10-K 1 ed10k2006_final.htm DECEMBER 31, 2006 FORM 10-K FINAL December 31, 2006 Form 10-K Final
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, 2006

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, 2006, determined using the per share closing price on the New York Stock Exchange Composite tape of $37.10 on that date was approximately $38,102,000,000.

As of February 16, 2007, there were 999,172,145 shares of Halliburton Company Common Stock, $2.50 par value per share, outstanding.

Portions of the Halliburton Company Proxy Statement for our 2007 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, 2006

PART I
 
PAGE
Item 1.
Business
 1
Item 1(a).
Risk Factors
 9
Item 1(b).
Unresolved Staff Comments
 9
Item 2.
Properties
10
Item 3.
Legal Proceedings
11
Item 4.
Submission of Matters to a Vote of Security Holders
      11
EXECUTIVE OFFICERS OF THE REGISTRANT
      12
PART II
   
Item 5.
Market for Registrant’s Common Equity, Related Stockholder Matters,
 
 
and Issuer Purchases of Equity Securities
      14
Item 6.
Selected Financial Data
      15
Item 7.
Management’s Discussion and Analysis of Financial Condition and
 
 
Results of Operation
      15
Item 7(a).
Quantitative and Qualitative Disclosures About Market Risk
      15
Item 8.
Financial Statements and Supplementary Data
      16
Item 9.
Changes in and Disagreements with Accountants on Accounting and
 
 
Financial Disclosure
      16
Item 9(a).
Controls and Procedures
      16
Item 9(b).
Other Information
        16
MD&A AND FINANCIAL STATEMENTS
 
Management’s Discussion and Analysis of Financial Condition and Results of Operations
      17
Management’s Report on Internal Control Over Financial Reporting
      69
Reports of Independent Registered Public Accounting Firm
      70
Consolidated Statements of Operations
      72
Consolidated Balance Sheets
      73
Consolidated Statements of Shareholders’ Equity
      74
Consolidated Statements of Cash Flows
      75
Notes to Consolidated Financial Statements
      76
Selected Financial Data (Unaudited)
     127
Quarterly Data and Market Price Information (Unaudited)
     128
PART III
   
Item 10.
Directors, Executive Officers and Corporate Governance
     129
Item 11.
Executive Compensation
      129
Item 12(a).
Security Ownership of Certain Beneficial Owners
      129
Item 12(b).
Security Ownership of Management
      129
Item 12(c).
Changes in Control
      129
Item 12(d).
Securities Authorized for Issuance Under Equity Compensation Plans
      129
Item 13.
Certain Relationships and Related Transactions, and Director
 
 
Independence
      129
Item 14.
Principal Accounting Fees and Services
      130
PART IV
   
Item 15.
Exhibits and Financial Statement Schedules
      131
SIGNATURES
      140

(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: Production Optimization, Fluid Systems, Drilling and Formation Evaluation, Digital and Consulting Solutions, Energy and Chemicals, and Government and Infrastructure. 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).
Our Energy and Chemicals and Government and Infrastructure segments are part of KBR, Inc. (KBR), which was formed in March 2006. In November 2006, KBR, Inc. completed the initial public offering (IPO) of approximately 32 million shares of KBR, Inc. common stock at a price of $17.00 per share. We received proceeds of approximately $508 million from the IPO, net of underwriting discounts and commissions and offering expenses. We currently hold an approximate 81% interest in KBR, Inc., which we consolidate for financial reporting purposes. We are working toward the separation of KBR, Inc., which is expected to occur no later than the end of April 2007.
KBR’s Production Services operations were moved into discontinued operations for reporting purposes in the first quarter of 2006. All prior period amounts have been reclassified to discontinued operations.
Within the ESG during the second quarter of 2006, we moved slickline services, tubing conveyed perforating services and products, and underbalanced applications from the Production Optimization segment to the Drilling and Formation Evaluation segment, as these services are more closely aligned with the Drilling and Formation Evaluation segment. Prior period balances have been reclassified to reflect this change. Because of this change, what we previously referred to as “logging services” within the Drilling and Formation Evaluation segment we now refer to as “wireline and perforating services.” In addition, for internal management purposes we combined our Drilling and Formation Evaluation and Digital and Consulting Solutions divisions, forming three Energy Services Group internal divisions. However, we continue to disclose four segments for the Energy Services Group.
See Note 5 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 provides products and services for completion of wells, testing and monitoring performance of wells and reservoirs, and treatments to improve well productivity and increase recoverable reserves. This segment consists of production enhancement services and completion tools and services.
Production enhancement services include stimulation services, pipeline process services, sand control services, and well intervention services. Stimulation services optimize oil and gas reservoir production through a variety of pressure pumping services, nitrogen services, and chemical processes, commonly known as hydraulic 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. Well intervention services enable live well intervention and continuous pipe deployment capabilities through the use of hydraulic workover systems and coiled tubing tools and services.

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Completion tools and services include subsurface safety valves and flow control equipment, surface safety systems, packers and specialty completion equipment, intelligent completion systems, expandable liner hanger systems, sand control systems, well servicing tools, and reservoir performance services. Reservoir performance services include testing tools, real-time reservoir analysis, and data acquisition services. Additionally, completion tools and services include WellDynamics, an intelligent well completions joint venture, which we consolidate for accounting purposes.
Until January 2005 when it was sold, subsea operations conducted by Subsea 7, Inc., of which we formerly owned 50%, were included in this segment. Subsea 7, Inc. was accounted for using the equity method.
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 equipment.
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 to increase stability and enhance oil production.
Drilling and Formation Evaluation
Our Drilling and Formation Evaluation segment is primarily involved in the drilling and formation evaluation process during bore-hole construction. Services and products offered in this segment include, drilling systems and services, drill bits, and wireline and perforating services.
Sperry Drilling Services provides drilling systems and services. These services include directional and horizontal drilling, measurement-while-drilling, logging-while-drilling, multilateral systems, underbalanced applications, and rig site information systems. Our drilling systems offer directional control while providing 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.
Wireline and perforating 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 and slickline services are also offered, which provide cement bond evaluation, reservoir monitoring, pipe evaluation, pipe recovery, mechanical services, well intervention, and perforating. Perforating services include tubing-conveyed perforating services and products.
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 seismic, well log, and other data into detailed computer models of petroleum reservoirs. The models are used by our customers for business and technical decisions in exploration, development, and production activities. Data management services provide storage, browsing, and retrieval 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.

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This segment also provides 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 direct and indirect 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, Energy and Chemicals and Government and Infrastructure. The nature of these two segments can result in a relatively small number of projects and joint ventures representing a substantial portion of operations. Following is a summary of KBR’s segments.
Energy and Chemicals
Our Energy and Chemicals segment designs and constructs energy and petrochemical projects, including large, technically complex projects in remote locations around the world. The Energy and Chemicals segment includes onshore oil and gas production facilities, offshore oil and gas production facilities, including platforms, floating production and subsea facilities, onshore and offshore pipelines, liquefied natural gas (LNG) and gas-to-liquids (GTL) gas monetization facilities, refineries, petrochemical plants (such as ethylene and propylene), and Syngas, primarily for fertilizer-related facilities. Energy and Chemicals provides a wide range of engineering, procurement, construction, and facility commissioning start-up services, as well as program and project management, consulting, and technology services.
Included in this segment are a number of joint ventures, including the TSKJ joint venture, which was 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.
Also included in this segment is M. W. Kellogg Limited (MWKL), which 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.
Brown & Root-Condor Spa (BRC), a joint venture with Sonatrach and another Algerian company, enhances our ability to operate in Algeria by providing access to local resources. BRC executes work for Algerian and international customers, including Sonatrach. BRC has built oil and gas production facilities and civil infrastructure projects, including hospitals and office buildings. KBR has a 49% interest in the joint venture. We account for this investment using the equity method of accounting. We have recently been notified by a joint venture partner in BRC that it wishes to dissolve the joint venture.
Government and Infrastructure
Our Government and Infrastructure segment delivers on-demand support services across the full military mission cycle from contingency logistics and field support to operations and maintenance on military bases. In the civil infrastructure market, we operate in diverse sectors, including transportation, waste and water treatment, and facilities maintenance. We provide program and project management, contingency logistics, operations and maintenance, construction management, engineering, and other services to military and civilian branches of governments and private customers worldwide. We currently provide these services in the Middle East to support our United States military deployments, as well as in other global locations where military personnel are stationed. A significant portion of the Government and Infrastructure segment’s current operations relate to the support of United States government operations in the Middle East. KBR is also the majority owner of Devonport Management Limited (DML), which owns and operates Devonport Royal Dockyard, Western Europe’s largest naval dockyard complex. The DML shipyard operations are primarily engaged in refueling nuclear submarines and performing maintenance on surface vessels for the United Kingdom Ministry of Defence (MoD), as well as limited commercial projects. DML is consolidated for financial reporting purposes.

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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 operates for some period and increases in value.
This segment includes 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 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.
Also included in this segment is Aspire Defence/Allenby-Connaught, a joint venture between us, Mowlem Plc. and a financial investor formed to contract with the MoD to upgrade and service certain United Kingdom military facilities. In addition to a package of ongoing services to be delivered over 35 years, the project includes a nine-year construction program. KBR indirectly owns a 45% interest in Aspire Defence, the project company that is the holder of the 35-year concession contract. In addition, KBR owns a 50% interest in each of the two joint ventures that provide the construction and related support services to Aspire Defence. We account for this investment using the equity method of accounting.
Acquisitions and dispositions
In January 2007, we acquired all of the intellectual property, current assets, and existing business associated with Calgary-based Ultraline Services Corporation, a division of Savanna Energy Services Corp., for approximately $177 million, subject to adjustment for working capital purposes. Ultraline is a provider of wireline services in Canada. Ultraline will be reported in our Drilling and Formation Evaluation segment.
In the second quarter of 2006, we completed the sale of KBR’s Production Services group, which was part of our Energy and Chemicals segment. In connection with the sale, we received net proceeds of $265 million. The sale of Production Services resulted in an adjusted pretax gain, net of post-closing adjustments, of approximately $120 million, which is reflected in discontinued operations.
Business strategy
Our business strategy is to maintain global leadership in providing energy services and products. 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.
In November 2006, KBR, Inc. completed an IPO, in which it sold approximately 32 million shares of KBR, Inc. common stock, at $17.00 per share. We received proceeds of approximately $508 million from the IPO, net of underwriting discounts and commissions and offering expenses. As the IPO was a result of a broader corporate reorganization, the increase in the carrying amount of our investment in KBR, Inc. was recorded in “Paid-in capital in excess of par value” on our consolidated balance sheet at December 31, 2006. We now hold an approximate 81% interest in KBR, Inc., represented by 135.6 million shares of KBR, Inc. common stock, and consolidate KBR, Inc. for financial reporting purposes.
We are now working toward the separation of KBR, Inc., which we expect to complete no later than the end of April 2007.
On February 26, 2007, our Board of Directors approved a plan under which we will dispose of our remaining interest in KBR, Inc. through a tax-free exchange with Halliburton shareholders pursuant to an exchange offer and, following the completion or termination of the exchange offer, a special pro rata dividend distribution of any and all of our remaining KBR, Inc. shares. In connection with the anticipated exchange offer, KBR, Inc. will file with the Securities and Exchange Commission (SEC) a registration statement on Form S-4 with respect to the offering, and we will file with the SEC a Schedule TO. The exchange offer will be conditioned on a minimum number of shares being tendered. Any exchange of KBR, Inc. stock for outstanding shares of Halliburton Company common

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stock pursuant to the exchange offer will be registered under the Securities Act of 1933, and such shares of common stock will 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, Inc. The exchange offer and any subsequent spin-off will complete the separation of KBR, Inc. from Halliburton and will result in two independent companies. In January 2007, we received a ruling from the Internal Revenue Service that, among other things, no gain or loss will be recognized by Halliburton or its shareholders as a result of a distribution of KBR, Inc. stock by means of a pro rata dividend. We have requested a supplemental ruling from the Internal Revenue Service that no gain or loss will be recognized by Halliburton or its shareholders as a result of a distribution of KBR, Inc. stock by means of an exchange offer whereby holders of Halliburton stock may tender their shares and receive KBR, Inc. shares in exchange, followed by a dividend distribution of any remaining shares of KBR, Inc. stock held by Halliburton to its shareholders. The exchange offer and any subsequent distribution of KBR, Inc. stock will not be conditioned on receipt of such a supplemental ruling from the Internal Revenue Service. We have also obtained an opinion of counsel related to the tax-free nature of the exchange offer and any subsequent spin-off distribution.
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;
 
-
knowledge of the reservoir;
 
-
product quality;
 
-
warranty; and
 
-
technical proficiency.
We conduct business worldwide in about 100 countries. In 2006, based on the location of services provided and products sold, 32% of our consolidated revenue was from the United States and 19% of our consolidated revenue was from Iraq, primarily related to our work for the United States Government. In 2005, 28% of our consolidated revenue was from the United States and 25% of our consolidated revenue was from Iraq, primarily related to our work for the United States Government. In 2004, 27% of our consolidated revenue was from Iraq and 22% of our consolidated revenue was from the United States. No other country accounted for more than 10% of our consolidated revenue during these periods. See Note 5 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.

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Customers
Our revenue during the past three years was mainly derived from the sale of services and products to the energy industry, including 68% in 2006, 60% in 2005, and 52% in 2004. Revenue from the United States Government, resulting primarily from work performed in the Middle East by our Government and Infrastructure segment, represented 26% of our 2006 consolidated revenue, 32% of our 2005 consolidated revenue, and 40% of our 2004 consolidated revenue. No other customer represented more than 10% of consolidated revenue in any period presented.
Backlog
Backlog represents the dollar amount of revenue we expect to realize in the future as a result of performing work under multi-period contracts that have been awarded 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. Not all of our revenue is recorded in backlog for a variety of reasons, including the fact that some projects begin and end within a short-term period. 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 total expected revenue in backlog when a contract is awarded and/or the scope is definitized. For our projects related to unconsolidated joint ventures, we have included in the table below our percentage ownership of the joint venture’s backlog. However, because these projects are accounted for under the equity method, only our share of future earnings from these projects will be recorded in our revenue. Our backlog for projects related to unconsolidated joint ventures in our continuing operations totaled $4.4 billion at December 31, 2006 and $3.0 billion at December 31, 2005. We also consolidate joint ventures which are majority-owned and controlled or are variable interest entities in which we are the primary beneficiary. Our backlog included in the table below for projects related to consolidated joint ventures with minority interest includes 100% of the backlog associated with those joint ventures and totaled $3.9 billion at December 31, 2006 and $3.6 billion at December 31, 2005.
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 depending on expected revenue and timing. Where contract duration is indefinite, projects included in backlog are limited to the estimated value of the amount of expected revenue 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 act solely in a project management capacity, we only include our management fee revenue of each project in backlog.

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The following table summarizes our project backlog:

   
December 31
 
Millions of dollars
 
2006
 
2005
 
Government and Infrastructure (1)
             
Middle East operations
 
$
3,066
 
$
2,139
 
DML shipyard operations
   
1,079
   
1,305
 
Other
   
3,658
   
1,708
 
Energy and Chemicals (2)
             
Gas monetization
   
3,883
   
3,651
 
Offshore projects
   
130
   
275
 
Other
   
1,700
   
1,511
 
Energy Services Group (3)
   
-
   
180
 
Total backlog for continuing operations
 
$
13,516
 
$
10,769
 
 
(1)
Our Government and Infrastructure segments total backlog from continuing operations attributable to firm orders was $5.7 billion at December 31, 2006 and $3.4 billion at December 31, 2005. Total backlog attributable to unfunded orders was $2.1 billion at December 31, 2006 and $1.8 billion at December 31, 2005.
 
(2)
The amounts presented represent backlog for continuing operations and do not include backlog associated with KBR’s Production Services operations, which were sold and were accounted for as discontinued operations. Backlog for the Production Services operations was $1.2 billion as of December 31, 2005.
 
(3)
ESG backlog excludes contracts for recurring hardware and software maintenance and support services offered by Landmark.

We estimate that, at December 31, 2006, 52% of the Energy and Chemicals segment backlog and 64% of the Government and Infrastructure segment backlog will be completed within one year. As of December 31, 2006, 57% of total backlog related to cost-reimbursable contracts with the remaining 43% related to fixed-price contracts. For contracts that contain both fixed-price and cost-reimbursable components, we characterize the entire contract based on the predominant component. We were awarded a task order for approximately $3.5 billion for our continued services in Iraq through September 2007 under the LogCAP III contract. As of December 31, 2006, our backlog under the LogCAP III contract was $3.0 billion.
Raw materials
Raw materials essential to our business are normally readily available. Current market conditions have triggered constraints in the supply of certain raw materials, such as, sand, cement, and specialty metals. Given high activity levels, particularly in the United States, we are seeking ways to ensure the availability of resources, as well as manage the rising costs of raw materials. Our procurement department is using our size and buying power through several programs designed to ensure that we have access to key materials at competitive 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 $256 million in 2006, $220 million in 2005, and $234 million in 2004, 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 to be material to our business operations.

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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, 2006, we employed approximately 104,000 people worldwide compared to 100,000 at December 31, 2005. At December 31, 2006, 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.
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 we have filed with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Room 1580, 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

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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. There have been no waivers from provisions of our Code of Business Conduct during 2006, 2005, or 2004.

Item 1(a). Risk Factors.
Information related 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.

9


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
     
Drilling and Formation Evaluation Segment:
   
     
Alvarado, Texas
Owned/Leased
Manufacturing facility
     
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
   
Energy and Chemicals Segment:
   
     
Greenford, Middlesex, United Kingdom
Owned (1)
High-rise office facility
     
Government and Infrastructure Segment:
   
     
Arlington, Virginia
Leased
High-rise office facility
     
Devonport, Plymouth, United Kingdom
Owned (2)
Shipyard facility
     
Shared Facilities:
   
     
Houston, Texas
Owned
Campus facility
     
Leatherhead, United Kingdom
Owned
Campus facility
     
Houston, Texas
Leased (3)
High-rise office facility -
   
KBR executive offices
Corporate
   
Houston, Texas
Leased
Corporate executive offices
(1) At December 31, 2006, KBR had a 55% interest in a joint venture which owns this office facility.
(2) At December 31, 2006, KBR had a 51% interest in a joint venture which owns this shipyard facility.
(3) At December 31, 2006, KBR had a 50% interest in a joint venture which owns this office facility.

10


All of our owned properties are unencumbered.
In addition, we have 140 international and 100 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 535 acres in England (primarily related to DML) and Scotland, which are used by KBR. Our marine facility located in Scotland is 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 2006, we estimate that our 18.6 million tons of proven reserves in areas of active mining are sufficient to fulfill our internal and external needs for the next 12 years. We estimate that our 3.8 million tons of proven reserves of barite in areas of active mining equate to a 15-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 related 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 3, 11, 12, and 13 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 2006.

11


Executive Officers of the Registrant

The following table indicates the names and ages of the executive officers of the registrant as of February 15, 2007, 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 57)
since December 2002
 
Director of KBR, Inc., since June 2006
 
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 50)
since March 2003
 
Director of KBR, Inc., since March 2006
 
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
   
* Andrew R. Lane
Executive Vice President and Chief Operating Officer of Halliburton Company,
(Age 47)
since December 2004
 
Director of KBR, Inc., since June 2006
 
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 53)
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

12



Name and Age
Offices Held and Term of Office
Mark A. McCollum
Senior Vice President and Chief Accounting Officer of Halliburton Company,
(Age 47)
since August 2003
 
Director of KBR, Inc., since June 2006
 
Senior Vice President and Chief Financial Officer of Tenneco Automotive, Inc.,
 
November 1999 to August 2003
   
Craig W. Nunez
Senior Vice President and Treasurer of Halliburton Company,
(Age 45)
since January 2007
 
Vice President and Treasurer of Halliburton Company, February 2006
 
to January 2007
 
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 60)
Vice President, Tax of Halliburton Energy Services, Inc.,
 
September 1998 to May 2002
   
* William P. Utt
President, Chief Executive Officer and Director of KBR, Inc., since March 2006
(Age 49)
President and Chief Executive Officer of SUEZ Energy North America,
 
2000 to March 2006

* 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.

13



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 related 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 128 of this annual report. Cash dividends on common stock in the amount of $0.075 for 2006 and $0.0625 for 2005 were paid in March, June, September, and December. 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.
The following graph and table compare total shareholder return on our common stock for the five-year period ending December 31, 2006, with the Standard & Poor’s 500 Stock Index and the Standard & Poor’s Energy Composite Index over the same period. This comparison assumes the investment of $100 on December 31, 2001, and the reinvestment of all dividends. The shareholder return set forth is not necessarily indicative of future performance.


   
December 31
 
   
2001
 
2002
 
2003
 
2004
 
2005
 
2006
 
Halliburton
 
$
100.00
 
$
147.23
 
$
209.15
 
$
320.59
 
$
511.22
 
$
516.89
 
Standard & Poor’s 500 Stock Index
   
100.00
   
77.90
   
100.25
   
111.15
   
116.61
   
135.03
 
Standard & Poor’s Energy Composite Index
   
100.00
   
88.87
   
111.65
   
146.86
   
192.93
   
239.63
 

    At February 19, 2007, there were 20,292 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.
14


Following is a summary of repurchases of our common stock during the three-month period ended December 31, 2006.

           
Total Number of Shares
 
           
Purchased as Part of
 
   
Total Number of
 
Average Price
 
Publicly Announced
 
Period
 
Shares
Purchased (1)
 
Paid per
Share
 
Plans or Programs (2)
 
October 1-31
   
1,910,828
 
$
32.04
   
1,866,315
 
November 1-30
   
3,688,046
 
$
32.68
   
3,670,853
 
December 1-31
   
3,072,593
 
$
33.04
   
3,026,508
 
Total
   
8,671,467
 
$
32.67
   
8,563,676
 

(1)   Of the 8,671,467 shares purchased during the three-month period ended December 31, 2006, 107,791 shares 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.
(2)   In February 2006, our Board of Directors approved a share repurchase program of up to $1.0 billion. In September 2006, our Board of Directors approved an increase to our existing common share repurchase program of up to an additional $2.0 billion. During the fourth quarter of 2006, we repurchased 8,563,676 shares of our common stock at a cost of $280 million, or an average price per share of $32.69. There is $1.7 billion remaining under this program for future repurchases as of December 31, 2006.

Item 6. Selected Financial Data.
Information related to selected financial data is included on page 127 of this annual report.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation.
Information related to Management’s Discussion and Analysis of Financial Condition and Results of Operations is included on pages 17 through 68 of this annual report.

Item 7(a). Quantitative and Qualitative Disclosures About Market Risk.
Information related 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 49 of this annual report.

15


Item 8. Financial Statements and Supplementary Data.

 
Page No.
Management’s Report on Internal Control Over Financial Reporting
   69
Reports of Independent Registered Public Accounting Firm
   70
Consolidated Statements of Operations for the years ended December 31, 2006, 2005, and 2004
      72
Consolidated Balance Sheets at December 31, 2006 and 2005
   73
Consolidated Statements of Shareholders’ Equity for the years ended
 
December 31, 2006, 2005, and 2004
        74
Consolidated Statements of Cash Flows for the years ended December 31, 2006, 2005, and 2004
     75
Notes to Consolidated Financial Statements
     76
Selected Financial Data (Unaudited)
    127
Quarterly Data and Market Price Information (Unaudited)
    128

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, 2006 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, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
See page 69 for Management’s Report on Internal Control Over Financial Reporting and page 71 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.

16


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

EXECUTIVE OVERVIEW

During 2006, the Energy Services Group (ESG) produced revenue of $13.0 billion and operating income of $3.4 billion, reflecting an operating margin of 26.1%. Revenue increased $2.9 billion or 28% over 2005, primarily driven by higher activity in North America, Asia Pacific, the Middle East, and the North Sea. ESG operating income increased $1.1 billion or 48% compared to 2005. Internationally, ESG experienced 23% revenue growth and 44% operating income growth during 2006 compared to the prior year. Increased customer drilling and production activity, increased demand for our technologies, higher utilization of assets, and continued price increases have allowed us to produce record revenue and operating income throughout the year.
In 2006, KBR revenue was down $519 million to $9.6 billion with operating income decreasing $214 million to $239 million compared to 2005. The revenue decline was primarily due to decreased military support activities in Iraq.
In August 2006, we were awarded a $3.5 billion task order under our LogCAP III contract for additional work through 2007. Backlog related to the LogCAP III contract at December 31, 2006 was $3.0 billion. In 2006, Iraq-related work contributed $4.7 billion to consolidated revenue and $166 million to consolidated operating income, resulting in a 3.5% margin before corporate costs and taxes. We were awarded $120 million in LogCAP award fees during 2006 as a result of our performance rating. During the almost five-year period we have worked under the LogCAP III contract, we have been awarded 64 “excellent” ratings out of 76 total ratings. We expect to complete all open task orders under our LogCAP III contract during the third quarter of 2007.
In August 2006, the United States Department of Defense (DoD) issued a request for proposals on a new competitively bid, multiple service provider LogCAP IV contract to replace the current LogCAP III contract. We are currently the sole service provider under the LogCAP III contract and in October 2006, we submitted the final portion of our bid on the LogCAP IV contract. We expect that the contract will be awarded during the second quarter of 2007. Despite the award of the August 2006 task order under our LogCAP III contract, and the possibility of being awarded a portion of the LogCAP IV contract, we expect our overall volume of work to decline as our customer scales back the amount of services we provide. However, as a result of the recently announced surge of additional troops in Iraq, we expect the decline to occur more slowly than previously expected.
In the second quarter of 2006, we identified a $148 million charge, before income taxes and minority interest, related to KBR’s consolidated 50%-owned gas-to-liquids (GTL) project in Escravos, Nigeria. This charge was primarily attributable to increases in the overall estimated cost to complete the project. The project experienced delays related to civil unrest and security on the Escravos River near the project site, with additional delays resulting from scope changes and engineering and construction modifications. As of September 30, 2006, we had approximately $269 million in unapproved change orders related to this project. In the fourth quarter of 2006, we reached agreement with the project owner to settle $264 million of these change orders. We recorded an additional $9 million loss in the fourth quarter of 2006 related to non-billable engineering services for the Escravos joint venture. As of December 31, 2006, we have recorded $43 million of unapproved change orders, which primarily relates to additional cost increases on this project.
In May 2006, we completed the sale of KBR’s Production Services group, which was part of our Energy and Chemicals segment. In connection with the sale, we received net proceeds of $265 million. The sale of Production Services resulted in a pretax gain, net of post-closing adjustments, of approximately $120 million.
In 2006, KBR recorded $58 million of impairment charges related to an investment in a railway joint venture in Australia. This joint venture has sustained losses since the railway commenced operations in early 2004 and violated the joint venture’s loan covenants by failing to make an interest and principal payment in October 2006. The write-down of our investment in this joint venture in the first and third quarters of 2006 resulted from decreases in anticipated freight volume, a slowdown in the planned expansion of the Port of Darwin, and the joint venture’s unsuccessful efforts to raise additional equity from third parties.

17


In April 2006, KBR, Petrobras, and the project lenders agreed to technical and operational acceptance of the completed Barracuda and Caratinga production vessels. In March 2006, Petrobras submitted to arbitration a $220 million claim related to the Barracuda-Caratinga project. The submission claimed that certain subsea flowline bolts failed and that the replacement of these bolts was our responsibility. We disagree with the Petrobras claim since the bolts met Petrobras’ design specification, and we do not believe there is any basis for the amount claimed by Petrobras. We have examined possible solutions to the problem and determined the cost would not exceed $140 million. We are defending ourselves in the arbitration process and will pursue recovery of our costs associated with this defense.
Separation of KBR
In November 2006, KBR, Inc. completed an initial public offering (IPO), in which it sold approximately 32 million shares of KBR, Inc. common stock at $17.00 per share. We received proceeds of approximately $508 million from the IPO, net of underwriting discounts and commissions and offering expenses. As the IPO was a result of a broader corporate reorganization, the increase in the carrying amount of our investment in KBR, Inc. was recorded in “Paid-in capital in excess of par value” on our consolidated balance sheet at December 31, 2006. We now hold an approximate 81% interest in KBR, Inc., represented by 135.6 million shares of KBR, Inc. common stock, and consolidate KBR, Inc. for financial reporting purposes.
We entered into various agreements relating to the separation of KBR from us, including, among others, a master separation agreement, a registration rights agreement, a tax sharing agreement, transition services agreements, and an employee matters agreement. The master separation agreement provides for, among other things, KBR’s responsibility for liabilities related to its business and Halliburton’s responsibility for liabilities unrelated to KBR’s business. Halliburton provided indemnification in favor of KBR under the master separation agreement for contingent liabilities, including Halliburton’s indemnification of KBR and any of its greater than 50%-owned subsidiaries as of November 20, 2006, the date of the master separation agreement, for:
 
-
fines or other monetary penalties or direct monetary damages, including disgorgement, as a result of a claim made or assessed by a governmental authority in the United States, the United Kingdom, France, Nigeria, Switzerland and/or Algeria, or a settlement thereof, related to alleged or actual violations occurring prior to November 20, 2006 of the United States Foreign Corrupt Practices Act (FCPA) or particular, analogous applicable foreign statutes, laws, rules and regulations in connection with current investigations, including with respect to the construction and subsequent expansion by TSKJ of a natural gas liquefaction complex and related facilities at Bonny Island in Rivers State, Nigeria; and
 
-
all out-of-pocket cash costs and expenses, or cash settlements or cash arbitration awards in lieu thereof, KBR may incur after the effective date of the master separation agreement as a result of the replacement of the subsea flowline bolts installed in connection with the Barracuda-Caratinga project.
The Halliburton performance guarantees and letter of credit guarantees that are currently in place in favor of KBR’s customers or lenders will continue after the separation of KBR until these guarantees expire at the earlier of: (1) the termination of the underlying project contract or KBR obligations thereunder or (2) the expiration of the relevant credit support instrument in accordance with its terms or release of such instrument by the customer. KBR will compensate Halliburton for these guarantees and indemnify Halliburton if Halliburton is required to perform under any of these guarantees. The tax sharing agreement provides for allocations of United States income tax liabilities and other agreements between us and KBR with respect to tax matters. Under the transition services agreements, we will continue to provide various interim corporate support services to KBR, and KBR continues to provide various interim corporate support services to us. The fees will be determined on a basis generally intended to approximate the fully allocated direct and indirect costs of providing the services, without any profit. Under an employee matters agreement, Halliburton and KBR have allocated liabilities and responsibilities related to current and former employees and their participation in certain benefit plans. KBR’s final prospectus for its initial public offering dated November 15, 2006 contains a more detailed description of these separation agreements.

18


In conjunction with the closing of the KBR, Inc. IPO, KBR, Inc. granted stock options, restricted stock, and restricted stock unit awards under the KBR, Inc. 2006 Stock and Incentive Plan. See Note 15 to the consolidated financial statements for further detail on KBR, Inc. stock incentive plans.
We are now working toward the separation of KBR, Inc., which we expect to complete no later than the end of April 2007.
On February 26, 2007, our Board of Directors approved a plan under which we will dispose of our remaining interest in KBR, Inc. through a tax-free exchange with Halliburton shareholders pursuant to an exchange offer and, following the completion or termination of the exchange offer, a special pro rata dividend distribution of any and all of our remaining KBR, Inc. shares. In connection with the anticipated exchange offer, KBR, Inc. will file with the Securities and Exchange Commission (SEC) a registration statement on Form S-4 with respect to the offering, and we will file with the SEC a Schedule TO. The exchange offer will be conditioned on a minimum number of shares being tendered. Any exchange of KBR, Inc. stock for outstanding shares of Halliburton company stock pursuant to the exchange offer will be registered under the Securities Act of 1933, and such shares of common stock will 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, Inc. The exchange offer and any subsequent spin-off will complete the separation of KBR, Inc. from Halliburton and will result in two independent companies. In January 2007, we received a ruling from the Internal Revenue Service that, among other things, no gain or loss will be recognized by Halliburton or its shareholders as a result of a distribution of KBR, Inc. stock by means of a pro rata dividend. We have requested a supplemental ruling from the Internal Revenue Service that no gain or loss will be recognized by Halliburton or its shareholders as a result of a distribution of KBR, Inc. stock by means of an exchange offer whereby holders of Halliburton stock may tender their shares and receive KBR, Inc. shares in exchange, followed by a dividend distribution of any remaining shares of KBR, Inc. stock held by Halliburton to its shareholders. The exchange offer and any subsequent distribution of KBR, Inc. stock will not be conditioned on receipt of such a supplemental ruling from the Internal Revenue Service. We have also obtained an opinion of counsel related to the tax-free nature of the exchange offer and any subsequent spin-off distribution.
Other corporate matters
In February 2006, our Board of Directors approved an increase in our quarterly dividend to $0.075 per share, a 20% increase over prior quarters, and subsequently declared equivalent dividends during each quarter of 2006. This increase in the per share dividend amount contributed to an increase of approximately $50 million in our annual dividend payment over prior year. The Board of Directors also finalized the terms of a two-for-one common stock split, following the 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. On July 14, 2006, each shareholder of record as of June 23, 2006, received one additional share for each outstanding share held. All periods presented have been adjusted to reflect the common stock split.
Also in February 2006, our Board of Directors approved a share repurchase program of up to $1.0 billion. In September 2006, our Board of Directors approved an increase to our existing common share repurchase program of up to an additional $2.0 billion. During 2006, we repurchased approximately 40 million shares of our common stock for $1.3 billion or an average price per share of $32.93.
At December 31, 2006, we adopted the recognition provisions of Statement of Financial Accounting Standards No. 158 (SFAS No. 158), “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R).” The adoption of SFAS No. 158 impacted our balance sheet at December 31, 2006 as follows: a decrease to total assets of $187 million, an increase to total liabilities of $157 million, a decrease to minority interest of $126 million, and a decrease to shareholders’ equity of $218 million.
In January 2006, we adopted Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (SFAS No. 123(R)), and began expensing the cost of our employee stock option awards and our employee stock purchase plan. On a pretax basis, these costs totaled approximately $41 million in 2006 and are in addition to $36 million in costs we have historically expensed related to other equity based compensation and $16 million of incremental compensation cost related to modifications of previously granted stock-based awards retained when certain employees left the company. All expense related to stock compensation awards were charged to the segments to which each affected employee is assigned.

19


Business outlook
The outlook for our business remains generally favorable. Worldwide demand for hydrocarbons continues to grow, and the reservoirs are becoming more complex. Despite some disruption in activity in late 2006 and early 2007 due to adverse weather conditions, at this time we continue to see steady demand for our services in North America. The future trend will depend on natural gas storage levels and the direction of natural gas prices. The Canadian market has softened significantly since mid-2006 with a decrease in year-end rig count of 21% as compared to 2005. If the slowdown in activity continues, we will adjust our allocation of capital in that market as necessary. Despite recent volatility of natural gas prices, we have been able to negotiate price increases, though not as high as in the previous two years, as contracts roll over. Finally, we expect the energy services sector in regions outside North America to grow. Therefore, we have been investing and will continue to invest in infrastructure, capital, and technology predominantly in the Eastern Hemisphere, consistent with our initiative to grow our operations in that part of the world. We expect to realize continued expansion in the Middle East, north Africa, offshore west Africa, and Russia.
In 2007, we will focus on:
 
-
maintaining optimal utilization of our equipment and resources;
 
-
increasing pricing and reducing discounts, as the market allows, for ESG’s services and products;
 
-
leveraging our technologies to provide our customers with the ability to more efficiently drill and complete their wells and to increase their productivity. To that end, we have plans for three international research and development centers with global technology and training missions;
 
-
expanding our manufacturing capability and capacity with new manufacturing plants;
 
-
hiring and training of additional personnel to meet the increased demand for our services;
 
-
pursuing strategic acquisitions in line with ESG’s core products and services to expand our portfolio in key geographic areas. Consistent with this objective, we acquired Ultraline Services Corporation, a provider of wireline services in Canada, in January 2007;
 
-
increasing capital spending, primarily directed toward Eastern Hemisphere operations for service equipment additions and infrastructure related to recent project wins; and
 
-
completing the separation of KBR from Halliburton.
Detailed discussions of 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.

Foreign Corrupt Practices Act investigations
The SEC is conducting a formal investigation into whether improper payments were made to government officials in Nigeria through the use of agents or subcontractors 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 SEC has also issued subpoenas seeking information, which we are furnishing, regarding current and former agents used in connection with multiple projects, including current and prior projects, over the past 20 years located both in and outside of Nigeria in which the Halliburton energy services business, The M.W. Kellogg Company, M.W. Kellogg Limited, Kellogg Brown & Root or their or our joint ventures, are or were participants. In September 2006, the SEC requested that we enter into a tolling agreement with respect to its investigation. We anticipate that we will enter into an appropriate tolling agreement with the SEC.
TSKJ is a private limited liability company registered in Madeira, Portugal whose members are Technip SA of France, Snamprogetti Netherlands B.V. (a subsidiary of Saipem SpA of Italy), JGC Corporation of Japan, and Kellogg Brown & Root (a subsidiary of ours and successor to The M.W. Kellogg Company), each of which had an approximately 25% interest in the venture at December 31, 2006. 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

20


Agip International B.V. (an affiliate of ENI SpA of Italy). M.W. Kellogg Limited is a joint venture in which KBR had a 55% interest at December 31, 2006; and M.W. Kellogg Limited and The M.W. Kellogg Company were subsidiaries of Dresser Industries before our 1998 acquisition of Dresser Industries. The M.W. Kellogg Company was later merged with a subsidiary of ours to form Kellogg Brown & Root, one of our subsidiaries.
The SEC and the DOJ have been reviewing these matters in light of the requirements of the FCPA. In addition to performing our own investigation, we have been cooperating with the SEC and the DOJ investigations and with other investigations into the Bonny Island project in France, Nigeria and Switzerland. We also believe that the Serious Frauds Office in the United Kingdom is conducting an investigation relating to the Bonny Island project. Our Board of Directors has appointed a committee of independent directors to oversee and direct the FCPA investigations. Through our committee of independent directors, we will continue to oversee and direct the investigations, and KBR’s directors who are independent of us and KBR, acting as a committee of KBR’s Board of Directors, will monitor the continuing investigation directed by us.
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 and continuing through the current time period). We have produced documents to the SEC and the DOJ both voluntarily and pursuant to company subpoenas from the files of numerous officers and employees of Halliburton and KBR, including current and former executives of Halliburton and KBR, 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 of our and KBR’s current and former employees, former executive officers of KBR, and at least one subcontractor of KBR. We further understand that the DOJ has issued 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.
The SEC and DOJ investigations include an examination of whether TSKJ’s engagements of Tri-Star Investments as an agent and a Japanese trading company as a subcontractor to provide services to TSKJ were utilized to make improper payments to Nigerian government officials. In connection with the Bonny Island project, TSKJ entered into a series of agency agreements, including with Tri-Star Investments, of which Jeffrey Tesler is a principal, commencing in 1995 and a series of subcontracts with a Japanese trading company commencing in 1996. 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.
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 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 accounts of Tri-Star Investments in banks in Switzerland transferred to Nigeria and to have the legal ownership of such sums determined in the Nigerian courts.
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 that, based on the ongoing investigations, payments may have been made by agents of TSKJ to Nigerian officials. In addition, information uncovered in the summer of 2006 suggests that, prior to 1998, plans may have been made by employees of The M.W. Kellogg Company to make payments to government officials in connection with the pursuit of a number of other projects in countries outside of Nigeria. We are reviewing a number of recently discovered documents related to KBR activities in countries outside of Nigeria with respect to agents for projects after 1998. Certain of the activities discussed in this paragraph involve current or former employees or persons who were or are consultants to us and our investigation continues.

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In June 2004, all relationships with Mr. Stanley and another consultant and former employee of M.W. Kellogg Limited were terminated. The terminations occurred because of violations of our Code of Business Conduct that allegedly involved the receipt of improper personal benefits from Mr. Tesler in connection with TSKJ’s construction of the Bonny Island project.
In 2006, we suspended the services of another agent who, until such suspension, had worked for KBR outside of Nigeria on several current projects and on numerous older projects going back to the early 1980s. The suspension will continue until such time, if ever, as we can satisfy ourselves regarding the agent’s compliance with applicable law and our Code of Business Conduct. In addition, we suspended the services of an additional agent on a separate current Nigerian project with respect to which we have received from a joint venture partner on that project allegations of wrongful payments made by such agent.
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 (if applicable) generally of profit, including prejudgment interest on such profits, causally connected to the violation, and injunctive relief. Criminal penalties could range up to the greater of $2 million per violation or twice the gross pecuniary gain or loss from the violation, which could be substantially greater than $2 million per violation. It is possible that both the SEC and the DOJ could assert that there have been multiple violations, which could lead to multiple fines. The amount of any fines or monetary penalties that could be assessed would depend on, among other factors, the findings regarding the amount, timing, nature, and scope of any improper payments, whether any such payments were authorized by or made with knowledge of us or our affiliates, the amount of gross pecuniary gain or loss involved, and the level of cooperation provided the government authorities during the investigations. Agreed dispositions of these types of violations also frequently result in an acknowledgement of wrongdoing by the entity and the appointment of a monitor on terms negotiated with the SEC and the DOJ to review and monitor current and future business practices, including the retention of agents, with the goal of assuring compliance with the FCPA. Other potential consequences could be significant and include suspension or debarment of our ability to contract with governmental agencies of the United States and of foreign countries. During 2006, KBR and its affiliates had revenue of approximately $5.8 billion from its government contracts work with agencies of the United States or state or local governments. If necessary, we would seek to obtain administrative agreements or waivers from the DoD and other agencies to avoid suspension or debarment. In addition, we may be excluded from bidding on United Kingdom Ministry of Defence (MoD) contracts in the United Kingdom if we are convicted for a corruption offense or if the MoD determines that our actions constituted grave misconduct. During 2006, KBR had revenue of approximately $1.0 billion from its government contracts work with the MoD. Suspension or debarment from the government contracts business would have a material adverse effect on our business, results of operations, and cash flows.
These investigations could also result in third-party claims against us, which may include claims for special, indirect, derivative or consequential damages, damage to our business or reputation, loss of, or adverse effect on, cash flow, assets, goodwill, results of operations, business prospects, profits or business value, adverse consequences on our ability to obtain or continue financing for current or future projects or claims by directors, officers, employees, affiliates, advisors, attorneys, agents, debt holders, or other interest holders or constituents of us or our subsidiaries. In this connection, we understand that the government of Nigeria gave notice in 2004 to the French magistrate of a civil claim as an injured party in that proceeding. We are not aware of any further developments with respect to this claim. In addition, we could incur costs and expenses for any monitor required by or agreed to with a governmental authority to review our continued compliance with FCPA law.
As of December 31, 2006, we are unable to estimate an amount of probable loss or a range of possible loss related to these matters.
Bidding practices investigation
In connection with the investigation into payments relating to the Bonny Island project in Nigeria, 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.

22


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. Criminal prosecutions under applicable laws of relevant foreign jurisdictions and civil claims by, or relationship issues with customers, are also possible.
As of December 31, 2006, we are unable to estimate an amount of probable loss or a range of possible loss related to these matters.
Possible Algerian investigation
We believe that an investigation by a magistrate or a public prosecutor in Algeria may be pending with respect to sole source contracts awarded to Brown & Root Condor Spa, a joint venture with Kellogg Brown & Root Ltd UK, Centre de Recherche Nuclear de Draria, and Holding Services para Petroliers Spa. KBR had a 49% interest in this joint venture as of December 31, 2006.

LIQUIDITY AND CAPITAL RESOURCES

We ended 2006 with cash and equivalents of $4.4 billion compared to $2.4 billion at December 31, 2005. We ended 2006 with a negative net debt-to-capitalization ratio, with cash and equivalents and short-term investments exceeding our total debt.
Significant sources of cash
Cash flows from operations contributed $3.7 billion to cash in 2006. In the second quarter of 2006, we completed the sale of KBR’s Production Services group, which was part of our Energy and Chemicals segment. In connection with the sale, we received net proceeds of $265 million. In the fourth quarter of 2006, we received approximately $76 million as part of two agreements to sell certain non-core assets, including several lift boats. Our working capital requirements for our Iraq-related work, excluding cash and equivalents, decreased from $495 million at December 31, 2005 to $248 million at December 31, 2006.
We received proceeds of $508 million, net of underwriting fees and commissions and offering expenses, from the initial public offering of KBR, Inc. common stock in November 2006.
In 2006 and January 2007, we received $59 million in insurance proceeds related to fixed asset casualty reimbursement and business interruption from hurricanes Katrina and Rita.
We received approximately $167 million in asbestos- and silica-related insurance proceeds in 2006 and expect to receive additional amounts as follows:

Millions of dollars
     
2007
 
$
68
 
2008
   
46
 
2009
   
131
 
2010
   
16
 
Total
 
$
261
 

Further available sources of cash. We have available an unsecured $1.2 billion five-year revolving credit facility for general working capital purposes. There were no cash drawings under this credit facility as of December 31, 2006.

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KBR has available an unsecured $850 million five-year revolving credit facility. Letters of credit that totaled $55 million were issued under the KBR revolving credit facility, thus reducing the availability under the credit facility to approximately $795 million at December 31, 2006. There were no cash drawings under the facility as of December 31, 2006.
Significant uses of cash
Capital expenditures of $891 million in 2006 were 37% higher than in 2005. Capital spending in 2006 included $831 million related to ESG, of which $260 million related to non-North American operations. ESG capital expenditures included increased spending on pressure pumping and drilling equipment to accommodate higher activity levels. KBR capital spending in 2006 was $57 million and included spending related to our DML shipyard and the build-out of KBR’s enterprise resource planning system.
During 2006, the company invested approximately $263 million on technology, including $256 million related to research and development costs.
In February 2006, our Board of Directors approved a share repurchase program of up to $1.0 billion. In September 2006, our Board of Directors approved an increase to our existing common share repurchase program of up to an additional $2.0 billion. During 2006, we repurchased approximately 40 million shares of our common stock for $1.3 billion, or an average price per share of $32.93. We paid $306 million in dividends to our shareholders in 2006.
We repurchased $41 million of debt at a total cost of $49 million in 2006. In the third quarter of 2006, we repaid, at par plus accrued interest, our $275 million 6.0% medium-term notes that matured.
In 2006, we contributed a total of $4 million to our domestic pension plans and $186 million to our international pension plans, which included an ESG contribution of $58 million and a KBR contribution of $115 million to their respective United Kingdom pension plans.
Future uses of cash. The following table summarizes our significant contractual obligations and other long-term liabilities as of December 31, 2006:

   
Payments Due
         
Millions of dollars
 
2007
 
2008
 
2009
 
2010
 
2011
 
Thereafter
 
Total
 
Long-term debt (1)
 
$
45
 
$
164
 
$
5
 
$
752
 
$
3
 
$
1,862
 
$
2,831
 
Interest on debt (2)
   
140
   
119
   
92
   
85
   
51
   
2,202
   
2,689
 
Operating leases
   
188
   
145
   
125
   
110
   
103
   
367
   
1,038
 
Purchase obligations (3)
   
1,336
   
127
   
96
   
24
   
9
   
11
   
1,603
 
Pension funding
                                           
obligations
   
84
   
-
   
-
   
-
   
-
   
-
   
84
 
Barracuda Caratinga
   
10
   
-
   
-
   
-
   
-
   
-
   
10
 
Total
 
$
1,803
 
$
555
 
$
318
 
$
971
 
$
166
 
$
4,442
 
$
8,255
 

(1)   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 provided that we would contribute an amount up to $15 million to the silica trust each year for 30 years. 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 annual installment payments beginning in January 2005. In 2004, we accrued $44 million, which represented 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.
(2)   Interest on debt includes 90 years of interest on $300 million of debentures at 7.6% interest which become due in 2096.

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(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.

Capital spending for 2007 is expected to be approximately $1.3 billion, of which $1.2 billion relates to the ESG. In 2007, the largest increases in capital expenditures will be in the Drilling and Formation Evaluation segment and the Fluid Systems segment. From a geographic perspective, much of the increase in capital spending will be directed toward the Eastern Hemisphere to supply additional service equipment and infrastructure related to recent project wins. We expect our 2007 investment in technology to increase approximately 34% compared to 2006.
There are no debt maturities scheduled in 2007.
In future periods, we expect to make $1.0 billion to $2.0 billion annually in discretionary acquisitions in order to add to our energy service products and technologies. In January 2007, we acquired all of the intellectual property, current assets, and existing wireline services business associated with Ultraline Services Corporation, a division of Savanna Energy Services Corp., for approximately $177 million subject to adjustments for working capital purposes.
We will also continue with our discretionary share repurchase program, which has $1.7 billion of remaining authorization as of December 31, 2006.
Subject to board approval, we expect to pay dividends of approximately $75 million per quarter in 2007.
As of December 31, 2006, we had commitments to fund approximately $156 million to related companies, including $119 million to fund our privately financed projects. These commitments arose primarily during the start-up of these entities or due to losses incurred by them. We expect approximately $13 million of the commitments to be paid during 2007.
Other factors affecting liquidity
KBR indemnifications. We have entered into various agreements relating to the separation of KBR from us, including, among others, a master separation agreement, a registration rights agreement, a tax sharing agreement, transition services agreements, and an employee matters agreement. The master separation agreement provides for, among other things, KBR’s responsibility for liabilities related to its business and Halliburton’s responsibility for liabilities unrelated to KBR’s business. Halliburton provided indemnification in favor of KBR under the master separation agreement for contingent liabilities, including Halliburton’s indemnification of KBR and any of its greater than 50%-owned subsidiaries as of November 20, 2006 the date of the master separation agreement, for:
 
-
fines or other monetary penalties or direct monetary damages, including disgorgement, as a result of a claim made or assessed by a governmental authority in the United States, the United Kingdom, France, Nigeria, Switzerland and/or Algeria, or a settlement thereof, related to alleged or actual violations occurring prior to November 20, 2006 of the FCPA or particular, analogous applicable foreign statutes, laws, rules, and regulations in connection with current investigations, including with respect to the construction and subsequent expansion by TSKJ of a natural gas liquefaction complex and related facilities at Bonny Island in Rivers State, Nigeria; and
 
-
all out-of-pocket cash costs and expenses, or cash settlements or cash arbitration awards in lieu thereof, KBR may incur after the effective date of the master separation agreement as a result of the replacement of the subsea flowline bolts installed in connection with the Barracuda-Caratinga project.
The Halliburton performance guarantees and letter of credit guarantees that are currently in place in favor of KBR’s customers or lenders will continue after the separation of KBR until these guarantees expire at the earlier of: (1) the termination of the underlying project contract or KBR obligations thereunder or (2) the expiration of the relevant credit support instrument in accordance with its terms or release of such instrument by the customer. KBR will compensate Halliburton for these guarantees and indemnify Halliburton if Halliburton is required to perform under any of these guarantees. The tax sharing agreement provides for allocations of United States income tax liabilities

25


and other agreements between us and KBR with respect to tax matters. Under the transition services agreements, we will continue to provide various interim corporate support services to KBR, and KBR continues to provide various interim corporate support services to us. The fees will be determined on a basis generally intended to approximate the fully allocated direct and indirect costs of providing the services, without any profit. Under an employee matters agreement, Halliburton and KBR have allocated liabilities and responsibilities related to current and former employees and their participation in certain benefit plans. KBR’s final prospectus for its initial public offering dated November 15, 2006 contains a more detailed description of these separation agreements.
Letters of credit. In the normal course of business, we have agreements with banks under which approximately $1.0 billion of letters of credit or bank guarantees were outstanding as of December 31, 2006, including $676 million that relate to KBR. These KBR letters of credit or bank guarantees include $516 million that relate to their joint ventures’ operations. 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 2006, Moody’s revised its outlook from “stable” to “positive” due to our progress in the KBR separation. In the second quarter of 2006, Standard & Poor’s revised its long-term senior unsecured debt rating from BBB to BBB+ with a “stable” outlook due to the significant improvement in ESG operating performance and the considerable reduction in debt over the past year. Our short-term credit and commercial paper ratings are A-2 for Standard & Poor’s and P-2 for Moody’s Investors Service. We do not anticipate any adverse impact on our credit ratings resulting from the separation of KBR from Halliburton.
Debt covenants. Letters of credit related to our $1.2 billion revolving credit facility contain restrictive covenants, including maintaining a below maximum debt-to-capitalization ratio. At December 31, 2006, we were in compliance with this requirement.
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, 2006, KBR was in compliance with these requirements.
Security. In February 2007, we received a letter from the Department of the Army informing us of their intent to adjust payments under the LogCAP III contract associated with the cost incurred by the subcontractors to provide security to their employees. Based on this letter, the DCAA withheld the Army’s initial assessment of $20 million. The Army based its assessment on one subcontract wherein, based on communications with the subcontractor, the Army estimated 6% of the total subcontract cost related to the private security costs. The Army indicated that not all task orders and subcontracts have been reviewed and that they may make additional adjustments. The Army indicated that, within 60 days, they intend to begin making further adjustments equal to 6% of prior and current subcontractor costs unless we can provide timely information sufficient to show that such action is not necessary to protect the government’s interest. We are working with the Army to provide the additional information they have requested.
The Army indicated that they believe our LogCAP III contract prohibits us from billing costs of privately acquired security. We believe that, while LogCAP III contract anticipates that the Army will provide force protection to KBR employees, it does not prohibit any of our subcontractors from using private security services to provide force protection to subcontractor personnel. In addition, a significant portion of our subcontracts are competitively bid lump sum or fixed price subcontracts. As a result, we do not receive details of the subcontractors’ cost estimate nor are we legally entitled to it. Accordingly, we believe that we are entitled to reimbursement by the Army for the cost of services provided by our subcontractors, even if they incurred costs for private force protection services. Therefore, we believe that the Army’s position that such costs are unallowable and that they are entitled to withhold amounts incurred for such costs is wrong as a matter of law.
If we are unable to demonstrate that such action by the Army is not necessary, a 6% suspension of all subcontractor costs incurred to date could result in suspended costs of approximately $400 million. The Army has asked us to provide information that addresses the use of armed security either directly or indirectly charged to LogCAP III. The actual costs associated with these activities cannot be accurately estimated at this time but we believe that they should be less than 6% of the total subcontractor costs. As of December 31, 2006, no amounts have been accrued for suspended security billings.

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BUSINESS ENVIRONMENT AND RESULTS OF OPERATIONS

We operate in approximately 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 and processing. Our six business segments are: Production Optimization, Fluid Systems, Drilling and Formation Evaluation, Digital and Consulting Solutions, Energy and Chemicals, and Government and Infrastructure. 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 Energy and Chemicals and Government and Infrastructure as KBR.
The industries we serve are highly competitive with many substantial competitors in each segment. In 2006, based upon the location of the services provided and products sold, 32% of our consolidated revenue was from the United States and 19% of our consolidated revenue was from Iraq. In 2005, 28% of our consolidated revenue was from the United States and 25% of our consolidated revenue was from Iraq. In 2004, 27% of our consolidated revenue was from Iraq and 22% of our consolidated revenue was from the United States. 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, 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 (WTI) and United Kingdom Brent crude oil, and Henry Hub natural gas:

Average Oil Prices (dollars per barrel)
 
2006
 
2005
 
2004
 
West Texas Intermediate
 
$
66.17
 
$
56.30
 
$
41.31
 
United Kingdom Brent
 
$
65.35
 
$
54.45
 
$
38.14
 
                     
Average United States Gas Prices (dollars per million British
                   
thermal units, or mmBtu)
                   
Henry Hub
 
$
6.81
 
$
8.79
 
$
5.85
 

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

Land vs. Offshore
 
2006
 
2005
 
2004
 
United States:
                   
Land
   
1,558
   
1,287
   
1,093
 
Offshore
   
90
   
93
   
97
 
Total
   
1,648
   
1,380
   
1,190
 
Canada:
                   
Land
   
467
   
454
   
365
 
Offshore
   
3
   
4
   
4
 
Total
   
470
   
458
   
369
 
International (excluding Canada):
                   
Land
   
656
   
593
   
548
 
Offshore
   
269
   
258
   
233
 
Total
   
925
   
851
   
781
 
Worldwide total
   
3,043
   
2,689
   
2,340
 
Land total
   
2,681
   
2,334
   
2,006
 
Offshore total
   
362
   
355
   
334
 
                     
Oil vs. Gas
   
2006
   
2005
   
2004
 
United States:
                   
Oil
   
273
   
194
   
165
 
Gas
   
1,375
   
1,186
   
1,025
 
Total
   
1,648
   
1,380
   
1,190
 
Canada:
                   
Oil
   
110
   
100
   
91
 
Gas
   
360
   
358
   
278
 
Total
   
470
   
458
   
369
 
International (excluding Canada):
                   
Oil
   
709
   
651
   
599
 
Gas
   
216
   
200
   
182
 
Total
   
925
   
851
   
781
 
Worldwide total
   
3,043
   
2,689
   
2,340
 
Oil total
   
1,092
   
945
   
855
 
Gas total
   
1,951
   
1,744
   
1,485
 

Heightened energy demand in 2006 contributed to a 13% increase in the average worldwide rig count compared to 2005. This increase was primarily driven by the United States rig count, which grew 19% year-over-year. Our ESG revenue in the United States grew 36% year-over-year with these rig count increases. Average Canadian rig counts increased 3% in 2006 compared to 2005. Outside of North America, average rig counts increased in Latin America, Africa, and the Middle East, with most of the increase related to oil drilling.
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 promotes additional investment by our customers in the sector. The opposite is true for lower oil and gas prices.

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United States oil prices experienced record highs in 2006 with WTI and Brent crude average yearly prices increasing 18% and 20% respectively, compared to 2005.
After declining from record highs during the third and fourth quarter of 2006, crude oil prices are expected to remain at these historically high levels due to a combination of the following factors:
 
-
continued growth in worldwide petroleum demand, despite high oil prices;
 
-
projected production growth in non-Organization of Petroleum Exporting Countries (non-OPEC) supplies is not expected to accommodate world wide demand growth;
 
-
OPEC’s commitment to control production; and
 
-
modest increases in OPEC’s current and forecasted production capacity.
According to the International Energy Agency’s January 2007 Oil Market report, the outlook for world oil demand remains strong, with China, the Middle East, and North America accounting for approximately 78% of the expected demand growth in 2007. Excess oil production capacity is expected to remain constrained and that, along with steady 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 2007 to increase 2% over 2006.
Volatility in natural gas prices has the potential to impact our customers' drilling and production activities, particularly in the United States. For example, mild temperatures and minimal hurricane-related disruptions to production on the Gulf of Mexico resulted in high natural gas storage levels and lower natural gas prices during the second half of 2006.
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 offset price book increases. The discount applied normally decreases if activity levels are 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.
The price book increases we implemented in 2005 and the first half of 2006 increased revenue and operating income across all segments during 2006. From April 2006 to July 2006, we implemented several United States price book increases ranging from 5% to 12%, led by our pressure pumping services. We will continue to evaluate future United States price book increases and focus on decreasing customer discounts.
Geographic discussion. North America revenue for 2006 grew $1.6 billion compared to 2005. This growth was primarily led by our production enhancement services, 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 have continued 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. As a result, our revenue from the Gulf of Mexico in 2006 was up 32% year-over-year, which contributed to a 152% increase in operating income in the Gulf of Mexico. Revenue from Canada was up 17% year-over-year, primarily driven by the Production Optimization segment. During the third quarter of 2006, our Drilling and Formation Evaluation and Fluid Systems segments were awarded multimillion-dollar contracts for a development project in Alaska.
During 2006, our ESG international revenue increased 23% or $1.3 billion compared to 2005.
In our Middle East/Asia region, Saudi Arabia experienced 49% revenue growth compared to 2005 due to increased activity. In July 2006, we signed a three-year agreement to provide the oilfield services component for the Saudi Aramco Al Khurais project. In the Asia Pacific area, Malaysia and Australia contributed the most to year-over-year revenue growth compared to 2005. In the third quarter of 2006, we were awarded two contracts in Indonesia totaling $110 million to provide cementing and stimulation services.

29


In our Europe/Africa/CIS region, North Sea activity has continued to grow, accounting for 25% of revenue growth year-over-year, led by the Production Optimization segment. In the second quarter of 2006, we signed a $193 million two-year contract with additional extension options for cementing services, pumping, and drilling and completion fluids in Norway. Also in the second quarter, we signed an estimated $100 million five-year contract with options for five single-year extensions to provide completion products and services for oil and gas operations in the United Kingdom, the Netherlands, Norway, and Ireland. In July 2006, we signed a $150 million contract to provide integrated drilling and well services in Norway for a duration of up to six years. Our operations in Russia experienced strong revenue and operating income growth year-over-year. In the fourth quarter of 2006, we signed a $59 million contract for the provision of hydraulic fracturing services in Russia. In the first quarter of 2007, we signed a $100 million three-year contract with options to renew for three additional one-year periods, for the provision of drilling fluids, waste management services, cementing, drill bits, directional drilling, and logging-while-drilling services in Russia. Activity in Africa grew $197 million, representing a 20% increase compared to 2005. Fluid Systems growth in both Nigeria and Angola, coupled with Production Optimization growth across Africa, accounted for the largest part of the revenue growth in Africa. We are continuing to deploy additional personnel into Libya as this market continues to grow after the elimination of sanctions by the United States.
In Latin America, we experienced 13% revenue growth year-over-year despite a decrease in revenue from Mexico. This came largely from revenue growth of 83% in Ecuador and 29% in Columbia, both aided by the Fluid Systems contract start-ups that began in 2005. Double digit revenue growth in Brazil, Argentina, and Venezuela also contributed to the improvement in Latin America. The revenue decline in Mexico is mostly attributable to the turnkey drilling project, which began in 2004 and was completed in July of 2006. In the fourth quarter of 2006, we signed a $73 million three-year contract to provide stimulation services in Mexico.
Technology is an important aspect of our business, and we continue to focus on the development, introduction, and application of new technologies. Therefore, we expect our 2007 investment in technology to increase approximately 34% compared to 2006. We have plans for three international research and development centers with global technology and training missions. The first will open in Pune, India in the second quarter of 2007, and the second in Singapore is planned for later in 2007.
ESG also has plans on expanding its manufacturing capability and capacity with new manufacturing plants in Mexico and Brazil during the first half of 2007 and in Singapore and Malaysia during the second half of 2007.
ESG hired over 13,000 employees in 2006, and we expect to add a similar number in 2007. To meet the increasing need for technical training, we also plan to open a new training center in Tyumen, Russia in the first quarter of 2007, which follows recent training center expansions in Malaysia, Egypt, and Mexico.
KBR
KBR provides a wide range of services to energy, chemical, and industrial customers and government entities worldwide. At any given time, a relatively few number of projects and joint ventures represent a substantial part of our operations. 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 its customers’ capital expenditures and budgets for construction and defense services. Additionally, the heightened focus on global security and major military force realignments, as well as a global expansion in government outsourcing, have all contributed to increased demand for KBR’s services.
Energy and Chemicals segment. Our Energy and Chemicals segment designs and constructs energy and petrochemical projects throughout the world, including liquefied natural gas (LNG) and GTL gas monetization facilities, refineries, petrochemical plants, offshore oil and gas production platforms, and Syngas facilities. Production companies are investing in development projects that may not have been economically viable when oil and gas price levels were lower than they are today. Our experience in providing engineering, design and construction services in the oil and gas industry positions us to benefit from the growth expected across the various oil and gas sectors. We are positioned to capitalize on the anticipated growth in LNG & GTL infrastructure.

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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 engineering, procurement, and construction management opportunities in northern and western Africa, the Caspian area, Asia Pacific, Latin America, and the North Sea. With regard to our energy and chemical projects, worldwide resource constraints, escalating material and equipment prices, and ongoing supply chain pricing pressures are causing delays in awards of and, in some cases, cancellations of major gas monetization and upstream prospects. Certain very large scale projects that KBR has been pursuing for new awards have either been cancelled, awarded to competitors or significantly delayed. These developments may negatively and materially impact KBR’s 2007 and 2008 results on a stand alone basis (excluding consideration of potential offsets such as the slower than expected decline in LogCAP III activity, or work in other areas and overhead reductions that may or may not be realized). It is generally very difficult to predict whether or when we will receive such awards as these contracts frequently involve a lengthy and complex bidding and selection process which is affected by a number of factors, such as market conditions, financing arrangements, governmental approvals and environmental matters.
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.
In the first quarter of 2006, we signed a $400 million contract for the construction of the Egypt Basic Industries Corporation (EBIC) ammonia plant project.  We also have an investment in a development corporation that has an indirect interest in the EBIC project.  We are performing the EPC work for the project and operations and maintenance services for the facility. In August 2006, the lenders providing the construction financing notified EBIC that it was in default of the terms of its debt agreement, which effectively prevented the project from making additional borrowings until such time as certain security interests in the ammonia plant assets related to the export facilities, could be perfected. Indebtedness under the debt agreement is non-recourse to us. This default was cured on December 8, 2006 subject to EBIC’s submission and the lender’s acceptance of the remaining documents by March 2007. No event of default has occurred pursuant to our EPC contract and we have been paid all amounts due from EBIC. In September 2006, we were instructed by EBIC to cease work on one location of the project on which the ammonia storage tanks were originally planned to be constructed due to a decision to relocate the tanks. The new location has been selected and the client and its lenders have agreed to compensate KBR for approximately $6 million in costs resulting from the relocation of the storage tanks. We resumed work on the ammonia tanks in February 2007.
In July 2006, KBR was awarded, through a 50%-owned consolidated joint venture, a $997 million contract with Qatar Shell GTL Limited to provide project management and cost-reimbursable engineering, procurement and construction management services for the Pearl GTL project in Ras Laffan, Qatar. The project, which is expected to be completed by 2011, consists of gas production facilities and a GTL plant.
Also in July 2006, we were awarded a $194 million fixed-price engineering, procurement, and construction management contract by a Saudi Kayan Petrochemical Company for a 1.35 million ton-per-year ethylene plant in Jubail City, Saudi Arabia.
In the second quarter of 2006, we identified a $148 million charge, before income taxes and minority interest, related to KBR’s consolidated 50%-owned GTL project in Escravos, Nigeria. This charge was primarily attributable to increases in the overall estimated cost to complete the project. The project, which was awarded in April 2005, has experienced delays relating to civil unrest and security on the Escravos River, near the project site. Further delays have resulted from scope changes, engineering and construction modifications due to necessary front-end engineering design changes and increases in procurement costs due to project delays. As of September 30, 2006, we had approximately $269 million in unapproved change orders related to this project. In the fourth quarter

31


of 2006, we reached agreement with the project owner to settle $264 million of these change orders. As a result, portions of the remaining work now have a lower risk profile, particularly with respect to security and logistics. Since we completed our first check estimate in the second quarter of 2006, the project has continued to estimate significant additional cost increases. We currently expect to recover these recently identified cost increases through change orders. As of December 31, 2006, we have recorded $43 million of unapproved change orders which primarily relate to these cost increases. Because of the civil unrest and security issues that currently exist in Nigeria, uncertainty regarding soil conditions at the property site and other matters, we could experience substantial additional cost increases on the Escravos project in the future. We believe that future cost increases attributed to civil unrest, security matters and potential differences in actual rather than anticipated soil conditions should ultimately be recoverable through future change orders pursuant to the terms of our contract as amended in 2006. However, should this occur, there could be timing differences between the recognition of cost and recognition of offsetting potential recoveries from our client, if any. We recorded an additional $9 million loss in the fourth quarter of 2006 related to non-billable engineering services for the Escravos joint venture. These services were in excess of the contractual limit of total engineering costs each partner can bill to the joint venture. As of December 31, 2006, the project was approximately 45% complete.
In the second quarter of 2006, we completed the sale of KBR’s Production Services group. Under the terms of the agreement, we received net proceeds of $265 million resulting in a pretax gain, net of post-closing adjustments, of $120 million. As a result of the sale agreement, Production Services operations and assets and liabilities have been classified as discontinued operations for all periods presented.
Government and Infrastructure segment. Our Government and Infrastructure segment provides support services to military and civilian branches of governments throughout the world, many of whom are increasing the use of outsourced service providers in order to focus on core functions and address budgetary constraints. The Government and Infrastructure segment’s most significant contract is the worldwide United States Army logistics contract, known as LogCAP III. We were awarded the competitively bid LogCAP III contract in December 2001 from the Army Materiel Command (AMC) to provide worldwide United States Army logistics services. The initial term of the contract was one-year, with nine one-year renewal options. We are currently in the fifth year of the contract.
In August 2006, we were awarded a $3.5 billion task order under our LogCAP III contract for additional work through 2007. Backlog related to the LogCAP III contract at December 31, 2006 was $3.0 billion. In 2006, Iraq-related work contributed $4.7 billion to consolidated revenue and $166 million to consolidated operating income, resulting in a 3.5% margin before corporate costs and taxes. We were awarded $120 million in LogCAP award fees during 2006 as a result of our performance rating. During the almost five-year period we have worked under the LogCAP III contract, we have been awarded 64 “excellent” ratings out of 76 total ratings. We expect to complete all open task orders under our LogCAP III contract during the third quarter of 2007.
In August 2006, the DoD issued a request for proposals on a new competitively bid, multiple service provider LogCAP IV contract to replace the current LogCAP III contract. We are currently the sole service provider under the LogCAP III contract and in October 2006, we submitted the final portion of our bid on the LogCAP IV contract. We expect that the contract will be awarded during the second quarter of 2007. Despite the award of the August 2006 task order under our LogCAP III contract, and the possibility of being awarded a portion of the LogCAP IV contract, we expect our overall volume of work to decline as our customer scales back the amount of services we provide. However, as a result of the recently announced surge of additional troops in Iraq, we expect the decline to occur more slowly than previously expected.
In addition, KBR was awarded the competitively bid Indefinite Delivery/Indefinite Quantity contract in the first quarter of 2006 to support the Department of Homeland Security’s U.S. Immigration and Customs Enforcement facilities in the event of an emergency. With a maximum total value of $385 million, this contract has a five-year term, consisting of a one-year base period and four one-year renewal options.
In the second quarter of 2006, a $13.9 billion private finance initiative contract was signed with the United Kingdom Ministry of Defence for the Allenby and Connaught project. This project is operated by a joint venture in which KBR has a 45% ownership interest. The project is for 35 years and consists of a nine-year construction

32


project to upgrade the British Army’s garrisons at Aldershot and the Salisbury Plain in the United Kingdom. The contract also includes provisions for additional services to be performed over the 35-year period, including catering, transportation, office services, and maintenance services.
In July 2006, we resumed work under the U.S. Army Europe Support Contract, which was originally awarded in 2005. Under this contract, we will continue to provide support services to U.S. forces deployed in the Balkans. In addition, we will provide camp operations and maintenance, and transportation and maintenance services in support of troops throughout the U.S. Army Europe’s area of responsibility, which includes over 90 countries.
We are also the majority owner of Devonport Management Limited (DML), the owner and operator of Western Europe’s largest naval dockyard complex. Our DML shipyard operations are primarily engaged in refueling nuclear submarines and performing maintenance on surface vessels for the MoD as well as limited commercial projects. We are engaging in discussions with the MoD regarding KBR’s ownership in DML and the possibility of reducing or disposing of our interest. Although no decision has been made with respect to a disposition or reduction of our interest in DML, we are supporting a process to identify potential bidders that may have an interest in acquiring our interest in DML. We do not know at this time if the process will result in a disposition or reduction of our interest in DML.
With respect to the Alice Springs-Darwin railroad project, KBR owns a 36.7% interest in a joint venture that is the holder of a 50-year concession contract with the Australian government to operate and maintain the railway. We account for this investment using the equity method of accounting in our Government and Infrastructure segment. This joint venture has sustained losses since commencing operations due to lower than anticipated freight volume and a slowdown in the planned expansion of the Port of Darwin. At the end of the first quarter of 2006, the joint venture’s revised financial forecast led us to record a $26 million impairment charge. In October 2006, the joint venture incurred an event of default under its loan agreement by failing to make an interest and principal payment. These loans are non-recourse to us. In light of the default, the joint venture’s need for additional financing, and the realization that the joint venture efforts to raise additional equity from third parties were not successful, we recorded an additional $32 million impairment charge in the third quarter of 2006. We will receive no tax benefit as this impairment charge is not deductible for Australian tax purposes. In December 2006, the senior lenders agreed to waive existing defaults and concede certain rights under the existing indenture. Among these were a reduction in the joint venture’s debt service reserve and the relinquishment of the right to receive principal payments for 27 months, through March 2009. In exchange for these concessions, the shareholders of the joint venture committed approximately $12 million of new subordinated financing, of which $6 million was committed by us. At December 31, 2006, our investment in this joint venture was $6 million. Our $6 million additional funding commitment was still outstanding.
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.
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.

33


RESULTS OF OPERATIONS IN 2006 COMPARED TO 2005

REVENUE:
         
Increase
 
Percentage
 
Millions of dollars
 
2006
 
2005
 
(Decrease)
 
Change
 
Production Optimization
 
$
5,360
 
$
3,990
 
$
1,370
   
34
%
Fluid Systems
   
3,598
   
2,838
   
760
   
27
 
Drilling and Formation Evaluation
   
3,221
   
2,552
   
669
   
26
 
Digital and Consulting Solutions
   
776
   
720
   
56
   
8
 
Total Energy Services Group
   
12,955
   
10,100
   
2,855
   
28
 
Energy and Chemicals
   
2,373
   
2,008
   
365
   
18
 
Government and Infrastructure
   
7,248
   
8,132
   
(884
)
 
(11
)
Total KBR
   
9,621
   
10,140
   
(519
)
 
(5
)
Total revenue
 
$
22,576
 
$
20,240
 
$
2,336
   
12
%
                           
Geographic - Energy Services Group segments only:
           
Production Optimization:
                         
North America
 
$
3,229
 
$
2,317
 
$
912
   
39
%
Latin America
   
410
   
349
   
61
   
17
 
Europe/Africa/CIS
   
1,027
   
802
   
225
   
28
 
Middle East/Asia
   
694
   
522
   
172
   
33
 
Subtotal
   
5,360
   
3,990
   
1,370
   
34
 
Fluid Systems:
                         
North America
   
1,871
   
1,424
   
447
   
31
 
Latin America
   
417
   
374
   
43
   
11
 
Europe/Africa/CIS
   
844
   
659
   
185
   
28
 
Middle East/Asia
   
466
   
381
   
85
   
22
 
Subtotal
   
3,598
   
2,838
   
760
   
27
 
Drilling and Formation Evaluation:
                         
North America
   
1,107
   
868
   
239
   
28
 
Latin America
   
474
   
400
   
74
   
19
 
Europe/Africa/CIS
   
744
   
619
   
125
   
20
 
Middle East/Asia
   
896
   
665
   
231
   
35
 
Subtotal
   
3,221
   
2,552
   
669
   
26
 
Digital and Consulting Solutions:
                         
North America
   
251
   
210
   
41
   
20
 
Latin America
   
213
   
221
   
(8
)
 
(4
)
Europe/Africa/CIS
   
183
   
168
   
15
   
9
 
Middle East/Asia
   
129
   
121
   
8
   
7
 
Subtotal
   
776
   
720
   
56
   
8
 
Total Energy Services Group revenue
                         
by region:
                         
North America
   
6,458
   
4,819
   
1,639
   
34
 
Latin America
   
1,514
   
1,344
   
170
   
13
 
Europe/Africa/CIS
   
2,798
   
2,248
   
550
   
24
 
Middle East/Asia
   
2,185
   
1,689
   
496
   
29
 
Total Energy Services Group revenue
 
$
12,955
 
$
10,100
 
$
2,855
   
28
%

34



OPERATING INCOME (LOSS):
         
Increase
 
Percentage
 
Millions of dollars
 
2006
 
2005
 
(Decrease)
 
Change
 
Production Optimization
 
$
1,530
 
$
1,053
 
$
477
   
45
%
Fluid Systems
   
795
   
544
   
251
   
46
 
Drilling and Formation Evaluation
   
818
   
536
   
282
   
53
 
Digital and Consulting Solutions
   
240
   
146
   
94
   
64
 
Total Energy Services Group
   
3,383
   
2,279
   
1,104
   
48
 
Energy and Chemicals
   
37
   
124
   
(87
)
 
(70
)
Government and Infrastructure
   
202
   
329
   
(127
)
 
(39
)
Total KBR
   
239
   
453
   
(214
)
 
(47
)
General corporate
   
(138
)
 
(115
)
 
(23
)
 
(20
)
Total operating income
 
$
3,484
 
$
2,617
 
$
867
   
33
%
                           
Geographic - Energy Services Group segments only:
           
Production Optimization:
                         
North America
 
$
1,059
 
$
759
 
$
300
   
40
%
Latin America
   
85
   
59
   
26
   
44
 
Europe/Africa/CIS
   
230
   
128
   
102
   
80
 
Middle East/Asia
   
156
   
107
   
49
   
46
 
Subtotal
   
1,530
   
1,053
   
477
   
45
 
Fluid Systems:
                         
North America
   
515
   
332
   
183
   
55
 
Latin America
   
70
   
58
   
12
   
21
 
Europe/Africa/CIS
   
127
   
103
   
24
   
23
 
Middle East/Asia
   
83
   
51
   
32
   
63
 
Subtotal
   
795
   
544
   
251
   
46
 
Drilling and Formation Evaluation:
                         
North America
   
333
   
223
   
110
   
49
 
Latin America
   
90
   
58
   
32
   
55
 
Europe/Africa/CIS
   
154
   
110
   
44
   
40
 
Middle East/Asia
   
241
   
145
   
96
   
66
 
Subtotal
   
818
   
536
   
282
   
53
 
Digital and Consulting Solutions:
                         
North America
   
126
   
62
   
64
   
103
 
Latin America
   
44
   
17
   
27
   
159
 
Europe/Africa/CIS
   
44
   
46
   
(2
)
 
(4
)
Middle East/Asia
   
26
   
21
   
5
   
24
 
Subtotal
   
240
   
146
   
94
   
64
 
Total Energy Services Group
                         
operating income by region:
                         
North America
   
2,033
   
1,376
   
657
   
48
 
Latin America
   
289
   
192
   
97
   
51
 
Europe/Africa/CIS
   
555
   
387
   
168
   
43
 
Middle East/Asia
   
506
   
324
   
182
   
56
 
Total Energy Services Group
                         
operating income
 
$
3,383
 
$
2,279
 
$
1,104
   
48
%

35


Note 1 -      All periods presented reflect the reclassification of KBR’s Production Services operations to discontinued operations, as well as the reorganization of tubing conveyed perforating, slickline, and underbalanced applications operations from Production Optimization into the Drilling and Formation Evaluation segment.

The increase in consolidated revenue in 2006 compared to 2005 was attributable to increased revenue from our Energy Services Group, predominantly resulting from increased activity, higher utilization of our equipment, and increased pricing due to higher exploration and production spending by our customers. This was partially offset by reduced activity in our Government and Infrastructure segment, primarily in the Middle East. Revenue in 2005 was impacted by an estimated $80 million in lost revenue due to Gulf of Mexico hurricanes. International revenue was 68% of consolidated revenue in 2006 and 72% of consolidated revenue in 2005. Revenue from the United States Government for all geographic areas was approximately $5.8 billion or 26% of consolidated revenue in 2006, compared to $6.6 billion or 32% of consolidated revenue in 2005.
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 declined primarily due to a $157 million loss recorded on the Escravos, Nigeria GTL project and reduced activity on government services projects, particularly in the Middle East. ESG operating income for 2006 included a $48 million gain on the sale of lift boats in west Africa and the North Sea and $47 million of insurance proceeds for business interruptions resulting from the 2005 Gulf of Mexico hurricanes. Operating income in 2005 was adversely impacted by an estimated $50 million due to Gulf of Mexico hurricanes, $45 million of which related to ESG and $5 million of which related to KBR.
In 2006, Iraq-related work contributed approximately $4.7 billion to consolidated revenue and $166 million to consolidated operating income, a 3.5% 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 2005 was derived from all regions. Production enhancement services revenue grew 36%, with improvements in all regions, largely driven by United States onshore operations due to strong demand for stimulation services, coupled with improved equipment utilization and pricing. Also contributing to production enhancement services revenue growth were improved pricing and equipment utilization in Canada, increased activity in Europe, and a new contract in Oman. Revenue from sales of completion tools increased 31% compared to 2005, with improvements in all regions, benefiting from improved completions and perforating sales in the United States and recovery of Gulf of Mexico activity. Additionally impacting the increase in sales of completion tools was the addition of Easywell to the completion tool portfolio in Europe and Asia and increased activity in Asia for WellDynamics. International revenue was 44% of total segment revenue in 2006 compared to 47% in 2005.
The Production Optimization segment operating income improvement spanned all regions. Production enhancement services operating income increased 59% largely due to improved product mix in the United States and Asia. A 41% improvement in completion tools operating income primarily resulted from increased sales in Asia and increased sand control tools activity in Brazil. Partially offsetting the improvements in completion tools was decreased activity in the Middle East for WellDynamics. The 2006 segment operating income was positively impacted by a $48 million gain on the sale of lift boats in west Africa and the North Sea. The Production Optimization segment received hurricane insurance proceeds of $12 million in 2006. The 2005 segment operating income included a $110 million gain on the sale in 2005 of our equity interest in the Subsea 7, Inc. joint venture and was negatively impacted by hurricanes in the Gulf of Mexico by an estimated $14 million.
Fluid Systems revenue increase compared to 2005 was driven by 27% growth in Baroid Fluid Services revenue and 26% growth in cementing services revenue. Both service lines increased primarily in the United States from improved pricing and increased activity. Baroid Fluid Services improvements spanned all regions with increased operations in Venezuela and Russia, new contracts in Norway and Nigeria, and increased activity in Angola and Sakhalin. The expiration of a contract in Indonesia partially offset Baroid Fluid Services revenue increase. Sales of cementing services also improved due to increased activity in Russia, the North Sea, and Nigeria, improved pricing and sales in Angola, and new contract start-ups and product sales in Asia Pacific. Partially offsetting the cementing services revenue increase was decreased activity in Mexico. International revenue was 52% of total segment revenue in 2006 compared to 55% in 2005.

36


Fluid Systems segment operating income increase compared to 2005 resulted from 54% growth from Baroid Fluid Services and 43% 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 in Asia. Cementing services results increased predominantly in the United States due to increased activity and new contracts along with increased activity in Europe. The Fluid Systems segment received hurricane insurance proceeds of $31 million in 2006, and was negatively impacted by an estimated $25 million in 2005 from hurricanes in the Gulf of Mexico.
Drilling and Formation Evaluation revenue increase in 2006 compared to 2005 was derived from all four regions in all product service lines. The segment improvement was led by a 27% increase in drilling services revenue, particularly in the United States due to improved pricing and increased drilling activity. Increased international activity and new contract start-ups contributed to other region revenue increases, especially evident in Asia and Europe. Drill bits revenue increased 26% compared to 2005, largely benefiting from increased rig counts, improved pricing, and increased sales of fixed cutter bits in the United States and increased drilling activity in the Middle East and Asia. Wireline and perforating services revenue grew 25% primarily due to increased activity and improved pricing in the United States land, new contract awards and increased cased hole activity in Asia, improved pricing in Latin America, and new contracts in the Middle East. Lower sales of logging equipment to Asia in 2006 partially offset the wireline and perforating services revenue improvement. International revenue was 71% of total segment revenue in 2006 compared to 72% in 2005.
Drilling and Formation Evaluation operating income increase compared to 2005 spanned all geographic regions in all product service lines, with the United States as the predominant contributor due to improved pricing and increased rig activity. Drilling services operating income increased 66% from 2005 on increased activity and new contracts in Europe and Asia. Drill bits operating income increased 15% compared to 2005, the majority of which occurred in the Middle East and Asia. Wireline and perforating services results grew 50%, additionally benefiting from higher activity in the Middle East and Asia along with improved product mix in Latin America. Operating income in 2005 included a $24 million gain related to a patent infringement case settlement, while hurricanes in the Gulf of Mexico negatively impacted segment operating income by an estimated $6 million.
Digital and Consulting Solutions revenue increase in 2006 was driven by Landmark, with 17% revenue growth spanning all four regions, largely due to increased consulting services and software sales in Latin America and the United States. Project management revenue decreased 11% in 2006 due to the completion of two fixed-price integrated solutions projects in southern Mexico. International revenue was 70% of total segment revenue in 2006 compared to 73% in 2005.
Digital and Consulting Solutions operating income improved both at Landmark where operating income increased 59% due to stronger software and service sales, and project management where results tripled. The 2006 segment results included a gain of $10 million from the sale of an investment accounted for under the cost method and operating income of $12 million from earnings on an equity method investment. Included in 2005 segment results was $23 million in losses on two fixed-priced integrated solutions projects in Mexico and a $17 million favorable insurance settlement related to a pipe fabrication and laying project in the North Sea.
Energy and Chemicals revenue for 2006 increased $365 million compared to 2005. The increase is due to the start-up of several projects awarded in 2005 or early 2006, including the front-end engineering and design work performed on the Pearl project and revenue earned on the Escravos GTL project, which increased $452 million. In addition, revenue from gas monetization projects in Yemen and Algeria increased $109 million. These increases were offset by a $246 million decrease in revenue from a crude oil project in Canada.
Operating income for 2006 was $37 million compared to $124 million in 2005. The decrease is primarily due to a $157 million charge on the Escravos, Nigeria GTL project in 2006. The charge was primarily due to increases in the overall estimated cost to complete the project. The project has experienced delays relating to civil unrest and security on the Escravos River, near the project site. Also negatively impacting operating income were a charge on the Barracuda-Caratinga project and a decrease in operating income from the Belanak project totaling $30 million. The decrease was partially offset by a $60 million increase in operating income from an ammonia project in Egypt and a gas development project in Algeria. In addition, we recorded $50 million of charges in 2005 related to an investment in an unconsolidated Algerian joint venture.

37


Government and Infrastructure revenue for 2006 totaled $7.2 billion, an $884 million decrease compared to 2005. This decrease was primarily due to a $698 million decrease in revenue from Iraq-related activities, a $151 million decrease in revenue related to hurricane repair efforts for United States naval facilities under the CONCAP III contract, and $58 million of impairment charges related to an equity investment in an Australian railroad operation.
Operating income for 2006 was $202 million compared to $329 million in 2005, a $127 million decrease. The 2006 results were also negatively impacted by $58 million in impairment charges recorded on an equity investment in an Australian railroad operation and a $17 million impairment charge and loss recorded on an equity investment in a joint venture road project in the United Kingdom. These decreases were partially offset by a $24 million increase in operating income from DML shipyard operations. The 2005 results include $96 million in operating income from the sale of and one-time cash distribution from an interest in a United States toll road.
General corporate expenses were $138 million in 2006 compared to $115 million in 2005. The increase was primarily due to increased legal costs and costs incurred for the separation of KBR from Halliburton.

NONOPERATING ITEMS

Interest expense decreased $32 million in 2006 compared to 2005, primarily due to the redemption in April 2005 of $500 million of our floating rate senior notes, the repayment in October 2005 of $300 million of our floating rate senior notes, and the repayment in August 2006 of $275 million of our medium-term notes.
Interest income increased $98 million in 2006 compared to 2005 due to higher cash investment balances.
Foreign currency losses, net grew to $22 million in 2006 from $13 million in 2005. The increase was primarily due to the impact of United States dollar proceeds from the sale of Production Services that were received by our United Kingdom-based subsidiary, which uses British sterling as its functional currency.
Other, net increased $14 million in 2006 compared to 2005. The 2005 year included costs related to our ESG accounts receivable securitization facility and sales of our United States government accounts receivable, neither of which had any outstanding amounts in 2006.
Provision for income taxes from continuing operations in 2006 of $1.1 billion resulted in an effective tax rate of 33%. The lower tax rate of 3% for 2005 resulted from recording favorable adjustments in 2005 totaling $805 million to our valuation allowance against the deferred tax asset related to asbestos and silica liabilities. Our strong 2005 earnings, coupled with an upward revision in our estimate of future domestic taxable income in 2006, drove these adjustments. We expect our 2007 tax rate to be approximately 35%.
Minority interest in net income of subsidiaries decreased $23 million compared to 2005 primarily due to the loss from the consolidated 50%-owned GTL project in Escravos, Nigeria. This is partially offset by earnings growth in our DML Shipyard, M.W. Kellogg Ltd., and our Pearl GTL project and an immaterial amount related to approximately 19% of KBR, Inc. sold in the IPO in November 2006.
Income (loss) from discontinued operations, net of tax in 2006 included a $120 million pretax gain on the sale of KBR’s Production Services group and $14 million of pretax income related to Production Services operations, partially offset by a $13 million legal settlement. Income from discontinued operations in 2005 primarily consisted of $45 million of pretax income related to Production Services operations.

38


RESULTS OF OPERATIONS IN 2005 COMPARED TO 2004

REVENUE:
         
Increase
 
Percentage
 
Millions of dollars
 
2005
 
2004
 
(Decrease)
 
Change
 
Production Optimization
 
$
3,990
 
$
3,047
 
$
943
   
31
%
Fluid Systems
   
2,838
   
2,324
   
514
   
22
 
Drilling and Formation Evaluation
   
2,552
   
2,038
   
514
   
25
 
Digital and Consulting Solutions
   
720
   
589
   
131
   
22
 
Total Energy Services Group
   
10,100
   
7,998
   
2,102
   
26
 
Energy and Chemicals
   
2,008
   
2,490
   
(482
)
 
(19
)
Government and Infrastructure
   
8,132
   
9,390
   
(1,258
)
 
(13
)
Total KBR
   
10,140
   
11,880
   
(1,740
)
 
(15
)
Total revenue
 
$
20,240
 
$
19,878
 
$
362
   
2
%
                           
Geographic - Energy Services Group segments only:
           
Production Optimization:
                         
North America
 
$
2,317
 
$
1,626
 
$
691
   
42
%
Latin America
   
349
   
315
   
34
   
11
 
Europe/Africa/CIS
   
802
   
710
   
92
   
13
 
Middle East/Asia
   
522
   
396
   
126
   
32
 
Subtotal
   
3,990
   
3,047
   
943
   
31
 
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
   
868
   
678
   
190
   
28
 
Latin America
   
400
   
301
   
99
   
33
 
Europe/Africa/CIS
   
619
   
504
   
115
   
23
 
Middle East/Asia
   
665
   
555
   
110
   
20
 
Subtotal
   
2,552
   
2,038
   
514
   
25
 
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
%

39



OPERATING INCOME (LOSS):
         
Increase
 
Percentage
 
Millions of dollars
 
2005
 
2004
 
(Decrease)
 
Change
 
Production Optimization
 
$
1,053
 
$
588
 
$
465
   
79
%
Fluid Systems
   
544
   
348
   
196
   
56
 
Drilling and Formation Evaluation
   
536
   
270
   
266
   
99
 
Digital and Consulting Solutions
   
146
   
60
   
86
   
143
 
Total Energy Services Group
   
2,279
   
1,266
   
1,013
   
80
 
Energy and Chemicals
   
124
   
(443
)
 
567
   
NM
 
Government and Infrastructure
   
329
   
84
   
245
   
292
 
Total KBR
   
453
   
(359
)
 
812
   
NM
 
General corporate
   
(115
)
 
(87
)
 
(28
)
 
(32
)
Total operating income (loss)
 
$
2,617
 
$
820
 
$
1,797
   
219