Derivative Financial Instruments

12 Months Ended

Dec. 31, 2011

Derivative Financial Instruments

Derivative Financial Instruments

6. Derivative Financial Instruments

• Commodity Contracts

        NGL and natural gas prices are volatile and are impacted by changes in fundamental supply and demand, as well as market uncertainty, availability of NGL transportation and fractionation capacity and a variety of additional factors that are beyond the Partnership's control. The Partnership's profitability is directly affected by prevailing commodity prices primarily as a result of processing or conditioning at its or third-party processing plants, purchasing and selling or gathering and transporting volumes of natural gas at index-related prices and the cost of third-party transportation and fractionation services. To the extent that commodity prices influence the level of drilling activity, such prices also affect profitability. To protect itself financially against adverse price movements and to maintain more stable and predictable cash flows so the Partnership can meet its cash distribution objectives, debt service requirements and fund its capital expenditures, the Partnership executes a strategy governed by the risk management policy approved by the Board. The Partnership has a committee comprised of senior management that oversees risk management activities, continually monitors the risk management program and adjusts its strategy as conditions warrant. The Partnership enters into certain derivative contracts to reduce the risks associated with unfavorable changes in the prices of natural gas, NGLs and crude oil. Derivative contracts utilized are swaps, options and fixed price forward contracts traded on the OTC market. The risk management policy does not allow for trading derivative contracts.

        To mitigate its cash flow exposure to fluctuations in the price of NGLs, the Partnership has entered into derivative financial instruments relating to the future price of NGLs and crude oil. Generally the Partnership manages its NGL price risk using crude oil as NGL financial markets lack adequate liquidity and historically there has been a strong relationship between changes in NGL and crude oil prices. The pricing relationship between NGLs and crude oil may vary in certain periods due to various market conditions. In periods where NGL prices and crude oil prices are not consistent with the historical relationship, the Partnership incurs increased risk and additional gains or losses. The Partnership enters into NGL derivative contracts when adequate market liquidity exists.

        To mitigate its cash flow exposure to fluctuations in the price of natural gas, the Partnership primarily utilizes derivative financial instruments relating to the future price of natural gas and takes into account the partial offset of its long and short gas positions resulting from normal operating activities.

        As a result of its derivative positions outstanding on December 31, 2011, the Partnership has mitigated a portion of its expected commodity price risk through the fourth quarter of 2014. The Partnership would be exposed to additional commodity risk in certain situations that include, but are not limited to, when producers under deliver or over deliver product or when processing facilities are operated in different recovery modes. In the event the Partnership has derivative positions in excess of the product delivered or expected to be delivered, the excess derivative positions will be terminated.

        The Partnership enters into derivative contracts primarily with financial institutions that are participating members of the amended and restated credit agreement as collateral is not posted by the Partnership as the participating members have a collateral position in substantially all the wholly-owned assets of the Partnership other than MarkWest Liberty Midstream. All of the Partnership's financial derivative positions are currently with participating bank group members. Management conducts a standard credit review on counterparties and the Partnership has agreements containing collateral requirements. For all participating bank group members, collateral requirements do not exist when a derivative contract favors the Partnership. The Partnership uses standardized agreements that allow for offset of positive and negative exposures (master netting arrangements).

        The Partnership records derivative contracts at fair value in the Consolidated Balance Sheets and has not elected hedge accounting or the normal purchases and normal sales designation which may cause volatility in the Statement of Operations as the Partnership recognizes in current earnings all unrealized gains and losses from the changes in the fair value of its derivatives.

• Embedded Derivative in Debt Contract

        On May 26, 2009, the Partnership completed the private placement of senior notes with contingent written put options as described in Note 16. The written put options were considered embedded derivatives and were not considered clearly and closely related to the indenture governing the notes. When a hybrid contract contains multiple embedded derivatives requiring separate accounting, the embedded derivatives must be aggregated and accounted for as a compound embedded derivative. These senior notes were redeemed in the fourth quarter of 2010 and the put options no longer exist as of December 31, 2010.

• Interest Rate Contracts

        The Partnership borrows funds using a combination of fixed and variable rate debt. The Partnership may utilize interest rate swap contracts to manage the interest rate risk associated with the fair value of its fixed rate borrowings and to effectively convert a portion of the underlying cash flows related to its long-term fixed rate debt securities into variable rate cash flows in order to achieve its desired mix of fixed and variable rate debt. As a result, the Partnership's future cash flows from these agreements will vary with the market rate of interest.

        During the first quarter of 2010, the Partnership terminated all of its outstanding interest rate swap contracts. The financial statement impact is disclosed in the tables below.

• Financial Statement Impact of Derivative Contracts

        See Note 2 for a description of how the Partnership values its derivative financial instruments and how the instruments impact its financial statements. The impact of the Partnership's derivative instruments on its Consolidated Balance Sheets and Statements of Operations are summarized below (in thousands):

	Assets				Liabilities
Derivative contracts not designated as hedging instruments and their balance sheet location	Fair Value at December 31, 2011		Fair Value at December 31, 2010		Fair Value at December 31, 2011			Fair Value at December 31, 2010
Commodity contracts(1)
Fair value of derivative instruments—current	$	8,698	$	4,345	$	(90,551	)	$	(65,489	)
Fair value of derivative instruments—long-term		16,092		417		(65,403	)		(66,290	)
Total	$	24,790	$	4,762	$	(155,954	)	$	(131,779	)

(1)

Includes Embedded Derivatives in Commodity Contracts as discussed below.

	Year ended December 31,
Derivative contracts not designated as hedging instruments and the location of gain or (loss) recognized in income	2011			2010			2009
Revenue: Derivative loss
Realized (loss) gain	$	(48,093	)	$	(33,560	)	$	87,289
Unrealized gain (loss)		19,058			(20,372	)		(207,641	)
Total revenue: derivative loss		(29,035	)		(53,932	)		(120,352	)
Derivative loss related to purchased product costs
Realized loss		(27,711	)		(21,909	)		(53,052	)
Unrealized loss		(25,249	)		(5,804	)		(15,831	)
Total derivative loss related to purchase product costs		(52,960	)		(27,713	)		(68,883	)
Derivative gain related to facility expenses
Unrealized gain		6,480			1,295			373
Derivative gain related to interest expense
Realized gain		—			2,380			2,000
Unrealized (loss) gain		—			(509	)		509
Total derivative gain related to interest expense		—			1,871			2,509
Miscellaneous income, net
Unrealized gain		—			190			336
Total loss	$	(75,515	)	$	(78,289	)	$	(186,017	)

        At December 31, 2011 and 2010, the fair value of the Partnership's commodity derivative contracts is inclusive of premium payments of zero and $4.4 million, net of amortization, respectively. For 2011, 2010 and 2009, the Realized (loss) gain—revenue includes amortization of premium payments of $4.4 million, $3.3 million and $5.7 million, respectively.

        During the first quarter of 2009, the Partnership settled a portion of its derivative positions covering 2009, 2010 and 2011 for $15.2 million of net realized gains. The settlement was completed prior to the contractual settlement to improve liquidity and to mitigate credit risk with certain counterparties, and as such does not represent trading activity. The settlement was recorded as $26.5 million of realized gains in Revenue: Derivative loss and $11.3 million of loss included in Derivative loss related to purchased product costs in the accompanying Consolidated Statements of Operations.

• Volume of Derivative Activity

        As of December 31, 2011, the Partnership had the following outstanding commodity contracts that were executed to manage the cash flow risk associated with future sales of NGLs or future purchases of natural gas.

Derivative contracts not designated as hedging instruments	Position	Notional Quantity (net)
Crude Oil (bbl)	Short		8,244,902
Natural Gas (MMBtu)	Long		16,021,887
NGLs (gal)	Short		86,563,841

• Embedded Derivatives in Commodity Contracts

        The Partnership has a commodity contract with a producer in the Appalachia region that creates a floor on the frac spread for gas purchases of 9,000 Dth/d. The commodity contract is a component of a broader regional arrangement that also includes a keep-whole processing agreement. This contract is accounted for as an embedded derivative and is recorded at fair value. The changes in fair value of this commodity contract are based on the difference between the contractual and index pricing and are recorded in earnings through Derivative loss related to purchased product costs. In February 2011, the Partnership executed agreements with the producer to extend the commodity contract and the related processing agreement from March 31, 2015 to December 31, 2022, with the producer's option to extend the agreement for successive five year terms through December 31, 2032. As of December 31, 2011, the estimated fair value of this contract was a liability of $114.9 million and the recorded value was a liability of $61.4 million. The recorded liability does not include the inception fair value of the commodity contract related to the extended period from April 1, 2015 to December 31, 2022. In accordance with GAAP for non-option embedded derivatives, the fair value of this extended portion of the commodity contract at its inception of February 1, 2011 is deemed to be allocable to the host processing contract and, therefore, not recorded as a derivative liability. See the following table for a reconciliation of the liability recorded for the embedded derivative as of December 31, 2011 (in thousands).

Fair value of commodity contract	$	114,928
Inception value for period from April 1, 2015 to December 31, 2022.		(53,507	)
Derivative liability as of December 31, 2011	$	61,421

        The Partnership has a commodity contract that gives it an option to fix a component of the utilities cost to an index price on electricity at its plant location in the Gulf Coast segment through the fourth quarter of 2014. Changes in the fair value of the derivative component of this contract are recognized as Derivative gain related to facility expenses. As of December 31, 2011 and 2010, the estimated fair value of this contract was an asset of $7.5 million and $1.0 million, respectively.