<PAGE>
 
=============================================================================

                                     1996

                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549

                                   FORM 10-K
                            -----------------------
               (MARK ONE)
         [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
                SECURITIES EXCHANGE ACT OF 1934 (FEE REQUIRED)

                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996

                                       OR

         [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
               SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED)

                         COMMISSION FILE NUMBER 1-10145

                        LYONDELL PETROCHEMICAL COMPANY
            (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
                           ------------------------
          DELAWARE                                            95-4160558
     (STATE OR OTHER JURISDICTION OF                      (I.R.S. EMPLOYER
     INCORPORATION OR ORGANIZATION)                       IDENTIFICATION NO.)

      1221 MCKINNEY STREET,                                    77010
     SUITE 1600, HOUSTON, TEXAS                             (ZIP CODE)
     (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)

      REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE:  (713) 652-7200

          SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:

                                                  NAME OF EACH EXCHANGE
               TITLE OF EACH CLASS                ON WHICH REGISTERED
               -------------------                ----------------------
          COMMON STOCK ($1.00 PAR VALUE)          NEW YORK STOCK EXCHANGE

          SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
                                     NONE

     INDICATE BY CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS
REQUIRED TO BE FILED BY SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF
1934 DURING THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE
REGISTRANT WAS REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH
FILING REQUIREMENTS FOR THE PAST 90 DAYS.
                                 YES X NO 
                                    ---  ---

     INDICATE BY CHECK MARK IF DISCLOSURE OF DELINQUENT FILERS PURSUANT TO ITEM
405 OF REGULATION S-K IS NOT CONTAINED HEREIN, AND WILL NOT BE CONTAINED, TO THE
BEST OF REGISTRANT'S KNOWLEDGE, IN DEFINITIVE PROXY OR INFORMATION STATEMENTS
INCORPORATED BY REFERENCE IN PART III OF THIS FORM 10-K OR ANY AMENDMENT TO THIS
FORM 10-K.
                                  X
                                 ---

     THERE WERE 80,000,000 SHARES OF THE REGISTRANT'S COMMON STOCK OUTSTANDING
ON DECEMBER 31, 1996.  THE  AGGREGATE  MARKET VALUE OF THE VOTING STOCK HELD BY
NON-AFFILIATES OF THE REGISTRANT ON FEBRUARY 28, 1997 BASED ON THE CLOSING PRICE
ON THE NEW YORK STOCK EXCHANGE COMPOSITE TAPE ON THAT DATE, WAS $890,488,029.

                      DOCUMENTS INCORPORATED BY REFERENCE
THE REGISTRANT'S DEFINITIVE PROXY STATEMENT, WHICH WILL BE FILED WITH THE
SECURITIES AND EXCHANGE COMMISSION WITHIN 120 DAYS AFTER DECEMBER 31, 1996
(INCORPORATED BY REFERENCE UNDER PART III).
================================================================================
<PAGE>
 
                               TABLE OF CONTENTS
                                    PART I

<TABLE>
<CAPTION>
 Item                                                             Page
 ----                                                             ----
<S>          <C>                                                  <C>
1. and 2.    Business and Properties............................     1
             The Company's Business.............................     1
             Development of Business............................     1
             Summary Description of Business Segments...........     2
             PETROCHEMICALS SEGMENT.............................     2
             Overview - Petrochemicals Operations...............     2
             -- Feedstocks......................................     4
             -- Marketing, Sales and Distribution...............     4
             Overview - Polymers Operations.....................     5
             -- Feedstocks......................................     6
             -- Marketing, Sales and Distribution...............     6
             Competition and Industry Conditions................     6
             Capital Program and Business Strategies............     7
             Properties.........................................     7
             Research and Technology; Patents and Trademarks....     8
             Employee Relations.................................     9
             Finance Matters....................................     9
             Long-Term Debt and Financing Arrangements..........     9
             REFINING SEGMENT...................................    10
             Overview...........................................    10
             Upgrade Project....................................    11
             Management of LCR..................................    11
             Feedstocks.........................................    12
             Marketing and Sales................................    12
             Agreements between Lyondell and LCR................    13
             Competition and Industry Conditions................    13
             Capital Program....................................    13
             Properties.........................................    13
             Employee Relations.................................    13
             LCR Unsecured Revolving Credit Facility............    14
             Environmental Matters..............................    15
  3.         Legal Proceedings..................................    16
             Related Party Transactions.........................    19
             Executive Officers of the Registrant...............    20
             Description of Capital Stock.......................    21
  4.         Submission of Matters to a Vote of Security Holders    24

                                    PART II

  5.         Market for Registrant's Common Equity and Related 
              Stockholder Matters...............................    24
  6.         Selected Financial Data............................    25
  7.         Management's Discussion and Analysis of Financial 
              Condition and Results of Operations...............    25
  8.         Financial Statements and Supplementary Data........    36
  9.         Changes in and Disagreements with Accountants on 
              Accounting and Financial Disclosure...............    60

                                    PART III
 
 10.         Directors and Executive Officers of the Registrant.    60
 11.         Executive Compensation.............................    60
 12.         Security Ownership of Certain Beneficial Owners and 
              Management........................................    60
 13.         Certain Relationships and Related Transactions.....    60
</TABLE>

                                       i
<PAGE>
 
<TABLE>
<CAPTION>
 Item                                                             Page
 ----                                                             ----
<S>          <C>                                                  <C>
                                    PART IV

14.          Exhibits, Financial Statement Schedules and Reports 
              on Form 8-K.......................................    61
</TABLE> 

                                      ii
<PAGE>
 
                                    PART I



ITEMS 1 AND 2.  BUSINESS AND PROPERTIES

                            THE COMPANY'S BUSINESS

Lyondell Petrochemical Company ("Lyondell" or the "Company") operates in the
petrochemicals and refining segments.  The Company manufactures a wide variety
of petrochemicals, including olefins, polyolefins, methyl tertiary butyl ether
("MTBE") and aromatics.  The Company's petrochemicals products are used
primarily in the manufacture of other chemicals and products, which in turn are
used in the production of a wide variety of consumer and industrial products.
Lyondell produces methanol through its interest in Lyondell Methanol Company,
L.P., a Texas limited partnership ("Lyondell Methanol").  Through its interest
in LYONDELL-CITGO Refining Company Ltd., a Texas limited liability company
("LCR") the Company produces refined petroleum products, including gasoline, low
sulfur diesel, jet fuel, aromatics and lubricants ("lube oils").  LCR sells its
principal refined products primarily to CITGO Petroleum Corporation ("CITGO").

DEVELOPMENT OF BUSINESS

From its formation in 1985 through June 1988, Lyondell operated as a division
("Lyondell Division") of Atlantic Richfield Company ("ARCO"). In July 1988, ARCO
transferred the division's assets and liabilities along with additional pipeline
assets, to its wholly owned subsidiary, Lyondell Petrochemical Company, a
Delaware corporation, in exchange for additional shares of Lyondell Common
Stock.  In January 1989, ARCO completed an initial public offering of
approximately 50.1 percent of the Company's Common Stock.  In August 1994, ARCO
completed an offering ("ARCO Note Offering") of three-year debt securities
("Exchangeable Notes") which are exchangeable upon maturity at September 15,
1997 into either Lyondell Common Stock or  an equivalent cash value, at ARCO's
option.  If ARCO elects to exchange the Notes for shares of Lyondell Common
Stock, ARCO's equity interest in Lyondell will be reduced or eliminated,
depending on the price of Lyondell Common Stock at maturity of the Exchangeable
Notes.  For additional information, see "RELATED PARTY TRANSACTIONS".  As of
March 1, 1997, ARCO owned 39,921,400 shares of Lyondell Common Stock,
representing 49.9 percent of the issued and outstanding Common Stock of the
Company.

In February 1990, the Company acquired a polypropylene plant and a low-density
polyethylene plant located in Pasadena, Texas ("Bayport Facility").

In July 1993, pursuant to agreements between the Company and CITGO (and its
affiliates), the Company contributed its refining business, including the
Houston, Texas refinery ("the Refinery"), the lube oil blending and packaging
plant in Birmingport, Alabama and refining working capital to LCR.  The Company
retained a participation interest in LCR through its wholly owned subsidiary,
Lyondell Refining Company.  At December 31, 1996, the Company had an approximate
90 percent interest in LCR while CITGO held the remaining approximate 10 percent
interest.  Through December 31, 1996, the results of LCR's operations were
consolidated into the Company's financial statements.  LCR completed a major
upgrade project (the "Upgrade Project") at the Refinery in the first quarter
1997.  See "REFINING SEGMENT -- Upgrade Project".  After completion of the
Upgrade Project, the Company's interest in LCR was reduced to approximately 60
percent and the authority and responsibility for certain management decisions
which were previously decided by majority vote, and therefore controlled by the
Company, were changed to unanimous vote, resulting in expanded joint control of
LCR by the Company and CITGO.  Effective January 1, 1997, the Company will
account for its investment in LCR under the equity method of accounting.  See
further discussion of the impact of this accounting change in Item 7 --
"Management's Discussion and Analysis of Financial Condition and Results of
Operations -- ACCOUNTING CHANGES" and Note 3 of "NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS".

In May 1995, the Company acquired Occidental Chemical Corporation's ALATHON
high-density polyethylene ("HDPE") business ("ALATHON Business").  Assets
involved in this acquisition included resin production facilities in Matagorda
(the "Matagorda Facility") and Victoria (the "Victoria Facility"), Texas,
related research and development activities and the rights to the Alathon(R)
trademark.

                                       1
<PAGE>
 
In July 1996, the Company announced the execution of a Letter of Intent with
three other olefins producers for the planned construction of a worldscale
olefins plant ("Joint Olefins Venture").  After the withdrawal of one of the
participants in October 1996, the Company and its partners are continuing to
evaluate options for the proposed plant including, alternative designs for
utilizing various different feedstock mixes, as well as size, schedule and
participants.

In December 1996, the Company announced the formation of Lyondell Methanol with
MCN Investment Corporation ("MCNIC"), a division of MCN Corporation, to own the
Company's 248 million gallons per year methanol plant.  Under the terms of the
agreement, MCNIC purchased a 25 percent interest in the methanol plant.
Lyondell retained a 75 percent interest and will serve as managing partner and
operator.

For additional information relating to certain continuing relationships and
potential conflicts of interest among Lyondell, LCR, ARCO and ARCO Chemical
Company, an 83.3 percent owned subsidiary of ARCO, ("ARCO Chemical"), see
"RELATED PARTY TRANSACTIONS", included herein, and "TRANSACTIONS BETWEEN THE
COMPANY AND ARCO" and "PRINCIPAL STOCKHOLDERS" which are included in the
Company's 1997 Proxy Statement and incorporated herein by reference as part of
Item 13 of this Annual Report on Form 10-K.

The Company's principal executive offices are located at 1221 McKinney Street,
Houston, Texas 77010 (Telephone (713) 652-7200).


                   SUMMARY DESCRIPTION OF BUSINESS SEGMENTS

                            PETROCHEMICALS SEGMENT

Through the year ended December 31, 1996, the Company reported its results of
operations in two segments, petrochemicals and refining.  Beginning in 1997, the
Company intends to report the results of its polymers operations as a separate
segment.  Currently the results of polymers operations are included in the
petrochemicals segment.

OVERVIEW

PETROCHEMICALS OPERATIONS

Channelview Facility -- Lyondell's Channelview petrochemical complex (the
"Channelview Facility") is located in Channelview, Texas, 20 miles east of
Houston.  The Channelview Facility includes two large olefins plants and related
processing units that produce ethylene, propylene, butadiene, butylenes,
benzene, toluene, hydrogen and certain specialty products, such as isoprene,
dicyclopentadiene, resin oils and piperylenes, along with gasoline blendstocks
and heavy liquid fuels.  The Company's petrochemicals products are used to
manufacture intermediate chemicals, which are primarily used in a variety of
consumer and industrial products.  Petrochemicals are fundamental to many
segments of the economy, including the production of consumer products, housing
components, automotive products and other durable and non-durable goods.
Ethylene is the most significant petrochemical in terms of worldwide production
volume and is the key building block for a large number of chemicals.  With the
wide proliferation of end-use products derived from ethylene during the past
several decades, especially as plastics have developed into low cost, high
performance substitutes for a wide range of materials such as metals and paper,
U.S. ethylene consumption has grown by an average annual rate of more than four
percent.

Mont Belvieu Facility -- Feedstocks for the Company's facilities and products
are stored at the Company's Mont Belvieu, Texas storage facility ("Mont Belvieu
Facility").  The Mont Belvieu Facility is connected by a comprehensive pipeline
system to the Channelview Facility.

                                       2
<PAGE>
 
The following table outlines the products manufactured at the Channelview
Facility.
<TABLE>
<CAPTION>
 
   PRODUCT                                      PRIMARY USES
---------------------------  ---------------------------------------------------
<S>                          <C>
ETHYLENE                     Ethylene is used as a feedstock to manufacture
                             polyethylene which is used in products such as
                             trash bags, packaging film, toys, housewares and
                             milk containers.  Ethylene also is used to produce
                             ethylene oxide (used to produce ethylene glycol
                             which is used to produce antifreeze and polyester
                             fibers), ethylene dichloride (used to produce
                             polyvinyl chloride for pipe and other vinyl
                             products), ethylbenzene (used to produce styrene,
                             which in turn is used to produce polystyrene for
                             packaging and containers) and alpha olefins (used
                             in the manufacture of detergents, as well as other
                             intermediate chemicals).

PROPYLENE                    Propylene is used to produce polypropylene,
                             acrylonitrile, propylene oxide and oxo products.
                             Polypropylene is used in products such as carpets,
                             food packaging, upholstery, automobile parts and
                             plastic bottles.   Acrylonitrile is used in
                             clothing and high impact plastics. Propylene oxide
                             is used in polyurethane foams for furniture and
                             insulation.  Oxo products are used in industrial
                             solvents, as well as other intermediate chemicals.

BUTADIENE                    Butadiene is used to manufacture styrene butadiene
                             rubber and polybutadiene rubber, which are used in
                             the manufacture of tires and other rubber
                             products. Butadiene is also used in the production
                             of nylon and acrylonitrile-butadiene-styrene
                             plastics.

AROMATICS                    Aromatics products include benzene and toluene.
                             Benzene is used to produce styrene, phenol and
                             nylon.  Toluene is used as an octane enhancer, for
                             benzene production and in urethane chemicals.
                             These products are used in the production of
                             plastics, rubber, fibers for carpet and apparel,
                             in gasoline and in polyurethane foams used in seat
                             cushions.

SPECIALTY PRODUCTS           Specialty products include feedstocks for the
                             production of various types of hydrocarbon resins
                             and unsaturated polyester resins.  These products
                             are used in the production of inks, adhesives,
                             paints and varnishes, rubber and fiberglass.

METHANOL                     Methanol is produced by Lyondell Methanol and is
                             used to produce MTBE and a variety of chemical
                             intermediates, including formaldehyde, acetic acid
                             and methyl methacrylate.  These intermediates are
                             used to produce bonding adhesives for plywood as
                             well as in polyester fibers and plastics.  Other
                             end uses include solvents and antifreeze
                             applications.

MTBE                         MTBE is an octane enhancer and clean fuel additive
                             in reformulated gasoline.
</TABLE>

The following table shows the current annual rated capacity for certain of the
Company's principal petrochemicals products.
<TABLE>
<CAPTION>
                           RATED CAPACITY (a)
                            AT DECEMBER 31,
                                 1996
                           ------------------
                               (MILLIONS)
<S>                        <C>
PETROCHEMICALS PRODUCT:
Ethylene (pounds)........       3,850 (b)
Propylene (pounds).......       2,250 (c)
Butadiene (pounds).......         615
Methanol (gallons).......         248 (d)
MTBE (gallons)...........         199
Aromatics (gallons)......         130
-------------
</TABLE>

(a) The term "rated capacity", as used in this table and throughout this report,
    is calculated by estimating the number of days in a typical year that a
    production unit of a plant is expected to operate, after allowing for
    downtime for regular maintenance, and multiplying that number by an amount
    equal to the unit's optimal daily output based on 

                                       3
<PAGE>
 
    the design feedstock mix. Because the rated capacity of a production unit is
    an estimated amount, the actual production volumes may be more or less than
    rated capacity.

(b) In 1996, the Company completed a debottleneck project of its olefins units
    that increased ethylene capacity by approximately seven percent.

(c) Does not include refinery grade material or production from the product
    flexibility unit, which has a current rated capacity of one billion pounds
    per year of propylene.

(d) Capacity as shown includes 100 percent of the methanol produced by Lyondell
    Methanol, of which the Company owns 75 percent.

FEEDSTOCKS

The primary feedstocks used in the production of olefins are natural gas liquids
feedstocks including ethane, propane and butane (collectively "NGLs") and
naphtha, condensates and gas oils (collectively "Petroleum Liquids").  As of
January 1, 1997, approximately 40 percent of domestic ethylene capacity was
limited to NGL feedstocks, and the remaining approximately 60 percent could
process to some extent both NGLs and Petroleum Liquids.  Olefins plants with the
flexibility to consume a wide range of feedstocks are better able to maintain
higher levels of profitability during periods of changing energy and
petrochemicals prices than olefins plants that are restricted in their feedstock
processing capability.  Feedstock cost is generally the largest element of total
cost for the petrochemicals business.

Petroleum Liquids have had a significant historical variable margin advantage
over ethane and propane.  The industry margin differential between these
feedstocks has been typically between one and four cents per pound of ethylene.
The Company has the capability to capture this differential at the Channelview
Facility due to its feedstock flexibility.  The Company's olefins plants can
process 100 percent Petroleum Liquids or up to 90 percent NGL feedstocks.

The Company obtains a portion of its olefins feedstock requirements from LCR
(NGLs, naphtha and gas oil) and additional olefins feedstock in the form of
petroleum condensates pursuant to a contract with an affiliate of a foreign
government.  The remainder of its Petroleum Liquids requirements are obtained
under short-term contracts or on the spot market from a variety of foreign and
domestic sources.  The Company also purchases NGLs from a wide variety of
domestic sources, many of which have pipeline connections to the Company's
facilities.

Lyondell Methanol's  plant processes natural gas feedstocks.  The Company is
connected to a diverse natural gas supply network and it purchases natural gas
for use as fuel at its facilities, and sells natural gas to Lyondell Methanol as
a feedstock for the methanol plant.

MARKETING, SALES AND DISTRIBUTION

Lyondell sells a majority of its olefins products to customers with whom it has
long-standing relationships.  Sales generally are made pursuant to written
agreements which typically provide for monthly negotiation of price.  The
parties are contractually committed to monthly price terms.  Nonetheless, in
some cases, if the parties fail to agree on a monthly price, deliveries may be
suspended for the month.  The contracts typically require the customer to
purchase a specified minimum quantity.  Contract terms are typically three to
six years with automatic one or two year term extension provisions.  Some
contracts are subject to early termination if deliveries have been suspended for
several months.

The Company sells substantially all of the methanol output from Lyondell
Methanol and most of its aromatics output under contracts that have initial
terms ranging from two to three years and that typically contain automatic one
year term extension provisions.  These contracts generally provide for monthly
or quarterly price adjustments based upon current market prices.  Aromatics
produced at the Refinery, with the exception of benzene, are marketed by
Lyondell for LCR under contracts with similar terms to its own.  Benzene
produced at the Refinery is sold directly to Lyondell at market-related prices.

Lyondell licenses MTBE technology from ARCO Chemical and sells MTBE produced at
one of its two units primarily to ARCO Chemical at market-based prices.  The
production from the second unit is produced for LCR for gasoline blending.  In
addition, Lyondell has entered into a joint development and licensing
arrangement to accelerate 

                                       4
<PAGE>
 
commercialization of two isomerization processes that produce feedstocks for
MTBE and tertiary amyl methyl ether ("TAME") which are blending components for
reformulated gasoline. See "RESEARCH AND TECHNOLOGY; PATENTS AND TRADEMARKS".

Most of the Company's ethylene and propylene is shipped or exchanged via an
extensive pipeline system which has connections to numerous Gulf Coast ethylene
and propylene consumers.  The pipeline system is owned  by ARCO PipeLine
Company, and substantially all of it is leased by the Company under long-term
leasing arrangements.  See "PETROCHEMICALS SEGMENT -- Properties" and "RELATED
PARTY TRANSACTIONS".  The Company has exchange agreements with other olefins
producers which allow access to customers who are not directly connected to the
pipeline system.  Some propylene is shipped by ocean-going vessel.  Butadiene,
methanol, aromatics and other petrochemicals are distributed by pipeline,
railcar, truck, barge or ocean-going vessel.

POLYMERS OPERATIONS

Bayport Facility -- The Bayport Facility converts propylene and ethylene into
polypropylene and low-density polyethylene that is sold into markets for end use
products. The Bayport Facility is connected by pipeline to the Company's Mont
Belvieu Facility for feedstock supply.

Matagorda Facility --  The Matagorda Facility converts ethylene and small
amounts of comonomer into HDPE.  In 1996, a significant portion of the ethylene
converted at the Matagorda Facility was supplied by the Channelview Facility.
The Matagorda Facility features three independent reaction and finishing process
lines that employ the Nissan slurry polymerization technology.  This enables
Lyondell to produce a wide variety of resins for blown film, blow molding and
injection molding applications.

Victoria Facility -- The Victoria Facility converts ethylene and small amounts
of comonomer into HDPE resins.   In 1996, a significant portion of the ethylene
converted at the Victoria Facility was supplied by the Channelview Facility.
The Victoria Facility features solution polymerization technology that minimizes
the presence of catalyst residues resulting in resins with excellent
organoleptic properties (no taste or odor) and extremely low moisture vapor
transmission rates.  This enables Lyondell to produce a wide variety of film and
injection molding resins for use in consumer products and industrial
applications.

Polymers Technology Center -- Research and development is conducted in a
catalyst laboratory with state-of-the-art analytical capabilities in Alvin,
Texas (the "Technology Center").  The Technology Center provides product and
process technology support for  the Company's polymers operations and its
customers.

The following table outlines the polymers products manufactured by the Company.
<TABLE>
<CAPTION>
 
          PRODUCT                               PRIMARY USES
---------------------------  ---------------------------------------------------
<S>                          <C>
HIGH-DENSITY POLYETHYLENE    Plastic films for grocery and merchandise
                             carry-out sacks, trash can liners and food produce
                             bags.  Molded and extruded plastic for packaging
                             food items, plastic drink cups, safety equipment,
                             housing insulation, detergent/motor oil bottles

POLYPROPYLENE                Fibers for carpets, rugs, upholstery; housewares;
                             plastic caps and seals for consumer items such as
                             shampoo and household cleaners

LOW-DENSITY POLYETHYLENE     Plastic films for packaging items such as ice and
                             bread, plastic bottles for packaging food and
                             medicines
</TABLE>

                                       5
<PAGE>
 
The following table shows the current annual rated capacity for each of the
Company's principal polyolefins products.

                                                        RATED CAPACITY
                                                        AT DECEMBER 31,
                                                             1996
                                                        --------------  
                                                          (MILLIONS)
POLYOLEFINS PRODUCT:
High-density polyethylene (pounds)                         1,500 (a)
Polypropylene (pounds)                                       400 (b)
Low-density polyethylene (pounds)                            140
________________

(a)  The Company is undertaking a debottleneck project at its Victoria Facility
     that will expand the plant's HDPE capacity by approximately 25 percent to
     575 million pounds and is scheduled to be completed in 1998.  In addition,
     the Company plans to expand HDPE capacity by an additional 440 million
     pounds.  This capacity expansion should be complete in 1999.

(b)  In the second quarter of 1996, the Company completed a debottleneck project
     that expanded polypropylene capacity by approximately 33 percent to 400
     million pounds.

FEEDSTOCKS

The ethylene and propylene converted at the Bayport Facility are supplied by the
Channelview Facility either directly or via exchange arrangements.  Under a
supply agreement with Occidental Chemical Company, portions of the Company's
ethylene supply needs at the Victoria and Matagorda Facilities are supplied by
Occidental.  In 1996 the Company began supplying significant amounts of ethylene
from its Channelview Facility to the Victoria and Matagorda Facilities via
exchange arrangements.

MARKETING, SALES AND DISTRIBUTION

The Company's polymers products are primarily sold to established customers,
many under term contracts, typically having a duration of one to four years.
The remainder is generally sold without contractual term commitments.  In either
case, in most of the continuous supply relationships, prices are subject to
change upon mutual agreement between Lyondell and the customer.  Polymers are
primarily distributed via railcar.  The Company owns or leases, pursuant to
long-term lease arrangements, approximately 3,200 railcars for use in its
polymers business.

COMPETITION AND INDUSTRY CONDITIONS

The basis for competition in Lyondell's petrochemicals products is product
quality, product deliverability, customer service and price.  Lyondell competes
with other large domestic producers of petrochemicals and polymers, including
Amoco Chemical Company, Chevron Chemical Company, Dow Chemical Company, Exxon
Chemical Company, Fina, Himont, Huntsman Chemical, Mobil Chemical Company,
Occidental Chemical Corporation, Phillips Petroleum Company, Shell Chemical
Company and Union Carbide Company.  Petrochemicals profitability is affected by
the level of demand for petrochemicals and petrochemical derivatives, including
exports throughout the world, along with vigorous price competition which may
intensify due to, among other things, new domestic and foreign industry
capacity.  In general, weak economic conditions either in the United States or
in the world tend to reduce demand and put pressure on margins.  It is not
possible to predict accurately the changes in feedstock costs, market conditions
and other factors which will affect petrochemical industry margins in the
future.

The combined rated capacity of the Company's olefins units at January 1, 1997
was approximately 3.8 billion pounds of ethylene per year or approximately 7
percent of total domestic production capacity.  Based on published rated
production capacities, the Company believes it is one of the six largest
producers of ethylene in the United States.  Of the total ethylene production
capacity in the United States, approximately 90 percent is located along the
Gulf Coast, and approximately 75 percent is owned by ten manufacturers.
Domestic industry ethylene rated capacity at January 1, 1997 was approximately
53 billion pounds per year.

                                       6
<PAGE>
 
The petrochemicals industry historically has experienced periods of high demand
and high capacity utilization which result in increasingly higher operating
margins and profitability.  This generally has resulted in new capacity
investment until industry supply exceeds demand.  This overcapacity in turn has
resulted in periods of decreasing capacity utilization and declining operating
margins until demand and supply factors come back into balance before the cycle
is repeated.  Historically, as a producer of olefins primarily for merchant
supply to unaffiliated customers, Lyondell has typically experienced greater
variations in its sales volumes and profitability when industry supply and
demand relationships are at extremes in comparison to more integrated
competitors, i.e., those with a higher proportion of captive demand for olefins
derivatives production.  However, as a result of the acquisition of the ALATHON
Business, a greater percentage of the Channelview Facility's annual ethylene
production will be converted at the Company's downstream facilities.

The Company's other major commodity chemical products also experience cyclical
market conditions similar to (although not necessarily coincident with) those of
ethylene.

CAPITAL PROGRAM AND BUSINESS STRATEGIES

The petrochemical segment's fixed asset capital expenditures totaled $77 million
in 1996 and its capital budget for 1997 is $116 million which includes initial
work on expansion of the Company's HDPE capacity.

As part of its ongoing operations, the Company periodically conducts maintenance
turnarounds on its facilities. Although turnarounds on principal facilities are
usually scheduled well in advance, the timing of such turnarounds can be
accelerated or delayed because of numerous factors, some of which are beyond the
Company's control. The Company completed a turnaround and debottleneck on one of
its two olefins units during the second quarter of 1996.  A similar turnaround
and debottleneck was completed on the other olefins unit in the third quarter
1995.  During the first quarter of 1997, the Company is undertaking a turnaround
at its Matagorda Facility.

The Company's business strategies are to maintain and improve its low-cost
position, reduce cyclicality and volatility and grow the business profitably.
Lyondell continually evaluates opportunities to expand or further diversify its
operations through potential acquisitions, joint ventures and other
opportunities involving third parties. Management believes that industry trends
may provide additional opportunities to enhance shareholder value. This could be
accomplished by applying the Company's expertise in the efficient and low-cost
operation of its facilities to a larger asset base. Additional vertical
integration with an ethylene or propylene consumer could increase olefins plant
operating rates during weak market periods by providing captive outlets.
Horizontal integration with another olefins producer could improve operating
efficiencies by spreading overhead costs across larger volumes and enhancing
operating flexibility. Consistent with the Company's overall strategy, however,
management's intent is to undertake such transactions only if it expects the
transactions would produce both near-term and long-term improved cash flow and
would produce returns in excess of the Company's cost of capital.

Potential funding sources for significant capital projects, whether involving
transactions with third parties or otherwise, could include, without limitation,
the Company's current financial resources, potential earnings growth, future
borrowings and future issuance of equity securities, as well as possible
contractual arrangements such as joint ventures or partnerships.  Both the
Company's ability to undertake and fund the particular strategies described
above and the level of the Company's capital commitments and expenditures from
period to period will be affected by a variety of factors including, without
limitation, the general business environment, as well as changes in applicable
government regulations and tax laws.   See "FINANCE MATTERS".

PROPERTIES

The Company owns all of the plant and equipment that comprise its two olefins
plants at its Channelview Facility and owns the approximately 2,945 acre parcel
on which the complex is situated.  The Company also owns the petrochemicals
processing units and a 75  percent interest in the Lyondell Methanol plant, all
of which are located at the Channelview Facility.  These include the product
flexibility unit, two MTBE units, a butylene isomerization unit, the butylene
alkylation unit, the benzene and toluene recovery unit, the butadiene recovery
unit, the isoprene recovery unit and an isopropyl alcohol unit.  The isopropyl
alcohol unit is used exclusively to process products for ARCO Chemical and the
majority of production from one of the MTBE units is sold to ARCO Chemical.  The
Company also operates a styrene maleic anhydride ("SMA") unit and a
polybutadiene unit which are owned by a third party and are located on 

                                       7
<PAGE>
 
property leased from the Company within the Channelview Facility. A third party
owns and operates a facility on land leased from the Company that is used to
purify hydrogen from the Company's methanol plant.

Lyondell owns several pipelines connecting the Channelview Facility, the
Refinery and the Mont Belvieu Facility, including six lines used to transport
liquid feedstocks, butylenes, benzene, hydrogen, butane, MTBE and unfinished
gasolines between the Channelview Facility and the Refinery.  The Company also
owns a barge docking facility capable of berthing eight barges and related
terminal equipment for loading and unloading.  This facility is used for loading
methanol, pyrolysis fuel oil and pyrolysis gas oil into barges for delivery to
customers and unloading petroleum condensate barges for olefins feedstocks.

At the Channelview Facility, the Company recovers and sells valuable
petrochemicals components contained in a number of intermediate product streams.
The Channelview Facility includes units for butadiene recovery and aromatics
recovery. In addition, the Channelview Facility recovers valuable components
such as high purity isoprene, piperylenes and dicyclopentadiene ("DCPD") and
resin oils from its gasoline products.  The Company uses its proprietary
butylene isomerization technology, known as ISOMPLUS(R) ("Isomplus(R)"), to
efficiently produce isobutylene from olefins plant butylene by-product streams.
See "RESEARCH AND TECHNOLOGY; PATENTS AND TRADEMARKS".

Lyondell also owns a storage facility, a brine pond facility and a tract of
vacant land at Mont Belvieu, Texas, located approximately 15 miles east of the
Channelview Facility.  Storage capacity for up to approximately 13 million
barrels of NGL feedstocks, ethylene, propylene and other hydrocarbons is
provided in salt domes at the Mont Belvieu Facility.  The Company also owns an
approximate 10 percent undivided joint interest in much of the real property
surrounding the Mont Belvieu Facility.  This property, which is owned jointly
with several other companies that operate storage or processing facilities at
Mont Belvieu, is maintained as a greenbelt for these facilities.  The Company
has a long-term lease on product pipelines from the Mont Belvieu Facility to
most olefins customers.

The Company owns the real property, plant and equipment which comprise the
Bayport Facility located on approximately 187 acres in Pasadena, Texas. The
Company's Matagorda Facility includes a 2,114 acre site 13 miles south of Bay
City, Texas in Matagorda County which  includes a pilot plant used to enhance
the Company's current product line and develop new products and processes.  The
Company's Victoria Facility is comprised of an HDPE unit located on a 33 acre
site within the DuPont Chemical complex in Victoria, Texas.  The Company owns or
leases pursuant to long-term lease arrangements approximately 3,200 railcars for
use in its polymers business.

Lyondell leases its executive offices and corporate headquarters in downtown
Houston.  In addition, the Company leases facilities which house the Technology
Center in Alvin, Texas and storage facilities for the handling of  products from
various third parties, primarily in the Gulf Coast area.

RESEARCH AND TECHNOLOGY; PATENTS AND TRADEMARKS

The Company uses numerous patents in its operations, many of which are licensed
from third parties, including ARCO.  See Item 13 -- "Certain Relationships and
Related Transactions".  Although the Company's licenses from ARCO and others are
significant to its operations, the Company is not dependent upon any particular
patent, trade secret or the like, and it believes that the loss of any
individual patent, trade secret or similar proprietary right would not have a
material adverse effect on the operations of the Company.  The Company submitted
several new patent applications during 1996 to protect new processes it
developed.

Lyondell's Channelview Facility employs a proprietary technology, the "product
flexibility" technology, that converts ethylene and other light petrochemical
streams into propylene.  In addition, the olefins facilities can upgrade
butylene into higher-value products such as MTBE and alkylates used in the
production of automotive fuels.  The Company is conducting a research project to
investigate alternative feedstocks for use at the Channelview Facility.

In 1992, the Company introduced Isomplus(R), a new technology for producing low-
cost isobutylene by isomerizing normal butylenes. Isobutylene is a key
ingredient in MTBE, which in turn is an important component of reformulated
gasoline. In an effort to accelerate worldwide commercialization of Lyondell's
butylene isomerization process, Lyondell has commercialized the technology
through a joint development and licensing relationship with CDTECH, a leading
supplier of ethers technologies used in reformulated fuels production, and has
entered into licensing arrangements with third parties. The arrangement with
CDTECH is intended to commercialize two processes,
                                       8
<PAGE>
 
isomerization and etherification, to produce blending agents for cleaner burning
gasolines. During the first quarter of 1995, the Isomplus(R) unit at the
Channelview Facility became operational and commercial production of isobutylene
using the new technology began. In connection with this project, the existing
MTBE unit at the Channelview Facility was expanded. Development efforts are
continuing on similar technology to produce isoamylene, a feedstock used to
produce TAME, another oxygenate used in the production of reformulated gasoline.

The Company also has product development efforts aimed at tailoring products to
meet specific customer needs, especially in such areas as consumer products and
fibers.  Lyondell's research and development efforts have resulted in the
invention of KromaLon(R), an enhanced polyolefin resin for the carpet market.
This advancement in resin technology enables the production of a recyclable
fiber with advanced coloring capabilities.  In addition to the inherent stain
resistance of polypropylene, the new fiber is dyeable and printable, providing
advantages for commercial and residential carpets.

Recent polymers industry announcements relate to the development of metallocene,
or single-site, catalysts.  Successful development and commercialization of
these catalysts are expected to result in enhanced polymer properties.  The
Company has undertaken a broad search to evaluate outside technology and is
concentrating in-house research in an effort to identify and develop single-site
catalysts for use in the production of polyolefins resins.  The Company has been
issued several U.S. patents and has filed others in connection with its research
and development efforts in this area.

Included in the acquisition of the ALATHON Business were rights to the
Alathon(R) trademark.  The ALATHON name is recognized by polymers customers as a
leading supplier of quality HDPE resins.  The Company uses numerous trademarks
in its marketing operations, a portion of which are licensed from third parties,
including ARCO.  The Company submitted several new trademark applications during
1996 to protect product line names and to enhance its marketing position.  The
Company is not dependent upon any particular trademark, and it believes the loss
of any individual trademark would not have a material adverse effect on its
operations.

EMPLOYEE RELATIONS

As of December 31, 1996, Lyondell, excluding LCR, employed approximately 1,500
full-time employees.  The Company also uses the services of approximately 1,000
employees of independent contractors in the routine conduct of its business.

FINANCE MATTERS

The Company's financial goals include maintaining investment-grade debt ratings
while maintaining sufficient liquidity and debt capacity through all phases of
the industry cycle to provide for what it deems to be sufficient capability to
invest in attractive capital projects and possible external business
opportunities.  The Company intends that cash flow in excess of the amounts
needed to fund its capital projects, external business opportunities and
appropriate liquidity needs, would be returned to the stockholders through stock
repurchases, increased dividends or some combinations thereof.

LONG-TERM DEBT AND FINANCING ARRANGEMENTS

As of December 31, 1996, the Company had $856 million of long-term debt
(including current portion) consisting of: (i) $100 million of notes due in
1997; (ii) $150 million of notes due in 1999;  (iii) $100 million of notes due
in 2002;  (iv) $150 million of notes due in 2006; (v) $150 million of debentures
due in 2026; and (vi) $206 million of medium-term notes due from 1997 to 2005.
In addition, the Company had $450 million of non-recourse borrowings under LCR's
credit facilities that mature in 2000.

The Notes due in 1999 and the medium-term notes contain provisions that would
allow the holders to require the Company to repurchase the debt upon the
occurrence of certain events combined with specified declines in public ratings
("Put Rights").  Events which may trigger the Put Rights include, among other
things, acquisitions by persons other than ARCO or the Company of more than 20
percent of the Company's Common Stock, any merger or transfer of substantially
all of the Company's assets in connection with which the Company's Common Stock
is changed into or exchanged for cash, securities or other property and payment
of "special" dividends.  See Item 5 -- "Market for Registrant's Common Equity
and Related Stockholder Matters".  The foregoing summary of the Put Rights is
not 

                                       9
<PAGE>
 
intended to be complete and it is subject to, and qualified in its entirety by
reference to, the terms of the Indenture for the Notes due in 1999 which has
been filed as an exhibit to the Company's Annual Report on Form 10-K for the
year ended December 31, 1989 and is incorporated herein by reference.

Company Unsecured Revolving Credit Facility --  The Company has a five-year,
$400 million revolving credit facility ("Facility") with a group of banks that
terminates in June 2000.  Borrowings under the Facility bear interest at either
the eurodollar, certificate of deposit or prime rates or based on a competitive
auction feature wherein the interest rate can be established by competitive bids
submitted by the sponsoring banks, all at the Company's option.  The Facility is
available for working capital and general corporate purposes as needed and
contains covenants relating to dividend payments, debt incurrence, liens,
disposition of assets, mergers and consolidations, fixed charge and leverage
ratios. The Company does not believe that the covenants or the other terms of
the Facility described below are reasonably likely to materially affect or
restrict the future operation of the Company's business or its ability to pay
dividends on its Common Stock.  At December 31, 1996, no amounts were
outstanding under the Facility.

The foregoing summary of the Facility is not intended to be complete and it is
subject to, and qualified in its entirety by reference to, the terms of the
Facility which has been filed as an exhibit to the Company's Quarterly Report on
Form 10-Q for the period ending June 30, 1995 and incorporated herein by
reference.

As of  December 31, 1996, the Company also had uncommitted lines of credit
totaling $285 million with banks and other financial institutions.  These
uncommitted lines of credit provide the Company with additional borrowing
flexibility and potentially more competitive interest rates.  The Company can
borrow money on these uncommitted lines of credit on such terms as may be
mutually agreed upon at the time amounts are borrowed.  The lines of credit can
be terminated by the lenders, in their sole discretion, on short notice.  As of
December 31, 1996, the Company had $50 million outstanding under these
uncommitted lines of credit.

For a further discussion of the Company's long-term debt and financing
arrangements, see Item 7 -- "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- FINANCIAL CONDITION" and  Note 13 of
"NOTES TO CONSOLIDATED FINANCIAL STATEMENTS".


                                REFINING SEGMENT

OVERVIEW

Lyondell participates in petroleum refining through an equity interest in LCR.
After completion of the Upgrade Project, Lyondell held an approximate 60 percent
interest and CITGO held an approximate 40 percent interest in LCR.  The Refinery
is located adjacent to the Houston Ship Channel in Pasadena, Texas.  Products
manufactured at the Refinery include gasoline, low sulfur diesel, jet fuel,
aromatics, lubricants (industrial lubricants, motor oils, white oils and process
oils)  carbon black oil, sulfur, residual fuel and petroleum coke fuel.
Aromatics are used to manufacture a variety of intermediate chemicals, including
ethylbenzene, cumene, urethane foam components and polyester intermediates for
films, fibers and resins.  End uses of these products include packaging and
containers, furniture, apparel and flooring.

LCR was formed in 1993 to upgrade the refinery's ability to process substantial
additional volumes of lower cost, very heavy crude oil supplied by Venezuela
through the Upgrade Project.  LCR has entered a long-term crude supply contract
("Crude Supply Contract") with Lagoven, S.A. ("LAGOVEN"), an affiliate of CITGO.
In addition, under the terms of a long-term product sales agreement ("Products
Agreement"), CITGO purchases from LCR a majority of the refined products
produced at the Refinery.  Both LAGOVEN and CITGO are direct or indirect wholly
owned subsidiaries of Petroleos de Venezuela, S.A. ("PDVSA"), the national oil
company of Venezuela.

The Company believes the principal benefits from its participation in LCR will
be more stabilized earnings and cash flow from the refining business following
the completion of  the Upgrade Project as well as the Crude Supply Contract and
the Products Agreement. Beginning in 1997, the earnings potential of LCR is
expected to be enhanced due to higher margins expected to be associated with the
resulting heavier crude oil mix and LCR's increased coking capability, enhanced
reformulated fuels and low sulfur diesel production capability and other yield
improvements.

                                       10
<PAGE>
 
As of March 1, 1997, CITGO contributed $130 million to LCR which was used for
ongoing LCR operations and capital projects.  Prior to the in-service date for
the Upgrade Project, CITGO reinvested its share of LCR's operating cash flow
totaling $42 million which was used for ongoing LCR capital projects.
Additional LCR capital requirements which occurred prior to the in-service date
(for purposes other than the Upgrade Project) were funded mostly by Lyondell,
primarily in the form of subordinated loans to LCR.

UPGRADE PROJECT

The Upgrade Project has increased the heavy crude oil processing capability of
the Refinery from 130,000 barrels per day of 22 degree API gravity crude oil to
a design capacity of more than 215,000 barrels per day of 17 degree API gravity
crude oil.  While not increasing the total throughput of the Refinery, the
Upgrade Project has improved the Refinery's ability to process heavier, higher
margin, crude oils. The 17 degree API gravity crude oil is more viscous and
dense than traditional crude oil and contains higher concentrations of sulfur
and heavy metals, making it more difficult to refine into gasoline and other
high value fuel products but less costly to purchase. The Upgrade Project also
included expansion of the Refinery's reformulated gasoline and low sulfur diesel
production capability.  Major components of the Upgrade Project include new
coking, crude distillation and sulfur recovery units.

Funding for the Upgrade Project, which cost approximately $1.1 billion, occurred
in four phases.  The first phase, the initial $300 million, was funded by CITGO.
The second phase was funded by an LCR borrowing of $200 million.  The third
phase of $500 million was funded (i) 50 percent through an LCR borrowing, (ii)
25 percent through contributions from CITGO, and (iii) 25 percent through
subordinated loans from the Company.  The fourth phase, which covers spending in
excess of $1 billion, was funded (i) 50 percent through subordinated loans from
the Company and (ii) 50 percent through contributions of $25 million from CITGO,
with the balance of CITGO's contribution in subordinated loans.  Prior to
completion of the Upgrade Project, the financing costs for the Upgrade Project
bank loans were funded by CITGO. In exchange for CITGO's Upgrade Project
contributions and the additional $130 million in equity contributions, CITGO's
participation interest in LCR increased to approximately 40 percent after
completion of the Upgrade Project. CITGO has a one-time option to increase its
participation interest in LCR up to 50 percent by making an additional equity
contribution.

MANAGEMENT OF LCR

LCR is a limited liability company organized under the laws of the state of
Texas and has pass-through tax characteristics similar to those of a partnership
for federal income tax purposes.  The Company owns its interest in LCR through a
wholly owned subsidiary, Lyondell Refining Company.  CITGO holds its interest
through CITGO Refining Investment Company, a wholly owned subsidiary of CITGO
(together with Lyondell Refining Company, "the Owners"). The operative agreement
with respect to the rights of each of the Owners and their parent companies is
the Amended and Restated Limited Liability Company Regulations ("Regulations")
of LCR.  The Regulations govern, among other things, ownership and cash
distribution rights. Under the terms of a reciprocal Performance Guarantee and
Control Agreement ("Performance Guarantee"), Lyondell and CITGO each
unconditionally guarantee the obligations and performance of their respective
subsidiary-Owner under the terms of the Regulations.

The Regulations provide that LCR is managed by an Owners Committee, which has
three representatives ("Representatives") from each Owner.  Actions requiring
unanimous consent of the Representatives, include, without limitation, amendment
of the Regulations, borrowing money in excess LCR's existing credit facilities,
delegations of authority to committees, certain purchase commitments and capital
expenditures in excess of designated amounts and budgetary approval.  The day-
to-day operations of the Refinery are managed by the executive officers of LCR.

                                       11
<PAGE>
 
FEEDSTOCKS

The following table sets forth the Refinery's runs of blended crude oils (which
include crude oil and other petroleum liquids, unfinished oils and other
hydrocarbons) and unfinished stock.
<TABLE>
<CAPTION>
 
                                             FOR THE YEAR ENDED DECEMBER 31
                                             ------------------------------
                                                   1996  1995  1994
                                                   ----  ----  ----
                                               (THOUSAND BARRELS PER DAY)
<S>                                                <C>   <C>   <C>
     REFINERY RUNS:
       Blended crude oils..................         218   238   209
       Unfinished stock....................          45    48    64
                                                   ----  ----  ----
     Total.................................         263   286   273
                                                   ====  ====  ====
</TABLE>

Prior to the Upgrade Project, only 40 percent of the crude oil processed at the
facility was heavy crude oil, and it was a significantly higher grade of heavy
crude oil than the 17 degree API gravity crude oil.  With the startup of new and
modified units and the closure of older distillation units, more than 95 percent
of the crude oil processed at LCR will be very heavy crude oil purchased
pursuant to the Crude Supply Contract.  LCR averaged approximately 131,000
barrels per day of 22 degree API Venezuelan crude oil in a full conversion mode
in 1996.

LCR is required to purchase and LAGOVEN is required to sell sufficient crude oil
to satisfy LCR's coking capacity, a minimum of 200,000 and up to 230,000 barrels
per day of very heavy Venezuelan crude oil.  LAGOVEN has the right, but not the
obligation, to supply incremental amounts above 230,000 barrels per day.

The Crude Supply Contract incorporates a formula price based on the market value
of a slate of refined products deemed to be produced from each particular crude
oil or feedstock, less: (i) certain deemed refining costs, adjustable for
inflation; (ii) certain actual costs, including crude transportation costs,
import duties and taxes; and (iii) a deemed margin, which varies according to
the grade of crude oil or other feedstock delivered.  Deemed margins and deemed
costs are adjusted periodically.  These adjustments are based on, and in the
case of deemed margins, less than, the rate of inflation.  Because deemed
operating costs and the slate of refined products deemed to be produced for a
given barrel of crude oil or other feedstock do not necessarily reflect the
actual costs and yields in any period and also because the market value of the
refined products used in the pricing formula does not necessarily reflect the
actual price received for the refined products, the actual refining margin
earned by LCR under the Crude Supply Contract will vary depending on, among
other things, the efficiency with which LCR conducts its operations during such
period.

There are risks associated with enforcing the provisions of contracts with an
affiliate of a foreign government such as LAGOVEN.  These risks include
enforcing judgments of United States courts against entities whose assets are
located outside of the United States and whose management does not reside in the
United States. Depending on then current market conditions, breach or
termination of the Crude Supply Contract could adversely affect the Company.
For example, the parties have negotiated alternative arrangements in the event
of certain force majeure conditions, including governmental or other actions
restricting or otherwise limiting LAGOVEN's ability to perform its obligations.
Any such alternative arrangements may not be as beneficial as the Crude Supply
Contract.  There can be no assurance that alternative crude oils with similar
margins would be available for purchase by LCR.  If LCR were required to return
to the practice of purchasing all of its crude oil feedstocks in the merchant
market, LCR would again be subject to significant volatility and price
fluctuations. However, the Company believes that this transaction holds
substantial economic and other incentives for all parties to perform their
obligations.  Lyondell believes PDVSA's strategic interest in expanding its
crude oil refining operations in the United States in order to increase the
markets for its heavy crude oil and continued financial commitments of CITGO
should provide an economic incentive for all PDVSA affiliates to perform their
obligations under the various agreements.

MARKETING AND SALES

The Refinery produces gasoline, low sulfur diesel, jet fuel, aromatics,
lubricants and certain industrial products.  On a weekly basis, LCR evaluates
and determines the optimal product output mix for the Refinery, based on spot
market prices and conditions. Pursuant to the Products Agreement, CITGO is
purchasing all of the gasoline, low sulfur diesel and heating oil manufactured
at the Refinery. These products are purchased by CITGO at market-based prices.
For example, the price for gasoline is based on prices published by Platts
Oilgram, an industry trade publication. Aromatics extracted as part of the
refining process are marketed for LCR by Lyondell.  With the startup of new and
modified 

                                       12
<PAGE>
 
hydrotreaters and sulfur plants, LCR is now producing all of its distillate as
low sulfur diesel fuel for sale as transportation fuel, a higher-valued product.
Blending facilities completed as part of the Upgrade Project enable LCR to
supply more than 70 percent of its gasoline capacity as higher-value
reformulated or oxygenated fuel.

Due to the increasingly competitive lubricants business, LCR elected to close
the base oils distillation units at year-end and now purchases lubricant base
stocks in the open market for blending into motor oils.  This eliminated
approximately 35,000 barrels per day of higher cost sweet crude oil previously
used in these units.  LCR will continue to participate in the naphthenic oil,
white oil and compounded oil businesses.

AGREEMENTS BETWEEN LYONDELL AND LCR

The Company and LCR have entered into multiple agreements designed to preserve
much of the synergy between the Refinery and the Channelview Facility.  Economic
evaluations at the Channelview Facility and the Refinery are based on sending
products to the highest-value disposition, which may be local use, use at the
other site, or third party sales.  Certain refinery products (propane, butane,
low-octane naphthas, heating oils, and gas oils) can be used as feedstocks for
olefins production, and certain Channelview Facility olefins by-products can be
processed by the Refinery into gasoline.  Butylenes from the Refinery are tolled
through the Channelview Facility for the production of alkylate and MTBE for
gasoline blending.  Hydrogen from the Channelview Facility is used at the
Refinery for sulfur removal and product stabilization.

Pursuant to the terms of a number of service agreements, Lyondell has contracted
with LCR to continue to perform services in certain areas, including
administrative services and marketing services.  Lyondell and LCR also entered
into a variety of contracts providing for the assignment or licensing of
intellectual property rights associated with the refining business.

COMPETITION AND INDUSTRY CONDITIONS

All of LCR's gasoline, low sulfur diesel and jet fuel are sold to CITGO under
the Products Agreement.  LCR continues to sell lube oils directly to major
industrial consumers and through distributors in domestic and international
markets.

The refining business tends to be volatile as well as cyclical.  Crude oil
prices, which are impacted by worldwide political events and the economics of
exploration and production in addition to refined products demand, are the
largest source of this volatility.  Demand for refined products is influenced by
seasonal and short-term factors such as weather and driving patterns, as well as
by longer term issues such as energy conservation and alternative fuels.
Industry refined products supply is also dependent on industry operating
capabilities and on long-term refining capacity trends. However, management
believes that the combination of the Crude Supply Contract and the Products
Agreement will stabilize future earnings and cash flows and reduce the market
driven aspects of such volatility.

Among LCR's refining competitors are major integrated petroleum companies that
have their own raw material resources and, in many cases, downstream markets,
both of which tend to decrease the impact of business cycles on these
competitor's sales volumes and profitability.  Many of the domestic refiners are
owned by or affiliated with major integrated oil companies.  Based on published
industry data, as of January 1, 1997, there were 163 crude oil refineries in
operation in the United States, and total domestic refinery capacity was
approximately 15 million barrels per day.  During 1996, LCR processed an average
of 218,000 barrels per day of blended crude oil or over one percent of domestic
capacity.

CAPITAL PROGRAM

The refining segment's capital expenditures for additions to fixed assets
(excluding spending on the Upgrade Project) totaled $56 million in 1996.  The
refining segment's capital budget (excluding the Upgrade Project) for 1997 is
approximately $50 million, of which the Company remains obligated for $16
million.  Of the total 1997 capital budget, approximately $15 million is
expected to be spent on environmentally-related capital projects.

As part of its ongoing operations, LCR periodically conducts maintenance
turnarounds on its facilities.  Although turnarounds on principal facilities are
usually scheduled well in advance, the timing of such turnarounds can be
accelerated or delayed because of numerous factors, some of which are beyond
LCR's control.

                                       13
<PAGE>
 
PROPERTIES

LCR owns the real property, plant and equipment which comprise the Refinery,
located on an approximately 700 acre site in Houston, Texas.  Units include the
fluid catalytic cracking unit, the coker, reformers, crude distillation units,
sulfur recovery plants and hydrodesulfurization units, as well as lube oil
manufacturing and packaging facilities and an aromatics recovery unit.  LCR also
owns the real property, plant and equipment which comprise a lube oil blending
and packaging plant in Birmingport, Alabama.  LCR owns a pipeline used to
transport gasoline, kerosene and heating oil from the Refinery to the GATX
Terminal to interconnect with common carrier pipelines.

Lyondell owns several pipelines connecting the Channelview Facility, the
Refinery and the Mont Belvieu Facility, including six lines used to transport
heavy liquid feedstocks, butylenes, benzene, hydrogen, butane, MTBE and
unfinished gasolines between the Channelview Facility and the Refinery.

EMPLOYEE RELATIONS

At year-end, LCR employed approximately 1,350 full-time employees.  LCR also
uses the services of approximately 250 employees of independent contractors in
the routine conduct of its business. Certain hourly workers at the Refinery are
covered by collective bargaining agreements between LCR and the Oil, Chemical
and Atomic Workers Union (approximately 820 employees).

LCR UNSECURED REVOLVING CREDIT FACILITY

Effective May 5, 1995, LCR entered into two credit facilities (the "LCR Credit
Facilities") totaling $520 million.  The first facility is a $70 million, 364-
day revolving credit facility, which replaced LCR's existing $70 million
revolving credit facility, that is utilized for general business purposes,
including letters of credit, unrelated to the Upgrade Project.  The second
facility is a $450 million, five-year term credit facility that has been used in
connection with the Upgrade Project.  Interest for the facilities is based on
prime, eurodollar or competitive rates at LCR's option.  Prior to the completion
of the Upgrade Project, substantially all financing costs related to the $450
million credit facility were funded by CITGO.  The facilities contain covenants
which require LCR to maintain a minimum net worth which increases each year
until 1998 and maintenance of certain financial ratios defined in the
agreements.  The facilities also contain other customary covenants which limit
LCR's ability to modify certain significant contracts, incur additional debt or
liens, dispose of assets, make restricted payments as defined in the agreements
or merge or consolidate with other entities.

At the end of the third quarter 1996, LCR was not in compliance with the
financial ratio covenant of adjusted average debt to earnings before interest,
taxes, depreciation and amortization ("EBITDA") contained in each of its
outstanding credit facilities.  Effective as of November 12, 1996, the LCR
Credit Facilities were amended to replace the adjusted average debt to EBITDA
covenant and one additional financial covenant with a covenant to maintain a
minimum EBITDA.  The amendments were retroactively effective as of the
noncompliance date and will continue through June 30, 1997.  The foregoing
summary of the facilities is not intended to be complete and is subject to, and
qualified in its entirety by reference to, the terms of the facilities, which
have been filed as exhibits to the Company's Quarterly Report on Form 10-Q for
the period ending March 31, 1995 and the amendments thereto, filed as exhibits
to the Company's Quarterly Report on Form 10-Q for the period ending September
30, 1996 and are incorporated herein by reference.

For a further discussion of the Company's long-term debt and financing
arrangements, see Item 7 -- "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- FINANCIAL CONDITION" and Note 13 of
"NOTES TO CONSOLIDATED FINANCIAL STATEMENTS".
 

                             ENVIRONMENTAL MATTERS

Lyondell's production facilities are generally required to have permits and
licenses regulating air emissions, discharges to water and generation, storage,
treatment and disposal of hazardous wastes.  Companies such as Lyondell that are
permitted to treat, store or dispose of hazardous waste and maintain underground
storage tanks pursuant to the Resource Conservation and Recovery Act ("RCRA")
also are required to meet certain financial responsibility requirements.  The
Company believes that it has all permits and licenses generally necessary to
conduct its business or, where necessary, is applying for additional, amended or
modified permits and that it meets applicable financial responsibility
requirements.

                                       14
<PAGE>
 
The Company's policy is to be in compliance with all applicable environmental
laws. The Company also is committed to Responsible Care(R), a chemical industry
initiative to enhance the industry's responsible management of chemicals.  The
Company (together with the industries in which it operates) is subject to
extensive federal, state and local environmental laws and regulations concerning
emissions to the air, discharges onto land or waters and the generation,
handling, storage, transportation, treatment and disposal of waste materials.
Some of these laws and regulations are subject to varying and conflicting
interpretations.  In addition, the Company cannot accurately predict future
developments, such as increasingly stricter requirements of environmental laws,
inspection and enforcement policies and compliance costs therefrom, which might
affect the handling, manufacture, use, emission or disposal of products, other
materials or hazardous and non-hazardous waste.  In particular, the ultimate
effect of the Clean Air Act on the Company's operations will depend on how the
law is interpreted and implemented pursuant to regulations that are currently
being developed and on additional factors such as the evolution of environmental
control technologies.  Some risk of environmental costs and liabilities is
inherent in particular operations and products of the Company, as it is with
other companies engaged in similar businesses, and there is no assurance that
material costs and liabilities will not be incurred. In general, however, with
respect to the capital expenditures and risks described above, the Company does
not expect that it will be affected differentially from the rest of the domestic
petrochemicals and refining industry.

In some cases, compliance with environmental, health and safety laws and
regulations can only be achieved by capital expenditures.  In the years ended
December 31, 1996 and 1995, the Company spent approximately $28 million and $35
million, respectively, for environmentally related capital expenditures at
existing facilities.  In 1997, the Company currently estimates that
environmentally related capital expenditures at existing facilities will be
approximately $25 million.  The Company does not anticipate that environmentally
related capital expenditures at its facilities in 1998 will be materially
different than for 1997.  The timing and amount of these expenditures are
subject to the regulatory and other uncertainties described above as well as
obtaining of the necessary permits and approvals.  For periods beyond 1998,
additional environmentally related capital expenditures will be required,
although the Company cannot accurately predict the levels of such expenditures
at this time.

The Refinery contains on-site solid-waste landfills which were used in the past
to dispose of waste generated at this facility.  It is anticipated that
corrective measures will be necessary to comply with federal and state
requirements with respect to this facility.  In addition, the Company negotiated
an order with the Texas Natural Resource Conservation Commission ("TNRCC") for
assessment and remediation of groundwater and soil contamination at the
Refinery.  The Company is also responsible for a portion of the remediation of
certain off-site waste disposal facilities.  The Company's policy is to accrue
remediation expenses when it is probable that such efforts will be required and
the related expenses can be reasonably estimated.  Estimated costs for future
environmental compliance and remediation are necessarily imprecise due to such
factors as the continuing evolution of environmental laws and regulatory
requirements, the availability and application of technology, the identification
of presently unknown remediation sites and the allocation of costs among the
responsible parties under applicable statutes.  The Company has reserved an
amount (without regard to potential insurance recoveries or other third party
reimbursements) it believes to be sufficient to cover current estimates of the
cost for remedial measures at its manufacturing facilities and off-site waste
disposal facilities based upon its interpretation of current environmental
standards.  In the opinion of management, there is no material range of loss in
excess of the amount recorded.  Based on the establishment of such reserves, and
the status of discussions with regulatory agencies described in this paragraph,
and although the reserves are subject to increase, the Company does not
anticipate any material adverse effect upon its financial statements or
competitive position as a result of compliance with the laws and regulations
described in this or the preceding paragraphs.  In the fourth quarter of 1992,
the Refinery underwent an EPA multi-media inspection. In February 1997, the
Company reached final settlement with the EPA and the Department of Justice.
The Company has paid a total fine in the amount of slightly less than $200,000
in final settlement of all issues raised in the inspection.  No other relief was
sought by the government.  See also Item 3 -- "Legal Proceedings -- Claims
Relating To Waste Disposal Sites",  "Other Matters" and Item 7 -- "Management's
Discussion and Analysis of Financial Condition and Results of Operations".

                                       15
<PAGE>
 
ITEM 3.  LEGAL PROCEEDINGS

GENERAL

In connection with the transfer of assets and liabilities from ARCO to Lyondell,
Lyondell agreed to assume certain liabilities arising out of the operation of
the Company's integrated petrochemicals and petroleum processing business prior
to July 1, 1988.  At that time, the Company and ARCO entered into an agreement
("Cross-Indemnity Agreement") whereby the Company agreed to defend and indemnify
ARCO against certain uninsured claims and liabilities which ARCO may incur
relating to the operation of the business of the Company prior to July 1, 1988,
including liabilities which may arise out of certain of the legal proceedings
described in this Item 3.  The Company has reached an agreement in principle
with ARCO to update the Cross-Indemnity Agreement ("Revised Cross-Indemnity
Agreement").  See Item 13 -- "Certain Relationships and Related Transactions".

In addition to the proceedings specifically described in this Item 3, ARCO, the
Company and its subsidiaries are defendants in other suits, some of which are
not covered by insurance.  Many of these additional suits involve smaller
amounts than the matters described herein, or make no specific claim for relief.
Although final determination of legal liability and the resulting financial
impact with respect to the litigation described in this Item 3, as well as the
other litigation affecting the Company, cannot be ascertained with any degree of
certainty, the Company does not believe that any ultimate uninsured liability
resulting from the legal proceedings in which it currently is involved (directly
or indirectly) will individually, or in the aggregate, have a material adverse
effect on the business or financial statements of the Company; however the
adverse resolution in any reporting period of one or more of the matters
discussed in this note could have a material impact on the Company's results of
operations for that period.  See Note 20 of "NOTES TO CONSOLIDATED FINANCIAL
STATEMENTS".

Although Lyondell is involved in numerous and varied legal proceedings, a
significant portion of its litigation arises in three contexts:  (1) claims for
personal injury or death allegedly arising out of exposure to the Company's
products; (2) claims for personal injury or death, and/or property damage
allegedly arising out of the generation and disposal of chemical wastes at
Superfund and other waste disposal sites; and (3) claims for personal injury
and/or property damage and air, noise and water pollution allegedly arising out
of the operation of the Company's facilities.  The following sections of this
Item 3 describe these types of pending proceedings.  Lyondell (either directly
or through ARCO as its indemnitee) is the real party at interest in these
proceedings.

CLAIMS RELATED TO COMPANY PRODUCTS

ARCO and the Company are involved in numerous suits arising in whole or in part
from the operation of the Company's petrochemical and petroleum processing
businesses and the assets related thereto in which the plaintiffs allege damages
arising from exposure to allegedly toxic chemical products, such as benzene and
butadiene.  Plaintiffs in these cases usually worked at a manufacturing facility
as employees of one of Lyondell's customers, were employees of the Company's
contractors, or were employees of companies involved in the transportation of
the Company's products to its customers.  These suits allege toxic effects of
exposure to chemicals sold in the ordinary course of business to third parties
by various industrial concerns, including ARCO or the Company, or allege toxic
chemical exposures at the Company's manufacturing facilities.  Issues common to
these cases include:  (1) whether the plaintiff can identify a specific product
to which he was allegedly exposed; (2) whether the Company supplied the
identified product to which plaintiff claims he was exposed; (3) whether the
plaintiff has a medical condition which, based upon competent scientific and
medical evidence, is causally related to the identified product; (4) whether,
and under what conditions, the plaintiff was exposed to the identified product;
and (5) if the plaintiff was exposed, whether the Company has any legal defenses
to the plaintiff's claims and whether there are other parties or defendants to
whom the Company can turn for contribution or indemnification.  The Company
believes that it has always followed a policy of not only complying with all
mandated standards related to product warnings and exposure levels but also of
complying with Company specific standards that were more strict than those
imposed by the law.  As a result, the Company believes that it has a basis to
avail itself of legal defenses against claims regarding its products due to
exposures by employees and by claims of exposures from third parties to whom the
Company sold its products.

The vast majority of chemical exposure cases name a large number of industrial
concerns, in addition to the Company, as defendants and are at various stages of
discovery.  Although the Company does not believe that the pending chemical
exposure cases will have a material adverse effect on its business or financial
statements, it is difficult to determine the potential outcome of this type of
case.  The majority of the plaintiffs in chemical exposure legal 

                                       16
<PAGE>
 
proceedings request relief in the form of unspecified monetary damages.
Furthermore, when specific amounts are requested they often bear no objective
relation to the merits of the case. It is possible that if one or more of the
presently pending chemical exposure cases were resolved against ARCO or the
Company, the resulting damage award could have a material impact on the
Company's results of operations for any reporting period, without giving effect
to contribution or indemnification obligations of co-defendants or others, or to
the effect of any insurance coverage that may be available to offset the effects
of any such award.  Under the Revised Cross-Indemnity Agreement, ARCO and the 
Company will bear a proportionate share of judgment and settlement costs for 
cases related to Company products and operations according to a formula that 
allocates responsibility based on years of ownership during the relevant time 
period.

CLAIMS RELATING TO WASTE DISPOSAL SITES
 
Wastes generated from products produced by facilities transferred from ARCO and
now owned by the Company have, from time to time, been disposed of at third-
party landfills.  Two of these facilities, known as the "French Ltd." and the
"Brio" sites, both of which are located near Houston, Texas, have been
classified as "Superfund" sites under the Comprehensive Environmental Response,
Compensation and Liability Act of 1980 ("CERCLA").  The EPA has named many
potentially responsible parties ("PRPs") at each site from whom wastes were
allegedly received. Based on the current law, the Company does not believe that
its obligation to ARCO related to ARCO's share of clean-up costs at either of
these sites will result in a liability that will have, individually or in the
aggregate, a material adverse effect on the business or financial statements of
the Company.  It is possible, however, that the Company may be involved in
future CERCLA and comparable state law investigations and clean-ups.  The
Superfund law has not been reauthorized since 1995, and  the Company is not able
to determine with specificity what the impact of a revised Superfund law would
be on the Company.

French Ltd. Site Remediation -- At the French Ltd. site, ARCO and the other PRPs
have entered into a settlement agreement relating to the allocation of clean-up
costs.  The EPA approved the clean-up plan and a Consent Decree was entered in
the Federal District Court for the Southern District of Texas in the first
quarter of 1990.  An amendment to the Consent Decree relating to natural
resource damages has been negotiated and submitted to the court for approval.
The remediation work was completed in 1996.  The Company believes that its share
of clean-up costs (as allocated pursuant to the Cross-Indemnity Agreement) will
be no more than five percent of total costs recovered without giving effect to
any insurance coverage which may be available to offset these costs.  The total
costs associated with the Consent Decree are currently expected to be
approximately $90 million and the Company's total costs to date have been
approximately $3.5 million.  The Revised Cross-Indemnity Agreement will not
change the allocation of remediation costs for this site.

French Ltd. Site Litigation -- Approximately 2,500 plaintiffs have made claims
related to wastes in the French Ltd. site.  In each of these cases, ARCO is one
of many defendants.  These suits generally allege that unspecified chemical
waste sent to the site by the defendants caused a decrease in property value, a
decrease in plaintiffs' ability to enjoy their property, and unspecified adverse
effects on plaintiffs' health.  Although some of the lawsuits request relief in
the form of unspecified monetary damages, the aggregate amount of actual damages
sought in those cases where damages are specified exceeds $5 billion.  The
aggregate amount of punitive damages sought in those cases where damages are
specified exceeds $20 billion.  In December 1992, after mediation, ARCO, along
with several other defendants, entered into a preliminary agreement to settle
claims of approximately 2,200 plaintiffs.  The remaining claims are in pretrial
discovery.  Under the Revised Cross-Indemnity Agreement, ARCO will waive any
claim for reimbursement for any prior defense costs or settlements associated
with these matters, and the Company will assume responsibility for its
proportionate share, which is less than 10 percent, of all future costs not
covered by ARCO insurance.

Brio Site Remediation -- At the Brio site, a definitive agreement allocating
these remedial costs among ARCO and the other PRPs was reached.  The EPA
approved the plan and a Consent Decree between the Department of Justice and a
group of PRPs (including ARCO on behalf of its former divisions and
subsidiaries) was entered in Federal District Court for the Southern District of
Texas, in April 1991. The total clean-up cost under the original consent decree
is currently estimated to be approximately $60 million.  Various objections have
been raised with respect to the provisions of the original remediation plan, and
the EPA and the PRP's have agreed to fund a new feasibility study to evaluate
alternatives for remediation. The Company believes that its share of the clean-
up costs (as allocated pursuant to the Cross-Indemnity Agreement) will be no
more than one percent of total costs without giving effect to any insurance
coverage which may be available to offset these costs. The Revised Cross-
Indemnity Agreement will not change the allocation of remediation costs for this
site.


                                       17
<PAGE>
 
Brio Site Litigation -- There currently are eight separate pending legal 
proceedings filed against ARCO or its affiliates and numerous others in 
connection with the Brio site. In these proceedings, there are approximately 600
plaintiffs, many of whom are suing in their capacity as next friend of minor
children. In each of these cases, ARCO is one of many defendants. Plaintiffs
allege personal injury as a result of exposure to various substances that were
disposed of or stored at the Brio site. These suits generally allege that
defendants were negligent in sending chemical substances to the site and also
contain allegations of nuisance and strict liability. The suits involve: a
school district alleging damages as a result of the closing of an elementary
school; employees of the various entities who operated the refining and
reprocessing facilities at the Brio site; and other plaintiffs. All of the
lawsuits request relief in the form of unspecified compensatory and exemplary
damages. These suits are in pretrial discovery. Under the Revised Cross-
Indemnity Agreement, ARCO will waive any claim for reimbursement for any prior
defense and settlement costs associated with these matters, and the Company will
assume responsibility for its proportionate share, which is 20 percent, of all
future costs not covered by ARCO insurance.

CLAIMS RELATED TO COMPANY OPERATIONS

Mont Belvieu Litigation -- Several organizations and groups of citizens who own
property in the vicinity of Mont Belvieu, Texas, have instituted suits for
monetary damages and injunctive relief against ARCO and others who own
underground storage and transportation facilities in the city of Mont Belvieu.

In September 1980, Warren Petroleum Company ("Warren") experienced a leak in one
of its underground hydrocarbon storage wells in Mont Belvieu.  Three lawsuits
were filed by approximately 120 plaintiffs, naming Warren, ARCO and other
companies with operations in Mont Belvieu as defendants.  These plaintiffs
claimed property damage, and, in some instances, personal injuries allegedly
resulting from storage operations in Mont Belvieu.  In February 1986, ARCO was
granted a directed verdict as to all of the claims of the plaintiffs in the
first of the three lawsuits to be tried which had the effect of dismissing all
the pending claims without the ability to refile.  Thereafter, the plaintiffs in
the two remaining cases dropped their claims against ARCO although ARCO remains
in these two cases as a result of cross claims for contribution filed by other
defendants.  These suits have not been set for trial.

ARCO is paying all defense costs in all of the Mont Belvieu litigation.  Under
the Revised Cross-Indemnity Agreement, ARCO will waive any right to
reimbursement under the existing Cross-Indemnity Agreement for costs associated
with this matter.

OTHER MATTERS

In July 1994, the Company reported results of an independent investigation
conducted by the Audit Committee of the Board of Directors regarding the
compliance status of two process waste water streams under the applicable
Benzene National Emissions Standard for Hazardous Air Pollutants ("NESHAPS")
regulations and certain issues raised by an employee.  Noncompliance with the
Benzene NESHAPS regulations and the related reporting requirements can result in
civil penalties and, under certain circumstances, substantial civil and,
potentially, criminal penalties.  The Company received a notice of violation
from the TNRCC regarding the two streams and paid a fine of $10,200.  In
addition, the Company incurred approximately $2 million in capital costs in
connection with these waste water streams to achieve on-going compliance with
the Benzene NESHAPS regulations.  Although the Criminal Enforcement Division of
the EPA is conducting a formal investigation, the Company does not believe any
aspects of the matters described above will subject the Company to criminal
liability or have a material adverse effect on the financial statements or
liquidity of the Company.

As a result of flooding during October 1994, three pipelines, owned by Colonial
Pipeline and Texaco ruptured in the San Jacinto River flood plain, resulting in
explosions and fires.  As a result of the explosions and fires, the Company was
forced to shut down operations at its Channelview Facility and destroy large
volumes of product.  The Company is seeking damages from Colonial Pipeline and
Texaco of $12.5 million for lost profits, destroyed product and repair costs.
Settlement in this matter has not been reached.

In June 1996, the Company experienced a fire at its Mont Belvieu terminal due to
a valve malfunction.  The fire resulted in damage estimated at approximately $14
million plus a before-tax impact on operating income of $2 million.  The Company
is seeking recovery of the loss from the valve manufacturer and refurbisher.


                                       18
<PAGE>
 
In July 1996, the Company experienced a fire at its Channelview Facility due to
a rupture in a pipeline owned and operated by ARCO PipeLine Company ("ARCO
PipeLine"). Although no operating units were directly involved in the fire, the
damage to the pipeline and electrical systems forced the Company to shut down
the Channelview Facility for several days and the olefins units for more than
two weeks. ARCO PipeLine has paid the Company approximately $31 million to
compensate the Company for incurred expenses and lost profits.

In addition to the matters reported in this Item 3, from time to time the
Company receives notices from federal, state or local governmental entities of
alleged violations of environmental laws and regulations pertaining to, among
other things, the disposal, emission and storage of chemical and petroleum
substances, including hazardous wastes.  Although the Company has not been the
subject of significant penalties to date, such alleged violations may become the
subject of enforcement actions or other legal proceedings and may (individually
or in the aggregate) involve monetary sanctions of $100,000 or more (exclusive
of interest and costs).


                           RELATED PARTY TRANSACTIONS

In connection with the transfer of assets and liabilities to Lyondell and the
initial public offering of Lyondell's common stock in January 1989, the Company
and ARCO entered into a number of agreements for the purpose of defining their
ongoing relationships.  In addition, in July 1987, Lyondell and ARCO Chemical,
then a wholly-owned subsidiary of ARCO, entered into a number of agreements in
connection with the organization of ARCO Chemical.  None of these agreements was
the result of arm's-length negotiations between independent parties.  It was the
intention of Lyondell, ARCO and ARCO Chemical that such agreements and the
transactions provided for therein, taken as a whole, accommodate the parties'
interests in a manner that was fair to the parties, while continuing certain
mutually beneficial arrangements.  The Audit Committee of the Board of Directors
of the Company, whose members are not affiliated with the Company, ARCO or its
affiliates, has determined that such agreements, taken as a whole, were fair to
the Company and its stockholders.  Because of the complexity of the various
relationships between Lyondell, ARCO, its direct and indirect subsidiaries,
including ARCO Chemical (together, "ARCO Affiliates"), there can be no assurance
that each of such agreements, or the transactions provided for therein, has been
effected on terms at least as favorable to the Company as could have been
obtained from unaffiliated parties.

The terms and provisions of many of these initial agreements have subsequently
been modified or supplemented and additional or modified agreements,
arrangements and transactions will be determined through negotiation among the
Company and ARCO Affiliates, and it is possible that conflicts of interest will
be involved.  As long as ARCO remains a 49.9 percent stockholder, future
contractual relations between the Company and ARCO Affiliates will be subject to
certain provisions of the Company's Certificate of Incorporation.  See "The
Company's Business - Development of Business".  In addition, the Audit Committee
of the Board of Directors of the Company has adopted a set of guidelines for the
review of all agreements entered into between the Company and ARCO Affiliates.
These guidelines include a provision that, at least annually, the Audit
Committee will review such agreements or the transactions provided for therein
to assure that such agreements are fair to the Company and its stockholders.

During 1996, Lyondell purchased certain of its feedstock requirements from ARCO
Affiliates and paid them fees for transportation of product and for other
services.  For the year ended December 31, 1996, Lyondell paid ARCO Affiliates
approximately $23 million.  During 1996, Lyondell sold products to and provided
services for ARCO Affiliates, including sales of propylene, MTBE, benzene,
ethylene and methanol to ARCO Chemical and crude oil resales and sales of lube
oil to other ARCO Affiliates.  For the year ended December 31, 1996, Lyondell
received approximately $318 million from sales to and services for ARCO
Affiliates, of which $287 million represented sales to and services for ARCO
Chemical.  See Note 8 of "NOTES TO CONSOLIDATED FINANCIAL STATEMENTS".

In connection with the ARCO Note Offering, the Company and ARCO entered into
agreements governing their ongoing relationships, including a Registration
Rights Agreement that provides ARCO with rights under certain circumstances to
compel the Company to file a registration statement with the SEC with respect to
all or a portion of the shares of Common Stock held by ARCO.  At the same time,
ARCO announced its intention to vote its shares in proportion to the votes of
the non-ARCO stockholders, except under certain limited circumstances.

For a summary of agreements, arrangements and transactions among the Company,
ARCO Chemical and ARCO see "TRANSACTIONS BETWEEN THE COMPANY AND ARCO", which is
included in the 1997 Proxy Statement and incorporated herein by reference as
part of Item 13 of this Annual Report on Form 10-K.

                                       19
<PAGE>
 
                   EXECUTIVE  OFFICERS  OF  THE  REGISTRANT

 
Set forth below are the executive officers of Registrant(*) as of March 1, 1997.

<TABLE>   
<CAPTION> 
NAME, AGE AND PRESENT                  BUSINESS EXPERIENCE DURING PAST
POSITION WITH LYONDELL           FIVE YEARS AND PERIOD SERVED AS OFFICER(S)
---------------------------  ---------------------------------------------------
<S>                          <C>  
John R. Beard, 44..........  Mr. Beard has served as Vice President,
Vice President,              Petrochemical Manufacturing since May 1995.  Mr.
Petrochemical Manufacturing  Beard served as Vice President in the areas of
                             Quality, Supply, Planning and Evaluations since
                             1992.  Prior to 1992, Mr. Beard served as the Site
                             Manager of Lyondell's Houston Refinery and in
                             management assignments in evaluations, marketing
                             and manufacturing for the Company, ARCO Products
                             Company and the ARCO Chemical Division.
 
 
Clifton B. Currin, Jr. 42..  Mr. Currin was named Vice President, Strategic
Vice President, Strategic    Development in January 1997.  Mr. Currin has
 Development                 served as a Vice President of the Company since
                             1994 with responsibilities in the areas of
                             Petrochemicals Business Management and Olefins.
                             Prior to 1994, Mr. Currin held positions in
                             management, evaluations and marketing for the
                             Company and for ARCO Products Company.
 
J. R. Fontenot, 44.........  Mr. Fontenot became Vice President, Technology in
Vice President, Technology   January 1997.  Mr. Fontenot served as Director of
                             Technology for the Company since 1995.  Prior to
                             1995, Mr. Fontenot held various positions in
                             operations, evaluations and technology for the
                             Company.
 
Richard W. Park, 57........  Mr. Park has served as Vice President, Human
Vice President,              Resources since June 1988.  Prior to 1988, Mr.
Human Resources              Park served as Vice President of Employee
                             Relations of the Lyondell Division and held
                             various personnel management positions with ARCO
                             Chemical.
 
 
Jeffrey R. Pendergraft, 48.  Mr. Pendergraft was named Senior Vice President in
Senior Vice President,       May 1993.  In addition, Mr. Pendergraft has served
General Counsel and          as Vice President, General Counsel and Secretary
 Secretary                   since 1988.  Prior to 1988, Mr. Pendergraft served
                             as General Attorney of the Lyondell Division and
                             as attorney in various operating divisions and
                             corporate units of ARCO.
 
 
W. Norman Phillips, Jr., 42  Mr. Phillips was named Vice President, Polymers in
Vice President,  Polymers    January 1997.  Mr. Phillips has served as Vice
                             President of the Company with responsibilities in
                             the areas of marketing and operations since 1993.
                             Prior to 1993, Mr. Phillips held the position of
                             Site Manager of Channelview Operations and various
                             management positions in the areas of planning,
                             marketing and manufacturing.
 
Joseph M. Putz, 56.........  Mr. Putz has served as Vice President and
Vice President and           Controller since October, 1988.  Prior to 1988,
 Controller                  Mr. Putz served as Vice President, Control and
                             Administration for the Company and the Lyondell
                             Division and held various positions with ARCO in
                             internal control, special projects and various
                             financial positions.
</TABLE>

                                       20
<PAGE>
 
<TABLE>
<CAPTION>
   NAME, AGE AND PRESENT               BUSINESS EXPERIENCE DURING PAST
  POSITION WITH LYONDELL         FIVE YEARS AND PERIOD SERVED AS OFFICER(S)
---------------------------  ---------------------------------------------------
 
<S>                          <C>
Dan F. Smith, 50...........  Mr. Smith was named Chief Executive Officer and
President,                   President in December 1996.  Mr. Smith has been a
Chief Executive Officer      Director since 1988.  Mr. Smith served as
 and Director                President and Chief Operating Officer of the
                             Company from 1994 to December 1996.  Prior to
                             1994, Mr. Smith held various positions including
                             Executive Vice President, Chief Financial Officer
                             of the Company, Vice President, Corporate Planning
                             of ARCO and Senior Vice President in the areas of
                             management, manufacturing, control and
                             administration for the Company and the Lyondell
                             Division.
 
 
Debra L. Starnes, 44.......  Ms. Starnes became Senior Vice President,
Senior Vice President,       Petrochemicals in January 1997.  Ms. Starnes has
 Petrochemicals              served the Company as a Senior Vice President
                             since 1995 and as a Vice President since 1991 with
                             various responsibilities including polymers,
                             petrochemicals business management and marketing
                             and corporate planning.  Prior to 1991, Ms.
                             Starnes held various positions in planning,
                             manufacturing and marketing with ARCO and Lyondell.
 
Russell S. Young, 48.......  Mr. Young has served as Senior Vice President,
Senior Vice President,       Chief Financial Officer and Treasurer since May
Chief Financial Officer      1992.  Prior to 1992, Mr. Young held various
and Treasurer                positions including Vice President and Treasurer
                             of the Company, Controller of the ARCO Products
                             Division and in various financial management
                             positions for ARCO.
</TABLE>

*  The By-Laws of the Company provide that each officer shall hold office until
   the officer's successor is elected or appointed and qualified or until the
   officer's death, resignation or removal by the Board of Directors.


                         DESCRIPTION OF CAPITAL STOCK

The authorized capital stock of the Company currently consists of 250,000,000
shares of Common Stock, par value $1 per share and 80,000,000 shares of
preferred stock, par value $.01 per share.  The following summary description of
the capital stock of the Company is qualified in its entirety by reference to
the Certificate of Incorporation, as amended and the Amended and Restated By-
Laws of the Company, as amended, copies of which are filed as exhibits to this
Annual Report on Form 10-K.

COMMON STOCK

The Company is currently authorized to issue 250,000,000 shares of Common Stock,
of which 80,000,000 shares of Common Stock are outstanding at the date hereof.

Holders of Common Stock ("Stockholders") are entitled (i) to receive such
dividends as may from time to time be declared by the Board of Directors of the
Company; (ii) to one vote per share on all matters on which the Stockholders are
entitled to vote; (iii) to act by written consent in lieu of voting at a meeting
of Stockholders; and (iv) to share ratably in all assets of the Company
available for distribution to the Stockholders, in the event of liquidation,
dissolution or winding up of the Company.  For additional information regarding
the Company's dividend policy, see Item 5 -- "Market for Registrant's Common
Equity and Related Stockholder Matters".  The holders of a majority of the
shares of Common Stock represented at a meeting can elect all of the directors.
See Item 12 -- "Security Ownership of Certain Beneficial Owners and Management"
which is incorporated herein by reference.

Shares of Common Stock are not liable to further calls or assessments by the
Company for any liabilities of the Company that may be imposed on its
Stockholders under the laws of the State of Delaware, the state of incorporation
of the Company.  There are no preemptive rights for the Common Stock in the
Certificate of Incorporation.

                                       21
<PAGE>
 
The Transfer Agent, Registrar and Dividend Disbursing Agent for the Common Stock
is The Bank of New York.

PREFERRED STOCK

In July 1994, the Stockholders approved  an amendment to the Certificate of
Incorporation of the Company authorizing the issuance of up to 80,000,000 shares
of Preferred Stock, $.01 par value per share. Pursuant to the terms of the
amendment, the Board will be able to specify the precise characteristics of the
Preferred Stock to be issued, in light of current market conditions and the
nature of specific transactions, and will not be required to solicit further
authorization from Stockholders for any specific issue of Preferred Stock.  The
Board of Directors has no present intention to issue any series of Preferred
Stock.

The Board of Directors has adopted a policy providing that no future issuance of
Preferred Stock will be effected without Stockholder approval unless the Board
of Directors (whose decision shall be conclusive) determines in good faith (i)
that such issuance is primarily for the purpose of facilitating a financing, an
acquisition or another proper corporate objective or transaction, and (ii) that
any anti-takeover effects of such issuance are not the Company's primary purpose
for effecting such issuance.  The Board of Directors will not amend or revoke
this policy without giving written notice to the holders of all outstanding
shares of the Company's stock; however, no such amendment or revocation will be
effective, without Stockholder approval, to permit a subsequent issuance of
Preferred Stock for the primary purpose of obstructing a takeover of the Company
by any person who has, prior to such written notice to stockholders, notified
the Board of Directors of such person's desire to pursue a takeover of the
Company.

RIGHTS TO PURCHASE COMMON STOCK

On December 8, 1995, the Board of Directors of Lyondell declared a dividend of
one right ("Right") for each outstanding share of the Company's Common Stock,
par value $1.00 per share, to stockholders of record at the close of business on
December 20, 1995.  Each Right entitles the registered holder to purchase from
the Company one share of Common Stock at a purchase price of $80 per share of
Common Stock, subject to adjustment (the "Purchase Price").  The description and
terms of the Rights are set forth in a Rights Agreement dated as of December 8,
1995 as it may from time to time be supplemented or amended (the "Rights
Agreement") between the Company and The Bank of New York, as Rights Agent.

Initially, the Rights will be attached to all certificates representing
outstanding shares of Common Stock, and no separate certificates for the Rights
("Rights Certificates") will be distributed.  The Rights will separate from the
Common Stock and a "Distribution Date" will occur, with certain exceptions, upon
the earlier of (i) ten days following a public announcement of the existence of
an "Acquiring Person" (the date of the announcement being the "Stock Acquisition
Date"), or  (ii) ten business days following the commencement of a tender offer
or exchange offer that would result in a person's becoming an Acquiring Person.
An "Acquiring Person" is any person or group of affiliated or associated persons
that has acquired or obtained the right to acquire beneficial ownership of 15
percent or more of the outstanding shares of Common Stock, except that ARCO will
not be or become an Acquiring Person unless and until such time as ARCO or any
person affiliated or associated with ARCO acquires or becomes the beneficial
owner of (or ARCO becomes affiliated or associated with any person who,
collectively with ARCO, is the beneficial owner of) more than the lesser of (i)
1,000,000 shares of Common Stock in addition to those ARCO beneficially owned as
of December 8, 1995 (or in addition to any lesser number of shares ARCO
beneficially owns from time to time thereafter) and (ii) one share less than 50
percent of the shares of Common Stock outstanding at any time.  In certain
circumstances prior to the time a person has become an Acquiring Person, the
Distribution Date may be deferred by the Board of Directors.  Certain
inadvertent acquisitions will not result in a person's becoming an Acquiring
Person if the person promptly divests itself of sufficient Common Stock.  Until
the Distribution Date, (a) the Rights will be evidenced by the Common Stock
certificates (together with this Summary of Rights or bearing the notation
referred to below) and will be transferred with and only with such Common Stock
certificates, (b) new Common Stock certificates issued after December 20, 1995
will contain a notation incorporating the Rights Agreement by reference and (c)
the surrender for transfer of any certificate for Common Stock (with or without
a copy of this Summary of Rights) will also constitute the transfer of the
Rights associated with the Common Stock represented by such certificate.  The
Rights are not exercisable until the Distribution Date and will expire at the
close of business on December 8, 2005, unless earlier redeemed or exchanged by
the Company as described below.

                                       22
<PAGE>
 
In the event (a "Flip-In Event") that a person becomes an Acquiring Person
(except pursuant to a tender or exchange offer for all outstanding shares of
Common Stock at a price and on terms that a majority of the independent
directors of the Company determines to be fair to and otherwise in the best
interests of the Company and its stockholders (a "Permitted Offer")), each
holder of a Right will thereafter have the right to receive, upon exercise of
such Right, a number of shares of Common Stock (or, in certain circumstances,
cash, property or other securities of the Company) having a Current Market Price
(as defined in the Rights Agreement) equal to two times the exercise price of
the Right.  Notwithstanding the foregoing, following the occurrence of any Flip-
In Event, all Rights that are, or (under certain circumstances specified in the
Rights Agreement) were, beneficially owned by or transferred to such Acquiring
Person (or by certain related parties) will be null and void in the
circumstances set forth in the Rights Agreement.

In the event (a "Flip-Over Event") that, at any time from and after the time an
Acquiring Person becomes such, (i) the Company is acquired in a merger or other
business combination transaction (other than certain mergers that follow a
Permitted Offer), or (ii) 50 percent or more of the Company's assets or earning
power is sold or transferred, each holder of a Right (except Rights owned by
such Acquiring Person or certain related parties) shall thereafter have the
right to receive, upon exercise, a number of shares of common stock of the
acquiring company having a Current Market Price equal to two times the exercise
price of the Right.

At any time until the time a person becomes an Acquiring Person, the Company may
redeem the Rights in whole, but not in part, at a price of $.0005 per Right,
payable, at the option of the Company, in cash, shares of Common Stock or such
other consideration as the Board of Directors may determine.  At any time after
the occurrence of a Flip-In Event and prior to the occurrence of a Flip-Over
Event or a person becoming the beneficial owner of 50 percent or more of the
shares of Common Stock then outstanding, the Company may exchange the Rights
(other than Rights owned by an Acquiring Person or an affiliate or an associate
of an Acquiring Person, which will have become void), in whole or in part, at an
exchange ratio of one share of Common Stock, and/or other equity securities
deemed to have the same value as one share of Common Stock, per Right, subject
to adjustment.

Until a Right is exercised, the holder thereof, as such, will have no rights as
a stockholder of the Company, including, without limitation, the right to vote
or to receive dividends.  While the distribution of the Rights should not be
taxable to stockholders or to the Company, stockholders may, depending upon the
circumstances, recognize taxable income in the event that the Rights become
exercisable for Common Stock (or other consideration) of the Company or for the
common stock of the acquiring company as set forth above or are exchanged as
provided in the preceding paragraph.

The Purchase Price payable, and the number of shares of Common Stock or other
securities or property issuable, upon exercise of the Rights are subject to
adjustment from time to time to prevent dilution (i) in the event of a stock
dividend on, or a subdivision, combination or reclassification of, the Common
Stock, (ii) if holders of the Common Stock are granted certain rights or
warrants to subscribe for Common Stock or securities convertible into Common
Stock at less than the current market price of the Common Stock, or (iii) upon
the distribution to holders of the Common Stock of evidences of indebtedness or
assets (excluding regular quarterly cash dividends) or of subscription rights or
warrants (other than those referred to above).

Other than the redemption price, any of the provisions of the Rights Agreement
may be amended by the Board of Directors of the Company as long as the Rights
are redeemable.  Thereafter, the provisions of the Rights Agreement (other than
the Redemption Price) may be amended by the Board of Directors in order to cure
any ambiguity, defect or inconsistency, to make changes that do not materially
adversely affect the interests of holders of Rights (excluding the interests of
any Acquiring Person), or to shorten or lengthen any time period under the
Rights Agreement; provided, however, that no amendment to lengthen the time
period governing redemption or amendment shall be made at such time as the
Rights are not redeemable.

The Rights have certain antitakeover effects.  The Rights will cause substantial
dilution to a person or group that attempts to acquire the Company on terms not
approved by its Board of Directors, except pursuant to an offer conditioned on a
substantial number of Rights being acquired.  The Rights should not interfere
with any merger or other business combination approved by the Board of Directors
at a time when the Rights are redeemable.

A copy of the Rights Agreement is filed as an exhibit hereto.  This summary
description of the Rights is qualified in its entirety by reference hereto.

                                       23
<PAGE>
 
ITEM 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders during the fourth
quarter of 1996.

                                    PART II

ITEM 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

The Common Stock is listed on the New York Stock Exchange.  ARCO has advised the
Company that, as of March 1, 1997, ARCO owned 39,921,400 shares of the Common
Stock, which represented 49.9 percent of the outstanding shares.

The reported high and low sale prices of the Common Stock on the New York Stock
Exchange (New York Stock Exchange Composite Tape) for each quarter from January
1, 1995 through December 31, 1996, inclusive, were as set forth below.

<TABLE>
<CAPTION>
          PERIOD               HIGH    LOW
          ------              ------  ------
          <S>                 <C>     <C>
          1995:
            First Quarter     26-3/4  21-5/8
            Second Quarter    26-3/4  22-5/8
            Third Quarter     29-1/8  25-1/2
            Fourth Quarter    26-1/4  21-1/8
 
          1996:
            First Quarter     32-1/4  22-1/2
            Second Quarter    31-1/8  22-1/4
            Third Quarter     24-3/4  21-5/8
            Fourth Quarter    24-1/8  20-3/8
</TABLE>

On February 28, 1997 the closing price of the Common Stock was $23.625, and
there were approximately 2,500 holders of record of the Common Stock.

During the last two years, Lyondell has declared $.225 per share quarterly cash
dividends (which were paid in the subsequent quarter).  The declaration and
payment of dividends is at the discretion of the Board of Directors.  The future
declaration and payment of dividends and the amount thereof will be dependent
upon the Company's results of operations, financial condition, cash position and
requirements, investment opportunities, future prospects and other factors
deemed relevant by the Board of Directors.  Subject to these considerations and
to the legal considerations discussed in the following paragraph, the Company
currently intends to distribute to its Stockholders cash dividends on its Common
Stock at a quarterly rate of $.225 per share. During 1996, the Company paid $72
million in dividends.

As detailed herein, certain of the Company's debt instruments contain provisions
that generally provide that the holders of such debt may, under certain limited
circumstances, require the Company to repurchase the debt ("Put Rights").  In
addition to the occurrences described  herein, the Put Rights may be triggered
by the making of certain unearned distributions to Stockholders, other than
regular dividends, that are followed by a specified decline in public ratings on
such debt.  See "Long Term Debt and Financing Arrangements".  Regular dividends
are those quarterly cash dividends determined in good faith by the Board of
Directors (whose determination is conclusive) to be appropriate in light of the
Company's results of operations and capable of being sustained.  These
determinations were made prior to the declaration of $.225 per share dividend
paid on March 15, 1997.  The Company's $400 million Facility also could limit
the Company's ability to pay dividends under certain circumstances.  See Items 1
and 2 -- "Business and Properties -- Long-Term Debt and Financing Arrangements".

The operation of certain of the Company's employee benefit plans may result in
the issuance of Common Stock upon the exercise of options granted to employees
of the Company, including its officers.  Although the terms of these plans
provide that additional shares may be issued to satisfy the Company's
obligations under the options, the Company generally intends to cause Common
Stock to be repurchased in the market in order to satisfy these obligations.

                                       24
<PAGE>
  
ITEM 6.    SELECTED FINANCIAL DATA


The following table sets forth selected financial information for the Company.

 
                                              FOR THE YEAR ENDED DECEMBER 31
                                        ----------------------------------------
MILLIONS OF DOLLARS EXCEPT PER SHARE       1996    1995    1994    1993    1992
 AMOUNTS                                  ------  ------  ------  ------  ------
------------------------------------
 
Sales and other operating revenues        $5,052  $4,936  $3,857  $3,850  $4,809
Income before cumulative effect of
 accounting changes                          126     389     223       4      26
Net income (*)                               126     389     223      26      16
Earnings per share before cumulative
 effect of accounting changes               1.58    4.86    2.78     .06     .32
Earnings per share                          1.58    4.86    2.78     .33     .20
Dividends per share                          .90     .90     .90    1.35    1.80
Total assets                               3,276   2,606   1,663   1,231   1,215
Long-term debt, less current portion       1,194     807     707     717     725

(*)  The 1993 amount includes an increase in net income from the cumulative
  effect of an accounting change for turnarounds of $22 million, or $.27 per
  share.  The 1992 amount includes a net decrease in net income of $10 million,
  or $.12 per share, related to the cumulative effect of accounting changes for
  postretirement benefits other than pensions and income taxes.


ITEM 7.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS


GENERAL


Lyondell Petrochemical Company ("Company" or "Lyondell") operates in the
petrochemicals and refining segments. The petrochemicals segment consists of
olefins including ethylene, propylene, butadiene, butylenes and specialty
products; polyolefins including polypropylene, high-density polyethylene
("HDPE") and low-density polyethylene; aromatics produced at the Channelview,
Texas petrochemicals facility ("Channelview Facility") including benzene and
toluene; methanol; methyl tertiary butyl ether ("MTBE"); and refinery blending
stocks.

In December 1996, the Company sold an undivided interest in its methanol
facility to MCN Investment Corporation ("MCNIC") and created Lyondell Methanol
Company L.L.P. ("Lyondell Methanol"), a partnership with the minority owner, to
own and operate the methanol facility.

In May 1995, the Company acquired Occidental Chemical Corporation's Alathon(R)
HDPE business ("ALATHON Business"). Assets involved in the acquisition included
resin production facilities in Matagorda (the "Matagorda Facility") and Victoria
(the "Victoria Facility"), Texas, related research and development activities
and the rights to the Alathon(R) trademark. See Note 4 of "NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS."

The refining segment consists of refined petroleum products, including gasoline,
low sulfur diesel, jet fuel; aromatics produced at the full-conversion Houston,
Texas refinery ("Refinery"), including benzene, toluene, paraxylene and
orthoxylene; lubricants, including industrial lubricants, motor oils, white
oils, process oils and base oils; carbon black oil; sulfur; residual oil;
petroleum coke fuel; olefins feedstocks; and crude oil resales.

As discussed in Note 3 of "NOTES TO CONSOLIDATED FINANCIAL STATEMENTS," in
July 1993, Lyondell and CITGO Petroleum Corporation ("CITGO") formed
LYONDELL-CITGO Refining Company Ltd. ("LCR"), a Texas limited liability company
owned by subsidiaries of the Company and CITGO. LCR owns and operates the

                                       25

<PAGE>
  
refining business formerly owned by the Company, including the Refinery. LCR has
undertaken and completed a major upgrade project at the Refinery to enable the
facility to process substantial additional volumes of very heavy crude oil
("Upgrade Project").

At inception, LCR entered into a long-term crude oil supply contract ("Crude
Supply Contract") with Lagoven, S.A. ("LAGOVEN"), an affiliate of CITGO.  In
addition, under terms of a long-term product sales agreement ("Products
Agreement"), CITGO purchases a majority of the refined products produced at the
Refinery.  Both LAGOVEN and CITGO are direct or indirect wholly-owned
subsidiaries of Petroleos de Venezuela, S.A., the national oil company of
Venezuela.

LCR is required to purchase and LAGOVEN is required to sell sufficient crude oil
to satisfy LCR's coking capacity, a minimum of 200,000 barrels per day and up to
230,000 barrels per day of very heavy Venezuelan crude oil.  LAGOVEN has the
right, but not the obligation, to supply incremental amounts above 230,000
barrels per day.

The following table sets forth sales volumes for the Company's major products
for the periods indicated.  Sales volumes include production, purchases of
products for resale, propylene production from the product flexibility unit,
products received on exchange and draws from inventory.


                                              FOR THE YEAR ENDED
                                                 DECEMBER 31
                                        ----------------------------
                                           1996      1995     1994
                                        ---------   -------  -------
SELECTED PETROCHEMICAL PRODUCTS
 (MILLIONS)
  (EXCLUDING INTERSEGMENT SALES):
    Ethylene, propylene and polymers        
     (pounds)                                6,985    6,832    6,090 
    Other olefins (pounds)                     980    1,030    1,048
    Methanol (gallons)                         209      199      169
    Aromatics (gallons)                        167      152      160
 
REFINED PRODUCTS (THOUSAND BARRELS PER
 DAY) (EXCLUDING INTERSEGMENT SALES):
    Gasoline                                   101      109      109
    Diesel and heating oil                      47       52       44
    Jet fuel                                    23       29       24
    Aromatics                                    7        8        8
    Other refined products                      59       56       46
                                           -------   ------   ------
        Total refined products volumes         237      254      231
                                           =======   ======   ======

                                       26

<PAGE>
  
The following table sets forth the Company's sales and other revenues for the
periods indicated.
 
                                              FOR THE YEAR ENDED
                                                 DECEMBER 31
                                        ----------------------------
MILLIONS OF DOLLARS                         1996     1995     1994
-------------------                     ----------  -------  -------
PETROCHEMICAL PRODUCTS REVENUES
  (EXCLUDING INTERSEGMENT SALES):
    Ethylene, propylene and polymers        $1,688   $1,790   $1,113
    Other olefins                              173      211      173
    Methanol                                    87      118      133
    Aromatics                                  161      144      171
    Other petrochemical products and          
     other revenues                            302      203      193 
                                            ------   ------   ------
        Total petrochemical products        
         sales                              $2,411   $2,466   $1,783
                                            ======   ======   ======
REFINED PRODUCTS REVENUES
  (EXCLUDING INTERSEGMENT SALES):
    Gasoline                                $  937   $  879   $  813
    Diesel and heating oil                     421      375      311
    Jet fuel                                   218      220      178
    Aromatics                                  155      240      152
    Other refined products and other           
     revenues                                  474      386      324
                                            ------   ------   ------
        Total refined products sales         2,205    2,100    1,778
    Crude oil resales (a)                      436      370      296
                                            ------   ------   ------
        Total refined products and          
         crude oil sales                    $2,641   $2,470   $2,074
                                            ======   ======   ====== 
--------------------------
(a)  Crude oil resales consist of revenues from the resale of previously
     purchased crude oil and from locational exchanges of crude oil that are
     settled on a cash basis.  Crude oil exchanges and resales facilitate the
     operation of the refining segment by allowing the Company to optimize the
     crude oil feedstock mix in response to market conditions and refinery
     maintenance turnarounds and to reduce transportation costs.

                                       27

<PAGE>
  
RESULTS OF OPERATIONS


OVERVIEW

Net income for 1996 was $126 million or $1.58 per share compared with $389
million or $4.86 per share in 1995 and $223 million or $2.78 per share in 1994.
Earnings for 1996 included an approximate $20 million after-tax gain from the
sale of an undivided interest in the methanol facility.  Excluding the effect of
this gain, the earnings decline in 1996 versus 1995 was primarily due to lower
sales margins for petrochemicals and aromatics, partially offset by higher
polymers earnings.  The $166 million earnings increase in 1995 versus 1994 was
primarily due to higher petrochemicals and aromatics sales margins and to higher
polymers earnings.


PETROCHEMICALS SEGMENT

Chart 1 - Large buyer clearing price (pipeline delivered) ethylene month-end
prices as reported by ChemData, Inc. from January 1994 through December 1996.
Chart indicates increasing prices in 1994 with an annual average of the month-
end prices of 20.43 cents per pound. 1995 prices decreased, however the annual
average of the month-end prices of 25.66 cents per pound is still above the 1994
average. The chart indicates the price drop in 1995 ended in February 1996 with
a steady increase in month-end prices throughout the remainder of 1996. However,
the annual average of the month-end prices in 1996 was 21.66 cents per pound,
below the 1995 average. Selected month-end prices are as follows: January 1994 -
16.70 cents per pound, December 1994 - 27.00 cents per pound, December 1995 -
18.50 cents per pound, December 1996 - 24.00 cents per pound.

Chart 2 - Spot price WTS low crude oil month-end prices as reported by Platts 
Oilgram Price Report from January 1994 through December 1996. Chart indicates 
increasing prices in 1994, 1995 and 1996 with an annual average of the month-end
prices of $16.69 per barrel in 1994, $17.84 per barrel in 1995 and $21.35 per 
barrel in 1996.  Prices were volatile in all three years although 1995 was 
somewhat flat.  Selected month-end prices are as follows:  January 1994 - $14.41
per barrel, December 1994 - $16.89 per barrel, December 1995 - $18.22 per 
barrel, December 1996 - $24.32 per barrel.

OPERATING INCOME  Operating income amounted to $337 million in 1996 compared to
$635 million in 1995 and $411 million in 1994.  The $298 million decline in
operating income in 1996 as compared to 1995 was primarily due to lower sales
margins for olefins and methanol, partially offset by higher profits from the
ALATHON Business.

The lower olefins sales margins for 1996 were primarily due to higher feedstock
costs.  Lyondell's olefins feedstocks are primarily condensates and other
petroleum liquids which tend to follow the cost trends of crude oil.  Since 1994
the price of crude oil has increased steadily (see Chart 2) which resulted in
higher feedstock costs for the petrochemicals business.  The sales prices for
various olefins products are primarily driven by two factors.  One is the demand
for ethylene, propylene and other by-products as a result of economic conditions
for end-use markets for these commodities such as the auto industry, housing
construction and consumer durable and non-durable goods.  Secondarily, sales
prices are driven by the underlying cost of the feedstock.  While demand was
strong, margins decreased during 1996 because sales price increases during the
year were not sufficient to cover the rapidly rising cost of the feedstocks.

Methanol is a primary component of MTBE which is a clean fuel additive in
reformulated gasoline that increases octane rating.   Effective January 1, 1995,
the Clean Air Act Amendments of 1990 ("Clean Air Act") required reformulated
fuels to be used in certain U.S. cities. The demand for MTBE just prior to
implementation of the Clean Air Act drove the price of MTBE and methanol to
historic highs. Since the second quarter of 1995 the price of methanol has been
dropping as new production of methanol has come onstream. Combined with the
methanol price decrease, the price of natural gas, the principal methanol
feedstock, has been increasing since the beginning of 1995, resulting in
methanol sales margins retreating to more historic levels.

                                       28

<PAGE>
 
The higher profits from the ALATHON Business were a result of including a full
12 months of operations in 1996 compared to only eight months of ownership of
the ALATHON Business in 1995.  The ALATHON Business was acquired in May 1995.

The $224 million improvement in operating income in 1995 compared to 1994 was
primarily due to higher olefins sales margins and the addition of the ALATHON
Business, partially offset by lower olefins sales volumes.

Olefins sales margins were higher in 1995 than 1994 due to significantly higher
sales prices that more than offset increased raw material prices (see Charts 1
and 2).  Olefins sales prices were higher in the first half of 1995 due to
favorable demand factors resulting from the improved economy.  These higher
prices were reduced later in the year due to increased industry supply as
additional olefins capacity came onstream in 1995.  Olefins sales volumes were
lower in the latter part of 1995 due to a slow down in demand as a result of
customers cutting back inventories in expectation of price reductions and a slow
down in economic conditions in the beginning of 1996.

REVENUES  Sales and other operating revenues, including intersegment sales, were
$2.6 billion in 1996 compared to $2.7 billion in 1995 and $2.0 billion in 1994.
The $14 million decrease in 1996 compared to 1995 was primarily due to lower
sales prices for petrochemicals and the decrease in methanol prices discussed
above, offset by higher sales resulting from a full year's revenues from the
ALATHON Business.  Compared to most of 1995 which was a period of strong market
conditions for petrochemicals generally, average sales prices for petrochemicals
during 1996 were lower due to a decline in market conditions which began in the
latter part of 1995.  This decline was due to additional olefins capacity that
came onstream in 1995 and customer inventory corrections in the latter part of
1995. However, 1996 was still a strong year for petrochemical demand, in
particular ethylene, and prices increased throughout the year after bottoming
early in 1996 (see Chart 1).

In July of 1996 a fire occurred at the ARCO PipeLine Company meter station
located within the Channelview Facility.  The fire forced the shutdown of the
entire Channelview Facility for several days and more than two weeks for some
units.  The Company recovered lost profits from ARCO PipeLine Company for this
shutdown.  The recovery was included in 1996 reported results.

The 1995 revenue increase of $684 million compared to 1994 was primarily due to
the addition of the ALATHON Business during 1995.  Contributing to the increase
were higher olefins sales prices reflecting continued strong market conditions
during the first half of 1995 for petrochemicals that resulted from the strong
U.S. economic growth rate, an improved worldwide economy and industry supply
disruptions during the latter part of 1994.

GAIN ON SALE OF ASSETS  Gain on sale of assets resulted primarily from the sale
of an undivided interest in the Company's methanol facility to MCNIC in December
1996.

COST OF SALES  Cost of sales was $2.2 billion in 1996 compared to $1.9 billion
in 1995 and $1.5 billion in 1994.  The 1996 increase of $286 million compared to
1995 was primarily due to higher olefins feedstock costs reflecting the higher
crude oil and related products prices (see Chart 2).  Also contributing to the
increase were higher operating expenses due to the ownership of the ALATHON
Business for a full year in 1996 compared to eight months in 1995.

The 1995 cost of sales increase of $416 million compared to 1994 was primarily
due to the operation of the ALATHON Business and to the higher olefins feedstock
costs.

SELLING EXPENSES  Selling expenses amounted to $112 million in 1996 compared to
$84 million in 1995 and $40 million in 1994.  The $28 million increase in
selling expenses in 1996 compared to 1995 was primarily due to the operation of
the ALATHON Business for a full year in 1996 compared to eight months in 1995.
In the ALATHON Business, the cost of transporting finished products to customers
by rail is classified as a selling expense.  Likewise, the $44 million increase
in selling expenses in 1995 compared to 1994 was primarily due to the inclusion
of the operations of the ALATHON Business for eight months in 1995 and, to a
lesser extent, to higher terminal expense related to storing product in
anticipation of shutting down one of the olefins units for a maintenance
turnaround.

                                       29
 
<PAGE>
 
REFINING SEGMENT

Chart 3 - Contract (barges FOB) orthoxylene month-end prices as reported by 
ChemData, Inc. from January 1994 through December 1996.  Chart indicates 
increasing prices in 1994 with an annual average of the month-end prices of
18.38 cents per pound. 1995 prices continued to increase through May 1995, then
began a sharp decline. However, the annual average of the month-end prices of
28.83 cents per pound for 1995 is still significantly above the 1994 average.
The chart indicates the price drop in 1995 ended in November 1995 but prices
remained relatively flat through the remainder of 1996. The annual average of
the month-end prices in 1996 was 16.50 cents per pound, well below the 1995
average. Selected month-end prices are as follows: January 1994 -14.50 cents per
pound, December 1994 - 28.00 cents per pound, December 1995 -16.00 cents per
pound, December 1996 - 18.00 cents per pound.

Chart 4 - Contract (tank car delivered) paraxylene month-end prices as reported 
by ChemData, Inc. from January 1994 through December 1996.  Chart indicates 
increasing prices in 1994 with an annual average of the month-end prices of 
24.13 cents per pound.  Prices continued to increase throughout 1995, then 
began a sharp decline in March 1996.  The annual average of the month-end prices
was 36.63 cents per pound for 1995.  The chart indicates the price drop ended in
October 1996 and prices remained flat for the remainder of 1996.  The annual 
average of the month-end prices in 1996 was 29.13 cents per pound.  Selected 
month-end prices are as follows:  January 1994 - 22.25 cents per pound, December
1994 - 28.00 cents per pound, December 1995 - 41.00 cents per pound, December 
1996 - 19.00 cents per pound.

OPERATING INCOME  Operating income amounted to $1 million in 1996 compared to
$130 million in 1995 and $56 million in 1994.  During 1996, profit performance
from refined products benefited from high processing rates of heavy Venezuelan
crude oil.  However, this improvement was offset by lower margins due to rising
feedstock costs for the crude oil runs not covered by the Crude Supply Contract.
Operating rates for the crude oil purchased outside the Crude Supply Contract
were reduced significantly in the third quarter due to poor economics.  The $129
million decrease in 1996 compared to 1995 was primarily due to lower aromatics
(primarily paraxylene and orthoxylene) and refined products (gasoline, low
sulfur diesel and jet fuel) sales margins and to higher period costs.  Overall,
aromatics sales margins were lower in 1996 primarily due to lower sales prices
for orthoxylene and paraxylene (see Charts 3 and 4).  Refined products sales
margins decreased due to higher crude oil (see Chart 2) and other feedstock
costs, which more than offset higher refined product sales prices, as well as
higher fuel costs.  Refining period costs were higher due to higher maintenance
expense and personnel compensation.

The $74 million increase in 1995 compared to 1994 resulted from higher sales
margins for aromatics and refined products, partially offset by higher refining
period expenses and selling, general and administrative expenses.  Aromatics
sales margins were higher due to higher sales prices, particularly for
paraxylene and orthoxylene.  Paraxylene prices increased due to expanding
polyethylene terephthalate (PET) bottle and polyester fiber markets, which, to a
certain extent, pulled orthoxylene prices upward.  Refined products sales
margins were higher due to processing higher volumes of Venezuelan crude oil
purchased under the Crude Supply Contract in both the coking and cracking modes.
Period expenses were higher due to higher employee compensation and higher
scheduled and unscheduled repair and maintenance expense.

REVENUES  Sales and other operating revenues, including intersegment sales, were
$2.8 billion in 1996 compared to $2.6 billion in 1995 and $2.3 billion in 1994.
The 1996 increase of $164 million compared to 1995 primarily resulted from
higher sales prices for refined products and higher prices on crude oil resales,
partially offset by lower paraxylene and orthoxylene prices.  Beginning in the
second quarter of 1996, paraxylene prices declined due to additional industry
capacity and continued inventory reductions in the PET business by plastic
beverage container customers and in the polyester fibers business by clothing
and fabric manufacturing customers.  Orthoxylene prices were at historical highs
during the first half of 1995 before returning to a more normal level in the
fourth quarter of 1995 due to increased industry production and lower demand as
a result of customers' inventory reductions.

The 1995 increase of $374 million compared to 1994 primarily resulted from
higher sales prices and volumes for refined products and aromatics and higher
sales volumes and prices for crude oil resales.  Refined products sales prices
tend to track the price trends of crude oil.  During 1995 refined products sales
prices were higher due to the higher worldwide crude oil prices.  Aromatics
sales prices and volumes, specifically for paraxylene and orthoxylene, increased
because of improved market conditions.  Paraxylene prices were positively
impacted by high 

                                       30

<PAGE>
  
worldwide growth of polyester, particularly in the PET bottle sector, and prices
continued to increase through all of 1995. Orthoxylene prices peaked and began
to decline in mid-1995 as a result of increased worldwide production and slower
demand. Refined products sales volumes were higher during 1995 compared to 1994
due to higher production rates as a result of less scheduled and unscheduled
downtime of production units during 1995.

COST OF SALES  Cost of sales was $2.7 billion in 1996 compared to $2.5 billion
in 1995 and $2.2 billion in 1994.  The 1996 increase compared to 1995 of $292
million was primarily due to higher crude oil and other petroleum feedstock
costs and higher costs of crude oil resales, both of which resulted from higher
industry crude oil prices.  Crude oil resales consist of revenues from the
resale of previously purchased crude oil and from locational exchanges of crude
oil that are settled on a cash basis.  Crude oil exchanges and resales
facilitate the operation of the refining segment by allowing the Company to
optimize the crude oil feedstock mix in response to market conditions and
refinery maintenance turnarounds and to reduce transportation costs.  For crude
oil purchases outside the Crude Supply Contract, approximately three barrels of
crude oil are purchased for every barrel processed with the remaining two
barrels traded or resold.

The 1995 increase compared to 1994 of $293 million was primarily due to higher
raw material costs and higher costs of crude oil resales.  Raw material costs
were higher due to higher crude oil and other feedstock prices and to higher raw
material consumption due to higher finished product production rates.  Finished
product production rates were higher in 1995 compared to 1994 due to less
scheduled and unscheduled downtime of production units during 1995.

SELLING, GENERAL AND ADMINISTRATIVE EXPENSES  Selling, general and
administrative expenses were $62 million in 1996 compared to $61 million in 1995
and $54 million in 1994.  The $7 million increase in 1995 compared to 1994 was
primarily due to higher employee compensation and higher product transportation
expense due to higher sales volumes.


UNALLOCATED

GENERAL AND ADMINISTRATIVE EXPENSES  General and administrative expenses were
$60 million in 1996 compared to $59 million in 1995 and $43 million in 1994.
The $16 million increase in 1995 compared to 1994 was primarily due to higher
management incentive compensation related expenses, a significant portion of
which was for a management incentive compensation plan adopted and approved by
the stockholders in 1995.

INTEREST EXPENSE AND INTEREST INCOME  Interest expense was $81 million in 1996
compared to $80 million in 1995 and $74 million in 1994.  The $6 million
increase in interest expense in 1995 compared to 1994 resulted from amounts
borrowed to partially finance the acquisition of the ALATHON Business.

Interest income was $3 million in 1996 compared to $6 million in 1995 and $5
million in 1994.  The $3 million decrease in interest income in 1996 compared to
1995 was primarily due to lower levels of excess cash available for investment.

MINORITY INTEREST  Minority interest was $4 million in 1996.  This represented
the allocated share of LCR net income to CITGO, the minority owner of LCR, and
the allocated share of Lyondell Methanol net income to MCNIC, the minority owner
of Lyondell Methanol.  Minority interest was $14 million in 1995 and $6 million
in 1994, representing the allocated share of LCR net income to CITGO.

INCOME TAX  The effective income tax rate during 1996 was 35.7 percent compared
to 37.1 percent for 1995 and 36.2 percent for 1994.  State income tax was the
primary difference between the effective tax rate and the 35 percent federal
statutory rate during each of the periods.

                                       31

<PAGE>
 
FINANCIAL CONDITION


CASH FLOW FROM OPERATIONS  Lyondell's cash flow from operations totaled $232
million during 1996 compared to $471 million and $155 million generated in 1995
and 1994, respectively.  The decrease in 1996 compared to 1995 was primarily
attributable to the decrease in net income.

INVESTING ACTIVITIES  Excluding refinery upgrade expenditures totaling $473
million, the Company made capital expenditures totaling $136 million during
1996, of which $28 million related to environmental projects primarily at the
Refinery and $108 million was for other projects primarily at the petrochemical
plants.  Refinery upgrade expenditures during 1996 were funded by $144 million
of contributions made during 1996 by CITGO, $199 million from external
borrowings by LCR, $123 million from Lyondell in the form of subordinated loans
to LCR and $7 million from the restricted cash balance.

CITGO has provided a major portion of the funding for the Upgrade Project which
through December 31, 1996 totaled cash contributions of approximately $472
million, including cash contributions for the carrying costs of the construction
debt, and has also reinvested approximately $42 million of cash distributions.
In addition, CITGO has provided $130 million for funding other non-Upgrade
Project capital projects and operations through March 1, 1997.  The Upgrade
Project was placed in service during the first quarter of 1997 at a total
cost of approximately $1.1 billion. Lyondell funded one-half of the costs in
excess of $1 billion through subordinated loans.

The 1997 capital expenditures budget, excluding the Upgrade Project and other
LCR capital projects, is $116 million.  In addition, approximately $25 million
will be loaned to LCR for the Upgrade Project and $16 million for other LCR
capital projects.  Capital spending in 1997 includes: design and engineering for
a 440 million pound or approximately 40 percent expansion of HDPE resin capacity
with a targeted start-up of mid-1999; initial construction spending for a 100
million pound or approximately 25 percent expansion of HDPE capacity at the
Victoria Facility with a targeted start-up in 1998; and, control and electrical
upgrades at the Channelview Facility and the Refinery.

FINANCING ACTIVITIES  During 1996 the Company completed a bond offering for $300
million of 10 and 30 year bonds.  Additionally, LCR acquired funds to complete
its Upgrade Project by borrowing $199 million under its five-year term credit
facility and receiving $144 million in contributions from CITGO.  MCNIC
contributed $2 million to Lyondell Methanol to fund ongoing operations.  The
Company used cash to pay dividends of $72 million, $150 million for scheduled
repayments of long-term notes and a net $43 million for repayments of short-term
borrowings.  See Note 13 of "NOTES TO CONSOLIDATED FINANCIAL STATEMENTS."

In February 1996, the Company issued $300 million of debt securities ("Debt
Securities") consisting of $150 million of 6.5 percent notes due in 2006 and
$150 million of 7.55 percent debentures due in 2026. A portion of the proceeds
received from the sale of the Debt Securities was used to repay short-term debt
during the first quarter of 1996, and the remainder was used for retirement of
maturing long-term debt and general corporate purposes. The Debt Securities are
unsecured obligations and rank on a parity with all other unsecured and
unsubordinated debt of the Company.

The Company has a five-year, $400 million revolving credit facility ("Facility")
with a group of banks expiring June 2000.  Borrowings under the Facility bear
interest at either the eurodollar, certificate of deposit or prime rates or
based on a competitive auction feature wherein the interest rate can be
established by competitive bids submitted by the sponsoring banks, all at the
Company's option.  The Facility is available for working capital and general
corporate purposes as needed and contains covenants relating to dividend
payments, debt incurrence, liens, disposition of assets, mergers and
consolidations, fixed charge and leverage ratios.  At December 31, 1996, no
amounts were outstanding under this Facility.

In May 1995, LCR entered into two credit facilities totaling $520 million with a
group of banks with The Bank of New York as agent (together the "LCR Credit
Facilities").  The first facility, a $70 million, 364-day revolving working
capital facility, was renewed in 1996 and is being utilized for general business
purposes unrelated to the Upgrade Project and for letters of credit.  At
December 31, 1996, $10 million was outstanding under this credit 

                                       32
 
<PAGE>
 
facility with a weighted average interest rate of 7.1 percent. The second
facility is a $450 million, five-year term credit facility being used in
connection with the Upgrade Project. At December 31, 1996, $450 million was
outstanding under this credit facility with a weighted average interest rate of
6.3 percent. Interest for both facilities is based on prime or eurodollar rates
at LCR's option. The LCR Credit Facilities contain covenants which require LCR
to maintain a minimum net worth which increases each year until 1998 and
maintenance of certain financial ratios defined in the agreements. The LCR
Credit Facilities also contain other customary covenants which limit LCR's
ability to modify certain significant contracts, incur additional debt or liens,
dispose of assets, make restricted payments as defined in the agreements or
merge or consolidate with other entities.

At the end of the third quarter of 1996, LCR was not in compliance with the
financial ratio covenant of adjusted average debt to earnings before interest,
taxes, depreciation and amortization ("EBITDA") contained in the LCR Credit
Facilities.  Effective as of November 12, 1996, the LCR Credit Facilities were
amended.  The substance of these amendments was to replace the adjusted average
debt to EBITDA covenant and one additional financial covenant with a covenant to
maintain a minimum EBITDA.  The amendments were retroactively effective as of
the noncompliance date and will continue through June 30, 1997.  As of December
31, 1996, LCR was in compliance with the terms of the LCR Credit Facilities.

The Company also has uncommitted lines of credit totaling $285 million with
banks and other financial institutions.  These uncommitted lines of credit
provide the Company with additional borrowing flexibility and potentially more
competitive interest rates.  The Company can borrow money on these uncommitted
lines of credit on such terms as may be mutually agreed upon at the time amounts
are borrowed.  The lines of credit can be terminated by the lenders, in their
sole discretion, on short notice.  As of December 31, 1996, the Company had $50
million outstanding under these uncommitted lines of credit.

On January 24, 1997, the Board of Directors declared a regular quarterly
dividend in the amount of $.225 per share of common stock, payable March 15,
1997 to stockholders of record on February 25, 1997.


ACCOUNTING CHANGES


LYONDELL-CITGO REFINING COMPANY LTD.  During the first quarter of 1997 the
Upgrade Project at LCR became fully operational.  As a result, the participation
interests will change to approximately 60 percent and 40 percent for Lyondell
and CITGO, respectively.  Pursuant to contractural arrangements and concurrent
with the completion of the Upgrade Project, the authority and responsibility for
certain management decisions previously decided by majority vote, and therefore
controlled by Lyondell, changed to unanimous vote resulting in expanded joint
control of LCR by Lyondell and CITGO.  Consequently, effective January 1, 1997,
Lyondell will account for its investment in LCR under the equity method of
accounting, meaning that the operations of LCR will no longer be consolidated
line by line with those of Lyondell. The net earnings of LCR will be included in
the income of Lyondell as income from equity investment and Lyondell's portion
of the LCR assets will appear on a single line as investment in affiliate. See
Note 3 of "NOTES TO CONSOLIDATED FINANCIAL STATEMENTS."

SEGMENT INFORMATION  Beginning in 1997, the Company intends to report the
results of its polymers operations as a separate segment.  Currently, the
results of polymers operations are included in the petrochemicals segment.


ACCOUNTING STANDARDS


In June 1996, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards ("SFAS") No. 125, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities."  SFAS No. 125
covers transactions that include:  securitizations, sales of partial interests
in financial assets, repurchase agreements, securities lending, pledges of
collateral, loan syndications and participations, sales of receivables with
recourse, servicing of mortgages and other loans, and in-substance defeasances.
The majority of the provisions of SFAS No. 125 become effective at the beginning
of 1997 while some items are effective at the 

                                       33

<PAGE>
 
beginning of 1998 based on the issuance of SFAS No. 127, "Deferral of the
Effective Date of Certain Provisions of FASB Statement No. 125." Based on
current circumstances, the Company does not believe the effect of adoption will
have a material impact on the Company.

In October 1996 the American Institute of Certified Public Accountants issued
Statement of Position 96-1 ("SOP 96-1"), "Environmental Remediation
Liabilities," which establishes new accounting and reporting standards for the
recognition and disclosure of environmental remediation liabilities. The
Company does not believe the effect of adoption of SOP 96-1 in 1997 will have a
material impact on the Company's financial position or results of operations.

ENVIRONMENTAL MATTERS

Various environmental laws and regulations impose substantial requirements upon
the operations of the Company. The Company's policy is to be in compliance with
such laws and regulations, which include, among others, the Comprehensive
Environmental Response, Compensation and Liability Act of 1980 ("CERCLA"), as
amended, the Resource Conservation and Recovery Act ("RCRA") and the Clean Air
Act. In connection with the transfer of assets and liabilities from Atlantic
Richfield Company ("ARCO") to the Company at the time the Company was formed
into a separate company, effective July 1, 1988, the Company and ARCO entered
into an agreement ("Cross-Indemnity Agreement") whereby the Company agreed to
defend and indemnify ARCO against certain uninsured claims and liabilities which
ARCO may incur relating to the operation of the business of the Company prior to
July 1, 1988, including certain liabilities which may arise out of pending and
future lawsuits. ARCO, along with many other companies, has been named a
potentially responsible party ("PRP") under CERCLA in connection with the past
disposal of waste at third party waste sites. Pursuant to the Cross-Indemnity
Agreement, the Company is currently contributing funds for one site pursuant to
its obligation to reimburse ARCO for a portion of its uninsured remediation
costs. The Company has reached an agreement-in-principle with ARCO to update the
Cross-Indemnity Agreement ("Revised Cross-Indemnity Agreement"). Under the
Revised Cross-Indemnity Agreement, both ARCO and the Company waive any claim for
reimbursement under the existing Cross-Indemnity Agreement for any prior defense
and settlement costs associated with waste site matters, and the Company will
assume responsibility for its proportionate share of future costs for waste site
matters not covered by ARCO insurance. The obligation described above will
continue under the Revised Cross-Indemnity Agreement.

The Company reserves for contingencies, including those based upon unasserted
claims, that are probable and reasonably estimable.  In connection with
environmental matters, the Company establishes reserves based upon known facts
and circumstances.  Based on current environmental laws and regulations, the
Company believes it has adequately reserved for the matters described above and,
based upon such reserves, does not anticipate any material adverse effect upon
its earnings, operations or competitive position, although the resolution in any
reporting period of one or more of these matters could have a material impact on
the Company's results of operations for that period.

The environmental reserve on December 31, 1996 was $14 million. The Company
spent $2.1 million, $9.4 million and $6.5 million in 1996, 1995 and 1994,
respectively, relating to environmental matters.  The Company estimates it will
spend approximately $4 million in conjunction with environmental matters in 1997
which is included in the December 31, 1996 environmental reserve.

CURRENT BUSINESS OUTLOOK

Lyondell's results in the second half of 1996 reflected a stronger business
environment for petrochemicals and polymers compared to the earlier part of
1996.  This improvement was partially offset, however, by higher petrochemicals
feedstock costs.  During 1997, management expects petrochemicals supply and
demand fundamentals to continue to be favorable with positive demand growth.
However, significant additional industry capacity is expected to be added late
in 1997 which may adversely impact margins.  Polymers demand has been 

                                       34

<PAGE>
 
relatively strong in the first quarter of 1997. HDPE supply and demand
fundamentals are expected to remain favorable, however, anticipated additional
industry polypropylene capacity may negatively impact margins.

Methanol business conditions returned to more typical levels in the latter part
of 1995 and through 1996 from the very favorable conditions that existed during
the early part of 1995.  Methanol demand growth is still good and natural gas
feedstock costs have fallen from their high levels in early 1997.  However,
substantial new capacity is expected in various parts of the world over the next
few years which may negatively impact margins.

Although refining industry margins are not expected to improve during 1997,
management believes the Company has improved its refining business with the
formation of LCR and the resulting benefits of the Crude Supply Contract and
Products Agreement. These arrangements are designed to diminish the impact of
market volatility and stabilize cash flows at attractive levels relative to
historic performance. With the completion of the Upgrade Project, more than 90
percent of the crude oil purchases will be under the Crude Supply Contract which
will significantly reduce the crude oil volume which is sensitive to market
conditions. The benefits of the Crude Supply Contract should begin to be fully 
realizable following completion of the Upgrade Project.  However, the learning
curve for the Upgrade Project may limit LCR's ability to achieve maximum 
operating efficiencies and therefore realize the full benefits of the Crude
Supply Contract.  Aromatics are in a weaker environment entering 1997 from 
the favorable conditions that existed in 1995 and early 1996 due to lower 
margins resulting from higher feedstock costs and continuing low sales prices 
for paraxylene as a result of excess supply.

Profitability and cash flows for the petrochemicals and refining businesses are
affected by industry supply and demand, feedstock cost volatility, capital
expenditures required to meet more stringent environmental standards, repair and
maintenance costs and downtime of production units due to maintenance
turnarounds.  Turnarounds on major units can have significant financial impacts
due to the associated loss of production, resulting in lower profitability.  The
Company is performing a turnaround of its Matagorda Facility during the first
quarter of 1997.

Management believes business conditions will be such that cash balances, cash
generated from operating activities and existing lines of credit will be
adequate to meet future cash requirements for scheduled debt repayments,
necessary capital expenditures and to sustain for the reasonably foreseeable
future the regular quarterly dividend.  Management anticipates increased cash
flow from its businesses.  Management intends that cash flow in excess of the 
amounts needed to fund capital projects, growth opportunities and appropriate 
liquidity needs, would be returned to the stockholders through stock 
repurchases, increased dividends or some combinations thereof.

The Company's business strategies are to maintain and improve its low-cost
position, reduce cyclicality and volatility and grow the business profitably.
Lyondell continually evaluates opportunities to expand or further diversify its
operations through potential acquisitions, joint ventures and other
opportunities involving third parties. Consistent with the Company's overall
strategy, however, management's intent is to undertake such transactions only if
it expects the transactions would produce both near-term and long-term improved
cash flow and would produce returns in excess of the Company's cost of capital.

Certain of the statements in this Current Business Outlook Section are forward-
looking statements that involve risks and uncertainties, and the factors
described herein could cause actual results to differ materially from the
estimates contained herein.

                               _________________

Management cautions against projecting any future results based on present or
prior earnings levels because of the cyclical nature of the refining and
petrochemical industries and uncertainties associated with the United States and
worldwide economies and current and potential United States governmental
regulatory actions.

                                       35

<PAGE>
 
ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA



                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
 
                                                                        PAGE
                                                                        ----
 
Report of Independent Accountants                                         37
 
Financial Statements:
 
     Consolidated Statements of Income and Retained Earnings (Deficit)    38
 
     Consolidated Balance Sheets                                          39
 
     Consolidated Statements of Cash Flows                                40
 
     Notes to Consolidated Financial Statements                           41

                                       36

<PAGE>
 
                       REPORT OF INDEPENDENT ACCOUNTANTS



To the Stockholders and Board of Directors
of Lyondell Petrochemical Company:

  We have audited the accompanying consolidated balance sheets of Lyondell
Petrochemical Company as of December 31, 1996 and 1995, and the related
consolidated statements of income and retained earnings (deficit), and cash
flows for each of the three years in the period ended December 31, 1996.  These
financial statements are the responsibility of the Company's management.  Our
responsibility is to express an opinion on these financial statements based on
our audits.

  We conducted our audits in accordance with generally accepted auditing
standards.  Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement.  An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements.  An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

  In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Lyondell
Petrochemical Company as of December 31, 1996 and 1995, and the consolidated
results of its operations and its cash flows for each of the three years in the
period ended December 31, 1996 in conformity with generally accepted accounting
principles.



Coopers & Lybrand L.L.P.
Houston, Texas
February 12, 1997

                                       37
 
<PAGE>
 
                         LYONDELL PETROCHEMICAL COMPANY

       CONSOLIDATED STATEMENTS OF INCOME AND RETAINED EARNINGS (DEFICIT)

 
 
                                              FOR THE YEAR ENDED
                                                  DECEMBER 31
                                        ------------------------------
MILLIONS OF DOLLARS, EXCEPT PER SHARE      
 AMOUNTS                                   1996        1995      1994 
-------------------------------------   ----------    ------    ------
 
SALES AND OTHER OPERATING REVENUES:
     Unrelated parties                      $4,734    $4,611    $3,543
     Related parties                           318       325       314
                                        ----------    ------    ------
                                             5,052     4,936     3,857
 
GAIN ON SALE OF ASSETS                          30        --        --
 
OPERATING COSTS AND EXPENSES:
     Cost of sales:
          Unrelated parties                  4,320     3,801     3,066
          Related parties                      250       225       230
     Selling, general and                     
      administrative expenses                  234       204       137
                                        ----------    ------    ------
                                             4,804     4,230     3,433
                                        ----------    ------    ------

     Operating income                          278       706       424
 
Interest expense                               (81)      (80)      (74)
Interest income                                  3         6         5
Minority interest                               (4)      (14)       (6)
                                        ----------    ------    ------
 
     Income before income taxes                196       618       349
 
Provision for income taxes                      70       229       126
                                        ----------    ------    ------
 
NET INCOME                                  $  126    $  389    $  223
                                        ==========    ======    ======
 
EARNINGS PER SHARE                          $ 1.58    $ 4.86    $ 2.78
                                        ==========    ======    ======
 
RETAINED EARNINGS (DEFICIT) AT              
 BEGINNING OF YEAR                          $  142    $ (175)   $ (326)
     Net income                                126       389       223
     Cash dividends                            (72)      (72)      (72)
     Other                                      (3)       --        --
                                        ----------    ------    ------
RETAINED EARNINGS (DEFICIT) AT END OF       
 YEAR                                       $  193    $  142    $ (175)
                                        ==========    ======    ======
 

                See notes to consolidated financial statements.

                                       38
 
<PAGE>
 
                         LYONDELL PETROCHEMICAL COMPANY

                          CONSOLIDATED BALANCE SHEETS
 
                                             DECEMBER 31
                                        -------------------
MILLIONS OF DOLLARS                        1996      1995
-------------------                     ---------  --------
 
ASSETS
Current assets:
     Cash and cash equivalents            $    68   $     3
     Restricted cash and cash                 
      equivalents                              --         7  
     Accounts receivable:
          Trade                               394       340
          Related parties                      62        22
     Inventories                              294       265
     Prepaid expenses and other current       
      assets                                   13        41 
                                        ----------  --------
          Total current assets                831       678
                                        ----------  --------
 
Property, plant and equipment               4,313     3,804
Less accumulated depreciation and          
 amortization                              (2,043)   (1,990)
                                        ----------  --------
                                            2,270     1,814
 
Deferred charges and other assets             175       114
                                        ----------  --------
 
Total assets                              $ 3,276   $ 2,606
                                        ==========  ========
 
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
     Accounts payable:
          Trade                           $   474   $   358
          Related parties                       1         1
     Notes payable                             60       103
     Current maturities of long-term          
      debt                                    112       150 
     Other accrued liabilities                124       138
                                        ----------  --------
          Total current liabilities           771       750
                                        ----------  --------

Long-term debt                              1,194       807
Other liabilities and deferred credits        114        95
Deferred income taxes                         157       115
Commitments and contingencies
Minority interest                             609       459
Stockholders' equity:
     Preferred stock, $.01 par value,
      80,000,000 shares
       authorized, none outstanding
     Common stock, $1 par value,
      250,000,000 shares
       authorized, 80,000,000 issued          
        and outstanding                        80        80 
     Additional paid-in capital               158       158
     Retained earnings                        193       142
                                        ----------  --------
          Total stockholders' equity          431       380
                                        ----------  --------

Total liabilities and stockholders        
 equity                                   $ 3,276   $ 2,606
                                        ==========  ========

 
                See notes to consolidated financial statements.

                                       39
 
<PAGE>
 
                         LYONDELL PETROCHEMICAL COMPANY

                     CONSOLIDATED STATEMENTS OF CASH FLOWS
 
 
                                              FOR THE YEAR ENDED
                                                  DECEMBER 31
                                        ------------------------------
MILLIONS OF DOLLARS                         1996       1995      1994
-------------------                     ----------   --------  -------
 
CASH FLOWS FROM OPERATING ACTIVITIES:
     Net income                              $ 126     $ 389     $ 223
     Adjustments to reconcile net
      income to net cash provided 
      by operating activities:
          Depreciation and amortization        110        86        65
          Deferred income taxes                 50         3        10
          Increase in accounts                 
           receivable                          (94)       (1)     (156)
          Increase in inventories              (29)      (36)      (38)
          Increase in accounts payable         160        54        59
          Net change in other working           
           capital accounts                      6        (1)       28 
          Minority interest                      4        14         6
          Gain on sale of assets               (30)       --        --
          Other                                (71)      (37)      (42)
                                        -----------  --------  --------
               Net cash provided by
                operating activities           232       471       155
                                        -----------  --------  --------

 
CASH FLOWS FROM INVESTING ACTIVITIES:
     Additions to property, plant and         
      equipment                               (609)     (982)     (252)
     Proceeds from sales of assets              55        --        --
     Purchases of short-term investments       (76)       --       (20)
     Proceeds from sales of short-term          
      investments                               76        --        26
                                        -----------  --------  --------
               Net cash used in               
                investing activities          (554)     (982)     (246)
                                        -----------  --------  --------

 
CASH FLOWS FROM FINANCING ACTIVITIES:
     Minority owners' contributions            146       176       136
     Net change in short-term debt             (43)       83        16
     Borrowings of long-term debt              499       250        --
     Repayments of long-term debt             (150)      (10)       (8)
     Dividends paid                            (72)      (72)      (72)
                                        -----------  --------  --------
               Net cash provided by            
                financing activities           380       427        72
                                        -----------  --------  --------

 
INCREASE (DECREASE) IN CASH, RESTRICTED         
 CASH AND CASH EQUIVALENTS                      58       (84)      (19)
Cash, restricted cash and cash                  
 equivalents at beginning of period             10        94       113
                                        -----------  --------  --------
Cash, restricted cash and cash               
 equivalents at end of period                $  68     $  10     $  94
                                        ===========  ========  ========



                See notes to consolidated financial statements.

                                       40
 
<PAGE>
 
                        LYONDELL PETROCHEMICAL COMPANY

                   NOTES TO CONSOLIDATED FINANCIAL STATEMNTS


1.  FORMATION OF THE COMPANY AND OPERATIONS

As the context may require, all references hereafter to the "Company" or
"Lyondell" include Lyondell Petrochemical Company and its wholly-owned
subsidiaries, LYONDELL-CITGO Refining Company Ltd. ("LCR"), a Texas limited
liability company, and Lyondell Methanol Company L.L.P. ("Lyondell Methanol").
Lyondell Methanol was formed in December 1996 by Lyondell and MCN Investment
Corporation ("MCNIC") to own and operate the methanol facility at the
Channelview, Texas petrochemicals facility ("Channelview Facility"). MCNIC has a
25 percent interest in Lyondell Methanol. Lyondell has a 75 percent interest in
Lyondell Methanol and will serve as managing partner and operator.

From its formation in 1985 through June 1988, Lyondell operated as a division of
Atlantic Richfield Company ("ARCO"). In July 1988, ARCO transferred the
division's assets and liabilities along with additional pipeline assets, to its
wholly-owned subsidiary, Lyondell Petrochemical Company, a Delaware corporation.
In January 1989, ARCO completed an initial public offering of approximately 50.1
percent of the Company's common stock. In August 1994, ARCO completed an
offering ("ARCO Note Offering") of three-year debt securities ("Exchangeable
Notes") which are exchangeable upon maturity on September 15, 1997 into Lyondell
common stock or an equivalent cash value, at ARCO's option. If ARCO elects to
deliver shares of Lyondell common stock at the maturity of the Exchangeable
Notes, ARCO's equity interest in Lyondell will be reduced or eliminated,
depending on the price of Lyondell common stock at maturity of the Exchangeable
Notes. As of December 31, 1996, ARCO owned 39,921,400 shares of Lyondell common
stock, representing 49.9 percent of the issued and outstanding common stock of
the Company.

The Company operates in the petrochemicals and refining segments.  The
petrochemicals segment manufactures a wide variety of petrochemicals including
olefins, polyolefins, aromatics, methanol and methyl tertiary butyl ether
("MTBE").  The Company's petrochemical products are used primarily in the
manufacturing of other chemicals and products, which in turn are used in the
production of a wide variety of consumer and industrial products. The refining
segment operates primarily through the Company's interest in LCR and
manufactures refined petroleum products, including gasoline, low sulfur diesel
and jet fuel; aromatics, including benzene, toluene, paraxylene and orthoxylene;
lubricants, including industrial lubricants, motor oils, white oils, process
oils and base oils; carbon black oil; sulfur; residual oil; petroleum coke fuel;
olefins feedstocks; and crude oil resales. LCR sells its principal refined
products to CITGO Petroleum Corporation ("CITGO") (see Note 3). Although during
the previous five years the contribution to operating profits made by the
petrochemicals segment has been nearly five times greater than the contribution
to operating profits made by the refining segment, this trend could be reversed
in any particular year due to margin volatility within the petrochemicals and
petroleum refining industries.

2.  SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation - The consolidated financial statements include the
accounts of the Company and its subsidiaries, including LCR and Lyondell
Methanol.  All significant transactions between the entities of the Company have
been eliminated from the consolidated financial statements.

Revenue Recognition - Revenue from product sales is generally recognized upon
delivery of products to the customer.

Cash and Cash Equivalents - Cash equivalents consist of highly liquid debt
instruments such as certificates of deposit, commercial paper and money market
accounts purchased with an original maturity date of three months or less.  Cash
equivalents are stated at cost, which approximates fair value.  The Company's
policy is to invest cash in conservative, highly rated instruments and limit the
amount of credit exposure to any one institution.  The Company performs periodic
evaluations of the relative credit standing of these financial institutions
which are considered in the Company's investment strategy.

                                       41
 
<PAGE>

                        LYONDELL PETROCHEMICAL COMPANY

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)
 
The Company has no requirements for compensating balances in a specific amount
at a specific point in time.  The Company does maintain compensating balances
for some of its banking services and products.  Such balances are maintained on
an average basis and are solely at the Company's discretion.  As a result, none
of the Company's cash is restricted with the exception of cash held for use in
connection with LCR capital projects and other expenditures as determined by the
LCR owners (see Note 6).

All investments in debt and equity securities are accounted for in accordance
with Statement of Financial Accounting Standards ("SFAS") No. 115, "Accounting
for Certain Investments in Debt and Equity Securities."  Management determines 
the appropriate classification of investments in debt securities as trading,
available-for-sale or held-to-maturity at the time of purchase and reevaluates
such designation as of each balance sheet date.

Accounts Receivable - The Company sells its products primarily to companies in
the petrochemicals and refining industries.  The Company performs ongoing credit
evaluations of its customers' financial condition and in certain circumstances
requires letters of credit from them.  The Company's allowance for doubtful
accounts receivable, which is reflected in the consolidated balance sheet as a
reduction of accounts receivable, totaled $3 million at December 31, 1996 and
1995.

Inventories - Inventories are stated at the lower of cost or market.  Cost is
determined on the last-in, first-out ("LIFO") basis except for materials and
supplies, which are valued at average cost.

Property, Plant and Equipment - Property, plant and equipment are recorded at
cost.  Depreciation of property, plant and equipment is computed using the
straight-line method over the estimated useful lives of the related assets as
follows.

  Manufacturing facilities and equipment    -  5 to 30 years
  Leased assets and improvements            -  5 to 20 years

Upon retirement or sale, the Company removes the cost of the assets and the
related accumulated depreciation from the accounts and reflects any resulting
gains or losses in income.  The Company's policy is to capitalize interest cost
incurred on debt during the construction of major projects exceeding one year.

Turnaround Maintenance and Repair Expenses - Cost of repairs and maintenance
incurred in connection with turnarounds of major units at the Company's
manufacturing facilities exceeding $5 million are deferred and amortized on a
straight-line basis until the next planned turnaround, generally four to six
years.

Environmental Remediation Costs - Expenditures related to investigation and
remediation of contaminated sites, which include operating facilities and waste
disposal sites, are accrued when it is probable a liability has been incurred
and the amount of the liability can reasonably be estimated.  Estimates have not
been discounted to present value.  Environmental remediation costs are expensed
or capitalized in accordance with generally accepted accounting principles.

Exchanges - Crude oil and finished product exchange transactions, which are of a
homogeneous nature of commodities in the same line of business and do not
involve the payment or receipt of cash, are not accounted for as purchases and
sales.  Any resulting volumetric exchange balances are accounted for as
inventory in accordance with the normal LIFO valuation policy.  Exchanges
settled through payment and receipt of cash are accounted for as purchases and
sales.

Income Taxes - Deferred income taxes result from temporary differences in the
recognition of revenues and expenses for tax and financial reporting purposes
and are calculated based upon cumulative book and tax differences in the
consolidated balance sheets in accordance with SFAS No. 109, "Accounting for
Income Taxes."

Use of Estimates - The preparation of financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and 

                                       42
 
<PAGE>
 
                        LYONDELL PETROCHEMICAL COMPANY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.

Reclassifications - Certain previously reported amounts have been restated to
conform to classifications adopted in 1996.


3.  LYONDELL-CITGO REFINING COMPANY LTD.

In July 1993, LCR was formed to own and operate the Company's refining business,
including the full-conversion Houston, Texas refinery ("Refinery").  LCR is a
limited liability company organized under the laws of the state of Texas and
owned by subsidiaries of the Company and CITGO.  At December 31, 1996, CITGO had
an approximate 13 percent participation interest in LCR.  LCR has undertaken and
completed a major upgrade project at the Refinery primarily funded by debt and
CITGO equity contributions to enable the facility to process substantial
additional volumes of very heavy crude oil ("Upgrade Project").  CITGO has
provided a major portion of the funds for the Upgrade Project and has provided
$100 million through December 31, 1996 for funding other capital projects.
Major components of the Upgrade Project include new coking, crude distillation
and sulfur recovery units.  CITGO has committed to reinvest its share of
operating cash flow during the Upgrade Project totaling $42 million through
December 31, 1996, while the Company has unrestricted access to its share of
operating cash flow from LCR.

LCR has entered into a long-term crude supply contract ("Crude Supply Contract")
with Lagoven, S.A. ("LAGOVEN"), an affiliate of CITGO. The Crude Supply Contract
incorporates a formula price based on the market value of a slate of refined
products deemed to be produced from each particular crude oil or feedstock,
less: (i) certain deemed refining costs, adjustable for inflation; (ii) certain
actual costs, including crude transportation costs, import duties and taxes; and
(iii) a deemed margin, which varies according to the grade of crude oil or other
feedstock delivered. Deemed margins and deemed costs are adjusted periodically.
These adjustments are based on and, in the case of deemed margins, less than
inflation rates. Because deemed operating costs and the slate of refined
products deemed to be produced for a given barrel of crude oil or other
feedstock do not necessarily reflect the actual costs and yields in any period
and because the market value of the refined products used in the pricing formula
does not necessarily reflect the actual price received for the refined products,
the actual refining margin earned by LCR under the Crude Supply Contract will
vary depending on, among other things, the efficiency with which LCR conducts
its operations during such period.

Despite the limitations discussed above, the Crude Supply Contract is designed
to reduce the inherent earnings and cash flow volatility of the refining
operations of LCR irrespective of market fluctuations of either crude oil or
refined products. Specifically, if the market value of refined products "deemed"
to be produced from the Venezuelan crude oil increases, the "deemed" cost of
crude oil to LCR will also increase. Alternatively, if the market value of
refined products "deemed" to be produced from the Venezuelan crude oil
decreases, the "deemed" cost of crude oil to LCR will also decrease. This
results in relatively stable "deemed" margins regardless of refined products
market volatility. If the actual yields, costs or volumes differ substantially
from those contemplated by the Crude Supply Contract, the benefits of this
agreement to LCR could be substantially different than anticipated.

In addition, under the terms of a long-term product sales agreement ("Products
Agreement"), CITGO purchases from LCR 100 percent of the refined products
produced at the Refinery.  Both LAGOVEN and CITGO are direct or indirect wholly-
owned subsidiaries of Petroleos de Venezuela, S.A. ("PDVSA"), the national oil
company of Venezuela.  LCR is required to purchase and LAGOVEN is required to
sell sufficient crude oil to satisfy LCR's coking capacity, a minimum of 200,000
barrels per day and up to 230,000 barrels per day of very heavy Venezuelan crude
oil.  LAGOVEN has the right, but not the obligation, to supply incremental
amounts above 230,000 barrels per day.

During the first quarter of 1997 the Upgrade Project at LCR became fully
operational.  As a result, the participation interests will change to
approximately 60 percent and 40 percent for Lyondell and CITGO, 

                                       43
 
<PAGE> 
                        LYONDELL PETROCHEMICAL COMPANY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

respectively, to reflect CITGO's equity contribution in the Upgrade Project.
CITGO has a one-time option to increase its participation interest in LCR up to
50 percent by making an additional equity contribution. Pursuant to contractual
arrangements and concurrent with the completion of the Upgrade Project, the
authority and responsibility for certain management decisions previously decided
by majority vote, and therefore controlled by Lyondell, changed to unanimous
vote resulting in expanded joint control of LCR by Lyondell and CITGO.
Consequently, effective January 1, 1997, Lyondell will account for its
investment in LCR under the equity method of accounting, meaning that the
operations of LCR will no longer be consolidated line by line with those of
Lyondell. The net earnings of LCR will be included in the income of Lyondell as
income from equity investment and Lyondell's portion of the LCR assets will
appear on a single line as investment in affiliate.

The following unaudited proforma financial information presents the financial
position, results of operations and cash flows of the Company as of and for the
year ended December 31, 1996 using the equity method of accounting for 
Lyondell's investment in LCR as if the change in accounting method had been
effective January 1, 1996. This unaudited proforma information may not be
indicative of results that will be obtained in the future.
<TABLE>
<CAPTION>
 
INCOME STATEMENT                               PROFORMA            AS REPORTED
----------------                             EQUITY METHOD        CONSOLIDATED
MILLIONS OF DOLLARS EXCEPT PER SHARE      FOR THE YEAR ENDED   FOR THE YEAR ENDED
 AMOUNTS                                   DECEMBER 31, 1996    DECEMBER 31, 1996
-----------------------------------     --------------------  -------------------
 
<S>                                       <C>                  <C>
Sales and other operating revenues                    $2,644               $5,052
Gain on sale of assets                                    30                   30
Cost of sales                                          2,228                4,570
Selling, general and administrative 
 expenses                                                172                  234
                                        --------------------  -------------------
Operating income                                         274                  278
Interest expense                                         (79)                 (81)
Interest income                                            1                    3
Minority interest                                         (2)                  (4)
Income from equity investment                              2                   --
Provision for income taxes                               (70)                 (70)
                                        --------------------  -------------------
Net income                                            $  126               $  126
                                        ====================  ===================
Earnings per share                                    $ 1.58               $ 1.58
                                        ====================  ===================
 
BALANCE SHEET                                  PROFORMA           AS REPORTED
-------------                               EQUITY METHOD         CONSOLIDATED
MILLIONS OF DOLLARS                       DECEMBER 31, 1996    DECEMBER 31, 1996
-------------------                     --------------------  -------------------
 
Current assets                                        $  619               $  831
Property, plant and equipment                            893                2,270
Investment in affiliate                                   83                   --
Receivable from affiliate                                177                   --
Deferred charges and other assets                        118                  175
                                        --------------------  -------------------
Total assets                                          $1,890               $3,276
                                        ====================  ===================
 
Notes payable                                         $   50               $   60
Current maturities of long-term debt                     112                  112
Other current liabilities                                323                  599
                                        --------------------  -------------------
Total current liabilities                                485                  771
Long-term debt                                           744                1,194
Other long-term liabilities                              227                  271
Minority interest                                          3                  609
Total stockholders' equity                               431                  431
                                        --------------------  -------------------
Total liabilities and stockholders'                    
 equity                                               $1,890               $3,276
                                        ====================  ===================
</TABLE>

                                       44
 
<PAGE>
 
                        LYONDELL PETROCHEMICAL COMPANY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

<TABLE>
<CAPTION>
STATEMENT OF CASH FLOWS                        PROFORMA            AS REPORTED
-----------------------                      EQUITY METHOD        CONSOLIDATED
                                          FOR THE YEAR ENDED   FOR THE YEAR ENDED
MILLIONS OF DOLLARS                        DECEMBER 31, 1996    DECEMBER 31, 1996
-------------------                     --------------------  -------------------
 
<S>                                       <C>                  <C>
Net income                                             $ 126                $ 126
Depreciation and amortization                             74                  110
Deferred income taxes                                     50                   50
Changes in working capital and other                    (128)                 (54)
                                        --------------------  -------------------
     Net cash provided by operating                      
      activities                                         122                  232
                                        --------------------  -------------------

Additions to property, plant and                         
 equipment                                               (80)                (609)
Proceeds from sales of assets                             55                   55
Contributions and advances to                            
 affiliate, net                                          (74)                  --
                                        --------------------  -------------------
     Net cash used in investing                          
      activities                                         (99)                (554)
                                        --------------------  -------------------
 
Minority owners' contributions                             2                  146
Net change in short-term debt                            (53)                 (43)
Borrowings of long-term debt                             300                  499
Repayments of long-term debt                            (150)                (150)
Dividends paid                                           (72)                 (72)
                                        --------------------  -------------------
     Net cash provided by financing 
      activities                                          27                  380
                                        --------------------  -------------------

Increase in cash and cash equivalents                     50                   58
Cash and cash equivalents, beginning of
 period                                                    6                   10
                                        --------------------  -------------------
Cash and cash equivalents, end of period               $  56                $  68
                                        ====================  ===================
 
</TABLE>

4.  ACQUISITION OF ALATHON(R) HIGH-DENSITY POLYETHYLENE BUSINESS

In May 1995, the Company acquired Occidental Chemical Corporation's Alathon(R)
high-density polyethylene ("HDPE") business ("ALATHON Business") for $356
million including certain direct costs, plus approximately $64 million for
inventory. Assets involved in the purchase included resin production facilities
at Victoria and Matagorda, Texas, associated research and development activities
and the rights to the Alathon(R) trademark. These facilities have a combined
annual production capacity of approximately 1.5 billion pounds of HDPE. The
Company financed the acquisition from internal cash and $230 million of short-
term borrowings from its existing financing arrangements.

The following unaudited proforma information combines the results of operations
of the Company and the ALATHON Business for the years ended December 31, 1995
and 1994 and assumes the acquisition of the ALATHON Business occurred on January
1, 1994.  This unaudited proforma information may not be indicative of results
that would have actually resulted if this transaction had occurred on January 1,
1994 or which may be obtained in the future.
 
MILLIONS OF DOLLARS EXCEPT PER SHARE                     
 AMOUNTS                                   1995     1994 
------------------------------------    ---------  -------
Sales and other operating revenues         $5,130   $4,289
Net income                                    409      240
Earnings per share                           5.11     3.00
 

                                       45
 
<PAGE>
 
                        LYONDELL PETROCHEMICAL COMPANY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


5.  SUPPLEMENTAL CASH FLOW INFORMATION

Supplemental cash flow information is summarized as follows.
 
MILLIONS OF DOLLARS               1996   1995   1994
-------------------             ------- ------ ------
Cash paid during the year for:
   Interest:
      Paid                        $ 103  $  83  $  72
      Less amount capitalized        32      6     --
                                ------- ------ ------
      Net                         $  71  $  77  $  72
                                ======= ====== ======
 
   Income taxes                   $  42  $ 252  $  90
                                ======= ====== ======

At December 31, 1996, 1995 and 1994, property, plant and equipment included $9
million, $53 million and $36 million, respectively, of non-cash additions which
related to accounts payable accruals.


6.  RESTRICTED FUNDS

At December 31, 1995, cash and cash equivalents in the amount of $7 million were
restricted for use in connection with LCR capital projects, including the
Upgrade Project and other expenditures as determined by the LCR owners.  No cash
or cash equivalents were restricted at December 31, 1996.  Presented below is a
reconciliation of changes in restricted funds for the year ended December 31,
1996.
 
MILLIONS OF DOLLARS
-------------------
Restricted cash and cash equivalents at
  December 31, 1995                       $   7
Minority owner investments:
    Contributions                           144
    Distributable cash reinvested            13
Lyondell investments:
    Loan for Upgrade Project                123
    Other loans                              29
    Contributions                            12
Proceeds from bank loan                     199
Additions to property, plant and
 equipment:
    Upgrade Project                        (471)
    Refining segment - other                (56)
                                          -----
Restricted cash and cash equivalents at
  December 31, 1996                       $  --
                                          =====
 

7.  FINANCIAL INSTRUMENTS

The fair value of all financial instruments included in current assets and
current liabilities, including cash and cash equivalents, accounts receivable,
accounts payable and notes payable, approximated their carrying value due to
their short maturity. Based on the borrowing rates currently available to the
Company for debt with terms and average maturities similar to the Company's debt
portfolio, the fair value of the Company's long-term debt, including amounts due
within one year, was $1.236 billion and $1.017 billion at December 31, 1996 and
1995, respectively.

At December 31, 1996, the Company had issued letters of credit totaling $12
million.

                                       46
 
<PAGE>
 
                        LYONDELL PETROCHEMICAL COMPANY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)



The Company is party to various unconditional purchase obligation contracts as a
purchaser for product and services.  At December 31, 1996, future minimum
payments under these contracts with noncancelable contract terms in excess of
one year were as follows.
 
MILLIONS OF DOLLARS                AMOUNT
-------------------                ------
            1997                     $ 35
            1998                       34
            1999                       33
            2000                       33
            2001                       31
            Thereafter                155
                                   ------
Total minimum contract payments      $321
                                   ======

The Company's total purchases under these agreements were $47 million and $21
million in 1996 and 1995, respectively.


8.  RELATED PARTY TRANSACTIONS

Related party transactions with ARCO, excluding sales to ARCO Chemical Company,
are summarized as follows.
 
MILLIONS OF DOLLARS                   1996    1995    1994
-------------------                 -------  ------  ------
Costs
    Crude oil purchases               $   2   $   2   $  16
    Product purchases                     2       3       4
    Transportation fees                  29      26      28
    Other, net                           (7)     (3)     (3)
    Business interruption recovery       (3)     --      --
                                    -------  ------  ------
        Total costs                   $  23   $  28   $  45
                                    =======  ======  ======
Sales
    Products                          $   2   $   1   $   1
    Crude oil                             2       3       3
    Business interruption recovery       27      --      --
                                    -------  ------  ------
        Total sales                   $  31   $   4   $   4
                                    =======  ======  ======

Sales to ARCO Chemical Company, an ARCO affiliate, consisting of propylene,
MTBE, benzene, ethylene, methanol and other products and services, were $287
million, $321 million and $310 million for the years ended December 31, 1996,
1995 and 1994, respectively.

In July of 1996 a fire occurred at the ARCO PipeLine Company meter station
located within the Channelview Facility.  The fire forced the shutdown of the
entire Channelview Facility for several days and more than two weeks for some
units.  The Company recovered lost profits from ARCO PipeLine Company for this
shutdown.  The recovery was included in 1996 reported results.

                                       47
 
<PAGE>
 
                        LYONDELL PETROCHEMICAL COMPANY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


9.  INVENTORIES

The categories of inventory and their book values at December 31, 1996 and 1995
were as follows.
 
MILLIONS OF DOLLARS       1996   1995
-------------------     ------- ------
Crude oil                 $  47  $  55
Refined products             34     33
Petrochemicals              172    135
Materials and supplies       41     42
                        -------  -----
    Total inventories     $ 294  $ 265
                        ======= ======

For the year ended December 31, 1996, the Company increased cost of sales by
approximately $2 million; for the year ended December 31, 1995, the Company
reduced cost of sales by approximately $2 million; and for the year ended
December 31, 1994, the Company increased cost of sales by approximately $1
million, all associated with the reduction in LIFO inventories.  The excess of
the current cost of inventories over book value was approximately $189 million
and $110 million at December 31, 1996 and 1995, respectively.


10.  PROPERTY, PLANT AND EQUIPMENT

The components of property, plant and equipment and their gross value at
December 31, 1996 and 1995 were as follows.
 
MILLIONS OF DOLLARS                        1996     1995
-------------------                     --------- --------
Manufacturing facilities and equipment     $3,329   $2,958
Construction projects in progress             953      808
Land                                           28       35
Leased assets and improvements                  3        3
                                        --------- --------
    Total property, plant and equipment    $4,313   $3,804
                                        ========= ========

Repair and maintenance expenses for 1996, 1995 and 1994 were $137 million, $133
million and $109 million, respectively.  The 1996, 1995 and 1994 amounts include
amortization of deferred turnaround costs of $13 million, $13 million and $12
million, respectively.  Total interest cost incurred during 1996 and 1995 was
approximately $114 million and $86 million, respectively, of which approximately
$33 million and $6 million, respectively, was capitalized.  No interest was
capitalized during 1994.


11.  DEFERRED CHARGES AND OTHER ASSETS

Deferred charges and other assets at December 31, 1996 and 1995 were as follows.
 
MILLIONS OF DOLLARS                       1996   1995
-------------------                     ------- ------
Deferred turnaround costs                 $  81  $  46
Company owned life insurance                 39     33
Deferred software costs                      32     15
Other                                        23     20
                                        ------- ------
    Total deferred charges and other      
     assets                               $ 175  $ 114 
                                        ======= ======
 

                                       48
 
<PAGE>
 
                        LYONDELL PETROCHEMICAL COMPANY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

12.  OTHER ACCRUED LIABILITIES

Other accrued liabilities at December 31, 1996 and 1995 were as follows.
 
MILLIONS OF DOLLARS                    1996   1995
-------------------                  ------- ------
Income taxes                           $   6  $  18
Accrued taxes other than income           35     37
Accrued interest                          18     11
Accrued payroll                           37     45
Other                                     28     27
                                     ------- ------
    Total other accrued liabilities    $ 124  $ 138
                                     ======= ======
 

13.  LONG-TERM DEBT AND FINANCING ARRANGEMENTS

Long-term debt at December 31, 1996 and 1995 was comprised of the following.
 
MILLIONS OF DOLLARS                 1996    1995
-------------------              --------- ------
9.95% Notes due in 1996                     $ 150
8.25% Notes due in 1997             $  100    100
10.00% Notes due in 1999               150    150
9.125% Notes due in 2002               100    100
6.5% Notes due in 2006                 150     --
7.55% Debentures due in 2026           150     --
LCR 5-year term credit facility        450    250
Medium-term notes                      206    207
                                 --------- ------
                                     1,306    957
Less current portion                   112    150
                                 --------- ------
    Total long-term debt            $1,194  $ 807
                                 ========= ======

Aggregate maturities of long-term debt during the five years subsequent to
December 31, 1996 are as follows: 1997-$112 million; 1998-$32 million; 1999-$150
million; 2000-$492 million; 2001-$90 million.

The Notes due in 1999 and the medium-term notes contain provisions that would
allow the holders to require the Company to repurchase the debt upon the
occurrence of certain events together with specified declines in public ratings
on the Notes due in 1999.  Certain events include acquisitions by persons other
than ARCO or the Company of more than 20 percent of the Company's common stock,
any merger or transfer of substantially all of the Company's assets, in
connection with which the Company's common stock is changed into or exchanged
for cash, securities or other property and payment of certain "special"
dividends.

In February 1996, the Company issued $300 million of debt securities ("Debt
Securities") consisting of $150 million of 6.5 percent notes due in 2006 and
$150 million of 7.55 percent debentures due in 2026. A portion of the proceeds
received from the sale of the Debt Securities was used to repay short-term debt
during the first quarter of 1996, and the remainder was used for retirement of
maturing long-term debt and general corporate purposes. The Debt Securities are
unsecured obligations and rank on a parity with all other unsecured and
unsubordinated debt of the Company.

The medium-term notes mature at various dates from 1997 to 2005 and have a
weighted average interest rate at December 31, 1996 and 1995 of 9.9 percent.

                                       49

 
<PAGE>
 
                        LYONDELL PETROCHEMICAL COMPANY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

The Company has a five-year, $400 million revolving credit facility ("Facility")
with a group of banks expiring June 2000.  Borrowings under the Facility bear
interest at either the eurodollar, certificate of deposit or prime rates or
based on a competitive auction feature wherein the interest rate can be
established by competitive bids submitted by the sponsoring banks, all at the
Company's option.  The Facility is available for working capital and general
corporate purposes as needed and contains covenants relating to dividend
payments, debt incurrence, liens, disposition of assets, mergers and
consolidations, fixed charge and leverage ratios.  In addition to other
customary events of default, the Facility provides that an event of default will
occur (i) if the Company fails to pay when due an aggregate amount of
indebtedness or interest thereon (other than with respect to loans under the
Facility) in excess of $15 million, or (ii) if the Company is determined to be
in default of a material obligation under the amended and restated limited
liability company regulations of LCR.  At December 31, 1996, no amounts were
outstanding under this Facility.

In May 1995, LCR entered into two credit facilities totaling $520 million with a
group of banks with the Bank of New York as agent (together the "LCR Credit
Facilities").  The first facility,  a $70 million, 364-day revolving working
capital facility, was renewed in 1996 and is being utilized for general business
purposes unrelated to the upgrade project and for letters of credit.  At
December 31, 1996, $10 million was outstanding under this credit facility with a
weighted average interest rate of 7.1 percent.  The second facility is a $450
million, five-year term credit facility being used in connection with the
Upgrade Project.  At December 31, 1996, $450 million was outstanding under this
credit facility with a weighted average interest rate of 6.3 percent.  Interest
for both facilities is based on prime or eurodollar rates at LCR's option.  The
LCR Credit Facilities contain covenants which require LCR to maintain a minimum
net worth which increases each year until 1998 and maintenance of certain
financial ratios defined in the agreements.  The LCR Credit Facilities also
contain other customary covenants which limit LCR's ability to modify certain
significant contracts, incur additional debt or liens, dispose of assets, make
restricted payments as defined in the agreements or merge or consolidate with
other entities.

At the end of the third quarter of 1996, LCR was not in compliance with the
financial ratio covenant of adjusted average debt to earnings before interest,
taxes, depreciation and amortization ("EBITDA") contained in the LCR Credit
Facilities.  Effective as of November 12, 1996, the LCR Credit Facilities were
amended.  The substance of these amendments was to replace the adjusted average
debt to EBITDA covenant and one additional financial covenant with a covenant to
maintain a minimum EBITDA.  The amendments were retroactively effective as of
the noncompliance date and will continue through June 30, 1997.  As of December
31, 1996, LCR was in compliance with the terms of the LCR Credit Facilities.

The Company also has uncommitted lines of credit totaling $285 million with
banks and other financial institutions.  These uncommitted lines of credit
provide the Company with additional borrowing flexibility and potentially more
competitive interest rates.  The Company can borrow money on these uncommitted
lines of credit on such terms as may be mutually agreed upon at the time amounts
are borrowed.  The lines of credit can be terminated by the lenders, in their
sole discretion, on short notice.  As of December 31, 1996, the Company had $50
million outstanding under these uncommitted lines of credit.


14.  EARNINGS PER SHARE

Earnings per share were computed based on the weighted average number of shares
outstanding of 80,000,000 for the years ended December 31, 1996, 1995 and 1994.

                                       50
 
<PAGE>
 
                        LYONDELL PETROCHEMICAL COMPANY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)


15.  STOCKHOLDERS' EQUITY

Dividends - During 1996, 1995 and 1994, the Company paid regular quarterly
dividends of $.225 per share of common stock outstanding.

Rights to Purchase Common Stock - On December 8, 1995, the Board of Directors of
Lyondell declared a dividend of one right ("Right") for each outstanding share
of the Company's common stock to stockholders of record on December 20, 1995.
The Rights become exercisable upon the earlier of (i) ten days following a
public announcement by another entity that it has acquired beneficial ownership
of 15 percent or more of the outstanding shares of common stock, or (ii) ten
business days following the commencement of a tender offer or exchange offer to
acquire beneficial ownership of 15 percent or more of the outstanding shares of
common stock, excluding ARCO, except under certain circumstances. The Rights
expire at the close of business on December 8, 2005 unless earlier redeemed at a
price of $.0005 per Right or exchanged by the Company as described in the Rights
Agreement dated as of December 8, 1995.

Preferred Stock - The Company has authorized 80,000,000 shares of preferred
stock, $.01 par value, of which none were issued or outstanding at December 31,
1996.

Stock Options - The Company's Executive Long-Term Incentive Plan ("LTI Plan")
became effective in November 1988.  The last stock options granted under the LTI
Plan were granted in March 1994.  No additional stock option grants will be made
under the LTI Plan.  The LTI Plan provided, among other compensation awards, for
the granting to officers and other key management employees of non-qualified
stock options for the purchase of up to 1,295,000 shares of the Company's common
stock.  The number of options exercisable each year is equal to 25 percent of
the number granted after each year of continuous service starting one year from
the date of grant.  The LTI Plan provided that the option price per share was
not less than 100 percent of the fair market value of the stock on the effective
date of the grant.  As of December 31, 1996, options covering 743,802 shares
were outstanding under the LTI Plan, of which 575,759 were exercisable at a
weighted average price of $23.25 per share.  The following summarizes stock
option activity for the LTI Plan.
 
                                             OPTION PRICE
                                  NUMBER       AVERAGE
                                OF SHARES     PER SHARE        TOTAL
                               -----------  ------------  -------------
    Balance, December 31, 1994    985,496         $23.34   $22,999,026
     Exercised                     (2,743)         20.25       (55,546)
     Canceled                     (34,497)         25.73      (887,531)
                               ----------                 ------------
    Balance, December 31, 1995    948,256          23.26    22,055,949
     Exercised                   (204,454)         22.64    (4,628,165)
                               ----------                 ------------
    Balance, December 31, 1996    743,802          23.43   $17,427,784
                               ==========                 ============

The Company's Incentive Stock Option Plan ("ISO Plan"), a tax qualified plan,
became effective in January 1989.  The last stock options granted under the ISO
Plan were granted in March 1993.  No additional grants will be made under the
ISO Plan.  All employees of the Company who were not on the executive payroll
were eligible to participate in the ISO Plan, subject to certain restrictions.
Various restrictions apply as to when and to the number of stock options that
may be exercised during any year.  As of December 31, 1996, options covering
175,804 shares were outstanding at an average exercise price of $29.91 per
share.  These options were held by 812 eligible employees.  At December 31,
1996, 1,175 stock options were exercisable at an average exercise price of
$19.44.  The following summarizes stock option activity for the ISO Plan.

                                       51
 
<PAGE>
  
                        LYONDELL PETROCHEMICAL COMPANY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

 
 
                                            OPTION PRICE
                                  NUMBER      AVERAGE
                                OF SHARES    PER SHARE       TOTAL
                               ----------   ------------  -----------
    Balance, December 31, 1994    204,715         $29.31   $6,000,622
     Canceled/forfeited           (11,120)         27.29     (303,472)
     Exercised                     (4,042)         19.44      (78,576)
                               ----------                 -----------
    Balance, December 31, 1995    189,553          29.64    5,618,574
     Canceled/forfeited           (10,303)         28.51     (293,725)
     Exercised                     (3,446)         19.44      (66,990)
                               ----------                 -----------
    Balance, December 31, 1996    175,804          29.91   $5,257,859
                               ==========                 ===========
 
16.  LEASES

At December 31, 1996, future minimum rental payments for operating leases with
noncancelable lease terms in excess of one year were as follows.
 
MILLIONS OF DOLLARS                 AMOUNT
-------------------               --------
1997                                  $ 58
1998                                    55
1999                                    40
2000                                    36
2001                                    29
Thereafter                             383
                                  --------
    Total minimum lease payments      $601
                                  ========

Operating lease net rental expenses for 1996, 1995 and 1994 were $66 million,
$60 million and $58 million, respectively.


17.  RETIREMENT PLANS

All full-time regular Lyondell and LCR employees are covered by defined benefit
pension plans.  Retirement benefits are based on years of service and the
employee's highest three consecutive years of compensation during the last ten
years of service.  The funding policy for these plans is to make periodic
contributions as required by applicable law.  Lyondell and LCR accrue pension
costs based on an actuarial valuation and fund the plans through contributions
to pension trust funds separate from Lyondell or LCR's funds. Lyondell and LCR
also have unfunded supplemental nonqualified retirement plans which provide
pension benefits for certain employees in excess of the tax qualified plans'
limits.

The following table sets forth the funded status of Lyondell and LCR's
retirement plans and the amounts recognized in the Company's consolidated
balance sheets at December 31, 1996 and 1995.

                                       52

<PAGE>
 
                        LYONDELL PETROCHEMICAL COMPANY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

<TABLE>
<CAPTION>
 
 
                                                    1996                      1995
                                        -------------------------  ------------------------
                                          PLANS WITH   PLANS WITH   PLANS WITH   PLANS WITH
                                           ASSETS IN     ABO IN      ASSETS IN     ABO IN
                                           EXCESS OF    EXCESS OF    EXCESS OF    EXCESS OF
                                              ABO        ASSETS         ABO        ASSETS
                                        ------------  -----------  -----------  -----------
<S>                                       <C>          <C>          <C>          <C>
MILLIONS OF DOLLARS
-------------------
Actuarial present value of benefit
 obligations:
    Vested benefit obligation                   $ 85        $   7        $  64        $  30
                                        ============  ===========  ===========  ===========
    Accumulated benefit obligation 
     ("ABO")                                    $ 94        $   7        $  65        $  33
                                        ============  ===========  ============ ===========
    Projected benefit obligation                $150        $  15        $ 100        $  61
Plan assets at fair value, primarily
 stocks and bonds                                122           --           79           26
                                        ------------  -----------  -----------  -----------
Projected benefit obligation in excess
 of plan assets                                  (28)         (15)         (21)         (35)
Unrecognized net loss                             11            7           24           18
Prior service cost not yet recognized
 in pension cost                                   4            2           (3)           2
Remaining unrecognized net asset                  (4)          (1)          (3)          -- 
                                        ------------  -----------  -----------  -----------
Net pension liability                           $(17)       $  (7)       $  (3)       $ (15)
                                        ============  ===========  ===========  ===========
</TABLE>

The Company's net periodic pension cost for 1996, 1995 and 1994 included the 
following components.

<TABLE> 
<CAPTION> 
 
MILLIONS OF DOLLARS                                        1996         1995         1994
-------------------                                    -----------  -----------  ----------
<S>                                                    <C>          <C>          <C> 
Service cost - benefits earned during                      
 the period                                                 $  10        $   8        $   8 
Interest cost on projected benefit                            
 obligations                                                   12            9            9 
Actual (gain) loss on plan assets                             (19)         (20)           3
Net amortization and deferral                                  11           13          (10)
                                                       -----------  -----------  -----------
    Net periodic pension cost                               $  14        $  10        $  10
                                                       ===========  ===========  ===========
</TABLE>

The assumptions used at December 31, 1996, 1995 and 1994, in determining the 
net periodic pension cost and net pension liability shown above were as follows.
 
PERCENT                               1996  1995  1994
-------                               ---- ----- -----
Discount rate                         7.50  7.10  8.25
Rate of salary progression            5.00  5.00  5.00
Long-term rate of return on assets    9.50  9.50  9.50

Effective July 1, 1995, Lyondell and LCR also maintain voluntary defined
contribution savings plans for eligible employees.  Under provisions of the
plans, Lyondell and LCR contribute an amount equal to 160 percent of employee
contributions up to a maximum Lyondell or LCR contribution of eight percent of
the employees base salary.  Prior to July 1, 1995, Lyondell and LCR had similar
voluntary defined contribution plans.  Lyondell and LCR contributions to all
voluntary defined contribution savings plans totaled $10 million, $9 million and
$8 million during the years ended December 31, 1996, 1995 and 1994,
respectively.


18.  POSTRETIREMENT BENEFITS OTHER THAN PENSIONS

Lyondell and LCR sponsor unfunded postretirement benefit plans other than
pensions ("OPEB") for both salaried and non-salaried employees which provide
medical and life insurance benefits.  The postretirement health care plans are
contributory while the life insurance plans are non-contributory.  Currently,
Lyondell and LCR pay approximately 80 percent of the cost of the health care
plans, but reserve the right to modify the cost-sharing provisions at any time.

                                       53
 
<PAGE>
 
                        LYONDELL PETROCHEMICAL COMPANY

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(CONTINUED)

The following table sets forth the plans' separate postretirement benefit
liabilities at December 31, 1996 and 1995.
<TABLE>
<CAPTION>
 
                                                                1996              1995
                                                       ------------------- ----------------
MILLIONS OF DOLLARS                                      MEDICAL     LIFE   MEDICAL   LIFE
-------------------                                    ----------  ------- --------- ------
<S>                                                      <C>         <C>     <C>       <C>
Accumulated postretirement benefit obligation:
    Retirees                                              $   (7)    $ (7)     $ (4)   $ (1)
    Fully eligible active plan participants                   (7)      (2)       (8)     (5)
    Other active plan participants                           (32)      (1)      (30)     (7)
                                                       ----------  -------  --------  ------
                                                             (46)     (10)      (42)    (13)
Unrecognized prior service cost                               (5)      --        (5)     --
Unrecognized net loss                                          1       --         3       4
                                                       ----------  -------  --------  ------ 
Accrued postretirement benefit liability                  $  (50)    $(10)     $(44)   $ (9)
                                                       ==========  =======  ========  =====
</TABLE> 

 
Net periodic postretirement benefit costs for 1996, 1995 and 1994 included the 
following components.

<TABLE> 
<CAPTION> 
 
                                              1996               1995             1994
                                        ---------------   ---------------  ----------------
MILLIONS OF DOLLARS                       MEDICAL  LIFE     MEDICAL  LIFE    MEDICAL   LIFE
-------------------                     ---------------   ---------------  ----------------
<S>                                     <C>        <C>    <C>        <C>   <C>         <C> 
Service cost - benefits
  attributed to service                      $ 3              $ 2             $  2
Interest cost on accumulated
  postretirement obligation                    3   $ 1          2    $ 1         3     $ 1
                                        ---------------   ---------------  ----------------
Net periodic postretirement
  benefit cost                               $ 6   $ 1        $ 4    $ 1      $  5     $ 1
                                        ===============   ===============  ================
</TABLE>

For measurement purposes, the assumed annual rate of increase in the per capita
cost of covered health care benefits as of December 31, 1996 was 7 percent for
1997-2001 and 5 percent thereafter.  The health care cost trend rate assumption
has a significant effect on the amounts reported.  To illustrate, increasing the
assumed health care cost trend rates by one percentage point in each year would
increase the accumulated postretirement benefit liability as of December 31,
1996 by $8 million and the net periodic postretirement benefit cost for the year
then ended by $1 million.

The accumulated postretirement benefit obligation was calculated utilizing a
weighted-average discount rate of 7.5 percent and 7.1 percent at December 31,
1996 and 1995, respectively, and an average rate of salary progression of 5.0
percent in each year.  Lyondell and LCR's current policy is to fund the
postretirement health care and life insurance plans on a pay-as-you-go basis.


19.  INCOME TAXES

Significant components of the Company's provision for income taxes follow.
 
MILLIONS OF DOLLARS       1996    1995    1994
-------------------       -----  -----  ------
Current
    Federal               $  19  $ 206   $ 106
    State                     1     20      11
                          -----  -----  ------
        Total current        20    226     117
                          -----  -----  ------
Deferred
    Federal                  48      4      13
    State                     2     (1)     (4)
                          -----  -----  ------ 
        Total deferred       50      3       9
                          -----  -----  ------
                          $  70  $ 229   $ 126
                          =====  =====  ======

                                       54
 
<PAGE>
 
                        LYONDELL PETROCHEMICAL COMPANY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred tax liabilities and assets as of December 31, 1996 and
1995 were as follows.
 
MILLIONS OF DOLLARS                       1996    1995
-------------------                       -----  -----
Deferred tax liabilities:
    Tax over book depreciation            $ 190  $ 139
    Deferred turnaround costs                11     10
    Business interruption recovery           11     --
    LIFO inventory                            4      5
                                          -----  -----
        Total deferred tax liabilities      216    154
                                          -----  -----
Deferred tax assets:
    Pension and other compensation
     related obligations                     23     18
    OPEB obligation                          18     16
    Environmental reserve                     6      6
    Other                                     9      4
                                          -----  -----
        Total deferred tax assets            56     44
                                          -----  -----
Net deferred tax liabilities                160    110
Less current portion of deferred tax
 liability (asset)                            3     (5)
                                          -----  -----
long-term deferred income taxes           $ 157  $ 115
                                          =====  =====

The reconciliation of income tax computed at the U.S. federal statutory tax
rates to the Company's effective tax rates follows.
 
                                      1996   1995   1994
DESCRIPTION                             %      %      %
-----------                           ----- ------ -----
U.S. statutory income tax rates       35.0   35.0   35.0
State income taxes, net of federal     1.2    2.0    1.2
Company owned life insurance           (.1)    --    (.3)
Other, net                             (.4)    .1     .3
                                      ----- ------ -----
    Effective income tax rate         35.7   37.1   36.2
                                      ===== ====== =====
 
20.  COMMITMENTS AND CONTINGENCIES

The Company has various purchase commitments for materials, supplies and
services incident to the ordinary conduct of business.  In the aggregate, such
commitments are not at prices in excess of current market.

Depending on then current market conditions, breach or termination of the Crude
Supply Contract could adversely affect the Company.  Although the parties have
negotiated alternative arrangements in the event of certain force majeure
conditions, including governmental or other actions restricting or otherwise
limiting LAGOVEN's ability to perform its obligations, any such alternative
arrangements may not be as beneficial as the Crude Supply Contract.  There can
be no assurance that alternative crude oils with similar margins would be
available for purchase by LCR.  Furthermore, the breach or termination of the
Crude Supply Contract would require LCR to return to the practice of purchasing
all of its crude oil feedstocks in the merchant market and would again subject
LCR to significant volatility and price fluctuations.

In connection with the transfer of assets and liabilities from ARCO to the
Company, the Company agreed to assume certain liabilities arising out of the
operation of the Company's integrated petrochemicals and petroleum processing
business prior to July 1, 1988.  In connection with the transfer of such
liabilities, the Company and ARCO entered into an agreement ("Cross-Indemnity
Agreement") whereby the Company agreed to defend and indemnify ARCO against
certain uninsured claims and liabilities which ARCO may incur relating to the
operation 

                                       55
 
<PAGE>
 
of the business of the Company prior to July 1, 1988, including certain
liabilities which may arise out of pending and future lawsuits.

ARCO indemnified the Company under the Cross-Indemnity Agreement with respect to
other claims or liabilities and other matters of litigation not related to the
assets or business included in the consolidated financial statements.  ARCO has
also indemnified the Company for all federal taxes which might be assessed upon
audit of the operations of the Company included in the consolidated financial
statements prior to January 12, 1989, and for all state and local taxes for the
period prior to July 1, 1988. The Company has reached an agreement-in-principle
with ARCO to update the Cross-Indemnity Agreement ("Revised Cross-Indemnity
Agreement"). For current and future cases related to Company products and
Company operations, ARCO and the Company will bear a proportionate share of
judgment and settlement costs according to a formula which allocates
responsibility based on years of ownership during the relevant time period. The
party with the most significant potential liability exposure will be responsible
for case management and associated costs while providing some provisions to
allow the non-case managing party to protect its interests. Under the Revised
Cross-Indemnity Agreement, both ARCO and the Company waive any claim for
reimbursement under the existing Cross-Indemnity Agreement for any prior defense
and settlement costs associated with waste site matters, and the Company will
assume responsibility for its proportionate share of future costs for waste site
matters not covered by ARCO insurance. Subject to the uncertainty inherent in
all litigation, management believes the resolution of the matters pursuant to
the Revised Cross-Indemnity Agreement will not have a material adverse effect
upon the financial statements or liquidity of the Company.

In addition to lawsuits for which the Company has indemnified ARCO, the Company
is also subject to various lawsuits and proceedings.  Subject to the uncertainty
inherent in all litigation, management believes the resolution of these
proceedings will not have a material adverse effect upon the financial
statements or liquidity of the Company.

The Company's policy is to be in compliance with all applicable environmental
laws. The Company is subject to extensive environmental laws and regulations
concerning emissions to the air, discharges to surface and subsurface waters and
the generation, handling, storage, transportation, treatment and disposal of
waste materials. Some of these laws and regulations are subject to varying and
conflicting interpretations.  In addition, the Company cannot accurately predict
future developments, such as increasingly strict requirements of environmental
laws, inspection and enforcement policies and compliance costs therefrom which
might affect the handling, manufacture, use, emission or disposal of products,
other materials or hazardous and non-hazardous waste.

Subject to the terms of the Cross-Indemnity Agreement, the Company is currently
contributing funds to the cleanup of one waste site (Brio, located near Houston,
Texas) under the Comprehensive Environmental Response, Compensation and
Liability Act ("CERCLA") as amended and the Superfund Amendments and
Reauthorization Act of 1986. The Company is also subject to certain assessment
and remedial actions at the Refinery under the Resource Conservation and
Recovery Act ("RCRA").  In addition, the Company has negotiated an order with 
the Texas Natural Resource Conservation Commission ("TNRCC"), formerly the 
Texas Water Commission, for assessment and remediation of groundwater and soil
contamination at the Refinery.

In July 1994, the Company reported results of an independent investigation
conducted by the Audit Committee of the Board of Directors regarding the
compliance status of two process waste-water streams under the applicable
Benzene National Emissions Standard for Hazardous Air Pollutants ("NESHAPS")
regulations and certain issues raised by an employee.  Noncompliance with the
Benzene NESHAPS regulations and the related reporting requirements can result in
civil penalties and, under certain circumstances, substantial civil and,
potentially, criminal penalties.  The Company received a notice of violation
from the TNRCC regarding the two streams and paid a fine of $10,200.  In
addition, the Company incurred approximately $2 million in capital costs in
connection with these waste-water streams to achieve ongoing compliance with the
Benzene NESHAPS regulations.  Although

                                       56
 
<PAGE>
 
                        LYONDELL PETROCHEMICAL COMPANY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

the Criminal Enforcement Division of the EPA is conducting a formal
investigation, the Company does not believe any aspects of the matters described
above will subject the Company to criminal liability or have a material adverse
effect on the financial statements or liquidity of the Company.

The Company has accrued $14 million related to future CERCLA, RCRA and TNRCC
assessment and remediation costs, of which $4 million is included in current
liabilities while the remaining amounts are expected to be incurred over the
next two to seven years.  In the opinion of management, there is currently no
material range of loss in excess of the amount recorded.  However, it is
possible that new information about the sites for which the reserve has been
established, new technology or future developments such as involvement in other
CERCLA, RCRA, TNRCC or other comparable state law investigations, could require
the Company to reassess its potential exposure related to environmental matters.

In the opinion of management, any liability arising from the matters discussed
in this Note will not have a material adverse effect on the consolidated
financial statements or liquidity of the Company.  However, the adverse
resolution in any reporting period of one or more of these matters discussed in
this Note could have a material impact on the Company's results of operations
for that period without giving effect to contribution or indemnification
obligations of co-defendants or others, or to the effect of any insurance
coverage that may be available to offset the effects of any such award.


21.  SEGMENT INFORMATION

The petrochemicals segment consists of olefins, including ethylene, propylene,
butadiene, butylenes and specialty products; polyolefins including
polypropylene, HDPE and low-density polyethylene; aromatics produced at the
Channelview Facility, including benzene and toluene; methanol; MTBE; and
refinery blending stocks.

The refining segment, which is primarily composed of LCR operations, consists of
refined petroleum products including gasoline, low sulfur diesel and jet fuel;
aromatics produced at the Refinery, including benzene, toluene, paraxylene and
orthoxylene; lubricants, including industrial lubricants, motor oils, white
oils, process oils and base oils; carbon black sulfur; residual oil; petroleum
coke fuel; olefins feedstocks; and crude oil resales. Crude oil resales consist
of revenues from the resale of previously purchased crude oil and from
locational exchanges of crude oil that are settled on a cash basis.  Crude oil
exchanges and resales facilitate the operation of the Company's petroleum
processing business by allowing the Company to optimize the crude oil feedstock
mix in response to market conditions and refinery maintenance turnarounds and
also to reduce transportation costs.  Crude oil resales amounted to $436
million, $370 million and $296 million for years ended December 31, 1996, 1995
and 1994, respectively.

Consolidated sales to CITGO totaled $1.7 billion in 1996, $1.4 billion in 1995
and $1.1 billion in 1994.  No other customer accounted for 10 percent or more of
consolidated sales.

Summarized below is the segment data for the Company which includes certain
reclassifications for an intersegment pricing adjustment recorded in 1996
retroactive to 1993.  Intersegment sales between the petrochemicals and refining
segments, including olefins feedstocks produced at the Refinery and gasoline
blending stocks produced at the Channelview Facility, were made at prices based
on current market values.

                                       57
 
<PAGE>
 
                        LYONDELL PETROCHEMICAL COMPANY

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

<TABLE>
<CAPTION>
                          PETROCHEMICALS  REFINING
MILLIONS OF DOLLARS          SEGMENT      SEGMENT   UNALLOCATED   ELIMINATIONS   CONSOLIDATED
-------------------     ----------------  --------  -----------   ------------   ------------
<S>                       <C>             <C>       <C>           <C>            <C>
1996
----
Sales and other
  operating revenues:
    Customers                     $2,411    $2,641                                     $5,052
    Intersegment                     232       171                       $(403)            --
                           -------------  --------                   ---------    -----------
                                   2,643     2,812                        (403)         5,052
Gain on sale of assets                30        --                          --             30
Cost of sales                      2,224     2,749                        (403)         4,570
Selling, general and
  administrative
  expenses                           112        62         $ 60             --            234
                           -------------  --------  -----------      ---------    -----------
Operating income                  $  337    $    1         $(60)            --         $  278
                           =============  ========  ===========      =========    ===========
Depreciation and
  amortization expense            $   73    $   34         $  3                        $  110
                           =============  ========  ===========                   ===========
Capital expenditures              $   77    $  529         $  3                        $  609
                           =============  ========  ===========                   ===========
Identifiable assets               $1,543    $1,706         $ 88          $ (61)        $3,276
                           =============  ========  ===========      =========    ===========

1995
----
Sales and other
  operating revenues:
    Customers                     $2,466    $2,470                                     $4,936
    Intersegment                     191       178                       $(369)            --
                           -------------  --------                   ---------    -----------
                                   2,657     2,648                        (369)         4,936
Cost of sales                      1,938     2,457                        (369)         4,026
Selling, general and
  administrative
  expenses                            84        61         $ 59             --            204
                           -------------  --------  -----------      ---------    -----------
Operating income                  $  635    $  130         $(59)            --         $  706
                           =============  ========  ===========      =========    ===========
Depreciation and
  amortization expense            $   54    $   30         $  2                        $   86
                           =============  ========  ===========                   ===========
Capital expenditures              $  471    $  505         $  6                        $  982
                           =============  ========  ===========                   ===========
Identifiable assets               $1,365    $1,212         $ 69          $ (40)        $2,606
                           =============  ========  ===========      =========    ===========
1994
----
Sales and other
  operating revenues:
    Customers                     $1,783    $2,074                                     $3,857
    Intersegment                     190       200                       $(390)            --
                           -------------  --------                   ---------    -----------
                                   1,973     2,274                        (390)         3,857
Cost of sales                      1,522     2,164                        (390)         3,296
Selling, general and
  administrative
  expenses                            40        54         $ 43             --            137
                           -------------  --------  -----------      ---------    -----------
Operating income                  $  411    $   56         $(43)            --         $  424
                           =============  ========  ===========      =========    ===========
Depreciation and
  amortization expense            $   44    $   20         $  1                        $   65
                           =============  ========  ===========                   ===========
Capital expenditures              $   39    $  210         $  3                        $  252
                           =============  ========  ===========                   ===========
Identifiable assets               $  925    $  739         $ 49          $ (50)        $1,663
                           =============  ========  ===========      =========    ===========
</TABLE>

                                       58
 
<PAGE>
 
                        LYONDELL PETROCHEMICAL COMPANY

           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED)

22.  UNAUDITED QUARTERLY RESULTS
<TABLE>
<CAPTION>
 
                                                     FOR THE QUARTER ENDED
                                        ----------------------------------------------
MILLIONS OF DOLLARS EXCEPT PER SHARE     
 AMOUNTS                                  MARCH 31  JUNE 30  SEPTEMBER 30  DECEMBER 31   
------------------------------------    ----------  -------  ------------  -----------  
<S>                                       <C>       <C>      <C>           <C>                                       
1996
----
Sales and other operating revenues          $1,165   $1,239        $1,247       $1,401
Operating income                                61       45            71          101
Income before income taxes                      38       23            55           80
Net income                                      24       15            35           52
Earnings per share                             .30      .19           .43          .66
 
1995
----
Sales and other operating revenues          $1,174   $1,370        $1,249       $1,143
Operating income                               222      237           183           64
Income before income taxes                     202      215           159           42
Net income                                     127      135           100           27
Earnings per share                            1.59     1.68          1.25          .34
 
</TABLE>

                                       59
 
<PAGE>
 
ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
         FINANCIAL DISCLOSURE

       None.

                                   PART III


ITEM 10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

ITEM 11.  EXECUTIVE COMPENSATION

ITEM 12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

ITEM 13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

Information regarding executive officers of the Company is included in Part I.
For the other information called for by Items 10, 11, 12 and 13, reference is
made to the Registrant's definitive proxy statement for its Annual Meeting of
Stockholders, to be held on May 9, 1997, which will be filed with the Securities
and Exchange Commission within 120 days after December 31, 1996, and which is
incorporated herein by reference.

                                       60
 
<PAGE>
  
                                    PART IV

ITEM 14.  EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K

  (a) The following documents are filed as a part of this report:

       1 and 2  --  Consolidated Financial Statements:  these documents are
                    listed in the Index to Consolidated Financial Statements.
<TABLE>
<CAPTION>
 
EXHIBITS:
---------
<S>      <C> 
 
3.1      -   Amended and Restated Certificate of Incorporation of the
             Registrant.
3.2      -   Amended and Restated By-Laws of the Registrant.
4.1      -   Indenture, as supplemented by a First Supplemental Indenture,
             between the Registrant and Texas Commerce Bank National
             Association, as Trustee.**
4.2      -   Indenture, as supplemented by a First Supplemental Indenture,
             between the Registrant and Continental Bank, National Association,
             as Trustee.++
4.3      -   Indenture, as supplemented by a First Supplemental Indenture,
             between the Registrant and Texas Commerce Bank, as Trustee. ++++
4.4      -   Specimen certificate.*
4.5      -   LYONDELL-CITGO Refining Company Ltd. $70,000,000 Credit
             Agreement.++++
4.5(a)   -   Amendment No. 1 to the $70,000,000 Credit Agreement.X
4.5(b)   -   Amendment No. 2 to the $70,000,000 Credit Agreement.XXX
4.6      -   LYONDELL-CITGO Refining Company Ltd. $450,000,000 Credit
             Agreement.++++
4.6(a)   -   Amendment No. 1 to the $450,000,000 Credit Agreement.X
4.6(b)   -   Amendment No. 2 to the $450,000,000 Credit Agreement.XXX
4.7      -   Lyondell Petrochemical Company $400,000,000 Amended and Restated
             Credit Agreement.+
4.7(a)   -   Amendment No. 1 to the $400,000,000 Credit Agreement.XX
4.8      -   Rights Agreement between the Registrant and the Bank of New York,
             as Rights Agent.+++
 
EXECUTIVE COMPENSATION:
 
10.1     -   Amended and Restated Executive Supplementary Savings Plan.
10.2     -   Amended and Restated Executive Long-Term Incentive Plan.***
10.3     -   Supplementary Executive Retirement Plan.***
10.3(a)  -   Amendment No. 1 to the Supplementary Executive Retirement Plan.+
10.3(b)  -   Amendment No. 2 to the Supplementary Executive Retirement Plan. ++
10.4     -   Executive Medical Plan.
10.4(a)  -   Amendment No. 1 to the Executive Medical Plan.
10.4(b)  -   Amendment No. 2 to the Executive Medical Plan.
10.5     -   Executive Deferral Plan.
10.5(a)  -   Amendment No. 1 to the Executive Deferral Plan.
10.6     -   Executive Long-Term Disability Plan. +
10.6(a)  -   Amendment No. 1 to the Executive Long-Term Disability Plan.
10.7     -   Executive Life Insurance Plan.+
10.8     -   Supplemental Executive Benefit Plans Trust Agreement.****
10.9     -   Restricted Stock Plan.+++
10.9(a)  -   Amendment to the Restricted Stock Plan.++
10.10    -   Amended and Restated Value Share Plan.
10.10(a) -   Amendment to the Value Share Plan.
10.11    -   Form of Executive Severance Agreement with Executive Officers.
10.12    -   Form of Registrant's Indemnity Agreement with Officers and
             Directors.*
10.13    -   Amended and Restated Elective Deferral Plan for Non-Employee
             Directors.
10.13(a) -   Amendment No. 1 to the Elective Deferral Plan for Non-Employee
             Directors.
10.14    -   Amended and Restated Retirement Plan for Non-Employee
             Directors.****
10.15    -   Restricted Stock Plan for Non-Employee Directors.X
</TABLE>

                                       61

<PAGE>
 
MATERIAL CONTRACTS WITH ARCO AFFILIATES:
<TABLE>
 
<S>      <C>
10.16    -   Joint Pipeline Use Agreement between ARCO Chemical Company and the
             Registrant.*
10.17    -   Agreements Implementing Transfer of Pipeline Rights from ARCO Pipe
             Line Company to Registrant.*
10.18    -   Conveyance (conformed without exhibits) between the Registrant and
             ARCO.*
10.19(a) -   Cross-Indemnification Agreement between the Registrant and ARCO and
             Amendment No. 1 to the Cross-Indemnification Agreement.*
10.19(b) -   Dispute Resolution Agreement between the Registrant, ARCO and ARCO
             Chemical Company.+++
10.19(c) -   Employee Services Agreement between the Registrant and ARCO.+
10.19(d) -   Investment Management Agreement between the Registrant and
             ARCO.+++
10.19(e) -   Form of Registration Rights Agreement between the Registrant and
             ARCO.+
10.20(a) -   Immunity From Suit Agreement between ARCO and the Registrant.*
10.20(b) -   Amendment to Immunity From Suit Agreement between ARCO and the
             Registrant.***
10.21(a) -   License Agreement between ARCO and the Registrant.*
10.21(b) -   License Agreement Amendment between ARCO and the Registrant.***
10.22(a) -   Technology Agreement between ARCO and the Registrant.**
10.22(b) -   Technology Agreement Amendment between ARCO and the Registrant.***
10.23    -   Assignment of Patents and Patent Applications between ARCO and the
             Registrant.**
10.24    -   Assignment of Technology Agreement, as amended, between ARCO and
             the Registrant.**
 
OTHER MATERIAL CONTRACTS:
 
10.26    -   Asset Purchase Agreement (conformed without exhibits) between the
             Registrant and Rexene Products Company.**
10.27    -   Crystalline Polymers License and Block Copolymer License between
             Phillips Petroleum Co. and the Registrant.**
10.28    -   Amended and Restated Limited Liability Company Regulations of
             LYONDELL-CITGO Refining Company Ltd.++
10.28(a) -   Amendment No. 1 to the Amended and Restated Limited Liability
             Company Regulations of LYONDELL-CITGO Refining Company Ltd.++++
10.29    -   Contribution Agreement between Lyondell Petrochemical Company and
             LYONDELL-CITGO Refining Company Ltd.++
10.30    -   Crude Oil Supply Agreement between LYONDELL-CITGO Refining Company
             Ltd. and Lagoven, S.A.++
10.31    -   Asset Purchase Agreement between the Registrant and Occidental
             Chemical Company. +++++
21       -   Subsidiaries of the Registrant.
23       -   Consent of Coopers & Lybrand L.L.P.
24       -   Powers of Attorney.
27       -   Financial Data Schedule.
</TABLE>

*          Filed as an exhibit to Registrant's Registration Statement on Form S-
           1 (No. 33-25407) and incorporated herein by reference.
**         Filed as an exhibit to Registrant's Annual Report on Form 10-K Report
           for the year ended December 31, 1989 and incorporated herein by
           reference.
***        Filed as an exhibit to Registrant's Annual Report on Form 10-K Report
           for the year ended December 31, 1990 and incorporated herein by
           reference.
****       Filed as an exhibit to Registrant's Annual Report on Form 10-K Report
           for the year ended December 31, 1991 and incorporated herein by
           reference.
+          Filed as an exhibit to Registrant's Annual Report on Form 10-K Report
           for the year ended December 31, 1992 and incorporated herein by
           reference.

                                       62
 
<PAGE>
 
<TABLE>
<S>       <C>
++         Filed as an exhibit to Registrant's Interim Report on Form 8-K dated
           as of July 1, 1993 and incorporated herein by reference.
+++        Filed as an exhibit to Registrant's Annual Report on Form 10-K for
           the year ended December 31, 1993 and incorporated herein by
           reference.
+          Filed as an exhibit to Registrant's Registration Statement on Form S-
           3 dated as of May 5, 1994 and incorporated herein by reference.
++         Filed as an exhibit to Registrant's Quarterly Report on Form 10-Q for
           the quarter ended September 30, 1994 and incorporated herein by
           reference.
+++        Filed as an exhibit to Registrant's Annual Report on Form 10-K for
           the year ended December, 31, 1994 and incorporated herein by
           reference.
++++       Filed as an exhibit to Registrant's Quarterly Report on Form 10-Q for
           the quarter ended March 31, 1995 and incorporated herein by
           reference.
+++++      Filed as an exhibit to Registrant's Interim Report on Form 8-K dated
           as of May 1, 1995 and incorporated herein by reference.
+          Filed as an exhibit to Registrant's Quarterly Report on Form 10-Q for
           the quarter ended June 30, 1995 and incorporated herein by reference.
++         Filed as an exhibit to Registrant's Quarterly Report on Form 10-Q for
           the quarter ended September 30, 1995 and incorporated herein by
           reference.
+++        Filed as an exhibit to Registrant's Interim Report on Form 8-K dated
           December 8, 1995 and incorporated herein by reference.
++++       Filed as an exhibit to Registrant's Registration Statement on Form S-
           3 dated as of January 31, 1996 and incorporated herein by reference.
+++++      Filed as an exhibit to Registrant's Annual Report on Form 10-K for
           the year ended December 31, 1995 and incorporated herein by reference
X          Filed as an exhibit to Registrant's Quarterly Report on Form 10-Q for
           the period ended March 31, 1996
XX         Filed as an exhibit to Registrant's Quarterly Report on Form 10-Q for
           the period ended June 30, 1996.
XXX        Filed as an exhibit to Registrant's Quarterly Report on Form 10-Q for
           the period ended September 30, 1996.
</TABLE> 

                                       63
 
<PAGE>
 
    (b)  Consolidated Financial Statements and Financial Statement Schedules

       (1)  Consolidated Financial Statements

            Consolidated Financial Statements filed as part of this Annual
            Report on Form 10-K are listed in the Index to Consolidated
            Financial Statements on page 36.

       (2)  Financial Statement Schedules

       All financial statement schedules are omitted because they are not
       applicable or the required information is contained in the Financial
       Statements or notes thereto.

       Copies of exhibits will be furnished upon prepayment of 25 cents per
       page. Requests should be addressed to the Secretary.

    (c)  Reports on Form 8-K:

       The following Current Reports on Form 8-K were filed during the quarter
       ended December 31, 1996 through March 17, 1997.

Date of Report                      Item No.               Financial Statements
--------------                      --------               --------------------

January 31, 1997                        5                           Yes
 

                                       64
 
<PAGE>
 
                                  SIGNATURES

PURSUANT TO THE REQUIREMENTS OF SECTION 13 OF THE SECURITIES EXCHANGE ACT OF
1934, THE REGISTRANT HAS DULY CAUSED THIS REPORT TO BE SIGNED ON ITS BEHALF BY
THE UNDERSIGNED, THEREUNTO DULY AUTHORIZED.

                        LYONDELL PETROCHEMICAL COMPANY

                                          By:  DAN F. SMITH
                                               --------------------------------
                                               Dan F. Smith
                                               President and Chief Executive 
                                               Officer

PURSUANT TO THE REQUIREMENTS OF THE SECURITIES EXCHANGE ACT OF 1934, THIS REPORT
HAS BEEN SIGNED BELOW BY THE FOLLOWING PERSONS ON BEHALF OF THE REGISTRANT AND
IN THE CAPACITIES AND ON THE DATES INDICATED.
<TABLE>
<CAPTION>
 
  SIGNATURE                                TITLE                      DATE
  ---------                                -----                      ----     
<S>                                 <C>                           <C>
 
BOB G. GOWER*                       Chairman of the Board         March 17, 1997
---------------------------
(Bob G. Gower)              

 
DAN F. SMITH                        President, Chief Executive    March 17, 1997
---------------------------          Officer and Director
(Dan F. Smith, Principal    
 Executive Officer)          

 
WILLIAM T. BUTLER*                        Director                March 17, 1997
---------------------------
(William T. Butler)

 
CURTIS J. CRAWFORD* 
---------------------------               Director                March 17, 1997
(Curtis J. Crawford)


TRAVIS ENGEN*  
---------------------------               Director                March 17, 1997
(Travis Engen)


STEPHEN F. HINCHLIFFE, JR.*  
---------------------------               Director                March 17, 1997
(Stephen F. Hinchliffe, Jr.)
 

DUDLEY C. MECUM II* 
---------------------------               Director                March 17, 1997
(Dudley C. Mecum  II)
 
PAUL R. STALEY*                           Director                March 17, 1997
---------------------------
(Paul R. Staley)
 
RUSSELL S. YOUNG                Senior Vice President, Chief      March 17, 1997
---------------------------    Financial Officer and Treasurer
(Russell S. Young,
 Principal Financial
 Officer)
 
JOSEPH M. PUTZ                  Vice President and Controller     March 17, 1997
---------------------------
(Joseph M. Putz, Principal
 Accounting Officer)
 
*By: DAN F. SMITH                                                 March 17, 1997
     ----------------------
(Dan F. Smith, as Attorney-in-fact)
 
</TABLE>

                                       65