Notes to the Group financial statements 11 – 20

• Note 11: Investments
• Note 12: Trade receivables
• Note 13: Inventories
• Note 14: Other current assets
• Note 15: Cash and cash equivalents
• Note 16: Trade and other payables
• Note 17: Financial liabilities
• Note 18: Financial instruments
• Note 19: Obligations under finance leases
• Note 20: Provisions

Note 11. Investments

The fair value of these investments is not materially different from their carrying value.

Details of the subsidiaries which the Directors consider are the most important subsidiaries as at 31 December 2010 and the percentage of share capital owned by the Company are set out below. All of these subsidiaries are included in the consolidated Group statements. A complete list of investments in subsidiary undertakings will be attached to the Company’s annual return made to the Registrar of Companies:

Note 12. Trade receivables

Trade receivables comprises amounts due for the sale of oil and gas. No receivables have been impaired and no allowance for doubtful debt has been recognised (2009: $nil, 2008: $nil).

Note 13. Inventories

Inventories includes a provision of $3.8 million (2009: $3.8 million, 2008: $3.5 million) for warehouse stock and materials where it is considered that the net realisable value is lower than the original cost.

Note 14. Other current assets

Included within other debtors are amounts due from joint venture partners of $58.0 million (2009: $120.4 million, 2008: $43.7 million), advances to contractors for the Jubilee FPSO $433.2 million (2009: $80.4 million, 2008: $nil), deferred expenses of $2.8 million (2009: $9.6 million, 2008: $12.5 million) and other sundry debtors of $110.4 million (2009: $21.7 million, 2008: $9.8 million).

Note 15. Cash and cash equivalents

Cash and cash equivalents includes an amount of $nil (2009: $2.4 million, 2008: $52.1 million) which is a reserve held on fixed term deposit in support of a Letter of Credit facility which relates to the Group’s share of certain decommissioning costs and an amount of $279.0 million (2009: $152.9 million, 2008: $221.5 million) which the Group holds as operator in joint venture bank accounts.

Note 16. Trade and other payables

Current liabilities

The other payables balance primarily contains payables in relation to operated licences (shown gross in the Group consolidated accounts).

Non-current liabilities

Trade and other payables are non-interest bearing except for finance leases note 19.

Note 17. Financial liabilities

Group bank loans are stated net of unamortised arrangement fees of $81.3 million (2009: $81.6 million, 2008: $17.1 million).

Short-term borrowings, term loans and guarantees are secured by fixed and floating charges over the oil and gas assets (note 10) of the Group.

Capital management

The Group defines capital as the total equity of the Group. Capital is managed in order to provide returns for shareholders and benefits to stakeholders and to safeguard the Group’s ability to continue as a going concern. Tullow is not subject to any externally-imposed capital requirements.

To maintain or adjust the capital structure, the Group may put in place new debt facilities, issue new shares for cash, repay debt, engage in active portfolio management, adjust the dividend payment to shareholders, or other such restructuring activities as appropriate.

No significant changes were made in the objectives, policies or processes during the year ended 31 December 2010.

The Group monitors capital on the basis of the net debt ratio, that is, the ratio of net debt to net debt plus equity. Net debt is calculated as gross debt, as shown in the balance sheet, less cash and cash equivalents.

The movement from 2009 is attributable to higher external borrowings during 2010, principally as a result of the Group’s $2,630 million investment in development, appraisal and exploration activities which is offset by an increase in equity attributable to the equity raise in January 2010.

Interest rate risk

The interest rate profile of the Group’s financial assets and liabilities, excluding trade and other receivables and trade and other payables, at 31 December 2010 was as follows:

The profile at 31 December 2009 for comparison purposes was as follows:

The profile at 31 December 2008 for comparison purposes was as follows:

Floating rate debt comprises bank borrowings at interest rates fixed in advance from overnight to three months at rates determined by US dollar LIBOR and sterling LIBOR. Fixed rate debt comprises bank borrowings at interest rates fixed in advance for periods greater than three months or bank borrowings where the interest rate has been fixed through interest rate hedging.

The $2.5 billion Reserves Based Lending Facility incurs interest on outstanding debt at sterling or US dollar LIBOR plus an applicable margin. The outstanding debt is repayable in variable amounts (determined semi-annually) over the period to 31 December 2015, or such time as is determined by reference to the remaining reserves of the assets, whichever is earlier.

The $650 million Revolving Credit Facility is repayable in full on 31 December 2011. The facility incurs interest on outstanding debt at US dollar LIBOR plus an applicable margin.

At the end of December 2010, the headroom under the two facilities amounted to $685 million; $175 million under the $2.5 billion Reserves Based Lending Facility and $510 million under the Revolving Credit Facility. At the end of December 2009, the headroom under the two facilities was $620 million; $370 million under the $2 billion Reserves Based Lending Facility and $250 million under the Revolving Corporate Facility.

The Group is exposed to floating rate interest rate risk as entities in the Group borrow funds at floating interest rates. The Group hedges its floating rate interest rate exposure on an ongoing basis through the use of interest rate derivatives, namely interest rate swaps, interest rate collars and interest rate caps. The mark-to-market position of the Group’s interest rate portfolio as at 31 December 2010 is $13.6 million out of the money (2009: $8.9 million out of the money, 2008: $3.0 million out of the money). The interest rate hedges are included in the fixed rate debt in 2010, in the above table, and also included in the fixed rate debt in 2009 and 2008.

Foreign currency risk

Wherever possible, the Group conducts and manages its business in sterling (UK) and US dollars (all other countries), the operating currencies of the industry in the areas in which it operates. The Group’s borrowing facilities are also denominated in sterling and US dollars, which further assists in foreign currency risk management. From time to time the Group undertakes certain transactions denominated in foreign currencies. These exposures are managed by executing foreign currency financial derivatives, typically to manage exposures arising on corporate transactions such as acquisitions and disposals. There were no foreign currency financial derivatives in place at the 2010 year end. Cash balances are held in other currencies to meet immediate operating and administrative expenses or to comply with local currency regulations.

As at 31 December 2010, the only material monetary assets or liabilities of the Group that were not denominated in the functional currency of the respective subsidiaries involved were £106.0 million ($164.0 million) cash drawings under the Group’s borrowing facilities. As at 31 December 2009, the only material monetary assets or liabilities of the Group that were not denominated in the functional currency of the respective subsidiaries involved were $1,337 million cash drawings under Group’s borrowing facilities.

The carrying amounts of the Group’s foreign currency denominated monetary assets and monetary liabilities at the reporting date are net liabilities of $164.0 million (2009: net liabilities of $1,337 million).

Foreign currency sensitivity analysis

The Group is mainly exposed to fluctuations in the US dollar. The Group measures its market risk exposure by running various sensitivity analyses including 20% favourable and adverse changes in the key variables. The sensitivity analyses include only outstanding foreign currency denominated monetary items and adjusts their translation at the period end for a 20% change in foreign currency rates.

As at 31 December 2010, a 20% increase in foreign exchange rates against the functional currencies of entities in the Group would have resulted in a decrease in foreign currency denominated liabilities and equity of $27.3 million (2009: $226.7 million) and a 20% decrease in foreign exchange rates against the functional currencies of entities in the Group would have resulted in an increase in foreign currency denominated liabilities and equity of $32.8 million (2009: $339.9 million).

Liquidity risk

The Group manages the liquidity requirements by the use of both short- and long-term cash flow projections, supplemented by maintaining debt financing plans and active portfolio management. Ultimate responsibility for liquidity risk management rests with the Board of Directors, which has built an appropriate liquidity risk management framework for the management of the Group’s short-, medium- and long-term funding and liquidity management requirements.

The Group closely monitors and manages its liquidity risk. Cash forecasts are regularly produced and sensitivities run for different scenarios including, but not limited to, changes in commodity prices, different production rates from the Group’s portfolio of producing fields and delays in development projects. The Group normally seeks to ensure that it has a minimum ongoing capacity of $500 million for a period of at least 12 months to safeguard the Group’s ability to continue as a going concern.

The major assumption in current cash flow forecasts is that the receipt of disposal proceeds from the Uganda farm-down, which has been delayed longer than expected, will now be received in Q2 2011. On this basis, the Group’s forecasts, taking into account reasonably possible changes as described above, show that the Group will be able to operate within its current debt facilities and have very significant financial headroom for the 12 months from the date of the 2010 Annual Report and Accounts. However, in the unlikely event that the Ugandan farm-down process is delayed beyond Q2 2011, the Directors are confident that the Group can manage its financial affairs, including the securing of additional funding, agreement with existing lenders, portfolio management and deferring of non-essential capital expenditure, so as to ensure that sufficient funding remains available for the next 12 months.

After taking account of the above, the Directors have a reasonable expectation that the Group has adequate resources to continue in operational existence for the foreseeable future. Accordingly, they continue to adopt the going concern basis in preparing the Annual Report and Accounts.

The following table details the Group’s remaining contractual maturity for its non-derivative financial liabilities with agreed repayment periods. The tables have been drawn up based on the undiscounted cash flows of financial liabilities based on the earliest date on which the Group can be required to pay.

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 predominantly 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 income or expense 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 (2009: 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 2010, the Group’s oil hedge position was summarised as follows:

At 31 December 2010, the Group’s gas hedge position was summarised as follows:

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

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

As at 31 December 2010 and 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. There is, however, the potential for 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 the potential for a degree of ineffectiveness inherent in the Group’s gas hedges which arises from, among other factors, field production performance on any day.

Income statement hedge summary

Gains from settlements during the period amounted to $3.4 million (2009:$23.8 million) (note 2) and these are included in the revenue line.

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:

Hedge reserve summary

The hedge reserve represents the portion of deferred 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.

Revaluation losses on open contracts arising during the year amounted to $26.8 million while reclassification adjustments for losses included in profit on realisation amounted to $10.3 million. After tax effects of $8.2 million the total movement in the hedge reserve amounts to ($28.9 million) (note 22):

The following table summarises the deferred (losses)/gains on derivative instruments in the hedge reserve, by type of commodity and net of tax effects:

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 2010, a 10% increase in the dated Brent oil price curve would have decreased equity by approximately $21.8 million (2009: $16.4 million, 2008: $31.9 million), a 10% decrease would have increased equity by approximately $5.9 million (2009: $10.5 million, 2008: $39.1 million).

As at 31 December 2010, a 10% increase in the UK D-1 Heren and M-1 Heren natural gas price curves would have decreased equity by approximately $8.6 million (2009: $4.6 million, 2008: $15.2 million), a 10% decrease would have increased equity by approximately $3.4 million (2009: $5.1 million, 2008: $14.9 million).

Interest rate sensitivity analysis

As at 31 December 2010, the interest rate derivative position was out-of-the-money to an amount of $13.6 million (2009: $8.9 million, 2008: $3.9 million); a 25bps increase in the underlying interest rate would increase equity by approximately $1.2 million (2009: $2.4 million, 2008: $0.8 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 2010 was $1,153.0 million (2009: $643.9 million, 2008: $709.7 million).

Note 19. Obligations under finance leases

The fair value of the Group’s lease obligations approximates the carrying amount. The average remaining lease term is 10 years (2009: two years, 2008: three years). For the year ended 31 December 2010, the effective borrowing rate was 14% (2009: 2.8%, 2008: 2.8%).

The significant increase in the year is due to the Jubilee FPSO (Kwame Nkrumah) being recognised as a finance lease in accordance with IAS 17, Leases.

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 2035. During 2010 a review of all decommissioning estimates was undertaken by an independent specialist and the 2010 financial statements now include estimates in accordance with this study.

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.