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Derivatives and Risk Management Activities
 9 Months Ended
Sep. 30, 2012
Derivatives and Risk Management Activities  
Derivatives and Risk Management Activities

Note 11—Derivatives and Risk Management Activities

 

We identify the risks that underlie our core business activities and use risk management strategies to mitigate those risks when we determine that there is value in doing so.  Our policy is to use derivative instruments for risk management purposes and not for the purpose of speculating on hydrocarbon commodity (referred to herein as “commodity”) price changes.  We use various derivative instruments to (i) manage our exposure to commodity price risk as well as to optimize our profits, (ii) manage our exposure to interest rate risk and (iii) manage our exposure to currency exchange rate risk.  Our commodity risk management policies and procedures are designed to help ensure that our hedging activities address our risks by monitoring our derivative positions, as well as physical volumes, grades, locations, delivery schedules and storage capacity.  Our interest rate and currency exchange rate risk management policies and procedures are designed to monitor our derivative positions and ensure that those positions are consistent with our objectives and approved strategies.  When we apply hedge accounting, our policy is to formally document all relationships between hedging instruments and hedged items, as well as our risk management objectives for undertaking the hedge.  This process includes specific identification of the hedging instrument and the hedged transaction, the nature of the risk being hedged and how the hedging instrument’s effectiveness will be assessed.  Both at the inception of the hedge and on an ongoing basis, we assess whether the derivatives used in a transaction are highly effective in offsetting changes in cash flows or the fair value of hedged items.

 

Commodity Price Risk Hedging

 

Our core business activities contain certain commodity price-related risks that we manage in various ways, including the use of derivative instruments.  Our policy is to (i) only purchase inventory for which we have a market, (ii) structure our sales contracts so that price fluctuations do not materially affect our operating income and (iii) not acquire and hold physical inventory or derivatives for the purpose of speculating on commodity price changes.  The material commodity-related risks inherent in our business activities can be divided into the following general categories:

 

Commodity Purchases and Sales — In the normal course of our operations, we purchase and sell commodities.  We use derivatives to manage the associated risks and to optimize profits.  As of September 30, 2012, net derivative positions related to these activities included:

 

·                  An approximate 201,700 barrels per day net long position (total of 6.3 million barrels) associated with our crude oil purchases, which was unwound ratably during October 2012 to match monthly average pricing.

 

·                  A net short spread position averaging approximately 30,800 barrels per day (total of 10.3 million barrels), which hedges a portion of our anticipated crude oil lease gathering purchases through October 2013.  These derivatives are time spreads consisting of offsetting purchases and sales between two different months.  Our use of these derivatives does not expose us to outright price risk.

 

·                  Approximately 11,500 barrels per day on average (total of 5.3 million barrels) of WTS/WTI crude oil basis swaps through December 2013, which hedge anticipated sales of crude oil (WTI).  These derivatives are grade spreads between two different grades of crude oil.  Our use of these derivatives does not expose us to outright price risk.

 

·                  Approximately 1,700 barrels per day on average (total of 0.8 million barrels) of LLS/WTI crude oil basis swaps from October 2012 through December 2013, which hedge anticipated sales of crude oil.  These derivatives are grade spreads between two different grades of crude oil. Our use of these derivatives does not expose us to outright price risk.

 

·                  An average of 1,000 barrels per day (total of 0.5 million barrels) of butane/WTI spread positions, which hedge specific butane sales contracts that are based on a percentage of WTI through March 2014.

 

·                  A long swap position of approximately 7.5 Bcf through April 2016 related to anticipated purchases of natural gas, including 5.0 Bcf of anticipated base gas requirements.

 

·                  A short swap position of approximately 24.3 Bcf through January 2013 related to anticipated sales of natural gas.

 

·      Approximately 1,022 barrels per day (total of 0.5 million barrels) of swaps, which hedge anticipated purchases of diesel fuel through December 2013.

 

Storage Capacity Utilization — We own approximately 100 million barrels of crude oil, NGL and refined products storage capacity other than that used in our transportation operations. This storage may be leased to third parties or utilized in our own supply and logistics activities, including for the storage of inventory in a contango market. For capacity allocated to our supply and logistics operations, we have utilization risk if the market structure is backwardated. As of September 30, 2012, we used derivatives to manage the risk of not utilizing approximately 1.1 million barrels per month of storage capacity through 2013. These positions are a combination of calendar spread options and futures contracts. These positions involve no outright price exposure, but instead enable us to profitably use the capacity to store hedged crude oil.

 

Inventory Storage — From time to time, we elect to purchase and store crude oil, NGL and refined products inventory in conjunction with our supply and logistics activities. When we purchase and store inventory, we enter into physical sales contracts or use derivatives to mitigate price risk associated with the inventory. As of September 30, 2012, we had derivatives totaling approximately 13.4 million barrels hedging our inventory. These positions are a combination of futures, swaps and option contracts.

 

Pipeline Loss Allowance Oil — As is common in the pipeline transportation industry, our tariffs incorporate a loss allowance factor that is intended to, among other things, offset losses due to evaporation, measurement and other losses in transit.  We utilize derivative instruments to hedge a portion of the anticipated sales of the allowance oil that is to be collected under our tariffs.  As of September 30, 2012, our PLA hedges included (i) a net short position consisting of crude oil futures and swaps for an average of approximately 1,100 barrels per day (total of 1.4 million barrels) through December 2015, (ii) a short put option position of approximately 0.1 million barrels through December 2012 and (iii) a long call option position of approximately 0.8 million barrels through December 2015.

 

Natural Gas Processing/NGL Fractionation — As part of our supply and logistics activities, we purchase natural gas for processing and NGL mix for fractionation, and we sell the resulting individual specification products (including ethane, propane, butane and condensate).  In conjunction with these activities, we hedge the purchase of natural gas and the subsequent sale of the individual specification products.  As of September 30, 2012, we had a long natural gas position of approximately 14.4 Bcf through October 2014, a short propane position of approximately 2.5 million barrels through October 2014, a short butane position of approximately 0.7 million barrels through October 2014 and a short WTI position of approximately 0.3 million barrels through October 2014.

 

All of our commodity derivatives that qualify for hedge accounting are designated as cash flow hedges.  We have determined that substantially all of our physical purchase and sale agreements qualify for the NPNS exclusion.  Physical commodity contracts that meet the definition of a derivative but are ineligible, or not designated, for the NPNS scope exception are recorded on the balance sheet at fair value, with changes in fair value recognized in earnings.

 

Interest Rate Risk Hedging

 

We use interest rate derivatives to hedge interest rate risk associated with anticipated debt issuances and outstanding debt instruments.  The derivative instruments we use to manage this risk consist primarily of interest rate swaps and treasury locks.  As of September 30, 2012, AOCI includes deferred losses of approximately $150 million that relate to open and terminated interest rate derivatives that were designated for hedge accounting.  The terminated interest rate derivatives were cash-settled in connection with the issuance or refinancing of debt agreements.  The deferred gain related to these instruments is being amortized to interest expense over the terms of the hedged debt instruments.

 

We have entered into forward starting interest rate swaps to hedge the underlying benchmark interest rate related to forecasted debt issuances through 2015.  The following table summarizes the terms of our forward starting interest rate swaps as of September 30, 2012 (notional amounts in millions):

 

Hedged Transaction

 

Number and Types of
Derivatives Employed

 

Notional
Amount

 

Expected
Termination Date

 

Average Rate
Locked

 

Accounting
Treatment

 

Anticipated debt offering

 

6 forward starting swaps (30-year)

 

$

250

 

6/17/2013

 

4.24

%

Cash flow hedge

 

Anticipated debt offering

 

5 forward starting swaps (30-year)

 

$

125

 

6/16/2014

 

3.39

%

Cash flow hedge

 

Anticipated debt offering

 

10 forward starting swaps (30-year)

 

$

250

 

6/15/2015

 

3.60

%

Cash flow hedge

 

 

During June 2011 and August 2011, PNG entered into three interest rate swaps to fix the interest rate on a portion of PNG’s outstanding debt.  The swaps have an aggregate notional amount of $100 million with an average fixed rate of 0.95%.  Two of these swaps terminate in June 2014 and the remaining swap terminates in August 2014.  These swaps are designated as cash flow hedges.

 

Concurrent with our March 2012 senior note issuances, we terminated four ten-year forward starting interest rate swaps.  These swaps had an aggregate notional amount of $200 million and an average fixed rate of 3.46%.  We made a cash payment of approximately $24 million in connection with the termination of the swaps.

 

Concurrent with our January 2011 senior notes issuance, we terminated three forward starting interest rate swaps.  These swaps had an aggregate notional amount of $100 million and an average fixed rate of 3.6%.  We received cash proceeds of approximately $12 million in connection with the termination of these swaps.

 

During July 2009, concurrent with our senior notes issuance, we entered into four interest rate swaps for which we received fixed interest payments and paid floating-rate interest payments based on three-month LIBOR plus an average spread of 2.42% on a semi-annual basis.  The swaps had an aggregate notional amount of $300 million with fixed rates of 4.25%.  Two of the swaps terminated in September 2011, and the remaining two swaps terminated in September 2012.

 

Currency Exchange Rate Risk Hedging

 

Because a significant portion of our Canadian business is conducted in CAD and, at times, a portion of our debt is denominated in CAD, we use foreign currency derivatives to minimize the risks of unfavorable changes in exchange rates.  These instruments include foreign currency exchange contracts and forwards.  As of September 30, 2012, AOCI includes net deferred gains of approximately $9 million that relate to foreign currency derivatives that were designated for hedge accounting

 

As of September 30, 2012, our outstanding foreign currency derivatives include derivatives we use to (i) hedge CAD-denominated interest payments on CAD-denominated intercompany notes, (ii) hedge currency exchange risk associated with USD-denominated commodity purchases and sales in Canada and (iii) hedge currency exchange risk created by the use of USD-denominated commodity derivatives to hedge commodity price risk associated with CAD-denominated commodity purchases and sales.

 

The following table summarizes our open forward exchange contracts as of September 30, 2012 (in millions):

 

 

 

 

 

USD

 

CAD

 

Average Exchange Rate
USD to CAD

 

Forward exchange contracts that exchange CAD for USD:

 

 

 

 

 

 

 

 

 

 

 

2012

 

$

94

 

$

92

 

$1.02 to $1.00

 

 

 

2013

 

9

 

9

 

$1.00 to $1.00

 

 

 

 

 

$

103

 

$

101

 

$1.01 to $1.00

 

 

 

 

 

 

 

 

 

 

 

Forward exchange contracts that exchange USD for CAD:

 

 

 

 

 

 

 

 

 

 

 

2012

 

$

123

 

$

124

 

$0.99 to $1.00

 

 

 

2013

 

149

 

150

 

$0.99 to $1.00

 

 

 

 

 

$

272

 

$

274

 

$0.99 to $1.00

 

 

 

 

 

 

 

 

 

 

 

Net position by currency:

 

 

 

 

 

 

 

 

 

 

 

2012

 

$

29

 

$

32

 

 

 

 

 

2013

 

140

 

141

 

 

 

 

 

 

 

$

169

 

$

173

 

 

 

 

Summary of Financial Impact

 

For derivatives that qualify as cash flow hedges, changes in fair value of the effective portion of the hedges are deferred in AOCI and recognized in earnings in the periods during which the underlying physical transactions impact earnings.  For our interest rate swaps that qualify as fair value hedges, changes in the fair value of the derivative and changes in the fair value of the underlying hedged item, attributable to the hedged risk, are recognized in earnings each period. Derivatives that do not qualify for hedge accounting and the portion of cash flow hedges that are not highly effective in offsetting changes in cash flows of the hedged items are recognized in earnings each period.  Cash settlements associated with our derivative activities are reflected as cash flows from operating activities in our condensed consolidated statements of cash flows.

 

A summary of the impact of our derivative activities recognized in earnings for the three and nine months ended September 30, 2012 and 2011 is as follows (in millions):

 

 

 

Three Months Ended September 30, 2012

 

Three Months Ended September 30, 2011

 

 

 

 

 

Derivatives

 

 

 

 

 

Derivatives

 

 

 

 

 

Derivatives in

 

Not

 

 

 

Derivatives in

 

Not

 

 

 

 

 

Hedging

 

Designated

 

 

 

Hedging

 

Designated

 

 

 

Location of gain/(loss)

 

Relationships (1)

 

as a Hedge (4)

 

Total

 

Relationships (1)(2)

 

as a Hedge (4)

 

Total

 

Commodity Derivatives

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Supply and Logistics segment revenues

 

$

123

 

$

(102

)

$

21

 

$

(1

)

$

50

 

$

49

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Facilities segment revenues

 

—

 

—

 

—

 

3

 

—

 

3

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Field operating costs

 

—

 

4

 

4

 

—

 

(1

)

(1

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest Rate Derivatives

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest expense

 

(1

)

—

 

(1

)

—

 

—

 

—

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign Currency Derivatives

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Supply and Logistics segment revenues

 

—

 

4

 

4

 

—

 

(6

)

(6

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other income/(expense), net

 

1

 

—

 

1

 

3

 

—

 

3

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Gain/(Loss) on Derivatives Recognized in Net Income

 

$

123

 

$

(94

)

$

29

 

$

5

 

$

43

 

$

48

 

 

 

 

Nine Months Ended September 30, 2012

 

Nine Months Ended September 30, 2011

 

 

 

 

 

Derivatives

 

 

 

 

 

Derivatives

 

 

 

 

 

Derivatives in

 

Not

 

 

 

Derivatives in

 

Not

 

 

 

 

 

Hedging

 

Designated

 

 

 

Hedging

 

Designated

 

 

 

Location of gain/(loss)

 

Relationships (1)(2)(3)

 

as a Hedge (4)

 

Total

 

Relationships (1)(3)

 

as a Hedge (4)

 

Total

 

Commodity Derivatives

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Supply and Logistics segment revenues

 

$

62

 

$

59

 

$

121

 

$

(237

)

$

90

 

$

(147

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Facilities segment revenues

 

13

 

—

 

13

 

(3

)

1

 

(2

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Purchases and related costs

 

41

 

—

 

41

 

—

 

(1

)

(1

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Field operating costs

 

—

 

2

 

2

 

—

 

—

 

—

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest Rate Derivatives

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest expense

 

(2

)

—

 

(2

)

1

 

—

 

1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign Currency Derivatives

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Supply and Logistics segment revenues

 

—

 

4

 

4

 

—

 

(3

)

(3

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other income/(expense), net

 

4

 

—

 

4

 

5

 

—

 

5

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Gain/(Loss) on Derivatives Recognized in Net Income

 

$

118

 

$

65

 

$

183

 

$

(234

)

$

87

 

$

(147

)

 

(1)

 

Amounts represent derivative gains and losses that were reclassified from AOCI to earnings during the period to coincide with the earnings impact of the hedged transaction.

(2)

 

Amounts include losses of approximately $2 million and gains of approximately $8 million for the nine months ended September 30, 2012 and the three months ended September 30, 2011, respectively. These amounts represent the ineffective portion of our commodity and interest rate derivatives that are designated as cash flow hedges.

(3)

 

Interest expense includes net gains of approximately $2 million and $1 million for the nine months ended September 30, 2012 and 2011, respectively, associated with interest rate swaps designated as a fair value hedge. These swaps terminated during September 2012.

(4)

 

Includes realized and unrealized gains or losses for derivatives not designated for hedge accounting during the period.

 

The following table summarizes the derivative assets and liabilities on our condensed consolidated balance sheet on a gross basis as of September 30, 2012 (in millions):

 

 

 

Asset Derivatives

 

Liability Derivatives

 

 

 

Balance Sheet
Location

 

Fair Value

 

Balance Sheet
Location

 

Fair Value

 

Derivatives designated as hedging instruments:

 

 

 

 

 

 

 

 

 

Commodity derivatives

 

Other current assets

 

$

32

 

Other current assets

 

$

(30

)

 

 

Other long-term assets

 

11

 

Other long-term assets

 

(3

)

 

 

 

 

 

 

Other current liabilities

 

(4

)

Interest rate derivatives

 

 

 

 

 

Other current liabilities

 

(84

)

 

 

 

 

 

 

Other long-term liabilities

 

(49

)

Foreign currency derivatives

 

Other current assets

 

3

 

Other current liabilities

 

(1

)

 

 

 

 

 

 

 

 

 

 

Total derivatives designated as hedging instruments

 

 

 

$

46

 

 

 

$

(171

)

 

 

 

 

 

 

 

 

 

 

Derivatives not designated as hedging instruments:

 

 

 

 

 

 

 

 

 

Commodity derivatives

 

Other current assets

 

$

161

 

Other current assets

 

$

(91

)

 

 

Other long-term assets

 

15

 

Other long-term assets

 

(5

)

 

 

 

 

 

 

Other current liabilities

 

(1

)

Foreign currency derivatives

 

Other current assets

 

4

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total derivatives not designated as hedging instruments

 

 

 

$

180

 

 

 

$

(97

)

 

 

 

 

 

 

 

 

 

 

Total derivatives

 

 

 

$

226

 

 

 

$

(268

)

 

The following table summarizes the derivative assets and liabilities on our condensed consolidated balance sheet on a gross basis as of December 31, 2011 (in millions):

 

 

 

Asset Derivatives

 

Liability Derivatives

 

 

 

Balance Sheet

 

 

 

Balance Sheet

 

 

 

 

 

Location

 

Fair Value

 

Location

 

Fair Value

 

Derivatives designated as hedging instruments:

 

 

 

 

 

 

 

 

 

Commodity derivatives

 

Other current assets

 

$

72

 

Other current assets

 

$

(47

)

 

 

Other long-term assets

 

20

 

Other long-term assets

 

(2

)

Interest rate derivatives

 

Other current assets

 

1

 

Other current liabilities

 

(24

)

 

 

 

 

 

 

Other long-term liabilities

 

(114

)

Foreign currency derivatives

 

Other current assets

 

1

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total derivatives designated as hedging instruments

 

 

 

$

94

 

 

 

$

(187

)

 

 

 

 

 

 

 

 

 

 

Derivatives not designated as hedging instruments:

 

 

 

 

 

 

 

 

 

Commodity derivatives

 

Other current assets

 

$

87

 

Other current assets

 

$

(39

)

 

 

Other long-term assets

 

6

 

Other long-term assets

 

(3

)

 

 

 

 

 

 

Other current liabilities

 

(1

)

Total derivatives not designated as hedging instruments

 

 

 

$

93

 

 

 

$

(43

)

 

 

 

 

 

 

 

 

 

 

Total derivatives

 

 

 

$

187

 

 

 

$

(230

)

 

As of September 30, 2012, there was a net loss of approximately $151 million deferred in AOCI including tax effects.  The total amount of deferred net loss recorded in AOCI is expected to be reclassified to future earnings contemporaneously with (i) the earnings recognition of the underlying hedged commodity transaction, (ii) interest expense accruals associated with underlying debt instruments or (iii) the recognition of a foreign currency gain or loss upon the remeasurement of certain CAD-denominated intercompany balances.  Of the total net loss deferred in AOCI at September 30, 2012, we expect to reclassify a net loss of approximately $11 million to earnings in the next twelve months.  Of the remaining deferred loss in AOCI, a net gain of approximately $5 million is expected to be reclassified to earnings prior to 2015 with the remaining deferred loss of $145 million being reclassified to earnings through 2045.  These amounts are predominantly based on market prices at the current period end, thus actual amounts to be reclassified will differ and could vary materially as a result of changes in market conditions.

 

During the three and nine months ended September 30, 2012, all of our hedged transactions were deemed probable of occurring.  During the three and nine months ended September 30, 2011, we reclassified a gain of approximately $1 million from AOCI to facilities segment revenues and a gain of approximately $1 million from AOCI to other expense, net as a result of anticipated hedged transactions that are no longer considered probable of occurring.  The net deferred gain/(loss), including tax effects, recognized in AOCI for derivatives during the three and nine months ended September 30, 2012 and 2011 are as follows (in millions):

 

 

 

For the Three Months Ended

 

For the Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2012

 

2011

 

2012

 

2011

 

Commodity derivatives, net

 

$

88

 

$

(15

)

$

88

 

$

(112

)

Foreign currency derivatives, net

 

—

 

5

 

—

 

4

 

Interest rate derivatives, net

 

9

 

(123

)

(19

)

(117

)

Total

 

$

97

 

$

(133

)

$

69

 

$

(225

)

 

Our accounting policy is to offset derivative assets and liabilities executed with the same counterparty when a master netting agreement exists.  Accordingly, we also offset derivative assets and liabilities with amounts associated with cash margin.  Our exchange-traded derivatives are transacted through brokerage accounts and are subject to margin requirements as established by the respective exchange.  On a daily basis, our account equity (consisting of the sum of our cash balance and the fair value of our open derivatives) is compared to our initial margin requirement resulting in the payment or return of variation margin.  As of September 30, 2012, we had a net broker receivable of approximately $28 million (consisting of initial margin of $82 million reduced by $54 million of variation margin that had been returned to us).  As of December 31, 2011, we had a net broker payable of approximately $7 million (consisting of initial margin of $52 million reduced by $59 million of variation margin that had been returned to us).  At September 30, 2012 and December 31, 2011, none of our outstanding derivatives contained credit-risk related contingent features that would result in a material adverse impact to us upon any change in our credit ratings.

 

Recurring Fair Value Measurements

 

Derivative Financial Assets and Liabilities

 

The following table sets forth by level within the fair value hierarchy our financial assets and liabilities that were accounted for at fair value on a recurring basis as of September 30, 2012 and December 31, 2011.  Financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.  Our assessment of the significance of a particular input to the fair value measurement requires judgment, which affects the placement of assets and liabilities within the fair value hierarchy levels.

 

 

 

Fair Value as of September 30, 2012
(in millions)

 

Fair Value as of December 31, 2011
(in millions)

 

Recurring Fair Value Measures (1)

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Level 1

 

Level 2

 

Level 3

 

Total

 

Commodity derivatives

 

$

30

 

$

45

 

$

10

 

$

85

 

$

80

 

$

1

 

$

12

 

$

93

 

Interest rate derivatives

 

—

 

(133

)

—

 

(133

)

—

 

(137

)

—

 

(137

)

Foreign currency derivatives

 

—

 

6

 

—

 

6

 

—

 

1

 

—

 

1

 

Total

 

$

30

 

$

(82

)

$

10

 

$

(42

)

$

80

 

$

(135

)

$

12

 

$

(43

)

 

(1)              Derivative assets and liabilities are presented above on a net basis but do not include related cash margin deposits.

 

The determination of the fair values above includes not only the credit standing of the counterparties involved and the impact of credit enhancements (such as cash deposits and letters of credit) but also the impact of our nonperformance risk on our liabilities.  The fair value of our commodity derivatives, interest-rate derivatives and foreign currency derivatives includes adjustments for credit risk.  Our credit adjustment methodology uses market observable inputs and requires judgment.  There were no changes to any of our valuation techniques during the period.

 

Level 1

 

Level 1 of the fair value hierarchy includes exchange-traded commodity derivatives such as futures, options and swaps.  The fair value of exchange-traded commodity derivatives is based on unadjusted quoted prices in active markets.

 

Level 2

 

Level 2 of the fair value hierarchy includes exchange-cleared commodity derivatives and over-the-counter commodity, interest rate and foreign currency derivatives that are traded in active markets.  The fair value of these derivatives is based on broker price quotations which are corroborated with market observable inputs.

 

Level 3

 

Level 3 of the fair value hierarchy includes over-the-counter commodity derivatives that are traded in markets that are active but not sufficiently active to warrant level 2 classification in our judgment and certain physical commodity contracts.  The fair value of our level 3 over-the-counter commodity derivatives is based on broker price quotations.  The fair value of our level 3 physical commodity contracts is based on a valuation model utilizing broker-quoted forward commodity prices, and timing estimates, which involve management judgment. The significant unobservable inputs used in the fair value measurement of our level 3 derivatives are forward prices obtained from brokers.  A significant increase (decrease) in these forward prices would result in a proportionately lower (higher) fair value measurement.

 

Rollforward of Level 3 Net Assets

 

The following table provides a reconciliation of changes in fair value of the beginning and ending balances for our derivatives classified as level 3 (in millions):

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

 

2012

 

2011

 

2012

 

2011

 

Beginning Balance

 

$

36

 

$

10

 

$

12

 

$

(14

)

Unrealized gains/(losses):

 

 

 

 

 

 

 

 

 

Included in earnings (1)

 

(9

)

17

 

(1

)

30

 

Included in other comprehensive income

 

—

 

3

 

3

 

2

 

Settlements

 

(4

)

(2

)

(18

)

31

 

Derivatives entered into during the period

 

1

 

8

 

23

 

4

 

Transfers out of level 3

 

(14

)

—

 

(9

)

(17

)

Ending Balance

 

$

10

 

$

36

 

$

10

 

$

36

 

 

 

 

 

 

 

 

 

 

 

Change in unrealized gains/(losses) included in earnings relating to level 3 derivatives still held at the end of the periods

 

$

(8

)

$

26

 

$

25

 

$

35

 

 

(1)     We reported unrealized gains and losses associated with level 3 commodity derivatives in our condensed consolidated statements of operations as Supply and Logistics segment revenues.

 

During the third quarter of 2012, we transferred commodity derivatives with an aggregate fair value of $14 million from level 3 to level 2.  These derivatives consist of over the counter derivatives that were previously valued using forward prices obtained from a broker and are now being valued using unadjusted quoted prices in active markets.  Our policy is to recognize transfers between levels as of the beginning of the reporting period in which the transfer occurred.

 

During the second quarter of 2012, we transferred commodity derivatives with an aggregate fair value of a $5 million loss from level 3 to level 2.  These derivatives consist of NGL derivatives that are cleared through the CME Clearport platform.  This transfer resulted from additional analysis regarding the CME’s pricing methodology.

 

During the first quarter of 2011, we transferred interest rate and commodity derivatives with an aggregate fair value of $17 million from level 3 to level 2. This transfer resulted from the implementation of additional valuation procedures, using market observable inputs, to validate the broker or dealer price quotations used for fair value measurement.

 

We believe that a proper analysis of our level 3 gains or losses must incorporate the understanding that these items are generally used to hedge our commodity price risk, interest rate risk and foreign currency exchange risk and will therefore be offset by gains or losses on the underlying transactions.