September 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 September 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 October 31, 2005: 115,992,412.
 




 
KERR-McGEE CORPORATION
 
     
 
INDEX
 
   
PAGE
PART I - FINANCIAL INFORMATION
 
     
Item 1. Financial Statements
 
 
   
 
Condensed Consolidated Statement of Income for the Three and Nine Months Ended September 30, 2005 and 2004
1
 
   
 
Condensed Consolidated Balance Sheet at September 30, 2005 and December 31, 2004
2
 
   
 
Condensed Consolidated Statement of Cash Flows for the Nine Months Ended September 30, 2005 and 2004
3
 
   
 
Condensed Consolidated Statement of Comprehensive Income (Loss) and Stockholders’ Equity for the Nine Months Ended September 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
42
 
 
 
Item 3. Quantitative and Qualitative Disclosures about Market Risk
66
 
 
 
Item 4. Controls and Procedures
70
     
Forward-Looking Information
70
   
   
PART II - OTHER INFORMATION
 
 
 
 
Item 1. Legal Proceedings
70
   
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
71
   
Item 6. Exhibits
71
 
 
 
SIGNATURE
72



 



PART I - FINANCIAL INFORMATION

Item 1. Financial Statements.

KERR-McGEE CORPORATION AND SUBSIDIARY COMPANIES
CONDENSED CONSOLIDATED STATEMENT OF INCOME
(UNAUDITED)
 
   
Three Months Ended
 
Nine Months Ended
 
   
September 30,
 
September 30,
 
(Millions of dollars, except per-share amounts)
 
2005
 
2004
 
2005
 
2004
 
                   
Revenues
 
$
1,208
 
$
1,203
 
$
4,152
 
$
3,006
 
                       
Costs and Expenses
                     
Costs and operating expenses
   
554
   
488
   
1,544
   
1,238
 
Selling, general and administrative expenses
   
104
   
81
   
302
   
231
 
Shipping and handling expenses
   
34
   
35
   
109
   
90
 
Depreciation and depletion
   
233
   
320
   
729
   
583
 
Accretion expense
   
6
   
5
   
17
   
13
 
Asset impairments
   
-
   
7
   
5
   
22
 
(Gain) loss on sale of assets
   
4
   
-
   
(42
)
 
7
 
Exploration, including dry holes and amortization
                         
of undeveloped leases
   
61
   
95
   
228
   
195
 
Taxes, other than income taxes
   
52
   
44
   
141
   
98
 
Provision for environmental remediation and restoration,
                         
net of reimbursements
   
7
   
72
   
33
   
75
 
Interest and debt expense
   
68
   
68
   
190
   
180
 
Loss on early repayment and modification of debt
   
9
   
-
   
9
   
-
 
Total Costs and Expenses
   
1,132
   
1,215
   
3,265
   
2,732
 
                           
     
76
   
(12
)
 
887
   
274
 
Other Income (Expense)
   
(3
)
 
(20
)
 
(16
)
 
(27
)
                           
Income (Loss) from Continuing Operations
                         
before Income Taxes
   
73
   
(32
)
 
871
   
247
 
Benefit (Provision) for Income Taxes
   
(19
)
 
8
   
(301
)
 
(89
)
                           
Income (Loss) from Continuing Operations
   
54
   
(24
)
 
570
   
158
 
Income from Discontinued Operations, net of taxes (Note 2)
   
306
   
31
   
515
   
112
 
                           
Net Income
 
$
360
 
$
7
 
$
1,085
 
$
270
 
                           
Income (Loss) per Common Share
                         
Basic -
                         
Continuing operations
 
$
.46
 
$
(.16
)
$
4.18
 
$
1.34
 
Discontinued operations
   
2.68
   
.21
   
3.77
   
.95
 
Net income
 
$
3.14
 
$
.05
 
$
7.95
 
$
2.29
 
                           
Diluted -
                         
Continuing operations
 
$
.46
 
$
(.16
)
$
4.09
 
$
1.33
 
Discontinued operations
   
2.63
   
.21
   
3.66
   
.94
 
Net income
 
$
3.09
 
$
.05
 
$
7.75
 
$
2.27
 
                           
Dividends Declared per Common Share
 
$
.05
 
$
.45
 
$
.55
 
$
1.35
 

 
The accompanying notes are an integral part of this statement.

- 1 -

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

   
September 30,
 
December 31,
 
(Millions of dollars)
 
2005
 
2004
 
   
 
 
 
 
ASSETS
 
Current Assets
           
Cash and cash equivalents (Note 2)
 
$
662
 
$
76
 
Accounts receivable
   
980
   
825
 
Inventories
   
339
   
314
 
Derivatives and other current assets
   
274
   
151
 
Deferred income taxes
   
714
   
327
 
Assets held for sale (Note 2)
   
295
   
194
 
Total Current Assets
   
3,264
   
1,887
 
               
Property, Plant and Equipment
   
15,331
   
14,806
 
Less reserves for depreciation, depletion and amortization
   
(6,199
)
 
(5,733
)
     
9,132
   
9,073
 
               
Investments, Derivatives and Other Assets
   
538
   
484
 
Goodwill and Other Intangible Assets
   
1,277
   
1,288
 
Assets Held for Sale (Note 2)
   
1,846
   
1,786
 
               
Total Assets
 
$
16,057
 
$
14,518
 

LIABILITIES AND STOCKHOLDERS' EQUITY
 
Current Liabilities
             
Accounts payable
 
$
623
 
$
607
 
Long-term debt due within one year
   
433
   
463
 
Income taxes payable
   
101
   
138
 
Derivative liabilities
   
2,219
   
350
 
Accrued liabilities
   
798
   
755
 
Liabilities associated with assets held for sale (Note 2)
   
491
   
192
 
Total Current Liabilities
   
4,665
   
2,505
 
               
Long-Term Debt
   
5,912
   
3,236
 
               
Noncurrent Liabilities
             
Deferred income taxes
   
1,552
   
1,727
 
Asset retirement obligations
   
324
   
336
 
Derivative liabilities
   
977
   
208
 
Other
   
595
   
571
 
Liabilities associated with assets held for sale (Note 2)
   
689
   
617
 
Total Noncurrent Liabilities
   
4,137
   
3,459
 
               
Contingencies and Commitments (Notes 16 and 17)
             
               
Stockholders' Equity
             
Common stock, par value $1 - 500,000,000 and 300,000,000 shares
             
authorized, 119,351,451 and 152,049,127 shares issued at
             
September 30, 2005 and December 31, 2004, respectively
   
119
   
152
 
Capital in excess of par value
   
3,635
   
4,205
 
Preferred stock purchase rights
   
1
   
2
 
Retained earnings (accumulated deficit)
   
(416
)
 
1,102
 
Accumulated other comprehensive loss
   
(1,677
)
 
(79
)
Common shares in treasury, at cost - 3,371,782 and 159,856 shares
             
at September 30, 2005 and December 31, 2004, respectively
   
(262
)
 
(8
)
Deferred compensation
   
(57
)
 
(56
)
Total Stockholders' Equity
   
1,343
   
5,318
 
               
Total Liabilities and Stockholders’ Equity
 
$
16,057
 
$
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)


   
Nine Months Ended
 
   
September 30,
 
(Millions of dollars)
 
2005
 
2004
 
   
 
     
Cash Flows from Operating Activities
           
Net income
 
$
1,085
 
$
270
 
Adjustments to reconcile net income to net cash
             
provided by operating activities -
             
Depreciation, depletion and amortization
   
908
   
785
 
Deferred income taxes
   
179
   
86
 
Dry hole expense
   
125
   
80
 
Asset impairments
   
5
   
22
 
Gain on sale of North Sea oil and gas assets
   
(306
)
 
-
 
(Gain) loss on sale of other assets
   
(42
)
 
7
 
Loss on early repayment and modification of debt
   
9
   
-
 
Accretion expense
   
24
   
22
 
Provision for environmental remediation and restoration,
             
net of reimbursements
   
44
   
81
 
Other noncash items affecting net income
   
497
   
165
 
Changes in assets and liabilities
   
(27
)
 
(191
)
Net Cash Provided by Operating Activities
   
2,501
   
1,327
 
               
Cash Flows from Investing Activities
             
Capital expenditures
   
(1,292
)
 
(832
)
Dry hole costs
   
(118
)
 
(46
)
Acquisitions, net of cash acquired (1)
   
-
   
43
 
Proceeds from sale of North Sea oil and gas assets
   
547
   
-
 
Proceeds from sale of other assets
   
68
   
11
 
Proceeds from sale of investments
   
-
   
39
 
Other investing activities
   
(7
)
 
(31
)
Net Cash Used in Investing Activities
   
(802
)
 
(816
)
               
Cash Flows from Financing Activities
             
Issuance of common stock
   
206
   
34
 
Purchases of treasury stock
   
(250
)
 
-
 
Shares repurchased under the tender offer
   
(3,975
)
 
-
 
Dividends paid
   
(148
)
 
(137
)
Repayment of debt
   
(998
)
 
(1,278
)
Proceeds from borrowings
   
4,250
   
906
 
Costs of obtaining financing
   
(58
)
 
(6
)
Cash paid for modification of debt
   
(9
)
 
-
 
Settlement of Westport derivatives
   
(134
)
 
(45
)
Net Cash Used in Financing Activities
   
(1,116
)
 
(526
)
               
Effects of Exchange Rate Changes on Cash and Cash Equivalents
   
3
   
1
 
Net Increase (Decrease) in Cash and Cash Equivalents
   
586
   
(14
)
Cash and Cash Equivalents at Beginning of Period
   
76
   
142
 
Cash and Cash Equivalents at End of Period
 
$
662
 
$
128
 

(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 (LOSS) 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 Loss:
                                           
Net income
   
-
   
-
   
270
   
-
   
-
   
-
   
270
 
Other comprehensive loss
   
-
   
-
   
-
   
(345
)
 
-
   
-
   
(345
)
Comprehensive loss
                                       
(75
)
Westport merger
   
49
   
2,402
   
-
   
-
   
-
   
(3
)
 
2,448
 
Exercise of stock options
   
2
   
33
   
-
   
-
   
-
   
-
   
35
 
Restricted stock activity
   
-
   
24
   
-
   
-
   
(6
)
 
(9
)
 
9
 
ESOP deferred compensation
   
-
   
-
   
-
   
-
   
-
   
5
   
5
 
Tax benefit from stock-based awards
   
-
   
15
   
-
   
-
   
-
   
-
   
15
 
Dividends declared ($1.35 per share)
   
-
   
-
   
(160
)
 
-
   
-
   
-
   
(160
)
Balance at September 30, 2004
 
$
152
 
$
4,182
 
$
1,037
 
$
(390
)
$
(8
)
$
(60
)
$
4,913
 
                                             
Balance at December 31, 2004
 
$
152
 
$
4,205
 
$
1,102
 
$
(79
)
$
(8
)
$
(54
)
$
5,318
 
Comprehensive Loss:
                                           
Net income
   
-
   
-
   
1,085
   
-
   
-
   
-
   
1,085
 
Other comprehensive loss
   
-
   
-
   
-
   
(1,598
)
 
-
   
-
   
(1,598
)
Comprehensive loss
                                       
(513
)
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
   
203
   
-
   
-
   
-
   
-
   
206
 
Restricted stock activity
   
1
   
25
   
-
   
-
   
(4
)
 
(7
)
 
15
 
ESOP deferred compensation
   
-
   
-
   
-
   
-
   
-
   
6
   
6
 
Tax benefit from stock-based awards
   
-
   
29
   
-
   
-
   
-
   
-
   
29
 
Dividends declared ($.55 per share)
   
-
   
-
   
(86
)
 
-
   
-
   
-
   
(86
)
Balance at September 30, 2005
 
$
119
 
$
3,635
 
$
(416
)
$
(1,677
)
$
(262
)
$
(56
)
$
1,343
 
                                             







 



The accompanying notes are an integral part of this statement.

- 4 -


KERR-McGEE CORPORATION AND SUBSIDIARY COMPANIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 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 and Trinidad. 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 terms “Kerr-McGee,”“the company,”“we,”“our,” and similar terms are used interchangeably in these condensed consolidated financial statements to refer to the consolidated group or to one or more of the companies that are part of the consolidated group.

In 2005, the company has 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. The company’s strategic plan includes the separation of the chemical business and divestitures of certain oil and gas assets. These transactions are expected to result in aggregate net cash proceeds of approximately $4.4 billion by the end of 2005, which will be used for debt reduction and other corporate purposes.

·  
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. In October 2005, the company completed its evaluation and the Board approved the separation of the chemical business through an initial public offering (IPO), followed by a distribution of Kerr-McGee’s remaining ownership in the chemical business subsidiary to Kerr-McGee’s stockholders through a spinoff, splitoff or a combination of these transactions, planned for 2006. Note 3 provides additional information about the IPO.

·  
In April 2005, the company announced its decision to divest lower-growth or shorter-life and higher-decline oil and gas properties. In connection with the divestiture program, in August 2005, the company entered into agreements to sell its North Sea oil and gas business for aggregate cash proceeds of $3.5 billion. Additionally, in October 2005, the company entered into agreements to divest certain noncore oil and gas properties onshore in the United States. Information about these transactions is provided in Note 2. Other selected oil and gas properties in the U.S. are also being considered for divestiture. The total combined divestitures may represent up to 30% of the company’s proved reserves at December 31, 2004, and up to 35% of its average daily production for the first nine 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.

·  
In March 2005, 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.

·  
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 15 provides additional information regarding this transaction. The tender offer was financed with the net proceeds of borrowings, which are discussed in Note 10, and cash on hand.

- 5 -

·  
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 July 2005 dividend payment, the annual dividend was reduced from $1.80 to $.20 per share.

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. Income from discontinued operations in the accompanying Condensed Consolidated Statement of Income for all periods presented relates to the company’s North Sea oil and gas business and former forest products operations. Note 2 provides additional information with respect to discontinued operations.

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
 
Nine Months Ended
 
   
September 30,
 
September 30,
 
(Millions of dollars, except per-share amounts)
 
2005
 
2004
 
2005
 
2004
 
                   
Net income, as reported
 
$
360
 
$
7
 
$
1,085
 
$
270
 
Add: stock-based employee compensation expense
                         
included in reported net income, net of taxes
   
7
   
4
   
20
   
10
 
Deduct: stock-based compensation expense determined
                         
using a fair-value method, net of taxes
   
(10
)
 
(7
)
 
(32
)
 
(20
)
Pro forma net income
 
$
357
 
$
4
 
$
1,073
 
$
260
 
                       
Net income per share -
                         
Basic -
                         
As reported
 
$
3.14
 
$
.05
 
$
7.95
 
$
2.29
 
Pro forma
   
3.13
   
.03
   
7.86
   
2.20
 
                           
Diluted -
                         
As reported
 
$
3.09
 
$
.05
 
$
7.75
 
$
2.27
 
Pro forma
   
3.07
   
.03
   
7.67
   
2.19
 


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
           

New/Revised Accounting Standards - In December 2004, the Financial Accounting Standards Board (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 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. The company is evaluating the effect of implementation on its results of operations.

In March 2005, the FASB issued FASB Interpretation No. 47, “Accounting for Conditional Asset Retirement Obligations” (FIN No. 47), to clarify that an entity must recognize a liability for the fair value of a conditional asset retirement obligation when incurred, if the liability’s fair value can be reasonably estimated. Conditional asset retirement obligations under this pronouncement are legal obligations to perform asset retirement activities when the timing and/or method of settlement are conditional on a future event or may not be within the control of the entity. FIN No. 47 also provides additional guidance for evaluating whether sufficient information to reasonably estimate the fair value of an asset retirement obligation is available. FIN No. 47 is effective for the company as of December 31, 2005. The company is evaluating the effect of implementation and at this time does not expect it to have a material effect on its financial statements.


- 7 -


 
In April 2005, the FASB issued a FASB Staff Position FAS 19-1, "Accounting for Suspended Well Costs" (FSP FAS 19-1) which amends FASB Statement No. 19, "Financial Accounting and Reporting by Oil and Gas Producing Companies." FSP FAS 19-1 requires the continued capitalization of drilling costs if the well has found a sufficient quantity of reserves to justify its completion as a producing well and the enterprise is making sufficient progress assessing the reserves and the economic and operating viability of the project. The FSP provides a number of indicators that can assist an entity in evaluating whether sufficient progress is being made in assessing the reserves and economic viability of the project and includes new disclosure requirements with respect to capitalized exploratory drilling costs. The company adopted FSP FAS 19-1 effective July 1, 2005. The adoption had no effect on the company's financial statements. Disclosures required by the FSP were provided in the notes to the consolidated financial statements included in the company's latest annual report on Form 10-K.
 
 
2.
Discontinued Operations and Assets Held for Sale

Overview - As discussed in Note 1, in 2005, the company made a number of strategic decisions with the goal of repositioning Kerr-McGee as a pure-play exploration and production company and enhancing value for its stockholders. The company’s strategic plan includes the separation of the chemical business and divestitures of certain lower-growth or shorter-life and higher-decline oil and gas assets, including the company’s North Sea oil and gas business and selected oil and gas properties in the U.S. At the same time, the company is accelerating its U.S. onshore development activities, with a focus on the Wattenberg and Greater Natural Buttes areas. Management believes this strategy will result in an asset base weighted toward longer-life, less capital-intensive properties that will provide greater stability of production and production replacement, while the company’s exploration program in the deepwater Gulf of Mexico, Alaska, Brazil, China, Trinidad and other areas will continue to provide growth opportunities.

The following summarizes divestiture transactions completed or which the company expects to complete in the fourth quarter. In addition, as discussed in Note 3, the company expects to realize net proceeds of $800 million to $900 million from the pending separation of its chemical business. The company intends to use net proceeds from the divestitures and the separation of the chemical business for debt repayment and other corporate purposes. Debt repayments made during the third and fourth quarters of 2005 in connection with completed transactions are discussed in Note 10.

(Millions of dollars)
 
Gross Proceeds
 
Completed Divestiture Transactions -
     
September
Nonoperated North Sea fields
 
$ 554
(1)
November
Nonoperating interest in gas processing facility
 
156
 
         
Expected Divestiture Transactions -
     
Fourth quarter
Remaining oil and gas operations in the North Sea
 
$2,950
(2)
Fourth quarter
Selected oil and gas properties onshore in the U.S.
 
476
(2)

(1)  
Includes $7 million of proceeds expected to be released from escrow in the fourth quarter and net of cash on hand of $4 million acquired by the purchaser at closing.
 
(2)  
Represents expected cash proceeds before considering working capital, interest or other adjustments.

Discontinued Operations - Income from discontinued operations in the Condensed Consolidated Statement of Income relates primarily to the company’s North Sea oil and gas business, but also includes losses from the former forest products operations, which the company exited in the fourth quarter of 2004.


- 8 -

The following summarizes the amounts included in income from discontinued operations for all periods presented:

   
Three Months Ended September 30,
 
   
2005
 
2004
 
   
North Sea
 
Forest
     
North Sea
 
Forest
     
   
Oil and Gas
 
Products
     
Oil and Gas
 
Products
     
(Millions of dollars) 
 
Business
 
Business
 
Total
 
Business
 
Business
 
Total
 
                           
Revenues
 
$
285
 
$
-
 
$
285
 
$
159
 
$
5
 
$
164
 
                                       
Income from Discontinued Operations:
                                     
Income (loss) from operations
 
$
157
 
$
-
 
$
157
 
$
59
 
$
(5
)
$
54
 
Gain on sale
   
306
   
-
   
306
   
-
   
-
   
-
 
Adjustments for contingencies (1)
   
-
   
(14
)
 
(14
)
 
-
   
-
   
-
 
Pretax income (loss) from discontinued
                                     
operations
   
463
   
(14
)
 
449
   
59
   
(5
)
 
54
 
Income tax (expense) benefit
   
(148
)
 
5
   
(143
)
 
(25
)
 
2
   
(23
)
Income (loss) from discontinued operations,
                                     
net of tax
 
$
315
 
$
(9
)
$
306
 
$
34
 
$
(3
)
$
31
 

   
Nine Months Ended September 30,
 
   
2005
 
2004
 
   
North Sea
 
Forest
     
North Sea
 
Forest
     
   
Oil and Gas
 
Products
     
Oil and Gas
 
Products
     
(Millions of dollars) 
 
Business
 
Business
 
Total
 
Business
 
Business
 
Total
 
                           
Revenues
 
$
908
 
$
-
 
$
908
 
$
555
 
$
18
 
$
573
 
                                       
Income from Discontinued Operations:
                                     
Income (loss) from operations
 
$
500
 
$
-
 
$
500
 
$
212
 
$
(14
)
$
198
 
Gain (loss) on sale
   
306
   
(1
)
 
305
   
-
   
-
   
-
 
Adjustments for contingencies (1)
   
-
   
(16
)
 
(16
)
 
-
   
-
   
-
 
Pretax income (loss) from discontinued
                                     
operations
   
806
   
(17
)
 
789
   
212
   
(14
)
 
198
 
Income tax (expense) benefit
   
(280
)
 
6
   
(274
)
 
(91
)
 
5
   
(86
)
Income (loss) from discontinued operations,
                                     
net of tax
 
$
526
 
$
(11
)
$
515
 
$
121
 
$
(9
)
$
112
 

(1)
These adjustments represent provisions for environmental remediation and restoration and other contingencies incurred subsequent to the exit of the forest products business.

As discussed in Note 10, the company is required to use 100% of the net after-tax cash proceeds from sales of certain assets for debt repayment. Because the North Sea oil and gas assets are subject to this requirement, interest expense on debt that is required to be repaid upon their sale is classified as a component of income from discontinued operations. For the three and nine months ended September 30, 2005, pretax interest expense so classified totaled $49 million and $67 million, respectively. These amounts represent interest expense on approximately $3 billion of the company’s obligations under the term loans described in Note 10 expected to be repaid upon completing the North Sea divestiture transactions. Interest expense was allocated to discontinued operations beginning in May 2005, to coincide with initial borrowings under the term loans requiring mandatory prepayments.

In connection with classifying the North Sea oil and gas business as held for sale, the company recognized certain provisions for income taxes on unremitted foreign earnings. Discussion of tax effects is provided in Note 9.
- 9 -


North Sea Oil and Gas Business - In August 2005, the company entered into agreements to sell its North Sea oil and gas business for cash consideration of approximately $3.5 billion. The North Sea business included proved reserves of approximately 242 million barrels of oil equivalent at December 31, 2004, and produced a daily average of 76 thousand barrels of oil equivalent during the first nine months of 2005, representing approximately 21% of the company’s production. The two-step transaction pursuant to the agreements includes:

·  
The sale of the company’s interests in four nonoperated fields and related exploratory acreage and facilities in the North Sea, which was completed on September 30, 2005, and

·  
The sale of all remaining North Sea operations through the sale of the stock of Kerr-McGee (G.B.) Ltd., the company’s wholly-owned subsidiary, and other affiliated entities, which is expected to close in November 2005.

The following summarizes assets and liabilities of the North Sea oil and gas business and their classification in the accompanying Condensed Consolidated Balance Sheet. Additionally, at September 30, 2005, a net after-tax loss of $171 million associated with cash flow hedges of the North Sea business was included in equity, as a component of accumulated other comprehensive loss. Upon the sale of Kerr-McGee (G.B.) Ltd., unrealized losses on these instruments, which will be assumed by the buyer, will be recognized in income from discontinued operations, as a component of gain on sale.

   
September 30,
 
December 31,
 
(Millions of dollars)
 
2005
 
2004
 
           
Cash and Cash Equivalents (1)
 
$
447
 
$
14
 
Current Assets
   
295
   
195
 
Long-Term Assets
   
1,535
   
1,778
 
Current Liabilities
   
(490
)
 
(192
)
Noncurrent Liabilities
   
(680
)
 
(616
)
Net Investment
 
$
1,107
 
$
1,179
 
               

(1)  
Of the total cash and cash equivalents of the North Sea business at September 30, 2005, approximately $330 million represents proceeds from the third-quarter asset sales that were not repatriated to the U.S. This amount will be received as additional consideration upon the sale of Kerr-McGee (G.B.) Ltd.

Forest Products Business - During 2002, the company approved a plan to exit its forest products business, which was part of the chemical - other operating unit. At that time, five plants were in operation. Four of these plants were closed and abandoned during 2003. The fifth plant, a leased facility, was operated throughout 2004 until the lease expired and the fixed assets at the facility were sold in January 2005. Criteria for classification of these assets as held for sale were met in the fourth quarter of 2004, at which time the results of the forest products operations met the requirements for reporting as discontinued operations. The carrying value of assets of discontinued forest products operations was $3 million at December 31, 2004, and is included in assets held for sale in the accompanying Condensed Consolidated Balance Sheet. Proceeds from the sale approximated the carrying value of the assets. As discussed in Note 16, the company retained obligations for environmental remediation and restoration at several wood-treating sites and other contingencies. Charges associated with such retained obligations have been incurred subsequent to the exit of the forest products business as a result of changes in estimates of remediation and restoration costs.

Assets Held for Sale - In addition to assets and liabilities of discontinued operations discussed above, assets held for sale at September 30, 2005 include the carrying value of certain U.S. onshore oil and gas properties, as well as the company’s nonoperating interest in the Javelina gas processing and fractionation facility. Based on the estimated fair value less cost to sell in relation to the carrying value, a loss of $6 million was recognized in the third quarter of 2005 for one U.S. onshore divestiture package. All other assets held for sale are expected to result in gains upon disposition.



- 10 -


3.
Pending Separation of Tronox Incorporated

In October 2005, the Board approved the separation of the chemical business through an IPO of shares of Class A common stock of the company’s wholly-owned subsidiary, Tronox Incorporated (Tronox). An amended registration statement was filed with the SEC relating to the proposed IPO, and is currently under review by the SEC.  Assuming the review is completed and the registration statement is declared effective by the SEC, the company expects to complete the IPO in the fourth quarter of 2005. Following the IPO, the company will continue to hold a controlling interest in Tronox through ownership of Tronox’s Class B common stock. The company expects to distribute those shares to its stockholders during 2006 through a spinoff, splitoff or a combination of those transactions (Distribution). It is expected that Tronox will be included in the company’s consolidated financial statements through the Distribution date. The Distribution is subject to certain conditions, including receipt of a favorable tax opinion, necessary regulatory approvals and approval by the company’s Board of Directors of the final form, structure and other terms of any transaction to effect the Distribution.

Prior to the completion of the IPO, the company will transfer subsidiaries that conduct Kerr-McGee’s chemical business to Tronox. Some of these subsidiaries previously were engaged in the production of ammonium perchlorate, the manufacturing of thorium, treatment of forest products, the refining and marketing of petroleum products, the mining, milling and processing of nuclear materials and other businesses. These subsidiaries are subject to environmental obligations associated with their current and former operations. Additional discussion regarding environmental obligations is provided below.

Historically, employees of the company’s chemical business participated in stock-based compensation, pension and postretirement plans established by Kerr-McGee. It is expected that in connection with the IPO, Tronox will issue stock-based awards to certain of its employees and non-management directors, while unvested Kerr-McGee stock options and restricted stock held by employees of Tronox will be converted to Tronox stock-based awards on the effective date of the Distribution. Tronox is also expected to establish pension and postretirement plans for its U.S. employees and assume the benefit obligations associated with its current and former employees following the Distribution. The anticipated effects of the separation on the company’s obligations for employee compensation and benefits are more fully discussed below.

It is expected that concurrent with the IPO, Tronox, through its wholly-owned subsidiary, will issue $350 million of unsecured notes in a private offering and will borrow $200 million in term loans. The net proceeds from these borrowings and from the offering of Tronox Class A common stock are expected to be $800 million to $900 million and will be distributed to Kerr-McGee. Any debt incurred by Tronox will affect the consolidated financial statements of Kerr-McGee until Tronox is no longer consolidated by the company.

Obligations for Environmental Remediation - Tronox and its subsidiaries will be subject to obligations for environmental remediation and restoration associated with the chemical business currently in operation, as well as with former operations described above. The carrying value of liabilities associated with such operations is $239 million as of September 30, 2005. Tronox and its subsidiaries also are expected to have contingent obligations of such current and former operations for which no liability is recognized as of September 30, 2005 because the loss is not considered probable or is not estimable. Discussion of the company’s material environmental obligations and other contingencies is provided in Note 16.

Upon completion of the IPO, Kerr-McGee is expected to agree to reimburse Tronox for a portion of the environmental costs incurred and paid by Tronox and its subsidiaries during the seven-year period following the IPO, to the extent such costs, net of any reimbursements received from insurers or other parties, exceed the carrying value of reserves at the time of the IPO. The reimbursement obligation extends to costs incurred at any site associated with any of the former businesses and operations of Tronox and is limited to a maximum aggregate reimbursement of $100 million for all covered sites. The company’s reimbursement obligation will be reflected in its Consolidated Balance Sheet at its estimated fair value at the time of origination. The estimated fair value will be determined considering expected cash outflows pursuant to the reimbursement obligation, their timing and probability of payment.


- 11 -


Pension and Postretirement Obligations - As discussed above, it is anticipated that Tronox will establish its own retirement and postretirement benefit plans for its current and former employees in the U.S. and assume the related benefit obligations. As of September 30, 2005, Kerr-McGee's Condensed Consolidated Balance Sheet included a prepaid pension cost associated with its U.S. qualified retirement plan of $239 million and a liability associated with the postretirement benefit plan of $231 million. It is estimated that upon completion of the Distribution, Kerr-McGee will transfer to Tronox approximately 40% of its pension benefit obligation as of that date. Kerr-McGee will also transfer trust assets to the newly established Tronox plan necessary to fund the transferred obligation in compliance with applicable regulatory requirements. It is also expected that approximately half of the benefit obligation associated with the U.S. postretirement plan, which is unfunded, will be transferred to Tronox following the Distribution. Actual values of the benefit obligation and associated plan assets transferred to Tronox will be determined at the time of the Distribution and will depend on the level of retirement plan assets, interest rates and other factors relevant to the measurement of the benefit obligation and determination of asset values to be transferred.

Stock-Based Awards - It is expected that the terms of the employee benefits agreement between Kerr-McGee and Tronox will provide that Tronox employees will have the right to exercise their vested Kerr-McGee stock options in accordance with the original terms of the awards. All unvested Kerr-McGee stock options held by Tronox employees on the effective date of the Distribution will be converted into options to purchase Tronox Class A common stock. The converted options will have the same terms and conditions, including the same vesting provisions and exercise periods, as the unvested Kerr-McGee stock options immediately prior to their conversion. The number of shares and exercise price of each Kerr-McGee stock option will be adjusted so that each Tronox option will have the same ratio of the exercise price per share to the market value per share and the same aggregate difference between market value and exercise price as the Kerr-McGee options prior to conversion. All shares of Kerr-McGee restricted stock held by Tronox employees on the effective date of the Distribution will be converted into restricted shares of Tronox Class A common stock with the same terms and conditions, except that the number of shares covered by the awards will be adjusted as specified in the employee benefits agreement. Based on the number of Kerr-McGee stock options and restricted stock held at September 30, 2005 by the company’s employees that are or are expected to become employees of Tronox, the company estimates that approximately 84,000 restricted shares of Kerr-McGee common stock and approximately 167,000 stock options will be unvested as of the date of the Distribution and will be converted into Tronox awards as described above. The conversion ratio will be determined on the effective date of the Distribution based on the relative values of Kerr-McGee common stock and Tronox Class A common stock.

As long as Tronox is included in the company’s consolidated financial statements, potentially issuable shares of Tronox common stock will continue to affect the company’s diluted earnings per share.


4.
Comprehensive Loss

Comprehensive loss for the three and nine months ended September 30, 2005 and 2004, is as follows:

   
Three Months Ended
 
Nine Months Ended
 
   
September 30,
 
September 30,
 
(Millions of dollars)
 
2005
 
2004
 
2005
 
2004
 
                   
Net income
 
$
360
 
$
7
 
$
1,085
 
$
270
 
After-tax changes in:
                         
Loss on cash flow hedges
   
(1,022
)
 
(159
)
 
(1,570
)
 
(344
)
Foreign currency translation adjustments
   
(14
)
 
7
   
(28
)
 
(3
)
Reclassification of foreign currency translation
                         
losses
   
-
   
7
   
-
   
7
 
Reclassification of unrealized gain on
                         
available-for-sale securities
   
-
   
-
   
-
   
(5
)
Comprehensive loss
 
$
(676
)
$
(138
)
$
(513
)
$
(75
)



- 12 -

 
5.
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 and with positions in excess of expected physical deliveries are recognized in current earnings as a component of revenues.

For the three- and nine-month periods ended September 30, 2005, as a result of significantly increased commodity prices and widening natural gas basis differentials, the company recognized losses on hedge ineffectiveness of $212 million and $256 million, respectively, associated with its commodity derivative instruments designated as hedges of future oil and gas sales. These losses represent the excess of mark-to-market losses on the company’s commodity derivatives over the higher cash flows expected to be realized upon sales of hedged production.

As a result of two major hurricanes in the Gulf of Mexico late in the third quarter of 2005, the company’s physical deliveries to certain Gulf of Mexico sales indices for the fourth quarter of 2005 are expected to be insufficient to cover the associated derivative contracts in place. Consequently, the company recognized an unrealized loss of $103 million in the third quarter associated with certain fourth-quarter 2005 derivative contracts assigned to hedge cash flows from sales of Gulf of Mexico natural gas production, although total U.S. natural gas production in the fourth quarter is still expected to exceed volumes covered by hedge instruments. Additionally, realized losses of $22 million associated with September derivative contracts in excess of hedged physical deliveries for that month are reported as overhedge derivative loss in revenues. The company believes that it is probable that by January 2006 deliveries in the Gulf of Mexico will resume in sufficient volumes to match its remaining 2006 and 2007 derivative contracts.

At September 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 $1.1 billion of the total net after-tax derivative loss from accumulated other comprehensive loss to earnings during the next 12 months, assuming no further changes in the fair value of the related contracts. This excludes $171 million of net after-tax losses associated with derivatives of our North Sea oil and gas business which will be recognized in income from discontinued operations, as a component of gain on sale, in connection with the expected completion of the divestiture transactions in November 2005.

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 help mitigate 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 September 30, 2005 was a liability of $130 million.


- 13 -


The following tables summarize the balance sheet presentation of the company’s derivatives and the related cash collateral held by counterparties as of September 30, 2005 and December 31, 2004. Derivative assets and liabilities associated with the company’s North Sea oil and gas business, which will be assumed by the buyer at closing, are included in assets and liabilities held for sale in the Condensed Consolidated Balance Sheet.


   
As of September 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
 
$
154
 
$
36
 
$
(2,006
)
$
(959
)
$
(1,532
)
Acquired Westport positions
   
2
   
-
   
(184
)
 
(15
)
 
(29
)
Cash collateral
   
2
   
-
   
-
   
-
   
-
 
Gas marketing-related derivatives
   
23
   
1
   
(23
)
 
(1
)
 
-
 
Foreign currency forward contracts
   
1
   
-
   
-
   
-
   
1
 
Interest rate swaps
   
2
   
-
   
(6
)
 
(2
)
 
-
 
Other derivatives
   
5
   
-
   
-
   
-
   
4
 
Total - continuing operations
   
189
   
37
   
(2,219
)
 
(977
)
 
(1,556
)
North Sea oil and gas business
   
28
   
-
   
(184
)
 
(145
)
 
(171
)
Total derivative contracts
 
$
217
 
$
37
 
$
(2,403
)
$
(1,122
)
$
(1,727
)


   
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
 
$
41
 
$
12
 
$
(213
)
$
(188
)
$
(174
)
Acquired Westport positions
   
1
   
1
   
(123
)
 
(16
)
 
(7
)
Gas marketing-related derivatives
   
6
   
2
   
(6
)
 
(2
)
 
-
 
Foreign currency forward contracts
   
(2
)
 
-
   
(6
)
 
-
   
(2
)
Interest rate swaps
   
4
   
-
   
(1
)
 
(2
)
 
-
 
Other derivatives
   
3
   
-
   
(1
)
 
-
   
1
 
Total - continuing operations
   
53
   
15
   
(350
)
 
(208
)
 
(182
)
North Sea oil and gas business
   
35
   
-
   
(22
)
 
-
   
25
 
Total derivative contracts
 
$
88
 
$
15
 
$
(372
)
$
(208
)
$
(157
)

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


- 14 -


The following tables summarize the income statement classification of gain (loss) on derivative instruments associated with continuing operations for the three- and nine-month periods ended September 30, 2005 and 2004:

   
Three Months Ended
 
Three Months Ended
 
   
September 30, 2005
 
September 30, 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
 
$
(180
)
$
-
 
$
-
 
$
(132
)
$
-
 
$
-
 
   Foreign currency contracts
   
1
   
-
   
-
   
-
   
2
   
-
 
   Interest rate swaps
   
-
   
(2
)
 
-
   
-
   
4
   
-
 
   Other derivatives
   
-
   
3
   
-
   
-
   
-
   
-
 
   Gain (loss) on hedge ineffectiveness
   
(212
)
 
-
   
-
   
3
   
-
   
-
 
Total hedging contracts
   
(391
)
 
1
   
-
   
(129
)
 
6
   
-
 
                                     
Nonhedge Activity:
                                   
   Oil and gas commodity derivatives -
                                     
Kerr-McGee positions
   
48
   
-
   
-
   
-
   
-
   
1
 
Acquired Westport positions
   
(77
)
 
-
   
-
   
(42
)
 
-
   
-
 
Overhedge derivative loss
   
(125
)
 
-
   
-
   
-
   
-
   
-
 
Gas marketing-related derivatives
   
1
   
-
   
-
   
1
   
-
   
-
 
DECS call option (1)
   
-
   
-
   
-
   
-
   
-
   
(29
)
Other derivatives
   
-
   
-
   
1
   
-
   
-
   
-
 
   Total nonhedge contracts
   
(153
)
 
-
   
1
   
(41
)
 
-
   
(28
)
                                       
   Total derivative contracts
 
$
(544
)
$
1
 
$
1
 
$
(170
)
$
6
 
$
(28
)


   
Nine Months Ended
 
Nine Months Ended
 
   
September 30, 2005
 
September 30, 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
 
$
(265
)
$
-
 
$
-
 
$
(283
)
$
-
 
$
-
 
   Foreign currency contracts
   
-
   
(4
)
 
-
   
-
   
7
   
-
 
   Interest rate swaps
   
-
   
(2
)
 
-
   
-
   
13
   
-
 
   Other derivatives
   
-
   
4
   
-
   
-
   
1
   
-
 
   Gain (loss) on hedge ineffectiveness
   
(256
)
 
-
   
-
   
2
   
-
   
-
 
Total hedging contracts
   
(521
)
 
(2
)
 
-
   
(281
)
 
21
   
-
 
                                       
Nonhedge Activity:
                                     
   Oil and gas commodity derivatives -
                                     
Kerr-McGee positions
   
62
   
-
   
-
   
(10
)
 
-
   
3
 
Acquired Westport positions
   
(130
)
 
-
   
-
   
(27
)
 
-
   
-
 
Overhedge derivative loss
   
(125
)
 
-
   
-
   
-
   
-
   
-
 
Gas marketing-related derivatives
   
5
   
-
   
-
   
5
   
-
   
(1
)
DECS call option (1) 
   
-
   
-
   
-
   
-
   
-
   
(101
)
Other derivatives
   
-
   
-
   
2
   
-
   
-
   
(1
)
   Total nonhedge contracts
   
(188
)
 
-
   
2
   
(32
)
 
-
   
(100
)
                                       
   Total derivative contracts
 
$
(709
)
$
(2
)
$
2
 
$
(313
)
$
21
 
$
(100
)

 
(1)
Other income (expense) for the three- and nine-month periods ended September 30, 2004 also includes unrealized gains on Devon Energy Corporation common stock of $29 million and $103 million, respectively.


- 15 -

6.
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.

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 in accordance with its terms, the company entered into an agreement to terminate the program by repurchasing the then outstanding balance of receivables sold of $165 million. Repurchased accounts receivable have subsequently been collected by the company.

In 2005, while the program was in effect, the company sold $384 million of pigment receivables.  During the three and nine months ended September 30, 2004, the company sold $297 million and $838 million, respectively, of its pigment accounts receivable. Losses on sales of accounts receivable are included in other income (expense) and are not material for all periods presented.


7.
Inventories

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

   
September 30,
 
December 31,
 
(Millions of dollars)
 
2005
 
2004
 
           
Chemicals and other products
 
$
249
 
$
236
 
Materials and supplies
   
84
   
71
 
Crude oil and natural gas liquids
   
6
   
7
 
Total
 
$
339
 
$
314
 


8.
Asset Exchanges and Exploratory Drilling Costs

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 area and $27 million in cash. The company recognized a gain of $25 million in connection with this transaction.


- 16 -


Exploratory Drilling Costs - At September 30, 2005, the company had capitalized exploratory drilling costs of approximately $224 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.  Capitalized exploratory well costs have increased by $88 million from December 31, 2004 primarily due to additional exploration activities in the Gulf of Mexico ($49 million), Alaska ($44 million) and Brazil ($18 million) partially offset by successful exploration costs in China that were reclassified to proved oil and gas properties.


9.
Income Taxes

The American Jobs Creation Act of 2004 - 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. During the second quarter of 2005, the company repatriated $200 million under the provisions of the Act and recognized income tax expense of $12 million. During the third quarter of 2005, an additional $21 million of foreign earnings were repatriated. However, the company reduced its provision for income taxes for repatriation of dividends under the provisions of the Act by $4 million, reflecting a change in the company’s expected utilization of foreign tax credits. The company may repatriate up to an additional $279 million in extraordinary dividends under the provisions of the Act. Pending completion of the divestiture of the company’s North Sea operations, management has not yet decided whether, and to what extent, additional amounts of foreign earnings will be repatriated, but will make this determination in the fourth quarter of 2005. Accordingly, the accompanying financial statements do not reflect any additional provision for taxes on unremitted foreign earnings that may be repatriated under the provisions of the Act. If the company decides to repatriate up to an additional $279 million as discussed above, additional income tax expense of up to $15 million may be recognized in the fourth quarter.

Income Tax, Continuing Operations - The effective tax rate for income from continuing operations for the three and nine months ended September 30, 2005 is 26% and 35%, respectively. Excluding the effect of the income tax provision for repatriation of foreign earnings under the Act discussed above and a $1 million tax benefit resulting from a change in estimated income tax obligations for 2004, the effective tax rate on income from continuing operations is 33% and 34% for the three and nine months ended September 30, 2005, respectively. The company expects that the effective tax rate for income from continuing operations for the full year 2005 will be approximately 35%.

Income Tax, Discontinued Operations </