Notes to the Group financial statements
Year ended 31 December 2009

• Note 18: Financial instruments
• Note 19: Obligations under finance leases
• Note 20: Provisions
• Note 21: Reconciliation of changes in equity
• Note 22: Called up equity share capital and share premium account
• Note 23: Other reserves
• Note 24: Minority interest
• Note 25: Cash flows from operating activities
• Note 26: Disposal of subsidiaries and oil and gas assets
• Note 27: Share-based payments
• Note 28: Operating lease arrangements
• Note 29: Capital commitments
• Note 30: Contingent liabilities
• Note 31: Related party transactions
• Note 32: Subsequent events
• Note 33: Pension schemes

Note 18. Financial instruments

Financial risk management objectives

The Group holds a portfolio of commodity derivative contracts, with various counterparties, covering both its underlying oil and gas businesses. In addition, the Group holds a small portfolio of interest rate derivatives. The use of financial derivatives is governed by the Group’s policies approved by the Board of Directors. Compliance with policies and exposure limits is reviewed by the internal auditors on a regular basis. The Group does not enter into or trade financial instruments, including derivative financial instruments, for speculative purposes.

Fair values of financial assets and liabilities

The Group considers the carrying value of all the financial assets and liabilities to be materially the same as the fair value. The Group has no material financial assets that are past due. The Group predominately sells to large oil and gas multinationals and no financial assets are impaired at the balance sheet date and all are considered to be fully recoverable.

Fair values of derivative instruments

Under IAS 39 all derivatives must be recognised at fair value on the balance sheet with changes in such fair value between accounting periods being recognised immediately in the income statement, unless the derivatives have been designated as cash flow or fair value hedges. The fair value is the amount for which the asset or liability could be exchanged in an arm’s length transaction at the relevant date. Fair values are determined using quoted market prices (marked-to-market values) where available. To the extent that market prices are not available, fair values are estimated by reference to market-based transactions, or using standard valuation techniques for the applicable instruments and commodities involved.

The Group’s derivative instrument book and fair values were as follows:

The derivatives’ maturity and the timing of the recycling into profit or loss coincide.

The following provides an analysis of financial instruments that are measured subsequent to initial recognition at fair value, grouped into Level 1 to 3 based on the degree to which the fair value is observable:

All derivative financial instruments of the Group are level 2 (2008: level 2).

Level 1: fair value measurements are those derived from quoted prices (unadjusted) in active markets for identical assets or liabilities;

Level 2: fair value measurements are those derived from inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly (i.e. as prices) or indirectly (i.e. derived from prices); and

Level 3: fair value measurements are those derived from valuation techniques that include inputs for the asset or liability that are not based on observable market data (unobservable inputs).

There were no transfers between Level 1 and 2 during the year.

Market risk

The Group’s activities expose it primarily to the financial risks of changes in commodity prices, foreign currency exchange rates and interest rates.

Oil and gas prices

The Group uses a number of derivative instruments to mitigate the commodity price risk associated with its underlying oil and gas revenues. Such commodity derivatives will tend to be priced using pricing benchmarks, such as Brent Dated, D-1 Heren and M-1 Heren, which correlate as far as possible to the underlying oil and gas revenues respectively. The Group hedges its estimated oil and gas revenues on a portfolio basis, aggregating its oil revenues from substantially all of its African oil interests and its gas revenues from substantially all of its UK gas interests.

At 31 December 2009, the Group’s oil hedge position was summarised as follows:

As at 31 December 2009, all of the Group’s oil and gas derivatives have been designated as cash flow hedges. The Group’s oil and gas hedges have been assessed to be ‘highly effective’ within the range prescribed under IAS 39 using regression analysis on oil and ratio analysis on gas. There is, however, a degree of ineffectiveness inherent in the Group’s oil hedges arising from, among other factors, the discount on the Group’s underlying African crude relative to Brent and the timing of oil liftings relative to the hedges. There is also a degree of ineffectiveness inherent in the Group’s gas hedges which arise from, among other factors, field production performance on any day.

Income statement hedge summary

The changes in the fair value of hedges which are required to be recognised immediately in the income statement for the year were as follows:

The following table summarises the deferred (losses)/gains on derivative instruments, net of tax effects, recorded in the hedge reserve (note 23) for the year:

The hedge reserve represents the cumulative portion of gains and losses on hedging instruments deemed effective in cash flow hedges. The movement for the period in the hedge reserve is recognised in other comprehensive income.

Gains from settlements during the period amounted to £15.3 million, while revaluation losses during the period amounted to £25.6 million. The resulting total reclassification from equity to profit or loss during the period was £40.9 million. Gains transferred from equity into profit and loss during the period of £15.3 million are included in the revenue line.

Financial derivatives

The Group internally measures its market risk exposure by running various sensitivity analyses, including utilising 10% favourable and adverse changes in the key variables.

Oil and gas sensitivity analysis

The following analysis, required by IFRS 7, is intended to illustrate the sensitivity to changes in market variables, being Dated Brent oil prices and UK D-1 Heren and M-1 Heren natural gas prices. The sensitivity analysis, which is used internally by management to monitor financial derivatives, has been prepared using the following assumptions:

• The pricing adjustments relate only to the point forward mark-to-market (MTM) evaluations;
• The price sensitivities assume there is no ineffectiveness related to the oil and gas hedges; and
• The sensitivities have been run only on the intrinsic element of the hedge as management consider this to be the material component of the MTM oil and gas hedges.

As at 31 December 2009, a 10% increase in the dated Brent oil price curve would have decreased equity by approximately £10.3 million (2008: £22.0 million), a 10% decrease would have increased equity by approximately £6.6 million (2008: £27.0 million).

As at 31 December 2009, a 10% increase in the UK D-1 Heren and M-1 Heren natural gas price curves would have decreased equity by approximately £2.9 million (2008: £10.5 million), a 10% decrease would have increased equity by approximately £3.2 million (2008: £10.3 million).

Interest rate sensitivity analysis

As at 31 December 2009, the interest rate derivative position was out-of-the-money to an amount of £5.6 million (2008: £2.1 million); a 25bps increase in the underlying interest rate would increase equity by approximately £1.5 million (2008: £0.5 million).

Credit risk

Credit risk refers to the risk that the counterparty will fail to perform or fail to pay amounts due, resulting in financial loss to the Group. The primary activities of the Group are oil and gas exploration and production. The Group has a credit policy that governs the management of credit risk, including the establishment of counterparty credit limits and specific transaction approvals. The Group limits credit risk by assessing creditworthiness of potential counterparties before entering into transactions with them and continuing to evaluate their credit worthiness after transactions have been initiated. The Group attempts to mitigate credit risk by entering into contracts that permit netting and allow for termination of the contract upon the occurrence of certain events of default. The Group’s exposure and the credit ratings of its counterparties are continuously monitored and the aggregate value of transactions concluded is spread amongst approved counterparties.

The Group does not have any significant credit risk exposure to any single counterparty or any group of counterparties having similar characteristics. The maximum financial exposure due to credit risk on the Group’s financial assets, representing the sum of cash and cash equivalents, investments, derivative assets, trade receivables and other current assets, as at 31 December was £404.2 million (2008: £490.2 million).

Note 19. Obligations under finance leases

The fair value of the Group’s lease obligations approximates the carrying amount. The remaining lease term is two years (2008: three years). For the year ended 31 December 2009, the effective borrowing rate was 2.8% (2008: 2.8%).

Note 20. Provisions

(i) Decommissioning costs

The decommissioning provision represents the present value of decommissioning costs relating to the UK, African and Asian oil and gas interests, which are expected to be incurred up to 2025. These provisions have been created based on Tullow’s internal estimates and, where available and appropriate, operator’s estimates. Assumptions, based on the current economic environment, have been made which management believe are a reasonable basis upon which to estimate the future liability. These estimates are reviewed regularly to take into account any material changes to the assumptions. However, actual decommissioning costs will ultimately depend upon future market prices for the necessary decommissioning works required which will reflect market conditions at the relevant time. Furthermore, the timing of decommissioning is likely to depend on when the fields cease to produce at economically viable rates. This in turn will depend upon future oil and gas prices, which are inherently uncertain.

(ii) Deferred taxation

No deferred tax has been provided on unremitted earnings of overseas subsidiaries, as the Group has no plans to remit these to the UK in the foreseeable future.

Deferred tax assets are recognised only to the extent it is considered probable that those assets will be recoverable. This involves an assessment of when those deferred tax assets are likely to reverse, and a judgement as to whether or not there will be sufficient taxable profits available to offset the tax assets when they do reverse. This requires assumptions regarding future profitability and is therefore inherently uncertain. To the extent assumptions regarding future profitability change, there can be an increase or decrease in the level of deferred tax assets recognised which can result in a charge or credit in the period in which the change occurs.

Note 21. Reconciliation of changes in equity

During 2009 the Company issued 66,938,141 ordinary shares via an equity placing. In accordance with the provisions of Section 612 of the Companies Act 2006, the Company has transferred the premium on the shares issued of £394.9 million (£384.8 million net of expenses), using the market value at the date of acquisition, to retained earnings as the premium is considered to be realised.

The foreign currency translation reserve represents exchange gains and losses arising on translation of foreign currency subsidiaries, monetary items receivable from or payable to a foreign operation for which settlement is neither planned nor likely to occur, which form part of the net investment in a foreign operation, and exchange gains or losses arising on long-term foreign currency borrowings which are a hedge against the Group’s overseas investments.

The hedge reserve represents gains and losses on hedging instruments classed as cash flow hedges that are determined as an effective hedge.

The treasury shares reserve represents the cost of shares in Tullow Oil plc purchased in the market and held by the Tullow Oil Employee Trust to satisfy awards held under the Group’s share incentive plans (see note 27).

Note 24. Minority interest

The minority interest materially relates to Tulipe Oil SA, where the Group acquired a 50% controlling shareholding during 2007.

Note 25. Cash flows from operating activities

Note 26. Disposal of subsidiaries and oil and gas assets

(i) Disposal of subsidiary

Tullow completed the sale of Tullow Oil UK Limited incorporating the 51.68% interest in the Hewett-Bacton complex to ENI in November 2008.

The net assets of Tullow Oil UK Limited at the date of disposal in November 2008 were as follows:

An additional £10.1 million has been recognised on this sale during 2009 following the settlement of tax and other working capital adjustments.

(ii) Disposal of oil and gas assets

Profit on disposal of oil and gas assets of £3.1 million (2008: £30.6 million) comprises £2.5 million deferred consideration received due to the extension of the Ngosso Permit in Cameroon that was sold during 2007 and £0.3 million in relation to the CMS disposal during 2008. The remaining £0.3 million is consideration received at first gas in relation to the West Bukha field in Oman that was sold during 1996.

Note 27. Share-based payments

2005 Performance Share Plan (PSP)

Under the PSP, senior executives can receive conditional awards of rights over whole shares worth up to 200% of salary p.a. (300% in exceptional circumstances). Awards granted in 2009 vest subject to a Total Shareholder Return (TSR) performance condition. Half of an award is tested against constituents of the FTSE 100 index (excluding investment trusts) and the other half against a comparator group of oil and gas companies. Performance is measured over a fixed three year period starting on 1 January prior to grant, and an individual must normally remain in employment for three-years from grant for the shares to vest. No dividends are paid over the vesting period. There are further details of PSP award measurement in the Directors’ Remuneration Report.

The shares outstanding under the PSP are as follows:

The expected life is the period from date of grant to vesting. Expected volatility was determined by calculating the historical volatility of the Company’s share price over a period commensurate with the expected life of the awards. The weighted average fair value of the awards granted in 2009 was 579.9p per award (2008: 653.9p).

The Group recognised a total expense of £3.6 million (2008: £4.0 million) in respect of the PSP.

2005 Deferred Share Bonus Plan (DSBP)

Under the DSBP, the portion of any annual bonus above 75% of the base salary (60% for bonuses paid for 2007 and earlier years) of a senior executive nominated by the Remuneration Committee is deferred into shares. DSBP awards normally vest following the end of three financial years commencing with that in which the award is granted.

The shares outstanding under the DSBP are as follows:

The expected life is the period from the date of grant to the vesting date. The fair value of the awards granted in 2009 was 760.2p per award (2008: 611.9p).

The Group recognised a total expense of £0.5 million (2008: £0.5 million) in respect of the DSBP.

2000 Executive Share Option Scheme (ESOS)

The only share option scheme operated by the Company during the year was the 2000 ESOS. Options normally only become exercisable from the third anniversary of the date of the grant and if the performance condition has been met. The awards are tested against constituents of an index and 100% of awards will vest if the Company’s TSR is above the median of the index over three years following grant. For awards from March 2008 the Index is the FTSE 100 index (excluding investment trusts); for awards before March 2008, the Index is the FTSE 250 index (excluding investment trusts).

Options granted under the previous 1998 ESOS had all been exercised at 31 December 2009. All awards under the 1998 ESOS were made prior to 7 November 2002 and therefore, under the IFRS transitional provisions, they have not been accounted for in accordance with IFRS 2 – Share-based payments.

The following table illustrates the number and weighted average exercise prices (WAEP) of, and movements in, share options under the 1998 ESOS and the 2000 ESOS during the year.

The weighted average share price at exercise for options exercised in 2009 was 1,000.5p (2008: 854.3p).

Options outstanding at 31 December 2009 had exercise prices of 63.0p to 1,179.0p and remaining contractual lives of 1 to 10 years.

The fair values were calculated using a proprietary binomial valuation model. The principal inputs to the options valuation model were:

Expected volatility was determined by calculating the historical volatility of the Company’s share price over a period commensurate with the expected lifetime of the awards.

The fair values and expected lives of the options valued in accordance with IFRS 2 were:

The Group recognised a total expense of £1.8 million (2008: £3.2 million) in respect of the ESOS.

UK & Irish Share Incentive Plans (SIPs)

The SIPs were launched at the beginning of 2004. These are all employee plans, which have been set up in the UK and Ireland, enable employees to save out of salary up to prescribed monthly limits. Contributions are used by the Plan trustees to acquire Tullow shares (‘Partnership Shares’). The Company makes a matching contribution to acquire a matching number of Tullow shares (‘Matching Shares’) on a one-for-one basis at the end of each three month accumulation period. Matching shares are subject to time based forfeiture over three years on leaving employment in certain circumstances or if the related Partnership shares are sold.

The fair value of a Matching Share is its market value at the start of the accumulation period.

For the UK plan, Partnership Shares are purchased at the lower of the market values at the start of the Accumulation Period and the purchase date (which is treated as a three month share option for IFRS 2 purposes). For the Irish plan, shares are bought at the market price at the purchase date which does not result in any IFRS 2 accounting charge.

Matching shares vest three years after grant and dividends are paid to the employee during this period.

The Group recognised a total expense of £0.1 million (2008: £0.1 million) for the matching shares and £0.1 million (2008: £0.1 million) for the partnership shares.

Note 28. Operating lease arrangements

At the balance sheet date, the Group had outstanding commitments for future minimum lease payments under non-cancellable operating leases, which fall due as follows:

Operating lease payments represent rentals payable by the Group for certain of its office properties and a lease for an FPSO vessel for use on the Chinguetti field in Mauritania. Leases on office properties are negotiated for an average of six years and rentals are fixed for an average of six years. The FPSO lease runs for a minimum period of seven years from February 2006 and the contract provides for an option to extend the lease for a further three years at a slightly reduced rate.

Note 29. Capital commitments

Capital commitments as at 31 December 2009 are £810.4 million (2008: £606.2 million).

Note 30. Contingent liabilities

At 31 December 2009 there existed contingent liabilities amounting to £150.3 million (2008: £73.3 million) in respect of performance guarantees for committed work programmes.

Note 31. Related party transactions

The Directors of Tullow Oil plc are considered to be the only key management personnel as defined by IAS 24 – Related party disclosures.

Short-term employee benefits

These amounts comprise fees paid to the Directors in respect of salary and benefits earned during the relevant financial year, plus bonuses awarded for the year.

Post employment benefits

These amounts comprise amounts paid into the pension schemes of the Directors.

Amounts awarded under long-term incentive schemes

These amounts relate to the shares granted under the annual bonus scheme that is deferred for three years under the Deferred Share Bonus Plan (DSBP).

Share-based payments

This is the cost to the Group of Directors’ participation in share-based payment plans, as measured by the fair value of options and shares granted, accounted for in accordance with IFRS 2 ‘Share-based Payments’.

There are no other related party transactions. Further details regarding transactions with the Directors of Tullow Oil plc are disclosed in the Remuneration Report.

Note 32. Subsequent events

Since the balance sheet date Tullow has continued to progress its exploration, development and business growth strategies.

In January 2010 the Group announced the successful placing and subsequent issue of a total of 80,431,796 new ordinary shares with institutions at 1,150 pence per share. This represents an increase of approximately 9.99% in Tullow’s existing issued share capital. These shares are credited as fully paid and rank pari passu in all respects with existing ordinary shares of 10 pence each in the capital of the Company, including the right to receive all dividends and other distributions declared, made or paid on or in respect of such shares after the date of issue.

In January 2010 the Group announced that it had exercised its pre-emption rights over Heritage Oil’s Ugandan sale for up to $1.5 billion (£1.0 billion). In addition, two new potential partners have been identified, CNOOC and Total, and it is expected that each partner will acquire a one third interest in each of the three Ugandan blocks. The Group expects the transaction to be signed in the coming weeks.

In January 2010 the Group announced that the appraisal well, Tweneboa 2, proved up a combined oil and gas-condensate column of at least 35 metres. This has confirmed Tweneboa as a major oil and gas-condensate field.

Note 33. Pension schemes

The Group operates defined contribution pension schemes for staff and Executive Directors. The contributions are payable to external funds which are administered by independent trustees. Contributions during the year amounted to £3.3 million (2008: £2.2 million). At 31 December 2009, there was a liability of £0.6 (2008: £0.1 million) for contributions payable included in creditors.