Notes to Consolidated Financial Statements

Note 2 Derivative Financial Instruments

Netting of Cash Collateral and Derivative Assets and Liabilities under Master Netting Arrangements

We maintain accounts with brokers to facilitate financial derivative transactions in support of our energy marketing and risk management activities. Based on the value of our positions in these accounts and the associated margin requirements, we may be required to deposit cash into these broker accounts.

The authoritative guidance related to derivatives and hedging requires that we offset cash collateral held in our broker accounts on our consolidated statements of financial position with the associated fair value of the instruments in the accounts. Our cash collateral amounts were $57 million as of December 31, 2009 and were $124 million as of December 31, 2008.

Derivative Financial Instruments

Our risk management activities are monitored by our Risk Management Committee, which consists of members of senior management and is charged with reviewing and enforcing our risk management activities and policies. Our use of derivative financial instruments and physical transactions is limited to predefined risk tolerances associated with pre-existing or anticipated physical natural gas sales and purchases and system use and storage. We use the following types of derivative financial instruments and physical transactions to manage natural gas price, interest rate, weather, automobile fuel price 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

Our derivative financial instruments do not contain any material credit-risk-related or other contingent features that could increase the payments for collateral we post in the normal course of business when our financial instruments are in net liability positions. For information on our energy marketing receivables and payables, which do have credit-risk-related or other contingent features, refer to Note 1. Our derivative financial instrument activities are included within operating cash flows as an adjustment to net income of $11 million in 2009, $(129) million in 2008 and $74 million in 2007.

Natural Gas Derivative Financial Instruments

The fair value of natural gas derivative financial instruments we use to manage exposures arising from changing natural gas prices 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 derivative financial instruments we use.

Distribution Operations In accordance with a directive from the New Jersey BPU, Elizabethtown Gas enters into derivative financial instruments to hedge the impact of market fluctuations in natural gas prices. Pursuant to the authoritative guidance related to derivatives and hedging, such derivative transactions are accounted for at fair value each reporting period in our consolidated statements of financial position. In accordance with regulatory requirements realized gains and losses related to these derivatives are reflected in natural gas costs and ultimately included in billings to customers. However, these derivative financial instruments are not designated as hedges in accordance with the guidance. As of December 31, 2009, Elizabethtown Gas had entered into OTC swap contracts to purchase approximately 18 Bcf of natural gas. Approximately 63% of these contracts have durations of one year or less, and none of these contracts extends beyond December 2011. The fair values of these derivative instruments were reflected as a current and longterm asset and liability of $11 million at December 31, 2009 and $23 million at December 31, 2008. For more information on our regulatory assets and liabilities see Note 1.

Retail Energy Operations We have designated a portion of SouthStar’s derivative financial instruments, consisting of financial swaps to manage the risk associated with forecasted natural gas purchases and sales, as cash flow hedges under the authoritative guidance related to derivatives and hedging. 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.

SouthStar currently has minimal hedge ineffectiveness defined as when the gains or losses on the hedging instrument do not offset the losses or gains on the hedged item. This cash flow hedge ineffectiveness is recorded in cost of gas in our consolidated statements of income in the period in which it occurs. We have not designated the remainder of SouthStar’s derivative financial instruments as hedges under the authoritative guidance related to derivatives and hedging and, accordingly, we record changes in their fair value within cost of gas in our consolidated statements of income in the period of change. For more information on SouthStar’s gains and losses reported within comprehensive income that affect equity, see our consolidated statements of comprehensive income (loss). SouthStar has hedged its exposures to natural gas price risk to varying degrees in the markets in which it serves retail, commercial and industrial customers. Approximately 97% of SouthStar’s purchase instruments and 98% of its sales instruments are scheduled to mature in 2010 and the remaining 3% and 2%, respectively, from January 2011 through March 2012.

At December 31, 2009, the fair values of these derivatives were reflected in our consolidated financial statements as a current asset of $21 million with no current liability representing a net position of 15 Bcf. This includes a $2 million current asset associated with a premium and related intrinsic value for weather derivatives. At December 31, 2008, the fair values of these derivatives were reflected in our consolidated financial statements as a current asset of $11 million, a long-term asset of $5 million and a current liability of $2 million representing a net position of 28 Bcf. This includes a $4 million current asset associated with a premium and related intrinsic value for weather derivatives and associated intrinsic value.

SouthStar also enters into both exchange and OTC derivative financial instruments to hedge natural gas price risk. Credit risk is mitigated for exchange transactions through the backing of the NYMEX member firms. For OTC transactions, SouthStar utilizes master netting arrangements to reduce overall credit risk. As of December 31, 2009, SouthStar’s maximum exposure to any single OTC counterparty was $7 million.

Wholesale Services 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 OTC 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 the authoritative guidance related to derivatives and hedging and are accounted for at fair value in our consolidated statements of financial position, with changes in fair value recorded in our consolidated statements of income in the period of change. However, these futures contracts are not designated as hedges in accordance with the guidance.

The impact of changes in fair value of Sequent’s derivative instruments utilized in its energy marketing and risk management activities, contract settlements and new business contracts acquired in 2009 increased the net fair value of its contracts outstanding by $36 million during 2009, $25 million during 2008 and reduced net fair value by $62 million during 2007.

At December 31, 2009, Sequent’s commodity-related derivative financial instruments represented purchases (long) of 1,571 Bcf and sales (short) of 1,494 Bcf with approximately 95% of purchase instruments sales instruments are scheduled to mature in less than 2 years and the remaining 5%in 3 to 6 years. At December 31, 2009, the fair values of these derivatives were reflected in our consolidated financial statements as an asset of $208 million and a liability of $51million. At December 31, 2008, the fair values of these derivatives were reflected in our consolidated financial statements as an asset of $206 million and a liability of $27 million.

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 fair value basis we utilize for the derivatives used to mitigate the natural gas 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.

Energy Investments
Golden Triangle Storage uses derivative financial instruments to reduce its exposure during the construction of the storage caverns to the risk of changes in the price of natural gas that will be purchased in future periods for pad gas. Pad gas includes volumes of non-working natural gas used to maintain the operational integrity of the caverns.

We have designated all of Golden Triangle Storage’s derivative financial instruments, consisting of financial swaps as cash flow hedges under the authoritative guidance related to derivatives and hedging. The pad gas is considered to be a component of the storage cavern’s construction costs; as a result, any derivative gains or losses arising from the cash flow hedges will remain in OCI until the pad gas is sold, which will not occur until the storage caverns are decommissioned. The fair value of these derivative financial instruments currently have minimal hedge ineffectiveness which is recorded in cost of gas in our consolidated statements of income in the period in which it occurs. Golden Triangle Storage began entering into these derivative financial transactions during 2009.

Weather Derivative Financial Instruments

In 2009 and 2008, SouthStar entered into weather derivative contracts as economic hedges of operating margins in the event of warmer-than-normal and colder-than-normal weather in the heating season, primarily from November through March. SouthStar accounts for these contracts using the intrinsic value method under the authoritative guidance related to financial instruments. These weather derivative financial instruments are not designated as derivatives or hedges and SouthStar has recorded a current asset of $2 million at December 31, 2009 and $4 million at December 31, 2008. SouthStar recognized losses on its weather derivative financial instruments of $6 million for the year ended December 31, 2009, $8 million for the year ended December 31, 2008 and gains of $4 million for the year ended December 31, 2007 which was reflected in cost of gas on our consolidated statements of income.

Derivative Financial Instruments – Fair Value Hierarchy

The following table sets forth, by level within the fair value hierarchy, our derivative financial assets and liabilities that were accounted for at fair value on a recurring basis as of December 31, 2009. As required by the authoritative guidance, derivative financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. Our assessment of the significance of a particular input to the fair value measurement requires judgment, and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels. For more information on a description of the fair value hierarchy, see Note 1.

 
Recurring fair values Natural gas derivative financial instruments 
 
December 31, 2009
December 31, 2008
In millions
Assets (1)
Liabilities
Assets (1)
Liabilities
Quoted prices in active markets (Level 1)
$ 36
$(37)
$ 52
$(117)
Significant other observable inputs (Level 2)
172
(52)
154
(28)
Netting of cash collateral
30
27
35
89
Total carrying value(2)
$238
$(62)
$241
$ (56)

(1) $2 million premium at December 31, 2009 and $4 million at December 31, 2008 associated with weather derivatives have been excluded as they are based on intrinsic value, not fair value.
(2) There were no significant unobservable inputs (level 3) for any of the periods presented.


The determination of the fair values above incorporates various factors required under the guidance. These factors include not only the credit standing of the counterparties involved and the impact of credit enhancements (such as cash deposits, letters of credit and priority interests), but also the impact of our nonperformance risk on our liabilities.

Quantitative Disclosures Related to Derivative Financial Instruments

As of December 31, 2009, our derivative financial instruments were comprised of both long and short natural gas positions. A long position is a contract to purchase natural gas, and a short position is a contract to sell natural gas. As of December 31, 2009, we had net long natural gas contracts outstanding in the following quantities:

 
Natural gas contracts
Hedge designation
(in Bcf)
Cash flow
5
Not designated
108
Total
113



Derivative Financial Instruments on the Consolidated Statements of Income

The following table presents the gain or (loss) on derivative financial instruments in our consolidated statements of income.

In millions
For the twelve months ended December 31, 2009
Designated as cash flow hedges under authoritative guidance related to derivatives and hedging
Natural gas contracts – loss reclassified from OCI into cost of gas for settlement of hedged item
$(31)
Not designated as hedges under authoritative guidance related to derivatives and hedging
Natural gas contracts – fair value adjustments recorded in operating revenues(1)
21
Natural gas contracts – net gain fair value adjustments recorded in cost of gas(2)
1
Total losses on derivative instruments
$ (9)
(1) Associated with the fair value of existing derivative instruments at December 31, 2009.
(2) Excludes $6 million of losses recorded in cost of gas associated with weather derivatives for the year ended December 31, 2009.


The following amounts (pre-tax) represent the expected recognition in our consolidated statements of income of the deferred losses recorded in OCI associated with retail energy operations’ derivative instruments, based upon the fair values of these financial instruments:

In millions As of December 31, 2009
Designated as hedges under authoritative guidance related to derivatives and hedging  
Natural gas contracts – expected net loss reclassified from OCI into cost of gas for settlement of
hedged item over next twelve months
$(8)


Derivative Financial Instruments on the Consolidated Statements of Financial Position


In accordance with regulatory requirements, $38 million of realized losses on derivative financial instruments used at Elizabethtown Gas in our distribution operations segment are reflected in deferred natural gas costs within our consolidated statements of financial position for the year ended December 31, 2009. The following table presents the fair value and statements of financial position classification of our derivative financial instruments.

In millions Statement of financial position location (1) As of December 31, 2009 (2)
Designated as cash flow hedges under authoritative guidance related to derivatives and hedging
Asset Financial Instruments    
Current natural gas contracts
Derivative financial instruments assets and liabilities – current portion $ 6
Liability Financial Instruments    
Current natural gas contracts
Derivative financial instruments assets and liabilities – current portion (5)
 
Total
1
Not designated as cash flow hedges under authoritative guidance related to derivatives and hedging
Asset Financial Instruments    
Current natural gas contracts
Derivative financial instruments assets and liabilities – current portion 590
Noncurrent natural gas contracts
Derivative financial instruments assets and liabilities 118
Liability Financial Instruments    
Current natural gas contracts
Derivative financial instruments assets and liabilities – current portion (510)
Noncurrent natural gas contracts
Derivative financial instruments assets and liabilities (78)
 
Total
120
 
Total derivative financial instruments
$121

(1) These amounts are netted within our consolidated statements of financial position. Some of our derivative financial instruments have asset positions which are presented as a liability in our consolidated statements of financial position, and we have derivative instruments that have liability positions which are presented as an asset in our consolidated statements of financial position.
(2) As required by the authoritative guidance related to derivatives and hedging, the fair value amounts above are presented on a gross basis. As a result, the amounts above do not include $57 million of cash collateral held on deposit in broker margin accounts as of December 31, 2009. Accordingly, the amounts above will differ from the amounts presented on our consolidated statements of financial position, and the fair value information presented for our derivative financial instruments in the recurring values table of this note.


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 nine 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 no less than 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 andMoody’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, 2009, Sequent’s top 20 counterparties represented approximately 58% of the total credit exposure of $534 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, 2009.

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 investmentgrade 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.