Effective July 1, 2005, the company adopted the provisions of Financial Accounting Standards Board (FASB) Statement No. 123R, Share-Based Payment (FAS 123R), for its share-based compensation plans. The company previously accounted for these plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations and disclosure requirements established by FASB Statement No. 123, Accounting for Stock-Based Compensation.

The company adopted FAS 123R using the modified prospective method, and accordingly, results for prior periods were not restated. Refer to Note 1 for the pro forma effect on net income and earnings per share as if the company had applied the fair-value recognition provisions of FAS 123R for the full year 2005.

For 2007, 2006 and 2005, compensation expense for stock options was $146 ($95 after tax), $125 ($81 after tax) and $65 ($42 after tax), respectively. In addition, compensation expense for stock appreciation rights, performance units and restricted stock units was $205 ($133 after tax), $113 ($73 after tax) and $59 ($39 after tax) for 2007, 2006 and 2005, respectively. There were no significant stock-based compensation costs that were capitalized at December 31, 2007 and 2006.

Cash received in payment for option exercises under all share-based payment arrangements for 2007, 2006 and 2005 was $445, $444 and $297, respectively. Actual tax benefits realized for the tax deductions from option exercises were $94, $91 and $71 for 2007, 2006 and 2005, respectively.

Cash paid to settle performance units and stock appreciation rights was $88, $68 and $110 for 2007, 2006 and 2005, respectively. Cash paid in 2005 included $73 for Unocal awards paid under change-in-control plan provisions.

The company presents the tax benefits of deductions from the exercise of stock options as financing cash inflows in the Consolidated Statement of Cash Flows. In 2006, the company implemented the transition method of FASB Staff Position FAS 123R-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards, for calculating the beginning balance of the pool of excess tax benefits related to employee compensation and determining the subsequent impact on the pool of employee awards that were fully vested and outstanding upon the adoption of FAS 123R. The company's reported tax expense for the period subsequent to the implementation of FAS 123R was not affected by this election. Refer to Note 3 for information on excess tax benefits reported on the company's Statement of Cash Flows.

Chevron Long-Term Incentive Plan (LTIP)

Awards under the LTIP may take the form of, but are not limited to, stock options, restricted stock, restricted stock units, stock appreciation rights, performance units and nonstock grants. From April 2004 through January 2014, no more than 160 million shares may be issued under the LTIP, and no more than 64 million of those shares may be in a form other than a stock option, stock appreciation right or award requiring full payment for shares by the award recipient.

Stock options and stock appreciation rights granted under the LTIP extend for 10 years from grant date. Effective with options granted in June 2002, one-third of each award vests on the first, second and third anniversaries of the date of grant. Prior to this change, options vested one year after the date of grant. Performance units granted under the LTIP settle in cash at the end of a three-year performance period. Settlement amounts are based on achievement of performance targets relative to major competitors over the period, and payments are indexed to the company's stock price.

Texaco Stock Incentive Plan (Texaco SIP)

On the closing of the acquisition of Texaco in October 2001, outstanding options granted under the Texaco SIP were converted to Chevron options. These options, which have 10-year contractual lives extending into 2011, retained a provision for being restored. This provision enables a participant who exercises a stock option to receive new options equal to the number of shares exchanged or who has shares withheld to satisfy tax withholding obligations to receive new options equal to the number of shares exchanged or withheld. The restored options are fully exercisable six months after the date of grant, and the exercise price is the market value of the common stock on the day the restored option is granted. Beginning in 2007, restored options were granted under the LTIP. No further awards may be granted under the former Texaco plans.

Unocal Share-Based Plans (Unocal Plans)

When Chevron acquired Unocal in August 2005, outstanding stock options and stock appreciation rights granted under various Unocal Plans were exchanged for fully vested Chevron options and appreciation rights. These awards retained the same provisions as the original Unocal Plans. Awards issued prior to 2004 generally may be exercised for up to three years after termination of employment (depending upon the terms of the individual award agreements) or the original expiration date, whichever is earlier. Awards issued since 2004 generally remained exercisable until the end of the normal option term if termination of employment occurred prior to August 10, 2007. Other awards issued under the Unocal Plans, including restricted stock, stock units, restricted stock units and performance shares, became vested at the acquisition date, and shares or cash were issued to recipients in accordance with change-in-control provisions of the plans.

The fair market values of stock options and stock appreciation rights granted in 2007, 2006 and 2005 were measured on the date of grant using the Black-Scholes option-pricing model, with the following weighted-average assumptions:

Year ended December 31
2007 2006 2005
1 Expected term is based on historical exercise and post-vesting cancellation data.
2 Volatility rate is based on historical stock prices over an appropriate period, generally equal to the expected term.
3 Represent options converted at the acquisition date.
Stock Options
Expected term in years1 6.3 6.4 6.4
Volatility2 22.0% 23.7% 24.5%
Risk-free interest rate based on zero coupon U.S. treasury note 4.5% 4.7% 3.8%
Dividend yield 3.2% 3.1% 3.4%
Weighted-average fair value per option granted $ 15.27 $ 12.74 $ 11.66
 
Restored Options
Expected term in years1 1.6 2.2 2.1
Volatility2 21.2% 19.6% 18.6%
Risk-free interest rate based on zero coupon U.S. treasury note 4.5% 4.8% 3.8%
Dividend yield 3.2% 3.3% 3.4%
Weighted-average fair value per option granted $ 8.61 $ 7.72 $ 6.09
 
Unocal Plans3
Expected term in years1 – – 4.2
Volatility2 – – 21.6%
Risk-free interest rate based on zero coupon U.S. treasury note – – 3.9%
Dividend yield – – 3.4%
Weighted-average fair value per option granted – – $ 21.48

A summary of option activity during 2007 is presented below:

Shares
(Thousands)		 Weighted-
Average
Exercise
Price		 Weighted-
Average
Remaining
Contractual
Term		 Aggregate
Intrinsic
Value
Outstanding at January 1, 2007 55,945 $ 47.91
Granted 12,848 $ 74.08
Exercised (14,340) $ 51.92
Restored 3,458 $ 80.45
Forfeited (554) $ 72.36
Outstanding at December 31, 2007 57,357 $ 54.50 6.3 yrs. $ 2,227
Exercisable at December 31, 2007 35,540 $ 45.93 5.1 yrs. $ 1,685

The total intrinsic value (i.e., the difference between the exercise price and the market price) of options exercised during 2007, 2006 and 2005 was $423, $281 and $258, respectively.

Upon adoption of FAS 123R, the company elected to amortize newly issued graded awards on a straight-line basis over the requisite service period. In accordance with FAS 123R implementation guidance issued by the staff of the Securities and Exchange Commission, the company accelerates the vesting period for retirement-eligible employees in accordance with vesting provisions of the company's share-based compensation programs for awards issued after adoption of FAS 123R. As of December 31, 2007, there was $160 of total unrecognized before-tax compensation cost related to nonvested share-based compensation arrangements granted or restored under the plans. That cost is expected to be recognized over a weighted average period of two years.

At January 1, 2007, the number of LTIP performance units outstanding was equivalent to 2,110,196 shares. During 2007, 931,200 units were granted, 784,364 units vested with cash proceeds distributed to recipients and 32,017 units were forfeited. At December 31, 2007, units outstanding were 2,225,015, and the fair value of the liability recorded for these instruments was $205. In addition, outstanding stock appreciation rights and other awards that were granted under various LTIP and former Texaco and Unocal programs totaled approximately 1 million equivalent shares as of December 31, 2007. A liability of $38 was recorded for these awards.

Broad-Based Employee Stock Options

In addition to the plans described above, Chevron granted all eligible employees stock options or equivalents in 1998. The options vested in February 2000 and expired in February 2008. A total of 9,641,600 options were awarded with an exercise price of $38.16 per share.

The fair value of each option on the date of grant was estimated at $9.54 using the Black-Scholes model for the preceding 10 years. The assumptions used in the model, based on a 10-year average, were: a risk-free interest rate of 7 percent, a dividend yield of 4.2 percent, an expected life of seven years and a volatility of 24.7 percent.

At January 1, 2007, the number of broad-based employee stock options outstanding was 1,306,059. During 2007, exercises of 637,044 shares and forfeitures of 16,300 shares reduced outstanding options to 652,715. As of December 31, 2007, these instruments had an aggregate intrinsic value of $36 and the remaining contractual term of these options was 0.1 year. The total intrinsic value of these options exercised during 2007, 2006 and 2005 was $30, $10 and $9, respectively.