Management’s Discussion and Analysis of Financial Condition and Results of Operations (continued)

February 21, 2008

 

CAUTIONARY STATEMENT FOR THE PURPOSES OF THE “SAFE HARBOR” PROVISIONS OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
This report includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. You can identify our forward-looking statements by the words “anticipate,” “estimate,” “believe,” “continue,” “could,” “intend,” “may,” “plan,” “potential,” “predict,” “should,” “will,” “expect,” “objective,” “projection,” “forecast,” “goal,” “guidance,” “outlook,” “effort,” “target” and similar expressions.

We based the forward-looking statements relating to our operations on our current expectations, estimates and projections about ourselves and the industries in which we operate in general. We caution you these statements are not guarantees of future performance and involve risks, uncertainties and assumptions we cannot predict. In addition, we based many of these forward-looking statements on assumptions about future events that may prove to be inaccurate. Accordingly, our actual outcomes and results may differ materially from what we have expressed or forecast in the forward-looking statements. Any differences could result from a variety of factors, including the following:

• Fluctuations in crude oil, natural gas and natural gas liquids prices, refining and marketing margins and margins for our chemicals business.
• Potential failure or delays in achieving expected reserve or production levels from existing and future oil and gas development projects due to operating hazards, drilling risks and the inherent uncertainties in predicting oil and gas reserves and oil and gas reservoir performance.
• Unsuccessful exploratory drilling activities or the inability to obtain access to exploratory acreage.
• Failure of new products and services to achieve market acceptance.
• Unexpected changes in costs or technical requirements for constructing, modifying or operating facilities for exploration and production projects, manufacturing or refining.
• Unexpected technological or commercial difficulties in manufacturing, refining, or transporting our products, including synthetic crude oil and chemicals products.
• Lack of, or disruptions in, adequate and reliable transportation for our crude oil, natural gas, natural gas liquids, LNG and refined products.
• Inability to timely obtain or maintain permits, including those necessary for construction of LNG terminals or regasification facilities, comply with government regulations, or make capital expenditures required to maintain compliance.
• Failure to complete definitive agreements and feasibility studies for, and to timely complete construction of, announced and future LNG and refinery projects and related facilities.
• Potential disruption or interruption of our operations due to accidents, extraordinary weather events, civil unrest, political events or terrorism.
• International monetary conditions and exchange controls.
• Substantial investment or reduced demand for products as a result of existing or future environmental rules and regulations.
• Liability for remedial actions, including removal and reclamation obligations, under environmental regulations.
• Liability resulting from litigation.
• General domestic and international economic and political developments, including: armed hostilities; expropriation of assets; changes in governmental policies relating to crude oil, natural gas, natural gas liquids or refined product pricing, regulation, or taxation; other political, economic or diplomatic developments; and international monetary fluctuations.
• Changes in tax and other laws, regulations (including alternative energy mandates), or royalty rules applicable to our business.
• Inability to obtain economical financing for projects, construction or modification of facilities and general corporate purposes.
• The operation and financing of our midstream and chemicals joint ventures.
• The factors generally described in the “Risk Factors” section included in “Items 1 and 2 — Business and Properties” in our 2007 Annual Report on Form 10-K.

 

Quantitative and Qualitative Disclosures About Market Risk

Financial Instrument Market Risk
We and certain of our subsidiaries hold and issue derivative contracts and financial instruments that expose our cash flows or earnings to changes in commodity prices, foreign exchange rates or interest rates. We may use financial and commodity-based derivative contracts to manage the risks produced by changes in the prices of electric power, natural gas, crude oil and related products, fluctuations in interest rates and foreign currency exchange rates, or to exploit market opportunities.

Our use of derivative instruments is governed by an “Authority Limitations” document approved by our Board of Directors that prohibits the use of highly leveraged derivatives or derivative instruments without sufficient liquidity for comparable valuations without approval from the Chief Executive Officer. The Authority Limitations document also authorizes the Chief Executive Officer to establish the maximum Value at Risk (VaR) limits for the company and compliance with these limits is monitored daily. The Chief Financial Officer monitors risks resulting from foreign currency exchange rates and interest rates, while the Senior Vice President of Commercial monitors commodity price risk. Both report to the Chief Executive Officer. The Commercial organization manages our commercial marketing, optimizes our commodity flows and positions, monitors related risks of our upstream and downstream businesses, and selectively takes price risk to add value.

 

Commodity Price Risk
We operate in the worldwide crude oil, refined products, natural gas, natural gas liquids, and electric power markets and are exposed to fluctuations in the prices for these commodities. These fluctuations can affect our revenues, as well as the cost of operating, investing, and financing activities. Generally, our policy is to remain exposed to the market prices of commodities; however, executive management may elect to use derivative instruments to hedge the price risk of our crude oil and natural gas production, as well as refinery margins.

Our Commercial organization uses futures, forwards, swaps, and options in various markets to optimize the value of our supply chain, which may move our risk profile away from market average prices to accomplish the following objectives:

• Balance physical systems. In addition to cash settlement prior to contract expiration, exchange traded futures contracts also may be settled by physical delivery of the commodity, providing another source of supply to meet our refinery requirements or marketing demand.
• Meet customer needs. Consistent with our policy to generally remain exposed to market prices, we use swap contracts to convert fixed-price sales contracts, which are often requested by natural gas and refined product consumers, to a floating market price.
• Manage the risk to our cash flows from price exposures on specific crude oil, natural gas, refined product and electric power transactions.
• Enable us to use the market knowledge gained from these activities to do a limited amount of trading not directly related to our physical business. For the years ended December 31, 2007 and 2006, the gains or losses from this activity were not material to our cash flows or net income.

 

We use a VaR model to estimate the loss in fair value that could potentially result on a single day from the effect of adverse changes in market conditions on the derivative financial instruments and derivative commodity instruments held or issued, including commodity purchase and sales contracts recorded on the balance sheet at December 31, 2007, as derivative instruments in accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended (SFAS No. 133). Using Monte Carlo simulation, a 95 percent confidence level and a one-day holding period, the VaR for those instruments issued or held for trading purposes at December 31, 2007 and 2006, was immaterial to our net income and cash flows. The VaR for instruments held for purposes other than trading at December 31, 2007 and 2006, was also immaterial to our net income and cash flows.

Interest Rate Risk
The following tables provide information about our financial instruments that are sensitive to changes in short-term U.S. interest rates. The debt table presents principal cash flows and related weighted-average interest rates by expected maturity dates. Weighted-average variable rates are based on implied forward rates in the yield curve at the reporting date. The carrying amount of our floating-rate debt approximates its fair value. The fair value of the fixed-rate financial instruments is estimated based on quoted market prices.

 

 

At the beginning of 2007, we held interest rate swaps that converted $350 million of debt from fixed to floating rate. Under SFAS No. 133, these swaps were designated as hedging the exposure to changes in the fair value of $350 million of 4.75% Notes due 2012. This hedge was terminated in December 2007, when we sold our positions in the swaps for approximately $3 million.

The following table presents principal cash flows of the fixed-rate 5.3 percent joint venture acquisition obligation owed to FCCL Oil Sands Partnership. The fair value of the obligation is estimated based on the net present value of the future cash flows, discounted at a year-end 2007 effective yield rate of 4.9 percent, based on yields of U.S. Treasury securities of a similar average duration adjusted for ConocoPhillips’ average credit risk spread and the amortizing nature of the obligation principal.

 

Foreign Currency Risk
We have foreign currency exchange rate risk resulting from international operations. We do not comprehensively hedge the exposure to currency rate changes, although we may choose to selectively hedge exposures to foreign currency rate risk. Examples include firm commitments for capital projects, certain local currency tax payments and dividends, and cash returns from net investments in foreign affiliates to be remitted within the coming year.

At December 31, 2007 and 2006, we held foreign currency swaps hedging short-term intercompany loans between European subsidiaries and a U.S. subsidiary. Although these swaps hedge exposures to fluctuations in exchange rates, we elected not to utilize hedge accounting as allowed by SFAS No. 133. As a result, the change in the fair value of these foreign currency swaps is recorded directly in earnings. Since the gain or loss on the swaps is offset by the gain or loss from remeasuring the intercompany loans into the functional currency of the lender or borrower, there would be no material impact to income from an adverse hypothetical 10 percent change in the December 31, 2007 or 2006, exchange rates. The notional and fair market values of these positions at December 31, 2007 and 2006, were as follows:

 

 

For additional information about our use of derivative instruments, see Note 19 — Financial Instruments and Derivative Contracts, in the Notes to Consolidated Financial Statements.