Note 1—Separation and Basis of Presentation

The Separation

On April 4, 2012, the ConocoPhillips Board of Directors approved the separation of its downstream businesses into an independent, publicly traded company named Phillips 66. In accordance with a separation and distribution agreement, the two companies were separated by ConocoPhillips distributing to its stockholders all 625,272,302 shares of common stock of Phillips 66 after the market closed on April 30, 2012. Each ConocoPhillips shareholder received one share of Phillips 66 stock for every two shares of ConocoPhillips stock held at the close of business on the record date of April 16, 2012. Fractional shares of Phillips 66 common stock were not distributed and any fractional shares of Phillips 66 common stock otherwise issuable to a ConocoPhillips shareholder were sold in the open market on such shareholder’s behalf, and such shareholder received a cash payment with respect to that fractional share. In conjunction with the separation, ConocoPhillips received a private letter ruling from the Internal Revenue Service to the effect that, based on certain facts, assumptions, representations and undertakings set forth in the ruling, for U.S. federal income tax purposes, the distribution of Phillips 66 stock was not taxable to ConocoPhillips or U.S. holders of ConocoPhillips common stock, except in respect to cash received in lieu of fractional share interests. Following the separation, ConocoPhillips retained no ownership interest in Phillips 66, and each company now has separate public ownership, boards of directors and management. A registration statement on Form 10, as amended through the time of its effectiveness, describing the separation was filed by Phillips 66 with the U.S. Securities and Exchange Commission (SEC) and was declared effective on April 12, 2012 (the Form 10). On May 1, 2012, Phillips 66 stock began trading the “regular-way” on the New York Stock Exchange under the “PSX” stock symbol. Pursuant to the separation and distribution agreement with ConocoPhillips, on April 30, 2012, we made a special cash distribution to ConocoPhillips of $5.95 billion. This special cash distribution is subject to true-up adjustments based on subsequent working capital determinations.

Basis of Presentation

The combined financial statements included in this Quarterly Report on Form 10-Q were derived from the consolidated financial statements and accounting records of ConocoPhillips. These financial statements reflect the combined historical results of operations, financial position and cash flows of ConocoPhillips’ refining, marketing and transportation operations; its natural gas gathering, processing, transmission and marketing operations, primarily conducted through its equity investment in DCP Midstream, LLC (DCP Midstream); its petrochemical operations, conducted through its equity investment in Chevron Phillips Chemical Company LLC (CPChem); its power generation operations; and an allocable portion of its corporate costs. Although the legal transfer of these downstream businesses of ConocoPhillips to Phillips 66 took place subsequent to March 31, 2012, for ease of reference, these combined financial statements are collectively referred to as those of Phillips 66. Unless otherwise stated or the context otherwise indicates, all references to “us,” “our” or “we” for a time period prior to the separation mean the downstream businesses of ConocoPhillips. For time periods after the separation, these terms refer to the legal entity Phillips 66.

These financial statements have been presented as if such downstream businesses had been combined for all periods presented. All intercompany transactions and accounts within Phillips 66 were eliminated. The assets and liabilities in the combined financial statements were reflected on a historical cost basis, as immediately prior to the separation all of the assets and liabilities presented were wholly owned by ConocoPhillips and were transferred within the ConocoPhillips consolidated group. The combined statement of income also included expense allocations for certain corporate functions historically performed by ConocoPhillips and not allocated to its operating segments, including allocations of general corporate expenses related to executive oversight, accounting, treasury, tax, legal, procurement and information technology. These allocations were based primarily on specific identification of time and/or activities associated with Phillips 66, employee headcount or capital expenditures. Our management believes the assumptions underlying the combined financial statements, including the assumptions regarding allocating general corporate expenses from ConocoPhillips, were reasonable. Nevertheless, the combined financial statements may not include all of the actual expenses that would have been incurred had we been a stand-alone company during the periods presented and may not reflect our combined results of operations, financial position and cash flows had we been a stand-alone company during the periods presented. Actual costs that would have been incurred if we had been a stand-alone company would depend on multiple factors, including organizational structure and strategic decisions made in various areas, including information technology and infrastructure.

ConocoPhillips uses a centralized approach to the cash management and financing of its operations. Prior to the separation, our cash was transferred to ConocoPhillips daily and ConocoPhillips funded our operating and investing activities as needed. Accordingly, the cash and cash equivalents held by ConocoPhillips at the corporate level were not allocated to us for any of the periods presented. We reflected transfers of cash to and from ConocoPhillips’ cash management system as a component of “Net parent company investment” on our combined balance sheet. We have included debt incurred from our direct financing on our balance sheet and interest and debt expense related to that debt in our combined statement of income, as this debt is specific to our business. We have not included interest expense for intercompany cash advances from ConocoPhillips, since historically ConocoPhillips has not allocated interest expense related to intercompany advances to any of its businesses.

Note 2—Interim Financial Information

The interim-period financial information presented in the financial statements included in this report is unaudited and includes all known accruals and adjustments necessary, in the opinion of management, for a fair presentation of the combined financial position of Phillips 66 and its results of operations and cash flows for the periods presented. All such adjustments are of a normal and recurring nature. To enhance your understanding of these interim financial statements, see the combined financial statements and notes included in Amendment No. 3 to the Form 10.

Note 3—Inventories

Inventories consisted of the following:

 

			December 31				December 31
		Millions of Dollars
		March 31 2012				December 31 2011
Crude oil and petroleum products		$	4,760				3,193
Materials and supplies			280				273
		$	5,040				3,466

Inventories valued on the last-in, first-out (LIFO) basis totaled $4,616 million and $3,046 million at March 31, 2012, and December 31, 2011, respectively. The estimated excess of current replacement cost over LIFO cost of inventories amounted to approximately $9,300 million and $8,600 million at March 31, 2012, and December 31, 2011, respectively.

Note 4—Assets Held for Sale or Sold

In the first quarter of 2012, equipment formerly associated with the cancelled Wilhelmshaven Refinery upgrade project was classified as held for sale. At March 31, 2012, the equipment had a net carrying value of $32 million, primarily properties, plants and equipment (PP&E). See Note 7—Impairments for additional information.

 

Subsequent to March 31, 2012, our refinery located on the Delaware River in Trainer, Pennsylvania was classified as held for sale. The refinery and associated terminal and pipeline assets are included in our Refining and Marketing segment and, at March 31, 2012, had a net carrying value of $15 million, which included $37 million of PP&E, $25 million of allocated goodwill and a $53 million asset retirement obligation. In late-April 2012, we entered into an agreement to sell the Trainer Refinery and associated terminal and pipeline assets for approximately $180 million, subject to normal working capital adjustments. The sale is expected to close in the second quarter of 2012, subject to regulatory approvals.

Note 5—Investments and Long-Term Receivables

Equity Investments

Summarized 100 percent financial information for WRB Refining LP and CPChem combined, was as follows:

 

			2012				2012
		Millions of Dollars
		Three Months Ended March 31
			2012				2011
Revenues		$	8,547				7,127
Income before income taxes			1,099				878
Net income			1,082				863

Other

Merey Sweeny, L.P. (MSLP) is a limited partnership that owns a delayed coker and related facilities at the Sweeny Refinery. MSLP processes long residue, which is produced from heavy sour crude oil, for a processing fee. Fuel-grade petroleum coke is produced as a by-product and becomes the property of MSLP. Prior to August 28, 2009, MSLP was owned 50/50 by ConocoPhillips and Petróleos de Venezuela S.A. (PDVSA). Under the agreements that govern the relationships between the partners, certain defaults by PDVSA with respect to supply of crude oil to the Sweeny Refinery gave ConocoPhillips the right to acquire PDVSA’s 50 percent ownership interest in MSLP, which was exercised on August 28, 2009. PDVSA has initiated arbitration with the International Chamber of Commerce challenging the exercise of the call right and claiming it was invalid. The arbitral tribunal is scheduled to hold hearings on the merits of the dispute in December 2012. We continue to use the equity method of accounting for our investment in MSLP.

Note 6—Properties, Plants and Equipment

Our investment in PP&E, with the associated accumulated depreciation and amortization (Accum. D&A), was:

 

		Millions of Dollars
		March 31, 2012												December 31, 2011
		Gross PP&E				Accum. D&A				Net PP&E				Gross PP&E				Accum. D&A				Net PP&E
R&M
Refining		$	19,654				6,829				12,825				19,400				6,651				12,749
Transportation			2,384				948				1,436				2,359				931				1,428
Marketing and Other			1,339				768				571				1,319				745				574
Total R&M			23,377				8,545				14,832				23,078				8,327				14,751
Midstream			62				49				13				64				51				13
Chemicals			—				—				—				—				—				—
Corporate and Other			17				8				9				14				7				7
		$	23,456				8,602				14,854				23,156				8,385				14,771

 

Note 7—Impairments

During the first three months of 2012 and 2011, we recognized the following before-tax impairment charges:

 

			2012				2012
		Millions of Dollars
		Three Months Ended March 31
		2012				2011
R&M
United States		$	1				—
International			42				—
		$	43				—

In the first quarter of 2012, we recorded a $42 million held-for-sale impairment in our R&M segment related to equipment formerly associated with the canceled Wilhelmshaven Refinery upgrade project.

Fair Value Remeasurements

There were no material fair value impairments for the three-month period ended March 31, 2011. The following table shows the values of assets at March 31, 2012, by major category, measured at fair value on a nonrecurring basis in periods subsequent to their initial recognition:

 

Measurements

Measurements

Measurements

Millions of Dollars

Fair Value *

Fair Value Measurements Using Level 1 Inputs

Before-Tax Loss

March 31, 2012

Net properties, plants and equipment (held for sale)

$

32

32

42

*	Represents the fair value at the time of the impairment.

During the three-month period ended March 31, 2012, net PP&E held for sale with a carrying amount of $74 million were written down to their fair value of $32 million, resulting in a before-tax loss of $42 million. The fair value was primarily determined by negotiated selling prices with third parties.

Note 8—Debt

Debt Issuance

During March 2012, we issued, through a private placement, $5.8 billion of debt consisting of:

 

•

$0.8 billion aggregate principal amount of 1.950% Senior Notes due 2015.

 

•

$1.5 billion aggregate principal amount of 2.950% Senior Notes due 2017.

 

•

$2.0 billion aggregate principal amount of 4.300% Senior Notes due 2022.

 

•

$1.5 billion aggregate principal amount of 5.875% Senior Notes due 2042.

The notes are guaranteed by Phillips 66 Company, a wholly owned subsidiary. In connection with the private placement, we and Phillips 66 Company granted the initial purchasers of the notes certain registration rights under a Registration Rights Agreement. We have agreed for the benefit of the holders of the notes to use our commercially reasonable efforts to file and cause to be effective a registration statement with the SEC on an appropriate form with respect to a registered offer to exchange each series of notes for new notes that are guaranteed by Phillips 66 Company with terms substantially identical in all material respects to such series of notes. Generally, we have one year from the issuance of the senior notes to complete the exchange offer.

 

At March 31, 2012, the net proceeds from the offering were held in two segregated escrow accounts for the benefit of the note holders, and these funds were restricted as to withdrawal and usage. Accordingly, the net proceeds of the offering of $5.76 billion, along with approximately $290 million of funds sufficient to pay a mandatory redemption price plus accrued interest to the note holders had the separation not occurred, were included in the “Restricted cash” line on our combined balance sheet at March 31, 2012. The amounts in the escrow accounts were released to us at the separation date of April 30, 2012.

Credit Facilities

In February 2012, we entered into a five-year revolving credit agreement with a syndicate of financial institutions. Under the terms of the revolving credit agreement, upon the consummation of the separation and the satisfaction of certain other conditions, we had, as of April 30, 2012, a borrowing capacity of up to $4.0 billion. We have not borrowed under this facility.

The revolving credit agreement contains covenants that we consider usual and customary for an agreement of this type for comparable commercial borrowers, including a maximum consolidated net debt-to-capitalization ratio of 60 percent. The agreement has customary events of default, such as nonpayment of principal when due; nonpayment of interest, fees or other amounts; violation of covenants; cross-payment default and cross-acceleration (in each case, to indebtedness in excess of a threshold amount); and a change of control.

Borrowings under the credit agreement will incur interest at LIBOR plus a margin based on the credit rating of our senior unsecured long-term debt as determined from time to time by S&P and Moody’s. The revolving credit agreement also provides for customary fees, including administrative agent fees and commitment fees.

April 2012 Transactions

 

•

We entered into a trade receivables securitization facility with an aggregate borrowing capacity of $1.2 billion and a tenor of three years. No amount has been drawn under the facility.

 

•

Approximately $185 million of previously existing debt was retired.

 

•

We closed the financing of $2.0 billion of new debt as a three-year amortizing term loan. The term loan incurs interest at a variable rate based on referenced rates plus a margin dependent upon the credit rating of our senior unsecured long-term debt as determined from time to time by S&P and Moody’s.

Note 9—Noncontrolling Interests

Activity related to the net investment attributable to noncontrolling interests for the three-month periods ended March 31, 2012 and 2011, was as follows:

 

		Millions of Dollars
		2012												2011
		Total Net Parent Company Investment				Non- Controlling Interests				Total Net Investment				Total Net Parent Company Investment				Non- Controlling Interests				Total Net Investment
Balance at January 1		$	23,264				29				23,293				26,001				25				26,026
Net income			636				2				638				676				1				677
Distributions to noncontrolling interests			—				—				—				—				—				—
Net transfers from parent company			974				—				974				1,732				—				1,732
Other changes, net*			38				—				38				(19	)			—				(19	)
Balance at March 31		$	24,912				31				24,943				28,390				26				28,416

*	Includes components of other comprehensive income, which are disclosed separately in the Combined Statement of Comprehensive Income.

 

Note 10—Guarantees

At March 31, 2012, we were liable for certain contingent obligations under various contractual arrangements as described below. We recognize a liability, at inception, for the fair value of our obligation as a guarantor for newly issued or modified guarantees. Unless the carrying amount of the liability is noted below, we have not recognized a liability either because the guarantees were issued prior to December 31, 2002, or because the fair value of the obligation is immaterial. In addition, unless otherwise stated, we are not currently performing with any significance under the guarantee and expect future performance to be either immaterial or have only a remote chance of occurrence.

Guarantees of Joint Venture Debt

At March 31, 2012, we had guarantees outstanding for our portion of certain joint venture debt obligations, which have remaining terms of up to 14 years. The maximum potential amount of future payments under the guarantees is approximately $49 million. Payment would be required if a joint venture defaults on its debt obligations.

In April 2012, in connection with the separation, we issued a guarantee for 100 percent of the 8.85% Senior Notes issued by MSLP in July 1999. The maximum potential amount of future payments to third parties under the guarantee is estimated to be $251 million, which could become payable if MSLP fails to meet its obligations under the Senior Note agreement. Also in connection with the separation, we provided a guarantee to ConocoPhillips for its 50 percent direct guarantee of Senior Notes issued by Excel Paralubes in 1995. The maximum potential amount of future payments to third parties under this guarantee is estimated to be $116 million, which could become payable if Excel fails to meet its obligations under the Senior Note agreement.

Other Guarantees

We have other guarantees with maximum future potential payment amounts totaling $188 million, which consist primarily of guarantees to fund the short-term cash liquidity deficits of certain joint ventures and guarantees of the lease payment obligations of a joint venture. These guarantees generally have remaining terms of up to 13 years or life of the venture.

Indemnifications

Over the years, we have entered into various agreements to sell ownership interests in certain corporations, joint ventures and assets that gave rise to qualifying indemnifications. Agreements associated with these sales include indemnifications for taxes, environmental liabilities, permits and licenses, employee claims, real estate indemnity against tenant defaults, and litigation. The terms of these indemnifications vary greatly. The majority of these indemnifications are related to environmental issues, relative to which the term is generally indefinite and the maximum amount of future payments is generally unlimited. The carrying amount recorded for these indemnifications at March 31, 2012, was $272 million. We amortize the indemnification liability over the relevant time period, if one exists, based on the facts and circumstances surrounding each type of indemnity. In cases where the indemnification term is indefinite, we will reverse the liability when we have information the liability is essentially relieved or amortize the liability over an appropriate time period as the fair value of our indemnification exposure declines. Although it is reasonably possible future payments may exceed amounts recorded, due to the nature of the indemnifications, it is not possible to make a reasonable estimate of the maximum potential amount of future payments. Included in the recorded carrying amount were $153 million of environmental accruals for known contamination that are included in asset retirement obligations and accrued environmental costs at March 31, 2012. For additional information about environmental liabilities, see Note 11—Contingencies and Commitments.

 

Indemnification and Release Agreement

In conjunction with, and effective as of, the separation, we entered into an Indemnification and Release Agreement with ConocoPhillips. This agreement governs the treatment between ConocoPhillips and us of all aspects relating to indemnification, insurance, litigation responsibility and management, and litigation document sharing and cooperation arising in connection with the separation. Generally, the agreement provides for cross-indemnities principally designed to place financial responsibility for the obligations and liabilities of our business with us and financial responsibility for the obligations and liabilities of ConocoPhillips’ business with ConocoPhillips. The agreement also establishes procedures for handling claims subject to indemnification and related matters.

Note 11—Contingencies and Commitments

A number of lawsuits involving a variety of claims have been made against Phillips 66 that arose in the ordinary course of business. We also may be required to remove or mitigate the effects on the environment of the placement, storage, disposal or release of certain chemical, mineral and petroleum substances at various active and inactive sites. We regularly assess the need for accounting recognition or disclosure of these contingencies. In the case of all known contingencies (other than those related to income taxes), we accrue a liability when the loss is probable and the amount is reasonably estimable. If a range of amounts can be reasonably estimated and no amount within the range is a better estimate than any other amount, then the minimum of the range is accrued. We do not reduce these liabilities for potential insurance or third-party recoveries. If applicable, we record receivables for probable insurance or other third-party recoveries. In the case of income-tax-related contingencies, we use a cumulative probability-weighted loss accrual in cases where sustaining a tax position is less than certain.

Based on currently available information, we believe it is remote that future costs related to known contingent liability exposures will exceed current accruals by an amount that would have a material adverse impact on our combined financial statements. As we learn new facts concerning contingencies, we reassess our position both with respect to accrued liabilities and other potential exposures. Estimates particularly sensitive to future changes include contingent liabilities recorded for environmental remediation, tax and legal matters. Estimated future environmental remediation costs are subject to change due to such factors as the uncertain magnitude of cleanup costs, the unknown time and extent of such remedial actions that may be required, and the determination of our liability in proportion to that of other responsible parties. Estimated future costs related to tax and legal matters are subject to change as events evolve and as additional information becomes available during the administrative and litigation processes.

Environmental

We are subject to international, federal, state and local environmental laws and regulations. When we prepare our combined financial statements, we record accruals for environmental liabilities based on management’s best estimates, using all information that is available at the time. We measure estimates and base liabilities on currently available facts, existing technology, and presently enacted laws and regulations, taking into account stakeholder and business considerations. When measuring environmental liabilities, we also consider our prior experience in remediation of contaminated sites, other companies’ cleanup experience, and data released by the U.S. Environmental Protection Agency (EPA) or other organizations. We consider unasserted claims in our determination of environmental liabilities, and we accrue them in the period they are both probable and reasonably estimable.

Although liability of those potentially responsible for environmental remediation costs is generally joint and several for federal sites and frequently so for state sites, we are usually only one of many companies cited at a particular site. Due to the joint and several liabilities, we could be responsible for all cleanup costs related to any site at which we have been designated as a potentially responsible party. We have been successful to date in sharing cleanup costs with other financially sound companies. Many of the sites at which we are potentially responsible are still under investigation by the EPA or the state agencies concerned. Prior to actual cleanup, those potentially responsible normally assess the site conditions, apportion responsibility and determine the appropriate remediation. In some instances, we may have no liability or may attain a settlement of liability. Where it appears that other potentially responsible parties may be financially unable to bear their proportional share, we consider this inability in estimating our potential liability, and we adjust our accruals accordingly. As a result of various acquisitions in the past, we assumed certain environmental obligations. Some of these environmental obligations are mitigated by indemnifications made by others for our benefit and some of the indemnifications are subject to dollar and time limits.

We are currently participating in environmental assessments and cleanups at numerous federal Superfund and comparable state sites. After an assessment of environmental exposures for cleanup and other costs, we make accruals on an undiscounted basis (except those acquired in a purchase business combination, which we record on a discounted basis) for planned investigation and remediation activities for sites where it is probable future costs will be incurred and these costs can be reasonably estimated. At March 31, 2012, our combined balance sheet included a total environmental accrual of $540 million, compared with $542 million at December 31, 2011. We expect to incur a substantial amount of these expenditures within the next 30 years. We have not reduced these accruals for possible insurance recoveries. In the future, we may be involved in additional environmental assessments, cleanups and proceedings.

Legal Proceedings

Our legal organization applies its knowledge, experience and professional judgment to the specific characteristics of our cases, employing a litigation management process to manage and monitor the legal proceedings against us. Our process facilitates the early evaluation and quantification of potential exposures in individual cases. This process also enables us to track those cases that have been scheduled for trial and/or mediation. Based on professional judgment and experience in using these litigation management tools and available information about current developments in all our cases, our legal organization regularly assesses the adequacy of current accruals and determines if adjustment of existing accruals, or establishment of new accruals, are required.

Other Contingencies

We have contingent liabilities resulting from throughput agreements with pipeline and processing companies not associated with financing arrangements. Under these agreements, we may be required to provide any such company with additional funds through advances and penalties for fees related to throughput capacity not utilized.

At March 31, 2012, we had performance obligations secured by letters of credit of $1,640 million (of which $26 million was issued under the provisions of ConocoPhillips’ revolving credit facility, and the remainder was issued as direct bank letters of credit) related to various purchase commitments incident to the ordinary conduct of business.

Note 12—Financial Instruments and Derivative Contracts

Derivative Instruments

We use financial and commodity-based derivative contracts to manage exposures to fluctuations in foreign currency exchange rates and commodity prices or to capture market opportunities. Since we are not currently using cash-flow hedge accounting, all gains and losses, realized or unrealized, from derivative contracts have been recognized in the combined statement of income. Gains and losses from derivative contracts held for trading not directly related to our physical business, whether realized or unrealized, have been reported net in “Other income” on our combined statement of income.

Purchase and sales contracts with fixed minimum notional volumes for commodities that are readily convertible to cash (e.g., crude oil and gasoline) are recorded on the balance sheet as derivatives unless the contracts are eligible for and we elect the normal purchases and normal sales exception (i.e., contracts to purchase or sell quantities we expect to use or sell over a reasonable period in the normal course of business). We generally apply this normal purchases and normal sales exception to eligible crude oil, refined product, natural gas and power commodity purchase and sales contracts; however, we may elect not to apply this exception (e.g., when another derivative instrument will be used to mitigate the risk of the purchase or sales contract but hedge accounting will not be applied, in which case both the purchase or sales contract and the derivative contract mitigating the resulting risk will be recorded on the balance sheet at fair value).

 

We value our exchange-traded derivatives using closing prices provided by the exchange as of the balance sheet date, and these are classified as Level 1 in the fair value hierarchy. Where exchange-provided prices are adjusted, non-exchange quotes are used or when the instrument lacks sufficient liquidity, we generally classify those exchange-cleared contracts as Level 2. Over-the-counter (OTC) financial swaps and physical commodity forward purchase and sales contracts are generally valued using quotations provided by brokers and price index developers such as Platts and Oil Price Information Service. These quotes are corroborated with market data and are classified as Level 2. In certain less liquid markets or for longer-term contracts, forward prices are not as readily available. In these circumstances, OTC swaps and physical commodity purchase and sales contracts are valued using internally developed methodologies that consider historical relationships among various commodities that result in management’s best estimate of fair value. These contracts are classified as Level 3. A contract that is initially classified as Level 3 due to absence or insufficient corroboration of broker quotes over a material portion of the contract will transfer to Level 2 when the portion of the trade having no quotes or insufficient corroboration becomes an insignificant portion of the contract. A contract would also transfer to Level 2 if we began using a corroborated broker quote that has become available. Conversely, if a corroborated broker quote ceases to be available or used by us, the contract would transfer from Level 2 to Level 3. There were no transfers in or out of Level 1 during the periods presented.

Financial OTC and physical commodity options are valued using industry-standard models that consider various assumptions, including quoted forward prices for commodities, time value, volatility factors, and contractual prices for the underlying instruments, as well as other relevant economic measures. The degree to which these inputs are observable in the forward markets determines whether the options are classified as Level 2 or 3.

We use a mid-market pricing convention (the mid-point between bid and ask prices). When appropriate, valuations are adjusted to reflect credit considerations, generally based on available market evidence.

The fair value hierarchy for our derivative assets and liabilities accounted for at fair value on a recurring basis was:

 

		Millions of Dollars
		March 31, 2012																December 31, 2011
		Level 1				Level 2				Level 3				Total				Level 1				Level 2				Level 3				Total
Assets
Commodity derivatives		$	1,089				391				6				1,486				389				270				6				665
Liabilities
Commodity derivatives			1,124				386				2				1,512				428				267				4				699
Net assets (liabilities)		$	(35	)			5				4				(26	)			(39	)			3				2				(34	)

The derivative values above are based on analysis of each contract as the fundamental unit of account; therefore, derivative assets and liabilities with the same counterparty are not reflected net where the legal right of setoff exists. Gains or losses from contracts in one level may be offset by gains or losses on contracts in another level or by changes in values of physical contracts or positions that are not reflected in the table above.

As reflected in the table above, Level 3 activity is not material.

 

Commodity Derivative Contracts—We operate in the worldwide crude oil, refined product, natural gas liquids, natural gas and electric power markets and are exposed to fluctuations in the prices for these commodities. These fluctuations can affect our revenues, as well as the cost of operating, investing and financing activities. Generally, our policy is to remain exposed to the market prices of commodities; however, we use futures, forwards, swaps and options in various markets to balance physical systems, meet customer needs, manage price exposures on specific transactions, and do a limited, immaterial amount of trading not directly related to our physical business. We also use the market knowledge gained from these activities to capture market opportunities such as moving physical commodities to more profitable locations, storing commodities to capture seasonal or time premiums, and blending commodities to capture quality upgrades. Derivatives may be used to optimize these activities, which may move our risk profile away from market average prices.

The following table indicates the balance sheet line items that include the fair values of commodity derivative assets and liabilities presented net (i.e., commodity derivative assets and liabilities with the same counterparty are netted where the right of setoff exists); however, the balances in the following table are presented gross:

 

			December 31				December 31
		Millions of Dollars
		March 31 2012				December 31 2011
Assets
Prepaid expenses and other current assets		$	1,484				665
Other assets			6				5
Liabilities
Other accruals			1,508				703
Other liabilities and deferred credits			8				1

Hedge accounting has not been used for any items in the table.

The gains (losses) from commodity derivatives incurred, and the line items where they appear on our combined statement of income were:

 

			December 31				December 31
		Millions of Dollars
		Three Months Ended March 31
		2012				2011
Sales and other operating revenues		$	(166	)			(609	)
Other income			7				(11	)
Purchased crude oil and refined products			21				(95	)

Hedge accounting has not been used for any item in the table.

The table below summarizes our material net exposures resulting from outstanding commodity derivative contracts. These financial and physical derivative contracts are primarily used to manage price exposure on our underlying operations. The underlying exposures may be from non-derivative positions such as inventory volumes. Financial derivative contracts may also offset physical derivative contracts, such as forward sales contracts.

 

			December 31				December 31
		Open Position Long/(Short)
		March 31 2012				December 31 2011
Commodity
Crude oil, refined products and natural gas liquids (millions of barrels)			(23	)			(13	)

 

Credit Risk

Financial instruments potentially exposed to concentrations of credit risk consist primarily of OTC derivative contracts and trade receivables.

The credit risk from our OTC derivative contracts, such as forwards and swaps, derives from the counterparty to the transaction. Individual counterparty exposure is managed within predetermined credit limits and includes the use of cash-call margins when appropriate, thereby reducing the risk of significant nonperformance. We also use futures, swaps and option contracts that have a negligible credit risk because these trades are cleared with an exchange clearinghouse and subject to mandatory margin requirements until settled; however, we are exposed to the credit risk of those exchange brokers for receivables arising from daily margin cash calls, as well as for cash deposited to meet initial margin requirements.

Our trade receivables result primarily from the sale of products from, or related to, our refinery operations and reflect a broad national and international customer base, which limits our exposure to concentrations of credit risk. The majority of these receivables have payment terms of 30 days or less. We continually monitor this exposure and the creditworthiness of the counterparties and recognize bad debt expense based on historical write-off experience or specific counterparty collectability. Generally, we do not require collateral to limit the exposure to loss; however, we will sometimes use letters of credit, prepayments, and master netting arrangements to mitigate credit risk with counterparties that both buy from and sell to us, as these agreements permit the amounts owed by us or owed to others to be offset against amounts due us.

Certain of our derivative instruments contain provisions that require us to post collateral if the derivative exposure exceeds a threshold amount. We have contracts with fixed threshold amounts and other contracts with variable threshold amounts that are contingent on our credit rating. The variable threshold amounts typically decline for lower credit ratings, while both the variable and fixed threshold amounts typically revert to zero if our credit ratings fall below investment grade. Cash is the primary collateral in all contracts; however, many contracts also permit us to post letters of credit as collateral.

The aggregate fair value of all derivative instruments with such credit-risk-related contingent features that were in a liability position was not material at March 31, 2012.

Fair Values of Financial Instruments

We used the following methods and assumptions to estimate the fair value of financial instruments:

 

•

Restricted cash: The carrying amount reported on the balance sheet approximates fair value.

 

•

Accounts and notes receivable: The carrying amount reported on the balance sheet approximates fair value.

 

•

Debt: The carrying amount of our floating-rate debt approximates fair value. The fair value of the fixed-rate debt is estimated based on quoted market prices as a Level 2 fair value.

 

•

Commodity swaps: Fair value is estimated based on forward market prices and approximates the exit price at period end. When forward market prices are not available, fair value is estimated using the forward prices of a similar commodity with adjustments for differences in quality or location.

 

•

Futures: Fair values are based on quoted market prices obtained from the New York Mercantile Exchange, the InterContinental Exchange Futures, or other traded exchanges.

 

•

Forward-exchange contracts: Fair values are estimated by comparing the contract rate to the forward rate in effect at the end of the respective reporting periods and approximating the exit price at those dates.

 

Our commodity derivative and financial instruments were:

 

		Millions of Dollars
		Carrying Amount								Fair Value
		March 31 2012				December 31 2011				March 31 2012				December 31 2011
Financial Assets
Commodity derivatives		$	75				73				75				73
Financial Liabilities
Commodity derivatives			50				52				50				52
Total debt, excluding capital leases			6,165				377				6,340				406

The amounts shown for derivatives in the preceding table are presented net (i.e., assets and liabilities with the same counterparty are netted where the right of setoff exists). In addition, the March 31, 2012, commodity derivative assets and liabilities appear net of $21 million of obligations to return cash collateral and $72 million of rights to reclaim cash collateral, respectively. The December 31, 2011, commodity derivative assets and liabilities appear net of $55 million of rights to reclaim cash collateral.

At March 31, 2012, we had $6,050 million of financial instruments designated as “Restricted cash” on our combined balance sheet, which represented the net funds received from a private placement of senior notes in connection with our separation from ConocoPhillips, along with approximately $290 million of funds sufficient to pay a mandatory redemption price plus accrued interest to the note holders had the separation not occurred. These amounts were deposited into two segregated escrow accounts for the benefit of the note holders and were restricted as to withdrawal and usage. At March 31, 2012, the funds in the escrow accounts were invested in U.S. Treasury Bills ($5,920 million) and U.S. Treasury Notes ($130 million), all with maturities within 30 days from March 31, 2012. For additional information, see Note 8—Debt.

Note 13—Accumulated Other Comprehensive Income (Loss)

Accumulated other comprehensive income (loss) in the net investment section of the balance sheet included:

 

			Comprehensive				Comprehensive				Comprehensive				Comprehensive
		Millions of Dollars
		Defined Benefit Plans				Foreign Currency Translation				Hedging				Accumulated Other Comprehensive Income
December 31, 2011		$	(145	)			270				(3	)			122
Other comprehensive income			3				34				1				38
March 31, 2012		$	(142	)			304				(2	)			160

Note 14—Employee Benefit Plans

Pension Plans

Prior to the separation, certain of our U.S. and U.K. employees participated in defined benefit pension plans and postretirement health and life insurance plans (Shared Plans) sponsored by ConocoPhillips, which include participants of other ConocoPhillips subsidiaries. Through the separation date, we accounted for such Shared Plans as multiemployer benefit plans. Accordingly, we did not record an asset or liability to recognize the funded status of the Shared Plans on our March 31, 2012, combined balance sheet. After the separation, our share of these assets and liabilities will be recorded on our balance sheet. We recorded expenses of $63 million for each of the three months ended March 31, 2012 and 2011, for our allocation of U.S. and U.K. pension costs.

 

Plans in Austria, Germany, and Ireland that are sponsored by entities included in Phillips 66 (Direct Plans) are accounted for as defined benefit pension plans. Accordingly, the funded and unfunded position of each Direct Plan is recorded in our combined balance sheet at March 31, 2012, and additional information on these Direct Plans follows:

 

		Millions of Dollars
		Three Months Ended March 31
		2012				2011
Components of Net Periodic Benefit Cost
Service cost		$	1				1
Interest cost			3				3
Expected return on plan assets			(2	)			(2	)
Recognized net actuarial loss			2				1
Net periodic benefit cost		$	4				3

During the first three months of 2012, we contributed $3 million to our Direct Plans.

Note 15—Related Party Transactions

Significant transactions with related parties were:

 

		Millions of Dollars
		Three Months Ended March 31
		2012				2011
Operating revenues and other income (a)		$	2,137				1,950
Purchases (b)			9,030				7,638
Operating expenses and selling, general and administrative expenses (c)			99				111
Net interest expense (d)			2				2

 

(a)

We sold crude oil to the Malaysian Refining Company Sdn. Bhd. (MRC). Natural gas liquids, solvents and petrochemical feedstocks were sold to CPChem, and gas oil and hydrogen feedstocks were sold to Excel Paralubes. Crude oil, blendstock and other intermediate products were sold to WRB. In addition, we charged several of our affiliates, including CPChem and MSLP, for the use of common facilities, such as steam generators, waste and water treaters and warehouse facilities.

 

(b)

We purchased refined products from WRB. We purchased natural gas and natural gas liquids from DCP Midstream and CPChem for use in our refinery processes and other feedstocks from various affiliates. We purchased refined products from MRC. We also paid fees to various pipeline equity companies for transporting finished refined products. In addition, we paid a price upgrade to MSLP for heavy crude processing. We purchased base oils and fuel products from Excel Paralubes for use in our refining and marketing businesses.

 

(c)	We paid utility and processing fees to various affiliates.

 

(d)	We incurred interest expense on a note payable to MSLP.

Also included in the table above are transactions with ConocoPhillips and its consolidated subsidiaries that are no longer affiliated with Phillips 66. These transactions include crude oil purchased from ConocoPhillips as feedstock for our refineries and power sold to ConocoPhillips from our power generation facilities. For the three months ended March 31, 2012 and 2011, sales to ConocoPhillips were $296 million and $267 million, respectively, while purchases from ConocoPhillips were $4,216 million and $3,751 million, respectively.

 

As discussed in Note 1—Separation and Basis of Presentation, the combined statement of income includes expense allocations for certain corporate functions historically performed by ConocoPhillips and not allocated to its operating segments, including allocations of general corporate expenses related to executive oversight, accounting, treasury, tax, legal, procurement and information technology. Net charges from ConocoPhillips for these services, reflected in selling, general and administrative expenses in the combined statement of income, were $61 million and $65 million for the three months ended March 31, 2012 and 2011, respectively.

Net Parent Company Investment

The following is a reconciliation of the net change in “Net parent company investment” as presented in the combined balance sheet and the amount presented as “Contributions from parent company” in the combined statement of cash flows.

 

			$1.610				$1.610
		Millions of Dollars
		Three Months Ended March 31
		2012				2011
Change in net parent company investment per the combined balance sheet		$	1,610				2,408
Net income attributable to Phillips 66			(636	)			(676	)
Non-cash adjustments
Foreign currency translation adjustments on net parent company investment			(25	)			(87	)
Net transfer of assets and liabilities with parent company			(58	)			(6	)
Contributions from parent company per the combined statement of cash flows		$	891				1,639

Note 16—Segment Disclosures and Related Information

We have organized our reporting structure based on the grouping of similar products and services, resulting in three operating segments:

 

1)

R&M—This segment purchases, refines, markets and transports crude oil and petroleum products, mainly in the United States, Europe and Asia. This segment also includes power generation operations. The R&M segment’s U.S. and international operations are disclosed separately for reporting purposes.

 

2)

Midstream—This segment gathers, processes, transports and markets natural gas and fractionates and markets natural gas liquids, predominantly in the United States. The Midstream segment primarily consists of our 50 percent equity investment in DCP Midstream.

 

3)

Chemicals—This segment manufactures and markets petrochemicals and plastics on a worldwide basis. The Chemicals segment consists of our 50 percent equity investment in CPChem.

Corporate and Other includes general corporate overhead, restricted cash, interest expense and various other corporate activities.

We evaluate performance and allocate resources based on net income attributable to Phillips 66. Intersegment sales are at prices that approximate market.

 

Analysis of Results by Operating Segment

 

		Millions of Dollars
		Three Months Ended March 31
		2012				2011
Sales and Other Operating Revenues
R&M
United States		$	29,448				29,954
International			14,653				12,880
Intersegment eliminations—U.S.			(105	)			(133	)
R&M			43,996				42,701
Midstream
Total sales			1,899				2,231
Intersegment eliminations			(115	)			(156	)
Midstream			1,784				2,075
Chemicals			3				3
Corporate and Other			—				—
Combined sales and other operating revenues		$	45,783				44,779
Net Income Attributable to Phillips 66
R&M
United States		$	407				423
International			(7	)			65
Total R&M			400				488
Midstream			89				61
Chemicals			217				185
Corporate and Other			(70	)			(58	)
Net income attributable to Phillips 66		$	636				676
		Millions of Dollars
		March 31 2012				December 31 2011
Total Assets
R&M
United States		$	26,207				25,056
International			11,469				8,902
Goodwill			3,329				3,332
Total R&M			41,005				37,290
Midstream			2,533				2,900
Chemicals			3,312				2,999
Corporate and Other			6,148				22
Combined total assets		$	52,998				43,211

 

Note 17—Income Taxes

Our effective tax rate for the first three months of 2012 was 40 percent, compared with 38 percent for the same period of 2011. The increase in the effective tax rate was primarily due to U.S. tax expense on foreign dividends, partially offset by the foreign income tax rate differential and a decrease in the effective state income tax rate.

The majority of the U.S. tax expense on foreign dividends is the result of corporate restructuring to effectuate the separation that recognized bases differences with respect to investment in certain foreign subsidiaries that was previously viewed as permanent in duration. Subject to the terms of its tax sharing agreement, ConocoPhillips’ foreign tax credits will be utilized to offset any tax liability attributable to these foreign dividends. We are not obligated to reimburse ConocoPhillips for these foreign tax credits.

The state income tax rate during the first three months of 2011 was higher due to a tax law change that was enacted and reflected in its entirety during that time period.

The combined financial statements included in this Quarterly Report on Form 10-Q were derived from the consolidated financial statements and accounting records of ConocoPhillips. These financial statements reflect the combined historical results of operations, financial position and cash flows of ConocoPhillips’ refining, marketing and transportation operations; its natural gas gathering, processing, transmission and marketing operations, primarily conducted through its equity investment in DCP Midstream, LLC (DCP Midstream); its petrochemical operations, conducted through its equity investment in Chevron Phillips Chemical Company LLC (CPChem); its power generation operations; and an allocable portion of its corporate costs. Although the legal transfer of these downstream businesses of ConocoPhillips to Phillips 66 took place subsequent to March 31, 2012, for ease of reference, these combined financial statements are collectively referred to as those of Phillips 66. Unless otherwise stated or the context otherwise indicates, all references to “us,” “our” or “we” for a time period prior to the separation mean the downstream businesses of ConocoPhillips. For time periods after the separation, these terms refer to the legal entity Phillips 66.

These financial statements have been presented as if such downstream businesses had been combined for all periods presented. All intercompany transactions and accounts within Phillips 66 were eliminated. The assets and liabilities in the combined financial statements were reflected on a historical cost basis, as immediately prior to the separation all of the assets and liabilities presented were wholly owned by ConocoPhillips and were transferred within the ConocoPhillips consolidated group. The combined statement of income also included expense allocations for certain corporate functions historically performed by ConocoPhillips and not allocated to its operating segments, including allocations of general corporate expenses related to executive oversight, accounting, treasury, tax, legal, procurement and information technology. These allocations were based primarily on specific identification of time and/or activities associated with Phillips 66, employee headcount or capital expenditures. Our management believes the assumptions underlying the combined financial statements, including the assumptions regarding allocating general corporate expenses from ConocoPhillips, were reasonable. Nevertheless, the combined financial statements may not include all of the actual expenses that would have been incurred had we been a stand-alone company during the periods presented and may not reflect our combined results of operations, financial position and cash flows had we been a stand-alone company during the periods presented. Actual costs that would have been incurred if we had been a stand-alone company would depend on multiple factors, including organizational structure and strategic decisions made in various areas, including information technology and infrastructure.

ConocoPhillips uses a centralized approach to the cash management and financing of its operations. Prior to the separation, our cash was transferred to ConocoPhillips daily and ConocoPhillips funded our operating and investing activities as needed. Accordingly, the cash and cash equivalents held by ConocoPhillips at the corporate level were not allocated to us for any of the periods presented. We reflected transfers of cash to and from ConocoPhillips’ cash management system as a component of “Net parent company investment” on our combined balance sheet. We have included debt incurred from our direct financing on our balance sheet and interest and debt expense related to that debt in our combined statement of income, as this debt is specific to our business. We have not included interest expense for intercompany cash advances from ConocoPhillips, since historically ConocoPhillips has not allocated interest expense related to intercompany advances to any of its businesses.

			December 31				December 31
		Millions of Dollars
		March 31 2012				December 31 2011
Crude oil and petroleum products		$	4,760				3,193
Materials and supplies			280				273
		$	5,040				3,466

			2012				2012
		Millions of Dollars
		Three Months Ended March 31
			2012				2011
Revenues		$	8,547				7,127
Income before income taxes			1,099				878
Net income			1,082				863

		Millions of Dollars
		March 31, 2012												December 31, 2011
		Gross PP&E				Accum. D&A				Net PP&E				Gross PP&E				Accum. D&A				Net PP&E
R&M
Refining		$	19,654				6,829				12,825				19,400				6,651				12,749
Transportation			2,384				948				1,436				2,359				931				1,428
Marketing and Other			1,339				768				571				1,319				745				574
Total R&M			23,377				8,545				14,832				23,078				8,327				14,751
Midstream			62				49				13				64				51				13
Chemicals			—				—				—				—				—				—
Corporate and Other			17				8				9				14				7				7
		$	23,456				8,602				14,854				23,156				8,385				14,771