* Valero expects narrowed U.S. crude discounts to widen again
* CEO says U.S. markets will price domestic crude to replace imports
* Valero increases expected spending on ethanol credits
By Kristen Hays
July 23 (Reuters) - Valero Energy Corp on Tuesday reported a 44 percent drop in second-quarter profit on higher domestic oil prices, but its executives expect profits to improve through the rest of the year as U.S. crudes fall relative to other global grades.
U.S. refiners have largely lost the cost advantage they enjoyed for nearly three years as wide U.S. benchmark crude discounts to London's Brent have sharply narrowed.
"But we fully expect these markets go back to a more normal pricing," Chief Operating Officer Joe Gorder told analysts on the company's second-quarter earnings conference call on Tuesday.
He said those spreads will widen as more pipeline capacity comes online to move Texas crude to the U.S. Gulf Coast and increased production stabilizes crude draws from the U.S. crude futures hub at Cushing, Oklahoma.
U.S. crude's discount to Brent was around $23 a barrel in February as booming U.S. oil production ramped up much faster than pipeline companies could build infrastructure to move it. The discounts and lack of infrastructure prompted refiners like Valero, the largest U.S. independent refiner, to use more expensive rail to tap that cheaper output.
The spread has since narrowed to less than $2 a barrel as pipeline projects came online to help alleviate the glut of oil at the U.S. crude futures hub in Cushing, Oklahoma.
However, Valero expects the discount to widen back to $6 to $8 a barrel as U.S. and Canadian production rises and more pipeline projects move Texas crude to the U.S. Gulf, Gorder said.
Chief Executive Bill Klesse added that markets will price the U.S. and Canadian crudes to be attractive to markets that had depended on more expensive imports.
"We think, over time, you're going to have these differentials because the crudes got to move to the markets. It's got to displace the foreign barrels," Klesse said.
Rising costs of ethanol credits mandated by the U.S. government also weighed on profits, Valero said. The company warned on July 11 that its second-quarter profit would be lower than a year earlier.
Valero said its costs for ethanol credits to comply with federal regulations on renewable fuels may rise to $600 million to $800 million, up from a previous estimate of $500 million to $750 million.
Exported gasoline doesn't require such credits, and companies including Valero have booked more tankers so far this month than in all of July 2012 to export U.S. fuel.
Valero exported 70,000 bpd of gasoline and 170,000 bpd of diesel fuel in the second quarter, Gorder said, and has capacity to export up to 225,000 bpd of gasoline and 280,000 bpd of diesel as projects to improve docks and add tankage wrap up.
Klesse said that Valero doesn't see going all-out on exports as a fix for the ethanol credit issue.
"I would not want to lead you down that path that this would be a significant solution for us. I don't think so," he said.
Valero reported net income attributable to stockholders fell to $466 million, or 85 cents per share, in the second quarter, from $831 million, or $1.50 per share, a year earlier.
Because the profit came in as expected, analysts at Wells Fargo characterized the earnings report as mostly "neutral," but noted the company's Gulf Coast refining margins came in below expectations.
Shares of Valero closed up 6 cents at $35.33 on the New York Stock Exchange on Tuesday.
The company earmarked a capital budget of $2.5 billion to $3.0 billion for 2014, compared with the $2.85 billion it expects to spend in 2013.