Derivative Financial Instruments and Fair Value of Financial Instruments

9 Months Ended

Sep. 30, 2012

Derivative Instruments and Hedging Activities Disclosure [Abstract]

DERIVATIVE FINANCIAL INSTRUMENTS AND FAIR VALUE OF FINANCIAL INSTRUMENTS

DERIVATIVE FINANCIAL INSTRUMENTS

Palmarejo Gold Production Royalty

On January 21, 2009, the Company entered into a gold production royalty transaction with Franco-Nevada Corporation. The royalty covers 50% of the life of mine production from the Palmarejo mine and adjacent properties. The royalty transaction included a minimum obligation of 4,167 ounces per month that ends when payments have been made on a total of 400,000 ounces of gold. As of September 30, 2012, a total of 209,853 ounces of gold remain outstanding under the minimum royalty obligation.

The price volatility associated with the minimum royalty obligation is considered an embedded derivative financial instrument under U.S. GAAP. As such, the Company is required to recognize the change in fair value of the remaining minimum obligation due to the changing gold prices. Unrealized gains are recognized in periods when the gold price has decreased from the previous period and unrealized losses are recognized in periods when the gold price increases. The fair value of the embedded derivative is reflected net of the Company's current credit adjusted risk free rate, which was 4.9% and 5.7% at September 30, 2012 and December 31, 2011, respectively. The fair value of the embedded derivative at September 30, 2012 and December 31, 2011, based on forward gold prices averaging approximately $1,793 and $1,611 per ounce, respectively, was a liability of $170.2 million and $159.4 million, respectively. During the three and nine months ended September 30, 2012 and 2011, mark-to-market adjustments for this embedded derivative amounted to a loss of $23.4 million and $14.5 million, and a loss of $10.8 million and $17.4 million, respectively.

Payments on the royalty obligation occur monthly resulting in a decrease to the carrying amount of the minimum obligation and the derivative liability and the recognition of realized gains or losses as a result of changing prices for gold. Each monthly payment is an amount equal to the greater of the minimum of 4,167 ounces of gold or 50% of the actual gold production per month multiplied by the excess of the monthly average market price of gold above $400 per ounce (which $400 floor is subject to a 1% annual inflation compounding adjustment beginning on January 21, 2013). For the three and nine months ended September 30, 2012 and 2011, realized losses on settlement of the liabilities were $10.9 million and $11.9 million, and $35.0 million and $29.1 million, respectively. The mark-to-market adjustments and realized losses are included in fair value adjustments, net in the consolidated statement of operations.

Forward Foreign Exchange Contracts

The Company periodically enters into forward foreign currency contracts to reduce the foreign exchange risk associated with forecasted Mexican peso (“MXN”) operating costs at its Palmarejo mine. At September 30, 2012, the Company had MXN foreign exchange contracts of $17.4 million in U.S. dollars. These contracts require the Company to exchange U.S. dollars for MXN at a weighted average exchange rate of 13.19 MXN to each U.S. dollar and the Company had an asset with a fair value of $0.2 million at September 30, 2012. At December 31, 2011, the Company had MXP foreign exchange contracts of $25.5 million in U.S. dollars. These contracts required the Company to exchange U.S. dollars for MXN at a weighted average exchange rate of 12.40 MXN to each U.S. dollar and the Company had a liability with a fair value of $3.2 million at December 31, 2011. The Company recorded mark-to-market gains on these contracts of $0.6 million and $3.4 million for the three and nine months ended September 30, 2012, respectively. The Company recorded mark-to-market losses of $4.1 million and $3.8 million for the three and nine months ended September 30, 2011, respectively. These mark-to-market adjustments are reflected in fair value adjustments, net. The Company recorded a realized gain of $0.4 million and a realized loss of $1.5 million in production costs applicable to sales during the three and nine months ended September 30, 2012, respectively. The Company recorded a realized loss of $0.1 million and a realized gain of $1.0 million in production costs applicable to sales during the three and nine months ended September 30, 2011, respectively.

Concentrate Sales Contracts

The Company enters into concentrate sales contracts with third-party smelters. The contracts, in general, provide for a provisional payment based upon provisional assays and quoted metal prices. The provisionally priced sales contain an embedded derivative that is required to be separated from the host contract for accounting purposes. The host contract is the receivable from the sale of concentrates at the forward price at the time of sale. The embedded derivative, which is the final settlement price based on a future price, does not qualify for hedge accounting. These embedded derivatives are recorded as derivative assets (in Prepaid expenses and other) or derivative liabilities (in Accrued liabilities and other) on the balance sheet and are adjusted to fair value through earnings each period until the date of final settlement. At September 30, 2012, the Company had outstanding provisionally priced sales of $20.9 million, consisting of 0.5 million ounces of silver and 3,734 ounces of gold, which had a fair value of $22.1 million including the embedded derivative. At December 31, 2011, the Company had outstanding provisionally priced sales of $22.5 million consisting of 0.2 million ounces of silver and 9,701 ounces of gold, which had a fair value of approximately $21.7 million including the embedded derivative.

Commodity Derivatives

As of September 30, 2012, the Company had outstanding call options requiring it to deliver 104,000 ounces of gold at a weighted average strike price of $1,970.05 per ounce if the market price of gold exceeds the strike price. At September 30, 2012, the Company had outstanding put options allowing it to sell 139,000 ounces of gold at a weighted average strike price of $962.42 per ounce if the market price of gold were to fall below the strike price. The contracts will expire over the next four years. At December 31, 2011, the Company had written outstanding call options requiring it to deliver 136,000 ounces of gold at a weighted average strike price of $1,919.83 per ounce if the market price of gold exceeds the strike price. At December 31, 2011, the Company had outstanding put options allowing it to sell 190,000 ounces of gold at a weighted average strike price of $951.93 per ounce if the market price of gold were to fall below the strike price. As of September 30, 2012 and December 31, 2011, the fair market value of these contracts was a net liability of $16.8 million and $17.9 million, respectively. During the three months ended September 30, 2012, 17,000 ounces of gold put options expired at a weighted average strike price of $923.34 per ounce, resulting in a realized loss of $0.7 million. During the nine months ended September 30, 2012, 51,000 ounces of gold put options expired at a weighted average strike price of $923.34 per ounce, resulting in a realized loss of $2.2 million. During the three and nine months ended September 30, 2012, 7,000 ounces of gold call options at a weighted average strike price of $2,000.00 expired. During the three and nine months ended September 30, 2012 and 2011, the Company recorded unrealized losses of $3.6 million and unrealized gains of $1.1 million, and unrealized losses of $19.9 million and $18.2 million, respectively, related to the outstanding options which was included in fair value adjustments, net.

In connection with the sale of the Cerro Bayo mine to Mandalay Resources Corporation, the Company received the right to 125,000 ounces of silver to be delivered in six equal quarterly installments commencing in the third quarter of 2011. The Company recognized mark-to-market gains of $0.1 million and mark-to-market losses of $0.1 million associated with this silver in the three and nine months ended September 30, 2012, respectively. The Company recognized mark-to-market gains of $0.8 million and $0.4 million associated with this silver in the three and nine months ended September 30, 2011, respectively. The silver ounces receivable from Mandalay Resources Corporation had a fair value of $1.4 million at September 30, 2012, and a fair value of $2.3 million at December 31, 2011.

As of September 30, 2012, the Company had the following derivative instruments that settle in each of the years indicated in the table (in thousands except average prices, ounces and notional data):

	2012		2013		2014		Thereafter
Palmarejo gold production royalty	$	8,392	$	25,097	$	24,895	$	45,831
Average gold price in excess of minimum contractual deduction	$	504	$	502	$	498	$	492
Notional ounces	16,668		50,004		50,004		93,177
Mexican peso forward purchase contracts	$	8,700	$	8,700	$	—	$	—
Average rate (MXP/$)	$	12.85	$	13.52	$	—	$	—
Mexican peso notional amount	111,798		117,628		—		—
Silver ounces receivable from Mandalay	$	769	$	—	$	—	$	—
Average silver forward price	$	18.45	$	—	$	—	$	—
Notional ounces	41,667		—		—		—
Silver concentrate sales agreements	$	14,343	$	—	$	—	$	—
Average silver price	$	30.74	$	—	$	—	$	—
Notional ounces	466,588		—		—		—
Gold concentrates sales agreements	$	6,508	$	—	$	—	$	—
Average gold price	$	1,743	$	—	$	—	$	—
Notional ounces	3,734		—		—		—
Gold put options purchased	$	720	$	1,800	$	720	$	—
Average gold strike price	$	923	$	928	$	979	$	1,010
Notional ounces	17,000		45,000		47,000		30,000
Gold call options sold	$	—	$	—	$	720	$	—
Average gold strike price	$	2,000	$	2,000	$	1,934	$	2,000
Notional ounces	7,000		20,000		47,000		30,000

The following summarizes the classification of the fair value of the derivative instruments as of September 30, 2012 and December 31, 2011 (in thousands):

	September 30, 2012
	Prepaid expenses and other		Accrued liabilities and other		Other long- term liabilities		Current portion of royalty obligation		Non-current portion of royalty obligation
Silver ounces receivable from Mandalay	$	676	$	—	$	—	$	—	$	—
Forward foreign exchange contracts	286		80		—		—		—
Palmarejo gold production royalty	—		—		—		46,005		124,148
Put and call options, net	—		2,840		13,915		—		—
Concentrate sales contracts	1,239		5		—		—		—
	$	2,201	$	2,925	$	13,915	$	46,005	$	124,148

	December 31, 2011
	Prepaid expenses and other		Accrued liabilities and other		Other long- term Liabilities		Current portion of royalty obligation		Non-current portion of royalty obligation
Silver ounces receivable from Mandalay	$	814	$	—	$	—	$	—	$	—
Forward foreign exchange contracts	—		3,188		—		—		—
Palmarejo gold production royalty	—		—		—		37,206		122,194
Put and call options, net	—		3,183		14,669		—		—
Concentrate sales contracts	—		825		—		—		—
	$	814	$	7,196	$	14,669	$	37,206	$	122,194

The following represent mark-to-market gains (losses) on derivative instruments for the three and nine months ended September 30, 2012 and 2011 (in thousands):

		Three months ended September 30,						Nine months ended September 30,
Financial statement line	Derivative	2012			2011			2012			2011
Sales of metal	Concentrate sales contracts	$	1,591		$	1,466		$	2,050		$	4,339
Production costs applicable to sales	Forward foreign exchange contracts	394			(65		)	(1,540		)	1,045
Fair value adjustments, net	Gold lease facility	—			—			—			(132		)
Fair value adjustments, net	Forward foreign exchange contracts	621			(4,089		)	3,394			(3,791		)
Fair value adjustments, net	Forward gold contract	—			—			—			35
Fair value adjustments, net	Silver ounces receivable	280			(554		)	302			(90		)
Fair value adjustments, net	Palmarejo gold royalty	(34,266		)	(26,464		)	(45,771		)	(46,505		)
Fair value adjustments, net	Put and call options	(4,283		)	(22,244		)	(2,647		)	(20,568		)
		$	(35,663	)	$	(51,950	)	$	(44,212	)	$	(65,667	)

Please see Note 4 - FAIR VALUE MEASUREMENTS for additional detail on the fair value amounts for derivatives.

Credit Risk

The credit risk exposure related to any potential derivative instruments is limited to the unrealized gains, if any, on outstanding contracts based on current market prices. To reduce counter-party credit exposure, the Company deals with financial institutions management deems credit worthy and limits credit exposure to each. The Company does not anticipate non-performance by any of its counterparties. In addition, to allow for situations where positions may need to be revised, the Company deals only in markets that management considers highly liquid.