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| 2002 Annual Report | 
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Management’s
Discussion and Analysis of Financial Management’s Discussion and Analysis is the company’s analysis of its financial performance and of significant trends that may affect future performance. It should be read in conjunction with the financial statements and notes, and supplemental oil and gas disclosures. It contains forward-looking statements including, without limitation, statements relating to the company’s plans, strategies, objectives, expectations, intentions, and resources that are made pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. The words “intends,” “believes,” “expects,” “plans,” “scheduled,” “anticipates,” “estimates,” and similar expressions identify forward-looking statements. The company does not undertake to update, revise or correct any of the forward-looking information. Readers are cautioned that such forward-looking statements should be read in conjunction with the company’s disclosures under the heading: “CAUTIONARY STATEMENT FOR THE PURPOSES OF THE ‘SAFE HARBOR’ PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995.” Results
of Operations As a condition of the merger, the U.S. Federal Trade Commission (FTC) required that the company divest specified Conoco and Phillips assets, the most significant of which were Phillips’ Woods Cross, Utah, refinery and associated motor fuel marketing operations; Conoco’s Commerce City, Colorado, refinery and related crude oil pipelines and Phillips’ Colorado motor fuel marketing operations. All assets and operations that are required by the FTC to be divested are included in Corporate and Other as discontinued operations. Included in the results of discontinued operations in 2002 was a $69 million after-tax charge for the write-down to fair value of the Phillips operations to be disposed. Because the Conoco assets to be disposed of were recorded at fair value in the purchase price allocation, no further write-downs were required. Discontinued operations also include other, non-FTC mandated assets held for sale. See Note 4 — Discontinued Operations in the Notes to Consolidated Financial Statements for additional information, including a complete list of assets required by the FTC to be divested. As a result of the merger, the company implemented a restructuring program in September 2002 to capture the synergies of combining Phillips and Conoco by eliminating redundancies, consolidating assets, and sharing common services and functions across regions. The restructuring program that was implemented in September 2002 is expected to be completed by the end of February 2004 and, through December 31, 2002, approximately 2,900 positions worldwide, most of which are in the United States, had been identified for elimination. Of this total, 775 employees were terminated by December 31, 2002. Associated with implementation of the restructuring program, ConocoPhillips accrued $770 million for merger-related restructuring and work force reduction liabilities in 2002. These liabilities primarily represent estimated termination payments and related employee benefits associated with the reduction in positions. These liabilities include $337 million related to Conoco operations, which was reflected in the purchase price allocation as an assumed liability, and $422 million ($253 million after-tax) related to Phillips operations that was charged to selling, general and administrative, and production and operating expenses; and $11 million before-tax included in discontinued operations. Of the above accruals, $598 million related primarily to severance benefits. Payments will be made to former Conoco and Phillips employees under each company’s respective severance plans. During 2002, payments of $223 million were made, resulting in a year-end 2002 severance accrual balance of $375 million. Also related to the merger and recorded in 2002 was a $246 million write-off of acquired in-process research and development costs related to Conoco’s natural gas-to-liquids and other technologies. In accordance with Financial Accounting Standards Board (FASB) Interpretation No. 4, “Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method,” value assigned to research and development activities in the purchase price allocation that have no alternative future use should be charged to expense at the date of the consummation of the combination. The $246 million charge was recorded in the Emerging Businesses segment and was the same on both a before-tax and after-tax basis. ConocoPhillips also accrued $22 million, after-tax, in 2002 for change-in-control costs associated with seismic contracts as a result of the merger. The expense was recorded in Corporate and Other and did not impact exploration expenses. In addition, the 2002 net loss also included transition costs of $36 million, bringing total after-tax merger-related costs to $557 million. See Note 3 — Merger of Conoco and Phillips in the Notes to Consolidated Financial Statements for additional information on the merger. Consolidated
Results A
summary of the company’s net income (loss) by business segment follows: 2002
vs. 2001 2001
vs. 2000 Income
Statement Analysis Sales and other operating revenues increased 128 percent in 2002. The increase was primarily attributable to increased product sales volumes due to the impact of the Tosco acquisition and the merger. These items were partially offset by lower natural gas sales prices in 2002 compared with 2001. Equity in earnings of affiliates increased 537 percent in 2002. In addition to equity earnings from affiliates acquired in the merger for the last four months of 2002, equity earnings from Chevron Phillips Chemical Company LLC (CPChem) improved in 2002 as a result of improved margins. Partially offsetting these items were lower earnings in 2002 from DEFS and Merey Sweeny, L.P. (MSLP). DEFS’ decline was primarily attributable to higher operating expenses, gas imbalance adjustments, and lower natural gas liquids prices, while MSLP’s decline was mainly due to lower crude oil light-heavy differentials. Other income increased 94 percent in 2002, mainly the result of a favorable revaluation and settlement of long-term incentive performance units held by former senior Tosco executives, as well as additional interest income following the merger. During 2002, the company recorded gains totaling $59 million before-tax, as the incentive performance units were marked-to-market each reporting period and eventually settled. See Note 6 — Acquisition of Tosco Corporation in the Notes to Consolidated Financial Statements for more information. Purchased crude oil and products increased 176 percent in 2002. The increase reflects higher purchase volumes of crude oil and petroleum products resulting from the Tosco acquisition and the merger. Production and operating expenses increased 89 percent in 2002, while selling, general and administrative (SG&A) expenses increased 171 percent. Both increases were primarily attributable to the Tosco acquisition and the merger. In conjunction with the merger, ConocoPhillips wrote off $246 million of acquired in-process research and development costs related to Conoco’s natural gas-to-liquids and other technologies to production and operating expenses in 2002. ConocoPhillips also expensed $135 million in merger-related costs to production and operating expenses and $379 million to SG&A expenses in 2002. Exploration expenses increased 93 percent in 2002. The increase reflects the merger, a $77 million leasehold impairment of deepwater Block 34, offshore Angola, and dry hole costs of $161 million in 2002, compared with $48 million in 2001. Depreciation, depletion and amortization increased 65 percent in 2002, compared with 2001. The increase was primarily the result of an increased depreciable base of properties, plants and equipment following the merger and the Tosco acquisition. During 2002, ConocoPhillips recorded property impairments totaling $49 million in connection with the sale of its Point Arguello assets, offshore California; two fields in the U.K. North Sea; and its interest in a non-producing field in Alaska. Impairment of tradenames ($102 million) was also recognized in the statement of operations in 2002. Property impairments recorded in 2001 consisted primarily of a $23 million impairment of the Siri field, offshore Denmark. See Note 10 — Impairments in the Notes to Consolidated Financial Statements for additional information. Taxes other than income taxes increased 153 percent in 2002, compared with 2001. The increase reflects higher excise taxes due to higher petroleum products sales and increased property and payroll taxes following the merger and the Tosco acquisition. Environmental liabilities assumed in acquisitions and mergers are recorded as liabilities at discounted amounts — i.e. the total future estimated cost is determined, then discounted back to current dollars using a time-value-of-money concept. Over time the liability is increased by accretion to reflect the time value of money. Accretion on discounted liabilities increased 214 percent in 2002, reflecting the impact of the environmental liabilities assumed in the Tosco acquisition and the merger. Interest expense increased 67 percent in 2002, mainly due to higher debt levels following the Tosco acquisition and the merger. Foreign currency losses of $24 million were recorded in 2002, compared with losses of $11 million in 2001. Preferred dividend requirements decreased in 2002, reflecting the redemption of $300 million of preferred securities in May 2002. The company’s effective tax rate from continuing operations in 2002 was 67 percent, compared with 51 percent in 2001. The increase in the effective tax rate in 2002 was primarily the result of the write-off of in-process research and development costs without a corresponding tax benefit and a higher proportion of income in higher-tax-rate jurisdictions. Losses from discontinued operations were $993 million in 2002, compared with income of $32 million in 2001. The 2002 amount includes after-tax impairments and loss accruals. See Note 4 — Discontinued Operations in the Notes to Consolidated Financial Statements for additional information. 2001
vs. 2000 Sales and other operating revenues increased 12 percent in 2001, primarily due to the Tosco acquisition and increased crude oil production. These items were partially offset by the use of equity-method accounting for the DEFS and CPChem joint ventures, as well as a reduction in revenues attributable to certain non-core assets sold at year-end 2000. Equity in earnings of affiliated companies decreased 64 percent in 2001. In the 2001 period, ConocoPhillips incurred a before-tax equity loss from its investment in CPChem of $240 million. ConocoPhillips’ equity earnings related to DEFS were higher in 2001, as a result of a full year’s activity in 2001, compared with only nine months in 2000. Equity earnings in 2001 benefited from a full year’s operations at MSLP, a 50-percent-owned equity company that owns and operates the coker unit at the Sweeny, Texas, refinery. Other income decreased 59 percent in 2001, primarily attributable to lower net gains on asset sales in 2001 compared with 2000. Total costs and expenses increased 16 percent in 2001, compared with 2000. The increase was mainly the result of the Tosco acquisition, as well as a full year’s ownership of the company’s Alaskan E&P operations that were acquired in April 2000. These items were partially offset by the use of equity-method accounting for the DEFS and CPChem joint ventures, and lower crude oil acquisition costs at the company’s refineries. Segment
Results 2002
vs. 2001 ConocoPhillips’ proved reserves at year-end 2002 were 7.81 billion barrels of oil equivalent, a 52 percent increase over 5.13 billion barrels at year-end 2001. The increase was attributable to the merger. 2001
vs. 2000 ConocoPhillips’ proved reserves at year-end 2001 were 5.13 billion barrels of oil equivalent, a 2 percent increase over 5.02 billion barrels at year-end 2000. U.S.
E&P The company’s U.S. crude oil production decreased slightly in 2002, while natural gas production increased 20 percent. The increase in natural gas production was mainly due to four months of production from fields acquired in the merger. The merger impact on total crude oil production was offset by lower production in Alaska, which experienced normal field declines, along with operating interruptions at the Prudhoe Bay field during the year. With a full year’s combined production from both Conoco and Phillips operations, the company expects that its total U.S. oil and gas production volumes will increase in 2003 over those of 2002. ConocoPhillips’ fourth quarter production volumes, which included a full period of combined operations, averaged 426,000 barrels per day of liquids and 1,548 million cubic feet per day of natural gas. 2001
vs. 2000 International
E&P The company’s international crude oil production increased 64 percent in 2002, while natural gas production increased 126 percent. The increases were mainly due to the addition of four months of production from fields acquired in the merger. With a full year’s combined production from both Conoco and Phillips operations, the company expects that its total international oil and gas production volumes will increase in 2003 over those of 2002. ConocoPhillips’ fourth quarter production volumes, which included a full period of combined operations, averaged 585,000 barrels per day of liquids and 1,994 million cubic feet per day of natural gas. 2001
vs. 2000 International crude oil production declined 3 percent in 2001, mainly due to lower production in the U.K. North Sea, Venezuela and Canada, partly offset by increased production from Norway and Nigeria. Canadian and Venezuelan crude oil production declined relative to 2000 due to asset dispositions. Production in the U.K. North Sea decreased on normal field declines. Production from Norway improved in 2001 due to improved processing reliability and well workovers, while Nigerian production increased on development activities and higher quotas. International natural gas production declined 10 percent in 2001, primarily the result of the Canadian asset dispositions and lower U.K. North Sea output noted above, partially offset by higher production in Nigeria and new natural gas production from offshore western Australia. Midstream 2002
vs. 2001 Included in the Midstream segment’s net income in 2002 was a benefit of $35 million, representing the amortization of the basis difference between the book value of ConocoPhillips’ contribution to DEFS and its 30.3 percent equity interest in DEFS. The corresponding amount for 2001 was $36 million. See Note 8 — Investments and Long-Term Receivables, in the Notes to Consolidated Financial Statements for additional information on the basis difference. 2001
vs. 2000 R&M 2002
vs. 2001 Worldwide crude oil refining capacity utilization was 90 percent in 2002, compared with 94 percent in 2001. The company’s refineries produced 2,011,000 barrels per day of petroleum products in 2002, compared with 814,000 barrels per day in 2001. The increase reflects a full year of operations for refineries acquired in the Tosco acquisition and four months of operations for the refineries acquired in the merger. 2001
vs. 2000 Worldwide crude oil refining capacity utilization was 94 percent in 2001, compared with 90 percent in 2000. The company’s refineries produced 814,000 barrels per day of petroleum products in 2001, compared with 365,000 barrels per day in 2000. The increase reflects the Tosco acquisition. U.S.
R&M The crude oil capacity utilization rate for ConocoPhillips’ U.S. refineries was 91 percent in 2002, compared with 94 percent in 2001. The lower utilization rate in 2002 reflects increased maintenance turnaround activity in 2002, the impact of tropical storms on the company’s Gulf Coast refineries in the third quarter of 2002, and the impact of the loss of Venezuelan crude oil supply in the fourth quarter. 2001
vs. 2000 In addition to the Tosco acquisition, R&M’s earnings benefited from higher gasoline and distillates margins, particularly during the second quarter of 2001, and the accounting change discussed above. Negatively affecting R&M results for the year were higher utility costs at the company’s refineries, resulting from higher natural gas prices experienced in the first half of 2001, as well as a $27 million write-down of inventories to market value. The Sweeny refinery’s 2001 net income benefited from the coker unit that was started up in late 2000. The coker unit allows for the processing of heavier, lower-cost crude oil, which reduced crude oil purchase costs and contributed to the improved gasoline and distillates margins experienced during 2001. ConocoPhillips’ U.S. refineries (including those acquired in the Tosco acquisition since the acquisition date) processed an average of 686,000 barrels per day of crude oil in 2001, yielding a 94 percent capacity utilization rate. This compares with 303,000 barrels per day and a utilization rate of 90 percent in 2000. The Tosco acquisition accounted for 378,000 barrels per day in 2001. International
R&M The crude oil capacity utilization rate for ConocoPhillips’ international refineries was 78 percent in 2002, compared with 91 percent in 2001. The lower utilization rate in 2002 reflects the extended shutdown at the Humber refinery noted above. 2001
vs. 2000 Chemicals 2002
vs. 2001 The Chemicals segment incurred a net loss of $14 million in 2002, compared with a net loss of $128 million in 2001. The worldwide chemicals industry experienced an economic downturn beginning in the second half of 2000, and these difficult conditions remained present through 2001 and 2002. The downturn has been marked by decreased product demand and low product margins across key product lines. The smaller net loss in 2002 was primarily the result of higher margins due to lower operating expenses, feedstock costs and energy prices, partially offset by decreased sales prices. A fire caused the shutdown of styrene production at CPChem’s St. James, Louisiana, facility in February 2001. Production was restored in October 2001. Production volumes for other major product lines were comparable between 2002 and 2001. The net loss in 2001 included several asset retirements and impairments totaling $84 million after-tax because of depressed economic conditions. A developmental reactor at the Houston Chemical Complex in Pasadena, Texas, was retired; property impairments were recorded on two polyethylene reactors at the Orange chemical plant in Orange, Texas; an ethylene unit was retired at the Sweeny complex in Old Ocean, Texas; an equity affiliate of CPChem recorded a property impairment related to a polypropylene facility; property impairments were taken on the manufacturing facility in Puerto Rico; and the benzene and cyclohexane units at the Puerto Rico facility were retired. In addition, the valuation allowance on the Puerto Rico facility’s deferred tax asset related to its net operating losses was increased in 2001 so that the deferred tax assets were fully offset by valuation allowances. Partially offsetting these impairments was a business interruption insurance settlement recorded by CPChem and a favorable deferred tax adjustment, related to the tax basis of its investment, recorded by ConocoPhillips that resulted from an impairment related to the Puerto Rico facility, together totaling $57 million after-tax. 2001
vs. 2000 The difficult marketing environment led to several asset retirements and impairments being recorded by CPChem in 2001. Partially offsetting these impairments was a business interruption insurance settlement recorded by CPChem and a favorable deferred tax adjustment recorded by ConocoPhillips that resulted from the Puerto Rico facility impairment, together totaling $57 million after-tax. The net loss for 2000 included ConocoPhillips’ share of a property impairment that CPChem recorded in the fourth quarter related to its Puerto Rico facility. The impairment was required due to the deteriorating outlook for future paraxylene market conditions and a shift in strategic direction at the facility. In addition, a valuation allowance was recorded against a related deferred tax asset. Combined, these two items resulted in a non-cash $180 million after-tax charge to CPChem’s earnings. ConocoPhillips’ share was $90 million. Emerging
Businesses 2002
vs. 2001 The Emerging Businesses segment posted a net loss of $310 million in 2002, compared with a net loss of $12 million in 2001. Results for 2002 included a $246 million write-off of acquired in-process research and development costs related to Conoco’s natural gas-to-liquids and other technologies. In accordance with FASB Interpretation No. 4, “Applicability of FASB Statement No. 2 to Business Combinations Accounted for by the Purchase Method,” value assigned to research and development activities in the purchase price allocation that have no alternative future use should be charged to expense at the date of the consummation of the combination. The $246 million charge was the same on both a before-tax and after-tax basis, as there was no tax basis to the assigned value prior to its write-off. The increased number of developing businesses after the merger also contributed to the larger losses in 2002. ConocoPhillips announced in February 2003 that it will shut down its carbon fibers project, as a result of market, operating and technology uncertainties. At the time of the merger, the company identified these uncertainties facing the carbon fibers project and initiated a strategic update for the new management of the company. In early 2003, the strategic update was completed and management made the decision to shut down the project. In the preliminary purchase price allocation, the company valued the carbon fibers technology at an amount equal to the plant construction costs. In the first quarter of 2003, the company will reduce the preliminary purchase price allocation associated with this project and accrue for shutdown, severance and other related costs that will result in a corresponding net increase in goodwill of $125 million. 2001
vs. 2000 Corporate
and Other 2002
vs. 2001 Corporate general and administrative expenses increased 52 percent in 2002, primarily due to the impact of the merger. In addition, 2002 also included higher benefit-related costs, primarily from the accelerated vesting of awards under certain long-term compensation plans that occurred at the time of stockholder approval of the merger. Losses from discontinued operations were $993 million in 2002, compared with income of $32 million in 2001. The 2002 amount included after-tax impairments and loss accruals of $1,077 million associated with the assets held for sale. See Note 4 — Discontinued Operations in the Notes to Consolidated Financial Statements for additional information on the impairments and loss accruals, as well as a description of the assets included in discontinued operations. Merger-related costs in 2002 included restructuring accruals of $252 million, primarily related to work force reduction charges; change-in-control costs associated with seismic contracts totaling $22 million; and other transition costs of $33 million. Other merger-related costs of $250 million were recorded by the operating segments, bringing total merger-related costs to $557 million after-tax. The category “Other” consists primarily of items not directly associated with the operating segments on a stand-alone basis, including captive insurance operations, certain foreign currency gains and losses, the tax impact of consolidations, and dividends on the preferred securities of the Phillips 66 Capital Trusts I and II. Results from Other were improved in 2002 primarily due to more favorable foreign currency transactions, and a favorable revaluation and settlement of certain long-term incentive units that were converted into Phillips performance units held by former senior Tosco executives, none of whom are employees of ConocoPhillips. Included in 2002 and 2001 were extraordinary losses on the early retirement of debt totaling $16 million and $10 million, respectively. 2001
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