June 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 June 30, 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.)


123 Robert S. Kerr Avenue, Oklahoma City, Oklahoma 73102
(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 July 31, 2005: 115,364,067.







 
KERR-McGEE CORPORATION
  
     
 
INDEX
  
   
PAGE
PART I - FINANCIAL INFORMATION
  
     
Item 1. Financial Statements
  
 
    
 
Condensed Consolidated Statement of Income for the Three and Six Months Ended June 30, 2005 and 2004
1
 
    
 
Condensed Consolidated Balance Sheet at June 30, 2005 and December 31, 2004
2
 
    
 
Condensed Consolidated Statement of Cash Flows for the Six Months Ended June 30, 2005 and 2004
3
 
    
 
Condensed Consolidated Statement of Comprehensive Income and Stockholders’ Equity for the Six Months Ended June 30, 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
34 
 
 
  
Item 3. Quantitative and Qualitative Disclosures about Market Risk
53
 
 
  
Item 4. Controls and Procedures
56
     
Forward-Looking Information
56
   
   
PART II - OTHER INFORMATION
  
 
 
  
Item 1. Legal Proceedings
56
   
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
57
   
Item 4. Submission of Matters to a Vote of Security Holders
57
   
Item 6. Exhibits
58
 
 
  
SIGNATURE
59
 
 
  
   


 

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements.

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


   
Three Months Ended
  
Six Months Ended
  
   
June 30,
  
June 30,
  
(Millions of dollars, except per-share amounts)
  
2005
  
2004
  
2005
  
2004
  
                   
Revenues
  
$
1,850
  
$
1,091
  
$
3,567
  
$
2,200
  
                           
Costs and Expenses
                          
Costs and operating expenses
    
556
    
428
    
1,077
    
823
  
Selling, general and administrative expenses
    
110
    
78
    
202
    
159
  
Shipping and handling expenses
    
50
    
38
    
98
    
76
  
Depreciation and depletion
    
308
    
191
    
618
    
381
  
Accretion expense
    
8
    
6
    
17
    
13
  
Asset impairments
    
1
    
1
    
5
    
14
  
(Gain) loss an sale of assets
    
(24
)
  
4
    
(46
)
  
7
  
      Exploration, including dry holes and amortization                          
   of undeveloped leases
    
121
    
65
    
184
    
116
  
Taxes, other than income taxes
    
45
    
28
    
92
    
56
  
      Provision for environmental remediation and restoration,                          
net of reimbursements
    
2
    
4
    
26
    
3
  
Interest and debt expense
    
81
    
56
    
142
    
113
  
Total Costs and Expenses
    
1,258
    
899
    
2,415
    
1,761
  
                           
     
592
    
192
    
1,152
    
439
  
Other Income (Expense)
    
(9
)
  
(7
)
  
(10
)
  
(7
)
                           
Income from Continuing Operations before Income Taxes
    
583
    
185
    
1,142
    
432
  
Provision for Income Taxes
    
(211
)
  
(71
)
  
(415
)
  
(163
)
                           
Income from Continuing Operations
    
372
    
114
    
727
    
269
  
Loss from Discontinued Operations
                         
(net of income tax benefit of $1, $2, $1 and $3, respectively)
    
(2
)
  
(3
)
  
(2
)
  
(6
)
                           
Net Income
 
$
370
  
$
111
  
$
725
  
$
263
  
                           
Income (Loss) per Common Share
                          
Basic -
                          
Continuing operations
  
$
2.64
  
$
1.11
  
$
4.92
  
$
2.64
  
Discontinued operations
    
(.01
)
  
(.04
)
  
(.01
)
  
(.06
)
Net income
  
$
2.63
  
$
1.07
  
$
4.91
  
$
2.58
  
                           
Diluted -
                          
Continuing operations
  
$
2.61
  
$
1.05
  
$
4.79
  
$
2.48
  
Discontinued operations
    
(.01
)
  
(.04
)
  
(.01
)
  
(.06
)
Net income
  
$
2.60
  
$
1.01
  
$
4.78
  
$
2.42
  
                           
Dividends Declared per Common Share
  
$
.05
  
$
.45
  
$
.50
  
$
.90
  
                           
                           
                           



The accompanying notes are an integral part of this statement.

 
- 1 -

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

   
June 30,
 
December 31,
 
(Millions of dollars)
  
2005
  
2004
  
   
 
  
 
  
ASSETS
  
Current Assets
  
 
  
 
  
Cash and cash equivalents
  
$
324
  
$
76
  
Accounts receivable
    
1,024
    
963
  
Inventories
    
362
    
329
  
Derivatives and other current assets
    
216
    
195
  
Deferred income taxes
    
337
    
324
  
Assets associated with properties held for sale
    
36
    
-
  
Total Current Assets
    
2,299
    
1,887
  
               
Property, Plant and Equipment
    
17,745
    
18,984
  
Less reserves for depreciation, depletion and amortization
    
(7,423
)
  
(8,157
)
     
10,322
    
10,827
  
               
Investments, Derivatives and Other Assets
    
614
    
508
  
Goodwill and Other Intangible Assets
    
1,280
    
1,288
  
Assets Associated with Properties Held for Sale
    
662
    
8
  
               
Total Assets
  
$
15,177
  
$
14,518
  

LIABILITIES AND STOCKHOLDERS' EQUITY
  
Current Liabilities
              
Accounts payable
  
$
546
  
$
644
  
Long-term debt due within one year
    
131
    
463
  
Income taxes payable
    
161
    
201
  
Derivative liabilities
    
800
    
372
  
Accrued liabilities
    
811
    
825
  
Liabilities associated with properties held for sale
    
19
    
-
  
Total Current Liabilities
    
2,468
    
2,505
  
               
Long-Term Debt
    
6,825
    
3,236
  
               
Noncurrent Liabilities
              
Deferred income taxes
    
2,203
    
2,177
  
Asset retirement obligations
    
475
    
503
  
Derivative liabilities
    
585
    
208
  
Other
   
592
    
571
  
Liabilities associated with properties held for sale
    
67
    
-
  
Total Noncurrent Liabilities
    
3,922
    
3,459
  
               
Contingencies and Commitments (Notes 13 and 14)
              
               
Stockholders' Equity
              
Common stock, par value $1 - 500,000,000 and 300,000,000 shares
              
authorized, 118,523,627 and 152,049,127 shares issued at
             
June 30, 2005 and December 31, 2004, respectively
    
119
    
152
  
Capital in excess of par value
    
3,580
    
4,205
  
Preferred stock purchase rights
    
1
    
2
  
Retained earnings (accumulated deficit)
    
(770
)
  
1,102
  
Accumulated other comprehensive loss
    
(641
)
  
(79
)
Common shares in treasury, at cost - 3,355,596 and 159,856 shares
             
at June 30, 2005 and December 31, 2004, respectively
    
(261
)
  
(8
)
Deferred compensation
    
(66
)
  
(56
)
Total Stockholders' Equity
    
1,962
    
5,318
  
               
Total Liabilities and Stockholders’ Equity
  
$
15,177
  
$
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)


   
Six Months Ended
  
   
June 30,
  
(Millions of dollars)
  
2005
  
2004
  
   
 
      
Cash Flows from Operating Activities
  
 
      
Net income
 
$
725
  
$
263
  
Adjustments to reconcile net income to net cash
              
provided by operating activities -
              
Depreciation, depletion and amortization
    
650
    
407
  
Deferred income taxes
    
265
    
111
  
Dry hole expense
    
91
    
26
  
Asset impairments
    
5
    
14
  
(Gain) loss on sale of assets
    
(46
)
  
7
  
Accretion expense
    
17
    
13
  
Provision for environmental remediation and restoration,
              
net of reimbursements
    
27
    
7
  
Other noncash items affecting net income
   
128
    
29
  
Changes in assets and liabilities
    
(284
)
  
(169
)
Net Cash Provided by Operating Activities
    
1,578
    
708
  
               
Cash Flows from Investing Activities
              
Capital expenditures
    
(808
)
  
(433
)
Dry hole costs
    
(75
)
  
(26
)
Acquisitions, net of cash acquired (1)
    
-
    
43
  
Proceeds from sales of assets
    
63
    
3
  
Proceeds from sale of investments
    
-
    
39
  
Other investing activities
    
(21
)
  
(26
)
Net Cash Used in Investing Activities
    
(841
)
  
(400
)
               
Cash Flows from Financing Activities
              
Issuance of common stock
    
159
    
7
  
Purchases of treasury stock
    
(250
)
  
-
  
Shares repurchased under the tender offer
    
(3,975
)
  
-
  
Dividends paid
    
(142
)
  
(91
)
Repayment of debt
    
(392
)
  
(347
)
Proceeds from borrowings
   
4,250
    
86
  
Credit Agreement financing costs
    
(58
)
  
-
  
Settlement of Westport derivatives
    
(80
)
  
-
  
Net Cash Used in Financing Activities
    
(488
)
  
(345
)
               
Effects of Exchange Rate Changes on Cash and Cash Equivalents
    
(1
)
  
-
  
Net Increase (Decrease) in Cash and Cash Equivalents
    
248
    
(37
)
Cash and Cash Equivalents at Beginning of Period
    
76
    
142
  
Cash and Cash Equivalents at End of Period
  
$
324
  
$
105
  


(1)  
In June 2004, the company completed a merger with Westport Resources Corporation (Westport). In exchange for Westport’s common stock and options, Kerr-McGee issued stock valued at $2.4 billion, options valued at $34 million and assumed debt of $1 billion, for a total of $3.5 billion (net of $43 million of cash acquired).

The accompanying notes are an integral part of this statement.
 
- 3 -
KERR-McGEE CORPORATION AND SUBSIDIARY COMPANIES
CONDENSED CONSOLIDATED STATEMENT OF COMPREHENSIVE
INCOME AND STOCKHOLDERS' EQUITY
(UNAUDITED)


(Millions of dollars)
  
Common
Stock
  
Capital in
Excess of
Par Value
  
Retained
Earnings
(Accumulated Deficit)
  
Accumulated
Other
Comprehensive
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:
                                            
Net income
    
-
    
-
    
263
    
-
    
-
    
-
    
263
  
Other comprehensive loss
   
-
    
-
    
-
    
(200
)
  
-
    
-
    
(200
)
Comprehensive income
                                        
63
  
Westport merger
    
49
    
2,402
    
-
    
-
    
-
    
(3
)
  
2,448
  
Exercise of stock options
    
1
    
10
    
-
    
-
    
-
    
-
    
11
  
Restricted stock activity
    
-
    
22
    
-
    
-
    
(3
)
  
(14
)
  
5
  
ESOP deferred compensation
    
-
    
-
    
-
    
-
    
-
    
3
    
3
  
Tax benefit from stock-based awards
    
-
    
2
    
-
    
-
    
-
    
-
    
2
  
Dividends declared ($.90 per share)
    
-
    
-
    
(91
)
  
-
    
-
    
-
    
(91
)
Balance at June 30, 2004
  
$
151
  
$
4,144
  
$
1,099
  
$
(245
)
$
(5
)
$
(67
)
$
5,077
  
                                             
Balance at December 31, 2004
  
$
152
  
$
4,205
  
$
1,102
  
$
(79
)
$
(8
)
$
(54
)
$
5,318
  
Comprehensive Income:
                                            
Net income
    
-
    
-
    
725
    
-
    
-
    
-
    
725
  
Other comprehensive loss
   
-
    
-
    
-
    
(562
)
  
-
    
-
    
(562
)
Comprehensive income
                                        
163
  
Shares issued upon conversion
                                            
of 5.25% debentures
    
10
    
583
    
-
    
-
    
-
    
-
    
593
  
Purchases of treasury shares
    
-
    
-
    
-
    
-
    
(250
)
  
-
    
(250
)
Shares repurchased and retired
    
(47
)
  
(1,410
)
  
(2,517
)
  
-
    
-
    
(1
)
  
(3,975
)
Exercise of stock options
    
3
    
156
    
-
    
-
    
-
    
-
    
159
  
Restricted stock activity
    
1
    
25
    
-
    
-
    
(3
)
  
(13
)
  
10
  
ESOP deferred compensation
    
-
    
-
    
-
    
-
    
-
    
3
    
3
  
Tax benefit from stock-based awards
    
-
    
21
    
-
    
-
    
-
    
-
    
21
  
Dividends declared ($.50 per share)
    
-
    
-
    
(80
)
  
-
    
-
    
-
    
(80
)
Balance at June 30, 2005
  
$
119
  
$
3,580
  
$
(770
)
$
(641
)
$
(261
)
$
(65
)
$
1,962
  
                                             







The accompanying notes are an integral part of this statement.

 
- 4 -

KERR-McGEE CORPORATION AND SUBSIDIARY COMPANIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 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 Angola, Australia, Benin, Bahamas, Brazil, Morocco, Canada, Trinidad and the Danish and Norwegian sectors of the North Sea. The chemical unit is primarily engaged in the 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.  The company expects asset divestitures discussed below to result in gross proceeds in excess of $4 billion. 

·  
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 separation during the third quarter of 2005. As of August 5, 2005, criteria for reporting the results of the chemical business unit as discontinued operations had 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 proceeded. 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.  In connection with the divestiture program, in June 2005, the company identified for sale certain oil and gas properties onshore in the United States and in the U.K. sector of the North Sea.  In August 2005, the company entered into agreements to sell all of its North Sea operations.  Information about these transactions in provided in Notes 6 and 17.  In addition, the company is considering for divestiture other selected U.S. onshore properties and Gulf of Mexico shelf properties.  The total combined divestitures are expected to represent approximately 25% to 30% of the company's proved reserves at December 31, 2004 and up to 35% of its average daily production for the first six months of 2005.  However, the actual impact of any divestitures may differ materially from 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 was completed in May 2005, the company repurchased 46.7 million of its shares at $85 per share, which represented 29% of shares outstanding at March 31, 2005. Note 12 provides additional information regarding this transaction. The tender offer was financed with the net proceeds of borrowings, which are discussed in Note 8, and cash on hand.

·  
In May 2005, the Board approved a recommendation to revise the company’s dividend policy to a level consistent with that of other pure-play exploration and production companies. Starting with the second quarter of 2005, the annual dividend was reduced 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 necessary to a fair statement of the results for the interim periods presented. Except as indicated below, such adjustments are normal and recurring in nature. 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 and six months ended June 30, 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. Additionally, as discussed in Note 6, the 2005 Condensed Consolidated Balance Sheet and the related Statement of Income include certain adjustments associated with properties that met the criteria for classification as held for sale.

Accounting Policies

Repurchases and Retirements of Capital Stock - The company records treasury stock purchases at cost, which includes incremental direct transaction costs. Upon retirement of repurchased shares, the excess of purchase cost over associated common stock par value and preferred stock purchase rights is allocated to capital in excess of par value, with the remaining cost, if any, charged against retained earnings. The allocation to capital in excess of par value is based on the per-share amount of capital in excess of par value for all shares.

Asset Exchanges - Effective July 1, 2005, the company implemented Statement of Financial Accounting Standards No. 153, “Exchanges of Nonmonetary Assets, an Amendment of APB Opinion No. 29” (FAS No. 153), for exchanges of nonmonetary assets occurring after the implementation date. Prior to implementing FAS No. 153, the company generally did not recognize gains on nonmonetary exchanges of its interest in oil and gas properties. However, for exchange transactions involving monetary consideration (if such consideration was less than 25% of the fair value of assets exchanged), a proportionate amount of the total gain was recognized. Exchanges of an interest in oil and gas properties involving receipt of monetary consideration of 25% or more were accounted for at fair value and the full amount of realized gain was recognized. According to the provisions of FAS No. 153, all nonmonetary asset exchanges that have commercial substance will be measured based on the fair values exchanged with any resulting gain or loss recognized in earnings. An exchange is deemed to have commercial substance if it results in a significant change in expected future cash flows.

Employee Stock-Based Compensation - The company accounts for its stock-based awards 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-based awards. Following this method, compensation expense for such awards is measured based on the estimated grant-date fair value and recognized as the related employee services are provided. If compensation expense for stock-based awards had been determined using the fair value-based method, net income would have been lower, as presented in the following table.
 
- 6 -
 
   
Three Months Ended
  
Six Months Ended
  
   
June 30,
  
June 30,
  
(Millions of dollars, except per-share amounts)
  
2005
  
2004
  
2005
  
2004
  
                   
Net income, as reported
  
$
370
  
$
111
  
$
725
  
$
263
  
Add: stock-based employee compensation expense
                          
included in reported net income, net of taxes
    
4
    
2
    
13
    
6
  
Deduct: stock-based compensation expense determined
                          
using a fair-value method, net of taxes
    
(6
)
  
(6
)
  
(22
)
  
(13
)
Pro forma net income
 
$
368
  
$
107
  
$
716
  
$
256
  
                           
Net income per share -
                          
Basic -
                          
As reported
  
$
2.63
  
$
1.07
  
$
4.91
  
$
2.58
  
Pro forma
    
2.61
    
1.03
    
4.85
    
2.51
  
                           
Diluted -
                         
As reported
  
$
2.60
  
$
1.01
  
$
4.78
  
$
2.42
  
Pro forma
    
2.56
    
.98
    
4.68
    
2.36
  
 
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 Financial Accounting Standards Board 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 SEC’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

Comprehensive income for the three and six months ended June 30, 2005 and 2004, is as follows:

   
Three Months Ended
  
Six Months Ended
  
   
June 30,
  
June 30,
  
(Millions of dollars)
  
2005
  
2004
  
2005
  
2004
  
                   
Net income
  
$
370
  
$
111
  
$
725
  
$
263
  
After-tax changes in:
                          
Loss on cash flow hedges
    
(89
)
  
(94
)
  
(548
)
  
(185
)
Foreign currency translation adjustments
    
(16
)
  
(3
)
  
(14
)
  
(10
)
Unrealized loss on available-for-sale securities
    
-
    
-
    
-
    
(5
)
Comprehensive income
 
$
265
  
$
14
  
$
163
  
$
63
  
 
- 7 -
 
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. At June 30, 2005, the net after-tax loss on oil and gas derivatives in accumulated other comprehensive loss relates to a portion of the company’s expected production through 2007. The company expects to reclassify $398 million of such loss 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 the company designated Westport’s fixed-price oil and gas swaps as hedges after the merger, 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 fair value of these derivatives at June 30, 2005 was a liability of $84 million.

The following tables summarize the balance sheet presentation of the company’s derivatives and the related collateral held by counterparties as of June 30, 2005 and December 31, 2004:
 
   
As of June 30, 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
  
$
68
  
$
34
  
$
(673
)
$
(564
)
$
(702
)
Acquired Westport positions
    
-
    
-
    
(120
)
  
(18
)
  
(18
)
Cash collateral
    
24
    
-
    
-
   
-
    
-
  
Gas marketing-related derivatives
    
6
    
-
    
(6
)
  
-
    
-
  
Foreign currency forward contracts
    
7
    
-
    
-
    
-
    
13
  
Interest rate swaps
    
-
    
-
    
(1
)
  
(3
)
  
-
  
Other derivatives
    
3
    
-
    
-
    
-
    
2
  
Total derivative contracts
  
$
108
  
$
34
  
$
(800
)
$
(585
)
$
(705
)

   
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 derivatives
    
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.
 
- 8 -

The following tables summarize the classification of gain (loss) on derivative instruments in the Condensed Consolidated Statement of Income for the three- and six-month periods ended June 30, 2005 and 2004:

   
Three Months Ended
  
Three Months Ended
  
   
June 30, 2005
  
June 30, 2004
  
       
Costs and
  
Other Income
      
Costs and
  
Other Income
  
   
Revenues
  
Expenses
  
(Expense)
  
Revenues
  
Expenses
  
(Expense)
  
Hedge Activity:
                          
    Oil and gas commodity derivatives
  
$
(78
)
$
-
  
$
-
  
$
(156
)
$
-
  
$
-
  
     Foreign currency contracts
    
-
    
(1
)
  
-
    
-
    
4
    
-
  
    Interest rate swaps
    
-
    
(1
)
  
-
    
-
    
5
    
-
  
    Other derivatives
    
-
    
1
    
-
    
-
    
1
    
-
  
    Loss on hedge ineffectiveness
    
(35
)
  
-
    
-
    
-
    
-
    
-
  
Total hedging contracts
    
(113
)
  
(1
)
  
-
    
(156
)
  
10
    
-
  
                                       
Nonhedge Activity:
                                      
    Oil and gas commodity derivatives -
                                      
Kerr-McGee positions
    
6
    
-
    
-
    
(10
)
  
-
    
2
  
Acquired Westport positions
    
6
    
-
    
-
    
15
    
-
    
-
  
Gas marketing-related derivatives
   
2
    
-
    
-
    
2
    
-
    
-
  
DECS call option (1)
    
-
    
-
    
-
    
-
    
-
    
(66
)
Other derivatives
    
-
    
-
    
(1
)
  
-
    
-
    
-
  
    Total nonhedge contracts
    
14
    
-
    
(1
)
  
7
    
-
    
(64
)
                                       
    Total derivative contracts
  
$
(99
)
$
(1
)
$
(1
)
$
(149
)
$
10
  
$
(64
)


   
Six Months Ended
  
Six Months Ended
  
   
June 30, 2005
  
June 30, 2004
  
       
Costs and
  
Other Income
      
Costs and
  
Other Income
  
   
Revenues
  
Expenses
  
(Expense)
  
Revenues
  
Expenses
  
(Expense)
  
Hedge Activity:
                                      
    Oil and gas commodity derivatives
 
$
(115
)
$
-
  
$
-
  
$
(217
)
$
-
  
$
-
  
    Foreign currency contracts
    
(1
)
  
-
    
-
    
-
    
8
    
-
  
    Interest rate swaps
    
-
    
-
    
-
    
-
    
9
    
-
  
    Other derivatives
    
-
    
1
    
-
    
-
    
1
    
-
  
    Loss on hedge ineffectiveness
    
(44
)
  
-
    
-
    
(1
)
  
-
    
-
  
Total hedging contracts
    
(160
)
  
1
    
-
    
(218
)
  
18
    
-
  
                                       
Nonhedge Activity:
                                      
    Oil and gas commodity derivatives -
                                      
Kerr-McGee positions
    
14
    
-
    
-
    
(10
)
  
-
    
2
  
Acquired Westport positions
    
(53
)
  
-
    
-
    
15
    
-
    
-
  
Gas marketing-related derivatives
   
4
    
-
    
-
    
4
    
-
    
(1
)
DECS call option (1) 
    
-
    
-
    
-
    
-
    
-
    
(72
)
Other derivatives
    
-
    
-
    
1
    
-
    
-
    
(1
)
    Total nonhedge contracts
    
(35
)
  
-
    
1
    
9
    
-
    
(72
)
                                       
    Total derivative contracts
  
$
(195
)
$
1
  
$
1
  
$
(209
)
$
18
  
$
(72
)

 
(1)
Other income (expense) for the three- and six-month periods ended June 30, 2004 also includes unrealized gains on Devon Energy Corporation common stock of $66 million and $74 million, respectively.


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. At December 31, 2004, the outstanding balance of receivables sold (and excluded from the company's Condensed Consolidated Balance Sheet as of that date) was $165 million, which was net of the company's retained interest in receivables serving as over-collateralization of $39 million.

- 9 -
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 and the related increase in the company’s leverage 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 company then executed an Assignment and Sale Agreement whereby it acquired all outstanding receivables from the SPE in exchange for the forgiveness of all debt owed by the SPE to the company (including the $165 million advance mentioned above). Accounts receivable acquired in this transaction are being collected by the company as they become due.

During the quarters ended June 30, 2005 and 2004, the company sold $105 million and $304 million, respectively, of its pigment receivables, resulting in pretax losses reflected in other income (expense) of $1 million and $3 million, respectively. The company sold $384 million and $541 million of receivables during the first six months of 2005 and 2004, respectively, and had pretax losses of $4 million in each of those periods.


5.
Inventories

Major categories of inventories at June 30, 2005 and December 31, 2004 are as follows:

   
June 30,
  
December 31,
  
(Millions of dollars)
  
2005
  
2004
  
           
Chemicals and other products
  
$
249
  
$
236
  
Materials and supplies
    
103
    
85
  
Crude oil and natural gas liquids
    
10
    
8
  
Total
  
$
362
  
$
329
  


6.
Exchanges, Divestitures and Impairments of Assets

Assets Held for Sale - In connection with the divestiture program discussed in Note 1, the company has identified for sale four packages of oil and gas properties located onshore in the United States and five packages of non-operated properties in the U.K. North Sea. These properties met the criteria for classification as held for sale in June 2005. Accordingly, associated assets and liabilities are classified as such in the accompanying June 30, 2005 Condensed Consolidated Balance Sheet. Based on the company’s expectation of selling prices for these packages less cost to sell in relation to their carrying values, no loss associated with assets held for sale was recognized in the second quarter of 2005. The company expects to close the sales of these properties by the end of the year.  One of the packages identified for sale would result in the sale of the company’s investment in the stock of a foreign subsidiary.  Upon concluding that such sale was likely to occur, the company recognized a tax benefit of $27 million related to the difference between the book and tax bases of its investment in the subsidiary during the second quarter of 2005.

- 10 -
As discussed in Note 8, the company is required to use 100% of the net cash proceeds from sales of certain assets for debt repayment. Oil and gas properties identified as held for sale are subject to this requirement. Because proceeds from the sale of U.K. oil and gas properties will be remitted to the United States for debt repayment, in connection with classifying such properties as held for sale, the company recognized $11 million of U.S. deferred income tax expense on foreign earnings previously intended to have been indefinitely reinvested overseas (in addition to a previously established liability for U.S. income taxes on U.K. earnings of $59 million). Any amounts remitted to the U.S. in connection with the divestiture of oil and gas properties in the U.K. will not be considered repatriated under the provisions of the American Jobs Creation Act of 2004 discussed in Note 7.
 
In August 2005, the company entered into agreements to sell its North Sea oil and gas business.  Additional information regarding these transactions in provided in note 17.
 
Exchanges of Assets - In the first quarter of 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. In connection with this transaction, the company received $24 million in cash and recognized a $19 million gain on sale based on the percentage of the Arkoma properties' fair value that was received in cash.

In the second quarter of 2005, the company sold its interests in oil and gas properties in the Table Mountain and Culp Draw fields of Wyoming to Anadarko Petroleum Corporation in exchange for Anadarko’s overriding royalty interests in the Greater Natural Buttes field and $27 million in cash. The company recognized a gain of $25 million in connection with this transaction.

Exploratory Drilling Costs - At June 30, 2005, the company had capitalized exploratory drilling costs of approximately $168 million associated with ongoing exploration and/or appraisal activities primarily in the deepwater Gulf of Mexico, Alaska, Brazil and China. 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. The company continues to evaluate the performance of this new oxidation line and expects to determine 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 or idling of certain assets and reduction of their future useful lives, resulting in the acceleration of depreciation expense and the recognition of other charges. However, the current production demands make it less likely that any existing production lines would be idled in the near term.


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. 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 decided to repatriate up to $500 million in extraordinary dividends, as defined in the Act, $200 million of which were repatriated during the quarter ended June 30, 2005, resulting in the recognition of income tax expense of $12 million. The company may repatriate up to an additional $300 million in extraordinary dividends under the provisions of the Act. Management has not yet decided whether, and to what extent, additional amounts of foreign earnings will be repatriated. Accordingly, the accompanying financial statements do not reflect any additional provision for taxes on unremitted foreign earnings, except for the provision of $11 million discussed in Note 6. Additional income tax expense of up to $16 million may be recognized in the quarter ending September 30, 2005, when the company expects to decide whether additional amounts of certain foreign earnings will be repatriated under the provisions of the Act.

- 11 -
The effective tax rate for income from continuing operations for the second quarter of 2005 is 36.2% and includes effects of the following:

·  
As discussed in Note 6, during the second quarter of 2005 the company recognized an income tax benefit of $27 million and tax expense of $11 million related to certain oil and gas properties held for sale, resulting in a corresponding increase (decrease) in the second-quarter effective tax rate of (4.6%) and 1.9%, respectively.
 
·  
Income tax expense of $12 million recognized in connection with the repatriation of $200 million in foreign earnings increased the effective tax rate by 2.1%.
 
8.
Debt

Long-term debt consisted of the following at June 30, 2005 and December 31, 2004:

   
June 30,
  
 
December 31,
  
(Millions of dollars)
  
2005
  
2004
  
 Debentures -              
5.25% Convertible subordinated debentures due February 15, 2010
              
(convertible at $61.08 per share, subject to certain adjustments)
 
$
-
  
$
600
  
7% Debentures due November 1, 2011, net of unamortized debt
              
discount of $74 and $77 (14.25% effective rate)
    
176
    
173
  
7.125% Debentures due October 15, 2027
    
150
    
150
  
 Notes payable -              
5.375% Notes due April 15, 2005 (includes a premium of $4 in 2004
              
for fair value hedge adjustment)
    
-
    
354
  
8.125% Notes due October 15, 2005, net of discount of $1 for fair
              
value hedge adjustment in both 2005 and 2004
    
108
    
108
  
5.875% Notes due September 15, 2006 (5.89% effective rate)
    
307
    
307
  
6.625% Notes due October 15, 2007, net of discount of $3 and $2
             
for fair value hedge adjustment
    
147
    
148
  
6.875% Notes due September 15, 2011, net of unamortized debt discount
              
of $1 in both 2005 and 2004 (6.90% effective rate)
    
674
    
674
  
6.95% Notes due July 1, 2024, net of unamortized debt discount of $5
             
in both 2005 and 2004 (7.02% effective rate)
    
645
    
645
  
7.875% Notes due September 15, 2031, net of unamortized debt
             
discount of $1 and $2 (7.91% effective rate)
    
499
    
498
  
 Term Loans -              
Variable rate Tranche X term loan due May 24, 2007 (1)
    
2,000
    
-
  
Variable rate Tranche B term loan due in installments through May 24, 2011 (1) (2)
    
2,250
    
-
  
               
 Commercial paper      -      41  
 Guaranteed Debt of Employee Stock Ownership Plan 9.61% Notes              
due in installments through January 2, 2005
    
-
    
1
  
     
6,956
    
3,699
  
 Long-term debt due within one year     (131 )     (463 ) 
               
Total
  
$
6,825
  
$
3,236
  


(1)  
The term loans are subject to certain mandatory prepayment provisions, as more fully described below.

(2)  
The scheduled principal payments on the Tranche B term loan are as follows: twenty quarterly payments of approximately $6 million commencing September 30, 2005, followed by four payments of approximately $534 million quarterly commencing September 30, 2010 through the maturity date.


- 12 -
The following summarizes the scheduled maturities of our debt at June 30, 2005:
   
  Scheduled
  
(Millions of dollars)
  
Maturities (1)
  
       
Six months ending December 31, 2005
  
$
119
  
2006
    
329
  
2007
    
2,169
  
2008
    
23
  
2009
    
23
  
2010
    
1,080
  
Thereafter
    
3,213
  
Total
  
$
6,956
  

(1)  
These amounts are inclusive of the unamortized discount on issuance of $81 million and the discount arising from fair value hedge adjustments of $4 million.
 
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.

As discussed in Note 12, in May 2005, the company completed a self tender offer for its common stock for an aggregate cost of $4 billion. In connection with the tender offer, the company entered into a $5.5 billion credit agreement (Credit Agreement) consisting of a $2 billion two-year term loan (Tranche X), a $2.25 billion six-year term loan (Tranche B) and a $1.25 billion five-year revolving credit facility (Revolving Facility). In satisfaction of one of the closing conditions, the company repaid all outstanding indebtedness under the $1.5 billion revolving credit agreement previously in effect and terminated the agreement. No penalties were incurred in connection with the early termination.

Interest on amounts borrowed under the Credit Agreement is payable, at the company’s election, at an alternate base rate (ABR) or a Eurodollar rate, in each case as defined in the Credit Agreement, plus a margin, as summarized below. Interest is paid at the end of an interest period selected by the company, but not less frequently than quarterly. The applicable margin may vary based on the company’s Consolidated Leverage Ratio, as defined in the Credit Agreement, and other specified events and conditions. The Consolidated Leverage Ratio determined pursuant to the terms of the Credit Agreement is based on the company's total funded debt and its earnings over a period of four consecutive quarters (before considering interest, taxes, depreciation, depletion and amortization, noncash exploration expense and other specified noncash items).
 
     
Applicable Interest Rate Margin
     
At June 30, 2005
  
Over the Term
 
Maturity
  
ABR
  
Eurodollar
  
ABR
  
Eurodollar
Revolving Facility
May 2010
  
1.25%
  
2.25%
  
0.25 - 1.25%
  
1.25 - 2.25%
Tranche X Term Loan
May 2007
  
1.25%
  
2.25%
  
1.25%
  
2.25%
Tranche B Term Loan
May 2011
  
1.50%
  
2.50%
  
1.25 - 1.50%
  
2.25 - 2.50%

Revolving Facility - The $1.25 billion Revolving Facility provides for borrowings and issuances of letters of credit. The commitment fee payable on the unused portion of the Revolving Facility is currently set at 0.5% annually. At June 30, 2005, no borrowings were outstanding under the Revolving Facility and outstanding letters of credit totaled $70 million. The company had total unused bank and revolving lines of credit of $1.2 billion at June 30, 2005.

Tranche X and Tranche B Term Loans - The term loans were fully funded at closing, with proceeds used to finance the tender offer and to pay fees and expenses associated with the Credit Agreement. From origination through June 30, 2005, the weighted average interest rates on the Tranche X and Tranche B term loans were 5.41% and 5.87%, respectively.

The company may make prepayments on the term loans at any time without penalty. Additionally, the term loans are subject to the following mandatory prepayment provisions:

·  
As long as the Tranche X loan is outstanding, 50% of the net cash proceeds, as defined, of certain equity issuances;
 
- 13 -
 
·  
100% of the net cash proceeds, as defined, from incurrence of certain indebtedness;
·  
Subject to certain exceptions, 100% of the net cash proceeds, as defined, from asset disposals; and
·  
Annually, a specified percentage of excess cash flow, as defined, ranging from zero to 50%. This prepayment requirement is reduced or eliminated upon repayment of the Tranche X loan and the achievement of a Consolidated Leverage Ratio below specified thresholds. Excess cash flow as calculated under the Credit Agreement is reduced by mandatory prepayments made with the net cash proceeds from asset disposals.
 
As discussed in Note 17, in August 2005, the company entered into agreements to sell its North Sea oil and gas business.  The net proceeds realized in connection with such sales will be used to repay debt.
 
Guarantee and Collateral Provisions - The company’s obligations under the Credit Agreement are (a) unconditionally guaranteed, jointly and severally, by certain of the company’s domestic subsidiaries and (b) 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 a substantial portion of the company’s tangible and intangible assets located in the United States (excluding assets relating to the company's chemical business), and all of the capital stock of specified direct and indirect subsidiaries (limited, in the case of foreign subsidiaries, to 66% of the capital stock of the company’s first tier foreign subsidiaries).
 
To the extent required under the terms of the company's existing indentures, all obligations under previously unsecured bonds became equally and ratably secured with the company's obligations under the Credit Agreement. Additionally, as discussed in Note 16, the company’s obligations under certain of the existing registered debentures and notes are unconditionally guaranteed, jointly and severally, by two of the company’s subsidiaries.

Debt Covenants - The terms of the Credit Agreement provide for customary representations and warranties, affirmative and negative covenants, and events of default. Specifically, the Credit Agreement limits the company’s ability to incur or secure other debt, make investments, sell assets, pay dividends and repurchase stock. Additionally, the company’s ability to make capital expenditures (including dry hole costs) is limited by the provisions of the Credit Agreement to $2.35 billion in any given year. The company also is required to maintain compliance with the following financial covenants (in each case, as defined in the Credit Agreement):

·  
Consolidated Leverage Ratio of no more than 4:1 in 2005, 3.75:1 in 2006 and 3.50:1 thereafter
·  
Consolidated Interest Coverage Ratio over a specified period of at least 3:1
·  
Asset Coverage Ratio of more than 1.25:1 in 2005, 1.50:1 in 2006 and 1.75:1 thereafter

The company’s current dividend level ($.20 per share annually) is expected to be in compliance with the annual limitation on dividend payments of $50 million.

For the second quarter of 2005, the company had a Consolidated Leverage Ratio of approximately 2:1, a Consolidated Interest Coverage Ratio of 11:1 and an Asset Coverage Ratio of 1.79:1, and was in compliance with its other debt covenants.


9.
Exit or Disposal Activities

Following are the changes in the reserve for exit activities during the six months ended June 30, 2005. Except as discussed below, no significant changes in the status of exit or disposal activities occurred during this period.

   
Dismantlement
  
Personnel
      
(Millions of dollars)
  
and Closure
  
Costs
  
Total
  
               
Balance at December 31, 2004
  
$
10
  
$
8
  
$
18
  
Provisions
    
1
    
8
    
9
  
Payments / Adjustments
    
(3
)
  
(3
)
  
(6
)
Balance at June 30, 2005
  
$
8
  
$
13
  
$
21
  
 
- 14 -
As discussed in Note 1, the company plans to sell or spin off 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 awards that may be made in future periods upon successful disposition of certain assets, as discussed below. Of the total expected cost of these programs, $21 million is associated with the company’s exploration and production segment, $4 million with the chemical-pigment segment and $9 million with corporate activities. During the second quarter of 2005, the company recognized $7 million as a component of selling, general and administrative expenses in connection with the retention programs. The remaining cost of $27 million will be recognized as the related services are provided by the participating employees. Under the plan covering employees of the chemical business unit, 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. Additional payments may be due to certain employees upon successful disposition of the chemical business or divestiture of certain oil and gas assets.
 
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 a three-year vesting period 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 any compensation expense.

In May 2005, the shareholders approved the 2005 Long Term Incentive Plan (2005 Plan), which authorizes the issuance of shares of the company’s common stock to certain employees and non-employee directors in the form of stock options, restricted stock or performance awards. The options may be accompanied by stock appreciation rights. A total of 10 million shares of the company’s common stock is authorized to be issued under the 2005 Plan any time prior to May 10, 2015, of which a maximum of 3 million shares of common stock is authorized for issuance in connection with awards of restricted stock and performance awards. Performance awards may be granted in the form of performance shares or performance units. Performance shares define a benefit to the grantee by reference to shares of stock, while performance units provide for cash awards based on the company’s achievement of certain financial performance measures over a stated period. As of June 30, 2005, no awards have been made under this plan.

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 postretirement benefits if they reach retirement age while working for the company.

The components of net periodic cost for the second quarter of 2005 and 2004 are as follows:

       
Postretirement
  
   
Retirement Plans
  
Health and Life Plans
  
   
Three Months Ended
  
Three Months Ended
  
   
June 30,
  
June 30,
  
(Millions of dollars)
  
2005
  
2004
  
2005
  
2004
  
Net periodic cost -
                          
Service cost
  
$
9
  
$
7
  
$
1
  
$
-
  
Interest cost
    
17
    
18
    
4
    
5
  
Expected return on plan assets
    
(26
)
  
(29
)
  
-
    
-
  
Net amortization -
                         
Prior service cost
    
2
    
2
    
(1
)
  
1
  
Net actuarial loss
    
2
    
1
    
1
    
1
  
Total net periodic cost
  
$
4
  
$
(1
)
$
5
  
$
7
  
 
- 15 -
 
The components of net periodic cost for the first six months of 2005 and 2004 are as follows:

       
Postretirement
  
   
Retirement Plans
  
Health and Life Plans
  
   
Six Months Ended
  
Six Months Ended
  
   
June 30,
  
June 30,
  
(Millions of dollars)
  
2005
  
2004
  
2005
  
2004
  
Net periodic cost -
                          
Service cost
  
$
18
  
$
14
  
$
2
  
$
1
  
Interest cost
    
35
    
36
    
8
    
10
  
Expected return on plan assets
    
(52
)
  
(58
)
  
-
    
-
  
Net amortization -
                         
Prior service cost
    
4
    
4
    
(2
)
  
1
  
Net actuarial loss
    
3
    
2
    
2
    
2
  
Total net periodic cost
  
$
8
  
$
(2
)
$
10
  
$
14
  
                           
                           
 
 
11.
Earnings Per Share

The following tables set forth the computation of basic and diluted earnings per share from continuing operations for the three and six months ended June 30, 2005 and 2004. All options outstanding at June 30, 2005 were in-the-money, and therefore, the dilutive effect of such options is reflected in diluted earnings per share for the three and six months ended June 30, 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.

   
Three Months Ended June 30,
  
       
2005
          
2004
      
   
Income from
  
Weighted-
      
Income from
  
Weighted-
      
(In millions, except
  
Continuing
  
Average
  
Per-Share
  
Continuing
  
Average
  
Per-Share
  
per-share amounts)
  
Operations
  
Shares
  
Income
  
Operations
  
Shares
  
Income
  
                           
Basic earnings per share
  
$
372
    
141
  
$
2.64
  
$
114
    
104
  
$
1.11
  
Effect of dilutive securities:
                                      
5.25% convertible debentures
    
-
    
-
          
6
    
10
        
Restricted stock
    
-
    
1
          
-
    
1
        
Stock options
    
-
    
1
          
-
    
-
        
Diluted earnings per share
  
$
372
  
143
  
$
2.61
  
$
120
  
115
  
$
1.05
  


   
Six Months Ended June 30,
  
       
2005
          
2004