Notes to Consolidated Financial Statements
Note 2 Financial Instruments and Risk Management
The carrying value of cash and cash equivalents, receivables, accounts payable, other current liabilities, derivative assets, derivative liabilities and accrued interest approximate fair value. The following table shows the carrying amounts and fair values of our long-term debt including any current portions included in our consolidated balance sheets.
The estimated fair values are determined based on interest rates that are currently available for issuance of debt with similar terms and remaining maturities. Considerable judgment is required to develop the fair value estimates; therefore, the values are not necessarily indicative of the amounts that could be realized in a current market exchange. The fair value estimates are based on information available to management as of December 31, 2007.
Our risk management activities are monitored by our Risk Management Committee (RMC). The RMC consists of members of senior management and is charged with reviewing and enforcing our risk management activities. Our risk management policies limit the use of derivative financial instruments and physical transactions within predefined risk tolerances associated with pre-existing or anticipated physical natural gas sales and purchases and system use and torage. We use the following derivative financial instruments and physical transactions to manage commodity price, interest rate, weather and foreign currency risks:
- forward contracts
- futures contracts
- options contracts
- financial swaps
- treasury locks
- weather derivative contracts
- storage and transportation capacity transactions
- foreign currency forward contracts
Interest Rate Swaps
To maintain an effective capital structure, our policy is to borrow funds using a mix of fixed-rate and variable-rate debt. We entered into interest rate swap agreements for the purpose of managing the appropriate mix of risk associated with our fixed-rate and variable-rate debt obligations. We designated these interest rate swaps as fair value hedges in accordance with SFAS 133. We record the gain or loss on fair value hedges in earnings in the period of change, together with the offsetting loss or gain on the hedged item attributable to the interest rate risk being hedged.
As of December 31, 2007, a notional principal amount of $100 million of these interest rate swap agreements effectively converted the interest expense associated with a portion of our senior notes from fixed rates to variable rates based on an interest rate equal to the LIBOR plus a 3.4% spread. The floating rate for our interest rate swap as of December 31, 2007 was 8.8% and was 9.0% as of December 31, 2006. The fair values of our interest rate swaps were reflected as a long-term liability of $2 million at December 31, 2007, and $6 million at December 31, 2006. For more information on our senior notes, see Note 6.
In August 2007, we executed a treasury-lock agreement covering a notional amount totaling $125 million to hedge the interest rate risk associated with our $125 million senior notes offering in December 2007. The 10-year treasury interest rate was locked in at a weighted average rate of 4.5%.
In December 2007, this treasury-lock agreement settled and we paid $5 million with our $125 million senior note issuance. The $5 million is included in our OCI, net of $2 million of income taxes, and will be amortized over the remaining life of the senior notes (through July 2016) as interest expense.
Commodity-related Derivative Instruments
Elizabethtown Gas In accordance with a directive from the New Jersey Commission, Elizabethtown Gas enters into derivative transactions to hedge the impact of market fluctuations in natural gas prices. Pursuant to SFAS 133, such derivative transactions are marked to market each reporting period. In accordance with regulatory requirements, realized gains and losses related to these derivatives are reflected in purchased gas costs and ultimately included in billings to customers. As of December 31, 2007, Elizabethtown Gas had entered into NYMEX futures contracts to purchase approximately 1.2 Bcf of natural gas and over-the-counter swap contracts with 3 counterparties to purchase approximately 8.1 Bcf of natural gas. Approximately 84% of these contracts have durations of one year or less, and none of these contracts extends beyond October 2009. The fair values of these derivative instruments were reflected as a current asset and liability of $4 million at December 31, 2007 and $16 million at December 31, 2006. For more information on our regulatory assets and liabilities see Note 1.
SouthStar Commodity-related derivative financial instruments (futures, options and swaps) are used by SouthStar to manage exposures arising from changing commodity prices. SouthStar's objective for holding these derivatives is to utilize the most effective method to reduce or eliminate the impact of this exposure. We have designated a portion of SouthStar's derivative transactions as cash flow hedges under SFAS 133. We record derivative gains or losses arising from cash flow hedges in OCI and reclassify them into earnings in the same period as the settlement of the underlying hedged item. We record any hedge ineffectiveness, defined as when the gains or losses on the hedging instrument do not offset and are greater than the losses or gains on the hedged item, in cost of gas in our statement of consolidated income in the period in which it occurs. SouthStar currently has minimal hedge ineffectiveness. We have not designated the remainder of SouthStar's derivative instruments as hedges under SFAS 133 and, accordingly, we record changes in their fair value in earnings in the period of change.
At December 31, 2007, the fair values of these derivatives were reflected in our consolidated financial statements as a current asset of $12 million and a current liability of $2 million representing a net position of 0.1 Bcf.
SouthStar also enters into both exchange and over-the-counter derivative transactions to hedge commodity price risk. Credit risk is mitigated for exchange transactions through the backing of the NYMEX member firms. For over-the-counter transactions, SouthStar utilizes master netting arrangements to reduce overall credit risk. As of December 31, 2007, SouthStar's maximum exposure to any single over-the-counter counterparty was $14 million.
Sequent We are exposed to risks associated with changes in the market price of natural gas. Sequent uses derivative financial instruments to reduce our exposure to the risk of changes in the prices of natural gas. The fair value of these derivative financial instruments reflects the estimated amounts that we would receive or pay to terminate or close the contracts at the reporting date, taking into account the current unrealized gains or losses on open contracts. We use external market quotes and indices to value substantially all the financial instruments we use.
We mitigate substantially all the commodity price risk associated with Sequent's natural gas portfolio by locking in the economic margin at the time we enter into natural gas purchase transactions for our stored natural gas. We purchase natural gas for storage when the difference in the current market price we pay to buy and transport natural gas plus the cost to store the natural gas is less than the market price we can receive in the future, resulting in a positive net operating margin. We use NYMEX futures contracts and other over-the-counter derivatives to sell natural gas at that future price to substantially lock in the operating margin we will ultimately realize when the stored natural gas is actually sold. These futures contracts meet the definition of derivatives under SFAS 133 and are recorded at fair value and marked to market in our consolidated balance sheets, with changes in fair value recorded in earnings in the period of change. The purchase, transportation, storage and sale of natural gas are accounted for on a weighted average cost or accrual basis, as appropriate rather than on the mark-to-market basis we utilize for the derivatives used to mitigate the commodity price risk associated with our storage portfolio. This difference in accounting can result in volatility in our reported earnings, even though the economic margin is essentially unchanged from the date the transactions were consummated.
At December 31, 2007, Sequent's commodity-related derivative financial instruments represented purchases (long) of 605 Bcf and sales (short) of 576 Bcf with approximately 91% of purchase instruments and 93% of the sales instruments are scheduled to mature in less than 2 years and the remaining 9% and 7%, respectively, in 3 to 9 years. At December 31, 2007, the fair values of these derivatives were reflected in our consolidated financial statements as an asset of $70 million and a liability of $13 million. Sequent recorded net unrealized losses related to changes in the fair value of derivative instruments utilized in its energy marketing and risk management activities and contract settlement of $62 million during 2007, $132 million of unrealized gains during 2006 and $30 million of unrealized losses during 2005.
In 2007 and 2006, SouthStar entered into weather derivative contracts as economic hedges of operating margins in the event of warmer-than-normal weather in the heating season, primarily from November through March. SouthStar accounts for these contracts using the intrinsic value method under the guidelines of EITF 99-02. SouthStar recorded current assets for this hedging activity of $5 million at December 31, 2007 and $7 million at December 31, 2006.
Concentration of Credit Risk
Atlanta Gas Light Concentration of credit risk occurs at Atlanta Gas Light for amounts billed for services and other costs to its customers, which consist of 12 Marketers in Georgia. The credit risk exposure to Marketers varies seasonally, with the lowest exposure in the nonpeak summer months and the highest exposure in the peak winter months. Marketers are responsible for the retail sale of natural gas to end-use customers in Georgia. These retail functions include customer service, billing, collections, and the purchase and sale of natural gas. Atlanta Gas Light's tariff allows it to obtain security support in an amount equal to a minimum of two times a Marketer's highest month's estimated bill from Atlanta Gas Light.
Wholesale Services Sequent has a concentration of credit risk for services it provides to marketers and to utility and industrial counterparties. This credit risk is measured by 30-day receivable exposure plus forward exposure, which is generally concentrated in 20 of its counterparties. Sequent evaluates the credit risk of its counterparties using a S&P equivalent credit rating, which is determined by a process of converting the lower of the S&P or Moody's rating to an internal rating ranging from 9.00 to 1.00, with 9.00 being equivalent to AAA/Aaa by S&P and Moody's and 1.00 being equivalent to D or Default by S&P and Moody's. For a customer without an external rating, Sequent assigns an internal rating based on Sequent's analysis of the strength of its financial ratios. At December 31, 2007, Sequent's top 20 counterparties represented approximately 53% of the total credit exposure of $366 million, derived by adding together the top 20 counterparties' exposures and dividing by the total of Sequent's counterparties' exposures. Sequent's counterparties or the counterparties' guarantors had a weighted average S&P equivalent rating of A- at December 31, 2007.
The weighted average credit rating is obtained by multiplying each customer's assigned internal rating by its credit exposure and then adding the individual results for all counterparties. That total is divided by the aggregate total exposure. This numeric value is converted to an S&P equivalent.
Sequent has established credit policies to determine and monitor the creditworthiness of counterparties, including requirements for posting of collateral or other credit security, as well as the quality of pledged collateral. Collateral or credit security is most often in the form of cash or letters of credit from an investment-grade financial institution, but may also include cash or U.S. Government Securities held by a trustee. When Sequent is engaged in more than one outstanding derivative transaction with the same counterparty and it also has a legally enforceable netting agreement with that counterparty, the "net" mark-to-market exposure represents the netting of the positive and negative exposures with that counterparty and a reasonable measure of Sequent's credit risk. Sequent also uses other netting agreements with certain counterparties with which it conducts significant transactions.
All activities associated with price risk management activities and derivative instruments are included as a component of cash flows from operating activities in our consolidated statements of cash flows. Our derivatives not designated as hedges under SFAS 133, included within operating cash flows as a source (use) of cash was $62 million in 2007, $(132) million in 2006, and $30 million in 2005.