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VALERO ENERGY CORPORATION
(Exact name of registrant as specified in its charter)

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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes   X   No __

The number of shares of the registrant’s only class of common stock, $0.01 par value, outstanding as of October 29, 2004 was 256,637,559.

VALERO ENERGY CORPORATION AND SUBSIDIARIES
 
INDEX

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PART I — FINANCIAL INFORMATION
Item 1. Financial Statements

VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Millions of Dollars, Except Par Value)

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)

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)

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)

See Condensed Notes to Consolidated Financial Statements.

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VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

As used in this report, the term Valero may refer to Valero Energy Corporation, one or more of its consolidated subsidiaries, or all of them taken as a whole.

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

These unaudited consolidated financial statements have been prepared in accordance with United States generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities Exchange Act of 1934. Accordingly, they do not include all of the information and notes required by GAAP for complete consolidated financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation have been included. All such adjustments are of a normal recurring nature unless disclosed otherwise. Financial information for the three and nine months ended September 30, 2004 and 2003 included in the Condensed Notes to Consolidated Financial Statements is derived from Valero’s unaudited consolidated financial statements. Operating results for the three and nine months ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004.

The consolidated balance sheet as of December 31, 2003 has been derived from the audited financial statements as of that date. For further information, refer to the consolidated financial statements and notes thereto included in Valero’s Annual Report on Form 10-K for the year ended December 31, 2003.

Share and per share data (except par value) presented for all periods reflect the effect of a two-for-one stock split, which was effected in the form of a common stock dividend distributed on October 7, 2004, as discussed in Note 8 under “Common Stock Split.”

Certain previously reported amounts have been reclassified to conform to the 2004 presentation.

2. ACCOUNTING PRONOUNCEMENTS

FASB Staff Position 106-2
In May 2004, the Financial Accounting Standards Board (FASB) issued Staff Position No. FAS 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003,” which provides guidance on accounting for the effects of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (the Act) for sponsors of postretirement health care plans. Staff Position No. FAS 106-2 is effective for interim or annual financial statements for periods beginning after June 15, 2004, and supersedes the guidance of Staff Position No. FAS 106-1 on the same subject, which allowed employers to defer accounting for the effects of the Act, including the effect of a federal subsidy provided for in the Act. For sponsors of postretirement health care plans that provide prescription drug benefits, Staff Position No. FAS 106-2 requires the sponsor to determine whether those benefits are actuarially equivalent to the Medicare prescription drug benefit, and, if so, to remeasure the postretirement benefit obligation, and the effect of such remeasurement on the net periodic

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VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

postretirement benefit cost, on a retroactive or prospective basis at the election of the sponsor. Valero has concluded that the enactment of the Act does not constitute a significant event under FASB Statement No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions,” and therefore, in lieu of remeasuring plan obligations at the beginning of the third quarter, the effects of the Act will be incorporated into the next regular measurement of plan obligations as of December 31, 2004.

3. ACQUISITIONS

Aruba Acquisition
On March 5, 2004, Valero completed the purchase of El Paso Corporation’s refinery located on the island of Aruba in the Caribbean Sea (Aruba Refinery), and related marine, bunkering and marketing operations (collectively, Aruba Acquisition). The purchase price for the Aruba Acquisition was $465 million plus approximately $177 million for working capital, subject to final adjustment as set out in the purchase agreement. The working capital amount includes a preliminary post-closing adjustment and excludes amounts related to certain refined product inventories owned by a third-party marketing firm under an agreement in existence on the date of acquisition, pursuant to which Valero paid $67.8 million upon termination of the agreement on May 4, 2004. The Aruba Acquisition was funded with $200 million in existing cash, approximately $36 million in borrowings under Valero’s existing bank credit facilities and approximately $406 million in net proceeds from the sale of 15.6 million shares of Valero common stock through a public offering discussed in Note 8 under “Common Stock Offering.” The additional amount paid to the third-party marketing firm described above was funded through borrowings under Valero’s existing bank credit facilities. The results of the Aruba Refinery’s operations are non-taxable in Aruba through December 31, 2010.

Valero’s management believes that the acquisition of the Aruba Refinery strengthens Valero’s geographic and product diversification and will ensure a more secure supply of intermediate feedstocks and blendstocks to certain of its other refineries. Valero’s management also believes that the Aruba Acquisition increases Valero’s potential ability to take advantage of positive heavy sour crude oil fundamentals.

The purchase price was allocated based on estimated fair values of the assets acquired and the liabilities assumed at the date of acquisition, pending the completion of an independent appraisal and other evaluations, which are currently expected to be completed by the end of the year. As of September 30, 2004, the preliminary purchase price allocation was as follows (in millions):

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VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

St. Charles Acquisition
On July 1, 2003, Valero completed the acquisition of the St. Charles Refinery (St. Charles Acquisition) from Orion Refining Corporation (Orion). Total consideration for the purchase, including various transaction costs incurred and the release of certain escrowed amounts discussed below, was $529.0 million and included the issuance of 10 million shares of mandatory convertible preferred stock with a fair value of $22 per share. The purchase agreement required 844,000 shares to be held in escrow pending the satisfaction of certain conditions. The purchase agreement also provided for the assumption of certain environmental and regulatory obligations as well as for potential earn-out payments up to an aggregate of $175 million as discussed in Note 15 under “Contingent Earn-Out Agreements.” As of December 31, 2003, the escrowed shares had been converted to cash, which was held in escrow and reflected in “restricted cash” in the consolidated balance sheet. Through September 30, 2004, Valero has released a total of $17.3 million of the escrowed cash as prescribed by the purchase agreement.

In accordance with FASB Statement No. 141, “Business Combinations,” the total potential earn-out payments of $175 million discussed above were recognized in “property, plant and equipment” (with $50 million recorded as a current liability in “accrued expenses” and $125 million recorded in “other long-term liabilities”) as part of the purchase price allocation since the net fair value of the assets acquired and liabilities assumed exceeded the cost of the acquisition by an amount greater than the potential earn-out amount. During the second quarter of 2004, an independent appraisal was completed and the resulting final purchase price allocation for the St. Charles Acquisition is summarized below (in millions). The amounts reflected include the accrual of the potential earn-out payments.

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VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

The unaudited pro forma financial information is not necessarily indicative of the results of future operations (in millions, except per share amounts):

4. INVENTORIES

Inventories consisted of the following (in millions):

As of September 30, 2004 and December 31, 2003, the replacement cost of LIFO inventories exceeded their LIFO carrying values by approximately $1.9 billion and $666 million, respectively.

5. INVESTMENT IN AND TRANSACTIONS WITH VALERO L.P.

As of September 30, 2004 and December 31, 2003, Valero owned approximately 45.6% and 45.7%, respectively, of Valero L.P., a limited partnership that owns and operates crude oil and refined product pipeline, terminalling and storage tank assets. Financial information reported by Valero L.P. is summarized below (in millions):

Valero provides Valero L.P. with legal, accounting, treasury, engineering, information technology and other services for an annual fee (Administrative Fee), which was originally established at $5.2 million. On March 11, 2004, an amendment to the Administrative Fee was approved. Under the amendment, which became effective on April 1, 2004, the new Administrative Fee is equal to the actual cost of Valero’s corporate employees dedicated to Valero L.P. matters plus an annual fee of $1.2 million. The annual fee of $1.2 million will be increased by $1.2 million per year over the next four years. The annual

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VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

fee may also be adjusted to account for changed service levels due to Valero L.P.’s acquisition, sale or construction of assets. The Administrative Fee is reflected by Valero as a reduction of general and administrative expenses. For the three and nine months ended September 30, 2004, the Administrative Fee charged to Valero L.P. was $2.9 million and $6.8 million, respectively. In addition, Valero L.P. amended its partnership agreement effective March 11, 2004 to cap the general partner’s distribution, including incentive distributions, at 25% for all distributions in excess of $0.66 per unit per quarter. Valero L.P. also amended its partnership agreement to reduce the minimum vote required to remove the general partner from 58% to a simple majority of Valero L.P.’s outstanding common and subordinated units, excluding the units held by affiliates of Valero.

As of September 30, 2004 and December 31, 2003, Valero’s “receivables, net” included $3.8 million and $9.8 million, respectively, from Valero L.P., representing amounts due for employee costs, insurance costs, operating expenses, administrative costs and rentals. As of September 30, 2004 and December 31, 2003, Valero’s “accounts payable” included $18.6 million and $15.8 million, respectively, to Valero L.P., representing amounts due for pipeline tariffs, terminalling fees and tank rentals and fees. The following table summarizes the results of transactions with Valero L.P.:

See Note 16 for a discussion of a proposed merger of Valero L.P. with Kaneb Services LLC and Kaneb Pipe Line Partners, L.P.

6. LONG-TERM DEBT

On March 22, 2004, Valero issued $200 million of 3.50% Senior Notes due April 1, 2009 and $200 million of 4.75% Senior Notes due April 1, 2014 under its shelf registration statement (together, the Notes). Interest is payable on the Notes on April 1 and October 1 of each year beginning October 1, 2004. The Notes are unsecured and are redeemable, in whole or in part, at Valero’s option. The net proceeds from this offering were used to repay borrowings under Valero’s revolving bank credit facilities.

On March 25, 2004, Valero entered into additional interest rate swap contracts with a total notional amount of $200 million to hedge against changes in interest rates. These interest rate swap contracts have the effect of converting the $200 million of 4.75% Senior Notes from fixed rate to floating rate debt.

On March 29, 2004, Valero borrowed $200 million under a five-year term loan, which matures March 31, 2009. The loan bears interest based on Valero’s debt rating, currently at LIBOR plus 75 basis points. Principal payments begin March 2007 with a $50.0 million principal payment due at that time and semi-annual payments of $37.5 million due thereafter until maturity. Valero used the net proceeds from this borrowing to repay borrowings under its revolving bank credit facilities.

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VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

7. OTHER LONG-TERM LIABILITIES

8. STOCKHOLDERS’ EQUITY

Common Stock Offering
On February 5, 2004, Valero sold in a public offering 15.6 million shares of its common stock, which included 2.0 million shares related to an overallotment option exercised by the underwriter, at a price of $26.63 per share and received proceeds, net of underwriter’s discount, commissions and other issuance costs, of $405.8 million. These shares were issued under Valero’s shelf registration statement to partially fund the acquisition of the Aruba Refinery and related operations discussed in Note 3.

Common Stock Purchases
Valero purchases shares of its common stock in open market transactions to meet its obligations under its employee benefit plans. Valero also purchases shares of its common stock from its employees and non-employee directors in connection with the exercise of stock options, the vesting of restricted stock and other stock compensation transactions. During the nine months ended September 30, 2004 and 2003, Valero purchased 8.0 million and 1.3 million shares of its common stock at a cost of $245.2 million and $24.2 million, respectively.

Common Stock Split
On July 15, 2004, Valero’s Board of Directors approved a two-for-one split of Valero’s common stock, to be effected in the form of a stock dividend, subject to shareholder approval of an amendment to Valero’s certificate of incorporation to increase the number of authorized common shares from 300 million to 600 million. On September 13, 2004, Valero’s shareholders approved that amendment. The distribution of the stock dividend occurred on October 7, 2004 to stockholders of record on September 23, 2004.

In connection with the common stock split, the number of shares of common stock issuable upon conversion of the mandatory convertible preferred stock, the exercise of outstanding stock options and the vesting of other stock awards, as well as the number of shares of common stock reserved for issuance under Valero’s various employee benefit plans, were proportionately increased in accordance with the terms of those respective agreements and plans.

Cash Dividends
On October 21, 2004, Valero’s Board of Directors declared a regular quarterly cash dividend of $0.08 per common share payable December 15, 2004 to holders of record at the close of business on November 10, 2004. Also on October 21, 2004, Valero’s Board of Directors declared a dividend on the mandatory convertible preferred stock of $0.125 per share payable on December 31, 2004 to holders of record on December 30, 2004.

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VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

9. EARNINGS PER COMMON SHARE

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

The following table reflects outstanding stock options that were not included in the computation of dilutive securities because the options’ exercise prices were greater than the average market price of the common shares during the reporting period, and therefore the effect of including such options would be anti-dilutive (in millions):

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VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

10. STATEMENTS OF CASH FLOWS

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):

Noncash investing activities for the nine months ended September 30, 2004 included various adjustments to property, plant and equipment and certain current and other noncurrent assets and liabilities resulting from adjustments to the purchase price allocations related to the Aruba and St. Charles Acquisitions discussed in Note 3 (including recognition of the $175 million of potential earn-out payments related to the St. Charles Acquisition).

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VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

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

11. PRICE RISK MANAGEMENT ACTIVITIES

The net gain (loss) recognized in income representing the amount of hedge ineffectiveness was as follows (in millions):

The above amounts were included in “cost of sales” in the consolidated statements of income. No component of the derivative instruments’ gains or losses was excluded from the assessment of hedge effectiveness. No amounts were recognized in income for hedged firm commitments that no longer qualify as fair value hedges.

During the nine months ended September 30, 2004, Valero recognized in “accumulated other comprehensive income” unrealized after-tax losses of $150.8 million on certain cash flow hedges, primarily related to forward sales of distillates, with $131.0 million of cumulative after-tax losses on cash flow hedges remaining in “accumulated other comprehensive income” as of September 30, 2004. Valero expects that $112.3 million of this amount will be reclassified into income over the next 12 months as a result of hedged transactions that are forecasted to occur over that period. The amount ultimately realized in income will differ as commodity prices change. As of September 30, 2004, the maximum length of time over which Valero was hedging its exposure to the variability in future cash flows for forecasted transactions was 15 months. For the nine months ended September 30, 2004 and 2003, there were no amounts reclassified from “accumulated other comprehensive income” into income as a result of the discontinuance of cash flow hedge accounting.

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VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

12. SEGMENT INFORMATION

Segment information for Valero’s two reportable segments, refining and retail, was as follows (in millions):

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

The entire balance of goodwill as of September 30, 2004 and December 31, 2003 has been included in the total assets of the refining reportable segment.

13. STOCK-BASED COMPENSATION

Valero accounts for its employee stock compensation plans using the intrinsic value method of accounting set forth in APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations as permitted by Statement No. 123, “Accounting for Stock-Based Compensation.”

Because Valero accounts for its employee stock compensation plans using the intrinsic value method, compensation cost is not recognized in the consolidated statements of income for Valero’s fixed stock option plans as all options granted had an exercise price equal to the market value of the underlying

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VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

common stock on the date of grant. Had compensation cost for Valero’s fixed stock option plans been determined based on the grant-date fair value of awards consistent with the method set forth in Statement No. 123, Valero’s net income applicable to common stock, net income and earnings per common share, both with and without dilution, for the three and nine months ended September 30, 2004 and 2003 would have been reduced to the pro forma amounts indicated below (in millions, except per share amounts):

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VALERO ENERGY CORPORATION AND SUBSIDIARIES
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

14. EMPLOYEE BENEFIT PLANS

The components of net periodic benefit cost related to Valero’s defined benefit plans were as follows for the three and nine months ended September 30, 2004 and 2003 (in millions):