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Derivative Instruments and Hedging Activities
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Jun. 30, 2011
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| Derivative Instruments and Hedging Activities |
Note 5 — 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 collars 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 counterparty credit risk, or the
risk that a counterparty will be unable to meet its commitments. To reduce the Company’s risk in
this area, counterparties to the Company’s 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.
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 terminate the arrangement or demand the posting of collateral,
which may involve cash, letters of credit or property.
Settlements and Financial Statement Presentation
Settlements of the Company’s oil and gas collar derivative contracts 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 estimated fair value of these collar contracts is
based upon closing exchange prices on NYMEX and the time value of options. See Note 6, “Fair Value
Measurements.”
The Company’s derivative contracts are designated as cash flow hedges, and are recorded at
fair market value with 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 oil and gas sales. Both changes in fair
value and cash settlements of ineffective derivative contracts are recognized as derivative expense
(income) and are included in other (income) expense within the Company’s consolidated statements of operations.
Listed in the table below are the outstanding oil and gas derivative contracts as of June 30, 2011:
The tables below present the effect of the Company’s derivative financial instruments on the
consolidated statements of operations as an increase (decrease) to oil and gas sales: for the effective portion and as an increase (decrease) to other (income) expense for the
ineffective portion and amounts excluded from effectiveness testing
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