Hess - 10-Q quarterly report FY2010 Q1

     The financial statements included in this report reflect all normal and recurring adjustments which, in the opinion of management, are necessary for a fair presentation of Hess Corporation’s (the Corporation) consolidated financial position at March 31, 2010 and December 31, 2009 and the consolidated results of operations and cash flows for the three month periods ended March 31, 2010 and 2009. The unaudited results of operations for the interim periods reported are not necessarily indicative of results to be expected for the full year.

     The financial statements were prepared in accordance with the requirements of the Securities and Exchange Commission (SEC) for interim reporting. As permitted under those rules, certain notes or other financial information that are normally required by U.S. generally accepted accounting principles (GAAP) have been condensed or omitted from these interim financial statements. These statements, therefore, should be read in conjunction with the consolidated financial statements and related notes included in the Corporation’s Form 10-K for the year ended December 31, 2009.

     Effective January 1, 2010, the Corporation adopted the amended accounting standards that eliminated the consolidation exception for a qualifying special-purpose entity and changed the analysis necessary to determine whether consolidation of a variable interest entity is required. The adoption of these standards resulted in an increase of approximately $10 million to Property, plant and equipment and a corresponding increase to Long-term debt. The debt was subsequently repaid during the first quarter of 2010.

     Inventories consist of the following (in millions):

     The Corporation accounts for its investment in HOVENSA L.L.C. (HOVENSA) using the equity method. Summarized financial information for HOVENSA follows (in millions):

     In December 2009, the Corporation agreed to a strategic exchange of all of its interests in Gabon and the Clair Field in the United Kingdom for additional interests in the Valhall and Hod fields offshore Norway. In March 2010, the Corporation agreed to the sale of a package of mature, non-operated natural gas production and transportation assets in the United Kingdom North Sea. These transactions are subject to various regulatory and other approvals. The Corporation has classified all of the properties to be disposed of as held for sale. At March 31, 2010, the carrying amount of these assets totaling $855 million was reported in Other current assets. In addition, asset retirement obligations and deferred income taxes totaling $431 million were reported in Accrued liabilities.

     The following table discloses the net changes in capitalized exploratory well costs pending determination of proved reserves for the three months ended March 31, 2010 (in millions):

     The preceding table excludes costs related to exploratory dry holes of $11 million which were incurred and subsequently expensed in 2010. Capitalized exploratory well costs greater than one year old after completion of drilling were $1,066 million at March 31, 2010. Approximately 57% of the capitalized well costs in excess of one year relate to the Pony and Tubular Bells projects in the deepwater Gulf of Mexico where development planning is progressing. In addition, the Corporation is currently drilling an appraisal well at Pony. Approximately 12% relates to Area 54 offshore Libya where commercial analysis and development planning activities are ongoing. Approximately 10% relates to

Block WA-390-P offshore Western Australia where further drilling is in progress. Approximately 8% relates to Block BM-S-22 offshore Brazil where the operator plans to commence drilling a third exploration well in the second half of 2010. The remainder of the capitalized well costs in excess of one year relate to projects where further drilling is planned or development planning and other assessment activities are ongoing to determine the economic and operating viability of the projects.

     In December 2009, the Corporation issued $750 million of 30 year bonds and tendered for the $662 million of bonds due in August 2011. The Corporation completed the purchase of $546 million of the 2011 bonds in December 2009. The remaining $116 million of the 2011 bonds were redeemed in January 2010, resulting in a charge of approximately $11 million ($7 million after income taxes).

     Pre-tax foreign currency gains (losses) amounted to the following (in millions):

     Components of net periodic pension cost consisted of the following (in millions):

     In 2010, the Corporation expects to contribute approximately $190 million to its pension plans. The Corporation contributed $58 million to its pension plans in the first quarter of 2010.

     In the normal course of its business, the Corporation is exposed to commodity risks related to changes in the prices of crude oil, natural gas, refined products and electricity, as well as to changes in interest rates and foreign currency values. In the disclosures that follow these activities are referred to as energy marketing and risk management activities. The Corporation also has trading operations, principally through a 50% voting interest in a consolidated partnership, that are exposed to commodity price risks primarily related to the prices of crude oil, natural gas and refined products.

     Following is a description of the Corporation’s activities that use derivatives as part of their operations and strategies. Derivatives include both financial instruments and forward purchase and sale contracts. Gross notional amounts of both long and short positions are presented in the volume tables below. These amounts include long and short positions that offset in a closed position and have not reached contractual maturity. Gross notional amounts do not quantify risk or represent assets or liabilities of the Corporation, but are used in the calculation of cash settlements under the contracts.

     Energy Marketing Activities: In its energy marketing activities the Corporation sells refined petroleum products, natural gas and electricity principally to commercial and industrial businesses at fixed and floating prices for varying periods of time. Commodity contracts such as futures, forwards, swaps and options together with physical assets, such as storage, are used to obtain supply and reduce margin volatility or lower costs related to sales contracts with customers.

     The table below shows the gross volume of the Corporation’s energy marketing commodity contracts outstanding:

     The changes in fair value of certain energy marketing commodity contracts that are not designated as hedges are recognized currently in earnings. Revenues from the sales contracts are recognized in Sales and other operating revenues, supply contract purchases are recognized in Cost of products sold and net settlements from financial derivatives related to these energy marketing activities are recognized in Cost of products sold. Net realized and unrealized pre-tax gains on derivative contracts not designated as hedges amounted to $74 million and $77 million for the quarters ended March 31, 2010 and 2009, respectively.

     At March 31, 2010, a portion of energy marketing commodity contracts are designated as cash flow hedges to hedge variability of expected future cash flows of forecasted supply transactions. The length of time over which the Corporation hedges exposure to variability in future cash flows is predominantly two years or less. For contracts outstanding at March 31, 2010, the maximum duration was four years. The Corporation records the effective portion of changes in the fair value of cash flow hedges as a component of Other comprehensive income. Amounts recorded in Accumulated other comprehensive income are reclassified into Cost of products sold in the same period that the hedged item is recognized in earnings. The ineffective portion of changes in fair value of cash flow hedges is recognized immediately in Cost of products sold.

     At March 31, 2010, the after-tax deferred losses relating to energy marketing activities recorded in Accumulated other comprehensive income were $438 million ($303 million at December 31, 2009). The Corporation estimates that approximately $317 million of this amount will be reclassified into earnings over the next twelve months. During the three months ended March 31, 2010 and 2009, the Corporation reclassified losses from Accumulated other comprehensive income of $91 million and $69 million respectively. The amount of loss from hedge ineffectiveness reflected in earnings was $1 million during each of the three month periods ended March 31, 2010 and 2009. The decrease in the fair value of energy marketing cash flow hedges was $226 million for the three months ended March 31, 2010 and $308 million for the three months ended March 31, 2009.

     Corporate Risk Management: Corporate risk management activities include transactions designed to reduce risk in the selling prices of crude oil or natural gas produced by the Corporation or to reduce exposure to foreign currency or interest rate movements. Generally, futures, swaps or option strategies may be used to fix the forward selling price of a portion of the Corporation’s crude oil or natural gas production. Forward contracts may also be used to purchase certain currencies in which the

Corporation does business with the intent of reducing exposure to foreign currency fluctuations. These forward contracts comprise various currencies including the British pound and Thai baht. In the first quarter of 2010, the Corporation executed interest rate swaps to convert interest payments on certain long term debt from fixed to floating rates.

     The table below shows the gross volume of the Corporate risk management derivative instruments outstanding:

     During 2008, the Corporation closed Brent crude oil cash flow hedges covering 24,000 barrels per day through 2012, by entering into offsetting contracts with the same counterparty. As a result, the valuation of those contracts is no longer subject to change due to price fluctuations. There were no other open hedges of crude oil or natural gas production at March 31, 2010. Hedging activities decreased Exploration and Production Sales and other operating revenue by $131 million for both the first quarter of 2010 and the first quarter of 2009. There was no hedge ineffectiveness for the first quarter of 2010 and 2009.

     At March 31, 2010, the after-tax deferred losses in Accumulated other comprehensive income relating to Corporate risk management cash flow hedges were $874 million ($941 million at December 31, 2009). These deferred losses result from the closed Brent crude oil hedges referred to above. The Corporation estimates that approximately $335 million of this amount will be reclassified into earnings over the next twelve months. The pre-tax amount of deferred hedge losses is reflected in Accounts payable and the related income tax benefits are recorded as Deferred income tax assets on the balance sheet.

     The Corporation designates interest rate swaps as fair value hedges. Changes in fair value of interest rate swaps and the hedged fixed rate debt are recorded in Interest expense. For the three months ended March 31, 2010, the Corporation recorded an increase of $1 million in the fair value of interest rate swaps and a corresponding increase in the fair value of the hedged fixed rate debt.

     The change in fair value of foreign exchange contracts are not designated as hedges. Gains or losses on foreign exchange contracts are recognized immediately in Other, net in Revenues and non-operating income.

     Net pre-tax gains (losses) on derivative contracts used for Corporate risk management and not designated as hedges amounted to the following (in millions):

     Trading Activities: Trading activities are conducted principally through a trading partnership in which the Corporation has a 50% voting interest. This consolidated entity intends to generate earnings through various strategies primarily using energy commodities, securities and derivatives. The Corporation also takes trading positions for its own account.

     The table below summarizes the gross volume of the Corporation’s trading and derivative instruments outstanding:

     Pre-tax gains (losses) recorded in Sales and other operating revenues from trading activities amounted to the following (in millions):

     Fair Value Measurements: The Corporation determines fair value in accordance with the fair value measurements accounting standard (ASC 820 – Fair Value Measurements and Disclosures), which established a hierarchy that categorizes the sources of inputs, which generally range from quoted prices for identical instruments in a principal trading market (Level 1) to estimates determined using related market data (Level 3). Multiple inputs may be used to measure fair value, however, the level of fair value for each financial asset or liability presented below is based on the lowest significant input level within this fair value hierarchy.

     When Level 1 inputs are available within a particular market, those inputs are selected for determination of fair value over Level 2 or 3 inputs in the same market. To value Level 2 and 3 derivatives the Corporation uses observable inputs for similar instruments that are available from exchanges, pricing services or broker quotes. These observable inputs may be supplemented with other methods, including internal extrapolation, that result in the most representative prices for instruments with similar characteristics. Instruments are classified as Level 2 or 3 based on the lowest significant input.

     The following table provides the fair value of the Corporation’s financial assets and (liabilities) based on this hierarchy (in millions):

     The following table provides changes in financial assets and liabilities that are measured at fair value based on Level 3 inputs (in millions):

     Effective January 1, 2010, the Corporation’s policy is to recognize transfers in and transfers out as of the end of the reporting period. During the three months ended March 31, 2010, transfers into Level 1 and Level 2 were $25 million and zero respectively, and transfers out of Level 1 and Level 2 were $15 million and $137 million, respectively. The majority of transfers into Levels 1 and 2 resulted from instruments that became more actively traded as they moved closer to maturity. The majority of transfers into Levels 2 and 3 were due to the increased significance of the lower level inputs to the instrument’s fair value.

     In addition to the financial assets and liabilities disclosed in the tables on pages 10 and 11, the Corporation had other short-term financial instruments, primarily cash equivalents and accounts receivable and payable, for which the carrying value approximated their fair value at March 31, 2010 and December 31, 2009. Long-term debt had a carrying value of $4,335 million compared with a fair value of $4,942 million at March 31, 2010, and a carrying value of $4,467 million compared with a fair value of $5,073 million at December 31, 2009.

     The table below reflects the gross and net fair values of the Corporation’s risk management and trading derivative instruments (in millions):

     Credit Risk: The Corporation is exposed to credit risks that may at times be concentrated with certain counterparties or groups of counterparties. Accounts receivable are generated from a diverse domestic and international customer base. The Corporation’s net receivables at March 31, 2010 are concentrated with counterparties as follows: Integrated Oil Companies – 19%, Government Entities – 13%, Manufacturing – 13% and Services – 13%. The Corporation reduces its risk related to certain counterparties by using master netting arrangements and requiring collateral, generally cash or letters of credit. The Corporation records the cash collateral received or posted as an offset to the fair value of derivatives executed with the same counterparty. At March 31, 2010 and December 31, 2009, the Corporation is holding cash from counterparties of approximately $197 million and $317 million, respectively. The Corporation has posted cash to counterparties at March 31, 2010 and December 31, 2009 of approximately $433 million and $269 million, respectively.

     At March 31, 2010, the Corporation had a total of $2,979 million of outstanding letters of credit, primarily issued to satisfy margin and collateral requirements. Certain of the Corporation’s agreements also contain contingent collateral provisions that could require the Corporation to post additional collateral if the Corporation’s credit rating declines. As of March 31, 2010, the net liability related to derivatives with contingent collateral provisions was approximately $2,265 million before cash collateral posted of approximately $411 million. At March 31, 2010, all three major credit rating agencies that rate the Corporation’s debt had assigned an investment grade rating. If two of the three agencies were to downgrade the Corporation’s rating to below investment grade, as of March 31, 2010, the Corporation would be required to post additional collateral of approximately $270 million.

     The weighted average numbers of common shares used in the basic and diluted earnings per share computations are as follows (in thousands):

     The Corporation issued 2,675,700 stock options and 891,900 shares of restricted stock in the first three months of 2010. The table above excludes the effect of 4,236,000 shares related to out-of-the money options for the quarter ended March 31, 2010.

     The table below summarizes changes in equity (amounts in millions):

     The Corporation’s results by operating segment were as follows (in millions):

     Hess Corporation (the Corporation) is a global integrated energy company that operates in two segments, Exploration and Production (E&P) and Marketing and Refining (M&R). The E&P segment explores for, develops, produces, purchases, transports and sells crude oil and natural gas. The M&R segment manufactures refined petroleum products and purchases, trades and markets refined petroleum products, natural gas and electricity. The Corporation reported net income of $538 million in the first quarter of 2010, compared with a loss of $59 million in the first quarter of 2009.

     Exploration and Production: E&P reported net income of $551 million for the first quarter of 2010, compared with a loss of $64 million in the first quarter of 2009. In the first quarter of 2010, the Corporation’s average worldwide crude oil selling price, including the effect of hedging, was $63.62 per barrel compared with $34.42 per barrel in the first quarter of 2009. The Corporation’s average worldwide natural gas selling price was $5.92 per thousand cubic feet (mcf) in the first quarter of 2010 compared with $5.08 per mcf in the first quarter of 2009. Worldwide crude oil and natural gas production was 423,000 barrels of oil equivalent per day (boepd) in the first quarter of 2010 an increase of 33,000 boepd from the same period in 2009.

     The following is an update of E&P activities during the first quarter of 2010:

     Marketing and Refining: M&R generated income of $87 million for the first quarter of 2010, compared with income of $102 million in the first quarter of 2009, primarily reflecting lower earnings from refining operations partially offset by higher marketing margins. During the first quarter of 2010, the Fluid Catalytic Cracking (FCC) unit at HOVENSA L.L.C. (HOVENSA) was shutdown for a scheduled turnaround. The Corporation’s share of HOVENSA’s turnaround expenses in the first quarter was approximately $20 million after income taxes.

     The after-tax results by major operating activity were as follows (in millions, except per share data):

     The following table summarizes, on an after-tax basis, items of income (expense) that are included in net income and affect comparability between periods (amounts in millions). The items in the table below are explained and the pre-tax amounts are shown on pages 21 and 24.

     In the discussion that follows, the financial effects of certain transactions are disclosed on an after-tax basis. Management reviews segment earnings on an after-tax basis and uses after-tax amounts in its review of variances in segment earnings. Management believes that after-tax amounts are preferable to pre-tax amounts for explaining variances in earnings, since they show the entire effect of a transaction. After-tax amounts are determined by applying the appropriate income tax rate in each tax jurisdiction to pre-tax amounts.

     Exploration and Production

     Following is a summarized income statement of the Corporation’s E&P operations (in millions):

     Sales volumes: Higher crude oil sales volumes increased revenue by approximately $195 million in the first quarter of 2010 compared with the corresponding period of 2009.

     Non-operating income: Non-operating income in the first quarter of 2010 included a gain of $58 million related to the sale of the Corporation’s interest in the Jambi Merang natural gas development project in Indonesia. This gain is reflected in the table of items affecting comparability of earnings between periods on page 17.

Operating costs and depreciation, depletion and amortization: Cash operating costs, consisting of production expenses and general and administrative expenses, increased by $79 million in the first quarter of 2010 compared with the corresponding period of 2009. The increase principally reflects higher production taxes as a result of higher selling prices and production volumes.

     Excluding the impact of the item affecting comparability of earnings between periods that is described below, depreciation, depletion and amortization charges were higher in 2010 largely reflecting the commencement of production from the Shenzi Field in March 2009. Rates per barrel also increased due to the mix of production from assets with varying per barrel rates. In the first quarter of 2009, an after-tax charge of $13 million ($26 million before income taxes) was recorded for the impairment of the Atlantic and Cromarty fields in the United Kingdom North Sea. This amount is reflected in the table of items affecting comparability of earnings on page 17.

     On December 31, 2009, the Securities and Exchange Commission’s updated standards for oil and gas reserve estimation became effective. The new rules allow, among other changes, the use of permitted technology in determining oil and gas reserve estimates. Since it was not practical to calculate reserve estimates under both the old and the new reserve estimation standards, it was not possible to precisely measure the effect of adopting the new SEC requirements on total proved reserves at December 31, 2009. However, the Corporation estimates that applying the new rules increased income in the first quarter of 2010 by approximately $20 million, after income taxes, due to lower depreciation, depletion and amortization expense.

Exploration expenses: Exploration expenses were lower in the first quarter of 2010 compared with the same period in 2009, principally reflecting lower geological and seismic expenses.

Income Taxes: The effective income tax rate for E&P operations in the first three months of 2010 was 45%, excluding the impact of the item affecting comparability between periods. In the first three months of 2009, E&P recorded tax expense of $80 million on pre-tax income of $16 million, primarily reflecting the impact of Libyan taxes in a lower commodity price environment together with the mix of income and losses from countries with varying tax rates.

Foreign Exchange: The pre-tax foreign currency loss related to E&P activities was $7 million in the first quarter of 2010 compared with a gain of $1 million in the first quarter of 2009. The after-tax foreign currency loss was $2 million for the three months ended March 31, 2010 and $6 million for the three months ended March 31, 2009.

     The Corporation’s future E&P earnings may be impacted by external factors, such as volatility in the selling prices of crude oil and natural gas, reserve and production changes, exploration expenses, industry cost inflation, changes in foreign exchange rates and income tax rates, the effects of weather, political risk, environmental risk and catastrophic risk. For a more comprehensive description of the risks that may affect the Corporation’s E&P business, see Item 1A.Risk Factors Related to Our Business and Operations in the December 31, 2009 Annual Report on Form 10-K.

     M&R activities generated income of $87 million in the first quarter of 2010 compared to $102 million in the first quarter of 2009. The Corporation’s downstream operations include HOVENSA, a 50% owned refining joint venture with a subsidiary of Petroleos de Venezuela S.A. (PDVSA), which is accounted for using the equity method. Additional M&R activities include a FCC facility in Port Reading, New Jersey, as well as retail gasoline stations, energy marketing and trading operations.

Refining: Refining operations generated losses of $56 million in the first quarter of 2010 and $18 million in the first quarter of 2009. The Corporation’s share of HOVENSA’s losses, after income taxes, was $52 million in the first quarter of 2010 and $25 million in the first quarter of 2009. The planned turnaround of HOVENSA’s FCC unit was completed in the first quarter of 2010 and operations re-commenced in March 2010. The Corporation’s share of HOVENSA’s turnaround expenses in the first quarter was approximately $20 million after income taxes.

     Port Reading’s loss after tax was $4 million in the first quarter of 2010 compared with earnings of $7 million in the corresponding period of 2009. The scheduled turnaround for the Port Reading refining facility commenced in April 2010 and is expected to last approximately 35 days. The estimated after-tax expenses to be recorded in the second quarter for this turnaround are approximately $20 million.

Marketing: Marketing operations, which consist principally of energy marketing and retail gasoline operations, generated earnings of $121 million in the first quarter of 2010 compared with $101 million in the first quarter of 2009. The increase in earnings was primarily due to improved margins. The table below summarizes marketing sales volumes:

     The Corporation has a 50% voting interest in a consolidated partnership that trades energy commodities and energy derivatives. The Corporation also takes trading positions for its own account. The Corporation’s after-tax results from trading activities, including its share of the results from the trading partnership, amounted to income of $22 million in the first quarter of 2010 compared with $19 million in the first quarter of 2009.

     The Corporation’s future M&R earnings may be impacted by volatility in margins, credit risk, supply and demand factors, the effects of weather, competitive industry conditions, political risk, environmental risk and catastrophic risk. For a more comprehensive description of the risks that may affect the Corporation’s M&R business, see Item 1A. Risk Factors Related to Our Business and Operations in the December 31, 2009 Annual Report on Form 10-K.

     The following table summarizes corporate expenses (in millions):

     Excluding items affecting comparability between periods, after-tax corporate expenses were higher in the first quarter of 2010 compared with the same period of 2009, mainly due to higher bank facility fees. In the first three months of 2010, a charge of $11 million before income taxes ($7 million after tax) was recorded for the repurchase of the remaining $116 million of bonds that were scheduled to mature in 2011. In the first quarter of 2009, a charge of $25 million before income taxes ($16 million after tax) for retirement benefits and employee severance costs was recorded in general and administrative expenses. Both of these charges are reflected in the table of items affecting comparability of earnings between periods on page 17.

     Interest expense was as follows (in millions):

     The increase in interest incurred in the first three months of 2010 principally reflects slightly higher average debt.

     Sales and other operating revenues increased by 34% in the first quarter of 2010 compared with the corresponding period of 2009, primarily due to higher crude oil, natural gas and refined product selling prices. The increase in Cost of products sold principally reflects higher prices of refined products.

     The following table sets forth certain relevant measures of the Corporation’s liquidity and capital resources (in millions, except ratios):

Cash Flows

     The following table summarizes the Corporation’s cash flows (in millions):

Operating Activities: Net cash provided by operating activities, including changes in operating assets and liabilities, amounted to $825 million in the first quarter of 2010 compared with $625 million in the first quarter of 2009, reflecting increased earnings partially offset by the period over period changes in operating assets and liabilities of $472 million.

Investing Activities: The following table summarizes the Corporation’s capital expenditures (in millions):

Financing Activities: In the first quarter of 2010, net repayments of debt were $142 million. In the first quarter of 2009, net borrowings increased by $373 million, following the issuance of $250 million of 5 year senior unsecured notes and $1 billion of 10 year senior unsecured notes. Dividends paid were $66 million in the first three months of 2010 ($65 million in the first three months of 2009).

     The Corporation anticipates investing a total of approximately $4.1 billion in capital and exploratory expenditures during 2010, substantially all of which is targeted for E&P operations. In the Corporation’s M&R operations, refining margins are currently weak, which have adversely affected HOVENSA’s liquidity position. The Corporation intends to provide its share of any necessary financial support for HOVENSA. The Corporation expects to fund its 2010 operations, including capital expenditures, dividends, pension contributions and required debt repayments and any necessary financial support for HOVENSA, with existing cash on-hand, cash flow from operations and its available credit facilities. Crude oil prices, natural gas prices and refining margins are volatile and difficult to predict. In addition, unplanned increases in the Corporation’s capital expenditure program could occur. If conditions were to change, such as a significant decrease in commodity prices or an unexpected increase in capital expenditures, the Corporation would take steps to protect its financial flexibility and may pursue other sources of liquidity, including the issuance of debt securities, the issuance of equity securities, and/or asset sales.

     The table below summarizes the capacity, usage, and remaining availability of the Corporation’s borrowing and letter of credit facilities at March 31, 2010 (in millions):