Edgar Filing: KERR MCGEE CORP /DE

March 2006 10Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-Q

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended March 31, 2006

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 a large accelerated filer, an accelerated filer, or a non-accelerated filer.

Large Accelerated Filer x Accelerated Filer o Non-Accelerated Filer o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No x

Number of shares of common stock, $1.00 par value, outstanding as of April 30, 2006: 113,503,806.

	KERR-McGEE CORPORATION

	INDEX
		PAGE
PART I - FINANCIAL INFORMATION

Item 1. Financial Statements (Unaudited)

	Condensed Consolidated Statement of Income for the Three Months Ended March 31, 2006 and 2005	1

	Condensed Consolidated Balance Sheet at March 31, 2006 and December 31, 2005	2

	Condensed Consolidated Statement of Cash Flows for the Three Months Ended March 31, 2006 and 2005	3

	Condensed Consolidated Statement of Comprehensive Income (Loss) and Stockholders’ Equity for the Three Months Ended March 31, 2006 and 2005	4

	Notes to Condensed Consolidated Financial Statements	5

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations		27

Item 3. Quantitative and Qualitative Disclosures about Market Risk		37

Item 4. Controls and Procedures		39

Forward-Looking Information		39


PART II - OTHER INFORMATION

Item 1. Legal Proceedings		39

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds		40

Item 5. Other Information		40

Item 6. Exhibits		40

SIGNATURE		41

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements.

KERR-McGEE CORPORATION AND SUBSIDIARY COMPANIES

CONDENSED CONSOLIDATED STATEMENT OF INCOME

(UNAUDITED)

	Three Months Ended
	March 31,
(Millions of dollars, except per-share amounts)	2006			2005

Revenues
Oil and gas sales	$	1,179		$	1,006
Loss on commodity derivatives		(114	)		(86	)
Gas marketing revenues		213			132
Other revenues		22			19
Total Revenues		1,300			1,071

Operating Expenses
Lease operating costs		131			108
Production and ad valorem taxes		31			30
Transportation expense		23			23
General and administrative expense		74			53
Exploration expense		52			55
Gas gathering, processing and other expenses		34			28
Gas marketing costs		214			130
Depreciation, depletion and amortization		189			223
Accretion expense		3			6
Asset impairments		-			4
Gain on sales of oil and gas properties		(4	)		(22	)
Total Operating Expenses		747			638

Operating Income		553			433

Interest expense		(41	)		(60	)
Loss on early repayment and modification of debt		(81	)		-
Other income (expense)		(3	)		(2	)

Income from Continuing Operations before Income Taxes		428			371
Provision for Income Taxes		(152	)		(128	)

Income from Continuing Operations		276			243
Income (loss) from discontinued operations, net of taxes		(23	)		112
Cumulative effect of change in accounting principle, net of taxes		2			-

Net Income	$	255		$	355

Income (Loss) per Common Share
Basic -
Continuing operations	$	2.43		$	1.57
Discontinued operations		(0.20	)		0.72
Cumulative effect of change in accounting principle		0.02			-
Net income	$	2.25		$	2.29

Diluted -
Continuing operations	$	2.39		$	1.51
Discontinued operations		(0.20	)		0.69
Cumulative effect of change in accounting principle		0.02			-
Net income	$	2.21		$	2.20

Dividends Declared per Common Share	$	.05		$	.45

The accompanying notes are an integral part of these consolidated financial statements.

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KERR-McGEE CORPORATION AND SUBSIDIARY COMPANIES

CONDENSED CONSOLIDATED BALANCE SHEET

(UNAUDITED)

	March 31,			December 31,
(Millions of dollars)	2006			2005

ASSETS
Current Assets
Cash and cash equivalents	$	83		$	1,053
Accounts receivable		677			753
Derivatives and other current assets		188			205
Deferred income taxes		341			547
Assets held for sale and Tronox assets		22			691
Total Current Assets		1,311			3,249

Property, Plant and Equipment		11,669			13,629
Less reserves for depreciation, depletion and amortization		(3,689	)		(5,194	)
		7,980			8,435

Investments, Derivatives and Other Assets		326			427
Goodwill and Other Intangible Assets		1,177			1,179
Assets Held for Sale and Tronox Assets		693			986

Total Assets	$	11,487		$	14,276

LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
Accounts payable	$	358		$	425
Long-term debt due within one year		302			306
Income taxes payable		166			429
Commodity derivative liabilities		920			1,506
Accrued liabilities		767			846
Liabilities associated with assets held for sale and Tronox		21			419
Total Current Liabilities		2,534			3,931

Long-Term Debt		2,099			2,277

Noncurrent Liabilities
Deferred income taxes		1,482			1,445
Asset retirement obligations		189			310
Commodity derivative liabilities		431			658
Other		431			471
Liabilities associated with assets held for sale and Tronox		126			1,069
Total Noncurrent Liabilities		2,659			3,953

Contingencies (Note 13)

Stockholders' Equity
Common stock, par value $1 - 500,000,000 shares authorized,
120,476,214 and 119,668,552 shares issued at March 31, 2006
and December 31, 2005, respectively		120			120
Capital in excess of par value		3,737			3,702
Preferred stock purchase rights		1			1
Retained earnings		1,713			1,704
Accumulated other comprehensive loss		(723	)		(1,079	)
Common shares in treasury, at cost - 7,034,469 and 3,456,918 shares
at March 31, 2006 and December 31, 2005, respectively		(629	)		(266	)
Deferred compensation		(24	)		(67	)
Total Stockholders' Equity		4,195			4,115

Total Liabilities and Stockholders’ Equity	$	11,487		$	14,276

The company followed the "successful efforts" method of accounting for oil and gas exploration and production activities in preparing these consolidated financial statements.

The accompanying notes are an integral part of these consolidated financial statements.

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KERR-McGEE CORPORATION AND SUBSIDIARY COMPANIES

CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS

(UNAUDITED)

	Three Months Ended
	March 31,
(Millions of dollars)	2006			2005

Cash Flows from Operating Activities
Net income	$	255		$	355
Adjustments to reconcile net income to net cash
provided by operating activities -
Depreciation, depletion and amortization		225			326
Deferred income taxes		58			138
Dry hole expense		15			20
Asset impairments		-			4
Gain on sale of assets		(4	)		(22	)
Accretion expense		3			9
Loss on early repayment and modification of debt		81			-
Provision for Tronox guarantee		56			-
Other noncash items affecting net income		(17	)		109
Changes in assets and liabilities		(537	)		(142	)
Net Cash Provided by Operating Activities		135			797

Cash Flows from Investing Activities
Capital expenditures		(453	)		(374	)
Dry hole costs		(23	)		(24	)
Proceeds from sales of assets		8			31
Other investing activities		23			(30	)
Net Cash Used in Investing Activities		(445	)		(397	)

Cash Flows from Financing Activities
Issuance of common stock upon exercise of stock options		29			132
Purchases of treasury stock		(363	)		(250	)
Repayment of debt		(250	)		(42	)
Dividends paid		(6	)		(68	)
Settlement of Westport derivatives		(21	)		(43	)
Tronox Distribution ⁽¹⁾		(57	)		-
Other financing activities		11			(5	)
Net Cash Used in Financing Activities		(657	)		(276	)

Effects of Exchange Rate Changes on Cash and Cash Equivalents		(3	)		1
Net Increase (Decrease) in Cash and Cash Equivalents		(970	)		125
Cash and Cash Equivalents at Beginning of Period		1,053			76
Cash and Cash Equivalents at End of Period	$	83		$	201

⁽¹⁾	Represents Tronox’s cash balance deconsolidated upon the Distribution.

The accompanying notes are an integral part of these consolidated financial statements.

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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 Other Comprehensive Income (Loss)			Treasury Stock			Deferred Compensation and Other			Total Stockholders' Equity
Balance at December 31, 2004	$	152	$	4,205		$	1,102		$	(79	)	$	(8	)	$	(54	)	$	5,318
Comprehensive Income (Loss):
Net income		-		-			355			-			-			-			355
Other comprehensive loss		-		-			-			(457	)		-			-			(457	)
Comprehensive loss																			(102	)
Shares issued upon conversion of debt		10		583			-			-			-			-			593
Purchases of treasury shares		-		-			-			-			(250	)		-			(250	)
Stock option exercises		2		130			-			-			-			-			132
Restricted stock activity		1		24			-			-			(2	)		(19	)		4
ESOP deferred compensation		-		-			-			-			-			2			2
Tax benefit from stock-based awards		-		16			-			-			-			-			16
Dividends declared ($.45 per share)		-		-			(74	)		-			-			-			(74	)
Other		-		-			(1	)		-			-			-			(1	)
Balance at March 31, 2005	$	165	$	4,958		$	1,382		$	(536	)	$	(260	)	$	(71	)	$	5,638

Balance at December 31, 2005	$	120	$	3,702		$	1,704		$	(1,079	)	$	(266	)	$	(66	)	$	4,115
Comprehensive Income:
Net income		-		-			255			-			-			-			255
Other comprehensive income		-		-			-			356			-			-			356
Comprehensive income																			611
Adoption of FAS No. 123(R)		-		(42	)		-			-			-			42			-
Purchases of treasury shares		-		-			-			-			(363	)		-			(363	)
Stock option exercises		-		29			-			-			-			-			29
Amortization of options and restricted
stock, net of forfeitures		-		34			-			-			-			-			34
ESOP deferred compensation		-		-			-			-			-			1			1
Tax benefit from stock-based awards		-		14			-			-			-			-			14
Dividends declared ($.05 per share)		-		-			(6	)		-			-			-			(6	)
Tronox Distribution (Note 2)		-		-			(238	)		-			-			-			(238	)
Other		-		-			(2	)		-			-			-			(2	)
Balance at March 31, 2006	$	120	$	3,737		$	1,713		$	(723	)	$	(629	)	$	(23	)	$	4,195

The accompanying notes are an integral part of these consolidated financial statements.

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KERR-McGEE CORPORATION AND SUBSIDIARY COMPANIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

MARCH 31, 2006

1.	The Company, Basis of Presentation and Accounting Policies

The Company

Kerr-McGee is an independent exploration and production company that explores for, develops, produces and markets crude oil and natural gas, with major areas of operation in the United States and China. Exploration efforts also extend to the North Slope of Alaska and offshore West Africa, Brazil and Trinidad and Tobago. Terms such as “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.

Recent Developments

In January 2006, the company entered into an agreement to sell its interests in Gulf of Mexico shelf oil and natural gas properties to W&T Offshore, Inc. for approximately $1.34 billion in cash, subject to certain adjustments. The transaction, which has an effective date of October 1, 2005 and is subject to customary closing conditions and regulatory approvals, is expected to close in late second quarter or early third quarter.

·	In January 2006, the company's Board of Directors (the Board) approved a $1 billion stock repurchase program. During the first quarter, approximately 3.4 million shares of Kerr-McGee’s stock were repurchased at an aggregate cost of $350 million.

In November 2005, Tronox Incorporated (Tronox), a former subsidiary that held Kerr-McGee's chemical business, completed an initial public offering (IPO) of 17.5 million shares of Class A common stock, which reduced Kerr-McGee’s equity interest in Tronox to 57%. On March 30, 2006, Kerr-McGee completed a pro rata distribution to its stockholders in the form of a dividend of shares of Tronox Class B common stock it owned (the Distribution) and no longer has any ownership or voting interest in Tronox.

On May 9, 2006, the Board authorized a two-for-one split of Kerr-McGee’s outstanding common stock. The stock split will be accomplished through a stock dividend to be issued on June 14, 2006 to stockholders of record at the close of business on June 2, 2006. Common shares issued and outstanding and earnings per share in the accompanying consolidated financial statements do not give effect to the stock split.

·	The Board also approved a 25% increase in the company's quarterly dividend effective with the dividend payable on July 3, 2006. On a pre-split basis, the quarterly dividend will increase from $.05 per share to $.0625 per share.

Basis of Presentation

The unaudited condensed consolidated financial statements included herein have been prepared 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 for adjustments to reflect the Distribution and reclassifications discussed 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.

With the separation of the chemical business, the income statement format has been changed to better reflect the operations of an exploration and production company. Certain 2005 amounts included in the accompanying condensed consolidated financial statements have been reclassified to conform to the 2006 presentation. The operating results of and other costs directly associated with Tronox and the company’s North Sea oil and gas business that was sold in November 2005 are reported as discontinued operations.

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Accounting Policies

Employee Stock-Based Compensation - Under Kerr-McGee's long-term incentive plans, the company generally grants nonvested stock, stock options and performance unit awards to nonemployee directors and qualifying employees (the terms of the awards are described in Note 9). Prior to 2006, the company’s stock-based employee compensation was accounted for under the recognition and measurement provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB No. 25), and related Interpretations, as permitted by Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (FAS No. 123). Under the intrinsic-value-based accounting model specified in APB No. 25, the company generally did not recognize compensation cost for its stock option awards, as most options granted had an exercise price equal to the market value of the underlying common stock on the date of grant.

Effective January 1, 2006, the company adopted the fair value recognition provisions of FAS No. 123 (Revised 2004), “Share-Based Payment” (FAS No. 123(R)), using the modified prospective transition method. Under this method, stock-based compensation cost recognized in income from continuing operations for the three months ended March 31, 2006 includes:

·	Compensation cost for all stock option and stock awards that were unvested as of January 1, 2006 based on the grant-date fair value estimated in accordance with the original provisions of FAS No. 123

·	Compensation cost for all stock options and nonvested stock awards granted subsequent to January 1, 2006 based on the grant-date fair value estimated in accordance with the provisions of FAS No. 123(R)

·	Compensation cost for all performance units (outstanding as of January 1, 2006 and granted subsequent to that date) based on the change in their estimated fair value during the first quarter 2006

Results for prior periods have not been restated. The company recognized cumulative effect of adoption as an increase in net income of $2 million ($3 million on a pretax basis). This adjustment reflects a reduction in the performance units liability to its estimated fair value and the effect of the change in the company’s accounting policy for forfeitures. FAS No. 123(R) requires that compensation cost be recognized only for awards for which the requisite service is expected to be rendered, using an estimated forfeiture rate. Prior to January 1, 2006, the company accounted for forfeitures as they occurred.

The following table presents the increase (decrease) in reported earnings for the first quarter of 2006 as a result of adopting FAS No. 123(R), as well as the change in classification of reported cash flows associated with excess tax benefits, as compared to results that would have been reported had the company continued to apply provisions of APB No. 25:

(Millions of dollars, except per-share amounts)

Increase (decrease) in:
Income from continuing operations before income taxes	$	(19	)
Income from continuing operations		(12	)
Net income		(10	)
Earnings per share:
Basic		(.09	)
Diluted		(.09	)
Net cash provided by operating activities		(14	)
Net cash used in financing activities		14

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The following table illustrates the effect on net income and earnings per share for the quarter ended March 31, 2005 assuming stock-based compensation cost was determined using the fair-value-based method prescribed by FAS No. 123:

(Millions of dollars, except per-share amounts)

Net income, as reported	$	355
Add: stock-based employee compensation expense
included in reported net income, net of taxes		9
Deduct: stock-based compensation expense determined
using a fair-value method, net of taxes		(16	)
Pro forma net income	$	348

Net income per share -
Basic -
As reported	$	2.29
Pro forma		2.25

Diluted -
As reported	$	2.20
Pro forma		2.15

2.	Tronox Separation

In November 2005, Tronox Incorporated, a former subsidiary that held Kerr-McGee's chemical business, completed an initial public offering (IPO) of 17.5 million shares of its Class A common stock. Following the IPO, Kerr-McGee continued to own 22.9 million shares of Tronox Class B common stock, representing approximately 57% of the equity interest and 89% of the total voting power of Tronox. On March 8, 2006, Kerr-McGee's Board of Directors approved a pro rata distribution to its stockholders of Tronox Class B common stock the company owned. The Distribution was completed on March 30, 2006 and resulted in holders of Kerr-McGee common stock as of March 20, 2006 receiving a dividend of .20164 of a share of Tronox Class B common stock for each share of Kerr-McGee common stock they owned. Stockholders entitled to fractional shares of Tronox Class B common stock received cash in lieu of fractional shares. The distribution of Tronox Class B shares in the form of a dividend to the company's stockholders reduced retained earnings and other comprehensive income by a total of $259 million, which represented the carrying amount of Kerr-McGee's investment in Tronox as of the Distribution date.

Under the terms of the Master Separation Agreement entered into between Kerr-McGee and Tronox in connection with the IPO, Kerr-McGee agreed to reimburse Tronox for 50% of certain qualifying environmental remediation costs incurred and paid by Tronox and its subsidiaries before November 28, 2012, subject to certain limitations and conditions. The seven-year reimbursement obligation is limited to a maximum aggregate reimbursement of $100 million. In connection with the Distribution, Kerr-McGee recognized a fair-value-based liability of $56 million associated with this reimbursement obligation, with the associated charge reflected as a component of loss from discontinued operations.

Historically, certain Tronox employees and retirees participated in stock-based compensation, retirement, and health and life postretirement plans established by Kerr-McGee. As more fully discussed in Note 9, except for vested stock options and performance unit awards, Kerr-McGee’s stock-based awards held by Tronox employees were forfeited on the date of the Distribution and replaced with stock-based awards of comparable value issued by Tronox. Additionally, on the Distribution date, Tronox assumed obligations for retirement and health and life postretirement benefits for Tronox’s U.S. employees and retirees. In connection with the assumption of the benefit obligations, the company also transferred to Tronox trust assets associated with the transferred benefit obligations. Note 10 provides additional information regarding the effects of the separation on Kerr-McGee's obligations for pension and postretirement health and life benefits.

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3.	Discontinued Operations and Assets Held for Sale

Discontinued Operations - The following table summarizes the components of income (loss) from discontinued operations for the periods presented:

	Three Months Ended March 31,
	2006			2005
				North Sea
				Oil and Gas
(Millions of dollars)	Tronox			Business			Tronox		Total

Revenues	$	336		$	312		$	334	$	646

Income (loss) from Discontinued Operations:
Income from operations	$	35		$	183		$	6	$	189
Provision for Tronox guarantee⁽¹⁾		(56	)		-			-		-
Pretax income (loss) from discontinued operations		(21	)		183			6		189
Income tax (expense) benefit		7			(78	)		1		(77	)
Net income from operations allocable to minority interests		(9	)		-			-		-
Income (loss) from discontinued operations, net of tax	$	(23	)	$	105		$	7	$	112

⁽¹⁾	Additional information about the guarantee is provided in Note 2.

Assets and liabilities of Tronox are segregated as assets and liabilities of discontinued operations in the accompanying Condensed Consolidated Balance Sheet as of December 31, 2005.

Assets Held for Sale - Assets held for sale at March 31, 2006 and associated liabilities consist of assets and liabilities associated with the company’s interests in Gulf of Mexico shelf oil and gas properties. The company expects to complete the sale late in the second quarter or early in the third quarter.

4.	Other Comprehensive Income (Loss)

Components of other comprehensive income (loss) for the three months ended March 31, 2006 and 2005 are presented in the following table and include amounts associated with discontinued operations. Components of accumulated other comprehensive income (loss) associated with Tronox were reclassified to retained earnings in connection with the Distribution.

	Three Months Ended
	March 31,
(Millions of dollars)	2006			2005

Foreign currency translation -
Translation adjustments, net of minority interest of $2	$	1		$	2
Reclassification to retained earnings		(24	)		-
Total foreign currency translation adjustments		(23	)		2
Net gains (losses) on cash flow hedges -
Unrealized gains (losses), net of taxes of $(111) and $272		207			(484	)
Reclassification of realized losses to net income,
net of taxes of $(97) and $(14)		179			25
Reclassification to retained earnings		1			-
Total gains (losses) on cash flow hedges, net		387			(459	)
Minimum pension liability -
Minimum pension liability adjustments, net of taxes of $5		(10	)		-
Reclassification to retained earnings, net of taxes of $(1)		2			-
Total minimum pension liability adjustments		(8	)		-
Other comprehensive income (loss)	$	356		$	(457	)

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Components of accumulated other comprehensive loss at March 31, 2006 and December 31, 2005, net of applicable tax effects, are as follows:

	March 31,			December 31,
(Millions of dollars)	2006			2005

Foreign currency translation adjustments	$	12		$	35
Unrealized loss on cash flow hedges		(708	)		(1,095	)
Minimum pension liability adjustments		(27	)		(19	)
	$	(723	)	$	(1,079	)

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 cash flows, the company enters into derivative contracts primarily comprised of swaps and collars for a portion of its future oil and gas production and interest rate swaps to hedge the fair value of its fixed-rate debt. Effects of interest rate swaps on the company's financial statements were not material for the periods presented.

The following tables summarize the balance sheet presentation of the company’s oil and gas commodity derivatives as of March 31, 2006 and December 31, 2005:

	As of March 31, 2006
	Derivative Fair Value
	Current		Long-Term		Current			Long-Term			Deferred
(Millions of dollars)	Asset		Asset		Liability			Liability			Loss in AOCI⁽¹⁾

Oil and gas production-related derivatives	$	72	$	32	$	(915	)	$	(431	)	$	(708	)
Gas marketing-related derivatives		5		-		(5	)		-			-
Total	$	77	$	32	$	(920	)	$	(431	)	$	(708	)

	As of December 31, 2005
	Derivative Fair Value
	Current		Long-Term		Current			Long-Term			Deferred
(Millions of dollars)	Asset		Asset		Liability			Liability			Loss in AOCI⁽¹⁾

Oil and gas production-related derivatives	$	101	$	34	$	(1,492	)	$	(658	)	$	(1,095	)
Gas marketing-related derivatives		13		1		(14	)		-			-
Total	$	114	$	35	$	(1,506	)	$	(658	)	$	(1,095	)

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

The following table summarizes components of gain (loss) on commodity derivative instruments associated with continuing operations for the first quarter of 2006 and 2005:

	Three Months Ended
	March 31,
(Millions of dollars)	2006			2005

Loss on hedge derivatives	$	(274	)	$	(26	)
Mark-to-market nonhedge derivative gain (loss)		130			(51	)
Gain (loss) due to hedge ineffectiveness		30			(9	)
		(114	)		(86	)
Gas marketing-related derivatives		1			2
Total	$	(113	)	$	(84	)

Discontinuation of Hedge Accounting - Because a large portion of the company’s natural gas derivatives no longer qualified for hedge accounting and to increase clarity in its financial statements, the company elected to discontinue hedge accounting prospectively for its commodity derivatives beginning March 1, 2006. Consequently, from that date forward, the company recognizes mark-to-market gains and losses in earnings, rather than deferring such amounts in accumulated other comprehensive income. The net mark-to-market loss on outstanding derivatives at March 31, 2006 included in accumulated other comprehensive income will be reported in future earnings through 2007 as the original hedged oil and gas sales occur. The company expects to reclassify $496 million of the net after-tax derivative loss from accumulated other comprehensive loss to earnings during the next 12 months.

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6.	Exploratory Drilling Costs

At March 31, 2006, the company had capitalized exploratory drilling costs of approximately $276 million associated with ongoing exploration and/or appraisal activities primarily in the deepwater Gulf of Mexico, Alaska and Brazil (including $37 million associated with the Gulf of Mexico shelf properties that the company expects to sell, as discussed in Note 1). 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.

Debt

The following table summarizes changes in total debt for the quarter ended March 31, 2006:

				Debt			Carrying
(Millions of dollars)	Principal			Discount			Amount

Balance at December 31, 2005 ⁽¹⁾	$	3,232		$	(99	)	$	3,133
Amortization of discount		-			2			2
Change in the fair value of hedged debt		-			(3	)		(3	)
Early redemption of 7% debentures due 2011		(250	)		69			(181	)
Tronox Distribution		(550	)		-			(550	)
Balance at March 31, 2006	$	2,432		$	(31	)	$	2,401

⁽¹⁾	Included $550 million of Tronox debt presented in the Condensed Consolidated Balance Sheet as liabilities associated with Tronox.

In February 2006, the company redeemed its 7% deep-discount debentures with a face value of $250 million using cash on hand. In connection with the early redemption, a pretax loss of $69 million, representing a write-off of unamortized discount on the debentures, was recognized. Additionally, in January 2006, the company terminated its $1.25 billion secured revolving credit facility, which resulted in a write-off of unamortized debt issue costs of $12 million associated with the facility. The terminated facility was replaced with a $1.25 billion unsecured revolving credit agreement. At March 31, 2006, no borrowings were outstanding under the revolving facility, while outstanding letters of credit that reduce the $1.25 billion borrowing capacity totaled $65 million.

8.	Exit, Disposal and Restructuring Activities

The following table presents the changes in the reserve for exit and restructuring activities during the first quarter of 2006. No significant changes in the status of exit activities occurred during this period.

	Reserve Activity⁽¹⁾
	Dismantlement			Personnel
(Millions of dollars)	and Closure			Costs ⁽²⁾			Total

Balance at December 31, 2005	$	6		$	21		$	27
Provisions/Accruals		-			5			5
Payments		(1	)		-			(1	)
Tronox Distribution		(5	)		(6	)		(11	)
Balance at March 31, 2006	$	-		$	20		$	20

⁽¹⁾

Provisions for exit, disposal and restructuring activities include a charge of $2 million related to Tronox, which is reflected in loss from discontinued operations in the Condensed Consolidated Statement of Income.

⁽²⁾	Of the $20 million reserve, approximately $11 million was paid in April 2006.

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9. Employee Stock-Based Compensation

Overview - The company's 2005 Long-Term Incentive Plan (the Plan) authorizes the issuance of shares of the company’s common stock to certain employees and non-employee directors at any time prior to May 10, 2015 in the form of fixed-price stock options, restricted stock or performance awards. At March 31, 2006, approximately 8.5 million shares of Kerr-McGee stock were available to be granted under the Plan. Prior to the approval of the Plan by the company’s stockholders, stock-based awards were granted under similar plans, all of which have been terminated. Although no more awards can be issued under those plans, their termination had no effect on awards that had been previously issued and outstanding.

Stock-based awards granted by the company to its employees and non-employee directors in recent years generally have the following terms:

		Vesting		Cash- or
	Contractual	Period	Vesting	Stock-	Vesting and Other
	Life (years)	(years)	Term ⁽¹⁾	Settled	Conditions

Stock options	10	3	Graded	Stock	Employee service
Restricted stock	not applicable	3	Cliff	Stock	Employee service
Performance units ⁽²⁾	3	3	Cliff	Cash	Employee service and
					achievement of specified
					stockholder return targets

⁽¹⁾

An employee holding stock options vests in one third of the award annually. An employee vests in the entire restricted stock award at the end of the three-year vesting period. Employees terminating their employment due to retirement fully vest in their stock option and restricted stock awards upon retirement; and, subject to certain conditions, retain the right to receive a pro rata payout under the performance units awards to the extent services have been provided.

⁽²⁾

Performance unit awards provide an employee with a potential cash payment at the end of a three-year performance cycle based on Kerr-McGee's total stockholder return (stockholder return assuming dividend reinvestment) relative to selected peer companies. Payout levels vary depending upon Kerr-McGee's rank relative to certain peer companies.

The following summarizes stock-based compensation expense recognized in income from continuing operations for the three months ended March 31, 2006 and 2005. Stock-based compensation expense recognized in 2006 is based on the fair value of the awards, while in 2005 it reflected the intrinsic value of the awards, if any. Refer to Note 1 for additional information on the change in the accounting policy for stock-based awards.

	Three Months Ended
	March 31,
(Millions of dollars)	2006			2005

Stock options	$	20		$	1
Restricted stock		15			5
Performance units		6			7
Total stock-based compensation expense, pretax		41			13
Income tax benefit		(14	)		(5	)
Total stock-based compensation expense, net of taxes	$	27		$	8

The following table presents unamortized cost associated with awards outstanding at March 31, 2006 and the weighted average period over which it is expected to be recognized (before considering the associated income tax benefit). Compensation cost ultimately recognized may differ from amounts presented below due to changes in the estimate of forfeitures and changes in fair value of performance units, which will be re-measured each reporting period.

	Unrecognized		Remaining
	Cost		Period
(Millions of dollars)	(Pretax)		(years)

Stock options	$	35		2.3
Restricted stock		30		2.1
Performance units		22		2.1
	$	87		2.2

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Effect of Tronox Separation - As provided in the Employee Benefits Agreement between Kerr-McGee and Tronox, except for vested stock options, vested performance unit awards, and awards held by retirement-eligible employees, Kerr-McGee stock-based awards held by Tronox employees at the date of the Distribution were forfeited and replaced with stock-based awards of comparable value issued by Tronox. Retirement-eligible Tronox employees fully vested in their Kerr-McGee stock options and restricted stock on the Distribution date. In connection with the Distribution, pretax expense reversal of $3 million was recognized as a component of loss from discontinued operations, reflecting the net effect of reversing previously recognized compensation cost for Kerr-McGee awards forfeited by Tronox employees and accelerated amortization of compensation cost for awards held by retirement-eligible employees of Tronox.

Stock Options - The following table presents a summary of activity for Kerr-McGee options for the three months ended March 31, 2006:

									Intrinsic
	Number of						Contractual		Value
Options	Shares			Price⁽³⁾			Life (years) ⁽³⁾		(Millions) ⁽⁴⁾

Outstanding at December 31, 2005		4,799,124		$	53.21
Granted		1,172,225			94.10
Exercised		(560,271	)		52.16
Forfeited ⁽¹⁾		(182,809	)		55.80
Expired		(808	)		57.40
Antidilution adjustment ⁽²⁾		193,655			(2.24	)
Outstanding at March 31, 2006		5,421,116		$	60.16			7.5	$	191
Exercisable at March 31, 2006		2,979,237		$	51.03			6.2	$	132

⁽¹⁾	Includes options to purchase 161,596 shares of Kerr-McGee stock that were forfeited by Tronox employees at the date of the Distribution.

⁽²⁾	Represents a modification to the terms of outstanding awards in connection with the distribution, as discussed below.

⁽³⁾	Represents weighted average exercise price and weighted average remaining contractual life, as applicable.

⁽⁴⁾	Reflects aggregate intrinsic value based on the difference between the market price of Kerr-McGee stock and the options' exercise price.

The holders of Kerr-McGee stock options were not entitled to receive the dividend in the form of Tronox Class B common stock distributed to Kerr-McGee stockholders in March 2006. Accordingly, in connection with the Distribution and following provisions of the relevant plans, the company adjusted the terms of stock options outstanding as of March 30, 2006 to reduce the exercise price and increase the number of shares subject to the options. This antidilution adjustment preserved the intrinsic value of the options and maintained the ratio of the exercise price of each option to the market price of Kerr-McGee stock as of the Distribution. The company evaluated the impact of this award modification on compensation cost and determined that the modification did not increase the fair value of modified options. Therefore, there was no effect on compensation cost recognized in the first quarter of 2006 and no effect is expected on cost recognition in future periods.

The following table presents selected information with respect to options exercised in the first quarter of 2006 and 2005:

	Three Months Ended
	March 31,
(Millions of dollars)	2006		2005

Intrinsic value	$	27	$	45
Cash proceeds received		29		132
Excess tax benefit		7		16

Compensation Cost Measurement

Valuation and cost attribution methods - Prior to January 1, 2006, the company utilized the Black-Scholes-Merton option-pricing model to estimate the fair value of its stock option awards. Starting with its 2006 grant, the company estimates the fair value of its option awards using a lattice model, which management believes results in a more accurate measurement as compared to the Black-Scholes-Merton formula. Options’ fair value is determined on the date of grant and recognized in earnings (net of expected forfeitures) on a straight-line basis over the employee service period necessary to earn the awards, which is generally the vesting period. However, compensation cost associated with employees whose retention of the options is not contingent on providing future service is recognized immediately upon grant.

- 12 -

The following table presents the weighted-average fair-value measurement assumptions for options granted in the first quarter of 2006 and 2005, followed by additional information regarding the assumptions.

	Three Months Ended
	March 31,
	2006			2005

Expected volatility (annualized)		28.0	%		26.4	%
Expected dividend yield (annualized)		0.2	%		3.5	%
Expected term (years)		5.6			6.0
Risk-free rate		4.49	%		3.9	%
Weighted average per-share fair value of options granted	$	33.61		$	20.96

Expected Volatility - In setting the volatility assumption, the company considers both the implied volatility of its traded options and historical volatility of its stock price over the same contractual term as the options.

Expected Dividend Yield - The dividend yield assumption is based on the company’s expectation, as of the grant date, about its dividend policy over the contractual option term. In March 2005, subsequent to the 2005 stock option grant, Kerr-McGee’s Board of Directors approved a change in the dividend policy that reduced quarterly dividends from $.45 to $.05 per share. The company’s 2006 dividend yield assumption reflects that change in the dividend policy.

Expected Term - The expected term represents the period that the company’s options are expected to be outstanding. Under the lattice model, expected term is derived from assumptions of employee post-vesting termination and retirement rates, as well as voluntary exercise behavior correlated to various market price scenarios for the company’s stock. Assumptions made regarding employee exercise behavior are based on analyses of historical experience of similar awards over a period of ten years, giving consideration to the contractual terms of the options, demographic characteristics of option holders, vesting schedules and expectations of future employee behavior.

Risk-Free Interest Rate - The company bases the risk-free interest rate on the U.S. Treasury securities over the contractual term of the options.

Nonvested and Restricted Stock - The following table summarizes information about nonvested and restricted stock activity during the first quarter of 2006:

	Shares			Fair Value ⁽¹⁾

Balance at December 31, 2005		1,240,625		$	53.85
Granted		241,070			98.58
Vested		(409,885	)		43.22
Forfeited ⁽²⁾		(79,784	)		62.16
Balance at March 31, 2006		992,026		$	68.44

⁽¹⁾	Represents the weighted-average grant-date fair value.

⁽²⁾	Includes approximately 73,000 shares forfeited by Tronox employees as of the Distribution date.

Valuation and cost attribution method - Grant-date fair value of nonvested shares is determined by reference to market quotes for the company’s common stock. Compensation cost is recognized in earnings (net of expected forfeitures) on a straight-line basis over the employee service period necessary to earn the awards, which is generally the vesting period. However, compensation cost associated with employees whose retention of stock awards is not contingent on providing future service is recognized immediately upon grant.

- 13 -

Performance Units - The following summarizes activity associated with the company's performance unit awards, as well as the rollforward of the performance units liability for the three months ended March 31, 2006:

				Carrying
	Performance			Amount of
(Millions of dollars)	Units			Liability

Balance at December 31, 2005		33,545,679		$	21
Cumulative effect of adopting FAS 123(R)		(675,871	)		(2	)
Forfeitures by Tronox employees upon Distribution		(2,794,330	)		(1	)
Units granted ⁽¹⁾		15,980,157			N/A
Award settlement		(9,292,084	)		(9	)
Compensation cost		-			6
Balance at March 31, 2006 ⁽²⁾		36,763,551		$	15

⁽¹⁾	Grant-date measurement of new performance unit awards is not required to be performed. Rather, fair value of the 2006 grant was estimated as of March 31, 2006 to determine the first quarter 2006 compensation cost associated with these awards.

⁽²⁾	Performance units balance represents units outstanding and expected to vest.

Valuation and cost attribution method - Fair value estimates as of the end of each reporting period are formed using a Monte Carlo simulation model, which utilizes multiple input variables to determine the probability of satisfying the market condition stipulated in the award terms. Inputs into the model include the following for Kerr-McGee and comparator companies: total stockholder return from the beginning of the performance cycle through the measurement date, volatility, risk-free rates, and correlation of Kerr-McGee's and comparator companies' total stockholder return. The inputs are based on historical capital market data. The total fair-value-based obligation associated with awards expected to vest is further adjusted to reflect the extent to which employee services necessary to earn the awards have been rendered. Compensation cost for any given period equals the increase or decrease in the liability for awards outstanding and expected to vest.

10. Employee Benefit Plans

Overview - Kerr-McGee is a sponsor of noncontributory defined-benefit retirement plans and contributory postretirement plans for health care and life insurance, in each case for the benefit of the company’s current and former U.S. employees. Most U.S. employees are covered under the company’s retirement plans, and substantially all U.S. employees may become eligible for the health and life postretirement benefits if they reach retirement age while working for the company and have 10 years of continuous service. As discussed in Note 2, under the provisions of the Employee Benefits Agreement between Kerr-McGee and Tronox, qualifying U.S. employees and retirees of Tronox participated in Kerr-McGee’s benefit plans through the date of the Distribution.

Effect of Tronox Separation - In connection with the Tronox separation, Tronox established employee benefit plans for its U.S. employees and retirees and, upon completion of the Distribution, assumed the benefit obligations associated with such employees. For funded U.S. retirement plans, Kerr-McGee also transferred to Tronox trust assets associated with the benefit obligations assumed. Additionally, foreign subsidiaries of Tronox retained their obligations for retirement plans they have sponsored in Germany and the Netherlands.

For Kerr-McGee's U.S. retirement and health and life postretirement plans, assumption of the benefit obligations by Tronox represented a partial settlement of the plan obligations. In connection with the settlement, the benefit obligations for the plans affected by the Tronox separation were remeasured as of March 30, 2006 and assets and liabilities associated with the benefit obligations assumed by Tronox were deconsolidated from Kerr-McGee's consolidated financial statements.

- 14 -

Benefit Obligations and Funded Status - The following provides a reconciliation of benefit obligations, plan assets and funded status of the company’s pension and other postretirement plans for the three months ended March 31, 2006:

				Postretirement
	Retirement			Health and Life
(Millions of dollars)	Plans			Plans

Change in benefit obligations -
Benefit obligation at December 31, 2005	$	1,255		$	297
Service cost		8			1
Interest cost		16			4
Plan amendments/law changes		15			-
Net actuarial gain		(32	)		(4	)
Contributions by plan participants		-			2
Benefits paid		(31	)		(7	)
Tronox Distribution		(500	)		(147	)
Benefit obligation at March 31, 2006	$	731		$	146
Change in plan assets -
Fair value of plan assets at December 31, 2005	$	1,132		$	-
Actual return on plan assets		31			-
Employer contributions		2			5
Participant contributions		-			2
Benefits paid		(31	)		(7	)
Tronox Distribution ⁽¹⁾		(503	)		-
Fair value of plan assets at March 31, 2006 ⁽²⁾	$	631		$	-

⁽¹⁾

Includes plan assets of $441 million transferred from Kerr-McGee’s U.S. qualified retirement plan trust to Tronox on March 30, 2006, the Distribution date. The initial transfer amount was determined based on census information and actuarial estimates as of an earlier date. A final determination of plan assets to be transferred to Tronox based on census data and other information as of the Distribution date will be completed in May 2006 and will result in an incremental transfer of plan assets between Kerr-McGee and Tronox. The company does not expect this incremental transfer to have a material effect on its financial statements.

⁽²⁾	Excludes the grantor trust assets of $67 million associated with the company’s supplemental nonqualified U.S. retirement plans.

The following table presents the funded status of the company's plans and its reconciliation to amounts recognized in the Condensed Consolidated Balance Sheet at March 31, 2006 and December 31, 2005:

							Postretirement
	Retirement Plans						Health and Life Plans
	March 31,			December 31,			March 31,			December 31,
(Millions of dollars)	2006			2005			2006			2005

Benefit obligation	$	731		$	1,255		$	146		$	297
Fair value of plan assets		631			1,132			-			-
Funded status of plans - under funded		(100	)		(123	)		(146	)		(297	)
Amounts not recognized in the Condensed
Consolidated Balance Sheet -
Prior service cost		37			42			(6	)		(14	)
Net actuarial loss		150			282			37			80
Net prepaid expense (accrued liability)
recognized	$	87		$	201		$	(115	)	$	(231	)
Classification of amounts recognized in the
Condensed Consolidated Balance Sheet -
Prepaid pension cost	$	126		$	249		$	-		$	-
Accrued benefit liability		(87	)		(79	)		(115	)		(231	)
Intangible asset		6			-			-			-
Accumulated other comprehensive loss (pretax)		42			31			-			-
Total	$	87		$	201		$	(115	)	$	(231	)

- 15 -

The following table summarizes the accumulated benefit obligations and the projected benefit obligations associated with the company’s unfunded benefit plans:

At March 31, 2006

At December 31, 2005

Nonqualified

Postretirement

Nonqualified

Postretirement

(Millions of dollars)

Retirement Plans ⁽¹⁾

Health and Life Plans

Retirement Plans ⁽¹⁾

Health and Life Plans

Accumulated benefit obligation

146

297

Projected benefit obligation

104

146

297

⁽¹⁾

Although not considered plan assets, a grantor trust was established from which payments for certain U.S. supplemental benefits are made. The trust assets had a balance of $67 million and $50 million at March 31, 2006 and December 31, 2005, respectively. In January 2006, the company made a discretionary contribution to the grantor trust of $22 million. In connection with the Distribution of Tronox, the company transferred $4 million of grantor trust assets to the newly-established Tronox nonqualified benefit plan.

Summarized below are the accumulated benefit obligation, the projected benefit obligation, the market value of plan assets and the funded status of the company’s U.S. qualified retirement plan:

(Millions of dollars)	At March 31, 2006		At December 31, 2005

Accumulated benefit obligation	$	575	$	990

Projected benefit obligation	$	627	$	1,093
Market value of plan assets		631		1,070
Funded status - over/(under) funded	$	4	$	(23	)

Expected Benefit Payments - Following are the expected benefit payments for the next five years and, in an aggregate, for the years 2011 through 2015:

											2011-
(Millions of dollars)	2006		2007		2008		2009		2010		2015

Retirement plans	$	63	$	76	$	62	$	65	$	65	$	340
Postretirement health and life plans		11		11		11		11		11		54

Net Periodic Cost - Income from continuing operations for the three months ended March 31, 2006 and 2005 includes the following components of net periodic cost:

					Postretirement
	Retirement Plans				Health and Life Plans
(Millions of dollars)	2006		2005		2006		2005

Net periodic cost -
Service cost	$	7	$	7	$	1	$