10-K 1 ed10k2005_final.htm HALLIBURTON COMPANY FORM 10-K FOR FISCAL YEAR ENDED DECEMBER 31, 2005 Halliburton Company Form 10-K for Fiscal Year Ended December 31, 2005
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K

(Mark One)
[X] Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the fiscal year ended December 31, 2005

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 1-3492

HALLIBURTON COMPANY
(Exact name of registrant as specified in its charter)

Delaware
75-2677995
(State or other jurisdiction of
(I.R.S. Employer
incorporation or organization)
Identification No.)
5 Houston Center
1401 McKinney, Suite 2400
Houston, Texas 77010
(Address of principal executive offices)
Telephone Number - Area code (713) 759-2600
   
Securities registered pursuant to Section 12(b) of the Act:
   
 
Name of each Exchange on
Title of each class
which registered
Common Stock par value $2.50 per share
New York Stock Exchange
   
Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.
Yes    X        No ______

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.
Yes              No      X     

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    X        No ______

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [    ]

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer      X    
Accelerated filer                  
Non-accelerated filer                

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes              No      X     
 
The aggregate market value of Common Stock held by nonaffiliates on June 30, 2005, determined using the per share closing price on the New York Stock Exchange Composite tape of $47.82 on that date was approximately $21,322,000,000.

As of February 15, 2006, there were 516,240,651 shares of Halliburton Company Common Stock, $2.50 par value per share, outstanding.

Portions of the Halliburton Company Proxy Statement for our 2006 Annual Meeting of Stockholders (File No. 1-3492) are incorporated by reference into Part III of this report.

 
 

 

HALLIBURTON COMPANY
Index to Form 10-K
For the Year Ended December 31, 2005

PART I
 
PAGE
Item 1.
Business
1
Item 1(a).
Risk Factors
7
Item 1(b).
Unresolved Staff Comments
7
Item 2.
Properties
8
Item 3.
Legal Proceedings
9
Item 4.
Submission of Matters to a Vote of Security Holders
9
EXECUTIVE OFFICERS OF THE REGISTRANT
  10
PART II
   
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters
 
 
and Issuer Purchases of Equity Securities
                  12
Item 6.
Selected Financial Data
  12
Item 7.
Management’s Discussion and Analysis of Financial Condition and
 
 
Results of Operations
  12
Item 7(a).
Quantitative and Qualitative Disclosures About Market Risk
  12
Item 8.
Financial Statements and Supplementary Data
  13
Item 9.
Changes In and Disagreements with Accountants on Accounting and
 
 
Financial Disclosure
  13
Item 9(a).
Controls and Procedures
  13
Item 9(b).
Other Information
  13
MD&A AND FINANCIAL STATEMENTS
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
  14
Management’s Report on Internal Control Over Financial Reporting
  61
Reports of Independent Registered Public Accounting Firm
  62
Consolidated Statements of Operations
  64
Consolidated Balance Sheets
  65
Consolidated Statements of Shareholders’ Equity
  66
Consolidated Statements of Cash Flows
  67
Notes to Consolidated Financial Statements
  68
Selected Financial Data (Unaudited)
    114
Quarterly Data and Market Price Information (Unaudited)
    115
PART III
   
Item 10.
Directors and Executive Officers of the Registrant
    116
Item 11.
Executive Compensation
116
Item 12(a).
Security Ownership of Certain Beneficial Owners
116
Item 12(b).
Security Ownership of Management
116
Item 12(c).
Changes in Control
116
Item 12(d).
Securities Authorized for Issuance Under Equity Compensation Plans
116
Item 13.
Certain Relationships and Related Transactions
116
Item 14.
Principal Accounting Fees and Services
116
PART IV
   
Item 15.
Exhibits and Financial Statement Schedules
117
SIGNATURES
126



(i)



PART I

Item 1. Business.
General description of business
Halliburton Company’s predecessor was established in 1919 and incorporated under the laws of the State of Delaware in 1924. Halliburton Company provides a variety of services, products, maintenance, engineering, and construction to energy, industrial, and governmental customers.
Our six business segments are organized around how we manage the business: Production Optimization, Fluid Systems, Drilling and Formation Evaluation, Digital and Consulting Solutions, Government and Infrastructure, and Energy and Chemicals. We refer to the combination of Production Optimization, Fluid Systems, Drilling and Formation Evaluation, and Digital and Consulting Solutions segments as our Energy Services Group (ESG) and to the Government and Infrastructure and Energy and Chemicals segments as KBR. See Note 4 to the consolidated financial statements for financial information about our business segments.
Description of services and products
We offer a broad suite of services and products through our six business segments. The following summarizes our services and products for each business segment.
ENERGY SERVICES GROUP
The ESG provides a wide range of services and products to customers for the exploration, development, and production of oil and gas. The ESG serves major, national, and independent oil and gas companies throughout the world.
Production Optimization
Our Production Optimization segment primarily tests, measures, and provides means to manage and/or improve well production once a well is drilled and, in some cases, after it has been producing. This segment consists of production enhancement services and completion tools and services.
Production enhancement services include stimulation services, pipeline process services, sand control services, coiled tubing tools and services, and hydraulic workover services. Stimulation services optimize oil and gas reservoir production through a variety of pressure pumping services and chemical processes, commonly known as fracturing and acidizing. Pipeline process services include pipeline and facility testing, commissioning, and cleaning via pressure pumping, chemical systems, specialty equipment, and nitrogen, which are provided to the midstream and downstream sectors of the energy business. Sand control services include fluid and chemical systems and pumping services for the prevention of formation sand production.
Completion tools and services include subsurface safety valves and flow control equipment, surface safety systems, packers and specialty completion equipment, intelligent completion systems, production automation, expandable liner hanger systems, sand control systems, slickline equipment and services, self-elevated workover platforms, tubing-conveyed perforating services and products, well servicing tools, and reservoir performance services. Reservoir performance services include drill stem and other well testing tools and services, underbalanced applications and real-time reservoir analysis, data acquisition services, and production applications.
Also included in this segment is WellDynamics, an intelligent well completions joint venture, which we consolidate for accounting purposes. Additionally, subsea operations conducted by Subsea 7, Inc., of which we formerly owned 50%, were included in this segment. We accounted for our 50% ownership of Subsea 7, Inc. using the equity method until January 2005, when we completed the sale of our interest in this joint venture to our partner, Siem Offshore (formerly DSND Subsea ASA).
Fluid Systems
Our Fluid Systems segment focuses on providing services and technologies to assist in the drilling and construction of oil and gas wells. This segment offers cementing and drilling fluids systems.
Cementing is the process used to bond the well and well casing while isolating fluid zones and maximizing wellbore stability. Cement and chemical additives are pumped to fill the space between the casing and the side of the wellbore. Our cementing service line also provides casing services and equipment.

1


Baroid Fluid Services provides drilling fluid systems, performance additives, solids control, and waste management services for oil and gas drilling, completion, and workover operations. In addition, Baroid Fluid Services sells products to a wide variety of industrial customers. Drilling fluids usually contain bentonite or barite in a water or oil base. Drilling fluids primarily improve wellbore stability and facilitate the transportation of cuttings from the bottom of a wellbore to the surface. Drilling fluids also help cool the drill bit, seal porous well formations, and assist in pressure control within a wellbore. Drilling fluids are often customized by onsite engineers for optimum stability and enhanced oil production.
Also included in this segment is our investment in Enventure, an expandable casing joint venture, which we account for using the cost method.
Drilling and Formation Evaluation
Our Drilling and Formation Evaluation segment is primarily involved in the drilling and formation evaluation process during bore-hole construction. Major services and products offered include:
 
-
drilling systems and services;
 
-
drill bits; and
 
-
logging services.
Sperry Drilling Services provides drilling systems and services. These services include directional and horizontal drilling, measurement-while-drilling, logging-while-drilling, multilateral systems, and rig site information systems. Our drilling systems offer directional control while providing important measurements about the characteristics of the drill string and geological formations while drilling directional wells. Real-time operating capabilities enable the monitoring of well progress and aid decision-making processes.
Security DBS Drill Bits provides roller cone rock bits, fixed cutter bits, and related downhole tools used in drilling oil and gas wells. In addition, coring services and equipment are provided to acquire cores of the formation drilled for evaluation.
Logging services include open-hole wireline services, which provide information on formation evaluation such as resistivity, porosity, and density, rock mechanics, and fluid sampling. Cased-hole services are also offered, which provide cement bond evaluation, reservoir monitoring, pipe evaluation, pipe recovery, and perforating.
Digital and Consulting Solutions
Our Digital and Consulting Solutions segment provides integrated exploration, drilling, and production software information systems, consulting services, real-time operations, and other integrated solutions.
Landmark is a supplier of integrated exploration, drilling, and production software information systems as well as professional and data management services for the upstream oil and gas industry. Landmark software transforms vast quantities of seismic, well log, and other data into detailed computer models of petroleum reservoirs. The models are used by our customers to achieve optimal business and technical decisions in exploration, development, and production activities. Data management services provide efficient storage, browsing, and retrieval of large volumes of exploration and petroleum data. The services and products offered by Landmark integrate data workflows and operational processes across disciplines, including geophysics, geology, drilling, engineering, production, economics, finance, corporate planning, and key partners and suppliers.
This segment also provides value-added oilfield project management and integrated solutions to independent, integrated, and national oil companies. These offerings make use of all of our oilfield services, products, technologies, and project management capabilities to assist our customers in optimizing the value of their oil and gas assets.
Additionally, this segment holds investments in upstream oil and gas properties, primarily in the North America region, which leverage our technology, knowledge, and access to services and products.
KBR
KBR provides a wide range of services to energy, chemical, and industrial customers and government entities worldwide through two business segments, Government and Infrastructure and Energy and Chemicals.
Government and Infrastructure
Our Government and Infrastructure segment focuses on:
 
-
construction, maintenance, and logistics services for government operations, facilities, and installations;

2


 
-
civil engineering, construction, consulting, and project management services for state and local government agencies and private industries;
 
-
integrated security solutions, including threat definition assessments, mitigation, and consequence management; design, engineering and program management; construction and delivery; and physical security, operations, and maintenance;
 
-
dockyard operation and management through the Devonport Royal Dockyard Limited (DML), which is consolidated for financial reporting purposes, with services that include design, construction, surface/subsurface fleet maintenance, nuclear engineering and refueling, and weapons engineering; and
 
-
privately financed initiatives, in which KBR funds the development or provision of an asset, such as a facility, service, or infrastructure for a government client, which we then own, operate and maintain, enabling our clients to utilize new assets at a reasonable cost.
Also included in this segment is our investment in the Alice Springs-Darwin Railroad (ASD). ASD is a privately financed project that was formed in 2001 to build and operate the transcontinental railroad from Alice Springs to Darwin, Australia. ASD has been granted a 50-year concession period by the Australian government. KBR provided engineering, procurement, and construction services for ASD and is the largest equity holder in the project with a 36.7% interest, with the remaining equity held by eleven other participants. We account for this investment under the equity method.
As part of our infrastructure projects, we occasionally take an ownership interest in the constructed asset, with a view toward monetization of that ownership interest after the asset has been operating for some period and increases in value. In this regard, in September 2005 we sold our 13% interest in a joint venture that owned the Dulles Greenway Toll Road in Virginia and recorded an $85 million gain on the sale.
Energy and Chemicals
Our Energy and Chemicals segment is a global engineering, procurement, construction, technology, and services provider for the energy and chemicals industries. Working both upstream and downstream in support of our customers, the Energy and Chemicals segment offers the following:
 
-
downstream engineering and construction capabilities, including global engineering execution centers, as well as engineering, construction, and program management of liquefied natural gas (LNG), gas-to-liquids (GTL), ammonia, petrochemicals, crude oil refineries, and natural gas plants;
 
-
upstream deepwater engineering, marine technology, and project management;
 
-
production services provides plant operations, maintenance, and start-up services for upstream oil and gas facilities worldwide;
 
-
in the United States, industrial services provides maintenance services to the petrochemical, forest product, power, and commercial markets;
 
-
industry-leading licensed technologies in the areas of fertilizers and synthesis gas, olefins, refining, and chemicals and polymers; and
 
-
consulting services in the form of expert technical and management advice that include studies, conceptual and detailed engineering, project management, construction supervision and design, and construction verification or certification in both upstream and downstream markets.
Included in this segment are a number of joint ventures including the following:
 
-
TSKJ is a joint venture company formed to design and construct large scale projects in Nigeria. TSKJ’s members are Technip, SA of France, Snamprogetti Netherlands B.V., which is an affiliate of ENI SpA of Italy, JGC Corporation of Japan, and KBR, each of which owns 25%. TSKJ has completed five LNG production facilities on Bonny Island, Nigeria and is currently working on a sixth such facility. We account for this investment under the equity method; and
 
-
M. W. Kellogg Limited (MWKL) is a London-based joint venture that provides full engineering, procurement, and construction contractor services for LNG, GTL, and onshore oil and gas projects. MWKL is owned 55% by KBR and 45% by JGC Corporation. We consolidate MWKL for financial reporting purposes.

3


Business strategy
Our business strategy is to maintain global leadership in providing energy services and products and engineering and construction services. Our ability to be a global leader depends on meeting four key goals:
 
-
establishing and maintaining technological leadership;
 
-
achieving and continuing operational excellence;
 
-
creating and continuing innovative business relationships; and
 
-
preserving a dynamic workforce.
We also plan to initiate the separation of KBR from Halliburton in 2006. Our decision to separate KBR arose primarily because we do not believe the full value of KBR is currently reflected in Halliburton’s stock price, and few synergies exist between the two business units. Our current plan is to effect an initial public offering (IPO) of less than 20% of KBR. We believe the IPO market is attractive, and valuation multiples of publicly traded engineering and construction companies are currently favorable. In response to interest we have received, we may consider selling some pieces of KBR, but this is not expected to change our IPO plans for the remainder of KBR. We expect that a Form S-1 for KBR will be filed with the United States Securities and Exchange Commission (SEC) after the 2005 audited financial statements of KBR are complete. Any sale of KBR stock would be registered under the Securities Act of 1933, and such shares of common stock would only be offered and sold by means of a prospectus. This annual report does not constitute an offer to sell or the solicitation of any offer to buy any securities of KBR, and there will not be any sale of any such securities in any state in which such offer, solicitation, or sale would be unlawful prior to registration or qualification under the securities laws of such state.
Markets and competition
We are one of the world’s largest diversified energy services and engineering and construction services companies. Our services and products are sold in highly competitive markets throughout the world. Competitive factors impacting sales of our services and products include:
 
-
price;
 
-
service delivery (including the ability to deliver services and products on an “as needed, where needed” basis);
 
-
health, safety, and environmental standards and practices;
 
-
service quality;
 
-
product quality;
 
-
warranty; and
 
-
technical proficiency.
We conduct business worldwide in about 100 countries. In 2005, based on the location of services provided and products sold, 27% of our consolidated revenue was from the United States, 24% of our consolidated revenue was from Iraq, primarily related to our work for the United States Government, and 10% of our consolidated revenue was from the United Kingdom. In 2004, 26% of our consolidated revenue was from Iraq and 22% of our consolidated revenue was from the United States. In 2003, 27% of our consolidated revenue was from the United States and 15% of our consolidated revenue was from Iraq. No other country accounted for more than 10% of our consolidated revenue during these periods. See Note 4 to the consolidated financial statements for additional financial information about geographic operations in the last three years. Because the markets for our services and products are vast and cross numerous geographic lines, a meaningful estimate of the total number of competitors cannot be made. The industries we serve are highly competitive and we have many substantial competitors. Largely all of our services and products are marketed through our servicing and sales organizations.
Operations in some countries may be adversely affected by unsettled political conditions, acts of terrorism, civil unrest, expropriation or other governmental actions, and exchange control and currency problems. Except for our government services work in Iraq discussed above, we believe the geographic diversification of our business activities reduces the risk that loss of operations in any one country would be material to the conduct of our operations taken as a whole.
Information regarding our exposure to foreign currency fluctuations, risk concentration, and financial instruments used to minimize risk is included in Management’s Discussion and Analysis of Financial Condition and Results of Operations - Financial Instrument Market Risk and in Note 17 to the consolidated financial statements.

4


Customers
Our revenue during the past three years was mainly derived from the sale of services and products to the energy industry, including 61% in 2005, 54% in 2004, and 66% in 2003. Revenue from the United States Government, resulting primarily from work performed in the Middle East by our Government and Infrastructure segment, represented 31% of our 2005 consolidated revenue, 39% of our 2004 consolidated revenue, and 26% of our 2003 consolidated revenue. No other customer represented more than 10% of consolidated revenue in any period presented.
Backlog
Backlog represents the total dollar amount of revenue we expect to realize in the future as a result of performing work under contracts that have been awarded to us. Backlog is not a measure defined by generally accepted accounting principles, and our methodology for determining backlog may not be comparable to the methodology used by other companies in determining their backlog. Backlog may not be indicative of future operating results. Many contracts do not provide for a fixed amount of work to be performed and are subject to modification or termination by the customer. The termination or modification of any one or more sizeable contracts or the addition of other contracts may have a substantial and immediate effect on backlog.
We generally include the full value of contracts in backlog when a contract is awarded and/or the scope is definitized. On our projects related to unconsolidated joint ventures, we include our percentage ownership of the joint venture’s backlog. For long-term contracts, the amount included in backlog is limited to five years. In many instances, arrangements included in backlog are complex, nonrepetitive in nature, and may fluctuate in contract value and timing. Where contract duration is indefinite, projects included in backlog are limited to the estimated value of work to be completed within the following twelve months. Certain contracts provide maximum dollar limits, with actual authorization to perform work under the contract being agreed upon on a periodic basis with the customer. In these arrangements, only the amounts authorized are included in backlog. For projects where we solely act in a project management capacity, we only include our management scope of each project in backlog.
The following table summarizes our project backlog:

   
December 31
 
Millions of dollars
 
2005
 
2004
 
Firm orders:
             
Government and Infrastructure
 
$
3,403
 
$
3,968
 
Energy and Chemicals - Gas monetization
   
3,651
   
443
 
Energy and Chemicals - Other
   
2,972
   
3,200
 
Energy Services Group segments
   
180
   
64
 
Total firm orders
   
10,206
   
7,675
 
Government orders firm but not yet funded, letters of
             
intent, and contracts awarded but not signed:
             
Government and Infrastructure
   
1,775
   
816
 
Total backlog
 
$
11,981
 
$
8,491
 

Gas monetization includes LNG and GTL projects.
We estimate that 76% of the Government and Infrastructure segment backlog and 52% of the Energy and Chemicals segment backlog at December 31, 2005 will be completed during 2006. Approximately 56% of total backlog at December 31, 2005 related to cost-reimbursable contracts with the remaining 44% relating to fixed-price contracts. Our backlog for projects related to unconsolidated joint ventures totaled $3.1 billion at December 31, 2005 and $1.1 billion at December 31, 2004. The increase in the government orders firm but not yet funded, letters of intent, and contracts awarded but not signed related to Task Order No. 89, assigned in the second quarter of 2005 under the LogCAP contract, that replaced several task orders that were nearing completion. Our backlog excludes contracts for recurring hardware and software maintenance and support services offered by Landmark.

5


Raw materials
Raw materials essential to our business are normally readily available. Current market conditions have triggered constraints in the supply chain of certain raw materials, such as, sand, cement, and specialty metals. The majority of our risk associated with the current supply chain constraints occurs in those situations where we have a relationship with a single supplier for a particular resource. Given high activity levels, particularly in the United States, we are proactively seeking ways to ensure the availability of resources, as well as manage the rising costs of raw materials. Our procurement department is actively leveraging our size and buying power through several programs designed to ensure that we have access to key materials at the best possible prices.
Research and development costs
We maintain an active research and development program. The program improves existing products and processes, develops new products and processes, and improves engineering standards and practices that serve the changing needs of our customers. Our expenditures for research and development activities were $220 million in 2005, $234 million in 2004, and $221 million in 2003, of which over 97% was company-sponsored in each year.
Patents
We own a large number of patents and have pending a substantial number of patent applications covering various products and processes. We are also licensed to utilize patents owned by others. We do not consider any particular patent or group of patents to be material to our business operations.
Seasonality
On an overall basis, our operations are not generally affected by seasonality. Weather and natural phenomena can temporarily affect the performance of our services, but the widespread geographical locations of our operations serve to mitigate those effects. Examples of how weather can impact our business include:
 
-
the severity and duration of the winter in North America can have a significant impact on gas storage levels and drilling activity for natural gas;
 
-
the timing and duration of the spring thaw in Canada directly affects activity levels due to road restrictions;
 
-
typhoons and hurricanes can disrupt coastal and offshore operations; and
 
-
severe weather during the winter months normally results in reduced activity levels in the North Sea and Russia.
In addition, due to higher spending near the end of the year by customers for software, Landmark results of operations are generally stronger in the fourth quarter of the year than at the beginning of the year.
Employees
At December 31, 2005, we employed approximately 106,000 people worldwide compared to 97,000 at December 31, 2004. At December 31, 2005, approximately 9% of our employees were subject to collective bargaining agreements. Based upon the geographic diversification of these employees, we believe any risk of loss from employee strikes or other collective actions would not be material to the conduct of our operations taken as a whole.
Environmental regulation
We are subject to numerous environmental, legal, and regulatory requirements related to our operations worldwide. In the United States, these laws and regulations include, among others:
 
-
the Comprehensive Environmental Response, Compensation and Liability Act;
 
-
the Resources Conservation and Recovery Act;
 
-
the Clean Air Act;
 
-
the Federal Water Pollution Control Act; and
 
-
the Toxic Substances Control Act.

6


In addition to the federal laws and regulations, states and other countries where we do business may have numerous environmental, legal, and regulatory requirements by which we must abide. We evaluate and address the environmental impact of our operations by assessing and remediating contaminated properties in order to avoid future liabilities and comply with environmental, legal, and regulatory requirements. On occasion, we are involved in specific environmental litigation and claims, including the remediation of properties we own or have operated, as well as efforts to meet or correct compliance-related matters. Our Health, Safety and Environment group has several programs in place to maintain environmental leadership and to prevent the occurrence of environmental contamination.
We do not expect costs related to these remediation requirements to have a material adverse effect on our consolidated financial position or our results of operations.
Website access
Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act of 1934 are made available free of charge on our internet website at www.halliburton.com as soon as reasonably practicable after we have electronically filed the material with, or furnished it to, the SEC. The public may read and copy any materials our company has filed with the SEC at the SEC’s Public Reference Room at 450 Fifth Street, NW, Washington, DC 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains an internet site that contains our reports, proxy and information statements, and our other SEC filings. The address of that site is www.sec.gov. We have posted on our website our Code of Business Conduct, which applies to all of our employees and Directors and serves as a code of ethics for our principal executive officer, principal financial officer, principal accounting officer, and other persons performing similar functions. Any amendments to our Code of Business Conduct or any waivers from provisions of our Code of Business Conduct granted to the specified officers above are disclosed on our website within four business days after the date of any amendment or waiver pertaining to these officers.

Item 1(a). Risk Factors.
Information relating to risk factors is described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under “Forward-Looking Information and Risk Factors.”

Item 1(b). Unresolved Staff Comments.
None.

7


Item 2. Properties.
We own or lease numerous properties in domestic and foreign locations. The following locations represent our major facilities.

Location
Owned/Leased
Description
Energy Services Group
   
Production Optimization Segment:
   
     
Carrollton, Texas
Owned
Manufacturing facility
     
Alvarado, Texas
Owned/Leased
Manufacturing facility
     
Drilling and Formation Evaluation Segment:
   
     
The Woodlands, Texas
Leased
Manufacturing facility
     
Shared Facilities:
   
     
Duncan, Oklahoma
Owned
Manufacturing, technology, and
   
campus facilities
     
Houston, Texas
Owned
Manufacturing and campus facilities
     
Houston, Texas
Owned/Leased
Campus facility
     
Houston, Texas
Leased
Campus facility
     
KBR
   
Government and Infrastructure Segment:
   
     
Arlington, Virginia
Leased
Campus facility
     
Energy and Chemicals Segment:
   
     
Houston, Texas
Leased
Campus facility
     
Shared Facilities:
   
     
Houston, Texas
Owned
Campus facility
     
Leatherhead, United Kingdom
Owned
Campus facility
     
Corporate
   
     
Houston, Texas
Leased
Corporate executive offices

8


All of our owned properties are unencumbered.
In addition, we have 145 international and 108 United States field camps from which the ESG delivers its services and products. We also have numerous small facilities that include sales offices, project offices, and bulk storage facilities throughout the world. We own or lease marine fabrication facilities covering approximately 446 acres in Texas, England (primarily related to DML), and Scotland, which are used by KBR. Our marine facilities located in Texas and Scotland are currently for sale.
We have mineral rights to proven and probable reserves of barite and bentonite. These rights include leaseholds, mining claims, and owned property. We process barite and bentonite for use in our Fluid Systems segment in addition to supplying many industrial markets worldwide. Based on the number of tons of bentonite consumed in fiscal year 2005, we estimate that our 20 million tons of proven reserves in areas of active mining are sufficient to fulfill our internal and external needs for the next 14 years. We estimate that our 2.6 million tons of proven reserves of barite in areas of active mining equate to a 12-year supply based on current rates of production. These estimates are subject to change based on periodic updates to reserve estimates, future consumption, mining economics, and changes in environmental legislation.
We believe all properties that we currently occupy are suitable for their intended use.

Item 3. Legal Proceedings.
Information relating to various commitments and contingencies is described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in “Forward-Looking Information and Risk Factors” and in Notes 2, 10, 11, and 12 to the consolidated financial statements.

Item 4. Submission of Matters to a Vote of Security Holders.
There were no matters submitted to a vote of security holders during the fourth quarter of 2005.

9


Executive Officers of the Registrant

The following table indicates the names and ages of the executive officers of the registrant as of February 15, 2006, along with a listing of all offices held by each:

Name and Age
Offices Held and Term of Office
* Albert O. Cornelison, Jr.
Executive Vice President and General Counsel of Halliburton Company,
   (Age 56)
since December 2002
 
Vice President and General Counsel of Halliburton Company, May 2002 to
 
December 2002
 
Vice President and Associate General Counsel of Halliburton Company,
 
October 1998 to May 2002
   
* C. Christopher Gaut
Executive Vice President and Chief Financial Officer of Halliburton Company,
   (Age 49)
since March 2003
 
Senior Vice President, Chief Financial Officer and Member - Office of the
 
President and Chief Operating Officer of ENSCO International, Inc.,
 
January 2002 to February 2003
 
Senior Vice President and Chief Financial Officer of ENSCO International,
 
Inc., December 1987 to December 2001
   
* Andrew R. Lane
Executive Vice President and Chief Operating Officer of Halliburton Company,
   (Age 46)
since December 2004
 
President and Chief Executive Officer of Kellogg Brown & Root, Inc., July 2004 to
 
November 2004
 
Senior Vice President, Global Operations of Halliburton Energy Services Group,
 
April 2004 to July 2004
 
President, Landmark Division of Halliburton Energy Services Group,
 
May 2003 to March 2004
 
President and Chief Executive Officer of Landmark Graphics, April 2002 to
 
April 2003
 
Chief Operating Officer of Landmark Graphics, January 2002 to March 2002
 
Vice President, Production Enhancement PSL, Completion Products PSL and
 
Tools/Testing/TCP of Halliburton Energy Services Group, January 2000
 
to December 2001
   
* David J. Lesar
Chairman of the Board, President and Chief Executive Officer of Halliburton
   (Age 52)
Company, since August 2000
 
Director of Halliburton Company, since August 2000
 
President and Chief Operating Officer of Halliburton Company, May 1997 to
 
August 2000
 
Chairman of the Board of Kellogg Brown & Root, Inc., January 1999 to
 
August 2000
 
Executive Vice President and Chief Financial Officer of Halliburton Company,
 
August 1995 to May 1997
   
   Mark A. McCollum
Senior Vice President and Chief Accounting Officer of Halliburton Company,
   (Age 46)
since August 2003
 
Senior Vice President and Chief Financial Officer of Tenneco Automotive, Inc.,
 
November 1999 to August 2003

10



Name and Age
Offices Held and Term of Office
   Craig W. Nunez
Vice President and Treasurer of Halliburton Company, since February 2006
   (Age 44)
Treasurer of Colonial Pipeline Company, November 1999 to January 2006
   
* Lawrence J. Pope
Vice President, Human Resources & Administration of Halliburton Company,
    (Age 38)
since January 2006
 
Senior Vice President, Administration of Kellogg Brown & Root, Inc.,
 
August 2004 to January 2006
 
Director, Finance and Administration for Drilling and Formation Evaluation
 
Division of Halliburton Energy Services Group, July 2003 to August 2004
 
Division Vice President, Human Resources for Halliburton Energy Services Group,
 
May 2001 to July 2003
 
Director, Human Resources for Halliburton Energy Services Group,
 
May 1999 to May 2001
   
   David R. Smith
Vice President, Tax of Halliburton Company, since May 2002
   (Age 59)
Vice President, Tax of Halliburton Energy Services, Inc.,
 
September 1998 to May 2002

* Members of the Policy Committee of the registrant.

There are no family relationships between the executive officers of the registrant or between any director and any executive officer of the registrant.

11


PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Halliburton Company’s common stock is traded on the New York Stock Exchange. Information relating to the high and low market prices of common stock and quarterly dividend payments is included under the caption “Quarterly Data and Market Price Information” on page 115 of this annual report. Cash dividends on common stock for 2005 and 2004 in the amount of $0.125 per share were paid in March, June, September, and December of each year. Our Board of Directors intends to consider the payment of quarterly dividends on the outstanding shares of our common stock in the future. The declaration and payment of future dividends, however, will be at the discretion of the Board of Directors and will depend upon, among other things, future earnings, general financial condition and liquidity, success in business activities, capital requirements, and general business conditions.
In February 2006, our Board of Directors approved a share repurchase program up to $1.0 billion. The Board of Directors approved a dividend for the first quarter of 2006 to shareholders of record at the close of business on March 2, 2006 of $0.15 per share, payable on March 23, 2006 reflecting a dividend increase of $0.025 per share. The Board of Directors also approved a 2:1 stock split, subject to shareholder approval at the 2006 annual shareholders meeting of a proposal to increase the number of authorized shares of common stock from one billion shares to two billion shares. Each shareholder would receive one additional share for each outstanding share held by the shareholder on the record date for the stock split. The record date will be announced after the approval of the increase in authorized shares of common stock.
At February 15, 2006, there were 20,912 shareholders of record. In calculating the number of shareholders, we consider clearing agencies and security position listings as one shareholder for each agency or listing.
Following is a summary of repurchases of our common stock during the three-month period ended December 31, 2005.

           
Total Number of Shares
 
       
Purchased as Part of Publicly
 
Period
 
Total Number of
Shares
Purchased (a)
 
Average Price
Paid per
Share
 
Announced Plans or Programs
 
October 1-31
   
14,775
 
$
66.57
   
-
 
November 1-30
   
3,551
 
$
60.32
   
-
 
December 1-31
   
19,162
 
$
64.16
   
-
 
Total
   
37,488
 
$
64.75
   
-
 

(a) All of the shares repurchased during the three-month period ended December 31, 2005 were acquired from employees in connection with the settlement of income tax and related benefit withholding obligations arising from vesting in restricted stock grants. These share purchases were not part of a publicly announced program to purchase common shares.

Item 6. Selected Financial Data.
Information relating to selected financial data is included on page 114 of this annual report.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
Information relating to Management’s Discussion and Analysis of Financial Condition and Results of Operations is included on pages 14 through 60 of this annual report.

Item 7(a). Quantitative and Qualitative Disclosures About Market Risk.
Information relating to market risk is included in Management’s Discussion and Analysis of Financial Condition and Results of Operations under the caption “Financial Instrument Market Risk” on page 46 of this annual report.

12


Item 8. Financial Statements and Supplementary Data.

 
Page No.
Management’s Report on Internal Control Over Financial Reporting
61
Reports of Independent Registered Public Accounting Firm
62
Consolidated Statements of Operations for the years ended December 31, 2005, 2004, and 2003
64
Consolidated Balance Sheets at December 31, 2005 and 2004
65
Consolidated Statements of Shareholders’ Equity for the years ended
 
December 31, 2005, 2004, and 2003
66
Consolidated Statements of Cash Flows for the years ended December 31, 2005, 2004, and 2003
67
Notes to Consolidated Financial Statements
68
Selected Financial Data (Unaudited)
 114
Quarterly Data and Market Price Information (Unaudited)
 115

The related financial statement schedules are included under Part IV, Item 15 of this annual report.

Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure.
None.

Item 9(a). Controls and Procedures.
In accordance with the Securities Exchange Act of 1934 Rules 13a-15 and 15d-15, we carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of December 31, 2005 to provide reasonable assurance that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms. Our disclosure controls and procedures include controls and procedures designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.
There has been no change in our internal control over financial reporting that occurred during the three months ended December 31, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
See page 61 for Management’s Report on Internal Control Over Financial Reporting and page 63 for Report of Independent Registered Public Accounting Firm on our assessment of internal control over financial reporting and opinion on the effectiveness of the Company’s internal control over financial reporting.

Item 9(b). Other Information.
None.

13


HALLIBURTON COMPANY
Management’s Discussion and Analysis of Financial Condition and Results of Operations

EXECUTIVE OVERVIEW

While 2005 began with the finalization of our asbestos and silica settlements in January, the highlight of the year was the strong operational performance of both of our business units, the Energy Services Group (ESG) and KBR.
ESG improved performance with a 26% increase in revenue and an 80% increase in operating income, compared to 2004. ESG operating margin (defined as operating income divided by revenue) increased nearly seven percentage points to 22.6% from 15.8% in 2004. ESG’s improved operating income and margins in 2005 compared to 2004 are a direct result of:
 
-
higher demand for oilfield services, with annual average worldwide rig counts increasing approximately 15%;
 
-
improved utilization of equipment, which was evident by an increase in our revenue per fracturing job over 2004;
 
-
increased pricing, particularly in areas of high demand and tight supply; and
 
-
our continued focus on operating performance and return on capital. Our focus centered on exiting underperforming operations, achieving improved contract terms with our customers, and redeploying resources to more attractive markets.
At KBR, we saw the benefits from restructuring KBR in 2004. KBR delivered $498 million in operating income in 2005, resulting in a 4.6% operating margin. KBR revenue decreased in 2005 as a result of lower revenue on government services projects in the Middle East, while operating income increased $840 million over 2004. These results reflect:
 
-
large losses in 2004 on our offshore fixed-price engineering, procurement, installation, and commissioning (EPIC) projects that did not recur in 2005, combined with improved profitability on our cost-reimbursable engineering projects;
 
-
award fees received for our work in Iraq and the complete resolution of disputed dining facilities, fuel costs, and other issues, which resulted in the recording of $103 million of operating income related to our LogCAP and RIO contracts; and
 
-
profit on newly awarded liquefied natural gas (LNG) and gas-to-liquids (GTL), or gas monetization infrastructure projects, designed to commercialize gas reserves around the world. Our backlog in these gas monetization projects was $3.7 billion at December 31, 2005.
During 2005, our operations were negatively impacted by several hurricanes in the Gulf of Mexico. ESG lost approximately $80 million in estimated revenue and approximately $45 million in estimated operating income primarily due to the temporary suspension of work related to damaged and lost customer rigs. KBR also incurred $5 million in expenses related to the hurricanes.
We achieved our goal of reducing our debt-to-capitalization ratio to the mid-30s. We redeemed $500 million of senior notes in April 2005 and paid off $300 million of floating rate senior notes that matured in October 2005. Our debt-to-capitalization ratio at December 31, 2005 was 33%.
The outlook for our business is positive. Strong commodity prices, a lack of excess oil supply compared to historical up-cycle periods, and continuing strong cash flow are driving increased spending plans for our exploration and production customers. We believe oil and gas prices will fluctuate in the future, but the fundamentals that support increased demand for our services or products are not expected to change significantly in the near term. We also expect continued growth in gas monetization projects, a particular strength for KBR. We believe the North American market will continue to grow in 2006, and we plan to deploy additional capital and labor resources in this market. We also expect regions outside North America to grow, particularly in the Middle East, Northern Africa, Russia, and the deep-water offshore markets, as we execute our international growth and investment strategy.
As such, in 2006 we are focusing on:
 
-
improving the utilization of our equipment and deploying additional resources to address the growing demand for our services and products;

14


 
-
increasing pricing (as the market allows) for ESG’s services and products due to expected labor and material cost increases and high demand from customers;
 
-
leveraging our technologies to provide our customers with the ability to more efficiently drill wells and to increase the productivity of those wells;
 
-
capitalizing on our strengths in the LNG and GTL markets. Forecasted LNG market growth remains strong and is expected to grow further. Significant numbers of new LNG liquefaction plant and LNG receiving terminal projects are proposed worldwide and are in various stages of development. Our experience in providing engineering, design, and construction services in the liquefied natural gas industry, particularly liquefaction facilities, positions us to benefit from the growth we are seeing in this industry; and
 
-
diversifying the services of our Government and Infrastructure segment. We expect our work under the LogCAP contract to see a more rapid decline during 2006 than we saw in 2005. As a result, we are focused on diversifying the Government and Infrastructure project portfolio and we continued to expand our work for the United States Navy under the CONCAP construction contingency contract and are positioned for future contingency work for the United States Air Force under the AFCAP contract. In addition, we have strengthened our position with the United Kingdom Ministry of Defence.
We also plan to initiate the separation of KBR from Halliburton in 2006. Our decision to separate KBR arose primarily because we do not believe the full value of KBR is currently reflected in Halliburton’s stock price, and few synergies exist between the two business units. Our current plan is to effect an initial public offering (IPO) of less than 20% of KBR. We believe the IPO market is attractive and valuation multiples of publicly traded engineering and construction companies are currently favorable. In response to interest we have received, we may consider selling some pieces of KBR, but this is not expected to change our IPO plans for the remainder of KBR. We expect that a Form S-1 for KBR will be filed with the United States Securities and Exchange Commission (SEC) after the 2005 audited financial statements of KBR are complete. Any sale of KBR stock would be registered under the Securities Act of 1933, and such shares of common stock would only be offered and sold by means of a prospectus. This annual report does not constitute an offer to sell or the solicitation of any offer to buy any securities of KBR, and there will not be any sale of any such securities in any state in which such offer, solicitation, or sale would be unlawful prior to registration or qualification under the securities laws of such state.
In February 2006, our Board of Directors approved a share repurchase program up to $1.0 billion. The Board of Directors approved a dividend for the first quarter of 2006 to shareholders of record at the close of business on March 2, 2006 of $0.15 per share, payable on March 23, 2006 reflecting a dividend increase of $0.025 per share. The Board of Directors also approved a 2:1 stock split, subject to shareholder approval at the 2006 annual shareholders meeting of a proposal to increase the number of authorized shares of common stock from one billion shares to two billion shares. Each shareholder would receive one additional share for each outstanding share held by the shareholder on the record date for the stock split. The record date will be announced after the approval of the increase in authorized shares of common stock.
Detailed discussions of our United States government contract work, the Foreign Corrupt Practices Act investigations, and our liquidity and capital resources follow. Our operating performance is described in “Business Environment and Results of Operations” below.

United States Government Contract Work
We provide substantial work under our government contracts to the United States Department of Defense and other governmental agencies. These contracts include our worldwide United States Army logistics contracts, known as LogCAP, and contracts to rebuild Iraq’s petroleum industry, such as PCO Oil South. Our government services revenue related to Iraq totaled approximately $5.4 billion in 2005, $7.1 billion in 2004, and $3.6 billion in 2003.

15


Given the demands of working in Iraq and elsewhere for the United States government, we expect that from time to time we will have disagreements or experience performance issues with the various government customers for which we work. If performance issues arise under any of our government contracts, the government retains the right to pursue remedies which could include threatened termination or termination, under any affected contract. If any contract were so terminated, we may not receive award fees under the affected contract, and our ability to secure future contracts could be adversely affected, although we would receive payment for amounts owed for our allowable costs under cost-reimbursable contracts. Other remedies that could be sought by our government customers for any improper activities or performance issues include sanctions such as forfeiture of profits, suspension of payments, fines, and suspensions or debarment from doing business with the government. Further, the negative publicity that could arise from disagreements with our customers or sanctions as a result thereof could have an adverse effect on our reputation in the industry, reduce our ability to compete for new contracts, and may also have a material adverse effect on our business, financial condition, results of operations, and cash flow.
DCAA audit issues
Our operations under United States government contracts are regularly reviewed and audited by the Defense Contract Audit Agency (DCAA) and other governmental agencies. The DCAA serves in an advisory role to our customer. When issues are found during the governmental agency audit process, these issues are typically discussed and reviewed with us. The DCAA then issues an audit report with its recommendations to our customer’s contracting officer. In the case of management systems and other contract administrative issues, the contracting officer is generally with the Defense Contract Management Agency (DCMA). We then work with our customer to resolve the issues noted in the audit report. If our customer or a government auditor finds that we improperly charged any costs to a contract, these costs are not reimbursable, or, if already reimbursed, the costs must be refunded to the customer.
Dining facilities (DFAC). During 2003, the DCAA raised issues related to our invoicing to the Army Materiel Command (AMC) for food services for soldiers and supporting civilian personnel in Iraq and Kuwait. During 2004, we received notice from the DCAA that it was recommending withholding 19.35% of our DFAC billings relating to subcontracts entered into prior to February 2004 until it completed its audits. Approximately $213 million had been withheld as of March 31, 2005. Subsequent to February 2004, we renegotiated our DFAC subcontracts to address the specific issues raised by the DCAA and advised the AMC and the DCAA of the new terms of the arrangements. We have had no objection by the government to the terms and conditions associated with our new DFAC subcontract agreements. On March 31, 2005, we reached an agreement with the AMC regarding the costs associated with the DFAC subcontractors, which totaled approximately $1.2 billion. Under the terms of the agreement, the AMC agreed to the DFAC subcontractor costs except for $55 million, which it retained from the $213 million previously withheld amount. In the second quarter of 2005, the government released the funds to KBR.
During 2005, we reached settlement agreements with all but one subcontractor, Eurest Support Services (Cyprus) International Limited, or ESS, and resolved $44 million of the $55 million disallowed DFAC subcontractor costs. Accordingly, we paid the amounts due to all subcontractors with whom settlements have been finalized, in accordance with the agreement reached with the government, but withheld the remaining $11 million pending settlement with ESS. On September 30, 2005, ESS filed suit against us alleging various claims associated with its performance as a subcontractor in conjunction with our LogCAP contract in Iraq. The case was settled during the first quarter of 2006 without material impact to us.
Fuel. In December 2003, the DCAA issued a preliminary audit report that alleged that we may have overcharged the Department of Defense by $61 million in importing fuel into Iraq. The DCAA questioned costs associated with fuel purchases made in Kuwait that were more expensive than buying and transporting fuel from Turkey. We responded that we had maintained close coordination of the fuel mission with the Army Corps of Engineers (COE), which was our customer and oversaw the project throughout the life of the task orders, and that the COE had directed us to use the Kuwait sources. After a review, the COE concluded that we obtained a fair price for the fuel. Nonetheless, Department of Defense officials referred the matter to the agency’s inspector general, which we understand commenced an investigation.

16


The DCAA issued various audit reports related to task orders under the RIO contract that reported $275 million in questioned and unsupported costs. The majority of these costs were associated with the humanitarian fuel mission. In these reports, the DCAA compared fuel costs we incurred during the duration of the RIO contract in 2003 and early 2004 to fuel prices obtained by the Defense Energy Supply Center (DESC) in April 2004 when the fuel mission was transferred to that agency. During the fourth quarter of 2005, we resolved all outstanding issues related to the RIO contract with our customer and settled the remaining questioned costs under this contract.
Laundry. Prior to the fourth quarter of 2005, we received notice from the DCAA that it recommended withholding $18 million of subcontract costs related to the laundry service for one task order in southern Iraq for which it believes we and our subcontractors have not provided adequate levels of documentation supporting the quantity of the services provided. In the fourth quarter of 2005, the DCAA issued a notice to disallow costs totaling approximately $12 million, releasing $6 million of amounts previously withheld. The $12 million has been withheld from the subcontractor. We are working with the DCMA and the subcontractor to resolve this issue.
Containers. In June 2005, the DCAA recommended withholding certain costs associated with providing containerized housing for soldiers and supporting civilian personnel in Iraq. Approximately $55 million has been withheld as of December 31, 2005 (down from $60 million originally reported because some issues have been resolved). The DCAA recommended that the costs be withheld pending receipt of additional explanation or documentation to support the subcontract costs. We have provided information we believe addresses the concerns raised by the DCAA. None of these amounts have been withheld from our subcontractors. We are working with the government and our subcontractors to resolve this issue.
Other issues. The DCAA is continuously performing audits of costs incurred for the foregoing and other services provided by us under our government contracts. During these audits, there are likely to be questions raised by the DCAA about the reasonableness or allowability of certain costs or the quality or quantity of supporting documentation. No assurance can be given that the DCAA might not recommend withholding some portion of the questioned costs while the issues are being resolved with our customer. Because of the intense scrutiny involving our government contracts operations, issues raised by the DCAA may be more difficult to resolve. We do not believe any potential withholding will have a significant or sustained impact on our liquidity.
Investigations
In early 2004, our internal audit function identified a potential $4 million overbilling by La Nouvelle Trading & Contracting Company, W.L.L. (La Nouvelle), one of our subcontractors under the LogCAP contract in Iraq, for services performed during 2003. In accordance with our policy and government regulation, the potential overcharge was reported to the Department of Defense Inspector General’s office as well as to our customer, the AMC. We reimbursed the AMC to cover that potential overbilling while we conducted our own investigation into the matter. We subsequently terminated La Nouvelle’s services under the LogCAP contract. In October 2004, La Nouvelle filed suit against us alleging $224 million in damages as a result of its termination. During the second quarter of 2005, this suit was settled without material impact to us. See Note 12 to the consolidated financial statements for further discussion.
In the first quarter of 2005, the United States Department of Justice (DOJ) issued two indictments associated with these issues against a former KBR procurement manager and a manager of La Nouvelle.
In October 2004, we reported to the Department of Defense Inspector General’s office that two former employees in Kuwait may have had inappropriate contacts with individuals employed by or affiliated with two third-party subcontractors prior to the award of the subcontracts. The Inspector General’s office may investigate whether these two employees may have solicited and/or accepted payments from these third-party subcontractors while they were employed by us.
In October 2004, a civilian contracting official in the COE asked for a review of the process used by the COE for awarding some of the contracts to us. We understand that the Department of Defense Inspector General’s office may review the issues involved.

17


We understand that the DOJ, an Assistant United States Attorney based in Illinois, and others are investigating these and other individually immaterial matters we have reported relating to our government contract work in Iraq. If criminal wrongdoing were found, criminal penalties could range up to the greater of $500,000 in fines per count for a corporation or twice the gross pecuniary gain or loss. We also understand that current and former employees of KBR have received subpoenas and have given or may give grand jury testimony related to some of these matters.
Withholding of payments
During 2004, the AMC issued a determination that a particular contract clause could cause it to withhold 15% from our invoices until our task orders under the LogCAP contract are definitized. The AMC delayed implementation of this withholding pending further review. During the third quarter of 2004, we and the AMC identified three senior management teams to facilitate negotiation under the LogCAP task orders, and these teams concluded their effort by successfully negotiating the final outstanding task order definitization on March 31, 2005. This made us current with regard to definitization of historical LogCAP task orders and eliminated the potential 15% withholding issue under the LogCAP contract.
Upon the completion of the RIO contract definitization process, the COE released all previously withheld amounts related to this contract in the fourth quarter of 2005.
The PCO Oil South project has definitized substantially all of the task orders, and we have collected a significant portion of the amounts previously withheld. We do not believe the withholding will have a significant or sustained impact on our liquidity because the withholding is temporary, and the definitization process is substantially complete.
We are working diligently with our customers to proceed with significant new work only after we have a fully definitized task order, which should limit withholdings on future task orders for all government contracts.
In addition, we had probable unapproved claims totaling $69 million at December 31, 2005 for the LogCAP and PCO Oil South contracts. These unapproved claims related to contracts where our costs have exceeded the customer’s funded value of the task order.
DCMA system reviews
Report on estimating system. On December 27, 2004, the DCMA granted continued approval of our estimating system, stating that our estimating system is “acceptable with corrective action.” We are in the process of completing these corrective actions. Specifically, based on the unprecedented level of support that our employees are providing the military in Iraq, Kuwait, and Afghanistan, we needed to update our estimating policies and procedures to make them better suited to such contingency situations. Additionally, we have completed our development of a detailed training program and have made it available to all estimating personnel to ensure that employees are adequately prepared to deal with the challenges and unique circumstances associated with a contingency operation.
Report on purchasing system. As a result of a Contractor Purchasing System Review by the DCMA during the fourth quarter of 2005, the DCMA granted the continued approval of our government contract purchasing system. The DCMA’s approval letter, dated October 28, 2005, stated that our purchasing system’s policies and practices are “effective and efficient, and provide adequate protection of the Government’s interest.”
Report on accounting system. We received two draft reports on our accounting system, which raised various issues and questions. We have responded to the points raised by the DCAA, but this review remains open. Once the DCAA finalizes the report, it will be submitted to the DCMA, who will make a determination of the adequacy of our accounting systems for government contracting.
The Balkans
We have had inquiries in the past by the DCAA and the civil fraud division of the DOJ into possible overcharges for work performed during 1996 through 2000 under a contract in the Balkans, for which inquiry has not yet been completed by the DOJ. Based on an internal investigation, we credited our customer approximately $2 million during 2000 and 2001 related to our work in the Balkans as a result of billings for which support was not readily available. We believe that the preliminary DOJ inquiry relates to potential overcharges in connection with a part of the Balkans contract under which approximately $100 million in work was done. We believe that any allegations of overcharges would be without merit. Amounts accrued related to this matter as of December 31, 2005 are not material.

18


Foreign Corrupt Practices Act investigations
The SEC is conducting a formal investigation into payments made in connection with the construction and subsequent expansion by TSKJ of a multibillion dollar natural gas liquefaction complex and related facilities at Bonny Island in Rivers State, Nigeria. The DOJ is also conducting a related criminal investigation. The government has also issued a subpoena to Halliburton seeking information, which we are furnishing, regarding current and former agents used in connection with multiple projects or services over the past 20 years located both in and outside of Nigeria in which The M .W. Kellogg Company, M. W. Kellogg, Ltd., Kellogg Brown & Root or their joint ventures, as well as the Halliburton energy services business, were participants. M. W. Kellogg, Ltd. is a joint venture in which Kellogg Brown & Root has a 55% interest. The M. W. Kellogg Company was a subsidiary of Dresser Industries before our 1998 acquisition of Dresser Industries and was later merged with a subsidiary of ours to form Kellogg Brown & Root.
The SEC and the DOJ have been reviewing these matters in light of the requirements of the United States Foreign Corrupt Practices Act (FCPA). We have been cooperating with the SEC and the DOJ, as well as with investigations into the Bonny Island project in France and Nigeria. Our Board of Directors has appointed a committee of independent directors to oversee and direct the FCPA investigations.
The matters under investigation relating to the Bonny Island project cover an extended period of time (in some cases significantly before our 1998 acquisition of Dresser Industries (which included M. W. Kellogg, Ltd. and The M .W. Kellogg Company)) and include TSKJ’s use of a Japanese trading company that contracted to provide services to TSKJ. We have produced documents to the SEC and the DOJ both voluntarily and pursuant to subpoenas, and we are making our employees available to the SEC and the DOJ for interviews. In addition, we understand that the SEC has issued a subpoena to A. Jack Stanley, who formerly served as a consultant and chairman of KBR, and to others, including certain current and former KBR employees and at least one subcontractor of KBR. We further understand that the DOJ has invoked its authority under a sitting grand jury to issue subpoenas for the purpose of obtaining information abroad, and we understand that other partners in TSKJ have provided information to the DOJ and the SEC with respect to the investigations, either voluntarily or under subpoenas.
TSKJ is a private limited liability company registered in Madeira, Portugal whose members are Technip SA of France, Snamprogetti Netherlands B.V. (an affiliate of ENI SpA of Italy), JGC Corporation of Japan, and Kellogg Brown & Root (as successor to The M. W. Kellogg Company), each of which owns 25% of the venture. TSKJ and other similarly owned entities entered into various contracts to build and expand the liquefied natural gas project for Nigeria LNG Limited, which is owned by the Nigerian National Petroleum Corporation, Shell Gas B.V., Cleag Limited (an affiliate of Total), and Agip International B.V. (an affiliate of ENI SpA). Commencing in 1995, TSKJ entered into a series of agency agreements in connection with the Bonny Island project, including with Tri-Star Investments, of which Jeffrey Tesler is a principal. We understand that a French magistrate has officially placed Mr. Tesler under investigation for corruption of a foreign public official. In Nigeria, a legislative committee of the National Assembly and the Economic and Financial Crimes Commission, which is organized as part of the executive branch of the government, are also investigating these matters. Our representatives have met with the French magistrate and Nigerian officials. In October 2004, representatives of TSKJ voluntarily testified before the Nigerian legislative committee.
As a result of these investigations, information has been uncovered suggesting that, commencing at least 10 years ago, members of TSKJ planned payments to Nigerian officials. We have reason to believe, based on the ongoing governmental and other investigations, that payments may have been made to Nigerian officials.
We notified the other owners of TSKJ of information provided by the investigations and asked each of them to conduct their own investigation. TSKJ has suspended the receipt of services from and payments to Tri-Star Investments and the Japanese trading company and has considered instituting legal proceedings to declare all agency agreements with Tri-Star Investments terminated and to recover all amounts previously paid under those agreements.
In June 2004, we terminated all relationships with Mr. Stanley and another consultant and former employee of M. W. Kellogg, Ltd. The terminations occurred because of violations of our Code of Business Conduct that allegedly involved the receipt of improper personal benefits in connection with TSKJ’s construction of the natural gas liquefaction facility in Nigeria.

19


Until such time, if ever, as we can satisfy ourselves regarding compliance with applicable law and our Code of Business Conduct, we have also suspended the services of another agent who has worked for KBR outside of Nigeria on several current projects and on numerous older projects going back to the early 1980’s. In addition, we are actively reviewing the compliance of an additional agent on a separate current Nigerian project with respect to which we have recently received from a joint venture partner on that project allegations of wrongful payments made by such agent.
In February 2005, TSKJ notified the Attorney General of Nigeria that TSKJ would not oppose the Attorney General’s efforts to have sums of money held on deposit in banks in Switzerland transferred to Nigeria and to have the legal ownership of such sums determined in the Nigerian courts.
If violations of the FCPA were found, a person or entity found in violation could be subject to fines, civil penalties of up to $500,000 per violation, equitable remedies, including disgorgement, and injunctive relief. Criminal penalties could range up to the greater of $2 million per violation or twice the gross pecuniary gain or loss. Both the SEC and the DOJ could argue that continuing conduct may constitute multiple violations for purposes of assessing the penalty amounts per violation. Often, agreed dispositions for these types of matters result in a monitor being appointed by the SEC and/or the DOJ to review future business and practices with the goal of ensuring compliance with the FCPA. Fines and civil and criminal penalties could be mitigated, in the government’s discretion, depending on the level of the cooperation in the investigations.
Potential consequences of a criminal indictment arising out of these matters could include suspension by the Department of Defense or another federal, state, or local government agency of KBR and its affiliates from their ability to contract with United States, state or local governments, or government agencies and, if a criminal or civil violation were found, KBR and its affiliates could be debarred from future contracts or new orders under current contracts to provide services to any such parties. During 2005, KBR and its affiliates had revenue of approximately $6.6 billion from its government contracts work with agencies of the United States or state or local governments. Consistent with our cooperation with the DOJ and the SEC, we would seek to obtain administrative agreements or waivers to avoid suspension or debarment. Generally, debarments can last up to three years. Suspension or debarment from the government contracts business would have a material adverse effect on the business and results of operations of KBR and Halliburton.
There can be no assurance that any governmental investigation or our investigation of these matters will not conclude that violations of applicable laws have occurred. The results of these investigations could have a material adverse effect on our business, prospects, results of operations, financial condition, and cash flows.
As of December 31, 2005, we have not accrued any amounts related to this investigation other than our current legal expenses.

Bidding practices investigation
In connection with the investigation into payments made in connection with the Nigerian project, information has been uncovered suggesting that Mr. Stanley and other former employees may have engaged in coordinated bidding with one or more competitors on certain foreign construction projects, and that such coordination possibly began as early as the mid-1980s, which was significantly before our 1998 acquisition of Dresser Industries.
On the basis of this information, we and the DOJ have broadened our investigations to determine the nature and extent of any improper bidding practices, whether such conduct violated United States antitrust laws, and whether former employees may have received payments in connection with bidding practices on some foreign projects.
If violations of applicable United States antitrust laws occurred, the range of possible penalties includes criminal fines, which could range up to the greater of $10 million in fines per count for a corporation, or twice the gross pecuniary gain or loss, and treble civil damages in favor of any persons financially injured by such violations. Suspension or debarment from contracting with the United States, state or local governments, or government agencies could also occur. Criminal prosecutions under applicable laws of relevant foreign jurisdictions and civil claims by or relationship issues with customers are also possible.
There can be no assurance that the results of these investigations will not have a material adverse effect on our business and results of operations.

20


As of December 31, 2005, we had not accrued any amounts related to this investigation other than our current legal expenses.

LIQUIDITY AND CAPITAL RESOURCES

We ended 2005 with cash and equivalents of $2.4 billion compared to $1.9 billion at December 31, 2004.
Significant sources of cash
Cash flows from operations contributed $701 million to cash in 2005. We received approximately $1.032 billion in asbestos- and silica-related insurance proceeds in 2005 and expect to receive additional amounts as follows:

Millions of dollars
     
2006
 
$
193
 
2007
   
41
 
2008
   
46
 
2009
   
131
 
2010
   
16
 
Total
 
$
427
 

During the first quarter of 2005, we sold $891 million in investments in marketable securities. Our cash flow was supplemented by approximately $200 million from the sale of our 50% interest in Subsea 7, Inc. in January 2005 and $85 million from the sale of an investment in a United States toll road in September 2005.
Our working capital requirements for our Iraq-related work, excluding cash and equivalents, decreased from $700 million at December 31, 2004 to $495 million at December 31, 2005.
Further available sources of cash. In the first quarter of 2005, we entered into an unsecured $1.2 billion five-year revolving credit facility for general working capital purposes. The new credit facility replaced our secured $700 million three-year revolving credit facility and our secured $500 million 364-day revolving credit facility. The letter of credit issued under the previous secured $700 million three-year revolving credit facility is now under our unsecured $1.2 billion revolving facility and has a balance of $107 million as of December 31, 2005. The letter of credit reduces the availability under the revolving credit facility to approximately $1.1 billion. There were no cash drawings under the unsecured $1.2 billion revolving credit facility as of December 31, 2005.
KBR entered into an unsecured $850 million five-year revolving credit facility in the fourth quarter of 2005. Three letters of credit that totaled $25 million were subsequently issued under the KBR revolving credit facility, thus reducing the availability under the credit facility to approximately $825 million at December 31, 2005. There were no cash drawings under the unsecured $850 million revolving credit facility as of December 31, 2005.
Significant uses of cash
In 2005, we used approximately $2.4 billion to fund the asbestos and silica liability trusts and made the following payments:

Millions of dollars
     
Cash payments related to asbestos and silica made in 2005:
       
Payment to the asbestos and silica trust in accordance with
       
the plan of reorganization
 
$
2,345
 
One-year non-interest-bearing note for the benefit of
       
asbestos claimants
   
31
 
Cash payment related to insurance partitioning agreement
       
in October 2004 - first of three installments
   
16
 
First installment payment for the silica note
   
15
 
Payments related to RHI Refractories agreement
   
11
 
Total
 
$
2,418
 

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On April 26, 2005, we redeemed, at par plus accrued interest, all $500 million of our floating rate senior notes due 2007 that were issued in January 2004. On October 17, 2005, we repaid, at par plus accrued interest, our $300 million floating rate senior notes that matured.
Capital expenditures of $651 million in 2005 were 13% higher than in 2004. Capital spending in 2005 continued to be primarily directed to the Energy Services Group for the Production Optimization, Drilling and Formation Evaluation, and Fluid Systems segments.
We paid $254 million in dividends to our shareholders in 2005.
We also continued to fund operating cash shortfalls on the Barracuda-Caratinga project, a multiyear construction project to develop the Barracuda and Caratinga crude oilfields off the coast of Brazil. During 2005, we funded approximately $169 million, net of revenue received. This amount was net of payments to us of $138 million related to change orders.
Future uses of cash. The following table summarizes our significant contractual obligations and other long-term liabilities as of December 31, 2005:

   
Payments due
         
Millions of dollars
 
2006
 
2007
 
2008
 
2009
 
2010
 
Thereafter
 
Total
 
Long-term debt (1) (2)
 
$
359
 
$
31
 
$
152
 
$
1
 
$
750
 
$
1,879
 
$
3,172
 
Operating leases
   
187
   
148
   
123
   
111
   
100
   
478
   
1,147
 
Purchase obligations (3)
   
644
   
30
   
19
   
10
   
4
   
10
   
717
 
Barracuda-Caratinga
   
12
   
-
   
-
   
-
   
-
   
-
   
12
 
Pension funding
                                           
obligations (4)
   
164
   
-
   
-
   
-
   
-
   
-
   
164
 
Total
 
$
1,366
 
$
209
 
$
294
 
$
122
 
$
854
 
$
2,367
 
$
5,212
 

(1)        Long-term debt excludes the effect of a terminated interest rate swap of approximately $2 million.
(2)        Long-term debt includes a silica note contributed to the trust for the benefit of silica personal injury claimants. Subsequent to the initial payment of $15 million, the silica note provides that we will contribute an amount to the silica trust at the end of each year for the next 30 years of up to $15 million. The note also provides for an extension of the note for 20 additional years under certain circumstances. We initially recorded the note at our estimated amount of approximately $24 million, including the initial payment of $15 million paid in January 2005. We will periodically reassess our valuation of this note based upon our projections of the amounts we believe we will be required to fund into the silica trust. Long-term debt also includes an asbestos insurance partitioning agreement that we reached in 2004 with Federal-Mogul, our insurance companies, and another party sharing in the insurance coverage to obtain their consent and support of a partitioning of the insurance policies. As part of the settlement, we agreed to pay $46 million in three installment payments. In 2004, we accrued $44 million, which represents the present value of the $46 million to be paid. The discount is accreted as interest expense (classified as discontinued operations) over the life of the expected future cash payments beginning in the fourth quarter of 2004. The first payment of $16 million was paid in January 2005, and the second payment of $15 million was paid in January 2006. The third and final payment of $15 million will be made in January 2007.
(3)       The purchase obligations disclosed above do not include purchase obligations that KBR enters into with its vendors in the normal course of business that support existing contracting arrangements with its customers. The purchase obligations with their vendors can span several years depending on the duration of the projects. In general, the costs associated with the purchase obligations are expensed as the revenue is earned on the related projects.
(4)       In order to mitigate a portion of the projected underfunding of our United Kingdom pension plans, ESG contributed $38 million and KBR contributed $74 million in February 2006. These amounts are included in the $164 million 2006 funding obligation.

Capital spending for 2006 is expected to be approximately $875 million. The capital expenditures budget for 2006 includes a steady level of activities related to our DML shipyard and increased spending in the Energy Services Group to accommodate higher activity levels.
In February 2006, our Board of Directors approved a share repurchase program up to $1.0 billion. The Board of Directors also approved a dividend for the first quarter of 2006 to shareholders of record at the close of business on March 2, 2006 of $0.15 per share, payable on March 23, 2006, reflecting a dividend increase of $0.025 per share.

22


As of December 31, 2005, we had commitments to fund approximately $79 million to related companies. These commitments arose primarily during the start-up of these entities or due to losses incurred by them. We expect approximately $61 million of the commitments to be paid during 2006.
We continue to fund operating cash shortfalls on the Barracuda-Caratinga project and are obligated to fund total shortages over the remaining project life. We expect the remaining project costs, net of revenue to be received, to be approximately $12 million.
Other factors affecting liquidity
Accounts receivable securitization facilities. In May 2004, we entered into an agreement to sell, assign, and transfer the entire title and interest in specified United States government accounts receivable of KBR to a third party. The total amount of receivables outstanding under this agreement as of December 31, 2004 was approximately $263 million. As of December 31, 2005, these receivables were collected, the balance was retired, and the facility was terminated.
In April 2002, we entered into an agreement to sell eligible United States Energy Services Group accounts receivable to a bankruptcy-remote limited-purpose funding subsidiary. As of December 31, 2004, we had sold $256 million of undivided ownership interest to unaffiliated companies. During the fourth quarter of 2005, these receivables were collected and the balance retired. No further receivables were sold, and the facility was terminated subsequent to December 31, 2005.
See “Off Balance Sheet Risk” below for further discussion regarding these facilities.
Letters of credit. In the normal course of business, we have agreements with banks under which approximately $1.2 billion of letters of credit or bank guarantees were outstanding as of December 31, 2005, including $434 million that relate to our joint ventures’ operations. Also included in the letters of credit outstanding as of December 31, 2005 were $183 million of performance letters of credit and $114 million of retainage letters of credit related to the Barracuda-Caratinga project. Some of the outstanding letters of credit have triggering events that would entitle a bank to require cash collateralization.
Credit ratings. Our current ratings are BBB on Standard & Poor’s and Baa1 on Moody’s Investors Service. In the fourth quarter of 2005, Moody’s revised its long-term senior unsecured debt rating from Baa2 to Baa1 with a “stable” outlook. In the third quarter of 2005, Standard & Poor’s revised its credit watch listing for us from “stable” to “positive,” citing improved operating performance and debt reduction as reasons for the upgrade. In the first quarter of 2005, Standard & Poor’s revised its credit watch listing for us from “developing” to “stable” and its short-term credit and commercial paper rating from A-3 to A-2. Our Moody’s Investors Service short-term credit and commercial paper rating is P-2.
Debt covenants. Letters of credit related to our Barracuda-Caratinga project and our $1.2 billion revolving credit facility contain restrictive covenants, including covenants that require us to maintain financial ratios as defined by the agreements. For the letters of credit related to our Barracuda-Caratinga project, we are required to maintain interest coverage and leverage ratios. We are also required to maintain a minimum debt-to-capitalization ratio under our $1.2 billion revolving credit facility. At December 31, 2005, we were in compliance with these requirements.
In addition, the unsecured $850 million five-year revolving credit facility entered into by KBR contains covenants including a limitation on the amount KBR can invest in unconsolidated subsidiaries. KBR must also maintain financial ratios including a debt-to-capitalization ratio, a leverage ratio, and a fixed charge coverage ratio. At December 31, 2005, KBR was in compliance with these requirements.

23


BUSINESS ENVIRONMENT AND RESULTS OF OPERATIONS

We currently operate in about 100 countries throughout the world, where we provide a comprehensive range of discrete and integrated services and products to the energy industry and to other industrial and governmental customers. The majority of our consolidated revenue is derived from the sale of services and products to major, national, and independent oil and gas companies and governments around the world. The services and products provided to major, national, and independent oil and gas companies are used throughout the energy industry from the earliest phases of exploration, development, and production of oil and gas through refining, processing, and marketing. Our six business segments are organized around how we manage the business: Production Optimization, Fluid Systems, Drilling and Formation Evaluation, Digital and Consulting Solutions, Government and Infrastructure, and Energy and Chemicals. We refer to the combination of Production Optimization, Fluid Systems, Drilling and Formation Evaluation, and Digital and Consulting Solutions segments as the ESG, and the combination of Government and Infrastructure and Energy and Chemicals as KBR.
The industries we serve are highly competitive with many substantial competitors for each segment. In 2005, based upon the location of the services provided and products sold, 27% of our consolidated revenue was from the United States, 24% of our consolidated revenue was from Iraq, primarily related to work for the United States Government, and 10% of our consolidated revenue was from the United Kingdom. In 2004, 26% of our consolidated revenue was from Iraq, and 22% of our consolidated revenue was from the United States. In 2003, 27% of our consolidated revenue was from the United States, and 15% of our consolidated revenue was from Iraq. No other country accounted for more than 10% of our revenue during these periods.
Operations in some countries may be adversely affected by unsettled political conditions, acts of terrorism, civil unrest, force majeure, war or other armed conflict, expropriation or other governmental actions, inflation, exchange controls, or currency devaluation. Except for our government services work in Iraq discussed above, we believe the geographic diversification of our business activities reduces the risk that loss of operations in any one country would be material to our consolidated results of operations.
Halliburton Company
Activity levels within our business segments are significantly impacted by the following:
 
-
spending on upstream exploration, development, and production programs by major, national, and independent oil and gas companies;
 
-
capital expenditures for downstream refining, processing, petrochemical, gas monetization, and marketing facilities by major, national, and independent oil and gas companies; and
 
-
government spending levels.
Also impacting our activity is the status of the global economy, which impacts oil and gas consumption, demand for petrochemical products, and investment in infrastructure projects.
Energy Services Group
Some of the more significant barometers of current and future spending levels of oil and gas companies are oil and gas prices, exploration and production spending by international and national oil companies, the world economy, and global stability, which together drive worldwide drilling activity. Our ESG financial performance is significantly affected by oil and gas prices and worldwide rig activity, which are summarized in the following tables.
This table shows the average oil and gas prices for West Texas Intermediate crude oil, United Kingdom Brent, and Henry Hub natural gas:

Average Oil Prices (dollars per barrel)
 
2005
 
2004
 
2003
 
West Texas Intermediate
 
$
56.30
 
$
41.31
 
$
31.14
 
United Kingdom Brent
 
$
54.45
 
$
38.14
 
$
28.78
 
                     
Average United States Gas Prices (dollars per million cubic feet)
                   
Henry Hub
 
$
8.79
 
$
5.85
 
$
5.63
 

24


The yearly average rig counts based on the Baker Hughes Incorporated rig count information were as follows:

Land vs. Offshore
 
2005
 
2004
 
2003
 
United States:
                
Land
 
 1,287
 
 1,093
 
 924
 
Offshore
 
 93
 
 97
 
 108
 
Total
 
 1,380
 
 1,190
 
 1,032
 
Canada:
                
Land
 
 454
 
 365
 
 368
 
Offshore
 
 4
 
 4
 
 4
 
Total
 
 458
 
 369
 
 372
 
International (excluding Canada):
                
Land
 
 643
 
 594
 
 544
 
Offshore
 
 265
 
 242
 
 226
 
Total
 
 908
 
 836
 
 770
 
Worldwide total
 
 2,746
 
 2,395
 
 2,174
 
Land total
 
 2,384
 
 2,052
 
 1,836
 
Offshore total
 
 362
 
 343
 
 338
 
                  
Oil vs. Gas
 
 2005
 
 2004
 
 2003
 
United States:
                
Oil
 
 194
 
 165
 
 157
 
Gas
   
1,186
   
1,025
   
875
 
Total
   
1,380
   
1,190
   
1,032
 
* Canada:
   
458
   
369
   
372
 
International (excluding Canada):
                   
Oil
   
703
   
648
   
576
 
Gas
   
205
   
188
   
194
 
Total
   
908
   
836
   
770
 
Worldwide total
   
2,746
   
2,395
   
2,174
 

* Canadian rig counts by oil and gas were not available.

Our customers’ cash flows, in many instances, depend upon the revenue they generate from the sale of oil and gas. Higher oil and gas prices usually translate into higher exploration and production budgets. Higher prices also improve the economic attractiveness of marginal exploration areas. This drives additional investment by our customers in the sector, which benefits us. The opposite is true for lower oil and gas prices.
Over 2005, United States oil prices continued their upward trend, leveling off in the high-$50 per barrel range by year-end. Recent increases in crude oil prices are due to a combination of the following factors:
 
-
growth in worldwide petroleum demand remains robust, despite high oil prices;
 
-
projected growth in non-Organization of Petroleum Exporting Countries (non-OPEC) supplies is not expected to accommodate worldwide demand growth;
 
-
worldwide spare crude oil production capacity has recently diminished and is projected to remain low;
 
-
downstream sectors, such as refining and shipping, are expected to keep the level of uncertainty in world oil markets high as there is limited refining capacity available, particularly in the United States; and
 
-
loss of additional capacity due to recent hurricanes in an already tight refining market.

25


The Energy Information Administration (EIA) forecasts prices for crude oil, petroleum products, and natural gas to remain high through 2006. The EIA projects West Texas Intermediate prices to average $63 per barrel in 2006 and $60 per barrel in 2007.
United States natural gas prices also continued to move higher in 2005. Despite adequate natural gas storage, high natural gas prices are expected to persist through 2006 according to Spears and Associates.
Heightened energy demand coupled with high petroleum and natural gas prices in 2005 contributed to a 15% increase in average worldwide rig count compared to 2004. This increase was primarily driven by the United States rig count, which grew 16% year-over-year. Our ESG revenue in the United States grew 36% year-over-year on this 16% rig count increase. Land gas drilling in the United States rose substantially, as gas prices remained high due to economic demand growth and higher fuel oil prices that discouraged switching to a lower-priced fuel source to minimize cost. Average Canadian rig counts increased 24% in 2005 compared to 2004. Outside of North America, average rig counts primarily increased in Latin America, Asia Pacific, and the Middle East, with most of the increase related to oil drilling.
In December 2005, Spears and Associates predicted that the United States average rig count in 2006 will increase 13% over 2005. Canadian and international average rig counts in 2006 are forecasted to rise 30% and 5%, respectively, over 2005. Many new land rigs are expected to enter the industry, as 2006 spending to drill and complete new wells is projected to increase more than 20% over 2005.
It is common practice in the United States oilfield services industry to sell services and products based on a price book and then apply discounts to the price book based upon a variety of factors. The discounts applied typically increase to partially or substantially offset price book increases in the weeks immediately following a price increase. The discount applied normally decreases over time if the activity levels remain strong. During periods of reduced activity, discounts normally increase, reducing the revenue for our services and, conversely, during periods of higher activity, discounts normally decline resulting in revenue increasing for our services.
In 2004 and 2005, we implemented several United States price book increases ranging from 5% to 18%, led by our pressure pumping services. We realized some of the benefits of these price book increases in 2005, and we expect further improvements during 2006. In addition, a price book increase of 5% for software products in our Digital and Consulting Solutions segment was implemented in January 2006. We anticipate that further price increases will be needed to offset the impact of inflationary pressures in our cost base.
Overall outlook. The outlook for world oil demand continues to remain strong, with China and North America accounting for approximately 45% of the expected demand growth in 2006. Chinese demand growth has declined recently, although oil demand growth is continuing in other populous countries, including India and Indonesia. Excess oil production capacity is expected to remain constrained and that, along with strong demand, is expected to keep supplies tight. Thus, any unexpected supply disruption or change in demand could lead to fluctuating prices. The International Energy Agency forecasts world petroleum demand growth in 2006 to increase 2% over 2005.
Our business is well-positioned in the United States. One of our fastest growing operations in this region is production enhancement, where we help our customers optimize the production rates from the wells by providing stimulation services. Among the other opportunities we expect is the recovery in deepwater drilling. Although overall rigs in the Gulf of Mexico are expected to decrease in 2006, demand for rigs to drill in the deepwater of the Gulf of Mexico is increasing. Despite having downsized our Gulf of Mexico operations due to its downturn in 2002-2003, we continue to have a significant presence in the area and are positioned to meet increasing customer demand. However, the Gulf of Mexico operations have been and can continue to be adversely affected by the hurricane season, which lasts from June through November. In the last half of 2005, four hurricanes adversely affected the Gulf of Mexico operations and some shut-in production remains. We expect customers to continue resuming activity in the Gulf of Mexico into the first half of 2006. These opportunities could be affected by sustained lower gas prices in the United States, which would reduce rig counts and activity in our production enhancement and other services.
In 2005, we were able to leverage our global infrastructure to increase the share of our business that comes from outside of the United States, as evidenced by a 20% increase over 2004 in ESG’s international revenue on a 13% increase in international rig count. Canada experienced tremendous activity growth in the latter half of 2005 and is expected to sustain growth in 2006.

26


In our Middle East/Asia region, Saudi Arabia is working to increase production and has increased its demand for oil services. Our 51%-owned subsidiary, WellDynamics, is currently supplying intelligent well completions in the region. Our involvement in Oman and Indonesia has expanded as a result of numerous multiyear contracts to provide an array of fluid, drilling, and logging services, as well as cementing, stimulation, and completion tools services. In 2005, our Drilling and Formation Evaluation, Fluid Systems, and Production Optimization segments also had new contract start-ups in Malaysia and Thailand. We have mobilized additional service equipment and personnel to the region to meet the overall rig and exploration and production demand, and we expect to see continued growth in these markets.
In our Europe/Africa/CIS region, strengthening demand in northern and western Africa and the North Sea has improved our asset utilization in all of our oilfield service product lines, and we are positioned to capitalize on this opportunity. In Libya, for example, we were recently awarded a four-well hydraulic fracturing contract that required a sharing of resources with a neighboring operation in Egypt and technical support from Europe. The successful completion of this contract has triggered new opportunities with customers in Libya. Our involvement in Russia is expanding as we believe that the business environment from a risk perspective has improved from a year ago. Landmark was recently awarded a software maintenance and support contract in Russia, and our field development work in Western Siberia was recently expanded to include services from our Fluid Systems and Drilling and Formation Evaluation segments. Awards during 2005 in Azerbaijan in our Drilling and Formation Evaluation segment and in northern Kazakhstan in our Drilling and Formation Evaluation, Fluid Systems, and Production Optimization segments will further improve our position in the Caspian as this area expands its demand for oilfield services. In Angola, where demand is driven by deepwater development, our Fluid Systems and Production Optimization segments were awarded contracts in 2005 and are actively pursuing more.
In Latin America, our overall performance has improved from a year ago. Despite the early problems with our fixed-price, turnkey drilling projects in southern Mexico, margins have improved, and we expect to complete them in the spring of 2006. In 2005, our Fluid Systems segment had new contract start-ups in Colombia and Ecuador, and in Argentina our Drilling and Formation Evaluation segment began work on new logging and drilling services contracts.
Finally, technology is an important aspect of our business, and we continue to focus on the development, introduction, and application of new technologies. See Note 1 to the consolidated financial statements for information about our research and development expense in the last three years. We expect our 2006 investment in new technology to increase compared to our 2005 investment.
KBR 
KBR provides a wide range of services to energy, chemical, and industrial customers and government entities worldwide. KBR’s customer base includes leading international oil and gas companies, national oil and gas companies, independent refiners, chemical producers, fertilizer producers, and domestic and foreign government entities. KBR projects are generally longer-term in nature than our ESG work and are impacted by more diverse drivers than short-term fluctuations in oil and gas prices and drilling activities, such as local economic cycles, introduction of new governmental regulation, and governmental outsourcing of services. Demand for KBR’s services depends primarily on customers’ capital expenditures for construction and defense services. KBR is currently benefiting from historically high crude oil and natural gas prices and general global economic expansion, primarily in the petroleum and petrochemical industries. Additionally, the heightened focus on domestic security, increased military operations and maintenance spending, and a global expansion in government outsourcing have all contributed to the growth of our business.
Effective October 1, 2004, we restructured KBR into two segments, Government and Infrastructure and Energy and Chemicals. As a result of the reorganization and in a continued effort to better position KBR for the future, we made several strategic organizational changes. We eliminated certain internal expenditures and took appropriate steps to streamline the entire organization. KBR’s results for 2005 reflect cost savings related to the restructuring.

27


Our Government and Infrastructure segment provides support services to military and civilian branches of governments throughout the world. Our most significant contract is the worldwide United States Army logistics contract, known as LogCAP. We were awarded the competitively bid LogCAP contract in December 2001 from the AMC to provide worldwide United States Army logistics services. The contract is a one-year contract with nine one-year renewal options. We are currently in year five of the contract. The AMC can terminate, reduce the amount of work, or replace our contract with a new competitively bid contract at any time during the term of the contract.
During the second quarter of 2005, a large task order was assigned for the next phase of work under the LogCAP contract in Iraq and replaces several task orders that are nearing completion. Despite this award, we expect the volume of work under our LogCAP contract to continue to decline into 2006, as our customer scales back the amount of services that we provide. In order to diversify our government services portfolio, we continue to expand our work for the United States Navy under the CONCAP construction contingency contract, the United States Air Force under the AFCAP contract, and the United Kingdom Ministry of Defence. In addition, KBR was recently awarded the competitively bid Indefinite Delivery/Indefinite Quantity contract to support the Department of Homeland Security’s United States Immigration and Customs Enforcement facilities in the event of an emergency. This contract has a five-year term, consisting of a one-year base period and four one-year options.
In the civil infrastructure sector, there has been a general trend of historic under-investment. In particular, infrastructure related to the quality of water, wastewater, roads and transit, airports, and educational facilities has declined while demand for expanded and improved infrastructure continues to outpace funding. As a result, we expect increased opportunities for our engineering and construction services and for our privately financed project activities as our financing structures make us an attractive partner for state and local governments undertaking important infrastructure projects.
Our Energy and Chemicals segment develops energy and chemical projects throughout the world, including LNG and GTL gas monetization facilities, refineries, petrochemical plants, offshore oil and gas production platforms, and synthesis gas facilities. The major focus is on our gas monetization work. Forecasted LNG market growth remains strong and is expected to grow rapidly, with demand projected to double through 2015. Significant numbers of new LNG liquefaction plant and LNG receiving terminal projects are proposed worldwide and are in various stages of development. Committed LNG liquefaction engineering, procurement, and construction (EPC) projects will yield substantial growth in worldwide LNG liquefaction capacity. This trend is expected to continue through 2007 and beyond. Our extensive experience in providing engineering, design, and construction services in the liquefied natural gas industry, particularly liquefaction facilities, positions us to benefit from the growth we are seeing in this industry.
In March 2005, KBR, with a 50% ownership, and its joint venture partners were awarded a gas monetization contract valued at $1.8 billion for the engineering, procurement, construction, and commissioning of the Tangguh LNG facility in Indonesia. In April 2005, KBR, with a 50% ownership, and a joint venture partner were also awarded an EPC contract valued at $1.7 billion for a GTL facility in Escravos, Nigeria. Also in April 2005, KBR and its joint venture partners were awarded a front end engineering and design contract (FEED) encompassing offshore and onshore operations to monetize significant gas resources from fields located offshore Angola. In July 2005, KBR and our joint venture partners were awarded a cost reimbursable FEED contract and an option for a cost reimbursable engineering, procurement, and construction management (EPCM) contract for the greater Gorgon Downstream LNG Project in Western Australia. In August 2005, KBR renewed an alliance with one of its joint venture partners in order to build upon their respective strengths and work together to pursue and execute the engineering and construction of LNG and GTL projects around the world. In September 2005, this joint venture was awarded a project management contract for a GTL project in Qatar. In September 2005, KBR, with a 33% ownership, and its joint venture partners were also awarded a lump-sum turnkey contract valued at more than $2.0 billion to provide engineering, procurement, construction, pre-commissioning, commissioning, start-up, and operations services for Yemen’s first LNG plant. At December 31, 2005, we had $3.7 billion in backlog related to major gas monetization projects.
In order to meet growing energy demands, oil and gas companies are increasing their exploration, production, and transportation spending to increase production capacity and supply. KBR is currently targeting reimbursable EPC and EPCM opportunities in northern and western Africa, the Caspian area, Asia Pacific, Latin America, and the North Sea.

28


Outsourcing of operations and maintenance work by industrial and energy companies has been increasing worldwide. Opportunities in this area are anticipated as the aging infrastructure in United States refineries and chemical plants requires more maintenance and repairs to minimize production downtime. More stringent industry safety standards and environmental regulations also lead to higher maintenance standards and costs.
Contract structure. Engineering and construction contracts can be broadly categorized as either cost-reimbursable or fixed-price, sometimes referred to as lump sum. Some contracts can involve both fixed-price and cost-reimbursable elements.
Fixed-price contracts are for a fixed sum to cover all costs and any profit element for a defined scope of work. Fixed-price contracts entail more risk to us as we must predetermine both the quantities of work to be performed and the costs associated with executing the work. While fixed-price contracts involve greater risk, they also are potentially more profitable for the contractor, since the owner/customer pays a premium to transfer many risks to the contractor.
Cost-reimbursable contracts include contracts where the price is variable based upon our actual costs incurred for time and materials, or for variable quantities of work priced at defined unit rates. Profit on cost-reimbursable contracts may be based upon a percentage of costs incurred and/or a fixed amount. Cost-reimbursable contracts are generally less risky, since the owner/customer retains many of the risks.
We are continuing with our strategy to move away from offshore fixed-price EPIC contracts within our Energy and Chemicals segment. We have only two remaining major fixed-price EPIC offshore projects. As of December 31, 2005, they were substantially complete.

29


RESULTS OF OPERATIONS IN 2005 COMPARED TO 2004

REVENUE:
         
Increase
 
Percentage
 
Millions of dollars
 
2005
 
2004
 
(Decrease)
 
Change
 
Production Optimization
 
$
4,284
 
$
3,303
 
$
981
   
30
%
Fluid Systems
   
2,838
   
2,324
   
514
   
22
 
Drilling and Formation Evaluation
   
2,258
   
1,782
   
476
   
27
 
Digital and Consulting Solutions
   
720
   
589
   
131
   
22
 
Total Energy Services Group
   
10,100
   
7,998
   
2,102
   
26
 
Government and Infrastructure
   
8,148
   
9,393
   
(1,245
)
 
(13
)
Energy and Chemicals
   
2,746
   
3,075
   
(329
)
 
(11
)
Total KBR
   
10,894
   
12,468
   
(1,574
)
 
(13
)
Total revenue
 
$
20,994
 
$
20,466
 
$
528
   
3
%
                           
Geographic - Energy Services Group segments only:
           
Production Optimization:
                         
North America
 
$
2,380
 
$
1,694
 
$
686
   
40
%
Latin America
   
384
   
335
   
49
   
15
 
Europe/Africa/CIS
   
924
   
802
   
122
   
15
 
Middle East/Asia
   
596
   
472
   
124
   
26
 
Subtotal
   
4,284
   
3,303
   
981
   
30
 
Fluid Systems:
                         
North America
   
1,424
   
1,104
   
320
   
29
 
Latin America
   
374
   
338
   
36
   
11
 
Europe/Africa/CIS
   
659
   
568
   
91
   
16
 
Middle East/Asia
   
381
   
314
   
67
   
21
 
Subtotal
   
2,838
   
2,324
   
514
   
22
 
Drilling and Formation Evaluation:
                         
North America
   
805
   
610
   
195
   
32
 
Latin America
   
365
   
281
   
84
   
30
 
Europe/Africa/CIS
   
497
   
412
   
85
   
21
 
Middle East/Asia
   
591
   
479
   
112
   
23
 
Subtotal
   
2,258
   
1,782
   
476
   
27
 
Digital and Consulting Solutions:
                         
North America
   
210
   
201
   
9
   
4
 
Latin America
   
221
   
128
   
93
   
73
 
Europe/Africa/CIS
   
168
   
142
   
26
   
18
 
Middle East/Asia
   
121
   
118
   
3
   
3
 
Subtotal
   
720
   
589
   
131
   
22
 
Total Energy Services Group revenue
                         
by region:
                         
North America
   
4,819
   
3,609
   
1,210
   
34
 
Latin America
   
1,344
   
1,082
   
262
   
24
 
Europe/Africa/CIS
   
2,248
   
1,924
   
324
   
17
 
Middle East/Asia
   
1,689
   
1,383
   
306
   
22
 
Total Energy Services Group revenue
 
$
10,100
 
$
7,998
 
$
2,102
   
26
%

30



OPERATING INCOME (LOSS):
         
Increase
 
Percentage
 
Millions of dollars
 
2005
 
2004
 
(Decrease)
 
Change
 
Production Optimization
 
$
1,106
 
$
633
 
$
473
   
75
%
Fluid Systems
   
544
   
348
   
196
   
56
 
Drilling and Formation Evaluation
   
483
   
225
   
258
   
115
 
Digital and Consulting Solutions
   
146
   
60
   
86
   
143
 
Total Energy Services Group
   
2,279
   
1,266
   
1,013
   
80
 
Government and Infrastructure
   
330
   
84
   
246
   
293
 
Energy and Chemicals
   
168
   
(426
)
 
594
   
NM
 
Total KBR
   
498
   
(342
)
 
840
   
NM
 
General corporate
   
(115
)
 
(87
)
 
(28
)
 
(32
)
Total operating income
 
$
2,662
 
$
837
 
$
1,825
   
218
%
                           
Geographic - Energy Services Group segments only:
           
Production Optimization:
                         
North America
 
$
765
 
$
376
 
$
389
   
103
%
Latin America
   
63
   
56
   
7
   
13
 
Europe/Africa/CIS
   
150
   
110
   
40
   
36
 
Middle East/Asia
   
128
   
91
   
37
   
41
 
Subtotal
   
1,106
   
633
   
473
   
75
 
Fluid Systems:
                         
North America
   
332
   
186
   
146
   
78
 
Latin America
   
58
   
55
   
3
   
5
 
Europe/Africa/CIS
   
103
   
70
   
33
   
47
 
Middle East/Asia
   
51
   
37
   
14
   
38
 
Subtotal
   
544
   
348
   
196
   
56
 
Drilling and Formation Evaluation:
                         
North America
   
217
   
102
   
115
   
113
 
Latin America
   
54
   
24
   
30
   
125
 
Europe/Africa/CIS
   
88
   
39
   
49
   
126
 
Middle East/Asia
   
124
   
60
   
64
   
107
 
Subtotal
   
483
   
225
   
258
   
115
 
Digital and Consulting Solutions:
                         
North America
   
62
   
58
   
4
   
7
 
Latin America
   
17
   
(5
)
 
22
   
NM
 
Europe/Africa/CIS
   
46
   
(5
)
 
51
   
NM
 
Middle East/Asia
   
21
   
12
   
9
   
75
 
Subtotal
   
146
   
60
   
86
   
143
 
Total Energy Services Group
                         
operating income by region:
                         
North America
   
1,376
   
722
   
654
   
91
 
Latin America
   
192
   
130
   
62
   
48
 
Europe/Africa/CIS
   
387
   
214
   
173
   
81
 
Middle East/Asia
   
324
   
200
   
124
   
62
 
Total Energy Services Group
                         
operating income
 
$
2,279
 
$
1,266
 
$
1,013
   
80
%

NM - Not Meaningful

31


The increase in consolidated revenue in 2005 compared to 2004 was attributable to increased revenue from our Energy Services Group, predominantly resulting from increased activity, higher utilization of our equipment, and our ability to raise prices due to higher exploration and production spending by our customers. This was partially offset by reduced activity in our government services projects, primarily in the Middle East, the winding down of offshore fixed-price EPIC operations, and other oil and gas projects nearing completion. Additionally, $80 million in estimated revenue was lost during 2005 due to Gulf of Mexico hurricanes. International revenue was 73% of consolidated revenue in 2005 and 78% of consolidated revenue in 2004, with the decrease primarily due to the decline of our government services projects abroad. Revenue from the United States Government for all geographic areas was approximately $6.6 billion or 31% of consolidated revenue in 2005 compared to $8.0 billion or 39% of consolidated revenue in 2004.
The increase in consolidated operating income was primarily due to stronger performance in our Energy Services Group resulting from improved demand due to increased rig activity and improved pricing and asset utilization. KBR’s operating income increased primarily due to the resolution of disputed fuel costs and other issues as a result of favorable settlement of government audits, improved project execution, and savings from KBR’s restructuring plan. Partially offsetting the consolidated operating income increase was an estimated $50 million adverse impact of Gulf of Mexico hurricanes in 2005, $45 million of which related to ESG and $5 million of which related to KBR.
In 2005, Iraq-related work contributed approximately $5.4 billion to consolidated revenue and $172 million to consolidated operating income, a 3.2% margin before corporate costs and taxes.
Following is a discussion of our results of operations by reportable segment.
Production Optimization increase in revenue compared to 2004 was derived from all regions. Production enhancement services revenue grew 37% largely driven by United States onshore operations due to strong demand for stimulation services coupled with improved equipment utilization and pricing. Higher rig activity in Canada and offshore Angola and increased equipment sales to China also contributed to production enhancement services revenue growth. Revenue from sales of completion tools increased 12% compared to 2004, benefiting from improved completions and perforating sales in Angola, the United Kingdom, and the United States, and increased underbalanced applications and perforating activity in southern Mexico. These improvements were partially offset by declines in the Caspian where completions, drill stem test, and reservoir information contracts concluded in 2004 and early 2005. WellDynamics revenue more than doubled in 2005 compared to 2004 due to a large contract for intelligent well completions in the Middle East. Our Subsea 7, Inc. joint venture, which was sold in January 2005, contributed $2 million equity income in 2004. International revenue was 49% of total segment revenue in 2005 compared to 54% in 2004.
The increase in segment operating income in 2005 included a $110 million gain on the sale in 2005 of our equity interest in the Subsea 7, Inc. joint venture, partially offset by a $54 million gain on the sale of our surface well testing operations in 2004. The segment operating income improvement spanned all regions. Production enhancement services operating income increased 81% largely due to higher land rig activity and improved utilization of resources in the United States, as well as higher utilization of marine vessels offshore Angola. A 44% improvement in completion tools operating income primarily resulted from a general increase in sales and activity in the United States and higher completions and perforating activity in West Africa and the United Kingdom. WellDynamics had operating income in 2005 compared to breakeven in 2004, primarily due to improved manufacturing efficiencies and improved customer acceptance of its intelligent well completions technology. Subsea 7, Inc. contributed $2 million equity income to segment results in 2004. Hurricanes in the Gulf of Mexico in 2005 negatively impacted Production Optimization operating income by an estimated $14 million.
Fluid Systems revenue increase compared to 2004 was driven by 24% growth in cementing services revenue and 21% growth in Baroid Fluid Services revenue. All geographic regions yielded increased revenue in both product service lines, with the largest increase in the United States due to higher onshore rig activity and higher deepwater rig activity in the Gulf of Mexico, as well as improved utilization and pricing. Sales of cementing services also improved due to increased activity in Canada and the North Sea and new contract start-ups in Indonesia. Baroid Fluid Services further benefited from increased activity in Angola, Indonesia, and the United Kingdom. International revenue was 55% of total segment revenue in 2005 compared to 58% in 2004.

32


Fluid Systems segment operating income increase compared to 2004 resulted from 62% growth from Baroid Fluid Services and 54% growth in operating income from cementing services. Baroid Fluid Services operating income benefited primarily from increased activity and improved pricing in the United States and increased activity and an improved product mix in Africa. Cementing services results increased predominantly in North America due to increased activity and improved pricing and asset utilization and in all other geographic regions due to generally higher global drilling activity. Hurricanes in the Gulf of Mexico in 2005 negatively impacted Fluid Systems operating income by an estimated $25 million.
Drilling and Formation Evaluation revenue increase in 2005 compared to 2004 was derived from all four regions in every product service line. The segment improvement was led by a 30% increase in drilling services revenue, particularly in North America due to improved pricing, higher rig activity, and new contract awards. Increased international activity, new contract start-ups, and expanded GeoPilot® services contributed to other region revenue increases, especially evident in the North Sea, the Middle East, and Latin America. Drill bits revenue increased 26% compared to 2004, largely benefiting from increased rig counts, improved pricing, and increased sales of fixed cutter bits in the United States. Logging services revenue grew 22% primarily due to increased cased hole activity and improved pricing in the United States, sales to India of logging equipment, and new contract awards in West Africa and the Middle East. Lower sales of logging equipment to China in 2005 partially offset the logging services revenue improvement. International revenue was 71% of total segment revenue in 2005 compared to 72% in 2004.
The segment operating income increase compared to 2004 spanned all geographic regions in all product service lines, with North America as the predominant contributor due to improved pricing, increased rig activity, and growth in higher margin services. Drill bits operating income in 2005 was nearly five times that of 2004, the majority of which occurred in North America. Drilling services operating income doubled from 2004 to 2005, resulting from increased global activity, improved utilization and pricing, and continued customer acceptance of GeoPilot® and other high margin services. Equipment sales in Nigeria also contributed to drilling services operating income increase. Logging services results grew 76%, additionally benefiting from higher activity in West Africa and the Middle East and sales of logging equipment to India. The increase in segment operating income included a $24 million gain related to a patent infringement case settlement. Hurricanes in the Gulf of Mexico in 2005 negatively impacted Drilling and Formation Evaluation operating income by an estimated $6 million.
Digital and Consulting Solutions revenue increase in 2005 was largely driven by project management services, with 40% revenue growth due to increased activity in Mexico and higher commodity prices in the United States, partially offset by the winding down of projects in the Middle East and Russia. Landmark revenue increased 13% in 2005 due to data bank project growth primarily in Nigeria, increased consulting, and higher sales and services in Algeria, partially offset by nonrecurring sales in India in 2004. International revenue was 73% of total segment revenue in 2005 compared to 69% in 2004.
The segment operating income improvement partially resulted from a 77% increase in Landmark operating income due to stronger software and service sales. Included in the 2005 results was a $17 million favorable insurance settlement related to a pipe fabrication and laying project in the North Sea. This was offset by $23 million in losses in 2005 on two fixed-price integrated solutions projects in Mexico, reflecting increased costs to complete the projects and longer drilling times than originally anticipated, chiefly due to unfavorable geologic conditions. Operating income in 2004 included a $13 million release of legal liability accruals in excess of the Anglo-Dutch settlement, offset by $33 million in losses on the fixed-price integrated solutions projects in Mexico and an $11 million charge for an intellectual property settlement.
Government and Infrastructure revenue for 2005 totaled $8.1 billion, a $1.2 billion decrease compared to 2004. Iraq-related activities in the Middle East decreased $1.6 billion primarily due to completion of our RIO contract. Partially offsetting the decrease was $362 million higher revenue earned by the DML shipyard and hurricane repair efforts to United States naval facilities on the Gulf Coast under the CONCAP contract.

33


Operating income for 2005 was $330 million compared to $84 million in 2004, a $246 million increase. Iraq-related income increased $97 million compared to 2004, primarily due to income from the award fees on definitized LogCAP task orders, settlement of DFAC issues, and resolution of disputed fuel costs and other issues. Increased activities from our DML shipyard positively impacted 2005 operating income by $13 million. In addition, hurricane repair efforts to United States naval facilities on the Gulf Coast under the CONCAP contract contributed to the increase. The 2005 results also included a combined $96 million in operating income from the sale of and one-time cash distribution from an interest in a United States toll road. The operating income comparison was adversely impacted by completion of the RIO contract in 2004. Segment results in 2004 included restructuring charges of $12 million.
Energy and Chemicals revenue for 2005 decreased $329 million compared to 2004. Revenue from offshore EPIC projects decreased $205 million as these projects were substantially completed during 2005. Additionally, revenue from several older LNG and oil and gas projects in Africa and Australia and an olefins project in the United States collectively decreased $424 million as these projects were also completed or substantially completed in 2005. Partially offsetting the decreases were higher activity on an offshore engineering and management project in the Caspian and a crude oil facility project in Canada, totaling $76 million. Additional increases resulted from revenue earned on projects awarded in 2005 located in Australia, Indonesia, and Nigeria, totaling $220 million.
Operating income totaled $168 million in 2005 compared to a $426 million loss in 2004, a $594 million increase. Contributing to improved operating income in 2005 were stronger results on many projects, including joint venture gas projects in Nigeria, offshore engineering and project management projects in Angola and the Caspian, and recently awarded LNG and GTL projects, collectively totaling $44 million. Additionally, 2005 results benefited from $21 million of gains on sales of assets and investments. Conversely, included in 2005 operating income were $30 million of losses on an Algerian gas processing plant project and $50 million of charges related to an unconsolidated Algerian joint venture. Included in the 2004 results were a $407 million loss on the Barracuda-Caratinga project in Brazil, $47 million of losses on the same gas processing plant project in Algeria, $29 million of losses on the Belanak project in Indonesia, and restructuring charges of $28 million.
General corporate expenses were $115 million in 2005 compared to $87 million in 2004. The increase was primarily due to increases to a self-insurance reserve, higher legal and other professional expenses on specific projects, and increased corporate communication costs.

NONOPERATING ITEMS

Interest expense decreased $22 million in 2005 compared to 2004, primarily due to the amortization in 2004 of issue costs related to a master letter of credit facility that expired in the fourth quarter of 2004, the redemption in April 2005 of $500 million of our floating rate senior notes, and interest on tax deficiencies in Indonesia in 2004.
Interest income increased $20 million in 2005 compared to 2004 due to higher cash investment balances.
Foreign currency losses, net grew to $13 million in 2005 from $3 million in 2004. The increase was primarily due to losses on the British pound sterling and the euro, partially offset by gains on the Brazilian real.
Other, net decreased $16 million in 2005 compared to 2004. The 2005 year included higher costs related to our ESG accounts receivable securitization facility and sales of our United States government accounts receivable. “Other, net” in 2004 included a $6 million pretax gain on the sale of our remaining shares of National Oilwell, Inc. common stock received in the January 2003 disposition of Mono Pumps.
Provision for income taxes from continuing operations in 2005 of $79 million resulted in an effective tax rate of 3% compared to an effective tax rate of 37% in 2004. Our 2005 tax rate is lower because we recorded favorable adjustments to our valuation allowance against our deferred tax asset related to asbestos and silica liabilities in 2005 totaling $805 million. Our strong 2005 earnings, coupled with an upward revision in our estimate of future domestic taxable income in 2006 and beyond, drove these adjustments. In 2006 and beyond, we expect our effective tax rate to return to the range of 35% to 37%.

34


Minority interest in net income of subsidiaries increased $31 million compared to 2004 primarily due to earnings growth from the DML shipyard, our GTL joint venture project in Nigeria, and our WellDynamics joint venture.
Income (loss) from discontinued operations, net of tax in 2004 included a $778 million pretax charge for the revaluation of the 59.5 million shares of Halliburton common stock contributed to the asbestos claimant trust, a $698 million pretax charge related to the write-down of the asbestos and silica insurance receivable, a $44 million accrual related to a partitioning agreement, and an $11 million pretax charge related to a delayed-draw term facility that expired in June 2004. The remaining amount primarily consisted of professional and administrative fees related to various aspects of the asbestos and silica settlement.

35


RESULTS OF OPERATIONS IN 2004 COMPARED TO 2003

REVENUE:
         
Increase
 
Percentage
 
Millions of dollars
 
2004
 
2003
 
(Decrease)
 
Change
 
Production Optimization
 
$
3,303
 
$
2,758
 
$
545
   
20
%
Fluid Systems
   
2,324
   
2,039
   
285
   
14
 
Drilling and Formation Evaluation
   
1,782
   
1,643
   
139
   
8
 
Digital and Consulting Solutions
   
589
   
555
   
34
   
6
 
Total Energy Services Group
   
7,998
   
6,995
   
1,003
   
14
 
Government and Infrastructure
   
9,393
   
5,417
   
3,976
   
73
 
Energy and Chemicals
   
3,075
   
3,859
   
(784
)
 
(20
)
Total KBR
   
12,468
   
9,276
   
3,192
   
34
 
Total revenue
 
$
20,466
 
$
16,271
 
$
4,195
   
26
%
                           
Geographic - Energy Services Group segments only:
           
Production Optimization:
                         
North America
 
$
1,694
 
$
1,337
 
$
357
   
27
%
Latin America
   
335
   
317
   
18
   
6
 
Europe/Africa/CIS
   
802
   
643
   
159
   
25
 
Middle East/Asia
   
472
   
461
   
11
   
2
 
Subtotal
   
3,303
   
2,758
   
545
   
20
 
Fluid Systems:
                         
North America
   
1,104
   
990
   
114
   
12
 
Latin America
   
338
   
258
   
80
   
31
 
Europe/Africa/CIS
   
568
   
516
   
52
   
10
 
Middle East/Asia
   
314
   
275
   
39
   
14
 
Subtotal
   
2,324
   
2,039
   
285
   
14
 
Drilling and Formation Evaluation:
                         
North America
   
610
   
558
   
52
   
9
 
Latin America
   
281
   
261
   
20
   
8
 
Europe/Africa/CIS
   
412
   
386
   
26
   
7
 
Middle East/Asia
   
479
   
438
   
41
   
9
 
Subtotal
   
1,782
   
1,643
   
139
   
8
 
Digital and Consulting Solutions:
                         
North America
   
201
   
200
   
1
   
1
 
Latin America
   
128
   
71
   
57
   
80
 
Europe/Africa/CIS
   
142
   
143
   
(1
)
 
(1
)
Middle East/Asia
   
118
   
141
   
(23
)
 
(16
)
Subtotal
   
589
   
555
   
34
   
6
 
Total Energy Services Group
                         
revenue by region:
                         
North America
   
3,609
   
3,085
   
524
   
17
 
Latin America
   
1,082
   
907
   
175
   
19
 
Europe/Africa/CIS
   
1,924
   
1,688
   
236
   
14
 
Middle East/Asia
   
1,383
   
1,315
   
68
   
5
 
Total Energy Services Group
                         
revenue
 
$
7,998
 
$
6,995
 
$
1,003
   
14
%

36



OPERATING INCOME (LOSS):
         
Increase
 
Percentage
 
Millions of dollars
 
2004
 
2003
 
(Decrease)
 
Change
 
Production Optimization
 
$
633
 
$
413
 
$
220
   
53
%
Fluid Systems
   
348
   
251
   
97
   
39
 
Drilling and Formation Evaluation
   
225
   
177
   
48
   
27
 
Digital and Consulting Solutions
   
60
   
(15
)
 
75
   
NM
 
Total Energy Services Group
   
1,266
   
826
   
440
   
53
 
Government and Infrastructure
   
84
   
194
   
(110
)
 
(57
)
Energy and Chemicals
   
(426
)
 
(225
)
 
(201
)
 
(89
)
Shared KBR
   
-
   
(5
)
 
5
   
100
 
Total KBR
   
(342
)
 
(36
)
 
(306
)
 
NM
 
General corporate
   
(87
)
 
(70
)
 
(17
)
 
(24
)
Total operating income (loss)
 
$
837
 
$
720
 
$
117
   
16
%
             
Geographic - Energy Services Group segments only:
           
Production Optimization:
                         
North America
 
$
376
 
$
194
 
$
182
   
94
%
Latin America
   
56
   
75
   
(19
)
 
(25
)
Europe/Africa/CIS
   
110
   
48
   
62
   
129
 
Middle East/Asia
   
91
   
96
   
(5
)
 
(5
)
Subtotal
   
633
   
413
   
220
   
53
 
Fluid Systems:
                         
North America
   
186
   
104
   
82
   
79
 
Latin America
   
55
   
52
   
3
   
6
 
Europe/Africa/CIS
   
70
   
58
   
12
   
21
 
Middle East/Asia
   
37
   
37
   
-
   
-
 
Subtotal
   
348
   
251
   
97