MRO-2012.9.30-10Q


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-Q

(Mark One)
 
[X]
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the Quarterly Period Ended September 30, 2012

OR

[   ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 
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 or other jurisdiction of incorporation or organization)
 
(I.R.S. Employer Identification No.)
5555 San Felipe Street, Houston, TX  77056-2723
(Address of principal executive offices)

(713) 629-6600
(Registrant’s telephone number, including area code)
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.       Yes þ No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes þ No o
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer    þ  
Accelerated filer            o
Non-accelerated filer       o        (Do not check if a smaller reporting company) 
Smaller reporting company        o   
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).         
Yes o No þ
 
There were 706,417,267 shares of Marathon Oil Corporation common stock outstanding as of October 31, 2012.



MARATHON OIL CORPORATION
 
Form 10-Q
 
Quarter Ended September 30, 2012


 
INDEX
 
 
 
Page
 
 
 
 
 
 
 
 
 
 

 
Unless the context otherwise indicates, references in this Form 10-Q to “Marathon Oil,” “we,” “our,” or “us” are references to Marathon Oil Corporation, including its wholly-owned and majority-owned subsidiaries, and its ownership interests in equity method investees (corporate entities, partnerships, limited liability companies and other ventures over which Marathon Oil exerts significant influence by virtue of its ownership interest).


1


Part I - Financial Information
Item 1. Financial Statements

MARATHON OIL CORPORATION
Consolidated Statements of Income (Unaudited)
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(In millions, except per share data)
2012
 
2011
 
2012
 
2011
Revenues and other income:
 
 
 
 
 
 
 
Sales and other operating revenues
$
4,018

 
$
3,633

 
$
11,513

 
$
10,969

Sales to related parties
16

 
16

 
43

 
45

Income from equity method investments
122

 
123

 
260

 
360

Net gain (loss) on disposal of assets
(12
)
 
13

 
126

 
63

Other income
17

 
14

 
43

 
36

Total revenues and other income
4,161

 
3,799

 
11,985

 
11,473

Costs and expenses:
 

 
 

 
 

 
 

Cost of revenues (excludes items below)
1,296

 
1,600

 
4,005

 
4,671

Purchases from related parties
72

 
57

 
191

 
184

Depreciation, depletion and amortization
625

 
517

 
1,779

 
1,716

Impairments
8

 
—

 
271

 
307

General and administrative expenses
139

 
104

 
389

 
371

Other taxes
63

 
59

 
208

 
170

Exploration expenses
176

 
129

 
491

 
504

Total costs and expenses
2,379

 
2,466

 
7,334

 
7,923

Income from operations
1,782

 
1,333

 
4,651

 
3,550

Net interest and other
(53
)
 
(30
)
 
(160
)
 
(62
)
Loss on early extinguishment of debt
—

 
—

 
—

 
(279
)
Income from continuing operations
 
 
 
 
 
 
 
   before income taxes
1,729

 
1,303

 
4,491

 
3,209

Provision for income taxes
1,279

 
898

 
3,231

 
2,051

Income from continuing operations
450

 
405

 
1,260

 
1,158

Discontinued operations
—

 
—

 
—

 
1,239

Net income
$
450

 
$
405

 
$
1,260

 
$
2,397

Per Share Data
 

 
 

 
 

 
 

Basic:
 

 
 

 
 

 
 

Income from continuing operations
$0.64
 
$0.57
 
$1.79
 
$1.63
Discontinued operations
—

 
—

 
—

 
$1.74
Net income
$0.64
 
$0.57
 
$1.79
 
$3.37
Diluted:
 

 
 

 
 
 
 

Income from continuing operations
$0.63
 
$0.57
 
$1.78
 
$1.62
Discontinued operations
—

 
—

 
—

 
$1.73
Net income
$0.63
 
$0.57
 
$1.78
 
$3.35
Dividends paid
$0.17
 
$0.15
 
$0.51
 
$0.65
Weighted average shares:
 

 
 

 
 

 
 

Basic
706

 
711

 
705

 
712

Diluted
709

 
714

 
709

 
716

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

2


MARATHON OIL CORPORATION
Consolidated Statements of Comprehensive Income (Unaudited)
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(In millions)
2012
 
2011
 
2012
 
2011
Net income
$
450

 
$
405

 
$
1,260

 
$
2,397

Other comprehensive income
 

 
 

 
 

 
 

Postretirement and postemployment plans
 

 
 

 
 

 
 

Change in actuarial loss and other
(90
)
 
13

 
(80
)
 
110

Spin-off downstream business
—

 
—

 
—

 
968

Income tax benefit (provision) on postretirement and
 

 
 

 
 

 
 

postemployment plans
32

 
6

 
28

 
(409
)
Postretirement and postemployment plans, net of tax
(58
)
 
19

 
(52
)
 
669

Derivative hedges
 

 
 

 
 

 
 

Net unrecognized gain (loss)
1

 
(1
)
 
1

 
9

Spin-off downstream business
—

 
—

 
—

 
(7
)
Income tax provision on derivatives
—

 
—

 
—

 
(1
)
Derivative hedges, net of tax
1

 
(1
)
 
1

 
1

Foreign currency translation and other
 

 
 

 
 

 
 

Unrealized loss
—

 
—

 
—

 
(1
)
Income tax provision on foreign currency translation and other
—

 
—

 
—

 
—

Foreign currency translation and other, net of tax
—

 
—

 
—

 
(1
)
Other comprehensive income (loss)
(57
)
 
18

 
(51
)
 
669

Comprehensive income
$
393

 
$
423

 
$
1,209

 
$
3,066

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


3


MARATHON OIL CORPORATION
Consolidated Balance Sheets (Unaudited)
 
September 30,
 
December 31,
(In millions, except per share data)
2012
 
2011
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
671

 
$
493

Receivables
2,553

 
1,917

Receivables from related parties
22

 
35

Inventories
324

 
361

Prepayments
111

 
96

Deferred tax assets
87

 
99

Other current assets
269

 
223

Total current assets
4,037

 
3,224

Equity method investments
1,319

 
1,383

Property, plant and equipment, less accumulated depreciation,
 

 
 

depletion and amortization of $18,438 and $17,248
27,446

 
25,324

Goodwill
525

 
536

Other noncurrent assets
1,231

 
904

Total assets
$
34,558

 
$
31,371

Liabilities
 

 
 

Current liabilities:
 

 
 

Commercial paper
$
1,839

 
$
—

Accounts payable
2,335

 
1,864

Payables to related parties
44

 
18

Payroll and benefits payable
148

 
193

Accrued taxes
2,027

 
2,015

Other current liabilities
206

 
163

Long-term debt due within one year
183

 
141

Total current liabilities
6,782

 
4,394

Long-term debt
4,518

 
4,674

Deferred tax liabilities
2,495

 
2,544

Defined benefit postretirement plan obligations
817

 
789

Asset retirement obligations
1,516

 
1,510

Deferred credits and other liabilities
366

 
301

Total liabilities
16,494

 
14,212

Commitments and contingencies


 


Stockholders’ Equity
 

 
 

Preferred stock – no shares issued and outstanding (no par value,
 

 
 

26 million shares authorized)
—

 
—

Common stock:
 

 
 

Issued – 770 million and 770 million shares  (par value $1 per share,
 

 
 

1.1 billion shares authorized)
770

 
770

Securities exchangeable into common stock – no shares issued and
 

 
 

outstanding (no par value, 29 million shares authorized)
—

 
—

Held in treasury, at cost – 64 million and 66 million shares
(2,607
)
 
(2,716
)
Additional paid-in capital
6,634

 
6,680

Retained earnings
13,688

 
12,788

Accumulated other comprehensive loss
(421
)
 
(370
)
Total equity of Marathon Oil's stockholders
18,064

 
17,152

Noncontrolling interest
—

 
7

Total equity
18,064

 
17,159

Total liabilities and stockholders' equity
$
34,558

 
$
31,371

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

4


MARATHON OIL CORPORATION
Consolidated Statements of Cash Flows (Unaudited)
 
Nine Months Ended
 
September 30,
(In millions)
2012
 
2011
Increase (decrease) in cash and cash equivalents
 
 
 
Operating activities:
 

 
 

Net income
$
1,260

 
$
2,397

Adjustments to reconcile net income to net cash provided by operating activities:
 

 
 

Discontinued operations
—

 
(1,239
)
Loss on early extinguishment of debt
—

 
279

Deferred income taxes
(27
)
 
(75
)
Depreciation, depletion and amortization
1,779

 
1,716

Impairments
271

 
307

Pension and other postretirement benefits, net
(56
)
 
28

Exploratory dry well costs and unproved property impairments
287

 
311

Net gain on disposal of assets
(126
)
 
(63
)
Equity method investments, net
(14
)
 
16

Changes in:
 
 
 

Current receivables
(646
)
 
202

Inventories
(6
)
 
47

Current accounts payable and accrued liabilities
156

 
361

All other operating, net
(66
)
 
113

Net cash provided by continuing operations
2,812

 
4,400

Net cash provided by discontinued operations
—

 
1,090

Net cash provided by operating activities
2,812

 
5,490

Investing activities:
 

 
 

Acquisitions, net of cash acquired
(806
)
 
—

Additions to property, plant and equipment
(3,509
)
 
(2,437
)
Disposal of assets
193

 
385

Investments - return of capital
42

 
41

Investing activities of discontinued operations
—

 
(493
)
Property deposit
—

 
(120
)
All other investing, net
49

 
13

Net cash used in investing activities
(4,031
)
 
(2,611
)
Financing activities:
 

 
 

Commercial paper, net
1,839

 
—

Debt issuance costs
(9
)
 
—

Debt repayments
(111
)
 
(2,843
)
Purchases of common stock
—

 
(300
)
Dividends paid
(360
)
 
(462
)
Financing activities of discontinued operations
—

 
2,916

Distribution in spin-off
—

 
(1,622
)
All other financing, net
26

 
129

Net cash provided by (used in) financing activities
1,385

 
(2,182
)
Effect of exchange rate changes on cash
12

 
(15
)
Net increase in cash and cash equivalents
178

 
682

Cash and cash equivalents at beginning of period
493

 
3,951

Cash and cash equivalents at end of period
$
671

 
$
4,633

 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; however, in the opinion of management, these statements reflect all adjustments necessary for a fair statement of the results for the periods reported.  All such adjustments are of a normal recurring nature unless disclosed otherwise.  These consolidated financial statements, including 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.
 As a result of the spin-off (see Note 2), the results of operations for our downstream (Refining, Marketing and Transportation) business have been classified as discontinued operations in 2011.  The disclosures in this report are presented on the basis of continuing operations, unless otherwise stated. Any reference to “Marathon” indicates Marathon Oil Corporation as it existed prior to the June 30, 2011 spin-off.
 These interim financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Marathon Oil Corporation 2011 Annual Report on Form 10-K.  The results of operations for the third quarter and first nine months of 2012 are not necessarily indicative of the results to be expected for the full year.
2.      Spin-off Downstream Business
 On June 30, 2011, the spin-off of the downstream business was completed, creating two independent energy companies: Marathon Oil and Marathon Petroleum Corporation (“MPC”).  On June 30, 2011, stockholders of record as of 5:00 p.m. Eastern Daylight Savings time on June 27, 2011 (the “Record Date”) received one common share of MPC stock for every two common shares of Marathon stock held as of the Record Date.
The following table presents selected financial information regarding the results of operations of our downstream business which are reported as discontinued operations.  Transaction costs incurred to affect the spin-off of $74 million are included in discontinued operations for 2011.
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(In millions)
2011
 
2011
Revenues applicable to discontinued operations
$
—

 
$
38,602

Pretax income from discontinued operations
—

 
2,012

3.     Accounting Standards
Recently Adopted
In September 2011, the Financial Accounting Standards Board (“FASB”) amended accounting standards to simplify how entities test goodwill for impairment.  The amendment reduces complexity by allowing an entity the option to make a qualitative evaluation of whether it is necessary to perform the two-step goodwill impairment test.  The amendment is effective for our interim and annual periods beginning with the first quarter of 2012.  Adoption of this amendment did not have a significant impact on our consolidated results of operations, financial position or cash flows.
 The FASB amended the reporting standards for comprehensive income in June 2011 to eliminate the option to present the components of Other Comprehensive Income (“OCI”) as part of the statement of changes in stockholders' equity.  All non-owner changes in stockholders’ equity are required to be presented either in a single continuous statement of comprehensive income or in two separate but consecutive statements.  In the two statement approach, the first statement should present total net income and its components followed consecutively by a second statement that should present total other comprehensive income, the components of OCI, and total comprehensive income.  The presentation of items that are reclassified from OCI to net income on the income statement is also required.  The amendments did not change the items that must be reported in OCI or when an item of OCI must be reclassified to net income.  The amendments are effective for us beginning with the first quarter of 2012, except for the presentation of reclassifications, which has been deferred.  Adoption of these amendments did not have a significant impact on our consolidated results of operations, financial position or cash flows.
In May 2011, the FASB issued an update amending the accounting standards for fair value measurement and disclosure, resulting in common principles and requirements under accounting principles generally accepted in the U.S. (“U.S. GAAP”) and International Financial Reporting Standards (“IFRS”).  The amendments change the wording used to describe certain of the U.S.

6

MARATHON OIL CORPORATION
Notes to Consolidated Financial Statements (Unaudited)


GAAP requirements either to clarify the intent of existing requirements, to change measurement or expand disclosure principles or to conform to the wording used in IFRS.  The amendments are to be applied prospectively for our interim and annual periods beginning with the first quarter of 2012.  The adoption of the amendments did not have a significant impact on our consolidated results of operations, financial position or cash flows.  To the extent they were necessary, we have made the expanded disclosures in Note 13.
4.     Variable Interest Entity
 The owners of the Athabasca Oil Sands Project (“AOSP”), in which we hold a 20 percent undivided interest, contracted with a wholly-owned subsidiary of a publicly traded Canadian limited partnership (“Corridor Pipeline”) to provide materials transportation capabilities among the Muskeg River and Jackpine mines, the Scotford upgrader and markets in Edmonton.  The contract, originally signed in 1999 by a company we acquired, allows each holder of an undivided interest in the AOSP to ship materials in accordance with its undivided interest.  Costs under this contract are accrued and recorded on a monthly basis, with a $3 million current liability recorded at September 30, 2012, consistent with December 31, 2011.  Under this agreement, the AOSP absorbs all of the operating and capital costs of the pipeline.  Currently, no third-party shippers use the pipeline.  Should shipments be suspended, by choice or due to force majeure, we remain responsible for the portion of the payments related to our undivided interest for all remaining periods.  The contract expires in 2029; however, the shippers can extend its term perpetually.  This contract qualifies as a variable interest contractual arrangement and the Corridor Pipeline qualifies as a Variable Interest Entity (“VIE”).  We hold a variable interest but are not the primary beneficiary because our shipments are only 20 percent of the total; therefore, the Corridor Pipeline is not consolidated by Marathon Oil.  Our maximum exposure to loss as a result of our involvement with this VIE is the amount we expect to pay over the contract term, which was $697 million as of September 30, 2012.  The liability on our books related to this contract at any given time will reflect amounts due for the immediately previous month’s activity, which is substantially less than the maximum exposure over the contract term.  We have not provided financial assistance to Corridor Pipeline and we do not have any guarantees of such assistance in the future.
5.    Income per Common Share
Basic income per share is based on the weighted average number of common shares outstanding.  Diluted income per share includes exercise of stock options and stock appreciation rights, provided the effect is not antidilutive.
 
Three Months Ended September 30,
 
2012
 
2011
(In millions, except per share data)
Basic
 
Diluted
 
Basic
 
Diluted
Net income
$
450

 
$
450

 
$
405

 
$
405

 
 
 
 
 
 
 
 
Weighted average common shares outstanding
706

 
706

 
711

 
711

Effect of dilutive securities
—

 
3

 
—

 
3

Weighted average common shares, including
 
 
 
 
 
 
 
dilutive effect
706

 
709

 
711

 
714

Per share:
 

 
 

 
 

 
 

Net income
$0.64
 
$0.63
 
$0.57
 
$0.57
 

7

MARATHON OIL CORPORATION
Notes to Consolidated Financial Statements (Unaudited)


 
Nine Months Ended September 30,
 
2012
 
2011
(In millions, except per share data)
Basic
 
Diluted
 
Basic
 
Diluted
Income from continuing operations
$
1,260

 
$
1,260

 
$
1,158

 
$
1,158

Discontinued operations
—

 
—

 
1,239

 
1,239

Net income
$
1,260

 
$
1,260

 
$
2,397

 
$
2,397

 
 
 
 
 
 
 
 
Weighted average common shares outstanding
705

 
705

 
712

 
712

Effect of dilutive securities
—

 
4

 
—

 
4

Weighted average common shares, including
 
 
 
 
 
 
 
dilutive effect
705

 
709

 
712

 
716

Per share:
 

 
 

 
 

 
 

Income from continuing operations
$1.79
 
$1.78
 
$1.63
 
$1.62
Discontinued operations
—

 
—

 
$1.74
 
$1.73
Net income
$1.79
 
$1.78
 
$3.37
 
$3.35
 The per share calculations above exclude 10 million stock options and stock appreciation rights for the third quarter and first nine months of 2012, as they were antidilutive.  Excluded for the third quarter and first nine months of 2011 were 9 million and 7 million stock options and stock appreciation rights.
6.     Acquisitions
We acquired approximately 20,000 net acres in the core of the Eagle Ford shale during the first nine months of 2012. All Eagle Ford properties are included in our Exploration and Production (“E&P”) segment.  The largest transaction was the acquisition of Paloma Partners II, LLC, which closed August 1, 2012 for cash consideration of $768 million. This transaction was accounted for as a business combination. Smaller transactions closed during the second quarter of 2012. 
The following table summarizes the amounts allocated to the assets acquired and liabilities assumed based upon their fair values at the acquisition date:
(In millions)
 
 
Assets:
 
 
Cash
 
$
8

Receivables
 
22

Inventories
 
1

Total current assets acquired
 
31

Property, plant and equipment
 
822

Total assets acquired
 
853

Liabilities:
 
 
Accounts payable
 
78

Asset retirement obligations
 
7

Total liabilities assumed
 
85

Net assets acquired
 
$
768

The fair values of assets acquired and liabilities assumed were measured primarily using an income approach, specifically utilizing a discounted cash flow analysis. The estimated fair values were based on significant inputs not observable in the market, and therefore represent Level 3 measurements. Significant inputs included estimated reserve volumes, the expected future production profile, estimated commodity prices and assumptions regarding future operating and development costs. A discount rate of approximately 10 percent was used in the discounted cash flow analysis. The accounting for this transaction is complete. The pro forma impact of this business combination is not material to our consolidated statements of income for the third quarter and first nine months of 2012 and 2011.

8

MARATHON OIL CORPORATION
Notes to Consolidated Financial Statements (Unaudited)


7.   Dispositions
2012
In the third quarter of 2012, we sold approximately 5,800 net undeveloped acres located outside the core of the Eagle Ford shale, held by our E&P segment, for proceeds of $9 million. A pretax loss of $18 million was recorded.
In May 2012, we executed agreements to relinquish our E&P segment’s operatorship of and participating interests in the Bone Bay and Kumawa exploration licenses in Indonesia.  As a result, we accrued and reported a $36 million loss on disposal of assets in the second quarter of 2012.  Government ratification of the agreements was received during the third quarter of 2012, which released us from our obligations and further commitments related to these licenses, and we paid the amount accrued. 
 In April 2012, we entered into agreements to sell all of our E&P segment’s assets in Alaska.  One transaction closed in the second quarter of 2012 with proceeds and a net pretax gain of $7 million.  The remaining transaction, with a value of $375 million before closing adjustments, is currently under review by the U.S. Federal Trade Commission and the Alaska Attorney General's office, which could impact the closing of this transaction. Assets held for sale are included in the September 30, 2012 balance sheet as follows:
(In millions)
 
Other current assets
$
59

Other noncurrent assets
190

Total assets
249

Other current liabilities
1

Deferred credits and other liabilities
90

Total liabilities
$
91

In January 2012, we closed on the sale of our E&P segment’s interests in several Gulf of Mexico crude oil pipeline systems for proceeds of $206 million.  This includes our equity method interests in Poseidon Oil Pipeline Company, L.L.C. and Odyssey Pipeline L.L.C., as well as certain other oil pipeline interests, including the Eugene Island pipeline system.  A pretax gain of $166 million was recorded in the first quarter of 2012.
2011
In September 2011, we sold our Integrated Gas segment's equity interest in a liquefied natural gas (“LNG”) processing facility in Alaska. A gain on the transaction of $8 million was recorded in the third quarter of 2011.
In April 2011, we assigned a 30 percent undivided working interest in our E&P segment’s approximately 180,000 acres in the Niobrara shale play located within the DJ Basin of southeast Wyoming and northern Colorado for total consideration of $270 million, recording a pretax gain of $39 million.  We remain operator of this jointly owned leasehold.
 In March 2011, we closed the sale of our E&P segment's outside-operated interests in the Gudrun field development and the Brynhild and Eirin exploration areas offshore Norway for net proceeds of $85 million, excluding working capital adjustments.  A $64 million pretax loss on this disposition was recorded in the fourth quarter of 2010.
8.    Segment Information
 We have three reportable operating segments.  Each of these segments is organized and managed based upon the nature of the products and services they offer.
•
 Exploration and Production (“E&P”) – explores for, produces and markets liquid hydrocarbons and natural gas on a worldwide basis;
•
Oil Sands Mining (“OSM”) – mines, extracts and transports bitumen from oil sands deposits in Alberta, Canada, and upgrades the bitumen to produce and market synthetic crude oil and vacuum gas oil; and
•
Integrated Gas (“IG”) – produces and markets products manufactured from natural gas, such as LNG and methanol, in Equatorial Guinea.
Information regarding assets by segment is not presented because it is not reviewed by the chief operating decision maker (“CODM”).  Segment income represents income from continuing operations, net of income taxes, attributable to the operating segments. Our corporate general and administrative costs are not allocated to the operating segments. These costs primarily consist

9

MARATHON OIL CORPORATION
Notes to Consolidated Financial Statements (Unaudited)


of employment costs (including pension effects), professional services, facilities and other costs associated with corporate activities, net of associated income tax effects.  Impairments, gains or losses on disposal of assets or other items that affect comparability (as determined by the CODM) also are not allocated to operating segments.
Differences between segment totals and our consolidated totals for income taxes and depreciation, depletion and amortization represent amounts related to corporate administrative activities and other unallocated items which are included in “Items not allocated to segments, net of income taxes” in the reconciliation below. Total capital expenditures include accruals but not corporate activities.
As discussed in Note 2, our downstream business was spun-off on June 30, 2011 and has been reported as discontinued operations in 2011.
 
Three Months Ended September 30, 2012
(In millions)
E&P
 
OSM
 
IG
 
Total
Revenues:
 

 
 

 
 

 
 

Customer
$
3,503

 
$
470

 
$
—

 
$
3,973

Related parties
16

 
—

 
—

 
16

Segment revenues
$
3,519

 
$
470

 
$
—

 
3,989

Unrealized gain on crude oil derivative instruments
 
 
 
 
 
 
45

Total revenues
 
 
 
 
 
 
$
4,034

Segment income
$
486

 
$
65

 
$
39

 
$
590

Income from equity method investments
74

 
—

 
48

 
122

Depreciation, depletion and amortization
556

 
60

 
—

 
616

Income tax provision
1,252

 
20

 
9

 
1,281

Capital expenditures
1,274

 
41

 
1

 
1,316

 
Three Months Ended September 30, 2011
(In millions)
E&P
 
OSM
 
IG
 
Total
Revenues:
 

 
 

 
 

 
 

Customer
$
3,190

 
$
427

 
$
16

 
$
3,633

Intersegment
6

 
—

 
—

 
6

Related parties
16

 
—

 
—

 
16

Segment revenues
$
3,212

 
$
427

 
$
16

 
3,655

Elimination of intersegment revenues
 
 


 


 
(6
)
Total revenues


 


 


 
$
3,649

Segment income
$
330

 
$
92

 
$
55

 
$
477

Income from equity method investments
63

 
—

 
60

 
123

Depreciation, depletion and amortization
454

 
55

 
—

 
509

Income tax provision
890

 
31

 
19

 
940

Capital expenditures
684

 
36

 
1

 
721


10

MARATHON OIL CORPORATION
Notes to Consolidated Financial Statements (Unaudited)


 
Nine Months Ended September 30, 2012
(In millions)
E&P
 
OSM
 
IG
 
Total
Revenues:
 

 
 

 
 

 
 

Customer
$
10,284

 
$
1,184

 
$
—

 
$
11,468

Related parties
43

 
—

 
—

 
43

Segment revenues
$
10,327

 
$
1,184

 
$
—

 
11,511

Unrealized gain on crude oil derivative instruments
 
 
 
 
 
 
45

Total revenues


 


 


 
$
11,556

Segment income
$
1,380

 
$
157

 
$
56

 
$
1,593

Income from equity method investments
176

 
—

 
84

 
260

Depreciation, depletion and amortization
1,593

 
159

 
—

 
1,752

Income tax provision
3,398

 
51

 
15

 
3,464

Capital expenditures
3,459

 
136

 
2

 
3,597

 
Nine Months Ended September 30, 2011
(In millions)
E&P
 
OSM
 
IG
 
Total
Revenues:
 

 
 

 
 

 
 

Customer
$
9,696

 
$
1,180

 
$
93

 
$
10,969

Intersegment
47

 
—

 
—

 
47

Related parties
45

 
—

 
—

 
45

Segment revenues
$
9,788

 
$
1,180

 
$
93

 
11,061

Elimination of intersegment revenues
 
 


 


 
(47
)
Total revenues
 
 
 
 
 
 
$
11,014

Segment income
$
1,599

 
$
193

 
$
158

 
$
1,950

Income from equity method investments
187

 
—

 
173

 
360

Depreciation, depletion and amortization
1,541

 
141

 
3

 
1,685

Income tax provision
2,101

 
64

 
62

 
2,227

Capital expenditures
2,101

 
236

 
2

 
2,339


The following reconciles total revenues to sales and other operating revenues as reported in the consolidated statements of income:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(In millions)
2012
 
2011
 
2012
 
2011
Total revenues
$
4,034

 
$
3,649

 
$
11,556

 
$
11,014

Less:  Sales to related parties
16

 
16

 
43

 
45

Sales and other operating revenues
$
4,018

 
$
3,633

 
$
11,513

 
$
10,969



11

MARATHON OIL CORPORATION
Notes to Consolidated Financial Statements (Unaudited)


The following reconciles segment income to net income as reported in the consolidated statements of income:
 
Three Months Ended
 
Nine Months Ended
 
September 30,
 
September 30,
(In millions)
2012
 
2011
 
2012
 
2011
Segment income
$
590

 
$
477

 
$
1,593

 
$
1,950

Items not allocated to segments, net of income taxes:
 

 
 

 
 

 
 

Corporate and other unallocated items
(158
)
 
(56
)
 
(267
)
 
(209
)
Unrealized gain on crude oil derivative instruments
29

 
—

 
29

 
—

     Gain (loss) on dispositions
(11
)
 
(1
)
 
72

 
23

     Impairments
—

 
—

 
(167
)
 
(195
)
Loss on early extinguishment of debt
—

 
—

 
—

 
(176
)
     Tax effect of subsidiary restructuring
—

 
—

 
—

 
(122
)
Deferred income tax items
—

 
(15
)
 
—

 
(65
)
Water abatement - Oil Sands
—

 
—

 
—

 
(48
)
Income from continuing operations
450

 
405

 
1,260

 
1,158

Discontinued operations
—

 
—

 
—

 
1,239

Net income
$
450

 
$
405

 
$
1,260

 
$
2,397

9.    Defined Benefit Postretirement Plans
The following summarizes the components of net periodic benefit cost:
 
Three Months Ended September 30,
  
Pension Benefits
 
Other Benefits
(In millions)
2012
 
2011
 
2012
 
2011
Service cost
$
12

 
$
12

 
$
1

 
$
1

Interest cost
16

 
17

 
4

 
4

Expected return on plan assets
(14
)
 
(16
)
 
—

 
—

Amortization:
 

 
 

 
 

 
 

– prior service cost (credit)
2

 
1

 
(2
)
 
(2
)
– actuarial loss
12

 
12

 
—

 
—

– net settlement loss(a)
34

 
—

 
—

 
—

Net periodic benefit cost
$
62

 
$
26

 
$
3

 
$
3

 
Nine Months Ended September 30,
  
Pension Benefits
 
Other Benefits
(In millions)
2012
 
2011
 
2012
 
2011
Service cost
$
37

 
$
35

 
$
3

 
$
3

Interest cost
48

 
50

 
11

 
12

Expected return on plan assets
(46
)
 
(49
)
 
—

 
—

Amortization:
 

 
 

 
 

 
 

– prior service cost (credit)
6

 
4

 
(5
)
 
(5
)
– actuarial loss
37

 
37

 
—

 
—

– net settlement loss(a)
34

 
—

 
—

 
—

Net periodic benefit cost
$
116

 
$
77

 
$
9

 
$
10

(a) 
Settlement losses are recorded when lump sum payments from a plan in a period exceed the plan's total service and interest costs for the period. Such settlements occurred in our U.S. pension plans during the third quarter of 2012.

12

MARATHON OIL CORPORATION
Notes to Consolidated Financial Statements (Unaudited)


During the third quarter of 2012, we recorded the effects of partial settlements of our U.S. pension plans. We remeasured the plans' assets and liabilities as of September 30, 2012 and, as a result, recognized settlement expense along with an increase of $103 million in actuarial losses, net of settlement expenses. The net increase in actuarial losses is reported in other comprehensive income.
 During the first nine months of 2012, we made contributions of $162 million to our funded pension plans.  We expect to make additional contributions up to an estimated $2 million over the remainder of 2012.  Current benefit payments related to unfunded pension and other postretirement benefit plans were $7 million and $12 million during the first nine months of 2012.
10.    Income Taxes
 The effective income tax rate is influenced by a variety of factors including the geographic and functional sources of income and the relative magnitude of these sources of income.  The provision for income taxes is allocated on a discrete, stand-alone basis to pretax segment income and to individual items not allocated to segments.  The difference between the total provision and the sum of the amounts allocated to segments and to individual items not allocated to segments is reported in “Corporate and other unallocated items” in Note 8.
 Our effective tax rate in the first nine months of 2012 was 72 percent.   This rate is higher than the U.S. statutory rate of 35 percent primarily due to earnings from foreign jurisdictions, primarily Norway and Libya, where the tax rates are in excess of the U.S. statutory rate.  An increase in earnings and associated taxes from foreign jurisdictions, primarily Norway, as compared to prior periods caused an increase in our valuation allowance on current year foreign tax credits.  In Libya, where the statutory tax rate is in excess of 90 percent, limited production resumed in the fourth quarter of 2011 and liquid hydrocarbon sales resumed in the first quarter of 2012.  A reliable estimate of 2012 annual ordinary income from our Libyan operations cannot be made and the range of possible scenarios when including ordinary income from our Libyan operations in the worldwide annual effective tax rate calculation demonstrates significant variability.  As such, for the first nine months of 2012, an estimated annual effective tax rate was calculated excluding Libya and applied to consolidated ordinary income excluding Libya and the tax provision applicable to Libyan ordinary income was recorded as a discrete item in the period.  Excluding Libya, the effective tax rate would be 64 percent for the first nine months of 2012.
Our effective tax rate in the first nine months of 2011 was 64 percent which is higher than the U.S. statutory tax rate of 35 percent primarily due to earnings from foreign jurisdictions where the tax rates are in excess of the U.S. statutory rate and the valuation allowance recorded against 2011 foreign tax credits.  In addition, in the second quarter of 2011, we recorded a deferred tax charge related to an internal restructuring of our international subsidiaries.
The following table summarizes the activity in unrecognized tax benefits:
 
Nine Months Ended September 30,
(In millions)
2012
 
2011
Beginning balance
$
157

 
$
103

Additions based on tax positions related to the current year
2

 
3

Reductions based on tax positions related to the current year
(1
)
 
(3
)
Additions for tax positions of prior years
97

 
71

Reductions for tax positions of prior years
(66
)
 
(24
)
Settlements
(12
)
 
(9
)
Ending balance
$
177

 
$
141

 If the unrecognized tax benefits as of September 30, 2012 were recognized, $114 million would affect our effective income tax rate.  There were $143 million of uncertain tax positions as of September 30, 2012 for which it is reasonably possible that the amount of unrecognized tax benefits would decrease during the next twelve months.

13

MARATHON OIL CORPORATION
Notes to Consolidated Financial Statements (Unaudited)


11.   Inventories
 Inventories are carried at the lower of cost or market value.
 
September 30,
 
December 31,
(In millions)
2012
 
2011
Liquid hydrocarbons, natural gas and bitumen
$
72

 
$
147

Supplies and sundry items
252

 
214

Total inventories, at cost
$
324

 
$
361

12.  Property, Plant and Equipment
 
September 30,
 
December 31,
(In millions)
2012
 
2011
E&P
 
 
 
United States
$
22,167

 
$
19,679

International
13,185

 
12,579

Total E&P
35,352

 
32,258

OSM
10,070

 
9,936

IG
38

 
37

Corporate
424

 
341

Total property, plant and equipment
45,884

 
42,572

Less accumulated depreciation, depletion and amortization
(18,438
)
 
(17,248
)
Net property, plant and equipment
$
27,446

 
$
25,324

In the first quarter of 2011, production operations in Libya were suspended. In the fourth quarter of 2011, limited production resumed.  Since that time, average net liquid hydrocarbon sales volumes have increased to 49 thousand barrels per day (“mbbld”) in the third quarter of 2012 and 37 mbbld in the first nine months of 2012.  We and our partners in the Waha concessions continue to assess the condition of our assets in Libya and uncertainty around sustained production and sales levels remains.
Exploratory well costs capitalized greater than one year after completion of drilling (“suspended”) were $207 million as of September 30, 2012.  The net decrease in such costs from December 31, 2011 primarily related to changes in three areas.  Norway exploration costs of $55 million incurred between 2009 and 2011 have been suspended for greater than one year, pending commencement of the Boyla development which was submitted to the Norwegian government for approval in June and approved in October 2012.  Drilling on the Shenandoah prospect in the Gulf of Mexico resumed in June 2012.  Costs of $38 million related to Shenandoah are no longer suspended. The Innsbruck well was reentered in September 2012; therefore, costs of $60 million related to the prospect are no longer suspended.

14

MARATHON OIL CORPORATION
Notes to Consolidated Financial Statements (Unaudited)


13.  Fair Value Measurements
 Fair Values - Recurring
The following table presents assets and liabilities accounted for at fair value on a recurring basis as of September 30, 2012 by fair value hierarchy level.
 
September 30, 2012
(In millions)
Level 1
 
Level 2
 
Level 3
 
Collateral
 
Total
Derivative instruments, assets
 
 
 
 
 
 
 
 
 
     Commodity
$
—

 
$
47

 
$
—

 
$
1

 
$
48

     Interest rate
—

 
22

 
—

 
—

 
22

     Foreign currency
—

 
20

 
—

 
—

 
20

          Derivative instruments, assets
—

 
89

 
—

 
1

 
90

Derivative instruments, liabilities
 
 
 
 
 
 
 
 
 
     Commodity
—

 
2

 
—

 
—

 
2

     Foreign currency
—

 
1

 
—

 
—

 
1

          Derivative instruments, liabilities
$
—

 
$
3

 
$
—

 
$
—

 
$
3

Commodity swaps in Level 2 are measured at fair value with a market approach using prices obtained from exchanges or pricing services, which have been corroborated with data from active markets for similar assets and liabilities.  Commodity options in Level 2 are valued using The Black-Scholes Model.  Inputs to this model include prices as noted above, discount factors, and  implied market volatility.  The inputs used to estimate fair value are categorized as Level 2 because predominantly all assumptions and inputs are observable in active markets throughout the term of the instruments.  Collateral deposits related to commodity derivatives are in broker accounts covered by master netting agreements.
Interest rate swaps are measured at fair value with a market approach using actionable broker quotes which are Level 2 inputs.  Foreign currency forwards are measured at fair value with a market approach using third-party pricing services, such as Bloomberg L.P., which have been corroborated with data from active markets for similar assets and liabilities, and are Level 2 inputs.
As of December 31, 2011, balances related to interest rate swaps accounted for at fair value on a recurring basis were noncurrent assets of $5 million measured at fair value using actionable broker quotes which are Level 2 inputs. There were no other significant recurring fair value measurements as of December 31, 2011.
Fair Values - Nonrecurring
The following tables show the values of assets, by major class, measured at fair value on a nonrecurring basis in periods subsequent to their initial recognition.
 
Three Months Ended September 30,
 
2012
 
2011
(In millions)
Fair Value
 
Impairment
 
Fair Value
 
Impairment
Long-lived assets held for use
$
2

 
$
8

 
$
—

 
$
—

 
 
Nine Months Ended September 30,
 
2012
 
2011
(In millions)
Fair Value
 
Impairment
 
Fair Value
 
Impairment
Long-lived assets held for use
$
77

 
$
271

 
$
226

 
$
282

Intangible assets
$
—

 
$
—

 
$
—

 
$
25

Our E&P segment’s Ozona development in the Gulf of Mexico began production in December 2011.  During the first quarter of 2012, production rates declined significantly and have remained below initial expectations.  Accordingly, our reserve engineers performed an evaluation of our future production as well as our reserves which concluded in early April 2012.  This resulted in a

15

MARATHON OIL CORPORATION
Notes to Consolidated Financial Statements (Unaudited)


2 million barrel of oil equivalent reduction in proved reserves and a $261 million impairment charge in the first quarter of 2012.  The fair value of the Ozona development was determined using an income approach based upon internal estimates of future production levels, prices and discount rate, all Level 3 inputs.  Inputs to the fair value measurement included reserve and production estimates made by our reservoir engineers, estimated liquid hydrocarbon prices based on the Louisiana Light Sweet 12-month price range, as we think production will not be significant beyond twelve months, adjusted for quality and location differentials, and forecasted operating expenses for the remaining estimated life of the reservoir.
In May 2011, significant water production and reservoir pressure declines occurred at our E&P segment’s Droshky development in the Gulf of Mexico. Consequently, 3.4 million barrels of oil equivalent of proved reserves were written off and a $273 million impairment of this long-lived asset to fair value was recorded in the second quarter of 2011.  The $226 million fair value of the Droshky development was determined using an income approach based upon internal estimates of future production levels, prices and discount rate, all Level 3 inputs.
In the second quarter of 2011, our outlook for U.S. natural gas prices indicated that it was unlikely that sufficient U.S. demand for LNG would materialize by 2021, which is when our rights lapse under arrangements at the Elba Island, Georgia regasification facility.  Using an income approach based upon internal estimates of natural gas prices and future deliveries, which are Level 3 inputs, we determined that the contract had no remaining fair value and recorded a full impairment of this intangible asset held in our Integrated Gas segment.
Other impairments of long-lived assets held for use by our E&P segment in the third quarter and first nine months of 2012 and 2011 were a result of reduced drilling expectations, reduction of estimated reserves or declining natural gas prices.  The fair values of those assets were measured using an income approach based upon internal estimates of future production levels, commodity prices and discount rate, which are Level 3 inputs.
Fair Values – Reported
Our current assets and liabilities include financial instruments, the most significant of which are accounts receivables and payables.  We believe the carrying values of these accounts receivables and payables approximate fair value.  Our fair value assessment incorporates a variety of considerations, including (1) the short-term duration of the instruments, (2) our investment-grade credit rating, and (3) our historical incurrence of and expected future insignificance of bad debt expense, which includes an evaluation of counterparty credit risk.  
The following table summarizes financial instruments, excluding trade accounts receivables and payables and derivative financial instruments, and their reported fair value by individual balance sheet line item at September 30, 2012 and December 31, 2011:
 
September 30, 2012
 
December 31, 2011
 
Fair
 
Carrying
 
Fair
 
Carrying
(In millions)
Value
 
Amount
 
Value
 
Amount
Financial assets
 
 
 
 
 
 
 
Other current assets
$
135

 
$
134

 
$
146

 
$
148

Other noncurrent assets
158

 
158

 
68

 
68

Total financial assets  
293

 
292

 
214

 
216

Financial liabilities
 

 
 

 
 

 
 

     Other current liabilities
13

 
13

 
—

 
—

     Long-term debt, including current portion(a)
5,639

 
4,653

 
5,479

 
4,753

Deferred credits and other liabilities
100

 
101

 
36

 
38

Total financial liabilities  
$
5,752

 
$
4,767

 
$
5,515

 
$
4,791

(a)      Excludes capital leases.
Fair values of our remaining financial assets included in other current assets and other noncurrent assets and of our financial liabilities included in other current liabilities and deferred credits and other liabilities are measured using an income approach and most inputs are internally generated, which results in a Level 3 classification.  Estimated future cash flows are discounted using a rate deemed appropriate to obtain the fair value.
Most of our long-term debt instruments are publicly-traded.  A market approach based upon quotes from major financial institutions is used to measure the fair value of such debt.  Because these quotes cannot be independently verified to an active

16

MARATHON OIL CORPORATION
Notes to Consolidated Financial Statements (Unaudited)


market they are considered Level 3 inputs.   The fair value of our debt that is not publicly-traded is measured using an income approach.  The future debt service payments are discounted using the rate at which we currently expect to borrow.  All inputs to this calculation are Level 3.
14.  Derivatives
For information regarding the fair value measurement of derivative instruments, see Note 13. The following table presents the gross fair values of derivatives instruments, excluding cash collateral, and where they appear on the consolidated balance sheets as of September 30, 2012.
 
September 30, 2012
 
 
(In millions)
Asset
 
Liability
 
Net Asset
 
Balance Sheet Location
Fair Value Hedges
 
 
 
 
 
 
 
     Foreign currency
$
20

 
$
—

 
$
20

 
Other current assets
     Interest rate
22

 
—

 
22

 
Other noncurrent assets
Total Designated Hedges
42

 
—

 
42

 
 
 
 
 
 
 
 
 
 
Not Designated as Hedges
 
 
 
 
 
 
 
     Commodity
30

 
—

 
30

 
Other current assets
     Commodity
20

 
—

 
20

 
Other noncurrent assets
Total Not Designated as Hedges
50

 
—

 
50

 
 
     Total
$
92

 
$
—

 
$
92

 
 
 
 
September 30, 2012
 
 
(In millions)
Asset
 
Liability
 
Net Liability
 
Balance Sheet Location
Fair Value Hedges
 
 
 
 
 
 
 
     Foreign currency
$
—

 
$
1

 
$
1

 
Other current liabilities
Total Designated Hedges
—

 
1

 
1

 
 
 
 
 
 
 
 
 
 
Not Designated as Hedges
 
 
 
 
 
 
 
     Commodity
—

 
5

 
5

 
Other current liabilities
Total Not Designated as Hedges
—

 
5

 
5

 
 
     Total
$
—

 
$
6

 
$
6

 
 
As of December 31, 2011, our derivatives outstanding were interest rate swaps that were fair value hedges, which had an asset value of $5 million and are located on the consolidated balance sheet in Other noncurrent assets.
Derivatives Designated as Fair Value Hedges
As of September 30, 2012, we had multiple interest rate swap agreements with a total notional amount of $600 million at a weighted average, London Interbank Offer Rate (“LIBOR”)-based, floating rate of  4.71 percent.
As of September 30, 2012, our foreign currency forwards had an aggregate notional amount of 3,939 million Norwegian Kroner at a weighted average forward rate of 5.911. These forwards hedge our current Norwegian tax liability and have settlement dates through February 2013.
In connection with the debt retired in February and March 2011 discussed in Note 15, we settled interest rate swaps with a notional amount of $1,450 million.

17

MARATHON OIL CORPORATION
Notes to Consolidated Financial Statements (Unaudited)


The pretax effect of derivative instruments designated as hedges of fair value in our consolidated statements of income are summarized in the table below.
 
 
Gain (Loss)
 
 
Three Months Ended
 
Nine Months Ended
 
 
September 30,
 
September 30,
(In millions)
Income Statement Location
2012
 
2011
 
2012
 
2011
Derivative
 
 
 
 
 
 
 
 
Interest rate
Net interest and other
$
6

 
$
26

 
$
17

 
$
25

Interest rate
Loss on early extinguishment of debt
—

 
—

 
—

 
29

Foreign currency
Provision for income taxes
$
22

 
$
—

 
$
(18
)
 
$
—

Hedged Item
 
 

 
 

 
 

 
 

Long-term debt
Net interest and other
$
(6
)
 
$
(26
)
 
$
(17
)
 
$
(25
)
Long-term debt
Loss on early extinguishment of debt
—

 
—

 
—

 
(29
)
Accrued taxes
Provision for income taxes
$
(22
)
 
$
—

 
$
18

 
$
—

 Derivatives not Designated as Hedges
In August 2012, we entered crude oil derivatives related to a portion of our forecast U.S. E&P crude oil sales through December 31, 2013. These commodity derivatives were not designated as hedges and are shown in the table below.
Term
Bbls per Day
Weighted Average Price per Bbl
Benchmark
Swaps
 
 
 
October 2012 - December 2013
20,000
$96.29
West Texas Intermediate
October 2012 - December 2013
25,000
$109.19
Brent
Option Collars
 
 
 
October 2012 - December 2013
15,000
$90.00 floor / $101.17 ceiling
West Texas Intermediate
October 2012 - December 2013
15,000
$100.00 floor / $116.30 ceiling
Brent
The following table summarizes the effect of all derivative instruments not designated as hedges in our consolidated statements of income.
 
 
Gain (Loss)
 
 
Three Months Ended
 
Nine Months Ended
 
 
September 30,
 
September 30,
(In millions)
Income Statement Location
2012
 
2011
 
2012
 
2011
Commodity
Sales and other operating revenues
$
45

 
$
2

 
$
46

 
$
3

15.   Debt
 On October 29, 2012, we issued $1 billion aggregate principal amount of senior notes bearing interest at 0.9 percent with a maturity date of November 1, 2015 and $1 billion aggregate principal amount of senior notes bearing interest at 2.8 percent with a maturity date of November 1, 2022. Interest on the senior notes is payable semi-annually beginning May 1, 2013. The proceeds are being used to pay off commercial paper and for general corporate purposes.
At September 30, 2012, we had no borrowings against our revolving credit facility, described below, and $1,839 million in commercial paper outstanding under our U.S. commercial paper program that is backed by the revolving credit facility.
 In April 2012, we terminated our $3.0 billion five-year revolving credit facility and replaced it with a new $2.5 billion unsecured five-year revolving credit facility (the “Credit Facility”).  The Credit Facility matures in April 2017 but allows us to request two one-year extensions.   It contains an option to increase the commitment amount by up to an additional $1.0 billion, subject to the consent of any increasing lenders, and includes sub-facilities for swing-line loans and letters of credit up to an aggregate amount of $100 million and $500 million, respectively.  Fees on the unused commitment of each lender range from 10 basis points to 25 basis points depending on our credit ratings.  Borrowings under the Credit Facility bear interest, at our option,

18

MARATHON OIL CORPORATION
Notes to Consolidated Financial Statements (Unaudited)


at either (a) an adjusted LIBOR rate plus a margin ranging from 87.5 basis points to 162.5 basis points per year depending on our credit ratings or (b) the Base Rate plus a margin ranging from 0.0 basis points to 62.5 basis points depending on our credit ratings.  Base Rate is defined as a per annum rate equal to the greatest of (a) the prime rate, (b) the federal funds rate plus one-half of one percent and (c) LIBOR for a one-month interest period plus 1 percent.
 The agreement contains a covenant that requires our ratio of total debt to total capitalization not to exceed 65 percent as of the last day of each fiscal quarter.  If an event of default occurs, the lenders may terminate the commitments under the Credit Facility and require the immediate repayment of all outstanding borrowings and the cash collateralization of all outstanding letters of credit under the Credit Facility.
In the second quarter of 2012, we retired the remaining $23 million principal amount of our 5.375 percent revenue bonds due December 2013.  No gain or loss was recorded on this early extinguishment of debt.  During the first quarter of 2012, $53 million principal amount of debt carrying a 9.375 percent interest rate was repaid at maturity.
During the first quarter of 2011, we retired $2,498 million aggregate principal amount of debt at a weighted average price equal to 112 percent of face value. A $279 million loss on early extinguishment of debt was recognized in the first quarter of 2011.  The loss includes related deferred financing and premium costs partially offset by the gain on settled interest rate swaps.
16.    Incentive Based Compensation
 Stock Option and Restricted Stock Awards
  The following table presents a summary of stock option award and restricted stock award activity for the first nine months of 2012: 
 
Stock Options
 
Restricted Stock
 
Number of
Shares
 
Weighted
Average
Exercise Price
 
Awards
 
Weighted
Average Grant
Date Fair Value
Outstanding at December 31, 2011
21,370,715

 

$24.41

 
3,703,978

 

$25.88

Granted
1,858,872

(a) 

$33.52

 
2,169,744

 

$31.61

Options Exercised/Stock Vested
(1,256,318
)


$18.25

 
(1,142,195
)
 

$25.18

Cancelled
(509,748
)


$28.29

 
(287,278
)
 

$27.96

Outstanding at September 30, 2012
21,463,521

 

$25.47

 
4,444,249

 

$28.72

(a)    The weighted average grant date fair value of stock option awards granted was $9.94 per share.
Performance Unit Awards
 During the first quarter of 2012, we granted 13 million performance units to executive officers.  These units have a 36-month performance period.
17.  Supplemental Cash Flow Information
 
Nine Months Ended September 30,
(In millions)
2012
 
2011
Net cash provided from operating activities:
 
 
 
Interest paid (net of amounts capitalized)
$
164

 
$
197

Income taxes paid to taxing authorities
3,457

 
2,183

Commercial paper, net:
 

 
 

Commercial paper - issuances
$
10,420

 
$
—

- repayments
(8,581
)
 
—

Noncash investing activities:
 

 
 

Debt payments made by United States Steel
$
19

 
$
18

Liabilities assumed in acquisition
85

 
—

Change in capital expenditure accrual
170

 
(61
)


19

MARATHON OIL CORPORATION
Notes to Consolidated Financial Statements (Unaudited)


18.   Commitments and Contingencies
 We are defendant in a number of lawsuits arising in the ordinary course of business, including, but not limited to, royalty claims, contract claims and environmental claims.  While the ultimate outcome and impact to us cannot be predicted with certainty, we believe the resolution of these proceedings will not have a material adverse effect on our consolidated financial position, results of operations or cash flows.  Certain of these matters are discussed below.
 Litigation – In March 2011, Noble Drilling (U.S.) LLC (“Noble”) filed a lawsuit against us in the District Court of Harris County, Texas, alleging, among other things, breach of contract, breach of the duty of good faith and fair dealing, and negligent misrepresentation, relating to a multi-year drilling contract for a newly constructed drilling rig to be deployed in the U.S. Gulf of Mexico.  We filed an answer in April 2011, contending, among other things, failure to perform, failure to comply with material obligations, failure to mitigate alleged damages and that Noble failed to provide the rig according to the operating, performance and safety requirements specified in the drilling contract. Noble is seeking an unspecified amount for damages.  We are vigorously defending this litigation.  The ultimate outcome of this lawsuit, including any financial effect on us, remains uncertain.  We do not believe an estimate of a reasonably probable loss (or range of loss) can be made for this lawsuit at this time.
Guarantees – After our 2009 sale of the subsidiary holding our interest in the Corrib natural gas development offshore Ireland, one guarantee of that entity's performance related to asset retirement obligations remains issued to certain Irish government entities until the Irish government and the current Corrib partners agree to release our guarantee and accept the purchaser's guarantee to replace it. The maximum potential undiscounted payments related to asset retirement obligations under this guarantee as of September 30, 2012 are $40 million.
Contractual commitments – At September 30, 2012 and December 31, 2011, Marathon’s contract commitments to acquire property, plant and equipment were $974 million and $664 million.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations 
We are an international energy company with operations in the U.S., Canada, Africa, the Middle East and Europe.  Our operations are organized into three reportable segments:
•
Exploration and Production (“E&P”) which explores for, produces and markets liquid hydrocarbons and natural gas on a worldwide basis.
•
Oil Sands Mining (“OSM”) which mines, extracts and transports bitumen from oil sands deposits in Alberta, Canada, and upgrades the bitumen to produce and market synthetic crude oil and vacuum gas oil.
•
Integrated Gas (“IG”) which produces and markets products manufactured from natural gas, such as liquefied natural gas (“LNG”) and methanol, in Equatorial Guinea.
 Certain sections of Management’s Discussion and Analysis of Financial Condition and Results of Operations include forward-looking statements concerning trends or events potentially affecting our business.  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 business, see Item 1A. Risk Factors in our 2011 Annual Report on Form 10-K.
Key Operating and Financial Activities
In the third quarter of 2012, notable items were:
•
Net liquid hydrocarbon and natural gas sales volumes of 452 thousand barrels of oil equivalent per day (“mboed”), of which 65 percent was liquid hydrocarbons
•
Net international liquid hydrocarbon sales volumes, for which average realizations have exceeded West Texas Intermediate (“WTI”) crude oil, were 62 percent of total liquid hydrocarbon sales
•
Eagle Ford shale average net sales volumes of 40 mboed, an increase of 90 percent from the second quarter of 2012
•
Production from Libya increased over the second quarter of 2012, with average net sales of 53 mboed
•
Bakken shale average net sales volumes of 30 mboed, a 87 percent increase over the same quarter of last year
•
Closed the acquisition of Paloma Partners II, LLC
•
Assumed operatorship of the Vilje field offshore Norway
Some significant fourth quarter activities through November 7, 2012 include:
•
Closed acquisition of an additional 4,300 net acres in the core of the Eagle Ford shale
•
Signed agreement for a 20 percent non-operated interest in the South Omo concession onshore Ethiopia
•
Reentered Gabon by acquiring an interest in an exploration license
•
Acquired interests in two onshore exploration blocks in Kenya
•
Farmed out 35 percent working interests in the Harir and Safen blocks in the Kurdistan Region of Iraq
•
Issued $2 billion of senior notes

21


Overview and Outlook
Exploration and Production
Production
 Net liquid hydrocarbon and natural gas sales averaged 452 mboed during the third quarter and 414 mboed in the first nine months of 2012 compared to 349 mboed and 362 mboed in the same periods of 2011.  Net liquid hydrocarbon sales volumes increased in the U.S. for both the third quarter and first nine months of 2012, reflecting the impact of production from the Eagle Ford shale assets acquired in the fourth quarter of 2011 and our ongoing development programs in the Eagle Ford, Bakken and Anadarko Woodford shale resource plays. The resumption of sales from Libya in the first quarter of 2012 after production had ceased there in February of 2011 was the most significant increase in international sales volumes. In addition, net liquid hydrocarbon sales volumes from the U.K. were lower in the 2012 periods than in the same periods of 2011 due to turnarounds in the third quarter and the timing of liftings.
In 2012, we continued to ramp up operations in the core of the Eagle Ford shale play in Texas. Average net sales volumes from the Eagle Ford shale were 40 mboed and 25 mboed in the third quarter and first nine months of 2012. As announced in August, we have reduced our rig count to 18 operated rigs while maintaining four dedicated hydraulic fracturing crews and two more on a spot basis.  During the third quarter of 2012, we drilled 78 gross wells and brought 73 gross wells to sales for a total of 180 gross wells drilled in the first nine months of 2012. Our average time to drill a well in the Eagle Ford shale has decreased to approximately 24 days; therefore, we now expect to drill 250 to 260 gross Eagle Ford wells during 2012, an increase of approximately 20 wells from previous estimates. In addition to the improvements in the speed and efficiency in drilling and completions, we continue to optimize well spacing which could significantly increase drillable locations and recoverable resources. We have been performing spacing pilot programs in the Eagle Ford shale which will complete early in 2013 so that we will have applicable technical results by mid-year. To complement drilling and completion activity in the Eagle Ford shale, we continue to build infrastructure to support production growth across the operating area. We ar