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Derivative Instruments
 3 Months Ended
Mar. 31, 2012
Derivative Instruments  
Derivative Instruments

C.        Derivative Instruments

 

Natural Gas Hedging Instruments

 

The Company’s primary market risk exposure is the volatility of future prices for natural gas and NGLs, which can affect the operating results of the Company primarily through EQT Production and the storage, marketing and other activities at EQT Midstream. The Company’s overall objective in its hedging program is to protect cash flows from undue exposure to the risk of changing commodity prices.

 

The Company uses derivative commodity instruments that are placed with major financial institutions whose creditworthiness is regularly monitored. Futures contracts obligate the Company to buy or sell a designated commodity at a future date for a specified price and quantity at a specified location. Swap agreements involve payments to or receipts from counterparties based on the differential between a fixed and variable price for the commodity. Collar agreements require the counterparty to pay the Company if the index price falls below the floor price and the Company to pay the counterparty if the index price rises above the cap price. The Company also engages in a limited number of basis swaps to protect earnings from undue exposure to the risk of geographic disparities in commodity prices and interest rate swaps to hedge exposure to interest rate fluctuations on short- or long-term debt.

 

The Company recognizes all derivative instruments as either assets or liabilities at fair value on a gross basis. The accounting for the changes in fair value of the Company’s derivative instruments depends on the use of the derivative instruments.  To the extent that a derivative instrument has been designated and qualifies as a cash flow hedge, the effective portion of the change in fair value of the derivative instrument is reported as a component of accumulated other comprehensive income, net of tax, and is subsequently reclassified into the Statements of Consolidated Income in the same period or periods during which the forecasted transaction affects earnings.

 

For a derivative instrument that has been designated and qualifies as a fair value hedge, the change in the fair value for the instrument is recognized as a portion of operating revenues in the Statements of Consolidated Income each period.  In addition, the change in the fair value of the hedged item (natural gas inventory) is recognized as a portion of operating revenues in the Statements of Consolidated Income.  The Company has elected to exclude the spot/forward differential for the assessment of effectiveness of the fair value hedges. Any hedging ineffectiveness and any change in fair value of derivative instruments that have not been designated as hedges, are recognized in the Statements of Consolidated Income each period.

 

Exchange-traded instruments are generally settled with offsetting positions. Over the counter (OTC) arrangements require settlement in cash. Settlements of derivative commodity instruments are reported as a component of cash flows from operations in the accompanying Statements of Condensed Consolidated Cash Flows.

 

Some of the derivative commodity instruments used by the Company to hedge its exposure to variability in expected future cash flows associated with the fluctuations in the price of natural gas related to the Company’s forecasted sale of equity production and forecasted natural gas purchases and sales have been designated and qualify as cash flow hedges. Some of the derivative commodity instruments used by the Company to hedge its exposure to adverse changes in the market price of natural gas stored in the ground have been designated and qualify as fair value hedges.

 

In addition, the Company enters into a limited amount of energy trading contracts to leverage its assets and limit its exposure to shifts in market prices and has a limited amount of other derivative instruments not designated as hedges. In 2008 and 2011, the Company effectively settled certain derivative commodity swaps scheduled to mature during the period 2010 through 2013 by de-designating the instruments and entering into directly counteractive instruments. These transactions result in offsetting positions which are the majority of the derivative asset and liability balances not designated as hedging instruments.

 

All derivative instrument assets and liabilities are reported in the Condensed Consolidated Balance Sheets as derivative instruments, at fair value. These derivative instruments are reported as either current assets or current liabilities due to their highly liquid nature. The Company can net settle its derivative instruments at any time.

 

 

 

Three Months Ended

 

 

 

March 31,

 

 

 

2012

 

2011

 

 

 

(Thousands)

 

Commodity derivatives designated as cash flow hedges

 

 

 

 

 

Amount of gain recognized in other comprehensive income (OCI) (effective portion), net of tax

 

$

107,488

 

$

4,199

 

Amount of gain reclassified from accumulated OCI into operating revenues (effective portion), net of tax

 

$

47,986

 

$

16,905

 

Amount of loss recognized in operating revenues (ineffective portion) (a)

 

$

(31

)

$

(625

)

 

 

 

 

 

 

Interest rate derivatives designated as cash flow hedges

 

 

 

 

 

Amount of gain recognized in OCI (effective portion), net of tax

 

$

2,373

 

$

—

 

Amount of loss reclassified from accumulated OCI into interest expense (effective portion), net of tax

 

$

(65

)

$

(30

)

 

 

 

 

 

 

Commodity derivatives designated as fair value hedges (b)

 

 

 

 

 

Amount of gain (loss) recognized in operating revenues for fair value commodity contracts

 

$

7,072

 

$

(1,896

)

Fair value gain (loss) recognized in operating revenues for inventory designated as hedged item

 

$

(9,931

)

$

1,633

 

 

 

 

 

 

 

Derivatives not designated as hedging instruments

 

 

 

 

 

Amount of gain (loss) recognized in operating revenues

 

$

2,463

 

$

(1,679

)

 

 

(a)          No amounts have been excluded from effectiveness testing of cash flow hedges.

 

(b)         For the quarter ended March 31, 2012, the net impact on operating revenues consisted of a $3.3 million loss due to the exclusion of the spot/forward differential from the assessment of effectiveness and a $0.4 million gain due to changes in basis. For the quarter ended March 31, 2011, the net impact on operating revenues related to the exclusion of the spot/forward differential from the assessment of effectiveness.

 

 

 

March 31,

 

December 31,

 

 

 

2012

 

2011

 

 

 

(Thousands)

 

Asset derivatives

 

 

 

 

 

Commodity derivatives designated as hedging instruments

 

$

508,680

 

$

412,626

 

Commodity derivatives not designated as hedging instruments

 

99,967

 

99,535

 

Total asset derivatives

 

$

608,647

 

$

512,161

 

 

 

 

 

 

 

Liability derivatives

 

 

 

 

 

Commodity derivatives designated as hedging instruments

 

$

4,432

 

$

3,681

 

Interest rate derivatives designated as hedging instruments

 

6,713

 

10,861

 

Commodity derivatives not designated as hedging instruments

 

108,899

 

108,764

 

Total liability derivatives

 

$

120,044

 

$

123,306

 

 

In August 2011, the Company entered into a forward-starting interest rate swap to mitigate the risk of rising interest rates. The forward-starting interest rate swap was designated as a cash flow hedge of forecasted future interest payments. The Company recorded a deferred loss of $5.2 million and $7.6 million in accumulated other comprehensive income, net of tax, as of March 31, 2012 and December 31, 2011, respectively, associated with the change in fair value of the interest rate swaps.

 

The net fair value of commodity derivative instruments changed during the first quarter of 2012 primarily as a result of a decrease in forward natural gas prices.  The absolute quantities of the Company’s derivative commodity instruments that have been designated and qualify as cash flow hedges totaled 316 Bcf and 349 Bcf as of March 31, 2012 and December 31, 2011, respectively, and are primarily related to natural gas swaps and collars.  The open positions at March 31, 2012 had maturities extending through December 2016.  The absolute quantities of the Company’s derivative commodity instruments that have been designated and qualify as fair value hedges totaled 11 Bcf and 9 Bcf as of March 31, 2012 and December 31, 2011, respectively.

 

The Company deferred net gains of $291.6 million and $232.1 million in accumulated other comprehensive income, net of tax, as of March 31, 2012 and December 31, 2011, respectively, associated with the effective portion of the change in fair value of its derivative commodity instruments designated as cash flow hedges.  Assuming no change in price or new transactions, the Company estimates that approximately $186.6 million of net unrealized gains on its derivative commodity instruments reflected in accumulated other comprehensive income, net of tax, as of March 31, 2012 will be recognized in earnings during the next twelve months due to the settlement of hedged transactions.

 

The Company is exposed to credit loss in the event of nonperformance by counterparties to derivative contracts.  This credit exposure is limited to derivative contracts with a positive fair value, which may change as market prices change.  The Company believes that New York Mercantile Exchange (NYMEX) traded futures contracts have limited credit risk because Commodity Futures Trading Commission regulations are in place to protect exchange participants, including the Company, from potential financial instability of the exchange members.  The Company’s OTC swap and collar derivative instruments are primarily with financial institutions and thus are subject to events that would impact those companies individually as well as that industry as a whole.

 

The Company utilizes various processes and analysis to monitor and evaluate its credit risk exposures.  These include closely monitoring current market conditions, counterparty credit spreads and credit default swap rates.  Credit exposure is controlled through credit approvals and limits.  To manage the level of credit risk, the Company deals with financial counterparties that are of investment grade or better, enters into netting agreements whenever possible and may obtain collateral or other security. As of March 31, 2012, all derivative contracts outstanding were with counterparties having an S&P rating of A- or above and a Moody’s rating of Baa1 or above.

 

When the net fair value of any of the Company’s swap agreements represents a liability to the Company which is in excess of the agreed-upon threshold between the Company and the financial institution acting as counterparty, the counterparty requires the Company to remit funds to the counterparty as a margin deposit for the derivative liability which is in excess of the threshold amount.  The Company records these deposits as a current asset.  When the net fair value of any of the Company’s swap agreements represents an asset to the Company which is in excess of the agreed-upon threshold between the Company and the financial institution acting as counterparty, the Company requires the counterparty to remit funds as margin deposit in an amount equal to the portion of the derivative asset which is in excess of the threshold amount.  The Company records a current liability for such amounts received. The Company had no such deposits in its Condensed Consolidated Balance Sheets as of March 31, 2012 and December 31, 2011.

 

When the Company enters into exchange-traded natural gas contracts, exchanges may require the Company to remit funds to the corresponding broker as good-faith deposits to guard against the risks associated with changing market conditions.  Participants must make such deposits based on an established initial margin requirement as well as the net liability position, if any, of the fair value of the associated contracts.  The Company records these deposits as a current asset in the Condensed Consolidated Balance Sheets.  In the case where the fair value of such contracts is in a net asset position, the broker may remit funds to the Company, in which case the Company records a current liability for such amounts received.  The initial margin requirements are established by the exchanges based on the price, volatility and the time to expiration of the related contract and are subject to change at the exchanges’ discretion.  The Company recorded a current asset of $1.3 million and $0.1 million as of March 31, 2012 and December 31, 2011, respectively, for such deposits in its Condensed Consolidated Balance Sheets.

 

Certain of the Company’s derivative instrument contracts provide that if the Company’s credit ratings by Standard & Poor’s Rating Services (S&P) or Moody’s Investor Services (Moody’s) are lowered below investment grade, additional collateral must be deposited with the counterparty.  This additional collateral can be up to 100% of the derivative liability.  As of March 31, 2012, the aggregate fair value of all derivative instruments with credit-risk-related contingent features that are in a net liability position was $2.0 million, for which the Company had no collateral posted.  If the Company’s credit rating by S&P or Moody’s had been downgraded below investment grade on March 31, 2012, the Company would have been required to post additional collateral of $2.0 million in respect of the liability position.  Investment grade refers to the quality of the Company’s credit as assessed by one or more credit rating agencies.  The Company’s unsecured medium-term debt was rated BBB by S&P and Baa2 by Moody’s at March 31, 2012. In order to be considered investment grade, the Company must be rated BBB- or higher by S&P and Baa3 or higher by Moody’s.  Anything below these ratings is considered to be non-investment grade.