March 2005 10Q

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549

FORM 10-Q

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

For the Quarterly Period Ended March 31, 2005

OR

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

For the Transition Period from _____ to _____

Commission File Number 1-16619


KERR-McGEE CORPORATION
(Exact Name of Registrant as Specified in its Charter)



Delaware
73-1612389
(State or Other Jurisdiction of
(I.R.S. Employer
Incorporation or Organization)
Identification No.)


Kerr-McGee Center, Oklahoma City, Oklahoma 73125
(Address of Principal Executive Offices and Zip Code)

Registrant's telephone number, including area code (405) 270-1313


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 o 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes x    No o 

Number of shares of common stock, $1.00 par value, outstanding as of April 30, 2005: 161,567,286.









 
KERR-McGEE CORPORATION
  
     
 
INDEX
  
   
PAGE
PART I - FINANCIAL INFORMATION
  
     
Item 1. Financial Statements
  
 
    
 
Condensed Consolidated Statement of Income for the Three Months Ended March 31, 2005 and 2004
1
 
    
 
Condensed Consolidated Balance Sheet at March 31, 2005 and December 31, 2004
2
 
    
 
Condensed Consolidated Statement of Cash Flows for the Three Months Ended March 31, 2005 and 2004
3
 
    
 
Condensed Consolidated Statement of Comprehensive Income (Loss) and Stockholders’ Equity for the Three Months Ended March 31, 2005 and 2004
4
     
 
Notes to Condensed Consolidated Financial Statements
5
     
Item 2. Management's Discussion and Analysis of Financial Condition
           and Results of Operations
27
 
 
  
Item 3. Quantitative and Qualitative Disclosures about Market Risk
41
 
 
  
Item 4. Controls and Procedures
44
     
Forward-Looking Information
44
   
   
PART II - OTHER INFORMATION
  
 
 
  
Item 1. Legal Proceedings
44
   
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
45
   
Item 6. Exhibits
46
 
 
  
SIGNATURE
46
 
 
  
   



PART I - FINANCIAL INFORMATION

Item 1. Financial Statements.

KERR-McGEE CORPORATION AND SUBSIDIARY COMPANIES
CONDENSED CONSOLIDATED STATEMENT OF INCOME
(UNAUDITED)


   
Three Months Ended
  
   
March 31,
  
(Millions of dollars, except per-share amounts)
  
2005
  
2004
  
           
Revenues
  
$
1,717
  
$
1,109
  
               
Costs and Expenses
              
Costs and operating expenses
    
521
    
395
  
Selling, general and administrative expenses
    
92
    
81
  
Shipping and handling expenses
    
48
    
38
  
Depreciation and depletion
    
310
    
190
  
Accretion expense
    
9
    
7
  
Asset impairments
    
4
    
13
  
(Gain) loss associated with assets held for sale
    
(22
)
  
3
  
       Exploration, including dry hole and amortization of undeveloped leases     63      51  
Taxes, other than income taxes
    
47
    
28
  
Provision for environmental remediation and restoration, net of reimbursements
    
24
    
(1
)
Interest and debt expense
    
61
    
57
  
Total Costs and Expenses
    
1,157
    
862
  
               
     
560
    
247
  
Other Income (Expense)
    
(1
)
  
-
  
               
Income from Continuing Operations before Income Taxes
    
559
    
247
  
Provision for Income Taxes
    
(204
)
  
(92
)
               
Income from Continuing Operations
    
355
    
155
  
Loss from Discontinued Operations (net of income tax benefit of $1)
    
-
    
(3
)
               
Net Income
 
$
355
  
$
152
  
               
Income (Loss) per Common Share
              
Basic -
              
Continuing operations
  
$
2.29
  
$
1.55
  
Discontinued operations
    
-
    
(.03
)
Net income
  
$
2.29
  
$
1.52
  
               
Diluted -
              
Continuing operations
  
$
2.20
  
$
1.44
  
Discontinued operations
    
-
    
(.03
)
Net income
  
$
2.20
  
$
1.41
  
               
Dividends Declared per Common Share
  
$
.45
  
$
.45
  
               
               



The accompanying notes are an integral part of this statement.

- 1 -

KERR-McGEE CORPORATION AND SUBSIDIARY COMPANIES
CONDENSED CONSOLIDATED BALANCE SHEET
(UNAUDITED)

   
March 31,
 
December 31,
 
(Millions of dollars)
  
2005
  
2004
  
   
 
  
 
  
ASSETS
  
Current Assets
    
   
 
Cash and cash equivalents
  
$
201
  
$
76
  
Accounts receivable
    
890
    
963
  
Inventories
    
364
    
329
  
Derivatives and other current assets
    
205
    
195
  
Deferred income taxes
    
397
    
324
  
Total Current Assets
    
2,057
    
1,887
  
               
Property, Plant and Equipment
    
19,297
    
18,984
  
Less reserves for depreciation, depletion and amortization
    
(8,430
)
  
(8,157
)
     
10,867
    
10,827
  
               
Investments, Derivatives and Other Assets
    
546
    
508
  
Goodwill and Other Intangible Assets
    
1,284
    
1,288
  
Long-Term Assets Associated with Properties Held for Disposal
    
4
    
8
  
               
Total Assets
  
$
14,758
  
$
14,518
  

LIABILITIES AND STOCKHOLDERS' EQUITY
  
Current Liabilities
          
Accounts payable
  
$
628
  
$
644
  
Long-term debt due within one year
    
110
    
463
  
Income taxes payable
    
206
    
201
  
Derivative liabilities
    
861
    
372
  
Accrued liabilities
    
757
    
825
  
Total Current Liabilities
    
2,562
    
2,505
  
               
Long-Term Debt
    
2,946
    
3,236
  
               
Noncurrent Liabilities
              
Deferred income taxes
    
2,129
    
2,177
  
Asset retirement obligations
    
509
    
503
  
Derivative liabilities
    
351
    
208
  
Other
   
623
    
571
  
Total Noncurrent Liabilities
    
3,612
    
3,459
  
               
Stockholders' Equity
              
Common stock, par value $1 - 300,000,000 shares authorized,
              
164,722,534 and 152,049,127 shares issued at March 31, 2005
              
and December 31, 2004, respectively
    
165
    
152
  
Capital in excess of par value
    
4,958
    
4,205
  
Preferred stock purchase rights
    
2
    
2
  
Retained earnings
    
1,382
    
1,102
  
Accumulated other comprehensive loss
    
(536
)
  
(79
)
Common shares in treasury, at cost - 3,334,384 and 159,856 shares
             
at March 31, 2005 and December 31, 2004, respectively
    
(260
)
  
(8
)
Deferred compensation
    
(73
)
  
(56
)
Total Stockholders' Equity
    
5,638
    
5,318
  
               
Total Liabilities and Stockholders’ Equity
  
$
14,758
  
$
14,518
  

The "successful efforts" method of accounting for oil and gas exploration and production activities has been followed in preparing this balance sheet.


The accompanying notes are an integral part of this statement.

- 2 -


KERR-McGEE CORPORATION AND SUBSIDIARY COMPANIES
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(UNAUDITED)


   
Three Months Ended
  
   
March 31,
  
(Millions of dollars)
  
2005
  
2004
  
   
 
      
Cash Flows from Operating Activities
  
 
      
Net income
 
$
355
  
$
152
  
Adjustments to reconcile net income to net cash
          
 
provided by operating activities -
              
Depreciation, depletion and amortization
    
326
    
203
  
Deferred income taxes
    
138
    
73
  
Dry hole expense
    
20
    
8
  
Asset impairments
    
4
    
13
  
(Gain) loss on assets held for sale and asset disposals
    
(22
)
  
3
  
Accretion expense
    
9
    
7
  
Provision for environmental remediation and restoration,
              
net of reimbursements
    
24
    
(1
)
Other noncash items affecting net income
   
82
    
8
  
Changes in assets and liabilities
    
(139
)
  
(191
)
Net Cash Provided by Operating Activities
    
797
    
275
  
     
       
Cash Flows from Investing Activities
    
       
Capital expenditures
    
(374
)
  
(162
)
Dry hole costs
    
(24
)
  
(8
)
Proceeds from sales of assets
    
31
    
4
  
Proceeds from sale of investments
    
-
    
39
  
Other investing activities
    
(30
)
  
(5
)
Net Cash Used in Investing Activities
    
(397
)
  
(132
)
     
       
Cash Flows from Financing Activities
    
       
Issuance of common stock
    
132
    
5
  
Purchases of common stock
    
(250
)
  
-
  
Repayment of debt
    
(42
)
  
(102
)
Dividends paid
    
(68
)
  
(45
)
Settlement of Westport derivatives
    
(43
)
  
-
  
Other financing activities
    
(5
)
  
-
  
Net Cash Used in Financing Activities
    
(276
)
  
(142
)
     
       
Effects of Exchange Rate Changes on Cash and Cash Equivalents
    
1
    
1
 
Net Increase in Cash and Cash Equivalents
    
125
    
2
  
Cash and Cash Equivalents at Beginning of Period
    
76
    
142
 
Cash and Cash Equivalents at End of Period
  
$
201
  
$
144
  



The accompanying notes are an integral part of this statement.


- 3 -


Consolidated Statement of Comprehensive Income (Loss) and Stockholders' Equity
  
(Millions of dollars)
  
Common
Stock
  
Capital in
Excess of
Par Value
  
Retained
Earnings
  
Accumulated
Other
Comprehensive
Income (Loss)
  
Treasury
Stock
  
Deferred
Compensation
and Other
  
Total
Stockholders'
Equity
  
Balance at December 31, 2003
  
$
101
  
$
1,708
  
$
927
  
$
(45
)
$
(2
)
$
(53
)
$
2,636
  
Comprehensive Income (Loss):
                                            
Net income
    
-
    
-
    
152
    
-
    
-
    
-
    
152
  
Other comprehensive loss
   
-
    
-
    
-
    
(103
)
  
-
    
-
    
(103
)
Comprehensive income
                                        
49
  
Exercise of stock options
    
-
    
5
    
-
    
-
    
-
    
-
    
5
  
Restricted stock activity
    
-
    
22
    
-
    
-
    
(1
)
  
(18
)
  
3
  
ESOP deferred compensation
    
-
    
-
    
-
    
-
    
-
    
2
    
2
  
Dividends declared ($.45 per share)
    
-
    
-
    
(45
)
  
-
    
-
    
-
    
(45
)
Balance at March 31, 2004
  
$
101
  
$
1,735
  
$
1,034
  
$
(148
)
$
(3
)
$
(69
)
$
2,650
  
                                             
Balance at December 31, 2004
  
$
152
  
$
4,205
  
$
1,102
  
$
(79
)
$
(8
)
$
(54
)
$
5,318
  
Comprehensive Income (Loss):
                                            
Net income
    
-
    
-
    
355
    
-
    
-
    
-
    
355
  
Other comprehensive loss
   
-
    
-
    
-
    
(457
)
  
-
    
-
    
(457
)
Comprehensive loss
                                        
(102
)
Shares issued upon conversion
                                            
of 5.25% debentures
    
10
    
583
    
-
    
-
    
-
    
-
    
593
  
Shares repurchased
    
-
    
-
    
-
    
-
    
(250
)
  
-
    
(250
)
Exercise of stock options
    
2
    
130
    
-
    
-
    
-
    
-
    
132
  
Restricted stock activity
    
1
    
24
    
-
    
-
    
(2
)
  
(19
)
  
4
  
ESOP deferred compensation
    
-
    
-
    
-
    
-
    
-
    
2
    
2
  
Tax benefit from stock-based awards
    
-
    
16
    
-
    
-
    
-
    
-
    
16
  
Dividends declared ($.45 per share)
    
-
    
-
    
(74
)
  
-
    
-
    
-
    
(74
)
Other
    
-
    
-
    
(1
)
  
-
    
-
    
-
    
(1
)
Balance at March 31, 2005
  
$
165
  
$
4,958
 
$
1,382
  
$
(536
)
$
( 260
)
$
(71
)
$
5,638
  
                                             

- 4 -

KERR-McGEE CORPORATION AND SUBSIDIARY COMPANIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2005


1.
The Company, Basis of Presentation and Accounting Policies

The Company

Kerr-McGee is an energy and inorganic chemical company with worldwide operations. The exploration and production unit explores for, develops, produces and markets crude oil and natural gas, with major areas of operation in the United States, the United Kingdom sector of the North Sea and China. Exploration efforts also extend to Australia, Benin, Bahamas, Brazil, Morocco, Canada, and the Danish and Norwegian sectors of the North Sea. The chemical unit is primarily engaged in production and marketing of titanium dioxide pigment and has production facilities in the United States, Australia, Germany and the Netherlands.

The company recently made a number of strategic decisions in an effort to reposition Kerr-McGee as a pure-play exploration and production company and enhance value for its stockholders, as outlined below.

·  
In March 2005, the company’s Board of Directors (the Board) authorized management to pursue alternatives for the separation of the chemical business, including a spinoff or sale. The company is actively pursuing both separation alternatives and expects to determine the timing and manner of disposal later in 2005. As of May 6, 2005, criteria for reporting results of the chemical business unit as discontinued operations have not been met.

·  
Concurrent with the decision to pursue the separation of the chemical business, the Board authorized a share repurchase program initially set at $1 billion, with an expectation to expand the program as the chemical business separation proceeds. The company repurchased 3.1 million shares of its common stock at an aggregate cost of $250 million under this program before its termination in connection with the Board's approval of the tender offer discussed below.

·  
In April 2005, the company announced its decision to divest of lower-growth, shorter-life and higher-decline oil and gas properties. Assets being considered for divestiture may include oil and gas properties onshore in the United States and in the U.K. sector of the North Sea and all of the company’s Gulf of Mexico shelf properties, representing approximately 10% to 15% of the company’s proved reserves at December 31, 2004. Divestitures are expected to result in gross proceeds of approximately $2 billion to $2.5 billion. However, the actual proceeds may differ materially form management’s estimates due to a change in market conditions or in the composition of the properties to be divested, as well as other factors.

·  
On April 14, 2005, the company announced its intention to commence a modified "Dutch Auction" self tender offer for its common stock with an aggregate purchase cost of up to $4 billion. Under the tender offer, which commenced on April 18, 2005, the company will repurchase its shares at a price not lower than $85 or higher than $92 per share. Based on the number of shares tendered and the prices specified by the tendering stockholders, the company will determine the lowest per-share price within the range that will enable it to buy up to $4 billion of its common stock. Assuming the tender offer is fully subscribed, between 43.5 million and 46.7 million shares may be repurchased, or 27% to 29% of shares outstanding at March 31, 2005. Unless extended, the tender offer will expire on May 18, 2005. Except for the company’s directors and executive officers, who have advised us that they do not intend to tender shares pursuant to the tender offer, no stockholders have made commitments to the company regarding the tender of their shares. The tender offer is expected to be financed with cash on hand and the net proceeds of borrowings. The company obtained commitments for financing which may be used to fund the tender offer, repay certain existing indebtedness and for general corporate purposes, as more fully discussed in Note 8. The tender offer is subject to customary terms and conditions, including those contained in the financing commitments.

·  
The Board approved a recommendation to revise the company’s dividend policy to a dividend level consistent with that of other pure-play exploration and production companies. Starting with the quarter ending June 30, 2005, the annual dividend is expected to be revised from $1.80 to $.20 per share.
 
- 5 -
Basis of Presentation

The unaudited condensed consolidated financial statements included herein have been prepared by the company, pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) and, in the opinion of management, include all adjustments, consisting only of adjustments that are normal and recurring in nature, necessary to a fair statement of the results for the interim periods presented. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations. Although the company believes that the disclosures are adequate to make the information presented not misleading, these financial statements should be read in conjunction with the consolidated financial statements and the notes thereto included in the company's latest annual report on Form 10-K.

Certain 2004 amounts included in these condensed consolidated financial statements have been reclassified to conform to the 2005 presentation. The Condensed Consolidated Statement of Income for the three months ended March 31, 2004 reflects results of the company’s former forest products operations as discontinued operations. Criteria for classification of the forest products business as discontinued operations were met in the fourth quarter of 2004.

Accounting Policies

Employee Stock-Based Compensation - The company accounts for its stock option plans under the intrinsic-value method permitted by Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB No. 25). Accordingly, net income reflects no stock-based employee compensation expense for the issuance of stock options under the company’s plans, since all options were fixed-price options with an exercise price equal to the market value of the underlying common stock on the date of grant.

Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation” (FAS No. 123) prescribes a fair-value method of accounting for employee stock options under which compensation expense is measured based on the estimated fair value of stock options at the grant date and recognized over the vesting period. The following table illustrates the effect on net income and earnings per share assuming the company had applied the fair-value recognition provisions of FAS No. 123 to stock-based employee compensation.

   
Three Months Ended
  
   
March 31,
  
(Millions of dollars, except per-share amounts)
  
2005
  
2004
  
           
Net income, as reported
  
$
355
  
$
152
  
Add: stock-based employee compensation expense
              
included in reported net income, net of taxes
    
9
    
4
  
Deduct: stock-based compensation expense determined
              
using a fair-value method, net of taxes
    
(16
)
  
(7
)
Pro forma net income
 
$
348
  
$
149
  
               
Net income per share -
              
Basic -
              
As reported
  
$
2.29
  
$
1.52
  
Pro forma
    
2.25
    
1.48
  
               
Diluted -
             
As reported
  
$
2.20
  
$
1.41
  
Pro forma
    
2.15
    
1.38
  



- 6 -

The fair value of each option granted in 2005 and 2004 was estimated as of the grant date using the Black-Scholes option pricing model with the following weighted-average assumptions:

   
Assumptions
  
Weighted-Average
  
   
Risk-Free
  
Expected
  
Expected
  
Expected
  
Fair Value of
  
   
Interest Rate
  
Dividend Yield
  
Life (years)
  
Volatility
  
Options Granted
  
2005
    
3.9
%
  
3.5
%
  
6.0
    
27.4
%
$
12.50
  
2004
    
3.5
    
3.6
    
5.8
    
22.6
    
8.63
  
                                 

In December 2004, the FASB issued Statement No. 123 (revised 2004), “Share-Based Payment” (FAS No. 123R), which replaces FAS No. 123 and supersedes APB No. 25. FAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values beginning with the first interim period after June 15, 2005, with early adoption encouraged. In April 2005, the SEC amended its rules to allow public companies more time to implement the standard. Following the Commission’s rule, the company intends to implement FAS No. 123R effective January 1, 2006. The company plans to adopt the standard using the modified prospective method, as permitted by the standard. The modified prospective method requires that compensation expense be recorded for all unvested share-based compensation awards at the beginning of the first quarter of adoption. The company expects that the adoption will not have a material effect on its financial condition and cash flows, and that the effect on its results of operations will be comparable to the pro forma disclosures under FAS No. 123 presented above.


2.
Comprehensive Income (Loss)

Comprehensive income (loss) for the three months ended March 31, 2005 and 2004, is as follows:

   
Three Months Ended
  
   
March 31,
  
(Millions of dollars)
  
2005
  
2004
  
           
Net income
  
$
355
  
$
152
  
After-tax changes in:
              
Deferred loss on cash flow hedges
    
(459
)
  
(91
)
Foreign currency translation adjustments
    
2
    
(7
)
Unrealized loss on available-for-sale securities
    
-
    
(5
)
Comprehensive income (loss)
  
$
(102
)
$
49
  
 
 
3.
Derivative Instruments
The company is exposed to risk from fluctuations in crude oil and natural gas prices, foreign currency exchange rates and interest rates. To reduce the impact of these risks on earnings and to increase the predictability of its cash flows, the company enters into certain derivative contracts, primarily swaps and collars for a portion of its future oil and gas production, forward contracts to buy and sell foreign currencies and interest rate swaps to hedge the fair value of its fixed-rate debt. Gains and losses on derivatives designated as cash flow hedges are deferred in accumulated other comprehensive income (loss) and reclassified into earnings when the hedged forecasted transactions affect earnings. Gains and losses associated with hedge ineffectiveness are recognized in current earnings as a component of revenues. For the quarters ended March 31, 2005 and 2004, losses on hedge ineffectiveness were $9 million and $1 million, respectively. At March 31, 2005, net after-tax losses on oil and gas derivatives deferred in accumulated other comprehensive loss related to a portion of the company’s expected production through 2007. The company expects to reclassify $440 million of such losses into earnings during the next 12 months, assuming no further changes in the fair value of the related contracts.

Realized and unrealized gains and losses arising from derivative instruments that have not been designated as hedges or that do not qualify for hedge accounting (“nonhedge derivatives”) are recognized in current earnings. In June 2004, the company assumed a net liability associated with commodity derivatives in connection with the Westport merger. While Westport’s fixed-price oil and gas swaps were designated as hedges, costless and three-way collars do not qualify for hedge accounting treatment because they represented “net written options” at the merger date. As a result, even though these collars effectively reduce commodity price risk, the company will recognize mark-to-market gains and losses in earnings until the collars mature, rather than deferring such amounts in accumulated other comprehensive income (loss). The net liability associated with these derivatives at March 31, 2005 was $112 million.

- 7 -
The following tables summarize the balance sheet presentation of the company’s derivatives as of March 31, 2005 and December 31, 2004:

   
As of March 31, 2005
  
   
Derivative Fair Value
      
   
Current
  
Long-Term
  
Current
  
Long-Term
  
Deferred Gain
  
(Millions of dollars)
  
Asset
  
Asset
  
Liability
  
Liability
  
(Loss) in AOCI(1)
  
Oil and gas commodity derivatives -
                                
Kerr-McGee positions
  
$
29
  
$
24
  
$
(683
)
$
(319
)
$
(604
)
Acquired Westport positions
    
-
    
-
    
(168
)
  
(22
)
  
(30
)
Gas marketing-related derivatives
    
10
    
1
    
(10
)
  
(1
)
  
-
  
Foreign currency forward contracts
    
14
    
-
    
-
    
-
    
14
  
Interest rate swaps
    
7
    
-
    
-
    
(9
)
  
-
  
Other
    
6
    
-
    
-
    
-
    
4
  
                                 
Total derivative contracts
  
$
66
  
$
25
  
$
(861
)
$
(351
)
$
(616
)

   
As of December 31, 2004
  
   
Derivative Fair Value
      
   
Current
  
Long-Term
  
Current
  
Long-Term
  
Deferred Gain
  
(Millions of dollars)
  
Asset
  
Asset
  
Liability
  
Liability
  
(Loss) in AOCI(1)
  
Oil and gas commodity derivatives -
                                
Kerr-McGee positions
  
$
54
  
$
12
  
$
(235
)
$
(188
)
$
(167
)
Acquired Westport positions
    
1
    
1
    
(123
)
  
(16
)
  
(7
)
Gas marketing-related derivatives
    
6
    
2
    
(6
)
  
(2
)
  
-
  
Foreign currency forward contracts
    
20
    
-
    
(6
)
  
-
    
16
  
Interest rate swaps
    
4
    
-
    
(1
)
  
(2
)
  
-
  
Other
    
3
    
-
    
(1
)
  
-
    
1
  
                                 
Total derivative contracts
  
$
88
  
$
15
  
$
(372
)
$
(208
)
$
(157
)

(1)  Amounts deferred in accumulated other comprehensive income (AOCI) are reflected net of tax.

The following table summarizes the classification of gain (loss) on derivative instruments in the Condensed Consolidated Statement of Income for the three-month periods ended March 31, 2005 and 2004:
 
   
Three Months Ended March 31,
  
   
2005
  
2004
  
                           
       
Costs and
  
Other Income
      
Costs and
  
Other Income
  
(Millions of dollars)
  
Revenues
  
Expenses
  
(Expense)
  
Revenues
  
Expenses
  
(Expense)
  
                           
Hedge Activity:
                                      
Oil and gas commodity derivatives
  
$
(37
)
$
-
  
$
-
  
$
(61
)
$
-
  
$
-
  
Foreign currency contracts
    
(1
)
  
1
    
-
    
-
    
4
    
-
  
Interest rate swaps
    
-
    
1
    
-
    
-
    
4
    
-
  
Total hedging contracts
    
(38
)
  
2
    
-
    
(61
)
  
8
    
-
  
                                       
Nonhedge Activity:
                                      
Oil and gas commodity derivatives -
                                      
Kerr-McGee positions
    
8
    
-
    
-
    
-
    
-
    
-
  
Acquired Westport positions
    
(59
)
  
-
    
-
    
-
    
-
    
-
  
Gas marketing-related derivatives
   
2
    
-
    
-
    
2
    
-
    
(1
)
DECS call option (1)
    
-
    
-
    
-
    
-
    
-
    
(6
)
Other
   
-
    
-
    
2
    
-
    
-
    
(1
)
Total nonhedge contracts
    
(49
)
  
-
    
2
    
2
    
-
    
(8
)
                                       
Total derivative contracts
  
$
(87
)
$
2
  
$
2
  
$
(59
)
$
8
  
$
(8
)
                                       
(1)  
Other income (expense) for the quarter ended March 31, 2004 also includes unrealized gains of $7 million on Devon Energy common stock classified as trading.

- 8 -

4.
Accounts Receivable Sales

Through April 2005, the company had an accounts receivable monetization program with a maximum availability of $165 million. Under the terms of the program, selected qualifying customer accounts receivable of the company’s chemical - pigment business were sold monthly to a special-purpose entity (SPE), which in turn sold an undivided ownership interest in the receivables to a third-party multi-seller commercial paper conduit sponsored by an independent financial institution. The company sold, and retained an interest in, excess receivables to the SPE as over-collateralization for the program. The retained interest in sold receivables was subordinate to, and provided credit enhancement for, the conduit's ownership interest in the SPE's receivables, and was available to the conduit to pay certain fees or expenses due to the conduit, and to absorb credit losses incurred on any of the SPE's receivables in the event of program termination. No recourse obligations were recorded since the company had no obligations for any recourse actions on the sold receivables.

During the quarters ended March 31, 2005 and 2004, the company sold $279 million and $237 million, respectively, of its pigment receivables, resulting in pretax losses reflected in other income (expense) of $3 million and $1 million, respectively. Both at March 31, 2005 and at December 31, 2004, the outstanding balance of receivables sold, net of the company's retained interest in receivables serving as over-collateralization, totaled $165 million. The outstanding balance of receivables serving as over-collateralization totaled $37 million and $39 million at March 31, 2005 and December 31, 2004, respectively. These balances are included in accounts receivable in the accompanying Condensed Consolidated Balance Sheet.

The accounts receivable monetization program included ratings downgrade triggers that provided for certain program modifications, including a program termination event upon which the program would effectively liquidate over time and the third-party multi-seller commercial paper conduit would be repaid with the collections on accounts receivable sold by the SPE. In April 2005, following the announcement of the self tender offer discussed in Note 1, the company’s senior unsecured debt was downgraded, triggering program termination. As opposed to liquidating the program over time or modifying its terms, the company elected to terminate the program by advancing the then outstanding balance of receivables sold of $165 million to the SPE, which in turn used the funds to repay the financial institution. The balances of outstanding receivables are expected to be collected as they become due and will be used by the SPE to repay the company for its advance.


5.
Inventories

Major categories of inventories at March 31, 2005 and December 31, 2004 are as follows:

   
March 31,
  
December 31,
  
(Millions of dollars)
  
2005
  
2004
  
           
Chemicals and other products
  
$
263
  
$
236
  
Materials and supplies
    
88
    
85
  
Crude oil and natural gas liquids
    
13
    
8
  
Total
  
$
364
  
$
329
  


6.
Exchange of Assets and Asset Impairments

Exchange of Assets - In February 2005, the company acquired a 37.5% interest in the Blind Faith discovery in the deepwater Gulf of Mexico from BP Exploration & Production in exchange for the company's interests in various proved oil and gas properties in the Arkoma basin of southeast Oklahoma. We received $22 million at the closing date of the transaction (subject to post-closing adjustments) with an additional $2 million to be received associated with certain preferential rights to purchase. The company recognized a $19 million gain on disposal based on the percentage of the Arkoma properties' fair value that was received in cash.


- 9 -

Exploratory Drilling Costs - At March 31, 2005, the company had capitalized exploratory drilling costs of approximately $192 million associated with ongoing exploration and/or appraisal activities primarily in the deepwater Gulf of Mexico, China, Alaska and Brazil. Such capitalized costs may be charged against earnings in a future period if management determines that commercial quantities of hydrocarbons have not been discovered or that future appraisal drilling or development activities are not likely to occur.

Asset Impairments - The chemical - pigment operating unit began production through a new high-productivity oxidation line at the Savannah, Georgia, chloride process pigment plant in January 2004. This new technology results in low-cost, incremental capacity increases through modification of existing chloride oxidation lines and allows for improved operating efficiencies through simplification of hardware configurations and reduced maintenance requirements. As of March 31, 2005, the company continued to operate its new high-productivity oxidation line and continued to evaluate its performance. The company expects to have a better understanding of how the Savannah site might be reconfigured to exploit its capabilities later in 2005. The possible reconfiguration of the Savannah site, if any, could include redeployment of certain assets, idling of certain assets and reduction of the future useful life of certain assets, resulting in the acceleration of depreciation expense and the recognition of other charges.


7.
Income Taxes

On October 22, 2004, the President of the United States signed into law the American Jobs Creation Act of 2004 (the “Act”). A provision of the Act includes a one-time dividends received deduction of 85% of certain foreign earnings that are repatriated, as defined in the Act. As of March 31, 2005, management had not decided on whether, and to what extent, foreign earnings may be repatriated by the company under the Act, and accordingly, the financial statements do not reflect any provision for taxes on unremitted foreign earnings. On April 11, 2005, management completed its analysis of the impact of the Act on the company's plans for repatriation. Based on this analysis, the company plans to repatriate up to $500 million in extraordinary dividends, as defined in the Act, by the end of 2005. Accordingly, a tax liability of approximately $28 million may be recognized in the quarter ending June 30, 2005. Cash requirements for the dividends are expected to be met with cash on hand, operating cash flows of certain of our foreign subsidiaries and proceeds from asset sales.


8.
Debt

In February 2005, the company called for redemption all of the $600 million aggregate principal amount of its 5.25% convertible subordinated debentures due 2010 at a price of 102.625%. Prior to March 4, 2005, the redemption date, all of the debentures were converted by the holders into approximately 9.8 million shares of common stock.

The company's $1.5 billion unsecured revolving credit agreement, which extends through November 2009, contains restrictive covenants, including a maximum total debt to total capitalization ratio, as defined in the agreement, of 65%. At March 31, 2005, the company’s total debt to total capitalization ratio was 35% and the company was in compliance with other debt covenants. On April 15, 2005, the company’s 5.375% Notes in the aggregate principal amount of $350 million matured and were repaid with the proceeds of borrowings under the revolving credit facility. Consequently, the carrying value of the 5.375% Notes was classified as long-term debt at March 31, 2005, based on the company’s ability and intent to maintain this obligation for longer than one year.

As discussed in Note 1, on April 18, 2005, the company commenced a self tender offer for its common stock. Prior to commencing its offer, the company obtained commitments for financing, totaling up to $6 billion, which may be used to fund the tender offer, repay certain existing indebtedness and for general corporate purposes. In connection with the commitments, the company expects to close the following facilities:

   
Amount
 
Term
Senior secured term loan facility
  
$2 billion
  
2 years
Senior secured term loan facility
  
$2.25 billion
  
6 years
Senior secured revolving credit facility
  
$1.25 billion
  
5 years

- 10 -
The availability of the facilities under the commitments is subject to certain conditions, including the repayment and termination of the company’s existing $1.5 billion revolving credit facility. The term facilities may be used to repay certain of the company’s existing indebtedness, to finance the tender offer and to pay related fees and expenses. The revolving credit facility may be used to repay certain of the company’s existing indebtedness and for general corporate purposes. Borrowings under the facilities will bear interest, at the company’s selection, based on LIBOR, the JPMorgan Chase Bank prime rate or the federal funds rate, plus a margin that ranges from .75% to 2.50%. Under the commitments, the six-year term loan facility will amortize in quarterly installments, amounts of which will be determined in the final agreements. Additionally, subject to certain exceptions and step-down provisions, the facilities will be subject to mandatory prepayment provisions, under which 50% of the net after-tax proceeds of certain equity issuances and excess cash flow and 100% of the net after-tax proceeds from dispositions of certain assets and incurrence of certain indebtedness must be used to repay the term loans. Each facility will be secured by a perfected first priority security interest, subject to existing liens and customary exceptions and to the rights of the company’s existing bondholders to be equally and ratably secured, in all of the company’s tangible and intangible assets located in the United States (other than certain assets), and all of the capital stock of the company’s direct and indirect subsidiaries (other than certain subsidiaries to be agreed and limited, in the case of foreign subsidiaries, to 66% of the capital stock of the company’s first tier foreign subsidiaries). The terms of the facilities are expected to include customary representations and warranties, conditions precedent, events of default, affirmative and negative covenants and financial covenants.


9.
Exit Activities

The following table presents a reconciliation of the beginning and ending balances of reserves for exit activities for the first quarter of 2005. No significant changes in the status of exit activities occurred during this period.

   
Dismantlement
  
Personnel
      
(Millions of dollars)
  
and Closure
  
Costs
  
Total
  
               
Balance at December 31, 2004
  
$
10
  
$
8
  
$
18
  
Payments
   
(1
)
  
(2
)
  
(3
)
Adjustments
    
(1
)
  
-
    
(1
)
Balance at March 31, 2005
  
$
8
  
$
6
  
$
14
  

As discussed in Note 1, the company plans to dispose of its chemical business unit and divest of selected oil and gas properties. In April 2005, in connection with the planned exit activities, the company initiated employee compensation programs designed to provide an incentive to certain employees to remain with the company over a stated period ranging from 6 to 18 months. A total of $34 million will be payable under these programs assuming all participating employees meet the service and other conditions and before considering any discretionary awards that may be made in future periods, as discussed below. The cost associated with these programs generally will be recognized as the related services are provided by the participating employees.

Under the plan covering employees of the chemical business unit, existing awards totaling $2 million are payable upon the earlier of the disposition of the chemical business or the end of a one-year service period. Additionally, the plan provides for discretionary bonuses that may be granted to participating employees if they continue their employment through the date the disposition of the chemical business is completed, as determined by management.


10.
Employee Stock-Based Compensation and Benefit Plans

Stock-Based Compensation - In January 2005, annual stock-based compensation awards were granted to eligible employees and directors under the company’s 2002 Long Term Incentive Plan. The awards included approximately 450,000 shares of restricted stock, 1.7 million stock options and 16.3 million performance units that provide for cash awards based on the company’s achievement of certain financial performance measures over a stated period. The fair value of the restricted stock grant on the grant date was $25 million, which will be recognized as compensation expense (net of forfeitures) ratably over the vesting period of three years or the service period, if shorter. The exercise price of the options granted of $56.57 per share equaled the fair value of the underlying stock on the date of grant, and therefore, did not result in compensation expense. See Note 1 for additional information related to the company’s accounting policy for stock-based compensation.

- 11 -
Retirement and Postretirement Benefits - The company has both noncontributory and contributory defined-benefit retirement plans and company-sponsored contributory postretirement plans for health care and life insurance. Most employees are covered under the company’s retirement plans, and substantially all U.S. employees may become eligible for the postretirement benefits if they reach retirement age while working for the company.

Total costs recognized for employee retirement and postretirement benefit plans for the first quarter of 2005 and 2004 were as follows:

       
Postretirement
  
   
Retirement Plans
  
Health and Life Plans
  
   
Three Months Ended
  
Three Months Ended
  
   
March 31,
  
March 31,
  
(Millions of dollars)
  
2005
  
2004
  
2005
  
2004
  
Net periodic cost -
                          
Service cost
  
$
9
  
$
7
  
$
1
  
$
1
  
Interest cost
    
18
    
18
    
4
    
5
  
Expected return on plan assets
    
(26
)
  
(29
)
  
-
    
-
  
Net amortization -
                         
Prior service cost
    
2
    
2
    
(1
)
  
-
  
Net actuarial loss
    
1
    
1
    
1
    
1
  
Total net periodic cost
  
$
4
  
$
(1
)
$
5
  
$
7
  


11.
Earnings Per Share

The following table sets forth the computation of basic and diluted earnings per share from continuing operations for the three months ended March 31, 2005 and 2004. Substantially all options outstanding at March 31, 2005 were in-the-money, and therefore, the dilutive effect of such options is reflected in diluted earnings per share for the three months ended March 31, 2005. As discussed in Note 8, during the first quarter of 2005, the company’s 5.25% convertible subordinated debentures were converted by the holders into approximately 9.8 million shares of common stock.

   
For the Three Months Ended March 31,
  
     2005    2004  
   
Income from
          
Income from
          
(In millions, except
  
Continuing
      
Per-Share
  
Continuing
      
Per-Share
  
per-share amounts)
  
Operations
  
Shares
  
Income
  
Operations
  
Shares
  
Income
  
                           
Basic earnings per share
  
$
355
    
154.8
  
$
2.29
  
$
155
    
100.3
  
$
1.55
  
Effect of dilutive securities:
                                      
5.25% convertible debentures
    
4
    
6.4
          
5
    
9.8
        
Restricted stock
    
-
    
.6
          
-
    
1.0
        
Stock options
    
-
    
1.0
          
-
    
.2
        
Diluted earnings per share
  
$
359
    
162.8
  
$
2.20
  
$
160
    
111.3
  
$
1.44
  


12.
Capital Stock

Authorized capital stock of the company consists of 300 million shares of common stock with a par value of $1.00 per share and 40 million shares of preferred stock without par value. No shares of preferred stock have been issued. In March 2005, the company’s Board of Directors recommended that the stockholders approve an increase of the authorized number of shares of the company’s common stock to 500 million shares. The stockholders will vote on this proposal at the May 10, 2005 Annual Meeting of Stockholders.


- 12 -

Changes in common stock issued and treasury stock held for the three-month periods ended March 31, 2005 and 2004, are as follows:

   
Common
  
Treasury
  
(Thousands of shares)
  
Stock
  
Stock
  
           
Balance at December 31, 2003
    
100,892
    
32
  
Exercise of stock options
   
128
    
-
  
Issuance of restricted stock
    
438
    
-
  
Forfeiture of restricted stock
    
-
    
28
  
Balance at March 31, 2004
    
101,458
    
60
  
               
Balance at December 31, 2004
    
152,049
    
160
  
Exercise of stock options
   
2,406
    
-
  
Issuance of restricted stock
    
450
    
-
  
Forfeiture of restricted stock
    
-
    
29
  
Shares issued upon conversion of 5.25% debentures
    
9,818
    
-
  
Shares repurchased
    
-
    
3,145
  
Balance at March 31, 2005
    
164,723
    
3,334
  

As more fully discussed in Note 1, the company repurchased 3.1 million shares of its common stock in March 2005 and has subsequently commenced a self tender offer to purchase additional shares of its common stock of up to $4 billion.


13.
Contingencies
 
The following table summarizes the contingency reserve balances, provisions, payments and settlements for the quarter ended March 31, 2005, as well as balances, accruals and receipts of environmental cost reimbursements from other parties.

       
Reserves for
      
   
Reserves for
  
Environmental
  
Reimbursements
  
(Millions of dollars)
  
Litigation
  
Remediation
 
Receivable
  
               
Balance at December 31, 2004
  
$
39
  
$
255
  
$
94
  
Provisions / Accruals
   
-
    
44
    
20
  
Payments / Settlements
    
(7
)
  
(9
)
  
(66
)
Balance at March 31, 2005
  
$
32
  
$
290
  
$
48
  


Management believes, after consultation with general counsel, that currently the company has reserved adequately for the reasonably estimable costs of environmental matters and other contingencies. However, additions to the reserves may be required as additional information is obtained that enables the company to better estimate its liabilities, including liabilities at sites now under review, though the company cannot now reliably estimate the amount of future additions to the reserves. Following are discussions regarding certain environmental sites and litigation. Reserves for each environmental site are based on assumptions regarding the volumes of contaminated soils and groundwater involved, as well as associated excavation, transportation and disposal costs.

The company provides for costs related to contingencies when a loss is probable and the amount is reasonably estimable. It is not possible for the company to reliably estimate the amount and timing of all future expenditures related to environmental and legal matters and other contingencies because, among other reasons:

- 13 -
·  
some sites are in the early stages of investigation, and other sites may be identified in the future;

·  
remediation activities vary significantly in duration, scope and cost from site to site depending on the mix of unique site characteristics, applicable technologies and regulatory agencies involved;

·  
cleanup requirements are difficult to predict at sites where remedial investigations have not been completed or final decisions have not been made regarding cleanup requirements, technologies or other factors that bear on cleanup costs;

·  
environmental laws frequently impose joint and several liability on all potentially responsible parties, and it can be difficult to determine the number and financial condition of other potentially responsible parties and their respective shares of responsibility for cleanup costs;

·  
environmental laws and regulations, as well as enforcement policies, are continually changing, and the outcome of court proceedings and discussions with regulatory agencies are inherently uncertain;

·  
some legal matters are in the early stages of investigation or proceeding or their outcomes otherwise may be difficult to predict, and other legal matters may be identified in the future;

·  
unanticipated construction problems and weather conditions can hinder the completion of environmental remediation; the inability to implement a planned engineering design or use planned technologies and excavation methods may require revisions to the design of remediation measures, which delay remediation and increase costs; and the identification of additional areas or volumes of contamination and changes in costs of labor, equipment and technology generate corresponding changes in environmental remediation costs.

West Chicago, Illinois

In 1973, the company’s chemical affiliate (Chemical) closed a facility in West Chicago, Illinois, that processed thorium ores for the federal government and for certain commercial purposes. Historical operations had resulted in low-level radioactive contamination at the facility and in surrounding areas. The original processing facility is regulated by the State of Illinois (the State), and four vicinity areas are designated as Superfund sites on the National Priorities List (NPL).

Closed Facility - Pursuant to agreements reached in 1994 and 1997 among Chemical, the City of West Chicago (the City) and the State regarding the decommissioning of the closed West Chicago facility, Chemical has substantially completed the excavation of contaminated soils and has shipped those soils to a licensed disposal facility. Surface restoration was completed in 2004, except for areas designated for use in connection with the Kress Creek and Sewage Treatment Plant remediation discussed below. Groundwater monitoring and remediation is expected to continue for approximately 10 years.

Vicinity Areas - The Environmental Protection Agency (EPA) has listed four areas in the vicinity of the closed West Chicago facility on the NPL and has designated Chemical as a Potentially Responsible Party (PRP) in these four areas. Chemical has substantially completed remedial work for two of the areas (known as the Residential Areas and Reed-Keppler Park). The other two NPL sites, known as Kress Creek and the Sewage Treatment Plant, are contiguous and involve low levels of insoluble thorium residues, principally in streambanks and streambed sediments, virtually all within a floodway. Chemical has reached an agreement with the appropriate federal and state agencies and local communities regarding the characterization and cleanup of the sites, past and future government response costs, and the waiver of natural resource damages claims. The agreement has been incorporated in a consent decree, which must be entered by a federal court. The consent decree was lodged with the court in April 2005, and is expected to be approved by the court in due course. The cleanup work, which is expected to take about four to five years to complete following entry of the consent decree, will require excavation of contaminated soils and stream sediments, shipment of excavated materials to a licensed disposal facility and restoration of affected areas.


- 14 -

Financial Reserves - In the first quarter of 2005, $13 million was added to the reserve for the West Chicago site to cover increased soil volumes encountered during the final stages of characterization of Kress Creek, increases in labor and materials and required future payments for past costs and access fees. As of March 31, 2005, the company had reserves of $111 million for costs related to West Chicago. Although actual costs may exceed current estimates, the amount of any increase cannot be reasonably estimated at this time. The amount of the reserve is not reduced by reimbursements expected from the federal government under Title X of the Energy Policy Act of 1992 (Title X) (discussed below).

Government Reimbursement - Pursuant to Title X, the U.S. Department of Energy (DOE) is obligated to reimburse Chemical for certain decommissioning and cleanup costs incurred in connection with the West Chicago sites in recognition of the fact that about 55% of the facility's production was dedicated to U.S. government contracts. The amount authorized for reimbursement under Title X is $365 million plus inflation adjustments. That amount is expected to cover the government's full share of West Chicago cleanup costs. Through March 31, 2005, Chemical had been reimbursed approximately $281 million under Title X.

Reimbursements under Title X are provided by congressional appropriations. Historically, congressional appropriations have lagged Chemical's cleanup expenditures. As of March 31, 2005, the government’s share of costs incurred by Chemical but not yet reimbursed by the DOE totaled approximately $14 million. The company believes receipt of the $14 million government share in due course following additional congressional appropriations is probable and has reflected that amount as a receivable in the accompanying financial statements. The company will recognize recovery of the government's share of future remediation costs for the West Chicago sites as Chemical incurs the cash expenditures.

Henderson, Nevada

In 1998, Chemical decided to exit the ammonium perchlorate business. At that time, Chemical curtailed operations and began preparation for the shutdown of the associated production facilities in Henderson, Nevada, that produced ammonium perchlorate and other related products. Manufacturing of perchlorate compounds began at Henderson in 1945 in facilities owned by the U.S. government. The U.S. Navy expanded production significantly in 1953, when it completed construction of a plant for the manufacturing of ammonium perchlorate. The Navy continued to own the ammonium perchlorate plant as well as other associated production equipment at Henderson until 1962, when the plant was purchased by a predecessor of Chemical. The ammonium perchlorate produced at the Henderson facility was used primarily in federal government defense and space programs. Perchlorate has been detected in nearby Lake Mead and the Colorado River.

Chemical began decommissioning the facility and remediating associated perchlorate contamination, including surface impoundments and groundwater, when it decided to exit the business in 1998. In 1999 and 2001, Chemical entered into consent orders with the Nevada Division of Environmental Protection (NDEP) that require Chemical to implement both interim and long-term remedial measures to capture and remove perchlorate from groundwater. In April 2005, Chemical entered into an amended consent order with NDEP that requires, in addition to the capture and treatment of groundwater, the closure of a certain impoundment related to the past production of ammonium perchlorate, including treatment and disposal of solution and sediment contained in the impoundment.

In 1999, Chemical initiated the interim measures required by the consent orders. A long-term remediation system is operating in compliance with the consent orders. Initially, the remediation system was projected to operate through 2007. However, studies of the decline of perchlorate levels in the groundwater indicate that Chemical may need to operate the system through 2011. The scope, duration and cost of groundwater remediation ultimately will be driven in the long term by drinking water standards, which to date have not been formally established by state or federal regulatory authorities. EPA and other federal and state agencies continue to evaluate the health and environmental risks associated with perchlorate as part of the process for ultimately setting drinking water standards. One state agency, the California Environmental Protection Agency (CalEPA), has set a public health goal for perchlorate, and the federal EPA has established a reference dose for perchlorate, which are preliminary steps to setting drinking water standards. The establishment of drinking water standards could materially affect the scope, duration and cost of the long-term groundwater remediation that Chemical is required to perform.


- 15 -

Financial Reserves - In the first quarter of 2005, $26 million was added to the reserve for Henderson to cover the operating and maintenance costs over the extended period for groundwater treatment and $4 million for closure of the ammonium perchlorate pond. Remaining reserves for Henderson totaled $39 million as of March 31, 2005. As noted above, the long-term scope, duration and cost of groundwater remediation and impoundment closure are uncertain and, therefore, additional costs beyond those accrued may be incurred in the future. However, the amount of any additional costs cannot be reasonably estimated at this time.

Litigation - In 2000, Chemical initiated litigation against the United States seeking contribution for response costs. The suit is based on the fact that the government owned the plant in the early years of its operation, exercised significant control over production at the plant and the sale of products produced at the plant, and was the largest consumer of products produced at the plant. The discovery stage of litigation is substantially complete, and the parties have filed certain pretrial motions that are being considered by the court. Although the outcome of the litigation is uncertain, Chemical believes it is likely to recover a portion of its costs from the government. The amount and timing of any recovery cannot be estimated at this time and, accordingly, the company has not recorded a receivable or otherwise reflected in the financial statements any potential recovery from the government.

In addition, on July 26, 2004, the company was served with a lawsuit, which was filed in the United States District Court for the District of Arizona. The lawsuit, Alan Curtis and Linda Curtis v. City of Bullhead City, et al., in which the company is one of several defendants (the Defendants), alleges various causes of action under a variety of common law theories and federal environmental laws and seeks recovery for damages allegedly caused by the alleged exposure to and the migration of various chemical contaminants contained in the Colorado River. The two plaintiffs, who are not suing on behalf of any other party, also seek an order requiring the Defendants to remediate the contamination. The company intends to vigorously defend against the lawsuit. The company believes that the litigation will not have a material adverse effect on its financial condition or results of operations.

Insurance - In 2001, Chemical purchased a 10-year, $100 million environmental cost cap insurance policy for groundwater and other remediation at Henderson. The insurance policy provides coverage only after Chemical exhausts a self-insured retention of approximately $61 million and covers only those costs incurred to achieve cleanup specified in the policy. As noted above, federal and state agencies have not established a drinking water standard and, therefore, it is possible that Chemical may be required to achieve a cleanup level more stringent than that covered by the policy. If so, the amount recoverable under the policy may be less than the ultimate cleanup cost.

At March 31, 2005, the company expects estimated aggregate cleanup costs of $95 million less the $61 million self-insured retention (for a net amount of $34 million) to be covered by the insurance policy. The estimated aggregate cleanup costs of $95 million include qualifying expenditures incurred to date of approximately $67 million and remaining qualifying expenditures to be incurred of approximately $28 million, which are included in the environmental reserve at March 31, 2005. The company believes that a reimbursement of approximately $34 million is probable, and, accordingly, the company has recorded a receivable in the financial statements for that amount.

Milwaukee, Wisconsin

In 1976, Chemical closed a wood-treatment facility it had operated in Milwaukee, Wisconsin. Operations at the facility prior to its closure had resulted in the contamination of soil and groundwater at and around the site with creosote and other substances used in the wood-treatment process. In 1984, EPA designated the Milwaukee wood-treatment facility as a Superfund site under the Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), listed the site on the NPL and named Chemical a PRP. Chemical executed a consent decree in 1991 that required it to perform soil and groundwater remediation at and below the former wood-treatment area and to address a tributary creek of the Menominee River that had become contaminated as a result of the wood-treatment operations. Actual remedial activities were deferred until after the decree was finally entered in 1996 by a federal court in Milwaukee.


- 16 -

Groundwater treatment was initiated in 1996 to remediate groundwater contamination below and in the vicinity of the former wood-treatment area. It is not possible to reliably predict how groundwater conditions will be affected by soil removal in the vicinity of the former wood-treatment area, which has been completed, and ongoing groundwater treatment; therefore, it is not known how long groundwater treatment will continue. Soil cleanup of the former wood-treatment area began in 2000 and was completed in 2002. Also in 2002, terms for addressing the tributary creek were agreed upon with EPA, after which Chemical began the implementation of a remedy to reroute the creek and to remediate associated sediment and stream bank soils. Completion of the creek remedy is expected to take about three more years.

Financial Reserves - As of March 31, 2005, the company had reserves of $6 million for the costs of the remediation work described above. Although actual costs may exceed current estimates, the amount of any increases cannot be reasonably estimated at this time.

Cushing, Oklahoma

In 1972, an affiliate of the company closed a petroleum refinery it had operated near Cushing, Oklahoma. Prior to closing the refinery, the affiliate also had produced uranium and thorium fuel and metal at the site pursuant to licenses issued by the Atomic Energy Commission (AEC). The uranium and thorium operations commenced in 1962 and were shut down in 1966, at which time the affiliate decommissioned and cleaned up the portion of the facility related to uranium and thorium operations to applicable standards. The refinery also was cleaned up to applicable standards at the time of closing.

Subsequent regulatory changes required more extensive remediation at the site. In 1990, the affiliate entered into a consent agreement with the State of Oklahoma to investigate the site and take appropriate remedial actions related to petroleum refining and uranium and thorium residuals. Investigation and remediation of hydrocarbon contamination is being performed with oversight of the Oklahoma Department of Environmental Quality. Soil remediation to address hydrocarbon contamination is expected to continue for about four more years. The long-term scope, duration and cost of groundwater remediation are uncertain and, therefore, additional costs beyond those accrued may be incurred in the future.

Additionally, in 1993, the affiliate received a decommissioning license from the Nuclear Regulatory Commission (NRC), the successor to AEC’s licensing authority, to perform certain cleanup of uranium and thorium residuals. All known radiological contamination has been removed from the site and shipped to a licensed disposal facility.

Financial Reserves - As of March 31, 2005, the company had reserves of $20 million for the costs of the ongoing remediation and decommissioning work described above. Although actual costs may exceed current estimates, the amount of any increases cannot be reasonably estimated at this time.

Los Angeles County, California

During 2004, the company began remediation and restoration of an oil and gas field in Los Angeles County, California. The company’s obligation for remediation and restoration of this oil and gas field is expected to take about five years, although completion could be delayed by permitting requirements.

Financial Reserves - As of March 31, 2005, the company had environmental reserves of $25 million for this project. Although actual costs may exceed current estimates, the amount of any increases cannot be reasonably estimated at this time.

New Jersey Wood-Treatment Site

Chemical and its ultimate parent were named in 1999 as PRPs under CERCLA at a former wood-treatment site in New Jersey at which EPA is conducting a cleanup. On April 15, 2005, Chemical and its ultimate parent received a letter from EPA asserting that they are liable under CERCLA as former owners or operators of the site and demanding reimbursement of costs expended by EPA at the site. The demand is for payment of past costs in the amount of approximately $179 million, plus interest. Chemical did not operate the site, which had been sold to a third party before Chemical succeeded to the interests of a predecessor owner in the 1960’s. The predecessor also did not operate the site, which had been closed down before it was acquired by the predecessor. Based on historical records, there are substantial uncertainties about whether or under what terms the predecessor assumed liabilities for the site. In addition, it appears there may be other PRPs, though it is not known whether the other PRPs have received similar letters from EPA. The company intends to vigorously defend against EPA’s claim. The company has not recorded a reserve for the site, as it is not possible to reliably estimate the liability, if any, it may have for the site because of the aforementioned uncertainties and the potential existence of other PRPs.

- 17 -
Other Sites

In addition to the sites described above, the company is responsible for environmental costs related to certain other sites. These sites relate primarily to wood-treating, chemical production, landfills, mining and oil and gas production and refining distribution and marketing. As of March 31, 2005, the company had remaining reserves of $89 million for the environmental costs in connection with these other sites. This includes the remaining portion of $1 million added to the reserves during the first quarter of 2005, primarily because additional remediation, characterization and/or monitoring costs were identified for certain of these sites. Although actual costs may exceed current estimates, the amount of any increases cannot be reasonably estimated at this time.

Coal Supply Contract

An affiliate of the company entered into a coal supply contract with Peabody Coaltrade, Inc. (“PCI”) in February 1998. In 1998, the company exited the coal business and assigned its rights and obligations under the coal supply contract to a third party. In connection with the assignment, the company agreed to guarantee performance under the contract. PCI has notified the company of a threatened default by the assignee under the coal supply contract and that PCI may seek to hold the company liable under the 1998 guaranty in the event of a default. In addition to other defenses to the enforceability of the guaranty, the company believes the guaranty expired in January 2003 when the primary term of the coal supply contract expired. No reserve has been provided for performance under the guaranty because the company does not believe a loss is probable and the amount of any loss is not reasonably estimable.

CNR Contract

In 2002, an affiliate of the company entered into a contract with CNR International (“CNR”) to sell certain assets located in the United Kingdom sector of the North Sea. In the fourth quarter of 2004, CNR asserted claims for alleged breaches of contractual representations and warranties and demanded damages. The company’s evaluation of the claims is in its early stages. The company has not provided a reserve for the claims because at this time the company cannot reasonably determine the probability of a loss and the amount of loss, if any, cannot be reasonably estimated. The company does not expect the resolution of the claims to have a material adverse effect on the company’s financial condition or results of operations.

Forest Products Litigation

Between 1999 and 2001, Chemical and its parent company were named in 22 lawsuits in three states (Mississippi, Louisiana and Pennsylvania) in connection with former forest products operations located in those states (in Columbus, Mississippi; Bossier City, Louisiana; and Avoca, Pennsylvania). The lawsuits sought recovery under a variety of common law and statutory legal theories for personal injuries and property damages allegedly caused by exposure to and/or release of creosote and other substances used in the wood-treatment process. Chemical has executed settlement agreements that are expected to resolve substantially all of the Louisiana, Pennsylvania and Columbus, Mississippi, lawsuits described above. Resolution of the remaining cases is not expected to have a material adverse effect on the company.

Following the adoption by the Mississippi legislature of tort reform, plaintiffs’ lawyers filed many new lawsuits across the state of Mississippi in advance of the reform’s effective date. On December 31, 2002, approximately 245 lawsuits were filed against Chemical and its affiliates on behalf of approximately 4,600 claimants in connection with Chemical’s Columbus, Mississippi, operations, seeking recovery on legal theories substantially similar to those advanced in the litigation referred to above. Substantially all of these lawsuits have been removed to the U.S. District Court for the Northern District of Mississippi, and the court has consolidated these lawsuits for pretrial and discovery purposes. On December 31, 2002, June 13, 2003, and June 25, 2004, three lawsuits were filed against Chemical in connection with a former wood-treatment plant located in Hattiesburg, Mississippi. On September 9, 2004, February 11, 2005, and March 2, 2005, three lawsuits were filed against Chemical in connection with a former wood-treatment plant located in Texarkana, Texas. In addition, on January 3, 2005, February 16, 2005, and March 11, 2005, 32 lawsuits were filed against Chemical in connection with the Avoca, Pennsylvania, facility described above. These lawsuits seek recovery on legal theories substantially similar to those advanced in the litigation referred to above. A total of approximately 3,300 claimants now have asserted claims in connection with the Hattiesburg plant; there are 64 plaintiffs named in the Texarkana lawsuits and approximately 4,600 plaintiffs are named in the new Avoca lawsuits. Chemical has resolved approximately 1,490 of the Hattiesburg claims pursuant to a settlement reached in April 2003, which has resulted in aggregate payments by Chemical of approximately $600,000.

- 18 -
Chemical and its affiliates believe that the follow-on Columbus and Avoca claims, the remaining Hattiesburg claims and the claims related to the Texarkana plants are without substantial merit and are vigorously defending against them. The company has not provided a reserve for these lawsuits because at this time it cannot reasonably determine the probability of a loss, and the amount of loss, if any, cannot be reasonably estimated. The company believes that the ultimate resolution of the forest products litigation will not have a material adverse effect on the company's financial condition or results of operations.

Other Matters

The company and/or its affiliates are parties to a number of legal and administrative proceedings involving environmental and/or other matters pending in various courts or agencies. In the ordinary course of its business, the company experiences disputes with federal, state, tribal and other regulatory authorities, as well as with private parties, regarding royalty payments. These disputes, individually and in the aggregate, are not expected to have a material adverse effect on the company. There are also proceedings associated with facilities currently or previously owned, operated or used by the company’s affiliates and/or their predecessors, some of which include claims for personal injuries and property damages. Current and former operations of the company’s affiliates also involve management of regulated materials and are subject to various environmental laws and regulations. These laws and regulations will obligate the company’s affiliates to clean up various sites at which petroleum and other hydrocarbons, chemicals, low-level radioactive substances and/or other materials have been contained, disposed of or released. Some of these sites have been designated Superfund sites by EPA pursuant to CERCLA. Similar environmental regulations exist in foreign countries in which the company’s affiliates operate.
 
Kemira

In 2000, Chemical acquired its titanium dioxide production facility in Savannah, Georgia, from Kemira Pigments Oy, a Finnish company, and its parent, Kemira, Oyj (together, “the Sellers”). After acquiring the facility, the company discovered that certain matters associated with environmental conditions and plant infrastructure were not consistent with representations made by the Sellers. Chemical sought recovery for breach of representations and warranties in a proceeding before the London Court of International Arbitration (LCIA). On May 9, 2005, Chemical received notice from the LCIA that the LCIA had found in favor of Chemical as to liability with respect to certain of the claims. The LCIA still must determine the amount of damages, and, in that regard, Chemical is seeking in excess of $40 million in damages, together with interest, costs and attorney fees. In light of the recent receipt of the lengthy arbitration decision on the liability phase and the complexity of the matter, the company currently cannot reasonably estimate the amount of damages that will be awarded.  The company will recognize a receivable if and when damages are awarded and all contingencies associated with any recovery are resolved.
 
 
14.
Commitments

In April 2005, the company entered into additional drilling rig commitments to assure availability for executing our deepwater drilling programs through the end of 2006. The company’s commitments under these arrangements total $135 million, a portion of which will be billed to other working interest partners once actual utilization is known.


15.
Business Segments

The company has three reportable segments: oil and gas exploration and production, production and marketing of titanium dioxide pigment, and production and marketing of other chemical products. As discussed in Note 1, the company is pursuing alternatives for the separation of its chemical business unit.


- 19 -

Segment performance is evaluated based on operating profit (loss), which represents results of continuing operations before considering general corporate expenses, interest and debt expense, environmental provisions related to businesses in which the company’s affiliates are no longer engaged, other income (expense) and income taxes. Following is a summary of revenues and operating profit for each of the company's business segments for the three months ended March 31, 2005 and 2004.


   
Three Months Ended
  
   
March 31,
  
(Millions of dollars)
  
2005
  
2004
  
           
Revenues
              
Exploration and production
  
$
1,383
  
$
834
  
Chemical - Pigment
    
311
    
252
  
Chemical - Other
    
23
    
23
  
               
Total Revenues
  
$
1,717
  
$
1,109
  
               
Operating Profit (Loss)
              
Exploration and production
  
$
655
  
$
330
  
Chemical - Pigment
    
32
    
7
  
Chemical - Other
    
(9
)
  
(3
)
Total Operating Profit
    
678
    
334
  
               
Interest and debt expense
    
(61
)
  
(57
)
Corporate expenses
    
(44
)
  
(31
)
Provision for environmental remediation and
             
restoration, net of reimbursements (1)
    
(13
)
  
1
  
Other income (expense) (2)
    
(1
)
  
-
  
               
Income from Continuing Operations
             
before Income Taxes
  
$
559
  
$
247
  


(1)  
Includes provisions, net of reimbursements, related to sites with no ongoing operations or various businesses in which the company’s affiliates are no longer engaged; for example, the refining and marketing of oil and gas and associated petroleum products, and the mining and processing of uranium and thorium. See Note 13.

(2)  
The company owns a 50% interest in Avestor, a joint venture involved in the production of lithium-metal-polymer batteries. Investment in Avestor is accounted for under the equity method. The company’s equity in the net losses of Avestor were $7 million and $9 million during the three months ended March 31, 2005 and 2004, respectively. The carrying value of the company’s investment in Avestor at March 31, 2005 and December 31, 2004, was $79 million and $60 million, respectively.


16.
Condensed Consolidating Financial Information

On October 3, 2001, Kerr-McGee Corporation issued $1.5 billion of long-term notes in a public offering. On July 1, 2004, Kerr-McGee Corporation issued an additional $650 million of long-term notes. The notes are general, unsecured obligations of the company and rank in parity with all of the company’s other unsecured and unsubordinated indebtedness. As discussed in Note 8, the company obtained commitments for secured term loan and revolving credit facilities, pursuant to which the company expects to close facilities totaling $5.5 billion. In accordance with the provisions of the indentures under which the company’s existing notes were issued, the company’s obligations under the notes will become equally and ratably secured with the new credit facilities. The notes have been fully and unconditionally guaranteed, on a joint and several basis, by Kerr-McGee Chemical Worldwide LLC and Kerr-McGee Rocky Mountain Corporation. Additionally, Kerr-McGee Corporation has guaranteed all indebtedness of its subsidiaries. As a result of these guarantee arrangements, the company is required to present condensed consolidating financial information.


- 20 -

The following tables present condensed consolidating financial information for (a) Kerr-McGee Corporation, the parent company, (b) the guarantor subsidiaries, and (c) the nonguarantor subsidiaries on a consolidated basis. The guarantor subsidiaries include Kerr-McGee Chemical Worldwide LLC and Kerr-McGee Rocky Mountain Corporation, wholly-owned subsidiaries of Kerr-McGee Corporation. Other income (expense) in the Condensed Consolidating Statement of Income includes equity interest in income (loss) of subsidiaries for all periods presented.


Kerr-McGee Corporation and Subsidiary Companies
Condensed Consolidating Statement of Income
For the Three Months Ended March 31, 2005

   
 
Kerr-McGee
  
 
Guarantor
  
Non-Guarantor
          
(Millions of dollars)
  
Corporation
  
Subsidiaries
  
Subsidiaries
  
Eliminations
  
Consolidated
  
                       
Revenues
  
$
-
  
$
280
  
$
1,437
  
$
-
  
$
1,717
  
                                 
Costs and Expenses
                                
Costs and operating expenses
    
-
    
156
    
365
    
-
    
521
  
Selling, general and administrative expenses
    
-
    
-
    
92
    
-
    
92
  
Shipping and handling expenses
    
-
    
3
    
45
    
-
    
48
  
Depreciation and depletion
    
-
    
28
    
282
    
-
    
310
  
Accretion expense
    
-
    
1
    
8
    
-
    
9
  
Asset impairments
    
-
    
-
    
4
    
-
    
4
  
Gain associated with assets held for sale
    
-
    
-
    
(22
)
  
-
    
(22
)
    Exploration, including dry holes and amortization
       of undeveloped leases
     -     2     61     -     63  
Taxes, other than income taxes
    
-
    
9
    
38
    
-
    
47
  
Provision for environmental remediation
                                
and restoration, net of reimbursements
    
-
    
13
    
11
    
-
    
24
  
Interest and debt expense
    
42
    
6
    
96
    
(83
)
  
61
  
Total Costs and Expenses
    
42
    
218
    
980
    
(83
)
  
1,157
  
                                 
     
(42
)
  
62
    
457
    
83
    
560
  
Other Income (Expense)
    
390
    
10
    
58
    
(459
)
  
(1
)
Income before Income Taxes
    
348
    
72
    
515
    
(376
)
  
559
  
Benefit (Provision) for Income Taxes
    
7
    
(21
)
  
(190
)
  
-
    
(204
)
Net Income
  
$
355
  
$
51
  
$
325
  
$
(376
)
$
355
  
                                 


- 21 -


Kerr-McGee Corporation and Subsidiary Companies
Condensed Consolidating Statement of Income
For the Three Months Ended March 31, 2004

   
 
Kerr-McGee
  
 
Guarantor
  
Non-Guarantor
          
(Millions of dollars)
  
Corporation
  
Subsidiaries
  
Subsidiaries
  
Eliminations
  
Consolidated
  
                       
Revenues
  
$
-
  
$
211
  
$
898
  
$
-
  
$
1,109
  
                                 
Costs and Expenses
                                
Costs and operating expenses
    
-
    
110
    
285
    
-
    
395
  
Selling, general and administrative expenses
    
-
    
-
    
81
    
-
    
81
  
Shipping and handling expenses
    
-
    
2
    
36
    
-
    
38
  
Depreciation and depletion
    
-
    
30
    
160
    
-
    
190
  
Accretion expense
    
-
    
1
    
6
    
-
    
7
  
Asset impairments
    
-
    
1
    
12
    
-
    
13
  
Loss associated with assets held for sale
    
-
    
-
    
3
    
-
    
3
  
Exploration, including dry holes and
                                
        amortization of undeveloped leases
    
-
    
4
    
47
    
-
    
51
  
Taxes, other than income taxes
    
-
    
8
    
20
    
-
    
28
  
Provision for environmental remediation
                                
        and restoration, net of reimbursements
    
-
    
(1
)
  
-
    
-
    
(1
)
Interest and debt expense
    
28
    
9
    
69
    
(49
)
  
57
  
      Total Costs and Expenses
    
28
    
164
    
719
    
(49
)
  
862
  
                                 
     
(28
)
  
47
    
179
    
49
    
247
  
Other Income (Expense)
    
271
    
(7
)
  
29
    
(293
)
  
-
  
Income from Continuing Operations
                               
before Income Taxes
   
243
    
40
    
208
    
(244
)
  
247
  
Provision for Income Taxes
    
(91
)
  
(14
)
  
(79
)
  
92
    
(92
)
Income from Continuing Operations
    
152
    
26
    
129
    
(152
)
  
155
  
Loss from Discontinued Operations, Net of                                 
Income Tax Benefit of $1
    
-
    
-
    
(3
)
  
-
    
(3
)
Net Income
 
$
152
  
$
26
  
$
126
  
$
(152
)
$
152
  
                                 

- 22 -

Kerr-McGee Corporation and Subsidiary Companies
Condensed Consolidating Balance Sheet
March 31, 2005

   
 
Kerr-McGee
  
 
Guarantor
  
Non-Guarantor
          
(Millions of dollars)
  
Corporation
  
Subsidiaries
  
Subsidiaries
  
Eliminations
  
Consolidated
  
               
 
      
ASSETS
  
Current Assets
              
 
      
Cash and cash equivalents
  
$
2
  
$
-
  
$
199
  
$
-
  
$
201
  
Intercompany receivables
    
-
    
-
    
55
    
(55
)
  
-
  
Accounts receivable
    
-
    
141
    
749
    
-
    
890
  
Inventories