Management’s Discussion and Analysis of Financial Condition and Results of Operations
February 21, 2008
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, and intentions, 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,” “should,” “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 unless required to do so under the federal securities laws. 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,” beginning on page 53.
Business Environment and Executive Overview
ConocoPhillips is an international, integrated energy company. We are the third-largest integrated energy company in the United States, based on market capitalization. We have approximately 32,600 employees worldwide, and at year-end 2007 had assets of $178 billion. Our stock is listed on the New York Stock Exchange under the symbol “COP.”
Our business is organized into six operating segments:
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Exploration and Production (E&P) — This segment primarily explores for, produces, transports and markets crude oil, natural gas, and natural gas liquids on a worldwide basis.
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Midstream — This segment gathers, processes and markets natural gas produced by ConocoPhillips and others, and fractionates and markets natural gas liquids, primarily in the United States and Trinidad. The Midstream segment primarily consists of our 50 percent equity investment in DCP Midstream, LLC.
- Refining and Marketing (R&M) — This segment purchases, refines, markets and transports crude oil and petroleum products, mainly in the United States, Europe and Asia.
- LUKOIL Investment — This segment consists of our equity investment in the ordinary shares of OAO LUKOIL (LUKOIL), an international, integrated oil and gas company headquartered in Russia. At December 31, 2007, our ownership interest was 20 percent based on issued shares, and 20.6 percent based on estimated shares outstanding.
- Chemicals — This segment manufactures and markets petrochemicals and plastics on a worldwide basis. The Chemicals segment consists of our 50 percent equity investment in Chevron Phillips Chemical Company LLC (CPChem).
- Emerging Businesses — This segment represents our investment in new technologies or businesses outside our normal scope of operations.
Crude oil and natural gas prices, along with refining margins, are the most significant factors in our profitability. Accordingly, our overall earnings depend primarily upon the profitability of our E&P and R&M segments. Crude oil and natural gas prices, along with refining margins, are driven by market factors over which we have no control. However, from a competitive perspective, there are other important factors we must manage well to be successful, including:
- Operating our producing properties and refining and marketing operations safely, consistently and in an environmentally sound manner. Safety is our first priority and we are committed to protecting the health and safety of everyone who has a role in our operations and the communities in which we operate. Maintaining high utilization rates at our refineries and minimizing downtime in producing fields enable us to capture the value available in the market in terms of prices and margins. During 2007, our worldwide refinery capacity utilization rate was 94 percent, compared with 92 percent in 2006. The improved utilization rate reflects less scheduled downtime and unplanned weather-related downtime. Concerning the environment, we strive to conduct our operations in a manner consistent with our environmental stewardship principles.
- Adding to our proved reserve base. We primarily add to our proved reserve base in three ways:
- Successful exploration and development of new fields.
- Acquisition of existing fields.
- Applying new technologies and processes to improve recovery from existing fields.
Access to additional resources has become increasingly difficult as direct investment is prohibited in some nations, while fiscal and other terms in other countries can make projects uneconomic or unattractive. In addition, political instability, competition from national oil companies, and lack of access to high-potential areas due to environmental or other regulation may negatively impact our ability to increase our reserve base. As such, the timing and level at which we add to our reserve base may, or may not, allow us to replace our production over subsequent years.
- Controlling costs and expenses. Since we cannot control the prices of the commodity products we sell, controlling operating and overhead costs and prudently managing our capital program, within the context of our commitment to safety and environmental stewardship, are high priorities. We monitor these costs using various methodologies that are reported to senior management monthly, on both an absolute-dollar basis and a per-unit basis. Because managing operating and overhead costs are critical to maintaining competitive positions in our industries, cost control is a component of our variable compensation programs.
With the rise in commodity prices over the last several years, and the subsequent increase in industry-wide spending on capital and major maintenance programs, we and other energy companies are experiencing inflation for the costs of certain goods and services in excess of general worldwide inflationary trends. Such costs include rates for drilling rigs, steel and other raw materials, as well as costs for skilled labor. While we work to manage the effect these inflationary pressures have on our costs, our capital program has been impacted by these factors. The continued weakening of the U.S. dollar has also contributed to higher costs. Our capital program may be further impacted by these factors going forward.
- Selecting the appropriate projects in which to invest our capital dollars. We participate in capital-intensive industries. As a result, we must often invest significant capital dollars to explore for new oil and gas fields, develop newly discovered fields, maintain existing fields, or continue to maintain and improve our refinery complexes. We invest in those projects that are expected to provide an adequate financial return on invested dollars. However, there are often long lead times from the time we make an investment to the time that investment is operational and begins generating financial returns.
In January 2007, we entered into two 50/50 business ventures with EnCana to create an integrated North American heavy-oil business, consisting of a Canadian upstream general partnership, FCCL Oil Sands Partnership (FCCL), and a U.S. downstream limited liability company, WRB Refining LLC (WRB). We are obligated to contribute $7.5 billion, plus accrued interest, to FCCL over a 10-year period beginning in 2007. EnCana is obligated to contribute $7.5 billion, plus accrued interest, to WRB over a 10-year period beginning in 2007.
Our capital expenditures and investments in 2007 totaled $11.8 billion, and we anticipate capital expenditures and investments to be approximately $14.3 billion in 2008. In addition to our capital program, we increased shareholder distributions in 2007 through a combination of increased dividends and share repurchases. Our cash dividends totaled $1.64 per share in 2007, an increase of 14 percent over $1.44 per share in 2006. We repurchased $7 billion of our common stock in 2007 and have $10 billion of share repurchase authority remaining through 2008.
- Managing our asset portfolio. We continue to evaluate opportunities to acquire assets that will contribute to future growth at competitive prices. We also continually assess our assets to determine if any no longer fit our strategic plans and should be sold or otherwise disposed. This management of our asset portfolio is important to ensuring our long-term growth and maintaining adequate financial returns. During 2006, we increased our investment in LUKOIL, ending the year with a 20 percent ownership interest based on issued shares. During 2006, we completed the $33.9 billion acquisition of Burlington Resources. Also during 2006, we announced the commencement of an asset rationalization program to evaluate our asset base to identify those assets that may no longer fit into our strategic plans or those that could bring more value by being monetized in the near term. This program generated proceeds of approximately $3.8 billion through December 31, 2007. In 2008, we expect to complete the disposition of our retail assets in the United States, Norway, Sweden and Denmark. We will evaluate additional opportunities to optimize and strengthen our asset portfolio as the year progresses.
- Hiring, developing and retaining a talented work force. We strive to attract, train, develop and retain individuals with the knowledge and skills to implement our business strategy and who support our values and ethics. In 2007, we hired approximately 2,900 new employees around the world, including university hires as well as experienced hires. Throughout the company, we focus on the continued learning, development and technical training of our employees. Professional new hires participate in structured development programs designed to accelerate their technical and functional skills. The ongoing hiring and training of employees is especially important given the significant number of experienced technical personnel potentially exiting the workplace over the next few years.
Our key performance indicators are shown in the statistical tables provided at the beginning of the operating segment sections that follow. These include crude oil, natural gas and natural gas liquids prices and production, refining capacity utilization, and refinery output.
Other significant factors that can affect our profitability include:
- Property and leasehold impairments. As mentioned above, we participate in capital-intensive industries. At times, these investments become impaired when our reserve estimates are revised downward, when crude oil or natural gas prices, or refinery margins decline significantly for long periods of time, or when a decision to dispose of an asset leads to a write-down to its fair market value. Property impairments in 2007, excluding the impairment of expropriated assets, totaled $442 million, compared with $383 million in 2006. We may also invest large amounts of money in exploration blocks which, if exploratory drilling proves unsuccessful, could lead to a material impairment of leasehold values.
- Goodwill. As a result of mergers and acquisitions, at year-end 2007 we had $29.3 billion of goodwill on our balance sheet, compared with $31.5 billion of goodwill at year-end 2006. Although our latest tests indicate that no goodwill impairment is currently required, future deterioration in market conditions could lead to goodwill impairments that would have a substantial negative, though non-cash, effect on our profitability.
- Effective tax rate. Our operations are located in countries with different tax rates and fiscal structures. Accordingly, even in a stable commodity price and fiscal/regulatory environment, our overall effective tax rate can vary significantly between periods based on the “mix” of pretax earnings within our global operations.
- Fiscal and regulatory environment. As commodity prices and refining margins improved over the last several years, certain governments have responded with changes to their fiscal take. These changes have generally negatively impacted our results of operations, and further changes to government fiscal take could have a negative impact on future operations. In June 2007, our Venezuelan oil projects were expropriated, and we recorded a $4,588 million before-tax ($4,512 million after-tax) impairment (see the “Expropriated Assets” section of Note 13 — Impairments, in the Notes to Consolidated Financial Statements). The company was also negatively impacted by increased production taxes enacted by the state of Alaska in the fourth quarter of 2007. In October 2007, the government of Ecuador increased the tax rate of the Windfall Profits Tax Law implemented in 2006, increasing the amount of government royalty entitlement on crude oil production to 99 percent of any increase in the price of crude oil above a contractual reference price. Also in October 2007, the Alberta provincial government publicly announced its intention to change the royalty structure for Crown lands, effective January 1, 2009 (see the "Outlook" section for additional information on the proposed royalty increase). In January 2008, we and our co-venturers agreed to the proportional dilution of our equity interests in the Republic of Kazakhstan’s North Caspian Sea Production Sharing Agreement, which includes the Kashagan field, to allow the state-owned energy company to increase its ownership percentage effective January 1, 2008, subject to completion of definitive agreements on dilution and other matters.
Partially offsetting the above fiscal take increases were lower corporate income tax rates enacted by Canada and Germany during 2007. These tax rate reductions applied to all corporations and were not exclusive to the oil and gas industry.
Segment Analysis
The E&P segment’s results are most closely linked to crude oil and natural gas prices. These are commodity products, the prices of which are subject to factors external to our company and over which we have no control. Industry crude oil prices for West Texas Intermediate were higher in 2007 compared with 2006, averaging $72.25 per barrel in 2007, an increase of 9 percent. The increase was primarily due to growth in global consumption associated with continuing economic expansions and limited spare capacity from major exporting countries. Industry natural gas prices for Henry Hub increased during 2007, primarily due to increased demand from the residential and electric power sector. These factors were moderated by higher domestic production, increased LNG imports, and high storage levels.
The Midstream segment’s results are most closely linked to natural gas liquids prices. The most important factor on the profitability of this segment is the results from our 50 percent equity investment in DCP Midstream. During 2005, we increased our ownership interest in DCP Midstream from 30.3 percent to 50 percent, and we recorded a gain of $306 million, after-tax, for our equity share of DCP Midstream’s sale of its general partnership interest in TEPPCO Partners, LP (TEPPCO). DCP Midstream’s natural gas liquids prices increased 19 percent in 2007.
Refining margins, refinery utilization, cost control, and marketing margins primarily drive the R&M segment’s results. Refining margins are subject to movements in the cost of crude oil and other feedstocks, and the sales prices for refined products, which are subject to market factors over which we have no control. Industry refining margins in the United States were stronger overall in comparison to 2006. Key factors contributing to the stronger refining margins in 2007 were lower industry refining utilization in the United States and higher distillate and gasoline demand. Wholesale marketing margins in the United States were lower in 2007, compared with those in 2006, as the market did not generally keep pace with the rising cost of crude oil.
The LUKOIL Investment segment consists of our investment in the ordinary shares of LUKOIL. In October 2004, we closed on a transaction to acquire 7.6 percent of LUKOIL’s shares from the Russian government for approximately $2 billion. During the remainder of 2004, all of 2005 and 2006, we invested an additional $5.5 billion, bringing our equity ownership interest in LUKOIL to 20 percent by year-end 2006, based on issued shares. At December 31, 2007, our ownership interest was 20 percent based on issued shares and 20.6 percent based on estimated shares outstanding. We initiated this strategic investment to gain further exposure to Russia’s resource potential, where LUKOIL has significant positions in proved reserves and production. We benefited from an increase in proved oil and gas reserves at an attractive cost, and our E&P segment should benefit from direct participation with LUKOIL in large oil projects in the northern Timan-Pechora province of Russia, and potential opportunities for participation in other developments.
The Chemicals segment consists of our 50 percent interest in CPChem. The chemicals and plastics industry is mainly a commodity-based industry where the margins for key products are based on market factors over which CPChem has little or no control. CPChem is investing in feedstock-advantaged areas in the Middle East with access to large, growing markets, such as Asia.
The Emerging Businesses segment represents our investment in new technologies or businesses outside our normal scope of operations. Activities within this segment are currently focused on power generation and other items, such as carbon-to-liquids, technology solutions, and alternative energy and programs, such as advanced hydrocarbon processes, energy conversion technologies, new petroleum-based products, and renewable fuels. Some of these technologies may have the potential to become important drivers of profitability in future years.
