Hess - 10-Q quarterly report FY2011 Q2

     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 June 30, 2011 and December 31, 2010 and the consolidated results of operations for the three and six month periods ended June 30, 2011 and 2010 and the consolidated cash flows for the six month periods ended June 30, 2011 and 2010. 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, 2010.

     In response to civil unrest in Libya, a number of measures were taken by the international community, including the imposition of sanctions by the United States, the United Nations, the United Kingdom and the European Union. The sanctions blocked and froze the assets of, and any payments to, the Libyan government and any entities owned or controlled by the Libyan government, as well as designated entities and individuals. As a consequence of the civil unrest and the sanctions, the Corporation delivered force majeure notices to the Libyan government relating to the agreements covering its exploration and production interests in order to protect its rights while it is temporarily prevented from fulfilling its obligations and benefiting from the rights granted by those agreements. Because of the on-going events, including the sanctions, the Corporation is unable to determine when or if it will resume operations in Libya. Libyan production averaged 23,000 barrels of oil equivalent per day (boepd) for the full year of 2010 and 14,000 boepd for the first quarter of 2011. Production was suspended in the first quarter of 2011. The Corporation had proved reserves of 167 million barrels of oil equivalent in Libya at December 31, 2010. At June 30, 2011, the net book value of the Corporation’s exploration and production assets in Libya was approximately $400 million.

     Inventories consist of the following:

     The Corporation accounts for its investment in HOVENSA L.L.C. (HOVENSA), which is included in Investments in affiliates in the Consolidated Balance Sheet, using the equity method. Summarized financial information for HOVENSA follows:

     In February 2011, the Corporation completed the sale of its interests in the Easington Catchment Area (Hess 30%), the Bacton Area (Hess 23%), the Everest Field (Hess 19%) and the Lomond Field (Hess 17%) in the United Kingdom North Sea for cash proceeds of $359 million, after closing adjustments. These disposals resulted in a pre-tax gain of $343 million ($310 million after income taxes), which has been included in Other, net in the Statement of Consolidated Income. The total combined net book value of the disposed assets prior to the sale was $16 million, including allocated goodwill of $14 million.

     The following table discloses the net changes in capitalized exploratory well costs pending determination of proved reserves for the six months ended June 30, 2011 (in millions):

     Capitalized exploratory well costs charged to expense in the preceding table excludes $134 million of exploratory well costs which were incurred and subsequently expensed in 2011. Capitalized exploratory well costs greater than one year old after completion of drilling were $1,341 million at June 30, 2011. Approximately 45% of the capitalized well costs in excess of one year relates to two separate projects in the deepwater Gulf of Mexico, Tubular Bells and Pony, where development planning is progressing, with sanction anticipated later in 2011 for Tubular Bells and 2012 for Pony. Approximately 22% relates to Block WA-390-P, offshore Western Australia, where further drilling, other appraisal activities and commercial analysis are ongoing. Approximately 20% relates to Area 54, offshore Libya, where force majeure has been declared following the imposition of sanctions against Libya. The remainder of the capitalized well costs in excess of one year relates 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 April 2011, the Corporation entered into a new $4 billion syndicated revolving credit facility that matures in April 2016. The new facility, which replaced a $3 billion facility that was scheduled to mature in May 2012, can be used for borrowings and letters of credit. Borrowings on the facility bear interest at 1.25% above the London Interbank Offered Rate. A facility fee of 0.25% per annum is also payable on the amount of the facility. The interest rate and facility fee are subject to adjustment if the Corporation’s credit rating changes. The restrictions on the amount of total borrowings and secured debt are consistent with the previous facility.

     Components of net periodic pension cost consisted of the following:

     In 2011, the Corporation expects to contribute approximately $190 million to its pension plans. Through June 30, 2011, the Corporation contributed $107 million to its pension plans.

     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 petroleum products and electricity, as well as to changes in interest rates and foreign currency values. In the disclosures that follow risk management activities are referred to as energy marketing and corporate risk management activities. The Corporation also has trading operations, principally through a 50% voting interest in a consolidated partnership, that trades energy-related commodities, securities and derivatives. These activities are also exposed to commodity price risks primarily related to the prices of crude oil, natural gas, refined petroleum products and electricity.

     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 closed positions 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 and pipeline capacity, 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, while supply contract purchases 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 $31 million and $38 million for the three months ended June 30, 2011 and 2010, respectively, and $28 million and $112 million for the six months ended June 30, 2011 and 2010, respectively.

     At June 30, 2011, 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 June 30, 2011, the maximum duration was approximately three 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 the fair value of cash flow hedges is recognized immediately in Cost of products sold.

     At June 30, 2011, the after-tax deferred losses relating to energy marketing activities recorded in Accumulated other comprehensive income were $91 million ($147 million at December 31, 2010). The Corporation estimates that approximately $59 million of this amount will be reclassified into earnings over the next twelve months. During the three months ended June 30, 2011 and 2010, the Corporation reclassified after-tax losses from Accumulated other comprehensive income of $33 million and $110 million, respectively, and $53 million and $201 million for the six months ended June 30, 2011 and 2010, respectively. The amounts reflected in earnings due to hedge ineffectiveness were a gain of less than $1 million and a gain of $1 million for the three months ended June 30, 2011 and 2010, respectively, and a loss of $2 million and a gain of less than $1 million for the six months ended June 30, 2011 and 2010, respectively. As a result of changes in the fair value of energy marketing cash flow hedge positions, after-tax deferred losses increased by $1 million and $67 million for the three months ended June 30, 2011 and 2010, respectively, and increased by $3 million and decreased by $159 million for the six months ended June 30, 2011 and 2010, respectively.

     Corporate Risk Management Activities: Corporate risk management activities include transactions designed to reduce risk in the selling prices of crude oil, refined petroleum products 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, refined petroleum products 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. Interest rate swaps may be used 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 June 30, 2011. Hedging activities decreased Exploration and Production Sales and other operating revenues by $128 million and $133 million for the three months ended June 30, 2011 and 2010, respectively ($81 million and $84 million after-tax, respectively), and $256 million and $264 million for the six months ended June 30, 2011 and 2010, respectively ($162 million and $167 million after-tax, respectively). Hedging activities decreased Exploration and Production Sales and other operating revenues by $533 million for the year ended December 31, 2010 ($338 million after-tax). At June 30, 2011, the after-tax deferred losses in Accumulated other comprehensive income relating to the closed Brent crude oil hedges were $483 million ($638 million at December 31, 2010). The Corporation estimates that approximately $325 million of this amount will be reclassified into earnings over the next twelve months.

     At June 30, 2011, the Corporation had interest rate swaps with a gross notional amount of $895 million, which were designated as fair value hedges. Changes in fair value of interest rate swaps and the hedged fixed-rate debt are recorded in Interest expense. During the three months ended June 30, 2011 and 2010, the Corporation recorded an increase of $5 million and $8 million (excluding accrued interest), respectively, in the fair value of interest rate swaps and a corresponding adjustment in the carrying value of the hedged fixed-rate debt. During the six months ended June 30, 2011 and 2010, the Corporation recorded an increase of $3 million and $9 million (excluding accrued interest), respectively, in the fair value of interest rate swaps and a corresponding adjustment in the carrying value of the hedged fixed-rate debt.

     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 activities and not designated as hedges amounted to the following:

     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-related commodities, securities and derivatives. The Corporation also takes trading positions for its own account. The information that follows represents 100% of the trading partnership and the Corporation’s proprietary trading accounts.

     The table below shows the gross volume of derivative instruments outstanding relating to trading activities:

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

     Fair Value Measurements: The Corporation determines fair value in accordance with the fair value measurements accounting standard 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). 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 derivatives that are characterized as Level 2 and 3, 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. 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.

     The following table provides the Corporation’s net financial assets and (liabilities) that are measured at fair value based on this hierarchy:

     Purchases and sales in the table above primarily represent option premiums paid or received during the reporting period. Settlements represent realized gains and losses on derivatives settled during the reporting period.

     The following table provides net transfers into and out of each level of the fair value hierarchy:

     The Corporation’s policy is to recognize transfers in and transfers out as of the end of the reporting period. Transfers between levels result from the passage of time as contracts move closer to their maturities, fluctuations in the market liquidity for certain contracts and/or changes in the level of significance of fair value measurement inputs.

     In addition to the financial assets and liabilities disclosed in the tables above, 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 June 30, 2011 and December 31, 2010. Fixed-rate long-term debt had a carrying value of $5,539 million, compared with a fair value of $6,285 million at June 30, 2011, and a carrying value of $5,569 million, compared with a fair value of $6,353 million at December 31, 2010.

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

     Credit Risk: The Corporation is exposed to credit risks that may at times be concentrated with certain counterparties, groups of counterparties or customers. Accounts receivable are generated from a diverse domestic and international customer base. The Corporation’s net receivables at June 30, 2011 are concentrated with the following counterparty and customer industry segments: Integrated Oil Companies — 30%, Government Entities — 9%, Manufacturing — 8%, Trading Companies — 8%, Real Estate — 7% and Services — 7%. 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 June 30, 2011 and December 31, 2010, the Corporation held cash from counterparties of $163 million and $213 million, respectively. The Corporation posted cash to counterparties at June 30, 2011 and December 31, 2010 of $42 million and $34 million, respectively.

     At June 30, 2011, the Corporation had a total of $2,132 million of outstanding letters of credit, primarily issued to satisfy margin 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 June 30, 2011, the net liability related to derivatives with contingent collateral provisions was approximately $1,175 million before cash collateral posted of $2 million. At June 30, 2011, 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 June 30, 2011, the Corporation would be required to post additional collateral of approximately $300 million.

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

     The Corporation issued 2,142,270 stock options and 713,280 shares of restricted stock during the six months ended June 30, 2011 (2,738,625 and 927,470 shares, respectively, for the same period in 2010). The weighted average common shares used in the diluted earnings per share calculations excludes the effect of 1,618,000 shares and 2,153,000 shares related to out-of-the-money options for the three and six months ended June 30, 2011 (4,224,000 and 4,230,000 shares for the same period in 2010).

     The table below summarizes changes in equity:

     The Corporation’s results by operating segment were as follows:

     Identifiable assets by operating segment were as follows:

     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, markets and trades refined petroleum products, natural gas and electricity. The Corporation reported net income of $607 million in the second quarter of 2011 compared to $375 million in the second quarter of 2010.

     E&P reported net income of $747 million in the second quarter of 2011 compared to $488 million in the second quarter of 2010. In the second quarter of 2011, the Corporation’s average worldwide crude oil selling price, including the effect of hedging, was $97.20 per barrel up from $64.81 per barrel in the second quarter of 2010. The Corporation’s average worldwide natural gas selling price was $5.93 per thousand cubic feet (mcf) in the second quarter of 2011 compared with $5.57 per mcf in the second quarter of 2010. Worldwide crude oil and natural gas production was 372,000 barrels of oil equivalent per day (boepd) in the second quarter of 2011 down from 415,000 boepd in the same period of 2010, due to lower production from Africa, primarily reflecting the suspension of production in Libya due to civil unrest, and the sale of certain natural gas producing assets in the United Kingdom in February 2011. The Corporation has lowered its full year production guidance to a range of 375,000 to 385,000 boepd, from 385,000 to 395,000 boepd, as a result of severe weather conditions that affected production operations in the Bakken oil shale play in North Dakota, a shut-in well at the outside operated Llano Field in the Gulf of Mexico and a fire in July 2011 at the Valhall Field, offshore Norway.

     The following is an update of E&P activities:

     Status of Libyan Operations: In response to civil unrest in Libya, a number of measures were taken by the international community, including the imposition of sanctions by the United States, the United Nations, the United Kingdom and the European Union. The sanctions blocked and froze the assets of, and any payments to, the Libyan government and any entities owned or controlled by the Libyan government, as well as designated entities and individuals. As a consequence of the civil unrest and the sanctions, the Corporation delivered force majeure notices to the Libyan government relating to the agreements covering its exploration and production interests in order to protect its rights while it is temporarily prevented from fulfilling its obligations and benefiting from the rights granted by those agreements. Because of the on-going events, including the sanctions, the Corporation is unable to determine when or if it will resume operations in Libya. The loss of Libyan production is not expected to have a material adverse impact on operating cash flows. Libyan production averaged 23,000 boepd for the full year of 2010 and 14,000 boepd for the first quarter of 2011. Production was suspended in the first quarter of 2011. The Corporation had proved reserves of 167 million barrels of oil equivalent in Libya at December 31, 2010. At June 30, 2011, the net book value of the Corporation’s exploration and production assets in Libya was approximately $400 million.

     Gulf of Mexico Update:The Corporation has filed Suspension of Operations (SOO) applications with the Bureau of Ocean Energy Management, Regulation and Enforcement (BOEMRE) for licenses covering a total of 183 exploration blocks in the Gulf of Mexico as permitted by a recent BOEMRE National Notice to Lessees. These SOO applications seek approval for extension of the lease expiration terms for licenses where activities required to hold the licenses have been delayed due to circumstances outside of the control of the Corporation. The Corporation has also applied for, and is waiting for approval of, drilling permits on three exploration blocks. In addition, the Corporation has responded to the BOEMRE’s requested revisions to its previously submitted oil spill response plan for its Gulf of Mexico operations and is awaiting approval.

     M&R generated a loss of $39 million for the second quarter of 2011 compared to a loss of $19 million in the second quarter of 2010, primarily reflecting increased losses from refining and trading, which were partly offset by higher earnings from marketing operations.

     The after-tax results by major operating activity are summarized below:

     The following table summarizes, on an after-tax basis, items of income (expense) that are included in net income and affect the comparability between periods. The items in the table below are explained and the pre-tax amounts are shown on pages 20 and 22.

     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 for explaining variances in earnings, since they show the entire effect of a transaction rather than only the pre-tax amount. After-tax amounts are determined by applying the income tax rate in each tax jurisdiction to pre-tax amounts.

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