Derivative Instruments

6 Months Ended

Jun. 30, 2012

Derivative Instruments

Derivative Instruments

C.        Derivative Instruments

Natural Gas Hedging Instruments

The Company’s primary market risk exposure is the volatility of future prices for natural gas and NGLs, which can affect the operating results of the Company primarily through EQT Production and the storage, marketing and other activities at EQT Midstream. The Company’s overall objective in its hedging program is to protect cash flows from undue exposure to the risk of changing commodity prices.

The Company uses derivative commodity instruments that are purchased from or placed with major financial institutions whose creditworthiness is regularly monitored. Futures contracts obligate the Company to buy or sell a designated commodity at a future date for a specified price and quantity at a specified location. Swap agreements involve payments to or receipts from counterparties based on the differential between a fixed and a variable price for the commodity. Collar agreements require the counterparty to pay the Company if the index price falls below the floor price and the Company to pay the counterparty if the index price rises above the cap price. The Company also engages in a limited number of basis swaps to protect earnings from undue exposure to the risk of geographic disparities in commodity prices and interest rate swaps to hedge exposure to interest rate fluctuations on short- or long-term debt.

The Company recognizes all derivative instruments as either assets or liabilities at fair value on a gross basis. The accounting for the changes in fair value of the Company’s derivative instruments depends on the use of the derivative instruments.  To the extent that a derivative instrument has been designated and qualifies as a cash flow hedge, the effective portion of the change in fair value of the derivative instrument is reported as a component of accumulated other comprehensive income, net of tax, and is subsequently reclassified into the Statements of Consolidated Income in the same period or periods during which the forecasted transaction affects earnings.

For a derivative instrument that has been designated and qualifies as a fair value hedge, the change in the fair value of the instrument is recognized as a portion of operating revenues in the Statements of Consolidated Income each period.  In addition, the change in the fair value of the hedged item (natural gas inventory) is recognized as a portion of operating revenues in the Statements of Consolidated Income.  The Company has elected to exclude the spot/forward differential for the assessment of effectiveness of the fair value hedges. Any hedging ineffectiveness and any change in fair value of derivative instruments that have not been designated as hedges, are recognized in the Statements of Consolidated Income each period.

Exchange-traded instruments are generally settled with offsetting positions. Over the counter (OTC) arrangements require settlement in cash. Settlements of derivative commodity instruments are reported as a component of cash flows from operations in the accompanying Statements of Condensed Consolidated Cash Flows.

Some of the derivative commodity instruments used by the Company to hedge its exposure to variability in expected future cash flows associated with the fluctuations in the price of natural gas related to the Company’s forecasted sale of equity production and forecasted natural gas purchases and sales have been designated and qualify as cash flow hedges. Some of the derivative commodity instruments used by the Company to hedge its exposure to adverse changes in the market price of natural gas stored in the ground have been designated and qualify as fair value hedges.

In addition, the Company enters into a limited number of energy trading contracts to leverage its assets and limit its exposure to shifts in market prices and has a limited number of other derivative instruments not designated as hedges. In 2008 and 2011, the Company effectively settled certain derivative commodity swaps scheduled to mature during the period 2010 through 2013 by de-designating the instruments and entering into directly counteractive instruments. These transactions result in offsetting positions which are the majority of the derivative asset and liability balances not designated as hedging instruments.

All derivative instrument assets and liabilities are reported in the Condensed Consolidated Balance Sheets as derivative instruments, at fair value. These derivative instruments are reported as either current assets or current liabilities due to their highly liquid nature. The Company can net settle its derivative instruments at any time.

		Three Months Ended						Six Months Ended
		June 30,						June 30,
		2012			2011			2012			2011
	(Thousands)
Commodity derivatives designated as cash flow hedges
Amount of (loss) gain recognized in other comprehensive income (OCI) (effective portion), net of tax		$	(8,930	)	$	33,253		$	98,558		$	37,453
Amount of gain reclassified from accumulated OCI into operating revenues (effective portion), net of tax		$	55,286		$	9,919		$	103,272		$	26,823
Amount of (loss) gain recognized in operating revenues (ineffective portion) (a)		$	(212	)	$	364		$	(243	)	$	(261	)
Interest rate derivatives designated as cash flow hedges
Amount of (loss) gain recognized in OCI (effective portion), net of tax		$	(6,670	)	$	—		$	(4,297	)	$	—
Amount of loss reclassified from accumulated OCI into interest expense (effective portion), net of tax		$	(64	)	$	(29	)	$	(129	)	$	(58	)
Commodity derivatives designated as fair value hedges (b)
Amount of (loss) gain recognized in operating revenues for fair value commodity contracts		$	(2,378	)	$	1,363		$	4,694		$	(533	)
Fair value gain (loss) recognized in operating revenues for inventory designated as hedged item		$	8,388		$	60		$	(1,543	)	$	1,693
Derivatives not designated as hedging instruments
Amount of (loss) gain recognized in operating revenues		$	(790	)	$	856		$	1,673		$	(823	)

(a)No amounts have been excluded from effectiveness testing of cash flow hedges.

(b)For the three months ended June 30, 2012, the net impact on operating revenues consisted of a $6.0 million gain related to the exclusion of the spot/forward differential from the assessment of effectiveness. For the three months ended June 30, 2011, the net impact on operating revenues consisted of a $2.1 million gain related to the exclusion of the spot/forward differential from the assessment of effectiveness and a $0.7 million loss due to changes in basis. For the six months ended June 30, 2012, the net impact on operating revenues consisted of a $2.8 million gain due to the exclusion of the spot/forward differential from the assessment of effectiveness and a $0.4 million gain due to changes in basis. For the six months ended June 30, 2011, the net impact on operating revenues consisted of a $1.5 million gain related to the exclusion of the spot/forward differential from the assessment of effectiveness and a $0.3 million loss due to changes in basis.

		June 30,		December 31,
		2012		2011
	(Thousands)
Asset derivatives
Commodity derivatives designated as hedging instruments		$	392,437	$	412,626
Commodity derivatives not designated as hedging instruments		75,150		99,535
Total asset derivatives		$	467,587	$	512,161
Liability derivatives
Commodity derivatives designated as hedging instruments		$	8,014	$	3,681
Interest rate derivatives designated as hedging instruments		18,374		10,861
Commodity derivatives not designated as hedging instruments		82,826		108,764
Total liability derivatives		$	109,214	$	123,306

In August 2011, the Company entered into a forward-starting interest rate swap to mitigate the risk of rising interest rates. The forward-starting interest rate swap was designated as a cash flow hedge of forecasted future interest payments. The Company recorded a deferred loss of $11.8 million and $7.6 million in accumulated other comprehensive income, net of tax, as of June 30, 2012 and December 31, 2011, respectively, associated with the change in fair value of the interest rate swap.

The net fair value of commodity derivative instruments changed during the first six months of 2012 primarily as a result of settlements, which were partially offset by a decrease in prices.  The absolute quantities of the Company’s derivative commodity instruments that have been designated and qualify as cash flow hedges totaled 343 Bcf and 349 Bcf as of June 30, 2012 and December 31, 2011, respectively, and are primarily related to natural gas swaps and collars.  The open positions at June 30, 2012 had maturities extending through December 2016.  The absolute quantities of the Company’s derivative commodity instruments that have been designated and qualify as fair value hedges totaled 10 Bcf and 9 Bcf as of June 30, 2012 and December 31, 2011, respectively.

The Company deferred net gains of $227.4 million and $232.1 million in accumulated other comprehensive income, net of tax, as of June 30, 2012 and December 31, 2011, respectively, associated with the effective portion of the change in fair value of its derivative commodity instruments designated as cash flow hedges.  Assuming no change in price or new transactions, the Company estimates that approximately $136 million of net unrealized gains on its derivative commodity instruments reflected in accumulated other comprehensive income, net of tax, as of June 30, 2012 will be recognized in earnings during the next twelve months due to the settlement of hedged transactions. During the second quarter of 2012, the Company identified an error related to the accounting for a derivative instrument put premium which should have been recognized over the period January 2010 through December 2011 in conjunction with the settlements of the related financial positions. The Company has evaluated materiality in accordance with SEC Staff Accounting Bulletins Topics 1.M and 1.N and considered relevant qualitative and quantitative factors. Based on this analysis, the Company corrected the error in the second quarter of 2012 through the reduction of EQT Production segment operating revenue by $8.2 million, the increase of accumulated other comprehensive income by $5.1 million and the decrease of deferred tax expense by $3.1 million.  The Company concluded that this error is not material to any prior periods, the expected annual results of 2012 or to the trend in earnings over the affected periods. The error had no effect on cash flows or debt covenant compliance.

The Company is exposed to credit loss in the event of nonperformance by counterparties to derivative contracts.  This credit exposure is limited to derivative contracts with a positive fair value, which may change as market prices change.  The Company believes that New York Mercantile Exchange (NYMEX) traded futures contracts have reduced credit risk because Commodity Futures Trading Commission regulations are in place to protect exchange participants, including the Company, from potential financial instability of the exchange members.  The Company’s OTC swap and collar derivative instruments are primarily with financial institutions and thus are subject to events that would impact those companies individually as well as that industry as a whole.

The Company utilizes various processes and analysis to monitor and evaluate its credit risk exposures.  These include closely monitoring current market conditions and credit default swap rates.  Credit exposure is controlled through credit approvals and limits.  To manage the level of credit risk, the Company deals with financial counterparties that are of investment grade or better, enters into netting agreements whenever possible and may obtain collateral or other security. As of June 30, 2012, all derivative contracts outstanding were with counterparties having a Standard & Poor’s Rating Services (S&P) rating of A- or higher and a Moody’s Investor Services (Moody’s) rating of Baa1 or higher.

When the net fair value of any of the Company’s swap agreements represents a liability to the Company which is in excess of the agreed-upon threshold between the Company and the financial institution acting as counterparty, the counterparty requires the Company to remit funds to the counterparty as a margin deposit for the derivative liability which is in excess of the threshold amount.  The Company records these deposits as a current asset.  When the net fair value of any of the Company’s swap agreements represents an asset to the Company which is in excess of the agreed-upon threshold between the Company and the financial institution acting as counterparty, the Company requires the counterparty to remit funds as margin deposit in an amount equal to the portion of the derivative asset which is in excess of the threshold amount.  The Company records a current liability for such amounts received. The Company had no such deposits in its Condensed Consolidated Balance Sheets as of June 30, 2012 and December 31, 2011.

When the Company enters into exchange-traded natural gas contracts, exchanges may require the Company to remit funds to the corresponding broker as good-faith deposits to guard against the risks associated with changing market conditions.  Participants must make such deposits based on an established initial margin requirement as well as the net liability position, if any, of the fair value of the associated contracts.  The Company records these deposits as a current asset in the Condensed Consolidated Balance Sheets.  In the case where the fair value of such contracts is in a net asset position, the broker may remit funds to the Company, in which case the Company records a current liability for such amounts received.  The initial margin requirements are established by the exchanges based on the price, volatility and the time to expiration of the related contract and are subject to change at the exchanges’ discretion.  The Company recorded a current asset of $0.7 million and $0.1 million as of June 30, 2012 and December 31, 2011, respectively, for such deposits in its Condensed Consolidated Balance Sheets.

Certain of the Company’s derivative instrument contracts provide that if the Company’s credit ratings by S&P or Moody’s are lowered below investment grade, additional collateral must be deposited with the counterparty.  This additional collateral can be up to 100% of the derivative liability.  As of June 30, 2012, the aggregate fair value of all derivative instruments with credit-risk-related contingent features that are in a net liability position was $3.8 million, for which the Company had no collateral posted.  If the Company’s credit rating by S&P or Moody’s had been downgraded below investment grade on June 30, 2012, the Company would have been required to post additional collateral of $1.7 million in respect of the liability position.  Investment grade refers to the quality of the Company’s credit as assessed by one or more credit rating agencies.  The Company’s unsecured medium-term debt was rated BBB by S&P and Baa2 by Moody’s at June 30, 2012. In order to be considered investment grade, the Company must be rated BBB or higher by S&P and Baa2 or higher by Moody’s.  Anything below these ratings is considered to be non-investment grade.