These derivative assets and liabilities appear as prepaid expenses and other current assets, other assets, other accruals, or other liabilities and deferred credits on the balance sheet.
In June 2005, we acquired two limited-term, fixed-volume overriding royalty interests in Utah and the San Juan Basin related to our natural gas production. As part of the acquisition, we assumed related commodity swaps with a negative fair value of $261 million at June 30, 2005. In late June and early July of 2005, we entered into additional commodity swaps to essentially offset any remaining exposure from the assumed swaps. At December 31, 2006 and 2005, the commodity swaps assumed in the acquisition had a negative fair value of $76 million and $316 million, respectively, and the commodity swaps entered into to offset the resulting exposure had a negative fair value of $6 million and a positive fair value of $109 million, respectively.
The accounting for changes in fair value (i.e., gains or losses) of a derivative instrument depends on whether it meets the qualifications for, and has been designated as, a SFAS No. 133 hedge, and the type of hedge. At this time, we are not using SFAS No. 133 hedge accounting for commodity derivative contracts and foreign currency derivatives, but we are using hedge accounting for the interest-rate derivatives noted below. All gains and losses, realized or unrealized, from derivative contracts not designated as SFAS No. 133 hedges have been recognized in the income statement. Gains and losses from derivative contracts held for trading not directly related to our physical business, whether realized or unrealized, have been reported net in other income.
SFAS No. 133 also requires purchase and sales contracts for commodities that are readily convertible to cash (e.g., crude oil, natural gas, and gasoline) to be recorded on the balance sheet as derivatives unless the contracts are for quantities we expect to use or sell over a reasonable period in the normal course of business (the normal purchases and normal sales exception), among other requirements, and we have documented our intent to apply this exception. Except for contracts to buy or sell natural gas, we generally apply this exception to eligible purchase and sales contracts; however, we may elect not to apply this exception (e.g., when another derivative instrument will be used to mitigate the risk of the purchase or sale contract but hedge accounting will not be applied). When this occurs, both the purchase or sales contract and the derivative contract mitigating the resulting risk will be recorded on the balance sheet at fair value in accordance with the preceding paragraphs. Most of our contracts to buy or sell natural gas are recorded on the balance sheet as derivatives, except for certain long-term contracts to sell our natural gas production, which either have been designated normal purchase/normal sales or do not meet the SFAS No. 133 definition of a derivative.
Interest Rate Derivative Contracts — At the beginning of 2004, we held interest rate swaps that converted $1.5 billion of debt from fixed to floating rates, but during 2005 we terminated the majority of these interest rate swaps as we redeemed the associated debt. This reduced the amount of debt being converted from fixed to floating by the end of 2005 to $350 million. These remaining swaps, which we continue to hold, have qualified for and been designated as fair-value hedges using the short-cut method of hedge accounting provided by SFAS No. 133, which permits the assumption that changes in the value of the derivative perfectly offset changes in the value of the debt; therefore, no gain or loss has been recognized due to hedge ineffectiveness.
Currency Exchange Rate Derivative Contracts — We have foreign currency exchange rate risk resulting from international operations. We do not comprehensively hedge the exposure to currency rate changes, although we may choose to selectively hedge exposures to foreign currency rate risk. Examples include firm commitments for capital projects, certain local currency tax payments and dividends, short-term intercompany loans between subsidiaries operating in different countries, and cash returns from net investments in foreign affiliates to be remitted within the coming year. Hedge accounting is not being used for any of our foreign currency derivatives.
Commodity Derivative Contracts — We operate in the worldwide crude oil, refined product, natural gas, natural gas liquids, and electric power markets and are exposed to fluctuations in the prices for these commodities. These fluctuations can affect our revenues as well as the cost of operating, investing, and financing activities. Generally, our policy is to remain exposed to the market prices of commodities; however, executive management may elect to use derivative instruments to hedge the price risk of our crude oil and natural gas production, as well as refinery margins.
Our Commercial organization uses futures, forwards, swaps, and options in various markets to optimize the value of our supply chain, which may move our risk profile away from market average prices to accomplish the following objectives:
- Balance physical systems. In addition to cash settlement prior to contract expiration, exchange traded futures contracts may also be settled by physical delivery of the commodity, providing another source of supply to meet our refinery requirements or marketing demand.
- Meet customer needs. Consistent with our policy to generally remain exposed to market prices, we use swap contracts to convert fixed-price sales contracts, which are often requested by natural gas and refined product consumers, to a floating market price.
- Manage the risk to our cash flows from price exposures on specific crude oil, natural gas, refined product and electric power transactions.
- Enable us to use the market knowledge gained from these activities to do a limited amount of trading not directly related to our physical business. For the years ended December 31, 2006, 2005 and 2004, the gains or losses from this activity were not material to our cash flows or net income.
We do not use hedge accounting for any commodity derivative contracts.
Credit Risk
Our financial instruments that are potentially exposed to concentrations of credit risk consist primarily of cash equivalents, over-the-counter derivative contracts, and trade receivables. Our cash equivalents are placed in high-quality commercial paper, money market funds and time deposits with major international banks and financial institutions. The credit risk from our over-the-counter derivative contracts, such as forwards and swaps, derives from the counterparty to the transaction, typically a major bank or financial institution. We closely monitor these credit exposures against predetermined credit limits, including the continual exposure adjustments that result from market movements. Individual counterparty exposure is managed within these limits, and includes the use of cash-call margins when appropriate, thereby reducing the risk of significant non-performance. We also use futures contracts, but futures have a negligible credit risk because they are traded on the New York Mercantile Exchange or the ICE Futures.
Our trade receivables result primarily from our petroleum operations and reflect a broad national and international customer base, which limits our exposure to concentrations of credit risk. The majority of these receivables have payment terms of 30 days or less, and we continually monitor this exposure and the creditworthiness of the counterparties. We do not generally require collateral to limit the exposure to loss; however, we will sometimes use letters of credit, prepayments, and master netting arrangements to mitigate credit risk with counterparties that both buy from and sell to us, as these agreements permit the amounts owed by us or owed to others to be offset against amounts due us.
Fair Values of Financial Instruments
We used the following methods and assumptions to estimate the fair value of financial instruments:
- Cash and cash equivalents: The carrying amount reported on the balance sheet approximates fair value.
- Accounts and notes receivable: The carrying amount reported on the balance sheet approximates fair value.
- Investments in LUKOIL shares: See Note 10 — Investments, Loans and Long-Term Receivables, for a discussion of the carrying value and fair value of our investment in LUKOIL shares.
- Debt: The carrying amount of our floating-rate debt approximates fair value. The fair value of the fixed-rate debt is estimated based on quoted market prices.
- Swaps: Fair value is estimated based on forward market prices and approximates the net gains and losses that would have been realized if the contracts had been closed out at year-end. When forward market prices are not available, they are estimated using the forward prices of a similar commodity with adjustments for differences in quality or location.
- Futures: Fair values are based on quoted market prices obtained from the New York Mercantile Exchange, the ICE Futures, or other traded exchanges.
- Forward-exchange contracts: Fair value is estimated by comparing the contract rate to the forward rate in effect on December 31 and approximates the net gains and losses that would have been realized if the contracts had been closed out at year-end.
Certain of our commodity derivative and financial instruments at December 31 were:
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