermediate feedstock tanks located at Valero Energy’s:

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	•		West plant of the Corpus Christi refinery in Corpus Christi, Texas, which has a current total capacity to process 225,000 barrels per day of crude oil and other feedstocks;
	•		Texas City refinery in Texas City, Texas, which has a current total capacity to process 243,000 barrels per day of crude oil and other feedstocks; and
	•		Benicia refinery in Benicia, California, which has a current total capacity to process 180,000 barrels per day of crude oil and other feedstocks.

The Corpus Christi refinery consists of two plants, the West plant and the East plant, with a combined total capacity to process 340,000 barrels per day of crude oil and other feedstocks. Since June 1, 2001 (the date Valero Energy began operating the East plant), Valero Energy has operated both plants as one refinery. Unless otherwise indicated, references to the Corpus Christi refinery include both the West and the East plants.

Historically, nearly all of the crude oil and intermediate feedstocks that are used in the West plant of the Corpus Christi refinery, the Texas City refinery and the Benicia refinery have passed through these tanks. These feedstocks are held in the tanks or are segregated and blended to meet the refineries’ process requirements. These tanks have approximately 11,000,000 barrels of storage capacity in the aggregate.

The following table reflects the number of crude oil and intermediate feedstock tanks and storage capacity, as well as mode of receipt and delivery, for each of the West plant of the Corpus Christi refinery, the Texas City refinery and the Benicia refinery.

The tanks are, on average, approximately 25 years old. The tank assets have been well maintained and the Partnership estimates that they have remaining useful lives of 25 to 30 years. The crude oil tank contribution does not include a transfer of the refined product tanks or the land underlying the tank assets at these three refineries nor does it include any of the crude oil and other feedstock or refined product tankage currently owned by Valero Energy at the East plant of Valero Energy’s Corpus Christi refinery or its other nine refineries. The land on which the tank assets are located will be leased to Valero Logistics by Valero Energy for an aggregate of $700,000 per year. The initial term of each lease will be 25 years, subject to automatic renewal for successive one-year periods thereafter. The Partnership may terminate any of these leases upon 30 days notice after the initial term or at the end of the renewal period. In addition, the Partnership may terminate any of these leases upon 180 days notice prior to the expiration of the current term if the Partnership ceases to operate the tank assets or ceases business operations.

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The following table sets forth the average daily throughput of the specified feedstocks (crude oil, gas oil, residual fuel oil, vacuum gas oil, vacuum tower bottoms and light cycle oil) for each of the West plant of the Corpus Christi refinery, the Texas City refinery and the Benicia refinery for the five-year period ended December 31, 2002.

Throughputs of the specified feedstocks at these refineries vary from year to year as a result of market conditions and maintenance turnarounds, as well as increases in refinery capacities resulting from capital expenditures. In 2002, refined product inventories industry-wide were high and imports of refined products were at record levels, resulting in unfavorable refining and marketing conditions. According to the Energy Information Agency, U.S. refinery utilization in 2002 was 89.9% of capacity compared to an average utilization of 93.6% for the period of 1997 through 2001. As a result of these conditions, Valero Energy initiated economic-based refinery production cuts, by as much as 25% during certain times of the year, at certain of its refineries. As refining margins increased in the latter half of 2002, the refineries returned to normal operating levels; however, full year 2002 throughput levels were lower than in 2001. Volumes at the West plant of the Corpus Christi refinery were negatively impacted by market conditions in 1999 and 2002. Additionally, the West plant of the Corpus Christi refinery underwent maintenance turnaround for a period of 20 days in 2002 that involved its heavy oil cracker.

Volumes at the Texas City refinery were adversely impacted in 2002 by market conditions and a 45-day plant-wide turnaround in which major units at the facility were expanded and upgraded. However, in 2001, volumes benefited from above-average refining margins and high refinery production rates. Additionally, 2000 volumes were adversely impacted by maintenance and construction activities related to the expansion of two crude units.

Volumes at the Benicia refinery were adversely impacted by unplanned downtimes in 2002. There have been no major turnarounds needed since Valero Energy purchased this refinery in 2000. Although this refinery is completing a capital project to convert its gasoline production to meet stricter California gasoline standards by the end of 2003, the Partnership does not believe that this project will materially impact volumes at this refinery.

Valero Energy does not have any significant turnarounds planned for 2003 at any of these refineries.

Throughput Fee. In connection with the crude oil tank contribution, Valero Logistics and Valero Energy will enter into a handling and throughput agreement pursuant to which Valero Energy will agree to pay Valero Logistics a fee, for an initial period of ten years, for 100% of specified feedstocks delivered to each of the West plant of the Corpus Christi refinery, the Texas City refinery and the Benicia refinery and to use Valero Logistics for handling all deliveries to these refineries as long as Valero Logistics is able to provide the handling and throughput services. Subject to force majeure and other exceptions, Valero Logistics will reimburse Valero Energy for the cost of substitute services should Valero Logistics not be able to provide these services. Valero Logistics and Valero Energy will agree, pursuant to the handling and throughput agreement, to the following initial throughput fee per barrel for each barrel of the specified feedstocks received by these refineries:

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For specified feedstocks delivered by Valero Logistics to these refineries after December 31, 2003, the throughput fee per barrel will be adjusted 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 will be ten years and may be extended by Valero Energy for up to an additional five years.

Operating Expenses. Valero Logistics will enter into services and secondment agreements with Valero Energy pursuant to which the Partnership anticipates that 25 employees, on a full-time equivalent basis, of Valero Energy will be seconded to Valero Logistics to provide operating and routine maintenance services with respect to the tank assets under the direction, supervision and control of a designated employee of Valero GP, LLC performing services for Valero Logistics. Valero Logistics will reimburse Valero Energy for the costs and expenses of the employees providing these operating and routine maintenance services. The annual reimbursement for services is an aggregate $3,500,000 for the year following closing and will be subject to adjustment for the actual operating and routine maintenance costs and expenses incurred and increases in the regional consumer price index. In addition, the Partnership has agreed to pay Valero Energy $700,000 a year for the lease of the real property on which the tank assets are located. In addition, the annual services reimbursement may be adjusted downward if the actual costs for the services provided by Valero Energy are lower. The initial terms of the services and secondment agreements will be ten years with an option to extend for an additional five years. Valero Logistics may terminate these agreements upon 30 days written notice.

In addition to the fees the Partnership has agreed to pay Valero Energy under the services and secondment agreement, the Partnership will be responsible for operating expenses and specified capital expenditures related to the tank assets that are not addressed in the services and secondment agreement. These operating expenses and capital expenditures include tank safety inspections, maintenance and repairs, certain environmental expenses, insurance premiums and ad valorem taxes. Based on the Partnership’s experience operating and maintaining similar assets and the Partnership’s knowledge of these assets, the Partnership estimates that:

	•		tank safety inspections, maintenance and repairs will initially cost approximately $4,500,000 per year;
	•		environmental expenses, insurance premiums and ad valorem taxes will initially be approximately $1,200,000 per year; and
	•		maintenance capital expenditures will initially be approximately $600,000 per year.

The operating expenses and maintenance capital expenditures that are not addressed in the services and secondment agreement are estimates only, even though they are based on assumptions made by the Partnership based on its experience operating and maintaining similar assets and the Partnership’s knowledge of these assets. Should the Partnership’s assumptions and expectations related to these operating expenses differ materially from actual future results, the Partnership may not be able to generate net income sufficient to sustain an increase in available cash per unit at the currently expected levels or at all.

Environmental Indemnification. In connection with the crude oil tank contribution, Valero Energy has agreed to indemnify the Partnership from environmental liabilities related to:

	•		the tank assets that arose as a result of events occurring or conditions existing prior to the closing of the crude oil tank contribution,
	•		any real or personal property on which the tank assets are located that arose prior to the closing of the crude oil tank contribution, and
	•		any actions taken by Valero Energy before, on or after the closing of the crude oil tank contribution, in connection with the ownership, use or operation of the West plant of the Corpus Christi refinery, the Texas City

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refinery and the Benicia refinery or the property on which the tank assets are located, or any accident or occurrence in connection therewith.

No Historical Financial Information. Historically, the tank assets have been operated as part of Valero Energy’s refining operations and, as a result, no separate fee has been charged related to these assets and, accordingly, no revenues related to these assets have been recorded. The tank assets have not been accounted for separately and have not been operated as an autonomous business unit. Instead, they have been operated as part of business units that comprise part of Valero Energy’s refining operations, and operating decisions have been made to maximize the overall profits of the refining businesses rather than the profits of any individual refinery asset such as the tank assets. The Partnership intends to manage and operate the tank assets to maximize revenues and cash available for distribution to its unitholders by charging Valero Energy and third parties a market-based throughput fee.

Financial Impact. Based on historical throughput volumes for the year ended December 31, 2002 and throughput fees for the year 2003 as agreed upon with Valero Energy, our aggregate revenues for the tank assets would have been approximately $32.4 million for the year ended December 31, 2002. Many factors could cause future results to differ from expected results, including a decline in Valero Energy’s refining throughput, due to market conditions or otherwise, at the West plant of the Corpus Christi refinery, the Texas City refinery or the Benicia refinery.

Conflicts Committee Approval. The crude oil tank contribution has been approved by a conflicts committee of the board of directors of Valero GP, LLC based on an opinion from its independent financial advisor that the consideration to be paid by the Partnership pursuant to the contribution agreement related to the crude oil tank contribution is fair, from a financial point of view, to the Partnership and its public unitholders.

Under the terms of the contribution agreements, the crude oil tank contribution is subject to customary closing conditions, including the absence of any material adverse change in the condition of the tank assets, the Partnership’s ability to obtain financing and consummation of the redemption transaction.

     South Texas Pipeline Contribution

The Partnership has entered into a contribution agreement with Valero Energy pursuant to which, upon satisfaction of the closing conditions, Valero Energy will contribute the South Texas pipeline system, comprised of the Houston pipeline system, the San Antonio pipeline system and the Valley Pipeline system and related terminalling assets, to the Partnership for $150,000,000 in cash. The three pipeline systems that make up the South Texas pipeline assets are intrastate common carrier refined product pipelines that connect Valero Energy’s Corpus Christi refinery to the Houston and Rio Grande Valley, Texas markets and connect Valero Energy’s Three Rivers refinery to the San Antonio, Texas market and to Valero Energy’s Corpus Christi refinery. The San Antonio pipeline system (the Pettus to San Antonio and the Pettus to Corpus Christi refined product pipelines) connects with the Three Rivers to Pettus refined product pipelines already owned by the Partnership. The San Antonio pipeline system delivers refined products to the San Antonio and Corpus Christi, Texas markets that it receives through the two existing pipelines. Each of the three intrastate pipelines is subject to the regulatory jurisdiction of the Texas Railroad Commission.

On June 1, 2001, Valero Energy and subsidiaries of El Paso Corporation consummated two capital leases with an associated purchase option with respect to the East plant of the Corpus Christi refinery and the related South Texas pipeline and terminal assets. Valero Energy has been operating these assets since that date. On February 28, 2003, Valero Energy exercised the purchase option for approximately $289,300,000 in cash.

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The following table sets forth the average daily throughput of gasoline, distillate and blendstocks volumes transported from the Corpus Christi refinery and the Three Rivers refinery and the mode of transportation for these volumes for the period from June 1, 2001 through December 31, 2001 and for the year ended December 31, 2002.

The Houston pipeline system and the Valley pipeline system provide the primary pipeline access for refined products from Valero Energy’s Corpus Christi refinery. Other than pipelines, marine transportation has historically been the primary mode of transportation for refined products from this refinery. The San Antonio pipeline system, in conjunction with existing refined product pipelines the Partnership owns, provide essentially the only pipeline access to end markets from Valero Energy’s Three Rivers refinery. Refined products are also delivered via Valero Energy’s truck loading rack at this refinery.

Houston Pipeline System. The Houston pipeline system includes the Corpus Christi to Houston refined product pipeline, which is a 12-inch refined product pipeline that runs approximately 204 miles from Valero Energy’s Corpus Christi refinery located in Corpus Christi, Texas, to Placedo, Texas and on to Pasadena, Texas. This pipeline interconnects with major third party pipelines with delivery points throughout the eastern United States. In October 2002, the Corpus Christi to Houston refined product pipeline was expanded from 95,000 per day to 105,000 barrels per day. At present, the Partnership is transporting over 100,000 barrels per day of refined product in this pipeline. In 2002, the Corpus Christi refinery provided 88% of the pipeline’s throughput and third party shippers provided the remaining 12%. In addition, this pipeline system includes the following four refined product terminals:

	•		Hobby Airport refined product terminal located at the Hobby airport in Houston, Texas, which includes 107,100 barrels of jet fuel storage and associated truck rack and re-fueler facilities;
	•		Placedo refined product terminal located near Victoria, Texas, which includes 98,000 barrels of refined product storage and associated truck loading rack;
	•		Houston asphalt terminal located on the Houston ship channel, which includes 75,000 barrels of asphalt storage, truck loading facilities and a barge dock; and

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•

Almeda refined product terminal located in south Houston, which includes 105,800 barrels of refined product storage and associated truck-loading rack, which is currently idle.

San Antonio Pipeline System. The San Antonio pipeline system is comprised of two segments: the north segment, which runs from Pettus to San Antonio and the south segment, which runs from Pettus to Corpus Christi. The north segment originates in Pettus, Texas, where it connects to the Partnership’s existing 12-inch Three Rivers to Pettus refined product pipeline and terminates in San Antonio, Texas at the San Antonio refined product terminal. This San Antonio refined product terminal, which has approximately 148,200 barrels of storage capacity and an associated truck loading rack, is separate from the San Antonio terminal currently owned by the Partnership. The north segment is 74 miles long and consists of 6-inch and 12-inch pipeline segments with a capacity of approximately 24,000 barrels per day. This pipeline segment transports refined products from the Three Rivers refinery, located between Corpus Christi and San Antonio to the San Antonio refined product terminal.

The south segment originates in Pettus, Texas, where it connects to the Partnership’s existing 8-inch Three Rivers to Pettus refined product pipeline and terminates in Corpus Christi, Texas at Valero Energy’s Corpus Christi refinery. The south segment is 60 miles long and consists of 6-inch, 8-inch, 10-inch and 12-inch pipeline segments with a capacity of approximately 15,000 barrels per day. This pipeline segment transports distillates and blendstocks, primarily raffinate, from the Three Rivers refinery to the Corpus Christi refinery. Valero Energy is the only shipper in both segments of the San Antonio Pipeline System. Although it is possible to operate the two segments of the San Antonio pipeline as a continuous pipeline from Corpus Christi to San Antonio, this is rarely done and the Partnership has no present intention to do so.

Valley Pipeline System. The Valley pipeline system contains the Corpus Christi to Edinburg refined product pipeline and the Edinburg refined product terminal. This pipeline is a refined product pipeline that consists of 6-inch and 8-inch segments and extends 130 miles from Corpus Christi, Texas to Edinburg, Texas. The capacity of the Corpus Christi to Edinburg refined product pipeline was expanded in 2002 from 24,000 barrels per day to approximately 27,100 barrels per day. Refined products shipped on the Valley pipeline system are distributed in the Southern Rio Grande Valley area of Texas, which includes the cities of Edinburg and McAllen, Texas with occasional spot sales to Petróleos Mexicanos (“Pemex”) for distribution in Mexico. Valero Energy is the only shipper in this pipeline. The Edinburg refined product terminal includes approximately 184,600 barrels of refined product storage and an associated truck loading rack.

The following table sets forth the origin and destination, length in miles, ownership percentage, capacity and average throughput for the period from June 1, 2001 (the date Valero Energy began operating the South Texas pipelines and terminals) through December 31, 2001 and the year ended December 31, 2002, for each refined product pipeline associated with the South Texas pipeline contribution.

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The following table outlines the location, capacity, number of tanks, mode of receipt and delivery and average throughput for the period from June 1, 2001 (the date Valero Energy began operating the South Texas pipelines and terminals) through December 31, 2001 and the year ended December 31, 2002 for each refined product terminal associated with the South Texas pipeline contribution.