Derivative Instruments and Hedging Activities

Commodity Price Risk Management

Our primary market risk is commodity price risk. We are exposed to market risks related to the volatility in crude oil and refined products, as well as volatility in the price of natural gas used in our refining operations. We periodically enter into derivative contracts in the form of commodity price swaps and futures contracts to mitigate price exposure with respect to:


•	our inventory positions;


•	natural gas purchases;


•	costs of crude oil and related grade differentials;


•	prices of refined products; and


•	our refining margins.

Accounting Hedges

We have swap contracts serving as cash flow hedges against price risk on forecasted purchases of natural gas and WTI crude oil and forecasted sales of ultra-low sulfur diesel and conventional unleaded gasoline. We also have forward sales contracts that lock in the prices of future sales of refined product. These contracts have been designated as accounting hedges and are measured at fair value with offsetting adjustments (gains/losses) recorded directly to other comprehensive income. These fair value adjustments are later reclassified to earnings as the hedging instruments mature. On a quarterly basis, hedge ineffectiveness is measured by comparing the change in fair value of the swap contracts against the expected future cash inflows/outflows on the respective transaction being hedged. Any hedge ineffectiveness is also recognized in earnings.

The following table presents the pre-tax effect on other comprehensive income (“OCI”) and earnings due to fair value adjustments and maturities of commodity price swaps under hedge accounting:



	Unrealized Gain (Loss) Recognized in OCI			Gain (Loss) Recognized in Earnings Due to Settlements				Gain (Loss) Attributable to Hedge Ineffectiveness Recognized in Earnings
	Unrealized Gain (Loss) Recognized in OCI			Location	Amount			Location	Amount
	(In thousands)
Three Months Ended September 30, 2014
Commodity price swaps
Change in fair value	$	4,580		Sales and other revenues	$	(6,202	)	Sales and other revenues	$	1,498
Gain reclassified to earnings due to settlements	(14,400		)	Cost of products sold	20,776			Cost of products sold	(6,189		)
Amortization of discontinued hedges reclassified to earnings	270			Operating expenses	(444		)	Operating expenses	(99		)
Total	$	(9,550	)		$	14,130			$	(4,790	)

Three Months Ended September 30, 2013
Commodity price swaps
Change in fair value	$	27,049		Sales and other revenues	$	(10,138	)	Sales and other revenues	$	1,949
Gain reclassified to earnings due to settlements	(22,007		)	Cost of products sold	32,874			Cost of products sold	(962		)
Amortization of discontinued hedges reclassified to earnings	270			Operating expenses	(999		)	Operating expenses	259
Total	$	5,312			$	21,737			$	1,246

Nine Months Ended September 30, 2014
Commodity price swaps
Change in fair value	$	145,046		Sales and other revenues	$	(80,475	)	Sales and other revenues	$	1,498
Gain reclassified to earnings due to settlements	(33,357		)	Cost of products sold	111,217			Cost of products sold	(6,189		)
Amortization of discontinued hedge reclassified to earnings	810			Operating expenses	1,805			Operating expenses	(905		)
Total	$	112,499			$	32,547			$	(5,596	)

Nine Months Ended September 30, 2013
Commodity price swaps
Change in fair value	$	41,410		Sales and other revenues	$	(25,454	)	Sales and other revenues	$	2,143
Gain reclassified to earnings due to settlements	(1,396		)	Cost of products sold	28,271			Cost of products sold	730
Amortization of discontinued hedge reclassified to earnings	630			Operating expenses	(2,051		)	Operating expenses	—
Total	$	40,644			$	766			$	2,873

As of September 30, 2014, we have the following notional contract volumes related to outstanding derivative instruments serving as cash flow hedges against price risk on forecasted purchases of natural gas and crude oil and sales of refined products:



		Notional Contract Volumes by Year of Maturity
Derivative Instrument	Total Outstanding Notional	2014	2015	2016	2017	Unit of Measure

Natural gas - long	31,200,000	2,400,000	9,600,000	9,600,000	9,600,000	MMBTU
WTI crude oil - long	11,418,000	7,038,000	4,380,000	—	—	Barrels
Ultra-low sulfur diesel - short	8,106,000	3,726,000	4,380,000	—	—	Barrels
Sub octane gasoline - short	3,312,000	3,312,000	—	—	—	Barrels

In 2013, we dedesignated certain commodity price swaps (long positions) that previously received hedge accounting treatment. These contracts now serve as economic hedges against price risk on forecasted natural gas purchases totaling 31,200,000 MMBTU's to be purchased ratably through 2017. As of September 30, 2014, we have an unrealized loss of $3.5 million classified in accumulated other comprehensive income that relates to the application of hedge accounting prior to dedesignation that is amortized as a charge to operating expenses as the contracts mature.

Economic Hedges

We also have swap contracts that serve as economic hedges (derivatives used for risk management, but not designated as accounting hedges) to fix our purchase price on forecasted natural gas purchases and WTI crude oil, and to lock in the spread between WCS and WTI crude oil and WTS and WTI crude oil on forecasted purchases of WCS and WTS, respectively. Also, we have NYMEX futures contracts to lock in prices on forecasted purchases of inventory. These contracts are measured at fair value with offsetting adjustments (gains/losses) recorded directly to income.

The following table presents the pre-tax effect on income due to maturities and fair value adjustments of our economic hedges:



	Three Months Ended September 30,					Nine Months Ended September 30,
Location of Gain (Loss) Recognized in Income	2014		2013			2014			2013
	(In thousands)
Cost of products sold	$	27,773	$	(29,515	)	$	3,367		$	5,916
Operating expenses	3		(157		)	(185		)	(5,458		)
Total	$	27,776	$	(29,672	)	$	3,182		$	458

As of September 30, 2014, we have the following notional contract volumes related to our outstanding derivative contracts serving as economic hedges:



		Notional Contract Volumes by Year of Maturity
Derivative Instrument	Total Outstanding Notional	2014	2015	2016	2017	Unit of Measure

Commodity price swap (WCS spread) - long	1,610,000	1,610,000	—	—	—	Barrels
Commodity price swap (WTS spread) - long	1,825,000	—	1,825,000	—	—	Barrels
Commodity price swap (WTI) - long	365,000	—	365,000	—	—	Barrels
Commodity price swap (natural gas) - long	31,200,000	2,400,000	9,600,000	9,600,000	9,600,000	MMBTU
Commodity price swap (natural gas) - short	31,200,000	2,400,000	9,600,000	9,600,000	9,600,000	MMBTU
NYMEX futures (WTI) - short	1,043,000	939,000	104,000	—	—	Barrels

Interest Rate Risk Management

HEP uses interest rate swaps to manage its exposure to interest rate risk.

As of September 30, 2014, HEP had three interest rate swap contracts that hedge its exposure to the cash flow risk caused by the effects of LIBOR changes on $305.0 million in credit agreement advances. The first interest rate swap effectively converts $155.0 million of LIBOR based debt to fixed-rate debt having an interest rate of 0.99% plus an applicable margin of 2.00% as of September 30, 2014, which equaled an effective interest rate of 2.99%. This swap matures in February 2016. HEP has two additional interest rate swaps with identical terms which effectively convert $150.0 million of LIBOR based debt to fixed rate debt having an interest rate of 0.74% plus an applicable margin of 2.00% as of September 30, 2014, which equaled an effective interest rate of 2.74%. Both of these swap contracts mature in July 2017. All of these swap contracts have been designated as cash flow hedges. To date, there has been no ineffectiveness on these cash flow hedges.

The following table presents the pre-tax effect on other comprehensive income and earnings due to fair value adjustments and maturities of HEP's interest rate swaps under hedge accounting:



	Unrealized Gain (Loss) Recognized in OCI			Loss Recognized in Earnings Due to Settlements
	Unrealized Gain (Loss) Recognized in OCI			Location	Amount
	(In thousands)
Three Months Ended September 30, 2014
Interest rate swaps
Change in fair value	$	553
Loss reclassified to earnings due to settlements	556			Interest expense	$	(556	)
Total	$	1,109			$	(556	)

Three Months Ended September 30, 2013
Interest rate swaps
Change in fair value	$	(1,626	)
Loss reclassified to earnings due to settlements	529			Interest expense	$	(529	)
Total	$	(1,097	)		$	(529	)

Nine Months Ended September 30, 2014
Interest rate swaps
Change in fair value	$	(1,189	)
Loss reclassified to earnings due to settlements	1,647			Interest expense	$	(1,647	)
Total	$	458			$	(1,647	)

Nine Months Ended September 30, 2013
Interest rate swaps
Change in fair value	$	1,329
Loss reclassified to earnings due to settlements	1,549
Amortization of discontinued hedge reclassified to earnings	849			Interest expense	$	(2,398	)
Total	$	3,727			$	(2,398	)

The following table presents the fair value and balance sheet locations of our outstanding derivative instruments. These amounts are presented on a gross basis with offsetting balances that reconcile to a net asset or liability position in our consolidated balance sheets. We present on a net basis to reflect the net settlement of these positions in accordance with provisions of our master netting arrangements.



	Derivatives in Net Asset Position							Derivatives in Net Liability Position
	Gross Assets		Gross Liabilities Offset in Balance Sheet			Net Assets Recognized in Balance Sheet		Gross Liabilities		Gross Assets Offset in Balance Sheet			Net Liabilities Recognized in Balance Sheet
			(In thousands)
September 30, 2014
Derivatives designated as cash flow hedging instruments:
Commodity price swap contracts	$	104,969	$	(31,480	)	$	73,489	$	12,735	$	(5,456	)	$	7,279
Interest rate swap contracts	1,545		—			1,545		1,231		—			1,231
	$	106,514	$	(31,480	)	$	75,034	$	13,966	$	(5,456	)	$	8,510

Derivatives not designated as cash flow hedging instruments:
Commodity price swap contracts	$	14,325	$	(3,961	)	$	10,364	$	11,624	$	(7,860	)	$	3,764
NYMEX futures contracts	1,848		—			1,848		—		—			—
	$	16,173	$	(3,961	)	$	12,212	$	11,624	$	(7,860	)	$	3,764

Total net balance						$	87,246						$	12,274

Balance sheet classification:	Prepayment and other					$	84,559
	Intangibles and other					2,687		Other long-term liabilities					$	12,274
						$	87,246						$	12,274



	Derivatives in Net Asset Position						Derivatives in Net Liability Position
	Gross Assets		Gross Liabilities Offset in Balance Sheet		Net Assets Recognized in Balance Sheet		Gross Liabilities		Gross Assets Offset in Balance Sheet			Net Liabilities Recognized in Balance Sheet
			(In thousands)
December 31, 2013
Derivatives designated as cash flow hedging instruments:
Commodity price swap contracts	$	—	$	—	$	—	$	63,561	$	(23,679	)	$	39,882
Interest rate swap contracts	1,670		—		1,670		1,814		—			1,814
	$	1,670	$	—	$	1,670	$	65,375	$	(23,679	)	$	41,696

Derivatives not designated as cash flow hedging instruments:
Commodity price swap contracts	$	6,972	$	—	$	6,972	$	19,766	$	(12,611	)	$	7,155
NYMEX futures contracts	—		—		—		3,569		—			3,569
	$	6,972	$	—	$	6,972	$	23,335	$	(12,611	)	$	10,724

Total net balance					$	8,642						$	52,420

Balance sheet classification:	Prepayment and other				$	6,972	Accrued liabilities					$	26,843
	Intangibles and other				1,670		Other long-term liabilities					25,577
					$	8,642						$	52,420

At September 30, 2014, we had a pre-tax net unrealized gain of $68.4 million classified in accumulated other comprehensive income that relates to all accounting hedges having contractual maturities through 2017. Assuming commodity prices and interest rates remain unchanged, an unrealized gain of $76.7 million will be effectively transferred from accumulated other comprehensive income into the statement of income as the hedging instruments contractually mature over the next twelve-month period.