Devon Energy - 10-Q quarterly report FY

 

(Mark One)

Registrant’s telephone number, including area code:
(405) 235-3611

Former name, former address and former fiscal year, if changed from last report.
Not applicable

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer þ      Accelerated filer o      Non-accelerated filer o

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

     The number of shares outstanding of Registrant’s common stock, par value $0.10, as of October 31, 2007, was 444,960,000.

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INDEX TO FORM 10-Q QUARTERLY REPORT
TO THE SECURITIES AND EXCHANGE COMMISSION

     This quarterly report on Form 10-Q includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements other than statements of historical facts included or incorporated by reference in this report, including, without limitation, statements regarding our future financial position, business strategy, budgets, projected revenues, projected costs and plans and objectives of management for future operations, are forward-looking statements. Such forward-looking statements are based on our examination of historical operating trends, the information which was used to prepare the December 31, 2006 reserve reports and other data in our possession or available from third parties. In addition, forward-looking statements generally can be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “intend,” “project,” “estimate,” “anticipate,” “believe,” or “continue” or the negatives or variations of such terms or similar terminology. Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to have been correct. Important factors that could cause actual results to differ materially from our expectations include, but are not limited to, our assumptions about:

     All subsequent written and oral forward-looking statements attributable to Devon, or persons acting on its behalf, are expressly qualified in their entirety by the cautionary statements. We assume no duty to update or revise our forward-looking statements based on changes in internal estimates or expectations or otherwise.

     “Bbl” or “Bbls” means barrel or barrels.

     “Bcf” means billion cubic feet.

     “Boe” means barrel of oil equivalent, determined by using the ratio of one Bbl of oil or NGLs to six Mcf of gas.

     “MMBbls” means million barrels.

     “MMBoe” means million Boe.

     “Mcf” means thousand cubic feet.

     “NGL” or “NGLs” means natural gas liquids.

     “Oil” includes crude oil and condensate.

     “SEC” means United States Securities and Exchange Commission.

     “Domestic” means the properties of Devon in the onshore continental United States and the offshore Gulf of Mexico.

     “United States Onshore” means the properties of Devon in the continental United States.

     “United States Offshore” means the properties of Devon in the Gulf of Mexico.

     “Canada” means the division of Devon encompassing oil and gas properties located in Canada.

     “International” means the division of Devon encompassing oil and gas properties that lie outside the United States and Canada.

See accompanying notes to consolidated financial statements.

See accompanying notes to consolidated financial statements.

See accompanying notes to consolidated financial statements.

See accompanying notes to consolidated financial statements.

See accompanying notes to consolidated financial statements.

     The accompanying consolidated financial statements and notes thereto of Devon Energy Corporation (“Devon”) have been prepared pursuant to the rules and regulations of the United States Securities and Exchange Commission. Accordingly, certain disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted. The accompanying consolidated financial statements and notes thereto should be read in conjunction with the consolidated financial statements and notes thereto included in Devon’s 2006 Annual Report on Form 10-K.

     In the opinion of Devon’s management, all adjustments (all of which are normal and recurring) that have been made are necessary to fairly state the consolidated financial position of Devon and its subsidiaries as of September 30, 2007, and the results of their operations and their cash flows for the three-month and nine-month periods ended September 30, 2007 and 2006.

     The following table reconciles earnings from continuing operations and common shares outstanding used in the calculations of basic and diluted earnings per share for the three-month and nine-month periods ended September 30, 2007 and 2006.

     Certain options to purchase shares of Devon’s common stock are excluded from the dilution calculations because the options are antidilutive. During the three-month and nine-month periods ended September 30, 2007, 2.1 million and 4.0 million shares were excluded from the diluted earnings per share calculations, respectively. During both the three-month and nine-month periods ended September 30, 2006, 2.6 million shares were excluded from the diluted earnings per share calculations.

     Devon owns approximately 14.2 million shares of Chevron Corporation (“Chevron”) common stock. The majority of these shares are held in connection with debt owed by Devon that contains an exchange option. This exchange option allows the debt holders, prior to the debt’s maturity, to exchange the debt for the shares of Chevron common stock owned by Devon.

     The shares of Chevron common stock and the exchange option embedded in the debt have always been recorded on Devon’s balance sheet at fair value. However, pursuant to accounting rules prior to January 1, 2007, only the change in fair value of the embedded option has historically been included in Devon’s results of operations. Conversely, the change in fair value of the Chevron common stock has not been included in Devon’s results of operations, but instead has been recorded directly to stockholders’ equity as part of “accumulated other comprehensive income.”

     Effective January 1, 2007, Devon adopted Statement of Financial Accounting Standards No. 159,The Fair Value Option for Financial Assets and Financial Liabilities – Including an Amendment of FASB Statement No. 115. Statement No. 159 allows a company the option to value its financial assets and liabilities, on an instrument by instrument basis, at fair value, and include the change in fair value of such assets and liabilities in its results of operations. Devon chose to apply the provisions of Statement No. 159 to its shares of Chevron common stock. Accordingly, beginning with the first quarter of 2007, the change in fair value of the Chevron common stock owned by Devon, along with the change in fair value of the related exchange option, are both included in Devon’s results of operations.

     In the three-month and nine-month periods ended September 30, 2007, the change in fair value of financial instruments caption on Devon’s statements of operations includes unrealized gains of $133 million and $285 million, respectively, related to the Chevron common stock, and unrealized losses of $111 million and $255 million, respectively, related to the embedded option. In the three-month and nine-month periods ended September 30, 2006, prior to adopting Statement No. 159, unrealized losses of $22 million and $83 million, respectively, related to the change in fair value of the embedded option were included in the change in fair value of financial instruments caption on Devon’s statements of operations.

     As of December 31, 2006, $364 million of after-tax unrealized gains related to Devon’s investment in the Chevron common stock was included in accumulated other comprehensive income. This is the amount of unrealized gains that, prior to Devon’s adoption of Statement No. 159, had not been recorded in Devon’s historical results of operations. Upon the adoption of Statement No. 159 as of January 1, 2007, this $364 million of unrealized gains was reclassified on Devon’s balance sheet from accumulated other comprehensive income to retained earnings.

     In conjunction with the adoption of Statement No. 159, Devon also adopted on January 1, 2007 Statement of Financial Accounting Standards No. 157, Fair Value Measurements. Statement No. 157 provides a common definition of fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements, but does not require any new fair value measurements. The adoption of Statement No. 157 had no impact on Devon’s financial statements, but it did result in additional required disclosures as set forth in Note 7.

     Devon and its subsidiaries are subject to current income taxes assessed by the federal and various state jurisdictions in the United States and by other foreign jurisdictions. In addition, Devon accounts for deferred income taxes related to these jurisdictions using the asset and

liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of assets and liabilities and their respective tax bases. Deferred tax assets are also recognized for the future tax benefits attributable to the expected utilization of existing tax net operating loss carryforwards and other types of carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences and carryforwards are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

     At September 30, 2007, undistributed earnings of foreign subsidiaries included in continuing operations were determined to be permanently reinvested. Therefore, no U.S. deferred income taxes were provided on such amounts at September 30, 2007. If it becomes apparent that some or all of the undistributed earnings will be distributed, Devon would then record taxes on those earnings.

     In June 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109.Interpretation No. 48 prescribes a threshold for recognizing the financial statement effects of a tax position when it is more likely than not, based on the technical merits, that the position will be sustained upon examination by a taxing authority. Recognized tax positions are initially and subsequently measured as the largest amount of tax benefit that is more likely than not of being realized upon ultimate settlement with a taxing authority. Liabilities for unrecognized tax benefits related to such tax positions are included in other long-term liabilities unless the tax position is expected to be settled within the upcoming year, in which case the liabilities are included in accrued expenses and other current liabilities. Interest and penalties related to unrecognized tax benefits are included in income tax expense.

     On January 1, 2007, Devon adopted Interpretation No. 48 and recorded a $10 million reduction to the January 1, 2007 balance of retained earnings related to unrecognized tax benefits. The $10 million includes $8 million for related interest and penalties. An additional $2 million of liabilities were recorded with a corresponding increase to goodwill.

     As a result of the adoption of Interpretation No. 48, certain liabilities included in income taxes payable and deferred income taxes were reclassified to other current and long-term liabilities in the accompanying balance sheet. The total $12 million increase in liabilities included a $15 million increase to long-term liabilities, partially offset by a $3 million reduction to current liabilities.

     As of January 1, 2007, Devon’s unrecognized tax benefits were $114 million. This amount included $82 million that, if recognized, would affect Devon’s effective income tax rate.

     Included below is a summary of the tax years, by jurisdiction, that remain subject to examination by taxing authorities.

     Devon is currently in the final stages of the administrative review process for certain open tax years. In addition, certain statute of limitation expirations are scheduled to occur in the next twelve months. Due to these factors, Devon anticipates it is reasonably possible that liabilities for certain tax positions will decrease between $15 million and $25 million within the next twelve months.

     On November 14, 2006, Devon announced that it intended to divest its operations in Egypt. Devon closed the sale of its Egyptian properties on October 4, 2007. Also, on January 23, 2007, Devon announced that it intends to divest its operations in West Africa. See Note 11 for more discussion regarding these divestiture activities.

     The following is a summary of the changes in Devon’s ARO for the first nine months of 2007 and 2006.

     During the nine months ended September 30, 2007 and 2006, Devon recognized a $311 million and $135 million revision to its ARO, respectively. The primary factors causing the 2007 fair value increase were an overall increase in abandonment cost estimates and an increase in the assumed inflation rate. The effect of these factors was partially offset by the effect of an increase in the discount rate used to calculate the present value of the obligations. The primary factor causing the 2006 fair value increase was an overall increase in abandonment cost estimates.

     In April 2007, Devon extended the maturity of its existing $2.5 billion five-year, syndicated, unsecured revolving line of credit (the “Senior Credit Facility”) from April 7, 2011 to April 7, 2012.

     The Senior Credit Facility contains only one material financial covenant. This covenant requires Devon to maintain a ratio of total funded debt to total capitalization, as defined in the credit agreement, of no more than 65%. As of September 30, 2007, Devon was in compliance with this covenant. Devon’s debt-to-capitalization ratio at September 30, 2007, as calculated pursuant to the terms of the agreement, was 24.8%.

     As of September 30, 2007, Devon had $400 million of outstanding borrowings under the Senior Credit Facility at an average rate of 5.85%. The available capacity under the Senior Credit Facility as of September 30, 2007, net of these borrowings as well as $1.7 billion of outstanding commercial paper and $280 million of outstanding letters of credit, was approximately $128 million.

     On August 7, 2007, Devon established a new $1.5 billion 364-day, syndicated, unsecured revolving senior credit facility (the “Short-Term Facility”). This new facility provides Devon with provisional interim liquidity until it receives the proceeds from divestitures of assets in Africa (see Note 11). The Short-Term Facility was also used to support an increase in Devon’s commercial paper program from $2 billion to $3.5 billion.

     The Short-Term Facility matures 364 days from the closing date. On the maturity date, all amounts outstanding will be due and payable at that time unless the maturity is extended. Prior to the maturity date, Devon has the option to convert any outstanding principal amount of loans under the Short-Term Facility to a term loan which will be repayable in a single payment 364 days from the maturity date.

     Amounts borrowed under the Short-Term Facility bear interest at various fixed rate options for periods of up to 12 months. Such rates are generally less than the prime rate. Devon may also elect to borrow at the prime rate. The Short-Term Facility currently provides for an annual facility fee of approximately $1.0 million that is payable quarterly in arrears.

     The agreement governing the Short-Term Facility contains substantially the same covenants and restrictions as Devon’s existing Senior Credit Facility, including a maximum allowed debt-to-capitalization ratio of 65% as defined in the agreement.

     As of September 30, 2007, there were no amounts borrowed under the Short-Term Facility, and the available capacity was $1.5 billion.

     As of September 30, 2007, Devon had $1.7 billion of outstanding commercial paper at an average rate of 5.66%.

     During the third quarter of 2007, certain holders of exchangeable debentures exercised their option to convert their debentures prior to the August 15, 2008 maturity date. Devon has the option to settle conversions of the exchangeable debentures with either shares of Chevron common stock or cash equal to the market value of Chevron common stock at the time of conversion. Devon paid $166 million in cash to settle the conversions in the third quarter of 2007. As a result of the $166 million payment, Devon retired outstanding exchangeable debentures totaling $104 million as well as the related embedded derivative option with a value of $62 million.

     As of September 30, 2007, the Chevron exchangeable debentures are due within one year. However, Devon continues to classify this debt as long-term because it has the intent and ability to refinance these debentures on a long-term basis with the available capacity under its existing credit facilities or other long-term financing arrangements.

     The following table presents the components of net periodic benefit cost and other comprehensive income for Devon’s pension and other post retirement benefit plans for the three-month and nine-month periods ended September 30, 2007 and 2006.

     In September 2006, the FASB issued Statement of Financial Accounting Standards No. 158,Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans—an amendment of FASB Statements No. 87, 88, 106, and 132(R). Statement No. 158 requires the measurement of plan assets and benefit obligations as of the date of the employer’s fiscal year-end, beginning with fiscal years ending after December 15, 2008. Although not required until 2008, Devon adopted this measurement-date requirement in the second quarter of 2007 and is changing its measurement date from November 30 to December 31. As a result, Devon used data as of December 31, 2006 to remeasure its plans assets and benefit obligations previously measured using data as of November 30, 2006. As a result of the remeasurement, Devon recognized the following amounts in the second quarter of 2007.

     Devon has various noncontributory defined benefit pension plans, including qualified and nonqualified plans (“Defined Benefit Plans”), that provide defined levels of benefits to its domestic employees. Devon also has a 401(k) Incentive Savings Plan (“401(k) Plan”) that covers its domestic employees. Benefits under the 401(k) Plan consist of a discretionary match of a percentage of employees’ contributions to the 401(k) Plan.

     In the second quarter of 2007, Devon adopted an enhanced defined contribution structure related to the 401(k) Plan to be effective January 1, 2008. Participants in this enhanced defined contribution structure will continue to receive a discretionary match of a percentage of their contributions to the 401(k) Plan. These participants will also receive additional, nondiscretionary contributions by Devon calculated as a percentage of annual compensation. The percentage will vary based on the employee’s years of service.

     On or before November 15, 2007, existing eligible employees will elect to either continue to participate in the Defined Benefit Plan or participate in the enhanced defined contribution structure of the 401(k) Plan. Employees who continue to participate in the Defined Benefit Plans will continue to accrue benefits under the existing provisions of the Defined Benefit Plans. Employees who elect to participate in the enhanced defined contribution structure will receive enhanced contributions to the 401(k) Plan and will retain the benefits which they have accrued under the Defined Benefit Plan as of December 31, 2007. However, such employees will only be entitled to the

benefits which have accrued in the Defined Benefit Plans as of December 31, 2007, after all applicable vesting requirements have been met. Employees hired on or after October 1, 2007 will not have an election and will only participate in the 401(k) Plan and the enhanced defined contribution structure.

     The effect the employee elections will have on Devon’s benefit obligations and related expenses will not be known until such elections are made with respect to the Defined Benefit Plans. However, based upon the most likely employee election scenarios, Devon expects that the effect, including any accelerated recognition of obligations of the Defined Benefit Plans, will be immaterial to its financial statements.

     In August 2005, Devon’s Board of Directors approved a stock repurchase program to repurchase up to 50 million shares of Devon’s common stock. This program was suspended in 2006 as a result of the $2.0 billion acquisition of oil and gas properties from Chief Holdings LLC (“Chief”) in June 2006. Prior to the suspension of the program and as of September 30, 2007, Devon had repurchased 6.5 million shares under this program for $387 million, or $59.80 per share. Although this program expires at the end of 2007, it could be extended. Should the Board of Directors elect to extend this repurchase program beyond the end of 2007, management expects to resume repurchases in conjunction with the closings of the planned sales of Devon’s operations in West Africa (see Note 11).

     On June 6, 2007, Devon’s Board of Directors approved an ongoing, annual stock repurchase program to offset dilution resulting from restricted stock issued to, and options exercised by, employees. The new repurchase program authorizes the repurchase of up to 4.5 million shares in 2007 and is in addition to the repurchase program described above. As of September 30, 2007, Devon had repurchased 1.8 million shares under the new program for $136 million, or $77.49 per share.

     Dividends on Devon’s common stock were paid in 2007 and 2006 at quarterly per share rates of $0.14 and $0.1125, respectively.

     Devon is party to various legal actions arising in the normal course of business. Matters that are probable of unfavorable outcome to Devon and which can be reasonably estimated are accrued. Such accruals are based on information known about the matters, Devon’s estimates of the outcomes of such matters and its experience in contesting, litigating and settling similar matters. None of the actions are believed by management to involve future amounts that would be material to Devon’s financial position or results of operations after consideration of recorded accruals although actual amounts could differ materially from management’s estimate.

     Devon is subject to certain laws and regulations relating to environmental remediation activities associated with past operations, such as the Comprehensive Environmental Response, Compensation, and Liability Act (“CERCLA”) and similar state statutes. In response to liabilities associated with these activities, accruals have been established when reasonable estimates are possible. Such accruals primarily include estimated costs associated with remediation. Devon has not used discounting in determining its accrued liabilities for environmental remediation, and no material claims for possible recovery from third party insurers or other parties related to environmental costs have been recognized in Devon’s consolidated financial statements. Devon adjusts the accruals when new remediation responsibilities are discovered and probable costs become estimable, or when current remediation estimates must be adjusted to reflect new information.

     Certain of Devon’s subsidiaries acquired in past mergers are involved in matters in which it has been alleged that such subsidiaries are potentially responsible parties (“PRPs”) under CERCLA or similar state legislation with respect to various waste disposal areas owned or operated by third parties. As of September 30, 2007, Devon’s consolidated balance sheet included $4 million of non-current accrued liabilities, reflected in “Other liabilities,” related to these and other environmental remediation liabilities. Devon does not currently believe there is a reasonable possibility of incurring additional material costs in excess of the current accruals recognized for such environmental remediation activities. With respect to the sites in which Devon subsidiaries are PRPs, Devon’s conclusion is based in large part on (i) Devon’s participation in consent decrees with both other PRPs and the Environmental Protection Agency, which provide for performing the scope of work required for remediation and contain covenants not to sue as protection to the PRPs, (ii) participation in groups as a de minimis PRP, and (iii) the availability of other defenses to liability. As a result, Devon’s monetary exposure is not expected to be material.

     Numerous gas producers and related parties, including Devon, have been named in various lawsuits alleging violation of the federal False Claims Act. The suits allege that the producers and related parties used below-market prices, improper deductions, improper measurement techniques and transactions with affiliates which resulted in underpayment of royalties in connection with natural gas and natural gas liquids produced and sold from federal and Indian owned or controlled lands. The principal suit in which Devon is a defendant is United States ex rel. Wright v. Chevron USA, Inc. et al. (the “Wright case”). The suit was originally filed in August 1996 in the United States District Court for the Eastern District of Texas, but was consolidated in October 2000 with the other suits for pre-trial proceedings in the United States District Court for the District of Wyoming. On July 10, 2003, the District of Wyoming remanded the Wright case back to the Eastern District of Texas to resume proceedings. On April 12, 2007, the court entered a trial plan and scheduling order in which the case will proceed in phases. A defendant other than Devon is set for trial in August 2008. The next phase trial is set for February 2009. Defendants, other than Devon, were selected for this trial. Devon believes that it has acted reasonably, has legitimate and strong defenses to all allegations in the suit, and has paid royalties in good faith. Devon does not currently believe that it is subject to material exposure in association with this lawsuit and no liability has been recorded in connection therewith.

     In 1995, the United States Congress passed the Deep Water Royalty Relief Act. The intent of this legislation was to encourage deep water exploration in the Gulf of Mexico by providing relief from the obligation to pay royalties on certain federal leases. Deep water leases issued in certain years by the Minerals Management Service (the “MMS”) have contained price thresholds, such that if the market prices for oil or natural gas exceeded the thresholds for a given year, royalty relief would not be granted for that year. Deep water leases issued in 1998 and 1999 did not include price thresholds. The MMS in 2006 informed Devon and other oil and gas companies that the omission of price thresholds from these leases was an error on its part and was not its intention. Accordingly, the MMS invited Devon and the other affected oil and gas producers to renegotiate the terms and conditions of the 1998 and 1999 leases to add price threshold provisions to the lease agreements for periods after October 1, 2006. Devon has since had several discussions with MMS representatives on this issue, but has not yet entered into renegotiated leases.

     The U.S. House of Representatives in January 2007 and July 2007 passed legislation that would require companies to renegotiate the 1998 and 1999 leases as a condition of securing future federal leases. If this legislation were to become law, it would require price thresholds to be effective in the renegotiated 1998 and 1999 leases effective October 1, 2006. Although Devon has not yet signed renegotiated leases, it has accrued through September 30, 2007 approximately $21 million for royalties that would be due if price thresholds were added to its 1998 and 1999 leases effective October 1, 2006.

     On October 25, 2007, the Alberta government proposed increases to the royalty rates on oil and natural gas production beginning in 2009. Devon believes this proposal would reduce future earnings and cash flows from its oil and gas properties located in Alberta. Additionally, assuming all other factors are equal, higher royalty rates would likely result in lower levels of capital investment in Alberta relative to Devon’s other areas of operation.

However, the magnitude of the potential impact, which will depend on the final form of enacted legislation and other factors which impact the relative expected economic returns of capital projects, cannot be reasonably estimated at this time.

     The SEC has been conducting an inquiry into payments made to the government of Equatorial Guinea and to officials and persons affiliated with officials of the government of Equatorial Guinea. On August 9, 2005, Devon received a subpoena issued by the SEC pursuant to a formal order of investigation. Devon has cooperated fully with the SEC’s requests for information in this inquiry. After responding in 2005 to such requests for information, Devon has not been contacted by the SEC. In the event that Devon receives any further inquiries, Devon will work with the SEC in connection with its investigation.

     Historically, Devon maintained a comprehensive insurance program that included coverage for physical damage to its offshore facilities caused by hurricanes. Devon’s historical insurance program also included substantial business interruption coverage which Devon is utilizing to recover costs associated with the suspended production related to hurricanes that struck the Gulf of Mexico in the third quarter of 2005. Under the terms of this insurance program, Devon was entitled to be reimbursed for the portion of production suspended longer than forty-five days, subject to upper limits to oil and natural gas prices. Also, the terms of the insurance include a standard, per-event deductible of $1 million for offshore losses as well as a $15 million aggregate annual deductible.

     Based on current estimates of physical damage and the anticipated length of time Devon will have production suspended, Devon expects its policy recoveries will exceed repair costs and deductible amounts. This expectation is based upon several variables, including the $467 million received in the third quarter of 2006 as a full settlement of the amount due from Devon’s primary insurers and $13 million received in the second quarter of 2007 as a full settlement of the amount due from certain of Devon’s secondary insurers. Devon continues to negotiate with its other secondary insurers and expects to receive additional policy recoveries as a result of such negotiations. As of September 30, 2007, $281 million of these proceeds had been utilized as reimbursement of past repair costs and deductible amounts. The remaining proceeds of $199 million are expected to be utilized as reimbursement of Devon’s anticipated future repair costs.

     Should Devon’s total policy recoveries, including settlements already received from Devon’s primary and secondary insurers, exceed all repair costs and deductible amounts, such excess will be recognized as other income in the statement of operations in the period in which such determination can be made.

     The policy underlying the insurance program terms described above expired on August 31, 2006. During the third quarter of 2006 and again in the third quarter of 2007, Devon was able to re-establish a comprehensive insurance program that includes business interruption and physical damage coverage for its business. However, due to significant changes in the marketplace, Devon was only able to obtain a de minimis amount of coverage for any damage that may be caused by named windstorms in the Gulf of Mexico. Devon has not experienced any windstorm losses covered by the new insurance arrangements through September 30, 2007.

     Certain of Devon’s assets and liabilities are reported at fair value in the accompanying balance sheets. The following table provides fair value measurement information for such assets and liabilities as of September 30, 2007.

     Statement No. 157 (see Note 1) establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value. As presented in the table above, this hierarchy consists of three broad levels. Level 1 inputs on the hierarchy consist of unadjusted quoted prices in active markets for identical assets and liabilities and have the highest priority. Level 3 inputs have the lowest priority.

     Devon uses appropriate valuation techniques based on the available inputs to measure the fair values of its assets and liabilities. When available, Devon measures fair value using Level 1 inputs because they generally provide the most reliable evidence of fair value. Devon owes debt that has an embedded exchange option. Because the exchange option is not actively traded in an established market, its fair value is measured using Level 2 inputs. Devon also has certain commodity and interest-rate derivative financial instruments which are measured using Level 2 inputs, such as forward commodity price curves or interest-rate yield curves. Devon only uses Level 3 inputs to measure the fair value of its ARO. A reconciliation of the beginning and ending balances of Devon’s ARO, including a revision of the fair value in 2007, is presented in Note 2.

     The components of change in fair value of financial instruments include the following:

     The following schedule summarizes the reductions of carrying value of oil and gas properties for the third quarter and first nine months of 2006.

     As a result of a decline in projected future net cash flows, the carrying value of Devon’s Russian properties exceeded the ceiling by $10 million in the third quarter of 2006. Therefore, in the third quarter of 2006, Devon recognized a $20 million reduction of the carrying value of its oil and gas properties in Russia, offset by a $10 million deferred income tax benefit.

     During the second quarter of 2006, Devon drilled two unsuccessful exploratory wells in Brazil and determined that the capitalized costs related to these two wells should be impaired. Therefore, in the second quarter of 2006, Devon recognized a $16 million impairment of its investment in Brazil equal to the costs to drill the two dry holes and a proportionate share of block-related costs. There was no tax benefit related to this impairment. The two wells were unrelated to Devon’s Polvo development project in Brazil.

     See Note 11 for information related to reductions of carrying value of oil and gas properties included in discontinued operations.

     The components of other income include the following:

     On November 14, 2006, Devon announced its plans to divest its operations in Egypt. On January 23, 2007, Devon announced its plans to divest its operations in West Africa. Pursuant to accounting rules for discontinued operations, Devon has classified all 2007 and prior period amounts related to its operations in Egypt and West Africa as discontinued operations.

     On October 4, 2007, Devon closed the sale of its Egyptian operations and received proceeds of $341 million. As a result of this sale, Devon will record an after-tax gain related to this transaction of approximately $130 million in the fourth quarter of 2007.

     Devon is finalizing purchase and sales agreements and obtaining the necessary partner and government

approvals for the properties in the West African divestiture package. Devon expects to complete these sales during the first half of 2008.

     Revenues related to Devon’s operations in Egypt and West Africa totaled $206 million and $223 million in the three months ended September 30, 2007 and September 30, 2006 and $596 million and $707 million in the nine months ended September 30, 2007 and September 30, 2006, respectively.

     The following table presents the main classes of assets and liabilities associated with Devon’s operations in Egypt and West Africa as of September 30, 2007 and December 31, 2006.

     Based on recent drilling activities in Nigeria, Devon reduced the carrying value of its Nigerian assets held for sale in the second quarter of 2007. As a result, earnings from discontinued operations in the nine months ended 2007 include a $13 million after-tax loss ($64 million pre-tax).

     As a result of unsuccessful exploratory activities in Egypt during the third quarter of 2006, the net book value of Devon’s Egyptian oil and gas properties, less related deferred income taxes, exceeded the ceiling by $18 million as of September 30, 2006. Therefore, in the third quarter of 2006, Devon recognized a $13 million after-tax loss Egypt ($31 million pre-tax).

     Due to unsuccessful drilling activities in Nigeria, in the first quarter of 2006, Devon recognized an $85 million impairment of its investment in Nigeria equal to the costs to drill two dry holes and a proportionate share of block-related costs. There was no income tax benefit related to this impairment.

     During the second quarter of 2007, the Canadian Federal government enacted a statutory rate reduction. As a result of this rate reduction, Devon recorded a $30 million deferred tax benefit in such quarter.

     Following is certain financial information regarding Devon’s reporting segments. The revenues reported are all from external customers.