Derivative Financial Instruments

6 Months Ended

Jun. 30, 2011

Derivative Financial Instruments

Derivative Financial Instruments

5. Derivative Financial Instruments

Commodity Derivatives

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 own 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 that the Partnership can meet its cash distribution objectives, debt service and capital expenditures, the Partnership executes a hedging strategy governed by the risk management policy approved by the General Partner’s board of directors (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 and options traded on the OTC market. The risk management policy does not allow for speculative 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 hedges its NGL price risk using crude oil as NGL financial markets are not as liquid 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 current derivative positions, 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 such as if 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 may be terminated.

The Partnership enters into derivative contracts primarily with financial institutions that are participating members of the Credit Facility and 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. 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 Condensed Consolidated Balance Sheets and has not elected hedge accounting or the normal purchases and normal sales designation which may cause volatility in the Condensed Consolidated Statements of Operations as the Partnership recognizes in current earnings all unrealized gains and losses from the mark to market on derivative activity.

As of June 30, 2011, the Partnership had the following outstanding commodity contracts that were entered into to economically hedge future sales of NGLs or future purchases of natural gas.

Derivative contracts not designated as hedging instruments	Notional Quantity (net)
Crude oil (bbl)	6,382,676
Natural gas (MMBtu)	15,635,865
Refined products (gal)	151,776,610

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. As of June 30, 2011, the estimated fair value of this contract was a liability of $104.1 million and the recorded value was $50.6 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 June 30, 2011 (in thousands).

Fair value of commodity contract	$	104,074
Inception value for period from April 1, 2015 to December 31, 2022	(53,507		)
Derivative liability as of June 30, 2011	$	50,567

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 one of its plant locations through the fourth quarter of 2014. The value of the derivative component of this contract is marked to market through Derivative gain related to facility expenses. As of June 30, 2011, the estimated fair value of this contract was an asset of $1.1 million.

Financial Statement Impact of Derivative Instruments

There were no material changes to the Partnership’s policy regarding the accounting for these instruments as previously disclosed in the Partnership’s Annual Report on Form 10-K for the year ended December 31, 2010. The impact of the Partnership’s derivative instruments on its Condensed Consolidated Balance Sheets and its Condensed Consolidated Statements of Operations is summarized below (in thousands):

	Assets				Liabilities
Derivative instruments not designated as hedging instruments and their balance sheet location	June 30, 2011		December 31, 2010		June 30, 2011			December 31, 2010
Fair value of derivative instruments - current	$	2,835	$	4,345	$	(78,345	)	$	(65,489	)
Fair value of derivative instruments - long-term	3,349		417		(81,121		)	(66,290		)
Total	$	6,184	$	4,762	$	(159,466	)	$	(131,779	)

Derivative instruments not designated as hedging	Three months ended June 30,						Six months ended June 30,
instruments and the location of gain or (loss) recognized in income	2011			2010			2011			2010
Revenue: Derivative gain (loss)
Realized loss	$	(12,186	)	$	(5,690	)	$	(26,577	)	$	(18,819	)
Unrealized gain (loss)	52,776			52,592			(18,512		)	58,485
Total revenue: derivative gain (loss)	40,590			46,902			(45,089		)	39,666
Derivative gain (loss) related to purchased product costs
Realized loss	(5,560		)	(5,733		)	(13,447		)	(11,171		)
Unrealized gain (loss)	5,814			14,125			(5,693		)	6,174
Total derivative gain (loss) related to purchased product costs	254			8,392			(19,140		)	(4,997		)
Derivative (loss)gain related to facility expenses
Unrealized (loss) gain	(2,927		)	(934		)	84			(128		)
Derivative gain related to interest expense
Realized gain	—			—			—			2,380
Unrealized loss	—			—			—			(509		)
Total derivative gain related to interest expense	—			—			—			1,871
Miscellaneous income (expense), net
Unrealized gain	—			3			—			59
Total gain (loss)	$	37,917		$	54,363		$	(64,145	)	$	36,471

At June 30, 2011, the fair value of the Partnership’s commodity derivative contracts is inclusive of premium payments of $2.3 million, net of amortization. For the three months ended June 30, 2011 and 2010, the Realized loss—revenue includes amortization of premium payments of $1.1 million and $0.5 million, respectively. For the six months ended June 30, 2011 and 2010, the Realized loss—revenue includes amortization of premium payments of $2.1 million and $1.1 million, respectively.