Interest based on debt outstanding increased $22 million from 2006 to 2007. This increase was largely due to higher average outstanding amounts for commercial paper and credit facility borrowings in 2007 than in 2006, partially offset by the effects of repaying various maturing notes in 2007 and 2006. Interest based on debt outstanding decreased $21 million from 2005 to 2006 primarily due to the repayment of various maturing notes in 2005 and 2006, partially offset by an increase in commercial paper borrowings during 2006 to fund the June 2006 Chief acquisition.
Capitalized interest increased from 2005 to 2007 primarily due to higher cumulative costs related to the development of the second phase of our Jackfish heavy oil development project in Canada and the construction of the related Access Pipeline. Higher development costs in the Gulf of Mexico and Brazil also contributed to the increase.
During 2005, we redeemed our $400 million 6.75% notes due March 15, 2011 and our zero coupon convertible senior debentures prior to their scheduled maturity dates. The other interest category in the table above includes $81 million in 2005 related to these early retirements.
Change in Fair Value of Financial Instruments
The details of the changes in fair value of financial instruments between 2005 and 2007 are shown in the table below.
| Year Ended December 31, | |||||||||
|---|---|---|---|---|---|---|---|---|---|
| 2007 | 2006 | 2005 | |||||||
| (In millions) | |||||||||
| Losses (gains) from: Option embedded in exchangeable debentures |
$ | 248 | 181 | 54 | |||||
| Chevron common stock | (281 | ) | — | — | |||||
| Interest rate swaps | (1 | ) | (3 | ) | (4 | ) | |||
| Non-qualifying commodity hedges | — | — | 39 | ||||||
| Ineffectiveness of commodity hedges | — | — | 5 | ||||||
| Total change in fair value of financial instruments | $ | (34 | ) | 178 | 94 | ||||
The change in the fair value of the embedded option relates to the debentures exchangeable into shares of Chevron common stock. These unrealized losses were caused primarily by increases in the price of Chevron's common stock.
Effective January 1, 2007 as a result of our adoption of Financial Accounting Standard No. 159, The Fair Value Option for Financial Assets and Financial Liabilities — Including an Amendment of FASB Statement No. 115, we began recognizing unrealized gains and losses on our investment in Chevron common stock in net earnings rather than as part of other comprehensive income. The change in fair value of our investment in Chevron common stock resulted from an increase in the price of Chevron's common stock during 2007.
In 2005, we recognized a $39 million loss on certain oil derivative financial instruments that no longer qualified for hedge accounting because the hedged production exceeded actual and projected production under these contracts. The lower than expected production was caused primarily by hurricanes that affected offshore production in the Gulf of Mexico.
Reduction of Carrying Value of Oil and Gas Properties
During 2006 and 2005, we reduced the carrying value of certain of our oil and gas properties due to full cost ceiling limitations and unsuccessful exploratory activities. A detailed description of how full cost ceiling limitations are determined is included in the "Critical Accounting Policies and Estimates" section of this report. A summary of these reductions and additional discussion is provided below.
| Year Ended December 31, | ||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| 2006 | 2005 | |||||||||||
| Gross | Net of Taxes |
Gross | Net of Taxes |
|||||||||
| (In millions) | ||||||||||||
| Brazil - unsuccessful exploratory reduction | $ | 16 | 16 | 42 | 42 | |||||||
| Russia - ceiling test reduction | 20 | 10 | — | — | ||||||||
| Total | $ | 36 | 26 | 42 | 42 | |||||||
2006 Reductions
During the second quarter of 2006, we drilled two unsuccessful exploratory wells in Brazil and determined that the capitalized costs related to these two wells should be impaired. Therefore, in the second quarter of 2006, we recognized a $16 million impairment of our investment in Brazil equal to the costs to drill the two dry holes and a proportionate share of block-related costs. There was no tax benefit related to this impairment. The two wells were unrelated to our Polvo development project in Brazil.
As a result of a decline in projected future net cash flows, the carrying value of our Russian properties exceeded the full cost ceiling by $10 million at the end of the third quarter of 2006. Therefore, we recognized a $20 million reduction of the carrying value of our oil and gas properties in Russia, offset by a $10 million deferred income tax benefit.
2005 Reduction
Prior to the fourth quarter of 2005, we were capitalizing the costs of previous unsuccessful efforts in Brazil pending the determination of whether proved reserves would be recorded in Brazil. At the end of 2005, it was expected that a small initial portion of the proved reserves ultimately expected at Polvo would be recorded in 2006. Based on preliminary estimates developed in the fourth quarter of 2005, the value of this initial partial booking of proved reserves was not sufficient to offset the sum of the related proportionate Polvo costs plus the costs of the previous unrelated unsuccessful efforts. Therefore, we determined that the prior unsuccessful costs unrelated to the Polvo project should be impaired. These costs totaled approximately $42 million. There was no tax benefit related to this Brazilian impairment.
Other Income, Net
The following schedule includes the components of other income between 2005 and 2007.
| Year Ended December 31, | |||||||||
|---|---|---|---|---|---|---|---|---|---|
| 2007 | 2006 | 2005 | |||||||
| (In millions) | |||||||||
| Interest and dividend income | $ | 89 | 100 | 95 | |||||
| Net gain on sales of non-oil and gas property and equipment | 1 | 5 | 150 | ||||||
| Loss on derivative financial instruments | — | — | (48 | ) | |||||
| Other | 8 | 10 | 1 | ||||||
| Total | $ | 98 | 115 | 198 | |||||
Interest and dividend income decreased from 2006 to 2007 primarily due to a decrease in income-earning cash and investment balances, partially offset by an increase in the dividend rate on our investment in Chevron common stock. Interest and dividend income increased from 2005 to 2006 primarily due to an increase in cash and short-term investment balances and higher interest rates.
During 2005, we sold certain non-core midstream assets for a net gain of $150 million. Also during 2005, we incurred a $55 million loss on certain commodity hedges that no longer qualified for hedge accounting and were settled prior to the end of their original term. These hedges related to U.S. and Canadian oil production from properties sold as part of our 2005 property divestiture program. This loss was partially offset by a $7 million gain related to interest rate swaps that were settled prior to the end of their original term in conjunction with the early redemption of the $400 million 6.75% senior notes in 2005.
Income Taxes
The following table presents our total income tax expense related to continuing operations and a reconciliation of our effective income tax rate to the U.S. statutory income tax rate for each of the past three years. The primary factors causing our effective rates to vary from 2005 to 2007, and differ from the U.S. statutory rate, are discussed below.
| Year Ended December 31, | |||||||||
|---|---|---|---|---|---|---|---|---|---|
| 2007 | 2006 | 2005 | |||||||
| Total income tax expense (In millions) | $ | 1,078 | 936 | 1,481 | |||||
U.S. statutory income tax rate |
35 | % | 35 | % | 35 | % | |||
| Canadian statutory rate reductions | (6 | %) | (7 | %) | — | ||||
| Texas income-based tax | — | 1 | % | — | |||||
| Repatriation of earnings | — | — | 1 | % | |||||
| Other, primarily taxation on foreign operations | (3 | %) | (3 | %) | (2 | %) | |||
| Effective income tax rate | 26 | % | 26 | % | 34 | % | |||
In 2007, 2006 and 2005, deferred income taxes were reduced $261 million, $243 million and $14 million, respectively, due to successive Canadian statutory rate reductions that were enacted in each such year.
In 2006, deferred income taxes increased $39 million due to the effect of a new income-based tax enacted by the state of Texas that replaced a previous franchise tax. The new tax was effective January 1, 2007.
In 2005, we recognized $28 million of taxes related to our repatriation of $545 million to the United States. The cash was repatriated to take advantage of U.S. tax legislation that allowed qualifying companies to repatriate cash from foreign operations at a reduced income tax rate. Substantially all of the cash repatriated by us in 2005 related to prior earnings of our Canadian subsidiary.
Earnings From Discontinued Operations
In November 2006 and January 2007, we announced our plans to divest our operations in Egypt and West Africa, including Equatorial Guinea, Cote d'Ivoire, Gabon and other countries in the region. Pursuant to accounting rules for discontinued operations, we have classified all 2007 and prior period amounts related to our operations in Egypt and West Africa as discontinued operations.
In October 2007, we completed the sale of our Egyptian operations and received proceeds of $341 million. As a result of this sale, we recognized a $90 million after-tax gain in the fourth quarter of 2007. In November 2007, we announced an agreement to sell our operations in Gabon for $205.5 million. We are finalizing purchase and sales agreements and obtaining the necessary partner and government approvals for the remaining properties in the West African divestiture package. We are optimistic we can complete these sales during the first half of 2008.
Following are the components of earnings from discontinued operations between 2005 and 2007.
| Year Ended December 31, | |||||||||
|---|---|---|---|---|---|---|---|---|---|
| 2007 | 2006 | 2005 | |||||||
| (In millions) | |||||||||
| Earnings from discontinued operations before income taxes | $ | 696 | 464 | 173 | |||||
| Income tax expense | 236 | 252 | 140 | ||||||
| Earnings from discontinued operations | $ | 460 | 212 | 33 | |||||
2007 vs. 2006 Earnings from discontinued operations increased $248 million in 2007. In addition to variances caused by changes in production volumes and realized prices, our earnings from discontinued operations in 2007 were impacted by other significant factors. Pursuant to accounting rules for discontinued operations, we ceased recording DD&A in November 2006 related to our Egyptian operations and in January 2007 related to our West African operations. This reduction in DD&A caused earnings from discontinued operations to increase $119 million in 2007. Earnings in 2007 also benefited from the $90 million gain from the sale of our Egyptian operations.
In addition, earnings from discontinued operations increased $90 million in 2007 due to the net effect of reductions in carrying value in 2006 and 2007. Our earnings in 2007 were reduced by $13 million from these reductions, compared to $103 million of reductions recorded in 2006. Due to unsuccessful drilling activities in Nigeria, in the first quarter of 2006, we recognized an $85 million impairment of our investment in Nigeria equal to the costs to drill two dry holes and a proportionate share of block-related costs. There was no income tax benefit related to this impairment. As a result of unsuccessful exploratory activities in Egypt during 2006, the net book value of our Egyptian oil and gas properties, less related deferred income taxes, exceeded the ceiling by $18 million as of the end of September 30, 2006. Therefore, in 2006 we recognized an $18 million after-tax loss ($31 million pre-tax). In the second quarter of 2007, based on drilling activities in Nigeria, we recognized a $13 million after-tax loss ($64 million pre-tax).
2006 vs. 2005 Earnings from discontinued operations increased $179 million in 2006. This increase was largely due to an increase in realized crude oil prices, partially offset by a 19% decline in oil production.
In addition, earnings from discontinued operations increased $16 million due to the net effect of a $119 million after-tax impairment of our investment in Angola in 2005, partially offset by the 2006 Nigerian and Egyptian impairments totaling $103 million as described above. Our interests in Angola were acquired through the 2003 Ocean Energy merger, and our Angolan drilling program discovered no proven reserves. After drilling three unsuccessful wells in the fourth quarter of 2005, we determined that all of the Angolan capitalized costs should be impaired. As a result, we recognized a $170 million impairment with a $51 million related tax benefit.