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CONOCOPHILLIPS

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PART I. FINANCIAL INFORMATION

Item 1. FINANCIAL STATEMENTS

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Note 1—Interim Financial Information

The financial information for the interim periods presented in the financial statements included in this report is unaudited and includes all known accruals and adjustments that, in the opinion of management, are necessary for a fair presentation of the consolidated financial position of ConocoPhillips and its results of operations and cash flows for such periods. All such adjustments are of a normal and recurring nature. These interim financial statements should be read in conjunction with Management’s Discussion and Analysis and the consolidated financial statements and notes included in ConocoPhillips’ 2002 Annual Report on Form 10-K. Certain amounts in the 2002 financial statements have been reclassified to reflect discontinued operations and to conform to ConocoPhillips’ 2003 presentation.

The financial statements reflect the August 30, 2002, merger of Conoco Inc. (Conoco) and Phillips Petroleum Company (Phillips). The transaction was accounted for using the purchase method of accounting as required by Statement of Financial Accounting Standards (SFAS) No. 141, “Business Combinations.” Phillips was designated as the acquirer. Results of operations for the third quarter of 2002 reflect two months of Phillips activity and one month of ConocoPhillips activity, while the first nine months of 2002 reflects eight months of Phillips activity and one month of ConocoPhillips activity.

Note 2—Changes in Accounting Principles

Accounting for Asset Retirement Obligations
Effective January 1, 2003, we adopted SFAS No. 143, “Accounting for Asset Retirement Obligations,” which applies to legal obligations associated with the retirement and removal of long-lived assets. SFAS No. 143 requires entities to record the fair value of a liability for an asset retirement obligation in the period when it is incurred (typically when the asset is installed at the production location). When the liability is initially recorded, the entity capitalizes the cost by increasing the carrying amount of the related property, plant and equipment. Over time, the liability is accreted upward for the change in its present value each period, and the initial capitalized cost is depreciated over the useful life of the related asset.

Application of this new accounting principle resulted in an initial increase in net properties, plants and equipment of $1.2 billion and an asset retirement obligation liability increase of $1.1 billion. The cumulative effect of the change increased first quarter 2003 net income by $145 million. The third quarter 2003 effect of the adoption increased income from continuing operations and net income by $8 million, $.01 per basic and diluted share. The effect of adoption on income from continuing operations and net income for the first nine months of 2003 was an increase of $24 million, or $.04 per basic and diluted share.

We have numerous asset removal obligations that we are required to perform under law or contract once an asset is permanently taken out of service. Most of these obligations are not expected to be paid until several years, or decades, in the future and will be funded from general company resources at the time of removal. Our largest individual obligations are related to fixed-base offshore production platforms around the world and to production facilities and pipelines in Alaska.

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SFAS No. 143 calls for measurements of asset retirement obligations to include, as a component of expected costs, an estimate of the price that a third party would demand, and could expect to receive, for bearing the uncertainties and unforeseeable circumstances inherent in the obligations, sometimes referred to as a market-risk premium. To date, the oil and gas industry has no examples of credit-worthy third parties who are willing to assume this type of risk, for a determinable price, on major oil and gas production facilities and pipelines. Therefore, because determining such a market-risk premium would be an arbitrary process, we have excluded it from our SFAS No. 143 estimates.

During the first nine months of 2003, ConocoPhillips’ overall asset retirement obligation changed as follows:

The following table presents the pro forma effects of the retroactive application of this change in accounting principle. There was no pro forma effect on income from discontinued operations.

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Consolidation of Variable Interest Entities
In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46, “Consolidation of Variable Interest Entities,” (FIN 46) to expand existing accounting guidance about when a company should include in its consolidated financial statements the assets, liabilities and activities of another entity. In general, a variable interest entity (VIE) is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN 46 requires a VIE to be consolidated by a company if that company is subject to a majority of the risk of loss from the VIE’s activities, is entitled to receive a majority of the VIE’s residual returns, or both (the company required to consolidate is called the primary beneficiary). It also requires deconsolidation of a VIE if a company is not the primary beneficiary of the VIE. The interpretation also requires disclosures about VIEs that a company does not consolidate, but in which it has a significant variable interest.

The consolidation requirements of FIN 46 applied immediately to VIEs created after January 31, 2003. In accordance with FASB Staff Position No. FIN 46-6, effective October 9, 2003, the consolidation requirements of FIN 46 for VIEs created before February 1, 2003, were deferred to the fourth quarter for calendar-year-end companies. However, early adoption of FIN 46 was permitted for some or all VIEs.

We adopted FIN 46 in the third quarter of 2003, with retroactive application to January 1, 2003, for VIEs involving synthetic leases and certain other financing structures as discussed below. We adopted FIN 46 for such VIEs because our work on these VIEs was complete and we believe the FASB’s potential modifications of FIN 46 interpretive guidance is unlikely to change the primary beneficiary determination for these VIEs. We consolidated all VIEs created prior to February 1, 2003 (except as noted below), in which we concluded we were the primary beneficiary. In addition, we deconsolidated an entity where we determined we were not the primary beneficiary.

The adoption of FIN 46 for VIEs involving synthetic leases and certain other financing structures resulted in the following:

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We consolidated certain VIEs from which we lease certain ocean vessels, airplanes, refining assets, marketing sites and office buildings. The consolidation increased net properties, plants and equipment by $940 million and increased assets of discontinued operations held for sale by $722 million (both are collateral for the debt obligations); increased cash by $225 million; increased debt by $2.4 billion; increased minority interest by $90 million; reduced other accruals by $263 million, and resulted in a cumulative after-tax effect-of-adoption loss that decreased net income and common stockholders’ equity by $258 million. The future minimum rental payments at December 31, 2002, related to our leasing arrangements that are now consolidated under FIN 46, were approximately $500 million, and their guaranteed residual values totaled approximately $1.8 billion. Since these leasing arrangements are now intercompany leases and eliminated in consolidation, they will no longer be included in our non-mineral lease disclosures. Other than certain performance obligations (i.e., make lease payments, provide insurance in some circumstances, etc.) and the residual value guarantees described above, the creditors of the entities above have no recourse to the general credit of ConocoPhillips. In addition, we discontinued hedge accounting for an interest rate swap since it had been designated as a cash flow hedge of the variable interest rate component of a lease with one of the entities now consolidated as a VIE. At September 30, 2003, the fair market value of the swap was $15 million.

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Ashford Energy Capital S.A. continues to be consolidated in our financial statements under the provisions of FIN 46 because we are the primary beneficiary. In December 2001, in order to raise funds for general corporate purposes, Conoco and Cold Spring Finance S.a.r.l. formed Ashford Energy Capital S.A. through the contribution of a $1 billion Conoco subsidiary promissory note and $500 million cash. Through its initial $500 million investment, Cold Spring is entitled to a cumulative annual preferred return, based on three-month LIBOR rates, plus 1.27 percent. In 2008, and each 10-year anniversary thereafter, Cold Spring may elect to remarket their investment in Ashford, and if unsuccessful, could require ConocoPhillips to provide a letter of credit in support of Cold Spring’s investment, or in the event that such letter of credit is not provided, then cause the redemption of their investment in Ashford. Should ConocoPhillips’ credit rating fall below investment grade, Ashford would require a letter of credit to support various term loans, totaling $600 million as of September 30, 2003, made by Ashford to other ConocoPhillips subsidiaries. If the letter of credit is not obtained within 60 days, Cold Spring could cause Ashford to sell the ConocoPhillips subsidiary notes. At September 30, 2003, Ashford held $1.6 billion of ConocoPhillips subsidiary notes. ConocoPhillips reports Cold Spring’s investment as a minority interest because it is not mandatorily redeemable and the entity does not have a specified liquidation date. Other than the obligation to make payment on the subsidiary notes described above, Cold Spring does not have recourse to the general credit of ConocoPhillips.

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Phillips 66 Capital II (Trust) was deconsolidated under the provisions of FIN 46 because ConocoPhillips is not the primary beneficiary. During 1997 in order to raise funds for general corporate purposes, we formed the Trust (a statutory business trust), in which we own all common beneficial interests. The Trust was created for the sole purpose of issuing mandatorily redeemable preferred securities to third-party investors and investing the proceeds thereof in an approximately equivalent amount of subordinated debt securities of ConocoPhillips, which were previously eliminated in consolidation. Application of FIN 46 required deconsolidation of the Trust, which increased debt by $361 million since the 8% Junior Subordinated Deferrable Interest Debentures due 2037 were no longer eliminated in consolidation, and the $350 million of mandatorily redeemable preferred securities were deconsolidated.

The third quarter 2003 effect of the adoption of FIN 46 for VIEs involving synthetic leases and certain other financing structures increased income from continuing operations $13 million, or $.02 per basic and diluted share, and increased net income $35 million, $.05 per basic and diluted share. The effect on income from continuing operations for the nine months of 2003 was an increase of $22 million, or $.03 per basic and diluted share, and the effect on net income for the same period was a decrease of $151 million, or $.22 per basic and diluted share.

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Restated income information for the first and second quarters and six months of 2003 as a result of the adoption of FIN 46 for VIEs involving synthetic leases and certain other financing structures follows:

The adoption of FIN 46 for VIEs involving synthetic leases and certain other financing structures reduced the balance of retained earnings at March 31, 2003, from $6,824 million, as previously reported, to $6,582 million; and reduced retained earnings at June 30, 2003, from $7,670 million, as previously reported, to $7,483 million.

We continue to monitor and assess the FASB’s ongoing modifications of FIN 46 interpretive guidance, which could have an impact on our determinations of VIEs and primary beneficiaries for our interests in joint ventures that hold non-financial assets that were created prior to February 1, 2003. The adoption of FIN 46 for our joint venture entities was deferred under the provisions of FASB Staff Position No. FIN 46-6. Our joint venture interests are in operating entities whose operations include petroleum exploration and production; petroleum refining, marketing, supply and transportation; and natural gas gathering, processing and marketing. As we continue to assess our joint venture entities, we may conclude

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that one or more of our joint venture entities is a VIE and that in some cases we are the primary beneficiary. For our joint venture entities that may be VIEs, we believe that our maximum exposure to loss would be equal to our investment in the entities, plus our potential obligations under our guarantees of their debt. At September 30, 2003, our total investment in these joint venture entities, plus the value of any debt guarantees for these entities was approximately $1 billion. These same entities had gross assets of approximately $4 billion at year-end 2002. We continue to assess FIN 46, but do not anticipate that it will have a material impact on our consolidated results of operations, cash flows or financial position.

The FASB continues to issue interpretive guidance on FIN 46 and has a goal of issuing final modified guidance in the fourth quarter of 2003. If subsequent FASB guidance is different from our current understanding, it is possible that our determination of VIEs and primary beneficiaries could be changed.

Other
Effective January 1, 2003, we adopted SFAS No. 145, “Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections.” The adoption of SFAS No. 145 requires that gains and losses on extinguishments of debt no longer be presented as extraordinary items in the income statement. Accordingly, a loss from the extinguishment of debt of $15 million (after reduction for income taxes of $6 million), previously reported as an extraordinary item in the nine months of 2002, has been reclassified as a $21 million charge to other income with the tax benefit reclassified to provision for income taxes.

In April 2003, the FASB released SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities,” which we adopted July 1, 2003. The adoption of this standard did not have a material impact on our results of operations or financial position.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Liabilities and Equity,” to address the balance sheet classification of certain financial instruments that have characteristics of both liabilities and equity. This statement was immediately effective for all contracts created or modified after May 31, 2003, and became effective July 1, 2003, for all previously existing contracts. On November 7, 2003, the FASB issued FASB Staff Position No. FAS 150-3, which deferred certain provisions of SFAS No. 150. As a result of adopting this new accounting standard in the third quarter of 2003, and the subsequent November 7, 2003, deferral of certain provisions, there was no impact on our financial statements.

Note 3—Merger of Conoco and Phillips

On August 30, 2002, Conoco and Phillips combined their businesses by merging with separate acquisition subsidiaries of ConocoPhillips (the merger). As a result, each company became a wholly owned subsidiary of ConocoPhillips. For accounting purposes, Phillips was treated as the acquirer of Conoco, and ConocoPhillips was treated as the successor of Phillips. Conoco’s operating results have been included in ConocoPhillips’ consolidated financial statements since the merger date.

The $16 billion purchase price attributed to Conoco for accounting purposes was based on an exchange of Conoco common shares for ConocoPhillips common shares. The allocation of the purchase price to specific assets and liabilities was based, in part, upon an outside appraisal of the fair value of Conoco’s assets. The following table summarizes, based on the final purchase price allocation, the fair values of the assets acquired and liabilities assumed as of August 30, 2002:

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Goodwill, land and certain identifiable intangible assets recorded in the acquisition are not subject to amortization, but the goodwill and intangible assets will be tested periodically for impairment as required by SFAS No. 142, “Goodwill and Other Intangible Assets.”

ConocoPhillips has not yet determined the assignment of Conoco goodwill to specific reporting units, but plans to do so by the end of 2003. Currently, Conoco goodwill is being reported as part of the Corporate and Other reporting segment. Included in the $12,745 million of goodwill is $3,859 million attributable to recording a net liability required under purchase accounting for deferred taxes. This and the remaining goodwill of $8,886 million will ultimately be assigned to reporting units based on the benefits received by the units from the synergies and strategic advantages of the merger. None of the goodwill is deductible for tax purposes. During the first nine months of 2003, the balance of goodwill was adjusted upward by $666 million, primarily due to revisions in properties, plants and equipment, and assumed contingent liabilities.

Note 4—Discontinued Operations

During 2002 and the first nine months of 2003, we disposed of, or had committed to a plan to dispose of, certain U.S. retail and wholesale marketing assets, certain U.S. refining and related assets, certain U.S. midstream natural gas gathering and processing assets, and exploration and production assets in the

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Netherlands. Certain of these planned dispositions were mandated by the FTC as a condition of the merger. For reporting purposes, these operations are classified as discontinued operations, and in Note 17—Segment Disclosures and Related Information, these operations are included in Corporate and Other.

FTC-Mandated Divestitures
In the fourth quarter of 2002, we sold our propane terminal assets at Jefferson City, Missouri, and East St. Louis, Illinois.

In the second quarter of 2003 we sold:

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our Woods Cross business unit, which includes the Woods Cross, Utah, refinery; the Utah, Idaho, Montana, and Wyoming Phillips-branded motor fuel marketing operations (both retail and wholesale) and associated assets; and a refined products terminal in Spokane, Washington; and

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certain midstream natural gas gathering and processing assets in southeast New Mexico, and certain midstream natural gas gathering assets in West Texas.

In the third quarter of 2003, we sold our Commerce City, Colorado, refinery, and related crude oil pipelines, and our Colorado Phillips-branded motor fuel marketing operations (both retail and wholesale).

All asset dispositions mandated by the FTC as a condition of the merger have been completed.

Other Dispositions
In the fourth quarter of 2002, we committed to a plan to dispose of 3,200 marketing sites that did not fit into our long-range plans. In the third quarter of 2003, we concluded the sale of all of our Exxon-branded marketing assets in New York and New England, including contracts with independent dealers and marketers. Approximately 230 of the 3,200 sites were included in this package.

We signed an agreement in October 2003 to sell The Circle K Corporation and its subsidiaries. The transaction would include 1,663 retail marketing outlets in 16 states and the Circle K brand, as well as the assignment of the franchise relationship with more than 350 franchised and licensed stores. Closing of the transaction is subject to government and regulatory reviews as appropriate for a transaction of this type, and is expected in the fourth quarter of 2003. Discussions are under way with potential buyers on the remaining packages, and we expect to complete the sales of these assets in the first half of 2004.

Sales and other operating revenues and income (loss) from discontinued operations were as follows:

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The major classes of assets and liabilities of discontinued operations held for sale were as follows:

Note 5—Subsidiary Equity Transactions

ConocoPhillips, through various affiliates, and its unaffiliated co-venturers received final approvals from authorities in June 2003 to proceed with the natural gas development phase of the Bayu-Undan project in the Timor Sea. The natural gas development phase of the project will include a pipeline from the offshore Bayu-Undan field to Darwin, Australia, and a liquefied natural gas facility, also located in Darwin. The pipeline portion of the project is owned and operated by an unincorporated joint venture, while the liquefied natural gas facility is owned and operated by Darwin LNG Pty Ltd (DLNG). Both of these entities are consolidated subsidiaries of ConocoPhillips.

In June 2003, as part of a broad Bayu-Undan ownership interest re-alignment with co-venturers, these entities issued equity and sold interests to the co-venturers (as described below), which resulted in a gain of $28 million before-tax, $25 million after-tax, in the second quarter of 2003. This non-operating gain is shown in the consolidated statement of income in the line item entitled “Gain on subsidiary equity transactions.”

DLNG—DLNG issued 118.9 million shares of stock, valued at 1 Australian dollar per share, to co-venturers for 118.9 million Australian dollars ($76.2 million U.S. dollars), reducing our ownership interest in DLNG from 100 percent to 56.72 percent. The transaction resulted in a before-tax gain of $21 million in the consolidated financial statements. Deferred income taxes were not recognized because this was an issuance of common stock and therefore not taxable.

Unincorporated Pipeline Joint Venture—The co-venturers purchased pro-rata interests in the pipeline assets held by ConocoPhillips Pipeline Australia Pty Ltd for $26.6 million U.S. dollars and contributed the purchased assets to the unincorporated joint venture, reducing our ownership interest from 100 percent to 56.72 percent. The transaction resulted in a before-tax gain of $7 million. A deferred tax liability of $1.3 million was recorded in connection with the transaction.

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Note 6—Stock-Based Compensation

Effective January 1, 2003, ConocoPhillips adopted the fair-value accounting method of SFAS No. 123, “Accounting for Stock-Based Compensation.” Using the prospective transition method, we recognize compensation expense using the fair-value accounting method for all stock options granted or modified after December 31, 2002, whereas we continue to account for options granted prior to 2003 in accordance with Accounting Principles Board (APB) No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations. The following table illustrates the effect on net income and earnings per share as if the fair-value-based method had been applied to all outstanding and unvested awards in each period.