Note 1—Interim Financial Information

 

The interim-period financial information presented in the financial statements included in this report is unaudited and includes all known accruals and adjustments, in the opinion of management, necessary for a fair presentation of the consolidated financial position of ConocoPhillips and its results of operations and cash flows for such periods.  All such adjustments are of a normal and recurring nature.  To enhance your understanding of these interim financial statements, see the consolidated financial statements and notes included in our 2008 Annual Report on Form 10-K.

Note 2—Changes in Accounting Principles

 

SFAS No. 165

Effective April 1, 2009, we adopted Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 165, “Subsequent Events.”  This Statement establishes the accounting for, and disclosure of, material events that occur after the balance sheet date, but before the financial statements are issued.  In general, these events will be recognized if the condition existed at the date of the balance sheet, and will not be recognized if the condition did not exist at the balance sheet date.  Disclosure is required for nonrecognized events if required to keep the financial statements from being misleading.  The guidance in this Statement is very similar to current guidance provided in auditing literature and, therefore, will not result in significant changes in practice.  Subsequent events have been evaluated through the date our interim financial statements were issued—the filing time and date of our second-quarter 2009 Quarterly Report on Form 10-Q.

 

SFAS No. 141 (Revised)

In December 2007, the FASB issued SFAS No. 141 (Revised), “Business Combinations” (SFAS No. 141(R)), which was subsequently amended by FASB Staff Position (FSP) FAS 141(R)-1 in April 2009.  This Statement applies prospectively to all transactions in which an entity obtains control of one or more other businesses on or after January 1, 2009.  In general, SFAS No. 141(R) requires the acquiring entity in a business combination to recognize the fair value of all assets acquired and liabilities assumed in the transaction; establishes the acquisition date as the fair value measurement point; and modifies disclosure requirements.  It also modifies the accounting treatment for transaction costs, in-process research and development, restructuring costs, changes in deferred tax asset valuation allowances as a result of a business combination, and changes in income tax uncertainties after the acquisition date.  Additionally, effective January 1, 2009, accounting for changes in valuation allowances for acquired deferred tax assets and the resolution of uncertain tax positions for prior business combinations impact tax expense instead of goodwill. 

 

SFAS No. 160

Effective January 1, 2009, we implemented SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements—an amendment of ARB No. 51,” which requires noncontrolling interests, previously called minority interests, to be presented as a separate item in the equity section of the consolidated balance sheet.  It also requires the amount of consolidated net income attributable to noncontrolling interests to be clearly presented on the face of the consolidated income statement.  Additionally, this Statement clarifies that changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation are equity transactions, and that deconsolidation of a subsidiary requires gain or loss recognition in net income based on the fair value on the deconsolidation date.  This Statement was applied prospectively with the exception of presentation and disclosure requirements, which were applied retrospectively for all periods presented, and did not significantly change the presentation of our consolidated financial statements.  Equity attributable to noncontrolling interests did not change materially from year-end 2008 to June 30, 2009.

 

SFAS No. 161

Effective January 1, 2009, we implemented SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities—an amendment of FASB No. 133.”  This Statement does not affect amounts reported in the financial statements; it only expands the disclosure requirements of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” to provide greater transparency for derivative instruments within the scope of that Statement.  Disclosures previously required only for the annual financial statements are now required in interim financial statements.  In addition, we now must include an indication of the volume of derivative activity by category (e.g., interest rate, commodity and foreign currency); derivative gains and losses, by category, for the periods presented in the financial statements; and expanded disclosures about credit-risk-related contingent features.  See Note 13—Financial Instruments and Derivative Contracts, for additional information.

 

SFAS No. 157

Effective January 1, 2008, we implemented SFAS No. 157, “Fair Value Measurements,” which defines fair value, establishes a framework for its measurement and expands disclosures about fair value measurements.  We elected to implement this Statement with the one-year deferral permitted by FSP FAS 157-2 for nonfinancial assets and nonfinancial liabilities measured at fair value, except those that are recognized or disclosed on a recurring basis (at least annually).  Following the one-year deferral permitted by FSP FAS 1572, effective January 1, 2009, we implemented SFAS No. 157 for nonfinancial assets and nonfinancial liabilities measured at fair value on a nonrecurring basis.  The implementation covers assets and liabilities measured at fair value in a business combination; impaired properties, plants and equipment, intangible assets and goodwill; initial recognition of asset retirement obligations; and restructuring costs for which we use fair value.  In the first six months of 2009, we did not have a business combination, impairment of goodwill or intangible asset, or restructuring accrual requiring the use of fair value.  Because there usually is a lack of quoted market prices for long-lived assets, the fair value of properties, plants and equipment is determined based on the present values of expected future cash flows using inputs reflecting our estimate of a number of variables used by industry participants when valuing similar assets, or based on a multiple of operating cash flow validated with historical market transactions of similar assets where possible.  Fair value used in the initial recognition of asset retirement obligations is determined based on the present value of expected future dismantlement costs incorporating our estimate of inputs used by industry participants when valuing similar liabilities.  There was no impact to our consolidated financial statements from the implementation of this Statement for nonfinancial assets and liabilities, and we do not expect any significant impact to our future consolidated financial statements, other than additional disclosures.

 

EITF No. 08-6

In November 2008, the FASB reached a consensus on Emerging Issues Task Force (EITF) Issue No. 08-6, “Equity Method Investment Accounting Considerations” (EITF 08-6), which was issued to clarify how the application of equity method accounting is affected by SFAS No. 141(R) and SFAS No. 160.  EITF 08-6 clarifies that an entity shall continue to use the cost accumulation model for its equity method investments.  It also confirms past accounting practices related to the treatment of contingent consideration and the use of the impairment model under Accounting Principles Board Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock.”  Additionally, it requires an equity method investor to account for a share issuance by an investee as if the investor had sold a proportionate share of the investment.  This Issue was effective January 1, 2009, and applies prospectively.

Note 3—Variable Interest Entities (VIEs)

 

We hold significant variable interests in VIEs that have not been consolidated because we are not considered the primary beneficiary.  Information on these VIEs follows.

 

We own a 24 percent interest in West2East Pipeline LLC, a company holding a 100 percent interest in Rockies Express Pipeline LLC, operated by Kinder Morgan Energy Partners, L.P.  Rockies Express is constructing a natural gas pipeline from Colorado to Ohio.  West2East is a VIE because a third party has a 49 percent voting interest through the end of the construction of the pipeline, but has no ownership interest.  This third party was originally involved in the project, but exited and retained its voting interest to ensure project completion.  We have no voting interest during the construction phase, but once the pipeline has been completed, our ownership will increase to 25 percent with a voting interest of 25 percent.  Additionally, we have contracted for approximately 22 percent of the pipeline capacity for a 10-year period once the pipeline becomes operational.  Construction commenced on the pipeline in 2006.  The operator anticipates construction completion in late 2009 and estimates total construction costs of approximately $6.7 billion.  Our portion is expected to be funded by a combination of equity contributions and a guarantee of debt incurred by Rockies Express.  Given our 24 percent ownership and the fact expected returns are shared among the equity holders in proportion to ownership, we are not the primary beneficiary.  We use the equity method of accounting for our investment.  At June 30, 2009, the book value of our investment in West2East was $437 million.  Construction cost estimates have increased significantly from original projections, and additional increases or other changes related to the investment may impact whether an other-than-temporary impairment of our equity investment in West2East is required.

 

We have a 30 percent ownership interest with a 50 percent governance interest in the OOO Naryanmarneftegaz (NMNG) joint venture to develop resources in the Timan-Pechora province of Russia.  The NMNG joint venture is a VIE because we and a related party, OAO LUKOIL, have disproportionate interests.  When related parties are involved in a VIE, reasonable judgment should take into account the relevant facts and circumstances for the determination of the primary beneficiary.  The activities of NMNG are more closely aligned with LUKOIL because they share Russia as a home country, and LUKOIL conducts extensive exploration activities in the same province.  Additionally, there are no financial guarantees given by LUKOIL or us, and LUKOIL owns 70 percent, versus our 30 percent direct interest.  As a result, we have determined we are not the primary beneficiary of NMNG, and we use the equity method of accounting for this investment. The funding of NMNG has been provided with equity contributions, primarily for the development of the Yuzhno Khylchuyu (YK) Field.  Initial production from YK was achieved in June 2008.  At June 30, 2009, the book value of our investment in the venture was $2,061 million.

 

Production from the NMNG joint venture fields is transported via pipeline to LUKOIL’s terminal at Varandey Bay on the Barents Sea and then shipped via tanker to international markets.  LUKOIL completed an expansion of the terminal’s gross oil-throughput capacity from 30,000 barrels per day to 240,000 barrels per day, with us participating in the design and financing of the expansion.  The terminal entity, Varandey Terminal Company, is a VIE because we and LUKOIL have disproportionate interests.  We had an obligation to fund, through loans, 30 percent of the terminal’s expansion costs, but have no governance or direct ownership interest in the terminal.  Similar to NMNG, we determined we are not the primary beneficiary for Varandey because of LUKOIL’s ownership, the activities are in LUKOIL’s home country, and LUKOIL is the operator of Varandey.  We account for our loan to Varandey as a financial asset.  Terminal expansion was completed in June 2008, and the final loan amount was $271 million at June 2009 exchange rates, excluding accrued interest.  Although repayments are not required to start until May 2010, beginning in the second half of 2008 and through June 30, 2009, Varandey used available cash to pay $40 million of interest.  The outstanding accrued interest at June 30, 2009, was $23 million at June 2009 exchange rates.

 

We have an agreement with Freeport LNG Development, L.P. (Freeport LNG) to participate in a liquefied natural gas (LNG) receiving terminal in Quintana, Texas.  We have no ownership in Freeport LNG; however, we own a 50 percent interest in Freeport LNG GP, Inc. (Freeport GP), which serves as the general partner managing the venture.  We entered into a credit agreement with Freeport LNG, whereby we agreed to provide loan financing for the construction of the terminal.  We also entered into a long-term agreement with Freeport LNG to use 0.9 billion cubic feet per day of regasification capacity.  The terminal became operational in June 2008, and we began making payments under the terminal use agreement.  In August 2008, the loan was converted from a construction loan to a term loan and consisted of $650 million in loan financing and $124 million of accrued interest.  Freeport LNG began making loan repayments in September 2008, and the loan balance outstanding as of June 30, 2009, was $737 million.  Freeport LNG is a VIE because Freeport GP holds no equity in Freeport LNG, and the limited partners of Freeport LNG do not have any substantive decision making ability.  We performed an analysis of the expected losses and determined we are not the primary beneficiary.  This expected loss analysis took into account that the credit support arrangement requires Freeport LNG to maintain sufficient commercial insurance to mitigate any loan losses.  The loan to Freeport LNG is accounted for as a financial asset, and our investment in Freeport GP is accounted for as an equity investment.

 

In the case of Ashford Energy Capital S.A., we consolidate this entity in our financial statements because we are the primary beneficiary of this VIE based on an analysis of the variability of the expected losses and expected residual returns.  In December 2001, in order to raise funds for general corporate purposes, ConocoPhillips and Cold Spring Finance S.a.r.l. formed Ashford through the contribution of a $1 billion ConocoPhillips subsidiary promissory note and $500 million cash by Cold Spring.  Through its initial $500 million investment, Cold Spring is entitled to a cumulative annual preferred return consisting of 1.32 percent plus a three-month LIBOR rate set at the beginning of each quarter.  The preferred return at June 30, 2009, was 2.51 percent.  Also on that date, Ashford held $2.1 billion of ConocoPhillips subsidiary notes and $28 million in investments unrelated to ConocoPhillips.  We report Cold Spring’s investment as a noncontrolling interest because it is not mandatorily redeemable, and the entity does not have a specified liquidation date.  Other than the obligation to make payment on the subsidiary notes described above, Cold Spring does not have recourse to our general credit.  On July 15, 2009, Ashford agreed to redeem the investment in Ashford held by Cold Spring.  The difference between the redemption amount and the carrying value of the investment was not material.

Note 4—Inventories

 

Inventories consisted of the following:

 

	Millions of Dollars
	June 30			December 31
		2009		2008
Crude oil and petroleum products	$	5,231		4,232
Materials, supplies and other		950		863
	$	6,181		5,095

 

 

Inventories valued on the last-in, first-out (LIFO) basis totaled $5,042 million and $3,939 million at June 30, 2009, and December 31, 2008, respectively.  The remaining inventories are valued under various methods, including first-in, first-out and weighted average.  The excess of current replacement cost over LIFO cost of inventories amounted to $4,873 million and $1,959 million at June 30, 2009, and December 31, 2008, respectively.

Note 5—Assets Held for Sale

 

In June 2009, we signed an agreement to sell our remaining interest in the Keystone Pipeline to TransCanada Corporation.  Subject to final regulatory approvals, the transaction is expected to close in the third quarter of this year.  As a result, at June 30, 2009, we reclassified $505 million from “Investments and long-term receivables” to “Prepaid expenses and other current assets” on our consolidated balance sheet, and recorded a noncash impairment of $59 million before-tax, including associated cumulative foreign currency translation losses of $36 million and allocable goodwill of $61 million.  This impairment, which is based on a Level 1 measurement in the fair value hierarchy, was reflected in “Equity in earnings of affiliates” in our consolidated income statement

Note 6—Investments, Loans and Long-Term Receivables

 

LUKOIL

Our ownership interest in LUKOIL was 20 percent at June 30, 2009, based on 851 million shares authorized and issued.  For financial reporting under U.S. generally accepted accounting principles (GAAP), treasury shares held by LUKOIL are not considered outstanding for determining our equity method ownership interest in LUKOIL. Our ownership interest, based on estimated shares outstanding, was 20.09 percent at June 30, 2009.

 

At June 30, 2009, the book value of our ordinary share investment in LUKOIL was $5,913 million.  Our 20 percent share of the net assets of LUKOIL was estimated to be $10,471 million.  A majority of this negative basis difference of $4,558 million is being amortized on a straight-line basis over a 22-year useful life as an increase to equity earnings.  On June 30, 2009, the closing price of LUKOIL shares on the London Stock Exchange was $44.37 per share, making the total market value of our LUKOIL investment $7,548 million.

 

Because LUKOIL’s accounting cycle close and preparation of U.S. GAAP financial statements occur subsequent to our reporting deadline, our equity earnings are estimated based on current market indicators, publicly available LUKOIL information and other objective data.  Once the difference between actual and estimated results is known, an adjustment is recorded.  Net income attributable to ConocoPhillips for the second quarter of 2009 included a $192 million positive alignment of our first-quarter estimate of LUKOIL’s results to LUKOIL’s reported results.

 

Loans to Related Parties

As part of our normal ongoing business operations and consistent with industry practice, we invest and enter into numerous agreements with other parties to pursue business opportunities, which share costs and apportion risks among the parties as governed by the agreements.  Included in such activity are loans made to certain affiliated companies.  Significant loans to affiliated companies at June 30, 2009, included the following:

 

·         $737 million in loan financing to Freeport LNG Development, L.P. for the construction of an LNG receiving terminal, which became operational in June 2008.  In August 2008, when the loan was converted from a construction loan to a term loan, it consisted of $650 million in loan financing and $124 million of accrued interest.  Freeport began making repayments in September 2008.

 

·         $271 million at June 2009 exchange rates, excluding accrued interest, in loan financing to Varandey Terminal Company associated with the costs of a terminal expansion.  Terminal expansion was completed in June 2008, and although repayments are not required to start until May 2010, beginning in the second half of 2008 and through June 30, 2009, Varandey used available cash to pay $40 million of interest.  The outstanding accrued interest at June 30, 2009, was $23 million at June 2009 exchange rates.

 

·         $956 million of project financing and an additional $82 million of accrued interest to Qatargas 3, an integrated project to produce and liquefy natural gas from Qatar’s North Field.  Our maximum exposure to this financing structure is $1.2 billion.

 

·         $150 million of loan financing to WRB Refining LLC to assist it in meeting its operating and capital spending requirements.  Due to its expected short-term nature, this loan financing is included in the “Other” line in the investing activities section of the consolidated statement of cash flows for the six months ended June 30, 2009.

The long-term portion of these loans are included in the “Loans and advances—related parties” line on the consolidated balance sheet, while the short-term portion is in “Accounts and notes receivable—related parties.”

 

Other Investments

We have investments remeasured at fair value on a recurring basis to support certain nonqualified deferred compensation plans.  The fair value of these assets at June 30, 2009, was $312 million, and substantially the entire value is categorized in Level 1 of the fair value hierarchy.

Note 7—Properties, Plants and Equipment

 

Our investment in properties, plants and equipment (PP&E), with accumulated depreciation, depletion and amortization (Accum. DD&A), was:

 

	Millions of Dollars
	June 30, 2009							December 31, 2008
	Gross PP&E			Accum. DD&A		Net PP&E		Gross PP&E		Accum. DD&A		Net PP&E
Exploration and Production (E&P)	$	108,846		40,404		68,442		102,591		35,375		67,216
Midstream		122		71		51		120		70		50
Refining and Marketing (R&M)		22,514		6,410		16,104		21,116		5,962		15,154
LUKOIL Investment		-		-		-		-		-		-
Chemicals		-		-		-		-		-		-
Emerging Businesses		1,191		290		901		1,056		293		763
Corporate and Other		1,579		831		748		1,561		797		764
	$	134,252		48,006		86,246		126,444		42,497		83,947

 

 

Suspended Wells

Our capitalized cost of suspended wells at June 30, 2009, was $861 million, an increase of $201 million from $660 million at year-end 2008.  For the category of exploratory well costs capitalized for a period greater than one year as of December 31, 2008, $13 million was charged to dry hole expense during the first six months of 2009.