Valero Energy Corporation Energy (NYSE: VLO)

Krause Fund Research Fall 2018 Valero Energy Corporation Energy (NYSE: VLO)

Recommendation: BUY November 11, 2018

Analysts Current Price $85.97 Andrew Ball Target Price $114-$118 [email protected] Samuel Bries Favorable Throughput and Margins [email protected] Will Propel VLO Above Expectations Adam Goedken [email protected] Investment Positives Gregory Hensley [email protected] • Valero achieved maximum capacity in Q3 of 2018, operating at 99% utilization, which represents throughput volumes of 3.1 million barrels of oil per day. We project Valero Company Overview to achieve a high efficiency level of 83% utilization on the year, and to improve utilization in the following years. Valero Energy Corporation is both a midstream and • Valero’s crack spread increased from $10.90 in 2016 to downstream energy company that operates by refining and $11.65 in 2017, and we project it to reach $12.18 in 2018. Due marketing oil and other fuels. Valero operates refineries to these more favorable margins, Valero saw a year-over-year both in North America and in Europe. Outside of refineries, jump in revenues of 31% to $30.8 billion in 2017. Valero has more than 1,000 branded gas stations worldwide. • Valero estimates that they will spend $2.7 billion on capital Valero is based in San Antonio, Texas and is in the process expenditures, with $1 billion of that being used for growth of solely acquiring their transportation segment of their products. As Valero invests more back into growth of its operations. By attaining sole ownership of their operations, they will reap the benefits of economies of scale. transportation segment, Valero expects to increase companywide revenues. Investment Negatives

• Valero’s net operating income is reliant on crack spreads, Stock Performance Highlights which are difficult to forecast accurately. A disappointing crack 52 week High $126.98 spread could make a large difference in the intrinsic value of 52 week Low $80.00 Valero’s stock. Beta Value 0.91 • Valero has a relatively high debt-to-equity ratio of 1.19, Average Daily Volume 3.432 m compared to the average of its peers of 0.86. As the Federal Reserve continues to raise interest rates to hedge against rising Share Highlights inflation, Valero might find itself in an uncomfortable, less Market Capitalization $36.478 b flexible position for investing back into its operations. Shares Outstanding 424.31 m EPS (2017) $9.17 One Year Stock Performance P/E Ratio 8.28 VLO one year stock performance relative to the S&P 500 Index Dividend Yield 3.65% and the U.S Energy Select Sector SPDR Fund Dividend Payout Ratio 30.53%

Company Performance Highlights ROA 8.44% ROE 18.58% Sales $93.980 b

Financial Ratios Current Ratio 1.74 Debt to Equity 1.19

Source: Wall Street Journal 1 1 | P a g e

Domestic Growth Outlook Executive Summary Healthy domestic growth will be a positive for energy companies in the U.S. The U.S. economy grew 4.2% and 3.5% As of November 11, 2018 our University of Iowa Krause Fund in the second and third quarters of 2018, respectively, a large analyst team recommends a BUY rating for Valero Energy increase from 3.1% and 3.2% growth in the second and third Corporation. Valero has been operating at a high level of quarters of 2017. Strong consumer and business spending are the efficiency for the past year, and is expected to achieve higher two primary factors that have helped drive the strong economic utilization in the coming years. These levels of efficiency, growth in the past two quarters.3 According to the Federal combined with a favorable outlook for oil crack spreads, will Reserve Bank of Atlanta, U.S GDP growth is expected to be guide the company to achieve higher earnings. Due to active and 2.9% in the fourth quarter of 2018.4 optimistic customers in the global marketplace, the macroeconomic environment looks bright for oil and gas Figure 2 refining and marketing companies, such as Valero. Unpredictable risks, like natural disasters, can impact Valero’s utilization numbers and crack spreads, both of which drive the company’s bottom line. However, the company is less vulnerable to changes in oil prices than integrated or upstream energy companies, due to Valero’s diversified midstream and downstream operations. Ultimately, we found Valero Energy Corporation’s investment positives to be greater than its potential risks, leading us to identify Valero stock as 3 undervalued. Source: FRED Economic Data

In the next year, we predict that U.S real GDP growth will grow Macroeconomic Outlook at a rate of 3.0%, a 70-basis-point increase from an annualized growth rate of 2.3% from 2017. The Tax Cuts and Jobs Act of

2017 has contributed to large corporate profits and business

investment in the last year. The Commerce Department noted World Real Gross Domestic Product (GDP) that after-tax profits across the U.S rose 16.1% in the 2nd quarter from the previous year, the largest year-over-year gain in six Real Gross Domestic Product (GDP) is one of the key indicators years.5 As a result, per-share earnings for companies in the S&P of economic development that influences the demand for oil and 500 rose 24.8% over the second quarter of 2017. other energy resources. Economic expansion occurs when the demand for goods and services increase. In an economic Figure 3 expansion, sales of products for which oil and natural gas are inputs increase, and consumers are less frugal with their energy consumption. Businesses look to grow, requiring more energy consumption than before. Consequently, real GDP growth increases demand for energy resources, leading oil prices to rise, driving revenue growth. Figure 1 shows a correlation between economic growth and oil demand and consumption.

Figure 1

Source: Wall Street Journal5

In addition to rising corporate profits and business investment, metrics such as consumer confidence, rising personal income, a strong labor market, and a jobless rate of 3.7%, has encouraged greater consumer and business consumption that has driven economic expansion. Figure 4 shows the U.S. Consumer Confidence level directed by the Conference Board Consumer Confidence, which current levels show at 98.3.6 Given that consumer confidence is measured based on household surveys of consumers’ opinions on current conditions and future expectations of the economy, we expect this trend to continue. Source: U.S. Energy Information Administration2 2 | P a g e

Given these metrics, we expect U.S. GDP to grow at 3.00% for With an expected 3.7% world GDP growth rate for 2018 and the foreseeable future. 2019, the international marketplace will be a significant driver for energy demand and consumption. Energy demand and Figure 4 consumption will not only come from larger economies such as China and India, but also emerging markets and developing countries benefiting from overall world growth, and a positive rotation in the global business cycle.9

Figure 7

Source: Trading Economics6

International Growth Outlook

For our analysis of the international marketplace, we consider China and India to be the main foreign drivers for energy resources. China and India together contribute nearly 50% of 7 global oil demand. Figure 5, below, shows world oil demand Source: International Monetary Fund8 growth by year, showing China and India’s dominance for the demand of oil. Interest Rates

Figure 5 Interest rates are a key economic variable to consider as they are one of the major determinants of a firm's cost of debt. Rising interest rates lead to higher borrowing costs, as investors require a higher return for riskier investments taken by the firm. The 10- Treasury Yield (3.186%) was used as the risk free rate to calculate the cost of debt in our valuation. Figure 8 shows that the 10-Treasury yield has been rising steadily over the past year with oil prices. Due to the recent hikes in the federal funds rate, we expect the rate to reach 4.00% by 2020 to trump rising inflation.

Source: International Energy Agency7 Figure 8

The International Monetary Fund has projected global GDP to grow at 3.7% for 2018 and 2019, with China and India’s GDP expected growth rates to be 6.20% and 7.70%, respectively.8 As China and India continue to expand their economies and international footprint, they will use more oil, which will drive oil demand and consumption higher. Future curves project that oil prices will reach $60.06 in 2022.

Figure 6

Source: FRED Economics Data10

As of September of 2018, Federal Reserve officials have raised interest rates for the third time this year and have reaffirmed their outlook for further rate hikes into 2019.11 The federal funds rate currently stands at 2.25%, a 25 basis-point increase in September from its last rate of 2.00%.

Source: International Monetary Fund8 3 | P a g e

Figure 9 In 2017, world oil production rose by 0.6 million b/d, below average for the second consecutive year. Production fell in the Middle East (-250,000 b/d) and South & Central America (- 240,000 Kb/d), but this was outweighed by growth in North America (820.00 b/d), specifically the U.S. (690,000 b/d).13

Figure 11

Source: Bloomberg11

Oil exploration and production companies are often highly leveraged, as they look to expand their operations by acquiring more reserves. As the federal funds rate is projected to increase three times during 2019, firms with a low cost of debt that have a history of paying back their lenders—like Valero—are able to maneuver better in this environment.

Energy Commodities Supply & Demand Source: U.S. Energy Information Administration14

For energy commodities, supply and demand is the definitive Figure 11 provides the growth U.S. production of crude oil, driver of price. Oil and gas prices fluctuate due to supply and showing a steep increase since the financial crisis of 2008. In demand of the commodity. If prices are high, energy companies 2017, global natural gas production increased by 4% - the fastest are more likely to produce more, and vice versa. Upstream rate since the immediate aftermath of the financial crisis15. companies benefit the most from high oil prices, while Figure 12 shows the growth of natural gas production in the midstream and downstream companies benefit less, though these world. Recently the U.S. has begun increasing production of oil companies are still impacted by oil prices. Oil prices increase as and natural gas as they work to become more energy oil demand increases. Oil demand is determined by independent. consumption. The oil production of OPEC and non-OPEC countries influence the supply of oil greatly. Figure 10 shows Figure 12 how changes in the oil production of Saudi Arabia, an OPEC country, can influence WTI crude oil prices. OPEC’s oil exports represent about 60% of the total petroleum traded internationally, producing 0.3 million barrels per day in quarter 3 of 2018, its largest production amount in over a year.12

Figure 10

Source: BP Global Report15

OPEC as a Geopolitical Player

Beyond world GDP and energy commodity supply/demand, geopolitics also influences the price of oil. One major player in the geopolitics of the supply and demand, and ultimately the price of oil, is OPEC. OPEC’s stated mission is to provide Source: U.S. Energy Information Administration12 regular supply, stable markets and a fair return on investments to 4 | P a g e investors. While OPEC does not control the price of oil, they spread”, which is the difference between the cost of materials play a big part in it. By restricting oil production and slashing oil and the revenues received from selling the finished energy supplies, OPEC could force oil prices to rise, benefiting net products. exporters of oil, but hurting large importers of oil, such as China. Refining companies “crack” crude oil apart in refineries, Figure 13 producing different products, such as gasoline, jet fuel, and diesel. Figure 15 shows a simplified version of how the oil refining process works.

Figure 15

Source: OPEC Annual Statistical Bulletin 201816.

As the U.S. looks to become more energy independent, the EIA projects that the United States will become a net energy exporter by 2020, primarily driven by higher oil prices and technology and a reduction in regulation within the oil and gas exploration industry.17 Source: CME Group.18

Figure 14 Another component of revenue for some oil and gas refining and marketing companies, including Valero, is production of ethanol.

Developments and Trends

Global oil production and consumption is expected to continue rising for the foreseeable future. The United States is becoming more energy independent, which makes OPEC less of a driver oil prices domestically. Recently, we have seen large growth in the natural gas production industry that has outpaced demand for natural gases. This large gap between supply and demand has caused natural gas prices to drop substantially in recent years. Source: U.S. Energy Information Administration17 Figure 16

Industry Analysis

Overview

The oil and gas industry has three main parts: upstream, midstream, and downstream. Upstream firms operate by exploring for oil and producing oil. Revenues are largely driven by the market price of oil. Mid-stream firms operate by storing and transporting oil, natural gas liquids (NGLs), and other natural gases. Mid-stream firms operate as a middle man between upstream and downstream firms. Downstream firms operate by refining oil, NGLS, and natural gases into Source: International Energy Agency19 consumable products, as well as marketing the finished products. Valero is considered an oil and gas refining and marketing company, operating in the midstream and downstream segments of the oil and gas industry. Income is largely driven by a “crack 5 | P a g e

price is mainly decided by market price of the commodity Industry Leaders purchased.

All of the largest firms in the oil and gas industry are integrated Rivalry Among Competitors oil firms, which means they operate across all three production Large companies simply have greater throughput capacity than streams. Exxon Mobil and British Petroleum are among the smaller ones. Companies are constantly fighting to be the largest firms in the industry. lowest-cost producer or to find ways to increase utilization.

Exxon Mobil – Exxon Mobil Corporation is an American multinational oil and gas corporation. Exxon Mobil is the largest Company Analysis of the world’s big oil companies, with daily production of 3.921 million BOE.20 The company is the world’s 9th largest company listed by revenue. Financial Summary Analysis

British Petroleum – The British Petroleum Company plc, or BP In fiscal year 2017, Valero reported revenues of $93.98 billion, plc, is a British multinational oil and gas company. BP is one of representing growth of 24% from 2016. Drivers of this revenue the world’s seven oil and gas “supermajors”. As of 2017, BP has increase were largely a 21% increase in gasoline revenues and a operations in 70 countries worldwide and produced around 3.6 21 31% increase in distillate revenue. We estimated Valero’s crack million barrels per day. spread to have increased from $10.90 per barrel in 2016 to $11.65 in 2017. An increase in crack spread is a positive for Industry leaders are able to operate at low costs relative to their Valero because it means they are able to operate at a higher competitors and are not solely reliant on crack spreads or the profit margin while producing the same product.20 price of oil to stay profitable. Leaders often implement derivative trading along with their operations to profit off of Valero saw an increase in their ending cash account for 2017 of trends in the oil and gas industry. Followers in the oil and gas 20 industry are often unable to produce energy products cheaply, approximately $1,034 million. We believe that almost all of this increase in the balance is attributable to the income tax and are reliant on high oil prices or crack spreads to remain profitable. These follower companies often have high levels of benefit that Valero received for the year. debt, and experience cash flow issues when oil prices dip below desirable levels. Valero is a mid-size company that does not On October 25, 2018, Valero released a bright Q3 earnings operate upstream, so they are steadier and safer than many report. Valero saw a year-over-year jump in revenues of 31% to smaller oil and gas companies, however, they typically do not $30.8 billion.21 Valero was able to achieved a 99% utilization of reap the same benefits as the large industry leaders. their refinery plants, which we believe is the maximum utilization a refining plant is able to have. 99% utilization Porter’s Five Forces Analysis represents throughput volumes of 3.1 million barrels of oil per day over the entire year.21 Valero did see a decrease in Q3 Threat of New Entrants operating income of $100 million, but Valero states that the While there is some disparity in level of risk and flexibility, decrease is due to lower margins on gasoline and secondary large established companies and smaller newer companies can products. On the year, Valero will likely have utilization of both compete in this space. Larger companies are usually more around 83% and a slightly higher crack spread than fiscal year profitable due to larger refineries and access to resources while 2017. For fiscal year 2018, Valero is estimating that they will smaller companies must focus more on efficiency to compete. spend $2.7 billion on capital expenditures, with $1 billion of that Valero is one of the largest oil refining companies in the being used for growth products.21 $975 million of the $1B in international marketplace, leading them to focus on expansion to growth projects is expected to go towards construction of a achieve greater economies of scale. recently-announced refinery in Port Arthur, Texas.21 This project, not included in our models, is expected to reduce Threat of Substitutes refining feedstock costs and increase throughput capacity, which New developments in renewable energy are a direct threat to the we expect to grow revenues. demand of fossil fuels in the long-term. The rise of all-electric cars could potentially cause a drastic reduction in global oil Products demand. Valero uses refining operations to produce gasoline, diesel fuel, Bargaining Power of Suppliers and other petroleum fuels, such as jet fuel. Valero also licenses Individual firms do not dictate crack spreads or the price of oil their name out to independent gas stations. Valero-branded gas and gas. Overall, production in the industry affects supply, stations include Valero, Beacon, Diamond Shamrock, and which in return affects commodity prices. Shamrock.

Bargaining Power of Buyers Along with production operations, Valero operates several Buyers are institutions and consumers that use refined oil pipelines through the transportation segment of their operations, products. They can negotiate some of the price that they pay, but Valero Energy Partners (VLP). Valero recently acquired VLP. Previously, Valero’s relationship to VLP was through a master 6 | P a g e limited partnership, a structure that created tax benefits for Figure 17 Valero. Recently, the industry has shifted away from this type of partnership, favoring operational simplicity, and Valero’s purchase of VLP follows this trend. Valero Energy Corporation bought Valero Energy Partners at a price of $42.25, for a 12.4% premium. The market reacted negatively to the news; VLO stock dropped from $103.37 to $94.13 when the news was announced. VLO’s merger with VLP is not included in our models.

Production

Valero’s operations are spread across 15 refineries and production facilities across the United States. Of the 15 20 locations, seven are located in the US Gulf Coast. We have Source: Phillips 66 Form 10-K22 highlighted these regions as being potentially at risk to weather events, particularly hurricanes. Major hurricanes in the Gulf region could have significant impacts on revenues given the high Phillips 66 is a diversified energy manufacturing and logistics concentration in the vulnerable region. Total production in the company with businesses in refining, midstream, chemicals and Gulf region accounts for 58% of Valero’s total production. Other marketing, and specialties. Phillips 66 is comparable to Valero facilities in North America include Tennessee and Oklahoma. because of their operations in the refining and marketing Valero does have an international presence with facilities in industry. The ratio comparison shows Valero lagging in all categories to Phillips 66, as ROA and net profit margin is Canada and the United Kingdom. Production at these two 22 international locations represents approximately 17% of total lagging around 1%. Debt-to-equity is best represented in this energy production. Valero’s profit is derived from production comparison, as Valero has a high ratio, but is close to a complete volumes and the crack spread on their energy products. The substitute. crack spread in 2017 was $11.65. Yearly crack spreads are difficult to predict. Spreads are generally cyclical throughout the Figure 18 year, as demand for products, such as heating oil, rises and falls with the seasons, and weather events impact supply and demand.

Markets and Customers

Due to their operations as an oil and gas refining and marketing company, Valero acts as both a producer and a middle man. Valero sells oil in both wholesale rack and bulk. Wholesale rack customers include Valero-branded gas stations (Valero, Beacon, Diamond Shamrock, Shamrock) and non-Valero gas stations with contractual agreements to purchase wholesale oil and diesel. Contracts with wholesale buyers allow Valero to have low transportation costs, and more importantly gives Valero a Source: Exxon Mobil Form 10-K23 steady demand for their products. As a bulk seller, Valero distributes crude oil to refineries and refined products, such as jet fuel, to consumers. Exxon Mobil is the largest publicly-traded oil and gas company in the world. Exxon is a major integrated oil and gas company, Competition which means that Exxon operates in the entire process of obtaining the commodity and selling it to customers. Exxon and Overview Valero share the same operations in the refining and marketing part of the business, but Valero does not have an exploration and drilling part of the business. The ratio shows that Valero Valero operates within the refining and marketing sub-industry outperforms Exxon Mobil in ROA, while Exxon Mobil of the energy sector. We identified competitors with refining and outperforms when considering net profit margin.23 However, this marketing operations that are not exclusively in this subindustry. may due to the different operating segments. Another variable we took into consideration is where operations are taking place, as the type of crude oil is being refined is important. We decided to select competitors that have a large presence in Texas. We decided to look at the ROA, net profit margin, and debt-to-equity ratio as a way to compare these competitors.

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Figure 19 Valuation Analysis

Overview

Our analyses of the macro economy and the oil and gas refining and marketing industry informed the models that ultimately led us to a BUY rating for Valero Energy Corporation. We based our valuation off the DCF/EP model, which included our forecasts for key company line items and characteristics. The model is strongly reliant on the margins Valero faces and Valero’s success in increasing production through greater efficiency. Based on the company’s past performance and 24 Source: HollyFrontier Corporation Form 10-K projected future earnings and growth, we believe Valero’s stock is undervalued. HollyFrontier Corporation (HFC) is an independent petroleum refiner in the United States. HFC produces and markets a wide Revenue Decomposition variety of petroleum products such as gasoline, lubricants, and jet fuel. HFC operates in similar operation lines, such as Gasoline and Blendstocks marketing and the refining process. The ratio comparison is We calculated sales of gasoline and blendstocks by multiplying similar to Exxon Mobil, as Valero outperforms in ROA, but lags refining segment throughput volume by an annualized price per in net profit margin.24 barrel of oil equivalent (BOE). Crude oil futures for December of each forecasted year determined projected refining revenue SWOT Analysis per barrel. We forecasted volume by holding capacity constant while incrementally increasing utilization from 83% in 2018 to Strengths 93% in 2022. Consistent historical yearly utilization Valero has a more diverse business model than other companies improvements informed our decision on how to project in the sector because of their partially integrated structure. utilization. Valero is not solely reliant on refining, as pure refining companies are, allowing them to remain profitable when the Distillates and Other Refining price of oil is volatile. We based future distillates and “other” refining revenue off a constant ratio. Barrels of oil are “cracked open”, producing Weaknesses consistent ratios of gasoline to other distillates (see Figure 20). Valero operates in areas that are vulnerable to weather events. In Valero’s distillates and “other” refining sales have, on average, 2017, Hurricane Harvey caused Valero to lose 6% of their daily been approximately 18% higher than sales of gasoline and refining output for the entire quarter (Q3 Earnings). As climate blendstocks in the past. That ratio was what we used in our change causes weather events to be more severe, Valero could calculation of future distillates and “other” refining revenue. see larger drops in output due to storms if they do not begin investing in areas safe from hurricanes. Figure 20

Opportunities Valero’s international presence could lead to contracts with gas stations located outside of the United States. Diversifying across international borders could allow Valero to become a global force after the model of Exxon Mobil.

Threats 77% of all transportation energy in the United States is from oil and gas distillates, with a large consumer of this energy being automobiles. With the innovation being observed in the auto industry, Valero is threatened by the rise of electric vehicles. Adoption of electric vehicles would hurt Valero on the production side, but also affect their revenues received from Source: U.S. Energy Information Administration25 contracts with gas stations.

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Ethanol WACC, we applied weights of 71% to equity and 29% to debt Ethanol revenues are the product of ethanol revenue per gallon based on market value, before multiplying those weights by cost and ethanol production volumes. We held revenue per gallon of equity and cost of debt, respectively. constant at the average price of the previous three years: $2.00. We made this decision based off past prices per gallon, which Cost of Equity showed no trends, and fluctuated little. We applied a steady growth rate when forecasting production volumes, since past To calculate cost of equity, we applied the Capital Asset Pricing years’ volume figures showed a consistent, positive trend. Model (CAPM) and calculated the cost of equity to be 8.027%. Our variables used in the CAPM are as follows: Other Ethanol We forecasted “other” ethanol revenues to slightly decrease. • Risk Free Rate = 3.186% “Other” ethanol revenues represent sales of distillers’ grain, • Equity Risk Premium = 5.32% which is sold as feed for livestock. Lower prices due to decreased export demand for distillers’ grain have driven a • Beta = 0.91 steady decline in “other” ethanol revenues in recent years, which Our risk free rate represents the yield on the 10-year U.S. we projected out into the future using the average negative 26 growth rate of the past three years. Treasury as of November 11, 2018. The equity risk premium was given by Damodaran’s implied ERP on November 1, 2018.27 We believe that this number accurately represents the Costs geometric average of our expected market risk premium. Our beta was calculated by taking the average of the 2 year raw betas Cost of Materials calculated daily, weekly, and monthly on Bloomberg. Cost of materials was based on our crack spread estimation. To calculate this figure, we used the equation: Cost of Debt

Crack spread = revenue/volume - cost/volume To calculate Valero’s cost of debt, we used the yield on a Valero corporate bond maturing in 10 years. We found the yield to be To estimate cost, we first weighted the ethanol and refining 4.41% on SEC’s EDGAR database.28 To find the after-tax cost segments by revenue, then multiplied those weights by total of debt to be used in our cost of capital calculation, we took the estimated cost of materials (which was calculated using an yield on the 10-year corporate bond and then adjusted it to average ratio of past cost of materials to volume). reflect the marginal tax rate of 21% due to the new tax plan. This calculation gave us an after-tax cost of debt of 3.49%. 2018 Cost= Valuation Models

+ We used a discounted cash flow/economic profit (DCF/EP) model, a dividend discount model, (DDM), and a relative valuation to analyze Valero’s stock value. Ultimately, we decided the DCF/EP model represented the most complete and Finally, to make cost of materials a function of the crack spread, accurate valuation for Valero. we multiplied the spread by volume, then subtracted from sales. To avoid an outsize impact on future crack spreads from price Results estimates, we applied an average growth rate to COGS after the first forecasted year. The impact of this assumption can be observed in our sensitivity analysis. DCF/EP DDM Relative Valuation

Operating and General and Administrative Expenses Target Price as of $116.06 $125.23 $86.29 We held operating and general and administrative expenses 11.11.18 constant, as we expect prices related to increases in production activity to be offset by more cost-efficient production. Production efficiencies will likely be improved through modernization or expansion of existing refineries; for example, DCF/EP in 2017, Valero invested in a cost-lowering cogeneration unit at their Wilmington refinery. The DCF/EP model is based on our research and beliefs about the Valero’s riskiness and growth; therefore, we believe it is the WACC most informed model for calculating the intrinsic value of Valero’s stock. Valero’s steady, strong growth through We estimated Valero’s WACC to be 7.09%. We used this efficiency improvements and expansion seem to justify a higher WACC for all years in the future because we do not expect stock value of $116.06. Valero’s capital structure to change in the future. To calculate 9 | P a g e

The DCF model determines the value of operating assets using the sum of the present values of free cash flows (net operating profit less adjusted taxes, i.e., NOPLAT, less capital expenditures). Alternatively, the EP model uses present value of economic profit (the difference between ROIC and WACC) added to beginning invested capital to calculate the value of operating assets. Both approaches use the WACC for discounting. For the DCF and EP models, we estimated continuing value (CV) growth of NOPLAT to be 3%, the effects Normal Cash Percentage of Sales, CV Growth of NOPLAT of which we tested in our sensitivity analysis. As CV growth Normal cash percentage of sales and CV growth of NOPLAT rises, intrinsic stock price falls, because our model predicts a affect the value of operations and make marginal differences in lower ROIC than WACC in the CV year. Given our short the dollar-value of equity. Normal cash percentage of sales is investment horizon, we do not believe this projected future based on the convention of the industry, which is low due to destruction of value is cause for concern. energy companies’ high sales figures that do not necessarily translate into proportionally high income. Increases in normal DDM cash percentage of sales raise invested capital. CV growth of NOPLAT causes stock price to fall when it rises, because CV ROIC is less than WACC. The DDM may be useful for understanding the value of VLO stock, however, it does not represent the whole story of Valero as a company. The DDM calculates intrinsic stock value using the present value of future dividend payments. This present value is found by discounting back estimated future dividends and a perpetual value of future cash flows past a CV year. We decided this model was less informative than the DCF/EP model, as the DDM is heavily based on one assumption: a 2018 Utilization, 2022 Crack Spread constant dividend per share of $3.60. Utilization and crack spread assumptions flow across the model from the revenue decomposition to the DCF/EP, and make Relative Valuation significant differences in the estimated stock price. We grow utilization from 83% to 93% from 2018 to 2022, based off Q1- The relative P/E valuation produces a stock price similar to Q3 2018 figures and consistent past utilization improvements. VLO’s current stock price, however, it is likely not a reflection Crack spreads largely determine Valero’s income, and of Valero’s fundamental value. The relative P/E calculation uses consequently have a large impact on the model. Both of these an average of industry peers’ estimated P/E ratio multiplied by are debatably strong assumptions, so this data table may be our forecasted earnings per share to estimate an implied value. useful for evaluation of our model. While this approach may be useful for comparison purposes or quick value estimations, its oversimplification of reality--that Valero’s P/E should be identical to the average of its peers-- is not particularly helpful for our analysis.

Sensitivity Analysis

WACC, Equity Risk Premium Current Dividend Yield, 2022 Refining Price per BOE As a key assumption in the DCF/EP model, the WACC has a Current dividend yield and refining price per BOE both have large impact on our estimation of intrinsic stock value. The little impact on the DCF/EP model. Dividend yield impacts cash equity risk premium influences the WACC, and we can see that and the partial-year adjustment, so as it increases, price changes in the equity risk premium make incremental decreases slightly. CV year refining price per barrel of oil has differences in stock price. little effect on price because Valero’s income is mainly driven by the crack spread they face, not pure revenues.

Beta, Risk Free Rate Small changes in the risk free rate make a larger impact on stock price than small changes in Beta; however, neither of these factors alone change the model too much. Both assumptions make up just a portion of the WACC, as they flow into equity risk premium.

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Important Disclaimer https://www.bloomberg.com/news/articles/2018-09-12/wall- street-is-bullish-on-global-economy-despite-emerging- This report was created by students enrolled in the Security markets Analysis (6F:112) class at the University of Iowa. The report 12. Changes in Saudi Arabia Crude Oil Production Can Affect was originally created to offer an internal investment Oil Prices (2018). U.S. Energy Information Administration. recommendation for the University of Iowa Krause Fund and its Retrieved from advisory board. The report also provides potential employers and https://www.eia.gov/finance/markets/crudeoil/supply- other interested parties an example of the students’ skills, opec.php. knowledge and abilities. Members of the Krause Fund are not 13. Statistical Review of World Energy (2018). BP Global. registered investment advisors, brokers or officially licensed Retrieved from financial professionals. The investment advice contained in this https://www.bp.com/content/dam/bp/en/corporate/pdf/energ report does not represent an offer or solicitation to buy or sell y-economics/statistical-review/bp-stats-review-2018-full- any of the securities mentioned. Unless otherwise noted, facts report.pdf and figures included in this report are from publicly available 14. U.S. Field Production of Crude Oil (2018). U.S. Energy sources. This report is not a complete compilation of data, and Information Administration. Retrieved from its accuracy is not guaranteed. From time to time, the University https://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=pet of Iowa, its faculty, staff, students, or the Krause Fund may hold &s=mcrfpus1&f=m. a financial interest in the companies mentioned in this report. 15. Natural Gas Production (2018). BP Global. Retrieved from https://www.bp.com/en/global/corporate/energy- References economics/statistical-review-of-world-energy/natural- 1. 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GDPNow: Center For Quantitative Economic Research reports/introduction-to-crack-spreads.html (2018). Federal Reserve Bank of Atlanta. Retrieved from 19. World Oil Demand (2018). International Energy Agency. https://www.frbatlanta.org/cqer/research/gdpnow.aspx Retrieved from 5. Torry, Harriety, Francis, Theo (2018). “U.S. Corporate https://www.iea.org/oilmarketreport/omrpublic/ Profits Soared in Second Quarter, Boosted by Tax Cuts and 20. Valero Energy Corporation Form 10-K (2017). Valero Economic Growth.” Wall Street Journal. Retrieved from Energy Corporation. Retrieved from https://www.wsj.com/articles/u-s-corporate-profits-soared- http://www.annualreports.com/HostedData/AnnualReports/ in-second-quarter-boosted-by-tax-cuts-and-economic- PDF/NYSE_VLO_2017.pdf. growth-1535559230. 21. Valero Energy Corporation Form 10-Q (2018). Valero 6. United States Consumer Sentiment (2018). Trading Energy Corporation. Retrieved from Economics.Retrieved from http://www.investorvalero.com/static-files/852b260f-54fe- https://tradingeconomics.com/united-states/consumer- 436a-bd45-88fed6ae9387. confidence. 22. Phillips 66 Form 10-K (2017). Phillips 66. Retrieved from 7. World Oil Demand Growth (2018). International Energy https://www.sec.gov/Archives/edgar/data/1534701/0001534 Agency. Retrieved from https://www.iea.org/oil2018/. 70118000065/psx- 8. Real GDP Growth: Annual Percent Change (2018). 20171231_10k.htm#s91285B0D4F5C58B280B76B88E833 International Monetary Fund. Retrieved from A11A. https://www.imf.org/external/datamapper/NGDP_RPCH@ 23. Exxon Mobil Corporation Form 10-K (2017). Exxon Mobil WEO/OEMDC/ADVEC/WEOWORLD. Corporation. Retrieved from 9. Kennedy, Simon (2018). “Economists Bullish on Global https://www.sec.gov/Archives/edgar/data/34088/000003408 Growth Despite Emerging Market Turmoil.” Bloomberg. 818000015/xom10k2017.htm Retrieved from 24. 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26. U.S. 10 Year Treasury (2018). CNBC. Retrieved from https://www.cnbc.com/quotes/?symbol=US10Y. 27. Implied Equity Risk Premium Update (2018). Damodaran Online. Retrieved from http://pages.stern.nyu.edu/~adamodar/. 28. Company Search: EDGAR Database (2018). U.S Securities and Exchange Commission. Retrieved from https://www.sec.gov/edgar/searchedgar/legacy/companysear c.

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Valero Energy Corporation Key Assumptions of Valuation Model

Ticker Symbol VLO Current Share Price $87.58 Current Model Date 11/13/2018 FY End (month/day) Dec. 31

Pre-Tax Cost of Debt 4.41% Beta 0.91 Risk-Free Rate 3.186% Equity Risk Premium 5.32% CV Growth of NOPLAT 3.00% CV Growth of EPS 3% CV ROIC 6.68% Current Dividend Yield 3.20% Marginal Tax Rate 21% Normal Cash % 0.70% Debt Rating BBB WACC 7.09% Cost of Equity 0.080272 2022 Crack Spread $ 12.46 2022 Refining Price per BOE $ 60.06

Intrinsic Stock Value $ 116.06

Refining Price per BOE $ 60.81 Utilization 83% Valero Energy Corporation Revenue Decomposition

Fiscal Years Ending Dec. 31 2015 2016 2017 2018E 2019E 2020E 2021E 2022E Refining Revenues Gasonline and Blendstocks $ 38,983.00 $ 33,450.00 $ 40,362.00 $ 57,662.08 $ 60,866.73 $ 62,129.38 $ 63,205.78 $ 64,098.74 Distillates and Other 45,538.00 38,500.00 50,289.00 67,896.97 72,419.12 73,399.34 75,366.39 76,828.62 Total $ 84,521.00 $ 71,950.00 $ 90,651.00 $ 125,559.05 $ 133,285.85 $ 135,528.72 $ 138,572.17 $ 140,927.37 Ethanol Revenues Ethanol $ 2,628.00 $ 3,105.00 $ 2,764.00 $ 2,963.39 $ 3,038.13 $ 3,111.62 $ 3,187.32 $ 3,264.09 Other 655.00 586.00 560.00 534.07 499.17 473.22 447.40 421.77 Total $ 3,283.00 $ 3,691.00 $ 3,324.00 $ 3,497.46 $ 3,537.31 $ 3,584.83 $ 3,634.72 $ 3,685.86 Total Revenue $ 87,804.00 $ 75,641.00 $ 93,980.00 $ 129,056.51 $ 136,823.16 $ 139,113.56 $ 142,206.89 $ 144,613.22 Refining Throughput Volumes in Millions of Barrels 870.53 889.75 939.15 948.23 976.68 1,005.98 1,036.16 1,067.25 Ethanol Production Volumes in Millions of Gallons 1,396.86 1,406.17 1,449.78 1,482.69 1,520.08 1,556.85 1,594.73 1,633.14 Refining Revenue Per Barrel $ 44.78 $ 37.59 $ 42.98 $ 60.81 $ 62.32 $ 61.76 $ 61.00 $ 60.06 Ethanol Revenue Per Gallon $ 1.88 $ 2.21 $ 1.91 $ 2.00 $ 2.00 $ 2.00 $ 2.00 $ 2.00 Crack Spread Estimation $ 16.02 $ 10.90 $ 11.65 $ 12.18 $ 12.25 $ 12.32 $ 12.39 $ 12.46 Valero Energy Corporation Income Statement

Fiscal Years Ending Dec. 31 2015 2016 2017 2018E 2019E 2020E 2021E 2022E (CV) Operating Revenues (a) $ 87,804.00 $ 75,659.00 $ 93,980.00 $ 129,056.51 $ 136,823.16 $ 139,113.56 $ 142,206.89 $ 144,613.22 Cost & Expenses: Cost of materials and other 73,861.00 65,962.00 83,037.00 117,328.68 124,685.98 126,545.10 129,192.60 131,136.37 Operating expenses 4,243.00 4,207.00 4,462.00 4,462.00 4,462.00 4,462.00 4,462.00 4,462.00 Depreciation & amortization expense 1,842.00 1,894.00 1,986.00 2,061.62 2,102.96 2,152.98 2,202.73 2,253.45 General & administrative expenses 710.00 715.00 835.00 835.00 835.00 835.00 835.00 835.00 Total Costs & Expenses $ 81,446.00 $ 72,087.00 $ 90,381.00 $ 124,687.30 $ 132,085.94 $ 133,995.08 $ 136,692.34 $ 138,686.82 Operating income (loss) 6,358.00 3,572.00 3,599.00 4,369.21 4,737.22 5,118.47 5,514.55 5,926.40 Other income (expense), net 46.00 56.00 76.00 57.30 57.30 57.30 57.30 57.30 Interest & debt expense, net of capitalized interest (433.00) (446.00) (468.00) (391.52) (364.01) (404.42) (440.81) (448.68) Income before income tax expense (benefit) 5,971.00 3,182.00 3,207.00 4,034.99 4,430.52 4,771.35 5,131.05 5,535.02 Income tax expense (benefit) 1,870.00 765.00 (949.00) 847.35 930.41 1,001.98 1,077.52 1,162.35 Net income (loss)$ 4,101.00 $ 2,417.00 $ 4,156.00 $ 3,187.64 $ 3,500.11 $ 3,769.37 $ 4,053.53 $ 4,372.66 Less: net income (loss) attributable to noncontrolling interests (111.00) (128.00) (91.00) (91.00) (91.00) (91.00) (91.00) (91.00) Net income (loss) attributable to Valero Energy Corporation stockholders $ 3,990.00 $ 2,289.00 $ 4,065.00 $ 3,096.64 $ 3,409.11 $ 3,678.37 $ 3,962.53 $ 4,281.66

Basic EPS $ 8.00 $ 4.94 $ 9.17 $ 6.99 $ 7.69 $ 8.30 $ 8.94 $ 9.66 Basic weighted average shares outstanding 498.75 463.36 443.29 443.29 443.26 443.23 443.20 443.17 Dividends per share $ 1.70 $ 2.40 $ 2.80 $ 3.60 $ 3.60 $ 3.60 $ 3.60 $ 3.60 Valero Energy Corporation Balance Sheet In Millions $ Fiscal Years Ending Dec. 31 2015 2016 2017 2018E 2019E 2020E 2021E 2022E ASSETS

Current Assets: Cash & temporary cash investments $ 4,114.00 $ 4,816.00 $ 5,850.00 $ 5,356.72 $ 7,277.57 $ 9,560.75 $ 11,449.99 $ 13,711.67 Receivables, net 4,464.00 5,901.00 6,922.00 7,448.78 7,897.05 8,029.24 8,207.78 8,346.67 Inventories 5,898.00 5,709.00 6,384.00 7,300.21 7,739.54 7,869.09 8,044.07 8,180.19 Income taxes receivable 218.00 58.00 ------Deferred income taxes 74.00 ------Prepaid expenses & other current assets 204.00 316.00 156.00 296.41 314.24 319.50 326.61 332.14 Total Current Assets $ 14,972.00 $ 16,800.00 $ 19,312.00 $ 20,402.11 $ 23,228.40 $ 25,778.59 $ 28,028.45 $ 30,570.67 Property, plant & equipment, at cost 36,907.00 37,733.00 40,010.00 42,622.55 45,392.33 48,208.47 51,087.23 54,014.71 Accumulated depreciation 10,204.00 11,261.00 12,530.00 14,591.62 16,694.58 18,847.56 21,050.29 23,303.74 Property, plant & equipment, net 26,703.00 26,472.00 27,480.00 28,030.93 28,697.75 29,360.91 30,036.94 30,710.96 Deferred charges & other assets, net 2,668.00 2,901.00 3,366.00 2,688.04 2,849.81 2,897.52 2,961.95 3,012.07 Total Assets $ 44,343.00 $ 46,173.00 $ 50,158.00 $ 51,121.09 $ 54,775.97 $ 58,037.02 $ 61,027.34 $ 64,293.70

LIABILITIES AND STOCKHOLDERS' EQUITY

Current Liabilities: Current portion of debt & capital lease obligations $ 127.00 $ 115.00 $ 122.00 $ 161.00 $ 811.00 $ 1,319.00 $ 1,319.00 $ 1,319.00 Accounts payable 4,907.00 6,357.00 8,348.00 9,028.59 9,571.94 9,732.17 9,948.57 10,116.92 Accrued expenses 554.00 694.00 712.00 756.32 801.83 815.25 833.38 847.48 Taxes other than income taxes payables 1,069.00 1,084.00 1,321.00 1,307.79 1,386.49 1,409.70 1,441.05 1,465.43 Income taxes payable 337.00 78.00 568.00 68.49 75.21 80.99 87.10 93.95 Deferred income taxes 366.00 ------Total Current Liabilities $ 7,360.00 $ 8,328.00 $ 11,071.00 $ 11,322.19 $ 12,646.46 $ 13,357.11 $ 13,629.10 $ 13,842.79 Debt & capital lease obligations, less current portion 7,250.00 7,886.00 8,750.00 8,087.47 8,353.30 8,669.81 8,848.30 9,049.28 Deferred income taxes 6,768.00 7,361.00 4,708.00 4,836.36 4,968.23 5,103.69 5,242.84 5,385.79 Total other long-term liabilities 1,611.00 1,744.00 2,729.00 2,508.53 2,659.49 2,704.01 2,764.14 2,810.91 Total Liabilities $ 22,989.00 $ 25,319.00 $ 27,258.00 $ 26,754.56 $ 28,627.49 $ 29,834.63 $ 30,484.38 $ 31,088.76 Stockholders' Equity: Common stock 7,071.00 7,095.00 7,046.00 7,046.00 7,046.00 7,046.00 7,046.00 7,046.00 Treasury stock, at cost (10,799.00) (12,027.00) (13,315.00) (13,349.25) (13,380.68) (13,409.51) (13,435.96) (13,460.23) Retained earnings (accumulated deficit) 25,188.00 26,366.00 29,200.00 30,700.78 32,514.16 34,596.90 36,963.92 39,650.16 Accumulated other comprehensive income (loss) (933.00) (1,410.00) (940.00) (940.00) (940.00) (940.00) (940.00) (940.00) Total Valero Energy Corporation stockholders' equity 20,527.00 20,024.00 21,991.00 23,457.53 25,239.48 27,293.39 29,633.96 32,295.93 Noncontrolling interests 827.00 830.00 909.00 909.00 909.00 909.00 909.00 909.00 Total Stockholders' Equity $ 21,354.00 $ 20,854.00 $ 22,900.00 $ 24,366.53 $ 26,148.48 $ 28,202.39 $ 30,542.96 $ 33,204.93 Total Liabilities and Stockholders' Equity $ 44,343.00 $ 46,173.00 $ 50,158.00 $ 51,121.09 $ 54,775.97 $ 58,037.02 $ 61,027.34 $ 64,293.70 Valero Energy Corporation Cash Flow Statement In Millions $ Fiscal Years Ending Dec. 31 2015 2016 2017 2018E 2019E 2020E 2021E 2022E CASH FLOWS FROM OPERATING ACTIVITIES

Net Income (loss) $ 4,101.00 $ 2,417.00 $ 4,156.00 $ 3,096.64 $ 3,409.11 $ 3,678.37 $ 3,962.53 $ 4,281.66 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation & amortization expense 1,842.00 1,894.00 1,986.00 2,061.62 2,102.96 2,152.98 2,202.73 2,253.45 Stock-based compensation expense ------Deferred income tax expense (benefit) 165.00 230.00 (2,543.00) 128.36 131.86 135.46 139.15 142.95 Changes in Assets and Liabilities: Restricted cash ------Receivables, net 1,294.00 (1,531.00) (870.00) (526.78) (448.27) (132.20) (178.54) (138.89) Inventories (222.00) 771.00 (516.00) (916.21) (439.33) (129.56) (174.98) (136.12) Income taxes receivable (104.00) 156.00 ------Prepaid expenses & other current assets (45.00) (109.00) 151.00 (140.41) (17.84) (5.26) (7.10) (5.53) Accounts payable (1,787.00) 1,556.00 1,842.00 680.59 543.34 160.23 216.40 168.34 Accrued expenses (40.00) 117.00 21.00 44.32 45.52 13.42 18.13 14.10 Taxes other than income taxes (74.00) 82.00 172.00 (13.21) 78.70 23.21 31.35 24.38 Income taxes payable (328.00) (66.00) 489.00 (499.51) 6.71 5.79 6.11 6.86 Deferred charges & credits & other operating activities, net 19.00 (6.00) 594.00 677.96 (161.77) (47.71) (64.43) (50.12) Net Cash Flows from Operating Activities $ 5,611.00 $ 4,820.00 $ 5,482.00 $ 4,593.38 $ 5,251.00 $ 5,854.74 $ 6,151.35 $ 6,561.10

CASH FLOWS FROM INVESTING ACTIVITIES

Capital expenditures $ (1,618.00) $ (1,278.00) $ (1,353.00) $ (2,612.55) $ (2,769.78) $ (2,816.14) $ (2,878.76) $ (2,927.47) Net Cash Flows from Investing Activities $ (2,487.00) $ (2,006.00) $ (2,382.00) $ (2,612.55) $ (2,769.78) $ (2,816.14) $ (2,878.76) $ (2,927.47)

CASH FLOWS FROM FINANCING ACTIVITIES

Borrowings under long-term debt 39.00 650.00 508.00 - - Current portion of long-term debt (662.53) 265.83 316.51 178.49 200.98 Other liabilities (220.47) 150.96 44.52 60.13 46.77 Purchase of common stock for treasury (2,838.00) (1,336.00) (1,372.00) (34.25) (31.43) (28.83) (26.45) (24.27) Dividends Paid (848.00) (1,111.00) (1,242.00) (1,595.86) (1,595.73) (1,595.62) (1,595.52) (1,595.42) Other financing activities, net 25.00 (184.00) (26.00) - - - - - Net Cash Flows from Financing Activities $ (2,545.00) $ (2,012.00) $ (2,272.00) $ (2,474.11) $ (560.37) $ (755.42) $ (1,383.35) $ (1,371.94)

Net increase (decrease) in cash & temporary cash investments 425.00 702.00 1,034.00 (493.28) 1,920.86 2,283.17 1,889.24 2,261.69 Cash & temporary cash investments at beginning of year 3,689.00 4,114.00 4,816.00 5,850.00 5,356.72 7,277.57 9,560.75 11,449.99 Cash & temporary cash investments at end of year $ 4,114.00 $ 4,816.00 $ 5,850.00 $ 5,356.72 $ 7,277.57 $ 9,560.75 $ 11,449.99 $ 13,711.67 Valero Energy Corporation Common Size Income Statement

Fiscal Years Ending Dec. 31 2015 2016 2017 2018E 2019E 2020E 2021E 2022E Operating revenues (a) 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% Cost of sales: Cost of materials and other 84.12% 87.18% 88.36% 90.91% 91.13% 90.97% 90.85% 90.68% Operating expenses 4.83% 5.56% 4.75% 3.46% 3.26% 3.21% 3.14% 3.09% Depreciation & amortization expense 2.10% 2.50% 2.11% 1.60% 1.54% 1.55% 1.55% 1.56% Total cost of sales 91.95% 94.26% 95.22% 95.97% 95.93% 95.72% 95.53% 95.32% General & administrative expenses 0.81% 0.95% 0.89% 0.65% 0.61% 0.60% 0.59% 0.58% Total costs & expenses 92.76% 95.28% 96.17% 96.61% 96.54% 96.32% 96.12% 95.90% Operating income (loss) 7.24% 4.72% 3.83% 3.39% 3.46% 3.68% 3.88% 4.10% Other income (expense), net 0.05% 0.07% 0.08% 0.04% 0.04% 0.04% 0.04% 0.04% Interest & debt expense, net of capitalized interest -0.49% -0.59% -0.50% -0.30% -0.27% -0.29% -0.31% -0.31% Income before income tax expense (benefit) 6.80% 4.21% 3.41% 3.13% 3.24% 3.43% 3.61% 3.83% Income tax expense (benefit) 2.13% 1.01% -1.01% 0.66% 0.68% 0.72% 0.76% 0.80% Net income (loss) 4.67% 3.19% 4.42% 2.47% 2.56% 2.71% 2.85% 3.02% Less: net income (loss) attributable to noncontrolling interests -0.13% -0.17% -0.10% -0.07% -0.07% -0.07% -0.06% -0.06% Net income (loss) attributable to Valero Energy Corporation stockholders 4.54% 3.03% 4.33% 2.40% 2.49% 2.64% 2.79% 2.96% Valero Energy Corporation Common Size Balance Sheet

Fiscal Years Ending Dec. 31 2015 2016 2017 2018E 2019E 2020E 2021E 2022E Assets Current assets: Cash & temporary cash investments 4.69% 6.37% 6.22% 4.15% 5.32% 6.87% 8.05% 9.48% Receivables, net 5.08% 7.80% 7.37% 5.77% 5.77% 5.77% 5.77% 5.77% Inventories 6.72% 7.55% 6.79% 5.66% 5.66% 5.66% 5.66% 5.66% Income taxes receivable 0.25% 0.08% ------Deferred income taxes 0.08% ------Prepaid expenses & other current assets 0.23% 0.42% 0.17% 0.23% 0.23% 0.23% 0.23% 0.23% Total current assets 17.05% 22.20% 20.55% 15.81% 16.98% 18.53% 19.71% 21.14% Property, plant & equipment, at cost 42.03% 49.87% 42.57% 33.03% 33.18% 34.65% 35.92% 37.35% Accumulated depreciation 11.62% 14.88% 13.33% 11.31% 12.20% 13.55% 14.80% 16.11% Property, plant & equipment, net 30.41% 34.99% 29.24% 21.72% 20.97% 21.11% 21.12% 21.24% Deferred charges & other assets, net 3.04% 3.83% 3.58% 2.08% 2.08% 2.08% 2.08% 2.08% Total assets 50.50% 61.03% 53.37% 39.61% 40.03% 41.72% 42.91% 44.46%

Liabilities and Equity Current Liabilities: Current portion of debt & capital lease obligations 0.14% 0.15% 0.13% 0.12% 0.59% 0.95% 0.93% 0.91% Accounts payable 5.59% 8.40% 8.88% 7.00% 7.00% 7.00% 7.00% 7.00% Accrued expenses 0.63% 0.92% 0.76% 0.59% 0.59% 0.59% 0.59% 0.59% Taxes other than income taxes 1.22% 1.43% 1.41% 1.01% 1.01% 1.01% 1.01% 1.01% Income taxes payable 0.38% 0.10% 0.60% 0.05% 0.05% 0.06% 0.06% 0.06% Deferred income taxes 0.42% ------Total current liabilities 8.38% 11.01% 11.78% 8.77% 9.24% 9.60% 9.58% 9.57% Debt & capital lease obligations, less current portion 8.26% 10.42% 9.31% 6.27% 6.11% 6.23% 6.22% 6.26% Deferred income taxes 7.71% 9.73% 5.01% 3.75% 3.63% 3.67% 3.69% 3.72% Total other long-term liabilities 1.83% 2.31% 2.90% 1.94% 1.94% 1.94% 1.94% 1.94% Total liabilities 26.18% 33.46% 29.00% 20.73% 20.92% 21.45% 21.44% 21.50% Equity: Valero Energy Corporation stockholders' equity: Common stock 8.05% 9.38% 7.50% 5.46% 5.15% 5.06% 4.95% 4.87% Additional paid-in capital -12.30% -15.90% -14.17% -10.34% -9.78% -9.64% -9.45% -9.31% Treasury stock, at cost -12.30% -15.90% -14.17% -10.34% -9.78% -9.64% -9.45% -9.31% Retained earnings (accumulated deficit) 28.69% 34.85% 31.07% 23.79% 23.76% 24.87% 25.99% 27.42% Accumulated other comprehensive income (loss) -1.06% -1.86% -1.00% -0.73% -0.69% -0.68% -0.66% -0.65% Total Valero Energy Corporation stockholders' equity 23.38% 26.47% 23.40% 18.18% 18.45% 19.62% 20.84% 22.33% Noncontrolling interests 0.94% 1.10% 0.97% 0.70% 0.66% 0.65% 0.64% 0.63% Total equity 24.32% 27.56% 24.37% 18.88% 19.11% 20.27% 21.48% 22.96% Total liabilities and equity 50.50% 61.03% 53.37% 39.61% 40.03% 41.72% 42.91% 44.46% Valero Energy Corporation Value Driver Estimation In Millions Fiscal Years Ending Dec. 31 2015 2016 2017 2018E 2019E 2020E 2021E 2022E

NOPLAT Computation EBITA: Net Sales $ 87,804.00 $ 75,659.00 $ 93,980.00 $ 129,056.51 $ 136,823.16 $ 139,113.56 $ 142,206.89 $ 144,613.22 - Cost of Goods Sold (73,861.00) (65,962.00) (83,037.00) (117,328.68) (124,685.98) (126,545.10) (129,192.60) (131,136.37) - Operating Expenses (4,243.00) (4,207.00) (4,462.00) (4,462.00) (4,462.00) (4,462.00) (4,462.00) (4,462.00) - Depletion, depreciation and amortization (1,842.00) (1,894.00) (1,986.00) (2,061.62) (2,102.96) (2,152.98) (2,202.73) (2,253.45) - General and administrative expenses 710.00 715.00 835.00 (835.00) (835.00) (835.00) (835.00) (835.00) + Implied Interest on Operating Leases 46.37 45.05 56.38 63.30 64.81 66.31 67.83 69.35 EBITA $ 8,614.37 $ 4,356.05 $ 5,447.38 $ 4,432.51 $ 4,802.03 $ 5,184.78 $ 5,582.39 $ 5,995.76

LESS: Adjusted Taxes Provision for Income Taxes 1,870.00 765.00 (949.00) 847.35 930.41 1,001.98 1,077.52 1,162.35 + Tax shield on interest & debt expense, net of capitalized interest 90.93 93.66 98.28 82.22 76.44 84.93 92.57 94.22 + Tax Shield on Implied Lease Interest 9.74 9.46 11.84 13.29 13.61 13.92 14.24 14.56 - Tax on Other Income (9.66) (11.76) (15.96) (12.03) (12.03) (12.03) (12.03) (12.03) Adjusted Taxes $ 1,970.67 $ 879.88 $ (838.88) $ 930.83 $ 1,008.43 $ 1,088.80 $ 1,172.30 $ 1,259.11

PLUS: Change in Deferred Tax Liabilities Current year DTL 366.00 ------Current year DTA 74.00 ------Net DTL for current year 292.00 ------

Previous year DTL 376.00 366.00 ------Previous year DTA 162.00 74.00 ------Net DTL for previous year 214.00 292.00 ------

Net Change in DtL (Current-Previous year) 78.00 (292.00) ------

NOPLAT: EBIT - Adjusted Taxes + Change in DT $ 6,721.71 $ 3,184.17 $ 6,286.26 $ 3,501.68 $ 3,793.60 $ 4,095.97 $ 4,410.09 $ 4,736.65

Invested Capital Computation

Operating Current Assets: Normal Cash 614.63 529.61 657.86 903.40 957.76 973.79 995.45 1,012.29 Accounts Recievable 4,464.00 5,901.00 6,922.00 7,448.78 7,897.05 8,029.24 8,207.78 8,346.67 Inventories 5,898.00 5,709.00 6,384.00 7,300.21 7,739.54 7,869.09 8,044.07 8,180.19 Prepaid Expenses 204.00 316.00 156.00 296.41 314.24 319.50 326.61 332.14 Income tax recievable 218.00 58.00 ------Operating Current Assets: $11,398.63 $12,513.61 $14,119.86 $15,948.79 $16,908.59 $17,191.64 $17,573.91 $17,871.29

Operating Current Liabilities: Accounts Payable 4,907.00 6,357.00 8,348.00 9,028.59 9,571.94 9,732.17 9,948.57 10,116.92 Income taxes payable 337.00 78.00 568.00 68.49 75.21 80.99 87.10 93.95 Operating Current Liabilities $ 5,244.00 $ 6,435.00 $ 8,916.00 $ 9,097.09 $ 9,647.14 $ 9,813.16 $ 10,035.67 $ 10,210.87

Net Working Capital $6,154.63 $6,078.61 $5,203.86 $6,851.70 $7,261.45 $7,378.48 $7,538.24 $7,660.41

PLUS: Net PPE 26,703.00 26,472.00 27,480.00 28,030.93 28,697.75 29,360.91 30,036.94 30,710.96

PLUS: PV of operating leases 1,050.85 1,020.78 1,277.48 1,434.45 1,468.58 1,502.51 1,537.11 1,571.60

PLUS: Other L-T operating assets Other 2,668.00 2,901.00 3,366.00 2,688.04 2,849.81 2,897.52 2,961.95 3,012.07 Total Other L-T operating assets 30,421.85 30,393.78 32,123.48 32,153.43 33,016.14 33,760.94 34,535.99 35,294.63

LESS: Other L-T operating liabilities 1,611.00 1,744.00 2,729.00 2,508.53 2,659.49 2,704.01 2,764.14 2,810.91

Invested Capital: $62,719.33 $62,221.18 $63,355.82 $65,961.98 $67,784.42 $69,298.83 $70,884.14 $72,426.69

ROIC=NOPLAT/Beginning IC NOPLAT $ 6,721.71 $ 3,184.17 $ 6,286.26 $ 3,501.68 $ 3,793.60 $ 4,095.97 $ 4,410.09 $ 4,736.65 Beginning IC $ 62,505.13 $ 62,719.33 $ 62,221.18 $ 63,355.82 $ 65,961.98 $ 67,784.42 $ 69,298.83 $ 70,884.14 Return on Invested Capital 10.75% 5.08% 10.10% 5.53% 5.75% 6.04% 6.36% 6.68% FCF=NOPLAT-Change in IC NOPLAT $ 6,721.71 $ 3,184.17 $ 6,286.26 $ 3,501.68 $ 3,793.60 $ 4,095.97 $ 4,410.09 $ 4,736.65 Change in IC $ 214.20 $ (498.15) $ 1,134.64 $ 2,606.16 $ 1,822.44 $ 1,514.41 $ 1,585.31 $ 1,542.55 Free Cash Flows $ 6,507.51 $ 3,682.32 $ 5,151.62 $ 895.52 $ 1,971.16 $ 2,581.57 $ 2,824.77 $ 3,194.09 EP=Beginning IC*(ROIC-WACC) Beginning IC $62,505.13 $62,719.33 $62,221.18 $63,355.82 $65,961.98 $67,784.42 $69,298.83 $70,884.14 ROIC 10.75% 5.08% 10.10% 5.53% 5.75% 6.04% 6.36% 6.68% WACC 10.00% 10.00% 10.00% 7.09% 7.09% 7.09% 7.09% 7.09% Economic Profit $ 471.19 $ (3,087.77) $ 64.14 $ (987.78) $ (880.54) $ (707.30) $ (500.51) $ (286.28) Valero Energy Corporation Weighted Average Cost of Capital (WACC) Estimation

Risk Free Rate 3.19% Risk Premium 5.32% Beta 0.91 Cost of Equity 8.03%

Cost of Debt Debt Rating BBB Pre-tax Cost of Debt 4.41% Tax Rate 21% After-Tax Cost of Debt 3.49%

MV of Equity Shares Outstanding 443.29 Share Price $87.58 MV of Equity 38,823.63

MV of Debt Current Portion of Long-Term Debt 122.00 Long-Term Debt 8,750.00 Operating Leases 1,277.48 MV of Debt 10,149.48

Weights % Equity 79% % Debt 21%

WACC 7.09% Valero Energy Corporation Discounted Cash Flow (DCF) and Economic Profit (EP) Valuation Models

Key Inputs: CV Growth 3.00% CV ROIC 6.36% WACC 7.09% Cost of Equity 8.03%

Fiscal Years Ending Dec. 31 2018E 2019E 2020E 2021E 2022E (CV)

DCF Model NOPLAT 3502 3794 4096 4410 4737 CapEx 2606 1822 1514 1585 1543 Unlevered Free Cash Flow 896 1971 2582 2825 3194 ROIC 5.53% 5.75% 6.04% 6.36% 6.68% Continuing Value 63878

Periods to Discount 1 2 3 4 4

Present Value of FCF 836 1719 2102 2148 Present Value of CV 48576

Value of Operating Assets (Millions) $ 55,381 Excess Cash $ 5,192 Debt $ 8,872 PV of Operating Leases $ 1,277 PV of Stock Options $ 24 Non controlling interests $ (940) Value of Equity $ 49,460.20 Shares Outstanding 444.00 Intrinsic Value per Share $ 111.40 Target Price as of 11/11/2018 $ 116.06

EP Model Beginning Invested Capital 63356 65962 67784 69299 70884 ROIC 5.53% 5.75% 6.04% 6.36% 6.68% Economic Profit -988 -881 -707 -501 -286 Economic Profit (CV) -7006

Periods to Discount 1 2 3 4 4 Present Value of Economic Profit -922 -768 -576 -381 -5328 Present Value -7975 Beginning Invested Capital 63356 Value of Operating Assets 55381 Excess Cash 5192 Debt 8872 PV of Operating Leases 1277 PV of Stock Options 24 Non controlling interests -940 Value of Equity $ 49,460.20 Shares Outstanding 444 Intrinsic Value per Share $ 111.40 Target Price as of 11/11/2018 $ 116.06 Valero Energy Corporation Dividend Discount Model (DDM) or Fundamental P/E Valuation Model

Fiscal Years Ending 2018E 2019E 2020E 2021E 2022E (CV)

EPS $ 6.99 $ 7.69 $ 8.30 $ 8.94 $ 9.66

Key Assumptions CV growth 3.00% CV ROE 12.89% Cost of Equity 8.03%

Future Cash Flows P/E Multiple (CV Year) $ 15.26 EPS (CV Year) $ 9.66 Future Stock Price $ 147.47 Dividends Per Share $ 3.60 $ 3.60 $ 3.60 $ 3.60 Number of Periods 1 2 3 4 4 Discounted Cash Flows 3.332 3.085 2.856 2.643 108.286

Intrinsic Value $ 120.20 Target Price as of 11/11/18 $ 125.23

For Discounting: Number of Periods 1 2 3 4 5

Model Date 11/13/2018 Next FYE 12/31/2018 Last FYE 12/31/2017 Days in FY 365 Days to FYE 317 Elapsed Fraction 0.868 Valero Energy Corporation Relative Valuation Models

EPS EPS Ticker Company Price 2018E 2019E P/E 18 P/E 19 Enterprise Value EBITA EV/EBITA DK Delek US Holdings, Inc. $38.95 $4.80 $6.75 8.11 5.77 4,220,000,000 631,736,527 6.68 PSX Phillips 66 $99.74 $8.89 $9.84 11.22 10.14 58,240,000,000 4,165,951,359 13.98 XOM Exxon Mobil Corporation $80.87 $4.78 $5.82 16.92 13.90 382,130,000,000 36,849,566,056 10.37 INT World Fuel Services Corporation $29.42 $2.06 $2.30 14.28 12.79 2,460,000,000 291,469,194 8.44 HFC HFC Inc. $64.70 $5.76 $7.65 11.23 8.46 13,220,000,000 2,101,748,808 6.29 Average 12.35 10.21 9.15

VLO Valero Energy Corporation $87.58 $ 6.99 $ 7.69 12.5 11.4 44,811,128,000 5,447,375,152 8.23

Implied Relative Value: P/E (EPS18) $ 86.29 P/E (EPS19) $ 78.53 Enterprise Value $ 44,811,128,000.00 Shares Outstanding $ 443,259,093.48 Share Price $ 101.09 Valero Energy Corporation Key Management Ratios

Fiscal Years Ending Definition 2015 2016 2017 2018E 2019E 2020E 2021E 2022E

Liquidity Ratios Current Ratio Current Assets/Current Liabilities 2.03 2.02 1.74 1.80 1.84 1.93 2.06 2.21 Operating CF Ratio Cash Flow from Operations/Current Liabilities 0.76 0.58 0.50 0.41 0.42 0.44 0.45 0.47 Quick Ratio Liquid Assets/Current Liabilities 1.17 1.29 1.15 1.13 1.20 1.32 1.44 1.59

Activity or Asset-Management Ratios Asset Turnover Sales/Average Total Assets 1.95 1.67 1.95 2.55 2.58 2.47 2.39 2.31 Receivables Turnover Credit Sales/Average Accounts Receivable 16.98 14.60 14.66 17.96 17.83 17.47 17.52 17.47 Inventory Turnover Sales/Average Inventory 14.03 13.04 15.54 18.86 18.19 17.83 17.87 17.83

Financial Leverage Ratios Debt-to-Equity Total Liabilities/Stockholders' Equity 1.08 1.21 1.19 1.10 1.09 1.06 1.00 0.94 Equity Ratio Stockholders' Equity/Total Assets 0.48 0.45 0.46 0.48 0.48 0.49 0.50 0.52

Profitability Ratios Return on Assets Net Income/Average Total Assets 8.88% 5.06% 8.44% 6.12% 6.44% 6.52% 6.66% 6.83% Return on Equity Net Income/Average Stockholders' Equity 18.73% 10.85% 18.58% 13.10% 13.50% 13.54% 13.49% 13.43% Profit Margin Net Income/Net Sales 4.54% 3.03% 4.33% 2.40% 2.49% 2.64% 2.79% 2.96% Gross Margin (Revenue-COGS)/Revenue 15.88% 12.82% 11.64% 9.09% 8.87% 9.03% 9.15% 9.32%

Payout Policy Ratios Payout Ratio Dividends per Share/Earnings per Share 21.25% 48.58% 30.53% 51.54% 46.81% 43.38% 40.27% 37.26% Total Payout (Dividends+Repurchases)/Net Income 89.881% 101.241% 62.897% 52.64% 47.73% 44.16% 40.93% 37.83% Present Value of Operating Lease Obligations (2017) Present Value of Operating Lease Obligations (2016) Present Value of Operating Lease Obligations (2015)

Operating Operating Operating Fiscal Years Ending Dec. 31 Leases Fiscal Years Ending Dec. 31 Leases Fiscal Years Ending 129.612845424997 Leases 2017 479 2016 430 2015 314 2018 321 2017 283 2016 229 2019 221 2018 200 2017 158 2020 162 2019 143 2018 131 2021 106 2020 100 2019 75 Thereafter 362 Thereafter 311 Thereafter 275 Total Minimum Payments 1651 Total Minimum Payments 1467 Total Minimum Payments 1182 Less: Interest 217 Less: Interest 190 Less: Interest 161 PV of Minimum Payments 1434 PV of Minimum Payments 1277 PV of Minimum Payments 1021

Capitalization of Operating Leases Capitalization of Operating Leases Capitalization of Operating Leases

Pre-Tax Cost of Debt 4.41% Pre-Tax Cost of Debt 4.41% Pre-Tax Cost of Debt 4.41% Number Years Implied by Year 6 Payment 3.4 Number Years Implied by Year 6 Payment 3.1 Number Years Implied by Year 6 Payment 3.7

Lease PV Lease Lease PV Lease Lease PV Lease Year Commitment Payment Year Commitment Payment Year Commitment Payment 1 479 458.8 1 430 411.8 1 314 300.7 2 321 294.4 2 283 259.6 2 229 210.1 3 221 194.1 3 200 175.7 3 158 138.8 4 162 136.3 4 143 120.3 4 131 110.2 5 106 85.4 5 100 80.6 5 75 60.4 6 & beyond 106 265.4 6 & beyond 100 229.5 6 & beyond 75 200.5 PV of Minimum Payments 1434.5 PV of Minimum Payments 1277.5 PV of Minimum Payments 1020.8

Present Value of Operating Lease Obligations (2014) Present Value of Operating Lease Obligations (2013) Present Value of Operating Lease Obligations (2012)

Operating Operating Operating Fiscal Years Ending 129.612845424997 Leases Fiscal Years Ending 78.0797690487375 Leases Fiscal Years Ending 36.2098774239726 Leases 2014 305 2013 337 2012 291 2015 230 2014 250 2013 198 2016 162 2015 179 2014 131 2017 111 2016 133 2015 106 2018 95 2017 86 2016 86 Thereafter 321 Thereafter 350 Thereafter 294 Total Minimum Payments 1224 Total Minimum Payments 1335 Total Minimum Payments 1106 Less: Interest 173 Less: Interest 191 Less: Interest 157 PV of Minimum Payments 1051 PV of Minimum Payments 1144 PV of Minimum Payments 949

Capitalization of Operating Leases Capitalization of Operating Leases Capitalization of Operating Leases

Pre-Tax Cost of Debt 4.41% Pre-Tax Cost of Debt 4.41% Pre-Tax Cost of Debt 4.41% Number Years Implied by Year 6 Payment 3.4 Number Years Implied by Year 6 Payment 4.1 Number Years Implied by Year 6 Payment 3.4

Lease PV Lease Lease PV Lease Lease PV Lease Year Commitment Payment Year Commitment Payment Year Commitment Payment 1 305 292.1 1 337 322.8 1 291 278.7 2 230 211.0 2 250 229.3 2 198 181.6 3 162 142.3 3 179 157.2 3 131 115.1 4 111 93.4 4 133 111.9 4 106 89.2 5 95 76.6 5 86 69.3 5 86 69.3 6 & beyond 95 235.5 6 & beyond 86 253.1 6 & beyond 86 215.5 PV of Minimum Payments 1050.9 PV of Minimum Payments 1143.6 PV of Minimum Payments 949.4 Effects of ESOP Exercise and Share Repurchases on Common Stock Balance Sheet Account and Number of Shares Outstanding

Number of Options Outstanding (shares): 1,018,716 Average Time to Maturity (years): 0.00 Expected Annual Number of Options Exercised: 0

Current Average Strike Price: $ - Cost of Equity: 9.00% Current Stock Price: $87.58

2018E 2019E 2020E 2021E 2022E 2023E 2024E 2025E 2026E 2027E Increase in Shares Outstanding: 0 0 0 0 0 0 0 0 0 0 Average Strike Price: $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - Increase in Common Stock Account: ------

Change in Treasury Stock 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 Expected Price of Repurchased Shares: $ 87.58 $ 95.46 $ 104.05 $ 113.42 $ 123.63 $ 134.75 $ 146.88 $ 160.10 $ 174.51 $ 190.21 Number of Shares Repurchased: 34,254 31,426 28,831 26,451 24,267 22,263 20,425 18,738 17,191 15,772

Shares Outstanding (beginning of the year) 443,293,348 443,259,093 443,227,667 443,198,836 443,172,386 443,148,119 443,125,856 443,105,431 443,086,693 443,069,502 Plus: Shares Issued Through ESOP ------Less: Shares Repurchased in Treasury 34,254 31,426 28,831 26,451 24,267 22,263 20,425 18,738 17,191 15,772 Shares Outstanding (end of the year) 443,259,093 443,227,667 443,198,836 443,172,386 443,148,119 443,125,856 443,105,431 443,086,693 443,069,502 443,053,730 VALUATION OF OPTIONS GRANTED IN ESOP

Ticker Symbol VLO Current Stock Price $87.58 Risk Free Rate 3.19% Current Dividend Yield 3.20% Annualized St. Dev. of Stock Returns 27.78%

Average Average B-S Value Range of Number Exercise Remaining Option of Options Outstanding Options of Shares Price Life (yrs) Price Granted Range 1 292,145 77.15 10.00 $ 24.27 $ 7,091,450 Range 2 216,415 81.21 10.00 $ 23.17 $ 5,015,278 Range 3 798 87.76 10.00 $ 21.53 $ 17,182 Range 4 509,358 83.83 10.00 $ 22.50 $ 11,459,846 Total 1,018,716 $ 81.36 10.00 $ 39.89 $ 23,583,755