Periodically, we enter into derivative arrangements relating to a portion of our oil and gas
production to achieve a more predictable cash flow, as well as to reduce our exposure to adverse price
fluctuations. A variety of derivative instruments may be utilized such as swaps, collars, puts, calls and
various combinations of these. The type of instrument we select is a function of market conditions,
available derivative prices and our operating strategy. While the use of these types of instruments
limits our downside risk to adverse price movements, we are subject to a number of risks, including
instances in which the benefit to revenues and cash flows is limited when commodity prices increase.
These contracts also expose us to credit risk of nonperformance by the counterparties.
The derivative instruments we have in place are not classified as hedges for accounting purposes.
These derivative contracts are reflected at fair value on our balance sheet and are marked-to-market
each quarter with fair value gains and losses, both realized and unrealized, recognized currently as a
gain or loss on mark-to-market derivative contracts on the income statement. Consequently, we expect
continued volatility in our reported earnings as changes occur in the NYMEX and ICE indices. Cash
flow is only impacted to the extent the actual settlements under the contracts result in making or
receiving a payment from the counterparty.
The estimation of fair values of derivative instruments requires substantial judgment. The fair value
amounts of our put and collar derivative instruments are estimated using an option-pricing model,
which uses various inputs including NYMEX and ICE price quotations, volatilities, interest rates and
contract terms. The fair value of our swap derivative instruments are estimated using a pricing model
which has various inputs including NYMEX price quotations, interest rates and contract terms. We
adjust the valuations from the model for credit quality, using the counterparties’ credit quality for asset
balances and our credit quality for liability balances. For asset balances, we use the credit default swap
value for counterparties when available or the spread between the risk-free interest rate and the yield
on the counterparties’ publicly traded debt for similar maturities. We consider the impact of netting
agreements on counterparty credit risk, including whether the position with the counterparty is a net
asset or net liability. We determine whether the market for our derivative instruments is active or
inactive based on transaction volume for such instruments. We value the instruments using similar
instruments and by extrapolating and/or interpolating data between data points for the thinly traded
instruments. These pricing and discounting variables are sensitive to market volatility as well as
changes in future price forecasts and interest rates.
For a further discussion concerning our risks related to oil and gas prices and our derivative
contracts, see Item 7A – Quantitative and Qualitative Disclosures about Market Risk – Commodity
Price Risk.
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