The market value of crude oil put options purchased last year, along with the impact of a rising stock price on a stock-based employee compensation plan, made Nexen one of the few producers to report sharply lower first quarter 2005 financial results. The company’s net income was down 80% to 29 cents/share ($37 million) despite its cash flow being up 26% and its production being up about 0.8%.

Following its $2.1 billion North Sea acquisition from EnCana late last year, Nexen purchased put options on 60,000 bbl/d of oil production for 2005 and 2006 for $144 million to ensure base cash flow to support development projects. The options created an average floor price for this production of US$43.17/bbl in 2005 and US$38.17/bbl in 2006. However, accounting rules required that the options be recorded at fair value throughout their term. As a result, changes in forward crude oil prices cause gains or losses to be recorded on these options each quarter.

While a gain of $56 million ($38 million after tax) was recorded in the fourth quarter of 2004, a significant increase in forward crude oil prices during the first quarter of 2005 resulted in an expense of $173 million ($114 million after tax). The carrying value of the options at the end of the first quarter was $27 million.

“Unlike other hedging strategies, the maximum cost of our put strategy is limited to the price we paid last year. This strategy allows us to realize the benefits of higher crude oil prices on all of our production while receiving protection against lower prices,” said Nexen CEO Charlie Fischer. “Although accounting for these options adds volatility to our earnings quarter over quarter, it does not change the fundamentals of the strategy, which cost $144 million to implement. The volatility will decrease as these instruments get closer to their expiry.”

The company also had an adverse impact from its stock-based compensation plan. During the first quarter, Nexen’s stock price increased 36% or $17.50/share, adding $2.3 billion in shareholder value. As a result, $125 million ($83 million after tax) of stock-based compensation expense was recognized. Approximately 20% of this expense was in cash, while the balance represents the change in value of Nexen’s accrued stock-based compensation.

Meanwhile, Nexen’s production rose slightly compared to the fourth quarter of 2004, with higher rates from Yemen and the North Sea and a solid quarter from Canada, more than offsetting shortfalls from the U.S. and Syncrude. Production from the Gulf of Mexico plummeted 15%, largely because of lower result from the Aspen field where Nexen experienced increased water production. Nexen’s U.S. natural gas production was down 24% to 127 MMcf/d compared to 167 MMcf/d in the first quarter of 2004. Its Canadian natural gas production was down 4% to 143 MMcf/d.

“Overall, our quarterly production was very strong from most areas of the business,” said Fischer. “[W]e continue to expect our production to average between 230,000 and 250,000 boe/d, but now we should be able to achieve these volumes even after completing our disposition program later this year.

“With Buzzard, Long Lake and our other development projects on schedule, we expect to be producing between 300,000 and 350,000 boe/d before royalties in 2007,” he added. “Much of this growth will come from projects where we pay little or no royalties, generating annual growth rates between 15% and 20% on an after royalties basis between now and 2007. With oil prices at US$40, we expect cash flow to be in excess of $3 billion for 2007, approximately 50% higher than we expect for 2005.”

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