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 natural gas drilling by the Partnership’s producer customers, 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 plans, the Partnership executes a strategy governed by the risk management policy approved by the General Partner’s board of directors. 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 and fixed price forward contracts. The risk management policy does not allow the Partnership to take speculative positions with its 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. The Partnership currently manages the majority of its NGL price risk using direct product NGL derivative contracts. The Partnership enters into NGL derivative contracts when adequate market liquidity exists and future prices are satisfactory.

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 2016. 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.

All of the Partnership’s financial derivative positions are with financial institutions that are participating members of the Credit Facility (“participating bank group members”). Management conducts a standard credit review on counterparties to derivative contracts. There are no collateral requirements for derivative contracts between the Partnership and any participating bank group member. Specifically, the Partnership is not required to post collateral when it enters into derivative contracts with participating bank group members, as the participating bank group members have a collateral position in substantially all the wholly-owned assets of the Partnership other than MarkWest Liberty Midstream & Resources, L.L.C. (“MarkWest Liberty Midstream”) and its subsidiaries. A separate agreement with certain participating bank group members allows MarkWest Liberty Midstream to enter into derivative positions without posting cash collateral. The Partnership uses standardized agreements that allow for offset of certain positive and negative exposures (“master netting arrangements”) in the event of default or other terminating events, including bankruptcy.

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. The Partnership’s accounting may cause volatility in the Condensed Consolidated Statements of Operations as the Partnership recognizes in current earnings all unrealized gains and losses from the changes in fair value of derivatives.

As of June 30, 2015, the Partnership had the following outstanding commodity contracts that were entered into to manage cash flow risk associated with future sales of NGLs or future purchases of natural gas:

Derivative contracts not designated as hedging instruments	Financial Position	Notional Quantity (net)
Crude Oil (Bbl)	Short	293,800
Natural Gas (MMBtu)	Long	1,311,126
NGLs (Gal)	Short	111,236,914

Embedded Derivatives in Commodity Contracts

The Partnership has a commodity contract with a producer in the Appalachia region that creates a floor on the spread between the NGL product sales price and the purchase price of natural gas with an equivalent Btu content (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 the Condensed Consolidated Statement of Operations. 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 June 30, 2015, the estimated fair value of this contract was a liability of $39.1 million and the recorded value was an asset of $11.8 million. The recorded asset does not include the inception fair value of the commodity contract related to the remaining extension period of July 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. In the second quarter of 2015, approximately $2.6 million of the original inception value, related to April through June 2015, is no longer included in the inception value below as it is deemed to have settled. See the following table for a reconciliation of the liability recorded for the embedded derivative as of June 30, 2015 (in thousands):

Fair value of commodity contract	$	(39,101	)
Inception value for period from July 1, 2015 to December 31, 2022	(50,928		)

Derivative asset as of June 30, 2015	$	11,827

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 a plant location in the Southwest segment through the fourth quarter of 2017. The contract is currently fixed through the fourth quarter of 2015 with the ability to fix the commodity contract for its remaining years. Changes in the fair value of the derivative component of this contract are recognized as Derivative loss related to facility expenses in the Condensed Consolidated Statements of Operations. As of June 30, 2015, the estimated fair value of this contract was a liability of $0.1 million on the Condensed Consolidated Balance Sheet.

Financial Statement Impact of Derivative Contracts

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, 2014. The impact of the Partnership’s derivative instruments on its Condensed Consolidated Balance Sheets is summarized below (in thousands):

	Assets				Liabilities
Derivative instruments not designated as hedging instruments and their balance sheet location	Fair Value at June 30, 2015		Fair Value at December 31, 2014		Fair Value at June 30, 2015			Fair Value at December 31, 2014
Commodity contracts(1)
Fair value of derivative contracts — current	$	15,151	$	20,921	$	(1,164	)	$	—
Fair value of derivative contracts — long-term	7,976		16,507		(55		)	—

Total	$	23,127	$	37,428	$	(1,219	)	$	—

(1)

Includes Embedded Derivatives in Commodity Contracts as discussed above.

Although certain derivative positions are subject to master netting agreements, the Partnership has elected not to offset any derivative assets and liabilities. The gross amounts in the table below equal the balances presented in the Condensed Consolidated Balance Sheets. The table below summarizes the impact if the Partnership had elected to net its derivative positions that are subject to master netting arrangements (in thousands):

	Assets							Liabilities
As of June 30, 2015	Gross Amounts of Assets in the Condensed Consolidated Balance Sheet		Gross Amounts Not Offset in the Condensed Consolidated Balance Sheet			Net Amount		Gross Amounts of Liabilities in the Condensed Consolidated Balance Sheet			Gross Amounts Not Offset in the Condensed Consolidated Balance Sheet		Net Amount
Current
Commodity contracts	$	11,241	$	(1,026	)	$	10,215	$	(1,073	)	$	1,026	$	(47	)
Embedded derivatives in commodity contracts	3,910		—			3,910		(91		)	—		(91		)

Total current derivative instruments	15,151		(1,026		)	14,125		(1,164		)	1,026		(138		)


Non-current
Commodity contracts	59		—			59		(55		)	—		(55		)
Embedded derivatives in commodity contracts	7,917		—			7,917		—			—		—

Total non-current derivative instruments	7,976		—			7,976		(55		)	—		(55		)


Total derivative instruments	$	23,127	$	(1,026	)	$	22,101	$	(1,219	)	$	1,026	$	(193	)

	Assets						Liabilities
As of December 31, 2014	Gross Amounts of Assets in the Condensed Consolidated Balance Sheet		Gross Amounts Not Offset in the Condensed Consolidated Balance Sheet		Net Amount		Gross Amounts of Liabilities in the Condensed Consolidated Balance Sheet		Gross Amounts Not Offset in the Condensed Consolidated Balance Sheet		Net Amount
Current
Commodity contracts	$	18,652	$	—	$	18,652	$	—	$	—	$	—
Embedded derivatives in commodity contracts	2,269		—		2,269		—		—		—

Total current derivative instruments	20,921		—		20,921		—		—		—


Non-current
Embedded derivatives in commodity contracts	16,507		—		16,507		—		—		—

Total non-current derivative instruments	16,507		—		16,507		—		—		—


Total derivative instruments	$	37,428	$	—	$	37,428	$	—	$	—	$	—

In the tables above, the Partnership does not offset a counterparty’s current derivative contracts with the counterparty’s non-current derivative contracts, although the Partnership’s master netting arrangements would allow current and non-current positions to be offset in the event of default. Additionally, in the event of a default, the Partnership’s master netting arrangements would allow for the offsetting of all transactions executed under the master netting arrangement. These types of transactions may include non-derivative instruments, derivatives qualifying for scope exceptions, receivables and payables arising from settled positions, and other forms of non-cash collateral (such as letters of credit). These types of transactions are excluded from the offsetting tables presented above.

The impact of the Partnership’s derivative instruments on its Condensed Consolidated Statements of Operations is summarized below (in thousands):

Derivative contracts not designated as hedging instruments and the location of gain	Three months ended June 30,						Six months ended June 30,
or (loss) recognized in income	2015			2014			2015			2014
Revenue: Derivative gain (loss)
Realized gain (loss)	$	5,132		$	(1,774	)	$	16,120		$	(9,381	)
Unrealized loss	(4,994		)	(4,979		)	(8,614		)	(1,339		)

Total revenue: derivative gain (loss)	138			(6,753		)	7,506			(10,720		)


Derivative loss related to purchased product costs
Realized gain (loss)	20			(144		)	20			(258		)
Unrealized loss	(2,275		)	(11,820		)	(6,815		)	(3,908		)

Total derivative loss related to purchased product costs	(2,255		)	(11,964		)	(6,795		)	(4,166		)


Derivative loss related to facility expenses
Unrealized (loss)	(91		)	(2,045		)	(91		)	(1,777		)

Total (loss) gain	$	(2,208	)	$	(20,762	)	$	620		$	(16,663	)