Notes to Consolidated Financial Statements

Note 23 — Employee Benefit Plans

Pension and Postretirement Plans

On December 31, 2006, we adopted the recognition and disclosure provisions of SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans — an amendment of FASB Statements No. 87, 88, 106, and 132(R)” (SFAS No. 158). This new Statement requires employers to recognize the funded status (i.e., the difference between the fair value of plan assets and benefit obligations) of all defined benefit postretirement plans in the statement of financial position, with corresponding adjustments to accumulated other comprehensive income, net of tax, and intangible assets. The adjustment to accumulated other comprehensive income at adoption represents the net unrecognized actuarial losses/gains and unrecognized prior service costs, both of which were previously netted against the plan’s funded status in the statement of financial position pursuant to the provisions of Statement Nos. 87 and 106. These amounts will be subsequently recognized as net periodic postretirement cost in accordance with our historical accounting policy for amortizing such amounts. Further, actuarial gains and losses that arise in subsequent periods and are not recognized as net periodic postretirement cost in the same periods will be recognized as a component of other comprehensive income. These amounts will be subsequently recognized as a component of net periodic postretirement cost on the same basis as the amounts recognized in accumulated other comprehensive income at adoption of SFAS No. 158. Additionally, the Statement provides guidance regarding the classification of plan assets and liabilities in the statement of financial position.

An analysis of the projected benefit obligations for our pension plans and accumulated benefit obligations for our postretirement health and life insurance plans follows:

For both U.S. and international pensions, the overall expected long-term rate of return is developed from the expected future return of each asset class, weighted by the expected allocation of pension assets to that asset class. We rely on a variety of independent market forecasts in developing the expected rate of return for each class of assets.

All of our plans use a December 31 measurement date, except for a plan in the United Kingdom, which has a September 30 measurement date.

The adoption of SFAS No. 158 had no effect on the consolidated statement of income for the year ended December 31, 2006, or for any prior period presented, and it will not affect our reported operating results in future periods. Had we not been required to adopt SFAS No. 158, we would have recognized an additional minimum liability at December 31, 2006, pursuant to the provisions of Statement No. 87.

The effect of recognizing the additional minimum liability is included in the table below in the column labeled “Prior to Adopting SFAS No. 158.” The incremental effects of adopting the provisions of SFAS No. 158 on our consolidated balance sheet at December 31, 2006, are presented in the following table:

Included in accumulated other comprehensive income at December 31, 2006, are the following before-tax amounts that have not yet been recognized in net periodic postretirement benefit cost:

Amounts included in accumulated other comprehensive income at December 31, 2006, that are expected to be amortized into net periodic postretirement cost during 2007 are provided below:

During 2005, we recorded charges to other comprehensive income related to minimum pension liability adjustments totaling $96 million ($55 million net of tax), resulting in accumulated other comprehensive loss due to minimum pension liability adjustments at December 31, 2005, of $177 million ($115 million net of tax).

For our tax-qualified pension plans with projected benefit obligations in excess of plan assets, the projected benefit obligation, the accumulated benefit obligation, and the fair value of plan assets were $6,366 million, $5,400 million, and $4,543 million at December 31, 2006, respectively, and $5,896 million, $4,899 million, and $3,906 million at December 31, 2005, respectively.

For our unfunded non-qualified supplemental key employee pension plans, the projected benefit obligation and the accumulated benefit obligation were $345 million and $304 million, respectively, at December 31, 2006, and were $292 million and $227 million, respectively, at December 31, 2005.

The components of net periodic benefit cost of all defined benefit plans are presented in the following table:

We recognized pension settlement losses of $11 million and $4 million and special termination benefits of $1 million and $3 million in 2006 and 2005, respectively.

In determining net pension and other postretirement benefit costs, we amortize prior service costs on a straight-line basis over the average remaining service period of employees expected to receive benefits under the plan. For net gains and losses, we amortize ten percent of the unamortized balance each year.

We have multiple non-pension postretirement benefit plans for health and life insurance. The health care plans are contributory, with participant and company contributions adjusted annually; the life insurance plans are non-contributory. For most groups of retirees, any increase in the annual health care escalation rate above 4.5 percent is borne by the participant. The weighted-average health care cost trend rate for those participants not subject to the cap is assumed to decrease gradually from 9.5 percent in 2007 to 5.5 percent in 2015.

The assumed health care cost trend rate impacts the amounts reported. A one-percentage-point change in the assumed health care cost trend rate would have the following effects on the 2006 amounts:

Plan Assets — We follow a policy of broadly diversifying pension plan assets across asset classes, investment managers, and individual holdings. Asset classes that are considered appropriate include U.S. equities, non-U.S. equities, U.S. fixed income, non-U.S. fixed income, real estate, and private equity investments. Plan fiduciaries may consider and add other asset classes to the investment program from time to time. Our funding policy for U.S. plans is to contribute at least the minimum required by the Employee Retirement Income Security Act of 1974. Contributions to foreign plans are dependent upon local laws and tax regulations. In 2007, we expect to contribute approximately $430 million to our domestic qualified and non-qualified benefit plans and $165 million to our international qualified and non-qualified benefit plans.

A portion of U.S. pension plan assets is held as a participating interest in an insurance annuity contract. This participating interest is calculated as the market value of investments held under this contract, less the accumulated benefit obligation covered by the contract. At December 31, 2006, the participating interest in the annuity contract was valued at $181 million and consisted of $412 million in debt securities and $53 million in equity securities, less $284 million for the accumulated benefit obligation covered by the contract. At December 31, 2005, the participating interest was valued at $175 million and consisted of $407 million in debt securities and $71 million in equity securities, less $303 million for the accumulated benefit obligation. The participating interest is not available for meeting general pension benefit obligations in the near term. No future company contributions are required and no new benefits are being accrued under this insurance annuity contract.

In the United States, plan asset allocation is managed on a gross asset basis, which includes the market value of all investments held under the insurance annuity contract. On this basis, the weighted-average asset allocations are as follows:

The above asset allocations are all within guidelines established by plan fiduciaries.

Treating the participating interest in the annuity contract as a separate asset category results in the following weighted-average asset allocations:

The following benefit payments, which are exclusive of amounts to be paid from the participating annuity contract and which reflect expected future service, as appropriate, are expected to be paid:

Defined Contribution Plans

Most U.S. employees (excluding retail service station employees) are eligible to participate in the ConocoPhillips Savings Plan (CPSP). Employees can deposit up to 30 percent of their pay in the thrift feature of the CPSP to a choice of approximately 32 investment funds. ConocoPhillips matches deposits, up to 1.25 percent of eligible pay. Company contributions charged to expense for the CPSP and predecessor plans, excluding the stock savings feature (discussed below), were $19 million in 2006, $18 million in 2005, and $17 million in 2004. For the Burlington Resources Inc. Retirement Savings Plan (Burlington Savings Plan), ConocoPhillips matches deposits, up to 6 percent or 8 percent of the employee’s eligible pay based upon years of service. During 2006, ConocoPhillips contributed $7 million to the Burlington Savings Plan, to match eligible contributions by employees.

The stock savings feature of the CPSP is a leveraged employee stock ownership plan. Employees may elect to participate in the stock savings feature by contributing 1 percent of their salaries and receiving an allocation of shares of common stock proportionate to their contributions.

In 1990, the Long-Term Stock Savings Plan of Phillips Petroleum Company (now the stock savings feature of the CPSP) borrowed funds that were used to purchase previously unissued shares of company common stock. Since the company guarantees the CPSP’s borrowings, the unpaid balance is reported as a liability of the company and unearned compensation is shown as a reduction of common stockholders’ equity. Dividends on all shares are charged against retained earnings. The debt is serviced by the CPSP from company contributions and dividends received on certain shares of common stock held by the plan, including all unallocated shares. The shares held by the stock savings feature of the CPSP are released for allocation to participant accounts based on debt service payments on CPSP borrowings. In addition, during the period from 2007 through 2010, when no debt principal payments are scheduled to occur, the company has committed to make direct contributions of stock to the stock savings feature of the CPSP, or make prepayments on CPSP borrowings, to ensure a certain minimum level of stock allocation to participant accounts. The debt was refinanced during 2004; however, there was no change to the stock allocation schedule.

We recognize interest expense as incurred and compensation expense based on the fair market value of the stock contributed or on the cost of the unallocated shares released, using the shares-allocated method. We recognized total CPSP expense related to the stock savings feature of $126 million, $124 million and $85 million in 2006, 2005 and 2004, respectively, all of which was compensation expense. In 2006, 2005 and 2004, we made cash contributions to the CPSP stock savings feature of less than $1 million. In 2006, 2005 and 2004, we contributed 1,921,688 shares, 2,250,727 shares and 2,419,808 shares, respectively, of company common stock from the Compensation and Benefits Trust. The shares had a fair market value of $132 million, $130 million and $99 million, respectively. Dividends used to service debt were $37 million, $32 million, and $27 million in 2006, 2005 and 2004, respectively. These dividends reduced the amount of compensation expense recognized each period. Interest incurred on the CPSP debt in 2006, 2005 and 2004 was $12 million, $9 million and $5 million, respectively.

The total CPSP stock savings feature shares as of December 31 were:

The fair value of unallocated shares at December 31, 2006 and 2005, was $755 million and $689 million, respectively.

We have several defined contribution plans for our international employees, each with its own terms and eligibility depending on location. Total compensation expense recognized for these international plans including heritage Burlington Resources plans was approximately $31 million in 2006, $27 million in 2005 and $20 million in 2004.

Share-Based Compensation Plans

The 2004 Omnibus Stock and Performance Incentive Plan (the Plan) was approved by shareholders in May 2004. Over its 10-year life, the Plan allows the issuance of up to 70 million shares of our common stock for compensation to our employees, directors and consultants. After approval of the Plan, the heritage plans were no longer used for further awards. Of the 70 million shares available for issuance under the Plan, 40 million shares of common stock are available for incentive stock options, and no more than 40 million shares may be used for awards in stock.

Our share-based compensation programs generally provide accelerated vesting (i.e., a waiver of the remaining period of service required to earn an award) for awards held by employees at the time of their retirement. For share-based awards granted prior to our adoption of SFAS No. 123(R), we recognize expense over the period of time during which the employee earns the award, accelerating the recognition of expense only when an employee actually retires. For share-based awards granted after our adoption of SFAS No. 123(R) on January 1, 2006, we recognize share-based compensation expense over the shorter of: 1) the service period (i.e., the stated period of time required to earn the award); or 2) the period beginning at the start of the service period and ending when an employee first becomes eligible for retirement, but not less than six months, as this is the minimum period of time required for an award to not be subject to forfeiture.

Some of our share-based awards vest ratably (i.e., portions of the award vest at different times) while some of our awards cliff vest (i.e., all of the award vests at the same time). For awards granted prior to our adoption of SFAS No. 123(R) that vest ratably, we recognize expense on a straight-line basis over the service period for each separate vesting portion of the award (i.e., as if the award was multiple awards with different requisite service periods). For share-based awards granted after our adoption of SFAS No. 123(R), we recognize expense on a straight-line basis over the service period for the entire award, whether the award was granted with ratable or cliff vesting.

Total share-based compensation expense recognized in income and the associated tax benefit for the three years ended December 31, 2006, was as follows:

Stock Options — Stock options granted under the provisions of the Plan and earlier plans permit purchase of our common stock at exercise prices equivalent to the average market price of the stock on the date the options were granted. The options have terms of 10 years and generally vest ratably, with one-third of the options awarded vesting and becoming exercisable on each anniversary date following the date of grant. Options awarded to employees already eligible for retirement vest within six months of the grant date, but those options do not become exercisable until the end of the normal vesting period.

The following summarizes our stock option activity for the three years ended December 31, 2006:

The weighted-average remaining contractual term of vested options and exercisable options at December 31, 2006, was 4.79 years and 4.74 years, respectively.

During 2006, we received $231 million in cash and realizeda tax benefit of $117 million from the exercise of options. At December 31, 2006, the remaining unrecognized compensation expense from unvested options was $18 million, which will be recognized over the next 31 months.

The significant assumptions used to calculate the fair market values of the options granted over the past three years, as calculated using the Black-Scholes-Merton option-pricing model, were as follows:

We calculate volatility using all of the ConocoPhillips end-of-week closing stock prices available since the merger of Conoco and Phillips Petroleum on August 31, 2002, and will continue to do so until the span of data used equals the expected life of the options granted. We periodically calculate the average period of time lapsed between grant dates and exercise dates of past grants to estimate the expected life of new option grants. The change in expected life from six years in 2004 to slightly more than seven years in 2005 reflects a change in the population of employees receiving options.

Stock Unit Program — Stock units granted under the provisions of the Plan vest ratably, with one-third of the units vesting in 36 months, one-third vesting in 48 months, and the final third vesting 60 months from the date of grant. Upon vesting, the units are settled by issuing one share of ConocoPhillips common stock per unit. Units awarded to employees already eligible for retirement vest within six months of the grant date, but those units are not issued as shares until the end of the normal vesting period. Until issued as stock, most recipients of the units receive a quarterly cash payment of a dividend equivalent that is charged to expense. The grant date fair value of these units is deemed equal to the average ConocoPhillips stock price on the date of grant. The grant date fair market value of units that do not receive a dividend equivalent while unvested is deemed equal to the average ConocoPhillips stock price on the grant date, less the net
present value of the dividends that will not be received.

The following summarizes our stock unit activity for the three years ended December 31, 2006:

At December 31, 2006, the remaining unrecognized compensation cost from the unvested units was $105 million, which will be recognized over approximately the next four years.

Performance Share Program — Under the Plan, we also annually grant to senior management stock units that do not vest until the employee becomes eligible for retirement, so we recognize compensation expense for these awards beginning on the date of grant and ending on the date the employee becomes eligible for retirement; however, since these awards are authorized three years prior to the grant date, for employees eligible for retirement by or shortly after the grant date, we recognize compensation expense over the period beginning on the date of authorization and ending on the date of grant. These units are settled by issuing one share of ConocoPhillips common stock per unit, generally when the employee retires from ConocoPhillips. Until issued as stock, recipients of the units receive a quarterly cash payment of a dividend equivalent that is charged to expense. In its current form, the first grant of units under this program was in 2006.

The following summarizes our Performance Share Program activity for the year ended December 31, 2006:

At December 31, 2006, the remaining unrecognized compensation cost from unvested Performance Share awards was $35 million, which will be recognized over the next 14 years.

Other — In addition to the above active programs, we have outstanding shares of restricted stock and restricted stock units that were either issued to replace awards held by employees of companies we acquired or issued as part of a compensation program that has been discontinued. Generally, the recipients of the restricted shares or units receive a quarterly dividend or dividend equivalent.

The following summarizes the aggregate activity of these restricted shares and units for the three years ended December 31, 2006:

At December 31, 2006, the remaining unrecognized compensation cost from the unvested units was $15 million, which will be recognized over the next two years.

Compensation and Benefits Trust

The Compensation and Benefits Trust (CBT) is an irrevocable grantor trust, administered by an independent trustee and designed to acquire, hold and distribute shares of our common stock to fund certain future compensation and benefit obligations of the company. The CBT does not increase or alter the amount of benefits or compensation that will be paid under existing plans, but offers us enhanced financial flexibility in providing the funding requirements of those plans. We also have flexibility in determining the timing of distributions of shares from the CBT to fund compensation and benefits, subject to a minimum distribution schedule. The trustee votes shares held by the CBT in accordance with voting directions from eligible employees, as specified in a trust agreement with the trustee.

We sold 58.4 million shares of previously unissued company common stock to the CBT in 1995 for $37 million of cash, previously contributed to the CBT by us, and a promissory note from the CBT to us of $952 million. The CBT is consolidated by ConocoPhillips, therefore the cash contribution and promissory note are eliminated in consolidation. Shares held by the CBT are valued at cost and do not affect earnings per share or total common stockholders’ equity until after they are transferred out of the CBT. In 2006 and 2005, shares transferred out of the CBT were 1,921,688 and 2,250,727, respectively. At December 31, 2006, the CBT had 44,010,405 shares remaining. All shares are required to be transferred out of the CBT by January 1, 2021. The CBT, together with a smaller grantor trust included in the Burlington Resources acquisition, comprise the “Grantor trusts” line in the equity section of the consolidated balance sheet.