September 30, 2005 Form 10-Q Final
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q


[X] Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the quarterly period ended September 30, 2005

OR

[ ] Transition Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the transition period from _____ to _____



Commission File Number 1-3492



HALLIBURTON COMPANY


(a Delaware Corporation)
75-2677995

5 Houston Center
1401 McKinney, Suite 2400
Houston, Texas 77010
(Address of Principal Executive Offices)

Telephone Number - Area Code (713) 759-2600

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 at least the past 90 days.
Yes   X       No  ____

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ____  No       X   

As of October 24, 2005, 512,840,219 shares of Halliburton Company common stock, $2.50 par value per share, were outstanding.







HALLIBURTON COMPANY

Index

   
Page No.
PART I.
FINANCIAL INFORMATION
 
     
Item 1.
Financial Statements
3-25
     
 
- Condensed Consolidated Statements of Operations
 3
 
- Condensed Consolidated Balance Sheets
 4
 
- Condensed Consolidated Statements of Cash Flows
 5
 
- Notes to Condensed Consolidated Financial Statements
6-25
     
Item 2.
Management’s Discussion and Analysis of Financial Condition and
 
 
Results of Operations
 26-64
     
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
  65
     
Item 4.
Controls and Procedures
  65
     
PART II.
OTHER INFORMATION
 
     
Item 1.
Legal Proceedings
  66
     
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
  66
     
Item 3.
Defaults Upon Senior Securities
  66
     
Item 4.
Submission of Matters to a Vote of Security Holders
  66
     
Item 5.
Other Information
  66
     
Item 6.
Exhibits
  67
     
Signatures
 
  68

2


PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
HALLIBURTON COMPANY
Condensed Consolidated Statements of Operations
(Unaudited)

   
Three Months Ended
 
Nine Months Ended
 
   
September 30
 
September 30
 
(Millions of dollars and shares except per share data)
 
2005
 
2004
 
2005
 
2004
 
Revenue:
                         
Services
 
$
4,496
 
$
4,264
 
$
13,354
 
$
13,748
 
Product sales
   
648
   
531
   
1,861
   
1,537
 
Equity in earnings (losses) of unconsolidated affiliates, net
   
(49
)
 
(5
)
 
(19
)
 
(20
)
Total revenue
   
5,095
   
4,790
   
15,196
   
15,265
 
Operating costs and expenses:
                         
Cost of services
   
3,857
   
3,926
   
11,666
   
13,163
 
Cost of sales
   
544
   
465
   
1,558
   
1,380
 
General and administrative
   
89
   
97
   
286
   
271
 
Gain on sale of business assets, net
   
(85
)
 
(40
)
 
(197
)
 
(40
)
Total operating costs and expenses
   
4,405
   
4,448
   
13,313
   
14,774
 
Operating income
   
690
   
342
   
1,883
   
491
 
Interest expense
   
(51
)
 
(51
)
 
(154
)
 
(160
)
Interest income
   
17
   
13
   
38
   
30
 
Foreign currency gains (losses), net
   
(2
)
 
1
   
(9
)
 
(9
)
Other, net
   
(2
)
 
(2
)
 
(7
)
 
2
 
Income from continuing operations before income taxes
                         
and minority interest
   
652
   
303
   
1,751
   
354
 
Provision for income taxes
   
(132
)
 
(111
)
 
(455
)
 
(131
)
Minority interest in net income of subsidiaries
   
(21
)
 
(6
)
 
(39
)
 
(19
)
Income from continuing operations
   
499
   
186
   
1,257
   
204
 
Loss from discontinued operations, net of tax (provision)
                         
benefit of $0, $72, $0, and $218
   
-
   
(230
)
 
(1
)
 
(980
)
Net income (loss)
 
$
499
 
$
(44
)
$
1,256
 
$
(776
)
Basic income (loss) per share:
                         
Income from continuing operations
 
$
0.99
 
$
0.43
 
$
2.50
 
$
0.47
 
Loss from discontinued operations, net
   
-
   
(0.54
)
 
-
   
(2.25
)
Net income (loss)
 
$
0.99
 
$
(0.11
)
$
2.50
 
$
(1.78
)
Diluted income (loss) per share:
                         
Income from continuing operations
 
$
0.95
 
$
0.42
 
$
2.44
 
$
0.46
 
Loss from discontinued operations, net
   
-
   
(0.51
)
 
-
   
(2.22
)
Net income (loss)
 
$
0.95
 
$
(0.09
)
$
2.44
 
$
(1.76
)
                           
Cash dividends per share
 
$
0.125
 
$
0.125
 
$
0.375
 
$
0.375
 
Basic weighted average common shares outstanding
   
506
   
438
   
503
   
437
 
Diluted weighted average common shares outstanding
   
525
   
442
   
516
   
441
 
See notes to condensed consolidated financial statements.

3


HALLIBURTON COMPANY
Condensed Consolidated Balance Sheets
(Unaudited)
   
September 30,
 
December 31,
 
(Millions of dollars and shares except per share data)
 
2005
 
2004
 
Assets
 
Current assets:
             
Cash and equivalents
 
$
2,124
 
$
1,917
 
Investments in marketable securities
   
-
   
891
 
Receivables:
             
Notes and accounts receivable (less allowance for bad debts of $88 and $127)
   
2,853
   
2,873
 
Unbilled work on uncompleted contracts
   
1,320
   
1,812
 
Insurance for asbestos- and silica-related liabilities
   
193
   
1,066
 
Total receivables
   
4,366
   
5,751
 
Inventories
   
962
   
791
 
Current deferred income taxes
   
429
   
301
 
Other current assets
   
610
   
379
 
Total current assets
   
8,491
   
10,030
 
Property, plant, and equipment, net of accumulated depreciation of $3,784 and $3,674
   
2,602
   
2,553
 
Goodwill
   
739
   
795
 
Noncurrent deferred income taxes
   
511
   
780
 
Equity in and advances to related companies
   
358
   
541
 
Insurance for asbestos- and silica-related liabilities
   
201
   
350
 
Other assets
   
793
   
815
 
Total assets
 
$
13,695
 
$
15,864
 
Liabilities and Shareholders’ Equity
Current liabilities:
             
Accounts payable
 
$
1,714
 
$
2,339
 
Current maturities of long-term debt
   
651
   
347
 
Advanced billings on uncompleted contracts
   
603
   
553
 
Accrued employee compensation and benefits
   
473
   
473
 
Short-term notes payable
   
35
   
15
 
Asbestos- and silica-related liabilities
   
-
   
2,408
 
Other current liabilities
   
756
   
997
 
Total current liabilities
   
4,232
   
7,132
 
Long-term debt
   
2,821
   
3,593
 
Employee compensation and benefits
   
638
   
635
 
Other liabilities
   
524
   
464
 
Total liabilities
   
8,215
   
11,824
 
Minority interest in consolidated subsidiaries
   
133
   
108
 
Shareholders’ equity:
             
Common shares, par value $2.50 per share - authorized 1,000 shares, issued 526 and 458 shares
   
1,315
   
1,146
 
Paid-in capital in excess of par value
   
2,764
   
277
 
Common shares to be contributed to asbestos trust - 59.5 shares
   
-
   
2,335
 
Deferred compensation
   
(95
)
 
(74
)
Accumulated other comprehensive income
   
(194
)
 
(146
)
Retained earnings
   
1,937
   
871
 
     
5,727
   
4,409
 
Less 13 and 16 shares of treasury stock, at cost
   
380
   
477
 
Total shareholders’ equity
   
5,347
   
3,932
 
Total liabilities and shareholders’ equity
 
$
13,695
 
$
15,864
 
See notes to condensed consolidated financial statements.

4


HALLIBURTON COMPANY
Condensed Consolidated Statements of Cash Flows
(Unaudited)
   
Nine Months Ended
 
   
September 30
 
(Millions of dollars)
 
2005
 
2004
 
Cash flows from operating activities:
             
Net income (loss)
 
$
1,256
 
$
(776
)
Adjustments to reconcile net income (loss) to net cash from operations:
             
Loss from discontinued operations
   
1
   
980
 
Depreciation, depletion, and amortization
   
377
   
374
 
Provision (benefit) for deferred income taxes, including $0 and $(163) related to
             
discontinued operations
   
209
   
(200
)
Distribution from (advances to) related companies, net of equity in (earnings) losses
   
59
   
(39
)
Gain on sale of assets
   
(195
)
 
(47
)
Asbestos and silica liability payments related to Chapter 11 filing
   
(2,345
)
 
-
 
Collection of asbestos- and silica-related receivables
   
1,030
   
-
 
Other changes:
             
Receivables and unbilled work on uncompleted contracts
   
614
   
(252
)
Accounts receivable facilities transactions
   
(263
)
 
458
 
Inventories
   
(172
)
 
(54
)
Accounts payable
   
(570
)
 
593
 
Restricted cash related to Chapter 11 proceedings
   
4
   
(107
)
Other
   
(116
)
 
47
 
Total cash flows from operating activities
   
(111
)
 
977
 
Cash flows from investing activities:
             
Capital expenditures
   
(474
)
 
(422
)
Sales of property, plant, and equipment
   
91
   
101
 
Dispositions (acquisitions) of business assets, net of cash disposed
   
275
   
102
 
Proceeds from sales of securities
   
15
   
21
 
Sales (purchases) of short-term investments in marketable securities, net
   
891
   
(1,462
)
Investments - restricted cash
   
1
   
88
 
Other investing activities
   
(27
)
 
(24
)
Total cash flows from investing activities
   
772
   
(1,596
)
Cash flows from financing activities:
             
Proceeds from long-term debt, net of offering costs
   
12
   
496
 
Proceeds from exercises of stock options
   
303
   
48
 
Payments to reacquire common stock
   
(10
)
 
(6
)
Borrowings (repayments) of short-term debt, net
   
(9
)
 
(7
)
Payments of long-term debt
   
(546
)
 
(16
)
Payments of dividends to shareholders
   
(190
)
 
(165
)
Other financing activities
   
(5
)
 
(4
)
Total cash flows from financing activities
   
(445
)
 
346
 
Effect of exchange rate changes on cash
   
(9
)
 
(8
)
Increase (decrease) in cash and equivalents
   
207
   
(281
)
Cash and equivalents at beginning of period
   
1,917
   
1,104
 
Cash and equivalents at end of period
 
$
2,124
 
$
823
 
Supplemental disclosure of cash flow information:
             
Cash payments during the period for:
             
Interest
 
$
172
 
$
136
 
Income taxes
 
$
218
 
$
190
 
See notes to condensed consolidated financial statements.

5


HALLIBURTON COMPANY
Notes to Condensed Consolidated Financial Statements
(Unaudited)

Note 1. Basis of Presentation
The accompanying unaudited condensed consolidated financial statements were prepared using generally accepted accounting principles for interim financial information and the instructions to Form 10-Q and Regulation S-X. Accordingly, these financial statements do not include all information or footnotes required by generally accepted accounting principles for annual financial statements and should be read together with our 2004 Annual Report on Form 10-K.
Certain prior period amounts have been reclassified to be consistent with the current presentation.
Our accounting policies are in accordance with generally accepted accounting principles in the United States of America. The preparation of financial statements in conformity with these accounting principles requires us to make estimates and assumptions that affect:
 
-
the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements; and
 
-
the reported amounts of revenue and expenses during the reporting period.
Ultimate results could differ from our estimates.
In our opinion, the condensed consolidated financial statements included herein contain all adjustments necessary to present fairly our financial position as of September 30, 2005, the results of our operations for the three and nine months ended September 30, 2005 and 2004, and our cash flows for the nine months ended September 30, 2005 and 2004. Such adjustments are of a normal recurring nature. The results of operations for the three and nine months ended September 30, 2005 and 2004 may not be indicative of results for the full year.

Note 2. Percentage-of-Completion Contracts
Unapproved claims
The amounts of unapproved claims included in determining the profit or loss on contracts and the amounts booked to “Unbilled work on uncompleted contracts” or “Other assets” as of September 30, 2005 and December 31, 2004 are as follows:

   
September 30,
 
December 31,
 
Millions of dollars
 
2005
 
2004
 
Probable unapproved claims
 
$
177
 
$
182
 
Probable unapproved claims accrued revenue
   
174
   
182
 
Probable unapproved claims from unconsolidated
             
related companies
   
78
   
51
 

The probable unapproved claims, including unconsolidated related companies, as of September 30, 2005, relate to five contracts, most of which are complete or substantially complete. See Note 12 for a discussion of government contract claims, which are not included in the table above.
A significant portion of the probable unapproved claims as of September 30, 2005 ($151 million related to our consolidated entities and $45 million related to our unconsolidated related companies) arose from three completed projects with Petroleos Mexicanos (PEMEX) that are currently subject to arbitration proceedings. In addition, we have “Other assets” of $64 million for previously approved services that are unpaid by PEMEX and have been included in these arbitration proceedings. Actual amounts we are seeking from PEMEX in the arbitration proceedings are in excess of these amounts. The arbitration proceedings are expected to extend through 2007. PEMEX has asserted unspecified counterclaims in each of the three arbitrations; however, it is premature based upon our current understanding of those counterclaims to make any assessment of their merits. As of September 30, 2005, we had not accrued any amounts related to the counterclaims in the arbitrations.

6


We have contracts with probable unapproved claims that will likely not be settled within one year totaling $174 million at September 30, 2005 and $153 million at December 31, 2004 included in the table above, which are reflected as “Other assets” on the condensed consolidated balance sheets. Other probable unapproved claims that we believe will be settled within one year, included in the table above, have been recorded to “Unbilled work on uncompleted contracts” on the condensed consolidated balance sheets. Our unconsolidated related companies include probable unapproved claims as revenue to determine the amount of profit or loss for their contracts. Probable unapproved claims from our related companies are included in “Equity in and advances to related companies.”
Unapproved change orders
We have other contracts for which we are negotiating change orders to the contract scope and have agreed upon the scope of work but not the price. These change orders amount to $59 million at September 30, 2005. Unapproved change orders at December 31, 2004 were $43 million. Our share of change orders from unconsolidated related companies totaled $27 million at September 30, 2005 and $37 million at December 31, 2004.
Barracuda-Caratinga project
Following is the status, as of September 30, 2005, of our Barracuda-Caratinga project, a multiyear construction project to develop the Barracuda and Caratinga crude oilfields located off the coast of Brazil:
 
-
the project was approximately 98% complete;
 
-
to date, we have recorded losses of $762 million reflecting cash shortfalls incurred and anticipated through completion of the project, of which $407 million was recorded in 2004 ($310 million during the second quarter of 2004, and $97 million during the first quarter of 2004), $238 million was recorded in 2003, and $117 million was recorded in 2002;
 
-
the losses recorded include $22 million in liquidated damages paid in 2004 based on the final agreement with Petrobras;
 
-
the $300 million of advance payments received from our customer have been completely repaid; and
 
-
we have received $138 million related to approved change orders.
The Barracuda and Caratinga vessels are each producing oil and gas, and we are currently working to complete construction-related items and to complete the contractually specified Lenders’ Reliability Test, which started in September 2005 for both vessels. In addition, at Petrobras’ direction, we have replaced certain bolts located on the subsea flow-lines that have failed and that were identified by Petrobras when it conducted inspections of the bolts. The original design specification for the bolts was issued by Petrobras, and as such, we believe the cost resulting from any replacements is not our responsibility. Petrobras has indicated, however, that they do not agree with our conclusion. Discussions with Petrobras remain ongoing.
We continue to fund operating cash shortfalls on this project and estimate that we will pay approximately $28 million during the remainder of 2005, which represents remaining project costs, net of revenue to be received.

Note 3. Dispositions
Dulles Greenway Toll Road
As part of our infrastructure projects, we occasionally take an ownership interest in the constructed asset, with a view toward monetization of that ownership interest after the asset has been operating for some period and increases in value. In September 2005, we sold our 13% interest in a joint venture that owned the Dulles Greenway Toll Road in Virginia. We received $85 million in cash from the sale. Because of unfavorable early projections of traffic to support the toll road after it had opened, we wrote down our investment in the toll road in 1996. At the time of the sale, our investment had a net book value of zero, and therefore, we recorded the entire $85 million to operating income in our Government and Infrastructure segment.

7


Subsea 7, Inc.
In January 2005, we completed the sale of our 50% interest in Subsea 7, Inc. to our joint venture partner, Siem Offshore (currently Subsea 7, Inc.), for $203 million in cash. As a result of the transaction, we recorded a gain of approximately $110 million during the first quarter of 2005. Prior to the sale, we accounted for our 50% ownership of Subsea 7, Inc. using the equity method in our Production Optimization segment.
Surface Well Testing
In August 2004, we sold our surface well testing and subsea test tree operations within our Production Optimization segment to Power Well Service Holdings, LLC, an affiliate of First Reserve Corporation, for approximately $129 million, of which we received $126 million in cash. In the third quarter of 2004, we recorded a $40 million gain on the sale. However, we continued to have significant involvement with portions of these operations in certain countries for a limited period of time and, therefore, did not recognize all the gain from the sale as of September 30, 2004. We recorded an additional $14 million of the remaining gain in the fourth quarter of 2004.

Note 4. Business Segment Information
Our six business segments are organized around how we manage the business: Production Optimization, Fluid Systems, Drilling and Formation Evaluation, Digital and Consulting Solutions, Government and Infrastructure, and Energy and Chemicals segments.
We refer to the combination of Production Optimization, Fluid Systems, Drilling and Formation Evaluation, and Digital and Consulting Solutions segments as the Energy Services Group and the combination of our Government and Infrastructure and Energy and Chemicals segments as KBR.
The table below presents information on our segments.

   
Three Months Ended
 
Nine Months Ended
 
   
September 30
 
September 30
 
Millions of dollars
 
2005
 
2004
 
2005
 
2004
 
Revenue:
                         
Production Optimization
 
$
1,107
 
$
886
 
$
3,053
 
$
2,391
 
Fluid Systems
   
731
   
618
   
2,061
   
1,707
 
Drilling and Formation Evaluation
   
588
   
450
   
1,643
   
1,317
 
Digital and Consulting Solutions
   
171
   
154
   
495
   
413
 
Total Energy Services Group
   
2,597
   
2,108
   
7,252
   
5,828
 
Government and Infrastructure
   
1,884
   
1,993
   
6,014
   
7,098
 
Energy and Chemicals
   
614
   
689
   
1,930
   
2,339
 
Total KBR
   
2,498
   
2,682
   
7,944
   
9,437
 
Total revenue
 
$
5,095
 
$
4,790
 
$
15,196
 
$
15,265
 
Operating income (loss):
                         
Production Optimization
 
$
263
 
$
222
 
$
799
 
$
425
 
Fluid Systems
   
139
   
113
   
387
   
250
 
Drilling and Formation Evaluation
   
129
   
62
   
335
   
164
 
Digital and Consulting Solutions
   
35
   
17
   
80
   
60
 
Total Energy Services Group
   
566
   
414
   
1,601
   
899
 
Government and Infrastructure
   
149
   
(6
)
 
275
   
75
 
Energy and Chemicals
   
1
   
(44
)
 
102
   
(417
)
Total KBR
   
150
   
(50
)
 
377
   
(342
)
General corporate
   
(26
)
 
(22
)
 
(95
)
 
(66
)
Total operating income
 
$
690
 
$
342
 
$
1,883
 
$
491
 

Intersegment revenue was immaterial. Our equity in pretax earnings and losses of unconsolidated affiliates that are accounted for on the equity method is included in revenue and operating income of the applicable segment.

8


Total revenue for the three and nine months ended September 30, 2005 included $1.5 billion and $4.8 billion or 29% and 32% of consolidated revenue from the United States Government, which was derived almost entirely by the Government and Infrastructure segment. Revenue from the United States Government during the three and nine months ended September 30, 2004 represented 34% and 40% of consolidated revenue. No other customer represented more than 10% of consolidated revenue in any period presented.

Note 5. Receivables (Other than “Insurance for asbestos- and silica- related liabilities”)
In April 2005, the term of our Energy Services Group accounts receivable securitization facility was extended to April 2006. We have the ability to sell up to $300 million in undivided ownership interest in the pool of receivables under this facility. As of both September 30, 2005 and December 31, 2004, $256 million of undivided ownership interest had been sold to unaffiliated companies.
In May 2004, we entered into an agreement under which we can sell, assign, and transfer the entire title and interest in specified United States government accounts receivable of KBR to a third party. The face value of the receivables sold to the third party is reflected as a reduction of accounts receivable in our condensed consolidated balance sheets. The amount of receivables that can be sold under the agreement varies based on the amount of eligible receivables at any given time and other factors, and the maximum amount that may be sold and outstanding under this agreement at any given time is $650 million. The total amount of receivables outstanding under this agreement was zero as of September 30, 2005 and approximately $263 million as of December 31, 2004.

Note 6. Inventories
Inventories are stated at the lower of cost or market. We manufacture in the United States finished products and parts inventories for drill bits, completion products, bulk materials, and other tools that are recorded using the last-in, first-out method totaling $45 million at September 30, 2005 and $37 million at December 31, 2004. If the average cost method had been used, total inventories would have been $21 million higher than reported at September 30, 2005 and $17 million higher than reported at December 31, 2004. Inventories consisted of the following:

Millions of dollars
 
September 30, 2005
 
December 31, 2004
 
Finished products and parts
 
$
708
 
$
602
 
Raw materials and supplies
   
191
   
156
 
Work in process
   
63
   
33
 
Total
 
$
962
 
$
791
 

Finished products and parts are reported net of obsolescence accruals of $110 million at September 30, 2005 and $119 million at December 31, 2004.

Note 7. Investments
Investments in marketable securities
Our investments in marketable securities are reported at fair value. At December 31, 2004, our investments in marketable securities consisted of auction rate securities classified as available-for-sale. The 2004 balance of the auction rate securities was previously classified as cash and equivalents due to our intent and ability to quickly liquidate these securities to fund current operations and due to their interest rate reset feature. The auction rate securities were reclassified as investments in marketable securities. There was no impact on net income or cash flow from operating activities as a result of the reclassification.
Restricted cash
At September 30, 2005, we had restricted cash of $122 million in “Other assets,” which consisted of:
 
-
$99 million as collateral for potential future insurance claim reimbursements; and
 
-
$23 million related to cash collateral agreements for outstanding letters of credit for various construction projects.

9


At December 31, 2004, we had restricted cash of $121 million in “Other assets” and $17 million in “Other current assets,” which consisted of similar items as above.

Note 8. Property, Plant, and Equipment
In the second quarter of 2004, we implemented a change in accounting estimate to more accurately reflect the useful life of some of the tools of our Drilling and Formation Evaluation segment. This resulted in a $9 million reduction in depreciation expense in the first quarter of 2005, as well as a combined $35 million reduction in depreciation expense in the last three quarters of 2004. There was no impact in the second and third quarters of 2005 compared to the same periods in the prior year. We extended the useful lives of these tools based on our review of their service lives, technological improvements in the tools, and recent changes to our repair and maintenance practices that helped to extend the lives.

Note 9. Comprehensive Income
The components of other comprehensive income (loss) include the following:

   
Three Months Ended
 
Nine Months Ended
 
   
September 30
 
September 30
 
Millions of dollars
 
2005
 
2004
 
2005
 
2004
 
Net income (loss)
 
$
499
 
$
(44
)
$
1,256
 
$
(776
)
                           
Cumulative translation adjustments
   
1
   
(6
)
 
(28
)
 
(3
)
Realization of losses included in net income (loss)
   
-
   
-
   
3
   
-
 
Net cumulative translation adjustments
   
1
   
(6
)
 
(25
)
 
(3
)
                           
Unrealized net gains (losses) on investments
                         
and derivatives
   
(8
)
 
17
   
(9
)
 
5
 
Realization of gains on investments and derivatives
                         
included in net income (loss)
   
(1
)
 
-
   
(14
)
 
-
 
Net unrealized gains (losses) on investments
                         
and derivatives
   
(9
)
 
17
   
(23
)
 
5
 
Total comprehensive income (loss)
 
$
491
 
$
(33
)
$
1,208
 
$
(774
)

Accumulated other comprehensive income consisted of the following:

   
September 30,
 
December 31,
 
Millions of dollars
 
2005
 
2004
 
Cumulative translation adjustments
 
$
(56
)
$
(31
)
Pension liability adjustments
   
(130
)
 
(130
)
Unrealized gains (losses) on investments and derivatives
   
(8
)
 
15
 
Total accumulated other comprehensive income
 
$
(194
)
$
(146
)

Note 10. Debt
Senior notes
On October 17, 2005, we repaid, at par plus accrued interest, our $300 million floating rate senior notes that matured. As of September 30, 2005, these notes were included in “Current maturities of long-term debt” in the consolidated balance sheet.
On January 26, 2004, we issued $500 million aggregate principal amount of senior notes due 2007 bearing interest at a floating rate equal to three-month LIBOR plus 0.75%, payable quarterly. On April 26, 2005, we redeemed, at par plus accrued interest, all $500 million of these senior notes.

10


Revolving credit facilities
In March 2005, we entered into a $1.2 billion variable rate, five-year unsecured revolving credit agreement, which replaced our secured $700 million three-year revolving credit facility and our secured $500 million 364-day revolving credit facility. The letter of credit outstanding under the previous $700 million revolving credit facility is now outstanding under our $1.2 billion revolving credit agreement and has a balance of $107 million as of September 30, 2005. As of September 30, 2005 approximately $1.1 billion was available for borrowing under the $1.2 billion revolving credit agreement, but no borrowings had been made.
We are subject to a maximum debt-to-capitalization ratio of not greater than 60% under this revolver and are in compliance at September 30, 2005.

Note 11. Asbestos and Silica Obligations and Insurance Recoveries
Several of our subsidiaries, particularly DII Industries and Kellogg Brown & Root, had been named as defendants in a large number of asbestos- and silica-related lawsuits. The plaintiffs’ alleged injuries were primarily a result of exposure to:
 
-
asbestos used in products manufactured or sold by former divisions of DII Industries (primarily refractory materials, gaskets, and packing materials used in pumps and other industrial products);
 
-
asbestos in materials used in the construction and maintenance projects of Kellogg Brown & Root or its subsidiaries; and
 
-
silica related to sandblasting and drilling fluids operations.
Effective December 31, 2004, we resolved all open and future claims in the prepackaged Chapter 11 proceedings of DII Industries, Kellogg Brown & Root, and our other affected subsidiaries (which were filed on December 16, 2003) upon the plan of reorganization becoming final and nonappealable. The following table presents a rollforward of our asbestos- and silica-related liabilities and insurance receivables.

Millions of dollars
     
Asbestos- and silica-related liabilities:
       
December 31, 2004 balance (of which $2,408 was current)
 
$
(2,445
)
Payment to trusts in accordance with the plan of reorganization
   
2,345
 
First installment payment of partitioning agreement with Federal-Mogul
   
16
 
Cash settlement payment to the silica trust
   
15
 
Payment on one-year asbestos note
   
8
 
Reclassification of remaining note balances to other current
       
liabilities and long-term debt
   
61
 
Asbestos- and silica-related liabilities - September 30, 2005 balance
 
$
-
 
Insurance for asbestos- and silica-related liabilities:
       
December 31, 2004 balance (of which $1,066 was current)
 
$
1,416
 
Payments received
   
(1,030
)
Write-off of insurance recoveries/net present value true-up
   
(3
)
Accretion
   
11
 
Insurance for asbestos- and silica-related liabilities - September 30, 2005
       
balance (of which $193 is current)
 
$
394
 

In accordance with the plan of reorganization, in January 2005 we contributed the following to trusts for the benefit of current and future asbestos and silica personal injury claimants:
 
-
approximately $2.345 billion in cash, which represents the remaining portion of the $2.775 billion total cash settlement after payments of $311 million in December 2003 and $119 million in June 2004;
 
-
59.5 million shares of Halliburton common stock;

11


 
-
a one-year non-interest-bearing note of $31 million for the benefit of asbestos claimants. We prepaid the initial installment on the note of approximately $8 million in January 2005 and paid an additional $15 million during the third quarter of 2005. The final payment of approximately $8 million under the note will be paid by the end of the fourth quarter of 2005; and
 
-
a silica note plus an initial payment into a silica trust of $15 million. The note provides that we will contribute an amount to the silica trust at the end of each year for the next 30 years of up to $15 million. The note also provides for an extension of the note for 20 additional years under certain circumstances. We have estimated the value of this note plus the initial cash payment to be approximately $24 million at December 31, 2004. 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.
Our plan of reorganization called for a portion of our total asbestos liability to be settled by contributing 59.5 million shares of Halliburton common stock to the trust. At March 31, 2004, we revalued the 59.5 million shares to approximately $1.7 billion ($29.37 per share) from $1.6 billion ($26.27 per share) at December 31, 2003, resulting in a $190 million charge to discontinued operations. At September 30, 2004, we revalued the 59.5 million shares to approximately $2.0 billion ($33.48 per share), resulting in a $245 million charge to discontinued operations. Effective December 31, 2004, concurrent with receiving final and nonappealable confirmation of our plan of reorganization, we reclassified from a long-term liability to shareholders’ equity the final value of the 59.5 million shares of Halliburton common stock to be contributed to the asbestos trust. In January 2005, when the 59.5 million shares were actually contributed to the trust, the $2.335 billion value of the common shares was reclassified to common stock and paid-in capital in excess of par value on the condensed consolidated balance sheets.
Insurance settlements. During 2004, we settled insurance disputes with substantially all the insurance companies for asbestos- and silica-related claims and all other claims under the applicable insurance policies and terminated all the applicable insurance policies. Under the terms of our insurance settlements, we will receive cash proceeds with a nominal amount of approximately $1.5 billion and with a present value of approximately $1.4 billion for our asbestos- and silica-related insurance receivables. The present value was determined by discounting the expected future cash payments with a discount rate implicit in the settlements, which ranged from 4.0% to 5.5%. This discount is being accreted as interest income (classified as discontinued operations) over the life of the expected future cash payments. Cash payments of approximately $1.030 billion related to these receivables were received in the first nine months of 2005. Under the terms of the settlement agreements, we will receive cash payments of the remaining amounts, totaling $428 million at September 30, 2005, in several installments through 2010.
A significant portion of the insurance coverage applicable to Worthington Pump, a former division of DII Industries, was alleged by Federal-Mogul (and others who formerly were associated with Worthington Pump prior to its acquisition by DII Industries) to be shared with them. During 2004, we reached an agreement 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. Under the terms of the agreement, DII Industries was allocated 50% of the limits of any applicable insurance policy, and the remaining 50% of limits of the insurance policies were allocated to the remaining policyholders. As part of the settlement, DII Industries agreed to pay $46 million in three installment payments. In 2004, we accrued $44 million, which represents the present value of the $46 million to be paid. The discount is accreted as interest expense (classified as discontinued operations) over the life of the expected future cash payments beginning in the fourth quarter of 2004. The first payment of $16 million was paid in January 2005. The second and third payments of $15 million each will occur on the first and second anniversaries from the date of the first payment.
DII Industries and Federal-Mogul agreed to share equally in recoveries from insolvent London-based insurance companies. To the extent that Federal-Mogul’s recoveries from certain insolvent London-based insurance companies received on or before January 1, 2006 do not equal at least $4.5 million, DII Industries agreed to also pay to Federal-Mogul the difference between their recoveries from the insolvent London-based insurance companies and $4.5 million. Any recoveries received by Federal-Mogul from the insolvent London-based insurance companies after January 1, 2006 will be reimbursed to DII Industries until such time as DII Industries is fully reimbursed for the amount of the payment.

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Under the insurance settlements entered into as part of the resolution of our Chapter 11 proceedings, we have agreed to indemnify our insurers under certain historic general liability insurance policies in certain situations. We have concluded that the likelihood of any claims triggering the indemnity obligations is remote, and we believe any potential liability for these indemnifications will be immaterial. At September 30, 2005, we had not recorded any liability associated with these indemnifications.

Note 12. United States Government Contract Work
We provide substantial work under our government contracts business to the United States Department of Defense and other governmental agencies, including worldwide United States Army logistics contracts, known as LogCAP, and contracts to rebuild Iraq’s petroleum industry, known as RIO and PCO Oil South. Our government services revenue related to Iraq totaled approximately $1.2 billion and $4.1 billion for the three and nine months ended September 30, 2005 compared to $1.4 billion and $5.4 billion for the three and nine months ended September 30, 2004.
Given the demands of working in Iraq and elsewhere for the United States government, we expect that from time to time we will have disagreements or experience performance issues with the various government customers for which we work. If performance issues arise under any of our government contracts, the government retains the right to pursue remedies, which could include threatened termination or termination, under any affected contract. If any contract were so terminated, we may not receive award fees under the affected contract, and our ability to secure future contracts could be adversely affected although we would receive payment for amounts owed for our allowable costs under cost-reimbursable contracts.
DCAA audit issues
Our operations under United States government contracts are regularly reviewed and audited by the Defense Contract Audit Agency (DCAA) and other governmental agencies. The DCAA serves in an advisory role to our customer. When issues are found during the governmental agency audit process, these issues are typically discussed and reviewed with us. The DCAA then issues an audit report with its recommendations to our customer’s contracting officer. In the case of management systems and other contract administrative issues, the contracting officer is generally with the Defense Contract Management Agency (DCMA). We then work with our customer to resolve the issues noted in the audit report.
Dining facilities (DFAC). During 2003, the DCAA raised issues related to our invoicing to the Army Materiel Command (AMC) for food services for soldiers and supporting civilian personnel in Iraq and Kuwait. During 2004, we received notice from the DCAA that it was recommending withholding 19.35% of our DFAC billings relating to subcontracts entered into prior to February 2004 until it completed its audits. Approximately $213 million had been withheld as of March 31, 2005. Subsequent to February 2004, we renegotiated our DFAC subcontracts to address the specific issues raised by the DCAA and advised the AMC and the DCAA of the new terms of the arrangements. We have had no objection by the government to the terms and conditions associated with our new DFAC subcontract agreements. On March 31, 2005, we reached an agreement with the AMC regarding the costs associated with the DFAC subcontractors, which totaled approximately $1.2 billion. Under the terms of the agreement, the AMC agreed to the DFAC subcontractor costs except for $55 million, which it retained from the $213 million previously withheld amount. In the second quarter of 2005, the government released the funds to KBR. As a result of the agreement with the AMC, we recorded $10 million in additional operating income during the first quarter of 2005.
Subsequently, we have reached settlement agreements with all but one subcontractor, Eurest Support Services (Cyprus) International Limited, or ESS, and have resolved $44 million of the $55 million disallowed DFAC subcontractor costs. Accordingly, we paid the amounts due to all subcontractors with whom settlements have been finalized in accordance with the agreement reached with the government and are continuing to withhold the remaining $11 million, pending settlement with ESS. On September 30, 2005, ESS filed suit against us alleging various claims associated with its performance as a subcontractor in conjunction with our LogCAP contract in Iraq. ESS seeks total damages of approximately $42 million. We intend to vigorously defend this matter.

13


Fuel. In December 2003, the DCAA issued a preliminary audit report that alleged that we may have overcharged the Department of Defense by $61 million in importing fuel into Iraq. The DCAA questioned costs associated with fuel purchases made in Kuwait that were more expensive than buying and transporting fuel from Turkey. We responded that we had maintained close coordination of the fuel mission with the Army Corps of Engineers (COE), which was our customer and oversaw the project, throughout the life of the task orders and that the COE had directed us to use the Kuwait sources. After a review, the COE concluded that we obtained a fair price for the fuel. However, Department of Defense officials thereafter referred the matter to the agency’s inspector general, which we understand has commenced an investigation.
The DCAA issued various audit reports related to task orders under the RIO contract that reported $275 million in questioned and unsupported costs. To date, the DCAA has not recommended that any portion of the questioned and unsupported costs be withheld from payments to us. The majority of these costs were associated with the humanitarian fuel mission. In these reports, the DCAA compared fuel costs we incurred during the duration of the RIO contract in 2003 and early 2004 to fuel prices obtained by the Defense Energy Supply Center (DESC) in April 2004 when the fuel mission was transferred to that agency. During the third quarter of 2005, we agreed with our customer on more than $1.0 billion worth of fuel delivery task orders under the RIO program, which reduced our exposure related to the questioned and unsupported costs from $275 million to $55 million. We are working with our customer to resolve the remaining fuel delivery task orders valued at approximately $266 million.
Laundry. During the third quarter of 2004, we received notice from the DCAA that it recommended withholding $16 million of subcontract costs related to the laundry service for one task order in southern Iraq for which it believes we and our subcontractors have not provided adequate levels of documentation supporting the quantity of the services provided. In the first quarter of 2005, the DCAA issued a second notice to withhold approximately $2 million. The DCAA recommended that the costs be withheld pending receipt of additional explanation or documentation to support the subcontract costs. The $18 million has been withheld from the subcontractor. We are working with the DCMA and the subcontractor to resolve this issue.
Containers. In June 2005, the DCAA recommended withholding certain costs associated with providing containerized housing for soldiers and supporting civilian personnel in Iraq. Approximately $55 million has been withheld as of September 30, 2005 (down from $60 million originally reported because some issues have been resolved). The DCAA recommended that the costs be withheld pending receipt of additional explanation or documentation to support the subcontract costs. We have provided information we believe addresses the concerns raised by the DCAA. None of these amounts have been withheld from our subcontractors. We are working with the government and our subcontractors to resolve this issue.
Other issues. The DCAA is continuously performing audits of costs incurred for the foregoing and other services provided by us under our government contracts. During these audits, there are likely to be questions raised by the DCAA about the reasonableness or allowability of certain costs or the quality or quantity of supporting documentation. No assurance can be given that the DCAA might not recommend withholding some portion of the questioned costs while the issues are being resolved with our customer. Because of the intense scrutiny involving our government contracts operations, issues raised by the DCAA may be more difficult to resolve. We do not believe any potential withholding will have a significant or sustained impact on our liquidity.
Investigations
On January 22, 2004, we announced the identification by our internal audit function of a potential overbilling of approximately $6 million by La Nouvelle Trading & Contracting Company, W.L.L. (La Nouvelle), one of our subcontractors, under the LogCAP contract in Iraq, for services performed during 2003. In accordance with our policy and government regulation, the potential overcharge was reported to the Department of Defense Inspector General’s office as well as to our customer, the AMC. On January 23, 2004, we issued a check in the amount of $6 million to the AMC to cover that potential overbilling while we conducted our own investigation into the matter. Later in the first quarter of 2004, we determined that the amount of overbilling was $4 million, and the subcontractor billing should have been $2 million for the services provided. As a result, we paid La Nouvelle $2 million and billed our customer that amount. We

14


subsequently terminated La Nouvelle’s services under the LogCAP contract. In October 2004, La Nouvelle filed suit against us alleging $224 million in damages as a result of its termination. During the second quarter of 2005, this suit was settled without material impact to us. See Note 13 for further discussion.
In October 2004, we reported to the Department of Defense Inspector General’s office that two former employees in Kuwait may have had inappropriate contacts with individuals employed by or affiliated with two third-party subcontractors prior to the award of the subcontracts. The Inspector General’s office may investigate whether these two employees may have solicited and/or accepted payments from these third-party subcontractors while they were employed by us.
In October 2004, a civilian contracting official in the COE asked for a review of the process used by the COE for awarding some of the contracts to us. We understand that the Department of Defense Inspector General’s office may review the issues involved.
We understand that the United States Department of Justice, an Assistant United States Attorney based in Illinois, and others are investigating these and other individually immaterial matters we have reported relating to our government contract work in Iraq. If criminal wrongdoing were found, criminal penalties could range up to the greater of $500,000 in fines per count for a corporation or twice the gross pecuniary gain or loss. We also understand that current and former employees of KBR have received subpoenas and have given or may give grand jury testimony related to some of these matters.
In the first quarter of 2005, the Department of Justice issued two indictments associated with these issues against a former KBR procurement manager and a manager of La Nouvelle.
Withholding of payments
During 2004, the AMC issued a determination that a particular contract clause could cause it to withhold 15% from our invoices until our task orders under the LogCAP contract are definitized. The AMC delayed implementation of this withholding pending further review. During the third quarter of 2004, we and the AMC identified three senior management teams to facilitate negotiation under the LogCAP task orders, and these teams concluded their effort by successfully negotiating the final outstanding task order definitization on March 31, 2005. This made us current with regard to definitization of historical LogCAP task orders and eliminated the potential 15% withholding issue under the LogCAP contract.
As of September 30, 2005, the COE had withheld approximately $56 million of our invoices related to a portion of our RIO contract pending completion of the definitization process (down from $120 million originally reported because some task orders were definitized during the third quarter of 2005). All 10 definitization proposals required under this contract have been submitted by us, and six have been finalized through task order modifications. These withholdings represent the amount invoiced in excess of 85% of the funding in the task order.
The PCO Oil South project has definitized substantially all of the task orders, and we have collected a significant portion of the amounts previously withheld. We do not believe the withholding will have a significant or sustained impact on our liquidity because the withholding is temporary, and the definitization process is substantially complete.
We are working diligently with our customers to proceed with significant new work only after we have a fully definitized task order, which should limit withholdings on future task orders for all government contracts.
In addition, we had probable unapproved claims totaling $57 million at September 30, 2005 for the LogCAP and PCO Oil South contracts. These unapproved claims related to contracts where our costs have exceeded the customer’s funded value of the task order.
DCMA system reviews
Report on estimating system. On December 27, 2004, the DCMA granted continued approval of our estimating system, stating that our estimating system is “acceptable with corrective action.” We are in process of completing these corrective actions. Specifically, based on the unprecedented level of support that our employees are providing the military in Iraq, Kuwait, and Afghanistan, we needed to update our estimating policies and procedures to make them better suited to such contingency situations. Additionally, we have completed our development of a detailed training program and have made it available to all estimating personnel to ensure that employees are adequately prepared to deal with the challenges and unique circumstances associated with a contingency operation.

15


Report on purchasing system. As a result of a Contractor Purchasing System Review by the DCMA during the second quarter of 2004, the DCMA granted the continued approval of our government contract purchasing system. The DCMA’s approval letter, dated September 7, 2004, stated that our purchasing system’s policies and practices are “effective and efficient, and provide adequate protection of the Government’s interest.”
Report on accounting system. We have received an initial draft report on our accounting system and have responded to the points raised by the DCAA. Once the DCAA finalizes the report, it will be submitted to the DCMA, who will make a determination of the adequacy of our accounting systems for government contracting.
The Balkans
We have had inquiries in the past by the DCAA and the civil fraud division of the United States Department of Justice into possible overcharges for work performed during 1996 through 2000 under a contract in the Balkans, for which inquiry has not yet been completed by the Department of Justice. Based on an internal investigation, we credited our customer approximately $2 million during 2000 and 2001 related to our work in the Balkans as a result of billings for which support was not readily available. We believe that the preliminary Department of Justice inquiry relates to potential overcharges in connection with a part of the Balkans contract under which approximately $100 million in work was done. We believe that any allegations of overcharges would be without merit. Amounts accrued related to this matter as of September 30, 2005 are not material.

Note 13. Other Commitments and Contingencies
Nigerian joint venture and investigations
Foreign Corrupt Practices Act investigation. The Securities and Exchange Commission (SEC) is conducting a formal investigation into payments made in connection with the construction and subsequent expansion by TSKJ of a multibillion dollar natural gas liquefaction complex and related facilities at Bonny Island in Rivers State, Nigeria. The United States Department of Justice is also conducting an investigation. TSKJ is a private limited liability company registered in Madeira, Portugal whose members are Technip SA of France, Snamprogetti Netherlands B.V., which is an affiliate of ENI SpA of Italy, JGC Corporation of Japan, and Kellogg Brown & Root, each of which owns 25% of the venture.
The SEC and the Department of Justice have been reviewing these matters in light of the requirements of the United States Foreign Corrupt Practices Act (FCPA). We have produced documents to the SEC both voluntarily and pursuant to subpoenas, and we are making our employees available to the SEC for testimony. In addition, we understand that the SEC has issued a subpoena to A. Jack Stanley, who most recently served as a consultant and chairman of Kellogg Brown & Root, and to others. We further understand that the Department of Justice has invoked its authority under a sitting grand jury to obtain letters rogatory for the purpose of obtaining information abroad.
TSKJ and other similarly owned entities entered into various contracts to build and expand the liquefied natural gas project for Nigeria LNG Limited, which is owned by the Nigerian National Petroleum Corporation, Shell Gas B.V., Cleag Limited (an affiliate of Total), and Agip International B.V., which is an affiliate of ENI SpA of Italy. Commencing in 1995, TSKJ entered into a series of agency agreements in connection with the Nigerian project. We understand that a French magistrate has officially placed Jeffrey Tesler, a principal of Tri-Star Investments, an agent of TSKJ, 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 and expressed our willingness to cooperate with those investigations. In October 2004, representatives of TSKJ voluntarily testified before the Nigerian legislative committee. We also understand that the matters under investigation include TSKJ’s use of a Japanese trading company that contracted to provide services to TSKJ.

16


As a result of our continuing investigation into these matters, information has been uncovered suggesting that, commencing at least 10 years ago, the members of TSKJ considered payments to Nigerian officials. We provided this information to the United States Department of Justice, the SEC, the French magistrate, and the Nigerian Economics and Financial Crimes Commission. We also notified the other owners of TSKJ of the recently uncovered information and asked each of them to conduct their own investigation.
We understand from the ongoing governmental and other investigations that payments may have been made to Nigerian officials. In addition, TSKJ has suspended the receipt of services from and payments to Tri-Star Investments and the Japanese trading company and is considering instituting legal proceedings to declare all agency agreements with Tri-Star Investments terminated and to recover all amounts previously paid under those agreements.
We also understand that the matters under investigation involve parties other than Kellogg Brown & Root and M. W. Kellogg, Ltd. (a joint venture in which Kellogg Brown & Root has a 55% interest), cover an extended period of time (in some cases significantly before our 1998 acquisition of Dresser Industries (which included M. W. Kellogg, Ltd.)), and possibly include the construction of a fertilizer plant in Nigeria in the early 1990s and the activities of agents and service providers. The government has also recently requested information, which we are furnishing, regarding the company’s participation in additional projects in and outside of Nigeria.
In June 2004, we terminated all relationships with Mr. Stanley and another consultant and former employee of M. W. Kellogg, Ltd. The termination occurred because of violations of our Code of Business Conduct that allegedly involved the receipt of improper personal benefits in connection with TSKJ’s construction of the natural gas liquefaction facility in Nigeria.
In February 2005, TSKJ notified the Attorney General of Nigeria that TSKJ would not oppose the Attorney General’s efforts to have sums of money held on deposit in banks in Switzerland transferred to Nigeria and to have the legal ownership of such sums determined in the Nigerian courts.
If violations of the FCPA were found, we could be subject to civil penalties of $500,000 per violation, and criminal penalties could range up to the greater of $2 million per violation or twice the gross pecuniary gain or loss.
There can be no assurance that any governmental investigation or our investigation of these matters will not conclude that violations of applicable laws have occurred or that the results of these investigations will not have a material adverse effect on our business and results of operations.
As of September 30, 2005, we have not accrued any amounts related to this investigation other than our current legal expenses.
Bidding practices investigation. In connection with the investigation into payments made in connection with the Nigerian project, information has been uncovered suggesting that Mr. Stanley and other former employees may have engaged in coordinated bidding with one or more competitors on certain foreign construction projects, and that such coordination possibly began as early as the mid-1980s, which was significantly before our 1998 acquisition of Dresser Industries.
On the basis of this information, we and the Department of Justice 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. If such violations occurred, the United States government also would have the discretion to deny future government contracts business to KBR or affiliates or subsidiaries of KBR. Criminal prosecutions under applicable laws of relevant foreign jurisdictions and civil claims by or relationship issues with customers are also possible.
There can be no assurance that the results of these investigations will not have a material adverse effect on our business and results of operations.
As of September 30, 2005, we had not accrued any amounts related to this investigation other than our current legal expenses.

17


SEC investigation of change in accounting for revenue on long-term construction projects and related disclosures
In August 2004, we reached a settlement in the investigation by the SEC involving our 1998 and 1999 disclosure of and accounting for the recognition of revenue from unapproved claims on long-term construction projects. Our settlement with the SEC covers a failure to disclose a 1998 change in accounting practice. We disclosed the change in accounting practice in our 1999 Form 10-K and continued to do so in subsequent periods. The SEC did not determine that we departed from generally accepted accounting principles nor did it find errors in accounting or fraud. We neither admitted nor denied the SEC’s findings but paid a $7.5 million civil penalty and recorded a charge of that amount in the second quarter of 2004. As part of the settlement, the company agreed to cease and desist from committing or causing future securities law violations.
Securities and related litigation
On June 3, 2002, a class action lawsuit was filed against us in federal court on behalf of purchasers of our common stock during the period of approximately May 1998 until approximately May 2002 alleging violations of the federal securities laws in connection with the accounting change and disclosures involved in the SEC investigation discussed above. In addition, the plaintiffs allege that we overstated our revenue from unapproved claims by recognizing amounts not reasonably estimable or probable of collection. In the weeks that followed, approximately twenty similar class actions were filed against us. Several of those lawsuits also named as defendants Arthur Andersen LLP, our independent accountants for the period covered by the lawsuits, and several of our present or former officers and directors. The class action cases were later consolidated, and the amended consolidated class action complaint, styled Richard Moore, et al. v. Halliburton Company, et al., was filed and served upon us on or about April 11, 2003 (the “Moore class action”). Subsequently, in October 2002 and March 2003, two derivative actions arising out of essentially the same facts and circumstances were filed. Both of those actions have now been dismissed.
In early May 2003, we announced that we had entered into a written memorandum of understanding setting forth the terms upon which the Moore class action would be settled. In June 2003, the lead plaintiffs in the Moore class action filed a motion for leave to file a second amended consolidated complaint, which was granted by the court. In addition to restating the original accounting and disclosure claims, the second amended consolidated complaint includes claims arising out of the 1998 acquisition of Dresser Industries, Inc. by Halliburton, including that we failed to timely disclose the resulting asbestos liability exposure (the “Dresser claims”). The Dresser claims were included in the settlement discussions leading up to the signing of the memorandum of understanding and were among the claims the parties intended to have resolved by the terms of the proposed settlement of the consolidated Moore class action and the derivative action. The memorandum of understanding called for Halliburton to pay $6 million, which would be funded by insurance proceeds.
On June 7, 2004, the court entered an order preliminarily approving the settlement. Following the transfer of the case to another district judge and a final hearing on the fairness of the settlement, on September 9, 2004, the court entered an order holding that evidence of the settlement’s fairness was inadequate, denying the motion for final approval of the settlement in the Moore class action, and ordering the parties, among other things, to mediate. After the court’s denial of the motion to approve the settlement, we withdrew from the settlement as we believe we are entitled to do by its terms. The mediation was held on January 27, 2005 and, at the conclusion of that day, was declared by the mediator to be at an impasse with no settlement having been reached.
After the mediation, the lead plaintiff and lead counsel filed motions to withdraw as lead plaintiff and lead counsel. The court conducted a hearing on those motions on April 29, 2005. At that hearing, the court granted the motions, appointed new co-lead counsel and a new lead plaintiff, directed that they file a third consolidated amended complaint not later than May 9, 2005, and that we file our motion to dismiss not later than June 8, 2005. That motion has now been filed and fully briefed. The court held oral argument on that motion on August 2, 2005, at which time the court took the motion under advisement. We await the court’s ruling. Should the motion to dismiss be denied, we intend to vigorously defend the action.

18


Newmont Gold
In July 1998, Newmont Gold, a gold mining and extraction company, filed a lawsuit over the failure of a blower manufactured and supplied to Newmont by Roots, a former division of Dresser Equipment Group. The plaintiff alleges that during the manufacturing process, Roots had reversed the blades on a component of the blower known as the inlet guide vane assembly, resulting in the blower’s failure and the shutdown of the gold extraction mill for a period of approximately one month during 1996. In January 2002, a Nevada trial court granted summary judgment to Roots on all counts, and Newmont appealed. In February 2004, the Nevada Supreme Court reversed the summary judgment and remanded the case to the trial court, holding that fact issues existed requiring a trial. Based on pretrial reports, the damages claimed by the plaintiff are in the range of $33 million to $39 million. We believe that we have valid defenses to Newmont Gold’s claims and intend to vigorously defend the matter. The case was scheduled for trial beginning the last full week of May 2005. At the conclusion of jury selection, we again requested a motion for change of venue we had filed earlier. That motion was denied by the trial court, and we have appealed the denial to the Nevada Supreme Court, resulting in an indefinite delay in the trial. We are awaiting the decision in that appeal. As of September 30, 2005, we had not accrued any amounts related to this matter.
Smith International award
In June 2004, a Texas district court jury returned a verdict in our favor in connection with a patent infringement lawsuit we filed against Smith International (Smith). We were awarded $24 million in damages by the jury. We filed the lawsuit in September 2002, seeking damages for Smith’s infringement of our patented Energy Balanced™ roller cone drill bit technology. The jury found that Smith’s competing bits willfully infringed on three of our patents. Under applicable law, the judge has the discretion to enhance the damages to a total amount of up to three times the amount awarded by the jury and to award attorneys’ fees and costs. Subsequent to the verdict, upon our motion, the court enhanced the jury verdict by $12 million and added another $5 million in attorneys’ fees and costs for a total judgment of $41 million. Post-trial motions for a new trial and for judgment as a matter of law were denied, and Smith appealed the judgment. Briefing of the appeal is underway, however, matters remain to be concluded that will delay the completion of briefing, resulting in oral argument likely taking place during the first quarter of 2006.
Related litigation dealing with claims of infringement of the same technology was tried in January and February 2005 in England. On July 21, 2005, the court in England entered a judgment in which it held that the disclosures in the patents at issue were insufficient under English law to support our claims. Additionally, the court held that one of the two patents involved was not infringed. We have appealed that judgment. Related litigation remains pending in Italy.
In anticipation of Smith filing an infringement action against us, in March 2005, we filed a declaratory judgment action against Smith related to certain patents held by Smith dealing with essentially the same technology that underlies our patents involved in the Texas, England, and Italy litigation. Smith then filed an infringement action against us. Those cases, which have been joined together, remain pending in Texas.
As of September 30, 2005, we had not recorded any amounts related to these matters.
Improper payments reported to the SEC
During the second quarter of 2002, we reported to the SEC that one of our foreign subsidiaries operating in Nigeria made improper payments of approximately $2.4 million to entities owned by a Nigerian national who held himself out as a tax consultant, when in fact he was an employee of a local tax authority. The payments were made to obtain favorable tax treatment and clearly violated our Code of Business Conduct and our internal control procedures. The payments were discovered during our audit of the foreign subsidiary. We conducted an investigation assisted by outside legal counsel, and, based on the findings of the investigation, we terminated several employees. None of our senior officers were involved. We are cooperating with the SEC in its review of the matter. We took further action to ensure that our foreign subsidiary paid all taxes owed in Nigeria. A preliminary assessment of approximately $4 million was issued by the Nigerian tax authorities in the second quarter of 2003. We are cooperating with the Nigerian tax authorities to determine the total amount due as quickly as possible.

19


Operations in Iran
We received and responded to an inquiry in mid-2001 from the Office of Foreign Assets Control (OFAC) of the United States Treasury Department with respect to operations in Iran by a Halliburton subsidiary incorporated in the Cayman Islands. The OFAC inquiry requested information with respect to compliance with the Iranian Transaction Regulations. These regulations prohibit United States citizens, including United States corporations and other United States business organizations, from engaging in commercial, financial, or trade transactions with Iran, unless authorized by OFAC or exempted by statute. Our 2001 written response to OFAC stated that we believed that we were in compliance with applicable sanction regulations. In January 2004, we received a follow-up letter from OFAC requesting additional information. We responded to this request on March 19, 2004. We understand this matter has now been referred by OFAC to the Department of Justice. In July 2004, we received a grand jury subpoena from an Assistant United States District Attorney requesting the production of documents. We are cooperating with the government’s investigation and have responded to the subpoena by producing documents on September 16, 2004. As of September 30, 2005, we had not accrued any amounts related to this investigation.
Separate from the OFAC inquiry, we completed a study in 2003 of our activities in Iran during 2002 and 2003 and concluded that these activities were in compliance with applicable sanction regulations. These sanction regulations require isolation of entities that conduct activities in Iran from contact with United States citizens or managers of United States companies. Notwithstanding our conclusions that our activities in Iran were not in violation of United States laws and regulations, we announced that, after fulfilling our current contractual obligations within Iran, we intend to cease operations within that country and to withdraw from further activities there.
Litigation brought by La Nouvelle
In October 2004, La Nouvelle, a subcontractor to us in connection with our government services work in Kuwait and Iraq, filed suit alleging breach of contract and interference with contractual and business relations. The relief sought included $224 million in damages for breach of contract, which included $34 million for wrongful interference and an unspecified sum for consequential and punitive damages. The dispute arose from our termination of a master agreement pursuant to which La Nouvelle operated a number of DFACs in Kuwait and Iraq and the replacement of La Nouvelle with ESS, which, prior to La Nouvelle’s termination, had served as La Nouvelle’s subcontractor. In addition, La Nouvelle alleged that we wrongfully withheld from La Nouvelle certain sums due La Nouvelle under its various subcontracts. During the second quarter of 2005, this litigation was settled without material impact to us.
David Hudak and International Hydrocut Technologies Corp.
On October 12, 2004, David Hudak and International Hydrocut Technologies Corp. (collectively, Hudak) filed suit against us in the United States District Court alleging civil Racketeer Influenced and Corrupt Organizations Act violations, fraud, breach of contract, unfair trade practices, and other torts. The action, which seeks unspecified damages, arises out of Hudak’s alleged purchase in early 1994 of certain explosive charges that were later alleged by the United States Department of Justice to be military ordnance, the possession of which by persons not possessing the requisite licenses and registrations is unlawful. As a result of that allegation by the government, Hudak was charged with, but later acquitted of, certain criminal offenses in connection with his possession of the explosive charges. As mentioned above, the alleged transaction(s) took place more than 10 years ago. The fact that most of the individuals that may have been involved, as well as the entities themselves, are no longer affiliated with us will complicate our investigation. For those reasons and because the litigation is in its most preliminary stages, it is premature to assess the likelihood of an adverse result. We have filed a motion to dismiss and, alternatively, a motion to transfer venue and are awaiting the court’s decision on those motions. It is, however, our intention to vigorously defend this action. As of September 30, 2005, we had not accrued any amounts related to this matter.
Convoy ambush litigation
Several of the families of truck drivers, employed by KBR and killed when a fuel convoy was ambushed in Iraq on April 9, 2004, have filed suit against us. These suits allege that we are responsible for the deaths of these drivers for a variety of reasons and assert legal claims for fraud, wrongful death, civil

20


rights violations, and violations of the Racketeer Influenced and Corrupt Organizations Act. We deny the allegations of wrongdoing and fully intend to vigorously defend the actions. We believe that our conduct was entirely lawful and that our liability is limited by federal law. On July 1, 2005, the federal court in Houston, Texas denied our motion to dismiss based upon a narrow exception to the Defense Base Act. As of September 30, 2005, we had not accrued any amounts related to these matters.
Environmental
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. Our accrued liabilities for environmental matters were $44 million as of September 30, 2005 and $41 million as of December 31, 2004. The liability covers numerous properties, and no individual property accounts for more than $5 million of the liability balance. We have been named as potentially responsible parties along with other third parties for 15 federal and state superfund sites for which we have established a liability. As of September 30, 2005, those 15 sites accounted for approximately $14 million of our total $44 million liability. In some instances, we have been named a potentially responsible party by a regulatory agency, but, in each of those cases, we do not believe we have any material liability.
Letters of credit
In the normal course of business, we have agreements with banks under which approximately $1.2 billion of letters of credit or bank guarantees were outstanding as of September 30, 2005, including $396 million that relate to our joint ventures’ operations. Also included in letters of credit outstanding as of September 30, 2005 were $276 million of performance letters of credit and $113 million of retainage letters of credit related to the Barracuda-Caratinga project. Some of the outstanding letters of credit have triggering events which would entitle a bank to require cash collateralization.
Other commitments
As of September 30, 2005, we had commitments to fund approximately $45 million to related companies. These commitments arose primarily during the start-up of these entities or due to losses incurred by them. We expect approximately $36 million of the commitments to be paid during the next year.
Liquidated damages
Many of our engineering and construction contracts have milestone due dates that must be met or we may be subject to penalties for liquidated damages if claims are asserted and we were responsible for the delays. These generally relate to specified activities within a project by a set contractual date or achievement of a specified level of output or throughput of a plant we construct. Each contract defines the conditions under which a customer may make a claim for liquidated damages. However, in most instances, liquidated damages are not asserted by the customer, but the potential to do so is used in negotiating claims and closing out the contract. We had not accrued liabilities for $111 million at September 30, 2005 and $44 million at December 31, 2004 for liquidated damages (including amounts related to unconsolidated subsidiaries) we could incur based upon completing the projects as forecasted.

21


Note 14. Accounting for Stock-Based Compensation
We have six stock-based employee compensation plans. We account for those plans under the recognition and measurement principles of Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations. No cost for stock options granted is reflected in net income, as all options granted under our plans have an exercise price equal to the market value of the underlying common stock on the date of grant. In addition, no cost for the 2002 Employee Stock Purchase Plan (ESPP) is reflected in net income because it is not considered a compensatory plan.
The fair value of options at the date of grant and the ESPP shares were estimated using the Black-Scholes option pricing model. The following table illustrates the effect on net income (loss) and income (loss) per share if we had applied the fair value recognition provisions of Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation.

   
Three Months Ended
 
Nine Months Ended
 
   
September 30
 
September 30
 
Millions of dollars except per share data
 
2005
 
2004
 
2005
 
2004
 
Net income (loss), as reported
 
$
499
 
$
(44
)
$
1,256
 
$
(776
)
Total stock-based employee compensation expense determined
                         
under fair value based method for all awards
                         
(except restricted stock), net of related tax effects
   
(7
)
 
(8
)
 
(21
)
 
(21
)
Net income (loss), pro forma
 
$
492
 
$
(52
)
$
1,235
 
$
(797
)
                           
Basic income (loss) per share:
                         
As reported
 
$
0.99
 
$
(0.11
)
$
2.50
 
$
(1.78
)
Pro forma
 
$
0.98
 
$
(0.13
)
$
2.46
 
$
(1.83
)
Diluted income (loss) per share:
                         
As reported
 
$
0.95
 
$
(0.09
)
$
2.44
 
$
(1.76
)
Pro forma
 
$
0.94
 
$
(0.11
)
$
2.40
 
$
(1.81
)

We also maintain a restricted stock program wherein the fair market value of the stock on the date of issuance is amortized and ratably charged to income over the average period during which the restrictions lapse. The related expense, net of tax, reflected in net income (loss) as reported was $4 million and $15 million for the three and nine months ended September 30, 2005 and $4 million and $9 million for the three and nine months ended September 30, 2004.
In December 2004, the FASB issued SFAS No. 123R, “Shared-Based Payment.” SFAS No. 123R is a revision of SFAS No. 123 and supersedes APB No. 25. In April 2005, the SEC adopted a rule that defers the required effective date of SFAS No. 123R. The SEC rule provides that SFAS No. 123R is now effective for registrants as of the beginning of the first fiscal year beginning after June 15, 2005. We will adopt the provisions of SFAS No. 123R on January 1, 2006 using the modified prospective application. Accordingly, we will recognize compensation expense for all newly granted awards and awards modified, repurchased, or cancelled after January 1, 2006. Compensation cost for the unvested portion of awards that are outstanding as of January 1, 2006 will be recognized ratably over the remaining vesting period based on the fair value at date of grant as calculated for our pro forma disclosure under SFAS No. 123. We will recognize compensation expense for our ESPP beginning with the January 1, 2006 purchase period.
We estimate that the effect on net income and earnings per share in the periods following adoption of SFAS No. 123R will be consistent with our pro forma disclosure under SFAS No. 123, except that estimated forfeitures will be considered in the calculation of compensation expense under SFAS No. 123R. Additionally, the actual effect on net income and earnings per share will vary depending upon the number of options granted in subsequent periods compared to prior years and the number of shares purchased under the ESPP.

22


Note 15. Income (Loss) per Share
Basic income (loss) per share is based on the weighted average number of common shares outstanding during the period and, effective January 1, 2005, includes the 59.5 million shares that were contributed to the trusts established for the benefit of asbestos claimants. Diluted income (loss) per share includes additional common shares that would have been outstanding if potential common shares with a dilutive effect had been issued. A reconciliation of the number of shares used for the basic and diluted income (loss) per share calculation is as follows:

   
Three Months Ended
 
Nine Months Ended
 
   
September 30
 
September 30
 
Millions of shares
 
2005
 
2004
 
2005
 
2004
 
Basic weighted average common shares outstanding
   
506
   
438
   
503
   
437
 
Dilutive effect of:
                         
Stock options
   
6
   
2
   
5
   
2
 
Convertible senior notes premium
   
11
   
-
   
6
   
-
 
Restricted stock
   
1
   
1
   
1
   
1
 
Other
   
1
   
1
   
1
   
1
 
Diluted weighted average common shares outstanding
   
525
   
442
   
516
   
441
 

In December 2004, we entered into a supplemental indenture that requires us to satisfy our conversion obligation for our $1.2 billion 3.125% convertible senior notes in cash, rather than in common stock, for at least the aggregate principal amount of the notes. This reduced the resulting potential earnings dilution to only include the conversion premium, which is the difference between the conversion price per share of common stock and the average share price. See the table above for the dilutive effect for the three and nine months ended September 30, 2005. The increase in the dilutive effect of the conversion premium from the second quarter of 2005 to the third quarter of 2005 resulted from a 33% increase in quarterly average stock price. The conversion price of $37.65 per share of common stock was greater than our average share price in the three and nine months ended September 30, 2004 and, consequently, did not result in dilution.
Excluded from the computation of diluted income (loss) per share are options to purchase one million shares of common stock that were outstanding during the nine months ended September 30, 2005 and nine million shares during the three and nine months ended September 30, 2004. These options were outstanding during these quarters but were excluded because the option exercise price was greater than the average market price of the common shares.

Note 16. Income Taxes
The provision for income taxes from continuing operations of $132 million resulted in an effective tax rate of 20% in the third quarter of 2005 compared to an effective tax rate of 37% for the third quarter of 2004. The provision for income taxes from continuing operations of $455 million resulted in an effective tax rate of 26% in the first nine months of 2005 compared to an effective tax rate of 37% for the first nine months of 2004. Our annualized tax rate as applied to 2005 is lower because we have been able to reduce our previously-recorded valuation allowance against our United States net operating loss. This reduction occurred due to an increase in our projection of full-year 2005 United States taxable income. This additional income reduces the number of years we project foreign tax credits to be displaced by the United States net operating loss. As of September 30, 2005, the remaining valuation allowance related to asbestos and silica liabilities is $812 million.

Note 17. Retirement Plans
The components of net periodic benefit cost related to pension benefits for the three and nine months ended September 30, 2005 and September 30, 2004 are as follows:

23



   
Three Months Ended
 
   
September 30
 
   
2005
 
2004
 
Millions of dollars
 
United States
 
International
 
United States
 
International
 
Components of net periodic
                         
benefit cost:
                         
Service cost
 
$
-
 
$
17
 
$
1
 
$
21
 
Interest cost
   
2
   
42
   
2
   
37
 
Expected return on plan assets
   
(3
)
 
(47
)
 
(2
)
 
(41
)
Amortization of prior service cost
   
-
   
1
   
-
   
-
 
Settlements/curtailments
   
-
   
-
   
-
   
-
 
Recognized actuarial loss
   
2
   
4
   
1
   
3
 
Net periodic benefit cost
 
$
1
 
$
17
 
$
2
 
$
20
 

   
Nine Months Ended
 
   
September 30
 
   
2005
 
2004
 
Millions of dollars
 
United States
 
International
 
United States
 
International
 
Components of net periodic
                         
benefit cost:
                         
Service cost
 
$
-
 
$
56
 
$
1
 
$
64
 
Interest cost
   
7
   
128
   
7
   
109
 
Expected return on plan assets
   
(8
)
 
(139
)
 
(8
)
 
(122
)
Amortization of prior service cost
   
-
   
1
   
-
   
-
 
Settlements/curtailments
   
-
   
5
   
1
   
-
 
Recognized actuarial loss
   
4
   
13
   
3
   
11
 
Net periodic benefit cost
 
$
3
 
$
64
 
$
4
 
$
62
 

In the first quarter of 2005, we amended the terms and conditions of one of our foreign defined benefit plans and ceased future service and benefit accruals for all plan participants. This action is defined as a curtailment under SFAS No. 88 and, therefore, during the first quarter of 2005, we recognized a curtailment loss of approximately $5 million.
We currently expect to contribute approximately $72 million to our international pension plans in 2005. As of September 30, 2005, we had contributed $52 million of this amount. Also, we had contributed $3 million to our domestic pension plans as of September 30, 2005 and do not expect to make additional contributions to our domestic plans in 2005.
The components of net periodic benefit cost related to other postretirement benefits for the three and nine months ended September 30, 2005 and September 30, 2004 are as follows:

   
Three Months Ended
 
Nine Months Ended
 
   
September 30
 
September 30
 
Millions of dollars
 
2005
 
2004
 
2005
 
2004
 
Components of net periodic
                         
benefit cost:
                         
Service cost
 
$
1
 
$
1
 
$
1
 
$
1
 
Interest cost
   
2
   
1
   
7
   
4
 
Amortization of prior service cost
   
-
   
(2
)
 
-
   
(7
)
Recognized actuarial loss
   
-
   
-
   
-
   
1
 
Net periodic benefit cost
 
$
3
 
$
-
 
$
8
 
$
(1
)

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Note 18. New Accounting Standards
In March 2005, the FASB issued FASB Interpretation No. 47 (FIN 47), “Accounting for Conditional Asset Retirement Obligations, an interpretation of FASB Statement No. 143.” This statement clarifies that an entity is required to recognize a liability for the fair value of a conditional asset retirement obligation when incurred, if the liability’s fair value can be reasonably estimated. The provisions of FIN 47 are effective no later than December 31, 2005. We are currently evaluating what impact, if any, this statement will have on our financial statements.

25


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

EXECUTIVE OVERVIEW
Throughout the first nine months of 2005, our Energy Services Group (ESG) continued its improved performance. During each quarter of 2005, ESG established new revenue and operating income records and, on a year-to-date basis, its operating margin increased seven percentage points compared to the first nine months of 2004. To date, ESG has benefited from:
 
-
price increases implemented during 2004 and 2005;
 
-
the return of activity in the deepwater Gulf of Mexico;
 
-
increased oilfield activity globally, especially within our pressure pumping businesses, which consist of production enhancement and cementing services; and
 
-
a strong natural gas production market in the United States.
During the third quarter of 2005, our operations were impacted by several hurricanes in the Gulf of Mexico. ESG lost approximately $46 million in revenue and approximately $28 million in operating income, primarily due to the temporary suspension of work related to damaged and lost customer rigs. We also estimate that the slow recovery in the Gulf of Mexico infrastructure and our customers’ ability to restore the operations of their rigs and platforms to pre-hurricane levels will negatively impact the fourth quarter of 2005 and the first six months of 2006.
KBR delivered $377 million in operating income in the first nine months of 2005, for a 4.7% operating margin. These results reflect improved project performance, recent award fees received for our work in Iraq, and the resolution of disputed fuel costs and other issues as a result of favorable settlement of government audits. KBR’s results also included $85 million of operating income from the sale of an interest in a toll road during the third quarter of 2005. We have received favorable job performance ratings for our work supporting the troops in Iraq. As a result, in the first nine months of 2005 we recorded $51 million of incremental operating income related to our LogCAP and RIO contracts. We also continue to build our backlog related to liquefied natural gas (LNG) and gas-to-liquids (GTL) infrastructure projects designed to commercialize gas reserves around the world. Our backlog in these “gas monetization projects” has grown to $3.8 billion at September 30, 2005. KBR incurred $5 million in pretax expenses related to the hurricanes in the Gulf of Mexico during the third quarter of 2005.
Looking ahead, the outlook for our business is positive. Strong commodity prices, a lack of excess oil supply compared to historical up-cycle periods, and continuing strong cash flow are driving increased spending plans for our exploration and production customers. We believe oil and gas prices will fluctuate in the future, but the fundamentals that support continued strong commodity prices and demand for our products or services should not change in the next several quarters. We also expect significant growth in gas monetization projects. Global energy demand continues to grow and world economies appear to be absorbing higher oil and gas prices with limited impact to gross domestic product growth rates. In October 2005, we implemented additional United States price book increases ranging from 6% to 18% for our products and services in ESG. While we will continue to monitor the situation and maintain a disciplined approach to costs and capital, we are encouraged about our prospects in this robust environment, both in the United States and abroad.
Having finalized our asbestos and silica settlements in January 2005, we have shifted our focus to the following priorities:
 
-
positioning KBR for a possible separation from Halliburton. In order to achieve the optimal value for our shareholders, we believe it is important for KBR to demonstrate a track record of positive earnings and backlog growth for a number of quarters and make progress in resolving outstanding issues regarding governmental contracts and investigations. We believe we are making progress positioning KBR for a possible separation. No timeline has been set for a separation of KBR nor has a decision been made on what form any potential separation might take. Although a number of forms of separation are under consideration, we currently believe an initial public offering of KBR may be the most attractive option. Any such sale of KBR stock will be registered under the Securities Act of 1933, and such shares of common stock will only be offered and

26


sold by means of a prospectus. This quarterly report does not constitute an offer to sell or the solicitation of any offer to buy any securities of KBR, and there will not be any sale of any such securities in any state in which such offer, solicitation, or sale would be unlawful prior to registration or qualification under the securities laws of such state;
 
-
focusing on maximizing return on capital. In ESG, we are focused on a “fix it or exit” program for underperforming operations, and we are implementing improvements in our supply chain, pricing, service quality, and capital discipline, as well as manufacturing efficiencies. As a result, ESG’s operating income has continued to grow throughout the first nine months of 2005, and operating margins have been positively impacted. Having completed the restructuring of KBR, we are also seeing results from our focus on project management and cost efficiencies; and
 
-
reducing our debt-to-capitalization ratio to the mid-30s by early 2006. To this end, we redeemed $500 million of senior notes in April 2005 and paid $300 million floating rate senior notes that matured on October 17, 2005. Our debt-to-capitalization ratio at September 30, 2005 was 40%. We estimate that the retirement of the $300 million senior notes in October 2005 will reduce our debt-to-capitalization ratio by three percentage points.
Detailed discussions of our United States government contract work, the Nigerian joint venture and investigations, and our liquidity and capital resources follow. Our operating performance is described in “Business Environment and Results of Operations” below.
United States Government Contract Work
We provide substantial work under our government contracts business to the United States Department of Defense and other governmental agencies, including worldwide United States Army logistics contracts, known as LogCAP, and contracts to rebuild Iraq’s petroleum industry, known as RIO and PCO Oil South. Our government services revenue related to Iraq totaled approximately $1.2 billion and $4.1 billion for the three and nine months ended September 30, 2005 compared to $1.4 billion and $5.4 billion for the three and nine months ended September 30, 2004.
Given the demands of working in Iraq and elsewhere for the United States government, we expect that from time to time we will have disagreements or experience performance issues with the various government customers for which we work. If performance issues arise under any of our government contracts, the government retains the right to pursue remedies, which could include threatened termination or termination, under any affected contract. If any contract were so terminated, we may not receive award fees under the affected contract, and our ability to secure future contracts could be adversely affected although we would receive payment for amounts owed for our allowable costs under cost-reimbursable contracts.
DCAA audit issues
Our operations under United States government contracts are regularly reviewed and audited by the Defense Contract Audit Agency (DCAA) and other governmental agencies. The DCAA serves in an advisory role to our customer. When issues are found during the governmental agency audit process, these issues are typically discussed and reviewed with us. The DCAA then issues an audit report with its recommendations to our customer’s contracting officer. In the case of management systems and other contract administrative issues, the contracting officer is generally with the Defense Contract Management Agency (DCMA). We then work with our customer to resolve the issues noted in the audit report.
Dining facilities (DFAC). During 2003, the DCAA raised issues related to our invoicing to the Army Materiel Command (AMC) for food services for soldiers and supporting civilian personnel in Iraq and Kuwait. During 2004, we received notice from the DCAA that it was recommending withholding 19.35% of our DFAC billings relating to subcontracts entered into prior to February 2004 until it completed its audits. Approximately $213 million had been withheld as of March 31, 2005. Subsequent to February 2004, we renegotiated our DFAC subcontracts to address the specific issues raised by the DCAA and advised the AMC and the DCAA of the new terms of the arrangements. We have had no objection by the government to the terms and conditions associated with our new DFAC subcontract agreements. On March 31, 2005, we reached an agreement with the AMC regarding the costs associated with the DFAC

27


subcontractors, which totaled approximately $1.2 billion. Under the terms of the agreement, the AMC agreed to the DFAC subcontractor costs except for $55 million, which it retained from the $213 million previously withheld amount. In the second quarter of 2005, the government released the funds to KBR. As a result of the agreement with the AMC, we recorded $10 million in additional operating income during the first quarter of 2005.
Subsequently, we have reached settlement agreements with all but one subcontractor, Eurest Support Services (Cyprus) International Limited, or ESS, and have resolved $44 million of the $55 million disallowed DFAC subcontractor costs. Accordingly, we paid the amounts due to all subcontractors with whom settlements have been finalized in accordance with the agreement reached with the government and are continuing to withhold the remaining $11 million, pending settlement with ESS. On September 30, 2005, ESS filed suit against us alleging various claims associated with its performance as a subcontractor in conjunction with our LogCAP contract in Iraq. ESS seeks total damages of approximately $42 million. We intend to vigorously defend this matter.
Fuel. In December 2003, the DCAA issued a preliminary audit report that alleged that we may have overcharged the Department of Defense by $61 million in importing fuel into Iraq. The DCAA questioned costs associated with fuel purchases made in Kuwait that were more expensive than buying and transporting fuel from Turkey. We responded that we had maintained close coordination of the fuel mission with the Army Corps of Engineers (COE), which was our customer and oversaw the project, throughout the life of the task orders and that the COE had directed us to use the Kuwait sources. After a review, the COE concluded that we obtained a fair price for the fuel. However, Department of Defense officials thereafter referred the matter to the agency’s inspector general, which we understand has commenced an investigation.
The DCAA issued various audit reports related to task orders under the RIO contract that reported $275 million in questioned and unsupported costs. To date, the DCAA has not recommended that any portion of the questioned and unsupported costs be withheld from payments to us. The majority of these costs were associated with the humanitarian fuel mission. In these reports, the DCAA compared fuel costs we incurred during the duration of the RIO contract in 2003 and early 2004 to fuel prices obtained by the Defense Energy Supply Center (DESC) in April 2004 when the fuel mission was transferred to that agency. During the third quarter of 2005, we agreed with our customer on more than $1.0 billion worth of fuel delivery task orders under the RIO program, which reduced our exposure related to the questioned and unsupported costs from $275 million to $55 million. We are working with our customer to resolve the remaining fuel delivery task orders valued at approximately $266 million.
Laundry. During the third quarter of 2004, we received notice from the DCAA that it recommended withholding $16 million of subcontract costs related to the laundry service for one task order in southern Iraq for which it believes we and our subcontractors have not provided adequate levels of documentation supporting the quantity of the services provided. In the first quarter of 2005, the DCAA issued a second notice to withhold approximately $2 million. The DCAA recommended that the costs be withheld pending receipt of additional explanation or documentation to support the subcontract costs. The $18 million has been withheld from the subcontractor. We are working with the DCMA and the subcontractor to resolve this issue.
Containers. In June 2005, the DCAA recommended withholding certain costs associated with providing containerized housing for soldiers and supporting civilian personnel in Iraq. Approximately $55 million has been withheld as of September 30, 2005 (down from $60 million originally reported because some issues have been resolved). The DCAA recommended that the costs be withheld pending receipt of additional explanation or documentation to support the subcontract costs. We have provided information we believe addresses the concerns raised by the DCAA. None of these amounts have been withheld from our subcontractors. We are working with the government and our subcontractors to resolve this issue.
Other issues. The DCAA is continuously performing audits of costs incurred for the foregoing and other services provided by us under our government contracts. During these audits, there are likely to be questions raised by the DCAA about the reasonableness or allowability of certain costs or the quality or quantity of supporting documentation. No assurance can be given that the DCAA might not recommend

28


withholding some portion of the questioned costs while the issues are being resolved with our customer. Because of the intense scrutiny involving our government contracts operations, issues raised by the DCAA may be more difficult to resolve. We do not believe any potential withholding will have a significant or sustained impact on our liquidity.
Investigations
On January 22, 2004, we announced the identification by our internal audit function of a potential overbilling of approximately $6 million by La Nouvelle Trading & Contracting Company, W.L.L. (La Nouvelle), one of our subcontractors, under the LogCAP contract in Iraq, for services performed during 2003. In accordance with our policy and government regulation, the potential overcharge was reported to the Department of Defense Inspector General’s office as well as to our customer, the AMC. On January 23, 2004, we issued a check in the amount of $6 million to the AMC to cover that potential overbilling while we conducted our own investigation into the matter. Later in the first quarter of 2004, we determined that the amount of overbilling was $4 million, and the subcontractor billing should have been $2 million for the services provided. As a result, we paid La Nouvelle $2 million and billed our customer that amount. We subsequently terminated La Nouvelle’s services under the LogCAP contract. In October 2004, La Nouvelle filed suit against us alleging $224 million in damages as a result of its termination. During the second quarter of 2005, this suit was settled without material impact to us. See Note 13 to our condensed consolidated financial statements for further discussion.
In October 2004, we reported to the Department of Defense Inspector General’s office that two former employees in Kuwait may have had inappropriate contacts with individuals employed by or affiliated with two third-party subcontractors prior to the award of the subcontracts. The Inspector General’s office may investigate whether these two employees may have solicited and/or accepted payments from these third-party subcontractors while they were employed by us.
In October 2004, a civilian contracting official in the COE asked for a review of the process used by the COE for awarding some of the contracts to us. We understand that the Department of Defense Inspector General’s office may review the issues involved.
We understand that the United States Department of Justice, an Assistant United States Attorney based in Illinois, and others are investigating these and other individually immaterial matters we have reported relating to our government contract work in Iraq. If criminal wrongdoing were found, criminal penalties could range up to the greater of $500,000 in fines per count for a corporation or twice the gross pecuniary gain or loss. We also understand that current and former employees of KBR have received subpoenas and have given or may give grand jury testimony related to some of these matters.
In the first quarter of 2005, the Department of Justice issued two indictments associated with these issues against a former KBR procurement manager and a manager of La Nouvelle.
Withholding of payments
During 2004, the AMC issued a determination that a particular contract clause could cause it to withhold 15% from our invoices until our task orders under the LogCAP contract are definitized. The AMC delayed implementation of this withholding pending further review. During the third quarter of 2004, we and the AMC identified three senior management teams to facilitate negotiation under the LogCAP task orders, and these teams concluded their effort by successfully negotiating the final outstanding task order definitization on March 31, 2005. This made us current with regard to definitization of historical LogCAP task orders and eliminated the potential 15% withholding issue under the LogCAP contract.
As of September 30, 2005, the COE had withheld approximately $56 million of our invoices related to a portion of our RIO contract pending completion of the definitization process (down from $120 million originally reported because some task orders were definitized during the third quarter of 2005). All 10 definitization proposals required under this contract have been submitted by us, and six have been finalized through task order modifications. These withholdings represent the amount invoiced in excess of 85% of the funding in the task order.
The PCO Oil South project has definitized substantially all of the task orders, and we have collected a significant portion of the amounts previously withheld. We do not believe the withholding will have a significant or sustained impact on our liquidity because the withholding is temporary, and the definitization process is substantially complete.

29


We are working diligently with our customers to proceed with significant new work only after we have a fully definitized task order, which should limit withholdings on future task orders for all government contracts.
In addition, we had probable unapproved claims totaling $57 million at September 30, 2005 for the LogCAP and PCO Oil South contracts. These unapproved claims related to contracts where our costs have exceeded the customer’s funded value of the task order.
DCMA system reviews
Report on estimating system. On December 27, 2004, the DCMA granted continued approval of our estimating system, stating that our estimating system is “acceptable with corrective action.” We are in process of completing these corrective actions. Specifically, based on the unprecedented level of support that our employees are providing the military in Iraq, Kuwait, and Afghanistan, we needed to update our estimating policies and procedures to make them better suited to such contingency situations. Additionally, we have completed our development of a detailed training program and have made it available to all estimating personnel to ensure that employees are adequately prepared to deal with the challenges and unique circumstances associated with a contingency operation.
Report on purchasing system. As a result of a Contractor Purchasing System Review by the DCMA during the second quarter of 2004, the DCMA granted the continued approval of our government contract purchasing system. The DCMA’s approval letter, dated September 7, 2004, stated that our purchasing system’s policies and practices are “effective and efficient, and provide adequate protection of the Government’s interest.”
Report on accounting system. We have received an initial draft report on our accounting system and have responded to the points raised by the DCAA. Once the DCAA finalizes the report, it will be submitted to the DCMA, who will make a determination of the adequacy of our accounting systems for government contracting.
The Balkans
We have had inquiries in the past by the DCAA and the civil fraud division of the United States Department of Justice into possible overcharges for work performed during 1996 through 2000 under a contract in the Balkans, for which inquiry has not yet been completed by the Department of Justice. Based on an internal investigation, we credited our customer approximately $2 million during 2000 and 2001 related to our work in the Balkans as a result of billings for which support was not readily available. We believe that the preliminary Department of Justice inquiry relates to potential overcharges in connection with a part of the Balkans contract under which approximately $100 million in work was done. We believe that any allegations of overcharges would be without merit. Amounts accrued related to this matter as of September 30, 2005 are not material.

Nigerian Joint Venture and Investigations
Foreign Corrupt Practices Act investigation. The Securities and Exchange Commission (SEC) is conducting a formal investigation into payments made in connection with the construction and subsequent expansion by TSKJ of a multibillion dollar natural gas liquefaction complex and related facilities at Bonny Island in Rivers State, Nigeria. The United States Department of Justice is also conducting an investigation. TSKJ is a private limited liability company registered in Madeira, Portugal whose members are Technip SA of France, Snamprogetti Netherlands B.V., which is an affiliate of ENI SpA of Italy, JGC Corporation of Japan, and Kellogg Brown & Root, each of which owns 25% of the venture.
The SEC and the Department of Justice have been reviewing these matters in light of the requirements of the United States Foreign Corrupt Practices Act (FCPA). We have produced documents to the SEC both voluntarily and pursuant to subpoenas, and we are making our employees available to the SEC for testimony. In addition, we understand that the SEC has issued a subpoena to A. Jack Stanley, who most recently served as a consultant and chairman of Kellogg Brown & Root, and to others. We further understand that the Department of Justice has invoked its authority under a sitting grand jury to obtain letters rogatory for the purpose of obtaining information abroad.

30


TSKJ and other similarly owned entities entered into various contracts to build and expand the liquefied natural gas project for Nigeria LNG Limited, which is owned by the Nigerian National Petroleum Corporation, Shell Gas B.V., Cleag Limited (an affiliate of Total), and Agip International B.V., which is an affiliate of ENI SpA of Italy. Commencing in 1995, TSKJ entered into a series of agency agreements in connection with the Nigerian project. We understand that a French magistrate has officially placed Jeffrey Tesler, a principal of Tri-Star Investments, an agent of TSKJ, 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 and expressed our willingness to cooperate with those investigations. In October 2004, representatives of TSKJ voluntarily testified before the Nigerian legislative committee. We also understand that the matters under investigation include TSKJ’s use of a Japanese trading company that contracted to provide services to TSKJ.
As a result of our continuing investigation into these matters, information has been uncovered suggesting that, commencing at least 10 years ago, the members of TSKJ considered payments to Nigerian officials. We provided this information to the United States Department of Justice, the SEC, the French magistrate, and the Nigerian Economics and Financial Crimes Commission. We also notified the other owners of TSKJ of the recently uncovered information and asked each of them to conduct their own investigation.
We understand from the ongoing governmental and other investigations that payments may have been made to Nigerian officials. In addition, TSKJ has suspended the receipt of services from and payments to Tri-Star Investments and the Japanese trading company and is considering instituting legal proceedings to declare all agency agreements with Tri-Star Investments terminated and to recover all amounts previously paid under those agreements.
We also understand that the matters under investigation involve parties other than Kellogg Brown & Root and M. W. Kellogg, Ltd. (a joint venture in which Kellogg Brown & Root has a 55% interest), cover an extended period of time (in some cases significantly before our 1998 acquisition of Dresser Industries (which included M. W. Kellogg, Ltd.)), and possibly include the construction of a fertilizer plant in Nigeria in the early 1990s and the activities of agents and service providers. The government has also recently requested information, which we are furnishing, regarding the company’s participation in additional projects in and outside of Nigeria.
In June 2004, we terminated all relationships with Mr. Stanley and another consultant and former employee of M. W. Kellogg, Ltd. The termination occurred because of violations of our Code of Business Conduct that allegedly involved the receipt of improper personal benefits in connection with TSKJ’s construction of the natural gas liquefaction facility in Nigeria.
In February 2005, TSKJ notified the Attorney General of Nigeria that TSKJ would not oppose the Attorney General’s efforts to have sums of money held on deposit in banks in Switzerland transferred to Nigeria and to have the legal ownership of such sums determined in the Nigerian courts.
If violations of the FCPA were found, we could be subject to civil penalties of $500,000 per violation, and criminal penalties could range up to the greater of $2 million per violation or twice the gross pecuniary gain or loss.
There can be no assurance that any governmental investigation or our investigation of these matters will not conclude that violations of applicable laws have occurred or that the results of these investigations will not have a material adverse effect on our business and results of operations.
As of September 30, 2005, we have not accrued any amounts related to this investigation other than our current legal expenses.
Bidding practices investigation. In connection with the investigation into payments made in connection with the Nigerian project, information has been uncovered suggesting that Mr. Stanley and other former employees may have engaged in coordinated bidding with one or more competitors on certain foreign construction projects, and that such coordination possibly began as early as the mid-1980s, which was significantly before our 1998 acquisition of Dresser Industries.

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On the basis of this information, we and the Department of Justice 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. If such violations occurred, the United States government also would have the discretion to deny future government contracts business to KBR or affiliates or subsidiaries of KBR. Criminal prosecutions under applicable laws of relevant foreign jurisdictions and civil claims by or relationship issues with customers are also possible.
There can be no assurance that the results of these investigations will not have a material adverse effect on our business and results of operations.
As of September 30, 2005, we had not accrued any amounts related to this investigation other than our current legal expenses.

LIQUIDITY AND CAPITAL RESOURCES

We ended the third quarter of 2005 with cash and equivalents of $2.1 billion compared to $1.9 billion at December 31, 2004.
Significant sources of cash
During 2004, we settled insurance disputes with substantially all the insurance companies for asbestos- and silica-related claims and all other claims under the applicable insurance policies and terminated all the applicable insurance policies. We received approximately $1.030 billion in insurance proceeds in the first nine months of 2005 and expect to receive additional amounts as follows:

Millions of dollars
     
October 1 through December 31, 2005
 
$
8
 
2006
   
185
 
2007
   
41
 
2008
   
46
 
2009
   
132
 
2010
   
16
 
Total
 
$
428
 

During the first quarter of 2005, we sold $891 million in investments in marketable securities.
Our cash flow was supplemented by $203 million from the sale of our 50% interest in Subsea 7, Inc. in January 2005 and $85 million from the sale of an investment in a United States toll road in September 2005.
Further sources of cash. In the first quarter of 2005, we entered into an unsecured $1.2 billion five-year revolving credit facility for general working capital purposes. The new credit facility replaced our secured $700 million three-year revolving credit facility and our secured $500 million 364-day revolving credit facility. The letter of credit issued under the previous secured $700 million three-year revolving credit facility is now under our unsecured $1.2 billion revolving facility and has a balance of $107 million as of September 30, 2005. The letter of credit reduces the availability under the revolving credit facility to approximately $1.1 billion. There were no cash drawings under the unsecured $1.2 billion revolving credit facility as of September 30, 2005.
Significant uses of cash
In January 2005, we used approximately $2.4 billion to fund the asbestos and silica liability trusts and made the following payments:

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Millions of dollars
     
Payment to the asbestos and silica trust in accordance
       
with the plan of reorganization
 
$
2,345
 
Payment related to insurance partitioning
       
agreement reached with Federal-Mogul in
       
October 2004 - first of three installments
   
16
 
Cash settlement payment to the silica trust
   
15
 
Payments related to RHI Refractories agreement
   
11
 
Initial payment on the one-year non-interest-
       
bearing note of $31 million for the benefit of
       
asbestos claimants
   
8
 
Total
 
$
2,395
 

During the first nine months of 2005, we paid $23 million on the one-year non-interest-bearing note for the benefit of asbestos claimants. The final payment of approximately $8 million under the note will be paid by the end of the fourth quarter of 2005.
Our working capital requirements for our Iraq-related work, excluding cash and equivalents, were up from $700 million at December 31, 2004 to approximately $729 million at September 30, 2005. However, at December 31, 2004, we had sold approximately $263 million of accounts receivable under our United States government accounts receivable facility, but there were no such sales at September 30, 2005.
On April 26, 2005, we redeemed, at par plus accrued interest, all $500 million of our floating rate senior notes due 2007 that were issued in January 2004.
Capital expenditures of $474 million in the nine months ended September 30, 2005 were 12% higher than in the nine months ended September 30, 2004. Capital spending in 2005 continued to be primarily directed to the Energy Services Group for the Production Optimization, Drilling and Formation Evaluation, and Fluid Systems segments.
We paid $190 million in dividends to our shareholders in the first nine months of 2005 and $165 million in the first nine months of 2004. Dividends increased as a result of the issuance of the 59.5 million shares of our common stock contributed to the asbestos trust in January 2005.
Future uses of cash. Capital spending for 2005 is expected to be approximately $675 million. The capital expenditures budget for 2005 includes increased software spending as KBR moves forward with the implementation of SAP and higher spending in the Energy Services Group to accommodate increased business.
As of September 30, 2005, we had commitments to fund approximately $45 million to related companies. These commitments arose primarily during the start-up of these entities or due to losses incurred by them. We expect approximately $36 million of the commitments to be paid during the remainder of 2005.
We continue to fund operating cash shortfalls on the Barracuda-Caratinga project, a multiyear construction project to develop the Barracuda and Caratinga crude oilfields off the coast of Brazil, and are obligated to fund total shortages over the remaining project life. Estimated cash flows related to the losses are as follows:

Millions of dollars
     
Amount funded from inception through September 30, 2005, net of
       
revenue received (including repayment of $300 million
       
of advance payments)
 
$
734
 
Remaining project costs, net of revenue to be received
   
28
 
Total cash shortfalls
 
$
762
 

The table above includes $148 million funded during the first nine months of 2005, net of revenue received. This amount includes payments to us of $138 million related to change orders.

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On October 17, 2005, we repaid, at par plus accrued interest, our $300 million floating rate senior notes that matured. As of September 30, 2005, these notes were included in “Current maturities of long-term debt” in the consolidated balance sheet.
Other factors affecting liquidity
Accounts receivable securitization facilities. In May 2004, we entered into an agreement under which we can sell, assign, and transfer the entire title and interest in specified United States government accounts receivable of KBR to a third party. The total amount outstanding under this agreement as of June 30, 2005 was approximately $257 million, and the amount outstanding as of December 31, 2004 was approximately $263 million. Subsequent to the second quarter of 2005, these receivables were collected and the balance retired, and we are not currently selling further receivables, although the facility continues to be available. See “Off Balance Sheet Risk” below for further discussion regarding this facility.
Letters of credit. In the normal course of business, we have agreements with banks under which approximately $1.2 billion of letters of credit or bank guarantees were outstanding as of September 30, 2005, including $396 million that relate to our joint ventures’ operations. Also included in the letters of credit outstanding as of September 30, 2005 and related to the Barracuda-Caratinga project were $276 million of performance letters of credit and $113 million of retainage letters of credit. Some of the outstanding letters of credit have triggering events which would entitle a bank to require cash collateralization.
Credit ratings. Investment grade ratings are BBB- or higher for Standard & Poor’s and Baa3 or higher for Moody’s Investors Service. Our current ratings are one level above BBB- on Standard & Poor’s and one level above Baa3 on Moody’s Investors Service. In the third quarter of 2005, Standard & Poor’s revised its credit watch listing for us from “stable” to “positive,” citing improved operating performance and debt reduction as reasons for the upgrade. In the first quarter of 2005, Standard & Poor’s revised its credit watch listing for us from “developing” to “stable” and its short-term paper and commercial rating from A-3 to A-2, and Moody’s Investors Service revised its outlook on us from “stable” to “positive.” Both companies revised their ratings in response to our announcement that, effective December 31, 2004, we had resolved all open and future asbestos and silica claims.
Debt covenants. Letters of credit related to our Barracuda-Caratinga project and our $1.2 billion revolving credit facility contain restrictive covenants, including covenants that require us to maintain certain financial ratios as defined by the agreements. For the letters of credit related to our Barracuda-Caratinga project, we are required to maintain an interest coverage ratio of at least 3.5 and a leverage ratio of not greater than 55%. We are also required to maintain a debt-to-capitalization ratio of not greater than 60% for the $1.2 billion revolving credit facility. At September 30, 2005, our interest coverage ratio was 11, our leverage ratio was 30%, and our debt-to-capitalization ratio was 40%.

BUSINESS ENVIRONMENT AND RESULTS OF OPERATIONS

We currently operate in over 100 countries throughout the world, where we provide a comprehensive range of discrete and integrated products and services 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 products and services provided to major, national, and independent oil and gas companies are used throughout the energy industry from the earliest phases of exploration, development, and production of oil and gas through refining, processing, and marketing. Our six business segments are organized around how we manage the business: Production Optimization, Fluid Systems, Drilling and Formation Evaluation, Digital and Consulting Solutions, Government and Infrastructure, and Energy and Chemicals. We refer to the combination of Production Optimization, Fluid Systems, Drilling and Formation Evaluation, and Digital and Consulting Solutions segments as the Energy Services Group (ESG), and the combination of Government and Infrastructure and Energy and Chemicals as KBR.
The industries we serve are highly competitive with many substantial competitors for each segment. In the first nine months of 2005, based upon the location of the services provided and products sold, 26% of our consolidated revenue was from Iraq, primarily related to work for the United States

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Government, and 26% of our consolidated revenue was from the United States. In the first nine months of 2004, 30% 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, exploration and production spending by international and national oil companies, the world economy, and global stability, which together drive worldwide drilling activity. Also, our margins associated with services and products for offshore rigs are generally higher than those associated with land rigs. 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 prices for two recognized benchmarks and average Henry Hub natural gas prices:

   
Three Months Ended
 
Year Ended
 
   
September 30
 
December 31
 
   
2005
 
2004
 
2004
 
Average Oil Prices (dollars per barrel)
                   
West Texas Intermediate
 
$
62.70
 
$
43.38
 
$
41.31
 
United Kingdom Brent
   
61.57
   
41.11
   
38.14
 
Average Gas Prices (dollars per million cubic feet)
                   
Henry Hub
 
$
9.53
 
$
5.46
 
$
5.85
 

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

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Three Months Ended
 
Nine Months Ended
 
   
September 30
 
September 30
 
Average Rig Counts
 
2005
 
2004
 
2005
 
2004
 
Land vs. Offshore
                         
United States:
                         
Land
   
1,330
   
1,134
   
1,250
   
1,074
 
Offshore
   
98
   
95
   
97
   
96
 
Total
   
1,428
   
1,229
   
1,347
   
1,170
 
Canada:
                         
Land
   
492
   
321
   
416
   
348
 
Offshore
   
5
   
5
   
4
   
4
 
Total
   
497
   
326
   
420
   
352
 
International (excluding Canada):
                         
Land
   
639
   
613
   
636
   
587
 
Offshore
   
272
   
233
   
265
   
240
 
Total
   
911
   
846
   
901
   
827
 
Worldwide total
   
2,836
   
2,401
   
2,668
   
2,349
 
Land total
   
2,461
   
2,068
   
2,302
   
2,009
 
Offshore total
   
375
   
333
   
366
   
340
 

   
Three Months Ended
 
Nine Months Ended
 
   
September 30
 
September 30
 
Average Rig Counts
 
2005
 
2004
 
2005
 
2004
 
Oil vs. Gas
                         
United States:
                         
Oil
   
195
   
169
   
179
   
160
 
Gas
   
1,233
   
1,060
   
1,168
   
1,010
 
Total
   
1,428
   
1,229
   
1,347
   
1,170
 
Canada: *
   
497
   
326
   
420
   
352
 
International (excluding Canada):
                         
Oil
   
711
   
662
   
696
   
640
 
Gas
   
200
   
184
   
205
   
187
 
Total
   
911
   
846
   
901
   
827
 
Worldwide total
   
2,836
   
2,401
   
2,668
   
2,349
 
* Canadian rig counts by oil and gas were not available.

Our customers’ cash flows, in many instances, depend upon the revenue they generate from the sale of oil and gas. Higher oil and gas prices usually translate into higher exploration and production budgets. Higher prices also improve the economic attractiveness of marginal exploration areas. This drives additional investment by our customers in the sector, which benefits us. The opposite is true for lower oil and gas prices.
United States oil prices continued to trend upward in the third quarter of 2005, and the Energy Information Administration (EIA) expects prices to remain above $60 per barrel for the rest of 2005 and 2006. Recent increases in crude oil prices are due to a combination of the following factors:
 
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growth in worldwide petroleum demand remains robust, despite high oil prices;
 
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projected growth in non-Organization of Petroleum Exporting Countries (non-OPEC) supplies is not expected to accommodate worldwide demand growth;
 
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worldwide spare crude oil production capacity has recently diminished and is projected to remain low;

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downstream sectors, such as refining and shipping, are expected to keep the level of uncertainty in world oil markets high as there is limited refining capacity available, particularly in the United States; and
 
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loss of additional capacity due to recent hurricanes in an already tight refining market.
United States natural gas prices for the third quarter of 2005 continued to move higher compared to last quarter and a year ago. Despite adequate natural gas storage, high natural gas prices are expected to persist into 2006 due to a continued strong economy, constraints on pipeline infrastructure, stalled growth in gas production in North America as a result of recent hurricanes in the Gulf of Mexico, and high global oil prices.
Heightened energy demand coupled with high petroleum and natural gas prices in the first nine months of 2005 contributed to a 14% increase in average worldwide rig count compared to the first nine months of 2004. This increase was primarily driven by the United States rig count, which grew 15% year-over-year. Our ESG revenue in the United States grew 35% year-over-year on this 15% rig count increase. Land gas drilling in the United States rose sharply, as gas prices remained high due to economic demand growth and higher fuel oil prices that discouraged switching to a lower-priced fuel source to minimize cost. Average Canadian rig counts increased 19% in the first nine months of 2005 compared to the same period in 2004. Outside of North America, average rig counts increased in Latin America, Asia Pacific, and the Middle East, with most of the increase related to oil drilling.
As of September 2005, Spears and Associates predicted that the United States average rig count in 2005 will increase 16% over 2004. Canadian and international average rig counts in 2005 are expected to rise 22% and 8% over 2004.
It is common practice in the United States oilfield services industry to sell services and products based on a price book and then apply discounts to the price book based upon a variety of factors. The discounts applied typically increase to partially or substantially offset price book increases in the weeks immediately following a price increase. The discount applied normally decreases over time if the activity levels remain strong. During periods of reduced activity, discounts normally increase, reducing the net revenue for our services and, conversely, during periods of higher activity, discounts normally decline resulting in net revenue increasing for our services.
In the second and third quarters of 2004 and in April 2005, we implemented several United States price book increases ranging from 5% to 15%, primarily in pressure pumping services. During the first nine months of 2005, we realized some of the benefits of these price book increases, and we expect further improvements during the remainder of 2005. In October 2005, we implemented additional price book increases ranging from 6% to 18% in our Fluid Systems, Drilling and Formation Evaluation, and Production Optimization segments. In addition, price book increases ranging from 5% to 9% in our Digital and Consulting Solutions segment will be implemented in January 2006. We continue to work diligently to minimize the impact of inflationary pressures in our cost base and are maintaining a steady focus on capital discipline.
Overall outlook. The outlook for world oil demand continues to remain strong, with China and North America accounting for approximately 45% of the expected demand growth in 2006. Chinese demand growth has declined recently, although we believe this is likely temporary as China’s economic indicators point to robust economic growth. Excess oil production capacity is expected to remain low and that, along with strong demand, should keep supplies tight. Thus, any unexpected supply disruption or change in demand could lead to fluctuating prices. The EIA forecasts world petroleum demand growth for 2005-2006 to remain strong, but down from the rate of demand growth seen in 2004.
We are well-positioned in the United States pressure pumping services market where we have a leading share. One of our fastest growing operations is production enhancement, where we help our customers optimize the production rates from the wells by providing stimulation services. Among the other opportunities we see ahead is the recovery in deepwater drilling. Demand for rigs to drill in the deepwater of the Gulf of Mexico is increasing. Despite having downsized our Gulf of Mexico operations due to its downturn in 2002-2003, we continue to have a significant presence in the area and are positioned to meet increasing customer demand. However, the Gulf of Mexico operations have been and can continue to be adversely affected by the hurricane season, which lasts from June through November. Since July 2005,

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four hurricanes adversely affected the Gulf of Mexico operations resulting in lower activity in the third quarter. We expect customers to resume activity in the Gulf of Mexico throughout the end of the year and into the first half of 2006. Finally, Canada is experiencing activity growth subsequent to constrained demand from weather-related slow-downs in the second quarter of 2005.
We also see potential to leverage our global infrastructure to increase the share of our business that comes from outside of the United States. We have begun to realize some of this growth in the first nine months of 2005, as ESG international revenue increased 18% over the same period in 2004 on a 9% increase in international rig count.
In our Middle East/Asia region, Saudi Arabia is working to increase production and has increased its demand for oil services. Our subsidiary, WellDynamics, is currently supplying intelligent well completions in the region. Our involvement in Oman has expanded as a result of three major contracts over the next five years to provide cementing, stimulation, directional drilling, logging-while-drilling, and mud logging services. In our Drilling and Formation Evaluation, Fluid Systems, and Production Optimization segments, we also have new multiyear contracts in Malaysia and Thailand. We have mobilized additional service equipment and personnel to meet the overall rig and exploration and production demand and, although revenue has fluctuated and may fluctuate from period to period as a result of moving equipment and personnel and timing of projects in specific countries, we are seeing growth in these markets.
In our Europe/Africa/CIS region, strengthening demand in Algeria, Nigeria, and the North Sea has improved our asset utilization in all of our oilfield service product lines, and we are positioned to capitalize on this opportunity. In Russia, we are working for various domestic and international customers and we believe that the business environment from a risk perspective has improved from nine months ago. Consequently, we are doubling our stimulation capacity in Russia. Recent awards in Azerbaijan in our Drilling and Formation Evaluation segment and in northern Kazakhstan in our Drilling and Formation Evaluation, Fluid Systems, and Production Optimization segments will further improve our position in the Caspian as this area expands its demand for oilfield services. In Angola, where demand is driven by deepwater development, our Fluid Systems and Production Optimization segments were recently awarded contracts and are actively pursuing more. We also see additional growth opportunities in the region through expanding our position in Libya.
In Latin America, our overall performance has declined, particularly in Venezuela where international oil companies are hesitant to enter into long-term commitments because of political uncertainty. Despite the early problems with our fixed-price, turnkey drilling projects in southern Mexico, margins have improved, and we expect to carry forward recent operational performance improvements through the remainder of the projects and complete them in the spring of 2006.
Finally, technology is an important aspect of our business, and we continue to focus on improving the development and introduction of new technologies, such as:
 
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DecisionSpace® Nexus™ software, a breakthrough technology designed to perform reservoir simulation on both simple and complex reservoirs at unprecedented speed;
 
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Zero-D™ diesel free liquid gel concentrates, which will help operators move to higher levels of environmental performance;
 
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Halliburton’s Diamond Series™ interventionless completion system solutions, which reduce completion costs as a result of reduced rig time and increases safety for all personnel on the rig site;
 
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Thermatek® water shutoff treatment technology, which helps to bring a field back on to production after being shut-in because of excessive water, to avoid the expense and lost production of either abandoning or re-drilling the well; and
 
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DeepQuestsSM technology, which is specifically aimed at deep shelf and deep water field development, but is also applicable in land applications. Using a weighted fluid makes it possible to achieve required treating pressure at the formation face by taking advantage of the hydrostatic pressure of the fluid column.

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KBR
KBR provides a wide range of services to energy and industrial customers and government entities worldwide. 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.
Effective October 1, 2004, we restructured KBR into two segments, Government and Infrastructure and Energy and Chemicals. As a result of the reorganization and in a continued effort to better position KBR for the future, we made several strategic organizational changes. We eliminated certain internal expenditures, we refocused our research and development expenditures with emphasis on the more profitable LNG market, and took appropriate steps to streamline the entire organization. KBR’s results in the first nine months of 2005 reflect cost savings related to the restructuring, which was designed to yield approximately $100 million in annual savings.
In our Government and Infrastructure segment, our most significant contract is the worldwide United States Army logistics contract, known as LogCAP. We were awarded the competitively bid LogCAP contract in December 2001 from the Army Material Command (AMC) to provide worldwide United States Army logistics services. The contract is a one-year contract with nine one-year renewal options. We are currently in year four of the contract. The AMC can terminate, reduce the amount of work, or replace our contract with a new competitively bid contract at any time during the term of the contract.
During the second quarter of 2005, a $4.97 billion task order was assigned for the next phase of work under the LogCAP contract in Iraq and replaces several task orders that are nearing completion. Despite this award, we expect the volume of work under our LogCAP contract to continue to decline into 2006, as our customer scales back the amount of services that we provide. We were also selected to provide logistics services to the United States forces deployed in the Balkans and throughout the United States Army Europe’s area of responsibility. This support contract has a maximum capacity of $1.25 billion for up to five years. We are currently looking into other opportunities with the United States Air Force, the United States Navy, and the United Kingdom Ministry of Defence in order to diversify our government services portfolio.
Within our Energy and Chemicals segment, the major focus is on our gas monetization work. Forecasted LNG market growth remains strong and is expected to grow rapidly, with demand projected to double in the period through 2015. Significant numbers of new LNG liquefaction plant and LNG receiving terminal projects are proposed worldwide and are in various stages of development. Committed LNG liquefaction engineering, procurement, and construction (EPC) projects will yield substantial growth in worldwide LNG liquefaction capacity. This trend is expected to continue through 2007 and beyond. Our extensive experience in providing engineering, design, and construction services in the liquefied natural gas industry, particularly liquefaction facilities, positions us to benefit from the growth we are seeing in this industry.
In March 2005, KBR and its joint venture partners were awarded a gas monetization contract valued at $1.8 billion for the engineering, procurement, construction, and commissioning of the Tangguh LNG facility in Indonesia. In April 2005, KBR and a joint venture partner were also awarded an EPC contract valued at $1.7 billion for a GTL facility in Escravos, Nigeria. Also in April 2005, KBR and its joint venture partners were awarded a front end engineering and design contract (FEED) encompassing offshore and onshore operations to monetize significant gas resources from fields located offshore Angola. In July 2005, KBR and our joint venture partners were awarded a cost reimbursable FEED contract and an option for a cost reimbursable engineering, procurement, and construction management (EPCM) contract for the greater Gorgon Downstream LNG Project in Western Australia. The award of the FEED contract continues to demonstrate KBR’s long-standing project execution experience on Australian LNG projects. In August 2005, KBR renewed an alliance with one of its joint venture partners in order to build upon their respective strengths and work together to pursue and execute the engineering and construction of LNG and GTL projects around the world. In September 2005, this joint venture was awarded a project management contract for a GTL project in Qatar. In September 2005, KBR and its joint venture partners were also awarded a lump-sum turnkey contract valued at more than $2.0 billion to provide engineering, procurement,

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construction, pre-commissioning, commissioning, start-up, and operations services for Yemen’s first LNG plant. In October 2005, KBR and its joint venture partners executed a contract to prepare the lump-sum turnkey price for Latin America’s first LNG facility to be located in Peru. At September 30, 2005, we had $3.8 billion in backlog related to major gas monetization projects.
We believe significant opportunities also exist within KBR’s traditional upstream oil and gas market that includes onshore and offshore oil and gas facilities and pipelines around the world. KBR is currently targeting reimbursable EPC and EPCM opportunities in North and West Africa, the Caspian region, Asia Pacific, Latin America, and the North Sea. KBR has a track record of profitability in this sector by employing execution expertise and these lower risk contracting structures. KBR continues to play an important role as a leading provider of gas monetization solutions around the world.
Outsourcing of operations and maintenance work by industrial and energy companies has been increasing worldwide. Even greater opportunities in this area are anticipated as the aging infrastructure in United States refineries and chemical plants requires more maintenance and repairs to minimize production downtime. More stringent industry safety standards and environmental regulations also lead to higher maintenance standards and costs.
Contract structure. Engineering and construction contracts can be broadly categorized as either cost-reimbursable or fixed-price, sometimes referred to as lump sum. Some contracts can involve both fixed-price and cost-reimbursable elements. Fixed-price contracts are for a fixed sum to cover all costs and any profit element for a defined scope of work. Fixed-price contracts entail more risk to us as we must predetermine both the quantities of work to be performed and the costs associated with executing the work. While fixed-price contracts involve greater risk, they also are potentially more profitable for the contractor, since the owner/customer pays a premium to transfer many risks to the contractor.
Cost-reimbursable contracts include contracts where the price is variable based upon our actual costs incurred for time and materials, or for variable quantities of work priced at defined unit rates. Profit elements on cost-reimbursable contracts may be based upon a percentage of costs incurred and/or a fixed amount. Cost-reimbursable con