Fitch Ratings has affirmed Valero Energy Corporation's (NYSE: VLO) and Valero Energy Partners LP's (VLP) Long-Term Issuer Default Rating (IDR) and senior unsecured ratings at 'BBB'.

The Rating Outlook is Stable.

Valero's ratings reflect de-leveraging actions taken to date; the current strength of the market for refined products, which has benefited from dislocations associated with Russian sanctions; the company's large size and high-quality refining assets, advantaged cost position, moderate capex, good liquidity, and diversification into renewable fuels.

These strengths are balanced by a challenging macroeconomic outlook in the context of high inflation and increasingly restrictive central bank interest rate policies, risks around demand destruction, periodically volatile working capital requirements across the industry, rising environmental compliance costs, and the long-term secular growth challenges from decarbonization trends.

Key Rating Drivers

Incremental Debt Repayment: To date Valero has repaid just under $3.6 billion of the $4.0 billion in debt incurred during the pandemic, including a $1.25 billion multi-tranche debt tender (upsized from $1.0 billion) in September. Tendered maturities were concentrated in the 2025-2029 time frame, which helps lower the near-to-medium term maturity wall. Debt reductions have restored headroom at the current 'BBB' rating.

Strong YTD Results: North American refiners experienced blockbuster YTD results, driven by record crack spreads, with the Gulf coast 321 benchmark $40-$50/barrel for much of the driving season, versus normalized levels in the $15 range. Strong YTD results were driven by bullish factors including recovering product demand, low inventories, market dislocations from Russian sanctions, and structural reductions in U.S. refining capacity. While spreads have come down significantly in Q3, they remain well above midcycle levels. As calculated by Fitch VLO generated FCF of just under $5.1 billion YTD.

Size, Scale and Diversification: Valero is one of the world's largest independent refiners, with 15 refineries and approximately 3.2 million barrels per day (bpd) of throughput capacity. Complexity is above average with a Nelson portfolio complexity of 11.6 (12.6 for the Gulf Coast region). North Atlantic assets outside the U.S. include the Pembroke refinery in the U.K. and Quebec City refinery in Quebec. Relative to peers, diversification is modest, but includes leading ethanol and renewable diesel footprints.

Cautious Outlook: Despite record YTD results there are reasons to be cautious about the forward outlook. In addition to the ongoing Russia-Ukraine conflict, high inflation and restrictive global central bank policies are expected to lower global GDP growth and result in a US recession, which could accelerate demand destruction for the industry. For more see Fitch's Global Economic Outlook-September 2022. Other challenges include risks around increased Chinese fuel exports, refinery capacity growth in the Middle East and Asia, and the long-term secular growth challenges from decarbonization trends and electric vehicles.

Focus on Shareholders: Similar to other refiners, Valero channels a significant portion of FCF to shareholder distributions, with a targeted payout ratio of 40%-50% of adjusted CFO, split between dividend and buybacks. YTD this includes approximately $2.8 billion in shares and $1.2 billion in dividends. The company had around $1.6 billion remaining in repurchase authorization as of Sept. 30, 2022, which was increased by an additional $2.5 billion in October. Fitch expects distributions will be managed in a leverage-neutral way but also notes the company funded its dividend with borrowings during the pandemic.

Leading Renewables Position: Valero is the second largest corn ethanol and renewable diesel producer in the world. Its ethanol position includes 12 plants in the Midwest with 1.6 billion gpy of capacity, and a pending expansion into carbon capture and storage. In renewable diesel, jv capacity is set to increase to 1.2 billion gpy with DGD3 (estimated online 4Q22). Renewables are a key plank of VLO's ESG strategy, providing a cash flow hedge against rising environmental compliance costs (RINs).

Renewable diesel is heavily reliant on continuing state and federal government credits to generate returns, including RINs, LCFS and the BTC (which was recently extended in the Inflation Reduction Act). Feedstock inflation and aggressive capacity expansion remain key concerns for the space, along with lower LCFS prices.

Feedstock Advantage: Valero's refineries enjoy feedstock advantages, including access to discounted crudes, especially at Gulf Coast and Mid-Continent facilities. Key crude discounts narrowed with the onset of the pandemic but have selectively widened, including light-heavy spreads. Fitch expects some spreads may remain subdued relative to historical levels given excess pipeline capacity. Higher natural gas prices have increased VLO's manufacturing costs, given gas is about 25% of VLO's opex; however, VLO's relative advantage remains intact given the higher spike at competing refining centers in Europe and Asia.

Long Term Regulatory Pressure: Refiners face long-term regulatory pressures that will cap product demand in the U.S., including rising RINs costs under the Renewable Fuel Standard program, higher corporate average fuel economy standards, greenhouse gas regulation on the federal and state levels, and recent administration discussions around a possible refined product export ban. Valero's investments in renewables and significant wholesale blending and exports moderate its exposure to these impacts.

Derivation Summary

Valero's ratings reflect its status as a premier independent refiner. In terms of size and scale, with 15 refineries and approximately 2.6 million bpd of crude capacity (3.2 million bpd of throughput capacity), Valero's core refining capacity is larger than peers Phillips 66 (PSX, 1.9 million bpd), PBF (1.04 million bpd), and HollyFrontier (HFC, 678,000 bpd pro forma for Sinclair transaction) but slightly smaller than Marathon Petroleum Corporation (MPC, 3.0 million bpd).

Valero's refining asset quality is high and advantaged in several ways, including geographically (large concentration of price-advantaged capacity on the Gulf and mid-continent); operationally (flexibility to take advantage of light-light and light-heavy crude spreads); and ongoing access to lower cost U.S. natural gas and power prices. Valero's Nelson complexity is above average at 11.6 (12.6 for the Gulf coast). VLO is well positioned to serve short haul export markets in Latam and has invested in terminal systems in both Mexico and Peru.

Diversification is limited versus peers. Unlike HF Sinclair or MPC, VLO does not have a separate logistics MLP, having folded its logistics MLP VLP into parent VLO in 2019. However, VLO has a leading renewables position in both ethanol (12 plants, 1.6 billion gpy of capacity in advantaged Midwestern locations), and is the largest U.S. renewable diesel producer through its Diamond Green Diesel Holdings joint venture (DGD). With the pending completion of the 470 million gpy DGD3 plant in Port Arthur at year end, jv capacity will rise to 1.2 billion gpy, as well as 50 million gpy of renewable naphtha.

Key Assumptions

WTI oil prices of $95/barrel in 2022, $81/barrel in 2023, $62/barrel in 2024, and $50 in 2025 and beyond;

Refining margins trend down over the forecast but remains above-midcycle levels in the medium term;

Consolidated capex (including turnaround expenses and joint venture capex) of approximately $2.5 billion in 2022, edging down to $2.2 billion by 2025;

Modest dividend growth resumes in 2023;

Excess FCF funneled to share buybacks but company retains above-average cash balances over forecast period.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

Greater earnings diversification or evidence of lower cash flow volatility;

Material incremental debt reduction relative to pre-pandemic levels;

Mid-cycle debt/EBITDA leverage at or below 1.2x.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

A change in philosophy on use of the balance sheet, including debt-funded shareholder distributions;

Mid-cycle debt/EBITDA leverage above approximately 2.2x.

Best/Worst Case Rating Scenario

International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from 'AAA' to 'D'. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.

Liquidity and Debt Structure

Robust Liquidity: Valero's liquidity was robust at Sept. 30, 2022, and included readily available cash of approximately $3.73 billion, after netting out cash held at DGD and other subsidiaries of $240 million, which is not available for general use by the parent. Availability on the company's main $4.0 billion unsecured revolver due March 2024 was approximately $3.5 billion after netting out LOCs of $538 million, for core liquidity of just under $7.2 billion.

In addition, Valero has a separate CAD150 million credit facility, (CAD145 million available), and a $1.3 billion accounts receivable securitization facility due July 2023 ($1.3 billion available). Separately Valero consolidates revolvers at IEnova (February 2028, $830 available, $705 million drawn), and revolvers at DGD ($400 million due March 2024 and $25 million due April 2023, with availability of $292 million and $25, respectively). These revolvers are non-recourse to parent Valero and not available for its general use.

Issuer Profile

Valero is a large independent refiner with 15 refineries and approximately 2.6 million bpd of crude distillation capacity (3.2 million bpd throughput capacity), as well as the second largest corn ethanol and renewable diesel producer in the world.

REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING

The principal sources of information used in the analysis are described in the Applicable Criteria.

ESG Considerations

Valero Energy Corporation has an ESG Relevance Score of '4' for Exposure to Environmental Impacts due to the material exposure that Gulf Coast refineries have to extreme weather events (hurricanes), which periodically lead to extended shutdowns. This has a negative impact on the credit profile, and is relevant to the rating in conjunction with other factors.

Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of '3'. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. For more information on Fitch's ESG Relevance Scores, visit www.fitchratings.com/esg.

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