Derivative Instruments and Hedging Activities
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Sep. 30, 2012
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Derivative Instruments and Hedging Activities Disclosure [Abstract] | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
Derivative Instruments and Hedging Activities |
Derivative Instruments and Hedging Activities
Objectives and Strategies for Using Derivative Instruments
The Company is exposed to fluctuations in crude oil and natural gas prices on its production. Consequently, the Company believes it is prudent to manage the variability in cash flows on a portion of its crude oil and natural gas production. The Company utilizes primarily collar, options and swap derivative financial instruments to manage fluctuations in cash flows resulting from changes in commodity prices. The Company does not use these instruments for speculative purposes.
Counterparty Risk
The use of derivative transactions exposes the Company to the risk that a counterparty will be unable to meet its commitments. To manage this risk, the Company's established counterparties for commodity derivative instruments include a large, well-known financial institution and a large, well-known oil and gas company. The Company monitors counterparty creditworthiness on an ongoing basis; however, it cannot predict sudden changes in counterparties' creditworthiness. In addition, even if such changes are not sudden, the Company may be limited in its ability to mitigate an increase in counterparty credit risk. Should one of these counterparties not perform, the Company may not realize the benefit of some of its derivative instruments under lower commodity prices. Counterparty credit risk is considered when determining a derivative instruments' fair value; See Note 6 for additional information.
The Company executes commodity derivative transactions under master agreements that have netting provisions that provide for offsetting payables against receivables. In general, if a party to a derivative transaction incurs an event of default, as defined in the applicable agreement, the other party will have the right to demand the posting of collateral, demand a cash payment transfer or terminate the arrangement.
Derivative positions and settlements
In the second quarter of 2012, the Company entered into fixed price natural gas swaps at $3.52 for the period October 2012 through December 2013 for 1,371 MMBtu over the 15-month period. To finance the uplift in the natural gas swap price for the period hedged, the Company sold natural gas put options at $3.00 for 1,095 MMbtu for fiscal year 2013 and sold natural gas call options at $4.75 for 456 MMbtu for fiscal year 2014.
Listed in the table below are the outstanding oil and natural gas derivative contracts as of September 30, 2012:
(1) A collar is a combination of a sold call option (ceiling) and a purchased put option (floor).
(2) The natural gas swap, put and call option were executed contemporaneously. The "above market" swap price the Company received was offset by the value of the two options sold by the Company. The short natural gas put option, when combined with the swap, creates the potential for a reduction in the effective swap price if NYMEX natural gas prices are below $3.00/MMbtu in 2013. The short natural gas call option, when combined with the Company's long production position, represents a "covered call," and creates a $4.75/MMbtu ceiling during the covered period.
Settlements of the Company's derivative instruments are based on the difference between the contract price or prices specified in the derivative instrument and a New York Mercantile Exchange ("NYMEX") price. The fair value of the Company's derivative instruments, depending on the type of instruments, was determined by the use of present value methods or standard option valuation models with assumptions about commodity prices based on those observed in underlying markets. See Note 6 for additional information regarding fair value.
The following table reflects the fair values of the Company's derivative instruments:
Derivatives designated as hedging instruments
Certain of the Company’s crude oil derivative contracts in effect during 2012 are designated as cash flow hedges, and are recorded at fair market value with the effective portion of the changes in fair value recorded net of tax through other comprehensive income (loss) (“OCI”) in stockholders’ equity. The cash settlements on contracts for future production are recorded as an increase or decrease in crude oil revenues. Both changes in fair value and cash settlements of ineffective derivative contracts are recognized as derivative expense (income).
The tables below present the effect of the Company's derivative financial instruments on the consolidated statements of operations as an increase (decrease) to crude oil revenues for the effective portion and as an increase (decrease) to other (income) expense for the ineffective portion and amounts excluded from effectiveness testing:
Derivatives not designated as hedging instruments
As discussed in the Company's Form 10-K for the year ended December 31, 2011, the Company elected not to designate any of its derivative contracts entered into subsequent to December 31, 2011 as an accounting hedge under FASB ASC 815, nor does it expect to designate future derivative contracts. Consequently, any derivative contract not designated as an accounting hedge is carried at its fair value on the balance sheet with both realized and unrealized (mark-to-market) gains or losses on these derivatives recorded on the statement of operations as a component of the Company's other income and expenses.
For the periods indicated, the Company recorded the following related to its derivative instruments that were not designated as accounting hedges:
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