UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

 

For the transition period from            to           

 

Commission file number 1-5153

 

Marathon Oil Corporation

(Exact name of registrant as specified in its charter)

 

Delaware		25-0996816
(State of Incorporation)		(I.R.S. Employer Identification No.)
5555 San Felipe Road, Houston, TX 77056-2723
(Address of principal executive offices)
Tel. No. (713) 629-6600

 

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 periods that the registrant was required to file such reports), and (2) has been subject to such filing requirements for at least the past 90 days.  Yes ý No o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes ý No o

 

There were 347,859,632 shares of Marathon Oil Corporation common stock outstanding as of April 30, 2005.

 

 

MARATHON OIL CORPORATION

Form 10-Q

Quarter Ended March 31, 2005

 

INDEX
PART I - FINANCIAL INFORMATION
Item 1.	Financial Statements:
	Consolidated Statement of Income
	Consolidated Balance Sheet
	Consolidated Statement of Cash Flows
	Selected Notes to Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures about Market Risk
Item 4.	Controls and Procedures
	Supplemental Statistics
PART II - OTHER INFORMATION
Item 1.	Legal Proceedings
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds
Item 4.	Submission of Matters to a Vote of Security Holders
Item 6.	Exhibits

 

2

 

Part I - Financial Information

 

MARATHON OIL CORPORATION

Consolidated Statement of Income (Unaudited)

 

		First Quarter Ended March 31
(Dollars in millions, except per share)		2005			2004
Revenues and other income:
Sales and other operating revenues (including consumer excise taxes)		$	9,840		$	8,392
Revenues from matching buy/sell transactions		2,809			2,045
Sales to related parties		283			215
Income from equity method investments		40			27
Net gains on disposal of assets		11			2
Other income		27			12
Total revenues and other income		13,010			10,693
Costs and expenses:
Cost of revenues (excludes items shown below)		7,692			6,435
Purchases related to matching buy/sell transactions		2,832			2,065
Purchases from related parties		56			31
Consumer excise taxes		1,084			1,052
Depreciation, depletion and amortization		323			299
Selling, general and administrative expenses		260			222
Other taxes		105			83
Exploration expenses		34			28
Total costs and expenses		12,386			10,215
Income from operations		624			478
Net interest and other financing costs		32			38
Minority interest in income (loss) of:
Marathon Ashland Petroleum LLC		70			17
Equatorial Guinea LNG Holdings Limited		(1		)	—
Income before income taxes		523			423
Provision for income taxes		199			165
Net income		$	324		$	258

 

Income Per Share (Unaudited)

 

		First Quarter Ended March 31
		2005			2004
Net income:
Per share – basic		$	.94		$	.83
Per share – diluted		$	.93		$	.83

 

The accompanying notes are an integral part of these consolidated financial statements.

 

3

 

MARATHON OIL CORPORATION

Consolidated Balance Sheet (Unaudited)

 

(Dollars in millions)		March 31 2005			December 31 2004
Assets
Current assets:
Cash and cash equivalents		$	3,191		$	3,369
Receivables, less allowance for doubtful accounts of $3 and $6		3,109			3,146
Receivables from United States Steel		19			15
Receivables from related parties		82			74
Inventories		2,273			1,995
Other current assets		308			268
Total current assets		8,982			8,867
Investments and long-term receivables, less allowance for doubtful accounts of $13 and $10		1,536			1,546
Receivables from United States Steel		585			587
Property, plant and equipment, less accumulated depreciation, depletion and amortization of $12,724 and $12,426		12,019			11,810
Prepaid pensions		119			128
Goodwill		252			252
Intangibles		106			108
Other noncurrent assets		115			125
Total assets		$	23,714		$	23,423
Liabilities
Current liabilities:
Accounts payable		$	4,416		$	4,430
Payable to related parties		44			44
Payroll and benefits payable		277			274
Accrued taxes		404			397
Accrued interest		52			92
Long-term debt due within one year		17			16
Total current liabilities		5,210			5,253
Long-term debt		4,032			4,057
Deferred income taxes		1,534			1,553
Employee benefits obligations		1,030			989
Asset retirement obligations		483			477
Payable to United States Steel		5			5
Deferred credits and other liabilities		240			288
Total liabilities		12,534			12,622
Minority interest in Marathon Ashland Petroleum		2,632			2,559
Minority interest in Equatorial Guinea LNG Holdings Limited		171			131
Commitments and contingencies		—			—
Stockholders’ Equity
Common stock:
Common Stock issued - 347,794,585 shares at March 31, 2005 and 346,727,029 at December 31, 2004 (par value $1 per share, authorized 550,000,000 shares)		348			347
Common stock held in treasury - 73,748 shares at March 31, 2005 and 29,569 shares at December 31, 2004		(3		)	(1		)
Additional paid-in capital		4,081			4,028
Retained earnings		4,036			3,810
Accumulated other comprehensive loss		(70		)	(64		)
Unearned compensation		(15		)	(9		)
Total stockholders’ equity		8,377			8,111
Total liabilities and stockholders’ equity		$	23,714		$	23,423

 

The accompanying notes are an integral part of these consolidated financial statements.

 

4

 

MARATHON OIL CORPORATION

Consolidated Statement of Cash Flows (Unaudited)

 

		First Quarter Ended March 31
(Dollars in millions)		2005			2004
Increase (decrease) in cash and cash equivalents
Operating activities:
Net income		$	324		$	258
Adjustments to reconcile to net cash provided from operating activities:
Deferred income taxes		3			(3		)
Minority interest in income of subsidiaries		69			17
Depreciation, depletion and amortization		323			299
Pension and other postretirement benefits - net		47			41
Exploratory dry well costs		12			7
Net gains on disposal of assets		(11		)	(2		)
Changes in the fair value of long-term natural gas contracts in the United Kingdom		57			(14		)
Changes in:
Current receivables		2			24
Inventories		(277		)	(247		)
Accounts payable and other current liabilities		(137		)	(53		)
All other - net		(57		)	(40		)
Net cash provided from operating activities		355			287
Investing activities:
Capital expenditures		(554		)	(344		)
Disposal of assets		36			6
Investments -loans and advances		(30		)	(31		)
All other - net		6			2
Net cash used in investing activities		(542		)	(367		)
Financing activities:
Commercial paper and revolving credit arrangements - net		—			76
Other debt repayments		(2		)	(253		)
Net proceeds from sale of common stock		—			1,004
Treasury common stock – proceeds from issuance		39			17
Dividends paid		(97		)	(78		)
Contributions from minority shareholder of Equatorial Guinea LNG Holdings Limited		73			—
Net cash provided from financing activities		13			766
Effect of exchange rate changes on cash		(4		)	(2		)
Net increase (decrease) in cash and cash equivalents		(178		)	684
Cash and cash equivalents at beginning of period		3,369			1,396
Cash and cash equivalents at end of period		$	3,191		$	2,080
Cash provided from operating activities included:
Interest and other financial costs paid (net of amount capitalized)		$	(91	)	$	(87	)
Income taxes paid		(194		)	(81		)

 

The accompanying notes are an integral part of these consolidated financial statements.

 

5

 

MARATHON OIL CORPORATION

Notes to Consolidated Financial Statements – (Unaudited)

 

1.     Basis of Presentation

 

These consolidated financial statements are unaudited but, in the opinion of management, reflect all adjustments necessary for a fair presentation of the results for the periods reported.  All such adjustments are of a normal recurring nature unless disclosed otherwise.  These financial statements, including selected notes, have been prepared in accordance with the applicable rules of the Securities and Exchange Commission and do not include all of the information and disclosures required by accounting principles generally accepted in the United States of America for complete financial statements.  Certain reclassifications of prior year data have been made to conform to 2005 classifications.  These interim financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the 2004 Annual Report on Form 10-K of Marathon Oil Corporation (“Marathon”).

 

2.     New Accounting Standards

 

Effective January 1, 2005, Marathon adopted FASB Staff Position (“FSP”) No. FAS 19-1, “Accounting for Suspended Well Costs” (“FSP FAS 19-1”), which amended the guidance for deferred exploratory well costs in Statement of Financial Accounting Standard No. 19, “Financial Accounting and Reporting by Oil and Gas Producing Companies” (“SFAS No. 19”).  SFAS No. 19 requires costs of drilling exploratory wells to be capitalized pending determination of whether the well has found proved reserves.  When a classification of proved reserves cannot yet be made, FSP FAS 19-1 allows exploratory well costs to continue to be capitalized when (a) the well has found a sufficient quantity of reserves to justify completion as a producing well and (b) the enterprise is making sufficient progress assessing the reserves and the economic and operating viability of the project.  Marathon’s current policy is in accordance with FSP FAS 19-1.  FSP FAS 19-1 also provides for certain disclosures to be made regarding capitalized exploratory well costs which were included in Marathon’s 2004 Annual Report on Form 10-K.  See Note 11 for activity related to the first quarter of 2005.

 

3.     Information about United States Steel

 

The Separation – On December 31, 2001, in a tax-free distribution to holders of Marathon’s USX—U. S. Steel Group class of common stock (“Steel Stock”), Marathon exchanged the common stock of its wholly owned subsidiary United States Steel Corporation (“United States Steel”) for all outstanding shares of Steel Stock on a one-for-one basis (the “Separation”).

 

Amounts Receivable from or Payable to United States Steel Arising from the Separation — Marathon remains primarily obligated for certain financings for which United States Steel has assumed responsibility for repayment under the terms of the Separation. When United States Steel makes payments on the principal of these financings, both the receivable and the obligation will be reduced.

 

Amounts receivable or payable to United States Steel were included in the balance sheet as follows:

 

(In millions)		March 31 2005			December 31 2004
Receivables:
Current:
Receivables related to debt and other obligations for which United States Steel has assumed responsibility for repayment		$	19		$	15
Noncurrent:
Receivables related to debt and other obligations for which United States Steel has assumed responsibility for repayment		$	585		$	587
Payables:
Noncurrent:
Reimbursements payable under nonqualified employee benefit plans		$	5		$	5

 

Marathon remains primarily obligated for $51 million of operating lease obligations assumed by United States Steel, of which $39 million has been assumed by other third parties that had purchased plants and operations divested by United States Steel.

 

6

 

4.     Computation of Income Per Share

 

Basic net income per share is based on the weighted average number of common shares outstanding.  Diluted net income per share assumes exercise of stock options, provided the effect is not antidilutive.

 

		First Quarter Ended March 31
		2005						2004
(Dollars in millions, except per share data)		Basic			Diluted			Basic			Diluted
Net income		$	324		$	324		$	258		$	258
Shares of common stock outstanding (thousands):
Average number of common shares outstanding		346,006			346,006			310,196			310,196
Effect of dilutive securities		—			2,639			—			1,489
Average common shares including dilutive effect		346,006			348,645			310,196			311,685
Net income per share		$	.94		$	.93		$	.83		$	.83

 

5.     Stock-Based Compensation Plans

 

The following net income and per share data illustrates the effect on net income and net income per share if the fair value method had been applied to all outstanding and unvested awards in each period:

 

		First Quarter Ended March 31
(In millions, except per share data)		2005			2004
Net income
As reported		$	324		$	258
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects		28			5
Deduct: Total stock-based employee compensation expense determined under fair value method for all awards, net of related tax effects		(28		)	(4		)
Pro forma net income		$	324		$	259
Basic net income per share
- As reported		$	.94		$	.83
- Pro forma		$	.94		$	.83
Diluted net income per share
- As reported		$	.93		$	.83
- Pro forma		$	.93		$	.83

 

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6.     Segment Information

 

Marathon’s operations consist of three operating segments: 1) Exploration and Production (“E&P”) - - explores for and produces crude oil and natural gas on a worldwide basis; 2) Refining, Marketing and Transportation (“RM&T”) - refines, markets and transports crude oil and petroleum products, primarily in the Midwest, the upper Great Plains and southeastern United States through its 62 percent owned consolidated subsidiary, Marathon Ashland Petroleum LLC (“MAP”); and 3) Integrated Gas (“IG”) – markets and transports natural gas and products manufactured from natural gas, such as liquid natural gas (“LNG”) and methanol, on a worldwide basis.

 

The following represents information by operating segment:

 

(In millions)		E&P			RM&T			IG			Total Segments
First Quarter 2005
Revenues:
Customer		$	1,214		$	11,073		$	419		$	12,706
Intersegment(a)		99			42			45			186
Related parties		2			281			—			283
Segment revenues		$	1,315		$	11,396		$	464		$	13,175
Elimination of intersegment revenues		(99		)	(42		)	(45		)	(186		)
Loss on U.K. long-term gas contracts		(57		)	—			—			(57		)
Total revenues		$	1,159		$	11,354		$	419		$	12,932
Segment income		$	555		$	210		$	7		$	772
Income from equity method investments		6			17			17			40
Depreciation, depletion and amortization(b)		210			104			2			316
Capital expenditures(c)		293			134			126			553
First Quarter 2004
Revenues:
Customer		$	1,162		$	8,835		$	426		$	10,423
Intersegment(a)		65			14			40			119
Related parties		3			212			—			215
Segment revenues		$	1,230		$	9,061		$	466		$	10,757
Elimination of intersegment revenues		(65		)	(14		)	(40		)	(119		)
Gain on U.K. long-term gas contracts		14			—			—			14
Total revenues		$	1,179		$	9,047		$	426		$	10,652
Segment income		$	464		$	49		$	15		$	528
Income from equity method investments		5			10			12			27
Depreciation, depletion and amortization(b)		192			98			2			292
Capital expenditures(c)		172			135			35			342

 

(a)          Management believes intersegment transactions were conducted under terms comparable to those with unrelated parties.

(b)         Differences between segment totals and Marathon totals represent amounts included in administrative expenses.

(c)          Differences between segment totals and Marathon totals represent amounts related to corporate administrative activities.

 

The following reconciles segment income to income from operations as reported in Marathon’s consolidated financial statement of income:

 

		First Quarter Ended March 31
(In millions)		2005			2004
Segment income		$	772		$	528
Items not allocated to segments:
Administrative expenses		(91		)	(64		)
Gain (loss) on U.K. long-term gas contracts		(57		)	14
Total income from operations		$	624		$	478

 

8

 

7.     Pensions and Other Postretirement Benefits

 

The following summarizes the components of net periodic benefit costs:

 

			First Quarter Ended March 31
			Pension Benefits						Other Benefits
(In millions)			2005			2004			2005			2004
Service cost			$	31		$	26		$	5		$	5
Interest cost			28			27			10			12
Expected return on plan assets			(23		)	(23		)	—			—
Amortization	– net transition gain		(1		)	(1		)	—			—
	– prior service costs (credits)		1			1			(3		)	(4		)
	– actuarial loss		15			13			2			4
Settlement losses			—			7			—			—
Net periodic benefit cost(a)			$	51		$	50		$	14		$	17

 

(a)     Includes MAP’s net periodic pension cost of $34 million and $30 million and other benefits cost of $9 million for the first quarter of 2005 and 2004.  Includes international net periodic pension cost of $6 million for the first quarter of 2005 and 2004.

 

On April 14, 2005, MAP made a contribution of $67 million to its qualified pension plan.  As of March 31, 2005, $6 million of contributions have been made to the foreign plans.  In addition, as of March 31, 2005, contributions made from the general assets of Marathon to cover current benefit payments related to unfunded pension and other postretirement benefit plans were $2 million and $7 million.  Marathon expects to contribute an additional $60 million to the MAP pension plan and $25 million to its foreign pension plans in the remainder of 2005.

 

8.     Income Taxes

 

The provision for income taxes for interim periods is based on management’s best estimate of the effective tax rate expected to be applicable for the current fiscal year plus any adjustments arising from a change in the estimated amount of taxes related to prior periods.

 

Effective January 1, 2005, the state of Kentucky enacted legislation which causes limited liability companies to be subject to Kentucky’s corporation income tax.  In the first quarter 2005, Marathon’s provision for income taxes includes $13 million related to the effects of this Kentucky income tax on deferred tax assets and liabilities as of January 1, 2005.  The effect on net income (after minority interest) was $6 million.

 

Also beginning in the first quarter of 2005, Marathon’s effective rate reflects the estimated impact of a special deduction for qualified domestic production expected to be taken related to the American Jobs Creation Act of 2004.  This deduction will be treated as a permanent difference.  Based on managements’ best estimates of taxable income for 2005, the effective rate will be reduced by approximately one-half percent.

 

9.     Comprehensive Income

 

The following sets forth Marathon’s comprehensive income for the periods shown:

 

		First Quarter Ended March 31
(In millions)		2005			2004
Net income		$	324		$	258
Other comprehensive income (loss), net of tax
Change in fair value of derivative instruments		(6		)	16
Total comprehensive income		$	318		$	274

 

9

 

10.  Inventories

 

Inventories are carried at lower of cost or market.  Cost of inventories of crude oil, refined products and merchandise is determined primarily under the last-in, first-out (“LIFO”) method.

 

(In millions)		March 31 2005			December 31 2004
Liquid hydrocarbons and natural gas		$	958		$	676
Refined products and merchandise		1,193			1,192
Supplies and sundry items		122			127
Total		$	2,273		$	1,995

 

11.  Suspended Exploratory Well Costs

 

The net changes in deferred exploratory well costs were as follows:

 

(In millions)
Balance at December 31, 2004		$	339
Additions		44
Dry well expense		(3		)
Transfer to proved properties		(32		)
Balance at March 31, 2005		$	348

 

During the first quarter of 2005, there were no impairments of capitalized exploratory well costs that were capitalized for a period of greater than one year after the completion of drilling at December 31, 2004.

 

12.  Debt

 

At March 31, 2005, Marathon had no borrowings against its $1.5 billion long-term revolving credit facility and no commercial paper outstanding under its U.S. commercial paper program that is backed by the long-term revolving credit facility.  Certain banks provide Marathon with uncommitted short-term lines of credit totaling $200 million.  At March 31, 2005, there were no borrowings against these facilities.

 

MAP has a $500 million long-term revolving credit facility that terminates in May 2009.  At March 31, 2005, there were no borrowings against this facility.

 

At March 31, 2005, in the event of a change in control of Marathon, debt obligations totaling $1.578 billion may be declared immediately due and payable.  In such event, Marathon may also be required to either repurchase certain equipment at United States Steel’s Fairfield Works for $88 million or provide a letter of credit to secure the remaining obligation.

 

13.  Contingencies and Commitments

 

Marathon is the subject of, or party to, a number of pending or threatened legal actions, contingencies and commitments involving a variety of matters, including laws and regulations relating to the environment.  Certain of these matters are discussed below.  The ultimate resolution of these contingencies could, individually or in the aggregate, be material to Marathon’s consolidated financial statements.  However, management believes that Marathon will remain a viable and competitive enterprise even though it is possible that these contingencies could be resolved unfavorably.

 

Environmental matters – Marathon is subject to federal, state, local and foreign laws and regulations relating to the environment.  These laws generally provide for control of pollutants released into the environment and require responsible parties to undertake remediation of hazardous waste disposal sites.  Penalties may be imposed for noncompliance.  At March 31, 2005 and December 31, 2004, accrued liabilities for remediation totaled $104 million and $110 million, respectively.  It is not presently possible to estimate the ultimate amount of all remediation costs that might be incurred or the penalties that may be imposed.  Receivables for recoverable costs from certain states, under programs to assist companies in cleanup efforts related to underground storage tanks at retail marketing outlets, were $61 million at March 31, 2005, and $65 million at December 31, 2004.

 

Contract commitments – At March 31, 2005, Marathon’s contract commitments to acquire property, plant and equipment and long-term investments totaled $1,301 million.  Included in these contract commitments is $64 million related to the approximately $300 million in refinery upgrade and expansion projects for its 74,000 bpd Detroit, Michigan refinery.  Marathon will loan MAP the funds necessary for the Detroit, Michigan refinery upgrade and expansion projects. The MAP LLC Agreement has been amended to allow the Detroit refinery cash flows to be dedicated to service this debt.  The Put/Call Agreement was amended to provide that, in the event Marathon exercises its call right, the Detroit refinery will not be valued at an amount less than the working capital related to the Detroit refinery, excluding working capital additions related to the expansion and clean fuels project.

 

10

 

Agreements with joint owners – In connection with the formation of Equatorial Guinea LNG Holdings Limited (“EGHoldings”), Compania Nacional de Petroleos de Guinea Ecuatorial (“GEPetrol”) was given certain contractual rights with respect to the purchase and resale to a third party of a 13 percent interest in EGHoldings currently held by Marathon.  These rights give GEPetrol the option to purchase this 13 percent interest and resell it to a third party.  These rights specify that Marathon will be reimbursed for its historical costs plus an additional specified rate of return.  If GEPetrol’s rights are not exercised within one year from date of project sanction on June 22, 2004, the rights expire.  In March 2005 these rights were extended until September 22, 2005.

 

14.  Proposed Acquisition

 

Marathon has entered into an agreement, as amended, which would result in the acquisition of the 38 percent ownership interest in MAP currently held by Ashland Inc. (“Ashland”).  In addition, Marathon would acquire a portion of Ashland’s Valvoline Instant Oil Change business and its maleic anhydride business.  As a result of the transaction, MAP will become a wholly owned subsidiary of Marathon.

 

As part of the amended transaction, Ashland will receive approximately $900 million in cash and accounts receivable from MAP to redeem a portion of its interest in MAP.  Marathon will assume approximately $1.9 billion of debt, which is expected to be repaid immediately following closing.  Additionally, Ashland shareholders will receive $915 million in Marathon common stock.  Ashland’s liabilities under certain existing environmental indemnification obligations related to MAP will be capped at $50 million.  Marathon has agreed to indemnify a portion of Ashland’s tax liability arising from the transaction. A tax under Section 355(e) of the Internal Revenue Code will be imposed if, as of the date of the closing of the transaction, the fair market value of the New Ashland common stock exceeds Ashland’s tax basis in the New Ashland common stock.  That tax basis cannot be determined with precision at this time because it depends, in part, on the amount of taxable income Ashland generates before the closing of the transaction.  Under the tax matters agreement among the parties, Marathon will bear the first portion of Section 355(e) tax, if any, up to $200 million (which may be increased under certain circumstances), New Ashland will bear the next $175 million of any Section 355(e) tax, and New Ashland and Marathon will each bear 50% of any remaining Section 355(e) tax.

 

The MAP Limited Liability Company Agreement has been amended to eliminate the requirement for MAP to make quarterly cash distributions to Marathon and Ashland between the date the principal transaction agreements were signed and the closing of the transaction.  As a result, the redemption proceeds to Ashland (cash and accounts receivable) will be increased by an amount equal to approximately 38 percent of the cash accumulated from MAP’s operations during that period, subject to certain adjustments.  At March 31, 2005, Ashland’s share of distributable cash would have been $560 million, if the agreement had been modified as of that date.  In the event of a termination of the acquisition agreement, MAP’s obligation to make cash distributions to Marathon and Ashland would be restored.

 

On June 1, 2004, the United States Federal Trade Commission (“FTC”) granted early termination of the pre-closing waiting period mandated by the Hart-Scott-Rodino Act, thereby indicating that it had no present intent to challenge the acquisition and permitting the parties to proceed toward closing.  Since the transaction will not close within one year after early termination was granted, Marathon and Ashland have filed a new request for early termination with the FTC.  Additionally, Marathon and Ashland submitted a request for a private letter ruling to the United States Internal Revenue Service (“IRS”) on the tax-free status of the proposed acquisition.  Also related to the proposed acquisition, Marathon filed a registration statement on Form S-4 with the United States Securities and Exchange Commission (“SEC”) on October 12, 2004, and Amendment No. 1 to the Form S-4 on May 2, 2005.  Ashland filed a preliminary proxy statement on Schedule 14A on June 21, 2004, and Amendment No. 1 to Schedule 14A on August 31, 2004.  ATB Holdings, Inc. and New EXM Inc. filed a Form S-4 with the SEC on October 12, 2004, and Amendment No. 1 to the Form S-4 on May 2, 2005.  The completion of the acquisition is subject to a number of conditions, including the expiration or termination of any applicable waiting period under the Hart-Scott-Rodino Act, the receipt of a private letter ruling or entering into a closing agreement with the IRS, Ashland shareholder approval and Ashland public debt holder consents.

 

15.  Accounting Standards Not Yet Adopted

 

During December 2004, the FASB issued Statement of Financial Accounting Standard No. 123 (revised 2004) “Share-Based Payment” (“SFAS No. 123R”) as a revision of Statement of Financial Accounting Standard No. 123 “Accounting for Stock Based Compensation”.  This statement requires entities to measure the cost of employee services received in exchange for an award of equity instruments based on the fair value of the award on the grant date.  That cost will be recognized over the period during which an employee is required to provide service in exchange for the award, usually the vesting period.  In addition, liability awards will be remeasured each reporting period.  In 2003, Marathon adopted the fair value method for grants made, modified or settled on or after January 1, 2003.  Accordingly, management does not expect the adoption of SFAS No. 123R to have a material affect on results of operations, financial position or cash flows.  This statement is effective for Marathon January 1, 2006.

 

11

 

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Marathon Oil Corporation is engaged in worldwide exploration and production of crude oil and natural gas; domestic refining, marketing and transportation of crude oil and petroleum products primarily through our 62 percent owned subsidiary, Marathon Ashland Petroleum LLC; and integrated gas.  Management’s Discussion and Analysis should be read in conjunction with the Consolidated Financial Statements and Notes to Consolidated Financial Statements. The discussion of the Consolidated Statement of Income should be read in conjunction with the Supplemental Statistics provided on page 26.

 

Certain sections of Management’s Discussion and Analysis include forward-looking statements concerning trends or events potentially affecting Marathon. These statements typically contain words such as ‘‘anticipates,’’ ‘‘believes,’’ ‘‘estimates,’’ ‘‘expects,’’ ‘‘targets,’’ “plans,” “projects,” “could,” “may,” “should,” “would” or similar words indicating that future outcomes are uncertain. In accordance with “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, these statements are accompanied by cautionary language identifying important factors, though not necessarily all such factors, which could cause future outcomes to differ materially from those set forth in the forward-looking statements. For additional risk factors affecting our businesses, see the information preceding Part I in our 2004 Form 10-K and subsequent filings.

 

Unless specifically noted, amounts for MAP include the 38 percent interest held by Ashland, and amounts for EGHoldings include the 25 percent interest held by GEPetrol.

 

Overview and Outlook

 

Exploration and Production

 

A key contributor to our first quarter E&P performance was strong overall production available for sale during the quarter which, at an average of approximately 347,000 barrels of oil equivalent per day (“boepd”), slightly exceeded previous guidance of between 330,000 and 340,000 boepd.  Reported crude oil and natural gas sales during the quarter averaged 334,000 boepd.  This period’s variance between production available for sale and actual sales volumes is primarily attributable to the timing of liquid hydrocarbon liftings from our operations in Gabon and the UK.

 

Also during the first quarter, our production operations benefited from the restart of the Petronius platform in the Gulf of Mexico following extensive repairs necessitated by damage caused by Hurricane Ivan.  Petronius came back online in early March, quickly ramping up to pre-Ivan levels of approximately 25,000 net boepd.

 

In addition, our condensate expansion project in Equatorial Guinea ramped up to full production, with total liquids production averaging 47,000 gross barrels per day (“bpd”) for the quarter (26,500 bpd net to Marathon), but exiting March at a rate of 62,000 gross bpd (35,000 bpd net to Marathon).  Commissioning of the Equatorial Guinea LPG expansion continued during the first quarter with start-up on schedule for mid-year.  With the LPG expansion at full production, total Equatorial Guinea liquids production is expected to exceed 80,000 gross bpd.

 

Sales volumes in Russia also improved during the quarter averaging 24,000 bpd compared to 16,000 bpd during the first quarter of 2004.  The increase is a result of the East Kamennoye development program.

 

In Norway, we made progress in advancing the Alvheim development with the award of two remaining major contracts for conversion of the MST Odin to a floating production, storage and offloading vessel.  All the major contracts for the Alvheim development have been placed.  MST Odin hull modifications have been initiated and development drilling will commence in the third quarter of 2005.  Project development is on schedule with first production expected in 2007.  In addition, the nearby Vilje field received plan of development and operation approval from the Norwegian Government.  Vilje will be tied back to Alvheim and also is expected to begin producing in 2007.

 

We also announced two discoveries in Angola during the quarter.  The Palas-1 and Ceres-1 discoveries are both located on Block 31 offshore Angola and mark the fifth and sixth deepwater discoveries we have announced on the Block.  The Palas-1 and Ceres-1 wells are located approximately 37 and 20 miles southeast, respectively, of the planned Northeast Development Area and provide the potential for a second development area on Block 31.  In addition, we are currently participating in a well on the Juno Prospect.  We hold a 10 percent interest in Block 31.

 

In the Gulf of Mexico, we participated in the Stones well, in which we hold a 15 percent working interest, located on Walker Ridge Block 508.  The well has reached total depth and encountered hydrocarbons.  Marathon and its partners are currently analyzing data from the well to determine next steps.

 

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We continue to estimate our 2005 production available for sale will average between 325,000 and 350,000 boepd, excluding the effect of any acquisitions or dispositions.  Reported volumes are based upon sales volumes which may vary from production available for sale primarily due to the timing of liftings of certain of our international liquid hydrocarbon volumes.

 

The above discussion includes forward-looking statements with respect to the timing and levels of Marathon’s worldwide liquid hydrocarbon, natural gas and condensate production, the exploration drilling program, the LPG expansion project and the development of the Alvheim and Vilje fields.  Some factors that could potentially affect worldwide liquid hydrocarbon, natural gas and condensate production, the exploration drilling program and the development of the Alvheim and Vilje fields include pricing, supply and demand for petroleum products, amount of capital available for exploration and development, occurrence of acquisitions or dispositions of oil and gas properties, regulatory constraints, timing of commencing production from new wells, drilling rig availability, inability or delay in obtaining necessary government and third party approvals and permits, unforeseen hazards such as weather conditions, acts of war or terrorist acts and the governmental or military response and other geological, operating and economic considerations.  Factors that could affect the LPG expansion project include unforeseen problems arising from construction, including equipment repairs, and unforeseen hazards such as weather conditions.  The foregoing factors (among others) could cause actual results to differ materially from those set forth in the forward-looking statements.

 

Refining, Marketing and Transportation

 

In the RM&T segment, MAP benefited from wider sweet/sour crude differentials and was able to run more sour crudes during the period, taking advantage of the substantial discounts on these feedstocks.  In addition, as a result of a relatively light planned maintenance schedule during the first quarter of 2005, MAP crude oil throughput was approximately 17 percent higher than the same 2004 period.  During the quarter MAP achieved record first quarter crude runs that averaged 922,000 bpd, with total throughput averaging a first quarter record of 1,094,000 bpd.  MAP’s strong operating performance positioned it to help meet rising demand for motor fuels, while capturing the benefits of the strong refining margins in the Midwest and Gulf Coast during the quarter.

 

Speedway SuperAmerica LLC continued to realize strong same store merchandise sales with an increase of approximately 11.5 percent, while same store gasoline sales volume increased 1.2 percent when compared to the first quarter of 2004.

 

MAP continued to make progress on its Detroit refinery expansion project during the quarter.  This $300 million project, which remains on schedule for completion during the fourth quarter of 2005, is expected to increase the refinery’s crude processing capacity from 74,000 bpd to 100,000 bpd and enable it to meet the Federal Tier II low-sulfur fuels regulations which become fully effective in 2006.

 

MAP also announced an agreement to purchase a 388,000 barrel light products terminal located in Ft. Lauderdale, Florida.  This purchase will increase MAP’s storage capacity at Ft. Lauderdale by more than 70 percent, enabling MAP to better serve the growing Florida market, improve logistics and to add flexibility to its product sourcing.  The transaction is expected to close in June 2005.

 

On March 18, 2004, we entered into an agreement with Ashland Inc. to acquire its 38 percent interest in MAP, along with a portion of its Valvoline Instant Oil Change business and its maleic anhydride business.  On April 27, 2005, we entered into amendments to the Master Agreement and Tax Matters Agreement.  With respect to the tax treatment of the transaction, Marathon and Ashland expect to receive a private letter ruling from the Internal Revenue Service (“IRS”) or enter into a closing agreement with the IRS.  The proposed transaction remains subject to a number of conditions, including termination or expiration of any waiting period under the Hart-Scott-Rodino Act, receipt of a favorable private letter ruling or entering into a closing agreement with the IRS, opinions of outside tax counsel, Ashland shareholder approval, Ashland public debt holder consents, and updated Ashland solvency opinions.  We are targeting a June 30, 2005 closing.  For additional information, see Note 14 to the Consolidated Financial Statements.

 

The above discussion includes forward-looking statements with respect to the Detroit capital project, the proposed acquisition of a Ft. Lauderdale terminal and the proposed acquisition of Ashland’s 38 percent interest in MAP.  Some factors that could potentially cause the actual results from the Detroit construction project to be different than expected include availability of materials and labor, unforeseen hazards such as weather conditions, and other risks customarily associated with construction projects.  Factors that could affect the acquisition of the terminal include satisfaction of closing conditions.  Some factors that could affect the proposed acquisition of Ashland’s 38 percent interest in MAP include the expiration or termination of any applicable waiting period under the Hart-Scott-Rodino Act, a favorable tax ruling from, or closing agreement with, the IRS, opinions of outside tax counsel, Ashland shareholder approval, Ashland public debt holder consents and updated Ashland solvency opinions.  These factors (among others) could cause actual results to differ materially from those set forth in the forward-looking statements.

 

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Integrated Gas

 

Our integrated gas activities during the quarter were marked by continued progress in constructing our LNG project in Equatorial Guinea.  Project expenditures totaled approximately $675 million as of March 31, 2005.  Construction remains on schedule with first shipments of LNG expected in late 2007.

 

During the quarter, we took delivery of two cargos of LNG under our long term delivery rights at the Elba Island (Georgia) regasification terminal.  In the second half of 2005, we will begin taking delivery of LNG at Elba Island under terms of a supply agreement reached with BP Energy Company (“BP”) last year under which BP will supply us with 58 billion cubic feet of natural gas per year, as LNG, for a minimum period of five years.

 

Following the successful demonstration of gas-to-liquids (“GTL”) technology at our Port of Catoosa (Oklahoma) GTL facility last year, we intend to further develop this important technology through an Integrated Technology Project (“ITP”).  The ITP, also at the Port of Catoosa, will combine higher efficiency syngas processing and liquid products treatment with the Syntroleum FT reactor.  This project will build upon last year’s successful demonstration with the objective of producing ultra-clean, low-sulfur fuels from stranded and flared natural gas at a range of economic plant sizes.

 

We have been advised by Qatar’s Energy Minister that our proposed Qatar GTL project will be delayed.  The principal reason for the delay is Qatar Petroleum’s desire to ensure that they manage the giant North Field gas resources in the most effective manner and they are currently reviewing their long-term gas production delivery plans.  In addition, they are examining the industry’s capacity to manage the design and construction of the large number of gas projects in a compressed time frame in a single location, which we believe to be a reasonable and responsible approach.  Despite this delay, we remain committed to fully exploring the potential of GTL technology.  Additionally, we continue to examine a variety of gas projects to apply our GTL technology package, as well as compressed natural gas and methanol processes which are ready for commercial application.

 

The above discussion contains forward-looking statements with respect to the estimated construction and startup dates of a LNG liquefaction plant and related facilities.  Factors that could affect the estimated construction and startup dates of the LNG liquefaction plant and related facilities include, without limitation, unforeseen problems arising from construction, inability or delay in obtaining necessary government and third-party approvals, unanticipated changes in market demand or supply, environmental issues, availability or construction of sufficient LNG vessels, and unforeseen hazards such as weather conditions.  The foregoing factors (among others) could cause actual results to differ materially from those set forth in the forward-looking statements.

 

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Results of Operations

 

Revenues for the first quarter of 2005 and 2004 are summarized in the following table:

 

		First Quarter Ended March 31
(In millions)		2005			2004
E&P		$	1,315		$	1,230
RM&T		11,396			9,061
IG		464			466
Segment revenues		13,175			10,757
Elimination of intersegment revenues		(186		)	(119		)
Gain (loss) on U.K. long-term gas contracts		(57		)	14
Total revenues		$	12,932		$	10,652
Items included in both revenues and costs and expenses:
Consumer excise taxes on petroleum products and merchandise		$	1,084		$	1,052
Matching crude oil, gas and refined product buy/sell transactions settled in cash:
E&P		36			42
RM&T		2,773			2,003
Total buy/sell transactions		$	2,809		$	2,045

 

E&P segment revenues increased by $85 million in the first quarter of 2005 from the comparable prior-year period. The increase was primarily due to higher worldwide liquid hydrocarbon and natural gas prices partially offset by lower domestic liquid hydrocarbon and natural gas sales volumes.  Derivative losses totaled $1 million in the first quarter of 2005, compared to $22 million in the first quarter of 2004.  Matching buy/sell transactions decreased by $6 million in the first quarter of 2005 from the comparable prior-year period due to decreased crude oil buy/sell transactions, partially offset by higher domestic liquid hydrocarbon prices.

 

Excluded from the E&P segment revenues were losses of $57 million and gains of $14 million for the first quarter of 2005 and 2004 on long-term gas contracts in the United Kingdom that are accounted for as derivative instruments.

 

RM&T segment revenues increased by $2,335 million in the first quarter of 2005 from the comparable prior-year period. The increase primarily reflected higher refined product and crude oil selling prices and increased refined product and crude oil sales volumes.  Matching buy/sell transaction revenues increased by $770 million in the first quarter of 2005 from the comparable prior-year period due to higher liquid hydrocarbon and refined product prices and increased crude oil buy/sell transaction volumes.  The value of the purchased volumes related to matching buy/sell transactions exceeded the sales value of the sold volumes during the first quarter of 2005 and 2004.  The value differences between purchases and sales are primarily due to grade/quality differentials, location differentials and timing differences, in those instances when the purchase and sale did not occur in the same quarter.

 

IG segment revenues decreased by $2 million in the first quarter of 2005 from the comparable prior-year period.  This decrease in the first quarter primarily reflected lower natural gas marketing volumes, partially offset by higher natural gas prices.  Derivative losses totaled $3 million in the first quarter of 2005, compared to gains of $8 million in the first quarter of 2004.

 

For additional information on segment results, see “Results of Operations by Segments” on page 16.

 

Cost of revenues for the first quarter of 2005 increased by $1,257 million from the comparable prior-year period.  The increase in the RM&T segment primarily reflected higher acquisition costs for crude oil and other refinery charge and blend stocks.  This was partially offset by a decrease in the E&P segment as a result of lower crude oil marketing activity.

 

Selling, general and administrative expenses for the first quarter of 2005 increased by $38 million primarily as a result of increased stock-based compensation expense.

 

Net interest and other financing costs for the first quarter of 2005 decreased by $6 million from the comparable prior-year period primarily as a result of increased interest income on investments and capitalized interest, partially offset by higher foreign exchange losses.

 

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Minority interest in income of MAP, which represents Ashland’s 38 percent ownership interest, increased $53 million in the first quarter of 2005 from the comparable 2004 period, due to higher MAP income as discussed below for the RM&T segment.

 

Provision for income taxes in the first quarter of 2005 increased by $34 million compared to the prior year comparable period primarily due to a $100 million increase in income before income taxes in 2005 compared to 2004.   Effective January 1, 2005, the state of Kentucky enacted legislation which causes limited liability companies to be subject to Kentucky’s corporation income tax.  In the first quarter 2005, Marathon’s provision for income taxes includes $13 million related to the effects of this Kentucky income tax on deferred tax assets and liabilities as of January 1, 2005.  The effect on net income (after minority interest) was $6 million.

 

Also beginning in the first quarter of 2005, Marathon’s effective rate reflects the estimated impact of a special deduction for qualified domestic production expected to be taken related to the American Jobs Creation Act of 2004.  This deduction will be treated as a permanent difference.  Based on managements’ best estimates of taxable income for 2005, the effective rate will be reduced by approximately one-half percent.

 

Net income for the first quarter increased by $66 million in 2005 from 2004, primarily reflecting the factors discussed above.

 

Results of Operations by Segments

 

Income from operations for the first quarter of 2005 and 2004 is summarized in the following table:

 

		First Quarter Ended March 31
(In millions)		2005			2004
E&P
Domestic		$	305		$	306
International		250			158
E&P segment income		555			464
RM&T		210			49
IG		7			15
Segment income		772			528
Items not allocated to segments:
Administrative expenses		(91		)	(64		)
Gain (loss) on U.K. long-term gas contracts		(57		)	14
Total income from operations		$	624		$	478

 

Domestic E&P income in the first quarter of 2005 remained relatively flat compared to last year’s first quarter.  Higher liquid hydrocarbon and natural gas prices and business interruption insurance recoveries of $46 million related to Hurricane Ivan storm-related damage claims were offset by lower liquid hydrocarbon and natural gas sales volumes. These lower volumes resulted primarily from storm-related downtime at Petronius and Camden Hills in the Gulf of Mexico and natural field declines in the Permian Basin.  Derivative losses totaled $1 million in the first quarter of 2005, compared to $17 million in the first quarter of 2004.

 

Our domestic average realized liquid hydrocarbons price excluding derivative activity was $38.47 per barrel (“bbl”) compared with $29.74 per bbl in the comparable prior period.  The average gas price of $4.95 per thousand cubic feet (“mcf”) excluding derivative activity compared with $4.71 per mcf in the corresponding 2004 period.

 

Domestic net liquid hydrocarbons sales volumes decreased 22 percent to 72 thousand barrels per day (“mbpd”), as a result of lower production primarily from storm-related downtime in the Gulf of Mexico.  Net natural gas sales volumes averaged 570 million cubic feet per day (“mmcfd”), down 19 percent as a result of lower production in the Gulf of Mexico and the Permian Basin from the 2004 comparable period.

 

International E&P income in the first quarter of 2005 increased by $92 million from last year’s first quarter.  The increase is primarily a result of higher liquid hydrocarbon and natural gas prices.  Derivative losses totaled $5 million in the first quarter of 2004.  There were none for 2005.

 

Our international average realized liquid hydrocarbons price excluding derivative activity was $39.10 per bbl compared with $28.22 per bbl in the comparable prior period.  The average gas price of $4.17 per mcf excluding derivative activity compared with $3.46 per mcf in the corresponding 2004 period.

 

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International net liquid hydrocarbons sales volumes remained flat at 92 thousand barrels per day (“mbpd).  Net natural gas sales volumes averaged 455 mmcfd, up 5 percent from the 2004 comparable period primarily from an increase in production in Norway.

 

RM&T segment income in the first quarter of 2005 increased by $161 million from last year’s first quarter.  The improvement was primarily due to a higher refining and wholesale marketing margin and increased refinery throughputs.  The refining and wholesale marketing margin in the first quarter of 2005 averaged 6.9 cents per gallon, versus the first quarter of 2004 level of 3.4 cents per gallon.  MAP benefited from wider sweet/sour crude differentials in general and was able to run more sour crudes during the period, taking advantage of the substantial discounts on these feedstocks.  In addition, as a result of a relatively light planned maintenance schedule during the first quarter of 2005, MAP achieved total throughputs averaging 1,094,000 bpd, compared to 985,000 bpd in the first quarter of 2004.

 

Derivative losses included in the refining and wholesale marketing margin were $172 million in the first quarter of 2005 as compared to losses of $120 million in the first quarter of 2004.  Included in derivative losses was a $73 million charge for crack spread derivative contracts in the March 2005 quarter, $61 million of which related to mark-to-market losses on crack spread derivative contracts primarily related to No. 2 high sulfur fuel oil crack spreads that expire over the remainder of 2005.  Derivative losses related to trading activities were $31 million in the first quarter of 2005 as compared to gains of $2 million in the comparable prior-year period.

 

IG segment income in the first quarter of 2005 decreased by $8 million from last year’s first quarter.  The decrease was due to mark-to-market changes in the value of derivatives used to support gas marketing activities, partially offset by increased earnings from our equity investment in the AMPCO methanol plant in Equatorial Guinea.  Equatorial Guinea methanol plant operations in 2005 have been operating at a 94 percent on-stream factor.  Derivative losses totaled $3 million in the first quarter of 2005, compared to gains of $8 million in the first quarter of 2004.

 

Dividends to Stockholders

 

On April 27, 2005, our Board of Directors (the “Board”) declared dividends of 28 cents per share, payable June 10, 2005, to stockholders of record at the close of business on May 18, 2005.

 

Cash Flows

 

Net cash provided from operating activities totaled $355 million in the first quarter of 2005, compared with $287 million in the first quarter of 2004.  The $68 million increase mainly reflects higher net income in the first quarter of 2005.

 

Capital expenditures in the first quarter of 2005 totaled $554 million compared with $344 million for the comparable prior-year period.  The $210 million increase mainly reflected increased spending in the E&P segment due to higher Norway expenditures related to the Alvheim development and increased spending in the IG segment related to continuing construction of our natural gas liquification plant in Equatorial Guinea.  For information regarding capital expenditures by segment, refer to the Supplemental Statistics on page 26.

 

Net cash provided from financing activities was $13 million in the first quarter of 2005, compared with $766 million in the first quarter 2004. The decrease was due to the issuance on March 31, 2004, of 34,500,000 shares of common stock resulting in net proceeds of $1.004 billion.  Additionally, MAP borrowed $76 million from Ashland in the first quarter of 2004.  This was partially offset by the repayment on maturity of $250 million 7.2% notes in the first quarter of 2004.  The first quarter of 2005 included contributions from GEPetrol of $73 million for its 25 percent interest in EGHoldings.

 

Derivative Instruments

 

See “Quantitative and Qualitative Disclosures About Market Risk” for discussion of derivative instruments and associated market risk.

 

Liquidity and Capital Resources

 

Our main sources of liquidity and capital resources are internally generated cash flow from operations, committed and uncommitted credit facilities, and access to both the debt and equity capital markets. Our ability to access the debt capital market is supported by our investment grade credit ratings. Our senior unsecured debt is currently rated investment grade by Standard and Poor’s Corporation, Moody’s Investor Services, Inc. and Fitch Ratings with ratings of BBB+, Baa1, and BBB+, respectively.  Because of the liquidity and capital resource alternatives available to us, including internally generated cash flow, we believe that our short-term and long-term liquidity is adequate to fund operations, including our capital spending programs, any amounts needed to complete the acquisition of Ashland’s 38% interest in MAP, repayment of debt maturities for the years 2005, 2006 and 2007, and any amounts that may ultimately be paid in connection with contingencies.

 

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We have a committed $1.5 billion five-year revolving credit facility that terminates in May 2009.  At March 31, 2005, there were no borrowings against this facility.  At March 31, 2005, we had no commercial paper outstanding under the U.S. commercial paper program that is backed by the five-year revolving credit facility.  Additionally, we have other uncommitted short-term lines of credit totaling $200 million, of which no amounts were drawn at March 31, 2005.

 

MAP has a committed $500 million five-year revolving credit facility with third-party financial institutions that terminates in May 2009.  At March 31, 2005, there were no borrowings against this facility.

 

The Marathon and MAP revolving credit facilities each require a representation at an initial borrowing that there has been no change in the respective borrower’s consolidated financial position or operations, considered as a whole, that would materially and adversely affect such borrower’s ability to perform its obligations under its revolving credit facility.

 

On March 31, 2004, we completed the sale of 34,500,000 shares of common stock at the offering price of $30 per share from the $2.7 billion universal shelf registration statement filed with the Securities and Exchange Commission in 2002.  We recorded net proceeds of $1.004 billion related to this issuance. As of March 31, 2005, there was $1.7 billion aggregate amount of common stock, preferred stock and other equity securities, debt securities, trust preferred securities or other securities, including securities convertible into or exchangeable for other equity or debt securities available to be issued under this shelf registration statement.

 

Cash distributions from MAP have been suspended pending consummation of the agreement to acquire the 38 percent ownership interest in MAP currently held by Ashland. If the proposed transaction closes, Ashland would receive additional proceeds equal to 38 percent of MAP’s distributable cash at the time of closing. If the transaction does not close, Ashland would receive its share of these funds as part of MAP’s normal distributions.  Ashland’s share on March 31, 2005 was $560 million.

 

Cash and cash equivalents totaled $3.191 billion at March 31, 2005, as compared to $3.369 billion at December 31, 2004.  We expect to utilize this cash to repay debt assumed in connection with the proposed acquisition of Ashland’s interest in MAP, to fund the cash distribution described above, to fund MAP working capital requirements arising from the approximately $900 million partial partnership redemption (described in Note 14 to the Consolidated Financial Statements on page 11), to retire other outstanding long-term debt or for other general corporate purposes.

 

Our cash-adjusted debt-to-capital ratio (total-debt-minus-cash to total-debt-plus-equity-minus-cash) was 9 percent at March 31, 2005, compared to 8 percent at year-end 2004 as shown below.  This includes approximately $592 million of debt that is serviced by United States Steel Corporation (“United States Steel”) and the above suspended distributions to Ashland.  We continually monitor our spending levels, market conditions and related interest rates to maintain what we perceive to be reasonable debt levels.

 

(Dollars in millions)		March 31 2005			December 31 2004
Long-term debt due within one year		$	17		$	16
Long-term debt		4,032			4,057
Total debt		$	4,049		$	4,073
Cash (includes $560 million in suspended distributions to Ashland for 2005)		$	3,191		$	3,369
Equity		$	8,377		$	8,111
Calculation
Total debt		$	4,049		$	4,073
Minus cash		3,191			3,369
Total debt minus cash		858			704
Total debt		4,049			4,073
Plus equity		8,377			8,111
Minus cash		3,191			3,369
Total debt plus equity minus cash		$	9,235		$	8,815
Cash-adjusted debt-to-capital ratio		9		%	8		%

 

Following completion of the proposed acquisition of Ashland’s interest in MAP, including the expected issuance of Marathon common stock of $915 million, we estimate cash-adjusted debt-to-capital ratio will be less than 35 percent.

 

Our opinions concerning liquidity and our ability to avail ourselves in the future of the financing options mentioned in the above forward-looking statements are based on currently available information. If this information proves to be inaccurate, future availability of financing may be adversely affected. Factors that affect the availability of financing include our performance (as measured by various factors including cash provided from operating activities), the state of

 

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worldwide debt and equity markets, investor perceptions and expectations of past and future performance, the global financial climate, and, in particular, with respect to borrowings, the levels of our outstanding debt and credit ratings by rating agencies.

 

Contractual Cash Obligations

 

Subsequent to December 31, 2004, there have been no significant changes to our obligations to make future payments under existing contracts.  The portion of our obligations to make future payments under existing contracts that have been assumed by United States Steel has not changed significantly subsequent to December 31, 2004.

 

Off-Balance Sheet Arrangements

 

Off-balance sheet arrangements comprise those arrangements that may potentially impact our liquidity, capital resources and results of operations, even though such arrangements are not recorded as liabilities under generally accepted accounting principles.  Although off-balance sheet arrangements serve a variety of our business purposes, we are not dependent on these arrangements to maintain our liquidity and capital resources; and we are not aware of any circumstances that are reasonably likely to cause the off-balance sheet arrangements to have a material adverse effect on liquidity and capital resources.  There have been no significant changes to our off-balance sheet arrangements subsequent to December 31, 2004.

 

Nonrecourse Indebtedness of Investees

 

Certain of our equity investees have incurred indebtedness that we do not support through guarantees or otherwise. If we were obligated to share in this debt on a pro rata ownership basis, our share would have been approximately $307 million as of March 31, 2005. Of this amount, $181 million relates to Pilot Travel Centers LLC (“PTC”).  If any of these equity investees default, we have no obligation to support the debt. Our partner in PTC has guaranteed $157 million of the total PTC debt.

 

Obligations Associated with the Separation of United States Steel

 

We remain obligated (primarily or contingently) for certain debt and other financial arrangements for which United States Steel has assumed responsibility for repayment under the terms of the Separation.  United States Steel’s obligations to Marathon are general unsecured obligations that rank equal to United States Steel’s accounts payable and other general unsecured obligations.  If United States Steel fails to satisfy these obligations, we would become responsible for repayment. Under the Financial Matters Agreement, United States Steel has all of the existing contractual rights under the leases assumed from Marathon, including all rights related to purchase options, prepayments or the grant or release of security interests.  However, United States Steel has no right to increase amounts due under or lengthen the term of any of the assumed leases, other than extensions set forth in the terms of the assumed leases.

 

As of March 31, 2005, we have obligations totaling $669 million that have been assumed by United States Steel.  Of the total $669 million, obligations of $604 million and corresponding receivables from United States Steel were recorded on our consolidated balance sheet (current portion - $19 million; long-term portion - $585 million). The remaining $65 million was related to off-balance sheet arrangements and contingent liabilities of United States Steel.

 

Environmental Matters

 

We have incurred and will continue to incur substantial capital, operating and maintenance, and remediation expenditures as a result of environmental laws and regulations. If these expenditures, as with all costs, are not ultimately recovered in the prices of our products and services, operating results will be adversely affected. We believe that substantially all of our competitors must comply with similar environmental laws and regulations. However, the specific impact on each competitor may vary depending on a number of factors, including the age and location of its operating facilities, marketing areas, production processes and whether it is also engaged in the petrochemical business or the marine transportation of crude oil and refined products.

 

Tier II gasoline and on-road diesel fuel rules require substantially reduced sulfur levels for gasoline and diesel starting in 2004 and 2006, respectively.  The combined capital costs to achieve compliance with the gasoline and diesel regulations could amount to approximately $900 million over the period between 2002 and 2006 and includes costs that could be incurred as part of other refinery upgrade projects.  This is a forward-looking statement. Costs incurred through March 31, 2005, were approximately $585 million.  Some factors (among others) that could potentially affect gasoline and diesel fuel compliance costs include completion of project detailed engineering, construction and start-up activities.

 

During 2001, MAP entered into a New Source Review consent decree and settlement of alleged Clean Air Act (‘‘CAA’’) and other violations with the U. S. Environmental Protection Agency covering all of MAP’s refineries. The

 

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settlement committed MAP to specific control technologies and implementation schedules for environmental expenditures and improvements to MAP’s refineries over approximately an eight-year period.  The total one-time expenditures for these environmental projects is approximately $370 million over the eight-year period, with about $245 million incurred through March 31, 2005.  The impact of the settlement on ongoing operating expenses is expected to be immaterial.  In addition, MAP has nearly completed certain agreed upon supplemental environmental projects as part of this settlement of an enforcement action for alleged CAA violations, at a cost of $9 million.  We believe this settlement will provide MAP with increased permitting and operating flexibility while achieving significant emission reductions.

 

There have been no other significant changes to our environmental matters subsequent to December 31, 2004.  Changes in accrued liabilities for remediation and receivables for recoverable costs since December 31, 2004 are described in Note 13 to the Consolidated Financial Statements on page 10.

 

Other Contingencies

 

We are the subject of, or a party to, a number of pending or threatened legal actions, contingencies and commitments involving a variety of matters, including laws and regulations relating to the environment. The ultimate resolution of these contingencies could, individually or in the aggregate, be material to us. However, we believe that we will remain a viable and competitive enterprise even though it is possible that these contingencies could be resolved unfavorably to us. See ‘‘Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity and Capital Resources.’’

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Management Opinion Concerning Derivative Instruments

 

Management has authorized the use of futures, forwards, swaps and options to manage exposure to market fluctuations in commodity prices, interest rates, and foreign currency exchange rates.

 

We use commodity-based derivatives to manage price risk related to the purchase, production or sale of crude oil, natural gas, and refined products.  To a lesser extent, we are exposed to the risk of price fluctuations on natural gas liquids and on petroleum feedstocks used as raw materials.

 

Our strategy has generally been to obtain competitive prices for our products and allow operating results to reflect market price movements dictated by supply and demand. We will use a variety of derivative instruments, including option combinations, as part of the overall risk management program to manage commodity price risk in our different businesses.  As market conditions change, we evaluate our risk management program and could enter into strategies that assume market risk whereby cash settlement of commodity-based derivatives will be based on market prices.

 

Our E&P segment primarily uses commodity derivative instruments selectively to protect against price decreases on portions of our future production when deemed advantageous to do so.  We also use financial derivative instruments to manage foreign currency exchange rate exposure on foreign currency denominated capital investment expenditures, operating expenses and foreign tax payments.

 

Our RM&T segment uses commodity derivative instruments:

•             to mitigate the price risk between the time foreign and domestic crude oil and other feedstock purchases for refinery supply are priced and when they are actually refined into salable petroleum products,

•             to manage the price risk associated with anticipated natural gas purchases for refinery use,

•             to protect the value of excess refined product, crude oil and LPG inventories,

•             to lock in margins associated with future fixed price sales of refined products to non-retail customers,

•             to protect against decreases in future crack spreads,

•             to mitigate price risk associated with freight on crude, feedstocks, and refined product deliveries, and

•             to take advantage of trading opportunities identified in the commodity markets.

 

Our IG segment is exposed to market risk associated with the purchase and subsequent resale of natural gas.  We use commodity derivative instruments to mitigate the price risk on purchased volumes and anticipated sales volumes.

 

We use financial derivative instruments to manage interest rate and foreign currency exchange rate exposures.  As we enter into these derivatives, assessments are made as to the qualification of each transaction for hedge accounting.

 

We believe that use of derivative instruments along with risk assessment procedures and internal controls does not expose us to material risk. However, the use of derivative instruments could materially affect our results of operations in particular quarterly or annual periods. We believe that use of these instruments will not have a material adverse effect on financial position or liquidity.

 

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